Module A

LEARNING PACK
Qualification Programme
Module A Financial Reporting
Second edition August 2011 First edition 2010 ISBN 9781 4453 8128 2 (previous ISBN 9780 7517 8857 0) British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. Published by BPP Learning Media Ltd The copyright in this publication is jointly owned by BPP Learning Media Ltd and HKICPA. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means or stored in any retrieval system, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the copyright owners. We are grateful to HKICPA for permission to reproduce the Learning Outcomes and past examination questions, the copyright of which is owned by HKICPA. Printed in Singapore
HKICPA and BPP Learning Media Ltd 2011
ii
Contents
Page Director's message Introduction Chapter features Learning outcomes List of accounting standards v vi viii ix xxiii
Module A Financial Reporting

Part A Legal environment
1 Legal environment 3
Part B Financial reporting framework

2 3 Financial reporting framework Small company reporting 21 61
Part C Accounting for business transactions

I Statements of financial position and comprehensive income
4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Non-current assets held for sale and discontinued operations Property, plant and equipment Investment property Government grants Intangible assets and impairment of assets Leases Inventories Provisions, contingent liabilities and contingent assets Construction contracts Share-based payment Revenue Income taxes Employee benefits Borrowing costs Financial instruments Foreign currency transactions 77 93 113 127 137 175 203 217 235 253 275 301 335 361 373 421
Introduction
iii
Page
II Statements of cash flows

20 Statements of cash flows 441
III Disclosure and reporting

21 22 23 24 25 26 Related party disclosures Accounting policies, changes in accounting estimates and errors; events after the reporting period Earnings per share Operating segments Interim financial reporting Presentation of financial statements 467 479 495 517 529 543
Part D Group financial statements

27 28 29 30 Principles of consolidation Consolidated accounts: accounting for subsidiaries Consolidated accounts: accounting for associates and joint arrangements Changes in group structures 567 593 635 657
Answers to exam practice questions Question bank questions Question bank answers Glossary of terms Index
701 739 755 787 803
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Financial Reporting
Director's message
Welcome to the Financial Reporting module of the Qualification Programme of the Hong Kong Institute of Certified Public Accountants (the HKICPA). You have made the decision to complete the HKICPA's qualification examination, Qualification Programme, a further step on your pathway to a successful business career as a CPA and a valued member of the HKICPA. The Qualification Programme comprising four core modules and a final examination will provide you with a foundation for life-long learning and assist you in developing your technical, intellectual, interpersonal and communication skills. You will find this programme challenging with great satisfaction that will open a wide variety of career opportunities bringing in attractive financial rewards. The Financial Reporting module, like the other three modules, involves approximately 120 hours of self-study over fourteen weeks, participation in two full-day workshops and a three-hour open-book module examination at the module end. We encourage you to read this Learning Pack which is a valuable resource to guide you through the Qualification Programme. The four core modules of the Qualification Programme are as follows: Module A: Module B: Module C: Module D: Financial Reporting Corporate Financing Business Assurance Taxation
Should you require any assistance at any time, please feel free to contact us on (852) 2287 7228. May I wish you every success in your Qualification Programme!
Jonathan Ng Deputy Executive Director Hong Kong Institute of Certified Public Accountants
Introduction
Introduction
This is the second edition of the Learning Pack for Module A Financial Reporting of the HKICPA Qualification Programme. The Institute is committed to updating the content of the Learning Pack on an annual basis to keep abreast of the latest developments. This edition has been developed after having consulted and taken on board the feedback received from different users of the previous edition. Some of the examples and self-test questions have been rewritten to better reflect current working practices in industry and facilitate the learning process for users of the Learning Pack. The Learning Pack has been written specifically to provide a complete and comprehensive coverage of the learning outcomes devised by HKICPA, and has been reviewed and approved by the HKICPA Qualification and Examinations Board for use by those studying for the qualification. The HKICPA Qualification Programme comprises two elements: the examinations and the workshops. The Learning Pack has been structured so that the order of the topics in which you study is the order in which you will encounter them in the workshops. There is a very close interrelationship between the module structure, the Learning Pack and the workshops. It is important that you have studied the chapters of the Learning Pack relevant to the workshops before you attend the workshops, so that you can derive the maximum benefit from them. On page (ix) you will see the HKICPA learning outcomes. Each learning outcome is mapped to the chapter in the Learning Pack in which the topic is covered. You will find that your diligent study of the Learning Pack chapters and your active participation in the workshops will prepare you to tackle the examination with confidence. One of the key elements in examination success is practice. It is important that not only you fully understand the topics by reading carefully the information contained in the chapters of the Learning Pack, but it is also vital that you take the necessary steps to practise the techniques and apply the principles that you have learned. In order to do this, you should: work through all the examples provided within the chapters and review the solutions, ensuring that you understand them; complete the self-test questions within each chapter, and then compare your answer with the solution provided at the end of the chapter; and attempt the exam practice questions that you will find at the end of the chapter. Many of these are HKICPA past examination questions, which will give an ideal indication of the standard and type of question that you are likely to encounter in the examination itself. You will find the solutions to exam practice questions at the end of the book.
In addition, you will find at the end of the Learning Pack a bank of past HKICPA case-study style questions. These are past Section A examination questions, which present a case study testing a number of different topics within the syllabus. These questions will provide you with excellent examination practice when you are in the revision phase of your studies, bringing together, as they do, the application of a variety of different topics to a scenario. Please note that the Learning Pack is not intended to be a 'know-it-all' resource. You are required to undertake background reading including standards, legislations and recommended texts for the preparation for workshop and examination.
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Financial Reporting
Module Structure
This module will enable you to exercise judgement in selecting and applying accounting policies to prepare financial statements (both at individual company and group levels) in compliance with the relevant Hong Kong Financial Reporting Framework and Hong Kong Accounting Standards ('HKFRSs').
Overall Structure of Module A (Financial Reporting)
Six-month rule
HKICPA operates a six-month rule whereby students will only be examined on standards and legislation that had been released six months prior to the examination date (the cut-off date). The cut-off dates are: Module Examination Session December 2011 June 2012 Cut-off date 28 June 2011 28 December 2011
The six-month rule refers to the enactment date of the legislation and the release date of the pronouncements, not their effective date. If you are studying for the examinations in December 2011, this Learning Pack is fully up to date and complies with the six-month rule.
Supplement
If you are studying for the examinations in June 2012, you will be issued with an online Supplement to the Learning Pack for the relevant Modules. This will guide you through the changes to legislation and standards that have occurred since the publication of this second edition of the Learning Pack, and you should use the Learning Pack and Supplement together in studying for the June 2012 examination.
Introduction
vii
Chapter features
Each chapter contains a number of helpful features to guide you through each topic. Topic list Tells you what you will be studying in the chapter. The topic items form the numbered headings within the chapter. Puts the chapter topic into perspective and explains why it is important, both within your studies and within your practical working life. The list of Learning Outcomes issued for the Module by HKICPA, referenced to the chapter in the Learning Pack within which coverage will be found. Summarise the key content of the particular section that you are about to start. They are also found within sections, when an important issue is introduced other than at the start of the section. Definitions of important concepts. You really need to know and understand these before the examination, and understanding will be useful at the workshops too. Illustrations of particular techniques or concepts with a worked solution or explanation provided immediately afterwards.
Learning focus
Learning Outcomes Topic highlights
Key terms
Examples
Case study
An example or illustration not requiring a solution, designed to enrich your understanding of a topic and add practical emphasis. Often based on real world scenarios and contemporary issues. These are questions that enable you to practise a technique or test your understanding. You will find the answer at the end of the chapter.
Self-test questions
Formula to learn
You may be required to apply financial management formulae in Module B, Corporate Financing.
Topic recap Exam practice
Reviews and recaps on the key areas covered in the chapter. A question at the end of the chapter to enable you to practise the techniques that you have learned. In most cases this will be a past HKICPA examination question, updated as appropriate. You will find the answers in a bank at the end of the Learning Pack entitled Answers to Exam Practice Questions. In Modules B and D you will find references to further reading that will help you to understand the topics and put them into the practical context. The reading suggested may be books, websites or technical articles. Throughout the Learning Pack you will see that some of the text is in bold type. This is to add emphasis and to help you to grasp the key elements within a sentence or paragraph.
Further reading
Bold text
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Financial Reporting
Learning outcomes
HKICPA's learning outcomes for the Module are set out below. They are cross-referenced to the chapter in the Learning Pack where they are covered.
Fields of competency
The items listed in this section are shown with an indicator of the minimum acceptable level of competency, based on a three-point scale as follows: 1 Awareness To have a general professional awareness of the field with a basic understanding of relevant knowledge and related concepts. 2 Knowledge The ability to use knowledge to perform professional tasks competently without assistance in straightforward situations or applications. 3 Application The ability to apply comprehensive knowledge and a broad range of professional skills in a practical setting to solve most problems generally encountered in practice.
Topics
Chapter where covered
Competency
LO1. Legal environment Describe the Hong Kong legal framework and related implications for business activities LO1.01 Types and relative advantage of alternative forms of organisation: 1.01.01 Identify the types and relative advantages of alternative forms of organisation LO1.02 Legal procedures for establishment and governance of companies: 1.02.01 Describe the legal procedures for the establishment and governance of companies Describe the obligations of directors and officers of companies LO1.03 Powers, duties and obligations of directors and company secretaries: 1.03.01 Describe the powers, duties and obligations of company directors 1.03.02 Describe the powers, duties and obligations of the company secretary 2 1 2 1 2 1
Introduction
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Competency
Describe the legal requirements associated with company structure, share offerings, debt obligations and restructuring LO1.04 Share issues and prospectus requirements: 1.04.01 Describe the procedure for issuing shares and the requirement for a prospectus LO1.05 Debt instruments and registration of charges: 1.05.01 Describe the procedure for the issue of debt instruments 1.05.02 Describe the procedure for the registration of charges over company debt LO1.06 Statutory reporting and documentation requirements: 1.06.01 Explain the statutory registers that must be kept by a company 1.06.02 Identify the financial statements that a company must prepare LO1.07 Appointment and removal of auditors: 1.07.01 Describe the procedures for the appointment, removal and resignation of company auditors LO1.08 Restructuring, including appointment of receivers and liquidators: 1.08.01 Identify the reasons for which a company may restructure, including the appointment of receivers and liquidators LO2. Financial reporting framework Describe the financial reporting framework in Hong Kong and the related implications for business activities LO2.01 The role and setting of accounting standards: 2.01.01 Understand the role of accounting standards 2.01.02 Understand the role of the HKICPA, Securities and Futures Commission (SFC), Financial Reporting Council (FRC), the Hong Kong Insurance Authority (HKIA), the Hong Kong Monetary Authority (HKMA) and the Hong Kong Stock Exchange (HKEx) LO2.02 Hong Kong Financial Reporting Standards: 2.02.01 Describe how Hong Kong Financial Reporting Standards are set 2 2 2 2 2 1 1 3 1 3 1 1 2 1 1 2 1
Financial Reporting
Competency
LO2.03
Small and Medium-sized Entity Financial Reporting Framework and Financial Reporting Standard: 2.03.01 Identify the conditions under which an entity may adopt the SME Financial Reporting Framework and Financial Reporting Standard 2.03.02 Describe the requirements of the SME Financial Reporting Framework and Financial Reporting Standard
2 3
LO2.04
Hong Kong Financial Reporting Standard for Private Entities 2.04.01 Identify the conditions under which an entity may adopt the HKFRS for Private Entities 2.04.02 Describe the requirements of the HKFRS for Private Entities
2 3 3 3 2 2 2
LO2.05
Code of Ethics for Professional Accountants: 2.05.01 Explain the requirements of the Code of Ethics for Professional Accountants
LO2.06
Hong Kong (IFRIC) Interpretations, Hong Kong Interpretations and Hong Kong (SIC) Interpretations: 2.06.01 Describe the status of Hong Kong (IFRIC) Interpretations, Hong Kong Interpretations and Hong Kong (SIC) Interpretations
LO2.07
Other professional pronouncements and exposure drafts: 2.07.01 Identify other professional pronouncements and exposure drafts relevant to the financial reporting framework
2 2
LO2.08
Regulatory bodies and their impact on accounting: 2.08.01 Identify relevant regulatory bodies and their impact on accounting
2 2 2 2 2 2 2
LO2.09
Accounting principles and conceptual frameworks: 2.09.01 Explain what is meant by a conceptual framework and GAAP 2.09.02 Identify the advantages and disadvantages of a conceptual framework 2.09.03 Identify the components and requirements of the HKICPA's Framework 2.09.04 Explain those requirements of HKAS 1 Presentation of Financial Statements which overlap with the HKICPA's Framework
LO2.10
Current developments 2.10.01 Identify areas of accounting in which current developments are occurring
2 2
Introduction
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Competency
LO3. Accounting for business transactions Account for transactions in accordance with Hong Kong Financial Reporting Standards LO3.01 Accounting policies, changes in accounting estimates and errors: 3.01.01 Distinguish between accounting policies and accounting estimates in accordance with HKAS 8 3.01.02 Account for a change in accounting policy 3.01.03 Account for a change in accounting estimate 3.01.04 Correct a prior period error LO3.02 Revenue: 3.02.01 Define revenue and identify revenue within the scope of HKAS 18 3.02.02 Measure revenue at the fair value of consideration received 3.02.03 Identify revenue transaction including multiple element arrangements 3.02.04 Determine the recognition criteria for specified types of revenue items including sales of goods, rendering of services and interest, royalties and dividends 3.02.05 Disclose revenue as appropriate in the financial statements 3.02.06 Explain the recognition and measurement principles LO3.03 Government grants and assistance: 3.03.01 Accounting and presentation of government grants 3.03.02 Disclosure of government grants and assistance in accordance with HKAS 20 LO3.04 Employee benefits: 3.04.01 Identify short-term employee benefits in accordance with HKAS 19 and apply the recognition and measurement principles in respect of short-term employee benefits 3.04.02 Distinguish between defined contribution plans and defined benefit plans 3.04.03 Account for defined contribution plans 3.04.04 Identify termination benefits in accordance with HKAS 19 and apply the recognition and measurement principles in respect of termination benefits 2 16 3 7 7 3 14 14 14 3 22 22 22 22
14
14 14
16 16 16
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Financial Reporting
Competency
LO3.05
Share-based payment: 3.05.01 Identify and recognise share-based payment transactions in accordance with HKFRS 2 3.05.02 Account for equity-settled and cash-settled sharebased payment transactions 3.05.03 Account for share-based payment transactions with cash alternatives 3.05.04 Account for unidentified goods or services in a share-based payment transaction 3.05.05 Account for group and treasury share transactions 3.05.06 Disclosure requirement of share option
2 13 13 13 13 13 13 3 10 10 10
LO3.06
Inventories: 3.06.01 Scope and definition of HKAS 2 Inventories 3.06.02 Calculate the cost of inventories in accordance with HKAS 2 3.06.03 Use accepted methods of assigning costs including the allocation of overheads to inventories 3.06.04 Explain the potential impact of net realisable value falling below cost and make the required adjustments 3.06.05 Calculate and analyse variances in a standard costing system and advise on the appropriate accounting treatment to be adopted in respect of inventories 3.06.06 Prepare a relevant accounting policy note and other required disclosures in respect of inventories
10
10
10
LO3.07
Construction contracts: 3.07.01 Define a construction contract 3.07.02 Explain when contract revenue and costs should be recognised in accordance with HKAS 11 3.07.03 Explain how contract revenue and costs should be measured and apply these principles 3.07.04 Account for the expected loss and changes in estimates 3.07.05 Disclose information related to construction contracts in the financial statements
3 12 12 12 12 12
Introduction
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Competency
LO3.08
Property, plant and equipment: 3.08.01 Identify the non-current assets which fall within or outside the scope of HKAS 16 3.08.02 State and apply the recognition rules in respect of property, plant and equipment 3.08.03 Determine the initial measurement of property, plant and equipment, including assets acquired by exchange or transfer 3.08.04 Determine the accounting treatment of subsequent expenditure on property, plant and equipment 3.08.05 Determine the available methods to measure property, plant and equipment subsequent to initial recognition 3.08.06 Account for the revaluation of property, plant and equipment 3.08.07 Define useful life and allocate an appropriate useful life for an asset in a straightforward scenario 3.08.08 Explain the different methods of depreciation: straight line and diminishing balance, and calculate the depreciation amount in respect of different types of asset 3.08.09 Account for the disposal of property, plant and equipment 3.08.10 Disclose relevant information relating to property, plant and equipment in the financial statements
3 5 5 5
5 5
5 5 3 8 8 8 8 8 8 8 8
LO3.09
Intangible assets: 3.09.01 Define an intangible asset and scope of HKAS 38 3.09.02 Apply the definition of an intangible asset to both internally-generated and purchased intangibles 3.09.03 Account for the recognition and measurement of intangible assets in accordance with HKAS 38 3.09.04 Describe the subsequent accounting treatment of intangible assets including amortisation 3.09.05 Distinguish between research and development and describe the accounting treatment of each 3.09.06 Explain how goodwill arises 3.09.07 Account for goodwill 3.09.08 Disclose relevant information in respect of intangible assets under HKAS 38
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Financial Reporting
Competency
LO3.10
Investment property: 3.10.01 Identify an investment property within the scope of HKAS 40 and situation when a property can be transferred in and out of the investment property category 3.10.02 Distinguish investment property from other categories of property holdings and describe the difference in accounting treatment 3.10.03 Apply the recognition and measurement rules relating to investment property 3.10.04 Account for investment property 3.10.05 Disclose relevant information, including an accounting policy note, for investment property
3 6
6 6 6
LO3.11
Financial assets, financial liabilities and equity instruments: 3.11.01 Discuss and apply the criteria for the recognition and de-recognition of a financial asset or financial liability 3.11.02 Discuss and apply the rules for the classification of a financial asset, financial liability and equity, and their measurement (including compound instrument) 3.11.03 Discuss and apply the treatment of gains and losses arising on financial assets or financial liabilities 3.11.04 Discuss the circumstances that give rise to and apply the appropriate treatment for the impairment of financial assets 3.11.05 Account for derivative financial instruments and simple embedded derivatives, including the application of own-use exemption 3.11.06 Disclose relevant information with regard to financial assets, financial liabilities and equity instruments
2 18
18
18
18
18
18
Introduction
xv
Competency
LO3.12
Borrowing costs: 3.12.01 Identify the expenses which constitute borrowing costs in accordance with HKAS 23 3.12.02 Identify the assets which are qualifying assets 3.12.03 Determine when the capitalisation of borrowing costs shall commence, be suspended and cease 3.12.04 Calculate the amount of borrowing costs to be capitalised from specific borrowing and general borrowing 3.12.05 Prepare journal entries for borrowing costs, including expensed and capitalised borrowing costs 3.12.06 Disclose relevant information with regard to borrowing costs
3 17 17 17 17
17
17 3 8 8
LO3.13
Impairment of assets: 3.13.01 Identify assets that are within the scope of HKAS 36 3.13.02 Identify an asset that may be impaired by reference to common external and internal indicators 3.13.03 Identify the cash generating unit an asset belongs to 3.13.04 Calculate the recoverable amount with reference to value-in-use and fair value less cost to sell 3.13.05 Calculate the impairment loss, including the loss relating to cash-generating units 3.13.06 Allocate impairment loss and account for subsequent reversal 3.13.07 Disclose relevant information with regard to impairment loss, including critical judgement and estimate
8 8 8 8 8
LO3.14
Leases: 3.14.01 Identify the types of lease within the scope of HKAS 17 and define the terminology used in relation to leases 3.14.02 Classify leases as operating or finance leases by looking at the substance of the transaction 3.14.03 Account for operating leases from the perspective of both the lessee and the lessor 3.14.04 Disclose the relevant information relating to operating leases in the accounts of both the lessee and the lessor
3 9
9 9 9
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Financial Reporting
Competency
3.14.05 Account for finance leases from the perspective of both the lessee and the lessor 3.14.06 Disclose the relevant information relating to finance leases in the accounts of both the lessee and the lessor 3.14.07 Account for manufacturer/dealer leases 3.14.08 Account for sale and leaseback transactions 3.14.09 Explain the term off-balance sheet finance and the importance of substance over form 3.14.10 Explain how to determine whether an arrangement contains a lease LO3.15 Events after the reporting period: 3.15.01 Explain the period during which there is responsibility for reporting events in accordance with HKAS 10 3.15.02 Define adjusting and non-adjusting events 3.15.03 Explain when the financial statements should be prepared on a basis other than going concern LO3.16 Provisions, contingent liabilities and contingent assets: 3.16.01 Define provisions, contingent liabilities and contingent assets within the scope of HKAS 37 3.16.02 Distinguish provisions from other types of liabilities 3.16.03 Explain the criteria for recognition of provisions and apply them to specific circumstances 3.16.04 Apply the appropriate accounting treatment for contingent assets and liabilities 3.16.05 Disclose the relevant information relating to contingent liabilities in the financial statements 3.16.06 Account for decommissioning, restoration and similar liabilities and their changes 3.16.07 Disclose the relevant information relating to contingent assets in the financial statements LO3.17 Hedge accounting: 3.17.01 Identify fair value hedges, cash flow hedges and hedges for net investment in accordance with HKAS 39 3.17.02 Account for fair value hedges, cash flow hedges and hedges for net investment 2 3 3
9 9
9 9 9 9
22
22 22
11 11 11 11 11 11 11
18
18
Introduction
xvii
Competency
LO3.18
Income taxes: 3.18.01 Account for current tax liabilities in accordance with HKAS 12 3.18.02 Record entries relating to income tax in the accounting records 3.18.03 Identify temporary differences (both inside and outside difference) and calculate deferred tax amounts 3.18.04 Account for tax losses and tax credits 3.18.05 Identify initial recognition exemption for assets and liabilities 3.18.06 Account for deferred tax relating to investments in subsidiaries, associates and joint ventures 3.18.07 Determine when tax assets and liabilities can be offset
2 15 15 15
15 15 15 15 2 19 19 19
LO3.19
The effects of changes in foreign exchange rates: 3.19.01 Determine the functional currency of an entity in accordance with HKAS 21 3.19.02 Translate foreign operation financial statements to the presentation currency 3.19.03 Account for foreign currency transactions within an individual company and in the consolidated financial statements 3.19.04 Account for disposal or partial disposal of a foreign operation
19 3 21 21 21 3 4
LO3.20
Related party disclosures: 3.20.01 Identify the parties that may be related to a business entity in accordance with HKAS 24 3.20.02 Identify the related party disclosures 3.20.03 Explain the importance of being able to identify and disclose related party transactions
LO3.21
Non-current assets held for sale and discontinued operations: 3.21.01 Define non-current assets (or disposal groups) held for sale or held for distribution to owners and discontinued operations within the scope of HKFRS 5 3.21.02 Explain what assets are within the measurement provision of HKFRS 5 3.21.03 Determine when a sale is highly probable
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Financial Reporting
Competency
3.21.04 Measure non-current assets held for sale and discontinued operations including initial measurement, subsequent measurement and change of plan 3.21.05 How to account for impairment loss and subsequent reversals 3.21.06 Present the non-current asset held for sale and discontinued operation in the financial statements (including the prior year restatement) LO3.22 Earnings per share: 3.22.01 Explain the meaning and significance of a company's earnings per share 3.22.02 Calculate the earnings per share, including the impact of a bonus issue, a rights issue and an issue of shares at full market value in accordance with HKAS 33 3.22.03 Explain the relevance of a company's diluted earnings per share 3.22.04 Discuss the limitations of using earnings per share as a performance measure LO3.23 Operating segments: 3.23.01 Identify and discuss the nature of segmental information to be disclosed in accordance with HKFRS 8 3.23.02 Explain when operating segments should be aggregated and disaggregated 3.23.03 Disclose the relevant information for operating segments and appropriate entity-wide information LO3.24 Interim financial reporting: 3.24.01 Identify the circumstances in which interim financial reporting is required in accordance with HKAS 34 3.24.02 Explain the purpose and advantages of interim financial reporting 3.24.03 Explain the recognition and measurement principle of interim financial statements and apply them 3.24.04 Disclose the relevant information for interim financial statements including seasonality 3 3 3
4 4
23 23
23 23
24
24 24
25
25 25
25
Introduction
xix
Competency
LO4. Preparation and presentation of financial statements Prepare the financial statements for an individual entity in accordance with Hong Kong Financial Reporting Standards and statutory reporting requirements LO4.01 Primary financial statement preparation: 4.01.01 Prepare the statement of financial position, the statement of comprehensive income, the statement of changes in equity and the statement of cash flows of an entity in accordance with Hong Kong accounting standards 4.01.02 Explain the minimum line items that should be presented in the financial statements and criteria for additional line items LO4.02 Financial statement disclosure requirements: 4.02.01 Disclose accounting policy and items required by the HKFRS, Companies Ordinance and other rules and regulations 4.02.02 Explain the importance to disclose significant judgement and estimates Prepare the financial statements for a group in accordance with Hong Kong Financial Reporting Standards and statutory reporting requirements LO4.03 Principles of consolidation: 4.03.01 Identify and describe the concept of a group as a single economic entity 4.03.02 Define a subsidiary and when a group should start and stop consolidating a subsidiary 4.03.03 Explain what constitutes control and the impact of potential voting rights 4.03.04 Describe the reasons why the directors of a company may not want to consolidate a subsidiary and the circumstances in which nonconsolidation is permitted 4.03.05 Explain the purpose of consolidated financial statements 4.03.06 Explain the importance of eliminating intra-group transactions 4.03.07 Explain the importance of uniform accounting policies and coterminous year ends in the preparation of consolidated accounts 4.03.08 Apply the appropriate accounting treatment of consolidated goodwill 4.03.09 Explain how to account for changes in parent's ownership interest in a subsidiary without losing control 3 27 27 27 27 3 26 3 20, 26
26
26
27 27 27
27 30
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Financial Reporting
Competency
LO4.04
Acquisition of subsidiaries: 4.04.01 Prepare a consolidated statement of financial position for a simple/complex group structure including pre and post acquisition profits, noncontrolling interests and goodwill 4.04.02 Prepare a consolidated statement of comprehensive income for a simple/complex group structure, dealing with an acquisition and the non-controlling interest
3 28
28
LO4.05
Disposal of subsidiaries: 4.05.01 Account for the disposal of a subsidiary by a group 4.05.02 Account for the change of ownership in subsidiaries without loss of control
3 30 30 3 27 27 27 27
LO4.06
Business combinations: 4.06.01 Explain the scope of business combinations in accordance with HKFRS 3 4.06.02 Identify business combination and the difference between acquisition of asset and business 4.06.03 Determine the acquisition date of an acquisition 4.06.04 Identify the identifiable assets (including intangibles) and liabilities acquired in a business combination 4.06.05 Explain the recognition principle and measurement basis of identifiable assets and liabilities and the exception 4.06.06 Explain what contingent consideration is and how to account for it initially and subsequently 4.06.07 Explain how to account for acquisition-related costs, including those related to issue debt or equity securities 4.06.08 Determine what is part of the business combination transaction and the consideration 4.06.09 Calculate goodwill (including bargain purchase) and account for it 4.06.10 Explain the accounting for step acquisition 4.06.11 Account for non-controlling interest when the subsidiary has negative equity balance 4.06.12 Explain and account for measurement period adjustments
27
27 27
27 27 30 27 27
Introduction
xxi
Competency
LO4.07
Investments in associates: 4.07.01 Define an associate in accordance with HKAS 28 (2011) 4.07.02 Explain what significant influence is and apply the principle 4.07.03 Explain the reasons for and impact of equity accounting, including notional purchase price allocation on initial acquisition, fair value adjustments, upstream and downstream transactions, and uniform accounting policies 4.07.04 Account for investors' share of losses of an associate in excess of its investments in associates 4.07.05 Explain the impairment test and related treatments for investments in associates 4.07.06 Account for the disposal of an associate 4.07.07 Prepare the disclosure in respect of associates
3 29 29 29
29
29 30 29 3 29 29
LO4.08
Interests in joint arrangements: 4.08.01 Define joint arrangements in accordance with HKFRS 11 4.08.02 Explain the difference among jointly controlled operations and joint ventures 4.08.03 Explain how an entity should account for a joint venture 4.08.04 Account for the transactions between a venturer and a joint venture 4.08.05 Disclose the relevant information in the venturer's financial statements
29 29 29 3 28 28 20 3 27
LO4.09
Consolidated financial statement preparation 4.09.01 Prepare a consolidated statement of financial position in compliance with HKFRS 10 4.09.02 Prepare a consolidated statement of comprehensive income 4.09.03 Prepare a consolidated statement of cash flows
LO4.10
Financial statement disclosure requirement 4.10.01 Disclose the relevant information for business combinations occurred during and subsequent to the reporting period
LO4.11
Merger accounting for common control combinations 4.11.01 Describe the principles and practices of merger accounting 4.11.02 Apply merger accounting to a common control combination
2 30 30
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Financial Reporting
List of Accounting Standards

The following list includes all the Hong Kong Accounting Standards in issue at 28 June 2011. Hong Kong Accounting Standards HKAS 1 (revised) HKAS 2 HKAS 7 HKAS 8 HKAS 10 HKAS 11 HKAS 12 HKAS 16 HKAS 17 HKAS 18 HKAS 19 HKAS 20 HKAS 21 HKAS 23 (revised) HKAS 24 (revised) HKAS 26 * HKAS 27 (2011) HKAS 28 (2011) HKAS 29 * HKAS 32 HKAS 33 HKAS 34 HKAS 36 HKAS 37 HKAS 38 HKAS 39 HKAS 40 HKAS 41 * Presentation of financial statements Inventories Statement of cash flows Accounting policies, changes in accounting estimates and errors Events after the reporting period Construction contracts Income taxes Property, plant and equipment Leases Revenue Employee benefits Accounting for government grants and disclosure of government assistance The effects of changes in foreign exchange rates Borrowing costs Related party disclosures Accounting and reporting by retirement benefit plans Separate financial statements Investments in associates and joint ventures Financial reporting in hyperinflationary economies Financial instruments: presentation Earnings per share Interim financial reporting Impairment of assets Provisions, contingent liabilities and contingent assets Intangible assets Financial instruments: recognition and measurement Investment property Agriculture
Introduction
xxiii
Hong Kong Accounting Standards HKFRS 1 (revised) HKFRS 2 HKFRS 3 (revised) HKFRS 4 * HKFRS 5 HKFRS 6 * HKFRS 7 HKFRS 8 HKFRS 9 HKFRS 10 HKFRS 11 HKFRS 12 HKFRS 13 HKFRS for PEs First-time adoption of Hong Kong Financial Reporting Standards Share-based payment Business combinations Insurance contracts Non-current assets held for sale and discontinued operations Exploration for and evaluation of mineral resources Financial instruments: disclosures Operating segments Financial instruments Consolidated financial statements Joint arrangements Disclosure of interests in other entities Fair value measurement HKFRS for Private Entities
* These standards are not examinable at the examination.
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Part A
Legal environment
The emphasis in this section is on the legal environment in Hong Kong. The purpose of this section is to develop your understanding of the Hong Kong legal environment, including the legal framework and the related implications for business activities. This is considered as the basic knowledge and foundation for a future certified public accountant.
Financial Reporting
chapter 1
Legal environment
Topic list
1 2 3 Hong Kong legal framework Obligations of directors and officers of companies Legal requirements associated with company structure, share offerings, debt obligations and restructuring
Learning focus
This chapter is partly background knowledge to set the scene about the legal environment before you look at financial reporting standards. It also discusses the legal framework and related implications for business activities. It is important that you are aware of these both for exam purposes and in practice.
Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Describe the Hong Kong legal framework and related implications for business activities 1.01 1.01.01 1.02 1.02.01 1.03 1.03.01 1.03.02 1.04 1.04.01 1.05 1.05.01 1.05.02 1.06 1.06.01 1.06.02 1.07 1.07.01 1.08 1.08.01 Types and relative advantage of alternative forms of organisation Identify the types and relative advantages of alternative forms of organisation Legal procedures for establishment and governance of companies Describe the legal procedures for the establishment and governance of companies Powers, duties and obligations of directors and company secretaries Describe the powers, duties and obligations of company directors Describe the powers, duties and obligations of the company secretary Share issues and prospectus requirements Describe the procedure for issuing shares and the requirement for a prospectus Debt instruments and registration of charges Describe the procedure for the issue of debt instruments Describe the procedure for the registration of charges over company debt Statutory reporting and documentation requirements Explain the statutory registers that must be kept by a company Identify the financial statements that a company must prepare Appointment and removal of auditors Describe the procedures for the appointment, removal and resignation of company auditors Restructuring, including appointment of receivers and liquidators Identify the reasons for which a company may restructure, including the appointment of receivers and liquidators 1 3 3 2 2 2 2 2
1: Legal environment | Part A Legal environment
1 Hong Kong legal framework

Topic highlights
Certified public accountants need to understand the different forms of business enterprises that operate in Hong Kong. You can apply the knowledge you obtain from this section of the Learning Pack to demonstrate this competence.
The liability of the members of companies can be unlimited or limited. We are mainly concerned with limited companies in this section.
1.1 Types and relative advantages of alternative forms of organisation

Topic highlights
Commercial organisations may take a number of forms, including sole trader businesses, partnerships, companies and joint ventures. These are considered in turn in this section.
1.1.1 Sole trader business

A sole proprietorship also known as a sole trader, or simply proprietorship is a type of business entity which is owned and run by one individual and where there is no legal distinction between the owner and the business. All profits and all losses accrue to the owner (subject to taxation). All assets of the business are owned by the proprietor and all debts of the business are their debts and they must pay them from their personal resources. This means that the owner has unlimited liability. It is a 'sole' proprietorship in the sense that the owner has no partners (partnership). A sole proprietor may do business with a trade name other than his or her legal name. This also allows the proprietor to open a business account with banking institutions. This form of business has a major advantage in that it is easy and quick to set up. Furthermore details of the business and its operation remain private as there is no requirement to file documents such as accounts. There are, however, drawbacks to operating as a sole trader, the main one being that the sole trader is not legally separated from his business and therefore remains individually and personally liable for any losses that the business makes. In Hong Kong, all the investor needs to do is to apply for a business licence from the Business Registration Office of the Inland Revenue Department. Every person carrying on a business shall make such an application within one month of the commencement of such business.
1.1.2 Partnerships
A partnership is a business entity formed by the Hong Kong Partnerships Ordinance, which defines a partnership as 'the relation between persons carrying on a business in common with a view of profit' and is not a joint stock company or an incorporated company. There must be at least two partners, but not more than 20 partners, otherwise it would be treated as a company (single entity) unless the partnership is a partnership of professional solicitors, accountants and stockbrokers referred to in s345(2) of the Companies Ordinance. The partners share any profits and losses and inject funding by way of partners capital.
Financial Reporting
There are two different kinds of partnership. If the business entity registers with the Registrar of Companies it takes the form of a limited partnership defined in the Limited Partnerships Ordinance. However, if this business entity fails to register with the Registrar of Companies, then it becomes a general partnership as a default. In a general partnership all partners are general partners so each one is liable for all debts and obligations of the firm. In a limited partnership the general partners are liable for all debts and obligations of the firm while the limited partners are liable only for the capital they contributed to the firm. In a limited partnership the general partners manage the firm while the limited partners may not and should limited partners do so then they become personally liable for the debts of obligations of the firm in the same manner as a general partner. Unless a partnership agreement between the partners demand otherwise, (1) a majority of the general partners decide ordinary business matters, (2) a limited partner may assign his partnership interests, (3) a limited partner cannot dissolve a partnership, (4) the introduction of a new partner does not require the consent of the existing limited partners. A partnership business, in common with a sole trader business, is not required to make accounts and other documents public. It also has the additional advantages of: greater access to capital since more individuals contribute to the business potentially a greater spread of skills provided by the partners shared risk
The disadvantages of a partnership include the issue of disputes in the running of the business, and unlimited liability. Additionally, partners are jointly and severally liable for their partners, meaning that any one may be held responsible for losses of the business.
1.1.3 Companies
A company is bound by applicable rules and regulations. This regulated formal structure is a reason why companies are such a popular business structure. It is a comparatively safe and stable system for different groups of people to join together in business activities. The liabilities of the shareholders of companies in Hong Kong can be either limited or unlimited. Extracts from section 4(2) of the Companies Ordinance explain the differences between unlimited companies and companies limited by shares or guarantee: (a) (b) Limited by shares the members of the company are liable to pay the company's debts only to the extent of the nominal value of their shares. Limited by guarantee the members of the company are liable to pay the company's debts only to the extent of a stated guarantee. This structure is often used by non-profit organisations which do not want to have share capital, but want the benefits of using the structure of a company. Unlimited the members of the company are personally responsible for the debts of the company. This type is less common but may suit partnerships who want to use the more formal company structure for their business operation but are restricted by some professional organisation from limiting their liability. In Hong Kong, sole proprietors operating small businesses may also use this form of company.
(c)
Advantages of operating as a limited liability company Advantages of a limited liability company include the following: (a) (b) The liability of the members is limited so reducing their personal exposure to debts should the company fail. The separation of ownership and management may result in the smoother running of the business and easier resolution of problems.
(c) (d)
A company may have better access to finance than unincorporated businesses and can create a floating charge by the way of security. The ownership of the business is easily achieved through the transfer of shares.
Drawbacks of operating as a limited liability company Drawbacks of a limited liability company include the following: (a) (b) (c) The regulated formal operating structure comes at the cost of registration, secretarial and audit fees. The stringent reporting requirements mean that details of the operation of the business are made public and this increases the accountability of management. The process of operating is governed and sometimes inhibited by legal requirements. For example, all limited companies are bound to compile accounts and to have their accounts audited annually.
For these reasons, small business operators may prefer to operate as a sole trader or as a partnership.
1.1.4 Joint ventures

A joint venture is a legal entity formed by two or more parties to undertake an economic activity together. The entity formed (the joint venture) may be any type of legal structure including a partnership or limited liability company. Joint ventures are often the preferred, or required, method of entry into a new market. By forming a joint venture with another company, entities can reduce the risks associated with accessing new geographical or product markets. In certain jurisdictions, including Saudi Arabia, a foreign entity cannot legally carry out business without forming an alliance with a national entity.
1.2 Legal procedures for establishment of companies

Companies are established under the provisions of the Companies Ordinance (Chapter 32 of the Law of Hong Kong). A company operates under a memorandum or agreement between subscribers or shareholders. It is common to also have articles of association for a company, which are more detailed rules and regulations regarding meetings, resolutions and activities of the company. Once registered with the Registrar of Companies, a company is issued with a certificate of incorporation as evidence that all the requirements of the Companies Ordinance have been met with respect to the registration. The most common form of business structure in Hong Kong is the limited liability company. Limited companies can be private limited companies or public limited companies. Any company that cannot meet the legal requirements to remain a private company must register as a public company. Private companies are devised for the small business and are intended for situations where the members are also the managers of the company. A private company is defined by s29(1) Companies Ordinance as a company which by its articles: (a) (b) restricts the right to transfer its shares; and limits the number of members to 50, not including employees of the company and former employees who were members of the company whilst employed and who have continued to be members; and prohibits any invitation to the public to subscribe for any shares or debentures in the company.
(c)
Financial Reporting
For the purposes of this section, two or more persons holding one share jointly are treated as one member. If a company's articles fail to satisfy the requirements of s29, it is a public company, although the term public company is not actually used in or defined by the Ordinance. The main advantage of private companies is that they need not file accounts with their annual return and, subject to a number of exceptions, they may waive compliance with certain requirements as to the content of their accounts (s141D). When a private company sends its annual return to the Registrar of Companies they are signed by a director or the secretary, stating that the company has complied with s29. If a company alters its articles so that it no longer satisfies s29, from the date of alteration the company will cease to be a private company and within 14 days it must deliver to the Registrar a prospectus or a statement in lieu of a prospectus in the form and containing the particulars specified in Schedule 2 (s30). These documents are also required before a company which is formed as a public company may allot any of its shares or debentures.
1.3 Corporate governance

Topic highlights
Corporate governance has become increasingly important in recent years due to a number of high profile corporate collapses.
Key term
Corporate governance is the system by which companies are directed and controlled. (Cadbury Report) Corporate governance may be defined as the system and processes by which companies are directed and controlled in response to the rights and expectations of shareholders and other stakeholders. Corporate governance therefore covers a very wide range of issues and disciplines from the appointment and the remuneration of directors, the procedures of the directors' meetings and the role of non-executive directors, to the company's objectives, business strategy and risk management, and to investor relations, employee relations and social responsibilities etc. Corporate governance has been the subject of much debate in the business world in recent years. The trigger for this debate was the collapse of major international companies during the 1980s, including Maxwell, BCCI and Polly Peck. These collapses were often unexpected, and dubious (or even fraudulent) activities were sometimes attributed to their owners and managers. These events represented a nasty shock for countries, such as the UK and the USA, that felt they had well-regulated markets and strong company legislation. It became obvious, however, that part of the problem was the way in which regulation was spread between different national authorities for these global conglomerates, so that no one national authority had the whole picture of the affairs of such companies, nor full powers over the whole of the business. Individual countries began to develop better guidelines for the corporate governance, and efforts have been made to produce an international standard on corporate governance. Since 1995, the Corporate Governance Committee of the Hong Kong Institute of CPAs has made a series of recommendations for enhanced corporate governance disclosure in Hong Kong. In the committee's latest report, Corporate Governance Disclosure in Annual Reports A Guide to Current Requirements and Recommendations for Enhancement, which was published in March 2001, the Committee repeated certain of those recommendations which have not yet been adopted in the Listing Rules and made further recommendations for enhancement.
Some of the recommendations are extracted as follows: (a) To communicate to shareholders the strength of their corporate governance structure, policies and practices, listed companies and public corporation are encouraged to include in their annual report a statement of corporate governance; To enhance comparability and transparency of the way directors are compensated, directors' remuneration should be analysed between 'performance based' and 'non-performance based'; Disclosure requirements in respect of directors' share options should be extended to include disclosure by individual director of the aggregate value realised. Aggregate value realised is calculated as the excess of the market price on the day of exercise of the option over the exercise price multiplied by the number of shares acquired as a result of the exercise of the option; To aid communication with the reader of the financial statements, the directors should set out in a separate statement their responsibilities in connection with the preparation of the financial statements; and To increase transparency regarding auditors' independence, disclosure of non-audit fees paid to auditors should be made.
(b)
(c)
(d)
(e)
2 Obligations of directors and officers of companies

Topic highlights
The directors have statutory duties laid down in the Companies Ordinance, common law duties of reasonable care and skill and fiduciary duties in equity.
2.1 Directors' responsibilities

Directors are first and foremost responsible for the operation of a company, ensuring that it operates as the shareholders intended within the corporate legal environment. The Companies Ordinance broadens the definition of director to "include any person occupying the position of director by whatever name called". Directors' responsibilities are therefore imposed on the senior management of a company, whether they are the directors, chief executives, senior managers or other officers; it depends on the role they actually fulfil. Every company (not being a private company) shall have at least two directors who must be over the age of 18. A company cannot have a corporate body as a director apart from a private company which is not a member of a group of companies which includes a listed company (Section 153).
2.1.1 Duties and responsibilities

(a) Fiduciary duties Directors must act honestly and in good faith for the benefit of the company. In particular, directors must act in good faith in what they believe to be the best interests of the company. Generally speaking, the interests of the company are to be equated with the interests of its members as a whole. Directors must not act just for the economic advantage of the majority of shareholders disregarding the interests of the minority. The position and interests of creditors must be considered in any case where the company is not fully solvent. The interests of the company's employees must also be taken into account.
Financial Reporting
Directors must act for a proper purpose. That is, directors must not abuse the powers given to them by using those powers for purposes other than those for which they were granted. Directors must not obtain a personal profit from transactions entered into by the company without the prior approval of the shareholders; otherwise such profits will be regarded as being held in trust for the company and they may have to account for them. Directors must not agree to fetter their discretion. As the powers delegated to directors by the memorandum and articles are held in trust by them for the company, they must not restrict their exercise of future discretion. Directors must act in such a way that there is no possibility of conflict between personal interests and company interests. Directors should also avoid any conflict of interest by not using corporate property, information or opportunity for any purpose other than in the company's interests. (b) Duty to exercise skill and care Directors must exercise reasonable care and skill in the performance of their duties. The wide range of skills required of directors has meant that there have been no precise standards of skill and care established in case law. In the past the courts have required that directors display the degree of skill and care which may reasonably be expected from a person with that director's knowledge and experience. If employed as having particular skills, for example, as being a certified public accountant, a director should display the skill or ability expected from a person of that profession. A certified public accountant may, depending on the circumstances, be held professionally responsible if he or she should be found negligent in the discharge of his or her duties as a director. Statutory duty Various company law statutes impose a number of duties on directors, such as the preparation of annual accounts and duties in relation to auditors. (c) Directors' responsibilities in respect of financial reporting Directors are responsible for ensuring that all information contained in prospectuses, financial statements and other financial documents is accurate and is presented in accordance with the laws and regulations that apply to the company. In respect of directors' liabilities, directors can be subject to fines and penalties under the Companies Ordinance or subject to other penalties by regulatory bodies and, in the event of legal proceedings, may be personally sued for negligence by investors, shareholders or other parties affected by their actions.
2.1.2 Powers and obligations

(a) Powers of directors The general power of managing a company is usually vested in the directors. Formally the powers of directors are defined by articles. The directors may meet together to despatch business, adjourn, and otherwise regulate their meetings as they think fit under Table A, art 100. At common law, directors can only exercise their powers collectively by passing resolutions at a properly convened meeting of the board of directors; they have no power to act individually as agents for the company. However, a company's articles will usually empower the board of directors to delegate its power to individual directors or to committees of directors (Table A, art 104), and to managing director (art 111), so that a meeting is not required for each and every decision taken by the board of directors. (b) Directors' obligations If a person does not comply with his duties as a director he may be liable to civil or criminal proceedings and may be disqualified from acting as a director.
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2.2 Officers of companies

Topic highlights
The secretary of a company is the chief administrative officer. The position involves communications with the Companies Registry and with members in relation to all legal and administrative issues. The secretary usually has actual power to bind the company in respect of actions normally expected of a company secretary.
The term 'officer' is a generic one that can be applied to directors, the secretary and some other senior managers. Officers are usually accountable in law for certain actions specified in legislation. Furthermore, they may be accountable under the principles established in decided cases. The secretary is the chief administrative officer of the company as regards relations with members and the Companies Registry. Every company must have a secretary. The position may be filled by an individual or a company. It is permitted to have more than one secretary. Details of the secretary must be registered in Chinese and English. The secretary can be a director of the company unless the company has only one member who is also the only director (Section 154, Companies Ordinance). Listed companies must segregate the roles of chairman and secretary under the Listing Rules.
2.2.1 The role of the secretary

The secretary is the vital link between the company and the Companies Registry, and the company and its members. The secretary receives all formal communications from the Registry. The secretary is responsible for submitting returns and registration of documents such as charges over assets, special resolutions, loans to directors and so on (though it is the directors who are accountable for these actions).
2.2.2 Powers and duties of the company secretary

The secretary: makes arrangements for meetings of the board of directors makes arrangements for annual and extraordinary general meetings records the formal minutes of meetings and makes these available for signature maintains the company's records, including the register of members deals with matters relating to liaison with members deals with formal communications between the company and the Companies Registry
3 Legal requirements associated with company structure, share offerings, debt obligations and restructuring
Topic highlights
There are legal requirements associated with the company structure, share offerings, debt obligations and restructuring.
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Financial Reporting
The issued share capital is made up of the shares already held by members. It is sometimes called subscribed share capital. A company does not have to issue all of its authorised share capital at once, or even at all if it chooses not to do so. Share capital not issued is called unissued share capital.
3.1 Share issues and prospectus requirements

When a company is first established, shares are issued as follows: (a) (b) In a private company they are issued by allotment, with the directors passing a resolution at a Board meeting stating that shares are to be issued to named persons. In a public company they are issued by a renounceable allotment letter, which allows issued shares to be transferred by the initial holder within a specified period of time.
The power to allot shares is normally delegated to the directors by the Articles or by an ordinary resolution passed by the members at a general meeting. When a public company seeks to raise capital from the general public it must issue a prospectus. Detailed requirements of such a prospectus may be found on the website of the Hong Kong Stock Exchange, although knowledge is not required for the Module A exam.
3.2 Debt instruments and registration of charges

Debt instruments are a type of financial instrument. The accounting treatment of these is found in a later chapter. Issuers of debt finance, such as banks, will often require security for their loan in case a company is unable to meet repayments. This security is normally a charge over individual assets (a fixed charge) or over a group of changing assets (a floating charge). Where the borrower defaults on repayment, a floating charge crystallises and the lender takes control of the asset(s) held as security and may sell it or them to realise funds.
3.2.1 Registration of charges

The Companies Ordinance specifies that two registers of charges must be maintained: (a) (b) The Companies Registry must keep a record for each company (Section 83) The company must keep its own register, either at its own office or at a location of which the Registry is aware (Section 89).
Fixed and floating charges must be registered at the Companies Registry within five weeks of their execution. Any charge not registered within this time period will be void against the liquidator and any creditor of the company. This does not mean that the company no longer owes the money, but it does relegate the obligation to the level of an unsecured creditor. Therefore, the charge remains valid against the company. Irrespective of the terms of the debenture, failure to register makes the whole debt immediately repayable. This will normally result in insolvency within a short period of time. Any fixed charge on land and buildings must be registered in the Land Office within one month of being executed. This also applies if any floating charge that includes land or buildings crystallises. The requirement to register is set out in Section 80 of the Companies Ordinance. Not all charges have to be registered, but the exclusions generally fall outside the Module A syllabus. Charges must be registered by the debtor company, though the creditor can perform this function (Section 81). Registration secures the position of the creditor and also serves as an indication of the obligation to prospective future lenders if they choose to search the register. Once registration has occurred, a non-current asset that secures a fixed charge can only be sold with the consent of the secured lender. Some debentures are issued under a trust deed so that
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only one registration is necessary. Also, if the directors seek release from the charge they need only approach the trustees instead of potentially many lenders. As we have seen, the creation of a floating charge does not prevent dealing in the asset. On liquidation, charges are prioritised using the following principles: Fixed charges rank ahead of floating charges Charges of the same kind are ranked in order of their date of creation
The security to the lender is the value of the asset at disposal and not the debt. Therefore, if a company is liquidated and an asset is sold for $50,000 with a loan outstanding of $70,000, the difference will rank as unsecured. Some lenders reinforce their position by including a negative pledge clause in their floating charge documents. This is a condition that states that the company will not create any later legal or equitable charges over specific assets ranking in priority to a floating charge.
3.3 Statutory reporting and documentation requirements

A company must keep statutory registers of: members directors directors' interests, including loans to directors charges over the company's assets meetings resolutions substantial interests in shares
The records must be kept at the registered office or another location if permission is granted by the Companies Registry. The company must prepare a statement of financial position statement of comprehensive income
Both of these documents must be approved and signed. These financial statements have to be filed with the Registrar and sent to all members and debenture holders. A listed public company is permitted to produce summary financial statements for the members in place of the full accounts. Companies must keep proper accounting records to enable the accounts to be prepared with reasonable accuracy. An annual return must be sent to the Registry.
3.4 Appointment and removal of auditors

The first auditors of a new company are appointed by the first directors of the company. For existing companies, the appointment or reappointment of auditors is confirmed by the members in the Annual General Meeting. If the AGM does not appoint an auditor, the court can make an appointment. If the auditors resign from their position, the directors or the shareholders at a general meeting may appoint new auditors.
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Financial Reporting
3.4.1 New auditors

Where new auditors are appointed at a general meeting it is necessary to serve special notice (28 days) to the members. In some cases this may be impossible, but the notice period may not be less than 21 days. Notification to the members may be by any mode of communication permitted by the Articles of Association. The remuneration of auditors is determined by whoever appoints the auditors.
3.4.2 Removal and resignation of auditors

The company must pass an Ordinary Resolution if it wishes to remove the auditors. If this occurs before the expiry of the period of office, special notice of 28 days to the company by the person seeking to remove the auditor is mandatory. Any representations by the auditors relating to (or relevant to) the removal or resignation must be sent to the members. The removed or resigning auditor is entitled to attend the next AGM. The auditor can resign in writing at any time. Unless the auditor wishes to make a statement to the members, the notice to the company must state that there are no relevant circumstances connected with the resignation that need to be brought to the attention of the members. The notice of resignation must be deposited with the Companies Registry. If there is a statement made by the auditor relating to the circumstances of resignation this must be sent to all of the members.
3.5 Restructuring, including appointment of receivers and liquidators

Companies may alter their capital structure or make other arrangements to improve profitability or liquidity, increase efficiency or ultimately rescue the business. The law sets out to protect the members and outside parties in the event of these actions.
3.5.1 Restructuring
Restructuring is a common response to a change in business conditions. A company may restructure its financing arrangements, its assets or its operations in order to save money and achieve efficiencies. Debt restructuring is the process where a company with cash flow problems restructures or renegotiates debts in order to improve or restore liquidity so that trading may continue. Capital restructuring involves reallocating assets to improve liquidity. Certain assets are sold and replaced with alternative assets which can be better utilised to earn revenue and profits. The overall motives of restructuring are reduced risk, reduced cost of capital and increased liquidity.
3.5.2 Liquidation
Key terms
Liquidation is the 'end of the road' for the company. It occurs when it is certain that the life of the company will come to an end. The process by which this occurs is called winding up. You can use the terms 'liquidation' and 'winding up' to mean broadly the same thing. However, the company does not have to be in financial difficulties to be wound up. The members of the company may decide at any time to take such action, and in some cases are obliged to do so (for example, if the company were set up to achieve a specific purpose and this has been fully achieved, there is no reason for the company to go on trading).
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The liquidator is the person appointed to wind up the company and is an insolvency practitioner (usually an accountant or solicitor) with expertise in such matters. Where a company is insolvent, the liquidator is appointed by the Official Receiver, a civil servant acting on instructions from the court. The Official Receiver is sometimes called the provisional liquidator.
3.5.3 Receivership
A receiver is different to both a liquidator and the Official Receiver. A receiver is a person or firm appointed by creditors to act if a company has broken the conditions of a debenture, such as not making payments when contractually obliged to do so. The job of the receiver is to get the money back for the creditor. If he does so and the company can still survive, it does not mean that the receiver's actions will bring an end to the company. The receiver is appointed under the provisions of the debenture. A receiver may also be appointed by the court or on the statutory basis provided by the Conveyancing and Property Ordinance: '... there shall be implied in any legal charge or equitable mortgage by deed, where the money has become due, a power exercisable in writing by the mortgagee and any person entitled to give a receipt for the mortgage money on its repayment to appoint a receiver...to remove any receiver...and appoint another in his place.' The court appoints a receiver if the security is in jeopardy. When a receiver is appointed it is necessary to inform the Companies Registry within seven days of appointment. From this time, the company's letterhead must make specific reference to the receiver.
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Financial Reporting
Topic recap
Certified public accountants need to understand the different forms of business enterprises that operate in Hong Kong. Commercial organisations may take a number of forms, including sole trader businesses, partnerships, companies and joint ventures. Companies in Hong Kong can be limited or unlimited. In turn, limited companies can be private or public companies. Any company that cannot meet the legal requirements to remain a private company must register as a public company. Corporate governance has become increasingly important in recent years due to a number of high profile corporate collapses. The directors have statutory duties laid down in the Companies Ordinance, common law duties of reasonable care and skill and fiduciary duties in equity. The secretary of a company is the chief administrative officer. The position involves communications with the Companies Registry and with members in relation to all legal and administrative issues. The secretary usually has actual power to bind the company in respect of actions normally expected of a company secretary. There are legal requirements associated with the company structure, share offerings, debt obligations and restructuring.
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Exam practice
Preparing financial statements
15 minutes
During an audit of the financial statements of a Hong Kong incorporated company listed on the Main Board of The Stock Exchange of Hong Kong Limited, the auditor reported to the Audit Committee of the company that no impairment assessment had been done by the management in respect of the goodwill arising on an acquisition of a subsidiary in the prior year under HKAS 36 Impairment of Assets. In a meeting with the directors of the company, one of the executive directors told the auditor that 'We are not responsible for the preparation of financial statements. We have delegated this task to our financial controller. Please talk to him directly.' The financial controller, being a professional accountant, responded that, 'the financial statements will be approved by the Board of Directors instead of me; it is not my problem if the financial statements are not prepared in accordance with Hong Kong Financial Reporting Standards.' Required Comment on the validity of the statements given by the executive director and the financial controller of the company in respect of their responsibilities in the preparation of the financial statements. (8 marks) HKICPA May 2009
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Financial Reporting
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Part B
Financial reporting framework
The emphasis in this section is on an in-depth understanding of the financial reporting framework in Hong Kong. The purpose of this section is to develop your understanding about the financial reporting framework in Hong Kong, the role of accounting standards and the financial reporting requirements under Hong Kong Financial Reporting Standards.
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Financial Reporting
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chapter 2
Financial reporting framework

Topic list
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Regulatory bodies and their impact on accounting Financial reporting requirements under HKFRS Hong Kong Financial Reporting Standards HK(IFRIC) Interpretations, Hong Kong Interpretations and HK(SIC) Interpretations Additional requirements for listed companies Code of Ethics for Professional Accountants Conceptual framework and GAAP The HKICPA's Framework Qualitative characteristics of financial information The elements of financial statements Recognition of the elements of financial statements Measurement of the elements of financial statements Fair presentation and compliance with HKFRS Management Commentary Current developments
Learning focus
The content of the HKICPA's Framework is vital as it underpins all HKFRSs. Both in exams and in practice, when an accounting standard does not appear to provide guidance on a particular topic, you may be required to fall back on the basic principles of the Framework.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Describe the financial reporting framework in Hong Kong and the related implications for business activities 2.01 The role and setting of accounting standards 2.01.01 Understand the role of accounting standards 2.01.02 Understand the role of the HKICPA, Securities and Futures Commission (SFC), Financial Reporting Council (FRC), the Hong Kong Insurance Authority (HKIA), the Hong Kong Monetary Authority (HKMA) and the Hong Kong Stock Exchange (HKEx) 2.02 Hong Kong Financial Reporting Standards 2.02.01 Describe how Hong Kong Financial Reporting Standards are set 2.05 Code of Ethics for Professional Accountants 2.05.01 Explain the requirements of the Code of Ethics for Professional Accountants 2.06 Hong Kong (IFRIC) Interpretations, Hong Kong Interpretations and Hong Kong (SIC) Interpretations 2.06.01 Describe the status of Hong Kong (IFRIC) Interpretations, Hong Kong Interpretations and Hong Kong (SIC) Interpretations 2.07 Other professional pronouncements and exposure drafts 2.07.01 Identify other professional pronouncements and exposure drafts relevant to the financial reporting framework 2.08 Regulatory bodies and their impact on accounting 2.08.01 Identify relevant regulatory bodies and their impact on accounting 2.09 Accounting principles and conceptual frameworks 2.09.01 Explain what is meant by a conceptual framework and GAAP 2.09.02 Identify the advantages and disadvantages of a conceptual framework 2.09.03 Identify the components and requirements of the HKICPA's Framework 2.09.04 Explain those requirements of HKAS 1 Presentation of Financial Statements which overlap with the HKICPA's Framework 2.10 Current developments 2.10.01 Identify areas of accounting in which current developments are occurring
2 3
2 2
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2: Financial reporting framework | Part B Financial reporting framework
1 Regulatory bodies and their impact on accounting

Topic highlights
The main regulatory bodies influencing accounting within Hong Kong are the Hong Kong Institute of Certified Public Accountants (HKICPA), and for listed companies, the Hong Kong Stock Exchange (HKEx). Other bodies include the Securities and Future Commissions (SFC), Financial Reporting Council (FRC), the Hong Kong Insurance Authority (HKIA) and the Hong Kong Monetary Authority (HKMA). Throughout this chapter we shall meet the regulations and requirements put in place by these bodies, but first, a brief introduction to each.
1.1 The role of the Hong Kong Institute of CPAs (HKICPA)

The HKICPA issues HKFRS and non-mandatory guidance documents including Accounting Guidelines and Accounting Bulletins. The HKICPA is the only statutory accounting body in existence in Hong Kong responsible for the establishment of accounting and auditing standards and guidelines, as well as for the administration and regulation of the accounting profession in Hong Kong. Pursuant to the Professional Accountants Ordinance (Chapter 50), the Council of the HKICPA (the Council) may, in relation to the practice of accountancy, issue or specify any standards of accounting practices required to be observed, maintained or otherwise applied by members of the Hong Kong Institute of CPAs. In this respect, the objectives of the Council are to: (a) develop, in the public interest, a single set of high quality, understandable and enforceable accounting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the capital markets and other users of the information to make economic decisions promote the use and rigorous application of those standards promote, support and enforce compliance with those standards by members of the HKICPA whether as preparers or auditors of financial information bring about convergence of accounting standards with International Financial Reporting Standards (IFRS).
(b) (c) (d)
1.2 The role of the Stock Exchange of Hong Kong (SEHK) Ltd
The principal function of the SEHK is to provide a fair, orderly and efficient market for the trading of securities, under the Stock Exchange Unification Ordinance. To enhance the competitiveness of the Hong Kong securities market so as to meet the challenge of an increasingly globalised market, there was a comprehensive market reform of the securities and futures market in March 2000, under which the SEHK, the Hong Kong Futures Exchange Ltd (HKFE) and the Hong Kong Securities Clearing Company Ltd (HKSCC) were amalgamated under a holding company, Hong Kong Exchanges and Clearing Ltd (HKEx). Currently, there are two established exchanges under the SEHK, the Main Board and the Growth Enterprise Market (GEM) Board, on which companies are listed in Hong Kong. Companies listed on the Main Board are required to comply with the Listing Rules whereas companies listed on the GEM Board are required to comply with the GEM Rules. The SEHK regulates the financial reporting compliance of listed companies through a Regulatory Affairs Group and a GEM Department for companies listed on the Main Board and the GEM Board respectively.
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Financial Reporting
1.3 Securities and Futures Commission (SFC)

Topic highlights
The Securities and Futures Commission (SFC) is an independent non-governmental statutory body, and is established by the Securities and Futures Commission Ordinance (SFCO). It is outside the civil service, responsible for regulating the securities and futures markets in Hong Kong.
The SFC is responsible for administering the laws governing the securities and futures markets in Hong Kong and facilitating and encouraging the development of these markets. The statutory regulatory objectives as set out in the SFO are: to maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness of the securities and futures industry; to promote understanding by the public of the operation and functioning of the securities and futures industry; to provide protection for members of the public investing in or holding financial products; to minimise crime and misconduct in the securities and futures industry; to reduce systemic risks in the securities and futures industry; and to assist the Financial Secretary in maintaining the financial stability of Hong Kong by taking appropriate steps in relation to the securities and futures industry.
In carrying out their mission, the SFC aims to ensure Hong Kong's continued success and development as an international financial centre. The SFC is divided into four operational divisions: Corporate Finance, Intermediaries and Investment Products, Enforcement, and Supervision of Markets. The Commission is supported by the Legal Services Division and Corporate Affairs Division.
1.3.1 Whom, What and How: SFC regulation

Areas of regulation Licensed corporations and individuals carrying out the following regulated activities: Dealing in securities Dealing in futures contracts Leveraged foreign exchange trading Advising on securities Advising on futures contracts Advising on corporate finance Providing automated trading services Securities margin financing Asset management Methods Set licensing standards to ensure that all practitioners are fit and proper Approve licenses and maintain a public register of licensees Issue codes and guidelines to inform the industry of its expected standard of conduct Monitor licensees' financial soundness and compliance with Ordinance, codes, guidelines, rules and regulations Handle misconduct complaints against licensees Investigate and take action against misconduct
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Areas of regulation Investment products offered to the public
Methods Set standards for the authorisation and regulation of investment products Authorise investment products offered to the public and their promotion (including advertisements and marketing materials)
Listed companies
Approve changes to the Listing Rules Monitor announcements and vet listing application materials under the Dual Filing regime Administer the Codes on Takeovers and Mergers and Share Repurchases Consider requests for exemptions from prospectus requirements under the Companies Ordinance Enquire into listed companies' suspected prejudicial or fraudulent transactions or provision of false or misleading information to the public
Hong Kong Exchanges and Clearing Limited (HKEx)
Oversee the performance of its role as the frontline regulator of listing related matters Approve the creation of new markets, new products and changes to its rules and regulations Monitor HKEx's own compliance with the Listing Rules Monitor the trading of shares, options and futures on its markets Oversee its systems and technology
Approved share registrars
Approve the Federation of Share Registrars as an association whose members shall be approved share registrars Require approved share registrars to comply with the requirements of the Code of Conduct for Share Registrars
Investor Compensation Company Limited (ICC)
Recognise the ICC as an independent compensation company Approve the rules and any amendment of rules of the ICC Require the ICC to prepare and regularly submit financial statements, auditors' report and other documents to the SFC
All participants in trading activities
Monitor unusual market movements and direct trade suspension of related stocks to maintain an informed and orderly market Investigate and take action against market misconduct and other breaches of the law
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Financial Reporting
1.4 Financial Reporting Council (FRC)

The FRC is an independent statutory body set up under the Financial Reporting Council Ordinance, which was enacted on 13 July 2006. The FRC was established on 1 December 2006. It became fully operational on 16 July 2007. The role of the FRC is to: conduct independent investigations into possible auditing and reporting irregularities in relation to listed entities enquire into possible non-compliances with financial reporting requirements on the part of listed entities require listed entities to remove any non-compliance identified
The FRC may initiate investigations into a possible relevant irregularity or enquiries upon receipt of complaints or on its own initiative an enquiry into possible relevant non-compliance with financial reporting requirements on the part of listed entities. Relevant irregularity means an auditing or reporting irregularity. It is defined in section 4 of the Financial Reporting Council Ordinance (the FRC Ordinance). Any auditing or reporting irregularity exists if an auditor in respect of the audit of the financial statements of a listed entity or a reporting accountant in respect of the preparation of an accountants' report required for a listing document: (a) (b) (c) (d) (e) falsified or caused to be falsified a document; made a statement, in respect of a document, that was material and that he knew to be false or did not believe to be true; has been negligent in the conduct of his profession; has been guilty of professional misconduct; did or omitted to do something that would reasonably be regarded as bringing or likely to bring discredit upon the auditor or reporting accountant himself, the Hong Kong Institute of Certified Public Accountants (HKICPA) or the accountancy profession; failed to comply with a professional standard, ie any (a) statement of professional ethics; or (b) standard of accounting, auditing and assurance practices, as issued or specified by the council of the HKICPA from time to time; failed to comply with the provisions of any bylaw or rule made or any direction lawfully given by the council of the HKICPA.
(f)
(g)
A relevant non-compliance exists if a relevant financial report of a listed entity does not comply with a relevant requirement. A relevant non-compliance is defined in section 5 of the Financial Reporting Council Ordinance (the FRC Ordinance). A relevant requirement refers to accounting requirements as provided in: the Companies Ordinance; the standards of accounting practice issued or specified by the Council of the Hong Kong Institute of Certified Public Accountants (ie the Hong Kong Financial Reporting Standards); the International Financial Reporting Standards issued by the International Accounting Standards Board; the Listing Rules; any generally acceptable accounting principles allowed for usage under the Listing Rules; or the relevant SFC Codes or guidelines.
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Any person who possesses information and/or evidence which suggest that there are or may be auditing and reporting irregularities or non-compliance with financial reporting requirements may lodge a complaint with the FRC. Any auditing or reporting irregularities identified by the FRC will be referred to the HKICPA for follow-up action. Any non-compliance relevant to the Listing Rules will be referred to the Securities and Futures Commission or The Stock Exchange of Hong Kong Limited for follow-up action. The FRC is not empowered to discipline or prosecute.
1.5 Hong Kong Insurance Authority (HKIA)

The Office of the Commissioner of Insurance (OCI) is the regulatory body set up for the administration of the Insurance Companies Ordinance (Cap. 41) (ICO). The OCI was established in June 1990. The Office is headed by the Commissioner of Insurance who has been appointed as the Insurance Authority (IA) for administering the ICO. The principal functions of the IA are to ensure that the interests of policy holders or potential policy holders are protected and to promote the general stability of the insurance industry. The IA has the following major duties and powers: (a) Authorisation: Authorisation of insurers to carry on insurance business in or from Hong Kong. The IA has set out the criteria for authorisation which include, among other things, strong financial position, proper management, viable business plan and physical presence in Hong Kong in order to ensure that an adequate level of security is provided to the insuring public. Regulation of insurers: The regulatory objective of the IA is to ensure the financial soundness and integrity of the insurance market. The primary duty is to ensure that insurers conduct their activities in a prudent manner so that their obligations and policy holders' expectations will be met. Other operational aspects, such as setting of premium rates and policy terms and conditions, are largely left to self-regulation by the industry. Regulatory work is done primarily through the examination of the annual audited financial statements and business returns submitted by the insurers. Where causes for concern are identified in respect of an insurer, the IA is empowered under the ICO to take interventionary actions for protection of the interests of policy holders and potential policy holders. Regulation of insurance intermediaries: An insurance agent is required to be properly appointed by an insurer and registered with the Insurance Agents Registration Board (IARB), in accordance with the Code of Practice for the Administration of Insurance Agents issued by The Hong Kong Federation of Insurers. Under this central registration system, the IARB provides enquiry services to and handles complaints from the public relating to insurance agents. An insurance broker may seek authorisation directly from the IA, or may apply to become a member of an approved body of insurance brokers, in order to carry on insurance broking business in or from Hong Kong. An approved body of insurance brokers is charged with the responsibilities of ensuring that its members comply with the statutory requirements and that the interests of policy holders and potential policy holders are properly protected. It also provides enquiry services to and handles complaints from the public relating to its members. An insurance broker who is directly authorised by the IA is subject to the same statutory requirements as applicable to a member of an approved body of insurance brokers. (d) Liaison with the Insurance Industry: The IA believes in consultation and has worked closely with the representative bodies of the insurance industry in promoting self-regulation by the industry with the aim of enhancing the protection of policy holders. As one of the selfregulatory measures, The Insurance Claims Complaints Bureau (ICCB) was established in 1990. Any claimant who feels aggrieved that his claim under a personal policy is not fairly treated may lodge a complaint with the ICCB. The ICCB is empowered to make an award of up to $800,000 per case. The IA also reviews the guidelines and regulations developed within the system regularly to ensure that they are keeping up with market developments and provide adequate protection to the insuring public.
(b)
(c)
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Financial Reporting
1.6 Hong Kong Monetary Authority (HKMA)

The Hong Kong Monetary Authority (HKMA) was established on 1 April 1993 by merging the Office of the Exchange Fund with the Office of the Commissioner of Banking. Its main functions and responsibilities are governed by the Exchange Fund Ordinance and the Banking Ordinance and it reports to the Financial Secretary. The HKMA is the government authority in Hong Kong responsible for maintaining monetary and banking stability. Its main functions are: maintaining currency stability within the framework of the Linked Exchange Rate system promoting the stability and integrity of the financial system, including the banking system helping to maintain Hong Kong's status as an international financial centre, including the maintenance and development of Hong Kong's financial infrastructure managing the Exchange Fund.
2 Financial reporting requirements under HKFRS

Topic highlights
The Companies Ordinance provides the legal requirements for companies.
The financial reporting regulations and requirements currently in place in Hong Kong applicable to limited liability companies are derived from a number of sources, including those bodies mentioned above. Some are mandatory and some are advisory. Those sources which are mandatory include: (a) (b) Legal requirements set out in the Companies Ordinance Hong Kong Financial Reporting Standards (HKFRSs, taken for the purpose of this Learning Pack to include both HKAS and HKFRS) and HKAS Interpretations (HKAS-lnt) issued by the Hong Kong Institute of Certified Public Accountants (Hong Kong Institute of CPAs) For companies listed in Hong Kong, the requirements set out in the Rules Governing the Listing of Securities (the Listing Rules) and the Rules Governing the Listing of Securities on the Growth Enterprise Market (the GEM Rules), both issued by The Stock Exchange of Hong Kong Ltd (SEHK) pursuant to Section 34 (1) of the Stock Exchanges Unification Ordinance (Cap. 361)
(c)
Those sources which are advisory in nature include: (a) (b) (c) Accounting Guidelines (AGs) issued by the Hong Kong Institute of CPAs Accounting Bulletins (ABs) issued by the Financial Accounting Standards Committee (FASC) of the Hong Kong Institute of CPAs Pronouncements of the International Accounting Standards Board (IASB), formerly known as International Accounting Standards Committee (IASC), and leading national standard setting bodies such as those from Australia, Canada, New Zealand, the United Kingdom and the United States of America.
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3 Hong Kong Financial Reporting Standards

3.1 The setting of HKFRS and due process
Topic highlights
The Financial Reporting Standards Committee (FRSC) of HKICPA has a mandate to develop financial reporting standards to achieve convergence with the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB).
Within this remit, the HKICPA Council permits the FRSC to work in whatever way it considers most effective and efficient and this may include forming advisory subcommittees or other forms of specialist advisory groups to give advice in preparing new and revised HKFRSs. The process for the development of a HKFRS normally involves the following steps: (a) Identifying and reviewing all the issues associated with an Exposure Draft or a draft Interpretation issued by the IASB for possible adoption in Hong Kong or any other topics and considering the application of the Framework to the issues, if needed. Studying pronouncements of the IASB and other standard-setting bodies and accepted industry practices about the issues. Consulting the Standard Setting Steering Board of the HKICPA (SSSB) about the advisability of adding the topic to the FRSC's agenda. Forming an advisory group to give advice to the FRSC on the project. Publishing for public comment a discussion document. (In the case of the IASB issuing a discussion document, also issuing an invitation to comment in Hong Kong with an earlier deadline than that imposed by the IASB, so as to allow the FRSC a reasonable time to consider the comments before the Council makes a submission to the IASB.) Publishing for public comment an Exposure Draft or a draft Interpretation. (In the case of the IASB issuing an Exposure Draft or a draft Interpretation, issuing an invitation to comment in Hong Kong on that Exposure Draft or draft Interpretation with a request for comment before the comment deadline imposed by the IASB so as to allow the FRSC a reasonable time to consider the comments before Council makes a submission to the IASB.) Publishing within an Exposure Draft a basis for conclusions. Considering all the comments received within the comment period on Discussion Papers and Documents, Exposure Drafts and draft Interpretations and those received in response to the Hong Kong invitation to comment on the IASB documents and, when appropriate, preparing a comment letter to the IASB. Following publication of the finalised IFRS or Interpretation of IFRS, considering the changes made, if any, by the IASB and adopting the finalised IFRS or Interpretation of IFRS in Hong Kong with the same effective date. Approving a standard or an Interpretation, including those converged with the equivalent IFRS or Interpretation of IFRS, by Council. Publishing within a standard a basis for conclusions, if appropriate, explaining how the conclusions were reached and giving background information that may help users of HKFRSs to apply them in practice or, in the case of a standard that is converged with IFRS, publishing within the standard the IASB Basis for Conclusions with an explanation of the extent to which Council agrees with the IASB Basis for Conclusions so as to enable users to understand any changes made to the IFRS.
(b) (c) (d) (e)
(f)
(g) (h)
(i)
(j) (k)
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Financial Reporting
3.2 Current Hong Kong FRSs

HKFRSs set out recognition, measurement, presentation and disclosure requirements dealing with transactions and events that are important in general purpose financial statements. The following table shows the list of Hong Kong Accounting Standards in issue as at 28 June 2011: Hong Kong Accounting Standards HKAS 1 (revised) HKAS 2 HKAS 7 HKAS 8 HKAS 10 HKAS 11 HKAS 12 HKAS 16 HKAS 17 HKAS 18 HKAS 19 HKAS 20 HKAS 21 HKAS 23 (revised) HKAS 24 (revised) HKAS 26 * HKAS 27 (2011) HKAS 28 (2011) HKAS 29 * HKAS 32 HKAS 33 HKAS 34 HKAS 36 HKAS 37 HKAS 38 HKAS 39 HKAS 40 HKAS 41 * Presentation of financial statements Inventories Statement of cash flows Accounting policies, changes in accounting estimates and errors Events after the reporting period Construction contracts Income taxes Property, plant and equipment Leases Revenue Employee benefits Accounting for government grants and disclosure of government assistance The effects of changes in foreign exchange rates Borrowing costs Related party disclosures Accounting and reporting by retirement benefit plans Separate financial statements Investments in associates and joint ventures Financial reporting in hyperinflationary economies Financial instruments: presentation Earnings per share Interim financial reporting Impairment of assets Provisions, contingent liabilities and contingent assets Intangible assets Financial instruments: recognition and measurement Investment property Agriculture
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Hong Kong Accounting Standards HKFRS 1 (revised) HKFRS 2 HKFRS 3 (revised) HKFRS 4 * HKFRS 5 HKFRS 6 * HKFRS 7 HKFRS 8 HKFRS 9 HKFRS 10 HKFRS 11 HKFRS 12 HKFRS 13 HKFRS for PEs First-time adoption of Hong Kong Financial Reporting Standards Share-based payment Business combinations Insurance contracts Non-current assets held for sale and discontinued operations Exploration for and evaluation of mineral resources Financial instruments: disclosures Operating segments Financial instruments Consolidated financial statements Joint arrangements Disclosure of interests in other entities Fair value measurement HKFRS for Private Entities
* These standards are not examinable at the examination. You need to keep yourself up to date with Hong Kong Accounting Standards as they are issued or reviewed. HKICPA operate a cut-off date for the standards and legislation to be applied in the examination. Various Exposure Drafts and Discussion Papers are currently at different stages within the HKFRS process, and by the end of your financial reporting studies, you will know all the Standards, Exposure Drafts and Discussion Papers.
3.3 Scope of HKFRSs

Any limitation of the applicability of a specific HKFRS is made clear within that standard. HKFRSs are not intended to be applied to immaterial items, nor are they retrospective. Each individual HKFRS lays out its scope at the beginning of the standard.
3.4 Accounting standards and choice

It is sometimes argued that companies should be given a choice in matters of financial reporting on the grounds that accounting standards are detrimental to the quality of such reporting. There are arguments on both sides.
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Financial Reporting
In favour of accounting standards (both national and international), the following points can be made: (a) (b) (c) (d) (e) They reduce or eliminate confusing variations in the methods used to prepare accounts. They provide a focal point for debate and discussions about accounting practice. They oblige companies to disclose the accounting policies used in the preparation of accounts. They are a less rigid alternative to enforcing conformity by means of legislation. They have obliged companies to disclose more accounting information than they would otherwise have done if accounting standards did not exist, for example HKAS 33 Earnings Per Share.
Many companies are reluctant to disclose information which is not required by national legislation. However, the following arguments may be put forward against standardisation and in favour of choice: (a) A set of rules which give backing to one method of preparing accounts might be inappropriate in some circumstances. For example, HKAS 16 on depreciation is inappropriate for investment properties (properties not occupied by the entity but held solely for investment), which are covered by HKAS 40 on investment property. Standards may be subject to lobbying or government pressure (in the case of national standards). For example, in the USA, the accounting standard FAS 19 on the accounts of oil and gas companies led to a powerful lobby of oil companies, which persuaded the SEC (Securities and Exchange Commission) to step in. FAS 19 was then suspended. Many national standards are not based on a conceptual framework of accounting, although HKFRSs are. There may be a trend towards rigidity, and away from flexibility in applying the rules.
(b)
(c) (d)
You should be able to discuss: Due process of the HKICPA Use and application of HKFRSs Future work of the HKICPA
One of the competences you are required to demonstrate is to recognise and apply the external legal and professional framework and regulations to financial reporting. The information in this chapter will give you knowledge to help you demonstrate this competence.
4 HK(IFRIC) Interpretations, Hong Kong Interpretations and HK(SIC) Interpretations

4.1 Framework for the Preparation and Presentation of Financial Statements (the Framework)
The Framework sets out the concepts underlying the preparation and presentation of financial statements for external users. Its objectives are to: (a) (b) assist the Council in the development of future accounting standards and guidelines and in its review of existing accounting standards and guidelines; assist preparers of financial statements in applying accounting standards and guidelines and in dealing with topics that have yet to form the subject of an accounting standard or guideline;
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(c) (d) (e)
assist auditors in forming an opinion as to whether financial statements conform with accounting standards; assist users of financial statements in interpreting the information contained in financial statements prepared in conformity with accounting standards and guidelines; and provide those who are interested in the work of the Council with information about its approach to the formulation of accounting standards and guidelines.
4.2 Hong Kong Financial Reporting Standards

For the purpose of this Learning Pack, the terms accounting standards, Standards and Interpretations, Hong Kong Accounting Standards and Hong Kong Financial Reporting Standards (HKFRSs) are used interchangeably and include all Hong Kong Financial Reporting Standards (HKFRSs), Hong Kong Accounting Standards (HKASs) and HKAS Interpretations (HKAS-Int) approved by Council and currently in issue unless otherwise specified. HKFRSs set out recognition, measurement, presentation and disclosure requirements dealing with transactions and events that are important in general purpose financial statements. HKFRSs are the most authoritative source of accounting principles generally accepted in Hong Kong (HK GAAP). Although HKFRSs do not have any statutory backing, their authority is ensured by the requirement of the Hong Kong Institute of CPAs that they should be observed by its members involved (either as preparers or as auditors) with financial statements intended to give a true and fair view, unless there are justifiable reasons for a departure in very exceptional circumstances. You will also see reference to HK(IFRIC)s. IFRICs are the publications of the International Financial Reporting Interpretations Committee. HK(IFRIC)s provide further guidance as to how HKFRSs should be applied.
4.3 Accounting Guidelines and implementation guidance

Accounting Guidelines (AGs) have effect as guidance statements and indicators of best practice. They are persuasive in intent. Unlike HKFRSs, AGs are not mandatory, but are consistent with the purpose of HKFRSs in that they help define accounting practice in the particular area or sector to which they refer. Therefore, they should normally be followed, and members of the Hong Kong Institute of CPAs should be prepared to explain departures if called upon to do so. Many AGs issued previously have already been superseded with the publication of a new HKFRS which addresses and sets out mandatory practice in relation to accounting issues which were previously the subject of an AG. The AGs in issue as at 28 June 2011 are: AG 1 Preparation and Presentation of Accounts from Incomplete Records AG 5 Merger Accounting for Common Control Combinations AG 7 Preparation of Pro Forma Financial Information for Inclusion in Investment Circulars In a number of HKFRSs, eg HKAS 39, guidance on implementing the standard is included, either with the standard or in a separate document. The Preface to Hong Kong Financial Reporting Standards has not clarified the status of this guidance. For the purpose of this Learning Pack, this implementation guidance is considered as having the same status as the accounting guidelines. (Implementation guidance is not the same as application guidance, which is often an integral part of the HKFRS.)
4.4 Accounting Bulletins

Accounting Bulletins (ABs) are informative publications on subjects of topical interest and are intended to assist members or to stimulate debate on important accounting issues. They do not require the approval of the Council of the Hong Kong Institute of CPAs and they do not have the same authority as either HKFRSs or AGs.
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There are currently three ABs in issue: AB 1 Disclosure of Loans to Officers AB 3 Guidance on Disclosure of Directors' Remuneration AB 4 Guidance on the Determination of Realised Profits and Losses in the Context of Distribution under the Hong Kong Companies Ordinance
5 Additional requirements for listed companies

Topic highlights
The SEHK requires listed companies to comply with its listing rules.
5.1 Companies listed on the Main Board

The disclosure requirements for companies listed on the Main Board, both in respect of annual financial reporting and interim financial reporting, are set out in the Appendix 16 of the Listing Rules. Companies listed on the Main Board are required to send their annual reports and audited financial statements to every member and other holders of their listed securities within three months after the end of the reporting period, and not less than 21 days before the date of the annual general meeting. Note that the three-month limit for the release of the annual report relates to annual accounting periods ending on or after 31 December 2010. Prior to that the limit was four months. The Listing Rules require certain financial information disclosures, other than those required by HKFRSs or the Companies Ordinance, which are normally presented in the notes to financial statements. These disclosures include: Analysis of the maturity profile of borrowings Analysis of directors' remuneration by emolument bands; analysis of employees' emoluments by emolument bands; pension schemes Credit policy and aged analysis of accounts receivable; and aged analysis of accounts payable
An entity which either meets the definition of a Financial Conglomerate or a Banking Company is subject to some additional disclosure requirements under the Listing Rules. The Main Board requirement for paid announcements was abolished on 25 June 2007. Main Board issuers are required to publish their announcements on their own website as well as the HKEx website. Any Main Board issuer that does not have its own website will be in breach of the Listing Rules.
5.1.1 Interim reports

A company listed on the Main Board is required to issue an interim report for the first six months of a financial year. This report must be published not later than two months after the end of that interim period. Note that the time limit applies to half-year accounting periods ending on or after 30 June 2010. Prior to that the limit was three months. Interim reports should contain the following financial information: Income statement or statement of comprehensive income. Balance sheet (statement of financial position).
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Cash flow statement (statement of cash flows). A statement of movements in equity other than those arising from capital transactions with shareholders and distributions to shareholders. Comparative figures, accounting policies and other notes to the financial statements.
Interim reports should comply with the requirements of HKAS 34 Interim Financial Reporting, or for companies reporting under international financial reporting standards, IAS 34. The Listing Rules require that the interim reports should be reviewed by the entity's audit committee or, where such a committee has not been formed, by the external auditors.
5.2 Companies listed on GEM

The disclosure requirements for companies listed on the GEM, both in respect of annual financial reporting and interim financial reporting, are principally set out in Chapter 18 Financial Information of the GEM Rules. Companies listed on the GEM are subject to tighter reporting requirements. For example, they are required to publish annual reports within three months; and half-yearly reports and quarterly reports within 45 days after the end of each relevant financial period. The disclosure requirements for annual reporting under the GEM Rules are in many ways similar to the Listing Rules though there are some specific disclosures which are only applicable under the GEM Rules. For instance, companies listed on GEM are subject to the following additional disclosure requirements: (a) (b) (c) (d) A comparison of actual business progress with business objectives stated in listing documents (for a few reporting periods after the year of listing only). Extension of the disclosure of directors' emoluments by showing the amount of emoluments by director on an anonymous basis. The interests (if any) of the sponsor, and its directors, employees and associates, and of the interests of the management shareholders of the issuer. As regards the compliance with corporate governance disclosure, specification of work undertaken by the audit committee and number of meetings held, and so on.
For companies listed on GEM, the principal means of information dissemination on GEM is publication on the Internet website operated by the SEHK. Companies listed on GEM are not generally required to issue paid announcements in the press. A GEM issuer that does not have its own website will be in breach of the Listing Rules.
5.3 Acceptance of Mainland Accounting and Auditing Standards

In December 2010, the Hong Kong Stock Exchange issued its Consultation Conclusions on the Acceptance of Mainland Accounting and Auditing Standards and Mainland Audit Firms for Mainland Incorporated Companies Listed in Hong Kong. The amendments to the listing rules: allow Mainland incorporated issuers to prepare their financial statements using Mainland accounting standards; and allow Mainland audit firms vetted, nominated and endorsed by the Ministry of Finance of China and the China Securities Regulatory Commission to service these issuers using Mainland auditing standards.
Both Hong Kong Auditing Standards and Mainland Auditing Standards are allowed for Mainland Incorporated Companies Listed in Hong Kong. As a result of this change, it is expected that compliance costs will be reduced for Mainland companies listed in Hong Kong and market efficiency increased.
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Financial Reporting
6 Code of Ethics for Professional Accountants

Topic highlights
Members of the HKICPA are bound by its Code of Ethics. Certified public accountants in business owe certain legal duties towards their employers. Additionally, they have ethical duties towards the HKICPA. The Council of HKICPA requires members of the Institute (and therefore certified public accountants) to comply with the Code of Ethics for Professional Accountants (the Code). Apparent failures by certified public accountants to comply with the Code are liable to be enquired into by the appropriate committee established under the authority of the Institute, and disciplinary action may result. Disciplinary action may include an order that the name of the certified public accountant be removed from the Institute's membership register. The Code of Ethics is likely to be taken into account when the work of a certified public accountant is being considered in a court of law or in other contested situations.
6.1 Fundamental principles

All certified public accountants, whether in business or in public practice, are required to comply with the following fundamental principles: (a) Integrity: a certified public accountant should be straightforward and honest in all professional and business relationships. Integrity also implies fair dealing and truthfulness. In particular, Section 110 of the Code of Ethics requires that a certified accountant should not be associated with reports, returns, communications or other information where they believe that the information: (1) contains a materially false or misleading statement; (2) contains statements or information furnished recklessly; or (3) omits or obscures information required to be included where such omission or obscurity would be misleading. A certified public accountant should not be associated with such reports, returns, communications or other information unless the certified public accountant provides a modified report in respect of the above mentioned matters. (b) Objectivity: a certified public accountant should not allow bias, conflict of interest or undue influence of others to override professional or business judgments. In particular, Section 120 of the Code of Ethics requires that all certified public accountants should not compromise their professional or business judgment because of bias, conflict of interest or the undue influence of others. Relationships that bias or unduly influence the professional judgment of the certified public accountant should be avoided. A certified public accountant may be exposed to situations that may impair objectivity. It is, however, impracticable to define and prescribe all such situations. (c) Professional competence and due care: a certified public accountant has a continuing duty to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional service based on current developments in practice, legislation and techniques. A certified public accountant should act diligently and in accordance with applicable technical and professional standards when providing professional services. Confidentiality: a certified public accountant should respect the confidentiality of information acquired as a result of professional and business relationships and should not disclose any such information to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose. Confidential information acquired as a result of professional and business relationships should not be used for the personal advantage of the certified public accountant or third parties.
(d)
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(e)
Professional behaviour: a certified public accountant should comply with relevant laws and regulations and should avoid any action that discredits the profession.
Ethics in accounting is of utmost importance to accounting professionals and those who rely on their services. Accounting professionals know that people who use their services, especially decision makers using financial statements, expect them to be highly competent, reliable, and objective. Those who work in the field of accounting must not only be well qualified but must also possess a high degree of professional integrity. A professional's good reputation is one of his or her most important assets. There is a very fine line between acceptable accounting practice and management's deliberate misrepresentation in the financial statements. The financial statements must meet the following criteria: (a) (b) (c) Technical compliance: a transaction must be recorded in accordance with generally accepted accounting principles (GAAP). Economic substance: the resulting financial statements must represent the economic substance of the event that has occurred. Full disclosure and transparency: sufficient disclosure must be made so that the effects of transactions are transparent to the reader of the financial statements.
Accounting plays a critical function in society. It affects human behaviour especially when pay or compensation is impacted, and to deliberately mask the nature of accounting transactions could be deemed as unethical behaviour.
Example: Shepherd Co
The finance director of Shepherd Co, a CPA, has carried out the following actions in June 20X9: (a) (b) (c) employed his brother's cleaning company to clean Shepherd Co's offices every week used information that he acquired while at work to recommend to his sister that she buys shares in Shepherd Co's parent company approved the monthly management accounts of the company by signing his name, even though he had not looked at them.
Has the finance director contravened any of the fundamental principles of the Code of Ethics for Professional Accountants?
Solution
(a) (b) (c) contravenes the principle of objectivity contravenes the principle of confidentiality contravenes the principle of integrity
6.2 Obligation to comply with the Code of Ethics

Professional accountants have obligations to comply with the Code of Ethics. Compliance is monitored by employers and the HKICPA. Disciplinary actions may be taken by HKICPA for non-compliance with the Code of Ethics, including removal from the Institute's membership register.
6.3 Revision to Code of Ethics

The Code of Ethics for Professional Accountants (the Code) was revised in 2010 so as to maintain convergence with the revised Code of Ethics for Professional Accountants issued by the IESBA in 37
Financial Reporting
July 2009. The revisions clarify requirements for all professional accountants and significantly strengthen the independence requirements of auditors. The revised Code is effective from 1 January 2011. In addition to the IESBA Code, the Hong Kong Code contains additional local requirements in Part D, such as the Prevention of Bribery Ordinance. These form an integral part of the Code, and members should ensure that they are aware of the additional requirements and comply with them.
7 Conceptual framework and GAAP

Topic highlights
A conceptual framework is a statement of generally accepted theoretical principles which form the frame of reference for financial reporting. There are advantages and disadvantages to having a conceptual framework.
7.1 A conceptual framework

A conceptual framework is a statement of generally accepted theoretical principles which form the frame of reference for financial reporting. In other words, a conceptual framework will form the basis for determining which events should be accounted for, how they should be measured and how they should be communicated to the user. It is used to aid the development of new accounting standards and the evaluation of those already in existence, and although theoretical in nature, a conceptual framework for financial reporting has highly practical final aims. Where a conceptual framework does not exist, standards tend to be produced in a haphazard fashion, generally in response to an accounting issue that has arisen. Inconsistencies and contradictions may therefore appear and, in turn, ambiguity which affects the true and fair concept of reporting. This ad hoc approach is avoided where a framework exists, and the specific rules within standards are based on sound basic principles, so ensuring a consistency of approach. Another problem with the lack of a conceptual framework has become apparent in the USA. The large number of highly detailed standards produced by the Financial Accounting Standards Board (FASB) has created a financial reporting environment governed by specific rules rather than general principles. However, accounting scandals such as Enron in the US have exposed the weaknesses of this approach.
7.2 Advantages and disadvantages of a conceptual framework

Advantages (a) Standards do not have to be developed on a haphazard, reactive basis, concentrating resources on combating a problem that has been identified in practice, rather than developing a consistent suite of standards that cover all problems. The standard-setting process in many countries in the past has been subject to political interference, where interested parties have tried to influence the setting of standards in their favour. For example, pharmaceutical companies may argue for the costs of research and development to be capitalised in all situations, regardless of the likely recoverability of the cost. A standard-setter should be better able to stand firm against pressure, if standards can be seen to be deriving from a published conceptual framework. In the past, some standards seem to have concentrated on the income statement (the calculation of profit or loss), while others have concentrated on the statement of financial position (the valuation of net assets).
(b)
(c)
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Disadvantages (a) Financial statements are drawn up to serve the interests of a variety of user groups, and it is not clear that a single conceptual framework can be devised that will satisfy the information needs of all users. It can be argued that different accounting statements should be drawn up to achieve different purposes. For example inventory might be of most use when measured at marginal cost in a decision-making statement, and at full absorption cost in a financial reporting statement. The experience in countries that have issued conceptual frameworks is that little notice is taken of them by standard-setting bodies when deciding on new standards.
(b)
(c)
Prior to a review of the HKICPA's attempt to bring forth the conceptual framework, it is important to consider the generally accepted accounting principles (or practice) or GAAP.
7.3 Generally Accepted Accounting Principles (GAAP)

GAAP signifies all the rules, from whatever source, which govern accounting. In individual countries this is seen as a combination of: national company law national accounting standards local stock exchange requirements
Although the above sources form the basis for the GAAP of individual countries, the effects of other non-mandatory sources in a particular country are also included in the concept, such as: International Accounting Standards statutory requirements in other countries long-standing accounting practices in areas not subject to a standard
Unlike countries such as the USA, GAAP does not have any statutory dominance or meaning in many countries, such as the UK. The term, if mentioned in legislation, is only to a limited extent. There are different views of GAAP in different countries. One view, held in most of Europe, is that GAAP is a dynamic concept with accounting practices constantly changing in response to circumstances. The term applies to those practices which the accounting profession regards as permissible and legitimate in the circumstances in which it has been applied. However, not all the countries share the same view. In the USA, the equivalent of a 'true and fair view' is 'fair presentation in accordance with GAAP'. Generally Accepted Accounting Principles are viewed as having 'substantial authoritative support'. The adoption of accounting principles that do not have substantial authoritative support in the preparation of accounts is presumed to be misleading or inaccurate. The above leads to the effect that 'new' or 'different' accounting principles are not acceptable unless they have been adopted by the mainstream accounting profession, usually the standardsetting bodies and/or professional accountancy bodies. A conceptual framework for financial reporting can be defined as an attempt to codify existing GAAP in order to reappraise current accounting standards and to produce new standards.
7.3.1 Mandatory and advisory sources

In Hong Kong, there are both mandatory and advisory sources of generally accepted accounting principles (GAAP). Mandatory sources are the following: (a) Companies Ordinance. Legal requirements include maintenance of accounting records, content of financial statements, and audits of companies incorporated in Hong Kong.
39
Financial Reporting
(b)
Hong Kong Financial Reporting Standards (HKFRSs). The term HKFRSs includes both Standards (HKFRSs and HKASs) and Interpretations (HK(IFRIC)-Ints, HK(SIC)-Ints, and HK-Ints). (i) (ii) Standards and Interpretations are developed by the Financial Accounting Standards Committee of the Hong Kong Institute of Certified Public Accountants (HKICPA). Standards and Interpretations are virtually identical to their international equivalents (International Financial Reporting Standards) except for three Hong Kong Interpretations (HK-Ints) which have been developed locally by the HKICPA.
(c)
Listing Rules. The Stock Exchange of Hong Kong Limited (SEHK) has adopted rules governing the listing of securities on its Main Board (the Listing Rules) and on its Growth Enterprise Market (the GEM Rules). These include some accounting and disclosure requirements.
Other sources of GAAP Hong Kong Accounting Standard 8 Accounting Policies, Changes in Accounting Estimates and Errors (HKAS 8, which is identical to IAS 8) states: 10. In the absence of a HKFRS that specifically applies to a transaction, other event or condition, management shall use its judgment in developing and applying an accounting policy that results in information that is: (a) (b) relevant to the economic decision-making needs of users; and reliable, in that the financial statements: (i) (ii) (iii) (iv) (v) represent faithfully the financial position, financial performance and cash flows of the entity; reflect the economic substance of transactions, other events and conditions, and not merely the legal form; are neutral, ie free from bias; are prudent; and are complete in all material respects.
11. In making the judgment described in paragraph 10, management shall refer to, and consider the applicability of, the following sources in descending order: (a) (b) the requirements and guidance in HKFRS dealing with similar and related issues; and the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework.
12. In making the judgment described in paragraph 10, management may also consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards, other accounting literature* and accepted industry practices, to the extent that these do not conflict with the sources in paragraph 11. *In the context of Hong Kong, other accounting literature includes Accounting Guidelines and Accounting Bulletins. The Accounting Guidelines and Accounting Bulletins referred to in the footnote to paragraph 12 of HKAS 8 (above) are 'best practice' guidance documents that have been published by the HKICPA to assist its members in applying HKFRSs. Accounting Guidelines, and Industry Accounting Guidelines, are persuasive in intent and, while not mandatory, should normally be followed. Accounting Bulletins are intended to assist members of the HKICPA in dealing with accounting issues and to stimulate debate on subjects of topical interest. TechWatch is a monthly publication prepared by the HKICPA to alert HKICPA members to topics and issues that impact on accountants and their working environment. It is intended for general guidance only.
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7.3.2 GAAP for Small and Medium-sized Entities

The HKICPA released its own Small and Medium-sized Entity Financial Reporting Framework and Financial Reporting Standard (SME-FRF & FRS) in August 2005. The SME-FRF and FRS became effective for optional use by a qualifying entity's first financial statements that cover a period beginning on or after 1 January 2005. Entities that qualify include Hong Kong incorporated companies that meet certain legal requirements and overseas companies that have no public accountability, meet size requirements and where the owners agree to use the SME-FRF and FRS. Those entities which do not meet the criteria to use the SME-FRF and FRS may be able to use the HKFRS for Private Entities, issued in 2010. Both of these options are discussed in more detail in the next chapter.
8 The HKICPA's Framework

Topic highlights
The Framework provides the conceptual framework for the development of HKFRSs / HKASs. In June 1997 the HKICPA produced a document, Framework for the Preparation and Presentation of Financial Statements (the Framework). This is, in effect, the conceptual framework upon which all HKFRSs are based and hence which determines how financial statements are prepared and the information they contain. The Framework is currently being revised with the project taking place in several stages and Exposure Drafts being issued as each progress stage approaches completion. The first amendments to the Framework were issued in October 2010, and the HKICPA has decided to amend the Framework on a piecemeal basis, so the revised parts of the Framework sit alongside the old Framework. The Framework has been renamed Conceptual Framework for Financial Reporting. The revised Conceptual Framework for Financial Reporting consists of several sections or chapters, following on after a preface and introduction. These chapters are as follows. The objective of general purpose financial reporting (issued October 2010) The reporting entity (not yet issued) Qualitative characteristics of useful financial information (issued October 2010) The Framework (1997): The Remaining Text Underlying assumption The elements of financial statements Recognition of the elements of financial statements Measurement of the elements of financial statements Concepts of capital and capital maintenance
Much of the content of the chapters is also included in HKAS 1 (revised), and covered in Sections 10 to 12 of this chapter. As you read through them, think about the impact the Framework has had on HKFRSs, particularly the definitions.
8.1 Preface
Financial statements are prepared and presented for external users worldwide, and although they may appear similar, differences are caused by social, economic and legal circumstances. The HKICPA wishes to narrow these differences by harmonising all aspects of financial statements, including the regulations governing their accounting standards and their preparation and presentation.
41
Financial Reporting
The HKICPA believes that financial statements prepared for the purpose of providing information that is useful in making economic decisions meet the common needs of most users. The types of economic decisions for which financial statements are likely to be used include the following: Decisions to buy, hold or sell equity investments Assessment of management stewardship and accountability Assessment of the entity's ability to pay employees Assessment of the security of amounts lent to the entity Determination of taxation policies Determination of distributable profits and dividends Inclusion in national income statistics Regulations of the activities of entities
Any additional requirements imposed by national governments for their own purposes should not affect financial statements produced for the benefit of other users. The Framework recognises that financial statements can be prepared using a variety of models. Although the most common is based on historical cost and a nominal unit of currency (such as the Hong Kong dollar), the Framework can be applied to financial statements prepared under a range of models.
8.2 Introduction
The introduction to the Framework lays out the purpose, status and scope of the document. It then looks at different users of financial statements and their information needs.
8.3 Purpose and status

The introduction gives a list of the purposes of the Framework. (a) To give guidance to the Council of HKICPA in developing new financial reporting standards and reviewing existing standards. Accounting standards will be more consistent and logical if they are developed from an orderly set of concepts. To assist preparers of financial statements in applying HKFRSs. The concepts guide preparers in their broader fulfilment of GAAP. To assist auditors in forming an opinion as to whether financial statements conform with HKFRSs. An independent review by the auditor of the recognition and measurement decisions by preparers relating to revenues, expenses, assets and liabilities in the financial statements can be undertaken by reference to the details about primary elements. To assist users of financial statements in interpreting the information. The quality of disclosures can be judged by users against the list of qualitative characteristics. To provide those who are interested in the work of the Council with information about its approach to the formulation of HKFRSs. The process of communication between the Council of HKICPA and its constituents can be enhanced because the conceptual underpinnings of proposed accounting standards will be more apparent.
(b) (c)
(d) (e)
The Framework is not an HKFRS and so does not overrule any individual HKFRS. In a limited number of cases there may be a conflict between an HKFRS and the Framework; here, the HKFRS will prevail. The number of such cases will diminish over time as the Framework is used as a guide in the production of new HKFRS. The Framework itself will be revised occasionally depending on the experience of the HKICPA in using it.
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8.4 Scope
The Conceptual Framework deals with the following: (a) (b) (c) (d) The objective of financial reporting. The qualitative characteristics of useful information. The definition, recognition and measurement of the elements from which financial statements are constructed. Concepts of capital and capital maintenance.
The Framework is concerned with 'general purpose' financial statements (that is, a normal set of annual statements), but it can be applied to other types of accounts. A complete set of financial statements includes: (a) (b) (c) (d) a statement of financial position a statement of comprehensive income a statement of changes in financial position (eg a statement of cash flows) notes, other statements and explanatory material
Supplementary information may be included, but some items are not included in the financial statements themselves, namely commentaries and reports by the directors, the chairman, management and so on. All types of financial reporting entities are included whether commercial, industrial, business; public or private sector.
Key term
A reporting entity is an entity for which there are users who rely on the financial statements as their major source of financial information about the entity. (Framework)
CF.OB5
8.5 Users and their information needs

Users of financial statements include investors, employees, lenders, suppliers and other trade creditors, customers, government and their agencies and the public. The Conceptual Framework places particular emphasis on existing and potential investors, lenders and other creditors. It states that other users of financial statements may find general purpose financial statements useful, however those reports are not primarily directed towards those other groups.
Self-test question 1
What are the information needs of the users of financial information? Your answer should not be restricted to the groups of users identified by the Conceptual Framework as the primary users. (The answer is at the end of the chapter)
43
Financial Reporting
CF.OB2-12
8.6 The objective of financial statements

Topic highlights
The Framework states that: The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.
This section of the Framework was amended in September 2010. As a result of the amendments, there is a new emphasis on specific users of accounts, namely investors, potential investors, lenders and creditors. They require information which is useful in making decisions about buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit. The type of information required by investors, creditors and lenders is that which provides an indication of potential future net cash inflows. Such information includes that relating to: the resources of the entity claims against the entity how efficiently and effectively the management have used the entitys resources, protected the entitys resources from the unfavourable effects of factors such as price changes and ensured that the entity complies with applicable laws and regulations.
Most investors, creditors and lenders cannot require entities to provide information directly to them, and therefore rely on general purpose financial statements. Although such financial statements do include a large amount of information, the revised Conceptual Framework states that general purpose financial statements do not and they cannot provide all of the information that investors, lenders and other creditors need. Therefore, these users must also consider information from other sources, such as general economic conditions and expectations, political events and political climate, and industry and company outlooks. This section of the Conceptual Framework also clarifies that: general purpose financial statements are not designed to show the value of an entity, although information contained within them may aid a valuation the management of an entity need not rely on general purpose financial statements as they can obtain necessary financial information internally other parties such as regulators and members of the public may also find general purpose financial reports useful, however, these reports are not primarily directed to these groups.
8.7 Information about economic resources, claims and changes in resources and claims
General purpose financial reports provide information about the financial position of a reporting entity, which is information about: the entitys economic resources, and claims against the reporting entity.
Financial reports also provide information about the effects of transactions and other events that change a reporting entitys economic resources and claims. Both types of information provide useful input for decisions about providing resources to an entity.
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CF.OB13-14
8.7.1 Economic resources and claims

Information about the nature and amounts of a reporting entitys economic resources and claims can help users to identify the reporting entitys financial strengths and weaknesses. That information can help users to assess: the reporting entitys liquidity and solvency, its needs for additional financing, and how successful it is likely to be in obtaining that financing.
Information about priorities and payment requirements of existing claims helps users to predict how future cash flows will be distributed among those with a claim against the reporting entity.
CF.OB15-21
8.7.2 Changes in economic resources and claims

Changes in a reporting entitys economic resources and claims result from: (a) (b) an entitys financial performance, and other events or transactions such as issuing debt or equity instruments.
To properly assess the prospects for future cash flows from the reporting entity, users need to be able to distinguish between both of these changes.
8.8 The Reporting Entity

This section of the Conceptual Framework has not yet been issued. An Exposure Draft was issued in 2010 in which a reporting entity is defined as follows: A reporting entity is a circumscribed area of economic activities whose financial information has the potential to be useful to existing and potential equity investors, lenders, and other creditors who cannot directly obtain the information they need in making decisions about providing resources to the entity and in assessing whether the management and the governing board of that entity have made efficient and effective use of the resources provided. A reporting entity has three features: (a) (b) (c) Economic activities of an entity are being conducted, have been conducted, or will be conducted Those economic activities can be objectively distinguished from those of other entities and from the economic environment in which the entity exists Financial information about the economic activities of that entity has the potential to be useful in making decisions about providing resources to the entity and in assessing whether the management and the governing board have made efficient and effective use of the resources provided.
These features are necessary but not always sufficient to identify a reporting entity. At the time of writing, this section of the Conceptual Framework is due to be re-deliberated, and a final chapter is unlikely to be issued in the very near future.
9 Qualitative characteristics of financial information

Topic highlights
The Conceptual Framework states that qualitative characteristics are the attributes that make the information provided in financial statements useful to existing and potential investors, lenders and creditors. The two fundamental qualitative characteristics are relevance and faithful representation. These are supported by four enhancing qualitative characteristics of comparability, verifiability, timeliness and understandability.
45
Financial Reporting
This section of the Conceptual Framework was revised in September 2010 and as a result, two fundamental and four enhancing qualitative characteristics replace the previous qualitative characteristics of relevance, reliability, comparability and understandability. The two fundamental qualitative characteristics are relevance and faithful representation; the four enhancing characteristics are comparability, verifiability, timeliness and understandability. If financial information is to be useful, it must be relevant and faithfully represents what it purports to represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable. The revised Framework states that the qualitative characteristics of useful financial information apply not only to financial information provided in financial statements, but also to financial information provided in other ways.
CF.QC5-16
9.1 Fundamental qualitative characteristics

The fundamental qualitative characteristics are relevance and faithful representation.
9.1.1 Relevance
Relevant financial information is capable of making a difference in the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or are already aware of it from other sources. Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value or both. Financial information has a confirmatory value if it confirms or changes previous evaluations. Materiality Materiality is related to relevance. Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. Materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entitys financial report. It is impossible to specify a quantitative threshold for materiality or predetermine what could be material in a particular situation as it depends on the individual entity.
9.1.2 Faithful representation

To be useful, in addition to being relevant, financial information must also faithfully represent the phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have three characteristics - it would be complete, neutral and free from error. Faithful representation does not mean accurate in all respects. Information that is complete means all necessary information is included for the user to understand the item being depicted. Neutral information is prepared without bias in the selection or presentation of the information. Free from error means there are no errors or omissions in the description of the item, and the process used to produce the reported information has been selected and applied with no errors in the process.
CF.QC17-18
9.1.3 Application of the fundamental qualitative characteristics

Useful information must be both relevant and faithfully represented; neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users to make good decisions. The most efficient and effective process for applying the fundamental qualitative characteristics would usually be as follows: (a) (b) Identify an economic phenomenon that has the potential to be useful to users of an entitys financial information Identify the type of information about that phenomenon that would be most relevant, if available and can be faithfully represented
46
(c) (d)
Determine whether that information is available and can be faithfully represented If so, the process of satisfying the fundamental qualitative characteristics ends; if not, the process is repeated with the next most relevant type of information.
CF.QC19-32
9.2 Enhancing qualitative characteristics

Comparability, verifiability, timeliness and understandability are qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented.
9.2.1 Comparability
Users decisions involve choosing between alternatives, for example, selling or holding an investment, or investing in one reporting entity or another. Consequently, information about a reporting entity is more useful if it can be compared with similar information about other entities and with similar information about the same entity for another period or another date. Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. Unlike the other qualitative characteristics, comparability does not relate to a single item. A comparison requires at least two items. Consistency, although related to comparability, is not the same. Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal.
9.2.2 Verifiability
Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Verification can be direct or indirect. Direct verification means verifying an amount through direct observation, for example, by counting cash. Indirect verification means checking the inputs to a model, formula or other technique and recalculating the outputs using the same methodology.
9.2.3 Timeliness
Timeliness means having information available to decision-makers in time to be capable of influencing their decisions. Generally, the older the information is the less useful it is. However, some information may continue to be timely long after the end of a reporting period because, for example, some users may need to identify and assess trends.
9.2.4 Understandability
Classifying, characterising and presenting information clearly and concisely makes it understandable. Some transactions are inherently complex and cannot be made easy to understand. While excluding information about those transactions from financial reports might make the information in those financial reports easier to understand, this may mean that information would be incomplete and therefore potentially misleading. The revised Conceptual Framework states that financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently. At times, even the well-informed, diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena.
47
Financial Reporting
CF.QC33-34
9.2.5 Application of the enhancing qualitative characteristics

Enhancing qualitative characteristics should be maximised to the extent possible. However, the enhancing qualitative characteristics, either individually or as a group, cannot make information useful if that information is irrelevant or not faithfully represented.
CF.QC35-39
9.3 The cost constraint on useful financial reporting

Cost is a constraint on the information that can be provided by financial reporting. Reporting financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information. There are several types of costs and benefits to consider. Providers of financial information expend most of the effort involved in collecting, processing, verifying and disseminating financial information, but users ultimately bear those costs in the form of reduced returns. Users of financial information also incur costs of analysing and interpreting the information provided. If needed information is not provided, users incur additional costs to obtain that information elsewhere or to estimate it. Reporting financial information that is relevant and faithfully represents what it purports to represent helps users to make decisions with more confidence.
CF.4.1
9.4 Underlying assumption

The Conceptual Framework identifies going concern as an underlying assumption in preparing financial statements. The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed.
10 The elements of financial statements

Topic highlights
Transactions and other events are grouped together in broad classes according to their economic characteristics. These broad classes are the elements of financial statements: assets, liabilities, equity, income and expenses.
The Framework lays out these elements as follows:
A process of sub-classification then takes place for presentation in the financial statements, eg assets are classified by their nature or function in the business to show information in the best way for users to take economic decisions.
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CF.4.4
10.1 Financial position

The elements related to the measurement of financial position are assets, liabilities and equity.
Key terms
Asset. A resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity. Liability. A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Equity. The residual interest in the assets of the entity after deducting all its liabilities. (Framework) These definitions are important, but they do not cover the criteria for recognition of any of these items, which are discussed in the next section of this chapter. This means that the definitions may include items which would not actually be recognised in the statement of financial position because they fail to satisfy recognition criteria particularly, as we will see below, the probable flow of any economic benefit to or from the business. Whether an item satisfies any of the definitions above will depend on the substance and economic reality of the transaction, not merely its legal form. For example, consider finance leases (see Chapter 9).
CF.4.8-4.14
10.1.1 Assets
Key term
Future economic benefit. The potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. The potential may be a productive one that is part of the operating activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce cash outflows, such as when an alternative manufacturing process lowers the cost of production. (Framework) Assets are usually employed to produce goods or services for customers; customers will then pay for these and so contribute to the cash flow of the entity. The existence of an asset is not reliant on: physical form or legal ownership
Non-physical items such as patents are assets provided that they are controlled and provide probable future economic benefits; similarly nonowned items, such as machinery obtained under a finance lease are assets, provided that they are controlled and provide probable future economic benefits. Transactions or events in the past give rise to assets; those expected to occur in the future do not in themselves give rise to assets. For example, an intention to purchase a non-current asset does not, in itself, meet the definition of an asset.
CF.4.15-4.18
10.1.2 Liabilities
An essential characteristic of a liability is that the entity has a present obligation.
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Financial Reporting
Key term
Obligation. A duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise, however, from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. (Framework) It is important to distinguish between a present obligation and a future commitment. A management decision to purchase assets in the future does not, in itself, give rise to a present obligation. Settlement of a present obligation will involve the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party. This may be done in various ways, not just by payment of cash. Liabilities must arise from past transactions or events. In the case of, say, recognition of future rebates to customers based on annual purchases, the sale of goods in the past is the transaction that gives rise to the liability.
CF.4.19
10.1.3 Provisions
Some liabilities can be measured only with a degree of estimation for example payments to be made under existing warranties. These liabilities are known as provisions.
Key term
Provision. A present obligation which satisfies the rest of the definition of a liability, even if the amount of the obligation has to be estimated. (Framework)
Consider the following situations. In each case, do we have an asset or liability within the definitions given by the Framework? Give reasons for your answer. (a) (b) (c) Manu Co has purchased a patent for $20,000. The patent gives the company sole use of a particular manufacturing process which will save $3,000 a year for the next five years. Hirecar Co paid Michael Wood $10,000 to set up a car repair shop, on condition that priority treatment is given to cars from the company's fleet. Sellcar Co provides a warranty with every car sold. (The answer is at the end of the chapter)
CF.4.20-4.23
10.1.4 Equity
Equity is defined above as a residual, but it may be sub-classified in the statement of financial position. This is relevant to the decision-making needs of the users as it will indicate legal or other restrictions on the ability of the entity to distribute or otherwise apply its equity. Some reserves are required by statute or other law, eg for the future protection of creditors. The amount shown for equity depends on the measurement of assets and liabilities. It has nothing to do with the market value of the entity's shares.
CF.4.24-4.28
10.2 Performance
Profit is used as a measure of performance, or as a basis for other measures (eg earnings per share).
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It depends directly on the measurement of income and expenses, which in turn depend (in part) on the concepts of capital and capital maintenance adopted. The elements of income and expense are therefore defined.
Key terms
Income. Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Expenses. Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. (Framework)
Income and expenses can be presented in different ways in the statement of comprehensive income, to provide information relevant for economic decision-making. For example, distinguish between income and expenses which relate to continuing operations and those which do not. Items of income and expense can be distinguished from each other or combined with each other.
CF.4.29-4.32
10.2.1 Income
Both revenue and gains are included in the definition of income. Revenue arises in the course of ordinary activities of an entity and may be referred to by names including sales, fees, interest, dividends rent or royalties.
Key term
Gains. Increases in economic benefits. As such they are no different in nature from revenue. (Framework) Gains include those arising on the disposal of non-current assets. The definition of income also includes unrealised gains, for example, on revaluation of marketable securities.
CF.4.33-4.35
10.2.2 Expenses
As with income, the definition of expenses includes losses as well as those expenses that arise in the course of ordinary activities of an entity.
Key term
Losses. Decreases in economic benefits. As such they are no different in nature from other expenses. (Framework) Losses will include those arising on the disposal of non-current assets. The definition of expenses will also include unrealised losses, for example, exchange rate effects on borrowings.
10.3 Capital maintenance

Capital maintenance refers to the concept that profits can only be made when the capital of an organisation is restored to, or maintained at the level that it was at the start of an accounting period. The concept is commonly separated into two types: physical and financial capital maintenance.
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Financial Reporting
Under the physical capital maintenance concept, a profit is earned only when the operating capability of an organisation at the end of a period exceeds the operating capability at the start of the period. Under the financial capital maintenance concept, a profit is earned when the money value of net assets at the end of a period exceeds their money value at the start of the period.
CF.4.36
10.3.1 Capital maintenance adjustments

A revaluation gives rise to an increase or decrease in equity.
Key term
Revaluation. Restatement of assets and liabilities. (Framework)
These increases and decreases meet the definitions of income and expenses. They are not included in the statement of comprehensive income under certain concepts of capital maintenance, however, but rather in equity.
10.4 Section summary

Make sure you learn the important definitions. Financial position: Assets Liabilities Equity
Financial performance: Income Expenses
11 Recognition of the elements of financial statements

CF.4.37-4.39
Topic highlights
Items which meet the definition of assets or liabilities may still not be recognised in financial statements because they must also meet certain recognition criteria.
Key term
Recognition. The process of incorporating in the statement of financial position or statement of comprehensive income an item that meets the definition of an element and satisfies the following criteria for recognition: (a) It is probable that any future economic benefit associated with the item will flow to or from the entity. (b) The item has a cost or value that can be measured with reliability. Regard must be given to materiality (see above). (Framework)
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CF.4.40
11.1 Probability of future economic benefits

Probability here means the degree of uncertainty that the future economic benefits associated with an item will flow to or from the entity. This must be judged on the basis of the characteristics of the entity's environment and the evidence available when the financial statements are prepared.
CF.4.41-4.43
11.2 Reliability of measurement

The cost or value of an item, in many cases, must be estimated. The Framework states, however, that the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. Where no reasonable estimate can be made, the item should not be recognised, although its existence should be disclosed in the notes, or other explanatory material. Items may still qualify for recognition at a later date due to changes in circumstances or subsequent events.
CF.4.44-4.53
11.3 Recognition of items

We can summarise the recognition criteria for assets, liabilities, income and expenses, based on the definition of recognition given above. Statement of financial position An asset is recognised when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. A liability is recognised when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.
Statement of comprehensive income Income is recognised when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. An expense is recognised when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably.
12 Measurement of the elements of financial statements

CF.4.54-4.56
Topic highlights
A number of different measurement bases are used in financial statements. They include: historical cost current cost realisable (settlement) value present value of future cash flows
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Financial Reporting
Key term
Measurement. The process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the statement of financial position and statement of comprehensive income. (Framework) This involves the selection of a particular basis of measurement. A number of these are used to different degrees and in varying combinations in financial statements. They include the following:
Key terms
Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. Current cost. 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 obligation currently. Realisable (settlement) value. Realisable value. The amount of cash or cash equivalents that could currently be obtained by selling an asset in an orderly disposal. Settlement value. The undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.
Present value. The present discounted value of the future net cash flows in the normal course of business. (Framework) Historical cost is the most commonly adopted measurement basis, but this is usually combined with other bases, eg inventory is carried at the lower of cost and net realisable value.
13 Fair presentation and compliance with HKFRS

HKAS 1.15,16,18-20
Topic highlights
Compliance with HKFRS is presumed to result in financial statements that achieve a fair presentation.
Most importantly, financial statements should present a true and fair view of the financial position, financial performance and cash flows of an entity. Compliance with HKFRS is presumed to result in financial statements that achieve a fair presentation and true and fair view. The following points made by HKAS 1 expand on this principle: (a) (b) (c) Financial statements should be prepared using the accrual basis, ie income and expenses are recognised as they arise rather than when the related cash is received or paid. Financial statements should be prepared on a going concern basis unless it is planned for the entity to cease trading. Compliance with HKFRS should be disclosed.
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(d) (e)
All relevant HKFRS must be followed if compliance with HKFRS is disclosed. Use of an inappropriate accounting treatment cannot be rectified either by disclosure of accounting policies or notes/explanatory material.
There may be (very rare) circumstances when management decides that compliance with a requirement of an HKFRS would be misleading. Departure from the HKFRS is therefore required to achieve a fair presentation. The following should be disclosed in such an event: (a) (b) (c) (d) Management confirmation that the financial statements fairly present the entity's financial position, performance and cash flows. Statement that all HKFRSs have been complied with except departure from one HKFRS to achieve a fair presentation. Details of the nature of the departure, why the HKFRS treatment would be misleading, and the treatment adopted. Financial impact of the departure.
This is usually referred to as the 'true and fair override'.

HKAS 1.17,23
13.1 Extreme case disclosures

In very rare circumstances, management may conclude that compliance with a requirement in a standard or interpretation may be so misleading that it would conflict with the objective of financial statements set out in the Framework, but the relevant regulatory framework prohibits departure from the requirements. In such cases the entity needs to reduce the perceived misleading aspects of compliance by disclosing: (a) (b) the title of the standard, the nature of the requirement and the reason why management has reached its conclusion. for each period, the adjustment to each item in the financial statements that would be necessary to achieve fair presentation.
HKAS 1 states what is required for a fair presentation. (a) (b) (c) Selection and application of accounting policies. Presentation of information in a manner which provides relevant, reliable, comparable and understandable information. Additional disclosures where required.
13.2 Break-up basis accounts

As noted above, financial statements should be prepared on a going concern basis unless it is planned (or expected) for the entity to cease trading. Where this is the case, the financial statements are prepared on the break-up basis. The following are characteristics of break-up basis financial statements: Non-current assets and long-term liabilities are reclassified as current assets and liabilities; Provisions are created in respect of anticipated further losses to be incurred to the date of termination of the business; Assets and liabilities are measured at net-realisable value.
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Financial Reporting
14 Management Commentary
A management commentary (known as management discussion and analysis in Hong Kong) is a narrative report that accompanies financial statements as part of an entity's financial reporting. It explains the main trends and factors underlying the development, performance and position of the entity's business during the period covered by the financial statements. It also explains the main trends and factors that are likely to affect the entity's future development, performance and position. An IFRS Practice Statement was issued on Management Commentary in December 2010. This is a broad, non-binding framework for the presentation of narrative reporting to accompany financial statements prepared in accordance with IFRS. The Practice Statement is not an IFRS. Therefore, entities applying IFRS are not required to comply with the Practice Statement, unless specifically required by their jurisdiction.
14.1 Purpose
The purpose of management commentary is to help investors to: (a) (b) (c) interpret and assess the related financial statements in the context of the environment in which the entity operates. assess what management views as the most important issues facing the entity and how it intends to manage those issues. assess the strategies adopted by the entity and the potential for those strategies to succeed.
14.2 Contents
A number of principles and qualitative characteristics should underlie the preparation and presentation of the management commentary. In particular, the management commentary should: supplement and complement financial statement information. provide an analysis of the entity through the eyes of management. have an orientation to the future. possess the fundamental characteristics of relevance and faithful representation and maximise the enhancing characteristics of comparability, verifiability, timeliness and understandability.
15 Current developments
15.1 Conceptual Framework
As we saw earlier in this chapter, the IASB and FASB have now completed the first phase of their joint project to develop a common Conceptual Framework for Financial Reporting. As a result, they have issued a Conceptual Framework which includes new chapters on the objective of financial statements and qualitative characteristics together with the remaining chapters from the old Framework. This revised Conceptual Framework has been adopted by the HKICPA. The remaining phases of the project relate to: Elements and recognition Measurement The Reporting Entity
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Presentation and Disclosure Purpose and Status of Framework Applicability to Not-For-Profit entities
At the time of writing, the timing of the last three phases has not yet been determined and deliberations will take place in the second half of 2011 with regard to the first two. As regards the Reporting Entity phase, an Exposure Draft was issued in March 2010, and as a result of the feedback received, deliberations are likely to continue for some time.
15.2 Other IASB Projects

The IASB is engaged in a number of ongoing projects. These are discussed in more detail in the relevant chapters of this Learning Pack.
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Topic recap
The main regulatory bodies influencing accounting within Hong Kong are the Hong Kong Institute of Certified Public Accountants (HKICPA), and for listed companies, the Hong Kong Stock Exchange (HKEx). Other bodies include the Securities and Future Commissions (SFC), Financial Reporting Council (FRC), the Hong Kong Insurance Authority (HKIA) and the Hong Kong Monetary Authority (HKMA). Companies Ordinance provides the legal requirements for companies. The Financial Reporting Standards Committee (FRSC) of the Hong Kong Institute of CPAs has a mandate to develop financial reporting standards to achieve convergence with the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). The SEHK requires listed companies to comply with its listing rules. Members of the HKICPA are bound by its Code of Ethics. A conceptual framework is a statement of generally accepted theoretical principles which form the frame of reference for financial reporting. There are advantages and disadvantages to having a conceptual framework. The Framework provides the conceptual framework for the development of HKFRSs / HKASs. The Framework states that: The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Going concern is the underlying assumption in preparing financial statements. The Framework states that qualitative characteristics are the attributes that make the information provided in financial statements useful to users. Transactions and other events are grouped together in broad classes according to their economic characteristics. These broad classes are the elements of financial statements: assets, liabilities, equity, income and expenses. Items which meet the definition of assets or liabilities may still not be recognised in financial statements because they must also meet certain recognition criteria. A number of different measurement bases are used in financial statements. They include: historical cost current cost realisable (settlement) value present value of future cash flows
Compliance with HKFRS is presumed to result in financial statements that achieve a fair presentation.
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Answers to self-test questions
Answer 1
(a) Investors are the providers of risk capital. (i) (ii) (iii) (iv) Information is required to help make a decision about buying or selling shares, taking up a rights issue and voting. Investors must have information about the level of dividend, past, present and future and any changes in share price. Investors will also need to know whether the management has been running the company efficiently. As well as the position indicated by the statement of comprehensive income, statement of financial position and earnings per share (EPS), investors will want to know about the liquidity position of the company, the company's future prospects, and how the company's shares compare with those of its competitors.
(b) (c)
Employees need information about the security of employment and future prospects for jobs in the company, and to help with collective pay bargaining. Lenders need information to help them decide whether to lend to a company. They will also need to check that the value of any security remains adequate, that the interest repayments are secure, that the cash is available for redemption at the appropriate time and that any financial restrictions (such as maximum debt/equity ratios) have not been breached. Suppliers need to know whether the company will be a good customer and pay its debts. Customers need to know whether the company will be able to continue producing and supplying goods. Government's interest in a company may be one of creditor or customer, as well as being specifically concerned with compliance with tax and company law, ability to pay tax and the general contribution of the company to the economy. The public at large would wish to have information for all the reasons mentioned above, but it could be suggested that it would be impossible to provide general purpose accounting information which was specifically designed for the needs of the public.
(d) (e) (f)
(g)
Answer 2
(a) (b) (c) This is an asset, albeit an intangible one. There is a past event, control and future economic benefit (through cost savings). This cannot be classified as an asset. Hirecar Co has no control over the car repair shop and it is difficult to argue that there are 'future economic benefits'. The warranty claims in total constitute a liability; the business has taken on an obligation. It would be recognised when the warranty is issued rather than when a claim is made.
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Financial Reporting
Exam practice
Accounting regulations and materiality

(a)
18 minutes
Explain the differences between the Hong Kong Financial Reporting Standards and the Accounting Guidelines issued by the Hong Kong Institute of Certified Public Accountants. (5 marks) Explain how materiality (and immateriality) is related to the relevance of the financial statements. (5 marks) (Total = 10 marks) HKICPA February 2008
(b)
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chapter 3
Small company reporting
Topic list
1 2 3 4 5 6 Background Financial Reporting in Hong Kong SME-FRF and SME-FRS Introduction to the HKFRS for Private Entities Contents of HKFRS for Private Entities Impact of the HKFRS for Private Entities
Learning focus
The HKFRS for Private Entities was issued in April 2010. It provides an option for non-publicly accountable entities which do not qualify for the SME-FRS to use simplified accounting and disclosure rules.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level LO2.03 Small and Medium-sized Entity Financial Reporting Framework and Financial Reporting Standard: 2.03.01 Identify the conditions under which an entity may adopt the SME Financial Reporting Framework and Financial Reporting Standard 2.03.02 Describe the requirements of the SME Financial Reporting Framework and Financial Reporting Standard LO2.04 Hong Kong Financial Reporting Standard for Private Entities 2.04.01 Identify the conditions under which an entity may adopt the HKFRS for Private Entities 2.04.02 Describe the requirements of the HKFRS for Private Entities 2 2
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3: Small company reporting | Part B Financial reporting framework
1 Background
Topic highlights
The SME-FRF and SME-FRS provide a framework for simplified reporting for smaller companies in Hong Kong. The HKFRS for Private Entities was issued in April 2010 and is based on the IASBs International Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs).
The objective of financial statements is to provide information about the financial position and performance of an entity that is useful to users of such information. Financial statements show the results of management's stewardship of, and accountability for, the resources entrusted to it. For small and medium-sized entities (SMEs), the most significant users are likely to be owners, government and creditors, who may have the power to obtain information additional to that contained in the financial statements. These users do not generally require the detailed disclosures required by full HKFRS, and indeed the preparing entities generally find the provision of such disclosures onerous in terms of the time and cost of preparation. In Hong Kong, there are therefore two options for simplified reporting for smaller, non-listed entities: 1 2 the SME-FRF and SME-FRS the new HKFRS for Private Entities.
This chapter considers each of these options, including who can use them and what simplifications are made compared to the use of full HKFRS.
2 Financial Reporting in Hong Kong

Topic highlights
Until recently, two financial reporting options existed in Hong Kong: the SME-FRS was applicable to most small and medium sized entities and full HKFRS to all others. The introduction of the HKFRS for Private Entities adds a third, middle tier, which can be adopted by unlisted entities.
2.1 Three financial reporting options

As a result of the introduction of the HKFRS for Private Entities, Hong Kong now has three financial reporting options: 1 2 3 The SME-FRF&FRS which can only be applied to certain unlisted entities (see section 3): The new HKFRS for Private Entities which can be applied by any private entity (see section 4.2) Full HKFRS which must be applied by publicly listed entities and may be applied by any private entity.
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The options available to each type of entity are summarised in the following table: Can apply: Non-listed companies which meet the criteria to use the SME-FRF&FRS SME-FRF&FRS HKFRS for Private Entities (meet the criteria to use HKFRS for Private Entities) Full HKFRS HKFRS for Private Entities (meet the criteria to use HKFRS for Private Entities) Full HKFRS Full HKFRS
Non-listed companies which do not meet the criteria to use the SME-FRF&FRS
Publicly listed companies
3 SME-FRF and SME-FRS

Topic highlights
SME-FRF sets out the conceptual basis and qualifying criteria for the preparation of financial statements in accordance with the Small and Medium-sized Entity Financial Reporting Standard (SME-FRS). SME-FRS sets out the recognition, measurement, presentation and disclosure requirements for an entity that prepares and presents the financial statements in accordance with the SME-FRS. Entities that qualify for reporting under the SME-FRF and preparing financial statements in accordance with the SME-FRS include: Hong Kong companies Companies applying Section 141D of the Companies Ordinance Overseas companies No public accountability An entity has public accountability for the purposes of the SME-FRF if: (1) at any time during the current or preceding reporting period, the entity (whether in the public or private sector) is an issuer of securities, that is, its equity or debt securities are publicly traded or it is in the process of issuing publicly traded equity or debt securities; the entity is an institution authorised under the Banking Ordinance; the entity is an insurer authorised under the Insurance Companies Ordinance; or the entity is a corporation which is granted a licence under the Securities and Futures Ordinance to carry on business in a regulated activity in Hong Kong.
(2) (3) (4)
Meet size test (any two of the following): annual revenue total assets employees <=HK$50 million <= HK$50 million <= 50 employees
For example, a company with a property valued at more than HK$50 million can still apply to use the SME-FRS if its annual revenue is less than HK$50 million and it has less than 50 employees. All owners agree to apply the SME-FRS. (A shareholder agreement should be signed every year.)
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For an entity that qualifies for reporting under the SME-FRF, the appropriate application of the SME-FRS, with additional disclosure when necessary, would result in financial statements that achieve a proper presentation appropriate for SMEs. For a company applying Section 141D of the Hong Kong Companies Ordinance, compliance with the SME-FRF and SME-FRS is necessary in order for financial statements to give a true and correct view. Sections 1 to 17 of SME-FRS set out detailed financial reporting requirements for entities reporting under SME-FRF and SME-FRS. You should refer to the original text of SME-FRF and SME-FRS when it is necessary.
4 Introduction to the HKFRS for Private Entities

On 30 April 2010, the HKICPA issued the HKFRS for Private Entities. This new standard became applicable immediately, and provided a new reporting option for those private companies which did not meet the criteria to use the SME-FRS&FRF and were therefore previously forced to apply full HKFRS. The standard is examinable in the 2011 exams.
4.1 Development of the HKFRS for Private Entities

The HKFRS for Private Entities is based on the International Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs), which was issued in July 2009. Despite its name, this IFRS for SMEs was developed by the IASB to apply to entities which are not publicly accountable and publish general purpose financial statements for external users, (rather than those which meet certain size definitions). Council considered that a variation of the IFRS for SMEs should be adopted in Hong Kong as a reporting option for eligible non-listed companies, and as a result issued the HKFRS for Private Entities.
4.1.1 Amendments made to the IFRS for SMEs in developing the HKFRS for Private Entities
The HKFRS for Private Entities is based on the IASBs IFRS for SMEs, however the following amendments are made to make the standard more relevant to Hong Kong: (a) The term SMEs is replaced by Private Entities The term SMEs is widely used in Hong Kong and associated with the locally developed SME-FRF&FRS. For clarity and differentiation, this HKFRS which is based on the IFRS for SMEs is called Hong Kong Financial Reporting Standard for Private Entities (HKFRS for Private Entities). (b) The recognition and measurement principles in section 29 Income Tax of the IFRS for SMEs is replaced by the extant version of HKAS 12 Income Taxes The Council considers that it is more appropriate to include the recognition and measurement principles contained in the extant version of HKAS 12 Income Taxes in the new HKFRS. The relevant disclosures contained in the IFRS for SMEs are, however, retained. (c) The measurement of deferred tax liabilities associated with an investment property measured at fair value is capped at the amount of tax that would be payable on its sale to an unrelated market participant at fair value at the end of the reporting period This amendment will restrict the amount of deferred taxation recognised in relation to revaluation gains of investment properties as such tax is in practice never paid in Hong Kong. This provision removes an anomaly currently in HKAS 12 Income Taxes.
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4.2 Eligibility to use the HKFRS for Private Entities

Council has approved the adoption of the HKFRS for Private Entities as a financial reporting option for companies that: (a) (b) do not have public accountability; and publish general purpose financial statements for external users.
4.2.1 Public accountability

An entity is defined as having public accountability (and so may not use the new standard) if: its debt or equity instruments are traded in a public market (or it is in the process of issuing its debt or equity instruments for trading in a public market), or it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses.
A public market means any domestic or foreign stock exchange market, or an over-the-counter market. In general, an entity that holds assets in a fiduciary capacity as one of its primary businesses may be a bank, insurance company, securities broker/dealer, mutual fund or investment bank. If an entity holds assets in a fiduciary capacity for a broad group of outsiders for reasons that are incidental to its primary business, it is not considered to have public accountability. Such entities may include schools, travel agents and charities.
4.2.2 General purpose financial statements

HKFRS are designed to apply to the general purpose financial statements of profit-oriented entities. General purpose financial statements are directed towards the common information needs of a wide range of users, for example, shareholders, creditors, employees and the public at large. The objective of financial statements is to provide information about the financial position, performance and cash flows of an entity that is useful to those users in making economic decisions.
4.2.3 Subsidiaries
A subsidiary of a group which applies full HKFRS may use the HKFRS for Private Entities provided that the subsidiary itself meets the eligibility criteria.
5 Contents of HKFRS for Private Entities

The HKFRS for Private Entities is a self-contained standard incorporating accounting principles that are based on full HKFRS, but which have been simplified to suit the private entities within its scope.
5.1 Overview
Topic highlights
The HKFRS for Private Entities is a self-contained standard incorporating accounting principles that are based on full HKFRS, but which have been simplified to suit the private entities within its scope.
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It includes simplifications that reflect the needs of users of private companies financial statements and the cost-benefit considerations of preparers. It facilitates financial reporting by unlisted entities by: simplifying requirements for recognition and measurement; eliminating topics and disclosure requirements that are not generally applicable to private entities; removing certain accounting treatments permitted under full HKFRS.
Note that entities are not permitted to mix and match the requirements of the HKFRS for Private Entities and full HKFRS, except for the option to apply the recognition and measurement rules of HKAS 39 (HKFRS 9) with regard to financial instruments. The HKFRS for Private Entities is effective immediately upon its issuance on 30 April 2010. Eligible entities are permitted to use HKFRS for Private Entities to prepare financial statements for prior period(s) where the relevant financial statements have not been finalised and approved.
5.1.1 Cost-benefit considerations

In order to provide additional relief to preparers of financial statements under the HKFRS for Private Entities, an undue cost or effort principle has been introduced in some sections of the standard to replace the impracticability relief criterion in the full HKFRS (a requirement is considered impracticable if an entity cannot apply it after making every reasonable effort to do so). Although the notion of undue cost or effort is not defined, it focuses on the concept of balancing costs and benefits, which might in turn require managements judgment of when a cost is considered excessive. In other words, the undue cost or effort principle implies that cost is always considered.
5.2 Simplified accounting

The HKFRS for Private Entities simplifies certain recognition and measurement principles in full HKFRS. The more useful simplifications are highlighted below: (a) (b) Research and development costs and borrowing costs must be expensed immediately. Financial instruments Financial instruments meeting specified criteria are measured at cost or amortised cost. All others are measured at fair value through profit or loss. In addition, a simplified principle is established for derecognition and hedge accounting requirements are simplified and tailored to private entities. (c) Property, plant and equipment and intangibles Only the cost model is allowed. There is no need to review residual value, useful life and depreciation method unless there is an indication that they have changed since the most recent reporting date. (d) Goodwill and other indefinite-life intangibles An impairment test is performed only if there are indications of impairment (rather than annually).Goodwill is measured at cost less accumulated amortisation and impairment losses. All intangible assets are considered to have a finite useful life. If a reliable estimate of goodwill or intangible assets cannot be made, it is presumed to be ten years. (e) Investments in associates and jointly-controlled entities The cost model, equity model and fair value model are permitted as an accounting policy choice that should be applied to the whole class of associates or jointly-controlled entities. An entity using the cost model must measure an investment for which there is a published price using the fair value model.
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(f)
Exchange differences An exchange difference that is recognised initially in other comprehensive income is not reclassified in profit or loss on disposal of the investment in a foreign subsidiary. This treatment is less burdensome than that required under full HKFRS because it eliminates the need for tracking exchange differences after initial recognition.
(g)
Non-current assets held for sale There is no separate held-for-sale classification; instead holding an asset or group of assets for sale is an indicator of impairment.
(h)
Equity-settled share-based payment If observable market prices are not available to measure the fair value of an equity-settled share-based payment, the directors' best estimate is used.
(i)
Defined benefit plans All actuarial gains and losses are recognised immediately (in profit or loss or other comprehensive income). All past service costs are to be recognised immediately in profit or loss. To measure the defined benefit obligation, the projected unit credit method should be used only if it can be applied without undue cost or effort.
(j)
Biological assets The cost-depreciation-impairment model is used unless the fair value is readily determinable without undue cost or effort. In this case, the fair value through profit or loss model should be applied.
(k)
Borrowing costs All borrowing costs are expensed immediately.
(l)
Government grants Government grants are recognised in income (at fair value) when the performance conditions are met.
(m)
Investment property If an entity can measure the fair value of an item of investment property reliably, without undue cost or effort, it must use fair value. Otherwise the cost model is applied.
5.3 Simplified presentation

In order to reduce costs for preparers, while still meeting the needs of users, the HKFRS for Private Entities has simplified financial statement presentation requirements as follows: An entity is not required to present a statement of financial position at the beginning of the earliest comparative period when the entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements as required under HKAS 1. An entity is permitted to present a single statement of income and retained earnings in place of separate statements of comprehensive income and changes in equity if the only changes to its equity during the periods for which financial statements are presented, arise from profit or loss, payment of dividends, corrections of prior period errors, and changes in accounting policy. All deferred tax assets and liabilities are classified as non-current assets or liabilities.
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5.4 Omitted topics

The HKFRS for Private Entities does not address the following topics that are covered in full HKFRS, because these topics are not generally considered to be relevant to private entities: Earnings per share Interim financial reporting Segment reporting Classification for non-current assets (or disposal groups) as held for sale
5.5 Examples of options in full HKFRS not included in the HKFRS for Private Entities
The HKFRS for Private Entities does not allow the following accounting treatments available under full HKFRS. This is generally because a simplified treatment is available instead (see Section 5.2 above): Treatment disallowed in HKFRS for Private Entities: Property, plant and equipment and intangible assets Borrowing costs Defined pension plans Financial instruments* Government grants Investment property Consolidation Revaluation model Capitalisation of borrowing costs Deferral of actuarial gains and losses Available-for-sale and held-to-maturity classifications are not available Various accounting options excluded Accounting policy choice Measurement of the non-controlling interest at fair value
* Note that entities are permitted to choose to apply HKAS 39 Financial Instruments: Recognition and Measurement in its entirety rather than the financial instruments section of the HKFRS for Private Entities.
5.6 Simplified disclosure

A number of disclosure requirements contained in full HKFRS have been omitted from the HKFRS for Private Entities, mainly because: They relate to topics covered in full HKFRS but omitted from the HKFRS for Private Entities. They relate to recognition and measurement principles contained in full HKFRS that have been replaced by simplifications. They relate to options in full HKFRS that are not included in the HKFRS for Private Entities. Some disclosures are not included on the basis of users needs or cost-benefit considerations.
Examples of simplified and reduced disclosure requirements include: There is no requirement to disclose the fair value of the carrying amount for property, plant and equipment and investment property. The vast majority of the disclosure requirements of HKFRS 7 Financial Instruments: Disclosures are not required. There is no requirement to disclose estimates used to measure the recoverable amount of cash generating units containing goodwill. 69
Financial Reporting
In relation to income taxes, entities are only required to provide an explanation of the significant differences in amounts reported in the statement of comprehensive income and amounts reported to tax authorities. In relation to investments in associates, the following disclosures are omitted: (a) (b) Summarised financial information relating to assets, liabilities, revenues and profit or loss. Share of contingent liabilities and the nature and extent of any significant restrictions on the ability of associates to transfer funds to the investor, if any.
5.7 Updates and amendments to the HKFRS for Private Entities

The HKICPA expects to undertake a review of HKFRS for Private Entities in accordance with the IASB timetable to review its IFRS for SMEs. The IASB expects to undertake a thorough review of user entities experience in applying IFRS for SMEs when two years of financial statements using the IFRS for SMEs have been prepared by a broad range of entities using the standard. At this time a review of users experiences will be conducted and amendments to the standard will be made to: 1 2 address any issues arising from this review, and consider new and amended full HKFRS issued since April 2010.
Beyond this, the HKICPA anticipate that the standard will be amended approximately once every three years, with proposed changes issued in one go within an omnibus Exposure Draft. Thus the number and frequency of amendments is reduced compared to those made to full HKFRS, and so the burden on companies to keep up to date is also reduced.
6 Impact of the HKFRS for Private Entities

Topic highlights
The HKFRS for Private Entities is likely to affect many companies, whether at an individual entity level, or subsidiaries in larger groups. Similar to full HKFRS, the HKFRS for Private Entities enables a true and fair view to be given on the financial statements.
6.1 Key concerns

A key area of concern for all businesses, especially individual companies in Hong Kong, is to ensure that the benefits of application of the HKFRS for Private Entities outweigh the costs associated with doing so. The principal issue is therefore to ensure that the financial costs of preparation do not increase and the needs of stakeholders are still met. The HKFRS addresses this concern, ensuring that financial statements are based on the same conceptual framework as full HKFRS, condensed and specifically tailored for private entities; and the burden of preparing financial statements in accordance with full HKFRSs is reduced.
6.2 Comparison with full HKFRSs

6.2.1 The omitted topics
The following topics have been completely omitted from the HKFRS for Private Entities (compare to full HKFRSs), because they are not expected to be relevant for majority of entities which meet the criteria of choosing HKFRS for Private Entities (PEs):
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(a) Earnings per share (b) Interim financial reporting (c) Segment reporting (d) Special accounting for assets held for sale
6.2.2 Not an option

The HKFRS for Private Entities does not include the following options, because it is considered that PEs will choose to follow the simpler options as they will generally be less costly, require less expertise and achieve greater comparability with their peers. If a PE feels strongly about using one or more of the complex options, it could elect to follow the full HKFRSs rather than the HKFRS for Private Entities. Property, plant and equipment The revaluation model is not an option. Property, plant and equipment carried at cost less accumulated depreciation and impairment.
Intangible assets The revaluation model is not an option. Intangible assets carried at cost less accumulated amortisation and impairment.
Borrowing costs The capitalisation model is not allowed. All borrowing costs should be expensed.
Jointly controlled entities No proportionate consolidation.
Government grants Various options excluded. Only single simplified method retained, that is, recognition in income (at fair value) when the performance conditions are met.
Investment property Measurement is driven by circumstances rather than allowing an accounting policy choice between the cost and fair value models.
Financial instruments Available-for-sale and held-to-maturity categories are not available.
Note: the above are just some of the differences between full HKFRSs and the HKFRS for Private Entities.
6.2.3 Considerations prior to adopting the HKFRS for Private Entities

Assuming the PEs meet the criteria of choosing HKFRS for Private Entities, how to select the reporting option for these PEs). The HKFRS for Private Entities aims to simplify and reduce the potentially ever-increasing reporting requirements of the full HKFRSs. However, in determining whether to adopt the HKFRS for Private Entities, management is advised to consider the facts and circumstances of the PE, including but not limited to the following matters:
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Financial Reporting
Must all PEs apply the HKFRS for Private Entities? No. The adoption of the HKFRS for Private Entities is an option for PEs. If compliance with the full HKFRSs is required, desired or preferred by a PE, the PE may continue using or adopt the full HKFRSs and need not adopt the HKFRS for Private Entities. Will the financial statements of a PE meet the needs of users? PEs will have to consider whether financial statements prepared under the HKFRS for Private Entities meet the needs of their own specific users. The financial statements of PEs generally are not widely circulated, and the needs of individual users of those financial statements tend to be specific, but not necessarily the same. The HKFRS for Private Entities is based on the same framework as the full HKFRSs. In developing the IFRS for SMEs, the IASB attempted to consider the needs of users of the financial statements of an SME. However, due to the specific needs of individual users, careful assessment will be needed by each SME to determine whether the IFRS for SMEs will meet their needs. The IFRS for SMEs concentrates on items such as short-term cash flows, liquidity, and balance sheet strength. The IASB concluded that the full IFRSs at times provided too much information for the needs of an SME user, while in other situations other needs were not being met by the full IFRSs. The HKICPA has held meetings with the Inland Revenue Department of the HKSAR Government and representatives of Hong Kong Association of Banks since the issuance of the IFRS for SMEs. Both parties acknowledged the standard setting role of the HKICPA and have no objection in principle to relieving PEs from complying with the full HKFRSs in the preparation of financial statements. Are there any long-term considerations that should be taken into account? The PEs long-term plans need to be considered; where such plans include becoming publicly accountable or a possible listing of debt or equity instruments, this could affect the choices made by the PE. A PE with such plans would be precluded from using the HKFRS for Private Entities in the future, as it would fail to meet the definition of a PE. This would then force the PE into a second conversion to the full HKFRSs. Another consideration is whether a PEs holding company reports (or will report) under the full HKFRSs. In such cases, it may be easier for that PE to also report under the full HKFRSs in order to facilitate the consolidation process in its parent company thereby avoiding the need for dual reporting.
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Topic recap
The HKFRS for Private Entities was issued in April 2010 and is based on the IASBs International Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs). Until recently, a two tier reporting system existed in Hong Kong: the SME-FRS was applicable to most small and medium sized entities and HKFRS to all others. The introduction of the HKFRS for Private Entities adds a third, middle tier, which can be adopted by unlisted entities. SME-FRF sets out the conceptual basis and qualifying criteria for the preparation of financial statements in accordance with the Small and Medium-sized Entity Financial Reporting Standard (SME-FRS). The HKFRS for Private Entities is a self-contained standard incorporating accounting principles that are based on full HKFRS, but which have been simplified to suit the private entities within its scope. The HKFRS for Private Entities is likely to affect many companies, whether at an individual entity level, or subsidiaries in larger groups. Similar to full HKFRS, the HKFRS for Private Entities enables a true and fair view to be given on the financial statements.
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Financial Reporting
Exam practice
HKFRS for Private Entities
45 minutes
Published in April 2010, the HKFRS for Private Entities has introduced new concepts and principles that are different from the full HKFRS and have simplified complexity without reducing the value of financial reporting by SMEs. The HKFRS for Private Entities simplifies accounting requirements by removing choices of accounting treatment, eliminating topics that are not generally relevant to private entities, simplifying methods for recognition and measurement and reducing the disclosure requirements of full HKFRS. Required (a) (b) Explain the advantages and disadvantages of unlisted entities adopting the HKFRS for Private Entities instead of using full HKFRS. (10 marks) Identify examples from full HKFRS where choice exists or there are complex recognition and measurement requirements. Explain how the HKFRS for Private Entities removes this choice or simplifies the recognition and measurement requirements. (13 marks) Appropriateness and quality of discussion (2 marks) (Total = 25 marks)
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Part C
Accounting for business transactions
The emphasis in this section is on an in-depth understanding of each accounting standard relating to transactions. The purpose of this section is to develop your knowledge about different accounting standards categorised into three areas: Statements of Financial Position and Comprehensive Income, Statement of Cash Flow, and Disclosure and Reporting. You should be able to identify and apply relevant accounting standards in resolving the accounting issues to be faced in the examination and the business world.
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Financial Reporting
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chapter 4
Non-current assets held for sale and discontinued operations

Topic list
1 2 3 4 5 HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations Classification of assets held for sale or for distribution to owners Measurement of assets held for sale Presentation of assets held for sale Discontinued operations
Learning focus
The measurement requirements for non-current assets and disposal groups held for sale are particularly important both for exam and practical purposes.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.21 3.21.01 Non-current assets held for sale and discontinued operations Define non-current assets (or disposal groups) held for sale or held for distribution to owners and discontinued operations within the scope of HKFRS 5 Explain what assets are within the measurement provision of HKFRS 5 Determine when a sale is highly probable Measure non-current assets held for sale and discontinued operations including initial measurement, subsequent measurement and change of plan How to account for impairment loss and subsequent reversals Present the non-current asset held for sale and discontinued operation in the financial statements (including the prior year restatement) 3
3.21.02 3.21.03 3.21.04
3.21.05 3.21.06
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4: Non-current assets held for sale and discontinued operations | Part C Accounting for business transactions
1 HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations

Topic highlights
HKFRS 5 requires assets and disposal groups 'held for sale' to be presented separately in the statement of financial position. The results of discontinued operations should be presented separately in the statement of comprehensive income.
HKFRS 5,Appendix A
1.1 Introduction and definitions

HKFRS 5 requires assets and groups of assets ('disposal groups') that are 'held for sale' to be presented separately in the statement of financial position. It also requires that the results of discontinued operations are presented separately in the statement of comprehensive income. These requirements ensure that users of financial statements are better able to make projections about the financial position, profits and cash flows of the entity.
Key terms
Disposal group. A group of assets to be disposed of, by sale or otherwise, together as a group in a single transaction, and liabilities directly associated with those assets that will be transferred in the transaction. (In practice, a disposal group could be a subsidiary, a cashgenerating unit or a single operation within an entity.) Discontinued operation. A component of an entity that either has been disposed of or is classified as held for sale and: (a) represents a separate major line of business or geographical area of operations (b) is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations or (c) is a subsidiary acquired exclusively with a view to resale. (HKFRS 5)
HKFRS 5.2,5,5A
1.2 Scope
The classification and presentation requirements of HKFRS 5 (Sections 2 and 4) apply to all recognised non-current assets and to all disposal groups. The measurement requirements of the HKFRS (Section 3) apply to all recognised non-current assets other than those listed below, which continue to be measured in accordance with the relevant HKFRS noted: (a) (b) (c) (d) (e) (f) Deferred tax assets (HKAS 12) Assets arising from employee benefits (HKAS 19) Financial assets (HKAS 39/HKFRS 9) Investment properties accounted for in accordance with the fair value model (HKAS 40) Agricultural and biological assets that are measured at fair value less costs to sell (HKAS 41) Insurance contracts (HKFRS 4)
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Financial Reporting
The measurement requirements of the standard also apply to all disposal groups and such a group may include any assets and liabilities including current assets, current liabilities and those assets listed above which are excluded from the scope of the standard on an individual basis. Where a non-current asset forms part of a disposal group, the measurement requirements of HKFRS 5 are applied to the group as a whole rather than to each asset within it on an individual basis. The classification, presentation and measurement requirements in this HKFRS applicable to a noncurrent asset (or disposal group) that is classified as held for sale apply also to a non-current asset (or disposal group) that is classified as held for distribution to owners acting in their capacity as owners (held for distribution to owners).
2 Classification of assets held for sale or for HKFRS 5.6,7 distribution to owners
Topic highlights
A non-current asset (or disposal group) should be classified as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continuing use. In order for this to be the case: (a) (b) the asset must be available for immediate sale in its present condition, and its sale must be highly probable (ie, significantly more likely than not).
HKFRS 5.8,8A,9,11
2.1 Highly probable sale

For an asset to qualify as being held for sale, the sale must be 'highly probable'. The following must apply: (a) (b) (c) (d) (e) Management must be committed to a plan to sell the asset. There must be an active programme to locate a buyer. The asset must be actively marketed for sale at a price that is reasonable in relation to its current fair value. The sale should be expected to take place within one year from the date of classification. It is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.
The probability of shareholders' approval (if required in the jurisdiction) should be considered as part of the assessment of whether the sale is highly probable. An entity that is committed to a sale plan involving loss of control of a subsidiary shall classify all the assets and liabilities of that subsidiary as held for sale when the criteria are met, regardless of whether the entity will retain a non-controlling interest in its former subsidiary after the sale. If an asset (or disposal group) is not sold within one year, it can still be classified as held for sale only when the delay has been caused by events or circumstances beyond the entity's control. The entity is required to produce sufficient evidence to show its commitment to sell the asset or disposal group, otherwise it must cease to classify the asset as held for resale. When a disposal group (eg, a subsidiary) is acquired solely with a view to its subsequent disposal, an entity is allowed to classify it as an asset held for sale only if the sale is expected to occur within a year and it is highly probable that all the criteria mentioned above will be satisfied within a short period (normally three months) after the acquisition of the disposal group.
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HKFRS 5.12A
2.2 Assets held for distribution to owners

A non-current asset (or disposal group) is classified as held for distribution to owners when the entity is committed to distribute the asset (or disposal group) to the owners. For this to be the case: the assets must be available for immediate distribution in their present condition, and the distribution must be highly probable.
In order for the distribution to be considered highly probable: 1. 2. actions to complete the distribution should have been initiated these actions should be expected to be completed within 12 months of the date of classification.
Actions required to complete the distribution should indicate that it is unlikely that significant changes to the distribution will be made or that the distribution will be withdrawn. The probability of shareholders approval (if required in the jurisdiction) should be considered as part of the assessment of whether the distribution is highly probable.
HKFRS 5.13
2.3 Assets to be abandoned

An asset that is to be abandoned should not be classified as held for sale. Since its carrying amount is to be recovered principally through continuing use rather than sale, it should not be classified as held for sale. However separate disclosure may be required (see Section 5 below) when a disposal group to be abandoned meets the definition of a discontinued operation.
Should the following be classified as held for sale at a 31 December 20X1 year end? (1) Lawnmo is committed to a plan to sell a manufacturing facility in its present condition and classifies the facility as held for sale at 31 March 20X1. After a firm purchase commitment is obtained, the buyers inspection of the property identifies environmental damage not previously known to exist. Lawnmo is required by the buyer to make good the damage, and this is likely to mean that the sale will not be completed until the end of August 20X2. Lawnmo has initiated actions to make good the damage, and satisfactory rectification of the damage is highly probable. Ficus is committed to a plan to sell its head office building and has engaged the services of an agent to locate a buyer. Ficus will use the building until the completion of its new premises, currently under construction. The existing head office will not be transferred to a buyer until such time as Ficus vacates the property. (The answer is at the end of the chapter)
(2)
3 Measurement of assets held for sale

HKFRS 5,Appendix A
Key terms
Fair value. The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Costs to sell. The incremental costs directly attributable to the disposal of an asset (or disposal group), excluding finance costs and income tax expense.
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Financial Reporting
Key terms (cont'd)

Recoverable amount. The higher of an asset's fair value less costs to sell and its value in use. Value in use. The present value of estimated future cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful life. (HKFRS 5)
HKFRS 5.15,15A
3.1 Initial measurement

On transfer to the held for sale category, a non-current asset (or the net assets of a disposal group) should be measured at the lower of carrying amount and fair value less costs to sell. An entity shall measure a non-current asset (or disposal group) classified as held for distribution to owners at the lower of its carrying amount and fair value less costs to distribute.
HKFRS 5.16
3.1.1 Carrying amount

HKFRS 5 clarifies that the carrying amount is that amount at which the asset or disposal group would have been included in the financial statements had the classification to the held for sale category not occurred. This carrying amount is measured in accordance with applicable HKFRSs.
HKFRS 5.17
3.1.2 Fair value less costs to sell

Fair value less costs to sell is equivalent to net realisable value. When the sale is expected to occur beyond one year, the standard specifies that costs to sell should be measured at present value. Any increase in the present value arising from the passage of time is recognised in profit or loss as a financing cost.
HKFRS 5.19,25
3.2 Subsequent measurement

Once classified as held for sale (or part of a disposal group held for sale), a non-current asset is not depreciated or amortised. Interest attributable to the liabilities of a disposal group does however continue to be recognised. On subsequent measurement of a disposal group, the carrying amount of those assets which are part of the disposal group but individually outside the scope of HKFRS 5 (see Section 1.2) should be re-measured in accordance with the relevant HKFRSs before the fair value less costs to sell of the disposal group is re-measured.
HKFRS 5.20
3.3 Impairment losses

Assets held for sale are outside the scope of HKAS 36 and the guidance on impairments provided within HKFRS 5 applies instead. Where fair value less costs to sell is lower than carrying amount, the asset or disposal group held for sale is impaired, and the difference between carrying amount and fair value less costs to sell must be recognised as an impairment loss.
Example: Tang Co
Tang Co has owned a printing machine for several years. The machine cost $400,000 and is being depreciated over a period of 10 years. At 1 October 20X8, the machine is carried in the statement of financial position at $280,000. On 31 March 20X9 the management of Tang Co decided to sell the machine and immediately instructed a specialist selling agency to market the machine. The current market value of such a machine is $270,000 and Tang Co has agreed to pay a 5 per cent commission to the specialist selling agency.
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At what value should the machine be included in the statement of financial position at 30 September 20X9, assuming that it has not yet been sold and that fair values remain unchanged since classification as held for sale?
Solution
At the date of transfer to held for sale the carrying amount was: $280,000 ($400,000/10 years 6/12) The fair value less costs to sell was: $270,000 95% = $256,500 = $260,000
On transfer to the held for sale category an impairment of $3,500 is recognised. Thereafter no depreciation is charged, meaning that the asset held for sale is included in the statement of position at 30 September 20X9 as a current asset carried at $256,500.
HKFRS 5.23
3.3.1 Impairment losses and disposal groups

An impairment loss recognised for a disposal group reduces the carrying amount of the non-current assets of the disposal group that are within the scope of HKFRS 5 in the following order: 1 2 Any goodwill within the disposal group Other assets on a pro rata basis.
Example: Random Co
Random Co makes the decision to dispose of a division of its business on 15 February 20X9 and immediately begins an active programme to find a buyer. The assets of this division make up a disposal group, and are measured as follows: Carrying amount at 15 February 20X9 $'000 Goodwill 450 Property, plant and equipment (revalued) 1,000 Property, plant and equipment (historic cost) 2,000 Inventory 1,300 Other current assets 900 Total 5,650 The fair value of the disposal group is $5.4 million and costs to sell are $290,000. An impairment loss is therefore recognised on transfer of the disposal group to held for sale of $540,000, and this is allocated to the non-current assets which fall within the scope of the measurement provisions of HKFRS 5. Therefore, no impairment loss is allocated to inventory or the other current assets. The loss is allocated in the first place to goodwill and thereafter to other non-current assets on a pro-rata basis:
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Financial Reporting
Goodwill Property, plant and equipment (revalued) Property, plant and equipment (historic cost) Inventory Other current assets Total
Carrying amount at 15 February 20X9 $'000 450 1,000 2,000 1,300 900 5,650
Impairment loss $'000 (450) (30) (60) 540
Carrying amount after allocation of impairment loss $'000 970 1,940 1,300 900 5,110
HKFRS 5.21
3.4 Reversal of impairment losses

Where an asset or disposal group held for sale is measured at fair value less costs to sell, any subsequent increase in fair value less costs to sell is recognised, however not in excess of cumulative impairment losses recognised in accordance with HKFRS 5 or HKAS 36.
HKFRS 5.27
3.5 Measurement where assets are no longer classified as held for sale
A non-current asset (or disposal group) that is no longer classified as held for sale (for example, because the sale has not taken place within one year) is measured at the lower of: (a) its carrying amount before it was classified as held for sale, adjusted for any depreciation, amortisation or revaluations that would have been charged had the asset not been classified as held for sale its recoverable amount at the date of the decision not to sell.
(b)
4 Presentation of assets held for sale

HKFRS 5.3840
4.1 Presentation of a non-current asset or disposal group classified as held for sale
Separate classifications are to be presented in the statement of financial position for non-current assets and disposal groups. Likewise separate disclosure is also required for the liabilities of a disposal group in the statement of financial position. (a) (b) Assets and liabilities held for sale should not be offset. The major classes of assets and liabilities held for sale should be separately disclosed either in the statement of financial position or in the notes.
If the disposal group is a newly acquired subsidiary that meets the criteria to be classified as held for sale on acquisition, disclosure of the major classes of assets and liabilities is not required. Re-presentation of prior year comparatives is not required to reflect those assets classified as held for sale only in the current year.
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Example: Colway Co
At the end of 20X9, Colway Co decides to dispose of a machine and Division D of its business. Division D is a disposal group. Both of these intended disposals meet the criteria to be classified as held for sale, and their carrying amount after this classification is: Machine Non-current assets of Division D Current assets of Division D Liabilities of Division D $'000 15 340 120 260
Presentation in the statement of financial position of Colway Co is therefore as follows: $'000 $'000 X X Non-current assets X X Current assets 475 X Non-current assets classified as held for sale X X Total assets Equity Non-current liabilities Current liabilities Liabilities associated with non-current assets classified as held for sale Total equity and liabilities X X X 260 X X X X X X
HKFRS 5.41,42
4.2 Additional disclosures

The following disclosures are required when a non-current asset (or disposal group) is either classified as held for sale or sold during a reporting period: (a) (b) (c) (d) A description of the non-current asset (or disposal group) A description of the facts and circumstances of the disposal Any gain or loss recognised when the item was classified as held for sale If applicable, the reportable segment in which the non-current asset (or disposal group) is presented in accordance with HKFRS 8 Operating Segments
When an entity reclassifies an asset as no longer held for sale, it should disclose the facts and circumstances leading to the decision and its resultant effect.
5 Discontinued operations
HKFRS 5.32
5.1 Definition of discontinued operations

A discontinued operation was defined at the start of this chapter as a component of an entity that has either been disposed of, or is classified as held for sale, and: (a) (b) (c) represents a separate major line of business or geographical area of operations is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations, or is a subsidiary acquired exclusively with a view to resale
A component of an entity comprises operations and cash flows that can be clearly distinguished from the rest of the entity, both operationally and for financial reporting purposes.
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Financial Reporting
HKFRS 5 requires that the results of a discontinued operation are disclosed separately in order to enable users of the financial statements to evaluate the financial effects of discontinued operations.
Discuss whether these situations meet the definition of discontinued operations in HKFRS 5. (i) Wong Co had used two factories to manufacture office equipment. A general slump in the economy has resulted in a reduced demand for such equipment and the company has decided to move all the production facilities to one of the factories but keep the now empty factory in the hope that there will be an upturn in demand and require the return to two factory output. In addition to the manufacture of office equipment, Wong Co supplied office stationery to private education establishments. In order to raise much needed cash the office stationery supply business was sold. The office stationery supply business was operated separately from the manufacturing activities. (The answer is at the end of the chapter)
(ii)
HKFRS 5.3335,37
5.2 Presentation of discontinued operations

An entity should disclose a single amount in the statement of comprehensive income comprising the total of: (a) (b) the post-tax profit or loss of discontinued operations and the post-tax gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of the assets or disposal group(s) constituting the discontinued operation.
An entity should also disclose an analysis of the above single amount into: (a) (b) (c) (d) the revenue, expenses and pre-tax profit or loss of discontinued operations the related income tax expense the gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of the assets or the discontinued operation the related income tax expense
The analysis may be shown separately from continuing operations, in a section identified as discontinued operations, in the statement of comprehensive income. As an alternative, it may also be presented in the notes to the financial statements. Such disclosure is not necessary where the discontinued operation relates to a newly acquired subsidiary that has been classified as held for sale. Disclosures relating to the net cash flows attributable to the operating, investing and financing activities of the discontinued operations may be presented on the face of the statement of cash flows. Alternatively they may be shown in the notes. The required disclosures must be re-presented for prior periods presented in the financial statements so that the disclosures relate to all operations that have been discontinued by the most recent reporting date. Any current year adjustments made to amounts previously presented in discontinued operations and directly related to the disposal of a discontinued operation in a prior period are classified separately in discontinued operations. The gains or losses arising from the reassessment of a disposal group, which is held for sale and is not a discontinued operation, should be incorporated in the profit or loss from continuing operations.
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Illustration
The following illustration is taken from the implementation guidance to HKFRS 5. Profit for the year from discontinued operations would be analysed in the notes.
Smart Group STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X9
20X9 $'000 Continuing operations Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Other expenses Finance costs Share of profit of associates Profit before tax Income tax expense Profit for the year from continuing operations Discontinued operations Profit for the year from discontinued operations Profit for the year Period attributable to: Owners of the parent Non-controlling interest X (X) X X (X) (X) (X) (X) X X (X) X X X X X X
20X8 $'000 X (X) X X (X) (X) (X) (X) X X (X) X X X X X X
The analysis of the profit from discontinued operations may also be presented in a separate column in the statement of comprehensive income.
A&Z STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X1 20X1 $'000 3,000 (1,000) 2,000 (400) (900) 700 (210) 490 40 530 20X0 $'000 2,200 (700) 1,500 (300) (800) 400 (120) 280 30 310
Revenue Cost of sales Gross profit Distribution costs Administrative expenses Profit before tax Income tax expense PROFIT FOR THE YEAR Other comprehensive income for the year, net of tax TOTAL COMPREHENSIVE INCOME FOR THE YEAR
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Financial Reporting
During the year the company ran down a material business operation with all activities ceasing on 26 December 20X1. The results of the operation for 20X0 and 20X1 were as follows: 20X1 $'000 320 (150) 170 (120) (100) (50) 15 (35) 5 (30) 20X0 $'000 400 (190) 210 (130) (90) (10) 3 (7) 4 (3)
Revenue Cost of sales Gross profit Distribution costs Administrative expenses Loss before tax Income tax expense LOSS FOR THE YEAR Other comprehensive income for the year, net of tax TOTAL COMPREHENSIVE INCOME FOR THE YEAR
The company recognised a loss of $30,000 on initial classification of the assets of the discontinued operation as held for sale, followed by a subsequent gain of $120,000 on their disposal in 20X1. These have been netted against administrative expenses. The income tax rate applicable to profits on continuing operations and tax savings on the discontinued operation's losses is 30%. Required Prepare the statement of comprehensive income for the year ended 31 December 20X1 for A&Z complying with the provisions of HKFRS 5. (The answer is at the end of the chapter)
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Topic recap
HKFRS 5 requires assets 'held for sale' to be presented separately in the statement of financial position. The results of discontinued operations should be presented separately in the statement of comprehensive income. A non-current asset (or disposal group) is classified as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continuing use. In order for this to be the case the asset must be available for immediate sale in its present condition, and its sale must be highly probable (ie, significantly more likely than not). On transfer to the held for sale category, a non-current asset (or the net assets of a disposal group) should be measured at the lower of carrying amount and fair value less costs to sell.
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Financial Reporting
Answer 1
(1) The manufacturing facility should be classified as held for sale. Although the sale will not be completed within 12 months of classification, the delay is caused by circumstances beyond Lawnmos control and Lawnmo is clearly committed to the sale. The building should not be classified as held for sale. The delay in transferring the building to a buyer demonstrates that it is not available for immediate sale. This is the case even if a firm purchase commitment were obtained.
(2)
Answer 2
(i) The closure of the factory does not result in the disposal of a separate major line of business or geographical area of operation nor is the factory being held for sale. The closure therefore does not appear to result in a need to classify any of the performance of Wong Co as discontinued in these circumstances. Nothing has been discontinued, merely production reduced to a more competitive level until demand returns. The office stationery supply business will probably be considered to represent a separate major line of business and should therefore be classified as a discontinued operation with separate disclosure of its activities in the income statement as required by HKFRS 5. Its disposal will probably have been a single co-ordinated plan, further confirming the business as a discontinued operation.
(ii)
Answer 3
A&Z STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X1 20X1 $'000 2,680 (850) 1,830 (280) (800) 750 (225) 525 (35) 490 40 530 20X0 $'000 1,800 (510) 1,290 (170) (710) 410 (123) 287 (7) 280 30 310
Revenue (3,000 320)/(2,200 400) Cost of sales (1,000 150)/(700 190) Gross profit Distribution costs (400 120)/(300 130) Administrative expenses (900 100)/(800 90) Profit before tax Income tax expense (210 + 15)/(120 + 3) Profit for the year from continuing operations Loss for the year from discontinued operations PROFIT FOR THE YEAR Other comprehensive income for the year, net of tax TOTAL COMPREHENSIVE INCOME FOR THE YEAR
90
Note: Discontinued operations During the year the company ran down a material business operation with all activities ceasing on 26 December 20X1. The results of the operation were as follows: 20X1 $'000 320 (150) 170 (120) (190) (140) 42 (98) 63 (35) 5 (30) 20X0 $'000 400 (190) 210 (130) (90) (10) 3 (7) (7) 4 (3)
Revenue Cost of sales Gross profit Distribution costs Administrative expenses (100 + 90) Loss before tax Income tax expense (15 + (90 30%)) Loss after tax Post-tax gain on remeasurement and subsequent disposal of assets classified as held for sale (90 70%) LOSS FOR THE YEAR Other comprehensive income for the year, net of tax TOTAL COMPREHENSIVE INCOME FOR THE YEAR
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Exam practice
Disposal Groups
22 minutes
Super Shoes Limited ('SS') is the holding company of Rocket Running Limited ('RR') and Soft Walking Limited ('SW'). At the board meeting of SS on 30 June 20X9, the management decided to dispose of all the assets of RR to an independent third party and close down the retailing operation of SW by the end of October 20X9. The assets of RR and SW as at 30 June 20X9 are measured in the consolidated financial statements before classification as held for sale and / or adjustment for impairment as a result of sales / closure of operation, if applicable, as follows: RR HK$000 2,400 12,500 48,300 16,600 4,500 8,000 92,300 SW HK$000 2,700 18,800 6,400 1,300 29,200
Goodwill Intangible assets Property, plant and equipment Inventories Trade receivables Financial assets held for trading TOTAL
Taking into consideration the range of the price offered by the potential buyer, the management estimates that the fair value less costs to sell of the group of assets of RR amounts to HK$85,000,000. Almost all of the property, plant and equipment of SW are leasehold improvement of retailing shops located at premises rented under operating leases which would be abandoned upon the early termination of the lease terms. No proceeds are expected to be received even upon disposal. SW would continue to sell its inventories but at an estimated discount of 40% of the cost. The trade receivables are expected to be fully recovered. Required Explain and calculate the impairment loss to be made to each of the assets of RR and SW. (12 marks) HKICPA February 2010
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chapter 5
Property, plant and equipment

Topic list
1 HKAS 16 Property, Plant and Equipment
Learning focus
Non-current assets form a large part of many entities' statements of financial position. Accounting for them is not necessarily straightforward and you may need to think critically and deal with controversial issues. This chapter deals with property, plant and equipment; how to account for transactions involving them, and the principles and methods of depreciation.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.08 3.08.01 3.08.02 3.08.03 3.08.04 3.08.05 3.08.06 3.08.07 3.08.08 Property, plant and equipment Identify the non-current assets which fall within or outside the scope of HKAS 16 State and apply the recognition rules in respect of property, plant and equipment Determine the initial measurement of property, plant and equipment, including assets acquired by exchange or transfer Determine the accounting treatment of subsequent expenditure on property, plant and equipment Determine the available methods to measure property, plant and equipment subsequent to initial recognition Account for the revaluation of property, plant and equipment Define 'useful life' and allocate an appropriate useful life for an asset in a straightforward scenario Explain the different methods of depreciation: straight line and diminishing balance, and calculate the depreciation amount in respect of different types of asset Account for the disposal of property, plant and equipment Disclose relevant information relating to property, plant and equipment in the financial statements 3
3.08.09 3.08.10
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5: Property, plant and equipment | Part C Accounting for business transactions
1 HKAS 16 Property, Plant and Equipment

Topic highlights
HKAS 16 covers all aspects of accounting for property, plant and equipment. This represents the bulk of items which are 'tangible' non-current assets.
HKAS 16.2,3
1.1 Scope
HKAS 16 should be followed when accounting for property, plant and equipment unless another accounting standard requires a different treatment. HKAS 16 does not apply to the following: (a) (b) (c) (d) Property, plant and equipment classified as held for sale in accordance with HKFRS 5 Biological assets related to agricultural activity The recognition and measurement of exploration and evaluation assets Mineral rights and mineral reserves, such as oil, gas and other non-regenerative resources.
However, the standard applies to property, plant and equipment used to develop the assets described in (b) and (d).
HKAS 16.6
1.2 Definitions
The standard gives a large number of definitions.
Key terms
Property, plant and equipment are tangible items that are: held for use in the production or supply of goods or services, for rental to others, or for administrative purposes expected to be used during more than one period
Cost is the amount of cash or cash equivalents paid or the fair value of other consideration given to acquire an asset at the time of its acquisition or construction. Residual value is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life. Entity specific value is the present value of the cash flows an entity expects to arise from the continuing use of an asset and from its disposal at the end of its useful life, or expects to incur when settling a liability. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Carrying amount is the amount at which an asset is recognised after deducting any accumulated depreciation and accumulated impairment losses. An impairment loss is the amount by which the carrying amount of an asset exceeds its recoverable amount. Recoverable amount is the higher of an asset's fair value less costs to sell and its value in use. (HKAS 16)
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HKAS 16.7
1.3 Recognition of non-current assets

An item of property, plant and equipment should be recognised in the statement of financial position as an asset when: (a) (b) It is probable that future economic benefits associated with the asset will flow to the entity. The cost of the asset to the entity can be measured reliably.
1.3.1 First criterion: Future economic benefits

The degree of certainty attached to the flow of future economic benefits must be assessed. This should be based on the evidence available at the date of initial recognition (usually the date of purchase). The entity should thus be assured that it will receive the rewards attached to the asset and it will incur the associated risks, which will only generally be the case when the rewards and risks have actually passed to the entity. Until then, the asset should not be recognised.
1.3.2 Second criterion: Cost measured reliably

It is generally easy to measure the cost of an asset as the transfer amount on purchase, ie what was paid for it. Self-constructed assets can also be measured easily by adding together the purchase price of all the constituent parts (labour, materials and so on) paid to external parties.
HKAS 16.8,9,11,13,14
1.3.3 Application to specific types of asset

Small separate assets Smaller items, such as tools, dies and moulds, are sometimes classified as consumables and written off as an expense. Where these are classified as property, plant and equipment, it is usual to aggregate similar items together and treat them as one. Major spare parts and stand-by equipment Major components or spare parts should be recognised as property, plant and equipment when they are expected to be used over more than one period, or where they can only be used in conjunction with an item of property, plant and equipment. Safety and environmental equipment When items of safety and environmental equipment are acquired they will qualify for recognition where they enable the entity to obtain future economic benefits from related assets in excess of those it would obtain otherwise. The recognition will only be to the extent that the carrying amount of the asset and related assets does not exceed the total recoverable amount of these assets. Complex assets For very large and specialised items, an apparently single asset should be broken down into its composite parts. This occurs where the different parts have different useful lives and different depreciation rates are applied to each part, eg an aircraft, where the body and engines are separated as they have different useful lives. Expenditure incurred in replacing or renewing a component of an item of property, plant and equipment must be recognised in the carrying amount of the item (and then depreciated to the next replacement date). Inspections and overhauls Certain assets require periodic overhauls or inspections in order to operate. The cost of these overhauls/inspections should be included in the carrying amount of the relevant asset and depreciated as a separate element of the asset to the date of the next overhaul/inspection.
HKAS 16.12
1.3.4 Subsequent expenditure

Subsequent expenditure on a non-current asset may be capitalised where the expenditure enhances the economic benefits of the asset beyond its current standard or performance. This may be achieved through extension of the asset's life, improved quality of output or an increased
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operating capacity. Day to day servicing costs, repairs and maintenance do not meet this criteria and therefore must be expensed to profit or loss.
1.4 Measurement
HKAS 16.1522
1.4.1 Initial measurement

Once an item of property, plant and equipment qualifies for recognition as an asset, it will initially be measured at cost. The standard lists the components of the cost of an item of property, plant and equipment. (a) (b) (c) Purchase price, less any trade discount or rebate Import duties and non-refundable purchase taxes Directly attributable costs of bringing the asset to working condition for its intended use, for example: (i) (ii) (iii) (iv) (v) (d) The cost of site preparation Initial delivery and handling costs Installation costs Testing Professional fees (architects, engineers)
Initial estimate of the unavoidable cost of dismantling and removing the asset and restoring the site on which it is located (HKAS 37 Provisions, Contingent Liabilities and Contingent Assets). Any borrowing costs incurred related to building the asset may be capitalised within the assets too (HKAS 23 Borrowing Costs).
(e)
Additional guidance is provided on directly attributable costs included in the cost of an item of property, plant and equipment. (a) These costs bring the asset to the location and working conditions necessary for it to be capable of operating in the manner intended by management, including those costs to test whether the asset is functioning properly. They are determined after deducting the net proceeds from selling any items produced when bringing the asset to its location and condition.
(b)
The standard also states that income and related expenses of operations that are incidental to the construction or development of an item of property, plant and equipment should be recognised in profit or loss. These include: costs of opening a new facility costs of introducing a new product or service costs of conducting business in a new location or with a new class of customer administration and other general overhead costs
In addition, the capitalisation of costs must cease when an asset is in the location and condition necessary for it to be capable of normal operation. Therefore, the following may not be capitalised: Costs incurred when an item is capable of normal use however is operating at less than full capacity Initial operating losses The costs of relocating or reorganising the entity's operations.
All of these will be recognised as an expense rather than an asset. In the case of self-constructed assets, the same principles are applied as for acquired assets. If the entity makes similar assets during the normal course of business for sale externally, then the
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cost of the asset will be the cost of its production under HKAS 2 Inventories. This also means that abnormal costs (wasted material, labour or other resources) are excluded from the cost of the asset. An example of a self-constructed asset is when a building company builds its own head office.
HKAS 16.24
1.4.2 Exchanges of assets

HKAS 16 specifies that exchange of items of property, plant and equipment, regardless of whether the assets are similar, are measured at fair value, unless the exchange transaction lacks commercial substance or the fair value of neither of the assets exchanged can be measured reliably. If the acquired item is not measured at fair value, its cost is measured at the carrying amount of the asset given up.
Example: Exchange of assets

A ship owner has properties with a carrying value of $10m. He is going to exchange his properties for a ship which has a market value of $20m by paying an additional sum of cash of $5m.
Solution
The ship owner shall capitalise the ship at a value of $20m. The properties are deemed to be disposed of at $15m ($20m $5m), thus a gain of $5m ($15m $10m) is recognised on disposal of the properties. Expressed as journal entries, we can see: $m DEBIT CREDIT Property, plant and equipment (Ship) Gain on disposal Property, plant and equipment (Properties) Cash 20 5 10 5 $m
HKAS 16.30,31
1.4.3 Measurement subsequent to initial recognition

HKAS 16 offers two possible treatments here, requiring you to choose between keeping an asset recorded at cost or revaluing it to fair value. (a) (b) Cost model. Carry the asset at its cost less any accumulated depreciation and any accumulated impairment losses. Revaluation model. Carry the asset at a revalued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. HKAS 16 makes clear that the revaluation model is available only if the fair value of the item can be measured reliably.
Depreciation, revaluation and impairment are discussed in more detail in the next three sections of the chapter.
1.5 Depreciation
Topic highlights
Where assets held by an entity have a limited useful life to that entity it is necessary to apportion the value of an asset over its useful life.
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With the exception of land held on freehold or very long leasehold, every non-current asset eventually wears out over time. Machines, cars and other vehicles, fixtures and fittings, and even buildings do not last for ever. When a business acquires a non-current asset, it will have some idea about how long its useful life will be, and it might decide what to do with it. (a) (b) Keep on using the non-current asset until it becomes completely worn out, useless, and worthless. Sell off the non-current asset at the end of its useful life, either by selling it as a second-hand item or as scrap.
Since a non-current asset has a cost, and a limited useful life, and its value eventually declines, it follows that a charge should be made in profit or loss to reflect the use that is made of the asset by the business. This charge is called depreciation. Depreciation must be charged even where an asset appears to be increasing in value over time. Other than assets classified as held for sale, to which HKFRS 5 applies, the only type of asset for which non-depreciation is permissible is freehold land.
Key terms
HKAS 16.6
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. Depreciable assets are assets which: are expected to be used during more than one accounting period have a limited useful life are held by an entity for use in the production or supply of goods and services, for rental to others, or for administrative purposes.
Useful life is one of two things. The period over which an asset is expected to be available for use by an entity. The number of production or similar units expected to be obtained from the asset by an entity.
Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value.
HKAS 16.48,50,55, 58,60
1.5.1 The mechanics of depreciation

The standard states: (a) (b) (c) The depreciable amount of an item of property, plant and equipment should be allocated on a systematic basis over its useful life. The depreciation method used should reflect the pattern in which the asset's economic benefits are consumed by the entity. The depreciation charge for each period should be recognised as an expense unless it is included in the carrying amount of another asset.
Land and buildings are dealt with separately even when they are acquired together because land use right normally is considered as a lease and accounted for in accordance with the requirements under HKAS 17. Buildings do have a limited life and must be depreciated. Any increase in the value of land on which a building is standing will have no impact on the determination of the building's useful life. Depreciation is usually treated as an expense, but not where it is absorbed by the entity in the process of producing other assets. For example, depreciation of plant and machinery can be
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Financial Reporting
incurred in the production of goods for sale (inventory items). In such circumstances, the depreciation is included in the cost of the new assets produced. Depreciation should commence when an asset is available for use. In other words it is in the location and condition necessary for ordinary use.
HKAS 16.56,57
1.5.2 Useful life

The useful life of a depreciable asset is estimated based on the following factors: Expected physical wear and tear Obsolescence Legal or other limits on the use of the assets
The judgment on useful life is based on the entity's past experience with similar assets or classes of assets. The task of estimating the useful life will be much more onerous when an entirely new type of asset is acquired (ie through technological advancement or through use in producing a brand new product or service). It is indicated in the standard that the useful life of an asset might be shorter than its physical life. The physical wear and tear the asset is likely to endure is one of the key factors that we need to look at. It is affected by circumstances such as the entity's repair and maintenance programme and number of shifts for which the asset will be used, and so on. Other factors such as obsolescence (due to technological advance, improvements in production, reduction in demand for the product or service produced by the asset) and legal restrictions, for example, the length of a related lease, also play a role in determining the useful life of an asset.
HKAS 16.53
1.5.3 Residual value

The residual value of an asset is likely to be immaterial in most instances. However, if the residual value is expected to be significant, it must then be estimated at the date of acquisition or at any subsequent revaluation. The residual value should be estimated based on the current situation with other similar assets, used in the same way, which are now at the end of their useful lives. Any future cost relating to the disposal should be netted off against the gross residual value.
HKAS 16.60,62
1.5.4 Depreciation methods

HKAS 16 requires the depreciation method used to reflect the pattern in which the asset's future economic benefits are expected to be consumed by the entity. A variety of methods are available and these include the straight line method, the diminishing balance method and the units of production method. Straight line depreciation results in a constant annual depreciation charge. This method simply spreads the depreciable amount evenly over the useful life. Diminishing balance depreciation results in a higher depreciation charge in the earlier years of an asset's useful life and a lower charge in later years. It is calculated as a constant percentage of an asset's carrying amount. The units of production method results in a charge based on expected output. The charge is therefore higher in periods of higher output and lower when there is a lower output. Consistency is important. The depreciation method selected should be applied consistently from period to period unless altered circumstances justify a change. When the method is changed, the effect should be quantified and disclosed and the reason for the change should be stated. Change of policy is not allowed simply because of the profitability situation of the entity.
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A computer system cost $20,000 and is being depreciated at 10 per cent using the diminishing balance method. How does this asset appear in the statement of financial position in the first and second year of ownership? Why is the diminishing balance method more appropriate for such an asset? (The answer is at the end of the chapter)
DSyne Co acquired an item of plant for $1.8m on 1 January 20X1. It identified that the asset had three major components as follows: Component 1 2 3 Useful life 15 years 5 years 10 years Cost $000 900 650 250
Under the terms of the 15-year license agreement for the use of the plant, component 1 (but not the other components) was to be dismantled at the end of the licence period. Dismantling costs were initially estimated at a total cost of $280,000 payable in 15 years time. DSynes discount rate appropriate to the risk specific to this liability is 7 per cent per annum. Component 1 developed a fault on 1 January 20X2 and had to be sold for scrap for $140,000. A replacement was purchased at a cost of $910,000 on 1 January 20X2, for use until the end of the license period, when dismantling costs on this component estimated at $250,000 would be payable. At a rate of 7 per cent per annum the present value of $1 payable in 15 years time is 0.3624 and of $1 payable in 14 years time is 0.3878. Required Calculate (a) (b) (c) the carrying amount of the machinery at 31 December 20X2 the profit/loss on the disposal of the faulty component the carrying amount of the machinery at 31 December 20X3 (The answer is at the end of the chapter)
HKAS 16.51
1.5.5 Review of useful life and residual value

A review of the useful life and residual value of property, plant and equipment should be carried out at least at each financial year end and the depreciation charge for the current and future periods should be adjusted if expectations have changed significantly from previous estimates. Changes to the useful life or residual value are treated as changes in accounting estimates and are accounted for prospectively as adjustments to future depreciation.
Example: Review of useful life

A machine costs $100,000 and has a useful life of 10 years since its acquisition in 20X7. At the end of the second year of use, the asset is assessed to have a remaining useful life of five years. The company adopts the straight line depreciation method. What will be the depreciation charge for 20X9?
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Solution
Original cost Depreciation 20X7 20X8 (100,000 2/10) Carrying amount at 1 January 20X9 Remaining life = 5 years Depreciation charge years 20X9 20Y3
$ 100,000 (20,000) 80,000
80,000 = $16,000 5
HKAS 16.61
1.5.6 Review of depreciation method

The depreciation method should also be reviewed at least at each financial year end and, if there has been a significant change in the expected pattern of economic benefits from those assets, the method should be changed to suit this changed pattern. When such a change in depreciation method takes place the change should be accounted for as a change in accounting estimate and the depreciation charge for the current and future periods should be adjusted.
Example: Review of depreciation method

Using the same data as above, assume that at the end of the second year the company changes from the straight line method to the diminishing balance method of depreciation, at a rate of 25 per cent per annum. The carrying amount of $80,000 is therefore written off from 20X9 onwards using the diminishing balance method over its remaining useful life. The depreciation charge for 20X9 is therefore $20,000 (25% $80,000).
HKAS 16.31
1.6 Revaluations
Where an entity chooses to apply the revaluation model to property, plant and equipment, the revalued assets are carried at a revalued amount less subsequent depreciation and impairment losses. Revalued amount is the fair value of the asset at the date of revaluation.
HKFRS 13.933,76,81,86
1.6.1 Fair value

HKFRS 13, issued in May 2011, amended the definition of fair value contained within HKAS 16 to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. HKFRS 13 also deleted the HKAS 16 guidance on establishing fair value and replaced this with a requirement to instead refer to the requirements of HKFRS 13 Fair Value Measurement. This standard requires that the following are considered in determining fair value: 1 2 The asset being measured The principal market (ie that where the most activity takes place) or where there is no principal market, the most advantageous market (ie that in which the best price could be achieved) in which an orderly transaction would take place for the asset The highest and best use of the asset and whether it is used on a standalone basis or in conjunction with other assets Assumptions that market participants would use when pricing the asset.
3 4
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Having considered these factors, HKFRS 13 provides a hierarchy of inputs for arriving at fair value. It requires that level 1 inputs are used where possible: Level 1 Level 2 Level 3 quoted prices in active markets for identical assets that the entity can access at the measurement date. inputs other than quoted prices that are directly or indirectly observable for the asset. unobservable inputs for the asset.
HKAS 16.34
1.6.2 Frequency of revaluations

Valuations must be kept up to date so that the carrying amount of a revalued asset does not differ materially from its fair value. In some cases annual revaluation is necessary, whereas in others it may be necessary to revalue the item only every three or five years.
HKAS 16.36,38
1.6.3 Consistency of revaluation

When an item of property, plant and equipment is revalued, the whole class of assets to which it belongs should be revalued. All items within a class should be revalued simultaneously. In this way, selective revaluation of certain assets and disclosure of a mixture of costs and values from different dates in the financial statements can be avoided. Entities are permitted to have revaluation on a rolling basis if the revaluations are kept up to date and the revaluation of the entire class is accomplished in a short period of time.
HKAS 16.39,40
1.6.4 Accounting for a revaluation

How should any increase in value be treated when a revaluation takes place? The debit will be the increase in value in the statement of financial position, but what about the credit? HKAS 16 requires the increase to be credited to other comprehensive income and accumulated in a revaluation surplus (ie part of owners' equity), unless the increase is reversing a previous decrease which was recognised as an expense. Where this is the case, the increase is recognised as income to the extent of the previous expense; any excess is then taken to the revaluation surplus. A decrease in value is recognised in the same way as an impairment loss (see Section 1.7 below).
Example: Revaluation
Paddington has acquired numerous buildings and accounts for these using the revaluation model. One particular piece of land is carried in Paddingtons statement of financial position at $560,000 at 1 January 20X1. At 31 December 20X1, further to a revaluation exercise, a fair value of $710,000 is identified in respect of this building. How is this revaluation accounted for assuming that (a) (b) The buildings have only ever risen in value Further to an economic downturn, at the time of the last revaluation exercise, an impairment of $80,000 was identified and recognised in profit.
Ignore depreciation.
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Solution
(a) The double entry is: DEBIT CREDIT (b) Buildings Other comprehensive income (revaluation surplus) $150,000 $150,000
The double entry is: DEBIT CREDIT Buildings Administrative expenses (profit or loss) Other comprehensive income (revaluation surplus) $150,000 $80,000 $70,000
Note. The line item for the credit to profit or loss is not specified in the standard, but it is generally made to the same account as any depreciation and other costs relating to the buildings.
The case is similar for a decrease in value on revaluation. Any decrease should be recognised as an expense, except where it offsets a previous increase taken as a revaluation surplus in owners' equity. Any decrease greater than the previous upwards increase in value must be taken as an expense in profit or loss.
Example: Revaluation decrease

Rupert Co acquired a building for an original cost of $3.5 million at the start of 20X1. It was revalued upwards to $3.8 million in January 20X3. The value has now fallen to $3 million at 31 December 20X3. How should the decrease in value be recorded at 31 December 20X3?
Solution
The double entry is: DEBIT CREDIT Other comprehensive income (revaluation surplus) Administrative expenses (profit or loss) Building $300,000 $500,000 $800,000
1.6.5 Depreciation of revalued assets

Where a depreciated asset is revalued, future depreciation is calculated based on the revalued amount. One effect of an upwards revaluation is therefore an increase to the depreciation charge. Normally, a revaluation surplus is only realised when the asset is sold, but when it is being depreciated, part of that surplus is being realised as the asset is used. The amount of the surplus realised is the difference between depreciation charged on the revalued amount and the (lower) depreciation which would have been charged on the asset's original cost. This amount can be transferred to retained (ie realised) earnings. This transfer is effected in the statement of changes in equity; it is not reflected in the statement of comprehensive income.
Example: Revaluation and depreciation

Roosevelt Co purchased a property on 1 January 20X1. Details are as follows:

Cost Useful life
$9million 50 years
On 1 January 20X6 the property was revalued to $8.5million, with the useful life unchanged. (a) (b) Account for the revaluation. Calculate depreciation for the year ended 31 December 20X6 and the amount that may be transferred to retained earnings from the revaluation surplus in that year.
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Solution
(a) On 1 January 20X6 the carrying value of the property is $9m (5 $9m 50) = $8.1m. For the revaluation: DEBIT CREDIT (b) Asset value Other comprehensive income (revaluation surplus) $400,000 $400,000
The depreciation for the year ended 31 December 20X6 will be $8.5m 45 = $188,889, compared to depreciation on cost of $9m 50 = $180,000. So each year, the extra $8,889 can be treated as part of the surplus which has become realised: DEBIT CREDIT Revaluation surplus Retained earnings $8,889 $8,889
This is a movement on owners' equity only, disclosed in the statement of changes in equity.
1.7 Impairment
An impairment loss should be treated in the same way as a revaluation decrease ie the decrease should be recognised as an expense. However, a revaluation decrease (or impairment loss) should be charged directly against any related revaluation surplus to the extent that the decrease does not exceed the amount held in the revaluation surplus in respect of that same asset. A reversal of an impairment loss should be treated in the same way as a revaluation increase, ie a revaluation increase should be recognised as income to the extent that it reverses a revaluation decrease or an impairment loss of the same asset previously recognised as an expense.
HKAS 16.68
1.8 Retirements and disposals

When an asset is permanently withdrawn from use, or sold or scrapped, and no future economic benefits are expected from its disposal, it should be withdrawn from the statement of financial position.
Gains or losses are the difference between the estimated net disposal proceeds and the carrying amount of the asset. They should be recognised as income or expense in profit or loss.
HKAS 16.67,68,68A
1.8.1 Derecognition
An entity is required to derecognise the carrying amount of an item of property, plant or equipment that it disposes of on the date the criteria for the sale of goods in HKAS 18 Revenue would be met. This also applies to parts of an asset. An entity cannot classify as revenue a gain it realises on the disposal of an item of property, plant and equipment. However, an entity that, in the course of its ordinary activities, routinely sells items of property, plant and equipment that it has held for rental to others shall transfer such assets to inventories at their carrying amount when they cease to be rented and become held for sale. The proceeds from the sale of such assets shall be recognised as revenue in accordance with HKAS 18 Revenue. HKFRS 5 does not apply when assets that are held for sale in the ordinary course of business are transferred to inventories.
Example: Derecognition
A property was purchased at a cost of $10m and has a useful life of 50 years. At the end of Year 20, the property was revalued to $30m and its useful life remains unchanged. The property was sold at the beginning of Year 22 for $33m.
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Financial Reporting
Solution
Accounting entries: At the end of Year 20, the following accounting entries reflect the revaluation: DEBIT CREDIT Property ($30m ( /50 $10m)) Revaluation surplus
30
$m 24
$m 24 $m 1.0 0.2 0.8
In Year 21, the following adjustments are to be made: Depreciation based on revalued amount ($30m x 1/30) Depreciation based on original cost ($10m x 1/50) Depreciation increase related to revaluation surplus is regarded as realised DEBIT CREDIT Revaluation surplus Retained profits 0.8
0.8
being realisation of part of revaluation reserve due to additional depreciation provided on revaluation surplus. In Year 22, the following adjustments are to be made: DEBIT CREDIT Bank (disposal proceeds) Accumulated depreciation Property Gain on disposal (in profit or loss) Revaluation reserve ($24m $0.8m) Retained profit $m 33 1 $m
30 4 23.2 23.2
being revalued property disposed of at a profit DEBIT CREDIT
being realisation of revaluation reserve upon disposal of asset. The following analysis shows that the distributable profits remain the same, whether the property is revalued or not: $m Without revaluation of the asset Cost 10.0 Less: Accumulated depreciation ($0.2 x 21 years) (4.2) Carrying amount 5.8 Disposal proceeds (33.0) Profit realised on disposal 27.2 $m
With revaluation of the asset Gain on disposal (as above) Revaluation surplus transferred to retained profits
4.0 23.2 27.2
A business purchased two rivet making machines on 1 January 20X5 at a cost of $15,000 each. Each had an estimated life of five years and a nil residual value. The straight line method of depreciation is used.
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Owing to an unforeseen slump in market demand for rivets, the business decided to reduce its output of rivets, and switch to making other products instead. On 31 March 20X7, one rivet making machine was sold (on credit) to a buyer for $8,000. Later in the year, however, it was decided to abandon production of rivets altogether, and the second machine was sold on 1 December 20X7 for $2,500 cash.
Required
Prepare the machinery account, provision for depreciation of machinery account and disposal of machinery account for the accounting year to 31 December 20X7.
(The answer is at the end of the chapter)
HKAS 16.73,74,77, 79
1.9 Disclosure
The standard has a long list of disclosure requirements, for each class of property, plant and equipment. (a) (b) (c) (d) (e)
Measurement bases for determining the gross carrying amount (if more than one, the gross carrying amount for that basis in each category). Depreciation methods used. Useful lives or depreciation rates used. Gross carrying amount and accumulated depreciation (aggregated with accumulated impairment losses) at the beginning and end of the period. Reconciliation of the carrying amount at the beginning and end of the period showing:
(i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (a) (b) (c) (d) (e)
Additions Disposals Acquisitions through business combinations (see Chapter 28) Increases/decreases during the period from revaluations and from impairment losses Impairment losses recognised in profit or loss Impairment losses reversed in profit or loss Depreciation Net exchange differences (from translation of statements of foreign entity) Any other movements.
The financial statements should also disclose the following: Any recoverable amounts of property, plant and equipment Existence and amounts of restrictions on title, and items pledged as security for liabilities Accounting policy for the estimated costs of restoring the site Amount of expenditures on account of items in the course of construction Amount of commitments to acquisitions
Revalued assets require further disclosures, in addition to those required by HKFRS 13 Fair Value Measurement:
(a) (b) (c) (d)
Basis used to revalue the assets Effective date of the revaluation Whether an independent valuer was involved Carrying amount of each class of property, plant and equipment that would have been included in the financial statements had the assets been carried at cost less accumulated depreciation and accumulated impairment losses Revaluation surplus, indicating the movement for the period and any restrictions on the distribution of the balance to shareholders
(e)
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Financial Reporting
The standard also encourages disclosure of additional information, which the users of financial statements may find useful. (a) (b) (c) (d) The carrying amount of temporarily idle property, plant and equipment The gross carrying amount of any fully depreciated property, plant and equipment that is still in use The carrying amount of property, plant and equipment retired from active use and held for disposal The fair value of property, plant and equipment when this is materially different from the carrying amount
The following format (with notional figures) is commonly used to disclose non-current assets movements: Land and Plant and buildings equipment Total $ $ $ Cost or valuation At 1 January 20X8 40,000 10,000 50,000 Revaluation surplus 12,000 12,000 Additions in year 4,000 4,000 Disposals in year (1,000) (1,000) At 31 December 20X8 52,000 13,000 65,000
Depreciation At 1 January 20X8 Charge for year Eliminated on disposals At 31 December 20X8 Carrying amount At 31 December 20X8
10,000 1,000 11,000 41,000 30,000
6,000 3,000 (500) 8,500 4,500 4,000
16,000 4,000 (500) 19,500 45,500 34,000
At 1 January 20X8
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Topic recap
HKAS 16 covers all aspects of accounting for property, plant and equipment. This represents the bulk of items which are 'tangible' non-current assets. HKAS 16 offers a choice for measuring property, plant and equipment between using either the cost model or the revaluation model. Where assets held by an entity have a limited useful life to that entity it is necessary to apportion the value of an asset over its useful life by charging depreciation.
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Financial Reporting
Answer 1
Cost Accumulated depreciation Yr 1 ($20,000 x 10%) Yr 2 ($18,000 x 10%) Carrying amount
First year ($) 20,000 Second year ($) 20,000
(2,000) 18,000
(2,000) (1,800) 16,200
The diminishing balance method of depreciation is used instead of the straight line method when it is considered fair to allocate a greater proportion of the total depreciable amount to the earlier years and a lower proportion to the later years on the assumption that the benefits obtained by the business from using the asset decline over time. It may be argued that this method links the depreciation charge to the costs of maintaining and running the computer system. In the early years these costs are low and the depreciation charge is high, while in later years this is reversed.
Answer 2
(a)
Cost $ Depreciation $ Carrying amount $
Component 1 Cost Dismantling ($280,000 x 0.3624) Component 2 Component 3 (b) Proceeds CV at disposal Loss on disposal
900,000 101,472 1,001,472 650,000 250,000
66,765 130,000 25,000 140,000 (934,707) (794,707)
934,707 520,000 225,000 1,679,707
(c)
Cost $ Depreciation $ Carrying amount $
Component 1 Cost Dismantling ($250,000 x 0.3878) Component 2 Component 3
910,000 96,950 1,006,950 650,000 250,000
71,925 260,000 50,000
935,025 390,000 200,000 1,525,025
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Answer 3
20X7
31 Mar
DEBIT
Loss on disposal Accumulated depreciation* Account receivable (sale price)
$ 250 6,750 8,000
CREDIT Non-current asset (cost) Being recording sales proceeds for disposal 31 Dec DEBIT Loss on disposal Accumulated depreciation** Cash (sale proceeds) CREDIT Non-current asset (cost) Being recording sales proceeds for disposal * ** Depreciation at date of disposal = $6,000 + $750 Depreciation at date of disposal = $6,000 + $2,750 3,750 8,750 2,500
15,000
15,000
You should be able to calculate that there was a loss on the first disposal of $250, and on the second disposal of $3,750, giving a total loss of $4,000. WORKINGS (1) At 1 January 20X7, accumulated depreciation on the machines will be: 2 machines 2 years (2) Monthly depreciation is $15,000 per machine pa = $12,000, or $6,000 per machine 5
$3,000 = $250 per machine per month 12
(3)
The machines are disposed of in 20X7. (a) (b) On 31 March after 3 months of the year. Depreciation for the year on the machine = 3 months $250 = $750. On 1 December after 11 months of the year. Depreciation for the year on the machine = 11 months $250 = $2,750
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Financial Reporting
Exam practice
Phoenix Real Estate
16 minutes
Phoenix Real Estate Limited ('Phoenix') is a property developer in China. In 20X3, Phoenix acquired the land use rights of two pieces of land in Beijing for hotel development: Property One Since the date of the acquisition of the land, the board of Phoenix has decided to run the hotel on its own and commenced the pre-operating activities of the hotel on 1 January 20X5 when the development is completed and the hotel is available for its intended use. The hotel's grand opening took place on 1 July 20X5. Property Two Since the date of the acquisition of the land, the board of Phoenix decided to lease the whole property to earn rental income. A lease agreement was entered into to lease the whole property to its holding company (the 'Tenant') for a period of eighteen years for the operation of a hotel. The monthly revenue amount of the hotel operation is provided by the Tenant at the close of business of each month-end date. Other information on these two properties:
Property One Property Two
RMB'000 Cost of land use right Cost of construction (excluding the right amortisation of land use right) Fair value of land use right at 31 December 20X5 Fair value of the building at existing status as at 31 December 20X5 Date of purchase of land use right Term of land use right of the property Estimated useful life of the property Completion of construction of the building 45,000 303,000 60,000 560,000 1 July 20X3 75 years 50 years December 20X4
RMB'000 48,000 267,000 100,000 340,000 1 October 20X3 60 years 40 years June 20X5
Phoenix has adopted the cost model under HKAS 16 for property, plant and equipment and the fair value model under HKAS 40 for investment property (buildings only). Depreciation is provided to write off the cost of property, plant and equipment using the straight-line method. The land use right is considered as a lease and accounted for in accordance with the requirements under HKAS 17. Amortisation of the cost of the land during the construction period is capitalised as part of the development cost of the property.
Required
Calculate the amount of (1) land use right and (2) carrying amount of the building for each property to be reflected in Phoenix's statement of financial position as at 31 December 20X5. (9 marks)
HKICPA September 2006 (amended)
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chapter 6
Investment property
Topic list
1 HKAS 40 Investment Property
Learning focus
Some entities own land or buildings and treat them as an investment, ie in order to generate income and cash flows independently of the other assets held by the entity. It is important that you understand the difference between investment properties and other classes of assets, and how to account for them.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.10 3.10.1 Investment property Identify an investment property within the scope of HKAS 40 and situation when a property can be transferred in and out of the investment property category Distinguish investment property from other categories of property holdings and describe the difference in accounting treatment Apply the recognition and measurement rules relating to investment property Account for investment property Disclose relevant information, including an accounting policy note, for investment property 3
3.10.2 3.10.3 3.10.4 3.10.5
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6: Investment property | Part C Accounting for business transactions
1 HKAS 40 Investment Property

Topic highlights
Land and building may be acquired for investment purpose rather than for use in the business. The cash flows generated by this investment are largely independent of other assets held by the entity. The accounting treatment of investment property is covered by HKAS 40. The objective of publishing HKAS 40 Investment Property in March 2000 is to regulate the accounting treatment for investment property and related disclosure requirements. HKAS 40 does not deal with issues covered in HKAS 17. It includes investment property held under a finance lease or leased out under an operating lease.
HKAS 40.5
1.1 Definitions
Key terms
Investment property is property (land or a building or part of a building or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for: (a) use in the production or supply of goods or services or for administrative purposes (b) sale in the ordinary course of business. Owner-occupied property is property held by the owner (or by the lessee under a finance lease) for use in the production or supply of goods or services or for administrative purposes. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Cost is the amount of cash or cash equivalents paid or the fair value of other consideration given to acquire an asset at the time of its acquisition or construction. Carrying amount is the amount at which an asset is recognised in the statement of financial position. A property interest that is held by a lessee under an operating lease may be classified and accounted for as an investment property, if and only if the property would otherwise meet the definition of an investment property and the lessee uses the HKAS 40 fair value model. This classification is available on a property-by-property basis. (HKAS 40.5) The standard provides the following examples of investment properties:
HKAS 40.812,15
(a) (b) (c) (d) (e) (f)
Land held for long-term capital appreciation rather than for short-term sale in the ordinary course of business. Land held for a currently undetermined future use. A building owned by the reporting entity (or held by the entity under a finance lease) and leased out under an operating lease. A building that is vacant but held to be leased out under one or more operating leases. Property that is being constructed or developed for future use as investment property. A building held by an entity and leased to a parent or another subsidiary. Note, however, that while this is regarded as an investment property in the individual entity's financial statements, in the consolidated financial statements this property will be regarded as owner-occupied (because it is occupied by the group) and will therefore be treated in accordance with HKAS 16.
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Financial Reporting
The standard also clarifies that the following are not investment properties, but are instead within the scope of the named standards: (a) (b) (c) (d) Property intended for sale in the ordinary course of business (HKAS 2) Property being constructed or developed for sale in the ordinary course of business (HKAS 2) Property being constructed or developed on behalf of third parties (HKAS 11) Owner occupied property (HKAS 16), which includes: (i) (ii) (iii) (iv) (e) property held for future owner-occupation property held for future development before owner-occupation property occupied by employees regardless of whether they pay market rent owner-occupied property awaiting disposal
Property leased to another entity under a finance lease.
Where a property is partly owner-occupied and partly held to earn rentals or for capital appreciation, its treatment depends on whether or not the portions of the property could be sold separately. If they could not be sold separately, the property is only treated as investment property if an insignificant portion is held for owner-occupier use. Where an entity provides ancillary services to the occupants of a property it holds: The property is treated as investment property where those ancillary services are insignificant to the arrangement as a whole The property is treated as owner-occupied where the ancillary services are significant, for example the services provided to a hotel guest by the owner of the hotel indicate that a hotel is owner-occupied.
Propex had the following properties but is unsure how to account for them: 1 Tennant House which cost $150,000 five years ago. The property is freehold and is let out to private individuals for six monthly periods. The current market value of the property is $175,000. Stowe Place which cost $75,000. This is used by Propex as its headquarters. The building was acquired 10 years ago. Crocket Square is a recently started development which is two thirds complete. Propex intends to let this out to a company called Speedex in which it has a controlling interest. Smith Tower is an office complex let out to a number of commercial tenants. Propex provides these tenants with security and maintenance services in the building.
2 3 4
Propex depreciates its buildings at 2% per annum on cost. Required Describe the most appropriate accounting treatment for each of these properties. (The answer is at the end of the chapter)
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Below is the decision tree showing which HKFRS should be applied to various kinds of property:
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Financial Reporting
HKAS 40.16
1.2 Recognition
Investment property should be recognised as an asset when two conditions are met: (a) (b) It is probable that the future economic benefits that are associated with the investment property will flow to the entity, and The cost of the investment property can be measured reliably.
HKAS 40.20,25

An investment property should be measured initially at its cost, including transaction costs. A property interest held under a lease and classified as an investment property shall be accounted for as if it were a finance lease. The asset is recognised at the lower of the fair value of the property and the present value of the minimum lease payments. An equivalent amount is recognised as a liability.
HKAS 40.30,34
1.4 Measurement subsequent to initial recognition

Topic highlights
Entities can choose between: Fair value model, with changes in fair value being measured Cost model the treatment most commonly used under HKAS 16
HKAS 40 requires an entity to choose between two models: The fair value model The cost model
Whatever policy it chooses should be applied to all of its investment property. Where an entity chooses to classify a property held under an operating lease as an investment property, there is no choice. The fair value model must be used for all the entity's investment property, regardless of whether it is owned or leased.
HKAS 40.33,35, 53, HKFRS 13.933,76, 81, 86
1.4.1 Fair value model

Where the fair value model is chosen, the following rules apply: (1) An entity that chooses the fair value model should measure all of its investment property at fair value, except in the extremely rare cases where this cannot be measured reliably. In such cases it should apply the HKAS 16 cost model. A gain or loss arising from a change in the fair value of an investment property should be recognised in net profit or loss for the period in which it arises.
(2)
HKAS 40 was the first time that the HKICPA has allowed a fair value model for non-financial assets. This is not the same as a revaluation of assets where increases in carrying amount above a cost-based measure are recognised as revaluation surplus (ie, as a reserve, in equity). Under the fair value model all changes in fair value are recognised in profit or loss. HKFRS 13 Fair Value Measurement, issued in May 2011, deleted much of the guidance provided in HKAS 40 in respect of the determination of fair value. Instead the requirements of HKFRS 13 apply in measuring the fair value of investment properties.
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This standard requires that the following are considered in determining fair value: 1 2 The asset being measured The principal market (ie that where the most activity takes place) or where there is no principal market, the most advantageous market (ie that in which the best price could be achieved) in which an orderly transaction would take place for the asset The highest and best use of the asset and whether it is used on a standalone basis or in conjunction with other assets Assumptions that market participants would use when pricing the asset.
3 4
The guidance which remains in HKAS 40 is as follows: (a) Double counting should be prevented in deciding on the fair value of the assets. For example, elevators or air conditioning, which form an integral part of a building should be incorporated in the investment property rather than recognised separately. According to the definition in HKAS 36 Impairment of Assets, fair value is not the same as 'value in use'. The latter reflects factors and knowledge as relating solely to the entity, while the former reflects factors and knowledge applicable to the market. In those uncommon cases in which the fair value of an investment property cannot be determined reliably by an entity, the cost model in HKAS 16 must be employed until the investment property is disposed of. The residual value must be assumed to be zero.
(b)
(c)
1.4.2 Operating lease and investment property

In respect of leased property that qualifies as an operating lease, the lessee has the option to classify the leased property as investment property provided that the lessee uses the fair value model of HKAS 40 and the relevant criteria are met and all of the investment property must only be accounted for under the fair value model. This means that the components of land and buildings of the lease need not be split in order to calculate whether it is a finance lease or operating lease.
HKAS 40.56
1.4.3 Cost model

The model here is the same as the cost model in HKAS 16. Investment property should be measured at depreciated cost, less any accumulated impairment losses. If an entity chooses the cost model, it should disclose the fair value of its investment property.
HKAS 40.31
1.4.4 Changing models

An entity should apply its chosen fair value model or cost model to all its investment property. It should not change its model unless the change will result in a more appropriate presentation. HKAS 40 states that it is very unlikely that a change from the fair value model to the cost model will end up in a more appropriate presentation.
HKAS 40.5765
1.5 Transfers
Transfers to or from investment property are justified only when there is a change in the use of the property.
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Financial Reporting
1.5.1 Transfers from investment property

HKAS 40 cites two instances when property is transferred from investment property to another category: (a) (b) Commencement of owner occupation Commencement of development with a view to sale.
In the first instance on transfer the property falls within the scope of HKAS 16, and the accounting guidance of that standard must be applied. In the second instance on transfer the property falls within the scope of HKAS 2. In both cases where the investment property was previously carried at fair value, the property's cost for subsequent accounting under HKAS 16 or HKAS 2 should be its fair value at the date of change of use.
1.5.2 Transfers to investment property

HKAS 40 also provides two instances when property is transferred to investment property from another category: (a) (b) end of owner occupation commencement of an operating lease to another party.
In the first instance, the transfer removes the property from the scope of HKAS 16 and in the second from the scope of HKAS 2. HKAS 16 is to be applied up to the date of change of use when an owner-occupied property becomes an investment property and the property has to be carried at fair value. The difference at the date of change between the carrying amount of the property under HKAS 16 and its fair value should be treated as a revaluation under HKAS 16. The following table summarises the requirements of HKAS 40 on recognition and measurement issues that arise when an entity uses the fair value model for investment property. Transfer from Investment property carried at fair value To Owneroccupied property Inventories Measurement rules The property's deemed cost for subsequent accounting in accordance with HKAS 16 shall be its fair value at the date of change in use. The property's deemed cost for subsequent accounting in accordance with HKAS 2 shall be its fair value at the date of change in use. Any difference between the fair value of the property at the date of change in use and its previous carrying amount shall be recognised in profit or loss.
Inventories
Investment property that will be carried at fair value
Owneroccupied property
An entity shall apply HKAS 16 to the owner-occupied property up to the date of change in use. The entity shall treat any difference at that date between the carrying amount of the property in accordance with HKAS 16 and its fair value in the same way as a revaluation in accordance with HKAS 16. (See Note below)
Note. Any resulting decrease in the carrying amount of the property is recognised in profit or loss. However, to the extent that an amount is included in revaluation surplus for that property, the decrease is recognised in other comprehensive income and reduces the revaluation surplus within equity.
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Any resulting increase in the carrying amount is treated as follows: (i) To the extent that the increase reverses a previous impairment loss for that property, the increase is recognised in profit or loss. The amount recognised in profit or loss cannot exceed the amount needed to restore the carrying amount to the carrying amount that would have been determined (net of depreciation) had no impairment loss been recognised; and Any remaining part of the increase is recognised in other comprehensive income and increases the revaluation reserve within equity. On subsequent disposal of the investment property, the revaluation surplus included in equity may be transferred to retained earnings. The transfer from revaluation reserve to retained earnings is not made through the statement of comprehensive income.
(ii)
HKAS 40.66,69,72
1.6 Disposals
An investment property should be derecognised (eliminated from the statement of financial position) on disposal or when it is permanently withdrawn from use and no future economic benefits are expected from its disposal. A gain or loss on disposal arises when there is a difference between the net disposal proceeds and the carrying amount of the asset. It should generally be recognised in profit or loss as income or expense. Compensation from third parties for investment property that was impaired, lost or given up should be recognised in profit and loss when the compensation becomes receivable.
1.7 Summary of accounting treatment of property

Depending on which standard's scope a property falls within, it may be subject to significantly different accounting treatment: HKAS 16 cost model Measurement in statement of financial position Cost less depreciation less impairment losses HKAS 16 revaluation model Revalued amount less depreciation less impairment losses Revaluations recognised in other comprehensive income HKAS 2 HKAS 40 cost model Cost less depreciation less impairment losses (same as cost model in HKAS 16) Depreciation and impairment recognised in profit or loss HKAS 40 fair value model Fair value
Lower of cost and net realisable value
Gains and losses
Depreciation and impairment recognised in profit or loss
No depreciation
Changes in fair value recognised in profit or loss. No depreciation
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Financial Reporting
HKAS 40.75
1.8 Disclosure requirements

Disclosures in respect of investment properties are particularly important due to the choice of accounting treatment provided by the standard. Users must be aware of whether the carrying amount represented in the statement of financial position relates to cost or fair value. Where the fair value model is used, users have an indication of the achievable proceeds on a sale of an investment property; where the cost model is used, the requirement to disclose fair value achieves the same end. In addition, detail of amounts recognised in profit or loss, such as rental income and changes in fair value, help users to determine the quality of an investment property in generating returns. The following must be disclosed: Whether an entity applies the cost model or fair value model Whether property interests held as operating leases are included in investment property Criteria for classification as investment property Use of independent professional valuer (encouraged but not required) Amounts recognised in profit or loss for: rental income direct operating expenses from property that did generate rental income direct operating expenses from property that did not generate rental income cumulative change in fair value recognised in profit or loss on sale of an investment property from a pool of assets in which the cost model is used to a pool in which the fair value model is used.
HKAS 40.76
Any restrictions or obligations associated with the investment property
1.8.1 Fair value model additional disclosures

An entity that adopts the fair value model must also disclose: (a) A reconciliation of the carrying amount of the investment property at the beginning and end of the period, including separate details for those properties for which reliable fair value cannot be determined Disclosure of adjustments to valuations obtained (for example to avoid double counting) Where fair value cannot be established reliably: (i) (ii) (iii) (iv) A description of the property Explanation of why fair value cannot be established reliably A range of estimates within which fair value is likely to lie (where possible) The carrying amount of any property disposed of and gain or loss recognised.
(b) (c)
HKAS 40.79
1.8.2 Cost model additional disclosures

An entity that adopts the cost model must also disclose: depreciation methods used useful lives or depreciation rates used the gross carrying amount and accumulated depreciation at the start and end of the period a reconciliation of the carrying amount of the investment property at the beginning and end of the period the fair value of investment property
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Topic recap
An entity may own land or a building as an investment rather than for use in the business. It may therefore generate cash flows largely independently of other assets which the entity holds. The treatment of investment property is covered by HKAS 40. HKAS 40 Investment Property defines investment property as property held to earn rental income or for capital appreciation or both, rather than for: Use in production or supply of goods or services. Sale in the ordinary course of business.
Entities can choose between a: Fair value model, with changes in fair value recognised in profit or loss. Cost model the treatment most commonly used under HKAS 16.
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Financial Reporting
Answer to self-test question
Answer 1
(1) Tennant House (2) Held for its investment potential and not for use by Propex Treat as investment property in accordance with HKAS 40 Rental income to profit or loss If following fair value model revalue to market value of $175,000. The difference of $25,000 credited to profit or loss. If following cost model depreciate based on cost and do not revalue. Depreciation for current period is $3,000 and net book value is $135,000 (150,000 (5 3,000)) Need to be consistent and use either fair value or cost model for all investment properties.
Stowe Place Held for use by Propex Considered as owner-occupied property and accounted for in accordance with HKAS 16 Depreciate over useful life 75,000 2% = 1,500 per annum to profit or loss Carrying Value of $75,000 ($1,500 10) = 60,000 to be shown in statement of financial position.
(3)
Crocket Square Not yet complete so accounting treatment relates to the cost incurred to date Propex is constructing the property to let out to another company, Speedex. During construction, and after completion, the property is therefore within the scope of HKAS 40 and should be accounted for as an investment property in Propexs individual accounts. As Speedex is a subsidiary of Propex, the property will be owner-occupied from a group perspective and therefore HKAS 16 is applied at a consolidation level.
(4)
Smith Tower The service and maintenance services provided by Propex to its tenants would be deemed insignificant to the arrangement as a whole. Therefore Propex should treat Smith Tower as an investment property and apply the provisions of HKAS 40.
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Exam practice
Cliff Land Limited

Cliff Land Limited (CLL) owns the following three buildings in Hong Kong: Building A Usage Date of acquisition Cost of the building Fair value of the building at 31 December 20X7 Warehouse 1 January 20X0 $20 million $28 million Building B Director's quarter 1 January 19X8 $36 million $22 million
27 minutes
Building C Earning rental income 1 January 20X5 $18 million $22 million
In the board meeting held on 30 September 20X7, the management of CLL determined to sell Buildings B and C. A property agency was appointed in the following month to identify potential buyers. In addition, CLL moved the storage of its inventories in Building A to a new production plant in Shenzhen. At 31 December 20X7, all three buildings were vacant. CLL has accounted for (i) the building under property, plant and equipment at cost basis and depreciated the cost with the estimated useful life of 30 years, (ii) the investment property at fair value model, and (iii) the land cost as operating lease under HKAS 17. Cost and fair value of the land are assumed to be zero. Cost to sell the buildings is estimated at 0.5 per cent of the disposal value of the asset. Required Determine the statement of financial position classification of these three buildings and calculate the respective amounts to be recognised on the statement of financial position as at 31 December 20X7. (15 marks) HKICPA February 2008 (amended)
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Financial Reporting
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chapter 7
Government grants
Topic list
1 HKAS 20 Government Grants
Learning focus
Entities in many different countries receive government grants for all sorts of reasons, very often to encourage growth and industry in certain areas, or to help them overcome external difficulties, such as economic difficulties. This chapter covers how to account for government grants.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.03 3.03.01 3.03.02 Government grants and assistance Accounting and presentation of government grants Disclosure of government grants and assistance in accordance with HKAS 20 3
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7: Government grants | Part C Accounting for business transactions
1 HKAS 20 Government Grants

Topic highlights
In many countries entities may receive government grants for various purposes (grants may be called subsidies, premiums, or given other titles). They may also receive other types of assistance which may be in many forms. The treatment of government grants is covered by HKAS 20 Accounting for Government Grants and Disclosure of Government Assistance.
HKAS 20.2
1.1 Scope
HKAS 20 does not cover the following situations: (a) (b) (c) (d) Accounting for government grants in financial statements reflecting the effects of changing prices Government assistance given in the form of 'tax breaks' The government acting as part-owner of the entity Government grants covered by HKAS 41 Agriculture
HKAS 20.3-5
1.2 Definitions
These definitions are provided in the standard.
Key terms
Government. Government, government agencies and similar bodies whether local, national or international. Government assistance. Action by government designed to provide an economic benefit specific to an entity or range of entities qualifying under certain criteria. Government grants. Assistance by government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. They exclude those forms of government assistance which cannot reasonably have a value placed upon them and transactions with government which cannot be distinguished from the normal trading transactions of the entity. Grants related to assets. Government grants whose primary condition is that an entity qualifying for them should purchase, construct or otherwise acquire non-current assets. Subsidiary conditions may also be attached restricting the type or location of the assets or the periods during which they are to be acquired or held. Grants related to income. Government grants other than those related to assets. Forgivable loans. Loans which the lender undertakes to waive repayment of under certain prescribed conditions. Fair value. This is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. (HKAS 20.3) Government assistance can be of various forms since both the type of assistance and the conditions related to it may differ. It may have the impact of encouraging an entity to undertake something it otherwise would not have done.
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Financial Reporting
How will the financial statements be affected by the receipt of government assistance? (a) (b) Any resources transferred to an entity must be accounted for using an appropriate method. Disclosure in the notes to the accounts is required to show the magnitude to which an entity has benefited from such assistance.
HKAS 20.711
1.3 Government grants

Government grants (including non-monetary grants at fair value) should only be recorded when the entity has reasonable assurance that: the entity will comply with any conditions attached to the grant. the entity will actually receive the grant.
The receipt of the grant does not mean that the conditions attached to it have been or will be fulfilled. The manner of receipt of the grant, whether it is in cash or as a reduction in a liability to the government, is irrelevant in the treatment of the grant. Once a grant has been recognised, any contingency associated with it should be accounted for under HKAS 37 Provisions, Contingent Liabilities and Contingent Assets. When a forgivable loan (as given in the key terms above) is received from the government and it is reasonably assured that the entity will meet the appropriate terms for forgiveness, it should be treated in the same way as a government grant. In addition, a loan at a below-market rate of interest is to be dealt with as a government grant. A benefit of a government loan at a below-market rate of interest is treated as a government grant. The loan shall be recognised and measured in accordance with HKFRS 9 Financial Instruments. The benefit of the below-market rate of interest shall be measured as the difference between the initial carrying value of the loan determined in accordance with HKFRS 9 and the proceeds received. The benefit is accounted for in accordance with this standard. The entity shall consider the conditions and obligations that have been, or must be, met when identifying the costs for which the benefit of the loan is intended to compensate.
HKAS 20.1222
1.3.1 Accounting treatment of government grants

There are two methods which could be used to account for government grants, and the arguments for each are given in HKAS 20. (a) (b) Capital approach: the grant is recognised outside profit or loss. Income approach: the grant is recognised in profit or loss over one or more periods.
What are the different arguments used in support of each method? (The answer is at the end of the chapter)
HKAS 20 requires that the income approach should be adopted in the recognition of grants. In other words grants received should be recognised in profit or loss on a systematic basis over the relevant accounting periods in which the entity recognises as expenses the related costs. A systematic basis of matching should be used to avoid a violation of the accrual assumption to treat grants in profit or loss on a receipts basis. This latter basis would only be acceptable when no other basis was available.
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The related cost to a government grant can easily be identified and thereby the period(s) in which the grant should be recognised in profit or loss, ie when the costs are incurred by the entity. Grants received relating to a depreciating asset will be recognised, in the same proportion, over the periods in which the asset is depreciated.
On 1 January 20X8, Xenon Co purchased a non-current asset for cash of $100,000 and received a grant of $20,000 towards the cost of the asset. Xenon Co's accounting policy is to treat the grant as deferred income. The asset has a useful life of five years. Required Show the accounting entries to record the asset and the grant in the year ended 31 December 20X8. (The answer is at the end of the chapter)
Certain obligations may have to be fulfilled for grants relating to non-depreciable assets. In such a case, the grant should be recognised in profit or loss over the periods in which the cost of meeting the obligation is incurred. For example, if a piece of land is granted on the condition that a building is erected on it, then the grant should be recognised in profit or loss over the building's life. If a series of conditions, in the form of a package of financial aid, are attached to the grant, then the entity must be careful in identifying precisely those conditions which give rise to costs which in turn determine the periods in which the grant will be earned. The grant may also be split into parts and allocated on different bases. Grants received as compensation for expenses or losses which an entity has already incurred and grants given merely to provide immediate financial support where there are no foreseeable related costs, should be recognised in profit or loss of the period in which they become receivable.
HKAS 20.23
1.3.2 Non-monetary government grants

When a non-monetary asset, such as a piece of land or other resources, is given by the government to an entity as a grant, the fair value of the asset is assessed and used to account for both the asset and the grant. On the other hand, both may be recorded at a nominal value.
HKAS 20.2428
1.3.3 Presentation of grants related to assets

Two choices are available for disclosing government grants related to assets (including nonmonetary grants at fair value) in the statement of financial position: (a) (b) Deduct the grant in arriving at the carrying amount of the asset. Set up the grant as deferred income.
The two alternatives are considered as equally acceptable and an example for both is shown below.
Example: Accounting for grants related to assets

In the year ended 31 December 20X8, Tiger-Lily Co receives a grant of $100,000 towards the cost of a new freehold property in a development zone. The cost of the property is $700,000, and the purchase was completed on 30 June 20X8. The property is to be depreciated at an annual rate of 2 per cent on cost. Illustrate how the grant will affect the financial statements of Tiger-Lily for the years ended 31 December 20X8, 20X9 and 20Y0 assuming profits before depreciation in those years of $250,000, $280,000 and $315,000.
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Financial Reporting
Solution
The results of the company would be as follows: (a) Reducing the cost of the asset 20X8 $ Profits Profit before depreciation Depreciation* Profit 250,000 12,000 238,000 20X9 $ 280,000 12,000 268,000 20Y0 $ 315,000 12,000 303,000
*The depreciation charge on a straight line basis, for each year, is 2% ($700,000 $100,000) = $12,000. STATEMENT OF FINANCIAL POSITION AT YEAR END (EXTRACT) Non-current asset at cost Depreciation Carrying amount (b) $ 600,000 12,000 588,000 20X8 $ Profits Profit before grant and dep'n Depreciation* Grant Profit 250,000 (14,000) 2,000 238,000 $ 700,000 (14,000) 686,000 $ 600,000 24,000 576,000 20X9 $ 280,000 (14,000) 2,000 268,000 $ 700,000 (28,000) 1672,000 $ 600,000 36,000 564,000 20Y0 $ 315,000 (14,000) 2,000 303,000 $ 700,000 (42,000) 658,000
Treating the grant as deferred income
STATEMENT OF FINANCIAL POSITION AT YEAR END (EXTRACT) Non-current asset at cost Depreciation Carrying amount Deferred income Government grant deferred income
98,000
96,000
94,000
Whichever of these methods is used, the cash flows in relation to the purchase of the asset and the receipt of the grant are often disclosed separately because of the significance of the movements in cash flow.
HKAS 20.2931
1.3.4 Presentation of grants related to income

Grants related to income are a credit in the statement of comprehensive income. There are two alternative methods of disclosure. (a) (b) Present as a separate credit or under a general heading, eg 'other income'. Deduct from the related expense.
The disclosure has been a subject of controversy. Some would argue that it is not good practice to offset income and expenses in the statement of comprehensive income, others would say that offsetting is acceptable since the expenses would not have been incurred had the grant not been available. A proper understanding of the financial statements is required for the disclosure of the grant, particularly the effect on any item of income or expense which is to be separately disclosed.
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HKAS 20.3233
1.3.5 Repayment of government grants

If a grant must be repaid it should be accounted for as a change in an accounting estimate. In other words, the revision is accounted for prospectively. HKAS 8 requires that the nature and amount of such a change in an accounting estimate is disclosed. (a) (b) Repayment of a grant related to income: apply first against any unamortised deferred income set up in respect of the grant; any excess should be recognised immediately as an expense. Repayment of a grant related to an asset: increase the carrying amount of the asset or reduce the deferred income balance by the amount repayable. The cumulative additional depreciation that would have been recognised to date in the absence of the grant should be immediately recognised as an expense.
The circumstances relating to repayment may entail a reassessment of the asset value and an impairment of the new carrying amount of the asset.
HKAS 20.3436
1.4 Excluded government assistance

The definition of government grants does not include some forms of government assistance. (a) (b) Some forms of government assistance cannot reasonably have a value placed on them, eg free technical or marketing advice, provision of guarantees. There are transactions with government which cannot be distinguished from the entity's normal trading transactions, eg government procurement policy resulting in a portion of the entity's sales. Any segregation would be arbitrary.
The government assistance may have to be disclosed because of its significance; nature, extent and duration.
HKAS 20.39
1.5 Disclosure
Disclosure is required of the following: (a) (b) (c) Accounting policy adopted, including method of presentation. Nature and extent of government grants recognised and other forms of assistance received. Unfulfilled conditions and other contingencies attached to recognised government assistance.
1.6 HK(SIC) Int-10 Government Assistance no specific relation to operating activities

The aim of government assistance to entities in some countries is to encourage entities or to provide long term support of business activities either in certain regions or industry sectors. Conditions to receive assistance may have no particular relationship with the operating activities of the entity. Examples of this kind of assistance are transfers of resources by governments to entities which: operate in a specific industry. continue to operate in newly privatised industries. commence or continue to operate in underdeveloped areas.
If the government assistance is considered as a 'government grant' within the scope of HKAS 20, then it should be accounted for in accordance with this standard. Even if there are no circumstances particularly relating to the operating activities of the entity other than the requirement to operate in certain regions or industry sectors, government assistance to entities still meets the definition of government grants in HKAS 20 and should not be credited directly to equity.
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Topic recap
It is common for entities to receive government grants for various purposes (grants may be called subsidies, premiums, or given other titles). They may also receive other types of assistance which may be in many forms. The treatment of government grants is covered by HKAS 20 Accounting for Government Grants and Disclosure of Government Assistance.
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Answer 1
The standard gives the following arguments in support of each method. Capital approach (a) The grants are a financing device, so should go through the statement of financial position. In the statement of comprehensive income they would simply offset the expenses which they are financing. No repayment is expected by the Government, so the grants should be recognised outside profit or loss. Grants are not earned, they are incentives without related costs, so it would be wrong to take them to profit or loss.
(b)
Income approach (a) (b) The grants are not received from shareholders so should not be recognised directly in equity, but should be recognised in profit or loss in appropriate periods. Grants are not given or received for nothing. They are earned by compliance with conditions and by meeting obligations. They should therefore be recognised in profit or loss over the periods in which the entity recognises as expenses the related costs for which the grant is intended to compensate. Grants are an extension of fiscal policies and so as income taxes and other taxes are expenses, so grants should be recognised in profit or loss.
(c)
Answer 2
Acquisition of the asset and receipt of the grant on 1 January 20X8: DEBIT Non current assets CREDIT Cash To record the asset at its cost DEBIT Cash CREDIT Deferred income To record the receipt of the grant In the year ended 31 December 20X8 the asset is depreciated and a portion of the grant is released to the income statement: DEBIT Depreciation expense ($100,000 / 5 years) CREDIT Accumulated depreciation DEBIT Deferred income ($20,000 / 5 years) CREDIT Operating expenses $4,000 $4,000 $20,000 $20,000 $20,000 $20,000 $100,000 $100,000
The release of the deferred income is matched to the depreciation expense, so the net effect is an expense of $16,000 relating to the asset.
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Financial Reporting
Exam practice
PMT and WY
9 minutes
Peak Medical Technology Corporation ('PMT') conducts research and product development for an anaesthetic injection under contract with WY Corporation ('WY'), a pharmaceutical company. The research and development contract requires that WY pays PMT an up-front amount of $1.5 million when the contract is signed, $2 million upon the successful completion of clinical trials, and $1.5 million upon the delivery of the first pilot unit of the injection. All payments are non-refundable. The total cost of completion of the project is estimated to be $3 million. PMT has invested $25 million in equipment for its research and development centre, which has an anticipated useful life of eight years. Depreciation is charged on a straight-line basis. In the period of acquisition, PMT received a government grant of $10 million towards purchase of the equipment, which is conditional on certain employment targets being achieved within the next four years. Required Determine how PMT should recognise and measure the government grant by reference to the relevant accounting standards. (5 marks) HKICPA May 2007 (amended)
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chapter 8
Intangible assets and impairment of assets

Topic list
1 2 3 4 HKAS 38 Intangible Assets Research and development costs Goodwill (HKFRS 3 (revised)) HKAS 36 Impairment of Assets
Learning focus
Impairment of assets is particularly relevant in the current economic climate and several companies are now having to apply the requirements with regard to accounting for impairment for the first time.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.09 3.09.01 3.09.02 3.09.03 3.09.04 3.09.05 3.09.06 3.09.07 3.09.08 3.13 3.13.01 3.13.02 3.13.03 3.13.04 3.13.05 3.13.06 3.13.07 Intangible assets Define an intangible asset and scope of HKAS 38 Apply the definition of an intangible asset to both internallygenerated and purchased intangibles Account for the recognition and measurement of intangible assets in accordance with HKAS 38 Describe the subsequent accounting treatment of intangible assets including amortisation Distinguish between research and development and describe the accounting treatment of each Explain how goodwill arises Account for goodwill Disclose relevant information in respect of intangible assets under HKAS 38 Impairment of assets Identify assets that are within the scope of HKAS 36 Identify an asset that may be impaired by reference to common external and internal indicators Identify the cash generating unit an asset belongs to Calculate the recoverable amount with reference to value-in-use and fair value less cost to sell Calculate the impairment loss, including the loss relating to cashgenerating units Allocate impairment loss and account for subsequent reversal Disclose relevant information with regard to impairment loss, including critical judgment and estimate 3 3
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8: Intangible assets and impairment of assets | Part C Accounting for business transactions
1 HKAS 38 Intangible Assets

Topic highlights
Intangible assets are defined by HKAS 38 as non-monetary assets without physical substance. They must be: identifiable. controlled as a result of a past event. able to provide future economic benefits.
HKAS 38 Intangible Assets was issued in August 2004 and revised in May 2009 to reflect changes introduced by HKFRS 3 (revised) Business Combinations.
1.1 The objectives of the standard

(a) (b) (c)
HKAS 38.2,3
To establish the criteria for when an intangible asset may or should be recognised. To specify how intangible assets should be measured. To specify the disclosure requirements for intangible assets.
1.2 The scope of the standard

HKAS 38 applies to all intangible assets with the following exceptions: Financial assets (HKAS 32) The recognition and measurement of exploration and evaluation assets (HKFRS 6) The development and extraction of minerals, oils, gas and other non-regenerative resources Intangible assets held for sale in the ordinary course of business (HKAS 2 and HKAS 11) Deferred tax assets (HKAS 12) Leases within the scope of HKAS 17 Assets arising from employee benefits (HKAS 19) Goodwill acquired in a business combination (HKFRS 3 (revised)) The recognition and measurement of insurance contracts (HKFRS 4) Intangible assets within the scope of HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations
HKAS 38.810
1.3 Definition of an intangible asset

Key terms
An intangible asset is an identifiable non-monetary asset without physical substance. An asset is a resource which is: (a) (b) Controlled by the entity as a result of events in the past Something from which the entity expects future economic benefits to flow
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Financial Reporting
Examples of items that might be considered as intangible assets therefore include computer software, patents, copyrights, motion picture films, customer lists, franchises, brands and fishing rights. An item should not be recognised as an intangible asset, however, unless it meets this definition in full. In other words: (a) (b) (c) It is identifiable It is controlled by the entity as a result of past events, and It is expected to result in future economic benefits.
Each of these elements of the definition is considered in turn below.

HKAS 38.11,12
1.3.1 Identifiable
An asset is identifiable if it: (a) (b) is separable, ie if it could be rented or sold either individually or together with a related contract or asset, or arises from contractual or other legal rights regardless of whether those rights are separable.
Goodwill, whether purchased or internally generated, is not identifiable and is therefore not considered to be an intangible asset within the scope of HKAS 38. Other internally generated intangible items, such as brands and customer lists do, however, meet these criteria, however they may not meet the remaining two criteria within the definition of an intangible asset, or the recognition criteria (Section 1.4). Purchased intangible assets, such as a purchased patent or brand are normally identifiable.
HKAS 38.1316
1.3.2 Control by the entity

An entity controls an asset if the entity has the power to obtain the future economic benefits flowing from the underlying resource and to restrict the access of others to those benefits. Whereas the application of the control criteria to purchased assets is relatively simple, it is less straightforward in the case of internally generated assets. Therefore additional guidance is provided: Market and technical knowledge The following provide evidence that an entity can control access to the future economic benefits arising from expenditure to develop market and technical knowledge: The existence of copyrights A legal duty of employees to maintain confidentiality with regard to the knowledge
If such a legal right exists, and provided that the knowledge is identifiable and is expected to result in future economic benefits, it qualifies as an intangible asset. Skilled staff Expenditure on training results in more skilled staff, and often increased revenues and better efficiency. The costs of such training, however, are very unlikely to qualify as an intangible asset because an entity does not control the future actions of its staff. These staff may leave the organisation at any time. Market share/customer base Expenditure on advertising and building customer relationships results in the growth of market share and a loyal customer base. However, unless relationships with customers are protected by legal rights, the entity can not control the actions of its customers, and they may change to a different supplier. Therefore such expenditure on creating market share does not qualify as an intangible asset.
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HKAS 38.17
1.3.3 Expected future economic benefits

An item can only be recognised as an intangible asset if economic benefits are expected to flow in the future from ownership of the asset. Future economic benefits may include: revenue from the sale of products or services cost savings other benefits resulting from the use of an asset by an entity
Again, this element of the definition is easily applied to purchase intangible assets, such as patents or copyrights allowing production of items to sell. It may be more difficult to apply to expenditure on internally generated items such as research and development projects, as the success of such a project may be hard to gauge. For this reason, HKAS 38 considers research and development in more detail and this is covered in Section 2 of this chapter.
HKAS 38.2123
1.4 Recognition of an intangible asset

An intangible asset meeting the definition above should be recognised if, and only if, both the following apply: (a) (b) It is probable that the future economic benefits that are attributable to the asset will flow to the entity. The cost of the asset can be measured reliably.
Management has to exercise its judgment in assessing the degree of certainty attached to the flow of economic benefits to the entity. External evidence is best.
HKAS 38.25
1.4.1 Separately acquired intangible assets

Normally, the fact that an entity purchases an intangible asset indicates an expectation that the expected future economic benefits embodied in the asset will flow to the entity. In addition, the cost can clearly be measured reliably. Therefore purchased intangible assets are normally recognised in the financial statements.
HKAS 38.3334
1.4.2 Intangible assets acquired as part of a business combination

In accordance with HKFRS 3 (revised), any intangible asset for which a fair value can be reliably determined should be recognised separately. This is the case even where the purchased entity does not recognise the asset in its own statement of financial position. Sufficient information exists to measure the fair value of an asset reliably where it is separable or arises from contractual or other legal rights.
HKAS 38.48,51,52, 63
1.4.3 Internally generated assets

Internally generated goodwill does not meet the definition of an intangible asset and therefore is never recognised in the financial statements. Other internally generated assets may meet the recognition criteria, however due to the difficulty of assessing future economic benefits and determining a reliable cost of an internally generated asset, HKAS 38 requires that all internal expenditure that may result in an intangible asset is classified as research or development, and provides more detailed recognition guidance which is applicable. This is considered in greater detail in Section 2 of the chapter. In any case, internally-generated brands, mastheads, publishing titles, customer lists and items similar in substance shall not be recognised as intangible assets.
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1.5 Initial measurement of an intangible asset

An intangible asset is initially measured at cost.
HKAS 38.2729
1.5.1 Separately acquired intangible assets

The cost of a separately acquired intangible asset includes its purchase price and any directly attributable costs of preparing the asset for its intended use. Directly attributable costs may include professional fees and testing costs, but not advertising and promotional expenditure or administration and general overhead costs.
HKAS 38.33,39,40
1.5.2 Intangible assets acquired as part of a business combination

When an intangible asset is acquired as part of a business combination (where one company has acquired the shares of another company), the cost of the intangible asset is its fair value at the date of the acquisition. For example, if company A has acquired company B, and company B owns a drilling license with a fair value of $2m at the date of acquisition, then the cost of the license in the consolidated accounts will be $2m. The most dependable estimate of the fair value of an intangible asset is the quoted market prices in an active market. If no active market exists, the fair value of an intangible asset is the amount that the entity would have paid for the asset at the date of acquisition in an arm's length transaction between knowledgeable and willing parties, on the basis of the best available information. To determine the fair value of an intangible asset, the entity should also consider the outcome of recent transactions for similar assets. Techniques for estimating the fair values of unique intangible assets (such as brand names) are available and they may be employed to measure an intangible asset acquired in a business combination.
HKAS 38.44
According to HKAS 38, intangible assets acquired by way of government grant and the grant itself may be recorded initially either at cost (which may be zero) or fair value.
HKAS 38.45
1.5.3 Exchanges of assets

Fair value is used to measure the cost of the intangible asset acquired if one intangible asset is exchanged for another unless: (a) (b) the exchange lacks commercial substance, or the fair values of both the asset received and the asset given up cannot be measured reliably.
In such cases, the cost of the intangible asset acquired is measured at the carrying amount of the asset given up.
1.5.4 Internally generated assets

Internally generated intangible assets are recognised at cost. The elements of this are discussed in more detail in Section 2.
HKAS 38.72,74,75
1.6 Subsequent measurement of an intangible asset

After recognition, an entity may choose to apply either the cost model or revaluation model. Intangible assets are therefore carried at either: cost less accumulated amortisation less accumulated impairment losses, or fair value at date of revaluation less subsequent accumulated amortisation and subsequent accumulated impairment losses.
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The detailed rules with regard to revaluation and amortisation are considered in more detail later in this chapter after the recognition rules and initial measurement rules for research and development costs are discussed.
2 Research and development costs

HKAS 38.8,52
Topic highlights
Research costs are always recognised as an expense. Development costs can be recognised as an asset if they meet certain criteria.
HKAS 38 requires that internally generated assets are classified into research and development phases.
2.1 Definitions
Key terms
Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use. HKAS 38 provides examples of both research and development as follows.
HKAS 38.56
2.1.1 Examples of research costs

(a) (b) (c) (d) Activities aimed at obtaining new knowledge The search for, evaluation and final selection of, applications of research findings or other knowledge The search for alternatives for materials, devices, products, processes, systems or services The formulation, design, evaluation and final selection of possible alternatives for new or improved materials, devices, products, systems or services
HKAS 38.59
2.1.2 Examples of development activities

(a) (b) (c) (d) The design, construction and testing of pre-production or pre-use prototypes The design of tools, jigs, moulds and dies involving new technology The design, construction and operation of a pilot plant on a scale which is not feasible for commercial production The design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services
HKAS 38.53
2.2 Recognition
Although it defines the terms research and development, HKAS 38 provides the accounting treatment for the 'research phase' and 'development phase' of a project. If an entity cannot
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distinguish between these phases, the standard requires that costs are treated as if incurred in the research phase only.
HKAS 38.55
2.2.1 Research phase

Research activities, which are carried out at the research stage of a project, do not meet the recognition criteria under HKAS 38. It is uncertain that future economic benefits will flow to the entity from the project at the research stage of a project and there is too much doubt about the likely success or otherwise of the project. Research costs should therefore be written off as an expense as they are incurred.
HKAS 38.57
2.2.2 Development phase

Development costs must be recognised as intangible assets when the following strict criteria can be demonstrated: (a) (b) (c) (d) The technical feasibility of completing the intangible asset so that it will be available for use or sale. Its intention to complete the intangible asset and use or sell it. Its ability to use or sell the intangible asset. How the intangible asset will generate probable future economic benefits. Among other things, the entity should demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset. Its ability to measure the expenditure attributable to the intangible asset during its development reliably.
(e)
When these criteria are not met, development costs should be written off as an expense as incurred.
HKAS 38.6566

Topic highlights
Internally generated intangible assets are initially measured at cost The costs allocated to an internally generated intangible asset should only be those costs that can be directly attributed or allocated on a reasonable and consistent basis to creating, producing or preparing the asset for its intended use. The principle here is similar to that applied to the cost of non-current assets and inventory. The cost of an internally operated intangible asset is the sum of the expenditure incurred from the date when the intangible asset first meets the recognition criteria. If, as often happens, considerable costs have already been recognised as expenses before management could demonstrate that the criteria have been met, this earlier expenditure should not be retrospectively recognised at a later date as part of the cost of an intangible asset.
Mountain Co is developing a new production process. During 20X1, expenditure incurred was $500,000, of which $310,000 was incurred before 1 December 20X1 and $190,000 between 1 December 20X1 and 31 December 20X1. Mountain can demonstrate that, at 1 December 20X1, the production process met the criteria for recognition as an intangible asset. How should the expenditure be treated? (The answer is at the end of the chapter)
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At this stage it may be useful to summarise the rules seen for the recognition and initial measurement of separately purchased intangibles, intangibles acquired as part of a business acquisition and internally generated development expenditure. Summary of the recognition and initial measurement requirements of HKAS 38 Separately purchased intangible Recognise as an asset if: Meets definition of intangible asset Probable economic benefits Cost reliably measured Intangible acquired as part of business combination Meets definition of intangible asset Probable economic benefits Fair value reliably measured Internally generated intangible development Initially measured at: Cost + directly attributable costs in preparing asset for use Fair value at date of acquisition Technically feasible Intention to complete Commercially viable Probable economic benefits Resources available to complete Expenditure reliably measured
Directly attributable costs from date when criteria first met
HKAS 38.68 70
2.4 Recognition of an expense

Expenditure on an intangible should be expensed as incurred when it does not meet the criteria for recognition either as an identifiable intangible asset or as goodwill arising on an acquisition. Examples of such expenditure are stated in the HKAS: Start up costs, i.e. costs of establishing a new business Training costs Advertising and promotional costs Business relocation or reorganisation costs
Prepaid costs for services, for example advertising or marketing costs for campaigns that have been prepared but not yet launched, can still be recognised as a prepayment.
HKAS 38 BC46A-46H
2.4.1 Advertising and promotional activities

There is often confusion as to whether the costs of advertising and promotional activities qualify as an intangible asset. HKAS 38 has been amended to clarify that for advertising and promotional activities: (a) (b) (c) (d) (e) In the case of goods, an expense is recognised when the entity has the right to access those goods. In the case of services, an expense is recognised when the entity receives those services. A right to access goods is received by the entity when the supplier has made them available to the entity. The contract terms for the supply of goods or services determine when an expense should be recognised. A prepayment can be recognised as an asset when payment has been made in advance of the entity obtaining the right to access the goods or receiving the services.
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The amendment clarifies that catalogues are considered to be a form of advertising and promotional activity. Expenses incurred in printing mail order catalogues are recognised once the catalogues are printed and not when they are distributed to customers.
HKAS 38.72,74,75,81
2.5 Measurement of intangible assets subsequent to initial recognition

HKAS 38 allows two methods of measuring for intangible assets after they have been first recognised: 1 2 Cost model: an intangible asset is carried at its cost, less any accumulated amortisation and less any accumulated impairment losses. Revaluation model: an intangible asset is carried at a revalued amount, which is its fair value at the date of revaluation, less any subsequent accumulated amortisation and any subsequent accumulated impairment losses.
The rules with regard to the application of the revaluation model are as follows: (a) (b) The fair value must be measured reliably with reference to an active market in that type of asset. The entire class of intangible assets of that type must be revalued at the same time (to prevent a business from choosing to revalue only those particular assets that have enjoyed favourable price movements, and retaining the others at cost). If an intangible asset in a class of revalued intangible assets cannot be revalued because there is no active market for this asset, the asset should be carried at its cost less any accumulated amortisation and impairment losses. Revaluations should be made with such regularity that the carrying amount does not differ from that which would be determined using fair value at the end of the reporting period.
(c)
(d)
HKAS 38.8,78
2.5.1 Active market

Key term
An active market is a market in which all the following conditions exist: (a) (b) (c) The items traded in the market are homogenous Willing buyers and sellers can normally be found at any time; and Prices are available to the public.
Since an active market for an intangible asset will not usually exist, the revaluation model will usually not be available. For example, intangible assets such as copyrights, publishing rights and film rights are each sold at unique sale value, so a continuous active market is not accessible. A revaluation to fair value would therefore be inappropriate. However, a fair value might be obtainable for assets such as fishing rights, quotas or taxi cab licenses.
HKAS 38.8587
2.5.2 Accounting for a revaluation

Where the carrying amount of an intangible asset is revalued upwards to its fair value, the amount of the revaluation should be credited to other comprehensive income and accumulated in a revaluation surplus in equity. However, a revaluation surplus resulting from a reversal of a previous revaluation decrease that has been charged to profit or loss can be recognised as income. On the other hand, the amount of a downward revaluation on an intangible asset should be charged as an expense against income, unless an upward revaluation has previously been
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recorded on the same intangible asset. In such case, the revaluation loss should be first debited to other comprehensive income against any previous revaluation surplus recorded for the asset.
A non-current asset with a carrying value of $160m was impaired and written down to its recoverable value of $120m two years ago. After an upturn in business, the asset has a market value of $135m. Had the impairment not taken place, the carrying value of the asset would have been $130m. Required Consider how this impairment is reversed. (The answer is at the end of the chapter)
When the revaluation model is adopted, the cumulative revaluation surplus of an intangible asset may be transferred to retained earnings when the asset is disposed of and the surplus is eventually realised. However, the surplus may also be realised over the period in which the intangible asset is being used by the entity. The amount of the surplus realised each year is calculated as the difference in amortisation charges based on the revalued amount of the asset and the historical cost of the asset. The realised surplus should not be included in profit or loss, instead it should be transferred from revaluation surplus directly to retained earnings and disclosed in the statement of changes in equity.
2.6 Amortisation of intangible assets

Topic highlights
Capitalised intangible assets are amortised over their expected useful life. Where this is indefinite, an annual impairment test replaces amortisation.
HKAS 38.88,90,94
2.6.1 Useful life

An intangible asset may have a finite or indefinite useful life. An indefinite useful life, in this sense, means that there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity. The useful life of an intangible asset is affected by many factors, including: technical, technological, commercial or other types of obsolescence; expected usage; life cycles of typical product; the level of maintenance expenditure required; the stability of the industry; expected actions by competitors; and legal or similar restrictions on the use of the asset, such as the expiry dates of related leases. Intangible assets which are susceptible to technological obsolescence, such as computer software, normally have short lives. However, uncertainty does not justify the choice of a life that is unrealistically short. The useful life of an intangible asset may originate from contractual or other legal rights. It should not exceed the period of the rights, though it may be shorter depending on the duration in which the asset is to be used by the entity.
HKAS 38.100
2.6.2 Residual value

The residual value of an intangible asset with a finite useful life is assumed to be zero. This is not the case when a third party has a commitment to buying the intangible asset at the end of its useful life or when an active market exists for that type of asset (so that its expected residual value can be measured) and it is likely that there will be a market for the asset at the end of its useful life.
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HKAS 38.97
2.6.3 Amortisation period

An intangible asset with a finite useful life is amortised over its expected useful life, starting when the asset is available for use. Amortisation should cease at the earlier of the date that the asset is classified as held for sale in accordance with HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations and the date that the asset is derecognised. Annual review of the amortisation period of an intangible asset with finite useful life should be carried out at the end of each financial year.
HKAS 38.98,104
2.6.4 Amortisation method

The amortisation method used should reflect the pattern in which the asset's future economic benefits are consumed. If such a pattern cannot be predicted reliably, the straight line method should be used. HKAS 38 has been amended to remove wording perceived as prohibiting the use of the unit of production method if it results in a lower amount of accumulated amortisation than under the straight line method. Entities may use the unit of production method when the resulting amortisation charge reflects the expected pattern of consumption of the expected future economic benefits embodied in an intangible asset. The amortisation method used for an intangible asset with a finite useful life should be reviewed at each financial year-end.
HKAS 38.99
2.6.5 Accounting for amortisation

The amortisation charge for a period is recognised in profit or loss in the same way as depreciation on tangible non-current assets.
HKAS 38.107-109
2.6.6 Intangible assets with indefinite useful lives

An intangible asset with an indefinite useful life should not be amortised, instead HKAS 36 requires that such an asset is tested for impairment at least annually. The useful life of an intangible asset that is not being amortised should be reviewed each year to determine whether it is still appropriate to assess its useful life as indefinite. Reassessing the useful life of an intangible asset as finite rather than indefinite is an indicator that the asset may be impaired and in these circumstances it should be tested for impairment as well as being amortised over its remaining life.
It can be difficult to establish the useful life of an intangible asset in practice. Write brief notes on factors to consider when determining the useful life of a purchased brand name and how to provide evidence that its useful life might, in fact, exceed 20 years. (The answer is at the end of the chapter)
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Example: Computer software and hardware

The treatments can be illustrated by reference to computer software and hardware. The treatment depends on the nature of the asset and its origin. Asset Computer software Operating system for hardware Computer software Operating system for hardware (For use or sale) Origin Purchased Purchased Internally developed Treatment Capitalise Include in hardware cost Charge to expense until 'Development criteria' are met. Amortise over useful life, based on pattern of benefits (straight line is default)
HKAS 38.112-113
2.7 Disposals/retirements of intangible assets

An intangible asset should be derecognised from the statement of financial position when it is disposed of or when there is no further expected economic benefit from its future use. On disposal the gain or loss arising from the difference between the net disposal proceeds and the carrying amount of the asset should be taken to profit or loss as a gain or loss on disposal (ie treated as income or expense). For example, if a fishing license with a carrying amount of $2m is sold for $3m, then the licence is derecognised from the statement of financial position and $1m profit on disposal is taken to profit.
HKAS 38.118,122, 124,126

Extensive disclosure is required for intangible assets as listed in the standard. The accounting policies for intangible assets that have been adopted are to be disclosed in the financial statements. For each class of intangible assets, disclosure is required of the following: (a) (b) (c) (d) The method of amortisation used (eg, straight line method). The useful life of the assets or the amortisation rate used. The gross carrying amount, the accumulated amortisation and the accumulated impairment losses as at the beginning and the end of the period. A reconciliation of the carrying amount as at the beginning and at the end of the period (additions, retirements/disposals, revaluations, impairment losses, impairment losses reversed, amortisation charge for the period, net exchange differences, other movements). The carrying amount of internally-generated intangible assets.
(e)
The financial statements should also disclose the following: (a) (b) In the case of intangible assets that are assessed as having an indefinite useful life, the carrying amounts and the reasons supporting that assessment. For intangible assets acquired by way of a government grant and initially recognised at fair value, the fair value initially recognised, the carrying amount, and whether they are carried under the cost model or the revaluation model for subsequent remeasurements. The carrying amount, nature and remaining amortisation period of any intangible asset that is material to the financial statements of the entity as a whole. The existence (if any) and amounts of intangible assets whose title is restricted and of intangible assets that have been pledged as security for liabilities. The amount of any commitments for the future acquisition of intangible assets.
(c) (d) (e)
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Where intangible assets are accounted for at revalued amounts, disclosure is required of the following: (a) (b) (c) (d) The effective date of the revaluation (by class of intangible assets). The carrying amount of revalued intangible assets. The carrying amount that would have been shown (by class of assets) if the cost model had been used, and the amount of amortisation that would have been charged. The amount of any revaluation surplus on intangible assets, as at the beginning and end of the period, and movements in the surplus during the year (and any restrictions on the distribution of the balance to shareholders).
The financial statements should also disclose the amount of research and development expenditure that has been charged as an expense of the period.
2.9 HK(SIC) Int-32 Intangible Assets Website Costs

Websites are being used for business purposes to a large extent, including taking orders for products or services; promotion and advertising of products and services; and trading access to information contained on the website. Many companies incur significant costs in developing such websites, and these may include the following: (a) Planning costs including, for example, the costs of undertaking feasibility studies, determining the objectives and functionalities of the website, exploring ways of achieving the desired functionalities, identifying appropriate hardware and web applications and selecting suppliers and consultants. Application and infrastructure development costs including the costs of obtaining and registering a domain name and of buying or developing hardware and operating software that relate to the functionality of the site (for example, updateable content management systems and e-commerce systems, including encryption software, and interfaces with other IT systems used by the entity). Content costs expenditure incurred on preparing, accumulating and posting the website content. Operating costs.
(b)
(c) (d)
The issue arises as to how these costs should be treated within the financial statements.
2.9.1 HK(SIC) Int-32 treatment

HK(SIC) Int-32 resolves that a website developed by an entity and funded by internal expenditure is viewed as an internally generated intangible asset that is subject to the requirements of HKAS 38 Intangible Assets. This is the case whether the website is for internal or external access. Specifically, the treatment is as follows: (a) (b) Website planning costs are an expense charged to profit or loss. Application and infrastructure development costs. Expenditure which can be directly attributed, or allocated on a reasonable and consistent basis, to preparing the website for its intended use is to be included in the cost of the website and recognised as an intangible asset. Examples include expenditure on purchasing or creating content (other than content for marketing an entity's own products and services) solely for a website, and expenditure to enable use of the content (such as acquisition fee of a licence to reproduce) on the website. These expenditures should be included in the cost of development when the condition is met. However, HKAS 38 does not allow the recognition of an expenditure as part of the cost of an intangible asset at a later date if the expenditure was initially recognised as an expense in previous financial statements (for instance, when the content of a fully amortised copyright is subsequently provided on a website).
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(c)
Content development. According to HKAS 38, expenditure incurred in the content development stage to advertise and promote an entity's own products and services (such as digital photographs of products) should be recognised as an expense when incurred. For example, expenditure on professional services for taking digital photographs of an entity's products and for enhancing their display should be recorded as an expense when the professional services are received, not when the digital photographs are displayed on the website. Operating. The operating stage commences when the development of a website is complete. Unless expenditure meets the criteria in HKAS 38, it should be recognised as an expense when it is incurred.
(d)
A website which is recognised as an intangible asset under HK(SIC) Int-32 should be measured after initial recognition by applying the requirements as stated in HKAS 38. The useful life of a website is best estimated to be short.

An intangible asset should be recognised only on the condition that it is probable that future economic benefits will flow to the entity and the cost of the asset can be measured reliably. An asset is initially recorded at cost but carried either at cost or revalued amount in subsequent periods. Expense the costs as incurred if the recognition criteria are not met. Amortisation of an intangible asset with finite useful life should be spread over the useful life of the asset. No amortisation should be recorded for an intangible asset with an indefinite useful life.
Stauffer is a public listed company reporting under HKFRSs. It has asked for your opinion on the accounting treatment of the following items: (a) The Stauffer brand has become well known and has developed a lot of customer loyalty since the company was set up eight years ago. Recently, valuation consultants valued the brand for sale purposes at $14.6m. Stauffer's directors are delighted and plan to recognise the brand as an intangible asset in the financial statements. They plan to report the gain in the revaluation surplus as they feel that crediting it to profit or loss would be imprudent. On 1 October 20X5 the company was awarded one of six licences issued by the government to operate a production facility for five years. A 'nominal' sum of $1m was paid for the licence, but its fair value is actually $3m. The company undertook an expensive, but successful advertising campaign during the year to promote a new product. The campaign cost $1m, but the directors believe that the extra sales generated by the campaign will be well in excess of that over its four year expected useful life. Stauffer owns a 30-year patent which it acquired two years ago for $8m which is being amortised over its remaining useful life of 16 years from acquisition. The product sold is performing much better than expected. Stauffer's valuation consultants have valued its current market price at $14m. On 1 August 20X6, Stauffer acquired a smaller company in the same line of business. Included in the company's statement of financial position was an in-process research and development project, which showed promising results (and was the main reason why Stauffer purchased the other company), but was awaiting government approval. The project was included in the company's own books at $3m at the acquisition date, while the company's net assets were valued at a fair value of $12m (excluding the project). Stauffer
(b)
(c)
(d)
(e)
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paid $18m for 100 per cent of the company and the research and development project was valued at $5m by Stauffer's valuation consultants at that date. Government approval has now been received, making the project worth $8m at Stauffer's year end. Required Explain how the directors should treat the above items in the financial statements for the year ended 30 September 20X6. (The answer is at the end of the chapter)
3 Goodwill (HKFRS 3 (revised))

Topic highlights
Purchased goodwill arising on consolidation is retained in the statement of financial position as an intangible asset under HKFRS 3 (revised). It must then be reviewed annually for impairment under HKAS 36.
Goodwill is a type of intangible asset, however as we have seen in the earlier sections of this chapter, it does not fall within the scope of HKAS 38. Instead, HKFRS 3 applies, providing guidance on the calculation and accounting treatment of goodwill. The detailed calculation of goodwill, and accounting treatment is considered in more detail in the chapters of the Learning Pack which cover group accounting. Here we introduce the concept of goodwill and its treatment in the accounts.
3.1 What is goodwill?

Goodwill is created by good relationships between a business and its customers: through reputation for high quality products or standard or service through good customer service through the personality of staff members
The value of goodwill to a business might be considerable, however as we have already seen, internally generated goodwill is not recognised in the statement of financial position. This may seem odd, given its value to a business in generating future revenues, which may be far more than many tangible assets, particularly in a service organisation, however there is good reason for not recognising internally generated goodwill: (a) Goodwill is inherent in the business but has not been paid for and it does not possess an 'objective' value. How much such goodwill is worth can be guessed, but the guesswork is a matter of subjective opinion and is not based on concrete facts. Goodwill keeps changing from day to day. It might be damaged by one bad act of customer relations and improved by a good one. Staff with a good personality might retire or leave the entity and new staff need time to familiarise themselves with the job, and so on. Since the value of goodwill is continually changing, it cannot practically be recorded in the accounts of the business.
(b)
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3.2 Purchased goodwill

Topic highlights
Purchased goodwill is shown in the statement of financial position because it has been paid for. It has no tangible substance, and so it is an intangible non-current asset.
Whereas a business which builds up internally generated goodwill over time cannot objectively value this goodwill, at such time as that business is sold, its goodwill becomes measurable. This is because the price paid to purchase an existing business will generally exceed the sum of the values of the individual assets within the business. The excess represents payment for the goodwill of the business.
3.2.1 Measurement of purchased goodwill

When a business is sold, the selling price is likely to include a premium for goodwill. The calculation of this premium is not really a problem for accountants, who must simply record the goodwill in the accounts of the new business. The value of the goodwill is a matter for the purchaser and seller to agree upon in fixing the purchase/sale price. Two approaches may be taken to this issue: 1 The selling price of the business is agreed by the seller and the buyer without specifically considering the value of goodwill. The purchased goodwill will then be the excess of the purchase consideration over the value of the identifiable net assets of the new business. Negotiation is a major element in the computation of goodwill. There are various ways of valuing goodwill and a majority of them are related to the profit record of the acquired business.
It does not matter how goodwill is calculated, the amount recorded by the buyer will be the difference between the purchase consideration and his own valuation of the net assets acquired. If A values his net assets at $40,000, goodwill is agreed at $21,000 and B agrees to pay $61,000 for the business when the net assets are valued at only $38,000, then the goodwill recorded by B will be $23,000 ($61,000 $38,000).
3.3 HKFRS 3 (revised) Business Combinations

Topic highlights
Purchased goodwill is retained in the statement of financial position as an intangible asset under the requirements of HKFRS 3 (revised). It must then be reviewed for impairment annually.
HKFRS 3 (revised) deals with the accounting treatment of goodwill obtained through a business combination, in other words goodwill arising when one company (the parent) acquires a controlling interest in another company (the subsidiary). Various definitions for goodwill are possible. HKFRS 3 (Revised) defines goodwill differently from the traditional definition and places much emphasis on benefits, rather than the method of computation.
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Key term
Goodwill. Future economic benefits arising from assets that are not capable of being individually identified and separately recognised. (HKFRS 3 (revised))
HKFRS 3.32
3.3.1 Accounting for goodwill arising in a business combination

Acquired goodwill is initially measured at cost and recognised as an asset in the accounts. Cost is the excess of the purchase consideration over the fair value of the acquiree's identifiable assets, liabilities and contingent liabilities. After initial recognition, acquired goodwill is not amortised, but is then measured at cost less any accumulated impairment losses. According to HKAS 36 Impairment of Assets, goodwill is to be tested for impairment at least once a year.
3.3.2 Goodwill and non-controlling interests

Where the parent company acquires less than 100 per cent of the equity shares in the subsidiary company, another party will own some of the subsidiary. This party is referred to as the noncontrolling interest. The revised HKFRS 3 considers the group as an economic entity. All providers of equity including non-controlling interests are treated as shareholders in the group, even if they are not shareholders in the parent. Therefore it may be necessary to recognise goodwill attributed to the non-controlling interest. We will have a discussion on this in a later chapter.
HKFRS 3.3436
3.3.3 Bargain purchase

A bargain purchase is sometimes referred to as negative goodwill. It arises when the value of the combination is less than the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed. This may occur where there is a forced sale, or the purchased company is loss-making. Alternatively, it may be the result of the application of recognition and measurement rules within HKFRS 3 (revised). Prior to the recognition of a gain on a bargain purchase, the acquirer must carry out a reassessment to see whether it has correctly identified all of the assets acquired and all of the liabilities assumed. The acquirer must recognise any additional assets or liabilities that are identified in that review and must review the procedures used to measure the amounts this HKFRS requires to be recognised at the date of acquisition for all of the following: (a) (b) (c) (d) The identifiable assets acquired and liabilities assumed. The non-controlling (formerly minority) interest in the accquiree, if any. For a business combination achieved in stages, the acquirer's previously held interest in the acquiree. The consideration transferred.
The purpose of this review is to ensure that the measurements appropriately reflect all the available information as at the acquisition date.
What are the characteristics of goodwill which separate it from other types of intangible assets? Should these differing characteristics affect the accounting treatment of goodwill? State your reasons. (The answer is at the end of the chapter)
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4 HKAS 36 Impairment of Assets

Topic highlights
HKAS 36 Impairment of Assets covers the write down of assets where their carrying value exceeds the recoverable amount.
4.1 Introduction
The fundamental principle of HKAS 36 is relatively simple. If an asset's carrying value is higher than its 'recoverable amount', then the asset is said to have suffered an impairment loss. Its value should therefore be reduced by the amount of the impairment loss. HKAS 36 provides guidance on: (a) (b) (c) when an asset should be tested for a possible impairment how the impairment test is carried out how any resulting impairment loss is accounted for and disclosed
Before we consider each of these in turn, the next two sections explain the scope of HKAS 36 and provide a list of important definitions within it.
HKAS 36.2
4.2 Scope
HKAS 36 applies to all tangible, intangible and financial assets including those which have been revalued, except for the following: Inventories Assets arising from construction contracts Deferred tax assets Assets arising under HKAS 19 Employee Benefits Financial assets within the scope of HKFRS 9 Financial Instruments Investment property measured at fair value Biological assets related to agricultural activity that are measured at fair value less costs to sell Deferred acquisition costs and intangible assets arising from an insurer's contractual rights under insurance contracts within the scope of HKFRS 4 Insurance Contracts Non-current assets held for sale, which are dealt with under HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations
Instead, the relevant standard's requirements for recognition and measurement of assets should be applied.
HKAS 36.6
4.3 Definitions
HKAS 36 provides a number of definitions, including the following:
Key terms
Impairment loss. The amount by which the carrying amount of an asset exceeds its recoverable amount.
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Key terms (cont'd)

Carrying amount. The amount at which an asset is recognised after deducting any accumulated depreciation (amortisation) and accumulated impairment losses thereon. Recoverable amount of an asset is the higher of its fair value less costs to sell and its value in use. Fair value less costs to sell is the amount obtainable from the sale of an asset or cashgenerating unit in an arm's length transaction between knowledgeable, willing parties, less the costs of disposal. Value in use is the present value of the future cash flows expected to be derived from an asset. (HKAS 36)
HKAS 36.10
4.4 Identification of a possible impairment

An impairment test is required for all assets when there is an indication of impairment at the reporting date. In addition, certain assets should be tested for impairment annually. They are: goodwill acquired in a business combination intangible assets with an indefinite useful life intangible assets which are not yet available for use.
Note that the concept of materiality applies, and only material impairment needs to be identified.
HKAS 36.12
4.4.1 Indications of impairment

The various ways in which the indications of a possible impairment of assets might be recognised are suggested in HKAS 36. These suggestions are mostly based on common sense. (a) External sources of information (i) (ii) (iii) (iv) (b) A fall in the asset's market value that is more significant than would normally be expected from passage of time over normal use. A significant change in the technological, market, legal or economic environment of the business in which the assets are employed. An increase in market interest rates or market rates of return on investments likely to affect the discount rate used in calculating value in use. The carrying amount of the entity's net assets being more than its market capitalisation.
Internal sources of information (i) (ii) Evidence is available of obsolescence or physical damage to an asset. Significant changes with an adverse effect on the entity have taken place in the period or are expected to in the near future with the result that the asset's expected use or useful life will change. Evidence is available that an asset is performing or will perform worse than expected. Cash outflows to operate and maintain an asset are significantly higher than those budgeted. Cash inflows from an asset are significantly lower than budgeted.
(iii) (iv) (v)
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4.5 Impairment test

Topic highlights
Impairment is determined by comparing the carrying amount of the asset with its recoverable amount. The recoverable amount of an asset is the higher of the asset's fair value less costs to sell and its value in use.
Where there are indications of impairment, or for those assets which require testing annually, an impairment test must be performed. This involves comparing the carrying amount of the asset with its recoverable amount. We have already defined recoverable amount as the higher of fair value less costs to sell and value in use.
HKAS 36.2528
4.5.1 Fair value less costs to sell

The net amount that could be obtained from the sale of the asset is equal to the fair value of an asset less costs to sell. Selling costs include transaction costs in sales, such as legal expenses. (a) (b) If an active market exists, the net selling price of the asset should be based on the market value or on the price of similar assets traded recently. If no active market exists, it might then be reasonable to estimate a net selling price of the asset using best estimates of what 'knowledgeable, willing parties' might pay in an arm's length transaction.
Net selling price cannot be reduced by the inclusion of any restructuring or reorganisation expenses, or any costs that have already been recognised as liabilities in selling costs.
HKAS 36.30,33,39, 44,54-56
4.5.2 Value in use

Value in use is the present value of the future cash flows expected to be derived from an asset. The pre-tax cash flows and a pre-tax discount rate should be employed to calculate the present value. The calculation of value in use must reflect the following: (a) (b) (c) (d) (e) An estimate of the future cash flows the entity expects to derive from the asset Expectations about possible variations in the amount and timing of future cash flows The time value of money The price for bearing the uncertainty inherent in the asset Other factors that would be reflected in pricing future cash flows from the asset
The standard provides further guidance in the assessment of cash flows and choice of discount rate. Cash flows The HKAS states the following: (a) (b) (c) Cash flow projections should be based on 'reasonable and supportable' assumptions. Projections of cash flows, normally up to a maximum period of five years, should be based on the most recent budgets or financial forecasts. A steady or declining growth rate for each subsequent year (unless a rising growth rate can be justified) can be used in extrapolating short-term projections of cash flows beyond this period. Unless a higher growth rate can be justified, the long-term growth rate employed
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should not be higher than the average long-term growth rate for the product, market, industry or country. HKAS 36 further states that future cash flows may include: (a) (b) (c) Projections of cash inflows from continuing use of the asset. Projections of cash outflows necessarily incurred to generate the cash inflows from continuing use of the asset. Net cash flows received/paid on disposal of the asset at the end of its useful life assuming an arm's length transaction.
An asset's current condition is the basis for estimating future cash flows. It should be noted that future cash flows associated with restructurings to which the entity is not yet committed, or to future costs to add to, replace part of, or service the asset are excluded. Estimates of future cash flows should exclude the following: (a) (b) Cash inflows/outflows from financing activities. Income tax receipts/payments.
Foreign currency future cash flows should initially be prepared in the currency in which they will arise and will be discounted using an appropriate rate. Translation of the resulting figure into the reporting currency should then be based on the spot rate at the year end. Discount rate The discount rate should be a current pre-tax rate (or rates) that reflects: the current assessment of the time value of money, and the risks specific to the asset.
A rate that reflects current market assessments of the time value of money and the risks specific to the asset is the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those that the entity expects to derive from the asset. This rate is estimated from: the rate implicit in current market transactions for similar assets, or the weighted average cost of capital of a listed entity that has a single asset which is similar to that under review in terms of service potential and risks
The discount should not include a risk weighting if the underlying cash flows have already been adjusted for risk.
Example: Recoverable amount

An entity has a single manufacturing plant which has a carrying value of $749,000. A new government elected in the country passes legislation significantly restricting exports of the product produced by the plant. As a result, and for the foreseeable future, the entity's production will be cut by 40 per cent. Cash flow forecasts have been prepared derived from the most recent financial budgets/forecasts for the next five years approved by management (excluding the effects of general price inflation): Year 1 $'000 Future cash flows 230 2 $'000 211 3 $'000 157 4 $'000 104 5 $'000 233 (including disposal proceeds)
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If the plant was sold now it would realise $550,000, net of selling costs. The entity estimates that the pre-tax discount rate specific to the plant to be 15 per cent, excluding the effects of general price inflation. Required Calculate the recoverable amount of the plant. Note. PV factors at 15% are as follows. Year 1 2 3 4 5 PV factor @15% 0.86957 0.75614 0.65752 0.57175 0.49718
Solution
The fair value less costs to sell is given as $550,000 The value in use is calculated as $638,000: Year Future cash flows $'000 1 2 3 4 5 230 211 157 104 233 0.86957 0.75614 0.65752 0.57175 0.49718 PV factor at 15% Discounted future cash flows $'000 200 160 103 59 116 638 The recoverable amount is the higher of $550,000 and $638,000, thus $638,000.
4.6 Recognition and measurement of an impairment loss

Topic highlights
Where the carrying amount exceeds the recoverable amount of an asset the difference should be recognised as an impairment loss. An impairment loss is recognised in profit or loss unless it reverses a previous upwards revaluation.
4.6.1 Measurement of an impairment loss

An impairment loss is measured as the excess of carrying amount over recoverable amount. When impairment is identified, the impaired asset must be written down to its recoverable amount.
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HKAS 36.30,33,39, 44,54-56
4.6.2 Recognition of an impairment loss

If the recoverable amount of an asset is less than its carrying amount in the statement of financial position, an impairment loss has occurred. This loss should be recognised immediately. (a) (b) The asset's carrying amount should be reduced to its recoverable amount in the statement of financial position. The impairment loss should be recognised immediately.
The recognition of an impairment loss depends on whether the asset in question is held at historic cost or a revalued amount. Where an asset is held at historic cost any impairment loss is recognised in profit or loss. Where an asset is held at a revalued amount any impairment loss is recognised as follows: (a) (b) To the extent that there is a revaluation surplus held in respect of the asset, the impairment loss should be charged to revaluation surplus. Any excess should be charged to profit or loss.
Example: Impairment loss

The accountant of Louella Co has identified a machine which she believes to be impaired. The machine cost $68,000 on 1 January 20X7 and was revalued to $75,000 on 31 December of that year, resulting in a revaluation surplus of $10,400. The machine continued to be depreciated over the remaining nine years of its ten-year life. By 31 December 20X8, the development of new technology meant that the machine had fallen in value such that its fair value less costs to sell was just $42,000. The accountant calculated a value in use of $45,000. What impairment loss should the accountant recognise and where should it be recorded?
Solution
The recoverable amount is $45,000, being the higher of fair value less costs to sell and value in use. The carrying amount of the machine is $66,667 ($75,000 8/9) Therefore an impairment loss of $21,667 must be recognised. The revaluation surplus at the year end in relation to the machine is $8,867 ($10,400 ($75,000/9 $68,000/10) being the depreciation reserves transfer). Therefore $8,867 is charged to other comprehensive income against the revaluation surplus and the remaining $12,800 is charged to profit or loss.
HKAS 36.63,110,114, 117,119
4.7 Subsequent accounting for an impaired asset

After reducing an asset to its recoverable amount, the depreciation charge on the asset should then be based on its new carrying amount, its estimated residual value (if any) and its estimated remaining useful life. The annual review of assets to determine whether there may have been some impairment should be applied to all assets, including assets that have already been impaired in the past.
4.7.1 Reversal of impairment losses

In some cases, the recoverable amount of an asset that has previously been impaired might turn out to be higher than the asset's current carrying value. An impairment loss recognised previously
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for an asset should be reversed if, and only if, there has been a change in the estimates used to determine the asset's recoverable amount since the last impairment loss was recognised. (a) (b) The reversal of the impairment loss should be recognised immediately as income in profit or loss for the year. The carrying amount of the asset should be increased to its new recoverable amount.
The asset cannot be revalued to a carrying amount that is higher than its value would have been if the asset had not been impaired originally, ie its depreciated carrying value had the impairment not taken place. Depreciation of the asset should now be based on its new revalued amount, its estimated residual value (if any) and its estimated remaining useful life.
HKAS 36.6,66
4.8 Cash generating units

Topic highlights
When it is not possible to calculate the recoverable amount of a single asset, then that of its cash generating unit (CGU) should be measured instead.
HKAS 36 explains the important concept of cash generating units. As a basic rule, the recoverable amount of an asset should be calculated for the asset individually. However, there will be occasions when it is not possible to estimate such a value for an individual asset, particularly in the calculation of value in use. This is because cash inflows and outflows cannot be attributed to the individual asset. If it is not possible to calculate the recoverable amount for an individual asset, the recoverable amount of the asset's cash generating unit should be measured instead.
Key term
A cash generating unit is the smallest identifiable group of assets for which independent cash flows can be identified and measured.
HKAS 36.69,72
4.8.1 Identifying the cash-generating unit to which an asset belongs

If recoverable amount cannot be determined for an individual asset, an entity should identify the smallest aggregation of assets that generate largely independent cash inflows. As part of the identification process, an entity may take into account: How management monitors the entity's operations (for example, by product line, business or location) How management makes decisions about continuing or disposing of the entity's operations and assets.
An asset or a group of assets is identified as a cash generating unit when there is an active market exists for the output produced by the asset or the group. This is so even if some or all of the output is used internally. Unless a change is justified, it is necessary to identify consistently from period to period, the cash generating units for the same type of asset. The group of net assets (less liabilities) considered for impairment and those considered in the computation of the recoverable amount should be alike. (For the treatment of goodwill and corporate assets see below.)
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Financial Reporting
Shrub is a retail store belonging to Forest, a chain of such stores. Shrub makes all its retail purchases through Forest's purchasing centre. Pricing, marketing, advertising and human resources policies (except for hiring Shrub's cashiers and salesmen) are decided by Forest. Forest also owns five other stores in the same city as Shrub (although in different neighbourhoods) and 20 other stores in other cities. All stores are managed in the same way as Shrub. Shrub and four other stores were purchased five years ago and goodwill was recognised. What is the cash generating unit for Shrub? (The answer is at the end of the chapter)
Motorbike Publishing Co owns 100 magazine titles of which 40 were purchased and 60 were selfcreated. The price paid for a purchased magazine title is recognised as an intangible asset. The costs of creating magazine titles and maintaining the existing titles are recognised as an expense when incurred. Cash inflows from direct sales and advertising are identifiable for each magazine title. Titles are managed by customer segments. The level of advertising income for a magazine title depends on the range of titles in the customer segment to which the magazine title relates. Management has a policy to abandon old titles before the end of their economic lives and replace them immediately with new titles for the same customer segment. What is the cash generating unit for the company? (The answer is at the end of the chapter)
4.9 Goodwill and impairment

HKAS 36.80,84
4.9.1 Allocating goodwill to cash generating units

Acquired goodwill does not generate independent cash flows and has to be allocated to the cash generating units (or groups of cash generating units) of the buyer. These units are expected to benefit from the synergies of the combination and should: (a) (b) Represent the lowest level within the entity at which the goodwill is monitored for internal management purposes. Not be larger than an operating segment as defined by HKFRS 8 Operating segments before aggregation.
Pragmatically, the allocation of goodwill may not be completed before the first reporting date after a business combination, especially if the buyer uses provisional values to account for the combination for the first time. The initial allocation of goodwill must be done before the end of the first reporting period after the date of acquisition.
HKAS 36.88
4.9.2 Testing cash generating units with goodwill for impairment

We have to consider the following two situations: (a) (b) where goodwill has been allocated to a cash generating unit. where goodwill has been allocated to a group of units because allocation to a specific cash generating unit is impossible.
In the first instance, the annual impairment test is to be carried out on the cash generating unit to which goodwill has been allocated. The carrying amount of the unit, including goodwill, is compared with the recoverable amount. An impairment loss must be recognised when the carrying amount of the unit is bigger than the recoverable amount.
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In the second instance, where goodwill is not allocated to a CGU, the impairment test of that CGU is carried out by comparing its carrying amount (excluding goodwill) with its recoverable amount. An impairment loss must be recognised if the carrying amount is bigger than the recoverable amount. The annual impairment test must be performed at the same time every year although it may be performed at any time during an accounting period.
4.9.3 Impairment of goodwill where there is a non-controlling interest

If there is a non-controlling (minority) interest in a cash generating unit to which goodwill has been allocated, and the non-controlling interest is measured as a proportion of the net assets of the subsidiary, adjustment is required before comparing carrying amount and recoverable amount. You may find it easier to come back to this section after studying the groups chapters where alternative measurements of the non-controlling interest are discussed. The issue here is that without adjustment, we are not comparing like with like: The carrying amount of goodwill represents only that goodwill attributable to the parent company, however, The recoverable amount of the cash-generating unit includes the value of full goodwill including that attributable to the non-controlling interest which is not recognised in the financial statements.
Therefore, the carrying amount of the goodwill should be grossed up to include the goodwill attributable to the non-controlling interest before the impairment test is conducted.
Example: Non-controlling interest

On 1 January 20X9 a parent acquires a 75 per cent interest in a subsidiary for $2,400,000, when the identifiable net assets of the subsidiary are $1,800,000. The non-controlling interest is measured as a proportion of the net assets of the subsidiary. The subsidiary is a cash generating unit. At 31 December 20X9, the recoverable amount of the subsidiary is $1,400,000. The carrying amount of the subsidiary's identifiable assets is $1,600,000. Calculate the impairment loss at 31 December 20X9.
Solution
At 31 December 20X9 the cash generating unit consists of the subsidiary's identifiable net assets (carrying amount $1,600,000) and goodwill of $1,050,000 (2,400,000 + (25% 1,800,000) 1,800,000). Goodwill is grossed up to reflect the 25 per cent non-controlling interest. At 31 December 20X9: Carrying amount Unrecognised non-controlling interest Recoverable amount Impairment loss Allocation of impairment loss unrecognised (goodwill) recognised (goodwill / net assets) Carrying value (350) (1,050) (200) 1,400 Goodwill $'000 1,050 350 1,400 Net assets $'000 1,600 1,600 Total $'000 2,650 350 3,000 (1,400) 1,600
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Financial Reporting
HKAS 36.100,102
4.10 Corporate assets

Corporate assets include group and divisional assets that do not generate cash inflows independently from other assets and hence their carrying amount cannot be fully attributed to a cash generating unit under review. Head office building, equipment or a research centre are examples of corporate assets. An entity should identify all the corporate assets that relate to a cash generating unit in an impairment test of that unit. (a) An entity compares the carrying amount of the unit (including the portion of the asset) with its recoverable amount when a portion of the carrying amount of a corporate asset can be allocated to the unit on a reasonable and consistent basis. If a portion of the carrying amount of a corporate asset cannot be reasonably and consistently allocated to the unit, the entity: (i) (ii) recognises the impairment loss by comparing the carrying amount of the unit (excluding the asset) with its recoverable amount. allocates a portion of the carrying amount of the asset on a reasonable and consistent basis by identifying the smallest group of cash generating units that includes the cash generating unit to which the asset belongs. recognises the impairment loss by comparing the carrying amount of that group of cash generating units (including the portion of the asset allocated to the group of units) with the recoverable amount of the group of units.
(b)
(iii)
Example: Corporate assets

Rainbow has identified three CGUs within its business, and allocated assets to each as follows: CGU 1 CGU 2 CGU 3 Carrying value of allocated assets $640,000 $2,150,000 $1,300,000
Screen operates from a corporate campus with a carrying value of $2 million. This has not yet been allocated to the CGUs, however it is considered that it can be allocated in full based on carrying value. The recoverable values of CGUs 1 to 3 are $980,000, $3,145,000 and $1,800,000 respectively. What impairment losses (if any) have the CGUs suffered?
Solution
CV of assets $ CGU 1 CGU 2 CGU 3 640,000 2,150,000 1,300,000 4,090,000 HO allocation $ 312,958 1,051,345 635,697 2,000,000 $312,958 $1,051,345 $635,697 Total $ 952,958 3,201,345 1,935,697 6,090,000 Recoverable amount $ 980,000 3,145,000 1,800,000 Impairment loss $ 56,345 135,697 192,042
Head office allocation: CGU 1 640/4,090 $2 million = CGU 2 2,150/4,090 $2 million = CGU 3 1,300/4,090 $2 million =
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HKAS 36.104,105
4.11 Allocating an impairment loss to the assets of a cashgenerating unit

An impairment loss should be recognised for a cash generating unit if the recoverable amount for the cash generating unit is less than the carrying amount in the statement of financial position for all the assets in the unit. When an impairment loss is recognised for a cash generating unit, the loss should be allocated between the assets in the unit in the following order: (a) (b) First, to the goodwill allocated to the cash generating unit (if any). Then, to all other assets in the cash generating unit within the scope of HKAS 36 (see Section 4.2), on a pro rata basis.
In allocating an impairment loss, the carrying amount of an asset should not be reduced below the highest of: (a) (b) (c) its fair value less costs to sell, its value in use (if determinable), or zero.
Any remaining amount of an impairment loss should be recognised as a liability if required by other HKASs.
Example: Impairment loss (1)

On 31 December 20X1 Invest purchased all the shares of MH for $2 million. The net fair value of the identifiable assets acquired and liabilities assumed of MH at that date was $1.8 million. MH made a loss in year ended 31 December 20X2 and at 31 December 20X2 the net assets of MH based on fair values at 1 January 20X2 were as follows: Property, plant and equipment Capitalised development expenditure Net current assets $'000 1,300 200 250 1,750
An impairment review on 31 December 20X2 indicated that the recoverable amount of MH at that date was $1.5 million. The capitalised development expenditure has no ascertainable external market value and the current fair value less costs to sell of the property, plant and equipment is $1,120,000. Value in use could not be determined separately for these two items. Required Calculate the impairment loss that would arise in the consolidated financial statements of Invest as a result of the impairment review of MH at 31 December 20X2 and show how the impairment loss would be allocated.
Solution
Asset values at 31 Dec 20X2 before impairment $'000 200 1,300 200 250 1,950 Allocation of impairment loss (W1)/(W2) $'000 (200) (180) (70) (450) Carrying value after impairment loss $'000 1,120 130 250 1,500
Goodwill (2,000 1,800) Property, plant and equipment Development expenditure Net current assets
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Financial Reporting
WORKINGS 1 Impairment loss Carrying value Recoverable amount Impairment loss Amount to allocate against goodwill Amount to allocate pro-rata against other assets 2 Allocation of the impairment losses on pro-rata basis Initial value $'000 1,300 200 Impairment pro-rated $'000 217 33 NBV if fully allocated $'000 1,083 167 Reallocation Actual loss allocated $'000 180 70 Impaired value $'000 1,120 130 1,950 1,500 450 200 250
PPE (250 1,300/1,500) Dev exp (250 200/1,500)
$'000 (37) 37
The amount not allocated to the PPE because they cannot be taken below their recoverable amount is allocated to other remaining assets pro-rata, in this case all against the development expenditure. Hence the development expenditure is reduced by a further 37 (217 180), making the total impairment 70 (33 + 37). The net current assets are not included when pro-rating the impairment loss as they are outside the scope of HKAS 36.
Example: Impairment loss (2)

The Burgos Group is made up of two cash-generating units (as a result of a combination of various past 100 per cent acquisitions), plus a head office, which was not allocated to any given cashgenerating unit as it supports both divisions. Due to falling sales as a result of an economic crisis, an impairment test was conducted at the year end. The consolidated statement of financial position showed the following net assets at that date. Head Unallocated office goodwill $'m $'m $'m $'m Property, plant & equipment (PPE) 780 620 90 Goodwill 60 30 10 Net current assets 180 110 20 1,020 760 110 10 The recoverable amounts (including net current assets) at the year end were as follows: Division A Division B Group as a whole Division A Division B Total $'m 1,490 100 310 1,900
$'m 1,000 720 1,825 (including Head office PPE at fair value less costs to sell of $80m)
The recoverable amounts of the two divisions were based on value in use. The fair value less costs to sell of any individual item was substantially below this. No impairment losses had previously been necessary.
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Required Discuss, with suitable computations showing the allocation of any impairment losses, the accounting treatment of the impairment test.
Solution
Where there are multiple cash-generating units, HKAS 36 Impairment of Assets requires two levels of tests to be performed to ensure that all impairment losses are identified and fairly allocated. First Divisions A and B are tested individually for impairment. In this instance, both are impaired and the impairment losses are allocated first to any goodwill allocated to that unit and secondly to other non-current assets (within the scope of HKAS 36) on a pro-rata basis. This results in an impairment of the goodwill of both divisions and an impairment of the property, plant and equipment in Division B only. A second test is then performed over the whole business including unallocated goodwill and unallocated corporate assets (the Head office) to identify if those items which are not a cashgenerating unit in their own right (and therefore cannot be tested individually) have been impaired. The additional impairment loss of (W2) $15m is allocated first against the unallocated goodwill of $10m, eliminating it and then to the unallocated head office assets reducing them to $85m. Divisions A and B have already been tested for impairment so no further impairment loss is allocated to them or their goodwill as that would result in reporting them at below their recoverable amount. Carrying values after impairment test: Division A $'m 780 40 180 1,000 Division B $'m 610 110 720 Head office $'m 85 20 105 Unallocated goodwill $'m Total $'m 1,475 40 310 1,825
PPE 780/(620 10)/(90 5) Goodwill (60 20)/(30 30)/(10 10) Net current assets WORKINGS 1 Test of individual CGUs:
Carrying value Recoverable amount Impairment loss Allocated to: Goodwill Other assets in the scope of HKAS 36
Division A $'m 1,020 (1,000) 20
Division B $'m 760 (720) 40
20 20
30 10 40
Test of group of CGUs: Revised carrying value (1,000 + 720 + 110 + 10) Recoverable amount Impairment loss Allocated to: Unallocated goodwill Other unallocated assets $'m 1,840 (1,825) 15
10 5 15
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Financial Reporting
HKAS 36.122,123
4.12 Reversal of an impairment loss

Topic highlights
Impairment of goodwill may never be reversed.
Where a cash-generating unit has been impaired in the past, this impairment can be reversed. The reversal of the loss is allocated to the assets of the unit, except for goodwill pro rata with the carrying amounts of those assets. The increases in carrying amounts are treated in the same way as reversals of individual asset impairment, in other words, the carrying amount of an asset cannot increase above the lower of: (a) (b) its recoverable amount the carrying amount of the asset net of depreciation had no impairment been recognised previously.
Cannon Co operates in a number of countries, with its operations in each being classified as separate cash generating units. In one of the countries of operation, Adascus, legislation was passed two years ago restricting exports, and as a result management of Cannon expected production to decrease by 30 per cent in their Adascan operation. Accordingly the Adascan CGU was tested for impairment and an impairment of $1.473 million recognised in profit: Goodwill $000 Cost at 1 January 20X1 Depreciation 1,000 Impairment CV at 31 December 20X1 (1,000) 0 1,000 Assets $000 2,000 (167) 1,833 (473) 1,360
The average remaining useful life of assets remained unchanged after the impairment, at 11 years. Two years later at 31 December 20X3, it is thought that the effect of the legislation is less drastic than expected, and production is expected to increase by 25 per cent. The recoverable amount of the Adascan CGU is now $1.91 million. Required Calculate the reversal of the impairment loss. (The answer is at the end of the chapter)
HKAS 36.126,130, 131
4.13 Disclosure
HKAS 36 calls for substantial disclosure about impairment of assets. The information to be disclosed includes the following: For each class of asset: (a) The amount of impairment losses recognised in profit or loss in the period and the line item in the statement of comprehensive income where they are included.
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(b) (c) (d)
The amount of reversals of impairment losses recognised in the period and the line item in the statement of comprehensive income where they are included. The amount of impairment losses on revalued assets recognised in other comprehensive income in the period. The amount of reversals of impairment losses on revalued assets recognised in other comprehensive income in the period.
For each material impairment loss recognised or reversed during the period for an individual asset, including goodwill, or a cash-generating unit: (a) (b) (c) The events and circumstances that led to the recognition or reversal of the impairment loss. The amount of the impairment loss recognised or reversed. For an individual asset: (d) the nature of the asset if the entity reports segment information in accordance with HKFRS 8, the reportable segment to which the asset belongs
For a cash-generating unit: a description of the cash-generating unit the amount of the impairment loss recognised or reversed by class of assets and reportable segment (if HKFRS 8 applies) if the aggregation of assets for identifying the cash-generating unit has changed, a description of the old and new ways of aggregating assets and reasons for the change
(e) (f) (g)
Whether the recoverable amount of the asset or cash-generating unit is fair value less costs to sell or value in use. If recoverable amount is fair value less costs to sell, the basis used to determine this amount. If recoverable amount is value in use, the discount rates used in the current and previous estimates.
For the aggregate impairment losses and the aggregate reversals of impairment losses recognised during the period which are not material: (a) (b) The main classes of assets affected by impairment losses and reversals. The main events and circumstances that led to the recognition of these impairment losses and reversals.

The main aspects of HKAS 36 to consider are: indications of impairment of assets measuring recoverable amount, as net selling price or value in use measuring value in use cash generating units accounting treatment of an impairment loss, for individual assets and cash generating units reversal of an impairment loss
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Financial Reporting
Topic recap
Intangible assets are defined by HKAS 38 as non-monetary assets without physical substance. They must be: identifiable. controlled as a result of a past event. able to provide future economic benefits.
An intangible asset is recognised if: it will result in probable economic benefits flowing to the entity and its cost can be measured reliably
Research costs are always recognised as an expense. Development costs can be recognised as an asset if they meet certain criteria. Intangible assets should be initially measured at cost, but subsequently they can be carried at cost or at a revalued amount. Capitalised intangible assets are amortised over their expected useful life. Where this is indefinite, an annual impairment test replaces amortisation. Purchased goodwill arising on consolidation is retained in the statement of financial position as an intangible asset under HKFRS 3 (revised). It must then be reviewed annually for impairment under HKAS 36. Purchased goodwill is shown in the statement of financial position because it has been paid for. It has no tangible substance, and so it is an intangible non-current asset. It must be reviewed for impairment annually. HKAS 36 Impairment of Assets covers the write down of assets where their carrying value exceeds the recoverable amount. An asset is impaired where its carrying amount exceeds its recoverable amount. The recoverable amount of an asset is the higher of the asset's fair value less costs to sell and its value in use. An impairment loss is recognised in profit or loss unless it reverses a previous upwards revaluation. When it is not possible to calculate the recoverable amount of a single asset, then that of its cash generating unit should be measured instead. Impairment of goodwill may never be reversed.
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Answer 1
At the end of 20X1, the production process is recognised as an intangible asset at a cost of $190,000. This is the expenditure incurred since the date when the recognition criteria were met, that is 1 December 20X1. The $310,000 expenditure incurred before 1 December 20X1 is expensed, because the recognition criteria were not met. It will never form part of the cost of the production process recognised in the statement of financial position.
Answer 2
The reversal of the impairment loss is recognised to the extent it increases the carrying amount of the non-current asset to what it would have been had the impairment not taken place. This means that the reversal of the impairment loss can only be recognised at $10m. The asset is recognised at $130m and a reversal of the impairment loss of $10m is recognised in the income statement.
Answer 3
Factors to consider would include the following: (a) (b) (c) (d) (e) (f) (g) Legal protection of the brand name and the control of the entity over the (illegal) use by others of the brand name (ie control over pirating). Age of the brand name. Status or position of the brand in its particular market. Ability of the management of the entity to manage the brand name and to measure activities that support the brand name (eg advertising and PR activities). Stability and geographical spread of the market in which the branded products are sold. Pattern of benefits that the brand name is expected to generate over time. Intention of the entity to use and promote the brand name over time (as evidenced perhaps by a business plan in which there will be substantial expenditure to promote the brand name).
Answer 4
Stauffer brand The Stauffer brand is an 'internally generated' intangible asset rather than a purchased one. HKAS 38 specifically prohibits the recognition of internally generated brands, on the grounds that they cannot be reliably measured in the absence of a commercial transaction. Stauffer will not therefore be able to recognise the brand in its statement of financial position.
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Financial Reporting
License The license is an intangible asset acquired by a government grant. It can be accounted for in one of two ways: The asset is recorded at the nominal price (cash paid) of $1m and depreciated at $200,000 per annum of its five year life, or The asset is recorded at its fair value of $3m and a government grant is shown as deferred income at $2m. The asset is depreciated over the five years at an annual rate of $600,000 per annum. The grant is amortised as income through profit or loss over the same period at a rate of $400,000 per annum. This results in the same net cost of $200,000 in profit or loss per annum as the first method.
Advertising campaign The advertising campaign is treated as an expense. Advertising expenditure cannot be capitalised under HKAS 38, as the economic benefits it generates cannot be clearly identified so no intangible asset is created. Patent The patent is amortised to a nil residual value at $500,000 per annum based on its acquisition cost of $8m and remaining useful life of 16 years. The patent cannot be revalued under the HKAS 38 rules as there is no active market as a patent is unique. HKAS 38 does not permit revaluation without an active market as the value cannot be reliably measured in the absence of a commercial transaction. Acquisition The difference between the price that Stauffer paid and the fair value of the net assets of the acquired company will represent goodwill. The research and development project must also be valued at fair value in a business combination to ensure the goodwill is stated accurately, while in the acquiree's own financial statements it would not be revalued as there is no active market because it is unique. Consequently, in a business combination HKAS 38/HKFRS 3 (revised) permit intangible assets that do not have an active market to be valued on an 'arm's length' basis. The values attributed in the group financial statements on the acquisition date are therefore: $m Net assets (excluding R&D project) R&D project Goodwill (remainder) Purchase price 12 5 1 18
The fair value of the research and development project is measured at the acquisition date, not at the year end and so it is not recorded at $8m. The project will be amortised over the expected useful life of the product developed once the product is available for production.
Answer 5
Goodwill may be distinguished from other intangible non-current assets by reference to the following characteristics. (a) (b) (c) It is incapable of realisation separately from the business as a whole. Its value has no reliable or predictable relationship to any costs which may have been incurred. Its value arises from various intangible factors such as skilled employees, effective advertising or a strategic location. These indirect factors cannot be valued.
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(d) (e)
The value of goodwill may fluctuate widely according to internal and external circumstances over relatively short periods of time. The assessment of the value of goodwill is highly subjective.
It could be argued that, because goodwill is so different from other intangible non-current assets it does not make sense to account for it in the same way. Thus the capitalisation and amortisation treatment would not be acceptable. Furthermore, because goodwill is so difficult to value, any valuation may be misleading, and it is best eliminated from the statement of financial position altogether. However, there are strong arguments for treating it like any other intangible non-current asset. This issue remains controversial.
Answer 6
In identifying Shrub's cash generating unit, an entity considers whether, for example: (a) (b) Internal management reporting is organised to measure performance on a store-by-store basis. The business is run on a store-by-store profit basis or on a region/city basis.
All Forest's stores are in different neighbourhoods and probably have different customer bases. So, although Shrub is managed at a corporate level, Shrub generates cash inflows that are largely independent from those of Forest's other stores. Therefore, it is likely that Shrub is a cash generating unit.
Answer 7
It is likely that the recoverable amount of an individual magazine title can be assessed. Even though the level of advertising income for a title is influenced, to a certain extent, by the other titles in the customer segment, cash inflows from direct sales and advertising are identifiable for each title. In addition, although titles are managed by customer segments, decisions to abandon titles are made on an individual title basis. Therefore, it is likely that individual magazine titles generate cash inflows that are largely independent one from another and that each magazine title is a separate cash generating unit.
Answer 8
At 31 December 20X3, the carrying amount of the assets are: CV at 31 December 20X1 Depreciation X2 (1,360/11) Depreciation X3 $000 1,360 (124) (124) 1,112
Recoverable amount is $1.91 million and the excess over carrying amount is therefore $798,000. The impairment of goodwill cannot be reversed. The impairment of assets can be reversed provided that the new carrying amount is not in excess of the carrying amount had no impairment arisen ie $1.5 million ($1.833m x 9/11 years). Therefore, a reversal of $388,000 ($1.5m-$1.112m) is recognised in profit or loss.
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Financial Reporting
Exam practice
Intangible assets
27 minutes
Revolution Co. is a design company based in Hong Kong. The company's year end is 31 December. In 20X2 the company began investigating the prospect of developing a new engine system which would, if successful, cut petrol engine carbon emissions by 50 per cent. In the period 20X2-20X3 Revolution Co. spent $15m on this research. Events in subsequent years were as follows: 20X4 The company's technical director was able to convince the company's board that the previous two years of research had paid off and that he had come up with a technically feasible design (codenamed 'Petrol Lite') which he believed could be sold for large sums to car manufacturers for at least the next five years. The technical director produced details of a prototype which appeared to show that Petrol Lite' worked. The board promised to make adequate resources available to the technical director to complete the project. The total sum spent during the year was made up as follows: $m Services and sundry materials 20 Staff costs associated with the project 15 Expenses associated with the project 10 Proportion of general overheads 6 Training potential 'Petrol Lite' technical staff 4 55 The company incurred completion costs of $5m made up entirely of staff costs associated with the project. The technical director produced very convincing details showing strong cash flow projections over the next five years. In September, at a launch party costing $1m, the Petrol Lite' design was finally marketed. The Revolution Co. financial statements were published on 31 March. On April 1, the first manufacturer to produce cars using the engine found it contained a fundamental design fault and demanded the immediate return of all monies paid together with costs. The company asked for confirmation of this from an independent engineer and, following his confirmation that the design was virtually useless, the technical director announced that a change in accounting policy would be necessary. Required Explain how the above events would have been dealt with in the financial statements of Revolution Co. for the period 20X2 20X3 and in each of the three years 20X4, 20X5 and 20X6. (15 marks)
20X5
20X6
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chapter 9
Leases
Topic list
1 2 3 4 5 6 7 HKAS 17 Leases Lessee accounting Lessor accounting Sale and leaseback transactions Off-balance sheet finance explained Interpretations relating to lease accounting Current developments
Learning focus
Leasing transactions are extremely common in business and you will often come across them in both your business and personal capacity. It is important for the accountant to be able to advise from the perspective of both the lessor and the lessee. Off balance sheet finance and substance over form are both vital issues of which the accountant should be aware.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.14 3.14.01 3.14.02 3.14.03 3.14.04 3.14.05 3.14.06 3.14.07 3.14.08 3.14.09 3.14.10 Leases Identify the types of lease within the scope of HKAS 17 and define the terminology used in relation to leases Classify leases as operating or finance leases by looking at the substance of the transaction Account for operating leases from the perspective of both the lessee and the lessor Disclose the relevant information relating to operating leases in the accounts of both the lessee and the lessor Account for finance leases from the perspective of both the lessee and the lessor Disclose the relevant information relating to finance leases in the accounts of both the lessee and the lessor Account for manufacturer/dealer leases Account for sale and leaseback transactions Explain the term off-balance sheet finance and the importance of substance over form Explain how to determine whether an arrangement contains a lease 3
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9: Leases | Part C Accounting for business transactions
1 HKAS 17 Leases
Topic highlights
HKAS 17 covers the accounting for lease transactions by both lessees and lessors. A lease is a contract for the hire of a specific asset.
A lease is a contract between a lessee and lessor for the hire of a specific asset. The lessor retains ownership of the asset but conveys the right of the use of the asset to the lessee for an agreed period of time in return for the payment of specified rentals.
HKAS 17.2
1.1 Scope of HKAS 17

HKAS 17 is applied in accounting for all leases other than: leases to explore for or use minerals, oil, natural gas and similar resources licensing agreements for items such as films, video recordings, plays, manuscripts, patents and copyrights.
The standard is not applied as the basis of measurement for: property held by lessee that is accounted for as an investment property investment property provided by lessors under operating leases biological assets held by lessees under finance leases biological assets provided by lessors under operating leases.
1.2 Types of lease

Topic highlights
There are two forms of lease: finance lease and operating lease.
In some cases, leasing can be considered to be a medium-term or long-term source of finance. From the point of view of the lessee, therefore, leasing such an asset is very similar to purchasing it using a loan. The lessee has all of the benefits and responsibilities of ownership except for the capital allowances. These types of longer-term lease are known as finance leases. Other leases are of a very different nature. For example, a businessman may decide to hire (lease) a car for a week while his own is being repaired. A lease of this nature is for a short period of time compared with the asset's useful life and the lessor will expect to lease it to many different lessees during that life. Furthermore, the lessor rather than the lessee will be responsible for maintenance. These types of lease are known as operating leases.
HKAS 17.4
1.2.1 Definitions
HKAS 17 Leases classifies leases as either finance leases or operating leases and requires that different accounting treatment is applied for each. In distinguishing between them, the standard gives the following definitions.
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Financial Reporting
Key terms
Lease. An agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. Finance lease. A lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. Operating lease. A lease other than a finance lease. (HKAS 17)
The classification of a lease as either finance or operating is therefore largely dependent upon the transfer of risks and rewards. The next section explains what is meant by this term.
HKAS 17.711
1.2.2 Risks and rewards

Risks are the risks of ownership, not other types of risk. These include: possibility of losses from idle capacity possibility of losses from technological obsolescence variations in return due to changing economic conditions.
Rewards are represented by: the expectation of profitable operation over the asset's economic life unrestricted access to the asset any gain from appreciation in value or realisation of a residual value.
HKAS 17 applies the same definitions and accounting principles to both lessees and lessors, but the different circumstances of each may lead each to classify the same lease differently. An assessment of risks and rewards may be inconclusive in deciding what type of lease a particular arrangement is. In this instance, the standard provides examples of situations which indicate an arrangement is a finance lease. HKAS 17 provides the following examples of finance lease: (a) (b) The lease transfers ownership of the asset to the lessee by the end of the lease term. The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair value at the date the option becomes exercisable such that, at the inception of the lease, it is reasonably certain that the option will be exercised. The lease term is for the major part of the economic life of the asset even if title is not transferred. At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset. The leased assets are of a specialised nature such that only the lessee can use them without major modifications being made.
(c) (d) (e)
There are also some indicators of situations which individually or in combination could also lead to a lease being classified as a finance lease. (a) (b) (c) If the lessee can cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee. Gains or losses from the fluctuation in the fair value of the residual fall to the lessee (eg in the form of a rent rebate equalling most of the sales proceeds at the end of the lease). The lessee has the ability to continue the lease for a secondary period at a rent which is substantially lower than market rent.
178
HKAS 17.13,15A
1.2.3 Classification of a lease

Classification is made at the inception of the lease. Any revised agreement should be treated as a new agreement over its term. In contrast, changes in estimates (eg of economic life or residual value of the property) or changes in circumstances (eg default by the lessee) do not lead to a new classification of a lease for accounting purposes. Land and buildings When a lease includes both land and building elements, an entity must consider each of these elements in turn and classify them as finance or operating lease separately. With regard to the land, the standard states that an important consideration is that land normally has an indefinite economic life. This is likely to result in the land element being classified as an operating lease in view of the low level of risks and rewards associated with the land which would have been transferred to the lessee during the lease period.
HKAS 17.4
1.3 Other definitions

HKAS 17 gives a substantial number of definitions.
Key terms
Minimum lease payments. The payments over the lease term that the lessee is or can be required to make, excluding contingent rent, costs for services and taxes to be paid by and be reimbursable to the lessor, together with: (a) (b) For a lessee, any amounts guaranteed by the lessee or by a party related to the lessee. For a lessor, any residual value guaranteed to the lessor by one of the following: (i) (ii) (iii) The lessee A party related to the lessee An independent third party financially capable of meeting this guarantee.
However, if the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised, the minimum lease payments comprise the minimum payments payable over the lease term to the expected date of exercise of this purchase option and the payment required to exercise it. Interest rate implicit in the lease. The discount rate that, at the inception of the lease, causes the aggregate present value of the: (a) (b) Minimum lease payments Unguaranteed residual value
to be equal to the sum of: (a) (b) The fair value of the leased asset Any initial direct costs
Initial direct costs are incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors. Examples of initial direct costs include amounts such as commissions, legal fees and relevant internal costs. Lease term. The non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option.
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Financial Reporting
Key terms (cont'd)

A non-cancellable lease is a lease that is cancellable only in one of the following situations: (a) (b) (c) (d) Upon the occurrence of some remote contingency. With the permission of the lessor. If the lessee enters into a new lease for the same or an equivalent asset with the same lessor. Upon payment by the lessee of an additional amount such that, at inception, continuation of the lease is reasonably certain.
The inception of the lease is the earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. As at this date: (a) (b) A lease is classified as either an operating lease or a finance lease In the case of a finance lease, the amounts to be recognised at the lease term are determined.
Economic life is either the: (a) (b) Period over which an asset is expected to be economically usable by one or more users Number of production or similar units expected to be obtained from the asset by one or more users
Useful life is the estimated remaining period, from the beginning of the lease term, without limitation by the lease term, over which the economic benefits embodied in the asset are expected to be consumed by the entity. Guaranteed residual value is: (a) For a lessee, that part of the residual value which is guaranteed by the lessee or by a party related to the lessee (the amount of the guarantee being the maximum amount that could, in any event, become payable). For a lessor, that part of the residual value which is guaranteed by the lessee or by a third party unrelated to the lessor who is financially capable of discharging the obligations under the guarantee.
(b)
Unguaranteed residual value is that portion of the residual value of the leased asset, the realisation of which by the lessor is not assured or is guaranteed solely by a party related to the lessor. Gross investment in the lease is the aggregate of: (a) (b) The minimum lease payments receivable by the lessor under a finance lease Any unguaranteed residual value accruing to the lessor
Net investment in the lease is the gross investment in the lease discounted at the interest rate implicit in the lease. Unearned finance income is the difference between the: (a) (b) Gross investment in the lease Net investment in the lease
The lessee's incremental borrowing rate of interest is the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset.
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Key terms (cont'd)

Contingent rent is that portion of the lease payments that is not fixed in amount but is based on a factor other than just the passage of time (eg percentage of sales, amount of usage, price indices, market rates of interest). (HKAS 17) Some of these definitions are only of relevance when we look at lessor accounting in Section 3.
1.4 Section summary

The following diagram should help you remember how to determine whether a lease is a finance lease or an operating lease.
Is ownership transferred by the end of the lease term?

No
Yes
Does the lease contain a bargain purchase option?

No
Yes
Is the lease term for a major part of the asset's useful life?
No
Yes
Is the present value of minimum lease payments greater than or substantially equal to the asset's fair value?
No
Yes
Operating lease
Finance lease
2 Lessee accounting
Topic highlights
Lessee accounting: Operating leases: recognise rental expense on a straight line basis. Finance leases: record an asset in the statement of financial position and a liability to pay for it (at the lower of fair value of the asset or present value of minimum lease payments); apportion the finance charge to give a constant periodic rate of return.
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Financial Reporting
HKAS 17.33
2.1 Operating leases

As stated in HKAS 17, rentals under an operating lease should be charged as an expense over the period of the lease on a straight line basis. This is so even if unequal lease payments are made, unless another systematic and rational basis is justified by the circumstances.
Example: Operating lease

Flora Co entered an operating lease agreement in order to obtain use of a photocopier for a period of three years starting on 1 October 20X9. The terms of the lease stated that payment of $2,500 should be made annually in arrears for each of the three years of the lease in addition to an initial non-refundable deposit of $1,500. What expense is recognised in Flora Co's financial statements for the year ended 31 December 20X9?
Solution
Total amount payable Annual expense Expense for y/e 31 Dec 20X9 $1,500 + (3 $2,500) $9,000/3 years $3,000 3/12 = = = $9,000 $3,000 $750
2.1.1 HK(SIC) Int-15 Operating Leases Incentives

In negotiating a new or renewed operating lease, the lessor may provide incentives for the lessee to enter into the agreement. Examples include an up-front cash payment to the lessee. The question arises as to how incentives in an operating lease should be recognised in the financial statements of both the lessee and the lessor. HK(SIC) Int-15 provides that all incentives for the agreement of a new or renewed operating lease should be recognised as an integral part of the net consideration agreed for the use of the leased asset, irrespective of the incentive's nature or the form or the timing of payments. The lessee should recognise the aggregate benefit of incentives as a reduction of rental expense over the lease term, generally on a straight line basis. Costs incurred by the lessee, including costs in connection with a pre-existing lease should be accounted for in accordance with the relevant HKAS.
Example: Operating lease incentives

Fauna Co enters into an operating lease agreement on 1 August 20X8 in order to obtain use of a machine. The lease term is four years and $5,000 is payable annually in advance. As an incentive, the lessor has agreed a reduction of 40 per cent off the first year's rental payment. What expense is recorded by Fauna Co in the year ended 31 December 20X8 in respect of this agreement?
Solution
Total amount payable Annual expense Expense for y/e 31 Dec 20X8 ($5,000 4) - $2,000 $18,000/4 years $4,500 5/12 = = = $18,000 $4,500 $1,875
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HKAS 17.35
2.1.2 Lessees' disclosures for operating leases

Disclosures of the following, which are in addition to the requirements under HKFRS 7 (see Chapter 18), are required: The total of future minimum lease payments under non-cancellable operating leases for each of the following periods: Not later than one year Later than one year and not later than five years Later than five years.
The total of future minimum sublease payments expected to be received under non-cancellable subleases at the end of the reporting period. Lease and sublease payments recognised as an expense for the period, with separate amounts for minimum lease payments, contingent rents, and sublease payments. A general description of the lessee's significant leasing arrangements including, but not limited to, the following: Basis on which contingent rent payments are determined Existence and terms of renewal or purchase options and escalation clauses
Restrictions imposed by lease arrangements, such as those concerning dividends, additional debt, and further leasing.
2.2 Finance leases

From the lessee's point of view there are two main accounting problems: (a) (b)
HKAS 17.20,25,27
Whether the asset should be capitalised as if it had been purchased. How the lease charges should be allocated between different accounting periods.
2.2.1 Accounting treatment

HKAS 17 requires that a finance lease is accounted for as follows: 1 An asset and corresponding liability are recorded At the inception of the lease an asset and corresponding liability are recorded at the lower of the fair value of the leased asset and the present value of the minimum lease payments. Note that HKAS 17 uses the term fair value in a way that differs from the definition of fair value in HKFRS 13 Fair Value Measurement. Therefore in respect of leases fair value should be measured in accordance with HKAS 17 rather than HKFRS 13. The interest rate implicit in the lease is used to determine the present value of the minimum lease payments. If it is not practical to determine this rate then the lessee's incremental borrowing rate may be used. Any initial direct costs of the lessee are added to the amount recognised as an asset. These may be incurred in connection with securing or negotiating the lease, but should only include costs which are directly attributable to activities performed by the lessee to obtain the finance lease. 2 The asset is depreciated The asset held under the finance lease is depreciated over the shorter of the lease term and the useful life of the asset. If there is a reasonable certainty that the lessee will obtain ownership at the end of the lease, the asset should be depreciated over the asset's useful life. The policy of depreciation adopted should be consistent with similar non-leased assets and calculations should follow the bases set out in HKAS 16 (see Chapter 5).
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Financial Reporting
HKAS 17 (revised) introduced guidance on impairment of leased assets by referring to HKAS 36. 3 Lease payments are recorded Minimum lease payments should be split into the finance charge under the finance lease and a reduction of the outstanding obligation for future amounts payable. The finance charge allocated to the accounting periods should produce a constant periodic rate of interest on the outstanding balance of the lease obligation for each accounting period, or a reasonable approximation thereto. The normal method applied in order to achieve this is the actuarial method, discussed in the next section. An alternative method is the sum of digits method, however this is not examinable. Contingent rents should be charged in the periods in which they are incurred.
2.2.2 Actuarial method

The actuarial method, which is the best and most scientific method for interest allocation, is derived from the assumption that interest charged by the lessor will be the same as the lessors desired rate of return, multiplied by its capital investment. (a) (b) The capital investment is identical to the fair value of the asset (less any initial deposit paid by the lessee) at the commencement of the lease. The amount of capital invested reduces as each instalment is paid. The interest on the lease decreases gradually as capital is repaid. It follows that the interest accruing is greatest in the early part of the lease term. We will go through a simple example of the actuarial method in this section.
Example: Finance lease with payments in arrears

On 1 January 20X0, Gordon Co leased an asset with a fair value of $38 million and a useful life of five years. The lease term was five years and the interest rate implicit in the lease was 9.9 per cent. The company is required to make five annual instalments of $10 million on 31 December, with the first payment on 31 December 20X0. Show the lease obligation working for each year of the lease and identify amounts to be recognised in profit or loss in 20X0.
Solution
Interest is calculated as 9.9 per cent of the outstanding capital balance at the beginning of each year. The outstanding capital balance reduces each year by the capital element comprised in each instalment. The outstanding capital balance at 1 January 20X0 is the $38 million fair value at which both the asset and liability are initially recorded. Depreciation on the plant is to be provided for at the rate of 20 per cent per annum on a straight line basis assuming a residual value of nil. Balance of lease at 1 Jan $'000 38,000 31,762 24,906 17,372 9,092 Interest 9.9% $'000 3,762 3,144 2,466 1,720 908 Annual lease payment at 31 Dec $'000 (10,000) (10,000) (10,000) (10,000) (10,000) $m 7.600 3.762 Balance of lease at 31 Dec $'000 31,762 24,906 17,372 9,092 -
Year 20X0 20X1 20X2 20X3 20X4
Amounts to be included in profit or loss in 20X0 are: Depreciation (38m/5 years) Finance cost
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Note that the $10m lease payment in 20X0 includes payment of the $3.762m interest for the year plus a capital amount of $6.238m.
Example: Finance lease with deposit and payments in arrears

On 1 January 20X5 Jennifer Co acquired a machine from Alice Co under a finance lease. The cash price of the machine was $7,710 while the minimum payments in the lease agreement totalled $10,000. The agreement required the immediate payment of a $2,000 deposit with the balance being settled in four equal annual instalments commencing on 31 December 20X5. The finance charge of $2,290 represents interest of 15 per cent per annum, calculated on the remaining balance of the liability during each accounting period. Required Show the breakdown of each instalment between interest and capital, using the actuarial method.
Solution
Interest is calculated as 15 per cent of the outstanding capital balance at the beginning of each year. The outstanding capital balance reduces each year by the capital element comprised in each instalment. The outstanding capital balance at 1 January 20X5 is $5,710 ($7,710 fair value less $2,000 deposit). Capital at Interest Capital at Year 1 Jan 15% Instalment 31 Dec $ $ $ $ 20X5 5,710 856 2,000 4,566 20X6 4,566 685 2,000 3,251 20X7 3,251 488 2,000 1,739 20X8 1,739 261 2,000 2,290 8,000
In the above examples, repayments are made at the end of each reporting period ie in arrears. It may be that repayments are made at the start of a reporting period, ie in advance, and in this case the lease obligation table takes a slightly different format. The following example illustrates this.
Example: Finance lease with payments in advance

Jesmond acquired an asset by way of a five year term finance lease on 1 July 20X0. The asset had a fair value of $102,500 and a useful life of five years and the lease contract required 5 payments in advance of $25,000. The interest rate implicit in the lease is 11%. Jesmonds year end is 30 June. Draw up the lease liability table for Jesmond for the whole five-year period, identifying amounts for inclusion in the income statement of the year ended 30 June 20X1.
Solution
B/f $ Repayment $ C/f $ 77,500 61,025 42,738 22,439 Interest at 11% $ 8,525 6,713 4,701 2,468 C/f $ 86,025 67,738 47,439 24,907
30.6.X1 102,500 (25,000) 30.6.X2 86,025 (25,000) 30.6.X3 67,738 (25,000) 30.6.X4 47,439 (25,000) 30.6.X5 24,907 (25,000)* * There is a rounding difference of $93.
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Financial Reporting
Income statement for the year ended 30 June 20X1 Depreciation ($102,500/5 years) Finance cost
$ 20,500 8,525
Note that in this example, interest is calculated after the repayment ie it is based on the amount owed throughout a period. Therefore the table includes items in a different order to that seen previously.
2.2.3 Finance leases with different payment schedules

In the examples above, all finance leases agreements have involved one annual payment. In some cases, payments are required monthly or quarterly. Where this is the case, the working should be drawn up as we have seen, with one row representing each payment period. Therefore where there are quarterly repayments, the table will include four rows for each accounting year: B/f 31.3.X1 30.6.X1 30.9.X1 31.12.X1 119,400 107,758 95,301 81,972 Interest 7% 8,358 7,543 6,671 5,738 28,310 Repayment (20,000) (20,000) (20,000) (20,000) C/f 107,758 95,301 81,972 67,710
Finance charge
HKAS 17.31
Year end liability
2.2.4 Lessees' disclosure for finance leases

HKAS 17 states that it is not appropriate to show liabilities for leased assets as deductions from the leased assets and therefore these amounts should not be netted off. In addition, a distinction should be made between current and non-current lease liabilities, if the entity makes this distinction for other liabilities. HKAS 17 also requires substantial disclosures to be provided in the notes to the accounts (in addition to those required by HKFRS 7: see Chapter 18), including the following: (a) (b) The net carrying amount at the end of the reporting period for each class of asset. A reconciliation between the total of minimum lease payments at the end of the reporting period, and their present value. In addition, an entity should disclose the total of minimum lease payments at the end of the reporting period, and their present value, for each of the following periods: (i) (ii) (iii) (c) (d) (e) Not later than one year Later than one year and not later than five years Later than five years.
Contingent rents recognised as an expense for the period. Total of future minimum sublease payments expected to be received under noncancellable subleases at the end of the reporting period. A general description of the lessee's significant leasing arrangements including, but not limited to, the following: (i) (ii) The basis on which contingent rent payments are determined The existence and terms of renewal or purchase options and escalation clauses
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(iii)
Restrictions imposed by lease arrangements, such as those concerning dividends, additional debt, and further leasing.
Example: Lessee disclosures

These disclosure requirements will be illustrated for Gordon Co (the first example in Section 2.2.2). We will assume that Gordon Co makes up its accounts to 31 December and uses the actuarial method, as shown in the example above, to apportion finance charges.
Solution
The company's accounts for the first year of the lease, the year ended 31 December 20X0, would include the information given below. STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X0 (EXTRACTS) $'000 Non-current assets Assets held under finance leases Plant and machinery at cost Less accumulated depreciation ($38,000/5 years) Non-current liabilities Obligations under finance leases (Balance at 31 December 20X1) Current liabilities Obligations under finance leases (31,762 24,906) 38,000 7,600 30,400 24,906 6,856 $'000
(Note that only the outstanding capital element is disclosed under liabilities, ie the total of the minimum lease payments with future finance charges separately deducted.) STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X0 (EXTRACT) $'000 Interest payable and similar charges Interest on finance leases 3,762
Potter leases an asset (as lessee) on 1 January 20X1, incurring $20,000 of costs in setting up the agreement. Potter agrees to pay a non-refundable deposit of $58,000 on inception together with six annual instalments of $160,000, payable in arrears. Potter also guaranteed to the lessor that the lessor would receive at least $80,000 when the asset is sold in the general market at the end of the lease term. The fair value of the asset (equivalent to the present value of minimum lease payments) on 1 January 20X1 is $800,000. Its useful life to the company is five years. The interest rate implicit in the lease has been calculated as 10 per cent.
187
Financial Reporting
Required (a) (b) Prepare the relevant extracts from the financial statements of Potter in respect of the above lease for the year ended 31 December 20X1. Explain what would happen at the end of the lease if the asset could be sold by the lessor: (i) (ii) For $80,000 For only $60,000 (The answer is at the end of the chapter)
2.2.5 Arguments against capitalisation

The main argument in favour of capitalisation of assets acquired under a finance lease is substance over form. The substance of the arrangement is that the lessee owns the asset, since the risks and rewards of ownership have transferred to them and they in effect pay for the asset by way of a financing arrangement. The main arguments against capitalisation are as follows: (a) Legal position. The benefit of a lease to a lessee is an intangible asset, not the ownership of the equipment. It may be misleading to users of accounts to capitalise the equipment when a lease is legally quite different from a loan used to purchase the equipment. Capitalising leases also raises the question of whether other executory contracts should be treated similarly, for example contracts of employment. Complexity. Many small businesses will find that they do not have the expertise necessary for carrying out the calculations required for capitalisation. Subjectivity. To some extent, capitalisation is a somewhat arbitrary process and this may lead to a lack of consistency between companies. Presentation. The impact of leasing can be more usefully described in the notes to financial statements. These can be made readily comprehensible to users who may not understand the underlying calculations.
(b) (c) (d)
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2.3 Recap
The following diagram gives a useful summary of the accounting treatment for a finance lease by a lessee. Accounting for a finance lease by a lessee
3 Lessor accounting
Topic highlights
Lessor accounting: Operating leases: record as long-term asset and depreciate over useful life, record income on a straight line basis over the lease term. Finance leases: record the amount due from the lessor in the statement of financial position at the net investment in the lease, recognise finance income to give a constant periodic rate of return.
To a certain extent at least, the accounting treatment of leases adopted by lessors will be a mirror image of that used by lessees.
189
Financial Reporting
HKAS 17.4953
3.1 Operating leases

Statement of financial position An asset held by a lessor under an operating lease is treated as a long-term asset and depreciation is recorded over its useful life. The depreciation basis should be the same as the lessor's policy on similar non-lease assets which shall follow the guidance in HKAS 16. In determining whether there is an impairment of the leased asset, the lessor should refer to the issues discussed in HKAS 36. Statement of comprehensive income Income under an operating lease, excluding charges for services such as insurance and maintenance, should be recognised over the period of the lease on a straight line basis. This is so even if the receipts are not on such a basis, unless another systematic and rational basis is identified as more representative of the time pattern in which the benefit from the leased asset is receivable. In accordance with HK(SIC)Int-15 Operating Leases Incentives (see Section 2.1.1), the lessor should recognise the aggregate cost of incentives as a reduction of rental income over the lease term, generally on a straight line basis. Initial direct costs incurred by lessors in negotiating and arranging an operating lease should be capitalised and amortised over the lease term. These costs are included in the carrying amount of the leased asset and recognised as an expense over the lease term on the same basis as lease income.
HKAS 17.56
3.1.2 Lessors' disclosures for operating leases

The following should be disclosed (on top of HKFRS 7 requirements). For each class of asset, the gross carrying amount, the accumulated depreciation and accumulated impairment losses at the end of the reporting period: Depreciation recognised in income for the period Impairment losses recognised in income for the period Impairment losses reversed in income for the period.
The future minimum lease payments under non-cancellable operating leases in the aggregate and for each of the following periods: Not later than one year Later than one year and not later than five years Later than five years.
Total contingent rents recognised in income. A general description of the lessor's leasing arrangements.
3.2 Finance leases

Some of the definitions listed in the Key terms in Section 1 of this chapter are relevant to lessor accounting and you should review them again. Unguaranteed residual value Gross investment in the lease Unearned finance income Net investment in the lease
190
HKAS 17.36,38-41

According to HKAS 17, the amount due from the lessee under a finance lease is to be shown as a receivable, at an amount of the net investment in the lease, in the statement of financial position of the lessor. The finance income under a finance lease should be recognised so as to generate a constant periodic rate of return on the lessor's outstanding net investment in each period. A reasonable approximation may be made to arrive at the constant periodic rate of return. The lease payments (excluding costs for services) for the accounting period should be applied against the gross investment in the lease. This will result in reducing both the principal and the unearned finance income. Regular review should be carried out on the estimated unguaranteed residual values used to calculate the lessor's gross investment in a lease. If there has been a reduction in the value, the income allocation over the lease term must be revised. Immediate recognition is required for any reduction in respect of amounts already accrued. The initial amount of the finance lease receivable should include the initial direct costs incurred by lessors (eg commissions, legal fees and other costs that are directly attributable to negotiating and arranging a lease).
Example: Finance leases: lessor accounting

Hire Co leased an asset to another company with effect from 1 January 20X8. The terms of the lease were as follows: Lease term of eight years Rentals of $11,000 are payable in advance The interest rate implicit in the lease is 12.8 per cent
The fair value of the asset on 1 January 20X8 was $59,500 and legal fees associated with the lease amounting to $500 were payable by Hire Co on this date. What amounts are recognised in Hire Co's financial statements for the year ended 31 December 20X8 in respect of the lease?
Solution
The net investment in the lease is calculated as: Amount due from lessee (fair value of the asset) Direct costs $ 59,500 500 60,000
This net investment reduces over the period of the lease due to payments received; it will also increase due to interest receivable. In other words, the movement is the direct opposite of the movement seen in the finance lease obligation of a lessee: $ Balance 1 January 20X8 60,000 Instalment 1 January 20X8 (11,000) Balance c/f 49,000 Interest at 12.8% 6,272 Balance at 31 December 20X8 55,272 Instalment 1 January 20X9 (11,000) Balance c/f 44,272 Therefore in the statement of financial position of Hire Co, a current and non-current asset is recognised:
191
Financial Reporting
Non-current asset: Net investment in finance lease Current asset: Net investment in finance lease (55,272 44,272)
$44,272 $11,000
Interest receivable of $6,272 is recognised in the statement of comprehensive income.
HKAS 17.4246
3.3 Manufacturer or dealer lessors

In some instances, manufacturers lease out assets which they have made, rather than sell them. Similarly, dealers acquire assets for resale but in some circumstances may instead lease these out to third parties. Unlike normal lessor companies which buy assets at their fair value and in leasing them out make a profit only on the financing arrangements, these companies acquire the asset in the first place for less than fair value: Manufacturers acquire the asset for cost Dealers generally acquire the asset at a discount
Therefore, the manufacturer or dealer makes two types of income: 1 2 a profit or loss (being the difference between the cost /reduced price and fair value), and interest from financing arrangements.
HKAS 17 therefore requires the following accounting treatment: (a) The selling profit/loss is recognised in income for the period as if it was an outright sale. For this purpose: (b) (c) revenue is the lower of the fair value of the asset or the present value of the minimum lease payments calculated using a market rate of interest cost of sales is the cost (or carrying amount if different) of the asset less the present value of any unguaranteed residual value.
If interest rates are artificially low, the selling profit is restricted to that which would apply had a commercial rate been applied. Costs incurred in connection with negotiating and arranging a lease are recognised as an expense when the selling profit is recognised (at the start of the lease term).
HKAS 17.55
3.3.1 Manufacturers or dealers and operating leases

A lessor who is a manufacturer or dealer should not recognise any selling profit on entering into an operating lease because it is not the equivalent of a sale. The manufacturer or dealer has retained the assets with a view to using them to generate rental income.
HKAS 17.47
3.4 Lessors' disclosures for finance leases

The following should be disclosed (in addition to the requirements of HKFRS 7): (a) A reconciliation between the total gross investment in the lease at the end of the reporting period, and the present value of minimum lease payments receivable at the end of the reporting period. In addition, an entity should disclose the total gross investment in the lease and the present value of minimum lease payments receivable at the end of the reporting period, for each of the following periods: (i) (ii) (iii) (b) (c) Not later than one year Later than one year and not later than five years Later than five years.
Unearned finance income. The unguaranteed residual values accruing to the benefit of the lessor.
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(d) (e) (f)
The accumulated allowance for uncollectible minimum lease payments receivable. Contingent rents recognised in income in the period. A general description of the lessor's material leasing arrangements.
4 Sale and leaseback transactions

HKAS 17.5865
In a sale and leaseback transaction, an asset is sold and then leased back by the same seller. The lease payment and sale price are normally linked because they are part of the same package in the negotiation. The type of lease involved determines the accounting treatment for the lessee and the seller. (a) In a sale and leaseback transaction which results in a finance lease, any apparent profit or loss (that is, the difference between the sale price and the previous carrying amount) should be deferred and amortised in the financial statements of the seller/lessee over the lease term. It should not be recognised as income immediately since, in substance, there has been no genuine sale. If the leaseback is an operating lease: (i) (ii) Any profit or loss should be recognised immediately, provided it is clear that the transaction is established at a fair value. Where the sale price is below fair value, any profit or loss should be recognised immediately except that if the apparent loss is compensated by future lease payments at below market price it should to that extent be deferred and amortised over the period for which the asset is expected to be used. If the sale price is above fair value, the excess over fair value should be deferred and amortised over the period over which the asset is expected to be used.
(b)
(iii)
Immediate recognition of the loss (carrying value less fair value) is required where the fair value of the asset at the time of the sale is less than the carrying amount in an operating lease. A sale and leaseback should be accounted in the same way as other leases by the buyer or lessor. If the disclosure requirements of both the lessees and lessors are followed, it should result in satisfactory disclosure of sale and leaseback transactions.
Example: Sale and finance leaseback

Osborne Co owned an asset with a carrying amount of $840,000 on 1 March 20X8. On this date Osborne Co sold the asset to a bank for $1,320,000, being the present value of the minimum lease payments, and then undertook to lease it back under a 40-year finance lease. The annual rental is $39,000 payable in advance. End of reporting period for Osborne Co is 28 February. Required How should the transaction be accounted for by Osborne Co?
Solution
At the date of sale/inception of the lease On the sale of the asset: DEBIT Cash CREDIT Asset Deferred income
$1,320,000 $840,000 $480,000
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Financial Reporting
On the lease back of the asset: DEBIT Asset CREDIT Finance lease obligation On the payment of the first instalment: DEBIT Finance lease obligation CREDIT Cash
$1,320,000 $1,320,000 $39,000 $39,000
Amounts charged to the statement of comprehensive income for the year ended 28 February 20X9 will include: depreciation of the asset ($1,320,000/40 years) a release of the deferred income ($480,000/40 years) interest accrued on the lease at the implicit rate $33,000 $12,000
Example: Sale and operating leaseback

On 1 January 20X2 Cable Co owned an asset with a carrying amount of $80,000. The fair value of the asset on that date was $90,000. In order to improve its liquidity position, Cable Co has negotiated possible agreements to sell the asset and lease it back under an operating lease for seven years. The financial controller is currently assessing the four agreements. The agreements are as follows: Agreement 1 Agreement 2 Agreement 3 Agreement 4 Sale for $90,000 with annual future lease payments at a market rate of $15,000 Sale for $75,000 with annual future lease payments of $15,000 Sale for $50,000 with annual future lease payments of $10,000 Sale for $110,000 with annual future lease payments of $17,500
How would each of these agreements be accounted for in Cable Co's financial statements?
Solution
Agreement 1 Agreement 2 Agreement 3 Sale is for fair value and therefore a profit of $10,000 is recognised immediately in profit or loss. Sale is for less than fair value however the loss is not compensated for by low future rentals. Therefore the loss of $5,000 is recognised immediately. Sale is for less than fair value and the loss is compensated for by low future rentals. Therefore the loss of $30,000 is recognised in the statement of financial position and released to profit or loss over the lease term. Sale is for more than fair value. Therefore a profit of $10,000 being the difference between the fair value and carrying amount is recognised in profit or loss immediately and the excess profit of $20,000 is recognised in the statement of financial position and released to profit over the lease term.
Agreement 4
5 Off-balance sheet finance explained

Topic highlights
HKAS 17 (revised) has closed many loopholes, but some still argue that it is open to manipulation.
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Key term
Off-balance sheet finance is the funding or refinancing of a company's operations in such a way that, under legal requirements and traditional accounting conventions, some or all of the finance may not be shown in its statement of financial position. 'Off-balance sheet transactions' are transactions which meet the above objective. These transactions may involve the removal of assets from the statement of financial position, as well as liabilities, and they are also likely to have a significant impact on profit or loss.
5.1 Reasons for off-balance sheet finance

Off-balance sheet transactions may be entered into for a number of reasons, including the following: (a) In some countries, companies traditionally have a lower level of gearing than companies in other countries. Off-balance sheet finance is used to keep gearing low, probably because of the views of analysts and brokers. A company may need to keep its gearing down in order to stay within the terms of loan covenants imposed by lenders. A listed company with high borrowings is often expected (by analysts and others) to declare a rights issue in order to reduce gearing. This has an adverse effect on a company's share price and so off-balance sheet financing is used to reduce gearing and the expectation of a rights issue. Analysts' short term views are a problem for companies developing assets which are not producing income during the development stage. Such companies will match the borrowings associated with such developing assets, along with the assets themselves, off-balance sheet. They are brought back into the statement of financial position once income is being generated by the assets. This process keeps return on capital employed higher than it would have been during the development stage. In the past, groups of companies have excluded subsidiaries from consolidation in an offbalance sheet transaction because they carry out completely different types of business and have different characteristics. The usual example is a leasing company (in say a retail group) which has a high level of gearing. This exclusion is now disallowed.
(b) (c)
(d)
(e)
You can see from this brief list of reasons that the overriding motivation is to avoid misinterpretation. In other words, the company does not trust the analysts or other users to understand the reasons for a transaction and so avoids any effect such transactions might have by taking them off-balance sheet. Unfortunately, the position of the company is then misstated and the user of the accounts is misled. You must understand that not all forms of 'off-balance sheet finance' are undertaken for cosmetic or accounting reasons. Some transactions are carried out to limit or isolate risk, to reduce interest costs and so on. In other words, these transactions are in the best interests of the company, not merely a cosmetic repackaging of figures which would normally appear in the statement of financial position.
5.2 The problem with off-balance sheet finance

Due to increasingly sophisticated off-balance sheet finance transactions, the users of financial statements do not always have a proper or clear view of the state of the company's affairs. The disclosures required by national company law and accounting standards did not in the past provide sufficient rules for disclosure of off-balance sheet finance transactions and so very little of the true nature of the transaction was exposed.
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Financial Reporting
Whatever the purpose of such transactions, insufficient disclosure creates a problem. This problem has been debated over the years by the accountancy profession and other interested parties and some progress has been made (see the later sections of this chapter). However, company collapses during recessions have often revealed much higher borrowings than originally thought, because part of the borrowing was off-balance sheet. The main argument used for banning off-balance sheet finance is that the true substance of the transactions should be shown, not merely the legal form, particularly when it is exacerbated by poor disclosure.
6 Interpretations relating to lease accounting

6.1 HK(SIC) Int-27 Evaluating the Substance of Transactions in the Legal Form of a Lease
HK(SIC) Int-27 addresses issues that may arise when an arrangement between an entity and an investor involves the legal form of a lease. It contains the following provisions: (a) Accounting for arrangements between an entity and an investor should reflect the substance of the arrangement. All aspects of the arrangement should be evaluated to determine its substance, with weight given to those aspects and implications that have an economic effect. In this respect, HK(SIC) Int-27 includes a list of indicators that individually demonstrate that an arrangement may not, in substance, involve a lease under HKAS 17 Leases. If an arrangement does not meet the definition of a lease, HK(SIC) Int-27 considers: (i) (ii) (iii) Whether a separate investment account and lease payment obligation that might exist represent assets and liabilities of the entity. How the entity should account for other obligations resulting from the arrangement. How the entity should account for a fee it might receive from an investor.
(b)
The HK(SIC) Int-27 includes a list of indicators that collectively demonstrate that, in substance, a separate investment account and lease payment obligations do not meet the definitions of an asset and a liability and should not be recognised by the entity. Other obligations of an arrangement, including any guarantees provided and obligations incurred upon early termination, should be accounted for under HKAS 37 or HKAS 39/HKFRS 9, depending on the terms. Further, it agreed that the criteria in HKAS 18.20 should be applied to the facts and circumstances of each arrangement in determining when to recognise a fee as income that an entity might receive. (c) A series of transactions that involve the legal form of a lease is linked, and therefore should be accounted for as one transaction, when the overall economic effect cannot be understood without reference to the series of transactions as a whole.
6.2 HK(IFRIC) Int-4 Determining whether an Arrangement contains a Lease

6.2.1 The issue
In recent years arrangements have developed that do not take the legal form of a lease but which convey rights to use assets in return for a payment or series of payments. Examples of such arrangements include the following: (a) (b) Outsourcing arrangements. Telecommunication contracts that provide rights to capacity.
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(c)
Take-or-pay and similar contracts, in which purchasers must make specified payments regardless of whether they take delivery of the contracted products or services.
6.2.2 HK(IFRIC) Int-4 treatment

The Interpretation specifies that an arrangement that meets the following criteria is, or contains, a lease that should be accounted for in accordance with HKAS 17 Leases: (a) Fulfilment of the arrangement depends upon a specific asset. The asset need not be explicitly identified by the contractual provisions of the arrangement. Rather, it may be implicitly specified because it is not economically feasible or practical for the supplier to fulfil the arrangement by providing use of alternative assets. The arrangement conveys a right to control the use of the underlying asset. This is the case if any of the following conditions is met: (i) The purchaser in the arrangement has the ability or right to operate the asset or direct others to operate the asset (while obtaining more than an insignificant amount of the output of the asset). The purchaser has the ability or right to control physical access to the asset (while obtaining more than an insignificant amount of the output of the asset). There is only a remote possibility that parties other than the purchaser will take more than an insignificant amount of the output of the asset and the price that the purchaser will pay is neither fixed per unit of output nor equal to the current market price at the time of delivery.
(b)
(ii) (iii)
6.3 HK-Int 4 Lease Determination of the Length of Lease Term in respect of Hong Kong Land Leases
6.3.1 The issue
This Interpretation addresses the issue of how the length of the lease term of a Hong Kong land lease should be determined for the purpose of applying the amortisation (depreciation) requirements under HKAS 16 and HKAS 17, as appropriate.
6.3.2 HK-Int 4 treatment

The lease term of a Hong Kong land lease for the purpose of applying the amortisation (depreciation) requirements under HKAS 16 and HKAS 17, as appropriate, shall be determined by reference to the legal form and status of the lease. Renewal of a lease is assumed only when the lessee has a renewal option and it is reasonably certain at the inception of the lease that the lessee will exercise the option. Options for extending the lease term that are not at the discretion of the lessee shall not be taken into account by the lessee in determining the lease term. Consequently, lessees shall not assume that the lease term of a Hong Kong land lease will be extended for a further 50 years, or any other period, while the HKSAR Government retains the sole discretion as to whether to renew. Any general intention to renew certain types of property leases expressed by the HKSAR Government is not sufficient grounds for a lessee to include such extensions in the determination of the lease term for amortisation (depreciation). Similarly, for the leases in the New Territories expiring shortly before 30 June 2047, the legal limit in these leases shall be assumed to be the maximum lease term. For those leases which extend beyond 30 June 2047 (eg those with an original lease term of 999 years), lessees shall assume that any legal rights under the leases that extend the lease term to beyond 30 June 2047 will be protected for the full duration of the lease in the absence of any indication to the contrary.
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Financial Reporting
In August 2010, the IASB and American standards board, FASB, issued an Exposure Draft of a new standard which it is intended will replace IAS 17. It is highly likely that such a new standard will in turn be adopted by the HKICPA and so replace HKAS 17. The Exposure Draft proposes that there is no distinction between operating and finance leases, and instead all leases are accounted for in the same way. A right of use approach is suggested for both lessees and lessors; this would result in the recognition of a liability for payments and an asset, being the right to use the underlying asset. The new standard is expected in the second half of 2011.
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Topic recap
HKAS 17 covers the accounting for lease transactions by both lessees and lessors. A lease is a contract for the hire of a specific asset. There are two forms of lease: Finance leases Operating leases
The definition of a finance lease is very important: it is a lease that transfers all the risks and rewards of ownership of the asset, regardless of whether legal title passes. An operating lease is any other lease. Lessee accounting: Operating leases: recognise rental expense on a straight line basis. Finance leases: record an asset in the statement of financial position and a liability to pay for it (at the fair value of the asset or present value of minimum lease payments); apportion the finance charge to give a constant periodic rate of return.
Lessor accounting: Operating leases: record as long-term asset and depreciate over useful life, record income on a straight line basis over the lease term. Finance leases: record the amount due from the lessor in the statement of financial position at the net investment in the lease, recognise finance income to give a constant periodic rate of return.
You should also know how to deal with: Manufacturer or dealer lessors Sale and leaseback transactions
HKAS 17 (revised) has closed many loopholes, but some still argue that it is open to manipulation.
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Financial Reporting

Answer 1
(a) Financial statement extracts INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X1 Depreciation [(800,000 + 20,000 80,000)/5)] Finance costs (Working) $ 148,000 74,200
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X1 (EXTRACT) $ Non-current assets Leased asset [(800,000 + 20,000) 148,000] 672,000 Non-current liabilities Finance lease liability over one year (Working) Current liabilities Finance lease liability within one year (Working) (656,200 561,820) WORKING Bal b/f $ 800,000 (58,000) 742,000 656,200 Interest accrued at 10% $ Payment 31 Dec $ 561,820 94,380 Bal c/f 31 Dec $
20X1 20X2 (b)
74,200 65,620
(160,000) (160,000)
656,200 561,820
Treatment of guaranteed residual value At the end of the lease, the lessee will have an asset at residual value of $80,000 in its statement of financial position and a finance lease liability of $80,000 representing the residual value guaranteed to the lessor. (i) If the lessor is able to sell the asset for the value guaranteed by the lessee, the lessee has no further liability and derecognises the asset and lease liability: DEBIT Finance lease liability CREDIT Asset carrying amount (ii) $80,000 $80,000
If the lessor is unable to sell the asset for the value guaranteed by the lessee, the lessee has a liability to make up the difference of $80,000 $60,000 = $20,000: Recognise impairment loss on asset (as soon as known during the lease term): DEBIT Profit or loss CREDIT Asset carrying amount DEBIT Finance lease liability CREDIT Cash CREDIT Asset carrying amount $20,000 $20,000 $80,000 $20,000 $60,000
Make guaranteed payment to lessor and derecognise the asset and lease liability:
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Exam practice
Thompson Manufacturing Inc.
27 minutes
On 1 January 20X7, Thompson Manufacturing Inc. (TMI), the lessor, entered into a non-cancellable lease agreement for equipment with Silver Rod Company (SRC), the lessee. The following information pertains to the lease: Annual lease payment due at the beginning of each year, beginning on 1 January 20X7 Option to purchase at the end of lease term Lease term Economic useful life of leased equipment Lessor's manufacturing cost Fair value of leased equipment at 1 January 20X7 Estimated unguaranteed residual value of leased equipment at the end of lease term Lessor's implicit rate Lessee's incremental borrowing rate Required (a) (b) (c) Discuss how the purchase option at the end of the lease term offered by TMI to SRC will affect the classification of this lease by SRC. (3 marks) Prepare an amortisation schedule that would be suitable for TMI for the lease term. (5 marks) Prepare all the journal entries that TMI should make for each of the years ended 31 December 20X7 and 20X8. (7 marks) $53,069 $10,000 5 years 8 years $200,000 $227,500 $30,000 12.93% 10%
(Total = 15 marks) HKICPA September 2008 (amended)
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Financial Reporting
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chapter 10
Inventories
Topic list
1 Accounting for inventories
Learning focus
Inventory and short-term work-in-progress valuation has a direct impact on a company's gross profit and it is usually a material item in any company's accounts. This is therefore an important subject area as far as the statement of comprehensive income is concerned as there are different accounting treatments for inventories.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.06 3.06.01 3.06.02 3.06.03 3.06.04 3.06.05 Inventories Scope and definition of HKAS 2 Inventories Calculate the cost of inventories in accordance with HKAS 2 Use accepted methods of assigning costs including the allocation of overheads to inventories Explain the potential impact of net realisable value falling below cost and make the required adjustments Calculate and analyse variances in a standard costing system and advise on the appropriate accounting treatment to be adopted in respect of inventories Prepare a relevant accounting policy note and other required disclosures in respect of inventories 3
3.06.06
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10: Inventories | Part C Accounting for business transactions
1 Accounting for inventories

Topic highlights
Inventory is measured at the lower of cost and net realisable value.
The inventory balance is significant to many companies both as an asset and due to its impact on profits. The measurement of inventory, however, remains a highly subjective area and a number of different methods may be used in practice. HKAS 2 provides guidance on the measurement of inventory and its recognition as an expense.
HKAS 2.2,3
1.1 Scope
HKAS 2 applies to all inventories other than: work in progress under construction contracts (covered by HKAS 11 Construction Contracts) financial instruments (covered by HKFRS 9 Financial Instruments) biological assets (covered by HKAS 41)
The standard does not apply to the measurement of inventories held by: producers of agricultural and forest products commodity-broker traders
HKAS 2.6,8
1.2 Definitions
The standard provides the following definitions:
Key terms
Inventories are assets: Held for sale in the ordinary course of business In the process of production for such sale In the form of materials or supplies to be consumed in the production process or in the rendering of services
Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. (HKAS 2) The definition of inventories in effect refers to: finished goods, being those held for sale work in progress (WIP), being those in the process of production, and raw materials, being those supplies to be consumed in the production process.
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Financial Reporting
HKAS 2.9
1.3 Measurement of inventories

The standard states that 'Inventories shall be measured at the lower of cost and net realisable value.' These terms are explained in more detail in Sections 1.4 and 1.7 of the chapter.
HKAS 2.10
1.4 Cost of inventories

Topic highlights
Cost includes all costs of purchase, costs of conversion and other costs incurred in bringing inventories to their present condition and location.
The cost of inventories includes all: costs of purchase costs of conversion other costs incurred
Each of these types of cost is covered in turn below.

HKAS 2.11
1.4.1 Costs of purchase

HKAS 2 states that the costs of purchase may include all of: purchase price import duties and other irrecoverable taxes transport, handling and any other cost directly attributable to the acquisition of finished goods, services and materials
Costs of purchase should be net of trade discounts, rebates and other similar amounts when measuring inventory.
HKAS 2.1214
1.4.2 Costs of conversion

Costs of conversion of inventories includes: (a) (b) costs directly related to the units of production, eg direct materials, direct labour. a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods.
Key terms
Fixed production overheads are defined by the standard as those indirect costs of production that remain relatively constant regardless of the volume of production such as depreciation and maintenance of factory buildings and equipment and the cost of factory management and administration. Variable production overheads are defined as those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and labour.
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Key terms (cont'd)

Fixed production overheads must be allocated to items of inventory on the basis of the normal capacity of the production facilities. Normal capacity is the expected achievable production based on the average over several periods/seasons, under normal circumstances, and taking into account the capacity lost through planned maintenance. The standard makes the following additional points: If it approximates to the normal level of activity then the standard states that the actual level of production can be used. Low production or idle plant will not result in a higher fixed overhead allocation to each unit. Unallocated overheads must be recognised as an expense in the period in which they were incurred. In periods of abnormally high production, the fixed production overhead allocated to each unit will be decreased, so that inventories are not measured at more than cost. Variable production overheads are allocated to each unit on the basis of the actual use of production facilities.
When a production process results in the simultaneous production of more than one product, and the costs of conversion are not separately identifiable, they should be allocated between products on a rational and consistent basis. An example of an appropriate basis given in the standard is the sales value of each product when complete.
HKAS 2.1517
1.4.3 Other costs

Other costs are included in the cost of inventories if they are incurred in bringing the inventories to their present location and condition. Examples of such costs are non-production overheads and the costs of designing products for specific customers. In limited circumstances, as identified by HKAS 23, borrowing costs are also included in the cost of inventories. The standard lists types of cost which would not be included in cost of inventories but should be recognised as an expense in the period they are incurred: (a) (b) (c) (d) Abnormal amounts of wasted materials, labour or other production costs. Storage costs (except costs which are necessary in the production process before a further production stage). Administrative overheads not incurred to bring inventories to their present location and conditions. Selling costs.
Example: Cost of inventory

Highdef Co manufactures component parts used in the production of televisions. The following details are relevant to a production run in August 20X4: Cost of raw materials per unit Import duty (raw materials) Labour costs per unit Production overheads Expected (normal) output Actual output $85 after 15% trade discount 5% $25 $400,000 50,000 units 40,000 units
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Financial Reporting
The cost of each unit is therefore calculated as: Direct materials Import duty (5% x $85) Direct labour Overheads allocation ($400,000/50,000) Cost $ 85.00 4.25 25.00 8.00 122.25
HKAS 2.19
1.4.4 Cost of inventory of a service provider

Service providers sometimes have inventory, for example the work in progress of a lawyer. This work in progress should be measured at cost ie the costs of labour and attributable overheads, excluding any profit margin. Labour and costs relating to sales and general administrative personnel and non-attributable overheads are not included in the cost of work in progress. They are expensed as incurred.
HKAS 2.21,22
1.5 Techniques for the measurement of cost

HKAS 2 allows that techniques for the measurement of cost may be used for convenience where these approximate to cost. The two methods mentioned within the standard are: (a) (b) Standard costs, which take into account normal levels of raw materials used, labour time etc. They are reviewed and revised on a regular basis. The retail method, which is often used in the retail industry where there are large numbers of items with a rapid turnover and similar margins. Here, the only practical method of inventory valuation may be to take the total selling price of inventories and deduct an overall average profit margin, thus reducing the value to an approximation of cost. The percentage must take into consideration reduced price lines. Sometimes different percentages are applied to different retail departments.
Example: Measurement of cost

Assume that a manufacturing company has a budgeted standard total production cost of $1 per unit for the year, based on a forecasted production of 1,000,000 units. There is no opening inventory and the year end accounts show actual production of 1,000,000 units, closing inventory of 200,000 units and an unfavourable cost variance of $100,000. The analysis shows that $80,000 of the variance comes from a charge in a purchase cost of goods resulting from a foreign currency alignment early in the year and the remaining $20,000 is from a labour strike in mid-year. The $20,000 unfavourable variance from the labour strike is a period cost wholly recognised as an expense since it was not incurred under normal operating conditions. Unless the exchange movement happened under unusual circumstances, the price variance resulting from exchange difference is regarded as arising under normal operating conditions. To better reflect the cost of goods sold and the cost of closing inventory, such price variance will be allocated between inventories and cost of goods sold based on the closing inventories of $200,000 as a percentage of the total number of units produced. The closing inventories at standard cost of $200,000 are 20 per cent of the actual production, so inventories will be allocated 20 per cent of the $80,000 price variance ie $16,000. Cost of goods sold will be charged with the balance of $64,000. Closing inventories will therefore amount to $216,000.
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HKAS 2.23,25-27
1.6 Cost formulae

Topic highlights
Where inventory is not interchangeable, cost should be specifically identified. Where inventories consist of interchangeable items, cost is assigned using the First in, First out (FIFO) or weighted average formula.
Where items of inventory are not normally interchangeable or goods or services are produced and segregated for specific projects, the cost of inventories should be specifically identified. Where inventories consist of a number of interchangeable items, cost is assigned by using the First In, First Out (FIFO) or weighted average cost formulae. Last In, First Out (LIFO) is not permitted. Under the weighted average cost method, a recalculation can be made after each purchase, or alternatively only at the period end. HKAS 2 requires that an entity should use the same cost formula for all inventories having similar nature and use to the entity. For inventories with different nature or use (for example, certain commodities used in one business segment and the same type of commodities used in another business segment), different cost formulae may be justified. A difference in geographical location of inventories (and in the respective tax rules), by itself, is not sufficient to justify the use of different cost formulae.
Example: Inventory valuation (1)

Arneson Co trades in widgets and has bought and sold the following inventory during the month of September 20X1: Date 1 September 3 September 5 September 10 September 18 September 25 September 29 September opening stock purchase sale purchase sale purchase sale Volume 100 units 100 units 75 units 50 units 80 units 80 units 100 units $2.40 each $2.35 each Cost $2.00 each $2.30 each
What is the value of inventory at 30 September using (a) (b) (c) FIFO Weighted average cost (period end) Weighted average cost (continuous)?
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Financial Reporting
Solution
FIFO Opening stock 3.9 Purchase 10.9 Purchase 25.9 Purchase 100 $2.00 100 $2.30 50 $2.35 80 $2.40 Sales 5 September 18 September 18 September 29 September 29 September 29 September Closing stock 75 units 25 units 55 units 45 units 50 units 5 units 75 units
Sales are matched to the earliest purchases such that closing stock is made up of 75 units purchased on 25 September. Closing stock is therefore measured at $180 (75 units x $2.40). Weighted average (period end) The weighted average cost of stocks during September is: 100 units $2.00 100 units $2.30 50 units $2.35 80 units $2.40 330 units 200.00 230.00 117.50 192.00 739.50 therefore weighted average cost per unit $2.24
Closing stock is therefore measured at $168 (75 units x $2.24) Weighted average (continuous) Date 1.9 3.9 Purchases 100 $2 100 x $2.30 Sales Balance 100 200 Weighted average price $2 (100 $2 ) + (100 $2.30 ) = $2.15 100 + 100 $2.15 ( 50 $2.35 ) + (125 $2.15 ) = $2.21 50 + 125 $2.21 ( 80 $2.40 ) + ( 95 $2.21) = $2.30 80 + 95 $2.30
5.9 10.9 18.9 25.9 29.9
50 $2.35
75
125 175 95 175 75
80 $2.40
80
100
Therefore closing stock is measured at $172.50 (75 units $2.30)

HKAS 2.2833
1.7 Net realisable value (NRV)

Topic highlights
NRV is the estimated selling price of an item of inventory less estimated costs to complete and sell it.
Prudence requires that assets are not overstated. In the case of inventories, this means that they should not be measured at an amount greater than the price that is expected to be realised from their sale.
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In some cases the cost of inventory may be greater than the amount for which it can be sold, for example where: goods are damaged or obsolete the costs to completion have increased the selling price has fallen the goods are to be sold at a loss as part of a marketing strategy production errors have led to increased costs.
In these cases, inventory is carried at the NRV which is less than cost. Inventory is normally written down on an item by item basis, but sometimes it may be appropriate to group similar or related items together. This grouping together is acceptable for, say, items in the same product line, but it is not acceptable to write down inventories based on a whole classification (eg finished goods) or a whole business. The assessment of NRV should be based on the most reliable evidence available and should take place at the same time as estimates are made of selling price. Fluctuations of price or cost should be taken into account if they relate directly to events after the reporting period, which confirm conditions existing at the end of the period. The reasons why inventory is held should also be taken into account. For example, where inventory is held to satisfy a firm contract, its NRV will be the contract price. Any additional inventory of the same type held at the period end will, in contrast, be assessed according to general sales prices when NRV is estimated. At each period end, NRV must be reassessed and compared with cost. Where circumstances have changed since the end of the previous period and there is a clear increase in NRV, then the previous write down must be reversed to the extent that the inventory is then valued at the lower of cost and the new NRV. This situation may arise when selling prices have fallen in the past and then risen again. On occasion a write down to NRV may be of such size, incidence or nature that it must be disclosed separately.
HKAS 2.34
1.8 Recognition as an expense

An expense related to inventory is recognised in profit or loss in the following circumstances: (a) (b) (c) When inventories are sold, the carrying amount of those inventories is recognised as an expense. Any write-down of inventories to NRV and all losses of inventories are recognised as an expense in the period the write-down or loss occurs. Any reversal of a previous write-down of inventories, arising from an increase in NRV, is recognised as a reduction in the amount of inventories recognised as an expense in the period in which the reversal occurs.
Example: Inventory valuation (2)

Given Co has the following categories of inventory:
Cost $m 4 10 8 14 Selling price $m 6 11 12 16 Costs to sell $m 0.5 1.5 2 3
Product A Product B Product C Product D

Required
Determine the amount at which inventory should be valued.
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Financial Reporting
Inventory must be valued line by line rather than as a whole, taking lower of cost and NRV in each case: Product A (Cost) Product B (NRV) Product C (Cost) Product D (NRV) $m 4 9.5 8 13 34.5
Ramsbottom Co is a manufacturer of components used in the motor industry. It makes two products, XX1 and ZZ2. Certain parts of the production process give rise to indirect costs specifically identifiable with only one of these products, although other costs are not separately identifiable. Budgeted cost information for March 20X1 is as follows. Budgeted output
XX1 1,000 units $ 365,000 ZZ2 1,200 units $ 380,000 Total
Direct cost 745,000 Indirect production overheads Identifiable 65,000 55,000 120,000 Other 80,000 During the month, costs were incurred in line with the budget, but due to a failure of calibration to a vital part of the process, only 1,050 units of ZZ2 could be taken into inventory. The remainder produced had to be scrapped, for zero proceeds. Ramsbottom allocates indirect costs which are not specifically identifiable to an individual product by reference to relative selling prices. This results in 55% being allocated to XX1 and 45% to ZZ2.
Required
Calculate the cost attributable to each product.

HKAS 2.3639

HKAS 2 requires the financial statements to disclose the following: (a) (b) (c) (d) (e) (f) The accounting policies adopted in measuring inventories, including the cost formula used The total carrying amount of inventories and the carrying amount in classifications appropriate to the entity The carrying amount of inventories carried at fair value less costs to sell The amount of inventories recognised as an expense during the period The amount of any write-down of inventories to net realisable value recognised as expense and in the period The amount of any reversal of any write-down of inventories to net realisable value recognised as reduction in the amount of inventories recognised as an expense in the period The circumstance or events that led to the reversal of a write-down of inventories The carrying amount of inventories pledged as security for liabilities.
(g) (h)
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Information about the carrying amounts held in different classifications of inventories and the extent of the changes in these assets is useful to financial statement users. Common classifications of inventories are merchandise, production supplies, materials, work in progress and finished goods. The inventories of a service provider may be described as work in progress. Some entities adopt a format for profit or loss that results in amounts being disclosed other than the cost of inventories recognised as an expense during the period. Under this format, an entity presents an analysis of expenses using a classification based on the nature of expenses. In this case, the entity discloses the costs recognised as an expense for raw materials and consumables, labour costs and other costs together with the amount of the net change in inventories for the period.
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Financial Reporting
Topic recap
Inventory is measured at the lower of cost and net realisable value. Cost includes all costs of purchase, costs of conversion and other costs incurred in bringing inventories to their present condition and location. Where inventory is not interchangeable, cost should be specifically identified. Where inventories consist of interchangeable items, cost is assigned using the FIFO or weighted average formula. Net realisable value (NRV) is the estimated selling price of an item of inventory less estimated costs to complete and sell it. Inventory is recognised as an expense when the goods are sold, when there is a write down to NRV or when a previous write down is reversed.
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Answer 1
The total cost attributable to XX1 is calculated as: $365,000 + $65,000 + (55% $80,000) = $474,000 The cost per unit therefore being $474,000 / 1,000 = $474 each. The total cost $474,000 attributable to XX1 can all be allocated to the inventories of XX1. The total cost attributable to ZZ2 is: $380,000 + $55,000 + (45% $80,000) = $471,000 The cost per unit therefore being $471,000 / 1,200 = $392.50 each. The allocation of the cost for ZZ2 is therefore: $392.50 1,050 = $412,125 as inventories $392.50 150 = $58,875 as an expense The indirect costs not specifically identifiable with either product which are allocated to the scrapped ZZ2 cannot be recovered into the cost of XX1.
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Financial Reporting
Exam practice
Lotto
9 minutes
After its end of year physical inventory count and valuation, the accounts staff of Lotto have reached a valuation of $153,699 at cost for total inventories held at the year end. However, on checking the figures, the chief bookkeeper has come across the following additional facts. (a) (b) The count includes damaged goods which originally cost $2,885. These could be repaired at a cost of $921 and sold for $3,600. The count excludes 300 units of item 730052 which were sold to a customer SC on a sale or return basis, at a price of $8 each. The original cost of the units was $5 each. SC has not yet indicated to Lotto whether these goods have been accepted, or whether they will eventually be returned. The count includes 648 units of item 702422. These cost $7.30 each originally but because of dumping on the market by overseas suppliers, a price war has flared up and the unit cost price of the item has fallen to $6.50. The price reduction is expected to be temporary, lasting less than a year or so, although some observers of the market predict that the change might be permanent. Lotto has already decided that if the price reduction lasts longer than six months, it will reduce its resale price of the item from $10.90 to about $10.
(c)
Required
Calculate the closing inventory figure for inclusion in the annual accounts of Lotto, making whatever adjustments you consider necessary in view of items (a) to (c). Explain your treatment of each item. (5 marks)
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chapter 11
Provisions, contingent liabilities and contingent assets

Topic list
1 2 3 4 5 HKAS 37 Provisions, Contingent Liabilities and Contingent Assets Provisions Contingent liabilities and contingent assets Interpretations relating to provision accounting Current developments
Learning focus
Accounting for uncertainty and contingencies requires some judgment and supporting evidence in applying the accounting standards. You must learn the recognition criteria for provisions and be able to apply them. You should also be able to advise the directors on the implications for the financial statements of the changes proposed.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.16 3.16.01 3.16.02 3.16.03 3.16.04 3.16.05 3.16.06 3.16.07 Provisions, contingent liabilities and contingent assets Define provisions, contingent liabilities and contingent assets within the scope of HKAS 37 Distinguish provisions from other types of liabilities Explain the criteria for recognition of provisions and apply them to specific circumstances Apply the appropriate accounting treatment for contingent assets and liabilities Disclose the relevant information relating to contingent liabilities in the financial statements Account for decommissioning, restoration and similar liabilities and their changes Disclose the relevant information relating to contingent assets in the financial statements 3
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11: Provisions, contingent liabilities and contingent assets | Part C Accounting for business transactions
1 HKAS 37 Provisions, Contingent Liabilities and Contingent Assets

Published financial statements must include all the information necessary for a proper understanding of the company's financial position. In some cases this means that uncertain events must be reported. HKAS 37 provides guidance on accounting for uncertainty with the result that provisions, or uncertain liabilities, may be included in the statement of financial position and contingent assets and liabilities may be disclosed. The provisions for liabilities covered by HKAS 37 are somewhat different from those provisions for depreciation and doubtful debts in your earlier studies. There was no accounting standard dealing with provisions before the issue of HKAS 37. Provisions often known as 'big bath' provisions are made by companies wanting to show their results in the most favourable way. They made large 'one off' provisions in years where a high level of underlying profits was generated. These provisions were then available to conceal expenditure in future years when perhaps the underlying profits were not favourable. That is to say, provisions were used to achieve profit smoothing. Since reported profits do not represent the level of actual profits achieved in the year, profit smoothing is viewed as misleading.
1.1 Objective
HKAS 37 Provisions, Contingent Liabilities and Contingent Assets aims to make sure that provisions, contingent liabilities and contingent assets are being dealt with based on appropriate recognition criteria and measurement bases. In addition, sufficient information should be disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount.
1.2 Definitions
The following definitions are provided within the standard:
Key terms
A provision is a liability of uncertain timing or amount. A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. A contingent liability is: (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity, or a present obligation that arises from past events but is not recognised because: (i) (ii) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or the amount of the obligation cannot be measured with sufficient reliability.
(b)
A contingent asset is a possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity. (HKAS 37.10) We shall meet more definitions as we consider the accounting treatment of provisions and contingencies.
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Financial Reporting
2 Provisions
Provisions are differentiated from other liabilities such as trade payables and accruals by the HKICPA. The main difference is that there is uncertainty about the timing or amount of the future expenditure for a provision. For certain accruals, uncertainty, though it exists, is generally much less than for provisions. HKAS 37 includes the criteria for recognising a provision as a liability in the statement of financial position and also provides guidance for measuring such a provision. In addition, and due to the subjective nature of the topic matter, it gives examples of common situations in which a provision can be made.
HKAS 37.14
2.1 Recognising a provision

Topic highlights
Under HKAS 37, a provision should be recognised: When an entity has a present obligation, legal or constructive It is probable that a transfer of economic benefits will be required to settle it A reliable estimate can be made of its amount
HKAS 37 states that a provision should be recognised as a liability in the financial statements when: an entity has a present obligation (legal or constructive) as a result of a past event; it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and a reliable estimate can be made of the obligation.
Some of these terms require further explanation, and this is given in the next two sections of the chapter.
HKAS 37.1722
2.1.1 Obligation
A legal obligation is a fairly easy idea to understand: it is a duty to act in a certain way deriving from a contract, legislation, or some other operation of the law. You should note that an event which does not currently give rise to a legal obligation may do so at a later date due to changes in the law. In this case the obligation arises when new legislation is virtually certain to be enacted as drafted; in many cases this is impossible to ascertain before actual enactment. You may not know what a constructive obligation is.
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Key term
HKAS 37 defines a constructive obligation as: 'An obligation that derives from an entity's actions where: By an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities, and As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.'
The following question shows how this definition is applied and will help your understanding of a constructive obligation.
(a) Black Gold Oil Co drills for oil in locations worldwide. Mindful of the public perception of such oil companies after recent disasters involving oil spills, Black Gold Oil Co has recently used press and television advertisements to promote its green credentials, and in particular, has pledged to clean up any contamination that it causes. In the year ended 31 December 2010, Black Gold Oil Co causes extensive contamination in a country in which there is no environmental legislation. Does a constructive obligation exist at 31 December 2010? (b) A well-known retailer is under legal obligation to refund money to customers who return unwanted goods within a 28 day period. The retailer has announced a policy of extending this return period to 60 days, and accordingly has printed this promise on its carrier bags. Does the retailer have a present obligation as a result of a past event? (The answer is at the end of the chapter)
In some instances, for example when a court case is underway, it is not clear whether there is a present obligation. In these cases, all available evidence should be considered, and if it is more likely that not that a present obligation exists at the reporting date, then a present obligation as a result of a past event is deemed to exist.
HKAS 37.2324
2.1.2 Probable transfer of economic benefits

A transfer of economic benefits is regarded as 'probable' if the event is more likely than not to occur for the purpose of HKAS 37 so the probability that the event will occur is greater than the probability that it will not. The standard clarifies that the probability should be based on considering the population as a whole, rather than one single item, in situations where there are a number of similar obligations.
Illustration: Transfer of economic benefits

In the case of a warranty obligation of a company, though the probability of an outflow of economic resources (transfer of economic benefits) may be extremely small in respect of one specific item, the probability of some transfer of economic benefits is quite likely to be much higher when the population is considered as a whole. A provision should be made for the expected amount when there is a greater than 50 per cent probability of some transfer of economic benefits.
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Financial Reporting
HKAS 37.3638, 41
2.2 Measuring a provision

Topic highlights
The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the year end. This may be calculated using expected values when the provision involves a large population of items.
The third criterion which must be met in order to recognise a provision is that a reliable estimate can be made of the obligation. HKAS 37 provides detailed guidance on how this estimate should be made. The overriding requirement is that the amount recognised as a provision shall be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. The standard goes on to say that this is the amount that an entity would pay to settle the obligation or transfer it to a third party at the reporting date, even though a settlement or transfer at this time will often be impossible or prohibitively expensive. The estimates will be determined by the judgment of the entity's management supplemented by the experience of similar transactions, and in some cases the reports from independent experts. A provision should be measured before any related tax effect.
HKAS 37.40
2.2.1 Most likely outcome

Where a single obligation is being measured, the most likely outcome may be the best estimate of the liability. HKAS 37 does, however, stipulate that all possible outcomes are considered and where these are mostly higher (or mostly lower) than the expected outcome, the best estimate will be higher (or lower).
HKAS 37.39
2.2.2 Expected values

Where the provision being measured involves a large population of items, the obligation is estimated by weighting all possible outcomes by their associated probabilities, ie expected value.
Alice Co sells goods with a warranty under which customers are covered for the cost of repairs of any manufacturing defect that becomes apparent within the first six months of purchase. The company's past experience and future expectations indicate the following pattern of likely repairs. % of goods sold 75 20 5 What is the expected cost of repairs? (The answer is at the end of the chapter) Defects None Minor Major Cost of repairs if all goods suffered from the defect $m 1.0 4.0
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HKAS 37.4252
2.2.3 Other considerations when measuring a provision

HKAS 37 requires that the following are considered when measuring a provision: Risks and uncertainties Risks and uncertainties surrounding an event should be taken into consideration when making the best estimate of a provision required. Uncertainty does not, however, justify the creation of excessive provisions or an overstatement of liabilities. Discounting Where the effect of the time value of money is material, the amount of a provision should be the present value of the expenditure required to settle the obligation. An appropriate discount rate should be used, and the standard requires this to be a pre-tax rate that reflects current market assessments of the time value of money. The discount rate(s) should not reflect risks for which future cash flow estimates have been adjusted. Future events Future events which may affect the amount required to settle the entity's obligation should be taken into account where there is sufficient evidence that they will occur. These events may include future changes in technology or new legislation. The standard does, however state that in the case of new legislation, in most cases sufficient objective evidence will not exist until the legislation is actually enacted. Expected disposal of assets Gains from the expected disposal of assets should not be taken into account in measuring a provision, even if the expected disposal is closely linked to the event giving rise to the provision.
HKAS 37.5357
2.3 Reimbursements
Some or all of the expenditure needed to settle a provision may be expected to be recovered from a third party through insurance contracts, indemnity clauses or suppliers warranties. These amounts may be reimbursed to the entity or paid directly to the party to who the amount is due. If so, the reimbursement shall be recognised when, and only when, it is virtually certain that reimbursement will be received if the entity settles the obligation. Generally, however, the entity will remain liable for the amount due, and would be required to pay all of this if the third party failed to pay. This is reflected in the accounting treatment: A provision is recognised for the full amount of the liability. The reimbursement should be treated as a separate asset, and the amount recognised should not be greater than the provision itself. The provision and the amount recognised for reimbursement may be netted off in the income statement.
In some cases the entity will not be liable for the costs if the third party fails to pay. In this case these costs are not included in the provision.
HKAS 37.5960
2.4 Changes in provisions

Provisions should be reviewed at each reporting date and adjusted to reflect the current best estimate. If it is no longer probable that a transfer of economic benefits will be required to settle the obligation, the provision should be reversed. Where the effect of the time value of money is significant, so that a provision has been measured at present value, the discount is unwound each year with a resulting increase to the provision. This increase is recognised as a finance cost in profit or loss.
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Financial Reporting
HKAS 37.6162
2.5 Use of provisions

A provision should be used only to set off expenditure for which the provision was originally recognised. It is not permitted to set off expenditure against a provision formerly organised for another purpose since this would conceal the impact of two different events.
HKAS 37.6365
2.6 Common scenarios

2.6.1 Future operating losses
No provisions should be recognised for future operating losses which do not meet the definition of a liability and the general recognition criteria stated in the standard. Expected future operating losses may, however, be indication of the impairment of assets related to that operation.
HKAS 37.6668
2.6.2 Onerous contracts

Key term
An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. The unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it. (HKAS 37.10) If an entity has a contract that is onerous, the present obligation under the contract should be recognised and measured as a provision. A common example would be leasehold property which is vacated before the lease term ends. For the remaining years of the lease, the cost of the property (future lease payments) exceeds the benefits derived from the property (likely to amount to nil if it is to be left vacant). In this case, provision should be made for the future unavoidable lease payments as at the date on which the property is vacated. The provision is released as these payments are made in future years. The provision is disclosed as current / non-current in accordance with HKAS 1. Practically this is likely to mean that the total provision is split between the amount payable within one year and the amount payable thereafter. There is no obligation where cancellation of a contract does not result in the need to pay compensation to another party.
HKAS 37.7083
2.6.3 Provisions for restructuring

One of the main purposes of HKAS 37 was to target abuses of provisions for restructuring. Accordingly, HKAS 37 lays down strict criteria to determine when such a provision can be made.
Key term
HKAS 37 defines a restructuring as: A programme that is planned and controlled by management and materially changes either: the scope of a business undertaken by an entity, or the manner in which that business is conducted (HKAS 37.10)
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The HKAS gives the following examples of events that may fall under the definition of restructuring. The sale or termination of a line of business The closure of business locations in a country or region or the relocation of business activities from one country or region to another Changes in management structure, for example, the elimination of a layer of management Fundamental reorganisations that have a material effect on the nature and focus of the entity's operations
The question is whether or not an entity has an obligation at the year end. In respect of restructuring, the standard states that there is a constructive obligation if: the entity has a detailed formal plan for the restructuring, and the entity has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it.
A mere management decision is not normally sufficient. Management decisions may sometimes trigger off recognition, but only if earlier events such as negotiations with employee representatives and other interested parties have been concluded subject only to management approval. When the sale of an operation is involved in the restructuring, HKAS 37 states that no obligation is to be recognised until the entity has entered into a binding sale agreement. Until then, the entity will be able to alter its decision and withdraw from the sale even if its intentions have been announced publicly. The HKAS states that a restructuring provision should include only the direct expenditures arising from the restructuring that are both:
HKAS 37 Appendix C
Necessarily entailed by the restructuring, and Not associated with the ongoing activities of the entity. Retraining or relocating continuing staff Marketing Investment in new systems and distribution networks Future operating losses Losses or gains on the expected disposal of assets
The following costs should specifically not be included within a restructuring provision.
2.6.4 Other scenarios

(a) Warranties. A provision is appropriate where on past experience it is probable, ie more likely than not, that some claims will emerge. The provision must be estimated, however, on the basis of the class as a whole and not on individual claims. There is a clear legal obligation in this case. Major repairs. In the past it has been quite popular for companies to provide for expenditure on a major overhaul to be accrued gradually over the intervening years between overhauls. Under HKAS 37 this is not permissible as HKAS 37 would argue that this is a mere intention to carry out repairs, not an obligation. The entity can always sell the asset in the meantime. The only solution is to treat major assets such as aircraft, ships, furnaces etc as a series of smaller assets where each part is depreciated over shorter lives. Therefore, any major overhaul may be argued to be replacement and therefore classified as capital rather than revenue expenditure.
(b)
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Financial Reporting
(c)
Self insurance. A number of companies have created a provision for self insurance based on the expected cost of making good fire damage etc instead of paying premiums to an insurance company. Under HKAS 37 this provision is not justifiable as the entity has no obligation until a fire or accident occurs. No obligation exists until that time. Environmental contamination. If the company has an environment policy such that other parties would expect the company to clean up any contamination or if the company has broken current environmental legislation then a provision for environmental damage must be made. Decommissioning or abandonment costs. When an oil company initially purchases an oilfield it is put under a legal obligation to decommission the site at the end of its life. Prior to HKAS 37 most oil companies built up the provision gradually over the life of the field so that no one year would be unduly burdened with the cost. HKAS 37, however, insists that a legal obligation exists on the initial expenditure on the field and therefore a liability exists immediately. This would appear to result in a large charge to profit or loss in the first year of operation of the field. However, the HKAS takes the view that the cost of purchasing the field in the first place is not only the cost of the field itself but also the costs of putting it right again. Therefore, all the costs of abandonment may be capitalised.
(d)
(e)
HKAS 37.84,85,92
2.7 Disclosure of provisions

Disclosures for provisions fall into two parts. Disclosure of details of the change in carrying value of a provision from the beginning to the end of the year, including: carrying amount at the beginning and end of the period additional provisions made in the period amounts incurred and charged against the provision in the period unused amounts reversed in the period the increase in the period in the discounted amount arising from the passage of time and effect of any change in the discount rate
Note that comparative information is not required. Disclosure of the background to the making of the provision and the uncertainties affecting its outcome, including for each class of provision: a brief description of the nature of the obligation and expected timing of any resulting outflows of economic benefits an indication of the uncertainties about the amount or timing of outflows the amount of any expected reimbursement stating the amount of any asset that has been recognised for the expected reimbursement.
In very rare circumstances, such disclosure may prejudice seriously the position of the entity in a dispute with other parties on the subject matter of the provision. In this case disclosure of the above information is not required, however the following should be disclosed: the general nature of the dispute the fact that, and reason why, the information has not been disclosed.
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3 Contingent liabilities and contingent assets

Topic highlights
An entity should not recognise a contingent liability, but they should be disclosed where there is a possible outflow of economic resources. An entity should not recognise a contingent asset, but they should be disclosed where there is a probable inflow of economic resources. Now you understand provisions it will be easier to understand contingent assets and liabilities.
HKAS 37.10
3.1 Contingent liabilities

We saw the definition of a contingent liability earlier in the chapter. To recap, a contingent liability is: A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the entity's control A present obligation that arises from past events but is not recognised because: It is not probable that a transfer of economic benefits will be required to settle the obligation The amount of the obligation cannot be measured with sufficient reliability
In other words, a contingent liability is an obligation that does not meet the HKAS 37 recognition criteria for a provision because there is no present obligation, or the transfer of resources is only possible or the amount cannot be measured reliably.
HKAS 37.2728

Contingent liabilities should not be recognised in financial statements but they should be disclosed, unless the probability of an outflow of economic resources is remote.
HKAS 37.8688,92
3.1.2 Disclosure: contingent liabilities

A brief description must be provided of all material contingent liabilities unless they are likely to be remote. In addition, the following should be provided for each class of contingent liability, where practicable: An estimate of their financial effect Details of any uncertainties relating to the amount or timing of the outflow The possibility of any reimbursement
When determining classes of contingent liability, an entity should consider whether the nature of items is sufficiently similar for aggregated amounts to fulfil the disclosure requirements. Where a provision and contingent liability result from the same circumstances, an entity should indicate the link between the provision and contingent liability. In very rare circumstances, such disclosure may prejudice seriously the position of the entity in a dispute with other parties on the subject matter of the contingent liability. In this case disclosure of the above information is not required, however the following should be disclosed: the general nature of the dispute the fact that, and reason why, the information has not been disclosed.
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Financial Reporting
3.2 Contingent assets

Earlier in the chapter we defined a contingent asset as a possible asset that arises from past events and whose existence will be confirmed by the occurrence of one or more uncertain future events not wholly within the entity's control.
HKAS 37.31,33,34

A contingent asset must not be recognised. Only when the realisation of the related economic benefits is virtually certain should recognition take place. At that point, the asset is no longer a contingent asset. Where a contingent asset offers a probable inflow of resources, it should be disclosed.
HKAS 37.89,92
3.2.2 Disclosure: contingent assets

Contingent assets must only be disclosed in the notes if they are probable. In that case the following should be provided: a brief description of the nature of the contingent asset an estimate of its likely financial effect, where practicable, or a statement to the effect that it is not practicable.
In very rare circumstances, such disclosure may prejudice seriously the position of the entity in a dispute with other parties on the subject matter of the contingent asset. In this case disclosure of the above information is not required, however the following should be disclosed: the general nature of the dispute the fact that, and reason why, the information has not been disclosed.
3.3 Summary
The objective of HKAS 37 is to ensure that appropriate recognition criteria and measurement bases are applied to provisions and contingencies and that sufficient information is disclosed. The HKAS seeks to ensure that provisions are only recognised when a measurable obligation exists. It includes detailed rules that can be used to ascertain when an obligation exists and how to measure the obligation. The standard attempts to eliminate the 'profit smoothing' which has gone on before it was issued.
Explain the accounting treatment required in the following scenarios at 31 December 20X0: 1. Rango Co, a healthcare provider, has been informed that due to upcoming legislation, it is required to fit carbon monoxide detectors in all of its properties at a cost of HK$40,000. Any failure to do so by 30 September 20X1 will result in penalties of $5,000. Rango has not undertaken the work by 31 December 20X0. Greenfingers Co specialises in the sale of gardening equipment. As part of a strategy to streamline operations, the company has decided to divest its plant division. A probable purchaser has been identified, although no agreement has been reached by 31 December 20X0. Until an agreement has been formalised, the directors of Greenfingers will not advise their employees of the divestment. Redundancy costs associated with the restructuring are expected to be $120,000, and a further $50,000 will be spent on retraining certain staff members to work in the furniture division of the company. (The answer is at the end of the chapter)
2.
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You may wish to study the flow chart below, taken from HKAS 37, which is a good summary of its requirements.
Cobo Co manufacture goods which are sold with a one year warranty against defects. (a) (b) Should a provision be recognised for the cost of repairing faulty goods? Cobo Co's sales for the year are $40m. They anticipate that 60 per cent of goods will not be faulty, 30 per cent will need minor repairs that would cost $2m if all items were affected and 10 per cent of goods will need major repairs that would cost $4m if all items were affected. How much should be provided for repairs? (The answer is at the end of the chapter)
4 Interpretations relating to provision accounting

4.1 HK(IFRIC) Int-1 Changes in Existing Decommissioning, Restoration and Similar Liabilities
4.1.1 The issue
HK(IFRIC) Int-1 applies where an entity has included decommissioning, restoration and similar costs within the cost of an item of property, plant and equipment under HKAS 16 and as a provision (liability) under HKAS 37. An example would be a liability that was recognised by the operator of an oil rig for costs that it expects to incur in the future when the rig is shut down (decommissioned). Such a provision should be discounted to present value.
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Financial Reporting
HK(IFRIC) Int-1 addresses changes in the value of the provision that may arise from: (a) (b) changes in the discount rate revised estimates of the timing and amount of costs
4.1.2 Required treatment

Where an entity applies the cost model to property, plant and equipment, these changes in value of the provision are required to be capitalised as part of the cost of the asset and depreciated over the remaining life of the item to which they relate. Where an entity applies the revaluation model to property, plant and equipment, the changes in value of the provision must be recognised as follows: A decrease in the liability is recognised in other comprehensive income and accumulated within the revaluation surplus (other than where it reverses a revaluation deficit on the asset that was previously recognised in profit or loss) An increase in the liability is recognised in profit or loss (other than where a credit balance exists in the revaluation surplus in respect of that asset, in which case it is recognised in other comprehensive income and reduces the revaluation surplus).
HK(IFRIC) Int-1 also deals with an increase in the liability that reflects the passage of time also referred to as the unwinding of the discount. This is recognised in profit or loss as a finance cost as it occurs.
4.2 HK(IFRIC) Int-5 Rights to Interests from Decommissioning Restoration and Environmental Rehabilitation Funds
4.2.1 The issue
Some entities have an obligation to decommission assets or to perform environmental restoration. Such entities may make contributions to a fund which is established to reimburse those costs of decommissioning, restoration or rehabilitation when they are incurred. This fund may be set up to meet the decommissioning costs of one contributor or for a number of contributors. Matters for discussion with reference to HK(IFRIC) Int-5 are: (a) (b) How should the interest in a fund be dealt with by a contributor? How should an obligation be accounted for when a contributor has an obligation to make additional contributions?
4.2.2 HK(IFRIC) Int-5 treatment

The following treatments are specified in HK(IFRIC) Int-5: (a) If an entity recognises a decommissioning obligation under HKFRSs and contributes to a fund to segregate assets to pay for the obligation, it should apply HKFRS 10 Consolidated Financial Statements, HKFRS 11 Joint Arrangements and, HKAS 28 Investments in Associates and Joint Ventures, to determine whether decommissioning funds should be consolidated or accounted for under the equity method. When a fund is not consolidated or accounted for under the equity method, and that fund does not relieve the contributor of its obligation to pay decommissioning costs, the contributor should recognise: (i) (ii) its obligation to pay decommissioning costs as a liability its rights to receive reimbursement from the fund as a reimbursement under HKAS 37
(b)
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(c)
A right to reimbursement should be measured at the lower of the: (i) (ii) amount of the decommissioning obligation recognised contributor's share of the fair value of the net assets of the fund attributable to contributors
Changes in the carrying amount of this right (other than contributions to and payments from the funds) should be recognised in profit or loss. (d) When a contributor has an obligation to make potential additional contributions to the fund, that obligation is a contingent liability within the scope of HKAS 37. When it becomes probable that the additional contributions will be made, a provision should be recognised.
HK(IFRIC) Int-5 amends HKAS 39 Financial Instruments: Recognition and Measurement to exclude from its scope the rights to reimbursement for expenditure required to settle a liability recognised as a provision. Such rights will be accounted for in accordance with HKAS 37 Provisions, Contingent Liabilities and Contingent Assets.
The IASB issued an Exposure Draft on Liabilities in 2005. This was re-exposed in 2010. The finalised standard will replace IAS 37, and in turn HKAS 37. The ED proposes that The probable recognition criterion is removed, and instead uncertainty is reflected in the measurement of a liability ie through use of a probability-weighted average of the outflows for the range of possible outcomes. A liability is measured at the amount an entity would pay at the end of a reporting period to be relieved of the present obligation. This should be determined as: The present value of the resources required to fulfil the obligation, or The amount an entity would have to pay to cancel the obligation, or The amount an entity would have to pay to transfer the obligation to a third party.
If the liability is to pay cash to a counterparty, the outflows would be any expected cash payments plus associated costs. If the liability is to undertake a service at a future date, the outflows would be the amounts that the entity estimates it would pay a contractor at the future date to undertake the service on its behalf.
The effects of these proposals will include the recognition of far more provisions than at present, and where these are measured by reference to third party payment, a profit margin will be included so increasing the amount of the provision.
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Financial Reporting
Topic recap
HKAS 37 provides guidance on accounting for uncertainties. In some cases a provision is recognised, in others a contingent asset or liability is disclosed. A provision is a liability of uncertain timing or amount. Under HKAS 37, a provision should be recognised: When an entity has a present obligation, legal or constructive It is probable that a transfer of economic benefits will be required to settle it A reliable estimate can be made of its amount
A provision is measured at the best estimate of the expenditure required to settle the obligation at the year end. This may be calculated using expected values when the provision involves a large population of items. An entity should not recognise a contingent liability, but they should be disclosed where there is a possible outflow of economic resources. An entity should not recognise a contingent asset, but they should be disclosed where there is a probable inflow of economic resources.
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Answer 1
(a) Black Gold Oil Co has a constructive obligation, as the advertising campaign has created a valid expectation on the part of those affected by it that the entity will clean up the contamination it has caused. The retailer has a legal obligation to refund money for unwanted goods within a 28 day period after the sale, and a constructive obligation to provide refunds for 32 days beyond this. The past event is the sale, and therefore the retailer has a present obligation as a result of a past event.
(b)
Answer 2
The cost is found using 'expected values' (75% $NIL) + (20% $1.0m) + (5% $4.0m) = $400,000
Answer 3
(a) At 31 December 20X0, there is no legal obligation to fit the carbon monoxide detectors, and therefore Rango should not make a provision for either the cost of doing so or the fines which would be incurred if it were in breach of the legislation. If Rango has still not fitted the detectors at the 20X1 year end (ie when the legislation is in force), then it should make a provision for the penalty of $5,000 for which it is liable (rather than the $40,000 cost of fitting the detectors). This is because there is still no obligation for the costs of fitting detectors because no obligating event has occurred (the fitting of the detectors). However, an obligation might arise to pay fines or penalties under the legislation because the obligating event has occurred (the non-compliant operation of Rango). (b) Greenfingers is planning a restructuring of its business. A provision in respect of restructuring can only be made when a year-end obligation is evidenced by a detailed formal plan and an expectation on the part of those affected that the restructuring will happen. As at 31 December 20X0, the employees of Greenfingers are unaware of the plan and therefore this criterion is not met. Therefore no provision can be made. If a provision could be made (ie if the sale had been announced to employees, so giving rise to a valid expectation that the restructuring will occur and thus creating a constructive obligation) then provision would be for the $120,000 redundancy costs but not the $50,000 retraining costs.
Answer 4
(a) (b) Yes. Cobo Co cannot avoid the expenditure on repairing faulty goods. A provision should be made for the estimated cost of repairs. The cost of the provision is found using expected values: (60% x $0m) + (30% x $2m) + (10% x $4) = $1m.
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Financial Reporting
Exam practice
Darren Company Limited
23 minutes
Darren Company Limited ('DCL') is engaged in the manufacture of batteries. On the unaudited statement of financial position as at 30 June 20X8, it has recognised the following provisions as current liabilities: (a) A provision for late delivery penalty In May 20X8, DCL received a sales order for 7,000,000 units of rechargeable batteries for which the agreed delivery date is 31 August 20X8. It is expected that DCL would earn a gross profit of $1 per unit. Due to a shortage in the supply of raw materials, at the reporting date, the management realised that they could only supply the goods at the earliest on 10 September 20X8. According to the sales contract, DCL would compensate the customer for late delivery at $0.01 per unit per day. (b) A provision for annual safety inspection of the production line The last inspection was carried out in June 20X7. Due to a large backlog of sales orders, the management decided to postpone the annual inspection until mid-September 20X8. (c) A provision for the loss on sales of aged finished goods The products were manufactured in late 20X6 with an expected normal usage period of two years from the date of production. Due to the short expiry period, they were sold at a price below cost in July 20X8. (d) A provision for bonus payments to two executive directors In accordance with the directors service contract, two executive directors are entitled to receive, in addition to monthly salaries, a bonus of equivalent to 5 per cent of the profit before taxation and the accrued bonus. Required Discuss the appropriateness of the provisions recognised by DCL. (13 marks)
HKICPA February 2008 (amended)
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chapter 12
Construction contracts
Topic list
1 2 3 HKAS 11 Construction Contracts Accounting for construction contracts Current developments
Learning focus
Long term contracts are an everyday part of business in many industry sectors, particularly construction. You should be able to advise a client how this type of contract is accounted for and why.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.07 3.07.01 3.07.02 3.07.03 3.07.04 3.07.05 Construction contracts Define a construction contract Explain when contract revenue and costs should be recognised in accordance with HKAS 11 Explain how contract revenue and costs should be measured and apply these principles Account for the expected loss and changes in estimates Disclose information related to construction contracts in the financial statements 3
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12: Construction contracts | Part C Accounting for business transactions
1 HKAS 11 Construction Contracts

Topic highlights
A construction contract is a contract specifically negotiated for the construction of an asset or a combination of interrelated assets.
1.1 The accounting problem

Imagine that you are the accountant at a company which is building a hospital under contract with the government. The hospital will take four years to build and over that time your company will have to pay for costs such as workers wages and building materials. The government will make periodic payments at pre-determined stages of construction. How do you decide what amounts to include in the statement of comprehensive income in each of the four years? This is the problem addressed by HKAS 11 Construction Contracts.
Example: Construction contract

Suppose that a contract is started on 1 January 20X1, with an estimated completion date of 31 December 20X2. The final contract price is $2,000,000. In the first year, to 31 December 20X1: (a) (b) (c) Costs incurred amounted to $800,000. Half the work on the contract was completed. Certificates of work completed have been issued, to the value of $1,000,000. (Note. It is usual, in a construction contract, for a qualified person such as an architect or engineer to inspect the work completed, and if it is satisfactory, to issue certificates. This will then be the notification to the customer that progress payments are due to the contractor. Progress payments are commonly the amount of valuation on the work certificates issued, minus a precautionary retention of 10 per cent.) It is estimated with reasonable certainty that further costs to completion in 20X2 will be $800,000.
(d)
What is the contract profit in 20X1, and what entries would be made for the contract at 31 December 20X1 if: (a) (b) profits are deferred until the completion of the contract? a proportion of the estimated revenue and profit is credited to profit or loss in 20X1?
Solution
(a) If profits are deferred until the completion of the contract in 20X2, the revenue and profit recognised on the contract in 20X1 would be nil, and the value of work in progress on 31 December 20X1 would be the costs incurred of $800,000. $000 DEBIT CREDIT Work-in-progress Cash 800 800 $000
HKAS 11 takes the view that this policy is unreasonable, because in 20X2, the total profit of $400,000 would be recorded. Since the contract revenues are earned throughout 20X1 and 20X2, a profit of nil in 20X1 and $400,000 in 20X2 would be contrary to the accruals concept of accounting.
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Financial Reporting
(b)
It is fairer to recognise revenue and profit throughout the duration of the contract. As at 31 December 20X1 revenue of $1,000,000 should be matched with cost of sales of $800,000 in the statement of comprehensive income, leaving an attributable profit for 20X1 of $200,000. $000 $000 DEBIT Account receivable Cost of sales CREDIT Sales Cash 1,000 800 1,000 800
The only entry in the statement of financial position as at 31 December 20X1 is a receivable of $1,000,000 recognising that the company is owed this amount for work done to date. No balance remains for work in progress, the whole $800,000 having been recognised in cost of sales.
1.2 Scope of the standard

Topic highlights
HKAS 11 applies to construction contracts which span a period end.
HKAS 11 is applied in accounting for construction contracts in the financial statements of contractors. A construction contract within the scope of HKAS 11 does not have to last for a period of more than one year. The main point is that the contract activity starts in one financial period and ends in another, thus creating the problem: to which of two or more periods should contract income and costs be allocated? Where the rendering of services is directly related to a construction contract, for example services provided by a project manager or architect, these services are also accounted for in accordance with HKAS 11. In all other cases, the rendering of services, even where a service contract spans a period end, is within the scope of HKAS 18.
HKAS 11.3-6
1.3 Definitions
HKAS 11 provides the following definitions:
Key terms
Construction contract. A contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use. A fixed price contract is a construction contract in which the contractor agrees to a fixed contract price, or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses. A cost plus contract is a construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee. (HKAS 11)
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The definition of a construction contract includes: Contracts for the construction of single assets such as bridges or roads Contracts for the construction of inter-related assets such as refineries or complex pieces of equipment Contracts for services related to the construction of an asset such as project manager services Contracts for the destruction or restoration of assets
Contracts are further broken down into fixed price and cost plus contracts. The distinction between these two types is relevant when accounting for construction contracts and is considered in Section 2.1.
1.4 Contract revenue and contract costs

As well as the more formal definitions above, the standard includes detailed guidance on what amounts should be included in contract revenue and contract costs.
HKAS 11.1115
1.4.1 Contract revenue

Contract revenue includes: (a) (b) the initial amount of revenue specified in the contract; and variations in contract work, claims and incentive payments:
Examples of variations: 1. 2. 3. 4. 5. A variation, or instruction by the customer for a change in the scope of work to be performed, may increase or decrease contract revenue. A claim, being an amount that an entity seeks to collect from the customer as reimbursement for extra costs, may increase contract revenue. Cost escalation clauses in a fixed price contract will increase contract revenue. Incentive payments, being additional amounts paid to a contractor if specified standards are met or exceeded will increase contract revenue. Penalties imposed on contractors due to delays will decrease contract revenue.
Variations are only included as part of contract revenue to the extent that: (i) (ii) it is probable that they will result in revenue; and they are capable of being reliably measured.
The result is that contract revenue is measured at the fair value of received or receivable revenue.
Example: Contract revenue

Loriload has a fixed price contract for $9 million to build a bridge. By the end of year 1 it is apparent that the associated costs have increased by around 5% and accordingly in year 2 the customer approves a variation of $500,000. The contract is completed in year 3. What amount should be used as contract revenue in calculations in relation to the construction contract at the end of the three years?
Solution
Year 1 Year 2 Year 3 $9 million $9.5 million $9.5 million
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Financial Reporting
HKAS 11.1620
1.4.2 Contract costs

Contract costs consist of: (a) (b) (c) costs that relate directly to the specified contract. costs that are attributable to contract activity in general and can be allocated to the contract such other costs as are specifically chargeable to the customer under the terms of the contract.
Costs that relate directly to a specific contract include the following: Site labour costs, including site supervision Costs of materials used in construction Depreciation of plant and equipment used on the contract Costs of moving plant, equipment and materials to and from the contract site Costs of hiring plant and equipment Costs of design and technical assistance that are directly related to the contract Estimated costs of rectification and guarantee work, including expected warranty costs Claims from third parties
Costs that are attributable to general contract activity and can be allocated to specific contracts include: insurance general costs of design and technical assistance construction overheads
These costs should be allocated systematically and rationally, and all costs with similar characteristics should be treated consistently. The allocation should be based on the normal level of construction activity. Borrowing costs may be attributed in this way (see HKAS 23: Chapter 17). Some costs cannot be attributed to contract activity and so the following should be excluded from construction contract costs: General administration costs (unless reimbursement is specified in the contract) Selling costs R&D (unless reimbursement is specified in the contract) Depreciation of idle plant and equipment not used on any particular contract
Example: Contract costs

Alphabeta has commenced a contract on 1 August 20X1 for the construction of a motorway. Information on contract costs incurred in the year ended 31 December 20X1 is as follows: Surveyors fees Direct labour costs Materials delivered to the site Transport of heavy plant to site The following information is also relevant: Overheads are to be apportioned at 35% of direct labour costs Inventory of materials on site at the 20X1 year end is $76,000 The heavy plant was acquired at a cost of $90,000 two years ago and is being depreciated over 10 years on a straight line basis. $000 12 134 250 10
What are contract costs incurred as at 31 December 20X1?
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Solution
Surveyors fees Direct labour costs Overheads (35% $134,000) Materials (250,000 76,000) Transport of heavy plant to site Depreciation of heavy plant (5/12 10% $90,000) $000 12 134 46.9 174 10 3.75 380.65
HKAS 11.7-9
1.5 Combining and separating construction contracts

HKAS 11 accounting rules are normally applied to each of an entitys construction contracts in turn. Sometimes, however, one contract is split into component parts and each is accounted for separately, or a group of contracts are grouped and accounted for together. The construction of a series of assets under one contract should be treated as several contracts where: separate proposals are submitted for each asset. separate negotiations are undertaken for each asset; the customer can accept/reject each individually. identifiable costs and revenues can be separated for each asset.
A group of contracts should be treated as one single construction contract where: the group of contracts are negotiated as a single package. contracts are closely interrelated, with an overall profit margin. the contracts are performed concurrently or in a single sequence.
2 Accounting for construction contracts

Topic highlights
Revenue and costs associated with a contract should be recognised according to the stage of completion of the contract when the outcome of the activity can be estimated reliably. If a loss is predicted on a contract, then it should be recognised immediately.
HKAS 11.23,24
2.1 Reliable estimate of outcome

The accounting treatment applied to a construction contract depends on whether the outcome of the contract can be measured reliably. HKAS 11 provides guidance on when this is the case for both fixed price and cost plus contracts: (a) Fixed price contracts In the case of a fixed price contract, the outcome of a construction contract can be estimated reliably when all of the following conditions are satisfied: (i) (ii) (iii) Total contract revenue can be reliably measured. It is probable that economic benefits of the contract will flow to the entity. Stage of contract completion at the period end and costs to complete the contract can be reliably measured.
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Financial Reporting
(iv) (b)
Costs attributable to the contract can be identified clearly and be reliably measured so that actual costs can be compared to previous estimates.
Cost plus contracts In the case of a cost plus contract, the outcome of a construction contract can be estimated reliably when both of the following conditions are satisfied: (i) (ii) it is probable that economic benefits of the contract will flow to the entity, the costs attributable to the contract (whether or not reimbursable) can be identified clearly and be reliably measured.
HKAS 11.30
2.1.1 Determining the stage of completion

Topic highlights
The stage of completion of a contract is normally measured using the costs basis, sales basis or physical completion basis. One of the criteria listed above which indicates that the outcome of a fixed price contract can be estimated reliably is that the stage of contract completion can be reliably measured. How should you decide on the stage of completion of any contract? The standard lists several methods: Proportion of contract costs incurred for work carried out to date Surveys of work carried out Physical proportion of the contract work completed
The proportion that contract costs incurred for work performed to date bear to the estimated total contract costs: % on total costs =
Costs incurred to date WIP inventories 100% Total costs + variation
Surveys of work performed, or physical proportion of the contract work completed: % on work performed =
Work certified 100% Total revenue + variation
2.2 Accounting treatment: outcome can be reliably estimated

HKAS 11.22,26
2.2.1 Profitable contract

Where the outcome of a contract can be reliably estimated and the contract is expected to be profitable based on contract revenue, costs to date and expected costs to complete, the percentage completion method is applied. The percentage of completion method is an application of the accruals assumption. Contract revenue is matched to the contract costs incurred in reaching the stage of completion, so revenue, costs and profit are attributed to the proportion of work completed: (a) (b) (c)
Contract revenue is recognised as revenue in the accounting periods in which the work is performed. Contract costs are recognised as an expense in the accounting period in which the work to which they relate is performed
Where amounts have been recognised as contract revenue, but their collectability from the customer becomes doubtful, such amounts should be recognised as an expense, not a deduction from revenue.
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Example: Profitable contract with reliably estimated outcome

Gosforth Construction assesses the stage of completion of its contracts by reference to costs incurred as a percentage of total costs. The company commenced Contract A in 20X1. The contract has a fixed price of $890,000, recorded costs during 20X1 are $389,000, of which $10,000 relates to unused inventory. Expected future costs are $150,000.
Required
How much profit should be reported in 20X1 in accordance with HKAS 11?
Solution
Costs incurred to date (389 10) Estimated future costs (150 + 10) Total estimated costs The contract is therefore 70.3% (379,000/539,000) complete Revenue to be recognised: $890,000 x 70.3% = $625,670 The profit earned to date is therefore $246,670 ($625,670 $379,000) $ 379,000 160,000 539,000
Example: Inclusion in financial statements

Discovery Construction commenced a $4 million contract to build a velodrome in the year ended 31 December 20X3. Details of the contract costs are as follows:
31 Dec 20X3 31 Dec 20X4 31 Dec 20X5
Estimated total costs Costs incurred to date
$3.2 million $1.2 million
What amounts should be included in Discovery Constructions financial statements for each of these years?
Solution
1 Calculate expected profit
20X3 $000 20X4 $000 20X5 $000
Contract price estimated total costs 2
800
700
700
Calculate percentage of completion 37.5% 1,500 (1,200) 300 75% 3,000 (2,475) 525 100% 4,000 (3,300) 700
Costs incurred/total costs 3 Revenue (% complete revenue) Cost of sales (costs incurred) Profit (% complete expected profit)
Calculate cumulative income statement amounts
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Financial Reporting
Calculate income statement amounts for each year (cumulative amounts minus amounts previously recognised) $000 $000 1,500 (1,275) 225 $000 1,000 (825) 175
Revenue Cost of sales Profit
1,500 (1,200) 300
It is evident from the first example above that when the contract costs incurred to date is used to determine the stage of completion, then only the contract costs reflecting the work to date should be incorporated in costs incurred to date. Costs relating to future activity, eg cost of materials delivered but not yet used, are to be excluded. Payments in advance made to subcontractors are to be excluded.
HKAS 11.36,37
2.2.2 Loss making contract

Topic highlights
When the outcome of a contract can be reliably estimated and the project is loss-making, the loss must be recognised in full.
Any loss on a contract should be recognised as soon as it is foreseen. The loss will be the amount by which total expected contract revenue is exceeded by total expected contract costs. The amount of the loss is not affected by: whether work has started on the contract the stage of completion of the work profits on other contracts (unless they are related contracts treated as a single contract).
Example: Loss making contract

Randall has a contract to construct a new head office for a multinational company. The contract price has been agreed as $7 million. When Randall first signed the contract, the estimated total costs to completion were assessed as $6.2 million. By the end of the first year of the contract, however, price rises have meant that estimated total costs are now $7.1 million. The contract is assessed as 28 per cent complete by the end of the first year, based on costs incurred. What amounts should be recognised in profit or loss in the first year of the contract?
Solution
The expected loss of $100,000 must be recognised in full, and forms part of cost of sales. Therefore: Revenue (balancing figure) Cost of sales (28% $7.1m) + $100,000 Loss $000 1,988 (2,088) (100)
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HKAS 11.3224
2.3 Accounting treatment: outcome cannot be reliably estimated

Topic highlights
When the outcome of a contract cannot be reliably estimated no profit or loss is recognised; revenue is recognised to the extent that recognised costs incurred are recoverable.
When the contract's outcome cannot be reliably estimated the following treatment should be followed: (1) (2) Contract costs are recognised as an expense as incurred Revenue is recognised to the extent that contract costs are recoverable
This no profit/no loss approach reflects the situation near the beginning of a contract, ie the outcome cannot be reliably estimated, but it is likely that costs will be recovered. Contract costs which cannot be recovered should be recognised as an expense straight away. HKAS 11 lists the following situations where this might occur: The contract is not fully enforceable, ie its validity is seriously in question The completion of the contract is subject to the outcome of pending litigation or legislation The contract relates to properties which will probably be expropriated or condemned The customer is unable to meet its obligations under the contract The contractor cannot complete the contract or in any other way meet its obligations under the contract
Where these uncertainties cease to exist, contract revenue and costs should be recognised as normal, ie by reference to the stage of completion.
HKAS 11.43,44
2.4 Construction contracts in the statement of financial position

The accounting treatment of construction contracts is profit or loss driven. Any amount included in the statement of financial position is a balancing amount, calculated as: Contract costs incurred Recognised profits less recognised losses Progress billings Amounts due from/to customers X X/(X) (X) X/(X)
Where an amount due from customers is calculated, this is normally shown within inventories. Where an amount due to customers is calculated, this is normally shown as payments on account within payables. Any amount invoiced but unpaid is shown as a receivable.
Example
Assume that in the previous example the customer had been billed a total of $1.5million, and had paid $1,280,000 of this. The amounts reported in the statement of financial position would therefore be: Amounts due from customers (W) Receivables $000 388 220
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Financial Reporting
(W) Contract costs incurred Recognised profits less recognised losses Progress billings Amounts due from customers
$000 1,988 (100) (1,500) 388
HKAS 11.38
2.5 Changes in estimates

According to HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, the effect of any change in the estimate of contract revenue, costs or the outcome of a contract should be treated as a change in accounting estimate. In other words, the change is accounted for prospectively and does not affect amounts recognised in respect of previous years of a contract.
Example: Changes in estimates

Revenues and costs relating to a three-year contract commencing 1 January 20X5 are as follows.
20X5 $000 20X6 $000 20X7 $000
Revenue per contract Agreed variation Total contract revenue Contract costs incurred to date Contract costs to completion Total contract costs Overall profit % complete, using costs basis
1,200 1,200 263 789 1,052 148 25%
1,200 1,200 700 600 1,300 (100) 54%
1,200 200 1,400 1,320 1,320 80 100%
The 20X6 contract costs incurred to date include $200,000 which relates to additional work required for unforeseen extras. In 20X6 the contractor negotiated with the customer to recover the cost of this additional work, but it was not until 20X7 that it became probable that the customer would accept this contract variation.
Required
What amounts should be recognised in profit or loss in each of the three years?
Solution
20X5 20X6 25% x expected profit of $148,000 Loss is expected and is recognised in full Less: profit previously recognised Loss recognised in 20X6 $000 37 (100) (37) (137)
20X7
Overall actual profit Add: cumulative loss previously recognised Profit recognised in 20X7
80 100 180
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2.6 Section summary

A methodical approach is crucial for the valuation of long-term construction contracts and the other disclosure requirements under HKAS 11. The following method suggests a breakdown of the process into five logical steps, and is to be applied where the outcome of a contract can be estimated reliably. 1 The contract value is compared to the estimated total costs (costs to date plus estimated costs to completion) to be incurred on the contract. If a foreseeable loss on the contract is expected (that is, if the estimated total costs exceed the contract value), then this loss must be charged against profits. If a loss has already been charged previously, then only the difference between this loss and the loss currently estimated needs to be charged. Apply the percentage of completion to date (or other formula given in the question) to the calculation of the sales revenue attributable to the contract for the period (for example, percentage of completion total contract value, less revenue already recognised in previous periods).
Calculate the cost of sales on the contract for the period.
Total contract costs percentage complete (or follow instructions in question) Less any costs charged in previous periods Add foreseeable losses in full (not previously charged) Cost of sales on contract for the period 4 5
$ X (X) X X X
Deduct the cost of sales for the period as calculated above (including any foreseeable loss) from the sales revenue calculated at step 2 to give profit (loss) recognised for the period. Calculate amounts due to/from customers for inclusion in the statement of financial position
Contract costs incurred to date Recognised profits/(losses) to date Progress billings to date Amounts due from/(to) customers
$ X X X (X) X
Note. The progress billings figure above represents the total billed revenue. Unpaid billed revenue will be shown under trade receivables.
HKAS 11.39,40,42
2.7 Disclosures
The following should be disclosed in respect of construction contracts: The amount of contract revenue recognised as revenue in the period The methods used to determine the contract revenue recognised in the period The methods used to determine the stage of completion of contracts in progress The aggregate amount of costs incurred and recognised profits (less recognised losses) to date The amount of advances received (amounts received before the related work is performed) The amount of retentions (amounts billed but unpaid until defects are rectified or conditions specified in the contract are met) The gross amount due from customers for contract work as an asset The gross amount due to customers for contract work as a liability.
In addition, the following should be disclosed for contracts in progress at the reporting date:
An entity should also present:
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Financial Reporting
At the start of 20X1 Globalle Company negotiated a fixed price contract of $14.0 million with Oceanic for the construction of a container port. Globalle had estimated the costs of the contract to be $13.3 million. Globalle estimates the stage of completion on its construction contracts by reference to the physical proportion of the work completed. During 20X1 the contract suffered protracted delays and difficulties, such that Globalle concluded that there would be material cost overruns. It negotiated with Oceanic to try to get some recompense for these unexpected difficulties in the form of contract variations, but without success. At 31 December 20X1 when the contract was 30% physically complete, the costs incurred amounted to $4.9 million and the costs to complete were estimated at $11.2 million. Throughout 20X2 Globalle continued to try to win recompense from Oceanic, but without success. At 31 December 20X2 when the contract was 80% physically complete, the costs incurred amounted to $12.6 million and the costs to complete were estimated at $3.5 million. On that day and after these figures had been drafted, Oceanic suddenly agreed in principle to a contract variation of $3.5 million, provided that Globalle agreed to pay Oceanic a penalty for late completion of $280,000. Globalle agreed to these terms and the relevant adjustments were made to the draft figures.
Required
Determine the following amounts in respect of the container port contract in Globalles financial statements according to HKAS 11 Construction Contracts. (a) (b) (c) The profit or loss to be recognised in the year ended 31 December 20X1 The revenue to be recognised in the year to 31 December 20X2 The profit or loss to be recognised in the year ended 31 December 20X2
Aero Company has the following information in respect of a construction contract: Total contract price Cost incurred to date Estimated cost to completion Progress billings (of which $50,000 has been received) Percentage complete (cost basis)
Required
$100,000 $48,000 $32,000 $58,000 60%
(a) (b)
Prepare relevant extracts from the statement of comprehensive income and statement of financial position. Show how the statement of financial position would differ if progress billings were $64,000 (of which $50,000 received). (The answer is at the end of the chapter)
The IASB and FASB issued an Exposure Draft in relation to revenue recognition in June 2010. It is proposed that the resulting standard will replace both IAS 18 Revenue and IAS 11 Construction Contracts (and so their HKAS equivalents). The new standard is expected in the second half of 2011 and is discussed in more detail in Chapter 14.
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Topic recap
A construction contract is a contract specifically negotiated for the construction of an asset or a combination of interrelated assets. HKAS 11 applies when such a contract spans a period end. When the outcome of a contract can be reliably estimated and the project is profitable, amounts are recognised in the statement of comprehensive income based on the stage of completion of the contract. The stage of completion of a contract is normally measured using the costs basis, sales basis or physical completion basis. When the outcome of a contract can be reliably estimated and the project is loss-making, the loss must be recognised in full. When the outcome of a contract cannot be reliably estimated no profit or loss is recognised; revenue is recognised to the extent that recognised costs incurred are recoverable. The statement of financial position amount (amounts due from/(to) customers) is calculated as: Costs to date Profits (losses) to date Progress billings X X/(X) (X) X/(X)
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Financial Reporting

Answer 1
(a) (b) (c) $(2,100,000) $9,576,000 $2,996,000
Profit / loss on contract 20X1 $000 14,000 14,000 (4,900) (11,200) (2,100) 20X2 $000 14,000 3,500 (280) 17,220 (12,600) (3,500) 1,120 20X2 cumulative $000 13,776 20X2 (cum 20X1) $000 9,576 6,580
Contract price Variation Penalty Costs incurred to date Estimated costs to completion Profit / loss on contract
Amounts to be recognised
Revenue (30% x $14m / 80% x $17.22m) Costs () Loss (in full) Profit (80% x $1.12m)
20X1 $000 4,200 (6,300)
(2,100) 896 2,996
At 31 December 20X1 the expected loss must be recognised immediately. Under the agreement made on 31 December 20X2, the contract revenue is increased by the variation and reduced by the penalty. The profit for the year ended 31 December 20X2 is the profit to date, PLUS the loss recognised in 20X1.
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Answer 2
(a) STATEMENT OF COMPREHENSIVE INCOME (EXTRACTS) Revenue (60% 100,000) Expenses (60% 80,000) Profit STATEMENT OF FINANCIAL POSITION (EXTRACTS)
Current assets Gross amounts due from customers
$ 60,000 (48,000) 12,000
Contract costs incurred to date Recognised profits Less: progress billings to date
Trade receivables
48,000 12,000 60,000 (58,000) 2,000 58,000 (50,000) 8,000
Progress billings to date Less: cash received
WORKING
Overall expected profitability Total revenue Total expected costs (48,000 + 32,000) Overall expected profit
$ 100,000 (80,000) 20,000 $
(b)
STATEMENT OF FINANCIAL POSITION (EXTRACTS)

Current assets Trade receivables Progress billings to date Less: cash received Current liabilities Gross amounts due to customers Contract costs incurred to date Recognised profits
64,000 (50,000) 14,000
Less: progress billings to date
48,000 12,000 60,000 (64,000) (4,000)
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Financial Reporting
Exam practice
Construction contracts
(a)
22 minutes
'It is not prudent to recognise profit on outstanding work in progress in construction contracts. Revenue and cost should only be recognised upon the completion of the construction work.' Discuss. (5 marks) At 30 June 20X9, Vertical Construction Company ('VC') had a fixed price construction contract in progress, named Waterfall Golf Villa, a project to construct 80 condominium units. 60 units have been completed and the remaining 20 units are expected to be completed in the last quarter of 20X9. A survey of completed construction work will be carried out upon completion of all units. Construction was begun in April 20X8 and the outcome of the contract could not be estimated reliably at 30 June 20X8. According to the original bid estimate, VC would have a profit margin of 20 per cent. Based on the actual costs incurred and the latest information, there will be an increase in the estimated total costs because of a 15 per cent increase in the price of construction material. However, a loss is not anticipated. An instalment contract sum for the construction has been received by VC in accordance with the contracted payment schedule.
Required
(b)
Explain how VC should account for this construction contract in the financial statements for the year ended 30 June 20X9. (7 marks)
(Total = 12 marks) HKICPA May 2009
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chapter 13
Share-based payment
Topic list
1 2 3 4 5 6 HKFRS 2 Share-Based Payment Recognition and measurement of share-based payments Share-based payment transactions further issues Disclosure of share-based payment transactions Share-based payment transactions and deferred tax Modifications to the terms and conditions on which equity instruments were granted, including cancellations and settlements
Learning focus
Share based payment is a controversial area. It is, however relevant, as share option schemes are common.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Accounts for transactions in accordance with Hong Kong Financial Reporting Standards 3.05 3.05.01 3.05.02 3.05.03 3.05.04 3.05.05 3.05.06 Share-based payment Identify and recognise share-based payment transactions in accordance with HKFRS 2 Account for equity-settled and cash-settled share-based payment transactions Account for share-based payment transactions with cash alternatives Account for unidentified goods or services in a share-based payment transaction Account for group and treasury share transactions Disclosure requirement of share option 2
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13: Share-based payment | Part C Accounting for business transactions
1 HKFRS 2 Share-Based Payment

Topic highlights
Share-based payment transactions are those transactions where an entity receives goods or services in return for its own equity instruments or an amount of cash related to the value of its equity instruments.
1.1 Introduction
It is increasingly common for entities to issue shares or share options to other parties, such as suppliers or employees, in return for goods or services received. In some instances neither shares nor share options are issued, but cash consideration is promised at a later date, measured in relation to share price. All of these transactions are examples of share-based payments. Share option schemes are a common feature of directors remuneration packages and many organisations also use such schemes to reward other employees. Share-based payments are also a very common form of consideration for internet businesses which are notoriously loss making in early years and therefore cash poor.
1.1.1 The accounting problem

Prior to the issue of HKFRS 2, no accounting guidance existed in relation to share-based payments. This resulted in inconsistent treatment of expenses: those paid in cash were recognised in profit or loss while those involving a share-based payment were not, because share options initially had no value (since the exercise price is generally more than the market price of the share on the date the option is granted). As we shall see in this chapter, the issue of HKFRS 2 meant that companies were required to recognise an expense in relation to share-based payments. As a result those companies which made share-based payments saw a reduction in earnings, in some cases of a significant amount. For this reason, HKFRS 2 remains controversial in practice.
HKFRS 2.1-6
1.2 Objective and scope

HKFRS 2 requires an entity to reflect in its profit or loss and financial position the effects of share-based payment transactions, including expenses associated with transactions in which share options are granted to employees. The standard must be applied to all share-based payment transactions whether or not the goods or services received under the share-based payment transaction can be individually identified, including: (a) (b) (c) Equity-settled share-based payment transactions Cash-settled share-based payment transactions Transactions in which the entity receives or acquires goods or services and the terms of the arrangement provide either the entity or the supplier of those goods or services with a choice of whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments.
The standard also applies to group-settled share-based transactions. That is where one group entity receives goods or services and another entity within the group settles the share-based payment transaction. In this case HKFRS 2 applies to both entities.
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Financial Reporting
Certain transactions are outside the scope of the HKFRS: (a) Transactions with employees and others in their capacity as a holder of equity instruments of the entity (for example, where an employee receives additional shares in a rights issue to all shareholders) The issue of equity instruments in exchange for control of another entity in a business combination, or business under common control or the contribution of a business on the formation of a joint venture.
(b)
HKFRS 2, Appendix A
1.3 Definitions
The standard provides the following definitions:
Key terms
Share-based payment transaction is a transaction in which the entity: (a) (b) receives goods or services from the supplier of those goods or services (including an employee) in a share-based payment arrangement, or incurs an obligation to settle the transaction with the supplier in a share-based payment arrangement when another group entity receives those goods or services.
Share-based payment arrangement is an agreement between the entity (or another group entity) and another party (including an employee) that entitles the other party to receive: (a) cash or other assets of the entity for amounts that are based on the price (or value) of equity instruments (including shares or share options) of the entity or another group entity, or equity instruments (including shares or share options) of the entity or another group entity
(b)
provided the specified vesting conditions are met. Equity instrument is a contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Equity instrument granted is the right (conditional or unconditional) to an equity instrument of the entity conferred by the entity on another party, under a share-based payment arrangement. Share option is a contract that gives the holder the right, but not the obligation, to subscribe to the entity's shares at a fixed or determinable price for a specified period of time. Fair value is the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm's length transaction. Grant date is the date at which the entity and another party (including an employee) agree to a share-based payment arrangement, being when the entity and the other party have a shared understanding of the terms and conditions of the arrangement. At grant date the entity confers on the other party (the counterparty) the right to cash, other assets, or equity instruments of the entity, provided the specified vesting conditions, if any, are met. If that agreement is subject to an approval process (for example, by shareholders), grant date is the date when that approval is obtained. Intrinsic value is the difference between the fair value of the shares to which the counterparty has the (conditional or unconditional) right to subscribe or which it has the right to receive, and the price (if any) the other party is (or will be) required to pay for those shares. For example, a share option with an exercise price of $15 on a share with a fair value of $20, has an intrinsic value of $5.
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Key terms (cont'd)

Measurement date is the date at which the fair value of the equity instruments granted is measured. For transactions with employees and others providing similar services, the measurement date is grant date. For transactions with parties other than employees (and those providing similar services), the measurement date is the date the entity obtains the goods or the counterparty renders service. Vest means to become an entitlement. Under a share-based payment arrangement, a counterparty's right to receive cash, other assets, or equity instruments of the entity vests when the counterpartys entitlement is no longer conditional on the satisfaction of any vesting conditions. Vesting conditions are the conditions that determine whether the entity receives the services that entitle the counterparty to receive cash, other assets or equity instruments of the entity, under a share-based payment arrangement. Vesting conditions are either service conditions or performance conditions. Service conditions require the counterparty to complete a specified period of service. Performance conditions require the counterparty to complete a specified period of service and specified performance targets to be met (such as a specified increase in the entitys profit over a specified period of time). A performance condition might include a market condition. Vesting period is the period during which all the specified vesting conditions of a sharebased payment arrangement are to be satisfied. Note that the definition of fair value within HKFRS 2 differs from that within HKFRS 13 Fair Value Measurement. When applying HKFRS 2, the definition contained within that standard should be used rather than HKFRS 13.
2 Recognition and measurement of share-based HKFRS 2.7-8 payments

The basic principle presented in HKFRS 2 with regard to recognition is that an entity should recognise goods or services received or acquired in a share-based payment transaction when it obtains the goods or as the services are received. The goods or services received should be recognised as an expense, or asset where appropriate. The corresponding accounting entry depends on whether the share-based payment will be equity or cash-settled.
HKFRS 2.10
2.1 Equity settled share-based payments

Topic highlights
Equity-settled share based payment transactions with parties other than employees are measured at the fair value of the goods or services received and recognised in equity, normally immediately. Equity settled share-based payment transactions with employees are measured at the fair value of the equity instruments on the grant date and recognised in equity over the vesting period.
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Financial Reporting
Goods or services received or acquired in an equity-settled share-based payment transaction should be recognised in equity: DEBIT CREDIT Expense / asset Equity
Before considering when this accounting entry is made, we must consider how an equity settled share-based payment is measured.
HKFRS 2.1113
2.1.1 Measurement of equity-settled share-based payment transactions

The general principle in HKFRS 2 is that an entity should measure a share-based payment transaction at the fair value of the goods or services received. In the case of equity-settled transactions, the application of this rule depends on who the transaction is with: Where the transaction is with employees and forms part of their remuneration package, it is not normally possible to measure directly the services received. Therefore the transaction is measured by reference to the fair value of the equity instruments granted at the grant date (the indirect method). Where the transaction is with parties other than employees, there is a rebuttable presumption that the fair value of the goods or services received can be estimated reliably, and therefore the transaction is measured at this amount (the direct method). Where this is not the case, the entity should measure the transactions value using the indirect method.
Where the indirect method (by reference to the fair value of the equity instruments granted) is adopted to measure a transaction, fair value is based on the market prices, if available, taking into consideration the terms and conditions upon which those equity instruments were granted. In the absence of market prices, the fair value of the equity instruments granted should be approximated using a valuation technique. (These are not within the scope of this exam.)
HKFRS 2.14,15
2.1.2 Recognition of equity settled share-based payment transactions

Where the equity instruments granted vest immediately ie the recipient party becomes entitled to them immediately, then the transaction is accounted for in full on the grant date. This is normally the case with transactions with parties other than employees, which are: measured at the fair value of the goods or services received, and recognised when the goods or services are provided.
Where the counterparty to the transaction has to meet specified conditions before they are entitled to the equity instruments, and these are to be met over a specified vesting period, the expense is spread over this vesting period. This is normally the case with transactions with employees, discussed in more detail in the next section.
HKFRS 2.14,15
2.1.3 Transactions with employees

Where the equity instruments granted to employees vest immediately (ie. the employee is not required to complete a specified period of service before becoming unconditionally entitled to the equity instruments), it is presumed that the services have already been received (in the absence of evidence to the contrary). The entity should therefore recognise the transaction in full on the grant date, by recognising the fair value of the equity instruments granted as an expense and a corresponding increase in equity. Where the equity instruments granted do not vest until the counterparty completes a specified period of service, the entity should account for those services as they are rendered by the
258
employee during the vesting period. For example if an employee is granted share options on condition that he or she completes three years' service, then the services to be rendered by the employee as consideration for the share options will be received in the future, over that three-year vesting period. Therefore the fair value of the equity instruments granted should be spread over the three years, with an expense and corresponding increase in equity recognised in each year. The expense recognised in each year of the vesting period should be based on the best available estimate of the number of equity instruments expected to vest. That estimate should be revised if subsequent information indicates that the number of equity instruments expected to vest differs from previous estimates. On the vesting date, the entity should revise the estimate to equal the number of equity instruments that actually vest. Once the goods and services received and the corresponding increase in equity have been recognised, the entity should make no subsequent adjustment to total equity after the vesting date.
Example: Equity-settled share-based payment transaction immediate vesting

Barbar Co issues 100 share options to each of its employees on 1 July 20X1. The share options vest immediately and there is a three-year period over which the employees may exercise the share options. Employees are entitled to exercise the options regardless of whether or not they remain in the entitys employment during the period of exercise. The fair value of the share options is $8 on grant date and there are 1,000 employees in the entitys employment at 1 July 20X1. Required How should the transaction be accounted for?
Solution
The total fair value for the share options issued at grant date is: $8 x 1,000 employees 100 options = $800,000 Barbar Co should therefore charge $800,000 to profit or loss as employee remuneration on 1 July 20X1 and the same amount will be recognised as part of equity on that date.
Example: Equity-settled share-based payment transaction vesting period 1

Whiston Co provides each of 200 managers with 500 share options on 1 January 20X1. Each option has a fair value of $8 at the grant date, $10 on 1 January 20X2, $13 on 1 January 20X3 and $12 on 31 December 20X3. The options do not vest until 31 December 20X3 and are dependent on continued employment. All 200 managers are expected to remain with the company. Required Explain the accounting treatment of the share options in each of the years 20X1, 20X2 and 20X3.
Solution
The total expense to be recognised over the three year vesting period is: 200 x 500 x $8 = $800,000
Note that the changes in the value of the options after grant date do not affect the charge to profit or loss for equity-settled transactions.
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Financial Reporting
The remuneration expense should be recognised over the vesting period of three years. An amount of $266,667 should be recognised for each of the three years 20X1, 20X2 and 20X3 in profit or loss with a corresponding credit to equity.
Example: Equity-settled share-based payment transaction vesting period (2)

The circumstances are as in the example above, however managers are expected to leave the company as follows: At 31 December 20X1, it is estimated that 10% of managers will have left by the end of 20X3 At 31 December 20X2, it is estimated that 14% of managers will have left by the end of 20X3 By the end of 20X3, 20% of the original managers awarded share options have actually left.
Required Explain the accounting treatment in each of the years 20X1, 20X2 and 20X3.
Solution
The expense to be recognised in each year in relation to the share options over the vesting period is based on the estimated number of shares expected to vest. As options held by employees who leave the company will not vest, these must be excluded from the amount recognised. Therefore: Total expense 20X1 200 managers 90% 500 options $8 fair value $720,000 $240,000 $688,000 $458,667 $218,667 $640,000
This is divided by the three year vesting period to give an annual expense in 20X1 of 20X2 200 managers 86% 500 options $8 fair value
To date two years of expense should have been recognised ie $688,000 2/3 As $240,000 was recognised in 20X1, the 20X2 expense is $458,667 - $240,000 20X3 200 managers 80% 500 options $8 fair value
All expense should now have been recognised as the vesting period is complete. Therefore in 20X3 the expense is $640,000 - $240,000 - $218,667 $181,333
Armley Co issues 10,000 options to each of the 50 directors and senior managers on 1 July 20X1. The exercise price of the options is $4.50 per share. The scheme participants have to stay with the company for four more years before being able to exercise their options. At 31 December 20X1, it is estimated that 75 per cent of the current directors and senior managers will remain with the company for four years or more. The estimated figure is 70 per cent by 31 December 20X2. The fair value of an option is $3 at the grant date. Required Show how the option scheme would be reflected in the financial statements for the years ended 31 December 20X1 and 31 December 20X2. (The answer is at the end of the chapter)
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An entity grants 100 share options on its $1 shares to each of its 500 employees on 1 January 20X5. Each grant is conditional upon the employee working for the entity over the next three years. The fair value of each share option as at 1 January 20X5 is $15. On the basis of a weighted average probability, the entity estimates on 1 January that 20 per cent of employees will leave during the three-year period and therefore forfeit their rights to share options. Required Show the accounting entries which will be required over the three-year period in the event of the following: 20 employees leave during 20X5 and the estimate of total employee departures over the three-year period is revised to 15 per cent (75 employees) 22 employees leave during 20X6 and the estimate of total employee departures over the three-year period is revised to 12 per cent (60 employees) 15 employees leave during 20X7, so a total of 57 employees left and forfeited their rights to share options. A total of 44,300 share options (443 employees x 100 options) are vested at the end of 20X7. (The answer is at the end of the chapter)
HKFRS 2.31,32
2.2 Cash-settled share-based payment transactions

Topic highlights
Cash-settled share-based payment transactions are recognised as a liability and measured at the fair value of that liability. They are remeasured at the end of each reporting period.
The following may be included as cash-settled share-based payment transactions: The grant of share appreciation rights to employees: instead of the entitlement to an equity instrument, the employees are entitled to a future cash payment which is based on the increase in the entity's share price from a specified level over a specified period of time, or The grant to its employees of a right to receive a future cash payment by giving them a right to shares that are redeemable
A liability should be recognised where goods or services are received or acquired in a cash-settled share-based payment transaction. It is recorded by a debit to an expense or asset account and a credit to a liability account. DEBIT CREDIT
HKFRS 2.30
Expense / asset Liability
2.2.1 Measurement of cash settled share-based payment transactions

The primary principle is that the fair value of the liability is used to measure the goods or services acquired and the liability incurred by the entity. The fair value of the liability should be reassessed at each reporting date till its settlement and also at the date of settlement. Any changes in fair value are recorded as profit or loss for the period.
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Financial Reporting
HKFRS 2.32
2.2.2 Recognition of cash settled share-based payment transactions

The services received from the employees, and a liability to pay for those services should be recognised as services are rendered. For example, if a specified period of service has to be completed by the employees before share appreciation rights are vested, the services received and the related liability should then be recognised over that period.
Example: Cash-settled share-based payment transaction

Arthing Co has provided a share incentive scheme to a number of its employees on 1 January 20X1. This allows for a cash payment to be made to the individuals concerned equal to the share price at the end of a three-year period subject to the following conditions. 1 2 3 Vesting will be after three years The share price must exceed $4 The employee must be with the company on 31 December 20X3
Each scheme issued will result in payment, subject to the conditions outlined, equal to the value of 10 shares at the end of the three-year period if the conditions are satisfied. The payments, once earned, are irrevocable. The Chief Operating Officer has been issued 20 such schemes. The share prices over the next three years were as follows. 31 December 20X1 31 December 20X2 31 December 20X3 Required (a) (b) Prepare the journal entries for the transactions of the share incentives issued to the Chief Operating Officer. Assuming that on 1 January 20X1 four other individuals were also granted equivalent rights to the Chief Operating Officer and that on 1 January 20X2, two of those individuals left the company, prepare the journal entries for the transactions relating to the incentive schemes. $4.20 $3.80 $4.40
Solution
(a) Journal entries for transactions: Chief Operating Officer The transactions are settled in cash and hence liabilities are created. 31 December 20X1 DEBIT Remuneration expense CREDIT Remuneration liability $ 280 $ 280
It is assumed that the current share price is the best estimate of the final share price. (calculation note: 20 10 $4.20 1/3 = $280) 31 December 20X2 DEBIT Remuneration liability CREDIT Remuneration expense Reverses entries for 20X1 as share price is less than minimum 31 December 20X3 DEBIT Remuneration expense CREDIT Remuneration liability DEBIT Remuneration liability CREDIT Cash (20 10 $4.40 3/3 = $880) $ 880 880 880 $ 880 $ 280 $ 280
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(b)
Journal entries for transactions: all individuals 31 December 20X1 DEBIT Remuneration expense CREDIT Remuneration liability (calculation note: 20 10 5 $4.20 1/3 = $1,400) 31 December 20X2: DEBIT Remuneration liability CREDIT Remuneration expense 31 December 20X3 DEBIT Remuneration expense CREDIT Remuneration liability DEBIT Remuneration liability CREDIT Cash (calculation note: 20 10 3 $4.40 3/3 = $2,640) 1,400 1,400 2,640 2,640 2,640 2,640 $ 1,400 $ 1,400
2.3 Share-based payments with a choice of settlement

Topic highlights
Where there is a choice of settlement and the counterparty has that choice, both a debt and equity component of the share-based transaction is identified and accounted for separately. Where there is a choice of settlement and the entity has that choice, a liability must be recognised to the extent there is an obligation to deliver cash.
Accounting for share-based transactions with a choice of settlement depends on which party has the choice. Where the counterparty has a choice of settlement, the entity is deemed to have granted a compound instrument, and a liability component and an equity component are identified. Where the entity has a choice of settlement, the whole transaction is treated either, as cashsettled or as equity-settled, depending on whether the entity has an obligation to settle in cash.
HKFRS 2.35,36,38
2.3.1 Counterparty has choice of settlement

Where the counterparty to the transaction has a choice of settlement, a compound instrument has been granted ie a debt and equity component must be identified. Where the transaction is with parties other than employees and the fair value of the goods or services received is measured directly, the entity shall measure the equity component of the compound financial instrument as the difference between the fair value of the goods or services received and the fair value of the debt component, at the date when the goods or services are received. Where the transaction is with employees, the fair value of the compound instrument is estimated as a whole. The debt and equity components must then be valued separately. Normally transactions are structured in such a way that the fair value of each alternative settlement is the same. The entity is required to account separately for the goods or services received or acquired in respect of each component of the compound financial instrument. The debt component is
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Financial Reporting
accounted for in the same way as a cash-settled share-based payment. The equity component is recognised in the same way as an equity-settled share-based payment.
HKFRS 2.4143
2.3.2 Entity has choice of settlement

Where the entity chooses what form the settlement will take, a liability should be recognised to the extent that there is a present obligation to deliver cash. This is the case where, for example, the entity is prohibited from issuing shares or where it has a stated policy, or past practice, of issuing cash rather than shares. Where a present obligation exists, the entity should record the transaction as if it is a cash-settled share-based payment transaction. If no present obligation exists, the entity should treat the transaction as if it was purely an equitysettled transaction. On settlement, if the transaction was treated as an equity-settled transaction and cash was paid, the cash should be treated as if it was a repurchase of the equity instrument by a deduction against equity.
Example: Fair value

On 1 January 20X7 an entity grants an employee a right under which he can, if he is still employed on 31 December 20X9, elect to receive either 10,000 shares or cash to the value, on that date, of 9,000 shares. The market price of the entity's shares is $310 at the date of grant, $370 at the end of 20X7, $430 at the end of 20X8 and $520 at the end of 20X9, at which time the employee elects to receive the shares. The entity estimates the fair value of the share route to be $290. Show the accounting treatment.
Solution
This arrangement results in a compound financial instrument. The fair value of the cash route is: 9,000 $310 = $2.79m The fair value of the share route is: 10,000 $290 = $2.90m The fair value of the equity component is therefore: $110,000 ($2,900,000 less $2,790,000) The share-based payment is recognised as follows: 20X7 20X8 20X9 1/3 9,000 $370 $110,000 1/3 2/3 9,000 $430 $110,000 1/3 9,000 $520 $110,000 1/3 Liability $ 1,110,000 2,580,000 36,667 4,680,000 36,666 Equity $ 36,667 Expense $ 1,110,000 36,667 1,470,000 36,667 2,100,000 36,666
As the employee elects to receive shares rather than cash, $4,680,000 is transferred from liabilities to equity at the end of 20X9. The balance on equity is $4,790,000.
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2.4 Section summary

Equity-settled share-based payment transactions Total expenses on equity settlement is expensed to income statement:
Number of shares granted Fair value of options on grant date Vesting period (years) Corresponding entry to equity Expensed annually over the vesting period No adjustment even though fair value of option changes Total expenses on liability settlement expensed to income statement: Number of shares granted Fair value of options at each reporting date Vesting period (years) Corresponding entry to liability Only the residual amount is expensed to income statement Expensed annually over the vesting period
Cash-settled share-based payment transactions
Choice of settlement counterpartys choice
Compound instrument is split into debt and equity components Debt component is accounted for as a cash-settled transaction Equity component is accounted for as an equity-settled transaction
Choice of settlement entitys choice
Account for as cash-settled if there is an obligation to deliver cash Account for as equity-settled otherwise
3 Share-based payment transactions further issues

Topic highlights
An entity that receives goods or services in a share based payment transaction must account for those goods or services no matter which entity in the group settles the transaction, and no matter whether the transaction is settled in shares or cash.
3.1 Group cash-settled share-based payment transactions

Amendments to HKFRS 2 Share-based Payment: Group Cash-Settled Share-Based Payment Transactions, which are effective for periods beginning on or after 1 January 2010 clarify how an individual subsidiary in a group should account for some share-based payment arrangements in its own financial statements.
HKFRS 2.43A-D
3.1.1 Share-based payment transactions among group entities

HKFRS 2 applies when an entity enters into a share-based payment transaction regardless of whether the transaction is to be settled by the entity itself, or by another group member on behalf of the entity.
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Financial Reporting
The amendments to HKFRS 2 clarify the classification of share-based payment transactions for both the entity that receives the goods or services, and the entity that settles the share-based payment transaction.
The entity receiving the goods or services will recognise the transaction as an equity-settled share-based payment transaction only if:
the awards granted are its own equity instruments it has no obligation to settle the transaction
In all other circumstances, the entity will measure the transaction as a cash-settled share-based payment. Subsequent remeasurement of such equity-settled transactions will only be carried out for changes in non-market vesting conditions.
The entity responsible for settling the transaction will recognise it as an equity-settled sharebased payment only if the transaction is settled in its own equity instruments. In all other circumstances, the transaction will be recognised by the entity that settles the award as a cashsettled share-based payment.
The guidance can be illustrated for the most commonly occurring scenarios as follows:
Classification Entity receiving goods and services Obligation to settle sharebased payment transaction Subsidiary's individual financial statements Consolidated financial statements
How is it settled?
Subsidiary Subsidiary Subsidiary Subsidiary Subsidiary
Subsidiary Subsidiary Subsidiary Parent* Parent*
Equity of the subsidiary Cash Equity of the parent Equity of the parent Cash
Equity Cash Cash Equity Equity
Equity Cash Equity Equity Cash
*The same classification will result if the settlement obligation lies with the shareholders or another group entity (eg a fellow subsidiary). As the classification may be different at the subsidiary and parent level, the amount recognised by the entity receiving the goods or services may differ from the amount recognised by the entity settling the transaction and in the consolidated financial statements. Intragroup repayment arrangements will not affect the application of the principles described above for the classification of group-settled share-based payment transactions.
3.2 Treasury share transactions

Where a company holds a number of its own shares, those shares are known as 'Treasury shares'. Guidance on treasury share transactions previously contained within HK(Int)IFRIC 11 is incorporated into HKFRS 2 with effect from 1 January 2010. Where an entity grants rights to its own equity instruments to employees, and then either chooses or is required to buy those equity instruments from another party, in order to satisfy its obligations to its employees under the share-based payment arrangement, the transaction is accounted for as an equity-settled transaction.
266
4 Disclosure of share-based payment transactions

HKFRS 2.44
HKFRS 2 has extensive disclosure requirements including: (a) (b) Information that enables users of the financial statements to understand the nature and extent of share-based payment arrangements that existed during the period. Information that enables users of the financial statements to understand how the fair value of the goods or services received, or the fair value of the equity instruments granted, during the period was determined. Information that enables users of the financial statements to understand the effect of sharebased payment transactions on the entitys profit or loss for the period and on its financial position.
(c)
HKFRS 2.45
4.1 Nature and extent of share-based payment arrangements

Information which aids an understanding of the nature and extent of share-based payment arrangements includes the following: (a) (b) A description of each type of share-based payment arrangement that existed at any time during the period. The number and weighted average exercise priced of share options outstanding at the beginning of the period, granted during the period, forfeited during the period, exercised during the period, expired during the period, outstanding at the end of the period and exercisable at the end of the period. For share options exercised during the period, the weighted average share price at the date of exercise. For share options outstanding at the end of the period, the range of exercise prices and weighted average remaining contractual life.
(c) (d)
HKFRS 2.4749
4.2 Determination of fair value

Information which enables an understanding of how fair value is determined includes the disclosures below: (a) (b) If the entity has measured directly the fair value of goods or services received during the period, the entity shall disclose how that fair value was determined. If the entity has rebutted the presumption that goods or services from parties other than employees can be measured reliably, it shall disclose that fact, and give an explanation of why the presumption was rebutted. If the entity has measured the fair value of goods or services received as consideration for equity instruments of the entity indirectly, by reference to the fair value of the equity instruments granted: For share options granted during the period, the weighted average fair value of those options at the measurement date and information on how that fair value was measured. For other equity instruments granted during the period (ie other than share options), the number and weighted average fair value of those equity instruments at the measurement date, and information on how that fair value was measured.
(c)
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Financial Reporting
HKFRS 2.50,51
4.3 Effect on profit or loss and financial position

Information which enables an understanding of the effect of share-based payment transactions on profit or loss and financial position includes the following: (a) The total expense recognised for the period arising from share-based payment transactions in which the goods or services received did not qualify for recognition as assets and hence were recognised immediately as an expense, including separate disclosure of that portion of the total expense that arises from transactions accounted for as equity-settled share-based payment transactions. The total carrying amount of liabilities arising from share-based payment transactions at the end of the period and the total intrinsic value at the end of the period of liabilities for which the counterpartys right to cash or other assets had vested by the end of the period.
(b)
5 Share-based payment transactions and deferred tax

HKAS 12.68A-C
Topic highlights
A share-based payment will result in a deductible temporary difference and so deferred tax asset.
As we have seen, an entity is required to recognise an expense in relation to share options over the vesting period. The related tax deduction is not, however, received until the options are exercised. In addition the accounting expense is based on the fair value of the options at the grant date, whereas the tax allowable expense is based on the share price at the exercise date. There is therefore a deferred tax implication. This is also true of other forms of share-based payments where the tax deduction differs from the cumulative remuneration expense.
5.1 Measurement of temporary difference

The deductible temporary difference is measured as: Carrying amount of share-based payment expense Less: tax base of share-based payment expense (estimated amount tax authorities will permit as a deduction in future periods, based on year end information) Temporary difference Deferred tax asset at X% X (X) (X) X
If the amount of the tax deduction (or estimated future tax deduction) exceeds the amount of the related cumulative remuneration expense, this indicates that the tax deduction relates also to an equity item. The excess is therefore recognised directly in equity.
Example: Deferred tax implications of share-based payment

Lamar Co has the following share option scheme at 31 December 20X1:
Fair value of options at grant Exercise date price $ $ 2.50 3.75 2.50 5.00
Directors name
Grant date
Options granted
Vesting date
N Yip D Chan
1 January 20X0 1 January 20X1
20,000 90,000
12/20X1 12/20X3
268
The price of the companys shares at 31 December 20X1 is $7 per share and at 31 December 20X0 was $7.50 per share. The directors must be working for Lamar on the vesting date in order for the options to vest. No directors have left the company since the issue of the share options and none are expected to leave before December 20X3. The shares can be exercised on the first day of the month in which they vest. In accordance with HKFRS 2 an expense of $25,000 has been charged to profits in the year ended 31 December 20X0 in respect of the share option scheme. The cumulative expense for the two years ended 31 December 20X1 is $110,000. Tax allowances arise when the options are exercised and the tax allowance is based on the options intrinsic value at the exercise date. Assume a notional tax rate of 16 per cent.
Required
What are the deferred tax implications of the share option scheme?
Solution
Year to 31 December 20X0 Deferred tax asset:
Fair value (20,000 $7.50 1/2) Exercise price of option (20,000 $3.75 1/2) Intrinsic value (estimated tax deduction) Tax at 16%
$ 75,000 (37,500) 37,500 6,000
The cumulative remuneration expense is $25,000, which is less than the estimated tax deduction of $37,500. Therefore: A deferred tax asset of $6,000 is recognised in the statement of financial position There is deferred tax income of $4,000 (25,000 16%) The excess of $2,000 goes to equity
Year to 31 December 20X1 Deferred tax asset:
$ 150,000 210,000 360,000 (75,000) (135,000) 150,000 24,000 (6,000) 18,000
Fair value (20,000 $7.50) (90,000 $7 1/3) Exercise price of options (20,000 $3.75) (90,000 $4.50 1/3) Intrinsic value (estimated tax deduction) Tax at 16% Less: previously recognised
The cumulative remuneration expense is $110,000, which is less than the estimated tax deduction of $150,000. Therefore: A deferred tax asset of $24,000 is recognised in the statement of financial position at 31 December 20X1 There is potential deferred tax income of $18,000 for the year ended 31 December 20X1 Of this, $13,600 (16% ($110,000 $25,000)) is recognised in the income statement The remainder ($4,400) is recognised in equity.
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Financial Reporting
6 Modifications to the terms and conditions on which equity instruments were granted, including cancellations and settlements
Topic highlights
An entity might modify the terms and conditions on which the equity instruments were granted.
For example, it might reduce the exercise price of options granted to employees (ie reprice the options), which increases the fair value of those options. The requirements to account for the effects of modifications are expressed in the context of share-based payment transactions with employees. However, the requirements shall also be applied to share-based payment transactions with parties other than employees that are measured by reference to the fair value of the equity instruments granted.
HKFRS 2.2729
6.1 Measurement in modification

The entity shall recognise, as a minimum, the services received measured at the grant date fair value of the equity instruments granted, unless those equity instruments do not vest because of failure to satisfy a vesting condition (other than a market condition) that was specified at grant date. This applies irrespective of any modifications to the terms and conditions on which the equity instruments were granted, or a cancellation or settlement of that grant of equity instruments. In addition, the entity shall recognise the effects of modifications that increase the total fair value of the share-based payment arrangement or are otherwise beneficial to the employee. If a grant of equity instruments is cancelled or settled during the vesting period (other than a grant cancelled by forfeiture when the vesting conditions are not satisfied): (a)
Cancellation
The entity shall account for the cancellation or settlement as an acceleration of vesting, and shall therefore recognise immediately the amount that otherwise would have been recognised for services received over the remainder of the vesting period. (b)
Payment made
Any payment made to the employee on the cancellation or settlement of the grant shall be accounted for as the repurchase of an equity interest, ie as a deduction from equity, except to the extent that the payment exceeds the fair value of the equity instruments granted measured at the repurchase date. Any such excess shall be recognised as an expense. However, if the share-based payment arrangement included liability components, the entity shall remeasure the fair value of the liability at the date of cancellation or settlement. Any payment made to settle the liability component shall be accounted for as an extinguishment of the liability. (c)
New equity instruments are granted
If new equity instruments are granted to the employee and, on the date when those new equity instruments are granted, the entity identifies the new equity instruments granted as replacement equity instruments for the cancelled equity instruments, the entity shall account for the granting of replacement equity instruments in the same way as a modification of the original grant of equity instruments. The incremental fair value granted is the difference between the fair value of the replacement equity instruments and the net fair value of the cancelled equity instruments, at the date the replacement equity instruments are granted. The net fair value of the cancelled equity instruments is their fair value, immediately before the cancellation, less the amount of any payment made to the employee on cancellation of the equity instruments that is accounted for as a deduction from equity.
270
If the entity does not identify new equity instruments granted as replacement equity instruments for the cancelled equity instruments, the entity shall account for those new equity instruments as a new grant of equity instruments. If an entity or counterparty can choose whether to meet a non-vesting condition, the entity shall treat the entitys or counterpartys failure to meet that non-vesting condition during the vesting period as a cancellation. If an entity repurchases vested equity instruments, the payment made to the employee shall be accounted for as a deduction from equity, except to the extent that the payment exceeds the fair value of the equity instruments repurchased, measured at the repurchase date. Any such excess shall be recognised as an expense.
Example: Cancellation
Flummery Co granted 3,000 share options to each of its 50 managers on 1 January 20X1. The options only vest if the managers are still employed by the entity on 31 December 20X3. The fair value of the options was estimated at $12 on the grant date and the entity estimated that the options would vest with 48 managers. In 20X2 the entity decided to base all incentive schemes around the achievement of performance targets and as a result the existing share option scheme was cancelled on 30 June 20X2 when the fair value of the options was $28 and the market price of the entitys shares was $45. Compensation was paid to the 49 managers in employment at that date, at the rate of $36 per option.
Required
How should the entity recognise the cancellation?
Solution
The original cost to the entity for the share option scheme was: 3,000 shares 48 managers $12 = $1,728,000 This was being recognised at the rate of $576,000 in each of the three years. At 30 June 20X2 the entity should recognise a cost based on the amount of options it had vested on that date. The total cost is: 3,000 49 managers $12 = $1,764,000 After deducting the amount recognised in 20X1, the 20X2 charge to profit or loss is $1,188,000. The compensation paid is: 3,000 49 $36 = $5,292,000 Of this, the amount attributable to the fair value of the options cancelled is: 3,000 49 $28 (the fair value of the option, not of the underlying share) = $4,116,000 This is deducted from equity as a share buyback. The remaining $1,176,000 ($5,292,000 less $4,116,000) is charged to profit or loss.
271
Financial Reporting
Topic recap
Share-based payment transactions are those transactions where an entity receives goods or services in return for its own equity instruments or an amount of cash related to the value of its equity instruments.
Share-based payment transactions may be: Equity settled Cash settled Settled in either equity or cash at the option of the entity or counterparty
Equity-settled share based payment transactions with parties other than employees are measured at the fair value of the good or services received and recognised in equity, normally immediately. Equity settled share-based payment transactions with employees are measured at the fair value of the equity instruments on the grant date and recognised in equity over the vesting period. Cash-settled share-based payment transactions are recognised as a liability and measured at the fair value of that liability. They are remeasured at the end of each reporting period. Where there is a choice of settlement and the counterparty has that choice, both a debt and equity component of the share-based transaction is identified and accounted for separately. Where there is a choice of settlement and the entity has that choice, a liability must be recognised to the extent there is an obligation to deliver cash. An entity that receives goods or services in a share based payment transaction must account for those goods or services no matter which entity in the group settles the transaction, and no matter whether the transaction is settled in shares or cash. A share based payment will result in a deductible temporary difference and so deferred tax asset.
272
Answer 1
The remuneration expense in respect of the options for the year ended 31 December 20X1 is calculated as follows: Fair value of options expected to vest at grant date: (75% x 50 employees) x 10,000 options x $3 =$1,125,000 Annual charge to profit or loss therefore $1,125,000 / 4 years = $281,250 Charge to profit or loss for y/e 31 December 20X1 = $281,250 x 6/12 months = $140,625 The accounting entry for the year ending 31 December 20X1 is: DEBIT CREDIT Remuneration expense Equity 1,050,000 $393,750 $ 140,625 $ 140,625
In 20X2 the remuneration charge is for the whole year, and is calculated as: (70% x 50 employees) x 10,000 options x $3 = Charge to date is $1,050,000 x 1.5/4 years = The accounting entry is: DEBIT CREDIT Remuneration expense Equity $ 253,125 $ 253,125
Therefore charge for the year is $393,750 - $140,625 = $253,125
Answer 2
20X5 Equity c/d and P/L expense ((500 75) 100 $15 1/3)
$ 212,500
DEBIT CREDIT
Expenses Equity
$212,500 $212,500 $ 212,500 227,500 440,000 $227,500 $ 440,000 224,500 664,500 $224,500
20X6 Equity b/d Profit or loss expense Equity c/d ((500 60) 100 $15 2/3) =
DEBIT CREDIT
Expenses Equity
$227,500
20X7 Equity b/d Profit or loss expense Equity c/d (443 100 $15) =
DEBIT CREDIT
Expenses Equity
$224,500
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Financial Reporting
Exam practice
Broom Limited
29 minutes
Broom Limited entered into an agreement to acquire 100 per cent interest in Fortune Limited, a company operating convenience stores in Hong Kong. The acquisition date was 1 November 20X6. During the negotiation process between Broom Limited and the shareholders of Fortune Limited, it was agreed that twenty Fortune Limited convenience stores would be closed down within three months of the change in control. Redundancy notices were sent to the staff of the twenty convenience stores immediately after Broom Limited has taken control over Fortune Limited. The closure of these stores was completed on 18 January 20X7. Total payment made in January 20X7 for redundancy of staff was $1,850,000. Prior to the date of acquisition, Fortune Limited had entered into a retrenchment package for two directors, such that if the company were to be acquired by another party these two directors would become entitled to a one-off aggregate payment of $1,200,000 each. The payment was made on 6 December 20X6. On 1 September 20X5, Fortune Limited granted a share option to the managing director to acquire 50,000 shares of the company with a three-year vesting period. The option had a strike price of $10 per share and the fair value determined at the grant date was $180,000. On 31 October 20X6, Fortune Limited cancelled the share option and agreed to pay the managing director $210,000 for the cancellation. The payment was made on 28 December 20X6. The fair value of the share option at the date of cancellation was $200,000. For the acquisition, Broom Limited engaged a certified public accountancy firm to perform a due diligence exercise on Fortune Limiteds financial statements. The due diligence report was issued on 30 October 20X6. A fee of $300,000 was paid for this service on 25 November 20X6.
Required
Explain the accounting treatment of the above payments in: (a) (b) Fortune Limiteds financial statements for the year ended 31 December 20X6; and (8 marks) Broom Limiteds consolidated financial statements for the year ended 31 December 20X6. (8 marks)
274
chapter 14
Revenue
Topic list
1 2 3 4 Revenue recognition HKAS 18 Revenue Interpretations related to revenue recognition Current developments
Learning focus
Revenue is an important part of any commercial organisations financial statements. You should therefore be able to explain the recognition and measurement criteria of HKAS 18 and apply them in practice.
275
Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.02 3.02.01 3.02.02 3.02.03 3.02.04 Revenue Define revenue and identify revenue within the scope of HKAS 18 Measure revenue at the fair value of consideration received Identify revenue transaction including multiple element arrangements Determine the recognition criteria for specified types of revenue items including sales of goods, rendering of services and interest, royalties and dividends Disclose revenue as appropriate in the financial statements Explain the recognition and measurement principles 3
3.02.05 3.02.06
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14: Revenue | Part C Accounting for business transactions
1 Revenue recognition
Topic highlights
Revenue recognition is straightforward in most business transactions, but can be complicated in some situations.
1.1 Accrual accounting

Accrual accounting is the fundamental concept which underpins the financial statements. This requires that costs are matched with the revenue they generate. Therefore the point at which revenue is recognised must be identified so that the correct treatment can be applied to the related costs. A simple example involves buying goods for resale: the cost of the purchases should be carried as an asset in the statement of financial position until such time as they are sold; they should then be written off as a charge to the trading account. The decision has a direct impact on profit since under the prudence concept it would be unacceptable to recognise the profit on sale until a sale had taken place in accordance with the criteria of revenue recognition.
1.2 Recognition at point of sale

In most circumstances revenue should be recognised as earned at the point of sale, because at that point four criteria will generally have been met. 1 2 The product or service has been provided to the buyer. The buyer has recognised his liability to pay for the goods or services provided. The converse of this is that the seller has recognised that ownership of goods has passed from himself to the buyer. The buyer has indicated his willingness to hand over cash or other assets in settlement of his liability. The monetary value of the goods or services has been established.
3 4
Thus, as you will be aware, the normal moment at which revenue should be recognised in the statement of comprehensive income is when the goods are sold. Before the point of sale, there is not normally firm evidence that the above criteria will be met, in particular: Until the production process is complete, there is a risk that a flaw or error in the process will result in goods being written off. Even when the product is complete there is no guarantee that a buyer will be found.
If revenue is recognised after the point of sale, for example when cash is received, costs may already have been charged and so will not necessarily be matched to revenue in the same period. Furthermore, revenue recognition would then depend on fortuitous circumstances, such as the cash flow of a company's customers, and might fluctuate misleadingly from one period to another.
1.3 Recognition at other times

There are times when revenue is recognised at other times than at the completion of a sale, for example in the recognition of profit on long-term construction contracts. Under HKAS 11 Construction Contracts contract revenue and contract costs associated with the construction contract should be recognised as revenue and expenses respectively by reference to the stage of
277
Financial Reporting
completion of the contract activity at the year end, once the outcome on the contract can be estimated reliably. (a) Owing to the length of time taken to complete such contracts, to defer taking profit into account until completion may result in the income statement reflecting, not so much a fair presentation of the activity of the company during the year, but rather the results relating to contracts which have been completed by the year end. Revenue in this case is recognised when production on, say, a section of the total contract is complete, even though no sale can be made until the whole is complete.
(b)
2 HKAS 18 Revenue
Topic highlights
HKAS 18 Revenue is concerned with the recognition of revenues arising from fairly common transactions. The sale of goods The rendering of services The use by others of entity assets yielding interest, royalties and dividends
Income, as defined by the HKICPA's Framework document, includes both revenues and gains. Revenue is income arising in the ordinary course of an entity's activities and it may be called different names, such as sales, fees, interest, dividends or royalties. HKAS 18 governs the recognition of revenue in specific (common) types of transaction, being: the sale of goods the rendering of services interest income royalty income dividend income
The standard also includes an appendix which provides examples of the measurement and recognition rules in particular circumstances.
HKAS 18.1,6
2.1 Scope
HKAS 18 covers the revenue from specific types of transaction or events. Sale of goods (manufactured products and items purchased for resale) Rendering of services Use by others of entity assets yielding interest, royalties and dividends
Interest, royalties and dividends are included as income because they arise from the use of an entity's assets by other parties. Various types of revenue arising from leases, changes in value of financial instruments or other current assets, insurance contracts, natural increases in agricultural assets and mineral ore extraction, are covered by other standards and are therefore specifically excluded from this standard. Reference can be made to the other specific standards for the accounting treatment of these types of revenue.
278
HKAS 18.7,8
2.2 Definitions
The following definitions are given in the standard.
Key terms
Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants. Interest is the charge for the use of cash or cash equivalents or amounts due to the entity. Royalties are charges for the use of non-current assets of the entity, eg patents, computer software and trademarks. Dividends are distributions of profit to holders of equity investments, in proportion with their holdings, of each relevant class of capital. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. (HKAS 18) Revenue does not include items which do not represent a flow of economic benefit into the entity, eg sales taxes, value added taxes or goods and service taxes which are only collected for third parties. The same should apply to revenues collected by an agent on behalf of a principal. Revenue for the agent is only the commission earned from the principal for acting as an agent.
HKAS 18.9,10
2.3 Measurement of revenue

Topic highlights
Revenue is measured at the fair value of consideration received or receivable.
Revenue shall be measured at the fair value of the consideration received or receivable, taking into account the amount of any trade discounts and volume rebates allowed by the entity. This is usually decided by agreement between the buyer and seller.
HKAS 18.11
2.3.1 Deferred consideration

When consideration is deferred, the fair value of the amount receivable may be less than the nominal amount of cash receivable. In this case, the arrangement effectively constitutes a financing transaction resulting in both revenue (sales) income and interest income. The fair value of sales consideration is determined by discounting all amounts receivable using an imputed rate of interest. This is the more clearly determinable of either: the prevailing rate for a similar instrument of an issuer with a similar credit rating; or a rate of interest that discounts the nominal amount of the instrument to the current cash sales price of the goods or services.
The difference between the fair value and nominal amount of consideration is recognised as interest revenue.
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Financial Reporting
Example: Sofa Co
Sofa Co manufactures and sells furniture. It provides all customers with two years' interest free credit. On 31 March 20X9, the last day of the accounting year, Sofa Co made sales of $790,000, with all customers taking advantage of the interest free credit option. Sofa Co has an imputed rate of interest of 6 per cent. What amounts are recorded in the financial statements of Sofa Co in respect of the above sale in the years ended 31 March 20X9, 20Y0 and 20Y1?
Solution
Sofa Co must discount the $790,000 before recording revenue in respect of the sales: $790,000 1/1.06 = $703,097 This discounted amount is recognised as revenue in the year ended 31 March 20X9 and as a receivable: DEBIT CREDIT Receivable Revenue $703,097 $703,097
2
In the year ended 31 March 20Y0, the discount is unwound and the receivable increased by $42,186 (6% $703,097) to $745,283. This amount is also recognised as interest income: DEBIT CREDIT Receivable Interest income $42,186 $42,186
In the year ended 31 March 20Y1, the discount is again unwound by $44,717 (6% $745,283): DEBIT CREDIT Receivable Interest income $44,717 $44,717
The receivable is now recorded at $790,000, and therefore when cash payment is received, it is recorded by: DEBIT CREDIT Cash Receivable $790,000 $790,000
HKAS 18.12
2.3.2 Exchanges of goods and services

Where goods and services are exchanged for other goods and services of a similar nature and value, the transaction is not considered to generate revenue. Where goods and services are exchanged for dissimilar goods or services, the transaction is regarded as generating revenue, and the revenue is measured at the fair value of the goods or services received (less any cash or cash equivalents paid). Where the fair value of the goods or services received cannot be reliably measured, revenue is measured at the fair value of goods or services given up (less any cash transfer).
HKAS 18.13
2.4 Identification of the transaction

Each transaction will usually be recognised in the financial statements as a whole. However, it may be necessary to break a complicated transaction into its component parts. For example, a sale may include both a transfer of goods and the provision of future services. The revenue from the latter should be deferred and recognised as income over the period in which the service is performed.
280
Example: Component parts of transaction

On 1 March 20X4 Mainframe Co contracted to deliver a customer a computer system on that date and provide support and maintenance services for the following three years. The price of the contract to provide both the computer system and support and maintenance services is $800,000. The cost of providing support and maintenance services is $50,000 per annum and Mainframe charges a standard 50 per cent profit mark-up What revenue is recognised in the financial statements of Mainframe in the year ended 31 December 20X4?
Solution
The revenue must be broken down into that relating to the provision of the computer system and that relating to the three years of support and maintenance. The revenue relating to the support and maintenance is calculated based on the profit mark-up of 50 per cent: 3 years $50,000 150% = $225,000 Therefore, the revenue relating to the supply of the system is the balance of $800,000 $225,000 = $575,000. Revenue recognised in the year ended 31 December 20X4 is $637,500 ($575,000 + 10/36 $225,000).
Conversely, seemingly separate transactions must be considered together if apart they lose their commercial meaning. An example would be to sell an asset and at the same time enter into an agreement to buy it back at a later date. The second transaction negates the substance of the first and so both must be considered together. This sale and repurchase situation is considered in more detail in Section 2.8 of this chapter.
HKAS 18.14
2.5 Recognition: sale of goods

Topic highlights
Generally revenue is recognised on the sale of goods when the entity has transferred to the buyer the significant risks and rewards of ownership and when the revenue can be measured reliably.
All of the following five conditions have to be fulfilled before revenue from the sale of goods can be recognised: (a) (b) (c) (d) (e) The entity has transferred to the buyer the significant risks and rewards of ownership of the goods The entity retains neither continuing managerial involvement to the degree usually associated with ownership, nor effective control over the goods sold The amount of revenue can be measured reliably It is probable that the economic benefits associated with the transaction will flow to the entity The costs incurred or to be incurred in respect of the transaction can be measured reliably
281
Financial Reporting
HKAS 18.1517
2.5.1 Transfer of risks and rewards

The transfer of risks and rewards can only be decided by examining each transaction. Usually, the transfer occurs at the same time as either the transfer of legal title, or the passing of possession to the buyer. This is what happens when you buy something in a shop both title and possession pass from the seller to the purchaser when the purchaser buys the goods and leaves the shop with them. If significant risks and rewards remain with the seller, then the transaction is not a sale and revenue cannot be recognised yet, for example if the receipt of the revenue from a particular sale depends on the buyer receiving revenue from his own sale of the goods. It is possible for the seller to retain only an 'insignificant' risk of ownership and for the sale and revenue to be recognised. The main example here is where the seller retains title only to ensure collection of what is owed on the goods. This is a common commercial situation, and when it arises the revenue should be recognised on the date of sale.
HKAS 18.18,19
2.5.2 Probable economic benefits

Revenue can only be recognised once the inflow of economic benefits to the seller is probable, thus the probability of the entity receiving the revenue arising from a transaction must be assessed. It may only become probable that the economic benefits will be received when an uncertainty is removed, for example government permission for funds to be received from another country. Only when the uncertainty is removed should the revenue be recognised. This is in contrast with the situation where revenue has already been recognised but where the collectability of the cash is now brought into doubt. Where recovery has ceased to be probable, the amount should be recognised as an expense, not an adjustment of the revenue previously recognised. These points also refer to services and interest, royalties and dividends in Section 2.7 below. Revenue and expenses relating to the same transaction should be recognised at the same time (an application of the matching concept). It is usually possible to estimate such expenses reliably at the date of sale (eg warranty costs, shipment costs, etc). Where they cannot be estimated reliably, then revenue cannot be recognised; any consideration which has already been received is treated as a liability.
2.6 Recognition: rendering of services

When the outcome of a transaction involving the rendering of services can be estimated reliably, the associated revenue should be recognised by reference to the stage of completion of the transaction at the reporting date.
HKAS 18.20,23
2.6.1 Estimated reliably

The outcome of a transaction can be estimated reliably when all of the following conditions are satisfied. (a) (b) (c) (d) The amount of revenue can be measured reliably. It is probable that the economic benefits associated with the transaction will flow to the entity. The stage of completion of the transaction at the reporting date can be measured reliably. The costs incurred for the transaction and the costs to complete the transaction can be measured reliably.
The parties to the transaction will normally have to agree the following before an entity can make reliable estimates.
282
(a) (b) (c)

HKAS 18.24,25
Each party's enforceable rights regarding the service to be provided and received by the parties The consideration to be exchanged The manner and terms of settlement
2.6.2 Stage of completion

There are various possible methods of determining the stage of completion of a transaction, including: surveys of work performed services performed to date as a percentage of total services to be performed costs incurred to date as a percentage of total estimated costs
For practical purposes, when services are performed by an indeterminate number of acts over a period of time, revenue should be recognised on a straight line basis over the period, unless there is evidence for the use of a more appropriate method. If one act is of more significance than the others, then the significant act should be carried out before revenue is recognised.
HKAS 18.2628
2.6.3 Outcome cannot be estimated reliably

In uncertain situations, when the outcome of the transaction involving the rendering of services cannot be estimated reliably, the standard requires that revenue is recognised only to the extent of the expenses recognised that are recoverable. This is particularly likely during the early stages of a transaction, but it is still probable that the entity will recover the costs incurred. So the revenue recognised in such a period will be equal to the expenses incurred, with no profit. If the costs are not likely to be reimbursed, then they must be recognised as an expense immediately. When the uncertainties cease to exist, revenue should be recognised as laid out in the first paragraph of Section 2.6.
HKAS 18.29
2.7 Recognition: interest, royalties and dividends

Revenue arising from the use by others of the entity's assets yielding interest, royalties and dividends is recognised when: (a) (b) it is probable that the economic benefits associated with the transaction will flow to the entity, and the amount of the revenue can be measured reliably
Once again, the points made above about probability and collectability on sale of goods also apply here.
HKAS 18.30,32
2.7.1 Interest
Interest is recognised on a time proportion basis that takes into account the effective yield on the asset. The effective yield is the rate of interest required to discount the stream of future cash receipts expected over the life of the asset to equate to the initial carrying amount of the asset. When unpaid interest has accrued before an interest-bearing investment is acquired, the subsequent interest received is allocated between pre and post acquisition periods. Only that amount allocated to the post acquisition period is recognised as revenue.
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Financial Reporting
HKAS 18.30,33
2.7.2 Royalties
Royalties are recognised on an accruals basis in accordance with the substance of the relevant agreement. Royalties are usually recognised on the same basis that they accrue under the relevant agreement. Practically this is often on a straight-line basis over the life of the agreement. Sometimes the true substance of the agreement may require some other systematic and rational method of recognition. Where rights are assigned for a fixed amount, the licensee is permitted to exploit those rights freely and the licensor has no remaining obligations to perform, then the assignment is in effect a sale and revenue should be recognised immediately. An example of this situation is a licensing agreement to use software which is immediately downloaded by the purchaser, In some cases the receipt of a royalty is contingent on a future event. Here revenue is recognised only when it is probable that the royalty will be received. This is normally when the event has occurred. Rules for determining whether an entity is acting as an agent were amended in 2009. In an agency relationship, the gross inflows of economic benefits include amounts collected on behalf of the principal and which do not result in increases in equity for the entity. The amounts collected on behalf of the principal are not revenue. Instead, revenue is the amount of commission. An entity is acting as a principal when it has exposure to the significant risks and rewards associated with the sale of goods or the rendering of services. Features that indicate that an entity is acting as a principal include: (a) the entity has the primary responsibility for providing the goods or services to the customer or for fulfilling the order, for example by being responsible for the acceptability of the products or services ordered or purchased by the customer; the entity has inventory risk before or after the customer order, during shipping or on return; the entity has latitude in establishing prices, either directly or indirectly, for example by providing additional goods or services; and the entity bears the customers credit risk for the amount receivable from the customer.
(b) (c) (d)
An entity is acting as an agent when it does not have exposure to the significant risks and rewards associated with the sale of goods or the rendering of services. One feature indicating that an entity is acting as an agent is that the amount the entity earns is predetermined, being either a fixed fee per transaction or a stated percentage of the amount billed to the customer.
2.7.3 Dividends
Dividends are recognised when the shareholder's right to receive payment is established.
HKAS 18,Illustrative examples
2.8 Revenue recognition: examples

The appendix to HKAS 18 provides a number of examples of the application of the recognition criteria. These examples assume that the amount of revenue can be measured reliably, it is probable that economic benefits will flow to the entity and costs can be measured reliably. The following transactions are common in practice:
2.8.1 Consignment sales

Consignment sales are transactions whereby one entity (the seller) sells goods to another (the buyer) and that entity undertakes to sell the goods to a third party on behalf of the seller. The goods which are transferred are often referred to as consignment inventory. The seller normally retains legal title to the goods until such time as they are sold on to a third party.
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This form of arrangement is common in the motor trade whereby a manufacturer sells cars to a dealer who sells them on to the ultimate customer. Often where an onward sale is not achieved, the dealer can return the cars to the manufacturer. In this situation, the risks and rewards are not deemed to have passed from the seller (the manufacturer) to the buyer (the dealer) until such time as an onward sale is made. Therefore the manufacturer does not record a sale until a car is sold to a third party. In the meantime, although the cars are in the dealers showroom, they remain the inventory of the manufacturer.
2.8.2 Bill and hold sales

Bill and hold sales refer to those sales where the buyer requests that delivery of goods purchased is delayed, however in the meantime accepts legal title and billing. In these circumstances, revenue is recognised when the buyer takes title, provided that: (a) (b) (c) (d) it is probable that delivery will be made the goods are available for delivery the buyer acknowledges the delayed delivery normal payment terms apply
2.8.3 Sale and repurchase agreements

A sale and repurchase agreement refers to a transaction where one party sells an asset to another, but the terms of the sale provide for the asset to be repurchased by the seller at a later date under certain conditions. This form of arrangement is common amongst whisky distillers, who sell their stocks to banks whilst they mature. When the whisky has matured, it is re-purchased by the distillery. The whisky is not, in the meantime physically transferred to bank premises, but remains on site at the distillery. In this case, the substance of the transaction is obviously a secured loan: the bank is effectively lending money to the distillery secured on the whisky. These arrangements should be accounted for in accordance with their commercial substance. Not all situations will be as straightforward as the whisky example, and the appendix to HKAS 18 states that consideration should be given as to whether the risks and rewards of ownership have been transferred to the buyer (regardless of legal title). Where this is the case, a sale should be recorded.
HKAS 18.35,36
2.8.4 Disclosure
The following items should be disclosed. (a) (b) The accounting policies adopted for the recognition of revenue, including the methods used to determine the stage of completion of transactions involving the rendering of services. The amount of each significant category of revenue recognised during the period including revenue arising from: (i) (ii) (iii) (iv) (v) (c) the sale of goods the rendering of services interest royalties dividends
The amount of revenue arising from exchanges of goods or services included in each significant category of revenue.
Any contingent gains or losses, such as those relating to warranty costs, claims or penalties should be treated according to HKAS 37 Provisions, Contingent Liabilities and Contingent Assets (covered earlier).
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Financial Reporting
Consider the following scenarios and discuss how HKAS 18 should be applied to each (a) Bradley Co owns an office building which cost $5m and has a market value of $7m. On 1 April 20X2, Bradley Co sold the building to Beck Co, a finance company, for $5.5m. Bradley Co has entered into an agreement to repurchase the building in three years' time for $7m and Bradley Co will continue to occupy the building after sale. Marianne Alltraders entered into a six-month contract to undertake accountancy training for a customer over the period 1 September 20X2 to 28 February 20X3. The value of services performed to the year-end amounts to $45,000 out of a total contract value of $60,000. All costs are expected to be recoverable. Maximum Velocity sold some bicycles to a customer for $15,000 on 1 October 20X2. The customer has the right to return any unsold bikes before 30 April 20X3 for a full refund. Admen performed advertising services for a customer costing $4,450 relating to a fixed price $20,000 contract covering the period 1 December 20X2 to 31 March 20X3. Due to fluctuating advertising costs, the expected total cost cannot be reliably measured at the year end, but Admen is certain that the customer will pay the costs incurred to date. The year end in all cases is 31 December 20X2. (The answer is at the end of the chapter)
(b)
(c) (d)
3 Interpretations related to revenue recognition

Topic highlights
Three Interpretations are relevant to revenue recognition: HK(IFRIC) Int-12 Service Concession Arrangements HK(IFRIC) Int-13 Customer Loyalty Programmes HK(IFRIC) Int-15 Agreements for the Construction of Real Estate
3.1 HK(IFRIC) Int-12 Service Concession Arrangements

3.1.1 What is a service concession arrangement?
Key term
Service concession arrangements are arrangements whereby a government or other body grants contracts for the supply of public services such as roads, energy distribution, prisons or hospitals to private operators. The objective of this project of the HK(IFRIC) is to clarify how certain aspects of existing HKICPA literature are to be applied to service concession arrangements. (HK(IFRIC) Int-12)
3.1.2 Two types of service concession arrangements

HK(IFRIC) Int-12 identifies two types of service concession arrangement: (a) One in which the operator has a contractual right to receive cash or another financial asset from the government
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(b)
One in which the operator receives an intangible asset being the right to charge for access to the public sector asset that it constructs or upgrades.
HK(IFRIC) Int-12 allows for the possibility that both types of arrangement may exist within a single contract: to the extent that the government has given an unconditional guarantee of payment for the construction of the public sector asset, the operator has a financial asset; to the extent that the operator has to rely on the public using the service in order to obtain payment, the operator has an intangible asset.
3.1.3 Accounting Financial asset model

For the first type of arrangement the operator recognises a financial asset measured at fair value to the extent that it has an unconditional contractual right to receive cash or another financial asset from or at the direction of the grantor for the construction services. The operator has an unconditional right to receive cash if the grantor contractually guarantees to pay the operator: (a) (b) specified or determinable amounts; the shortfall, if any, between amounts received from users of the public service and specified or determinable amounts, even if payment is contingent on the operator ensuring that the infrastructure meets specified quality or efficiency requirements.
3.1.4 Accounting Intangible asset model

The operator recognises an intangible asset measured at fair value to the extent that it receives a right (a licence) to charge users of the public service.
3.1.5 Operating revenue

The operator of a service concession arrangement recognises and measures revenue in accordance with HKASs 11 and 18 for the services it performs.
Example: Electricity Co
Electricity Co is a private sector entity, which has entered into an arrangement with Government to supply a minimum quantity of electricity for 30 years to the public within a specific district. Electricity Co designs and builds a power plant on government land to produce the needed electricity and maintains control over all significant aspects of operating the power plant within the terms of the agreement. The agreement provides for the following: The legal title to the power plant will be transferred to the government body at the end of the arrangement. Electricity Co is responsible for repairs, maintenance, and capital expenditure related to the power plant. Electricity Co must stand ready to deliver a minimum quantity of electricity each month. Electricity Co is paid by the public directly, charge is based primarily on their own usage. The government regulates the prices that Electricity Co may charge to the public such that Electricity Cos return is capped by reference to operating costs and capital investment. The government does not guarantee any minimum level of income for Electricity Co.
How should the above transaction be accounted for?
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Financial Reporting
Solution
The transaction illustrates certain characteristics of a service concession arrangement that falls within the scope of HK(IFRIC) 12: The arrangement is between a public sector entity (the government) and an entity from the private sector (Electricity Co) An infrastructure asset is constructed by Electricity Co for the purpose of the arrangement, and is used to supply electricity to public; The government (the grantor) has control over the use of the power plant through the following means: The government specifies the goods to be delivered (electricity) and to whom the electricity should be provided (the public in the specified district); and The income that Electricity Co needs to generate to cover both its operating costs and the initial capital outlay from constructing the facility is wholly dependent on the users demand for the electricity, the demand risk borne by Electricity Co. However, the arrangement still falls within the scope of HK(IFRIC) 12 as the government controls the pricing through a capping mechanism (provided the cap is considered to be substantive) and controls the residual interest in the facility, through the agreement specifying that the facility must revert to government at the end of the concession period.
Electricity Co provides construction services to the grantor by constructing the facility. However, instead of receiving an unconditional right to receive cash, it has obtained a right to charge the public for electricity usage, ie it has obtained an intangible asset. As stated in HK(IFRIC) 12, Electricity Co does not recognise the facility as its own property, plant and equipment, even though it is fully exposed to demand risk in respect of the electricity users. During the construction phase: DEBIT CREDIT Intangible asset Construction revenue
Being the fair value of construction service provided under development DEBIT CREDIT Construction cost Cash
Being construction costs incurred During the operating phase: DEBIT CREDIT Cash Operating revenue
Being electricity charges levied on the users DEBIT CREDIT Operating costs Cash
Being operating cost incurred (eg fuel, employee cost etc) DEBIT CREDIT Operating costs Intangible asset
Being amortisation and/or impairment of the intangible asset during the year If the government had guaranteed that Electricity Co would receive a minimum amount, ie had agreed to top up a short-fall in receipts from the public, Electricity Co would recognise a financial asset to the extent that it had an unconditional contractual right to receive cash (or another financial asset) and an intangible asset for the right to receive cash from users above the guaranteed minimum.
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3.2 HK(IFRIC) Int-13 Customer Loyalty Programmes

3.2.1 The issue
Customer loyalty programmes are programmes whereby customers who buy goods or services are awarded credits by an entity. These may include reward points or travel miles and can be redeemed in the future for free or discounted goods. HK(IFRIC) Int-13 Customer Loyalty Programmes addresses accounting for such arrangements by the entities which grant the credits. The deferred amount is recognised as revenue only when the entity has fulfilled its obligations by supplying the awards itself or paying a third party to do so.
3.2.2 Key provisions

The Interpretation requires that the proceeds of the initial sale are split between: revenue, and deferred revenue associated with the credits awarded
The proceeds recognised as deferred revenue is measured by reference to the fair value of the credits awarded. The fair value of award credits should take into account: the amount of discounts or incentives that would otherwise be offered to customers who have not earned award credits from an initial sale; and the proportion of award credits that are not expected to be redeemed by customers (any expected forfeitures), If customers can choose from a range of different awards, the fair value of the award credits will reflect the fair values of the range of available awards, weighted in proportion to the frequency with which each award is expected to be selected.
The deferred amount is recognised as revenue only when the entity has fulfilled its obligations by supplying the awards itself or paying a third party to do so. If at any time the expected costs of meeting the obligation exceed the consideration received, the entity has an onerous contract for which HKAS 37 would require recognition of a liability. If HK(IFRIC) Int-13 causes an entity to change its accounting policy for customer loyalty awards, HKAS 8 applies.
Example: Loyalty points

Loyalty points can arise in one of two ways - either by the entity implementing its own loyalty programmes (eg Park-N-Shop) or by a third party applying such loyalty programmes (eg HSBC credit card providing the programme for the retailers who participate in its programme). The entity can also recognise this deferred revenue by either allocating the deferred revenue systematically (amortisation) or on a sale-by-sale basis. The following examples are shown on a sale-by-sale basis for convenience: Case 1 is easy, according to paragraph 7 of the Interpretation: If the entity supplies the awards itself, it shall recognise the consideration allocated to award credits as revenue when award credits are redeemed and it fulfils its obligations to supply awards. The amount of revenue recognised shall be based on the number of award credits that have been redeemed in exchange for awards, relative to the total number expected to be redeemed. What that essentially means is this - take Park-N-Shop for example, 1 point for every $100 a customer spends: DEBIT CREDIT CREDIT Cash / credit card receivables Deferred revenue - Loyalty points ($200/$100 x 1 point) Revenue $ 200 2 198 $
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Financial Reporting
A portion of the loyalty points earned by the customers will be deferred as above. Then when the customers utilise their points the next time they spend: $ $ DEBIT Cash / credit card receivables 98 DEBIT Deferred revenue 2 CREDIT Revenue 100 So in essence you have deferred your revenue until later. Case 2 refers to para. 8 of the Interpretation: If a third party supplies the awards, the entity shall assess whether it is collecting the consideration allocated to the award credits on its own account (ie as the principal in the transaction) or on behalf of the third party (ie as an agent for the third party). (a) If the entity is collecting the consideration on behalf of the third party, it shall: (i) measure its revenue as the net amount retained on its own account, ie the discounts or incentives that otherwise would be offered to customers that have not earned the award credits; and recognise this net amount as revenue when the third party becomes obliged to supply the awards and entitled to receive consideration for doing so. These events may occur as soon as the award credits are granted. Alternatively, if the customer can choose to claim awards from either the entity or a third party, these events may occur only when the customer chooses to claim awards from the third party.
(ii)
(b)
If the entity is collecting the consideration on its own account, it shall measure its revenue as the gross consideration allocated to the award credits and recognise the revenue when it fulfils its obligations in respect of the awards.
Para. 8 (a)(i) and (ii) of the Interpretation is similar to the case with airline loyalty programmes (let's use Asia miles as an example) where retailers or other service firms pay the airline a cost per mile for using their loyalty programmes. However in case (b) the reference is to the same programme but where the retailer acts as an agent to the airline, so the entries will be: At initial spending, the entity recognises (if the customer spends $10 to get 1 mile from the retailer, and assume that the retailer has to pay $8 for every 1 mile granted to the customers): DEBIT CREDIT CREDIT Cash / credit card receivables Deferred revenue - Loyalty points Revenue $ 200 $ 20 180
When the airline has the obligation to grant these points for spending, either immediately or in the future when you as the customer buys goods again: $ $ DEBIT Cash / credit card receivables 80 DEBIT Deferred revenue - loyalty points 20 DEBIT Expense (paid to airline for loyalty points) 16 CREDIT Revenue 100 CREDIT Cash / AP to airline 16 The above entries are prepared based on the situation described under para. 8 (b) of the Interpretation. If the situation is based on para 8. (a)(i) and (ii), it will be like this: DEBIT CREDIT CREDIT Deferred revenue - loyalty points Revenue Cash / AP to airline $ 200 $ 20 180
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The only difference is the net amount shown in the entry. For para. 8(a), because the entity is merely acting as agents and "collecting" the points on behalf of the airline ie. as an agent of the airline, so no actual expenses regarding the loyalty points should be incurred by them, and their revenue represents a kind of agency fees (the difference between the $10 per point revenue and the $8 cost, the cost in this case will be transferred to the airline). In para. 8(b), the company is taking on the loyalty points in its own account, and hence must recognise the $8 cost as an expense (not revenue as it's not really a direct cost, but rather it's a cost of administering the points programme.)
3.3 HK(IFRIC) Int-15 Agreements for the Construction of Real Estate

HK(IFRIC) Int-15 Agreements for the Construction of Real Estate is effective for annual periods beginning on or after 1 January 2009.
3.3.1 Reasons for issuing HK(IFRIC) Int-15

The issues addressed in the Interpretation were first published in a draft Interpretation D21 Real Estate Sales in July 2007. In response to concerns expressed in relation to improving the articulation between HKAS 11 Construction Contracts and HKAS 18 Revenue and providing additional guidance on how to account for revenue in HKAS 18, the Hong Kong Financial Reporting Interpretations Committee (HK(IFRIC)) provides guidance on the following two issues in HK(IFRIC) Int-15: Determining whether an agreement for the construction of real estate is within the scope of HKAS 11 or HKAS 18 When revenue from the construction of real estate should be recognised
The Interpretation standardises accounting practice across jurisdictions for the recognition of revenue among real estate developers for sales of units, such as apartments or houses, 'off plan', that is, before construction is complete.
3.3.2 Main features of HK(IFRIC) Int-15

The detailed guidance in HK(IFRIC) Int-15 assumes that the entity has previously analysed the agreement for the construction of real estate and any related agreements and concluded that it will retain neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the constructed real estate to an extent that would preclude recognition of some or all of the consideration as revenue. If recognition of some of the consideration as revenue is precluded, the following discussion applies only to the part of the agreement for which revenue will be recognised. In some circumstances, agreements may need to be split into separately identifiable components, with each such component being accounted for separately and the fair value of the total consideration received or receivable for the agreement allocated to each component. The seller then applies the requirements of HK(IFRIC) Int-15 to any components for the construction of real estate in order to determine whether each component is within the scope of HKAS 11 or HKAS 18.
3.3.3 Determining whether the agreement is within the scope of HKAS 11 or HKAS 18
HKAS 11 applies when the agreement meets the definition of a construction contract set out in paragraph 3 of HKAS 11. An agreement for the construction of real estate meets the definition of a construction contract when the buyer is able to specify:
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(a) (b)
the major structural elements of the design of the real estate before construction begins, and/or major structural changes once construction is in progress (whether or not it exercises that ability).
In contrast, if construction could take place independently of the agreement and buyers have only limited ability to influence the design of the real estate, the agreement will be for the sale of goods or the rendering of services and within the scope of HKAS 18.
3.3.4 Accounting for revenue from construction of real estate

Construction contracts (within the scope of HKAS 11) Where the agreement is a construction contract under HKAS 11, and the outcome of the contract can be estimated reliably, revenue is recognised by reference to the stage of completion of the contract activity in accordance with HKAS 11. HK (IFRIC) Int-15 has not introduced any new requirements or guidance that will affect such contracts. Agreements for the rendering of services (HKAS 18) Where the agreement falls within the scope of HKAS 18, and the entity is not required to acquire and supply construction materials, it may be only an agreement for the rendering of services. This may arise, for example, in arrangements where the customer acts in essence as its own general contractor and enters into agreements with individual suppliers for specific goods and services. Where the entity is responsible only for assembling materials supplied by others (ie it has no inventory risk for the construction materials), the agreement is an agreement for the rendering of services. In such circumstances, if the criteria in HKAS 18 are met, revenue is recognised by reference to the stage of completion of the transaction using the percentage of completion method. The requirements of HKAS 11 are generally applicable to the recognition of revenue and the associated expenses for such a transaction. Agreements for the sale of goods (HKAS 18) An agreement for the construction of real estate will be an agreement for the sale of goods under HKAS 18 if it involves the provision of services together with construction materials. For such contracts, the applicable recognition criteria are those set out in HKAS 18. The Interpretation focuses on the criteria that revenue can only be recognised when the entity has transferred to the buyer control and the significant risks and rewards of ownership of the goods, and distinguishes between circumstances in which these criteria are met 'at a single point in time' and 'continuously as construction progresses'. If transfer of control and the significant risks and rewards of ownership of the real estate in its entirety occurs at a single point of time (eg at completion, upon or after delivery), revenue is recognised only when all the criteria in HKAS 18 are satisfied. Assuming that all of the other criteria in HKAS 18 are met, this will be upon the occurrence of that single critical transfer of control and the significant risks and rewards of ownership. The Interpretation also envisages that the entity may transfer to the buyer control and the significant risks and rewards of ownership of the work in progress in its current state as construction progresses. In this case, if all of the criteria in HKAS 18 are met continuously as construction progresses, revenue is recognised by reference to the stage of completion using the percentage of completion method. The requirements of HKAS 11 are generally applicable to the recognition of revenue and the associated expenses for such a transaction.
3.3.5 Disclosures
When an entity recognises revenue using the percentage of completion method for agreements that meet all the criteria in HKAS 18 continuously as construction progresses (see above), the following disclosures are required:
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How the entity determines which agreements meet all the criteria in HKAS 18 continuously as construction progresses The amount of revenue arising from such agreements in the period The methods used to determine the stage of completion of agreements in progress
For any such agreements that are in progress at the reporting date, the following disclosures are also required: The aggregate amount of costs incurred and recognised profits (less recognised losses) to date The amount of advances received
Consequential amendments to the Appendix in HKAS 18 HK(IFRIC) Int-15 superseded the real estate guidance (Example 9) in HKAS 18. Additional guidance HK(IFRIC) Int-15 is accompanied by an information note which, although not part of the Interpretation, summarises its requirements in the form of two flowcharts, which are reproduced in the Appendix. In addition, three illustrative examples designed to assist in the application of the Interpretation accompany HK(IFRIC) Int-15. Effective date and transition HK(IFRIC) Int-15 is effective for annual periods beginning on or after 1 January 2009. Earlier application is permitted. If an entity applies the Interpretation for a period beginning before 1 January 2009, that fact should be disclosed. Changes in accounting policy resulting from the adoption of the Interpretation are required to be accounted for retrospectively in accordance with HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. Therefore, entities will be required to re-examine and, where applicable, retrospectively restate the revenue recognition for agreements that are in progress as at the opening date of the earliest period presented for comparative purposes.
Example: Apartment purchase

An entity is developing residential real estate and starts marketing individual units (apartments) while construction is still in progress. Buyers enter into a binding sale agreement that gives them the right to acquire a specified unit when it is ready for occupation. They pay a deposit that is refundable only if the entity fails to deliver the completed unit in accordance with the contracted terms. Buyers are also required to make progress payments between the time of the initial agreement and contractual completion. The balance of the purchase price is paid only on contractual completion, when buyers obtain possession of their unit. Buyers are able to specify only minor variations to the basic design but they cannot specify or alter major structural elements of the design of their unit. In the jurisdiction, no rights to the underlying real estate asset transfer to the buyer other than through the agreement. Consequently, the construction takes place regardless of whether sale agreements exist. How should the above transaction be accounted for?
Solution
In this transaction, the terms of the agreement and all the surrounding facts and circumstances indicate that the agreement is not a construction contract. The agreement is a forward contract that gives the buyer an asset in the form of a right to acquire, use and sell the completed real estate at a later date and an obligation to pay the purchase price in accordance with its terms.
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Although the buyer might be able to transfer its interest in the forward contract to another party, the entity retains control and the significant risks and rewards of ownership of the work in progress in its current state until the completed real estate is transferred. Therefore, revenue should be recognised only when all the criteria of HKAS 18 are met (at completion in this example). Alternatively, assume that, in the jurisdiction, the law requires the entity to transfer immediately to the buyer ownership of the real estate in its current state of completion and that any additional construction becomes the property of the buyer as construction progresses. The entity would need to consider all the terms of the agreement to determine whether this change in the timing of the transfer of ownership means that the entity transfers to the buyer control and the significant risks and rewards of ownership of the work in progress in its current state as construction progresses. For example, the fact that if the agreement is terminated before construction is complete, the buyer retains the work in progress and the entity has the right to be paid for the work performed, might indicate that control is transferred along with ownership. If it does, and if all the criteria in HKAS 18 are met continuously as construction progresses, the entity recognises revenue by reference to the stage of completion using the percentage of completion method taking into account the stage of completion of the whole building and the agreements signed with individual buyers.
(a) Realbuild operates in the house building sector and currently does not report under HKFRSs. In the market in which Realbuild operates, the custom is to sign a contract which includes a completion date when funds are transferred and the keys passed to the buyer. Realbuild's accounting policy is to recognise revenue on signing the contract. Where there is still building work to be completed after the keys are passed to the buyer, Realbuild delays revenue recognition until the completion of the work. BCN Productions is a film production house. The company licences one of its new films to a distributor in a foreign country over which BCN Productions has no control. The film is expected to appear before the public over a period of six months and BCN Productions intends to recognise the revenue over this period. KSoft is a start-up company that will develop bespoke software systems for corporate clients. The company's policy is to invoice fixed amounts which include the software development and fees for ongoing post-delivery support while the new software system is implemented. KSoft intends to recognise the revenue for both elements on installation of the software.
(b)
(c)
Required Advise the directors as to the acceptability of the above accounting policies for revenue recognition under HKAS 18 Revenue. (The answer is at the end of the chapter)
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Analysis of a single agreement for the construction of real estate

Can components other than for the construction of real estate be identified within the agreement (eg a sale of land or provision of property management service)? Yes No
Split the agreement into separately identifiable components Allocate the fair value of the consideration received or receivable to each component Separate components
Component(s) for the delivery of other goods or services
Component for the construction of real estate and directly related services (in accordance with HKAS 18)
Apply HKAS 18
Does the agreement or component meet the definition of a construction contract? No
Yes
The agreement or component is a construction contract within the scope of HKAS 11*
Revenue and costs are recognised by reference to the stage of completion
Is the agreement or component only for the rendering of services? No
Yes
The agreement or component is for the rendering of services within the scope of HKAS 18
The agreement or component is for the sale of goods within the scope of HKAS 18 **
Are the criteria for recognising revenue from the sale of goods met on a continuous basis?
Yes
No
Revenue is recognised when all the conditions in paragraph 14 of HKAS 18 have been satisfied
* The construction contract may need to be segmented in accordance with paragraph 8 of HKAS 11 ** Directly related services may need to be separated in accordance with paragraph 13 of HKAS 18
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Financial Reporting
The IASB and FASB issued an Exposure Draft in relation to revenue recognition in June 2010. It is proposed that the resulting standard will replace both IAS 18 Revenue and IAS 11 Construction Contracts (and so their HKAS equivalents). The proposals would require an entity to: 1. 2. 3. 4. 5. Identify a contract with a customer Identify separate performance obligations in the contract (such that if more than one good or service is promised, each is accounted for separately only if it could be sold separately) Determine the transaction price, being the probability-weighted amount of consideration expected to be received, taking into account collectability and the time value of money Allocate the transaction price to the separate performance obligations in proportion to the standalone selling price of the goods or services underlying each performance obligation Recognise revenue when each performance obligation is satisfied by the transfer of the promised good or service to the customer.
The ED also proposes that the costs of obtaining a contract are expensed as incurred. Costs of fulfilling a contract which are not eligible for capitalisation in accordance with another standard would be capitalised only if they: relate directly to a contract generate or enhance resources which will be used to satisfy future performance obligations, and are expected to be recovered.
For many companies this new approach will not result in a significant change to the amount or timing of revenue recognised. In other cases there will be a change, for example, when a mobile phone contract is sold and a handset is provided free of charge, the standard would now require separate up front recognition of revenue relating to the handset. The new standard is expected in the second half of 2011.
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Topic recap
Revenue recognition is straightforward in most business transactions, but some situations are more complicated. HKAS 18 Revenue is concerned with the recognition of revenues arising from fairly common transactions. The sale of goods The rendering of services The use by others of entity assets yielding interest, royalties and dividends
Revenue is measured at the fair value of consideration received or receivable. Generally revenue is recognised when the entity has transferred to the buyer the significant risks and rewards of ownership and when the revenue can be measured reliably. Three Interpretations are relevant to revenue recognition: HK(IFRIC) Int-12 Service Concession Arrangements HK(IFRIC) Int-13 Customer Loyalty Programmes HK(IFRIC) Int-15 Agreements for the Construction of Real Estate
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Financial Reporting
Answer 1
(a) There are a number of factors that suggest the substance of this transaction is different to its legal form. First, the building has a market value of $7m and is being sold for less than market value, which immediately looks odd. Second, there is an agreement for Bradley Co to repurchase the assets in the future. If it were a genuine sale, this would be an unlikely clause. Third, Bradley Co retain occupancy of the building again if this were a genuine sale it would be very unlikely that an asset would be sold and not occupied or used by the purchaser. Therefore it seems obvious that the substance of this transaction is a secured loan. Bradley Co should continue to recognise the building in the statement of financial position as they have the risks and rewards of ownership. The cash received from Beck Co should be recorded as a non-current liability and the finance on the loan should be charged in the income statement over the three-year period. The finance charge could be calculated as the difference between the 'sale' proceeds and the repurchase amount. (b) Revenue should be accrued by Marianne Alltraders based on value of work performed rather than accrued on a time apportioned basis in accordance with HKAS 18. Revenue recognised is therefore $45,000. Maximum Velocity should not recognise any revenue in respect of the bicycles as the significant risks and rewards of ownership have not been transferred at the year end. The bikes remain in Maximum Velocitys inventories until confirmation has been received from the customer that they have been sold on and any money received from him is treated as a payment in advance. Since the outcome of the service transaction cannot be reliably measured at the year end, only $4,450 is recognised as revenue by Admen rather than on a time apportioned basis. This matches with the costs recognised ensuring that no profit is recorded until the outcome can be reliably measured.
(c)
(d)
Answer 2
(a) The general rule under HKAS 18 Revenue is that revenue is recognised when the significant risks and rewards of ownership have been transferred and there is no continuing managerial involvement or effective control. HK(IFRIC) 15 provides additional guidance re real estate sales and states that revenue is recognised when the entity transfers control as well as the risks and rewards of ownership, ie when the legal completion occurs and the keys are handed over in this case. Realbuild's current policy recognises the revenue before this is the case: revenue should be recognised on the contract completion date rather than on signing the contract. Where there is continuing building work to be undertaken, revenue can be recognised provided the property has been delivered, so Realbuild's policy needs to be amended here as well. However, a provision is also required to be recognised for the cost of work yet to be performed and this is charged to profit or loss at the same time as the revenue is recognised, ie on delivery of the property. NB: a house-builder such as Realbuild selling to the general public is entering into contracts to sell goods rather than a construction contract, as the buyer is not able to specify the major structural elements of the design, which would be an indication of a construction contract.
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(b)
Licence fees (and royalty income) are normally recognised straight line over the life of the agreement. However, where the licensee has no remaining obligations to perform, or, as in this case, no control over the use of the images once licensed, the substance of the transaction is a sale, and revenue should be recognised at the time of sale, so BCN Productions' policy is not appropriate. HKAS 18 provides guidance on the recognition of revenue from the development of customised software: it should be recognised by reference to the stage of completion of the development including completion of the services provided for post-delivery support. Consequently, it is not appropriate to recognise the revenue on installation: it should be recognised over the period of development and support (although not necessarily straight line as can be matched to the level of work done in each period).
(c)
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Exam practice
Peak Medical Technology Corporation
13 minutes
Peak Medical Technology Corporation (PMT) conducts research and product development for an anaesthetic injection under contract with WY Corporation (WY), a pharmaceutical company. The research and development contract requires that WY pays PMT an up-front amount of $1.5 million when the contract is signed, $2 million upon the successful completion of clinical trials, and $1.5 million upon the delivery of the first pilot unit of the injection. All payments are non-refundable. The total cost of completion of the project is estimated to be $3 million. PMT has invested $25 million in equipment for its research and development centre, which has an anticipated useful life of eight years. Depreciation is charged on a straight-line basis. In the period of acquisition, PMT received a government grant of $10 million towards purchase of the equipment, which is conditional on certain employment targets being achieved within the next four years. Required Determine how PMT should recognise and measure the research and development contract by reference to the relevant accounting standards. (7 marks) HKICPA May 2007 (amended)
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chapter 15
Income taxes
Topic list
1 2 3 4 5 6 7 8 Current tax Introduction to deferred tax Taxable temporary differences Deductible temporary differences Measurement of deferred tax Recognition of deferred tax Presentation of deferred tax Deferred taxation and business combinations
Learning focus
Tax in one form or another is relevant to all organisations. You should therefore ensure that you fully understand its operation in the financial statements. Hence this topic may appear with other topics. You must study it and understand its relationship with other assets and liabilities. Of course, in a business situation, the deferred tax consideration is always an important topic as it may change the investment decision.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.18 3.18.01 3.18.02 3.18.03 3.18.04 3.18.05 3.18.06 3.18.07 Income taxes Account for current tax liabilities in accordance with HKAS 12 Record entries relating to income tax in the accounting records Identify temporary differences (both inside and outside difference) and calculate deferred tax amounts Account for tax losses and tax credits Identify initial recognition exemption for assets and liabilities Account for deferred tax relating to investments in subsidiaries, associates and joint ventures Determine when tax assets and liabilities can be offset 2
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15: Income taxes | Part C Accounting for business transactions
1 Current tax
Topic highlights
Taxation consists of two components: Current tax Deferred tax
HKAS 12 Income Taxes covers both current and deferred tax. Current tax is the amount actually payable to the tax authorities in relation to the trading activities of the entity during the period. Deferred tax is an accounting measure, used to match the tax effects of transactions with their accounting impact and thereby produce less distorted results.
The parts of the standard relating to current tax are fairly brief, because this is the simple and uncontroversial area. This section of the chapter deals with current tax and we come on to deferred tax in Section 2.
HKAS 12.5
1.1 Definitions
These are some of the definitions given in HKAS 12. We will look at the rest later.
Key terms
Accounting profit. Profit or loss for a period before deducting tax expense. Taxable profit/(tax loss). The profit (loss) for a period, determined in accordance with the rules established by the taxation authorities, upon which income taxes are payable (recoverable). Tax expense/(tax income). The aggregate amount included in the determination of profit or loss for the period in respect of current tax and deferred tax. Current tax. The amount of income taxes payable (recoverable) in respect of the taxable profit (tax loss) for a period. (HKAS 12)
HKAS 12.12,13
1.2 Recognition of current tax liabilities and assets

Topic highlights
Current tax is the amount payable to the tax authorities in relation to the trading activities during the period. It is generally straightforward.
The amount of tax payable (or receivable) must be calculated and then charged (or credited) to profit or loss for the period and shown in the statement of comprehensive income. Any unpaid tax in respect of the current or prior periods must be recognised as a liability. Conversely, any excess tax paid in respect of current or prior periods over what is due should be recognised as an asset.
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Financial Reporting
1.2.1 Over and underprovisions

The year end tax liability (or asset) is generally an estimated amount, not settled until a later date. It is often the case, therefore, that the liability (or asset) recognised is not equal to the amount eventually paid (or recovered): Where the estimated tax liability exceeds the tax later paid to the authorities, tax has been overprovided. Where the estimated tax liability is less than the tax later paid to the authorities, tax has been underprovided.
This under or over provision must be adjusted for in the following years tax charged to profit or loss: $ Estimated current year tax charge X Under/over provision in respect of prior year X/(X) X Income tax charge for the year
Moorland operates in Hong Kong and is subject to a 16.5% tax rate. In the year ended 31 December 20X1, the company had tax-adjusted profits of $760,000. In the year ended 31 December 20X0, a current year tax liability of $130,000 was recognised; tax subsequently paid in respect of the year was $126,700. (a) (b) What amounts are recognised in Moorlands financial statements in respect of tax in the year ended 31 December 20X1? How does your answer change if the tax paid in respect of 20X0 was $131,000? (The answer is at the end of the chapter)
HKAS 12.14
1.2.2 Tax losses carried back

HKAS 12 also requires recognition as an asset of the benefit relating to any tax loss that can be carried back to recover current tax of a previous period. This is acceptable because it is probable that the benefit will flow to the entity and it can be reliably measured. In Hong Kong, tax losses carried back are not allowed from the tax perspective.
Example: Tax losses carried back

Dredger operates in a jurisdiction where trading losses may be carried back one year to offset against trading profits for the purposes of tax. In the year ended 31 December 20X1, Dredger had tax-adjusted profits of $126,000; in the following year, the company reported a tax-adjusted loss of $46,000. Dredger pays tax at 20%. Required Calculate the tax effect and prepare the corresponding journal entry for 20X2.
Solution
Tax due on profits in 20X1 is $25,200 ($126,000 x 20%) Tax repayment due on losses in 20X2 is $9,200 ($46,000 x 20%) The taxable profits of 20X1 are sufficient to absorb the losses of 20X2 and therefore a repayment for the full $9,200 can be claimed. The double entry will be: DEBIT CREDIT Tax receivable (statement of financial position) Tax repayable (statement of comprehensive income) $9,200 $9,200
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The tax receivable will be shown as an asset until the repayment is received from the tax authorities.
HKAS 12.46
1.3 Measurement of current tax

The measurement of current tax liabilities (assets) for the current and prior periods is straightforward. Their measurement is the amount expected to be paid (or recovered from) the tax authorities. The enacted (or substantively enacted) tax rates (and tax laws) at the end of reporting period should be used.
HKAS 12.58,61A
1.4 Recognition of current tax

Current tax payable or repayable is recognised in profit or loss in the period to which it relates. There are three exceptions to this rule: (a) (b) (c) Tax arising from a business combination which is an acquisition (refer to Sections 8 and 8.4 of this chapter). Tax arising from a transaction or event recognised in other comprehensive income Tax arising from a transaction or event recognised directly in equity
If a transaction or event is charged or credited to other comprehensive income or directly to equity, it is logical to show its related tax in other comprehensive income or equity. An example of this is where, under HKAS 8, a change in accounting policy that is applied retrospectively, or a correction of a material prior period error is adjusted to the opening balance of the retained earnings.
HKAS 12.77
1.5 Presentation of current tax

Tax assets and liabilities should be disclosed distinctly from other assets and liabilities in the statement of financial position of an entity. The tax expense (income) relating to the current period should be presented on the face of the statement of comprehensive income.
HKAS 12.71
1.5.1 Offsetting current tax assets and liabilities

Current tax assets and liabilities can be offset, but this should happen only when certain conditions apply. (a) (b) The entity has a legally enforceable right to set off the recognised amounts. The entity intends to settle the amounts on a net basis, or to realise the asset and settle the liability at the same time.
An entity may have a right to set off a current tax asset against a current tax liability when they relate to income taxes levied by the same taxation authority and the taxation authority permits the entity to make or receive a single net payment. The tax expense (income) related to the profit or loss from ordinary activities should be shown in the statement of comprehensive income.
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2 Introduction to deferred tax

Topic highlights
Deferred tax is an accounting measure, used to match the tax effects of transactions with their accounting impact. It is quite complex.
Deferred tax is an accounting measure which recognises the future tax impact of assets and liabilities currently held in the statement of financial position. It is important to realise that deferred tax is not an amount currently payable to the tax authorities, or relevant to tax practitioners; it is quite simply an accounting adjustment. For example, if an entity holds an asset in its statement of financial position, it is reasonable to assume that at some point in the future that asset will be realised (for example, an amount owed will be received). At such a time as the asset is realised, tax will be payable on the related income (assuming that tax arises on the cash receipt rather than when the asset is recognised for accounting purposes). This tax payable at some point in the future is referred to as a deferred tax liability.
Example: Deferred tax liability

A non-current asset that cost $300 has a carrying amount of $200. Cumulative depreciation for tax purposes is $180 and the tax rate is 16.5%. What is the deferred tax impact?
Solution
The tax base of the asset is $120 (cost of $300 less cumulative tax depreciation of $180). In recovering the carrying amount of $200, the entity will derive taxable amounts of $200, but will only be able to deduct tax depreciation of $120. Consequently, the entity will pay income taxes of $13.2 (calculated as $80 x 16.5%) as a result of recovering the carrying amount of the asset. The difference between the carrying amount of $200 and the tax base of $120 is a taxable temporary difference of $80. Therefore, the entity recognises a deferred tax liability of $13.2 representing the effect on income tax payable as a consequence of recovering the carrying amount of the asset.
Equally, if an entity has a liability, and tax relief is provided when payment is actually made to settle the liability (rather than when the liability is recognised for accounting purposes), then there is a future tax benefit, known as a deferred tax asset.
Example: Deferred tax asset

Monarchy Co operates in a jurisdiction where general provisions for bad debt recognised in the statement of financial position do not benefit from tax relief until such time as they are certified as bad debt. Monarchy Co recognises such a provision in 20X1 for $200,000. It expects to be certified as bad debt in two years time. The company has always paid tax on all income at 16.5% and does not believe that this will change in the near future. What is the deferred tax impact?
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Solution
When the balance is certified as bad debt (e.g. clients company was liquidated) , Monarchy will benefit from $33,000 tax relief ($200,000 x 16.5%) This is not a current tax asset as the benefit is not yet virtually certain. Instead a deferred tax asset of $33,000 may be recognised in respect of the doubtful debt. This asset is only recognised if Monarchy Co expects to have sufficient profits in two years time against which the bad debt expense may be relieved.
The remainder of this section of the chapter provides an overview of the process to recognise and measure deferred tax. Later sections then consider each of the stages in the process in more detail.
2.1 Calculation of deferred tax

The HKAS 12 method of calculating deferred tax assets and liabilities is as follows. It is referenced to the examples in the above section in order to aid understanding: Asset 1. What is the carrying value of the item in the statement of financial position? Note that for the purposes of this exercise, liabilities should be regarded as negative amounts. 2. What is the 'tax base' of the item? Tax base is defined in the next section, but in simple terms think of it as the carrying value of the item in a tax version of the statement of financial position. $120 asset Nil (there is no liability / expense from the tax perspective until the case is certified as bad debt) $80 ($200,000) $200 asset General provision for bad debt ($200,000) provision
3. What is the difference between carrying value and tax base known as temporary difference? 4. What type of temporary difference? A Taxable temporary difference arises where carrying value > tax base. A Deductible temporary difference arises where tax base > carrying value 5. Apply tax rate to the temporary difference 6. Deferred tax asset or liability? A deferred tax liability arises from a taxable temporary difference. A deferred tax asset arises from a deductible temporary difference.
Taxable
Deductible
$13.2
$33,000
Liability
Asset
The table above includes a number of new terms such as tax base and temporary difference. The next section considers the HKAS 12 definitions of each of them.
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HKAS 12.5
2.2 Definitions
Key terms
Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of taxable temporary differences. Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of: Deductible temporary differences The carry forward of unused tax losses The carry forward of unused tax credits
Temporary differences are differences between the carrying amount of an asset or liability in the statement of financial position and its tax base. Temporary differences may be either: Taxable temporary differences, which are temporary differences that will result in taxable amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled; or Deductible temporary differences, which are temporary differences that will result in amounts that are deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled.
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes. (HKAS 12) HKAS 12 provides further guidance on some of the definitions seen above, and Sections 2.2.12.2.3 below consider tax base, temporary differences and deferred tax asset / liability in turn.
HKAS 12.7
2.2.1 Tax base

The tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to the entity when it recovers the carrying amount of the asset. Where those economic benefits are not taxable, the tax base of the asset is the same as its carrying amount. Make sure that you understand this idea by attempting the following self-test question.
State the tax base of each of the following assets: (a) (b) (c) Interest receivable has a carrying amount of $1,000. The related interest revenue is not taxable. Dividends receivable from a subsidiary have a carrying amount of $5,000. The dividends are not taxable. A machine cost $10,000. For tax purposes, depreciation of $3,000 has already been deducted in the current and prior periods and the remaining cost will be deductible in future periods, either as depreciation or through a deduction on disposal. Revenue generated by using the machine is taxable, any gain on disposal of the machine will be taxable and any loss on disposal will be deductible for tax purposes. Trade receivables have a carrying amount of $10,000. The related revenue has already been included in taxable profit (tax loss).
(d)
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(e)
A loan receivable has a carrying amount of $1 million. There are no tax consequences for repayment of the loan. (The answer is at the end of the chapter)
HKAS 12.8
The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes in relation to the liability in future periods. For revenue received in advance, the tax base of the resulting liability is its carrying amount, less any amount of the revenue that will not be taxable in future periods.
State the tax base of each of the following liabilities. (a) (b) (c) (d) Current liabilities include accrued expenses with a carrying amount of $1,000. The related expense will be deducted for tax purposes on an accrual basis. Current liabilities include revenue received in advance, with a carrying amount of $1,000. The related revenue was taxed on an accrual basis. Current liabilities include accrued fines and penalties with a carrying amount of $100. Fines and penalties are not deductible for tax purposes. A loan payable has a carrying amount of $1 million. There are no tax consequences for repayment of the loan. (The answer is at the end of the chapter)
HKAS 12, Illustrative Examples
HKAS 12 gives the following examples of circumstances in which the carrying amount of an asset or liability will be equal to its tax base. Accrued expenses have already been deducted in determining an entity's current tax liability for the current or earlier periods. A loan payable is measured at the amount originally received and this amount is the same as the amount repayable on final maturity of the loan. Accrued expenses will never be deductible for tax purposes. Accrued income will never be taxable.
2.2.2 Temporary differences

HKAS 12 adopts a balance sheet approach to deferred tax, and as we have seen, temporary differences arise when there is a difference between the carrying amount of an asset or liability and its tax base. If this seems a bit confusing, think about the reason for deferred tax from a profit or loss point of view instead (remembering that assets and liabilities are of course related to income and expenses!). Accounting profits and taxable profits are different, as you will know from your tax studies. There are two reasons for the differences. (a) Permanent differences occur when revenue or expenses included in accounting profits are excluded from the computation of taxable profits (for example, client entertainment expenses may not be allowable for tax purposes). Temporary differences occur when revenue or expenses are included in both accounting profits and taxable profits, but in different accounting periods. We have already seen two examples of this where depreciation on an asset is charged faster for tax purposes than for
(b)
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accounting purposes, and where a provision is recognised as an expense when payable but does not benefit from tax relief until paid. In the long run, there is no difference between total taxable profits and total accounting profits (except for permanent differences) so that temporary differences originate in one period and will be reversed in one or more subsequent periods. Deferred tax is the tax caused by temporary differences. Explanations and examples given in the standard and its appendices give a clear distinction of the definition between taxable temporary differences and deductible temporary differences. In short, though: a taxable temporary difference arises where an asset's carrying amount exceeds its tax base. a deductible temporary difference arises where an asset's tax base exceeds its carrying amount.
Sections 3 and 4 of this chapter consider taxable and deductible temporary differences in more detail.
2.2.3 Deferred tax assets and liabilities

Temporary differences give rise to deferred tax liabilities and assets: A taxable temporary difference results in a deferred tax liability. A deductible temporary difference results in a deferred tax asset.
Deferred tax assets also arise from unused tax losses that tax law allows to be carried forward.
HKAS 12.47
2.3 Measurement of deferred tax

A deferred tax asset or liability is measured by applying the tax rate to the temporary difference calculated. The tax rate applied to the temporary difference should be that which is expected to apply to the period when the asset is realised or the liability is settled, based on tax laws in place by the reporting date. More detailed measurement rules are provided in Section 5 of this chapter.
HKAS 12.58
2.4 Recognition of deferred tax

Deferred tax assets and liabilities relating to all temporary differences should be aggregated and the overall deferred tax liability or asset recorded in the financial statements. From year to year, only the movement in this amount is recorded. The opposite entry is to the deferred tax charge, which forms part of the overall tax charge in the statement of comprehensive income. More detailed recognition rules are provided in Section 6 of this chapter.
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3 Taxable temporary differences

Topic highlights
Deferred tax liabilities arise from taxable temporary differences. Remember the basic rule that a taxable temporary difference arises where the carrying amount of an item in the statement of financial position exceeds its tax base, and this taxable temporary difference results in a deferred tax liability. Try to understand the reasoning behind the recognition of deferred tax liabilities on taxable temporary differences. (a) (b) (c) (d) (e) When an asset is recognised, it is expected that its carrying amount will be recovered in the form of economic benefits that flow to the entity in future periods. If the carrying amount of the asset is greater than its tax base, then taxable economic benefits will also be greater than the amount that will be allowed as a deduction for tax purposes. The difference is therefore a taxable temporary difference and the obligation to pay the resulting income taxes in future periods is a deferred tax liability. As the entity recovers the carrying amount of the asset, the taxable temporary difference will reverse and the entity will have taxable profit. It is then probable that economic benefits will flow from the entity in the form of tax payments, and so the recognition of all deferred tax liabilities (except those excluded below) is required by HKAS 12.
The following are examples of circumstances that give rise to taxable temporary differences.
3.1 Examples of taxable temporary differences

HKAS 12 provides a number of examples of situations where taxable temporary differences may arise.
3.1.1 Transactions affecting the statement of comprehensive income

(a) Depreciation of an asset is accelerated for tax purposes. When new assets are purchased, allowances may be available against taxable profits which exceed the amount of depreciation chargeable on the assets in the financial accounts. Development costs which have been capitalised will be amortised in profit or loss, but they were deducted in full from taxable profit in the period in which they were incurred.
(b)
3.1.2 Transactions that affect the statement of financial position

(a) (b) Depreciation of an asset is not deductible for tax purposes. No deduction will be available for tax purposes when the asset is sold/scrapped. A borrower records a loan at proceeds received (amount due at maturity) less transaction costs. The carrying amount of the loan is subsequently increased by amortisation of the transaction costs against accounting profit. The transaction costs were, however, deducted for tax purposes in the period when the loan was first recognised. A loan payable is measured on initial recognition at net proceeds (net of transaction costs). The transaction costs are amortised to accounting profit over the life of the loan. Those transaction costs are not deductible in determining the taxable profit of future, current or prior periods.
(c)
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(d)
The liability component of a compound financial instrument (eg a convertible bond) is measured at a discount to the amount repayable on maturity, after assigning a portion of the cash proceeds to the equity component (see HKAS 32). The discount is not deductible in determining taxable profit. Development costs may be capitalised and amortised over future periods in determining accounting profit but deducted in determining taxable profit in the period in which they are incurred. Such development costs have a tax base of nil as they have already been deducted from taxable profit. The temporary difference is the difference between the carrying amount of the development costs and their tax base of nil.
(e)
Example: Taxable temporary differences

A company purchased a machine for production costing $200,000. At the end of 20X9 the carrying amount is $120,000. The total depreciation allowance for tax purposes is $90,000 and the current tax rate is 16.5 per cent. Required Calculate the deferred tax liability for the machinery.
Solution
The carrying value of the asset is $120,000. The tax base of the asset is $200,000 $90,000 = $110,000. The difference is $10,000, and as carrying value exceeds tax base, this is a taxable temporary difference. A deferred tax liability of $1,650 (16.5% x $10,000) therefore arises.
The logic behind this liability is as follows: In order to recover the carrying amount of $120,000, the entity must earn taxable income of $120,000, but it will only be able to deduct $110,000 as a taxable expense. The entity must therefore pay income tax of $10,000 16.5% = $1,650 when the carrying amount of the asset is recovered.
HKAS 12.20
3.1.3 Fair value adjustments and revaluations

In the following examples, an asset in the statement of financial position is adjusted to be carried at fair value, however such an adjustment is not made for tax purposes and original cost remains the tax base. (a) (b) Current investments or financial instruments carried at fair value. Investment properties carried at fair value.
In the case of revalued property, plant and equipment, there is a taxable temporary difference only where the revaluation does not affect current taxable profits. If the revaluation affects the taxable profit for the current period, the tax base of the asset changes to become equal to fair value (and so carrying value) and no temporary difference arises.
Example
During the year ended 31 December 20X1, Marshall revalues a non-current asset to $8,000,000. The asset cost $6,000,000 three years ago and was being depreciated at 2 per cent straight line. Capital allowances were available at 4 per cent straight line. Marshalls rate of tax is 16.5 per cent. What deferred tax arises on the revaluation in 20X1, assuming that the revaluation gain is not taxable in 20X1?
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Solution
$000 Carrying value of non-current asset prior to revaluation ($6,000,000 x 94%) Revalued amount Taxable temporary difference = revaluation gain Therefore deferred tax liability (16.5% x 2.36m) 5,640 8,000 2,360 389.4
HKAS 12.21,22
3.2 Taxable temporary differences which do not result in deferred tax liabilities
There are two circumstances given in the standard where a taxable temporary difference does not result in a deferred tax liability: (a) (b) The deferred tax liability arises from the initial recognition of goodwill. The deferred tax liability arises from the initial recognition of an asset or liability in a transaction which: (i) (ii) is not a business combination (see Section 8) at the time of the transaction affects neither accounting profit nor taxable profit (tax loss).
HKAS 12.22
3.2.1 Initial recognition of an asset or liability

A temporary difference can arise on initial recognition of an asset or liability, eg if part or all of the cost of an asset will not be deductible for tax purposes. The nature of the transaction which led to the initial recognition of the asset is important in determining the method of accounting for such temporary differences. If the transaction affects either accounting profit or taxable profit, an entity will recognise any deferred tax liability or asset. The resulting deferred tax expense or income will be recognised in profit or loss. Where a transaction affects neither accounting profit nor taxable profit it would be normal for an entity to recognise a deferred tax liability or asset and adjust the carrying amount of the asset or liability by the same amount. However, HKAS 12 does not permit this recognition of a deferred tax asset or liability as it would make the financial statements less transparent. This will be the case both on initial recognition and subsequently, nor should any subsequent changes in the unrecognised deferred tax liability or asset as the asset is depreciated be made. An example of the initial recognition of an asset in a transaction which does not affect either accounting or taxable profit at the time of the transaction is an intangible asset with a finite life which attracts no tax allowances. In this case, taxable profit is never affected, and amortisation is only charged to accounting profit after the transaction.
Example: Initial recognition

As an example of the last paragraph, suppose Perris Co intends to use an asset which cost $10,000 in 20X7 through its useful life of five years. Its residual value will then be nil. The tax rate is 16.5 per cent. Any capital gain on disposal would not be taxable (and any capital loss not deductible). Depreciation of the asset is not deductible for tax purposes. Required State the deferred tax consequences in each of years 20X7 and 20X8.
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Solution
As at 20X7, as it recovers the carrying amount of the asset, Perris Co will earn taxable income of $10,000 and pay tax of $1,650. The resulting deferred tax liability of $1,650 would not be recognised because it results from the initial recognition of the asset. As at 20X8, the carrying value of the asset is now $8,000. In earning taxable income of $8,000, the entity will pay tax of $1,320. Again, the resulting deferred tax liability of $1,320 is not recognised, because it results from the initial recognition of the asset.
The following question on accelerated depreciation should clarify some of the issues and introduce you to the calculations.
Jojo Co buys equipment for $50,000 on 1 January 20X1 and depreciates it on a straight line basis over its expected useful life of five years. For tax purposes, the equipment is depreciated at 25 per cent per annum on a straight line basis. The tax rate is 15 per cent. Required Show the current and deferred tax impact in years 20X1 to 20X5 of the acquisition of the equipment. (The answer is at the end of the chapter)
4 Deductible temporary differences

Topic highlights
Deferred tax assets arise from deductible temporary differences. The standard states that deferred tax assets can only be recognised when sufficient future taxable profits exist against which they can be utilised.
Remember the basic rule that a deductible temporary difference arises where the carrying amount of an asset or liability is less than its tax base, and this deductible temporary difference normally results in a deferred tax asset. Try to understand the reasoning behind the recognition of deferred tax assets on taxable temporary differences: (a) (b) (c) (d) When a liability is recognised, it is assumed that its carrying amount will be settled in the form of outflows of economic benefits from the entity in future periods. When these resources flow from the entity, part or all may be deductible in determining taxable profits of a period later than that in which the liability is recognised. A temporary tax difference then exists between the carrying amount of the liability and its tax base. A deferred tax asset therefore arises, representing the income taxes that will be recoverable in future periods when that part of the liability is allowed as a deduction from taxable profit.
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(e)
Similarly, when the carrying amount of an asset is less than its tax base, the difference gives rise to a deferred tax asset in respect of the income taxes that will be recoverable in future periods.
The following are common examples of situations that result in a deductible temporary difference.
4.1 Examples of deductible temporary differences

HKAS 12 provides a number of examples of deductible temporary differences.
4.1.1 Transactions affecting the statement of comprehensive income

(a) Retirement benefit costs (pension costs) are deducted from accounting profit as service is provided by the employee. They are not deducted in determining taxable profit until the entity pays either retirement benefits or contributions to a fund. (This may also apply to similar expenses.) Accumulated depreciation of an asset in the financial statements is greater than the accumulated depreciation allowed for tax purposes up to the end of the reporting period. The net realisable value of inventory, or the recoverable amount of an item of property, plant and equipment falls and the carrying value is therefore reduced, but that reduction is ignored for tax purposes until the asset is sold. Research costs (or organisation/other start-up costs) are recognised as an expense for accounting purposes but are not deductible against taxable profits until a later period. Income is deferred in the statement of financial position, but has already been included in taxable profit in current/prior periods.
(b) (c)
(d) (e)
A non-taxable government grant related to an asset is deducted in arriving at the carrying amount of the asset but, for tax purpose, is not deducted from the assets depreciable amount (in other words its tax base); the carrying amount of the asset is less than its tax base and this gives rise to a deductible temporary difference. Government grants may also be set up as deferred income in which case the different between the deferred income and its tax base of nil is a deductible temporary difference. (Note. Whichever method of presentation an entity adopts, a deferred tax asset may not be recognised here according to the standard.)
4.1.2 Fair value adjustments and revaluations

A fair value which is lower than cost may be shown for current investments or financial instruments. However, no equivalent adjustment for tax is to be made.
HKAS 12.2730
4.2 Recognition of deferred tax assets

Although the circumstances listed above will result in a deductible temporary difference, they will not necessarily result in a deferred tax asset. This is because the recognition criteria of HKAS 12 state that a deferred tax asset can only be recognised to the extent that it is probable that taxable profit will be available against which it can be utilised.
4.2.1 Sufficient taxable profit

When can we be sure that sufficient taxable profit will be available against which a deductible temporary difference can be utilised? HKAS 12 states that this will be assumed when sufficient taxable temporary differences exist which relate to the same taxation authority and the same taxable entity. These should be expected to reverse as follows: (a) In the same period as the expected reversal of the deductible temporary difference.
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Financial Reporting
(b)
In periods into which a tax loss arising from the deferred tax asset can be carried back or forward.
Only in these circumstances is the deferred tax asset recognised, in the period in which the deductible temporary differences arise.
4.2.2 Insufficient taxable profit

What happens when there are insufficient taxable temporary differences (relating to the same taxation authority and the same taxable entity)? It may still be possible to recognise the deferred tax asset, but only to the following extent. (a) Taxable profits are sufficient in the same period as the reversal of the deductible temporary difference (or in the periods into which a tax loss arising from the deferred tax asset can be carried forward or backward), ignoring taxable amounts arising from deductible temporary differences arising in future periods. Tax planning opportunities exist that will allow the entity to create taxable profit in the appropriate periods.
(b)
With reference to (b), tax planning opportunities are actions that an entity would take in order to create or increase taxable income in a particular period before the expiry of a tax loss or tax credit carry forward. For example, in some countries it may be possible to increase or create taxable profit by electing to have interest income taxed on either a received or receivable basis, or deferring the claim for certain deductions from taxable profit. In any case, where tax planning opportunities advance taxable profit from a later period to an earlier period, the utilisation of a tax loss or a tax credit carry forward will still depend on the existence of future taxable profit from sources other than future originating temporary differences. If an entity has a history of recent losses, then this is evidence that future taxable profit may not be available.
Example: Deductible temporary differences

Rombauld Co recognises a liability of $75,000 for accrued product warranty costs on 31 December 20X1. These product warranty costs will not be deductible for tax purposes until the entity pays claims. The tax rate is 16.5 per cent. Required State the deferred tax implications of this situation.
Solution
The carrying amount of the provision is ($75,000) The tax base of the liability is nil (carrying amount of $75,000 less the $75,000 that will be deductible for tax purposes when the warranty costs are paid). The tax base of nil exceeds the carrying amount of ($75,000) and therefore a deductible temporary difference arises. This results in a deferred tax asset of $12,375 (16.5% x $75,000)
The logic behind this is as follows: when the liability is settled for its carrying amount, the entity's future taxable profit will be reduced by $75,000 and so its future tax payments by $75,000 16.5% = $12,375
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4.3 Deductible temporary differences that do not result in deferred tax assets
HKAS 12.33
4.3.1 Initial recognition of an asset or liability

There are circumstances where the overall rule for recognition of deferred tax asset is not allowed. This applies where the deferred tax asset arises from initial recognition of an asset or liability in a transaction which is not a business combination, and at the time of the transaction, affects neither accounting nor taxable profit / tax loss. The example given by the standard is of a non-taxable government grant related to an asset, deducted in arriving at the carrying amount of the asset. For tax purposes, however, it is not deducted from the asset's depreciable amount (ie its tax base). The carrying amount of the asset is less than its tax base and this gives rise to a deductible temporary difference, however this is not recognised as a deferred tax asset.
HKAS 12.3436
4.4 Tax losses and credits carried forward

HKAS 12 states that a deferred tax asset may be recognised by an entity which has unused tax losses or credits (ie which it can offset against taxable profits) at the end of a period, to the extent that it is probable future taxable profits will be available to set off the unused tax losses/credits. The recognition criteria for deferred tax assets here is identical to the recognition criteria for deferred tax assets arising from deductible differences. The fact that future taxable profits may not be available is confirmed by the existence of unused tax losses. For an entity with a past record of recent tax losses, a deferred tax asset arising from unused tax losses or credits should be recognised only to the extent that it has adequate taxable temporary differences or where it is certain that taxable profit will be available to set off the unused losses/credits. The following are important criteria for assessing the probability that taxable profit will be available against which unused tax losses/credits can be utilised: Availability of sufficient taxable temporary differences (same tax authority/taxable entity) against which unused tax losses/credits can be utilised before they expire The likelihood that the entity will have taxable profits before the expiry of the unused tax losses/credits The unlikely recurrence of unused tax losses resulting from identifiable causes Availability of tax planning opportunities (see above)
Deferred tax asset is not recognised if it is probable that taxable profit will not be available.
Example: Taxable profit not available

Jerome Co has made trading profits for a number of years, however due to an economic downturn in the first half of the year, reported a taxable loss of $270,000 in the year ended 31 December 20X1. In accordance with local tax law, Jerome intends to carry $130,000 of this back to 20X0 to set against the taxable profits of that year, and carrying the remaining $140,000 forward indefinitely. By the end of 20X1, management had identified an upturn in orders and felt that Jerome would return to profit in 20X2. What is the deferred tax impact, if any, of Jeromes losses? Jerome pays tax at 16.5 per cent.
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Financial Reporting
Solution
The $130,000 carried back to 20X0 is relevant to current tax rather than deferred tax, and a receivable of $21,450 should be recognised. It appears that the $140,000 carried forward will be able to be utilised by Jerome and therefore a deferred tax asset of $23,100 can be recognised (16.5% x $140,000).
HKAS 12.37
4.5 Reassessment of unrecognised deferred tax assets

An entity should carry out a reassessment for all unrecognised deferred tax assets at the end of each reporting period. The availability of future taxable profits and whether part or all of any unrecognised deferred tax assets should now be recognised are the issues to be considered. This may be due to an expected continuation in improvement of trading conditions. Conversely, a previously recognised deferred tax asset may require decreasing or derecognising where future taxable profits are no longer available.
5 Measurement of deferred tax

Topic highlights
A deferred tax asset or liability is measured by applying the tax rate which is expected to apply to the period when the asset is realised or the liability is settled to the temporary difference. The resulting amount is not discounted.
5.1 Full provision method

HKAS 12 adopts the full provision method of providing for deferred tax, in other words deferred tax is provided for on all temporary differences, irrespective of the future plans of an entity. This method has the advantage that it recognises that each temporary difference at the year end has an effect on future tax payments. The disadvantage of full provision is that, under certain types of tax system, it gives rise to large liabilities that may fall due only far in the future.
HKAS 12.47
5.2 Applicable tax rate

Where the tax rate fluctuates year to year, consideration must be given to which tax rate to apply to temporary differences in calculating a deferred tax asset or liability. HKAS 12 requires deferred tax assets and liabilities to be measured at the tax rates expected to apply in the period when the asset is realised or liability settled, based on tax rates and laws enacted (or substantively enacted) at the end of the reporting period. This is referred to as the liability method.
HKAS 12.49
5.2.1 Different rates of tax

Some countries apply different tax rates to different levels of taxable income. Average tax rates should then be used to measure the deferred tax assets and liabilities since these rates are expected to be applied to the taxable profit (loss) of the periods in which the temporary differences are expected to reverse.
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HKAS 12.51,51A
5.2.2 Manner of recovery or settlement

In some jurisdictions either the tax rate or the tax base will differ depending on the way in which an entity recovers or settles the carrying amount of an asset or liability. For example, the tax rate applicable to income from the ongoing use of an asset may differ from the tax rate applicable to a chargeable gain on its sale. In this instance the entity must consider the expected manner of recovery or settlement. Deferred tax liabilities and assets must be measured accordingly, using an appropriate tax rate and tax base.
Example: Manner of recovery/settlement

Clio Co has an asset with a carrying amount of $100,000 and a tax base of $60,000. If the asset were sold, a tax rate of 18 per cent would apply. A tax rate of 25 per cent would apply to other income. Required State the deferred tax consequences if the entity: (a) (b) sells the asset without further use. expects to keep the asset and recover its carrying amount through use.
Solution
(a) (b) A deferred tax liability is recognised of $(100,000 60,000) 18% = $7,200. A deferred tax liability is recognised of $(100,000 60,000) 25% = $10,000.
HKAS 12.51C
In 2010, HKAS 12 was amended to include a rebuttable presumption that deferred tax on investment properties carried at fair value under HKAS 40 should be measured based on recovery through sale. The amendment was intended to avoid any subjective assessment in trying to decide whether the carrying amount of an investment property will be recovered through use or through sale. As there is no capital gains tax in Hong Kong, this amendment will generally result in the deferred tax liability on such investment properties being limited to the tax effect of any claw back on sale of any depreciation allowances previously given.
Example
A company based in Hong Kong owns an investment property with a fair value carrying amount of $10 million. The property cost $9 million. The tax base of the property is $8 million and the tax rate on income is 16.5 per cent. Prior to the amendment to HKAS 12, if it were presumed that the carrying value of the property would be recovered through use, the deferred tax liability would have been $330,000 (16.5% x ($10 million - $8 million)). The amendment, however, means that it is presumed that the carrying value will be recovered through sale. Therefore the deferred tax liability is restricted to the excess of allowances given ie $165,000 (16.5% x ($9million - $8million)).
The presumption is rebutted where the investment property is depreciable and is held with the intention of consuming substantially all the economic benefits of the property through use rather than sale, in other words, where the entity expects the assets income-generating ability to wear out while the asset is still owned by the entity.
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Financial Reporting
Crescent Co owns a building with an original cost of $10m. In 20X1, the carrying value was $8m and the asset was revalued to $15m. No equivalent adjustment was made for tax purposes. Total depreciation allowance for tax purposes is $3m and the tax rate is 30 per cent. If the asset is sold for more than cost, the total tax depreciation allowance of $3m will be included in taxable income but sale proceeds in excess of cost will not be taxable. Required State the deferred tax consequences if the entity: (a) (b) expects to recover the carrying value through use, expects to sell the building. (The answer is at the end of the chapter)
The facts are as in Self-test question 5 above, except that if the building is sold for more than cost, the total tax depreciation allowance will be included in taxable income (taxed at 30 per cent) and the sale proceeds will be taxed at 40 per cent after deducting an inflation-adjusted cost of $11m. Required State the deferred tax consequences if the entity: (a) (b) expects to recover the carrying value through use, expects to sell the building. (The answer is at the end of the chapter)
If the tax base is not immediately apparent in Self-test question 6 above, it may be helpful to consider the fundamental principle of HKAS 12: that an entity should recognise a deferred tax liability (asset) whenever recovery or settlement of the carrying amount of an asset or liability would make future tax payments larger (smaller) than they would be if such recovery or settlement would have no consequences.
HKAS 12.53,54
5.3 Discounting
The standard does not allow deferred tax assets and liabilities to be discounted. This is because the complexities and difficulties involved will affect reliability. Discounting would require detailed scheduling of the timing of the reversal of each temporary difference, but this is often impracticable. In addition, if discounting were permitted, it would affect comparability. It is, however the case that some temporary differences are based on discounted amounts eg retirement benefit obligations.
6 Recognition of deferred tax

HKAS 12.58,61A
As with current tax, deferred tax is normally recognised as income or an expense and included in the profit or loss for the period. The amount recognised is comprised of: (a) deferred tax relating to temporary differences
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(b)
adjustments arising as a result of changes in the carrying amount of deferred tax assets and liabilities due to changes in the tax rates, reassessment of the recoverability of deferred tax assets or a change in the expected recovery of an asset.
The exceptions to recognition of deferred tax in profit or loss are where the tax arises from the events below. (a) (b) (c) A transaction or event which is recognised in other comprehensive income eg a revaluation. A transaction or event which is recognised (in the same or a different period) directly in equity eg the correction of an error. A business combination that is an acquisition (see Section 8.4 of the chapter).
Where transactions or events are recognised in other comprehensive income or directly in equity, the related tax is also recognised in other comprehensive income or directly in equity. Where it is not possible to determine the amount of tax that relates to items recognised in other comprehensive income or directly in equity, such tax amounts should be based on a reasonable pro rata allocation of the entity's tax.
7 Presentation of deferred tax

HKAS 12.74
Deferred tax assets and liabilities can be offset only if: (a) (b) the entity has a legally enforceable right to set off current tax assets against current tax liabilities, and the deferred tax assets and liabilities relate to income taxes levied by the same taxation authority on either: (i) (ii) the same taxable entity, or different taxable entities which intend either to settle current tax liabilities and assets on a net basis, or to realise the assets and settle the liabilities simultaneously, in each future period in which significant amounts of deferred tax liabilities or assets are expected to be settled or recovered.
8 Deferred taxation and business combinations

Topic highlights
Temporary differences may arise as a result of business combinations. There are a number of deferred tax implications of a business combination. Everything that HKAS 12 states in relation to deferred tax and business combinations is brought together in this section.
8.1 Temporary differences arising as a result of business combinations

Earlier in the chapter we considered a number of common situations which result in either a taxable or deductible temporary difference. When interests are held in subsidiaries, branches, associates or joint ventures, temporary differences arise because the carrying amount of the investment (ie the parent's share of the net assets including goodwill) becomes different from the tax base (often the cost) of the investment.
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Financial Reporting
Reasons for these differences include: The existence of undistributed profits of subsidiaries, branches, associates and joint ventures Changes in foreign exchange rates when a parent and its subsidiary are based in different countries A reduction in the carrying amount of an investment in an associate to its recoverable amount
The temporary difference in the consolidated financial statements may be different from the temporary difference associated with that investment in the parent's separate financial statements when the parent carries the investment in its separate financial statements at cost or revalued amount. HKAS 12 provides examples of both taxable and deductible temporary differences.
8.1.1 Taxable temporary differences

In a business combination, such as when one company buys all the shares of another company, the cost of the acquisition must be allocated to the fair values of the identifiable assets and liabilities acquired as at the date of the transaction. Temporary differences can arise when the tax bases of the identifiable assets and liabilities acquired are not affected by the business combination. For example, where the carrying amount of an asset is increased to fair value but the tax base of the asset remains at cost to the previous owner, a taxable temporary difference arises which results in a deferred tax liability and this will also affect goodwill. The following are also provided by the standard as examples of situations which will result in a taxable temporary difference: (a) (b) Unrealised losses resulting from intragroup transactions are eliminated by inclusion in the carrying amount of inventory or property, plant and equipment. Retained earnings of subsidiaries, branches, associates and joint ventures are included in consolidated retained earnings, but income taxes will be payable if the profits are distributed to the reporting parent. Investments in foreign subsidiaries, branches or associates or interests in foreign joint ventures are affected by changes in foreign exchange rates. An entity accounts in its own currency for the cost of the non-monetary assets of a foreign operation that is integral to the reporting entity's operations but the taxable profit or tax loss of the foreign operation is determined in the foreign currency.
(c) (d)
On 31 December 20X1, Basil Co acquired a 60% stake in Lemongrass Co. Among Lemongrasss identifiable assets at that date was inventory with a carrying amount of $8,000 and a fair value of $12,000. The tax base of the inventory was the same as the carrying amount. The consideration given by Basil Co resulted in the recognition of goodwill acquired in the business combination. Income tax is payable by Basil Co at 25 per cent and by Lemongrass at 20 per cent. Required What is the deferred tax impact of this transaction in the Basil group financial statements? (The answer is at the end of the chapter)
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8.1.2 Deductible temporary differences

In a business combination, when a liability is recognised on acquisition but the related costs are not deducted in determining taxable profits until a later period, a deductible temporary difference arises resulting in a deferred tax asset. A deferred tax asset will also arise when the fair value of an identifiable asset acquired is less than its tax base. In both these cases goodwill is affected (see below). The standard also provides the following examples of situations will result in a deductible temporary difference: (a) Unrealised profits resulting from intragroup transactions are eliminated from the carrying amount of assets, such as inventory or property, plant or equipment, but no equivalent adjustment is made for tax purposes. Investments in foreign subsidiaries, branches or associates or interests in foreign joint ventures are affected by changes in foreign exchange rates. A foreign operation accounts for its non-monetary assets in its own (functional) currency. If its taxable profit or loss is determined in a different currency (under the presentation currency method) changes in the exchange rate result in temporary differences. The resulting deferred tax is charged or credited to profit or loss.
(b) (c)
Oregano Co owns 70 per cent of Thyme Co. During 20X1 Thyme sold goods to Oregano for $120,000 at a mark-up of 20 per cent above cost. Half of these goods are held in Oreganos inventories at the year end. The rate of income tax is 30 per cent. Required What is the deferred tax impact of this transaction in the Oregano group financial statements? (The answer is at the end of the chapter)
8.2 Recognition criteria

HKAS 12 provides recognition criteria for both deferred tax liabilities and assets in a business combination situation.
HKAS 12.39
8.2.1 Deferred tax liability

Entities should recognise a deferred tax liability for all taxable temporary differences associated with investments in subsidiaries, branches and associates, and interests in joint ventures, except to the extent that both of these conditions are satisfied: (a) (b) The parent/investor/venturer is able to control the timing of the reversal of the temporary difference It is probable that the temporary difference will not reverse in the foreseeable future.
HKAS 12.44
8.2.2 Recognition of deferred tax asset

HKAS 12 requires that a deferred tax asset should be recognised for all deductible temporary differences arising from investments in subsidiaries, branches and associates, and interests in joint ventures, to the extent that (and only to the extent that) both these are probable that: (a) (b) the temporary difference will reverse in the foreseeable future taxable profit will be available against which the temporary difference can be utilised
The prudence principle discussed above for the recognition of deferred tax assets should be considered.
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8.3 Application of the recognition criteria

HKAS 12.40
8.3.1 Undistributed profits

Where a parent company controls the dividend policy of its subsidiary, it can control the timing of the reversal of temporary differences. In addition, it would often be impracticable to determine the amount of income taxes payable when the temporary differences reverses. Therefore, when the parent has determined that those profits will not be distributed in the foreseeable future, the parent does not recognise a deferred tax liability. The same applies to investments in branches.
HKAS 12.41
8.3.2 Foreign exchange

Where a foreign operation's taxable profit or tax loss (and therefore the tax base of its nonmonetary assets and liabilities) is determined in a foreign currency, changes in the exchange rate give rise to temporary differences. These relate to the foreign entity's own assets and liabilities, rather than to the reporting entity's investment in that foreign operation, and so the reporting entity should recognise the resulting deferred tax liability or asset. The resulting deferred tax is charged or credited to profit or loss.
HKAS 12.42
8.3.3 Associates
An investor in an associate does not control that entity and so cannot determine its dividend policy. Therefore, unless there is an agreement requiring that the profits of the associate should not be distributed in the foreseeable future, the investor should recognise a deferred tax liability arising from taxable temporary differences associated with its investment in the associate. Where an investor cannot determine the exact amount of tax, but only a minimum amount, then the deferred tax liability should be that amount.
HKAS 12.43

In a joint venture, the agreement between the parties usually deals with profit sharing. When a venturer can control the sharing of profits and it is probable that the profits will not be distributed in the foreseeable future, a deferred liability is not recognised.
HKFRS 3.24, HKAS 12.15,66-68
8.4 Recognition of deferred tax arising from business combinations

HKFRS 3 Business Combinations requires an entity to recognise any deferred tax assets (to the extent that they meet the relevant recognition criteria) or deferred tax liabilities resulting from temporary differences on a business combination as identifiable assets and liabilities at the date of acquisition. These deferred tax assets and deferred tax liabilities, consequently, will affect the amount of goodwill or the bargain purchase gain the entity recognises. An entity will not, however, recognise deferred tax liabilities arising from the initial recognition of goodwill. A business combination may result in a change in the probability of realising a pre-acquisition deferred tax asset of the acquirer. There is a chance that the acquirer will recover its own deferred tax asset that was not recognised before the combination of the businesses, eg by setting off unused tax losses against the future taxable profit of the acquiree. Alternatively, as a result of the business combination it might no longer be probable that future taxable profit will allow the deferred tax asset to be recovered. The acquirer should recognise a change in the deferred tax asset in the period of the business combination, but does not take it into account in calculating the goodwill or bargain purchase gain it recognises in the business combination.
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The potential benefit of the acquiree's income tax loss carryforwards or other deferred tax assets might not satisfy the criteria for separate recognition when a business combination is initially accounted for but might be realised subsequently. An entity shall recognise acquired deferred tax benefits that it realises after the business combination as follows: (a) Acquired deferred tax benefits recognised within the measurement period that result from new information about facts and circumstances that existed at the acquisition date shall be applied to reduce the carrying amount of any goodwill related to that acquisition. If the carrying amount of that goodwill is zero, any remaining deferred tax benefits shall be recognised in profit or loss. All other acquired deferred tax benefits realised shall be recognised in profit or loss (or, if this standard so requires, outside profit or loss).
(b)
On 1 September 20X1, Orchid acquired 90% of the ordinary share capital of Daffodil for consideration totalling $1.75million. At the date of acquisition, Daffodils statement of financial position showed net assets of $1.8million, although the fair value of inventory was assessed to be $100,000 above its carrying amount. Required Explain the deferred tax implications, assuming a tax rate of 16.5 per cent. (The answer is at the end of the chapter)
Self test question 10

Dandelion purchased 75% of the ordinary share capital of Bluebell for $1.1m when the net assets of Bluebell were $1m, giving rise to goodwill of $350,000. At 31 December 20X1 the following is relevant: 1 2 Goodwill has not been impaired The net assets of Bluebell amount to $1.2m
Required What temporary difference arises on this investment at 31 December 20X1? (The answer is at the end of the chapter)
Example
In recent years, Lily Co has made the following acquisitions of other companies: On 1 January 20X6, it acquired 90 per cent of the share capital of Blossom, resulting in goodwill of $1.4 million. On 1 July 20X6 it acquired the whole of the share capital of Snowdrop for $6 million. At this date the fair value of the net assets of Snowdrop was $4.5 million and their tax base was $4 million.
The following information is relevant to Lily Groups year ended 31 December 20X6:
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Financial Reporting
Blossom 1 Blossom has made a provision amounting to $1.8 million in its accounts in respect of litigation. This is tax allowable only when the cost is actually incurred. The case is expected to be settled within 12 months. Blossom has a number of investments classified as at fair value through profit or loss in accordance with HKFRS 9. The remeasurement gains and losses recognised in profit or loss for accounting purposes are not taxable / tax allowable until such date as the investments are sold. To date the cumulative unrealised gain is $2.5 million. Blossom has sold goods to Lily in the year making a profit of $1 million. A quarter of these goods remain in Lilys inventory at the year end. At its acquisition date, Snowdrop had unrelieved brought forward tax losses of $0.4 million. It was initially believed that Snowdrop would have sufficient taxable profits to utilise these losses and a deferred tax asset was recognised in Snowdrops financial statements at acquisition. Subsequent events have proven that the future taxable profits will not be sufficient to utilise the full brought forward loss. At acquisition Snowdrops retained earnings amounted to $3.5 million. The directors of Lily Group have decided that in each of the next four years to the intended listing date of the group, they will realise earnings through dividend payments from the subsidiary amounting to $600,000 per annum. Snowdrop has not declared a dividend for the current year. Tax is payable on remittance of dividends. $300,000 of the purchase price of Snowdrop has been allocated to intangible assets. The recognition and measurement criteria of HKFRS 3 and HKAS 38 do not appear to have been met, however the directors believe that the amount is allowable for tax and have calculated the tax charge accordingly. It is believed that this may be challenged by the tax authorities.
Snowdrop 1
Required What are the deferred tax implications of the above issues for the Lily Group?
Solution
Acquisitions Any fair value adjustments made for consolidation purposes will affect the group deferred tax charge for the year. A taxable temporary difference will arise where the fair value of an asset exceeds its carrying value, and the resulting deferred tax liability should be recorded against goodwill. A deductible temporary difference will arise where the fair value of a liability exceeds its carrying value, or an asset is revalued downwards. Again the resulting deferred tax amount (an asset) should be recognised in goodwill. In addition, it may be possible to recognise deferred tax assets in a group which could not be recognised by an individual company. This is the case where tax losses brought forward, but not considered to be an asset, due to lack of available taxable profits to set them against, can now be used by another group company. Goodwill Goodwill arose on both acquisitions. According to HKAS 12, however, no provision should be made for the temporary difference arising on this. Blossom 1 A deductible temporary difference arises when the provision is first recognised. This results in a deferred tax asset calculated as $540,000 (30% x $1.8m). The asset may, however, only be recognised where it is probable that there will be future taxable profits against which the
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future tax allowable expense may be set. There is no indication that this is not the case for Blossom. 2 A taxable temporary difference arises where investments are revalued upwards for accounting purposes but the uplift is not taxable until disposal. In this case the carrying value of the investments has increased by $2.5 million, and this has been recognised in profit or loss. The tax base has not, however changed. Therefore, a deferred tax liability should be recognised on the $2.5 million, and in line with the recognition of the underlying revaluation, this should be recognised in profit or loss. This intra-group transaction results in unrealised profits of $250,000 which will be eliminated on consolidation. The tax on this $250,000 will, however, be included within the group tax charge (which is comprised of the sum of the individual group companies tax charges). From the perspective of the group there is a temporary difference. Deferred tax should be provided on this difference using the tax rate of Lily (the recipient company).
Snowdrop 1 Unrelieved tax losses give rise to a deferred tax asset only where the losses are regarded as recoverable. They should be regarded as recoverable only where it is probable that there will be future taxable profits against which they may be used. It is indicated that the future profits of Snowdrop will not be sufficient to realise all of the brought forward loss, and therefore the deferred tax asset is calculated only on that amount expected to be recovered. Deferred tax is recognised on the unremitted earnings of investments, except where: (a) (b) The parent is able to control the payment of dividends It is unlikely that the earnings will be paid out in the foreseeable future
Lily controls Snowdrop and is therefore able to control its dividend payments, however it is indicated that $2.4million will be paid as dividends in the next four years. Therefore a deferred tax liability related to this amount should be recognised. 3 The directors have assumed that the $300,000 relating to intangible assets will be tax allowable, and the tax provision has been calculated based on this assumption. However this is not certain, and extra tax may have to be paid if this amount is not allowable. Therefore a liability for the additional tax amount should be recognised.
8.5 Section summary

In relation to deferred tax and business combinations you should be familiar with: circumstances that give rise to taxable temporary differences circumstances that give rise to deductible temporary differences their treatment once an acquisition takes place reasons why deferred tax arises when investments are held recognition of deferred tax on business combinations
9 Interpretations relating to deferred tax

9.1 HK(SIC) Int-21 Income Taxes Recovery of Revalued Nondepreciable Assets
HK(SIC) Int-21 deals with cases where a non-depreciable asset (freehold land) is carried at revaluation under HKAS 16.
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The Interpretation deems that no part of such an assets carrying amount will be recovered through use. Therefore the deferred tax asset or liability that arises from revaluation must be measured based on recovery through sale of the asset. In some jurisdictions, this will result in the use of a capital gains tax rate rather than the rate applicable to corporate earnings. HK(SIC) Int-12 has been incorporated into HKAS 12 as part of the amendments to HKAS 12 issued in December 2010. It is therefore withdrawn for accounting periods starting on or after 1 January 2012.
9.2 HK(SIC) Int-25 Income Taxes Changes in the Tax Status of an Entity or its Shareholders
A change in the tax status of an entity or its shareholders may have consequences for an entity by increasing or decreasing its tax liabilities or assets. This may, for example, occur upon: the public listing of an entity's equity instruments the restructuring of an entity's equity a controlling shareholder's move to a foreign country.
As a result of such an event, an entity may be taxed differently; it may for example gain or lose tax incentives or become subject to a different rate of tax in the future. A change in the tax status of an entity or its shareholders may have an immediate effect on the entity's current tax liabilities or assets. The change may also increase or decrease the deferred tax liabilities and assets recognised by the entity, depending on the effect the change in tax status has on the tax consequences that will arise from recovering or settling the carrying amount of the entity's assets and liabilities. A change in the tax status of an entity or its shareholders does not give rise to increases or decreases in amounts recognised directly in equity. The current and deferred tax consequences of a change in tax status shall be included in net profit or loss for the period, unless those consequences relate to transactions and events that result, in the same or a different period, in a direct credit or charge to the recognised amount of equity. Those tax consequences that relate to changes in the recognised amount of equity, in the same or a different period (not included in net profit or loss), shall be charged or credited directly to equity.
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Topic recap
Taxation consists of two components. Current tax Deferred tax
Current tax is the amount payable to the tax authorities in relation to the trading activities during the period. It is generally straightforward. Deferred tax is an accounting measure, used to match the tax effects of transactions with their accounting impact. It is quite complex. Deferred tax adjusts the tax charge for the effects of temporary differences. These are calculated as the difference between the carrying amount of an asset or liability and its tax base. Deferred tax liabilities arise from taxable temporary differences. Deferred tax assets arise from deductible temporary differences. The standard states that deferred tax assets can only be recognised when sufficient future taxable profits exist against which they can be utilised. A deferred tax asset or liability is measured by applying the tax rate which is expected to apply to the period when the asset is realised or the liability is settled to the temporary difference. The resulting amount is not discounted. Temporary differences may arise as a result of business combinations.
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Financial Reporting
Answer 1
(a) Current year tax liability ($760,000 x 16.5%) Overprovision in 20X0 ($130,000 - $126,700) Therefore (b) $125,400 is recognised as a current tax liability in the statement of financial position at 31 December 20X1 $122,100 ($125,400 - $3,300) is recognised as tax charge in the statement of comprehensive income for the year ended 31 December 20X1 $ 125,400 3,300
If the previous years tax was settled at $131,000, tax was underprovided. Therefore the underprovision of $1,000 is added to the 20X1 tax charge to make it $126,400. The liability in the statement of financial position remains unchanged at $125,400.
Answer 2
(a) (b) (c) (d) (e) The tax base of the interest receivable is $1,000. The tax base of the dividend is $5,000. The tax base of the machine is $7,000. The tax base of the trade receivables is $10,000. The tax base of the loan is $1 million.
In the case of (b), in substance the entire carrying amount of the asset is deductible against the economic benefits. There is no taxable temporary difference. An alternative analysis is that the accrued dividends receivable have a tax base of nil and a tax rate of nil is applied to the resulting taxable temporary difference ($5,000). Under both analyses, there is no deferred tax liability.
Answer 3
(a) (b) (c) (d) The tax base of the accrued expenses is $1,000. The tax base of the revenue received in advance is $1,000. The tax base of the accrued fines and penalties is $100. The tax base of the loan is $1 million.
Answer 4
The temporary differences associated with the equipment are as follows: 20X1 $ 40,000 37,500 2,500 375 375 20X2 $ 30,000 25,000 5,000 375 375 750 Year 20X3 $ 20,000 12,500 7,500 750 375 1,125 20X4 $ 10,000 10,000 1,125 375 1,500 20X5 $ 1,500 (1,500)
Carrying amount Tax base Taxable temporary difference Opening deferred tax liability Deferred tax expense (income): bal fig Closing deferred tax liability @ 15%
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Answer 5
The tax base of the building is $7m ($10m $3m). (a) If the entity expects to recover the carrying amount by using the building, it must generate taxable income of $15m, but will only be able to deduct depreciation of $7m. On this basis there is a deferred tax liability of $2.4m (($15m-$7m) 30%). If the entity expects to recover the carrying amount by selling the building immediately for proceeds of $15m the deferred tax liability will be computed as follows: Taxable temporary difference $000 3,000 5,000 8,000 Tax rate 30% NIL Deferred tax liability $000 900 900
(b)
Total tax depreciation allowance Proceeds in excess of cost Total
Note. The additional deferred tax that arises on the revaluation is charged directly to equity: see Answer 6 below.
Answer 6
(a) (b) If the entity expects to recover the carrying amount by using the building, the situation is as in answer 5(a) in the same circumstances. If the entity expects to recover the carrying amount by selling the building immediately for proceeds of $15m, the entity will be able to deduct the indexed costs of $11m. The net profit of $4m will be taxed at 40 per cent. In addition, the total tax depreciation allowance of $3m will be included in taxable income and taxed at 30 per cent. On this basis, the tax base is $8m ($11m $3m), there is a taxable temporary difference of $7m and there is a deferred tax liability of $2.5m ($4m 40% plus $3m 30%).
Answer 7
The excess of an assets fair value over its tax base at the time of a business combination results in a deferred tax liability. As it arises in Lemongrass, the tax rate used is 20 per cent and the liability is $800 (($12,000 - $8,000) 20%). The recognition of a deferred tax liability in relation to the initial recognition of goodwill is specifically prohibited by HKAS 12.
Answer 8
There is an unrealised profit relating to inventories still held within the group of $20,000 = $10,000, which must be eliminated on consolidation. But the tax base of the inventories is unchanged, so it is higher than the carrying amount in the consolidated statement of financial position and there is a deductible temporary difference of $10,000.
Answer 9
The carrying amount of the inventory in the group accounts is $100,000 more than its tax base (being carrying amount in Daffodils own accounts). Deferred tax on this temporary difference is 16.5% x $100,000 = $16,500. A deferred tax liability of $16,500 is recognised in the group statement of financial position. Goodwill is increased by ($16,500 90%) = $14,850.
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Financial Reporting
Answer 10
The tax base of the investment in Bluebell is the cost of $1.1m. The carrying value is the share of net assets (75% x $1.2m) + goodwill of $350,000 = $1.25m The temporary difference is therefore $1.25m - $1.1m = $150,000. This is equal to the group share of post acquisition profits: 75% x $200,000 change in net assets since acquisition.
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Exam practice
Bestpoint Printing Limited
22 minutes
Bestpoint Printing Limited (BP), established in the Peoples Republic of China (PRC), is a whollyowned subsidiary of Glory Publishing Group (GP). BP is entitled to a two-year exemption from foreign enterprise income tax (FEIT) from its first profit-making year, as computed under PRC accounting standards (PRC GAAP) and tax regulations. For the following three years, it enjoyed a 50 per cent reduction in the rate of FEIT. 20X3 was BPs first profit-making year. The standard tax rate for BP was 24 per cent for the periods up to 31 December 20X7. With the enactment of the new tax law during 20X7, BP will be subject to FEIT at 25 per cent for the year beginning 1 January 20X8. GP is subject to Hong Kong profits tax at 17.5 per cent. BP acquired a printing machine on 1 July 20X3 at a cost of $20 million. For the purpose of FEIT calculations, the machine is depreciated over 10 years with a residual value of 10 per cent of the cost from the corresponding date of acquisition, which is the same for the preparation of BPs PRC GAAP financial statements. In the preparation of GPs consolidated financial statements, the machine is depreciated over 16 years with nil residual value. Required (a) (b) Calculate the deferred tax asset or liability position in relation to the machine at 31 December 20X7 accounted for in GPs consolidated financial statements. (5 marks)
Prepare the journal entry(ies) to record the deferred income taxes at 31 December 20X8 for GP's consolidated financial statements with calculations supporting the balances recorded. (5 marks) Assuming GP has a deferred tax asset of $500,000 in respect of its own plant and equipment at 31 December 20X8, explain how the deferred taxes will appear on the consolidated statement of financial position at that date. (2 marks) (Total = 12 marks) HKICPA February 2008 (amended)
(c)
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Financial Reporting
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chapter 16
Employee benefits
Topic list
1 2 3 4 5 6 7 HKAS 19 Employee Benefits Short-term employee benefits Post-employment benefits Defined contribution plans Defined benefit plans Termination benefits Current developments
Learning focus
An increasing number of companies and other entities now provide a pension and other employee benefits as part of their employees' remuneration package. In view of this trend, it is important that there is standard best practice for the way in which employee benefit costs are recognised, measured, presented and disclosed in the sponsoring entities' accounts. You must ensure that you understand and can apply the rules of HKAS 19.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.04 3.04.01 Employee benefits Identify short-term employee benefits in accordance with HKAS 19 and apply the recognition and measurement principles in respect of short-term employee benefits Distinguish between defined contribution plans and defined benefit plans Account for defined contribution plans Identify termination benefits in accordance with HKAS 19 and apply the recognition and measurement principles in respect of termination benefits 2
3.04.02 3.04.03 3.04.04
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16: Employee benefits | Part C Accounting for business transactions
1 HKAS 19 Employee Benefits

Topic highlights
HKAS 19 Employee Benefits provides guidance on the accounting treatment to be applied to shortterm employment benefits, post-employment benefits (pensions), other long-term employment benefits and termination benefits.
Before we look at HKAS 19, we should consider the nature of employee benefit costs and why there is an accounting problem which must be addressed by a standard.
HKAS 19.4,8
1.1 Employee benefits

Companies generally provide their employees with a package of pay and benefits, which may include some or all of the following: Short-term benefits including: Wages and salaries Contributions to Mandatory Provident Fund Paid annual leave Paid sick leave Paid maternity/paternity leave Profit shares and bonuses paid within 12 months of the year end Paid jury service Paid military service Non-monetary benefits, eg medical care, cars, free goods
Post-employment benefits, eg pensions and post-employment medical care Other long-term benefits, eg profit shares, bonuses or deferred compensation payable later than 12 months after the year end, sabbatical leave, long-service benefits Termination benefits, eg early retirement payments and redundancy payments
Benefits may be paid to the employees themselves, to their dependants (spouses, children, etc) or to third parties.
1.2 The accounting problem

In the case of the short term benefits listed above, the employee will receive the benefit at about the same time as he or she earns it. The accounting is therefore relatively straightforward with the costs of providing the benefit recognised as an expense in the employer's financial statements. Accounting for the cost of deferred employee benefits is less clear cut. This is because of the long time scale, complicated estimates and uncertainties involved in these types of benefit. In addition, the costs could be viewed in a number of ways, for example as deferred salary to the employee or as a deduction from the employees true gross salary. In the past, entities accounted for these benefits simply by making a charge to the profit or loss of the employing entity on the basis of actual payments made. This led to substantial variations in reported profits of these entities and disclosure of information on these costs was usually sparse.
1.2.1 The accounting solution

HKAS 19 addresses the problem described above by prescribing how employee benefits should be recognised and measured.
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Financial Reporting
The standard requires an entity to recognise: (a) (b) A liability when an employee has provided a service in exchange for benefits to be received by the employee at some time in the future. An expense when the entity receives the economic benefits from a service provided by an employee regardless of when the employee received or will receive the benefits for providing the service.
The application of these basic rules to each of the categories of employee benefits described in Section 1.1 is provided in HKAS 19 and described throughout the remainder of this chapter. First, however, we must consider a number of important definitions within the standard.
HKAS 19.7
1.3 Definitions
You should refer back to the following definitions as necessary as you work through the rest of this chapter.
Key terms
Employee benefits are all forms of consideration given by an entity in exchange for service rendered by employees. Short-term employee benefits are employee benefits (other than termination benefits) that are due to be settled within twelve months after the end of the period in which the employees render the related service. Post-employment benefits are employee benefits (other than termination benefits) which are payable after the completion of employment. Post-employment benefit plans are formal or informal arrangements under which an entity provides post-employment benefits for one or more employees. Defined contribution plans are post-employment benefit plans under which an entity pays fixed contributions into a separate entity (a fund) and will have no legal or constructive obligation to pay further contributions if the fund does not hold sufficient assets to pay all employee benefits relating to employee service in the current and prior periods. Defined benefit plans are post-employment benefit plans other than defined contribution plans. Multi-employer plans are defined contribution plans (other than state plans) or defined benefit plans (other than state plans) that: (a) (b) Pool the assets contributed by various entities that are not under common control Use those assets to provide benefits to employees of more than one entity, on the basis that contribution and benefit levels are determined without regard to the identity of the entity that employs the employees concerned
Other long-term employee benefits are employee benefits (other than post-employment benefits and termination benefits) that are not due to be settled within twelve months after the end of the period in which the employees render the related service. Termination benefits are employee benefits payable as a result of either an: (a) (b) Entity's decision to terminate an employee's employment before the normal retirement date Employee's decision to accept voluntary redundancy in exchange for those benefits
Vested employee benefits are employee benefits that are not conditional on future employment.
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Key terms (cont'd)

The present value of a defined benefit obligation is the present value, without deducting any plan assets, of expected future payments required to settle the obligation resulting from employee service in the current and prior periods. Current service cost is the increase in the present value of the defined benefit obligation resulting from employee service in the current period. Interest cost is the increase during a period in the present value of a defined benefit obligation which arises because the benefits are one period closer to settlement. Plan assets comprise: (a) (b) Assets held by a long-term employee benefit fund Qualifying insurance policies
The return on plan assets is interest, dividends and other revenue derived from the plan assets, together with realised and unrealised gains or losses on the plan assets, less any cost of administering the plan (other than those included in the actuarial assumptions used to measure the defined benefit obligation) and less any tax payable by the plan itself. Actuarial gains and losses comprise: (a) (b) Experience adjustments (the effects of differences between the previous actuarial assumptions and what has actually occurred) The effects of changes in actuarial assumptions
Past service cost is the change in the present value of the defined benefit obligation for employee service in prior periods, resulting in the current period from the introduction of, or changes to, post-employment benefits or other long-term employee benefits. Past service cost may be either positive (when benefits are introduced or changed so that the present value of the defined benefit obligation increases) or negative (when existing benefits are changed so that the present value of the defined benefit obligation decreases). (HKAS 19)
2 Short-term employee benefits

Topic highlights
Short-term employee benefits are those benefits that fall within 12 months from the end of the period in which the employees provide the related services. The cost of the benefits to be paid in exchange for the employee's services should be recognised in the period on an accruals basis.
As mentioned in Section 1.1, short-term employee benefits include:

HKAS 19.10
Monetary benefits such as wages and salaries, annual leave, sick leave, maternity leave, and profit shares and bonuses paid within 12 months. Non-monetary benefits such as medical care, housing and company cars.
2.1 Recognition and measurement

HKAS 19 requires that short-term employee benefits are recognised in the period in which the related service is provided by the employee as:
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Financial Reporting
(a) (b)
a liability (after deducting any amount already paid), and an expense unless another standard (such as HKAS 2 or HKAS 16) requires or permits inclusion in the cost of an asset.
The amount recognised should not be discounted. Where the amount already paid exceeds the undiscounted amount of the benefits, the resulting asset should be recognised as a prepayment to the extent that it will lead to a reduction in future payments or refund. The standard explains how these rules are applied in the case of short-term compensated absences and profit-sharing and bonus plans.
HKAS 19.1113
2.2 Short-term compensated absences

Short-term compensated absences include paid holiday leave, sick leave, maternity or paternity leave and jury service leave. These are classified by the standard as either: accumulating compensated absences, or non-accumulating compensated absences.
Accumulating absences are those that can be carried forward and used in future periods if the current periods entitlement is not used in full; non-accumulating absences are those which cannot be carried forward and lapse if the current year entitlement is not used.

The cost of accumulating absences should be recognised as an expense when the employee provides the service which results in entitlement to such absences. Where there is an unused entitlement at the reporting date, a liability is recognised, based on an estimated amount. The cost of non-accumulating absences should be recognised as an expense when the absences occur.
Example: Sick pay

An entity has 10 employees, each of whom is entitled to 7 days of paid sick leave per annum. Unused sick leave may be carried forward for one year. Carried forward leave must be used before current year leave. At 31 December 20X8, each employee had, on average, two days of leave unused. Based on past experience the entity expects 8 employees to take no more than 7 days of sick leave in the coming year. The remaining 2 employees are expected to take 5 days each. Assuming that each sick day costs the entity $60, how is this reflected in the financial statements for the year ended 31 December 20X8?
Solution
An expense is recognised for the cost of providing the sick leave: 10 employees x 7 days x $60 DEBIT CREDIT Employee expense Liability = $4,200 $ 4,200 $ 4,200
Being sick leave accrued during the year. A liability is also recognised in the statement of financial position to the extent that the unused amount is expected to be carried forward:
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2 employees x 2 days x $60 DEBIT CREDIT
$240 $ 3,960 $ 3,960
Liability ($4,200 240) Employee expense
being unused leave forfeited during the year.
HKAS 19.1720
2.3 Profit-sharing schemes and bonus plans

HKAS 19 requires that an entity recognises the expected cost of profit-sharing and bonus payments only when: the entity has a present legal or constructive obligation to make such payments as a result of past events, and a reliable estimate of the obligation can be made.
In this case an expense and liability should be recognised. Often conditions are attached to bonus payments, for example an employee must still be in the entity's employment when the bonus becomes payable. Therefore an estimate should be made based on the expectation of the level of bonuses that will ultimately be paid. A reliable estimate can only be made when: the formal terms of the plan include a formula to determine the amount of the benefit; the entity determines the amount payable before the financial statements are authorised for issue; or past practice provides clear evidence of the amount of a constructive obligation.
Example: Bonus plan

Lowdown Co has a contractual agreement to pay a total of 5 per cent of its net profit each year as a bonus. The bonus is divided between the employees who are with the entity at its year end. The following data is relevant: Net profit Average employees Employees at start of year Employees at end of year Required How should the expense be recognised? $2,000,000 50 60 40
Solution
An expense should be recognised for the year in which the profits were made and therefore the employees services were provided, for: $2m 5% = $100,000 Each of the 40 employees remaining with the entity at the year end is entitled to $2,500. A liability of $100,000 should be recognised if the bonuses remain unpaid at the year end.
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Financial Reporting
3 Post-employment benefits
Topic highlights
There are two types of retirement benefit plan: Defined contribution plans Defined benefit plans
HKAS 19.2427
3.1 Types of post-employment benefits

Post employment benefits are those benefits provided to employees after they have stopped working. They may include: retirement benefits (pensions), and other benefits such as post-employment life insurance or medical care.
Post-employment benefit schemes are often referred to as 'plans'. Employers (and sometimes employees) make regular contributions to the plan and this money is invested in long-term assets such as stocks and shares. The return on the plan assets, and sometimes the proceeds of the sale of plan assets, is used to pay for the post-employment benefits. There are two types of post-employment benefit plans: defined contribution, and defined benefit.
3.1.1 Defined contribution plans

These plans involve fixed amounts (normally a percentage of an employees salary) being paid into the plan each year. These amounts, or contributions, may be made by the employer and current employees. The level of benefits paid out to former employees is resultant on how the plans investments have performed. In other words there is no guarantee of a fixed amount of benefit.
3.1.2 Defined benefit plans

These plans involve fixed amounts being paid out of the plan to former employees as benefits. The fixed amount is normally calculated as a percentage (based on the number of years service) of final salary. As before, contributions are made by the employer (and possibly current employees) and these are invested. The level of contributions is not, however, fixed. Instead it is set at an amount that is expected to result in sufficient investment returns to meet the obligation to pay the defined postretirement benefits. Where it appears that there are insufficient assets in the fund, the employer will be required to make increased contributions; where it appears that there are surplus assets in the fund, the employer may stop paying contributions for a period (known as a contributions holiday).
HKAS 19.2930
3.2 Multi-employer plans

Multiemployer plans were defined above in Section 1.3. They are retirement benefit plans in which various entities contribute assets to a pool. These pooled assets are then used to provide benefits to employees of the various contributing entities.
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HKAS 19 requires that an entity should classify such a plan as a defined contribution plan or a defined benefit plan, under the terms of the plan (including any constructive obligation that exceeds the formal terms of the plan). If the multi-employer plan is a defined contribution plan, it is accounted for as normal, by recognising the contributions made to the plan as an expense. If, on the other hand, the multi-employer plan is a defined benefit plan, then HKAS 19 requires the entity to account for it as a defined benefit plan. However, it should do so only on a proportional basis. In other words it recognises its proportionate share of the obligation, assets and cost associated with the plan. It should also make all of the normal disclosures for defined benefit plans. However, determining the extent to which an entity participates in a defined benefit multi-employer plan may be problematic. Therefore, it may be difficult to determine reliably the appropriate proportionate share of the relevant data. In this case, where there is insufficient information to determine the relevant amounts to use defined benefit accounting, then the entity should recognise the plan as a defined contribution plan. However, it should also make as many additional disclosure as possible to enable users to understand the nature of the plan. For examples, an entity should disclose that the plan is, in fact, a defined benefit plan and information about any known surplus or deficit.
4 Defined contribution plans

Topic highlights
Contributions to a defined contribution plan are recognised as an expense in the period in which they are payable.
HKAS 19.4445
4.1 Recognition and measurement

Accounting for defined contribution plans is relatively straightforward: 1 Contributions to a defined contribution plan should be recognised as an expense in the period they are payable (except to the extent that labour costs may be included within the cost of assets). Any liability for unpaid contributions that are due as at the end of the period should be recognised as a liability (accrued expense). Any excess contributions paid should be recognised as an asset (prepaid expense), but only to the extent that the prepayment will lead to, for example, a reduction in future payments or a cash refund.
2 3
Where contributions are not payable during the period (or within 12 months of the end of the period) in which the employee provides the services to which they relate, the amount recognised should be discounted, to reflect the time value of money.
Example: Defined contribution plan

Highlife Co agrees to contribute 4 per cent of employees total remuneration into a postemployment plan each period. In the year ended 31 December 20X1, the company paid total salaries of $16 million. A bonus of $4 million based on the income for the period was paid to the employees in March 20X2. The company had paid $760,000 into the plan by 31 December 20X1.
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Financial Reporting
Required Calculate the total expense for post-employment benefits for the year and the accrual which will appear in the statement of financial position at 31 December 20X1.
Solution
Salaries Bonus $ 16,000,000 4,000,000 20,000,000 4% = $800,000 Staff costs expense Cash Accrual $ 800,000 $ 760,000 40,000
DEBIT CREDIT
HKAS 19.46
4.2 Disclosure
HKAS 19 requires that the following is disclosed in respect of defined contribution schemes: (a) (b) A description of the plan The amount recognised as an expense in the period
5 Defined benefit plans

Topic highlights
Defined benefit plans are recognised in the statement of financial position. Changes in the plan are broken down into their constituent parts and recognised in profit or loss or other comprehensive income.
5.1 Introduction to accounting treatment

As we have already discussed, contributions made to defined benefit plans may vary considerably from year to year. The accounting treatment applied to defined contribution plans is therefore not appropriate here, as expensing contributions would result in volatile profits. Instead, HKAS 19 requires a defined benefit plan to be shown in the statement of financial position at the present value of the obligation to pay future benefits (a liability) and the fair value of the plan assets (an asset). Where the liability exceeds the asset, a plan is in deficit and an overall pension liability is recognised; where the asset exceeds the liability, a plan is in surplus and an overall pension asset is recognised. Both the present value of the obligation and the fair value of the plan assets are normally calculated and advised by an actuary. HKAS 19 provides guidance on this. The role of the accountant is therefore to recognise the changes in these amounts from year to year in accordance with HKAS 19. Before we consider this, the following two sections provide information regarding the nature and measurement of the plan obligation and assets.
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HKAS 19.56,64
5.2 Defined benefit plan obligation

The present value of the obligation to pay future benefits is measured using the projected unit credit method, which assumes that each period of service by an employee gives rise to additional units of future benefits. Measurement of the obligation is not required at every period end. However it must be made sufficiently regularly such that reported amounts are not materially different from the actual value at the reporting date. HKAS 19 encourages, but does not require, the use of a qualified actuary.
HKAS 19.72,73,77
5.2.1 Actuarial assumptions

In measuring the obligation, the actuary must make a number of actuarial assumptions, both demographic and financial, for example: What the defined benefits will be (this depends upon factors such as length of service and final salary) When benefits will be paid (this depends upon retirement age) How many employees will draw a pension (this depends upon factors such as mortality rate)
The standard requires actuarial assumptions to be neither too cautious nor too imprudent: they should be unbiased. They should also be based on market expectations at the year end, over the period during which the obligations will be settled.
HKAS 19.78
5.2.2 Discount rate

As the obligation is measured at present value, the actuary is also required to apply an appropriate discount rate. The standard requires that this is determined by reference to market yields at the end of the reporting period on high quality corporate bonds. In the absence of a deep market in such bonds, the yields on comparable government bonds should be used as reference instead. The maturity of the corporate bonds that are used to determine a discount rate should have a term to maturity that is consistent with the expected maturity of the post-employment benefits obligations, although a single weighted average discount rate is sufficient.
HKAS 19.83
5.2.3 Constructive obligation

In determining the extent of the obligation to provide retirement benefits, an entity must assess the commercial substance of its obligation and not just its legal form. In other words an entity must evaluate and account for any constructive obligation it may have with its employees, which exceed the formal terms of the relevant employment contracts. These constructive obligations can arise where the entity has an informal but well-established practice of providing certain benefits to employees. There may be no formal contractual requirement to provide these benefits. However, if the entity has created valid expectations in the minds of its employees such that in practice it would not be able change or cancel those benefits (except with unacceptable damage to its industrial relations or public reputation with their all the concomitant costs), then the entity may have such a constructive obligation.
HKAS 19.BC69
5.3 Defined benefit plan assets

Plan assets are: (a) (b) assets such as stocks and shares, held by a fund that is legally separate from the reporting entity, which exists solely to pay employee benefits. insurance policies, issued by an insurer that is not a related party, the proceeds of which can only be used to pay employee benefits.
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Financial Reporting
Investments which may be used for purposes other than to pay employee benefits are not plan assets. The standard requires that the plan assets are measured at fair value, defined in accordance with HKFRS 13 as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. HKAS 19 includes the following specific requirements: (a) (b) The plan assets should exclude any contributions due from the employer but not yet paid. Plan assets are reduced by any liabilities of the fund that do not relate to employee benefits, such as trade and other payables.
5.3.1 Fair value

The standard provides no guidance on how the fair value of plan assets may be established. The provisions of HKFRS 13 should therefore be applied. These state that an asset is measured according to a hierarchy of inputs. Therefore, where possible, plan assets should be measured by reference to unadjusted quoted prices in active markets for identical assets. Where such prices are not available, other observable inputs for plan assets should be used, such as quoted prices in active markets for similar assets.
5.4 Accounting for a defined benefit plan

Topic highlights
The present value of the plan obligation moves due to: benefits paid out of the plan, the unwinding of the discount, the current service cost and actuarial differences. The fair value of plan assets moves due to: contributions paid into the plan, benefits paid out of the plan, the expected return and actuarial differences. The present value of the plan obligation and the fair value of the plan assets, and therefore the overall plan surplus or deficit is normally advised by an actuary. The movement in the value of the plan from year to year must be accounted for. The overall movement can be broken down into constituent parts, best shown in the following reconciliation: Present value of plan obligation (X) X (X) (X) (X) X/(X) (X) Fair value of plan assets X X (X) X
At start of period Contributions paid into plan Benefits paid out of plan Expected return on plan assets Unwinding of discount Current service cost Actuarial differences (bal fig) At end of period (as advised by actuary)
X X/(X) X
We shall now consider each of these elements of the overall movement in turn.
5.4.1 Contributions paid into plan

An actuary will advise of the level of contributions necessary in a year. Contributions paid into the plan obviously increase the fair value of the plan assets, with the corresponding credit entry charged to cash or other relevant asset.
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5.4.2 Benefits paid out of plan

Benefits paid out of the plan to retired former employees discharge part of the plan obligation and also reduce the plan assets.
HKAS 19.105,106
5.4.3 Expected return on plan assets

The expected return on plan assets is an actuarial assumption. It is a forward looking estimate based on market expectations at the beginning of the period for returns over the life of the pension scheme. The expected return is normally expressed as a percentage which is applied to the fair value of the plan assets outstanding throughout the accounting period. This amount is debited to plan assets and credited to profit or loss, normally to investment income. The difference between this expected return and the actual return on plan assets is an actuarial difference, the accounting for which is explained in Section 5.5.
5.4.4 Unwinding of discount

The defined benefit obligation is measured at present value. Therefore each year, as the liability is one year closer to being settled, the discount must be unwound. The interest cost is calculated by applying the discount rate at the start of the period to the present value of the defined benefit obligation at the start of the period. This increases the obligation with the corresponding debit charged to profit or loss as part of the finance cost.
HKAS 19.61,64
5.4.5 Current service cost

The current service cost is the increase in the present value of the defined benefit obligation resulting from employee service in the current period. This increase arises from the fact that most defined benefit pensions provide an incremental benefit for each year of service. The current service cost is calculated using the projected unit credit method which we mentioned earlier. Consider a situation where a defined benefit plan provides for a benefit of 2.5 per cent of the employee's salary in his/her final year, for each full year of service. The pension is payable from the age of 65. If an employee is expected to earn $10,000 in his final year of employment, then each year of service will result in an extra $250 for each year of retirement (assuming a 40 year working life). If the employee is expected to live for 15 years after retirement, the benefit payable is the discounted value at retirement date of $250 per annum for 15 years. The current service cost is the present value of this discounted amount. The current service cost increases the plan obligation and is charged to operating expenses in profit or loss. Probabilities The effect of probabilities should be accounted for in the calculations. Let's say a benefit of $1,000 is payable to employees for each year of service at the retirement age of 60 on condition that they continue to work for the employer until they retire. Assume also that an employee joins the firm at the age of 40 and continues to work for 20 years. The annual benefit accrued to the employee is $1,000 multiplied by the probability that he/she continues to work for the same employer until the retirement age of 60. Since the benefit is payable as a lump sum on retirement, the current service cost is to be determined by discounting the benefit to its present value as at the year end. Therefore the obligation in this example is equal to the present value of $40,000 (40 years x $1,000) multiplied by the same probability. No extra post-benefit obligations arise after all significant post-employment benefits have vested since the employer has done its part to qualify fully for post-employment benefit. Suppose employees are entitled to $2,000 for each year of service they have worked, up to a maximum of 10 years (the benefit vests after 10 years), the maximum lump sum payment will then be $20,000.
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Financial Reporting
In accounting for this lump sum benefit on retirement, the current service cost in each of the first ten years should be the present value of $2,000 ie an annual benefit of the same amount should be calculated in the ten years of an employee's service. If an employee works for the employer for 25 years before retirement, service cost should be accounted for in each of the first ten years, but none in the 15 years thereafter (other than the interest cost on the obligation).
JSX, a listed entity, has a defined benefits pension scheme. The following information relates to the pension scheme for the year ended 31 October 20X8: $ Current service cost 362,600 Contributions to scheme 550,700 Benefits paid 662,400 Fair value of scheme assets at 1 November 20X7 10,660,000 Fair value of scheme assets at 31 October 20X8 11,204,000 Interest cost in respect of defined benefit obligation 730,600 The expected return on scheme assets for the year ended 31 October 20X8 was 6.2 per cent. Calculate the actuarial gain or loss on JSXs pension scheme assets for the year ended 31 October 20X8. (The answer is at the end of the chapter)
HKAS 19.9294
5.4.6 Actuarial gains or losses

Topic highlights
Actuarial gains and losses arise where the value of the plan obligations or plan assets changes more than was reasonably expected at the beginning of the period. This will occur, for example, due to changes in estimates of mortality rates or employee numbers, or to actual returns and growth in plan assets being greater or less than expected. HKAS 19 permits entities a choice in how to account for these gains and losses. Entities can either recognise them immediately in profit or loss, or, in some cases, recognise them in equity and defer their impact on profit or loss.
Actuarial gains and losses can arise in respect of both the plan obligation and plan assets. If they reduce the plan obligation or increase plan assets, they are actuarial gains. On the other hand, if they reduce plan assets or increase the plan obligation, they are actuarial losses. Actuarial gains or losses may arise for various reasons: Actual events: The calculation of the plan obligation and the current service cost is based on estimates of numbers of employees remaining in the plan during the current year as well as estimates about salary changes during the current year. Where staff leave or salaries are increased by amounts different from those expected, the year end obligation will be different from that previously expected. Actuarial assumptions are revised: The valuation of the plan obligation depends upon a number of what are called actuarial assumptions. These include the discount rate, estimates of staff remaining in the plan until retirement long, projected salaries on retirement, mortality rates and the length of time over which benefits need to be paid. These estimates can be changed as the entity, or its actuaries, reassess the future. Actual returns on plan assets: The valuation of the plan assets includes an estimated rate of return for the current year. At the year end the plan assets may have grown by an amount different from that expected.
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Accounting treatment of actuarial differences Under HKAS 19 there are three options for recognising these actuarial gains and losses: 1 2 3 Recognise them immediately in profit or loss; Recognise them immediately in other comprehensive income; or Recognise them as a deferred gain or loss on the statement of financial position (ie effectively as an asset or liability account) and then release them to the profit or loss on an appropriate or systematic basis.
Option 3 has some complexity to it. HKAS 19 sets out the appropriate or systematic basis which should be used. It requires that the deferred gain or loss on the statement of financial position be released when it exceeds a certain threshold. This threshold is called the 10% corridor. Under this method the amount of deferred gain or loss being assessed is the net cumulative unrecognised actuarial gain or loss at the start of the accounting period. The 10 per cent corridor threshold is defined as the greater of: 10 per cent of the present value of the defined benefit obligation (ie before deducting plan assets) at the start of the accounting period 10 per cent of the fair value of the plan assets at the start of the accounting period.
This calculation should be done on a plan-by-plan basis. Different defined benefit plans should not be aggregated when assessing the above threshold. If the net cumulative unrecognised actuarial gain or loss is less than the 10 per cent corridor, no actuarial gain or loss need be recognised in the period. However if the net cumulative unrecognised actuarial gain or loss exceeds the 10 per cent corridor, part of the excess should be recognised in profit or loss. HKAS 19 does not require all of the excess to be recognised immediately. It allows entities to spread the excess on a straight line basis over the expected average remaining working lives of participating employees. However, HKAS 19 also allows entities to spread the excess gain or loss on any alternative basis, provided that it results in faster recognition of actuarial gains and losses. The same basis must be applied to both gains and losses and applied consistently between periods. Where an entity uses option 3 above and defers actuarial gains and losses, the deferred gains and losses account on the statement of financial position is offset against the plan obligation and plan assets. The total the pension plan at the year end is then measured in the statement of financial position as follows: $ Present value of defined benefit obligations X Unrecognised actuarial gains/losses (X)/X Fair value of plan assets (X) Plan deficit / surplus X/(X)
Example: Actuarial differences

Lord Co introduced a new defined benefit retirement plan on 1 January 20X1 and at its 31 December 20X1 year end there were no unrecognised actuarial gains and losses. At 1 January 20X2: The defined benefit liability was measured at $3million. The fair value of plan assets was measured at $2.6million. Actuarial losses were measured at $350,000; The average remaining working lives of employees within the plan was 20 years.
At 31 December 20X2:
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Financial Reporting
Required How may Lord Co recognise the actuarial gain or loss?
Solution
The entity may recognise the actuarial losses in any of the following ways. 1 2 3 $350,000 in profit or loss for the year ended 31 December 20X2 $350,000 as other comprehensive income for the year ended 31 December 20X2 Nil in profit or loss for the year ended 31 December 20X2 and $2,500 in profit or loss for year ended 31 December 20X3 and each of the following 19 years WORKING: 10% corridor is higher of 10% x $3m = $300,000 10% x $2.6m = $260,000
of net cumulative actuarial loss of $350,000 therefore: 4 $300,000 is unrecognised (deferred) $50,000 is taken to profit or loss, spread over the 20 year average remaining service life of employees
Another systematic method, such as nil in profit or loss for the year ended 31 December 20X2 and $17,500 in profit or loss for each of the following 20 years (the deferral method without the 10 per cent corridor, which results in faster recognition than the corridor method).
Example: Unrecognised actuarial losses

Harrogate Co has adopted an accounting policy which takes advantage of those provisions of HKAS 19 Employee Benefits, which result in the slowest recognition of actuarial gains and losses. The following is relevant at 1 January 20X1: Value of plan assets Value of defined benefit obligations Unrecognised actuarial losses $8,400,000 $9,000,000 $1,120,000 20 years
Expected average remaining working lives of the employees
During the year ending 31 December 20X1 actuarial gains of $165,000 arose and at the year end the expected average remaining working lives of the employees was still 20 years. Required Under HKAS 19 Employee Benefits, what are the unrecognised actuarial losses carried forward at 31 December 20X1?
Solution
$354,000 10% corridor is the higher of 10% $8.4 million = $840,000, or 10% $9 million = $900,000
Net cumulative unrecorded actuarial loss b/f = $1,120,000
350
Therefore $900,000 is within the corridor and so is not recognised $220,000 is recognised over the expected average remaining working lives of the employees of 20 years ie $11,000 per annum $ 1,120,000 (11,000) (165,000) 944,000
Actuarial losses carried forward are: b/f loss Recognised Current year gain
Apptus Co adopts the corridor approach for its defined benefit pension plan according to HKAS 19. It is preparing its financial statements for the year to 31 December 20X1 and provides the following extracts of information. 31 Dec 20X0 $m 510 600 31 Dec 20X1 $m 524 652
Plan assets Plan obligations
The unrecognised actuarial loss at 31 December 20X0 was $120 million. The average service life of employees is 20 years. The following information is provided in respect of Apptuss defined benefit pension plan for the year to 31 December 20X1. $m Current service cost 46 Interest cost 54 Contributions 48 Benefits paid 45 Return on assets 41 Required Determine the charge to profit or loss for Apptus Co for the year to 31 December 20X1 in respect of its defined benefit pension plan. (The answer is at the end of the chapter)
5.5 Further issues

Topic highlights
Past service costs arise when benefits are introduced or improved; they are recognised in profit or loss over the period until they vest. Curtailments and settlements occur when plan benefits are reduced. They are recognised in profit or loss immediately.
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Financial Reporting
Although we have now met the most common items which reconcile the plan surplus or deficit at the start and end of a period, there are two further complications which you must be able to deal with:
HKAS 19.61
past service cost curtailments and settlements
5.5.1 Past service cost

An entity will sometimes introduce a new defined benefits plan or improve an existing plan. An additional obligation is therefore created for which no provision has been made in the financial statements. Past service costs will therefore arise in the current and future periods in order to account for this obligation. The past service cost can be calculated as: Defined benefit obligation immediately after additional benefits introduced Defined benefit obligation immediately before additional benefits introduced Past service cost X (X) X
This amount should be deferred in the statement of financial position and recognised in profit or loss on a straight line basis over the period from the additional benefits being introduced to the date on which the employees become entitled to the additional benefit (the vesting date). If vesting is immediate, the past service cost is recognised in profit or loss immediately.
HKAS 19.109,110
5.5.2 Curtailments and settlements

HKAS 19 deals with two ways in which an entity may terminate its obligations under a defined benefit plan. A curtailment occurs under two scenarios: 1 2 the entity demonstrates its commitment to making a significant reduction in the number of employees in a plan (even to the extent of cancelling the whole plan); or the entity amends the terms of the plan so that, for example, it significantly reduces the benefits to be provided to current employees.
This can occur when an entity discontinues one of its operations or enters into a restructuring plan, or a reduction in the extent to which future salary increases are linked to the benefits payable for past service. A settlement is when an entity extinguishes its existing obligation under a defined benefit plan. This can occur when an entity makes a lump sum payment to plan participants. A curtailment and settlement can happen together. This is when the entity pays out a lump sum and the plan ceases to exist. The curtailment or settlement of a plan can lead to a gain or loss when the plan assets and obligations are derecognised. Any gain or loss in these circumstances should be recognised in full in the financial year that they occur. These gains or losses can include the following: a change in the present value of the future obligations as the obligation is extinguished; a change in the fair value of the plan assets as these assets are paid out; and any actuarial gains/losses and past service cost for this plan that had been deferred on the statement of financial position.
In order to distinguish between the effects of the curtailment or settlement and those of events prior to it, the entity must remeasure the obligation (and the related plan assets, if any) using current actuarial assumptions, before determining the effect of a curtailment or settlement.
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5.6 Summary of accounting treatment

This section summarises the accounting treatment that we have met in Sections 5.4 and 5.5. Opening figures Plan assets Plan obligation Any unrecognised gains and losses As advised by the actuary Pension payments made to retired former employees Based on long term expectations as advised by actuary and plan assets at start of period. Y% x plan assets b/f Based on discount rate and present value of obligation at start of period. DR% x plan obligation b/f Current service cost Past service cost Increase in plan obligation as a result of one extra years service. As advised by actuary Increase in plan obligation as a result of introduction or improvement of benefits. Vested when any minimum employee period has been completed. DEBIT Operating expense (profit or loss) CREDIT Plan obligation Vested: DEBIT Operating expense (profit or loss) CREDIT Plan obligation Unvested: DEBIT Past service cost (asset) CREDIT Plan obligation Actuarial differences Due to revised assumptions and actual events differing from expected events. Recognise: in profit or loss immediately in other comprehensive income immediately DEBIT Plan assets CREDIT Cash / other asset DEBIT Plan obligation CREDIT Plan assets DEBIT Plan assets CREDIT Investment income (profit or loss) DEBIT Finance cost (profit or loss) CREDIT Plan obligation
Contributions Benefits paid Expected return on plan assets
Unwinding of discount
or where falls within 10 per cent corridor, defer.

HKAS 19.54,58,120, 120A
5.7 Disclosure of defined benefit plans

5.7.1 The statement of financial position
In the statement of financial position, the amount recognised as a defined benefit liability (which may be a negative amount, ie an asset) should be calculated as: $ Present value of defined benefit obligation at year end X Unrecognised actuarial gains/losses X/(X) Unrecognised past service costs (X) (X) Fair value of plan assets at year end Plan deficit/surplus X/(X)
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Financial Reporting
If this total is a negative amount, there is a pension asset and this should be shown in the statement of financial position as the lower of (a) and (b) below. (a) (b) The figure as calculated above The total of the present values of: (i) (ii) (iii) any unrecognised actuarial losses and past service costs any refunds expected from the plan any reductions in future contributions to the plan because of the surplus
The determination of a discount rate is covered below.
5.7.2 The statement of comprehensive income

The expense that should be recognised in the statement of comprehensive income (in profit or loss for the year) for post-employment benefits in a defined benefit plan is the total of the following: (a) (b) (c) (d) (e) (f) The current service cost Interest on the unwinding of the discounted obligation The expected return on any plan assets The actuarial gains or losses, to the extent that they are recognised Past service cost to the extent that it is recognised The effect of any curtailments or settlements
A defined benefit plan provides for retirement benefits at the rate of 1 per cent of salary per annum for all employees from the commencement of their employment. On 31 December 20X1, the defined benefit obligation is measured at $18 million. On 1 January 20X2, the rules of the plan are changed to provide for benefit at the rate of 2 per cent of salary for employees with 15 or more years service and the defined benefit obligation on the new basis is $20 million. It is estimated that 60 per cent of the past service cost is attributable to employees with less than 15 years of service, each of whom has, on average, served for nine years. Required How should the past service cost be accounted for? (The answer is at the end of the chapter)
Lewis, a public limited company, has a defined benefit plan for its employees. The present value of the future benefit obligations at 1 January 20X7 was $890m and fair value of the plan assets was $1,000 million. There were unrecognised actuarial gains of $120m at the same date (Lewis' accounting policy is to use the 10 per cent corridor approach to recognition of actuarial gains and losses). Further data concerning the year ended 31 December 20X7 is as follows: Current service cost Benefits paid to former employees Contributions paid to plan Present value of benefit obligations at 31 December Fair value of plan assets at 31 December Interest cost (gross yield on 'blue chip' corporate bonds) Expected return on plan assets $millions 127 150 104 1,100 1,230 10% 12% As valued by professional actuaries
354
Existing employees participating in the plan have an average remaining working life of 10 years at 31 December 20X7. On 1 January 20X7 the plan was amended to provide additional benefits with effect from that date subject to a minimum employment period of eight years. The present value of the additional benefits was calculated by actuaries at $10 million with respect to employees who had already completed the minimum service requirements and $20 million for employees who on average had worked for the company for three years. Required Prepare the required notes to the statement of comprehensive income and statement of financial position for the year ended 31 December 20X7. Assume the contributions and benefits were paid on 31 December 20X7. (The answer is at the end of the chapter)
6 Termination benefits
Topic highlights
Termination benefits are recognised as a liability and expense when an entity is demonstrably committed to them. Termination benefits are those employee benefits payable as a result of either: an entitys decision to terminate an employees employment before the normal retirement date; or an employees decision to accept voluntary redundancy in exchange for those benefits.
These benefits are dealt with separately in HKAS 19 as unlike other benefits, the event which gives rise to an obligation is the termination rather than the service of the employee.
HKAS 19.133
6.1 Recognition
HKAS 19 states that termination benefits should be recognised only when an entity is demonstrably committed to a termination of employment. Where an entity is demonstrably committed, it should recognise a liability and corresponding expense.
HKAS 19.134
6.1.1 Demonstrably committed

The standard states that the existence of a detailed formal plan for the termination of employment is evidence of being demonstrably committed to such a termination. There should be no realistic possibility of the withdrawal of the plan and it should include at least: the location, function and number of employees to be terminated the termination benefits for each job classification or function the time at which the plan will be implemented.
HKAS 19.139-140
6.2 Measurement
Those termination benefits that fall due more than 12 months after the end of the reporting period should be discounted using a rate determined by reference to market yields at the end of the reporting period on high quality corporate bonds. Where an offer is made to encourage voluntary redundancy, termination benefits should be measured based on the number of employees expected to accept the offer. Where there is
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Financial Reporting
uncertainty, a contingent liability should be disclosed in accordance with HKAS 37 Provisions, Contingent Liabilities and Contingent Assets.
The IASB issued amendments to IAS 19 in June 2011 with the aim of significantly improving pension accounting. It is highly likely that HKICPA will adopt these amendments and apply them to HKAS 19 in due course. The amendments: Require recognition of changes in the net defined benefit liability (asset) including: o o o immediate recognition of defined benefit cost disaggregation of defined benefit cost into components recognition of re-measurements in other comprehensive income
Introduce enhanced disclosures about defined benefit plans Modify accounting for termination benefits, including distinguishing benefits provided in exchange for service and benefits provided in exchange for the termination of employment and affect the recognition and measurement of termination benefits.
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Topic recap
HKAS 19 Employee Benefits provides guidance on the accounting treatment to be applied to short-term employment benefits, post-employment benefits (pensions), other long-term employment benefits and termination benefits. Short-term employee benefits are those benefits that fall within 12 months from the end of the period in which the employees provide the related services. The cost of the benefits to be paid in exchange for the employee's services should be recognised in the period on an accruals basis. There are two types of retirement benefit plan: Defined contribution plans Defined benefit plans
Contributions to a defined contribution plan are recognised as an expense in the period in which they are payable. Defined benefit plans are recognised in the statement of financial position. Changes in the plan are broken down into their constituent parts and recognised in profit or loss or other comprehensive income. The present value of the plan obligation moves due to: benefits paid out of the plan, the unwinding of the discount, the current service cost and actuarial differences. The fair value of plan assets moves due to: contributions paid into the plan, benefits paid out of the plan, the expected return and actuarial differences. Actuarial gains and losses arise due to revisions to actuarial assumptions, and actual events differing from expected events. HKAS 19 allows a choice of treatment: actuarial gains and losses can be recognised immediately or, in some cases, deferred. Past service costs arise when benefits are introduced or improved; they are recognised in profit or loss over the period until they vest. Curtailments and settlements occur when plan benefits are reduced. They are recognised in profit or loss immediately. Termination benefits are recognised as a liability and expense when an entity is demonstrably committed to them.
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Financial Reporting
Answer 1
Fair value of plan assets at 1 November 20X7 Expected return on plan assets (6.2% 10,660,000) Contributions Benefits paid Actuarial loss on plan assets (balancing figure) Fair value of plan assets at 31 October 20X8 $ 10,660,000 660,920 550,700 (662,400) (5,220) 11,204,000
Answer 2
Charge to profit or loss Current service cost Interest cost Return on plan assets Amortisation of unrecognised actuarial losses (ie corridor) Working Net pension expense WORKING Corridor approach Unrecognised actuarial loss at 31 Dec 20X0 10% of opening obligation Excess to be amortised Average life is 20 years Amortisation of unrecognised actuarial loss $m 120 60 60 $3m $m 46 54 (41) 3 62
Answer 3
The past service cost measured as the increase in the defined benefit obligation is $2 million. $800,000 (40%) relates to vested benefits for those employees who have already completed 15 or more years of service, so it should be recognised in profit or loss immediately; and $1.2 million (60%) relates to benefits which will, on average, vest in six years time. The annual cost is therefore $200,000.
The employer should recognise $1 million of past service costs in the year ended 31 December 20X2, and $200,000 in each of the following five years.
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Answer 4
Note to the statement of comprehensive income Defined benefit expense recognised in profit or loss Current service cost Interest cost [(890 10%) + (30 10%)] Expected return on plan assets (1,000 12%) Past service cost vested benefits non-vested benefits (20/(8 3 years)) Net actuarial (gains)/losses recognised in the year (Working) Note to the statement of financial position Net defined benefit liability recognised in the statement of financial position Present value of defined benefit obligation Fair value of plan assets Unrecognised actuarial gains/(losses) (Working) Unrecognised past service cost [20 (20/(8 3 years)] Net liability Changes in the present value of the defined benefit obligation Opening defined benefit obligation Interest cost [(890 10%) + (30 10%)] Current service cost Benefits paid Past service cost - vested - non-vested Actuarial (gain)/loss (balancing figure) Closing defined benefit obligation Changes in the fair value of plan assets Opening fair value of plan assets Expected return on plan assets (1,000 12%) Contributions Benefits paid Actuarial gain/(loss) (balancing figure) Closing fair value of plan assets WORKING Recognised/unrecognised gains and losses Corridor limits, higher of: 10% b/d obligation 10% b/d assets Corridor limit Unrecognised gains/(losses) b/d Gain recognised [(120100)/10] Gain/(loss) on obligation in the year Gain/(loss) on assets in the year Unrecognised gains/(losses) c/d $m 89 100 100 120 (2) (111) 156 163 $m 1,100 (1,230) (130) 163 (16) 17 $m 890 92 127 (150) 10 20 111 1,100 $m 1,000 120 104 (150) 156 1,230 $m 127 92 (120) 10 4 (2) 111
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Financial Reporting
Exam practice
Employee benefits
(a) Required
36 minutes
HKAS 19 Employee Benefits allows a choice of methods for the recognition of actuarial gains and losses.
Explain the treatments of actuarial gains and losses currently permitted by HKAS 19. (6 marks) (b) The following information relates to the defined benefit employee compensation scheme of an entity: Present value of obligation at start of 20X8 ($'000) Market value of plan assets at start of 20X8 ($'000) Expected annual return on plan assets Discount rate per year 20X8 $'000 1,250 987 1,000 23,000 21,500 20,000 20,000 10% 8% 20X9 $'000 1,430 1,100 1,100 25,500 22,300
Current service cost Benefits paid out Contributions paid by entity Present value of obligation at end of the year Market value of plan assets at end of the year
Actuarial gains and losses outside the 10 per cent corridor are to be recognised in full in the income statement. Assume that all transactions occur at the end of the year. Required (i) Calculate the present value of the defined benefit plan obligation as at the start and end of 20X8 and 20X9 showing clearly any actuarial gain or loss on the plan obligation for each year. (4 marks) Calculate the market value of the defined benefit plan assets as at the start and end of 20X8 and 20X9 showing clearly any actuarial gain or loss on the plan assets for each year. (4 marks) Applying the 10 per cent corridor show the total charge in respect of this plan in the statement of comprehensive income for 20X8 and the statement of comprehensive income for 20X9. (6 marks) (Total = 20 marks)
(ii)
(iii)
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chapter 17
Borrowing costs
Topic list
1 HKAS 23 Borrowing Costs
Learning focus
Borrowing costs may be considered in the context of non-current assets or may be considered in isolation. HKAS 23 concentrates particularly on the situation where the related borrowings are applied to the construction of certain assets.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.12 3.12.01 3.12.02 3.12.03 3.12.04 3.12.05 3.12.06 Borrowing costs Identify the expenses which constitute borrowing costs in accordance with HKAS 23 Identify the assets which are qualifying assets Determine when the capitalisation of borrowing costs shall commence, be suspended and cease Calculate the amount of borrowing costs to be capitalised from specific borrowing and general borrowing Prepare journal entries for borrowing costs, including expensed and capitalised borrowing costs Disclose relevant information with regard to borrowing costs 3
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17: Borrowing costs | Part C Accounting for business transactions
1 HKAS 23 Borrowing Costs

Topic highlights
HKAS 23 looks at the treatment of borrowing costs, particularly where the related borrowings are applied to the construction of certain assets. These are what are usually called 'self-constructed assets', where an entity builds its own inventory or non-current assets over a substantial period of time.
HKAS 23.5
1.1 Definitions
Only two definitions are given by the standard.
Key terms
Borrowing costs. Interest and other costs incurred by an entity in connection with the borrowing of funds. Qualifying asset. An asset that necessarily takes a substantial period of time to get ready for its intended use or sale. (HKAS 23)
HKAS 23.6
1.1.1 Borrowing costs

The standard lists what may be included in borrowing costs: (a) (b) (c) Interest expense calculated using the effective interest method as described in HKFRS 9 Financial Instruments Finance charges in respect of finance leases recognised in accordance with HKAS 17 Leases (See Chapter 9) Exchange differences arising from foreign currency borrowings to the extent they are regarded as an adjustment to interest costs
HKAS 23.7
1.1.2 Qualifying assets

The standard says that any of the following may be qualifying assets: Inventories Manufacturing plants Power generation facilities Intangible assets Investment properties
Financial assets and inventories manufactured or produced over short periods are not qualifying assets, nor are assets ready for sale or their intended use when purchased.
HKAS 23.8,9
1.2 Recognition
All eligible borrowing costs must be capitalised. Only borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset can be capitalised as part of the cost of that asset. The standard lays out the criteria for determining which borrowing costs are eligible for capitalisation. All other borrowing costs are expensed to profit or loss.
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Financial Reporting
The journal entry to record borrowing costs is therefore: DEBIT CREDIT

HKAS 23.1015
Qualifying asset cost Finance cost Cash / Accrual
Eligible borrowing costs Ineligible borrowing costs Total borrowing costs
1.2.1 Borrowing costs eligible for capitalisation

It is necessary to identify those borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset. These borrowing costs would have been avoided had the expenditure on the qualifying asset not been made. This is straightforward where funds have been borrowed for the financing of one particular asset. Where an entity uses a number of debt instruments to finance a variety of assets, difficulties arise since there is no direct link between particular borrowings and a specific asset. For example, central borrowings are lent to different parts of the group or entity. Judgment is therefore necessary, particularly where more complex situations can arise (eg foreign currency loans). Once the relevant borrowings are identified with a specific asset, the amount of borrowing costs to be capitalised during a period will be the actual borrowing costs incurred on those borrowings, less any investment income on the temporary investment of those borrowings. It is not unusual to invest some or all of the funds before they are actually used to finance the qualifying asset.
On 1 January 20X9 Vitality Co borrowed $1.5 million to finance the production of two assets, both of which were expected to take a year to build. Work started at the beginning of 20X9. Expenditure was as follows, with the remaining funds invested temporarily. Asset A $'000 250 250 Asset B $'000 500 500
1 January 20X9 1 July 20X9 Required
The loan rate was 8 per cent and Vitality Co can invest surplus funds at 5 per cent.
Ignoring compound interest, calculate the borrowing costs which may be capitalised for each of the assets and consequently the cost of each asset as at 31 December 20X9. Show the relevant journal entries with regard to borrowing costs. (The answer is at the end of the chapter)
In a situation where general borrowings are acquired and applied in part to finance a qualifying asset, then the amount of borrowing costs eligible for capitalisation is arrived at by applying the 'capitalisation rate' to the capital expenditure on the asset. The capitalisation rate is computed as the weighted average of the borrowing costs applicable to the entity's outstanding borrowings during the period, excluding specific borrowings made to obtain a qualifying asset. However, the amount of these borrowing costs must not exceed actual borrowing costs incurred. It may be more appropriate to compute a weighted average for borrowing costs for individual parts of the group or entity, though an overall weighted average can be used for a group or entity sometimes.
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Example: Capitalising interest

On 1 March 20X5 Dunedin Co drew down $500,000 from existing general borrowings in order to finance the construction of a new asset. Existing borrowings were as follows: Bank loan Loan notes $2,000,000 $6,000,000 5% annual interest 8% annual interest
Construction of the asset commenced on 1 April 20X8 and was completed on 31 March 20X9. What amount of interest must be capitalised in accordance with HKAS 23?
Solution
The weighted average cost of borrowing is: 5% 2m/(2m + 6m) + 8% 6m/(2m + 6m) = 7.25% Therefore, interest to be capitalised is calculated as: 7.25% $500,000 12/12 = $36,250
Tumble Co had the following loans in place at the beginning and end of 20X8. 1 January 20X8 $m 150 90 31 December 20X8 $m 150 90 200
9% Bank loan repayable 20Y0 8% Bank loan repayable 20Y1 7.5% debenture repayable 20Y2
The 7.5 per cent debenture was issued to fund the construction of a qualifying asset (a piece of mining equipment), construction of which began on 1 July 20X8. On 1 January 20X8, Tumble Co began construction of a qualifying asset, a piece of machinery for a hydro-electric plant, using existing borrowings. Expenditure drawn down for the construction was: $25 million on 1 January 20X8, $30 million on 1 October 20X8. Required Calculate the borrowing costs that can be capitalised for the hydro-electric plant machine. (The answer is at the end of the chapter)
HKAS 23.16
1.2.2 Carrying amount exceeds recoverable amount

As required by other HKFRS, the carrying amount of a qualifying asset must be written down or written off in situations where the carrying amount (or expected ultimate cost) of the asset exceeds its recoverable amount or net realisable value. These written down amounts may be written back in future periods under certain circumstances (again as allowed by other HKFRS).
HKAS 23.1719
1.2.3 Commencement of capitalisation

Three events or transactions must be taking place for capitalisation of borrowing costs to be started: (a) (b) (c) Expenditure on the asset is being incurred Borrowing costs are being incurred Activities are in progress that are necessary to prepare the asset for its intended use or sale
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Expenditure must result in cash payments, transfer of other assets or assumption of interestbearing liabilities. Any progress payments or grants received in connection with the asset will be treated as deductions from expenditure. It is allowed by HKAS 23 to use the average carrying amount of the asset during a period (including capitalised borrowing costs) as a reasonable approximation of the expenditure to which the capitalisation rate is applied in the period. Presumably more exact calculations can be used. Activities necessary to prepare the asset for its intended sale or use encompass not only physical construction work, but also technical and administrative work prior to construction, eg obtaining permits. However, holding an asset when no production or development that changes the asset's condition is taking place, eg where land is held without any associated development activity, is to be excluded.
HKAS 23.2021
1.2.4 Suspension of capitalisation

Capitalisation of borrowing costs should be suspended for any extended periods where active development is interrupted. Any borrowing costs incurred during such periods should be expensed through profit or loss. Capitalisation of borrowing costs is not normally suspended during: a period when substantial technical and administrative work is being carried out a temporary delay occurs which is a necessary part of getting an asset ready for intended use, eg while inventories are maturing
HKAS 23.2225
1.2.5 Cessation of capitalisation

Once all the activities necessary to prepare the qualifying asset for its intended use or sale are substantially complete, the capitalisation of borrowing costs should come to an end. This will normally be the case when the physical construction of the asset is completed, though routine administrative work and minor modifications may still be outstanding. An asset may be completed in parts or stages and each part can be used while construction is still in progress on the other parts. Capitalisation of borrowing costs should be terminated for each part as it is completed. The example quoted in the standard is a business park consisting of several buildings.
Example: Commencement, suspension and cessation of capitalisation

Lam Co borrowed $10 million on 1 January 20X8 in anticipation of commencing work to build a new head office later in the year. The interest rate provided by Lam Cos bank was 8 per cent per annum, and the loan had a term of 5 years. Construction began on 15 February and the property was occupied for use on 20 December 20X8. The following information is relevant: 1 February 15 February 6 May 16 May 30 November 1 December 15 December Expenditure on building materials began to be incurred Building work began Building work was suspended due to tropical storms, common to the region through May and June Building work recommenced Building work is completed and approved by the regulatory authorities Decoration and finishing of the property to Lam Cos specification commences Decoration and finishing work is completed.
What journal entries are required to record the borrowing costs in the year ended 31 December 20X8?
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Solution
Total borrowing costs incurred in the year are $10 million x 8% = $800,000 Capitalisation of borrowing costs commences on 15 February when building work commences and both expenditure and borrowing costs are being incurred. Capitalisation ceases on 30 November when the physical construction of the property is complete. Decoration and finishing qualify as minor modifications not construction. Capitalisation does not cease during the temporary suspension of work for inclement weather in May. Therefore, capitalised costs are: $10 million 8% 288/365 days = $631,233 DEBIT CREDIT Property under construction Finance costs (800,000 631,233) Cash / interest accrual $ 631,233 168,767 $
800,000
HKAS 23.26
1.2.6 Disclosure
The following should be disclosed in the financial statements in relation to borrowing costs: (a) (b) Amount of borrowing costs capitalised during the period. Capitalisation rate used to determine the amount of borrowing costs eligible for capitalisation.
On 1 January 20X8 Allan Lee Co borrowed $20 million to finance the production of two assets, both of which were expected to take a year to build. Production started at the beginning of 20X8. The loan facility was drawn down on 1 January 20X8, and was utilised as follows, with the remaining funds invested temporarily: Asset X Asset Y $m $m 1 January 20X8 4.0 6.0 1 July 20X8 7.0 3.0 The loan rate was 10 per cent and Allan Lee can invest surplus funds at 8 per cent. Required Ignoring compound interest, calculate the borrowing costs which may be capitalised for each of the assets and consequently the cost of each asset as at 31 December 20X8. (The answer is at the end of the chapter)
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Financial Reporting
Autofact, a car manufacturer, prepares its accounts to 30 June each year. On 1 July 20X8, it purchased for $20million a leasehold interest in a site on which it began to construct a factory with an estimated useful life of 30 years. The building cost $7million to construct and the plant and equipment cost $5million. The construction of the factory was complete on 31 March 20X9 and it was brought into use on 1 July 20X9. To finance this project, Autofact borrowed $32million on 1 July 20X8. The rate of interest on the loan was 5% per annum and it was repaid on 31 December 20X9. Required Calculate the total amount to be included at cost in property, plant and equipment in respect of this project at 30 June 20X9.
368
Topic recap
HKAS 23 looks at the treatment of borrowing costs, particularly where the related borrowings are applied to the construction of certain assets. These are what are usually called 'self-constructed assets', where an entity builds its own inventory or non-current assets over a substantial period of time.
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Financial Reporting
Answer 1
Asset A $ Borrowing costs To 31 December 20X9 ($0.5m, $1m) x 8% Less: investment income To 30 June 20X9 ($0.25m, $0.5m) x 5% x 6/12 Cost of assets Expenditure incurred Borrowing costs 40,000 (6,250) 33,750 500,000 33,750 533,750 $ 33,750 67,500 18,750 Asset B $ 80,000 (12,500) 67,500 1,000,000 67,500 1,067,500 $
DEBIT Asset A DEBIT Asset B DEBIT Finance costs (6,250 + 12,500) CREDIT Accrued interest
120,000
Answer 2
150 90 Capitalisation rate = weighted average rate = 9% + 8% = 8.625% 150 + 90 150 + 90 Borrowing costs = ($25m 8.625%) + ($30m 8.625% 3/12) = $2.803m
Answer 3
Asset X $'000 Borrowing costs To 30 June 20X8 To 31 December 20X8 Asset Y $'000
$4.0m/$6.0m 10% /12 6 $11.0m/$9.0m 10% /12 $7.0m/$3.0m 8% 6/12
200 550 750 (280) 470 11,000 470 11,470
300 450 750 (120) 630 9,000 630 9,630
Less: investment income To 30 June 20X8

Cost of assets Expenditure incurred Borrowing costs
370
Answer 4
The total amount to be included in property, plant and equipment at 30 June 20X9 is as follows: Lease Building Plant and equipment Interest capitalised ($32,000 5% 9/12) $000 20,000 7,000 5,000 1,200 33,200
HKAS 23 states that capitalisation of borrowing costs must cease when substantially all the activities necessary to prepare the asset for its intended use or sale are complete. Accordingly, only nine months' interest (1 July 20X8 to 31 March 20X9) can be capitalised.
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Financial Reporting
Exam practice
PPY
9 minutes
PPY is a company incorporated in Hong Kong and is principally engaged in the manufacturing of consumer products. On 1 April 20X7, PPY commenced construction of plant which was expected to take three years to complete. Property, plant and equipment in the course of construction for production, supply or administrative purposes, or for purposes not yet determined, are carried at cost, less any recognised impairment loss. On 1 April 20X8, a two-year term loan of HK$10,000,000 was drawn down to finance the construction costs. The relevant effective interest rate was 9% per annum. On 1 April 20X8 and 20X9, the carrying amount of the plant under construction was HK$10,000,000 and HK$18,000,000 respectively. Construction of the plant was accelerated and it was completed four months earlier than expected, on 30 November 20X9, however, the specific borrowing for the construction of this plant could not be repaid until 31 March 20X0. The relevant borrowing costs for the past years had been correctly capitalised, but the amount for the current year has not yet been capitalised in the financial statements of PPY. Briefly discuss and calculate the amount of borrowing costs that should be capitalised as part of the cost of the plant for the year ended 31 March 20X0.
(5 marks) HKICPA December 2010 (adapted)
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chapter 18
Financial instruments
Topic list
1 2 3 4 5 6 7 8 Financial instruments HKAS 32: Presentation of financial instruments HKFRS 9: Recognition of financial instruments HKFRS 9: Measurement of financial instruments HKFRS 9: Embedded derivatives HKAS 39: Hedging HKFRS 7: Disclosure of financial instruments Current developments
Learning focus
This is a highly controversial and very complex topic. You should concentrate on the essential points. It is also the subject of ongoing change, as over a period of time HKAS 39 is being replaced by HKFRS 9. You need plenty of practice on the topics in this chapter in order to familiarise yourself with this difficult area.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.11 3.11.01 3.11.02 Financial assets, financial liabilities and equity instruments Discuss and apply the criteria for the recognition and de-recognition of a financial asset or financial liability Discuss and apply the rules for the classification of a financial asset, financial liability and equity, and their measurement (including compound instrument) Discuss and apply the treatment of gains and losses arising on financial assets or financial liabilities Discuss the circumstances that give rise to and apply the appropriate treatment for the impairment of financial assets Account for derivative financial instruments and simple embedded derivatives, including the application of own-use exemption Disclose relevant information with regard to financial assets, financial liabilities and equity instruments Hedge accounting Identify fair value hedges, cash flow hedges and hedges for net investment in accordance with HKAS 39 Account for fair value hedges, cash flow hedges and hedges for net investment 2 2
3.11.03 3.11.04 3.11.05 3.11.06 3.17 3.17.01 3.17.02
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18: Financial instruments | Part C Accounting for business transactions
1 Financial instruments
Topic highlights
Accounting guidance on financial instruments is provided in four standards: HKAS 32 Financial Instruments: Presentation HKAS 39 Financial Instruments: Recognition and Measurement HKFRS 7 Financial Instruments: Disclosures HKFRS 9 Financial Instruments
1.1 Background
Financial instruments have, in recent years, become increasingly complex. They vary from straightforward, traditional instruments, such as loan stock or shares through to complex 'derivative instruments'. The emergence of more complex instruments towards the end of the 20th century created a problem in that existing accounting guidance was insufficient. Accounting standards boards worldwide were forced to address this through the development of lengthy and detailed standards. In Hong Kong the relevant standards were: HKAS 32 Financial Instruments: Presentation, issued in 2004, which originally dealt with: the classification of financial instruments between liabilities and equity presentation of certain compound instruments disclosure of financial instruments
HKAS 39 Financial Instruments: Recognition and Measurement, issued in 2006, which dealt with: recognition and derecognition of financial instruments the measurement of financial instruments hedge accounting
Both of these standards have, subsequent to their original issue, been amended numerous times as the topic to which they relate continually evolves. In addition, two new standards have been issued HKFRS 7 Financial Instruments: Disclosures, issued in 2005 replaced the part of HKAS 32 dealing with disclosure. In doing so, it revised, simplified and added to financial instrument disclosure requirements. HKFRS 9 Financial Instruments, originally issued in 2009 replaced certain parts of HKAS 39, in particular with respect to the classification of financial assets. HKFRS 9 was expanded in 2010 to include guidance on the classification and measurement of financial liabilities and the derecognition of financial assets and liabilities. This standard continues to be a work in progress and in due course will be developed further to replace HKAS 39 in its entirety.
This chapter is based on those parts of all four standards extant in April 2011. You should, however, note that HKFRS 9 is not applicable on a mandatory basis until accounting periods commencing on or after 1 January 2013, and therefore you may not see it in practice yet.
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HKAS 32.11, HKFRS 9, Appendix A
1.2 Definitions
A number of definitions are common to all four standards.
Key terms
Financial instrument. Any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial asset. Any asset that is: (a) (b) (c) Cash; An equity instrument of another entity; A contractual right to receive cash or another financial asset from another entity; or to exchange financial instruments with another entity under conditions that are potentially favourable to the entity; or A contract that will or may be settled in the entity's own equity instruments and is a: (i) (ii) Non-derivative for which the entity is or may be obliged to receive a variable number of the entity's own equity instruments Derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments
(d)
Financial liability. Any liability that is a: (a) Contractual obligation to: (i) (ii) (b) Deliver cash or another financial asset to another entity Exchange financial instruments with another entity under conditions that are potentially unfavourable
Contract that will or may be settled in the entity's own equity instruments and is a: (i) (ii) Non-derivative for which the entity is or may be obliged to deliver a variable number of the entity's own equity instruments Derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments
Equity instrument. Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Derivative. A financial instrument or other contract with all three of the following characteristics: (a) Its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable (sometimes called the 'underlying') It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors It is settled at a future date (HKAS 32 and HKFRS 9)
(b)
(c)
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Some of the terms used within the definitions themselves need defining: (a)
HKAS 32.1314
A 'contract' need not be in writing, but it must comprise an agreement that has 'clear economic consequences' and which the parties to it cannot avoid, usually because the agreement is enforceable in law. An 'entity' here could be an individual, partnership, incorporated body or government agency.
(b)
HKAS 32.AG4, AG8, AG11-12, AG20-21
1.2.1 Financial assets and liabilities

The definitions of financial assets and financial liabilities may seem complicated, but the essential point is that while there may be a chain of contractual rights and obligations, it will lead ultimately to the receipt or payment of cash or the acquisition or issue of an equity instrument. Examples of financial assets and liabilities may include: Financial assets Trade receivables An investment in shares A loan made to another party Financial liabilities Trade payables Loans payable Redeemable preference shares
HKAS 32 makes it clear that the following items are not financial assets or liabilities: Physical assets, eg inventories, property, plant and equipment, leased assets and intangible assets (patents, trademarks etc) Prepaid expenses, deferred revenue and most warranty obligations Liabilities or assets that are not contractual in nature Contractual rights/obligations that do not involve transfer of a financial asset, eg commodity futures contracts, operating leases
Why do you think that physical assets and prepaid expenses do not qualify as financial instruments? (The answer is at the end of the chapter) Contingent rights and obligations meet the definition of financial assets and financial liabilities respectively, even though many do not qualify for recognition in financial statements. This is because the contractual rights or obligations exist because of a past transaction or event (eg assumption of a guarantee).
HKAS 32.AG15
1.2.2 Primary and derivative instruments

The examples of financial assets and liabilities given in the previous section may be referred to as 'primary instruments'. You should also be aware of derivative financial instruments. A derivative is a financial instrument that derives its value from the price or rate of an underlying item. Common examples of derivatives include the following: Forward contracts which are agreements to buy or sell an asset at a fixed price at a fixed future date. Futures contracts, which are similar to forward contracts except that contracts are standardised and traded on an exchange. Options, which are rights (but not obligations) for the option holder to exercise at a predetermined price; the option writer loses out if the option is exercised.
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Financial Reporting
Swaps, which are agreements to swap one set of cash flows for another (normally interest rate or currency swaps).
A simple example of a forward contract may help you to understand how it derives its value from an underlying item. Say a forward contract exists to sell an asset for $8 on a given date. At today's date the market price of the asset is $5 and therefore it would be fair to say that the contract is worth $3. This value cannot, however, be established without reference to the price of the underlying item, being the market price of the asset. If the underlying item is volatile, then the settlement of the derivative can lead to a very different result from the one originally envisaged. Derivatives usually have no, or very little, initial cost. Therefore before the development of HKAS 32 and HKAS 39, they may not have been recognised in the financial statements at all, or recognised at a value bearing no relation to the current value. This is obviously misleading and leaves users of the accounts unaware of the uncertainty and risk to which a company holding derivatives is exposed. Part of the reason why HKAS 32 and HKAS 39 were developed was in order to correct this situation.
2 HKAS 32: Presentation of Financial Instruments

HKAS 32.2
2.1 Objective
The objective of HKAS 32 is: To establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and financial liabilities. It applies to the classification of financial instruments, from the perspective of the issuer, into financial assets, financial liabilities and equity instruments; the classification of related interest, dividends, losses and gains; and the circumstances in which financial assets and financial liabilities should be offset. (HKAS 32)
HKAS 32.4
2.2 Scope
HKAS 32 should be applied in the presentation of all types of financial instruments, whether recognised or unrecognised. Certain items are excluded: (a) (b) (c) (d) Interests in subsidiaries, associates and joint ventures, unless these are accounted for using HKFRS 9 as allowed by HKAS 27, HKAS 28 and HKAS 31 Employers' rights and obligations under employee benefit plans (HKAS 19: Chapter 16) Insurance contracts Financial instruments, contracts and obligations under share-based payment transactions (HKFRS 2: Chapter 13)
2.3 Classification of financial instruments as financial assets, financial liabilities and equity
Topic highlights
Financial instruments are classified as financial assets, financial liabilities or equity. Financial instruments issued to raise capital must be classified as liabilities or equity. The critical feature of a financial liability is the contractual obligation to deliver cash or another financial instrument.
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HKAS 32 requires that the issuer of a financial instrument classifies it, or its component parts, as a financial asset, financial liability or equity based on: The substance of the contractual arrangement on initial recognition The definitions in the Key terms provided in Section 1.2 above
The classification of the financial instrument is made when it is first recognised and this classification will continue until the financial instrument is removed from the entity's statement of financial position.
HKAS 32.16
2.3.1 Distinguishing financial liabilities and equity

Distinguishing a financial liability from equity may not be straightforward and therefore HKAS 32 provides additional guidance. The underlying principle is that of substance over form. Although substance and legal form are often consistent with each other, this is not always the case. An instrument is an equity instrument only if there is no contractual obligation to deliver cash or another financial asset to another entity or to exchange another financial instrument with the holder under potentially unfavourable conditions to the issuer. Therefore, for example, a redeemable preference share is classified as a liability, rather than equity, as there is an obligation to deliver cash at the redemption date. On the other hand, ordinary shares are classified as equity as, although the holder of an equity instrument may be entitled to a pro rata share of any distributions out of equity, the issuer does not have a contractual obligation to make such a distribution. A financial liability exists regardless of the way in which the contractual obligation to deliver cash or a financial asset will be settled. The issuer's ability to satisfy an obligation may be restricted, eg by lack of access to foreign currency, but this is irrelevant as it does not remove the issuer's obligation or the holder's right under the instrument.
During the financial year ended 31 December 20X5, Kim issued the financial instrument described below. Identify whether it should be classified as liability or equity, explaining in not more than 40 words the reason for your choice. You should refer to the relevant Hong Kong Accounting Standards. Redeemable preference shares with a coupon rate 5 per cent. The shares are redeemable on 31 December 20X9 at premium of 20 per cent. (The answer is at the end of the chapter)
2.4 Specific classification rules

As well as providing the general classification rules explained in the section above, HKAS 32 also provides guidance on the classification of specific instruments and instruments with specific characteristics. They are: puttable financial instruments and obligations arising on liquidation financial instruments with contingent settlement provisions financial instruments with settlement options compound instruments rights issues
The remainder of this section deals with each in turn.

HKAS 32.16A-B,E
2.4.1 Puttable financial instruments and obligations arising on liquidation

HKAS 32 was amended in 2008 to introduce criteria for certain puttable instruments and obligations arising on liquidation to be classified as equity. Prior to these amendments, these instruments would have been classified as financial liabilities.
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Financial Reporting
Puttable financial instruments A puttable financial instrument is an instrument where the holder can 'put' the instrument ie require the issuer to redeem it in cash. For example, some ordinary shares are puttable, and prior to the revision to HKAS 32, these were classified as liabilities. They are now classified as equity, but only if: (a) (b) (c) (d) the holder is entitled to a pro-rata share of the entity's net assets on liquidation. the instrument is in the class of instruments that is the most subordinate and all instruments in that class have identical features. the instrument has no other characteristics that would meet the definition of a financial liability. the total expected cash flows attributable to the instrument over its life are based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognised net assets of the entity (excluding any effects of the instrument itself). Profit or loss or change in recognised net assets for this purpose is as measured in accordance with relevant HKFRSs.
In addition to the criteria set out above, the entity must have no other instrument that has terms equivalent to (d) above and that has the effect of substantially restricting or fixing the residual return to the holders of the puttable financial instruments. Where the specified criteria are no longer met, or when they are subsequently met, the instrument should be reclassified. If the instrument presented as equity is reclassified as a financial liability, it will be measured at fair value at the date of reclassification with any difference between the fair value and the carrying amount to be recognised in equity. When the inverse applies, the financial liability will be reclassified to equity at its carrying amount at the date of reclassification.
HKAS 32.16C
Obligations arising on liquidation As a result of the amendment mentioned above, instruments imposing an obligation on an entity to deliver to another party a pro-rata share of the net assets on liquidation should be classified as equity. The following examples illustrate the types of instruments impacted by the new requirements: Classification under HKAS 32 before amendment Liability Classification under amended HKAS 32 Equity
Issued financial instrument Share puttable throughout its life at fair value, that is also the most subordinate, does not contain any other obligation, with discretionary dividends based on profits of the issuer Share puttable at fair value, that is not the most subordinate Share puttable at fair value only on liquidation, that is also the most subordinate, but contains a fixed non-discretionary dividend Share puttable at fair value only on liquidation, that is also the most subordinate, but contains a fixed discretionary dividend and does not contain any other obligation Any of the instruments described above issued by a subsidiary held by non-controlling parties, in the consolidated financial statements
Liability Liability
Liability Compound (part equity, part liability) Equity
Liability
Liability
Liability
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Even though the amendments permit certain instruments that were previously presented as financial liabilities to now be presented as equity, derivatives over such equity instruments may not be presented as equity. Puttable instruments and instruments puttable only on liquidation that are classified as equity in the separate or individual financial statements of the issuing entity and represent non-controlling interests should be classified as financial liabilities in the consolidated financial statements of the group.
HKAS 32.25
2.4.2 Financial instruments with contingent settlement provisions

The settlement of some financial instruments depends on events which are beyond the control of both the holder and issuer of the instrument: (a) (b) The occurrence or non-occurrence of uncertain future events The outcome of uncertain circumstances
For example, an entity might have to deliver cash instead of issuing equity shares. In this situation it is not immediately clear whether the entity has an equity instrument or a financial liability. Such financial instruments should be classified as financial liabilities unless the possibility of settlement is remote.
HKAS 32.26
2.4.3 Financial instruments with settlement options

When a derivative financial instrument gives one party a choice over how it is settled (eg, the issuer can choose whether to settle in cash or by issuing shares) the instrument is a financial asset or a financial liability unless all the alternative choices would result in it being an equity instrument.
HKAS 32.28,29,32
2.4.4 Compound financial instruments

Topic highlights
Compound instruments are split into equity and liability parts and presented accordingly in the statement of financial position.
Where a financial instrument contains both a liability and an equity element, HKAS 32 requires that these component parts are classified separately according to the substance of the contractual arrangement and the definitions of a financial liability and an equity instrument. A common type of compound instrument is convertible debt. On the issue of such debt, the holder is granted an option to convert it into an equity instrument (usually ordinary shares) of the issuer rather than redeem it. This is the economic equivalent of the issue of conventional debt plus a warrant to acquire shares in the future. In this case the instrument is presented as part liability, part equity, and the usual way to calculate the split is to: (a) (b) calculate the value for the liability component based on similar instruments with no conversions rights, and deduct this from the instrument as a whole to leave a residual value for the equity component.
The reasoning behind this approach is that an entity's equity is its residual interest in its assets amount after deducting all its liabilities. The sum of the carrying amounts assigned to liability and equity will always be equal to the carrying amount that would be ascribed to the instrument as a whole. The following example should make this split clearer:
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Financial Reporting
Example: Valuation of compound instruments

Strauss Co issues 1,000 convertible bonds at the start of 20X0. The bonds have a three-year term, and are issued at par with a face value of $2,500 per bond, giving total proceeds of $2,500,000. Interest is payable annually in arrears at a nominal annual interest rate of 5 per cent. Each bond is convertible at any time up to maturity into 300 common shares. When the bonds are issued, the prevailing market interest rate for similar debt without conversion options is 8 per cent. At the issue date, the market price of one common share is $2. The dividends expected over the three-year term of the bonds amount to 11 cents per share at the end of each year. The risk-free annual interest rate for a three-year term is 4 per cent. Required What is the value of the equity component in the bond issue?
Solution
The liability component is valued first, and the difference between the proceeds of the bond issue and the fair value of the liability is assigned to the equity component. The present value of the liability component is calculated using a discount rate of 8 per cent, the market interest rate for similar bonds having no conversion rights, as shown. $ Present value of the principal: $2,500,000 payable at the end of three years 1,985,000 ($2.5m 0.794)* Present value of the interest: $125,000 payable annually in arrears for three 322,125 years ($125,000 2.577)* Total liability component 2,307,125 Equity component (balancing figure) 192,875 Proceeds of the bond issue 2,500,000 * These figures can be obtained from discount and annuity tables. The split between the liability and equity components remains the same throughout the term of the instrument, even if there are changes in the likelihood of the option being exercised. This is because it is not always possible to predict how a holder will behave. The issuer continues to have an obligation to make future payments until conversion, maturity of the instrument or some other relevant transaction takes place.
On 1 January 20X1, an entity issued 100,000 6 per cent convertible bonds at their par value of $20 each. The bonds will be redeemed on 1 January 20X6. Each bond is convertible at the option of the holder at any time during the five-year period. Interest on the bond will be paid annually in arrears. The prevailing market interest rate for similar debt without conversion options at the date of issue was 8 per cent. Required At what value should the equity element of the hybrid financial instrument be recognised in the financial statements of the entity at the date of issue? (The answer is at the end of the chapter)
Convertible debt instruments where conversion is at the option of the issuing entity are not compound instruments and do not require the split-accounting approach described above. Instead, such instruments are accounted for as a liability in their entirety.
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HKAS 32.16
2.4.5 Rights issues

A 2009 amendment to HKAS 32 (effective for periods starting on or after 1 February 2010) requires that rights, options or warrants to acquire a fixed number of the entity's own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. This is a very narrow amendment and does not extend to other instruments that grant the holder the right to purchase the entity's own equity instruments such as the conversion feature in convertible bonds.
Example: Rights issue

Background On 1 December 20X2, ABC offered all of its existing shareholders rights to acquire one new common share for every 3 common shares held at a price of $15 per share. ABC's functional currency is Y, and ABC has only one class of shares outstanding. There were a total of 3,000 rights offered and they initially traded at $2 each. The rights were subject to expiry on 31 December 20X2 and were fully subscribed on that date. On 31 December 20X2, the common share price was $18 per share and the closing fair value of the rights was $3 per share (ie $18 $15). Exchange rate: Y/$ = 1.5/1 Accounting treatment prior to amendment The rights offered in $ would have been accounted for as derivative liabilities. On 1 December 20X2, a liability of Y4,000 ($2 3,000 1.5) would have been recognised with a corresponding debit to equity, representing the distribution of the rights to common shareholders. Subsequently, the liability would have been re-measured at fair value, increasing to $6,000 (3,000 $3 1.5), and a loss of Y2,000 (Y6,000 Y4,000) would have been recognised in profit or loss. On exercise of the rights, the cash proceeds of Y30,000 ($15 3,000 1.5) and the closing fair value of the rights of Y6,000 would have been credited to equity. Accounting treatment after the amendment The rights offered in $ would be classified as equity. Hence, no liability or gain or loss would be recognised in respect of the rights. On exercise of the rights, the cash proceeds of $30,000 would be credited to equity. Journal entries for accounting treatment prior to amendment Y 1 December 20X2 DEBIT Equity (statement of changes in equity) CREDIT Derivative liability being the issue of rights 31 December 20X2 DEBIT Profit or loss CREDIT Derivative liability being the remeasurement of the liability to fair value 31 December 20X2 DEBIT Derivative liability Cash CREDIT Equity being the exercise of rights in full 4,000 4,000 Y
2,000 2,000
6,000 30,000 36,000
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Journal entries for accounting treatment after the amendment Y 31 December 20X2 DEBIT Cash CREDIT Equity being the exercise of rights in full 30,000 30,000 Y
HKAS 32.42
2.5 Offsetting a financial asset and a financial liability

Financial assets and liabilities are normally presented separately in the statement of financial position. A financial asset and financial liability should only be offset, with the net amount reported in the statement of financial position, when an entity: (a) (b) has a legally enforceable right of set off intends to settle on a net basis, or to realise the asset and settle the liability simultaneously, ie at the same moment
This will reflect the expected future cash flows of the entity in these specific circumstances. In all other cases, financial assets and financial liabilities are presented separately.
HKAS 32.35
2.6 Interest, dividends, losses and gains

Topic highlights
Interest, dividends, losses and gains are treated according to whether they relate to an equity instrument or a financial liability.
The HKAS 32 guidance considered so far all relates to the classification of financial instruments for presentation in the statement of financial position. The standard also considers how financial instruments are presented in the statement of comprehensive income and statement of changes in equity: Financial liabilities Interest, dividends, gains and losses are recognised in profit or loss. Equity instruments Dividends are recognised directly in equity (and so disclosed in the statement of changes in equity). Transaction costs are a deduction from equity. You should look at the requirements of HKAS 1 Presentation of Financial Statements for further details of disclosure, and HKAS 12 Income Taxes for disclosure of tax effects.
2.7 Section summary

Financial instruments issued to raise capital must be classified as liabilities or equity. The substance of the financial instrument is more important than its legal form. The critical feature of a financial liability is the contractual obligation to deliver cash or another financial instrument.
384
Compound instruments are split into equity and liability parts and presented accordingly. Interest, dividends, losses and gains are treated according to whether they relate to an equity instrument or a financial liability.
3 HKFRS 9: Recognition of financial instruments

Topic highlights
HKFRS 9 applies to the recognition of financial assets and liabilities.
The guidance on recognition of financial instruments now comes from HKFRS 9.
3.1 Scope
All entities are required to apply HKFRS 9 to all types of financial instruments with the exception of the following: (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) Investments in subsidiaries, associates, and joint ventures that are accounted for under HKASs 27, 28 and 31. Leases covered in HKAS 17. Employee benefit plans covered in HKAS 19. Insurance contracts. Equity instruments issued by the entity eg ordinary shares issued, or options and warrants. Financial guarantee contracts. Contracts for contingent consideration in a business combination, covered in HKFRS 3. Contracts requiring payment based on climatic, geological or other physical variables. Loan commitments that cannot be settled net in cash or another financial instrument. Financial instruments, contracts and obligations under share based payment transactions, covered in HKFRS 2.
HKFRS 9, 3.1.1
3.2 Initial recognition

Topic highlights
Financial instruments are recognised when the entity becomes a party to the contractual provisions of the instrument. Financial assets are classified as measured at amortised cost or fair value. Financial liabilities are classified at fair value through profit or loss or amortised cost.
HKFRS 9 requires that financial instruments are recognised in the statement of financial position when the entity becomes a party to the contractual provisions of the instrument. Notice that this is different from the recognition criteria in the Framework and in most other standards. Items are normally recognised when there is a probable inflow or outflow of resources and the item has a cost or value that can be measured reliably.
385
Financial Reporting
HKFRS 9, 4.1.1-4.1.2
3.2.1 Classification of financial assets

On recognition, HKFRS 9 requires that financial assets are classified as measured at either: amortised cost, or fair value
This classification is made on the basis of both: (a) (b) (a) (b) the entity's business model for managing the financial assets, and the contractual cash flow characteristics of the financial asset. the objective of the business model within which the asset is held is to hold assets in order to collect contractual cash flows and the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal outstanding.
A financial asset is classified as measured at amortised cost where:
An application of these rules means that equity investments may not be classified as measured at amortised cost and must be measured at fair value. This is because contractual cash flows on specified dates are not a characteristic of equity instruments. In addition, all derivatives are measured at fair value. A debt instrument may be classified as measured at either amortised cost or fair value depending on whether it meets the criteria above. Even where the criteria are met at initial recognition, a debt instrument may be classified as measured at fair value through profit or loss if doing so eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an 'accounting mismatch') that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases. Note that the HKFRS 9 requirement to classify financial assets on recognition as one of two types is a significant simplification of the previous HKAS 39 rules. These required financial assets to be classified as one of four types, being:
HKFRS 9, 4.2.1
at fair value through profit or loss held to maturity available for sale, and loans and receivables
3.2.2 Classification of financial liabilities

On initial recognition, HKFRS 9 requires that financial liabilities are classified as either: (a) (b) (a) (b) at fair value through profit or loss, or financial liabilities at amortised cost it is held for trading, or upon initial recognition it is designated at fair value through profit or loss.
A financial liability is classified at fair value through profit or loss if:
Derivatives are always measured at fair value through profit or loss. These classification rules are unchanged from those previously contained within HKAS 39.
HKFRS 9, 4.4.1-4.4.2
3.3 Reclassification of financial instruments

Topic highlights
Financial assets may be reclassified from one category to another in certain circumstances.
386
Although on initial recognition financial assets must be classified in accordance with the requirements of HKFRS 9, in some cases they may be subsequently reclassified. When an entity changes its business model for managing financial assets, it should reclassify all affected financial assets. This reclassification applies only to debt instruments, as equity instruments must be classified as measured at fair value. HKFRS 9 prohibits the reclassification of financial liabilities.
HKFRS 9, 3.2.3-3.2.6
3.4 Derecognition
Topic highlights
Financial assets should be derecognised when the rights to the cash flows from the asset expire or where substantially all the risks and rewards of ownership are transferred to another party. Financial liabilities should be de-recognised when they are extinguished.
HKFRS 9 now provides the rules with regard to derecognition. Derecognition refers to the removal of a previously recognised financial instrument from an entity's statement of financial position.
3.4.1 Derecognition of financial assets

A financial asset should be derecognised by an entity when: (a) (b) the contractual rights to the cash flows from the financial asset expire, or the entity transfers substantially all the risks and rewards of ownership of the financial asset to another party
HKFRS 9 includes the following examples of the transfer of substantially all risks and rewards of ownership: An unconditional sale of a financial asset A sale of a financial asset together with an option to repurchase the financial asset at its fair value at the time of repurchase
The standard also provides examples of situations where the risks and rewards of ownership have not been transferred: A sale and repurchase transaction where the repurchase price is a fixed price or the sale price plus a lender's return A sale of a financial asset together with a total return swap that transfers the market risk exposure back to the entity A sale of short-term receivables in which the entity guarantees to compensate the transferee for credit losses that are likely to occur.
3.4.2 Derecognition of financial liabilities

A financial liability is derecognised when it is extinguished ie when the obligation specified in the contract is discharged or cancelled or expires. Where an existing borrower and lender of debt instruments exchange one financial instrument for another with substantially different terms, this is accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. Similarly, a substantial modification of the terms of an existing financial liability or a part of it should be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. For this purpose, a modification is substantial where the discounted present value of cash flows under the new terms, discounted using the original effective interest rate, is at least 10 per cent different from the discounted present value of the cash flows of the original financial liability. 387
Financial Reporting
The difference between the carrying amount of a financial liability (or part of a financial liability) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, shall be recognised in profit or loss.
Example: Derecognition
A number of years ago Beijing Company issued loan stock with the following terms: Interest to be paid annually in arrears at a rate of 5.5 per cent Loan to be repaid on 31 December 20X7
Taking into account the transaction costs, the effective interest rate was 6 per cent. Beijing had paid all interest and capital due up to 31 December 20X1, and at that date the carrying amount of the loan was $10million. During 20X1, the worldwide economic recession caused Beijing to suffer financial difficulties, and an agreement to revise the terms of the loan stock from 20X2 onwards was reached with lenders. The revised terms included an extension to the term of the loan and an increase to the coupon rate. The effective interest rate of the revised terms, excluding transaction costs was 8 per cent per annum. The present value of the cash flows, excluding transaction costs, under the revised terms was $10.5million at 6 per cent and $9.5million at 8 per cent. Transaction costs of $700,000 were payable on 1 January 20X2 in respect of the negotiations for the revised terms. How should the revision to the terms of the loan be treated in Beijings financial statements? Solution The revised terms negotiated by Beijing are such that the original loan should be derecognised and a new financial liability recognised. Derecognition of the old loan and recognition of the new liability is required if the present value of the cash flows under the new terms is 10 per cent or more different from the present value of the original loan. The cash flows under the new terms must be discounted at the 6 per cent effective interest rate of the original loan and include the $700,000 transaction costs.
HKFRS 9. B3.3.6
With transaction costs payable at the start of the period of the revised terms, they are added on in full to the $10.5m present value, giving a total of $11.2m. This is 12 per cent different from the $10.0m present value of the old loan, so the original loan should be derecognised and the new financial liability recognised.
Discuss whether the following financial instruments would be derecognised. (a) (b) (c) ABC sells an investment in shares, but retains a call option to repurchase those shares at any time at a price equal to their current market value at the date of repurchase. DEF enters into a stocklending agreement where an investment is lent to a third party for a fixed period of time for a fee. XYZ sells title to some of its receivables to a debt factor for an immediate cash payment of 90 per cent of their value. The terms of the agreement are that XYZ has to compensate the factor for any amounts not recovered by the factor after six months. (The answer is at the end of the chapter)
388
A financial liability which is extinguished ie, when the obligation specified in the contract is discharged or cancelled or expires, should be derecognised by an entity.
HKFRS 9, 3.2.2
3.4.3 Partial derecognition

Partial derecognition of a financial asset or liability is possible on condition that the derecognised part comprises only: (a) (b) identifiable cash flows a share of the total cash flows on a fully proportionate (pro rata) basis
For example, a holder of bonds has the right to two separate sets of cash inflows: those relating to the principal and those relating to the interest. It could retain the right to receive the principal and sell the right to receive interest to another party. Where only part of a financial asset is derecognised, the carrying amount of the asset should be allocated between the part retained and the part transferred based on their relative fair values on the date of transfer. A gain or loss should be recognised based on the proceeds for the portion transferred. On derecognition, the amount to be included in net profit or loss for the period is calculated as follows: $ $ Carrying amount of asset/liability (or the portion of asset/liability) transferred X Less: proceeds received/paid X any cumulative gain or loss reported as other comprehensive income X (X) Profit or loss X
3.5 Section summary

HKFRS 9 applies to the recognition of financial assets and liabilities. Financial instruments are recognised when the entity becomes a party to the contractual provisions of the instrument. Financial assets are classified as measured at amortised cost or fair value; financial liabilities are classified at fair value through profit or loss or amortised cost. Financial assets may be reclassified from one category to another in certain circumstances. Financial liabilities may not be reclassified. Financial assets should be derecognised when the rights to the cash flows from the asset expire or where substantially all the risks and rewards of ownership are transferred to another party. Financial liabilities should be derecognised when they are extinguished.
4 HKFRS 9: Measurement of financial instruments

Topic highlights
Financial instruments are initially measured at fair value. Transaction costs increase this amount for financial assets classified as measured at amortised cost and decrease this amount for financial liabilities classified as measured at amortised cost.
The classification of financial assets and financial liabilities is of particular importance in terms of how they are measured throughout their life.
389
Financial Reporting
HKFRS 9, 5.1.1, 5.1.2A

Financial assets HKFRS 9 requires that financial assets are initially measured at the transaction price, ie the fair value of consideration given, except where part of the consideration given is for something other than the financial asset. In this case the financial asset is initially measured at fair value evidenced by a quoted price in an active market for an identical asset (ie an HKFRS 13 level 1 input) or based on a valuation technique that uses only data from observable markets. The difference between the fair value at initial recognition and the transaction price is recognised as a gain or loss. In the case of financial assets classified as measured at amortised cost, transaction costs directly attributable to the acquisition of the financial asset increase this amount. Financial liabilities HKFRS 9 requires that financial liabilities are initially measured at transaction price, ie the fair value of consideration received except where part of the consideration received is for something other than the financial liability. In this case the financial liability is initially measured at fair value determined as for financial assets (see above). Transaction costs are deducted from this amount for financial liabilities classified as measured at amortised cost.
HKFRS 9, 5.2.1
4.2 Subsequent measurement of financial assets

Topic highlights
Financial assets are subsequently measured at: fair value with changes in value normally recognised in profit or loss, or amortised cost with interest recognised in profit or loss.
As the classifications suggest, financial assets are measured, subsequent to initial recognition at:
HKFRS 13.76,81,86
fair value, or amortised cost.
4.2.1 Financial assets measured at fair value

Where a financial asset is classified as measured at fair value, fair value is established at each period end in accordance with HKFRS 13 Fair Value Measurement. That standard requires that a fair value hierarchy is applied with three levels of input: Level 1 inputs Level 2 inputs unadjusted quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. These may include quoted prices for similar assets or liabilities in active markets or quoted prices for identical or similar assets and liabilities in markets that are not active. unobservable inputs for the asset or liability.
Level 3 inputs
Any changes in fair value are normally recognised in profit or loss. There is an exception to this rule where the financial asset is an investment in an equity instrument not held for trading. In this case the entity can make an irrevocable election to recognise changes in the fair value in other comprehensive income.
390
Example: Asset measurement

On 6 November 20X3 Stripe Co acquires a listed equity investment with the intention of holding it in the long term. The investment cost $500,000. At Stripe Co's year end of 31 December 20X3, the market price of an identical investment is $520,000. How is the asset initially and subsequently measured? Stripe Co has elected to present the equity investment in other comprehensive income.
Solution
The asset is initially recognised at the fair value of the consideration, being $500,000 At the period end it is remeasured to $520,000 This results in the recognition of $20,000 in other comprehensive income.
HKAS 39.9
4.2.2 Financial assets measured at amortised cost

HKFRS 9 does not itself define amortised cost, however it does refer to the definition of this and other relevant terms within HKAS 32 and HKAS 39. The example which follows the definitions will help you to understand their application.
Key terms
Amortised cost of a financial asset or financial liability is the amount at which the financial asset or liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectability. The effective interest method is a method of calculating the amortised cost of a financial instrument and of allocating the interest income or interest expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount of the financial asset or liability. (HKAS 39)
Example: Financial asset measured at amortised cost

On 1 January 20X5 Abacus Bee Co (ABC) purchases a debt instrument for its fair value of $100,000. The debt instrument is due to mature on 31 December 20X9. The instrument has a principal amount of $125,000 and the instrument carries fixed interest at 4.72 per cent that is paid annually. (The effective interest rate is 10 per cent.) How should ABC account for the debt instrument over its five-year term?
Solution
ABC will receive interest of $5,900 (125,000 4.72%) each year and $125,000 when the instrument matures. ABC must allocate the discount of $25,000 and the interest receivable over the five-year term at a constant rate on the carrying amount of the debt. To do this, it must apply the effective interest rate of 10 per cent.
391
Financial Reporting
The following table shows the allocation over the years: Amortised cost at beginning of year $ 100,000 104,100 108,610 113,571 119,028 Profit or loss: Interest income for year (@10%) $ 10,000 10,410 10,861 11,357 11,872 Interest received during year (cash inflow) $ (5,900) (5,900) (5,900) (5,900) (125,000 + 5,900) Amortised cost at end of year $ 104,100 108,610 113,571 119,028
Year 20X5 20X6 20X7 20X8 20X9
Each year the carrying amount of the financial asset is increased by the interest income for the year and reduced by the interest actually received during the year. Investments whose fair value cannot be reliably measured should be measured at cost. Note that interest income is recognised in profit or loss each year, being the amount of interest actually received plus the interest income related to the winding up of the financial asset to its redemption value.
4.2.3 'Old' rules for subsequent measurement of financial assets

As we have already said, HKFRS 9 has superseded HKAS 39 in respect of providing guidance for the accounting for financial assets. An understanding of the 'old' rules with regard to subsequent accounting for financial assets will help you to understand the reduction in complexity afforded by the introduction of HKFRS 9. Old HKAS 39 Category Financial asset at fair value through profit or loss Available for sale financial asset Financial asset held to maturity Loans and receivables Measured at Fair value Fair value Amortised cost Amortised cost Gains and losses Profit or loss Other comprehensive income Profit or loss Profit or loss
While the treatment under HKAS 39 seems very similar to that under HKFRS 9, the initial classification of each financial instrument was more complex as certain instruments could fall into more than one category or indeed fall foul of strict classification rules after initial classification and have to be reclassified. The transition to HKFRS 9 must be applied retrospectively, although the business model assessment need only be made on the date of initial application of the new standard.
St Ives purchased a $20 million 6 per cent debenture at par on 1 January 20X1 when the market rate of interest was 6 per cent. Interest is paid annually on 31 December. The debenture is redeemable at par on 31 December 20X2. The market rate of interest on debentures of equivalent term and risk changed to 7 per cent on 31 December 20X1.
392
Required Show the charge or credit to profit or loss for each of the two years to 31 December 20X2 if the debentures are classified as: (a) (b) Financial assets at amortised cost. Financial assets at fair value through profit or loss
Fair value is to be calculated using discounted cash flow techniques. (The answer is at the end of the chapter)
HKFRS 9, 5.3.1
4.3 Subsequent measurement of financial liabilities

Topic highlights
Financial liabilities are subsequently measured at fair value or amortised cost with gains and losses recognised in profit or loss.
Except for financial liabilities at fair value through profit or loss (including most derivatives), all financial liabilities should be recognised and measured at amortised cost. The exceptions should be measured at fair value. However, if the fair value cannot be measured reliably, they should then be measured at cost.
4.3.1 Financial liabilities measured at amortised cost

The definitions seen above in relation to financial assets at amortised cost remain relevant here. Again, their application is best seen through examples.
Example: Finance cost

On 1 January 20X5 a company issued $200,000 loan notes. Issue costs were $320. The loan notes do not carry interest, but are redeemable at a premium of $41,613 on 31 December 20X6. The effective finance cost of the loan notes is 10 per cent. What is the finance cost in respect of the loan notes for the year ended 31 December 20X6, and what is the carrying amount of the loan notes at that date?
Solution
The premium on redemption of the loan notes represents a finance cost. The effective rate of interest must be applied so that the debt is measured at amortised cost. At the time of issue, the loan notes are recognised at their net proceeds of: $199,680 (200,000 320). The finance cost for the year ended 31 December 20X6 is calculated as follows: B/f $ 199,680 219,648 Interest @ 10% $ 19,968 21,965 C/f $ 219,648 241,613
20X5 20X6
393
Financial Reporting
On 1 January 20X2, an entity issued a debt instrument with a coupon rate of 5 per cent at a par value of $1,000,000. The directly attributable costs of issue were $30,000. The debt instrument is repayable on 31 December 20X8 at a premium of $260,000. Required What is the total amount of the finance cost associated with the debt instrument? A B C D $294,000 $318,000 $514,000 $640,000 (The answer is at the end of the chapter)
Grumble Co issues a bond for $839,619 on 1 January 20X2. No interest is payable on the bond, but it will be held to maturity and redeemed on 31 December 20X4 for $1m. The bond has not been designated as at fair value through profit or loss. Required Calculate the charge to profit or loss of Grumble Co for the year ended 31 December 20X2 and the balance outstanding at 31 December 20X2. (The answer is at the end of the chapter)
HKFRS 9, 5.7.1
4.3.2 Financial liabilities at fair value through profit or loss

Financial liabilities which are held for trading and classified as fair value through profit or loss are remeasured to fair value each year in accordance with HKFRS 13 (see Section 4.2.1) with any gain or loss recognised in profit or loss.
HKFRS 9 B5.7.16
HKFRS 9 requires that financial liabilities which are designated as measured at fair value through profit or loss are treated differently. In this case the gain or loss in a period must be classified into: 1 2 Gain or loss resulting from credit risk; and Other gain or loss. as the amount of change in the fair value that is not attributable to changes in market conditions giving rise to market risk, or using an alternative method which an entity believes to more faithfully represent changes in value due to credit risk.
The gain or loss resulting from credit risk is established either:
The gain or loss as a result of credit risk is recognised in other comprehensive income, unless it creates or enlarges an accounting mismatch (in which case it is recognised in profit or loss). The other gain or loss is recognised in profit or loss. On derecognition any gains or losses recognised in other comprehensive income are not recycled to profit or loss.
HKFRS 9, 3.1.2-3.1.6, Appendix A
4.4 Trade date v settlement date accounting

A regular way purchase or sale of financial assets shall be recognised and derecognised using trade date accounting or settlement date accounting.
394
A regular way purchase or sale is a purchase or sale of a financial asset under a contract whose terms require delivery of the asset within the time frame established generally by regulation or convention in the marketplace concerned. HKFRS 9 refers to two methods of accounting, being trade date and settlement date accounting. An entity shall apply the same method consistently for all purchase and sales of financial assets that are classified in the same way in accordance with HKFRS 9. For this purpose, assets that the definition of held for trading form a separate classification from assets designated as measured at fair value through profit or loss. In addition, investments in equity instruments accounted for using the option provided in HKFRS 9 (irrevocable election to present in other comprehensive income subsequent changes in the fair value of an investment in an equity instrument) form a separate classification. The trade date is the date on which an entity commits to purchase or sell an asset, and trade date accounting results in: the recognition of an asset to be received and liability to pay for it on the trade date, and the derecognition of an asset to be sold and corresponding receivable on the trade date (together with any gain or loss).
The settlement date is the date on which an asset is delivered to or by an entity, and settlement date accounting results in: the recognition of an asset on the settlement date and the derecognition of an asset on the settlement date.
When trade date accounting is used interest does not start to accrue until the settlement date when title passes. When settlement date accounting is used: (a) (b) (c) An asset subsequently measured at amortised cost is recognised initially at its fair value on the trade date. Any change in the fair value of the asset to be received between the trade and settlement date is not recognised for assets measured at amortised cost. Any change in the fair value of the asset to be received between the trade and settlement date is recognised in profit or loss or other comprehensive income for assets measured at fair value.
Example: Trade date and settlement date accounting

Gaylord entered into a contractual commitment on 27 December 20X4 to purchase a financial asset for $1,000. On 31 December 20X4, the entitys reporting date, the fair value was $1,005. The transaction was settled on 5 January 20X5 when the fair value was $1,007. The entity has classified the asset as at fair value through profit or loss. Required How should the transactions be accounted for under trade date accounting and settlement date accounting?
Solution
Trade date accounting On 27 December 20X4, the entity should recognise the financial asset and the liability to the counterparty at $1,000. At 31 December 20X4, the financial asset should be remeasured to $1,005 and a gain of $5 recognised in profit or loss.
395
Financial Reporting
On 5 January 20X5, the liability to the counterparty of $1,000 will be paid in cash. The fair value of the financial asset should be remeasured to $1,007 and a further gain of $2 recognised in profit or loss.
Settlement date accounting No transaction should be recognised on 27 December 20X4. On 31 December 20X4, a receivable of $5 should be recognised (equal to the fair value movement since the trade date) and the gain recognised in profit or loss. On 5 January 20X5, the financial asset should be recognised at its fair value of $1,007. The receivable should be derecognised, the payment of cash to the counterparty recognised and the further gain of $2 recognised in profit or loss.
HKAS 39.58
4.4.1 Impairment and uncollectability of financial assets

Topic highlights
Financial assets measured at amortised cost must be tested for impairment when there is objective evidence of impairment. Any loss is recognised in profit or loss.
At each year end, an entity should assess whether there is any objective evidence that a financial asset or group of assets is impaired. Although HKFRS 9 now applies to the recognition and measurement of financial assets, HKAS 39 continues to provide the guidance on impairments. Due to the reduced number of classifications of financial assets under HKFRS 9, this area is less complex than it was prior to the issue of the new standard, and only those financial assets classified as measured at amortised cost need be tested for impairment.
Can you think of three examples of indications that a financial asset or group of assets may be impaired? (The answer is at the end of the chapter)
HKAS 39.5960
4.4.2 Objective evidence of impairment

Where there is objective evidence of impairment, an entity should determine the amount of any impairment loss. It may not be possible to identify a single, discrete event that caused the impairment. Rather the combined effect of several events may have caused the impairment. Losses expected as a result of future events, no matter how likely, are not recognised. Objective evidence that a financial asset or group of assets is impaired includes observable data that comes to the attention of the holder of the asset about the following events: (a) (b) (c) (d) Significant financial difficulty of the issuer or obligor. A breach of contract, such as a default or delinquency in interest or principal payments. The lender, for economic or legal reasons relating to the borrower's financial difficulty, granting to the borrower a concession that the lender would not otherwise consider. It becoming probable that the borrower will enter bankruptcy or other financial reorganisation.
396
(e) (f)
The disappearance of an active market for that financial asset because of financial difficulties. Observable data indicating that there is a measurable decrease in the estimated future cash flows from a group of financial assets since the initial recognition of those assets, although the decrease cannot yet be identified with the individual financial assets in the group, including: (i) Adverse changes in the payment status of borrowers in the group (eg an increased number of delayed payments or an increased number of credit card borrowers who have reached their credit limit and are paying the minimum monthly amount). National or local economic conditions that correlate with defaults on the assets in the group (eg an increase in the unemployment rate in the geographical area of the borrowers, a decrease in property prices for mortgages in the relevant area, a decrease in oil prices for loan assets to oil producers, or adverse changes in industry conditions that affect the borrowers in the group).
(ii)
The disappearance of an active market because an entity's financial instruments are no longer publicly traded is not evidence of impairment. A downgrade of an entity's credit rating is not, of itself, evidence of impairment, although it may be evidence of impairment when considered with other available information. A decline in the fair value of a financial asset below its cost or amortised cost is not necessarily evidence of impairment (for example, a decline in the fair value of an investment in a debt instrument that results from an increase in the risk-free interest rate).
HKAS 39.6365
4.4.3 Impairment of financial assets carried at amortised cost

The impairment loss is the difference between the asset's carrying amount and its recoverable amount. The asset's recoverable amount is the present value of estimated future cash flows, discounted at the financial instrument's original effective interest rate. The amount of the loss should be recognised in profit or loss. If the impairment loss decreases at a later date (and the decrease relates to an event occurring after the impairment was recognised) the reversal is recognised in profit or loss. The carrying amount of the asset must not exceed the original amortised cost.
Example: Impairment
Floribunda has a 7 per cent loan receivable of $1m. Interest is payable annually in arrears and the principal is repayable in three years time. The amortised cost of the loan is $1m. The original effective rate of interest was 7 per cent and the current effective interest rate is 8 per cent. The borrower is in financial difficulty and Floribunda has granted a concession in that no annual interest is payable and the principal will be repaid in three years time at a premium of 10 per cent. Required Explain how the carrying amount of the loan should be calculated.
Solution
The financial difficulty of, and the granting of a concession to, the issuer are both objective evidence of impairment. The recoverable amount should be calculated as $839,185 by discounting the $1.1m agreed repayment at the original effective interest rate of 7 per cent over a four-year period. An impairment loss of $160,815 is therefore recognised in profit or loss. In Year 1, interest income of $58,743 (7% $839,185) should be recognised and the carrying amount of the loan increased to $897,928. This process should be repeated through Years 2 to 4, at which point the loan will be carried at $1.1m immediately prior to repayment.
397
Financial Reporting
HKFRS 9, 5.6.1-5.6.3
4.5 Reclassification
Earlier we saw that an entity may reclassify financial assets from one category to another. Where financial assets are reclassified, that reclassification is applied prospectively from the reclassification date. Previously recognised gains, losses or interest are not restated. If an entity reclassifies a financial asset so that it is now measured at fair value, its fair value is determined at the reclassification date. Any gain or loss arising from a difference between the previous carrying amount and fair value is recognised in profit or loss. If an entity reclassifies a financial asset so that it is now measured at amortised cost, its fair value at the reclassification date becomes its new carrying amount.
4.6 Section summary

Financial instruments are initially measured at fair value. Transaction costs increase this amount for financial assets classified as measured at amortised cost and decrease this amount for financial liabilities classified as measured at amortised cost. Financial assets are subsequently measured at: fair value with changes in value normally recognised in profit or loss, or amortised cost with interest recognised in profit or loss.
Financial liabilities are subsequently measured at fair value or amortised cost with gains and losses recognised in profit or loss. Financial assets measured at amortised cost must be tested for impairment when there is objective evidence of impairment. Any loss is recognised in profit or loss.
5 HKFRS 9: Embedded derivatives

Topic highlights
Embedded derivatives are derivative instruments that are embedded within a host contract that may or may not be a financial instrument.
Derivative contracts may be 'embedded' in contracts that are not themselves derivatives (and may not be financial instruments). These non-derivatives are known as host contracts, and may comprise: leases sale or purchase contracts insurance contracts construction contracts a debt or equity instrument
5.1 Examples of embedded derivatives

Possible examples include: (a) Contingent rentals based on sales included as a term in a lease of retail premises:
398
'Host' contract
Lease
Accounted for as normal
Embedded derivative (b) (c)
Contingent rentals
Treat as derivative, ie re-measured to fair value with changes recognised in profit or loss
A bond which is redeemable in five years' time with part of the redemption price based on the increase in the Hong Kong Index. An embedded derivative caused by changes in the foreign exchange can be found in a construction contract which is priced in a foreign currency.
HKFRS 9, 4.3.2-4.3.4
5.2 Accounting treatment of embedded derivatives

Topic highlights
Where the host contract is within the scope of HKFRS 9 the hybrid contract is accounted for as one instrument. Otherwise HKFRS 9 requires that the embedded derivative is separated from the host contract where certain conditions are met and accounted for separately.
HKFRS 9 now provides the accounting guidance in relation to embedded derivatives. Unless the host contract is a financial asset within the scope of the standard, HKFRS 9 requires that an embedded derivative is separated from its host contract and accounted for as a derivative when the following conditions are met: (a) (b) (c) The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract. A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative. The hybrid (combined) instrument is not measured at fair value with changes in fair value recognised in profit or loss (a derivative embedded in a financial liability need not be separated out if the entity holds the combined instrument at fair value through profit or loss).
The host contract is accounted for in accordance with relevant accounting standards.
HKFRS 9, 4.3.2
5.2.1 Financial asset host contract

Where the host contract is a financial asset within the scope of the standard, the classification and measurement rules of the standard are applied to the entire hybrid contract. This is a simplification of the rules which applied to financial assets as well as other host contracts prior to the issue of HKFRS 9.
HKFRS 9, B4.3.1
5.3 Reassessment of embedded derivatives

As a result of the expansion of HKFRS 9, the contents of HK(IFRIC) Int-9 Reassessment of Embedded Derivatives have been incorporated into the standard and the Interpretation itself has been withdrawn. The standard states that an entity is not permitted to reassess the treatment of an embedded derivative throughout the life of a contract unless there is a significant change to the terms of the contract.
399
Financial Reporting
6 HKAS 39: Hedging

Topic highlights
Hedge accounting means designating one or more instruments so that their change in fair value is offset by the change in fair value or cash flows of another item.
6.1 Introduction
It is normal business practice for a company to engage in hedging activities in order to reduce their exposure to risk and uncertainty, such as changes in prices, interest rates or foreign exchange rates. For example, an entity may have a fixed amount of foreign currency to pay on a particular date, and hedge against unfavourable exchange rate movements by taking out a forward contract to purchase the currency it needs to meet its obligation from a third party at a particular exchange rate. In this instance the forward contract is a derivative and so measured at fair value with changes in value recognised in profit or loss. An accounting hedge involves recognising these changes in value at the same time as any opposite gain or loss on a year end revaluation and then settlement of the payable so as to minimise the impact on profit or loss of the transaction. This is an example of a hedge that happens automatically. HKAS 39 provides the guidance relating to hedging and requires hedge accounting where there is a designated hedging relationship between a hedging instrument and a hedged item. It is prohibited otherwise.
HKAS 39.9
6.2 Definitions
The definitions in HKAS 39 relevant to hedging are given below.
Key terms
Hedging, for accounting purposes, means designating one or more hedging instruments so that their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item. A hedged item is an asset, liability, firm commitment, or forecasted future transaction that: (a) (b) Exposes the entity to risk of changes in fair value or changes in future cash flows, and that Is designated as being hedged.
A hedging instrument is a designated derivative or (in limited circumstances) another financial asset or liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. (A non-derivative financial asset or liability may be designated as a hedging instrument for hedge accounting purposes only if it hedges the risk of changes in foreign currency exchange rates.) Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged item attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument. (HKAS 39) Generally only assets, liabilities etc that involve external parties can be designated as hedged items. The foreign currency risk of an intragroup monetary item (eg payable/receivable between two subsidiaries) may qualify as a hedged item in the group financial statements if it results in an exposure to foreign exchange rate gains or losses that are not fully eliminated on consolidation.
400
This can happen (per HKAS 21) when the transaction is between entities with different functional currencies. In addition, the foreign currency risk of a highly probable group transaction may qualify as a hedged item if it is in a currency other than the functional currency of the entity and the foreign currency risk will affect profit or loss.
HKAS 39.86
6.3 Types of hedge

There are three types of hedge covered by HKAS 39: (a) Fair value hedges, which involve hedging against a change in the value of a recognised asset or liability (the above example involving a foreign currency payable is an example of a fair value hedge) Cash flow hedges, which involve hedging against a change in the value of future certain cash flows (for example, where an entity is due to receive a payment in foreign currency), and Net investment hedges, which involves hedging an investment in a foreign group company,
(b)
(c)
The formal definitions of each type of hedge are as follows:
Key terms
Fair value hedge. A hedge of the exposure to changes in the fair value of a recognised asset or liability, or an identified portion of such an asset or liability, that is attributable to a particular risk and could affect profit or loss. Cash flow hedge. A hedge of the exposure to variability in cash flows that: (a) is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction (such as an anticipated purchase or sale), and that could affect profit or loss.
(b)
Hedge of a net investment in a foreign operation. HKAS 21 defines a net investment in a foreign operation as the amount of the reporting entity's interest in the net assets of that operation. (HKAS 39) We shall consider each type of hedge in detail in a moment, but first it is important to understand the conditions for hedge accounting.
HKAS 39.88
6.4 Conditions for hedge accounting

Topic highlights
Hedge accounting is permitted in certain circumstances, provided the hedging relationship is clearly defined, measurable and actually effective.
Before a hedging relationship qualifies for hedge accounting, all of the following conditions must be met: (a) The hedging relationship must be formally documented (including the identification of the hedged item, the hedging instrument, the nature of the hedged risk and the assessment of the hedging instrument's effectiveness in offsetting the exposure to changes in the hedged item's fair value or cash flows attributable to the hedged risk). The hedging relationship must also be designated at its inception as a hedge based on the entity's risk management objective and strategy.
401
Financial Reporting
(b)
There is an expectation that the hedge is highly effective in offsetting changes in fair value or cash flows ascribed to the hedged risk. (Note. The hedge does not have to be fully effective.) For cash flow hedges, it must be highly probable that there is a forecast transaction since such a transaction is the subject of the hedge. In addition, the transaction must present an exposure to variations in cash flows that could eventually affect profit and loss. Reliable measurement of the effectiveness of the hedge. The assessment of the hedge is carried out on an ongoing basis (annually) and it has been effective during the reporting period.
(c)
(d) (e)
Effectiveness Hedge effectiveness must be tested regularly and must fall within the range 80 per cent to 125 per cent. If it falls outside eg 75 per cent or 130 per cent, then hedge accounting cannot be applied. Both the hedged item and hedging instrument will be accounted for based on their respective accounting standard. Hedge effectiveness =
Change in hedging instrument Change in hedged item
6.5 Accounting treatment

Topic highlights
There are three types of hedge: fair value hedge; cash flow hedge; hedge of a net investment in a foreign operation. The accounting treatment of a hedge depends on its type.
HKAS 39.89
6.5.1 Fair value hedges

In a fair value hedge, the hedged item is a recognised asset or liability. When hedge accounting is applied, this is remeasured to fair value at the period end in accordance with HKFRS 13 Fair Value Measurement and any gain or loss on the hedged item attributable to the hedged risk is recognised in profit or loss. The hedging instrument is a derivative and in accordance with HKAS 39 / HKFRS 9 any gain or loss resulting from re-measuring the hedging instrument at fair value is also recognised in profit or loss.
Example: Fair value hedge (1)

A company owns inventories of 30,000 gallons of oil which cost $660,000 on 1 December 20X8. In order to hedge the fluctuation in the market value of the oil the company signs a futures contract to deliver 30,000 gallons of oil on 31 March 20X9 at the futures price of $25 per gallon. The market price of oil on 31 December 20X8 is $27 per gallon and the futures price for delivery on 31 March 20X9 is $30 per gallon.
Required
Explain the impact of the transactions on the financial statements of the company: (a) (b) without hedge accounting with hedge accounting.
402
Solution
The futures contract was intended to protect the company from a fall in oil prices (which would have reduced the profit when the oil was eventually sold). However, oil prices have actually risen, so that the company has made a loss on the contract.
Without hedge accounting
The futures contract is a derivative and therefore must be remeasured to fair value at 31 December 20X8 under HKAS 39. The loss on the futures contract is recognised in profit or loss: DEBIT CREDIT Profit or loss (30,000 (30 25)) Financial liability $150,000 $150,000
With hedge accounting
The loss on the futures contract is recognised in profit or loss as before, however with hedge accounting, the inventories are also remeasured to fair value: $ 810,000 Fair value at 31 December 20X8 (30,000 27) Cost (660,000) Gain 150,000 The gain is also recognised in profit or loss: DEBIT CREDIT Inventory Profit or loss $150,000 $150,000
With hedging the net effect on profit or loss is zero compared with a loss of $150,000 without hedging.

As at 1 January 20X3, a company purchases a debt instrument that has a principal amount of $1 million at a fixed interest rate of 6 per cent per year. The instrument is classified as a financial asset measured at fair value. The fair value of the instrument is $1 million. The company is exposed to a risk of the decline in the fair value of the instrument if the market interest rate increases because of the fixed interest rate. The company enters into an interest rate swap. It exchanges the fixed interest rate payments it receives on the bond for floating interest rate payments, in order to offset the risk of a decline in fair value. If the derivative hedging instrument is effective, any decline in the fair value of the bond should be offset by opposite increases in the fair value of the derivative instrument. The company designates and documents the swap as a hedging instrument. On entering into the swap, the swap has a fair value of zero. Assuming market interest rates have increased to 7 per cent, the fair value of the bond will have decreased to $960,000. At the same time, the company determines that the fair value of the swap has increased by $40,000. Since the swap is a derivative, it is measured at fair value with changes in fair value recognised in profit or loss. The changes in fair value of the hedged item and the hedging instrument exactly offset each other; the hedge is 100 per cent effective and the net effect on profit or loss is zero.
Required
Explain the impact of the transactions on the financial statements of the company with hedge accounting.
403
Financial Reporting
Solution
STATEMENT OF FINANCIAL POSITION
1 January 20X3 $'000 1,000 (1,000) 31 December 20X3 $'000 960 40
Debt instrument (hedged item) Derivative asset (hedging instrument) Cash STATEMENT OF COMPREHENSIVE INCOME Loss on debt instrument Gain on derivative No ineffectiveness
$'000 (40) 40 $'000 (40) 40
Gains and losses on hedged item and hedging instrument are both taken to the statement of comprehensive income (income statement).

Assuming the information is the same as above. However, the company determines that the fair value of the swap has increased by $45,000 instead of $40,000.
Required
Explain the impact of the transactions on the financial statements of the company. Hedge effectiveness =
Change in hedging instrument Change in hedged item $45,000 $40,000
= 112.5% Hedge effectiveness of 112.5 per cent is still within the window of 80 per cent 125 per cent. Thus, hedge accounting may be applied. STATEMENT OF FINANCIAL POSITION
1 January 20X3 $'000 1,000 (1,000) 31 December 20X3 $'000 960 45
Debt instrument (hedged item) Derivative asset (hedging instrument) Cash STATEMENT OF COMPREHENSIVE INCOME Loss on debt instrument Gain on derivative Ineffective hedge
$'000 (40) 45
(40) 45 5
This results in an ineffective hedge of $5,000 gain recognised in profit or loss.
404
HKAS 39.95
6.5.2 Cash flow hedges

A cash flow hedge involves hedging future cash flows. Initially therefore, only the hedging instrument (the derivative) is recognised. The part of the gain or loss arising from an effective hedge of a hedging instrument is recognised in other comprehensive income while the ineffective portion of the gain or loss on the hedging instrument should be recognised in profit and loss. In the case where a hedging transaction results in the recognition of a non-financial asset or liability, changes in the value of the hedging instrument recognised in other comprehensive income. (a) (b) are adjusted against the carrying value of the asset or liability are reclassified from equity to profit or loss as a reclassification adjustment in the same period or periods during which the hedged forecast cash flows affect profit or loss (such as in the periods that depreciation expense is recognised).
Example: Cash flow hedge

Sparkle is a manufacturer and retailer of gold jewellery. On 31 October 20X1, the cost of Sparkles inventories of finished jewellery was $8.280 million with a gold content of 24,000 troy ounces. At that date their sales value was $9.938 million. The selling price of gold jewellery is heavily dependent on the current market price of gold (plus a standard percentage for design and production costs). Sparkles management wished to reduce their business risk of fluctuations in future cash inflow from sale of the jewellery by hedging the value of the gold content of the jewellery. In the past this has proved to be an effective strategy. Therefore it sold futures contracts for 24,000 troy ounces of gold at $388 per troy ounce at 31 October 20X1. The contracts mature on 30 October 20X2. On 30 September 20X2 the fair value of the jewellery was $9.186m and the forward price of gold per troy ounce for delivery on 30 October 20X2 was $352.
Required
Explain how the above transactions would be treated in Sparkles financial statements for the year ended 30 September 20X2.
Solution
Sparkle is hedging the volatility of the future cash inflow from selling the gold jewellery. The futures contracts can be accounted for as a cash flow hedge in respect of those inflows, providing the criteria for hedge accounting are met. The gain on the forward contract should be calculated as: Forward value of contract at 31.10.X1 (24,000 $388) Forward value of contract at 30.9.X2 (24,000 $352) Gain on contract $ 9,312,000 8,448,000 864,000
The change in the fair value of the expected future cash flows on the hedged item (which is not recognised in the financial statements) should be calculated as: At 31.10.X1 At 30.9.X2 $ 9,938,000 9,186,000 752,000
405
Financial Reporting
As this change in fair value is less than the gain on the forward contract, the hedge is not fully effective and only $752,000 of the gain on the forward should be recognised in other comprehensive income. The remainder should be recognised in profit or loss: DEBIT Financial asset (Forward a/c) CREDIT Other comprehensive income Profit or loss $864,000 $752,000 $112,000
Note that the hedge is still highly effective (and hence hedge accounting should continue to be used): $864,000/$752,000 = 115% which is within the 80% 125% range.
HKAS 39.102
6.5.3 Hedges of a net investment

Hedges of a net investment arise in the consolidated accounts where a parent company takes a foreign currency loan in order to buy shares in a foreign subsidiary. The loan and the investment need not be denominated in the same currency, however assuming that the currencies perform similarly against the parent company's own currency, it should be the case that fluctuations in the exchange rate affect the asset (the net assets of the subsidiary) and the liability (the loan) in opposite ways, hence gains and losses are hedged. In this type of accounting hedge, the hedging instrument is the foreign currency loan rather than a derivative. You may understand this type of hedge better after studying Chapter 19, Foreign Currency Transactions, but in a simple sense, without applying hedging rules:

The loan would be retranslated to the parent's own currency at the year end using the spot exchange rate; any resultant gain or loss would be recognised in profit or loss. Prior to consolidation, the subsidiary's accounts would be translated into the parent's own currency with any gain or loss recognised in other comprehensive income. On consolidation, the gain or loss on the loan would affect consolidated profit or loss and the loss or gain on the translation of the subsidiary's net assets would affect consolidated reserves.
The net investment hedge ensures that the gains and losses are both recognised in other comprehensive income and accumulated in reserves by:

recognising the portion of the gain or loss on the hedging instrument that is determined to be effective in other comprehensive income recognising the ineffective portion in profit or loss
Any gain or loss recognised in other comprehensive income is reclassified to profit or loss on the disposal or partial disposal of the foreign operation.
6.6 Exposures qualifying for hedge accounting

HKAS 39 was amended in 2008 to clarify what can be designated as a hedged risk and when an entity may designate a portion of the cash flows of a financial instrument as a hedged item. The risks specified are:

interest rate risk foreign currency rate risk credit risk prepayment risk
406
The portions of the cash flows of a financial instrument that may be designated as a hedged item are one or more of the following: (a) (b) (c) (d) (e) (f) The cash flows of a financial instrument for part of its time period to maturity. A percentage of the cash flows of a financial instrument. The cash flows of a financial instrument associated with a one-sided risk of that instrument. Any contractually specified cash flows of a financial instrument that are independent from the other cash flows of that instrument. The portion of the cash flows of an interest bearing financial instrument that is equivalent to a financial instrument with a risk-free rate. The portion of the cash flows of an interest bearing financial instrument that is equivalent to a financial instrument with a quoted or variable inter-bank rate.
6.7 Recap
Hedge accounting means designating one or more instruments so that their change in fair value is offset by the change in fair value or cash flows of another item. Hedge accounting is permitted in certain circumstances, provided the hedging relationship is clearly defined, measurable and actually effective.
There are three types of hedge: fair value hedge; cash flow hedge; hedge of a net investment in a foreign operation. The accounting treatment of a hedge depends on its type.
7 HKFRS 7: Disclosure of financial instruments

Topic highlights
HKFRS 7 specifies the disclosures required for financial instruments. In addition, HKFRS 13 disclosures are applied where financial instruments are measured at fair value. HKFRS 7 requires qualitative and quantitative disclosures about exposure to risks arising from financial instruments and specifies minimum disclosures about credit risk, liquidity risk and market risk.
HKFRS 7 was issued in 2005 to replace the disclosure requirements of HKAS 32. In doing so it has revised and enhanced disclosure requirements in response to new techniques and approaches to measuring risk management. The standard requires qualitative and quantitative disclosures about exposure to risks arising from financial instruments, and specifies minimum disclosures about credit risk, liquidity risk and market risk. The HKICPA maintains that users of financial instruments need information about an entity's exposures to risks and how those risks are managed, as this information can influence a user's assessment of the financial position and financial performance of an entity or of the amount, timing and uncertainty of its future cash flows. In June 2011 HKFRS 13 Fair Value Measurement was issued. As a result, disclosures in relation to financial instruments measured at fair value were relocated from HKFRS 7 to HKFRS 13.
407
Financial Reporting
HKFRS 7.1
7.1 Objective
The objective of HKFRS 7 is to require entities to provide disclosures in their financial statements that enable users to evaluate: (a) (b) the significance of financial instruments for the entity's financial position and performance. the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the reporting date, and how the entity manages those risks.
The principles in HKFRS 7 complement the principles for recognising, measuring and presenting financial assets and financial liabilities in HKAS 32 Financial Instruments: Presentation, HKAS 39 Financial Instruments: Recognition and Measurement and HKFRS 9 Financial Instruments.
HKFRS 7.6
7.2 Classes of financial instruments and levels of disclosure

When HKFRS 7 requires disclosures by class of financial instrument, an entity must group financial instruments into classes that are appropriate to the nature of the information disclosed and that take into account the characteristics of those financial instruments. Sufficient information should be provided to permit reconciliation to the line items presented in the statement of financial position.
HKFRS 7.719
7.3 Statement of financial position disclosures

The following must be disclosed in the notes to the financial statements: (a) (b) (c) (d) (e)
Carrying amount of financial assets and liabilities by HKAS 39 or HKFRS 9 category.
Details of financial instruments designated as at fair value through profit or loss and financial assets designated as at fair value through other comprehensive income.
Reason for any reclassification between fair value and amortised cost (and vice versa).
The carrying amount of financial assets the entity has pledged as collateral for liabilities or contingent liabilities and the associated terms and conditions. When financial assets are impaired by credit losses and the entity records the impairment in a separate account (eg an allowance account used to record individual impairments or a similar account used to record a collective impairment of assets) rather than directly reducing the carrying amount of the asset, it must disclose a reconciliation of changes in that account during the period for each class of financial assets. The existence of multiple embedded derivatives, where compound instruments contain these. Defaults and breaches.
(f) (g)
HKFRS 7.20
7.4 Statement of comprehensive income disclosures

The entity must disclose the following items of income, expense, gains or losses, either on the face of the financial statements or in the notes: (a) (b) (c) Net gains/losses by HKAS 39 or HKFRS 9 category (broken down as appropriate: eg interest, fair value changes, dividend income). Interest income/expense. Impairment losses by class of financial asset.
408
HKFRS 7.21
7.5 Other disclosures

Entities must disclose in the summary of significant accounting policies the measurement basis used in preparing the financial statements and the other accounting policies that are relevant to an understanding of the financial statements.
HKFRS 7.2224
7.5.1 Hedge accounting

Disclosures must be made relating to hedge accounting, as follows: (a) (b) (c) (d) (e) (f) Description of hedge. Description of financial instruments designated as hedging instruments and their fair value at the reporting date. The nature of the risks being hedged. For cash flow hedges, periods when the cash flows will occur and when they will affect profit or loss. For fair value hedges, gains or losses on the hedging instrument and the hedged item. The ineffectiveness recognised in profit or loss arising from cash flow hedges and net investments in foreign operations.
HKFRS 7.25, 26,29
7.5.2 Fair value

HKFRS 7 retains the following general requirements in relation to the disclosure of fair value for those financial instruments measured at amortised cost: (a) For each class of financial assets and financial liabilities an entity shall disclose the fair value of that class of assets and liabilities in a way that permits it to be compared with its carrying amount. In disclosing fair values, an entity shall group financial assets and financial liabilities into classes, but shall offset them only to the extent that their carrying amounts are offset in the statement of financial position.
(b)
It also states that disclosure of fair value is not required where:

HKFRS 13.91,93, 95, 97
carrying amount is a reasonable approximation of fair value for investments in equity instruments that do not have a quoted market price in an active market for an identical instrument, or derivatives linked to such equity instruments
HKFRS 13 provides disclosure requirements in respect of the fair value of financial instruments measured at fair value. It requires that information is disclosed to help users assess:
(a) (b)
for assets and liabilities measured at fair value after initial recognition, the valuation techniques and inputs used to develop those measurements. For recurring fair value measurements (ie those measured at each period end) using significant unobservable (level 3) inputs, the effect of the measurements on profit or loss or other comprehensive income for the period.
In order to achieve this, the following should be disclosed as a minimum for each class of financial assets and liabilities measured at fair value (asterisked disclosures are also required for financial assets and liabilities measured at amortised cost but for which fair value is disclosed): 1 2 3 The fair value measurement at the end of the period The level of the fair value hierarchy within which the fair value measurements are categorised in their entirety For assets and liabilities measured at fair value at each reporting date (recurring fair value measurements), the amounts of any transfers between level 1 and level 2 of the fair value hierarchy and reasons for the transfers
409
Financial Reporting
For fair value measurements categorised within level 2 and 3 of the hierarchy, a description of the valuation techniques and inputs used in the fair value measurement, plus details of any changes in valuation techniques For recurring fair value measurements categorised within level 3 of the fair value hierarchy A reconciliation from the opening to closing balances The amount of unrealised gains or losses recognised in profit or loss in the period and the line item in which they are recognised A narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs For recurring and non-recurring fair value measurements categorised within level 3 of the fair value hierarchy, a description of the valuation processes used by the entity.
5 6 7 8 9
An entity should also disclose its policy for determining when transfers between levels of the fair value hierarchy are deemed to have occurred.
Example: Fair value disclosures

For assets and liabilities measured at fair value at the end of the reporting period, the HKFRS requires quantitative disclosures about the fair value measurements for each class of assets and liabilities. An entity might disclose the following for assets to comply with points 1 and 2 above: HK$000 Description Trading equity securities Non-trading equity securities Corporate securities Derivatives interest rate contracts Total recurring fair value measurements 31.12.X9 45 32 90 78
Fair value measurements at the end of the reporting period using Level 1 inputs Level 2 inputs Level 3 inputs 45 32 9 81 78
245
54
159
32
7.6 Nature and extent of risks arising from financial instruments

In undertaking transactions in financial instruments, an entity may assume or transfer to another party one or more of different types of financial risk as defined below. The disclosures required by the standard show the extent to which an entity is exposed to these different types of risk, relating to both recognised and unrecognised financial instruments.
Credit risk Currency risk Interest rate risk Liquidity risk Loans payable
The risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation. The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates. The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. The risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities. Loans payable are financial liabilities, other than short-term trade payables on normal credit terms.
410
Market risk
The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises three types of risk: currency risk, interest rate risk and other price risk. The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than those arising from interest rate risk or currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the market. A financial asset is past due when a counterparty has failed to make a payment when contractually due.
Other price risk
Past due
HKFRS 7.33
7.6.1 Qualitative disclosures

For each type of risk arising from financial instruments, an entity must disclose: (a) (b) (c) the exposures to risk and how they arise. its objectives, policies and processes for managing the risk and the methods used to measure the risk. any changes in (a) or (b) from the previous period.
HKFRS 7.3438
7.6.2 Quantitative disclosures

For each financial instrument risk, summary quantitative data about risk exposure must be disclosed. This should be based on the information provided internally to key management personnel. More information should be provided if this is unrepresentative of an entity's exposure to risk. Information about credit risk must be disclosed by class of financial instrument: (a) Maximum exposure at the year end without taking account of collateral held or other credit enhancements. (This disclosure is not required where the carrying amount of financial instruments best represents the maximum exposure to credit risk.) A description of collateral held as security and of other credit enhancements, and their financial effect, in respect of the maximum exposure to credit risk (whether as disclosed in (a) or represented by carrying amount). Information about the credit quality of financial assets that are neither past due nor impaired. Information about the credit quality of financial assets whose terms have been renegotiated. An analysis of the age of financial assets that are past due as at the end of the reporting period but not impaired. An analysis of financial assets that are individually determined to be impaired as at the end of the reporting period, including the factors the entity considered in determining that they are impaired. Collateral and other credit enhancements obtained during the reporting period and held at the reporting date, including the nature and carrying amount of the assets and policy for disposing of assets not readily convertible into cash.
(b)
(c) (d) (e) (f)
(g)
Example: Credit risk disclosure (1)

An entity holds equity investments in other entities. Its management asserts that the HKFRS 7 credit risk disclosures are not relevant. Do the credit risk disclosures required by HKFRS 7 apply to an entity's holdings of equity investments?
411
Financial Reporting
Solution
The definition of equity in HKAS 32 requires the issuer to have no obligation to pay cash or transfer other assets. It follows that such equity investments are subject to price risk, not credit risk. Most of the HKFRS 7 credit risk disclosures are not therefore relevant to investments in equity instruments. However, HKFRS 7 requires entities to disclose an analysis of financial assets that are impaired. This disclosure is relevant and should be given for impaired equity investments that are available for sale.
Example: Credit risk disclosure (2)

HKFRS 7 defines credit risk as 'the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation'. If an entity issues a financial guarantee, the financial loss will not result from a default by the other party of the contract (the holder), but from a default by the third party (the debtor). Does this mean that the credit risk of financial guarantees can be excluded from the disclosure of the maximum exposure to credit risk?
Solution
No, the credit risk of financial guarantees should be included in the disclosures, as HKFRS 7 clarifies that the definition of credit risk includes that arising from financial guarantees.
HKFRS 7.39
7.6.3 Liquidity risk

For liquidity risk entities must disclose:

a maturity analysis of both derivative and non-derivative financial liabilities a description of the way risk is managed
Within the maturity analysis, any amounts repayable under a loan agreement that includes a clause giving the lender the unconditional right to demand repayment at any time must be classified in the earliest time bracket.
Example: Liquidity risk (1)

HKFRS 7 requires the disclosure of a maturity analysis for financial liabilities that shows the remaining contractual maturities.
Should the following financial instruments be shown in one maturity bracket, or split across the maturity brackets in which the cash flows occur? (a) (b) (c) A derivative which has multiple cash flows A loan which has annual contractual interest payments A loan which has annual contractual interest and principal repayments
Solution
All the financial instruments should be split across the maturity brackets in which the cash flows occur. The requirement is to disclose each of the contractual payments in the period when they are due (including principal and interest payments). The objective of this particular disclosure is to show the liquidity risk of the entity.
412
Example: Liquidity risk (2)

HKFRS 7 requires entities to disclose (a) a maturity analysis for financial liabilities that shows the remaining contractual maturities; and (b) a description of how it manages the liquidity risk inherent in (a).
Does this mean that a maturity analysis for financial assets based on remaining contractual maturities, is no longer required?
Solution
Yes, HKFRS 7 requires a maturity analysis based on the remaining contractual maturity only for financial liabilities. Management can choose to disclose the maturity analysis showing remaining contractual maturity for financial assets also as one of the disclosures to comply with the requirement in HKFRS 7. However, it is not obligatory. In practice, an entity should disclose a maturity analysis of financial assets and financial liabilities showing expected maturity if this is the information provided to key management personnel to manage the business. However, a maturity analysis based on the remaining contractual maturity for financial liabilities should be disclosed.
HKFRS 7.4041
7.6.4 Market risk: sensitivity analysis

An entity shall disclose a sensitivity analysis for each type of market risk to which the entity is exposed at the reporting date, showing how profit or loss and equity would have been affected by changes in the relevant risk variable that were reasonably possible at that date; the methods and assumptions used in preparing the sensitivity analysis; and changes from the previous period in the methods and assumptions used, and the reasons for such changes. Assuming that a reasonably possible change in the relevant risk variable had occurred at the reporting date and had been applied to the risk exposures in existence at that date: Disclosures required in connection with market risk are: (a) (b) sensitivity analysis, showing the effects on profit or loss of changes in each market risk. if the sensitivity analysis reflects interdependencies between risk variables, such as interest rates and exchange rates the method, assumptions and limitations must be disclosed.
413
Financial Reporting
7.6.5 Risk variables that are relevant to disclosing market risk

Market Risk Interest Rate Risk Currency Risk Other Price Risk
Yield curve of market interest rates
Foreign exchange rates
Equity Price Risk Commodity Price Risk Prepayment Risk Residual Value Risk
Prices of equity instruments Market prices of commodities
7.7 Capital disclosures

Certain disclosures about capital are required. An entity's capital does not relate solely to financial instruments, but has more general relevance. Accordingly, those disclosures are included in HKAS 1, rather than in HKFRS 7.
The issue of IFRS 9 (HKFRS 9) and its subsequent expansion in 2010 represent the first stages of the culmination of a long-standing project carried out by the IASB and FASB concerned with reducing the complexity surrounding financial instruments. HKICPA are following the lead of the IASB and it is intended that HKFRS 9 will ultimately replace HKAS 39 in its entirety. The IASB continue to work on the replacement project and in response to requests from interested parties that the accounting for financial instruments should be improved quickly, the project to replace IAS 39 (and in turn HKAS 39) is divided into five main phases. As each phase is completed, as well as its separate project on the derecognition of financial instruments, the relevant portions of IAS 39 will be deleted and chapters in IFRS 9 will be created to replace the requirements in IAS 39. The replacement of IAS 39 in its entirety is aimed to be completed by the end of 2011. As the IASB issues new sections of IFRS 9, HKICPA will adopt these to form HKFRS 9. Phases 1 and 2 of the project relating to the classification and measurement of financial assets and financial liabilities are now obviously complete. Phase 3 of the project relates to impairment methodology. The Request for Information on the feasibility of an expected loss model for the impairment of financial assets was published on 25 June 2009. This formed the basis of an Exposure Draft, Financial Instruments: Amortised Cost and Impairment, published in November 2009 with a comment deadline of 30 June 2010. A supplement to the ED was issued in January 2011. The comment period for this has now passed, and a final standard is expected in the third quarter of 2011. Phases 4 and 5 of the project relate to hedge accounting and asset and liability offsetting respectively. Proposals have been exposed and final amendments to IFRS 9 are expected in both cases in the third quarter of 2011.
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Topic recap

Financial instruments can be very complex, particularly derivative instruments, although primary instruments are more straightforward. The important definitions to learn are:
Financial asset Financial liability Equity instrument
Financial instruments must be classified as liabilities or equity according to their substance. The critical feature of a financial liability is the contractual obligation to deliver cash or another financial asset.
Compound instruments are split into equity and liability components and presented accordingly in the statement of financial position. Interest, dividends, losses and gains are treated according to whether they relate to an equity instrument or a financial liability.
HKFRS 9 applies to the recognition of financial assets and liabilities. Financial instruments are recognised when the entity becomes a party to the contractual provisions of the instrument. Financial assets are classified as measured at amortised cost or fair value. Financial liabilities are classified at fair value through profit or loss or amortised cost.
Financial assets may be reclassified from one category to another in certain circumstances. Financial assets should be derecognised when the rights to the cash flows from the asset expire or where substantially all the risks and rewards of ownership are transferred to another party. Financial liabilities should be de-recognised when they are extinguished.
Financial instruments are initially measured at fair value. Transaction costs increase this amount for financial assets classified as measured at amortised cost and decrease this amount for financial liabilities classified as measured at amortised cost. Financial assets are subsequently measured at:

fair value with changes in value normally recognised in profit or loss, or amortised cost with interest recognised in profit or loss.
Financial liabilities are subsequently measured at fair value or amortised cost with gains and losses recognised in profit or loss.
HKFRS 9 Financial Instruments is a recent standard designed to simplify accounting for financial instruments.
The HKFRS states that all financial assets and liabilities should be recognised in the statement of financial position, including derivatives.
Financial assets should initially be measured at cost = fair value Subsequently they should be re-measured to fair value except for financial assets classified as measured at amortised cost.
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Financial Reporting
Hedge accounting is permitted in certain circumstances, provided the hedging relationship is clearly defined, measurable and actually effective. There are three types of hedge: fair value hedge; cash flow hedge; hedge of a net investment in a foreign operation. The accounting treatment of a hedge depends on its type. Many users and preparers of accounts have found financial instruments to be complex. The HKICPA has recently issued a Discussion Paper, which aims at reducing complexity.
HKFRS 7 specifies the disclosures required for financial instruments. The standard requires qualitative and quantitative disclosures about exposure to risks arising from financial instruments and specifies minimum disclosures about credit risk, liquidity risk and market risk.
Financial assets measured at amortised cost must be tested for impairment when there is objective evidence of impairment. Any loss is recognised in profit or loss. Embedded derivatives are derivative instruments that are embedded within a host contract that may or may not be a financial instrument. Where the host contract is within the scope of HKFRS 9 the hybrid contract is accounted for as one instrument. Otherwise HKFRS 9 requires that the embedded derivative is separated from the host contract where certain conditions are met and accounted for separately.
Hedge accounting means designating one or more instruments so that their change in fair value is offset by the change in fair value or cash flows of another item.
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Answer 1
Refer to the definitions of financial assets and liabilities given above: (a)
Physical assets: control of these creates an opportunity to generate an inflow of cash or other assets, but it does not give rise to a present right to receive cash or other financial assets. Prepaid expenses, etc: the future economic benefit is the receipt of goods/services rather than the right to receive cash or other financial assets.
(b)
Answer 2
Liability. The preference shares require regular distributions to the holders but more importantly have the debt characteristic of being redeemable. Therefore, according to HKAS 32 Financial Instruments: Presentation they must be classified as liability.
Answer 3
Note. The method to use here is to find the present value of the principal value of the bond, $2m (100,000 $20) and the interest payments of $120,000 annually (6% $2m) at the market rate for non-convertible bonds of 8 per cent, using the discount factor tables. The difference between this total and the principal amount of $2m is the equity element.
Present value of principal $2m 0.681 Present value of interest $120,000 3.993 Liability value Principal amount Equity element
$ 1,362,000 479,160 1,841,160 2,000,000 158,840
Answer 4
(a) (b) ABC should derecognise the asset as its option to repurchase is at the prevailing market value. DEF should not derecognise the asset as it has retained substantially all the risks and rewards of ownership. The stock should be retained in its books even though legal title is temporarily transferred. XYZ has received 90% of its transferred receivables in cash, but whether it can retain this amount permanently is dependent on the performance of the factor in recovering all of the receivables. XYZ may have to repay some of it and therefore retains the risks and rewards of 100% of the receivables amount. The receivables should not be derecognised. The cash received should treat as a loan. The 10% of the receivables that XYZ will never receive in cash should be treated as interest over the six month period; it should be recognised as an expense in profit or loss and increase the carrying amount of the loan. At the end of the six months, the receivables should be derecognised by netting them against the amount of the loan that does not need to be repaid to the factor. The amount remaining is bad debts which should be recognised as an expense in profit or loss.
(c)
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Financial Reporting
Answer 5
(a) Amortised cost 20X1 20X2 $000 $000 Profit or loss Interest income (W1)/(W2) Gain/(loss) due to change in FV (W2) (b) FV through P/L 20X1 20X2 $000 $000
1,200 1,200
1,200 1,200
1,200 (187) 1,013
1,387 1,387
Statement of financial position Financial asset (W1)/(W2)
20,000
19,813
* reclassified from equity to profit or loss on derecognition. WORKINGS 1

Amortised cost
Cash 1.1.20X1 Effective interest at 6% (same as nominal as no discount on issue/premium on redemption) Coupon received (nominal interest 6% 20m) At 31.12.20X1 Effective interest at 6% Coupon and capital received ((6% 20m) + 20m) At 31.12.20X2 2
Fair value
$000 20,000 1,200 (1,200) 20,000 1,200 (21,200) $000 20,000 1,200 (1,200) (187) 19,813 1,387 (21,200) $000 19,813
Cash Effective interest (as above) Coupon received (as above) Fair value loss (balancing figure) At 31.12.20X1 (W3) Interest at 7% (7% 19,813) Coupon and capital received ((6% 20m) + 20m) At 31.12.20X2 3
Fair value at 31.12.20X1
Interest and capital due on 31.12.20X2 at new market rate (21.2m/1.07)
Answer 6
D Issue costs Interest $1,000,000 x 5% x 7 Premium on redemption Total finance cost $ 30,000 350,000 260,000 640,000
Answer 7
The bond is a 'deep discount' bond and is a financial liability of Grumble Co. It is measured at amortised cost. Although there is no interest as such, the difference between the initial cost of the
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bond and the price at which it will be redeemed is a finance cost. This must be allocated over the term of the bond at a constant rate on the carrying amount. To calculate amortised cost we need to calculate the effective interest rate of the bond: 1,000,000 = 1.191 over three years 839,619 To calculate an annual rate, we take the cube root, (1.191) 6 per cent
1/3
= 1.06, so the annual interest rate is
The charge to the statement of comprehensive income is $50,377 ($839,619 6%) The balance outstanding at 31 December 20X2 is $889,996 ($839,619 + $50,377)
Answer 8
A financial asset or group of assets is impaired when its recoverable amount is less than its carrying amount. Possible indications would be: (a) (b) (c) a trade receivable balance where it is now learnt that the credit customer is in financial difficulties a borrower not paying an interest payment on time an investment in shares where the underlying company has filed for bankruptcy protection
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Financial Reporting
Exam practice
Gibb Investment Inc

(a)
27 minutes
At 1 July 20X8, Gibb Investment Inc ('GII') entered into contracts for the following financial instruments: An investment in 300,000 units of mandatorily convertible bonds ('Bonds') issued by a listed company with a principal amount of in aggregate $15 million, carrying an interest rate of 6 per cent per annum payable semi-annually in arrears on 30 June and 31 December up to and including 31 December 20Y0. At 31 December 20Y0, each unit of the Bonds will be mandatorily converted into one share of HK$1 each in the listed company at the conversion price of $50 per share. A deposit of a principal amount of $10 million with a commercial bank, carries an interest rate of 2.5% per annum and has a maturity date of 30 June 20Y0. Interest will be receivable at maturity together with the principal. In addition, an additional 3 per cent interest per annum will be payable by the bank if the exchange rate of HKD against RMB exceeds or is higher or equal to $1.15 to RMB 1.
(b)
Gll's functional currency is Hong Kong dollars.

Required
Explain how GII shall account for the above financial instruments in the financial statements for the year ended 31 December 20X8. (15 marks)
HKICPA May 2009 (amended)
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chapter 19
Foreign currency transactions

Topic list
1 2 3 HKAS 21 The Effects of Changes in Foreign Exchange Rates Foreign currency transactions in individual company accounts Consolidation of foreign operations
Learning focus
The issue of foreign currency, be it recording a few foreign currency transactions or consolidating several foreign currency subsidiaries, is relevant to a large number of companies. It is therefore important that you understand how transactions and financial statements are translated, and how the resulting exchange differences are recognised.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Accounts for transactions in accordance with Hong Kong Financial Reporting Standards 3.19 The effects of changes in foreign exchange rates 3.19.01 3.19.02 3.19.03 3.19.04 Determine the functional currency of an entity in accordance with HKAS 21 Translate foreign operation financial statements to the presentation currency Account for foreign currency transactions within an individual company and in the consolidated financial statements Account for disposal or partial disposal of a foreign operation
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19: Foreign currency transactions | Part C Accounting for business transactions
1 HKAS 21 The Effects of Changes in Foreign Exchange Rates

Topic highlights
HKAS 21 provides accounting guidance on the translation of foreign currency transactions and foreign currency financial statements. It prescribes which exchange rates should be used and how exchange differences are recognised.
1.1 Objective
An entity may be involved in foreign activities in two ways: (a) It may be involved in transactions in foreign currencies, such as buying or selling goods. For example, an Indian company might buy materials from Canada, pay for them in US dollars, and then sell its finished goods in Germany receiving payment in Euros, or perhaps in some other currency. If the company owes money in a foreign currency at the end of the accounting year, or holds assets which were bought in a foreign currency, those liabilities or assets must be translated into the local currency (in this Learning Pack $), in order to be shown in the books of account. It may have foreign operations, for example an overseas subsidiary. This subsidiary is likely to trade, and keep accounts, in its own local currency. However in order to consolidate its results into the group accounts, its financial statements must be translated into the currency in which the group reports.
(b)
HKAS 21 provides guidance on how foreign currency transactions should be translated and accounted for, and how the financial statements of foreign operations should be translated into a presentation currency prior to consolidation. In particular, the standard considers: which exchange rate to use, and how exchange differences should be recognised in the financial statements.
Sections 2 and 3 of this chapter deal with foreign currency transactions in individual companies and the translation of foreign currency financial statements. First, however, we must consider a number of important definitions.
HKAS 21.8
1.2 Definitions
The following definitions are given within HKAS 21:
Key terms
Foreign currency is a currency other than the functional currency of the entity. Functional currency is the currency of the primary economic environment in which the entity operates. Presentation currency is the currency in which the financial statements are presented. Exchange rate is the ratio of exchange for two currencies. Exchange difference is the difference resulting from translating a given number of units of one currency into another currency at different exchange rates. Spot exchange rate is the exchange rate for immediate delivery.
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Financial Reporting
Key terms (cont'd)

Closing rate is the spot exchange rate at the end of the reporting period. Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. Foreign operation is an entity that is a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity. Net investment in a foreign operation is the amount of the reporting entity's interest in the net assets of that operation. (HKAS 21)
1.2.1 Functional and presentation currencies

As defined above, the functional currency of an entity is the currency of the primary economic environment in which the entity operates, in other words the currency in which it normally spends and receives cash. Each entity should determine its functional currency and measure its results and financial position in that currency. For most individual companies the functional currency will be the currency of the country in which they are located and in which they carry out most of their transactions. Regardless of its functional currency, an entity can choose any currency to be its presentation currency ie the currency in which the financial statements are presented.
HKAS 21.911
1.2.2 Determining functional currency

HKAS 21 states that the following should be considered in determining functional currency: (a) (b) (c) The currency that mainly influences sales prices for goods and services (often the currency in which prices are denominated and settled) The currency of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services The currency that mainly influences labour, material and other costs of providing goods or services (often the currency in which prices are denominated and settled)
The following may also provide evidence of an entity's functional currency: (a) (b) The currency in which funds from financing activities (raising loans and issuing equity) are generated The currency in which receipts from operating activities are usually retained
Where a parent has a foreign operation a number of factors are considered in order to decide whether the functional currency is the same as that of the parent: (a) (b) (c) (d) Whether the activities of the foreign operation are carried out as an extension of the parent, rather than being carried out with a significant degree of autonomy. Whether transactions with the parent are a high or a low proportion of the foreign operation's activities. Whether cash flows from the activities of the foreign operation directly affect the cash flows of the parent and are readily available for remittance to it. Whether the activities of the foreign operation are financed from its own cash flows or by borrowing from the parent.
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HKAS 21.35
1.2.3 Change in functional currency

The functional currency of an entity can be changed only if there is a change to the underlying transactions, events and conditions that are relevant to the entity. For example, an entity's functional currency may change if there is a change in the currency that mainly influences the sales price of goods and services. Where there is a change in an entity's functional currency, the entity translates all items into the new functional currency prospectively (ie, from the date of the change) using the exchange rate at the date of the change.
2 Foreign currency transactions in individual company accounts

Topic highlights
Foreign currency transactions are initially translated at the spot rate on the transaction date. Balances relating to monetary items are re-translated at the reporting date. An exchange gain or loss may be recognised on re-translation and settlement.
It is increasingly common for individual entities to engage in transactions denominated in a foreign currency. They may: sell to foreign customers buy from foreign suppliers borrow from foreign banks
In each of these instances the foreign currency transaction must be translated to the functional currency of the entity before it is recorded in the accounts. Where a balance denominated in foreign currency remains at the period end, this may require re-translating.
HKAS 21.21,22
2.1 Foreign currency transactions: initial recognition

HKAS 21 states that a foreign currency transaction should initially be translated to the functional currency, by applying the spot exchange rate between the reporting currency and the foreign currency at the date of the transaction. An average rate for a period may be used if exchange rates do not fluctuate significantly. For example, suppose a local company buys a large consignment of goods from a supplier in Singapore. The order is placed on 1 March and the agreed price is SG $124,000. At the time of delivery the rate of foreign exchange was SG$4 to $1. The local company would record the amount owed in its books as follows. DEBIT CREDIT Purchases (124,000 4) Payables account $31,000 $31,000
2.2 Foreign currency transactions: settlement before the period end

When the outstanding foreign currency balance is settled, an exchange difference is likely to arise. This is because exchange rates commonly fluctuate. To consider the example given above, let's assume that the Singapore supplier is paid on 1 July, and on this date the rate of exchange was SG$5 to $1. The local company is obliged to pay SG$124,000, and can obtain this amount on 1 July for $24,800 (SG$124,000 5). The company
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Financial Reporting
has therefore made an exchange gain of $6,200, being the difference between the amount of the payable in the books and the amount actually paid: DEBIT CREDIT Payables account Cash Exchange gain $31,000 $24,800 $6,200
HKAS 21.23
2.3 Foreign currency transactions: settlement after the period end

Where a foreign currency balance is not settled before the end of the reporting period, it may require re-translating for inclusion in the period end accounts. HKAS 21 requires that foreign currency balances are classified as either monetary or nonmonetary for this purpose. Monetary items are cash or amounts that will be settled in cash, for example receivables, payables and loans. Non-monetary items are balances such as non-current assets and inventories which do not involve a transfer of cash. The following rules apply at each period end. (a) (b) (c) Monetary items are re-translated using the closing rate. Non-monetary items which are carried at historical cost are not re-translated (ie they continue to be reported based on the spot exchange rate on the date of acquisition). Non-monetary items which are carried at fair value are not re-translated (ie they continue to be reported based on the exchange rates that existed when fair value was determined).
Example: Exchange
Silk Co sells goods to a Japanese company on 1 May 20X9, and agrees that payment should be made in Japanese Yen at a price of Y116,000 at the end of July 20X9. Silk Co prepares its accounts to 30 June. Relevant exchange rates are: 1 May 20X9 30 June 20X9 31 July 20X9 Y10.75 to $1 Y11 to $1 Y11.6 to $1
Silk Co would record the sale as follows: DEBIT CREDIT Receivables account (Y116,000 10.75) Sales $10,791 $10,791
At the period end, Silk Co must re-translate the receivable amount based on the spot rate on 30 June 20X9. The re-translated receivables balance will be $10,545 (Y116,000 11). Therefore: DEBIT CREDIT Exchange loss Receivables account ($10,791 $10,545) $246 $246
An exchange loss arises as the receivables amount has lost value in $. When the Y116,000 are paid at the end of July, Silk Co will convert them into $, to obtain (Y116,000 11.6) $10,000. Therefore a further loss arises: DEBIT CREDIT Cash Exchange loss Receivables account $10,000 $545 $10,545
HKAS 21.28
2.4 Recognition of exchange differences

As we have seen, exchange differences arise where the exchange rate changes between the transaction date and the reporting and settlement date.
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These exchange differences should be recognised in profit or loss: Exchange differences relating to items settled in the period in which they arise are recognised in that period. Exchange differences relating to items which are not settled in the period in which they arise are recognised in more than one period: At each reporting date an exchange difference is recognised on re-translation At the settlement date a further exchange difference is recognised.
In some unusual cases, an entity may recognise exchange differences relating to trading items (such as receivables and payables) as operating expenses or income, and exchange differences relating to financing as part of interest expense or income. HKAS 12 Income Taxes should be applied when there are tax effects arising from gains or losses on foreign currency transactions. Where exchange losses are allowable expenses in a particular jurisdiction, tax relief will be given. Exchange gains may be treated as taxable income.
FineRt is a retailer of artworks and sculptures. The company has a year end of 31 December 20X1 and uses $ as its functional currency. On 28 October 20X1, FineRt purchased 10 paintings from a supplier for 920,000 pesas each, a total of 9,200,000 pesas. Exchange rates were as follows: 28 October 20X1 12 December 20X1 31 December 20X1 1 February 20X2 $1:1.8 pesa $1:1.9 pesa $1:2.0 pesa $1:2.4 pesa
FineRt sold seven of the paintings for cash on 12 December 20X1 with the remaining three paintings being sold on 1 February 20X2. All 10 of the paintings were paid for by FineRt on 1 February 20X2. Required What accounting entries are made in respect of the payable amount on each of the key dates? (The answer is at the end of the chapter)
When a gain or loss on a non-monetary item is recognised in other comprehensive income (for example, where property is revalued), any related exchange differences should also be recognised in other comprehensive income.
3 Consolidation of foreign operations

Topic highlights
Where a foreign operation has the same functional currency as the parent company, its accounts are translated as if it were an extension of the parent company. Where a foreign operation has a different functional currency from the parent company, its accounts are translated using the method specified in HKAS 21.
A holding or parent company with foreign operations must translate the financial statements of those operations into its own reporting currency before they can be consolidated into the group
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Financial Reporting
accounts. There are two methods: the method used depends upon whether the foreign operation has the same functional currency as the parent. If the foreign operation carries out its business as though it were an extension of the parent's operations, it almost certainly has the same functional currency as the parent. If the foreign operation has some degree of autonomy (so it accumulates cash and other monetary items, generates income and incurs expenses, and may also arrange borrowings, all in its own local currency) it almost certainly has a different functional currency from the parent.
The translation method used has to reflect the economic reality of the relationship between the reporting entity (the parent) and the foreign operation. A foreign subsidiary could be an extension of the parent or have a degree of autonomy. Which it is will depend upon the specific circumstances and its relations with its parent. However, a foreign associate is never merely an extension of its investor, since the investor only significantly influences it. Therefore, the identification of the functional currency of an associate will be independent of the identification of the functional currency of the investor.
3.1 Same functional currency as the reporting entity

Where the foreign operation has the same functional currency as the parent, any movement in the exchange rate between the functional currency of the foreign operation (and so of the parent) and any other currency will have an immediate impact on the parent entity's cash flows from the foreign operations. This is because the foreign operation is an extension of the parent. In other words, changes in the exchange rate affect the individual monetary items held by the foreign operation, not the reporting entity's net investment in that operation. In this case: Statement of financial position Monetary items are re-translated at the period end using the closing rate Non-monetary items continue to be carried at the historical rate on the date of acquisition (or on the date of revaluation in the case of revalued items) Shareholders' funds is a balancing figure
Statement of comprehensive income Sales, purchases and expenses are translated at the average rate Opening inventory and closing inventory are translated at inventory opening rate and inventory closing rate Depreciation of non-monetary items is translated based on historical rate (HR) Exchange differences are reported as part of profit or loss.
3.2 Different functional currency from the reporting entity

Where the foreign operation has a different functional currency from the parent, a change in the exchange rate between the functional currency of the parent and that of the foreign operation will produce little or no direct effect on the present and future cash flows from operations of either the foreign operation or the reporting entity. This is because the cash flows of the foreign operation and its foreign exchange risk are relatively independent of the parent. Rather, the change in exchange rate affects the reporting entity's net investment in the foreign operation, not the individual monetary and non-monetary items held by the foreign operation. In this case HKAS 21 describes a specific method of translation to the presentation currency (which is often the parent's functional currency), which is considered in more detail in the next sections. 428
HKAS 21.39,40
3.2.1 Accounting treatment: different functional currency from the reporting entity
Topic highlights
Assets and liabilities are translated at the closing rate. Income and expenditure are translated at the average rate. Exchange differences are recognised as other comprehensive income.
HKAS 21 specifies the following rules to be applied in translating the financial statements of a foreign operation with a different functional currency from the parent company: In the statement of financial position, assets and liabilities are translated at the closing rate at the year end, regardless of the date on which those items originated. In the statement of comprehensive income, income and expenditure should be translated at the rate ruling at the date of the transaction, although an average rate will usually be used for practical purposes where the exchange rate does not fluctuate significantly over a period. Exchange differences arising from the re-translation at the end of each year of the parent's net investment should be recognised in other comprehensive income, not through the profit or loss for the year, until the disposal of the net investment.
The rules of HKAS 21 are summarised in the following tables: Statement of financial position Balance Property, plant & equipment Inventory Receivables Cash Loan Payables Shareholders' funds: Share capital Pre-acquisition reserves Post-acquisition reserves Historical rate (HR) at date of acquisition of foreign operation Historical rate (HR) at date of acquisition of foreign operation Balancing figure (which includes exchange differences) Translation rate Closing rate (CR) Closing rate (CR) Closing rate (CR) Closing rate (CR) Closing rate (CR) Closing rate (CR)
Statement of comprehensive income Particular Sales (Cost of sales) (Operating expenses) (Interest) (Tax) Other comprehensive income Translation rate Average (AR) Average (AR) Average (AR) Average (AR) Average (AR) Average (AR) Includes exchange difference arising on translation
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Any dividend paid, as reported in the statement of changes in equity is translated using the spot rate on the date on which the dividend was paid.
HKAS 21.41
3.2.2 Exchange differences

The exchange difference arising on the translation of financial statements to the presentation currency is due to: translating income/expense items at the exchange rates at the date of transactions (or average rate), whereas assets/liabilities are translated at the closing rate translating the opening net investment (opening net assets) in the foreign entity at a closing rate different from the closing rate at which it was previously reported translating the dividend received or paid at the exchange rates at the date of the dividend being received or paid
The exchange difference for inclusion within other comprehensive income can therefore be calculated in the following way: $ $ Opening net assets at closing rate X Opening net assets at opening rate (X) Exchange gain / (loss) X/(X) Retained profits at closing rate X Retained profits at average rate (X) Exchange gain / loss X/(X) Overall exchange gain / loss X/(X) HKAS 12 Income Taxes should be applied when there are tax effects arising on the translation of the financial statements of foreign operations.
Example: Exchange difference

Stockpot has a wholly-owned foreign subsidiary, Crockpot, with net assets at 1 January 20X1 of N$800 million. Crockpot made a profit for the year ending 31 December 20X1 of N$280 million. The functional currency of Crockpot is the N$. Stockpots consolidated financial statements were prepared to 31 December 20X1 and the presentation currency is Hong Kong dollars. Exchange rates were as follows: 1 January 20X1 31 December 20X1 Average rate for 20X1 Required How would the exchange gain or loss on the investment in Crockpot be recognised in the consolidated financial statements of Stockpot for the year ending 31 December 20X1? N$2.0:$1 N$3.0:$1 N$2.5:$1
Solution
Net assets at 1 January 20X1 at rate on 31.12.X0 Net assets at 1 January 20X1 at rate on 31.12.X1 Profit for the year at average rate Profit at 31 December 20X1 rate N$800 @ 2.0 N$800 @ 3.0 N$280 @ 2.5 N$280 @ 3.0 $m 400 267 112 93 $m 133 loss 19 loss 152 loss
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3.3 Further matters relating to the consolidation of foreign operations

3.3.1 Goodwill and fair value adjustments
Goodwill arising under HKFRS 3 Business Combinations from the acquisition of a foreign operation should initially be calculated in the functional currency of the subsidiary. It is then treated as an asset of the foreign operation and should be translated at the closing rate each year. The exchange difference arising is recorded as other comprehensive income in the consolidated accounts and accumulated in group equity.
Example: Goodwill
Surf Co acquired 100 per cent of Wave Co for consideration of 78.6 million (Foreign Currency) on 1 April 20X8 when the net assets of Wave Co were 66 million. Surf Co's presentation currency is the $ and relevant exchange rates are: 1 April 20X8 31 March 20X9 12:$1 11:$1
At what amount is goodwill recognised in the consolidated statement of financial position on 31 March 20X9 and what amount is recognised as an exchange difference on goodwill for the period?
Solution
Goodwill Consideration transferred Net assets of Wave at 1 April 20X8 At 1 April 20X8 Foreign exchange gain At 31 March 20X9 * ** Historical rate Closing rate '000 78,600 (66,000) 12,600 12,600 Rate 12 * Balance 11 ** $'000 1,050 95 1,145
Goodwill is therefore reported in the statement of financial position at $1,145,000 and an exchange gain of $95,000 is recognised in other comprehensive income.
3.3.2 Consolidation procedures

When a parent has a foreign subsidiary, consolidation procedures are applied as normal. Therefore, intra-group transactions and balances are eliminated. However, transactions between parent and foreign subsidiary can lead to exchange gains and losses in the individual books and records of each entity. These exchange gains and losses are recognised in the profit or loss of each entity in accordance with the normal rules in transactions in foreign currencies. On consolidation any exchange gains and losses in the individual profit or loss of parent and subsidiary which do not eliminate are reported in the consolidated profit or loss. They are not in general transferred to equity unless certain criteria are met. (See Section 3.3.4 below for when this exception takes place.) Because of different laws in different countries, it can happen that the foreign operation's reporting date is different from that of the parent. In this case HKFRS 10 allows the use of the foreign operation's accounts as at its own reporting date to be consolidated with the accounts of the parent as at the parent's own reporting date as long as the foreign operations reporting date is within
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Financial Reporting
three months of the parents. However, adjustments are made for any significant changes in exchange rates which took place in the intervening period between the two dates.
Little was incorporated over twenty years ago, operating as an independent entity for fifteen years until 20X1 when it was taken over by Large. Large's directors decided that the local expertise of Little's management should be utilised as far as possible, and since the takeover they have allowed the subsidiary to operate independently, maintaining its existing supplier and customer bases. Large exercises 'arm's length' strategic control, but takes no part in day-to-day operational decisions. The statements of financial position of Large and Little at 31 March 20X7 are given below. The statement of financial position of Little is prepared in francos (F), its reporting currency. Large $'000 $'000 Non-current assets Property, plant and equipment Investments Current assets Inventories Trade receivables Cash Equity Share capital (50c/1 Franco shares) Retained earnings Revaluation reserve Non-current liabilities Long-term borrowings Deferred tax Current liabilities Trade payables Tax Bank overdraft 20,000 6,000 26,000 25,000 7,000 3,000 35,000 126,000 NOTES TO THE STATEMENTS OF FINANCIAL POSITION (1) Investment by Large in Little On 1 April 20X1 Large purchased 36,000,000 shares in Little for 72 million francos. The accumulated profits of Little at that date were 26 million francos. There was no impairment of goodwill. (2) Intra-group trading Little sells goods to Large, charging a mark-up of one-third on production cost. At 31 March 20X7, Large held $1 million (at cost to Large) of goods purchased from Little in its inventories. The goods were purchased during March 20X7 and were recorded by Large using an exchange rate of $1 = 5 francos. (There were minimal fluctuations between the two currencies during March 20X7.) At 31 March 20X6, Large's inventories included no goods purchased from Little. On 29 March 20X7, Large sent Little a cheque for $1 million to clear the intra-group payable. Little received and recorded this cash on 3 April 20X7. 20,000 8,000 28,000 143,000 63,000 12,000 75,000 25,000 20,000 6,000 51,000 126,000 30,000 35,000 65,000 25,000 10,000 35,000 30,000 28,000 5,000 63,000 143,000 40,000 34,000 6,000 80,000 Little F'000 80,000 80,000 F'000
432
(3)
Accounting policies The accounting policies of the two companies are the same, except that the directors of Little have decided to adopt a policy of revaluation of property, whereas Large includes all properties in its statement of financial position at a depreciated historical cost. Until 1 April 20X6, Little operated from rented warehouse premises. On that date, the entity purchased a leasehold building for 25 million francos, taking out a long-term loan to finance the purchase. The building's estimated useful life at 1 April 20X6 was 25 years, with an estimated residual value of nil, and the directors decided to adopt a policy of straight-line depreciation. The building was professionally revalued at 30 million francos on 31 March 20X7, and the directors have included the revalued amount in the statement of financial position. No other property was owned by Little during the year. Large measures non-controlling interests at acquisition at the proportionate share of the fair value of the subsidiary's net assets.
(4)
Exchange rates Date 1 April 20X1 31 March 20X6 31 March 20X7 Average rate for the year to 31 March 20X7 Average rate for the dates of acquisition of closing inventory Exchange rate Francos to $1 6.0 5.5 5.0 5.2 5.1
Required (a) Explain (with reference to relevant accounting standards to support your argument) how the financial statements (statement of financial position and income statement) of Little should be translated into $ for the consolidation of Large and Little. Translate the statement of financial position of Little at 31 March 20X7 into $ and prepare the consolidated statement of financial position of the Large group at 31 March 20X7.
(b)
Note. Ignore any deferred tax implications of the property revaluation and the intra-group trading. (The answer is at the end of the chapter)
HKAS 21.48,48C
3.3.3 Disposal of foreign entity

A parent may dispose of its foreign operation in total or in part. When it does so, it calculates the profit or loss on disposal as expected. In addition, there will be historical cumulative exchange differences which arise on consolidation, as calculated in Self-test question 2 above, included in reserves up to the date of disposal. On disposal these cumulative exchange differences are transferred from reserves and shown in the profit or loss for the period along with the profit or loss on disposal. This does mean that these exchange differences are effectively recognised twice. The first time they are recognised in reserves as they arise each period on consolidation. They are then recognised for a second time, albeit in a different place, when they are transferred to the profit or loss on disposal. This double recognition is called recycling of profits or losses. Partial disposal If the parent disposes of only part of its holding of a foreign operation which is a division (rather than a subsidiary), it only recycles a proportionate part of the cumulative exchange gains or losses arising on consolidation from reserves to the profit or loss for the period. If the foreign operation is a subsidiary and only part is disposed of, then the relevant proportion of the cumulative exchange differences recognised in reserves now are attributed to the noncontrolling interests in the foreign operation. Accordingly they are transferred to the non-controlling interests account in equity (rather than profit or loss). 433
Financial Reporting
In any other partial disposal of a foreign operation the relevant proportion of the cumulative exchange differences are reclassified to profit or loss. If the carrying value of a foreign operation is written down as an impairment, no recycling of exchange gains or losses takes place.
3.3.4 In the parent's accounts

As explained in Section 3.3.2 above exchange differences arising on a monetary item such as an intra-group receivable or payable in the parent's accounts should be recognised in the profit or loss in the parent's separate financial statements. However, where this intra-group monetary item is a long term intra-group loan that is not planned or likely to be received or paid in the foreseeable future, that balance is regarded as part of the parent's investment in the foreign operation. In this case the exchange gain or loss arising on the translation of this balance which was recognised in the profit or loss in the parent's separate financial statements is recognised in reserves in the consolidated financial statements. This will require a consolidation adjustment transferring the gain or loss from the parent's own profit or loss where it was initially recognised to reserves in the consolidated accounts.
434
Topic recap
HKAS 21 provides accounting guidance on the translation of foreign currency transactions and foreign currency financial statements. It prescribes which exchange rates should be used and how exchange differences are recognised. Foreign currency transactions are initially translated at the spot rate on the transaction date. Balances relating to monetary items are re-translated at the reporting date. An exchange gain or loss may be recognised on re-translation and settlement. Where a foreign operation has the same functional currency as the parent company, its accounts are translated as if it were an extension of the parent company. Where a foreign operation has a different functional currency from the parent company, its accounts are translated using the method specified in HKAS 21: assets and liabilities are translated at the closing rate; income and expenditure are translated at the average rate. Exchange differences are recognised as other comprehensive income. Assets and liabilities are translated at the closing rate. Income and expenditure are translated at the average rate. Exchange differences are recognised as other comprehensive income.
435
Financial Reporting
Answer 1
28 October 20X1 The paintings are purchases and the purchase is translated into $ using the spot rate (ie the exchange rate on the date of the transaction): $ DEBIT CREDIT 31 December 20X1 At the year end, the payable balance is re-translated using the closing rate (the exchange rate at the period end). The resulting gain is recognised in profit or loss for the year: Retranslate payable to 9.2m/2 = $4.6m DEBIT CREDIT 1 February 20X2 On the settlement date, an exchange gain arises, being the difference between the cash required to purchase 9.2million pesas and the carrying value of the payable extinguished: DEBIT CREDIT Payable Cash (9.2m/2.4) Exchange gain 4,600,000 3,833,333 766,667 Payable Exchange gain 511,111 511,111 Purchases (9.2m/1.8) Payable 5,111,111 5,111,111 $
Answer 2
(a) From the information in the question it is clear that Little operates on a largely independent basis from Large with its own supplier and customer bases and no day to day part being played by Large in operational decisions. Therefore the cash flows of Little will not have a day to day impact on those of Large. As such HKAS 21 The Effects of Changes in Foreign Exchange Rates requires that the financial statements of Little for consolidation purposes should be translated using the presentation currency or closing rate method. Under this method the statement of financial position assets and liabilities are translated at the closing rate of exchange on the reporting date and the income statement is translated at an average rate of exchange for the year. Any exchange differences are not reported in the income statement, as they have no impact on the cash flows of the group, but instead are reported as a movement on equity.
436
(b)
TRANSLATION OF LITTLE STATEMENT OF FINANCIAL POSITION INTO $ F'000 Non-current assets Property, plant and equipment (80,000 6,000 revaluation adjustment) Current assets Inventories Trade receivables Cash Equity Share capital Revaluation surplus (6,000 6,000) Pre acquisition retained reserves Post acquisition retained reserves (34,000 26,000) Non-current liabilities Long-term borrowings Deferred tax Current liabilities Trade payables Tax 74,000 30,000 28,000 5,000 137,000 40,000 26,000 8,000 74,000 25,000 10,000 20,000 8,000 137,000 Rate 5 5 5 5 6 6 Bal 5 5 5 5 $'000 14,800 6,000 5,600 1,000 27,400 6,667 4,333 3,800 14,800 5,000 2,000 4,000 1,600 27,400
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X7 $'000 Non-current assets Goodwill (W2) Property, plant and equipment (63,000 + 14,800) Current assets Inventories (25,000 + 6,000 (1,000 25%)) Trade receivables (20,000 + 5,600 1,000) Cash (6,000 + 1,000 + 1,000 cash in transit) Equity Share capital Retained earnings (W3) Non-controlling interest (W4) Non-current liabilities Long-term borrowings (20,000 + 5,000) Deferred tax (6,000 + 2,000) Current liabilities Trade payables (25,000 + 4,000) Tax (7,000 + 1,600) Bank overdraft 25,000 8,000 33,000 29,000 8,600 3,000 40,600 143,670 $'000 2,520 77,800 30,750 24,600 8,000 63,350 143,670 30,000 38,615 1,455 70,070
437
Financial Reporting
WORKINGS (1) Group structure Investment in Little = 36,000/40,000 = 90% Large 1.4.X1 Little Pre-acquisition retained earnings 26 million francos (2) Goodwill F'000 Consideration transferred (12,000 6) Non-controlling interest (66,000 10%) Share capital 40,000 Pre acquisition ret'd earnings 26,000 F'000 72,000 Rate 6 $'000 12,000
36,000 40,000
90%
6,600 (66,000) 12,600 12,600
1,100 (11,000) 2,100 420 2,520 $'000 35,000 3,420 (225) 420 38,615 $'000 1,100 355 1,455
At 1.4.20X1 Foreign exchange gain At 31.3.20X7 (3)

Retained earnings
6 Bal 5
Large Little post acquisition (3,800 90%) Unrealised profit (90% 250) Foreign exchange gain on goodwill (W2) (4)
Non controlling interest
At acquisition (W2) Share of post acquisition retained earnings ((translated SOFP 3,800 250) 10%)
Note: Unrealised profit on inventory. As mark-up is one-third, this means that 25 per cent of the cost to Large is profit. So the unrealised profit on the inventory of 1,000 is 25 per cent, ie 250.
438
Exam practice
Roland Limited
27 minutes
Roland Limited ('RL') has Hong Kong Dollar ('$') functional currency and presentation currency. On 1 January 20X8, RL entered into a contract to acquire a printing machine from a French supplier at a consideration of EURO 10 million. A 30 per cent deposit was paid on 1 February 20X8. RL received the printing machine on 1 April 20X8. The remaining 70 per cent consideration was paid on 30 September 20X8 in accordance with the contract. Depreciation is provided to write off the cost of the printing machine over 10 years using the straight-line method. Exchange rates of EURO 1 at the dates below were: 1 January 20X8 1 February 20X8 1 April 20X8 30 September 20X8 31 December 20X8 $11.6 $11.7 $11.5 $11.3 $11.8
Average rates of EURO 1 for the periods below were: 1 April to 30 September 20X8 1 April to 31 December 20X8
Required
$11.35 $11.4
(a) (b)
Prepare all the journal entries that RL should make for the year ended 31 December 20X8. (9 marks) Explain the implication for the statement of financial position at 31 December 20X8 and the statement of comprehensive income for the year ended 31 December 20X8 if RL chooses the EURO as its presentation currency. (6 marks)
439
Financial Reporting
440
chapter 20
Statements of cash flows
Topic list
1 2 3 Cash flows and HKAS 7 Single company statements of cash flows Consolidated statements of cash flows
Learning focus
Statements of cash flows are very relevant in practice. They are a required element of a set of financial statements and often provide more useful information than that within the other financial statements with regard to liquidity.
441
Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Prepare the financial statements for an individual entity in accordance with Hong Kong Financial Reporting Standards and statutory reporting requirements 4.01 4.01.01 4.09 4.09.03 Primary financial statement preparation Prepare the statement of cash flows of an entity in accordance with Hong Kong accounting standards Consolidated financial statement preparation Prepare a consolidated statement of cash flows 3 3
442
20: Statements of cash flows | Part C Accounting for business transactions
1 Cash flows and HKAS 7

Topic highlights
Statements of cash flows are a useful addition to the financial statements of companies because it is recognised that accounting profit is not the only indicator of a company's performance. A statement of cash flows focuses on the sources and uses of cash and is a useful indicator of companys liquidity and solvency.
Cash is a key element of any business. It must be monitored and managed in order to maintain a liquid position. While the statement of financial position provides a period end cash balance, this in itself does not provide any indication of how an entity generates, uses and manages its cash. Similarly, profit, while providing a good indication of the performance of an entity does not provide any indication of the liquidity of a business, since it is calculated using the accrual basis. The statement of cash flows is therefore required to form part of a set of financial statements by HKAS 1. HKAS 1 does not, however, prescribe the format and content of a statement of cash flows. This guidance is provided within HKAS 7 Statement of Cash Flows. Before considering the standard, it is important to appreciate the advantages of cash flow information.
1.1 Cash flows: advantages

The main advantages of using cash flow accounting (including both historical and forecast cash flows) are as follows. (a) (b) (c) (d) A company's ability to generate cash affects its survival. Cash flow accounting addresses this critical issue. Since profit is dependent on accounting conventions and concepts, cash flow is viewed as more comprehensive. Cash flow is factual, objective and is not subject to as much manipulation as profits. Both long and short term creditors have more interest in an entity's ability to repay them than in its profitability. Cash flow accounting is more direct than profits in pointing out the availability of cash. Cash flow reporting is better than traditional profit reporting in the comparison of the results of different companies. The needs of all users are better satisfied by cash flow reporting. (i) It provides management with information that is useful in decision making ('relevant costs' to a decision are future cash flows in management accounting). Traditional profit accounting does not provide exclusive help in decision making. A satisfactory basis for stewardship accounting is provided by cash flow accounting for shareholders and auditors. Cash flow accounting better serves the information needs of creditors and employees.
(e) (f)
(ii) (iii) (g) (h) (i)
When compared with profit forecasts, cash flow forecasts are more useful and easier to prepare. It is easier to audit cash flow accounts than accounts prepared based on the accruals concept. The accrual concept can be confusing whereas cash flows are easily understood.
443
Financial Reporting
(j) (k)
Cash flow accounting can be retrospective and also prospective in providing a forecast for the future. This information can be of great value to all users of accounting information. Variance statements, which compare actual cash flows against the forecast, can be used to monitor forecasts.
Looking at the same question from a different angle, readers of accounts can be misled by the profit figure. (a) Shareholders might believe that if a company makes a profit after tax of, say $1 million then this is the amount which it could afford to pay as a dividend. Unless the company has sufficient cash available to stay in business and also to pay a dividend, the shareholders' expectations would be wrong. Employees might believe that if a company makes profits, it can afford to pay higher wages next year. This opinion may not be correct: the ability to pay wages depends on the availability of cash. Creditors might consider that a profitable company is a going concern. (i) If a company builds up large amounts of unsold inventories of goods, their cost would not be chargeable against profits, but cash would have been used up in making them, thus weakening the company's liquid resources. A company might capitalise large development costs, having spent considerable amounts of money on research and development, but only charge small amounts against current profits. As a result, the company might show reasonable profits, but get into severe difficulties with its liquidity position.
(b)
(c)
(ii)
(d)
Management might suppose that if their company makes a historical cost profit, and reinvests some of those profits, then the company must be expanding. This is not the case: in a period of inflation, a company might have a historical cost profit but a current cost accounting loss, which means that the operating capability of the firm will be declining. Survival of a business entity depends not so much on profits as on its ability to pay its debts when they fall due. Such payments might include 'profit and loss' items such as material purchases, wages, interest and taxation etc, but also capital payments for new non-current assets and the repayment of loan capital when this falls due (eg on the redemption of debentures).
(e)
1.2 HKAS 7 Statement of Cash Flows

Topic highlights
HKAS 7 provides the format of a statement of cash flows and guidance on the required content.
1.2.1 Objective
The objective of this standard is to require the provision of information about the historical changes in cash and cash equivalents of an entity by means of a statement of cash flows which classifies cash flows during the period from operating, investing and financing activities.
1.2.2 Scope
Users of an entitys financial statements are interested in how the entity generates and uses cash and cash equivalents. This is the case regardless of the nature of the entitys activities. Therefore, all entities must provide a statement of cash flows as an integral part of an entity's financial statements.
444
HKAS 7.6-9
1.2.3 Definitions
The standard gives the following definitions, the most important of which are cash and cash equivalents.
Key terms
Cash comprises cash on hand and demand deposits. Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. Cash flows are inflows and outflows of cash and cash equivalents. Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities. Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. Financing activities are activities that result in changes in the size and composition of the contributed equity and borrowings of the entity. (HKAS 7) The standard expands on the definition of cash equivalents: they are held to meet short-term cash commitments rather than for investment or other long-term purposes. They are required to be readily convertible to a known amount of cash and therefore their maturity date should normally be three months from its acquisition date. It would usually be the case then that equity investments (ie shares in other companies) are not cash equivalents. An exception would be where preferred shares were acquired with a very close maturity date. Loans and other borrowings from banks are normally classified as financing activities. In some countries, however, bank overdrafts are repayable on demand and are treated as part of an entity's total cash management system. In these circumstances an overdrawn balance will be included in cash and cash equivalents. Such banking arrangements are characterised by a balance which fluctuates between overdrawn and credit. Movements between different types of cash and cash equivalents are not included in cash flows. The investment of surplus cash in cash equivalents is part of cash management, not part of operating, investing or financing activities.
2 Single company statements of cash flows

Topic highlights
Cash flows are classified as cash flows from operating, investing and financing activities in a statement of cash flows. Cash flows from operating activities may be calculated using the direct or indirect method.
HKAS 7.10,11
2.1 Presentation of a statement of cash flows

According to HKAS 7, reported cash flows during a period should be classified into operating, investing and financing activities in a statement of cash flows. The way of presenting cash flows under operating, investing and financing activities is dependent on the nature of the reporting entity. The classification enables users to understand the impact of each activity on cash and cash equivalents and their interrelationship.
445
Financial Reporting
HKAS 7.1315
2.1.1 Operating activities

This section of the statement of cash flows shows whether, and to what extent, companies can generate cash from their operations. It is this cash from day to day trading which must, in the end pay for all cash outflows relating to other activities, such as paying loan interest, tax and dividends. The standard gives the following as examples of cash flows from operating activities. Cash receipts from the sale of goods and the rendering of services Cash receipts from royalties, fees, commissions and other revenue Cash payments to suppliers for goods and services Cash payments to and on behalf of employees Cash payments/refunds of income taxes unless they can be specifically identified with financing or investing activities Cash receipts and payments from contracts held for dealing or trading purposes
The effects of these transactions are all included in the calculation of profit or loss, however certain items may be included in the net profit or loss for the period which do not relate to operational cash flows. For example, the profit or loss on the disposal of property, plant and equipment will be included in net profit or loss, but the cash flows will be classed as investing. However, cash payments to manufacture or acquire assets held for rental to others and subsequently held for sale as described in paragraph 68A of HKAS 16 Property, Plant and Equipment are cash flows from operating activities. The cash receipts from rents and subsequent sales of such assets are also cash flows from operating activities.
HKAS 7.16
2.1.2 Investing activities

Cash flows from investing activities show the extent of new investment in assets that will generate future income and cash flows. Only expenditures that result in a recognised asset in the statement of financial position are eligible for classification as investing activities. The standard gives the following examples of cash flows arising from investing activities. Cash payments to acquire property, plant and equipment, intangibles and other long-term assets, including those relating to capitalised development costs and self-constructed property, plant and equipment Cash receipts from sales of property, plant and equipment, intangibles and other long-term assets Cash payments to acquire shares or debentures of other entities Cash receipts from sales of shares or debentures of other entities Cash advances and loans made to other parties Cash receipts from the repayment of advances and loans made to other parties Cash payments for or receipts from futures/forward/option/swap contracts except when the contracts are held for dealing purposes, or the payments/receipts are classified as financing activities
446
HKAS 7.17
2.1.3 Financing activities

Cash flows from financing activities show the share of cash claimed by capital providers during the period. This serves as an indicator of likely future interest and dividend payments. The standard gives the following examples of cash flows which might arise under these headings. Cash proceeds from issuing shares Cash payments to owners to acquire or redeem the entity's shares Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or long-term borrowings Cash repayments of amounts borrowed Cash payments by a lessee for the reduction of the outstanding liability relating to a finance lease
2.1.4 Example of statement of cash flows

Statement of cash flows for the year ended 31 December 20X9 Cash flows from operating activities Cash receipts from customers Cash paid to suppliers and employees Cash generated from operations Interest paid Income taxes paid Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment Proceeds from sale of equipment Interest received Dividends received Net cash used in investing activities Cash flows from financing activities Proceeds from issuance of share capital Proceeds from long-term borrowings Payment of finance lease liabilities Dividends paid* Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period * This could also be shown as an operating cash flow Cash and cash equivalents: Cash on hand and balances with banks Short-term investments Cash and cash equivalents 20X9 $'000 50 270 320 20X8 $'000 35 195 230 330 330 (100) (1,250) (690) 90 230 320 $'000 $'000
34,630 (32,400) 2,230 (320) (820) 1,090 (840) 30 250 250 (310)
447
Financial Reporting
HKAS 7.18
2.2 Cash generated from operations

The standard offers a choice of method for the calculation of cash generated from operations: (a) (b) The direct method involves disclosing major classes of gross cash receipts and gross cash payments The indirect method involves adjusting the profit or loss for the effects of: 1 2 3 transactions of a non-cash nature any deferrals or accrual of past or future operating cash receipts or payments and items of income or expense associated with investing or financing cash flows
The example shown above in Section 2.1.4 uses the direct method.
HKAS 7.19
2.2.1 The direct method

The direct method involves listing cash receipts and cash payments in respect of day to day transactions. A simple example may be as follows: $ Cash in respect of cash sales X Cash received from credit customers X Cash purchases (X) Cash paid to credit suppliers (X) Cash expenses paid (including wages) (X) Cash generated from operations X The most obvious way to obtain information about gross cash receipts and payments is simply to extract the information from the accounting records. An alternative method involves adjusting sales, cost of sales and other items in the statement of comprehensive income for: changes in inventories, receivables and payables during the period other non-cash items other items for which the cash effects are investing or financing cash flow.
Practically, this involves reconstructing nominal ledger accounts in order to extract cash flows. This may be a laborious task, however, and the indirect method described below may be easier.
HKAS 7.20
2.2.2 The indirect method

This method is undoubtedly easier from the point of view of the preparer of the statement of cash flows. The profit or loss for the period is adjusted for the following: Changes during the period in inventories, operating receivables and payables Non-cash items, eg depreciation, provisions, profits/losses on the sales of assets Other items, the cash flows from which should be classified under investing or financing activities. $ X X X (X)/X (X)/X X/(X) X (X) (X) X
A proforma of such a calculation is as follows: Profit before taxation (statement of comprehensive income) Depreciation Loss (profit) on sale of non-current assets (working capital) (Increase)/decrease in inventories (Increase)/decrease in receivables Increase/(decrease) in payables Cash generated from operations Interest (paid)/received Income taxes paid Net cash flows from operating activities
448
It is important to understand why certain items are added and others subtracted. Note the following points. (a) Depreciation is not a cash expense, but is deducted in arriving at the profit figure in the statement of comprehensive income. It makes sense, therefore, to eliminate it by adding it back. By the same logic, a loss on a disposal of a non-current asset (arising through underprovision of depreciation) needs to be added back and a profit deducted. An increase in inventories means less cash you have spent cash on buying inventory. An increase in receivables means the company's debtors have not paid as much, and therefore there is less cash. A decrease in payables means the company has paid more to suppliers and so has less cash.
(b) (c) (d) (e)
The illustration below shows a full statement of cash flows using the indirect method.
Illustration: Indirect method

STATEMENT OF CASH FLOWS (INDIRECT METHOD) FOR THE YEAR ENDED 31 DECEMBER 20X9 $'000 Cash flows from operating activities Profit before taxation Adjustments for: Depreciation Investment income Interest expense Increase in trade and other receivables Decrease in inventories Decrease in trade payables Cash generated from operations Interest paid Income taxes paid Net cash from operating activities Cash flows from investing activities Purchase of property, plant and equipment Proceeds from sale of equipment Interest received Dividends received Net cash used in investing activities Cash flows from financing activities Proceeds from issue of share capital Proceeds from long-term borrowings Payment of finance lease liabilities Dividends paid* Net cash used in financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period * This could also be shown as an operating cash flow 330 330 (100) (1,250) (690) 90 230 320 (840) 30 250 250 (310) 2,630 540 (450) 390 3,110 (600) 1,000 (1,280) 2,230 (320) (820) 1,090 $'000
449
Financial Reporting
Cash and cash equivalents: Cash on hand and balances with banks Short-term investments Cash and cash equivalents
20X9 $'000 50 270 320
20X8 $'000 35 195 230
2.2.3 Indirect versus direct

Use of the direct method is encouraged, but not required, by HKAS 7, as this method provides information which may be useful in estimating future cash flows, which is not available under the indirect method.
2.3 Specific cash flows

HKAS 7.31,34
2.3.1 Interest and dividends

Sources (cash inflows) and uses (outflows) of cash relating to interest and dividends should be separately disclosed. Each cash flow should be classified consistently from period to period either as operating, investing or financing. Dividends paid by the entity can be classified in one of two ways. (a) (b) As a financing cash flow, showing the cost of obtaining financial resources. As a component of cash flows from operating activities so that users can assess the entity's ability to pay dividends out of operating cash flows.
Interest paid or received is calculated by reference to the income statement amount for the year adjusted for any accrual or other statement of financial position amount. Dividends paid or received are identified in the notes to a set of financial statements.
Example: Interest
Odile Co reports the following amounts in its financial statements relating to interest: Finance costs in the income statement Interest accrued at start of year Interest accrued at end of year What is Odile Cos interest paid? $ 8.7m 1.2m 3.1m
Solution
Interest paid is calculated as 1.2m + 8.7m 3.1m = $6.8 million.
HKAS 7.35,36
2.3.2 Taxes on income

Cash flows relating to taxes should also be separately disclosed. They should be classified as items under operating activities unless they can be specifically identified with financing and investing activities. It is often difficult to match cash flows arising from taxes with the originating underlying transaction, therefore tax cash flows are usually classified as arising from operating activities.
450
Tax paid (or refunded) is calculated by reference to the tax charge (or credit) for the year, adjusted for any statement of financial position amounts.
Example: Taxes on income

Allisters estimated tax payable for the year ended 31 March 20X1 is $89,100. The equivalent figure for the year ended 31 March 20X0 was $97,200. The tax charge reported in the income statement for the year ended 31 March 20X1 was $101,000, which included a $12,000 increase in deferred tax. What tax was paid in the year?
Solution
Tax liability b/f Tax charge ($101,000-$12,000) Tax liability c/f Tax paid $ 97,200 89,000 186,200 (89,100) 97,100
2.3.3 Finance lease payments

Rentals under a finance lease include capital and interest elements. These are split out for the purpose of inclusion in the statement of cash flows and reported as financing and operating cash flows respectively.
Example: Lotus Co
The notes to the financial statements of Lotus Co show the following in respect of finance leases: 20X9 20X8 $000 $000 Amounts payable within one year 12 8 Within 2-5 years 110 66 122 74 Less finance charges allocated (14) (8) 108 66 Additions to non-current assets acquired under finance leases were shown in the non-current asset note at $56,000. What is the capital repayment to be shown in the statement of cash flows for Lotus Co in the year ended 31 December 20X9? Year ended 31 December
Solution
Finance leases Balance at 31 December 20X8 Additions for the year Balance at 31 December 20X9 Capital repayment (balancing fig) $000 66 56 (108) 14
451
Financial Reporting
2.3.4 Cash flows associated with non-current assets

Where non-current assets are acquired through purchase, rather than lease, the additions figure in the non-current asset note (adjusted for any outstanding amount owed) equates to the cash outflow. Where non-current assets are disposed of, the cash proceeds is calculated by adding any profit on disposal (or deducting any loss) to (from) the carrying value of the disposals (identified from the non-current asset note).
Example
The following extracts are taken from the financial statements of Rooibus for the year ended 30 September 20X0: STATEMENT OF FINANCIAL POSITION Cost of PPE Accumulated depreciation STATEMENT OF COMPREHENSIVE INCOME Depreciation charge Loss on disposal of PPE Other comprehensive income Revaluation surplus (land) Assets costing $85m were disposed of in the year. Required What cash has Rooibus paid to acquire new non-current assets in the period, and what are the proceeds of sale of old non-current assets? 20 55 5.5 20X0 $m 520 165 20W9 $m 420 189
Solution
Cost $m b/f 420 Additions (balancing) 165 Revaluation 20 Disposal (85) c/f 520 Cash paid to acquire non-current assets Depreciation b/f Charge Disposals (balancing) c/f $165m $0.5m $m 189 55 (79) 165
Proceeds of sale of non-current assets (85m-79m-5.5m)
2.3.5 Borrowings and share capital

When calculating the proceeds of a share or loan issue or loan repaid, the balance outstanding at the start of the period should be compared with the balance at the end of the period. In respect of shares it is important to consider the aggregate of share capital and share premium.
2.4 Disclosure
HKAS 7.43
2.4.1 Non cash transactions

Investing and financing transactions that do not require the use of cash or cash equivalents shall be excluded from a statement of cash flows. Such transactions shall be disclosed elsewhere in the
452
financial statements in a way that provides all the relevant information about these investing and financing activities.
HKAS 7.45,46
2.4.2 Components of cash and cash equivalents

The components of cash and cash equivalents should be disclosed and a reconciliation should be presented, showing the amounts in the statement of cash flows reconciled with the equivalent items reported in the statement of financial position. It is also necessary to disclose the accounting policy used in deciding the items included in cash and cash equivalents, in accordance with HKAS 1, but also because of the wide range of cash management practices worldwide.
HKAS 7.48,50
2.4.3 Other disclosures

All entities should disclose, together with a commentary by management, any other information likely to be of importance. (a) (b) (c) Restrictions on the use of or access to any part of cash equivalents. The amount of undrawn borrowing facilities which are available. Cash flows which increased operating capacity compared to cash flows which merely maintained operating capacity.
2.5 Producing a statement of cash flows

Remember the steps involved in preparation of a statement of cash flows.
Step 1
Set out the proforma leaving plenty of space.
Step 2
Complete the reconciliation of operating profit to net cash from operating activities, as far as possible.
Step 3
Calculate the following where appropriate. Tax paid Dividends paid Interest paid / received Purchase and sale of non-current assets Issues of shares Repayment of loans
Step 4
Work out the profit if not already given using: opening and closing balances, tax charge and dividends.
Step 5
Complete the note of gross cash flows. Alternatively, the information may go straight into the statement.
Step 6
Slot the figures into the statement and any notes required.
Example: Kowloon Co
Set out below are the financial statements of Kowloon Co. You are the financial controller, faced with the task of implementing HKAS 7 Statement of Cash Flows.
453
Financial Reporting
KOWLOON CO STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X9 $'000 Revenue 2,553 Cost of sales (1,814) Gross profit 739 Other income: interest received 25 Distribution costs (125) Administrative expenses (264) Finance costs (75) Profit before tax 300 Income tax expense (140) Profit for the year 160 KOWLOON CO STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER Assets Non-current assets Property, plant and equipment Intangible assets Investments Current assets Inventories Receivables Short-term investments Cash at bank Total assets Equity and liabilities Equity Share capital ($1 ordinary shares) Share premium account Revaluation surplus Retained earnings Non-current liabilities Long-term loan Current liabilities Trade payables Bank overdraft Taxation Total equity and liabilities The following information is available. (a) (b) (c) The proceeds of the sale of non-current asset investments amounted to $30,000. Fixtures and fittings, with an original cost of $85,000 and a net book value of $45,000, were sold for $32,000 during the year. The following information relates to property, plant and equipment. 31.12.20X9 $'000 720 (340) 380 31.12.20X8 $'000 595 (290) 305 20X9 $'000 380 250 150 390 50 2 1,222 20X8 $'000 305 200 25 102 315 1 948
200 160 100 260 170 127 85 120 1,222
150 150 91 180 50 119 98 110 948
Cost Accumulated depreciation Net book value (d) (e) (f) 454
50,000 $1 ordinary shares were issued during the year at a premium of 20 cents per share. The short-term investments are highly liquid and are close to maturity. Dividends of $80,000 were paid during the year.
Required Prepare a statement of cash flows for the year to 31 December 20X9 using the format laid out in HKAS 7.
Solution
KOWLOON CO STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X9 $'000 Cash flows from operating activities Profit before tax Depreciation charge (W1) Loss on sale of property, plant and equipment (45 32) Profit on sale of non-current asset investments (30 25) Interest expense (net) (75 25) (Increase)/decrease in inventories (102 150) (Increase)/decrease in receivables (315 390) Increase/(decrease) in payables (127 119) Interest paid Dividends paid Tax paid (110 + 140 120) Net cash from operating activities Cash flows from investing activities Payments to acquire property, plant and equipment (W2) Payments to acquire intangible non-current assets (250 200) Receipts from sales of property, plant and equipment Receipts from sale of non-current asset investments Interest received Net cash used in investing activities Cash flows from financing activities Issue of share capital (200 + 160 150 150) Long-term loan (170 50) Net cash from financing activities Increase in cash and cash equivalents Cash and cash equivalents at 1.1.X9 Cash and cash equivalents at 31.12.X9 ANALYSIS OF CASH AND CASH EQUIVALENTS Cash at bank Short-term investments Overdraft 31.12.X9 $'000 2 50 (85) (33) 31.12.X8 $'000 1 (98) (97) 300 90 13 (5) 50 (48) (75) 8 333 (75) (80) (130) 48 (201) (50) 32 30 25 (164) 60 120 180 64 (97) (33) $'000
WORKINGS 1 Depreciation charge Accumulated depreciation at 31 December 20X8 Accumulated depreciation on assets sold (85 45) Accumulated depreciation 31 December 20X9 Charge for the year $'000 290 (40) (340) (90)
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Financial Reporting
Purchase of property, plant and equipment Cost at 31 December 20X8 Revaluation (10091) Cost on assets sold Cost 31 December 20X9 Purchase for the year (balancing fig)
$'000 595 9 (85) (720) (201)
3 Consolidated statements of cash flows

Topic highlights
A consolidated statement of cash flows includes extra line items for cash flows associated with: acquisitions and disposals of subsidiaries non-controlling interests associates and joint ventures
Consolidated statements of cash flows are prepared in the same way as a single company statement of cash flows, however they include extra line items: Acquisitions and disposals of subsidiaries are reported as cash flows from investing activities Dividends paid to the non-controlling interests are reported as cash flows from financing activities Dividends received from associates and joint ventures accounted for using the equity method are reported as cash flows from operating activities
Cash flows that are internal to the group should be eliminated in the preparation of a consolidated statement of cash flows.
HKAS 7.39,42
3.1 Acquisitions and disposals of subsidiaries

Where a subsidiary undertaking joins or leaves a group during a financial year the cash flows of the group should include the cash flows of the subsidiary undertaking concerned for the same period as that for which the group's statement of comprehensive income includes the results of the subsidiary undertaking. If a subsidiary is acquired or disposed of during the accounting period the net cash effect of the purchase or sale transaction should be shown separately under Cash flows from investing activities. The net cash effect is the cash purchase price/cash disposal proceeds net of any cash or cash equivalents acquired or disposed of: Subsidiary acquired Cash price Subsidiarys cash and cash equivalents at acquisition date Cash to acquire subsidiary (X) X (X) Subsidiary disposed of Cash proceeds X
Subsidiarys cash and cash equivalents at disposal date (X) Proceeds of sale of subsidiary X
456
As the cash effect of the acquisition/disposal of the subsidiary is dealt with in a single line item, care must be taken not to double count the effects of the acquisition/disposal when looking at the movements in individual asset balances. Each of the individual assets and liabilities of a subsidiary acquired/disposed of during the period must be excluded when comparing group statements of financial position for cash flow calculations as follows: Where a subsidiary is acquired in the period: property, plant and equipment, inventories, payables, receivables etc at the date of acquisition should be subtracted from the movement on these items Where a subsidiary is disposed of in the period: property, plant and equipment, inventories, payables, receivables etc at the date of disposal should be added to the movement on these items.
HKAS 7.40
3.1.1 Disclosure
An entity shall disclose, in aggregate, in respect of both obtaining and losing control of subsidiaries or other businesses during the period each of the following: (a) (b) (c) (d) The total consideration paid or received. The portion of the consideration consisting of cash and cash equivalents. The amount of cash and cash equivalents in the subsidiaries or other businesses over which control is obtained or lost. The amount of the assets and liabilities other than cash or cash equivalents in the subsidiaries or other businesses over which control is obtained or lost, summarised by each major category.
HKAS 7.42A
3.1.2 Changes in ownership interest with no loss of control

Changes in ownership interests in a subsidiary that do not result in a loss of control, such as the subsequent purchase or sale by a parent of a subsidiary's equity instruments, are accounted for as equity transactions (see HKFRS 10 Consolidated Financial Statements). Accordingly, the resulting cash flows are classified in the same way as other transactions with owners, as cash flows from financing activities.
3.2 The non-controlling interest

The group statement of cash flows should only deal with flows of cash and cash equivalents which are external to the group, so all intra-group cash flows should be eliminated. Dividends paid to non-controlling interests should be included under the heading 'Cash from financing activities' and disclosed separately.

The following are extracts of the consolidated results for Marcus Company for the year ended 31 December 20X9.
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (EXTRACT)
Group profit before tax Income tax expense Profit for the year Profit attributable to: Owners of the parent Non-controlling interests
$'000 200 (32) 168 126 42 168
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Financial Reporting
CONSOLIDATED STATEMENT OF FINANCIAL POSITION (EXTRACT)
Non-controlling interests
20X9 $'000 362
20X8 $'000 345
Calculate the dividends paid to the non-controlling interest during the year.
Solution
The non-controlling interests share of profit after tax represents retained profit plus dividends paid. NON-CONTROLLING INTEREST Balance as at 31 December 20X8 Profit for the period Balance as at 31 December 20X9 Dividend paid (balancing fig) $'000 345 42 (362) 25
3.3 Associates and joint ventures

Only the actual cash flows from sales or purchases between the group and an associate, and investments in and dividends from the entity should be included. Dividends should be included in operating cash flows, where they are shown within operating profit in the statement of comprehensive income.
Example: Associate
The following are extracts of the consolidated results of Connie Company for the year ended 31 December 20X9.
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (EXTRACT)
Group profit before tax Share of associate's profit after tax Tax (group) Profit after tax
CONSOLIDATED STATEMENT OF FINANCIAL POSITION (EXTRACTS)
$'000 224 36 260 42 218 20X8 $'000 306
Investment in associate Calculate the dividend received from the associate.
20X9 $'000 312
Solution
The associate profit before tax represents retained profit plus dividend plus tax. ASSOCIATE Balance as at 31 December 20X8 Share of profit for the period Balance as at 31 December 20X9 Dividend received from associate (balancing fig) $'000 306 36 (312) 30
458

Where an interest in a jointly controlled entity is accounted for using the equity method, related cash flows are calculated in the same way as those relating to associates. Where an interest in a jointly controlled entity is accounted for using proportionate consolidation, the reporting entity's proportionate share of the jointly controlled entity's cash flows are shown in the consolidated statement of cash flows.
3.4 Foreign currency cash flows

The cash flows of a foreign subsidiary must be translated into the functional currency of the group for inclusion in the consolidated statement of cash flows. The applicable exchange rate is the spot rate on the dates of the cash flows, however the average rate for a period may be used if this approximates to the actual rate. HKAS 21 does not allow the use of the closing rate. Foreign exchange gains and losses arising from changes in exchange rates are not cash flows, however must be taken into account in reconciling cash and cash equivalents at the start and end of a period. Such gains and losses are presented separately in the statement of cash flows.
The draft consolidated accounts for Bestway Co are shown below: DRAFT CONSOLIDATED INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X8 Operating profit Share of profits after tax of associates Finance cost Profit before taxation Income tax Profit for the year Attribute to: owners of the parent non-controlling interest $'000 13,365 4,950 (1,350) 16,965 (4,860) 12,105 11,205 900 12,105 20X7 $'000 $'000 Assets Non-current assets Buildings Machinery Goodwill Investments in associates Current assets Inventories Trade receivables Cash 9,000 11,475 16,380 36,855 72,045 19,800 2,700 22,500 - 12,690 35,190 17,775 16,650 40,635 75,060 124,425 20X8 $'000 $'000 18,675 16,200 34,875 900 13,590 49,365
DRAFT CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER
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Financial Reporting
20X7 $'000 $'000 Equity and liabilities Equity Share capital: 25c shares Share premium account Retained earnings Total equity Non-controlling interest Non-current liabilities Loans Deferred tax Current liabilities Trade payables Income tax Accrued finance charges 18,000 18,855 22,500 59,355 59,355 6,030 117 6,147 4,320 1,953 270 6,543 72,045 Notes 1
20X8 $'000 35,460 25,947 31,005 92,412 1,035 93,447 19,530 270 19,800 6,660 4,158 360 11,178 124,425 $'000
There had been no acquisitions or disposals of buildings during the year. The depreciation charge for the year was $1,125,000 for buildings and $1,800,000 for machinery. Machinery costing $3m was sold for $3m resulting in a profit of $900,000. On 1 January 20X8 Bestway Co acquired a 75% interest in Oneway Co. The net assets at acquisition were as follows: $'000 Machinery 1,485 Inventories 288 Trade receivables 252 Cash 1,008 Trade payables (612) Income tax (153) 2,268 Non-controlling interest (567) 1,701 Goodwill 900 2,601 7,920,000 shares issued as part consideration Balance of consideration paid in cash 2,475 126 2,601
A dividend of $2,700,000 was paid during the year.
Required Prepare a consolidated statement of cash flows for the Bestway Group for the year ended 31 December 20X8 as required by HKAS 7. (The answer is at the end of the chapter)
460
Topic recap
Statements of cash flows are a useful addition to the financial statements of companies because it is recognised that accounting profit is not the only indicator of a company's performance. Statements of cash flows concentrate on the sources and uses of cash and are a useful indicator of a company's liquidity and solvency. Cash flows are classified as cash flows from operating, investing and financing activities in a statement of cash flows. Cash flows from operating activities may be calculated using the direct or indirect method. A consolidated statement of cash flows includes extra line items for cash flows associated with: acquisitions and disposals of subsidiaries non-controlling interests associates and joint ventures
461
Financial Reporting
Answer 1
BESTWAY CO CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X8 $'000 $'000 Cash flows from operating activities Net profit before tax 16,965 Adjustments for: Depreciation (1,125 + 1,800) 2,925 Profit on sale of plant (900) Share of associate's profits (4,950) Interest payable 1,350 Operating profit before working capital changes 15,390 Increase in trade and other receivables (16,650 11,475 252) (4,923) Increase in inventories (17,775 9,000 288) (8,487) Increase in trade payables (6,660 4,320 612) 1,728 Cash generated from operations 3,708 Interest paid (270 + 1,350 360) (1,260) Income taxes paid (W1) (2,655) Net cash used in operating activities (207) Cash flows from investing activities Purchase of subsidiary undertaking (W2) Purchase of property, plant and equipment (W3) Proceeds from sale of plant Dividends from associate (W4) Dividends paid to non-controlling interest (W5) Net cash used in investing activities Cash flows from financing activities Issue of ordinary share capital (W6) Issue of loan notes (19,530-6,030) Dividends paid Net cash from financing activities Net increase in cash and cash equivalents Cash and cash equivalents at 1.1.X8 Cash and cash equivalents at 31.12.X8 WORKINGS 1 Taxation Opening balance Income tax Deferred tax Income statement expense On acquisition of subsidiary Closing balances Income tax Deferred tax Cash outflow $'000 1,953 117 2,070 4,860 153 4,158 270 (4,428) 2,655 $'000 882 (15,915) 3,000 4,050 (432) (8,415) 22,077 13,500 (2,700) 32,877 24,255 16,380 40,635
462
Purchase of subsidiary Cash received on acquisition Less cash consideration Cash inflow
$'000 1,008 (126) 882 $'000 2,700 (1,800) (2,100) 1,485 285 15,915 16,200 $'000 12,690 4,950 17,640 (13,590) 4,050 $'000 900 567 1,467 (1,035) 432 $'000 35,460 25,947 61,407 1,980 495 (2,475) 18,000 18,855 (36,855) 22,077 $'000
Purchase of tangible non-current assets: machinery Carrying value at 1 Jan X8 Depreciation Disposal (3,000 900) On acquisition of subsidiary Cash outflow on additions Carrying value at 31 Dec 20X8
Dividends from associate Opening balance Share of profit after tax Closing balance Cash inflow
Non-controlling interest Opening balance Profit for year On acquisition Closing balance Cash outflow
Issue of ordinary share capital Closing balance Shares Premium Non-cash consideration Shares (7,920 x 25c) Premium (2,475 1,980) Opening balance Shares Premium Cash inflow
463
Financial Reporting
Exam practice
Chong Co.
36 minutes
Chong Co. provides bookkeeping services for over 1,000 clients. The company now plans to expand into banking and finance services but feels to do so it may have to expand the office. This has prompted worries about the companys current cash flow position, especially the cash flow from its present operations, and whether the cash flow is sufficient to support such a relocation and expansion. The directors of Chong Co. require cash flow information quickly and have asked you to provide a calculation of the companys net cash flow from operating activities for the year ended 31 October 20X7. Unfortunately, the urgency of the request has meant that the companys statement of comprehensive income is not yet available. However, they have provided you with the following information: SUMMARISED DRAFT STATEMENTS OF FINANCIAL POSITION AS AT 31 OCTOBER 20X7 $'000 Assets Non-current assets Property, plant and equipment at cost Less depreciation Current assets Receivables Cash at bank Total assets Equity and liabilities Capital and reserves Equity share capital Share premium Retained profits Non-current liabilities Long-term bond Deferred taxation Current liabilities Trade payables Bank overdraft Taxation payable 20X6 $'000
1,240 276 964 380 64 444 1,408 319 1
1,016 232 784
320 1,104
600 140 224 964 120 72 192 212 40 252 1,408
400 60 86 546 280 44 324 146 56 32 234 1,104
464
Additional cash flow information: (i) Property, plant and equipment costing $52,000, and in respect of which $32,000 depreciation had been provided, was disposed of during the year. The items were sold for $16,000. Operating profit includes any profits or losses on disposal. The company paid a dividend of $40,000 during the year. A finance charge of $15,000 has been recognised as an expense for the year. The actual cash payment was $12,000. The tax charge of $88,000 includes deferred tax of $28,000. Part of the bond was repaid during the year. This incurred a redemption penalty of $8,000 which has been written off against income.
(ii) (iii) (iv) (v)
Required (a) Prepare a statement of cash flows in accordance with HKAS 7 to calculate the companys net cash flow from operating activities. (Note: a full statement of cash flows showing cash flow from investing activities and cash flow from financing activities is NOT required in answer to this part of the question.) (12 marks) Comment on whether the net cash flow from operating activities calculated in (a) above is sufficient to support the proposed expansion of the office. (8 marks) (Total = 20 marks)
(b)
465
Financial Reporting
466
chapter 21
Related party disclosures
Topic list
1 HKAS 24 Related Party Disclosures
Learning focus
Related party transactions are a controversial area of accounting. They are, however, relatively common in practice. You must be able to identify related parties and make the necessary disclosures.
467
Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.20 Related party disclosures 3.20.01 3.20.02 3.20.03 Identify the parties that may be related to a business entity in accordance with HKAS 24 Identify the related party disclosures Explain the importance of being able to identify and disclose related party transactions
468
21: Related party disclosures | Part C Accounting for business transactions
1 HKAS 24 Related Party Disclosures

Topic highlights
HKAS 24 is a disclosure standard. It does not prescribe any debits or credits. Its aim is to help users understand whether the financial statements may have been affected by transactions which were not on normal commercial terms. These sorts of transactions can arise when an entity has transactions with entities or individuals who influence or are influenced by the entity. These entities and individuals are called related parties. Disclosures of these transactions increase the accountability of management to users of the financial statements.
Users of financial statements would normally and reasonably assume that the transactions reported in those financial statements took place on normal commercial terms, ie on terms to which two knowledgeable and willing parties would freely agree. In other words the transactions were undertaken on what is called an arm's length basis. If the two parties to the transaction were in some way closely related, eg family members or fellow companies in a group, normal commercial terms may not apply. One party may influenced or be influenced by the other. It can sometimes be very difficult to determine whether a transaction is on an arms length basis. Therefore, HKAS 24 requires full disclosure of transactions with certain parties who are defined as being related to the reporting entity which is producing the financial statements. These transactions and these parties are the sorts which a reasonable user of the financial statements may wish to be aware of when making decisions based upon those financial statements. It is important to remember that disclosure of a related party transaction does not necessarily mean there is anything wrong with the transaction. The transaction may in fact be on normal commercial terms, or, if it is not, there may be very good reasons which are in the best interests of the entity. It is simply about providing users with information which may be of interest to them and to allow them to draw their own conclusions about the nature of the transaction, its effect on the financial statements, its appropriateness and the stewardship of management. On the other hand, where no information is obtainable, it is assumed that arms length transactions have been entered into by entities ie on terms such as those transacted with an external party, in which each party bargained freely and knowledgeably, unaffected by any relationship between them. Where related party relationships exist, this assumption may not be justified because the requisite conditions for competitive, free market dealings may not be present. While the parties may endeavour to achieve arm's length bargaining the very nature of the relationship may preclude this occurring.
HKAS 24.1
1.1 Objective
HKAS 24 aims to ensure that financial statements contain the disclosures necessary to draw attention to the possibility that the reported financial position and results may have been affected by the existence of related parties and by material transactions with them. In other words, this is a standard which is primarily concerned with disclosure.
HKAS 24.3
1.2 Scope
According to the standard, related party transactions and outstanding balances are to be presented in separate financial statements of a parent, venturer or investor as well as in consolidated financial statements. Disclosures should be in accordance with HKAS 27 and HKFRS 10.
469
Financial Reporting
This is an amendment to the previous version of HKAS 24 which did not require disclosure in the separate financial statements of a parent or wholly-owned subsidiary that are made available or published with the groups financial statements. Related party transactions and outstanding balances with other entities in the group are to be disclosed in an entitys financial statements. However no intragroup transactions and balances are to be shown as they are eliminated in the preparation of consolidated financial statements.
HKAS 24.9
1.3 Definitions
The following important definitions are given by the standard. The definitions of control and significant influence are the same as those given in HKASs 27, 28 and 31.
Key terms
Related party is a person or entity that is related to the entity that is preparing its financial statements. (a) A person or a close member of that persons family is related to a reporting entity if that person: (i) (ii) (iii) (b) has control or joint control over the reporting entity; has significant influence over the reporting entity; or is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.
An entity is related to a reporting entity if any of the following conditions applies: (i) (ii) (iii) (iv) (v) the entity and the reporting entity are members of the same group one entity is an associate or joint venture of the other entity (or an associate or joint venture of a group of which the other entity is a member) both entities are joint ventures of the same third party one entity is a joint venture of a third entity and the other entity is an associate of the third entity the entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity the entity is controlled or jointly controlled by a person identified in (a) the person identified in (a)(i) has significant influence over the entity or is a member of the key management personnel of the entity (or a parent of the entity)
(vi) (vii)
Related party transaction is a transfer of resources, services or obligations between a reporting entity and a related party, regardless of whether a price is charged. Control is the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. Significant influence is the power to participate in the financial and operating policy decisions of an entity, but is not control over those policies. Significant influence may be gained by share ownership, statute or agreement. Joint control is the contractually agreed sharing of control over an economic activity.
470
Key terms (cont'd)

Key management personnel are those persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity. Close members of the family of a person are those family members who may be expected to influence, or be influenced by, that person in their dealings with the entity and include: (a) (b) (c)
HKAS 24.10,12
that persons children and spouse or domestic partner children of that persons spouse or domestic partner; and dependants of that person or that persons spouse or domestic partner
(HKAS 24)
1.3.1 Related party relationships

When considering each possible related party relationship, attention must be paid to the substance of the relationship, not merely the legal form. The standard also clarifies that in the definition of a related party: an associate includes subsidiaries of the associate a joint venture includes subsidiaries of the joint venture
For example, an associates subsidiary and the investor that has significant influence over the associate are related to each other.
Example: Parent and subsidiaries

Parent entity has a controlling interest in Subsidiaries A, B and C, and has significant influence over Associates 1 and 2. Subsidiary C has significant influence over Associate 3. Are they related parties of each other?
Solution
For Parents separate financial statements, both subsidiaries and all three associates are classified as related parties. For Subsidiary As financial statements, Parent, Subsidiaries B and C, and all three associates are classified as related parties. For Subsidiary Bs separate financial statements, Parent, Subsidiaries A and C, and all three associates are related parties. For Subsidiary Cs financial statements, Parent, Subsidiaries A and B and all three associates are related parties. For the financial statements of Associates 1, 2 and 3, Parent and Subsidiaries A, B and C are their related parties. Associates 1, 2 and 3 are not classified as related to each other. For Parents consolidated financial statements, Associates 1, 2 and 3 are related to the Group.
HKAS 24.11
1.3.2 Relationships which are not related parties

HKAS 24 lists the following which are not necessarily related parties. (a) Two entities simply because they have a director or other key management personnel in common or because a member of key management personnel of one entity has significant influence over the other entity. Two venturers, simply because they share joint control over a joint venture.
(b)
471
Financial Reporting
(c)
Certain other bodies, simply as a result of their role in normal business dealings with the entity: (i) (ii) (iii) (iv) providers of finance trade unions public utilities government departments and agencies of a government that does not control, jointly control or significantly influence the reporting entity
simply by virtue of their normal dealings with an entity (even though they may affect the freedom of action of an entity or participate in its decision-making process). (d) Any single customer, supplier, franchisor, distributor, or general agent with whom the entity transacts a significant amount of business, simply by virtue of the resulting economic dependence.
HKAS 24.21
1.3.3 Related party transactions

HKAS 24 provides examples of transactions which may take place between related parties. They include: purchases or sales of goods (finished or unfinished) purchases or sales of property and other assets rendering or receiving of services leases transfer of research and development transfers under licence agreements provision of finance provisions of guarantees and collateral security settlement of liabilities on behalf of the entity or by the entity on behalf of another party.
HKAS 24.13,1719,23,24
1.4 Disclosure
A notable feature of HKAS 24 is that it is almost wholly concerned with disclosures. Its provisions supplement those disclosure requirements required by national company legislation and other HKASs (especially HKASs 1, 27 and 28). Relationships between parents and subsidiaries must be disclosed irrespective of whether any transactions have taken place between the related parties. An entity must disclose the name of its parent and, if different, the ultimate controlling party. This will enable a reader of the financial statements to be able to form a view about the effects of a related party relationship on the reporting entity. If neither the parent nor the ultimate controlling party produces financial statements available for public use, the name of the next most senior parent that does so shall also be disclosed. An entity should disclose key management personnel compensation in total for each of the following categories: Short term employee benefits Post-employment benefits Other long-term benefits Termination benefits Share-based payment
Where related party transactions have occurred during the period, the nature of the related party relationship should be disclosed together with (as a minimum):
472
(a) (b)
The amount of the transactions The amount of outstanding balances, including commitments, and (i) (ii) their terms and conditions including whether they are secured and the nature of the consideration to be provided in settlement; and details of any guarantees given or received
(c) (d)
Provisions for doubtful debts related to the amount of outstanding balances, and The expense recognised during the period in respect of bad and doubtful debts due from related parties.
These disclosures should be made separately for the following categories of related party: The parent Entities with joint control or significant influence over the entity Subsidiaries Associates Joint ventures in which the entity is a venturer Key management personnel of the entity or its parent, and Other related parties
Substantiation is a must if an entity decides to put up disclosures that related party transactions were made on terms equivalent to those that prevail in arm's length transactions. Items of a similar nature may be disclosed in aggregate except when separate disclosure is necessary for an understanding of the effects of related party transactions on the financial statements of the entity.
HKAS 24.25,26
1.4.1 Government related entities

The disclosures listed above need not be made in respect of transactions with: (a) (b) a government that has control, joint control or significant influence over the reporting entity, and another entity that is a related party because the same government has control, joint control or significant influence over both the reporting entity and the other entity. the name of the government and the nature of its relationship with the reporting entity information in sufficient detail to enable users of the financial statements to understand the effect of related party transactions on those financial statements, including: (i) (ii) the nature and amount of each individually significant transaction, and for other transactions that are collectively significant, a qualitative or quantitative indication of their extent.
Instead, the reporting entity should disclose: (a) (b)
1.5 The importance of disclosure

As we have already said, in the absence of information to the contrary, users of the financial statements are likely to assume that an entity has entered into all of its transactions on an arm's length basis, and acted in its own interests throughout an accounting period. Therefore they would assume that the entitys results and position are a true reflection of the performance of the entity and the stewardship of the management. Where related party transactions have occurred this is not always the case. For example, the following may affect the financial statements: The provision of a longer credit period to related parties A lower selling price to related parties
473
Financial Reporting
Transactions which would not occur without the related party relationship Transactions with third parties which are affected by a related party relationship
Such transactions may have an adverse effect on the financial statements. Take, for example, the situation where a director of Company A is the majority shareholder in Company B, and uses the position of influence in Company A to ensure that Company A buys goods from Company B at inflated prices. The profits of Company A are therefore lower than they might otherwise be and the profits of Company B are higher. The shareholders of Company A are entitled to know about this related party transaction so that they may assess its effect on the profits of Company A, and the stewardship of the director. Of course not all related party transactions are on preferential terms for one party or the other, however they may be. The disclosures required by the standard are therefore designed to allow users of the accounts to assess this.
1.6 Section summary

HKAS 24 is primarily concerned with disclosure. You should learn the following: Definitions: these are very important Relationships covered Relationships that may not necessarily be between related parties Disclosures: again, very important, representing the whole purpose of the standard
Anthony Co (A) is an 80 per cent owned subsidiary of Basso Co (B) . The directors of A are W, X, Y and Z. Which of the following are related parties of A? C, which is not part of the B group, but of which W is a director. D, who owns 20 per cent of the shares in A. E, the financial controller of A (who is not a director of A). F, the wife of the chairman of P, a company in the B group. (The answer is at the end of the chapter)
474
Topic recap
HKAS 24 is a disclosure standard. It does not prescribe any debits or credits. Its aim is to help users understand whether the financial statements may have been affected by transactions which were not on normal commercial terms. These sorts of transactions can arise when an entity has transactions with entities or individuals who influence or are influenced by the entity. These entities and individuals are called related parties. Disclosures of these transactions increase the accountability of management to users of the financial statements.
475
Financial Reporting
Answer 1
Basso Group F Wife of Chairman of P
B 80%
R/P
20%
Directors
W, X, Y and Z
Financial Controller of
Director
(1)
C and A are subject to common influence from W, but C is not a related party unless one or both companies have subordinated their own separate interests in entering into a transaction. (This assumes that W is the only director to serve on both boards; if there were a common nucleus of directors, a related party relationship would almost certainly exist). D is almost certainly not a related party. According to the definition, D might be presumed to be a related party, but the existence of a parent company means that D is unlikely to be able to exert significant influence over A in practice (depends on your argument.) E may be a related party, despite the fact that he or she is not a director. A financial controller would probably come within the definition of key management personnel. The issue would be decided by the extent to which E is able to control or influence the policies of the company in practice. F may be a related party. Companies P and A are under common control and F presumably falls within the definition of close family of a related party of B. F is not a related party if it can be demonstrated that she has not influenced the policies of A in such a way as to inhibit the pursuit of separate interest.
(2)
(3)
(4)
476
Exam practice
EI
9 minutes
EI is an entity specialising in importing a wide range of non-food items and selling them to retailers. Elaine is EI's president and founder and owns 40 per cent of EI's equity shares: EI's largest customer, XC, accounts for 35 per cent of EI's revenue. XC has just completed negotiations with EI for a special 5 per cent discount on all sales. During the accounting period, Elaine purchased a property from EI for $500,000. EI had previously declared the property surplus to its requirements and had valued it at $750,000. Elaine's son, Johnson, is a director in a financial institution, FC. During the accounting period, FC advanced $2 million to EI as an unsecured loan at a favourable rate of interest.
Required Explain, with reasons, the extent to which each of the above transactions should be classified and disclosed in accordance with HKAS 24 Related Party Disclosures in EI's financial statements for the period. (5 marks)
477
Financial Reporting
478
chapter 22
Accounting policies, changes in accounting estimates and errors; events after the reporting period
Topic list
1 2 3 4 5 HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors Accounting policies Accounting estimates Errors HKAS 10 Events after the Reporting Period
Learning focus
HKAS 8 is relevant to all organisations preparing financial statements in accordance with HKFRS; it is important that you know how accounting policies should be selected, and when they, and accounting estimates can be changed. HKAS 10 is also very relevant in practice as all entities have a period between the reporting date and authorising of the accounts during which time significant events may occur.
479
Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.01 3.01.01 3.01.02 3.01.03 3.01.04 3.15 3.15.01 3.15.02 3.15.03 Accounting policies, changes in accounting estimates and errors Distinguish between accounting policies and accounting estimates in accordance with HKAS 8 Account for a change in accounting policy Account for a change in accounting estimate Correct a prior period error Events after the reporting period Explain the period during which there is responsibility for reporting events in accordance with HKAS 10 Define adjusting and non-adjusting events Explain when the financial statements should be prepared on a basis other than going concern 3 3
480
22: Accounting policies, changes in accounting estimates and errors; events after the reporting period | Part C Accounting for business transactions
1 HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors

Topic highlights
HKAS 8 deals with the treatment of changes in accounting estimates, changes in accounting policies and errors.
HKAS 8.4
1.1 Objective
The objective of HKAS 8 is to prescribe: The criteria for selecting and changing accounting policies The accounting treatment and disclosure of: changes in accounting policies, changes in accounting estimates, and corrections of errors.
The standard is intended to enhance the relevance and reliability of an entitys financial statements, and the comparability of those financial statements over time and with the financial statements of other entities. The standard was extensively revised in October 2008. The new title reflects the fact that the material on determining profit or loss for the period has been transferred to HKAS 1.
HKAS 8.5
1.2 Definitions
The following definitions are given in the standard.
Key terms
Accounting policies are the specific principles, bases, conventions, rules and practices adopted by an entity in preparing and presenting financial statements. A change in accounting estimate is an adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors. Material. Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. Prior period errors are omissions from, and misstatements in, the entity's financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that: was available when financial statements for those periods were authorised for issue could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements
481
Financial Reporting
Key terms (cont'd)

Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud. Retrospective application is applying a new accounting policy to transactions, other events and conditions as if that policy had always been applied. Retrospective restatement is correcting the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior period error had never occurred. Prospective application of a change in accounting policy and of recognising the effect of a change in an accounting estimate, respectively, are: applying the new accounting policy to transactions, other events and conditions occurring after the date as at which the policy is changed recognising the effect of the change in the accounting estimate in the current and future periods affected by the change
Impracticable. Applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so. It is impracticable to apply a change in an accounting policy retrospectively or to make a retrospective restatement to correct an error if one of the following applies. The effects of the retrospective application or retrospective restatement are not determinable. The retrospective application or retrospective restatement requires assumptions about what management's intent would have been in that period. The retrospective application or retrospective restatement requires significant estimates of amounts and it is impossible to distinguish objectively information about those estimates that: (i) (ii) provides evidence of circumstances that existed on the date(s) at which those amounts are to be recognised, measured or disclosed; and would have been available when the financial statements for that prior period were authorised for issue, from other information. (HKAS 8.5)
2 Accounting policies
Topic highlights
Changes in accounting policy are applied retrospectively.
HKAS 8.7,1013
2.1 Selection of accounting policy

Where a HKFRS specifically applies to a transaction, then the relevant accounting policy should be determined by applying that standard or interpretation. Where there is no applicable HKFRS, management should use its judgment in developing and applying an accounting policy that results in information that is relevant and reliable. Management should refer to: (a) (b) the requirements in HKFRSs dealing with similar and related issues. the definitions, recognition criteria and measurement concepts for assets, liabilities and expenses in the Framework.
482
Management may also consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop standards, other accounting literature, including Accounting Guidelines and Accounting Bulletins, and accepted industry practices if these do not conflict with the sources above. An entity must select and apply its accounting policies for a period consistently for similar transactions, other events and conditions, unless a HKFRS specifically requires or permits categorisation of items for which different policies may be appropriate. If a HKFRS requires or permits categorisation of items, an appropriate accounting policy must be selected and applied consistently to each category.
HKAS 8.14,16,17
2.2 Changes in accounting policy

The same accounting policies are usually adopted from period to period, to allow users to analyse trends over time in profit, cash flows and financial position. Changes in accounting policy will therefore be rare and should be made only if the change: (a) (b) is required by a HKFRS, or results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entitys financial position, financial performance or cash flows.
The standard highlights two types of event which do not constitute changes in accounting policy. (a) (b) Adopting an accounting policy for a new type of transaction or event not dealt with previously by the entity. Adopting a new accounting policy for a transaction or event which has not occurred in the past or which was not material.
In the case of tangible non-current assets, if a policy of revaluation is adopted for the first time then this is treated, not as a change of accounting policy under HKAS 8, but as a revaluation under HKAS 16 Property, Plant and Equipment (see Chapter 5). The following paragraphs do not therefore apply to a change in policy to adopt revaluations.
HKAS 8.19,22-25
2.2.1 Accounting for a change in accounting policy

Where a change in accounting policy is the result of the initial application of a HKFRS, that change should be accounted for in accordance with the specific transitional provisions, if any, in that HKFRS. For example, HKFRS 13 Fair Value Measurement, issued in June 2011 should be applied prospectively from the first date on which it is applied. Otherwise, a change in accounting policy should be applied retrospectively. Retrospective application means that the new accounting policy is applied to transactions and events as if it had always been in use. In other words, the policy is applied from the earliest date such transactions or events occurred. Where it is impracticable (see Key terms) to apply a change in accounting policy retrospectively because the cumulative amount of change cannot be determined, it should be applied prospectively.
HKAS 8.29,30
2.3 Disclosing changes in accounting policy

As a result of a change in accounting policy, retrospective adjustments should be reported as an adjustment to the opening balance of each affected component of equity. Comparative information should also be restated unless it is impracticable to do so. This means that all comparative information must be restated as if the new policy had always been in force, with amounts relating to earlier periods reflected in an adjustment to opening reserves of the earliest period presented.
483
Financial Reporting
Certain disclosures are required when a change in accounting policy has a material effect on the current period or any prior period presented, or when it may have a material effect in subsequent periods. These include: (a) (b) (c) (d) reasons for the change amount of the adjustment for the current period and for each period presented amount of the adjustment relating to periods prior to those included in the comparative information the fact that comparative information has been restated or that it is impracticable to do so
An entity should also disclose information relevant to assessing the impact of new HKFRS on the financial statements where these have not yet come into force.
Example: Retrospective application

A training company capitalises all equipment based on cost but has not depreciated it over its useful life due to the amounts involved being immaterial. In advance of extensive capital expenditure, the company now wishes to change its accounting policy and apply in full the provisions of HKAS 16 Property, Plant and Equipment. Details of the equipment are as follows: Acquisition date Equipment A Equipment B 1 January 20X5 Unknown Fair value as at 1 January 20X6 $ unknown 8,000 Useful life/ remaining useful life (years) 10 10
Cost $ 6,000 10,000
The value-in-use is the same as fair value at 1 January 20X6. The financial period of the company ends on 31 December. Opening retained earnings are $700,000 on 1 January 20X5 and the company made a profit of $20,000 for the year ended 31 December 20X6 and $30,000 for the year ended 31 December 20X5 (excluding any adjustment for depreciation). In the year ended 31 December 20X6, the company elects to adopt HKAS 16 in full. 1 January 1 January 31 December 20X5 Depreciation 20X6 Depreciation 20X6 $ $ $ Equipment A 6,000 10 Cost 6,000 6,000 6,000 Acc depreciation (600) (1,200) (600) (600) Carrying amount 6,000 5,400 4,800 1 January 20X5 $ Equipment B Cost Acc depreciation Carrying amount Alternative 1 December 20X5 $ Equipment B Cost Acc depreciation Carrying amount 10,000 10,000 Depreciation 10,000 10 (1,000) 31 December 20X5 $ 10,000 (1,000) 9,000 Revaluation 1 January 20X6 $ 8,000 8,000 10,000 10,000 Impairment loss (2,000) 1 January 20X6 $ 8,000 8,000 Depreciation 8,000 10 (800) 8,000 (800) 7,200 31 December 20X6 $
(2,000) 1,000 Impairment loss
484
As the company did not depreciate the equipment the carrying amount of the equipment would have been the original cost of $6,000 and $10,000 as at 31 December 20X6. As there has been a change in accounting policy in 20X6, the financial statements must be adjusted to present noncurrent assets as though HKAS 16 has always been applied. The table above depicts the changes in carrying amount if the HKAS 16 had been applied on the initial recognition of the equipment. Under these circumstances, the company must apply HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors to adopt HKAS 16 and present one year's comparative information. The financial statement extracts will be as follows: STATEMENT OF FINANCIAL POSITION RESTATED - EXTRACTS 1 January 20X5 $ Equipment A Cost Acc Depreciation 6,000 6,000 1 January 20X5 $ Equipment B Cost Acc Depreciation Retained earnings 10,000 10,000 700,000 Comparative 6,000 10 (600) 6,000 (600) 5,400 31 December 20X5 $ 8,000 10 (2,000) 8,000 8,000 727,400 (800) +18,600 8,000 (800) 7,200 746,000 (600) 6,000 (1,200) 4,800 31 December 20X6 $ 31 December 20X5 $ 31 December 20X6 $
Comparative
+27,400
STATEMENT OF COMPREHENSIVE INCOME RESTATED - EXTRACTS Year ended Depreciation Impairment I/S (alternative) Depreciation Impairment Equipment A Equipment B Equipment B 31 December 20X5 $ 30,000 (600) 0 (2,000) 27,400 30,000 (600) (1,000) (1,000) 27,400 31 December 20X6 $ 20,000 (600) (800) 18,600 20,000 (600) (800) 18,600
Equipment A Equipment B Equipment B
Based on the above extract, the 20X6 profit would be adjusted for depreciation of $1,400 and the opening retained earnings also adjusted for 20X5's depreciation/impairment charge of $2,600. One year's comparative must be presented which means the profits for last year and the opening retained earnings for last year is recalculated. The adjustment must be made from the original date it affects the financial statements, this is known as retrospective application.
485
Financial Reporting
3 Accounting estimates
HKAS 8.32,33
Topic highlights
Changes in accounting estimate are not applied retrospectively. Estimates arise in relation to business activities because of the uncertainties inherent within them. Judgments are made based on the most up to date information and the use of such estimates is a necessary part of the preparation of financial statements. It does not undermine their reliability. Examples of accounting estimates include:
HKAS 8.36
a necessary irrecoverable debt allowance useful lives of depreciable assets provision for obsolescence of inventory warranty obligations
3.1 Accounting for a change in accounting estimate

The effect of a change in an accounting estimate should be included in the determination of net profit or loss in one of: (a) (b) the period of the change, if the change affects that period only. the period of the change and future periods, if the change affects both.
In other words the change is applied prospectively. Changes may occur in the circumstances which were in force at the time the estimate was calculated, or perhaps additional information or subsequent developments have come to light. An example of a change in accounting estimate which affects only the current period is the irrecoverable debt estimate. However, a revision in the life over which an asset is depreciated would affect both the current and future periods, in the amount of the depreciation expense. Reasonably enough, the effect of a change in an accounting estimate should be included in the same expense classification as was used previously for the estimate. This rule helps to ensure consistency between the financial statements of different periods. The materiality of the change is also relevant. The nature and amount of a change in an accounting estimate that has a material effect in the current period (or which is expected to have a material effect in subsequent periods) should be disclosed. If it is not possible to quantify the amount, this impracticability should be disclosed.
HKAS 8.39,40
3.2 Disclosure of a change in accounting estimate

Where there is a change in accounting estimate, an entity must disclose the nature and amount of the change that has an effect in the current period or is expected to have an effect in future periods, unless it is impracticable to estimate that effect. If the amount of the effect in future periods is not disclosed because estimating it is impracticable, that fact must be disclosed.
Illustration: Prospective application

All equipment is capitalised based on cost and depreciated over its useful life. As at 1 January 20X6, the equipment's productivity is lower than expected and machines frequently break down. A re-assessment of the remaining useful life has been done. Details of the equipment are as follows:
486
Equipment
Acquisition date 1 January 20X5 1 January 20X5 $ 10,000 10,000
Cost $10,000
Original useful life from 1 January 20X5 10 years 1 January 20X6 $ 10,000 (1,000) 9,000
Remaining useful life from 1 Jan 20X6 5 years 31 December 20X6 $ 9,000 (1,800) 7,200
Equipment Cost Acc depreciation
10,000 10 (1,000)
9,000 5 (1,800)
When the useful life changes, the depreciation charge will also change resulting in $1,800 being charged in the 20X6 financial statements. No adjustment to the comparative figures is required.
4 Errors
Topic highlights
Prior period errors must be corrected retrospectively.
Errors discovered during a current period which relate to a prior period may arise through: mathematical mistakes mistakes in the application of accounting policies misinterpretation of facts oversights fraud
Most of the time these errors can be corrected through net profit or loss for the current period. Where they are material prior period errors, however, this is not appropriate. The standard considers two possible treatments.
HKAS 8.4245
4.1 Accounting treatment to correct an error

Prior period errors must be corrected retrospectively. This involves: (a) (b) either restating the comparative amounts for the prior period(s) in which the error occurred or, when the error occurred before the earliest prior period presented, restating the opening balances of assets, liabilities and equity for that period
so that the financial statements are presented as if the error had never occurred. Only where it is impracticable to determine the cumulative effect of an error on prior periods can an entity correct an error prospectively.
HKAS 8.49
4.2 Disclosure of an error

The following must be disclosed in relation to an error: (a) (b) Nature of the prior period error. For each prior period, to the extent practicable, the amount of the correction.
487
Financial Reporting
(i) (ii) (c) (d)
For each financial statement line item affected If HKAS 33 applies, for basic and diluted earnings per share
The amount of the correction at the beginning of the earliest prior period presented. If retrospective restatement is impracticable for a particular prior period, the circumstances that led to the existence of that condition and a description of how and from when the error has been corrected.
Subsequent periods need not repeat these disclosures.
During 20X7 Gordon Co discovered that certain items had been included in inventory at 31 December 20X6, valued at $4.2 million, which had in fact been sold before the end of the reporting period and included correctly in revenue. The following figures for 20X6 (as reported) and 20X7 (draft) are available: 20X6 $'000 47,400 (34,570) 12,830 (2,245) 10,585 20X7 (draft) $'000 67,200 (55,800) 11,400 (1,880) 9,520
Sales Cost of goods sold Profit before taxation Income taxes Profit for the period
Retained earnings at 1 January 20X6 were $13 million. The cost of goods sold for 20X7 includes the $4.2 million error in opening inventory. The income tax rate was 16 per cent for 20X6 and 20X7. No dividends have been declared or paid. Required Show the statement of comprehensive income for 20X7, with the 20X6 comparative, and retained earnings. (The answer is at the end of the chapter)
5 HKAS 10 Events after the Reporting Period

Topic highlights
HKAS 10 identifies events arising between the reporting date and date on which the financial statements are authorised for issue as either adjusting or non-adjusting. HKAS 10 should be familiar from your earlier studies, but it still could come up in part of a question.
HKAS 10.1
5.1 Objective
HKAS 10 prescribes: when an entity should adjust its financial statements for events after the reporting period; and the disclosures that an entity should give about the date when the financial statements were authorised for issue and about events after the reporting period.
488
HKAS 10.3
5.2 Definitions
Key terms
The standard defines event after the reporting period as: Those events, favourable and unfavourable, that occur between the end of the reporting period and the date when the financial statements are authorised for issue. It goes on to classify such events as one of two types: (a) (b) those that provide evidence of conditions that existed at the end of the reporting period (adjusting events after the reporting period); and those that are indicative of conditions that arose after the reporting period (nonadjusting events after the reporting period).
HKAS 10.4-7
5.3 Events after the reporting period

The definition above defines an event after the reporting period as an event that occurs between the reporting date and the date that the financial statements are authorised for issue: End of reporting period Accounting period Events after the reporting period Date of authorisation
The authorisation process varies from entity to entity: (a) (b) Where an entity must submit its financial statements to shareholders for approval after the financial statements have been issued, the date of authorisation is the same as the date of issue; Where the management of an entity must issue the financial statements to a supervisory board for approval, the date of authorisation is the date on which the management authorises the financial statements for issue to the supervisory board.
Events after the reporting period include all events up to the date when the financial statements are authorised for issue, even if those events occur after the public announcement of profit or of other selected financial information.
HKAS 10.9
5.3.1 Adjusting events

Adjusting events add information on conditions that existed at the reporting date. They may include the following: (a) (b) (c) (d) (e) (f) The settlement after the reporting period of a court case which confirms an entity had a present obligation at the end of the reporting period The bankruptcy of a customer after the reporting period which confirms that the receivables balance was overstated at the end of the reporting period The sale of inventories after the year end at an amount lower than cost which confirms that inventories were overstated at the end of the reporting period The determination after the reporting period of the cost of assets purchased or proceeds of the sale of assets before the end of the reporting period The determination after the reporting period of the amount of profit-sharing or bonus payments which confirms the existence of obligation at the end of the reporting period The discovery of fraud or errors showing the financial statements are incorrect.
489
Financial Reporting
Any event after the reporting period which indicates that an entity is no longer a going concern is classified as an adjusting event.
HKAS 10.12,22
5.3.2 Non-adjusting events

Non-adjusting events provide information about conditions arising after the reporting date. Examples may include the following: (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) The destruction of a non-current asset in the period after the reporting date due to fire or flood A decline in the fair value of investments after the reporting date due to circumstances arising after the reporting date A major business combination after the reporting period An announcement of a plan to discontinue an operation Purchases of assets, classification of assets as held for sale (HKFRS 5), disposals of assets or expropriation of assets by government An announcement of or commencement of a major restructuring Share transactions after a reporting period Abnormally large changes after the reporting period in foreign exchange rates Changes in tax rates or tax laws enacted or announced after the reporting period Entering into significant commitments Commencing litigation due to events arising after the reporting period.
HKAS 10 is also clear that an equity dividend declared after the end of the reporting period is a non-adjusting event and should not be recognised as a liability. This is because there is no obligation at the reporting date; the obligation does not arise until the dividend is declared.
5.4 Accounting treatment

The accounting treatment of an event after the reporting period depends on how it is classified.
HKAS 10.8,14,19
5.4.1 Adjusting events

As the name suggests, the financial statements are adjusted to reflect an adjusting event. For example, the bankruptcy of a customer after the reporting period should be written off in the year end financial statements as irrecoverable. Disclosures within the financial statements should also be updated in the light of the adjusting event. Where an event after the reporting date results in going concern issues, for example, management decides that it intends to liquidate the business or cease trading or that it has no other choice but to either cease trading or liquidate the business, the financial statements should be presented to reflect this decision. Therefore, the going concern assumption is no longer appropriate and the financial statements should be prepared on the break-up basis.
HKAS 10.10,21
5.4.2 Non-adjusting events

Non-adjusting events do not result in adjustment to the financial statements, however where nonadjusting events are material, they should be disclosed. The following should be disclosed for each material category of non-adjusting event after the reporting period: (a) (b) the nature of the event, and an estimate of its financial effect, or a statement that such an estimate cannot be made.
490
HKAS 10.17
5.5 Further disclosure

In addition to the disclosures in respect of both adjusting and non-adjusting events, an entity must disclose the date when the financial statements were authorised for issue and who gave that authorisation. If the entitys owners or others have the power to amend the financial statements after issue, the entity must also disclose that fact.
Example: Adjusting or non-adjusting events

A company has a financial year end of 31 December 20X0 and the financial statements are authorised for issue on 31 March 20X1. The following events have arisen during the three months after the end of the reporting period: (1) The inventory of motor vehicles has deteriorated in value due to legislation passed on 31 January 20X1 which increases road tax and the new policy to introduce a one car per family limit. An ordinary dividend of $0.1 million is declared after the reporting date. The credit department discovered that a major customer owing $2 million has gone into liquidation.
(2) (3)
Required Discuss the implication of the above events and indicate whether they are adjusting or nonadjusting events.
Solution
The impairment of inventory is a non-adjusting event because legislation is not passed until after the reporting date. Therefore, at the reporting date the value of inventory is unaffected. The dividend declared after the reporting date is non-adjusting also because as at the reporting date there is no obligation to pay a dividend. The discovery of an irrecoverable debt in the post-reporting date period provides evidence that the debt could not be paid at the reporting date. Therefore, it is an adjusting event.
491
Financial Reporting
Topic recap
HKAS 8 deals with the treatment of changes in accounting estimates, changes in accounting policies and errors. Changes in accounting policy are applied retrospectively. Changes in accounting estimate are not applied retrospectively. Prior period errors must be corrected retrospectively. Events after the reporting period are those events, favourable and unfavourable, that occur between the end of the reporting period and the date when the financial statements are authorised for issue. They may be classified as: (a) (b) those that provide evidence of conditions that existed at the end of the reporting period (adjusting events after the reporting period); and those that are indicative of conditions that arose after the reporting period (nonadjusting events after the reporting period).
Adjusting events should be adjusted for in the financial statements and disclosures should be updated in the light of the new information. Non-adjusting events should not be adjusted for, but disclosed if material. The financial statements should be adjusted to reflect non-adjusting events which affect going concern; in this event the financial statements are prepared on the break-up basis.
492
Answer 1
STATEMENT OF COMPREHENSIVE INCOME 20X6 $'000 47,400 (38,770) 8,630 (1,573) 7,057 20X7 $'000 67,200 (51,600) 15,600 (2,552) 13,048
Sales Cost of goods sold (W1) Profit before tax Income tax (W2) Profit for the year RETAINED EARNINGS Opening retained earnings As previously reported Correction of prior period error (4,200 672) As restated Profit for the year Closing retained earnings WORKINGS (1) Cost of goods sold As stated in question Inventory adjustment (2) Income tax As stated in question Inventory adjustment (4,200 16%)
20X6 $'000 13,000 13,000 7,057 20,057
20X7 $'000 23,585 (3,528) 20,057 13,048 33,105
20X6 $'000 34,570 4,200 38,770 20X6 $'000 2,245 (672) 1,573
20X7 $'000 55,800 (4,200) 51,600 20X7 $'000 1,880 672 2,552
493
Financial Reporting
Exam practice
Prior errors
Discuss the following statement:
18 minutes
All errors in prior years financial statements must be corrected in the current years financial statements. (10 marks) HKICPA September 2006
494
chapter 23
Earnings per share

Topic list
1 HKAS 33 Earnings per Share
Learning focus
HKAS 33 is applicable to listed entities. You should be aware of the calculation of EPS and, since this is a measurement of performance, how it can be manipulated.
495
Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.22 Earnings per share 3.22.01 3.22.02 Explain the meaning and significance of a companys earnings per share Calculate the earnings per share, including the impact of a bonus issue, a rights issue and an issue of shares at full market value in accordance with HKAS 33 Explain the relevance of a companys diluted earnings per share Discuss the limitations of using earnings per share as a performance measure
3.22.03 3.22.04
496
23: Earnings per share | Part C Accounting for business transactions
1 HKAS 33 Earnings Per Share

Topic highlights
Earnings per share is a measure of the amount of profits earned by a company for each ordinary share. Earnings are profits after tax and preference dividends.
HKAS 33.1
1.1 Objective of HKAS 33

HKAS 33 provides guidance on calculating and disclosing earnings per share (EPS). The purpose of disclosing EPS is to enable comparison of the performance of an entity, both over time and with other entities.
HKAS 33.2-4
1.2 Scope of HKAS 33

HKAS 33 has the following scope restrictions: (a) (b) (c) Only companies with (potential) ordinary shares which are publicly traded need to present EPS (including companies in the process of being listed). EPS need only be presented on the basis of consolidated results where the parent's results are shown as well. Where companies choose to present EPS, even when they have no (potential) ordinary shares which are traded, they must do so according to HKAS 33.
HKAS 33.5-7
1.3 Definitions
The following definitions are given in HKAS 33.
Key terms
Ordinary share. An equity instrument that is subordinate to all other classes of equity instruments. Potential ordinary share. A financial instrument or other contract that may entitle its holder to ordinary shares. Options, warrants and their equivalents. Financial instruments that give the holder the right to purchase ordinary shares. Contingently issuable ordinary shares are ordinary shares issuable for little or no cash or other consideration upon the satisfaction of specified conditions in a contingent share agreement. Contingent share agreement. An agreement to issue shares that is dependent on the satisfaction of specified conditions. Dilution is a reduction in earnings per share or an increase in loss per share resulting from the assumption that convertible instruments are converted, that options or warrants are exercised, or that ordinary shares are issued upon the satisfaction of specified conditions. Antidilution is an increase in earnings per share or a reduction in loss per share resulting from the assumption that convertible instruments are converted, that options or warrants are exercised, or that ordinary shares are issued upon the satisfaction of certain conditions. (HKAS 33.5)
497
Financial Reporting
1.3.1 Ordinary shares

Ordinary shares are defined above as those shares which are subordinate to other classes of share capital. This means that ordinary shares participate in profit for the period only after other types of shares, eg preference shares. The standard also notes that there may be more than one class of ordinary shares and ordinary shares of the same class have the same right to receive dividends.
1.3.2 Potential ordinary shares

HKAS 33 identifies the following examples of potential ordinary shares: (a) (b) (c) Financial liabilities or equity instruments, including preference shares, that are convertible into ordinary shares Share warrants and options Shares that would be issued upon the satisfaction of certain conditions resulting from contractual arrangements, such as the purchase of a business or other assets
HKAS 33.10
1.4 Basic EPS

Topic highlights
Basic EPS is calculated by dividing the profit or loss for the period attributable to ordinary shareholders by the weighted average number of ordinary shares outstanding during the period.
Basic EPS is calculated as:
Profit / (loss) attributable to ordinary shareholders Weighted average number of ordinary shares outstanding during the period Both of the terms within this calculation require further explanation.
HKAS 33.12,14,16
1.4.1 Profit attributable to ordinary shareholders

The profit or loss attributable to ordinary shareholders for a period is calculated as:

profit after all items of income and expense (including tax and non-controlling interests), less profit after tax attributable to irredeemable preference shareholders, including preference dividends and differences arising on the settlement of preference shares.
Note that the adjustment above only related to irredeemable preference shares since amounts relating to preference shares classified as debt (redeemable preference shares) are included in profit or loss for the period.
Preference dividends deducted from profit consist of the following:
(a) (b)
Preference dividends on non-cumulative preference shares declared in respect of the period. Preference dividends for cumulative preference shares required for the period, whether or not they have been declared (excluding those paid/declared during the period in respect of previous periods).
If an entity purchases its own preference shares for more than their carrying amount the excess should be treated as a return to the preference shareholders and deducted from profit or loss attributable to ordinary equity holders.
498
Example: Profit attributable to ordinary shareholders

Sunwin Co is a listed company with the following shares in issue at 31 December 20X0:
Number of shares
$1 ordinary shares 50c 6% irredeemable cumulative preference shares $1 5% redeemable preference shares
100 million 10 million 20 million
On 30 June 20X0, 5 million irredeemable cumulative preference shares of the same class as the 10 million remaining were cancelled and shareholders paid 67c per share. Profit after tax reported for the year ended 31 December 20X0 was $36,900,000.
Required
What are profits attributable to ordinary shareholders for the purposes of calculating basic EPS?
Solution
$ Profit after tax Redeemable preference share dividend does not need adjustment as it will already have been accounted for as a finance cost within the calculation of profit Irredeemable preference dividend: 1.1.X0 30.6.X0 15m shares x 50c x 6% 1.7.X0 31.12.X0 10m shares x 50c x 6% Excess paid to cancel shares (67c-50c) x 5m Profits attributable to ordinary shareholders 36,900,000
(450,000) (300,000) (850,000) 35,300,000
HKAS 33.1924
1.4.2 Weighted average number of ordinary shares

The number of ordinary shares used should be the weighted average number of ordinary shares outstanding during the period. This figure therefore reflects changes in capital during the period due to new share issues and so on. The time-weighting factor is the number of days the shares were outstanding compared with the total number of days in the period. A reasonable approximation is usually adequate. Shares are usually included in the weighted average number of shares from the date consideration is receivable which is usually the date of issue. HKAS 33 does provide the following guidance on the application of this rule:
Consideration Start date for inclusion
In exchange for cash On the voluntary reinvestment of dividends on ordinary or preference shares As a result of the conversion of a debt instrument to ordinary shares In place of interest or principal on other financial instruments In exchange for the settlement of a liability of the entity As consideration for the acquisition of an asset other than cash For the rendering of services to the entity
When cash is receivable The dividend payment date Date interest ceases accruing Date interest ceases accruing The settlement date The date on which the acquisition is recognised As services are rendered
499
Financial Reporting
Ordinary shares issued as purchase consideration in an acquisition should be included as of the date of acquisition because the acquired entity's results will also be included from that date. Where a uniting of interests takes place the number of ordinary shares used for the calculation is the aggregate of the weighted average number of shares of the combined entities, adjusted to equivalent shares of the entity whose shares are outstanding after the combination. Ordinary shares that will be issued on the conversion of a mandatorily convertible instrument are included in the calculation from the date the contract is entered into. If ordinary shares are partly paid, they are treated as a fraction of an ordinary share to the extent they are entitled to dividends relative to fully paid ordinary shares.
Contingently issuable shares (including those subject to recall) are included in the computation when all necessary conditions for issue have been satisfied.
1.4.3 Required Basic EPS

Basic EPS should be calculated for profit or loss attributable to ordinary equity holders of the parent entity and profit or loss from continuing operations attributable to those equity holders (if this is presented).
1.5 Weighted average number of ordinary shares: the effect of changes in capital
Where there is a change in the share capital structure of an entity, the issue with regard to earnings per share is ensuring that like is compared with like. This will become more clear as you read through Sections 1.5.1 to 1.5.3 and work the examples within them.
1.5.1 New share issues and share buy backs

Where new shares are issued at market price the number of shares will increase and there is a corresponding increase in resources which may be utilised to generate profits. Where ordinary shares are issued but not fully paid, they are treated in the calculation of basic earnings per share as a fraction of an ordinary share to the extent that they were entitled to participate in dividends during the period relative to a fully paid ordinary share. Therefore if 2 million shares are issued, but only half of the issue price is paid and therefore the shareholder is entitled to only 50% of a dividend, then only 1million shares (ie 50% x 2million) are included in the calculation of weighted average number of shares. Where a share buy back takes place, there is a reduction in the number of shares and a corresponding decrease in resources available to generate profits (as cash is paid by the entity to the selling shareholders). In both of these cases, therefore, EPS after the share issue or buy back can be compared on a like for like basis with EPS before the event as the increase (or decrease) in the numerator of the EPS fraction corresponds to the increase (or decrease) in the denominator of the fraction.
Example: Issue of ordinary shares at full market price

The profit after tax of AB Co for the year ended 31 December 20X5 was $3,000,000. At 31 December 20X4 the company had in issue 1,000,000 ordinary shares of $1 each. On 1 July 20X5, AB Co issued 400,000 ordinary shares at the full market price for cash. What is the basic EPS for the year ended 31 December 20X5?
500
Solution
Weighted average number of ordinary shares outstanding for year 20X5: 1,000,000 + 400,000 x
6 months = 1,200,000 12 months
Therefore, EPS for year 20X5 =
$3,000,000 = $2.50 1,200,000
HKAS 33.28,29
1.5.2 Bonus issues, share splits and reverse share splits

Events such as bonus issues change the number of shares outstanding, without a corresponding change in resources. Here it is necessary to make adjustments so that the current and prior period EPS figures are comparable. Bonus issues and share splits can be considered together as they have a similar effect. In both cases, ordinary shares are issued to existing shareholders for no additional consideration. The number of ordinary shares has increased without an increase in resources. Therefore the number of ordinary shares outstanding before the event must be adjusted for the proportionate change in the number of shares outstanding as if the event had occurred at the beginning of the earliest period reported. Reverse share splits are a consolidation of ordinary shares which generally reduces the number of ordinary shares outstanding without a corresponding reduction in resources. However, when the overall effect is a share repurchase at fair value, the reduction in the number of ordinary shares outstanding is the result of a corresponding reduction in resources. The weighted average number of ordinary shares outstanding for the period in which the combined transaction takes place is adjusted for the reduction in the number of ordinary shares from the date the special dividend is recognised.
Example: Issue of ordinary share by bonus issue

The profit of CD Co for the year ended 31 December 20X6 was $5,600,000. For the year ended 31 December 20X7 this increased to $7,000,000. The company had issued share capital of 1,000,000 ordinary shares of $1 each as at 31 December 20X6. On 1 July 20X7, CD Co issued 400,000 ordinary shares fully paid by way of capitalisation of reserves in the proportion of 2 for 5. What is the basic EPS of CD Co for both years?
Solution
Weighted average number of ordinary shares outstanding for year 20X7:
1,000,000 + 1,000,000 /5 = 1,400,000 An alternative calculation of this amount is as follows: 1 Jan 20X7 30 June 20X7 Bonus issue 1 July 20X7 31 Dec 20X7 1,000,000 400,000 1,400,000 x 6/12 months 700,000 1,400,000 x 7/5 x 6/12 months 700,000
501
Financial Reporting
Calculation using the tabular approach may prove easier to use in examples where there is more than one issue in the year. Note that the bonus fraction of 7/5 is calculated as the number of shares post bonus issue/number of shares pre bonus issue, and is applied to all periods in the table before the bonus issue. EPS (20X7) Original EPS (20X6) Restated EPS (20X6) = = = $7,000,000 = $5.00 1,400,000 $5,600,000 = $5.60 1,000,000 $5,600,000 = $4.00 1,400,000
The restated EPS for 20X6 may alternatively be calculated using the reciprocal of the bonus fraction ($5.60 x 5/7 = $4.00).
Note. Number of shares for all earlier accounting periods should be adjusted by the new issue as the reserves used for the bonus issue are carried down from prior periods.
HKAS 33, Appendix A.A2
1.5.3 Rights issues

A rights issue of shares is an issue of new shares to existing shareholders at a price below the current market value. The offer of new shares is made on the basis of x new shares for every y shares currently held, eg a 1 for 3 rights issue is an offer of one new share at the offer price for every three shares currently held. As the issue price is below market value, a rights issue is treated as a combination of an issue at fair value and a bonus issue. In order to calculate the weighted average number of shares when there has been a rights issue, an adjustment factor is required: Adjustment factor = Pre rights issue price of shares Theoretical ex - rights price (TERP)
The TERP is the theoretical price at which the shares would trade after the rights issue and takes into account the diluting effect of the bonus element in the rights issue. It is calculated as: TERP = Total market value of original shares pre rights issue + Proceeds of rights issue Number of shares post rights issue
The adjustment factor is used to increase the number of shares in issue prior to the rights issue for the bonus element. The comparative EPS for the previous period is adjusted by the reciprocal of the rights adjustment factor.
Example: Theoretical ex-rights value

The following information is provided for an entity which is making a rights issue. Profit attributable to ordinary equity holders of the parent entity
20X2 $600,000 20X3 $720,000
Shares outstanding before rights issue: 100,000 shares Rights issue: One new share for each five outstanding shares (20,000 new shares total) Exercise price: $5.00 Date of rights issue: 1 March 20X3 Market price of one ordinary share immediately before exercise on 1 March 20X3: $8.00 Reporting date 31 December
502
Required
Calculate the theoretical ex-rights value per share and the basic EPS for each of the years 20X2 and 20X3.
Solution
(1) Theoretical ex-rights price is calculated as: (100,000 $8.00) + (20,000 $5.00) 900,000 = $7.50 = 120,000 120,000 An alternative calculation is: Old shares New shares (2) (3) 5 @ $8.00 = 1 @ $5.00 = 6 $40.00 $5.00 $45.00 therefore $45.00/6 = $7.50
The adjustment factor is therefore $8.00/$7.50 The weighted average number of ordinary shares for 20X3 is therefore calculated as: 1 January 28 February 1 March 31 December Weighted average 100,000 shares $8.00 $7.50 120,000 shares
2/12 10/12
17,778 100,000 117,778
(1) (2) (3)
Basic EPS for 20X3 is therefore $720,000/117,778 shares = $6.11 Basic EPS for 20X2 as originally reported is $600,000/100,000 shares = $6.00 Basic EPS for 20X2 as adjusted is $6.00 $7.50/$8.00 = $5.63
Random Co, a listed company, had 5 million ordinary shares in issue at 1 January 20X1. Between this date and 31 December 20X2, the following share issues took place: 1 May 20X1 1 October 20X1 1 for 5 bonus issue Cash issue: 1 million shares were issued at $3.50. $2.10 has been paid in respect of each share and accordingly holders of these 1m shares are entitled to 60 per cent dividends until such time as the share is fully paid on 31 December 20X1. 1 for 7 rights issue at $3.55. The issue was fully subscribed and the market price of a share immediately prior to the issue was $3.65.
1 August 20X2
Profits for the years ended 31 December 20X1 and 20X2 are $4,981,500 and $6,165,200 respectively.
Required
(a) (b)
What is the basic earnings per share as reported in 20X1 and 20X2? What is the restated 20X1 basic earnings per share figure for inclusion in the 20X2 financial statements?
503
Financial Reporting
1.6 Diluted EPS

Topic highlights
Diluted EPS is calculated by adjusting the net profit attributable to ordinary shareholders and the weighted average number of shares outstanding for the effects of all dilutive potential ordinary shares.
Like basic EPS, diluted EPS provides a measure of the interest of each ordinary share in the profits of an entity. Unlike basic earnings per share, diluted EPS takes into account dilutive potential ordinary shares outstanding during the period. Diluted EPS is therefore the calculation of what the EPS would have been if all the dilutive potential ordinary shares had been actual shares in issue during the period.
HKAS 33.4144
1.6.1 Dilutive potential ordinary shares

Dilutive potential ordinary shares are securities which do not (at present) have any 'claim' to a share of equity earnings, but may be converted to ordinary shares and so give rise to such a claim in the future. They include:

options or warrants convertible loan stock or convertible preference shares equity shares which at present are not entitled to any dividend, but will be entitled after some future date.
If these instruments are converted into ordinary shares, the number of shares ranking for dividend will increase, however the profits figure will generally not increase proportionately. Therefore such a conversion will reduce the profits attributable to each share. In other words they will have a dilutive effect on EPS. Diluted EPS is therefore calculated to indicate to investors the possible effects of a future dilution. Note that only dilutive potential ordinary shares form part of the diluted EPS calculation. Potential ordinary shares may also be anti-dilutive. In this case a conversion would increase the number of ordinary shares but increase earnings to a greater extent, meaning that EPS increases overall. In determining whether potential ordinary shares are dilutive or antidilutive, each issue or series of potential ordinary shares is considered separately rather than in aggregate.
HKAS 33.44
1.6.2 Calculation of diluted earnings per share

Diluted earnings per share is calculated as: Profits in basic EPS + effect on profit of dilutive potential ordinary shares Number of shares in basic EPS + dilutive potential ordinary shares This calculation is achieved in steps, with each group of potentially dilutive ordinary shares added in turn from the most dilutive to the least dilutive. Options and warrants are generally included first as they do not affect the profits part of the calculation. After each addition, diluted EPS is calculated and the diluted earnings per share is the lowest figure calculated at any stage in the sequence.
HKAS 33.33,35
1.6.3 Impact of potential ordinary shares on profits

The earnings calculated for basic EPS should be adjusted by the post-tax (including deferred tax) effect of converting potential ordinary shares. Adjustments may include:
504
any dividends on dilutive potential ordinary shares that were deducted to arrive at earnings for basic EPS.
interest recognised in the period for the dilutive potential ordinary shares.
any other changes in income or expenses (fees and discount, premium accounted for as yield adjustments) that would result from the conversion of the dilutive potential ordinary shares.
The conversion of some potential ordinary shares may lead to changes in other income or expenses. For example, the reduction of interest expense related to converting some convertible loan stock and the resulting increase in net profit for the period may lead to an increase in the expense relating to a non-discretionary employee profit-sharing plan. When calculating diluted EPS, the profit or loss for the period is adjusted for any such consequential changes in income or expense.
HKAS 33.36,39,40
1.6.4 Impact of potential ordinary shares on weighted average number of shares

The number of shares calculated for basic EPS should be increased by the weighted average number of ordinary shares that would be issued on the conversion of all the dilutive potential ordinary shares into actual ordinary shares in issue. It should be assumed that dilutive ordinary shares were converted into ordinary shares at the beginning of the period or, if later, at the actual date of issue. There are two other points: (a) (b) The computation assumes the most advantageous conversion rate or exercise rate from the standpoint of the holder of the potential ordinary shares. A subsidiary, joint venture or associate may issue potential ordinary shares that are convertible into either ordinary shares of the subsidiary, joint venture or associate, or ordinary shares of the reporting entity. If these potential ordinary shares have a dilutive effect on the consolidated basic EPS of the reporting entity, they are included in the calculation of diluted EPS.
HKAS 33.4547A
1.6.5 Share options

Share options are potential ordinary shares which will not impact future profits. Therefore only the denominator (ie number of shares) is affected in the diluted earnings per share calculation. The exercise price of share options is generally lower than the market value of a share, and therefore any exercise of options is viewed as an issue of shares at full (average) market value and an issue of free shares. It is these free shares which are dilutive. The denominator of the DEPS calculation is increased by the number of free shares issuable to reflect this. Note that where the exercise price of share options exceeds average market value in a period, the options are not dilutive.
Example: A listed company has issued share options

The profit after tax of XY Ltd for the year ended 31 December 20X3 was $3,000,000.
Capital structure
Issued share capital as at 31 December 20X2: 2,000,000 ordinary shares of $1 each. On 1 January 20X3, XY Ltd issued 50,000 share options each of which entitled the holder to one ordinary share on payment of $2. The average fair value of one ordinary share during 20X3 was $4.
505
Financial Reporting
Solution
Discussion: A company should assume the exercise of options in calculating diluted EPS. The assumed proceeds from these issues should be considered to have been received from the issues of shares at fair value. The difference between the number of shares issued and the number of shares that would have been issued at fair value should be treated as an issue of ordinary shares for no consideration.
The exercise of options has no impact on profits. Basic EPS (20X3) = $3,000,000 = $1.50 2,000,000
Shares 2,000,000
For calculation of Diluted EPS (20X3) Number of ordinary shares in issue during 20X3 Number of shares under share options 50,000 Number of shares that would have been issued at fair value = (50,000 x $2/$4) Therefore, number of shares issued for no consideration Therefore, diluted EPS (20X3) =
$3,000,000 = $1.48 2,025,000
25,000 2,025,000
Where expenses related to employee share options have not yet been recognised in profit or loss in accordance with HKFRS 2, a further adjustment is required to the calculation of diluted earnings per share. Here, the expense which has not yet been recognised is calculated as a per share option amount. This is then added to the exercise price, before the number of free shares is calculated.
Example: Share options (continued)

Assume that in the above example, the share options in issue have been awarded to employees and $15,000 expense has not yet been recognised in accordance with HKFRS 2. Therefore: Exercise price per share Proceeds raised on exercise of options = $2 + ($15,000/50,000) = $2.30 = $2.30 x 50,000 = $115,000
$115,000 / $4 = 28,750 shares would be issued at fair value, therefore 50,00028,750 = 21,250 'free' shares would be issued Diluted EPS is therefore based on 2,021,250 shares: diluted EPS (20X3) =
$3,000,000 = $1.48 2,021,250
HKAS 33.4950
1.6.6 Convertible instruments

Convertible loan stock may be dilutive or anti-dilutive. In order to ascertain which the case is, a stand-alone earnings per share amount should be calculated as: Post tax interest saved on conversion of loan stock Maximum number of potential ordinary shares in respect of the stock
506
If the amount calculated is less than basic earnings per share, the loan stock is dilutive and should be included in diluted earnings per share.
Example: loan stock

Ollivander Co has a basic earnings per share of 45c for the year ended 30 April 20X1, based on 30 million shares. The company has in issue $4 million 5% loan stock convertible into ordinary shares at a rate of 20 per $100 in 20X9. Ollivander pays tax at a rate of 26%. What is Ollivanders diluted earnings per share for the year ended 30 April 20X1?
Solution
The increase in profits on conversion is: The number of potential ordinary shares is $4 million 5% 74% $4 million / $100 20 = = $148,000 800,000
Earnings per share is therefore $148,000/800,000 = 18.5c. As this is lower than the basic earnings per share of 45c, the convertible loan stock is dilutive and should be considered in the calculation of diluted earnings per share:
Diluted earnings per share
Profits for the year attributable to ordinary shareholders: 45c 30million = $13.5million. DEPS $13,500,000 + $148,000 = 44.31c 30,000,000 + 800,000
Convertible preference shares are antidilutive whenever the amount of the dividend on such shares declared in or accumulated for the current period per ordinary share obtainable on conversion exceeds basic earnings per share. In this case the instrument should be ignored for the purposes of calculating diluted EPS.

Lytton Co has calculated amounts for basic earnings per share for the year ended 28 February 20X5 in accordance with HKAS 33 as: Profit attributable to ordinary shareholders Weighted average number of ordinary shares 1 2 $29,295,000 46,500,000
The following is also relevant at 28 February 20X5: There are 100,000 vested employee share options outstanding with an exercise price of $3.20 Lytton is also financed via $10 million 6% loan stock convertible into ordinary shares at a rate of: 18 per $100 in 20X6 20 per $100 in 20X7 22 per $100 in 20X8 3 4 The average market value of a Lytton ordinary share in the year ended 28 February 20X5 was $4.20 Lytton pays tax at a rate of 25%
What is diluted earnings per share for the year ended 28 February 20X5?
507
Financial Reporting
HKAS 33.52
1.7 Diluted EPS: contingently issuable ordinary shares

Contingently issuable shares may form: part of the consideration for the acquisition of another entity. In this case they will only be issued if certain targets are met in the future. a performance reward for senior staff members, payable if certain targets are met.
With regard to the calculation of EPS, the following apply in respect of contingently issuable shares: (a) (b) Until such time as the shares are issued they should not be taken into account when calculating basic EPS. They should be taken into account when calculating diluted EPS if the conditions leading to their issue have already been satisfied. If the conditions are not satisfied, the number of contingently issuable shares used in the diluted EPS calculation is the number of shares if the end of the period were the end of the contingency period. Contingently issuable shares are included from the beginning of the period (or from the date of the contingent share agreement, if later).
(c)
Restatement is not permitted if the conditions are not met when the contingency period expires. For example, Company A issued contingently issuable ordinary shares (CIOS) on 1 July 20X7. The conditions are satisfied on 1 July 20X9.
Year ended Basic EPS Diluted EPS
31 December 20X7
Do not include the CIOS since the conditions were not satisfied as at that date. Do not include the CIOS since the conditions were not satisfied as at that date. Include the CIOS from 1 July 20X9.
Include, from 1 July 20X7 to 31 December 20X7, the CIOS shares that would be issuable if 31 December 20X7 was the end of the contingency period. Include, from 1 January 20X8 to 31 December 20X8, the CIOS that would be issuable if 31 December 20X8 was the end of the contingency period. Include, from 1 January 20X9 to 30 June 20X9, the CIOS that would be issuable at 30 June 20X9.
31 December 20X8
31 December 20X9
Restatement of 20X7 and 20X8's diluted EPSs is not permitted.

HKAS 33.53
1.7.1 Contingent on future earnings

The condition for contingent issue may be achieving or maintaining a specified level of earnings for a particular period. In this case, if the effect is dilutive, the calculation of diluted EPS is based on the number of ordinary shares that would be issued if the amount of earnings at the end of the reporting period were the amount of earnings at the end of the contingency period. Because earnings may change in future periods, the calculation of basic EPS does not include such CIOS until the end of the contingency period because not all necessary conditions have been satisfied.
HKAS 33.54
1.7.2 Contingent on future market price of the ordinary shares

The number of ordinary shares contingently issuable may depend on the future market price of the ordinary shares. In that case, if the effect is dilutive, the calculation of diluted EPS is based on the number of ordinary shares that would be issued if the market price at the end of the reporting period were the market price at the end of the contingency period.
508
If the condition is based on an average of market prices over a period of time that extends beyond the end of the reporting period, the average for the period of time that has lapsed is used. Because the market price may change in a future period, the calculation of basic EPS does not include such CIOS until the end of the contingency period because not all necessary conditions have been satisfied.
HKAS 33.55
1.7.3 Contingent on both future earnings and future market price of the ordinary shares
The number of ordinary shares contingently issuable may depend on future earnings and future prices of the ordinary shares. In such cases, the number of ordinary shares included in the diluted EPS calculation is based on both conditions (ie earnings to date and the current market price at the end of the reporting period). CIOS are not included in the diluted EPS calculation unless both conditions are met.
Example: Contingently issuable shares

QQ Co had 20,000,000 ordinary shares outstanding as at 1 January 20X6. On 1 July 20X6, it acquired a business from YY Co. In accordance with the agreement, the initial consideration of $20 million is to be satisfied by the issue of 1,000,000 ordinary shares in QQ Co and, if the average annual profit of the business acquired for the following three financial years ending 31 December 20X8 is more than $8 million, additional shares should be issued to YY Co at 1 July 20X9. The number of shares to be issued will be calculated as follows: Average annual profit $8,000,000 20 The audited financial statements of the business for the year ended 31 December 20X6, 20X7 and 20X8 report a profit of $12,000,000, $5,000,000 and $4,000,000 respectively.
Required
Calculate the weighted average number of shares (WANOS) to use when calculating basic and diluted EPS of QQ Co for each of the three years ended 31 December 20X6, 20X7 and 20X8.
Solution
Year ended 31 December 20X6
As the conditions for the issue of the additional ordinary shares to YY Co have not been satisfied as at 31 December 20X6, no contingently issuable shares were considered outstanding for inclusion in the computation of basic EPS for the year ended 31 December 20X6. The denominator of basic EPS was calculated as follows: 20,000,000 + (1,000,000 /12) = 20,500,000 shares The original contingency period is the three-year period ending 31 December 20X8. Assuming the contingency period ended at 31 December 20X6, the average annual profit was $12,000,000 and according to the agreement 200,000 ordinary shares should be issued to YY Co: $12,000,00 0 $8,000,000 = 200,000 shares 20 The denominator of the diluted EPS was calculated as follows: 20,500,000 + (200,000 /12) = 20,600,000 shares
6 6
509
Financial Reporting
As the conditions for the issue of the additional ordinary shares to YY Co have not been satisfied as at 31 December 20X7, no contingently issuable shares were considered outstanding for inclusion in the computation of basic EPS for the year ended 31 December 20X7. The denominator of basic EPS was 21,000,000 shares. Assuming the contingency period ended at 31 December 20X7, the average annual profit was:
$12,000,00 0 + $5,000,000 = $8,500,000 2 and according to the agreement 25,000 ordinary shares should be issued to YY Co: $8,500,000 - $8,000,000 =25,000 shares 20 The denominator of the diluted EPS was calculated as follows: 21,000,000 + 25,000 = 21,025,000 shares Restatement of diluted EPS for the year ended 31 December 20X6 previously reported is not permitted.
As the conditions for the issue of the additional ordinary shares to YY Co have not been satisfied as at 31 December 20X8, no contingently issuable shares were considered outstanding for inclusion in the computation of basic EPS for the year ended 31 December 20X8. The denominator of basic EPS was 21,000,000 shares. Assuming the contingency period ended at 31 December 20X8, the average annual profit was: $12,000,00 0 + $5,000,000 + $4,000,000 = $7,000,000 3 and according to the agreement no ordinary shares should be issued to YY Co.
HKAS 33.66.68,69
1.8 Presentation
An entity should present on the face of the statement of comprehensive income the basic and diluted EPS for profit and loss: from continuing operations for the period
for each class of ordinary share that has a different right to share in the net profit for the period. The basic and diluted EPS should be presented with equal prominence for all periods presented. If an entity is reporting a discontinued operation, the basic and diluted EPS for the discontinuing operation must also be presented. Disclosure must still be made where the EPS figures (basic and/or diluted) are negative (ie a loss per share).
1.9 Significance of earnings per share

EPS is one of the most frequently quoted statistics in the financial analysis of listed companies. Because of the widespread use of the price/earnings (P/E) ratio as a yardstick for investment decisions, it has become increasingly important. Since the P/E ratio is calculated as the market price per share divided by the EPS, it is important that a standard method of calculating EPS is used by all quoted companies.
510
It seems that reported and forecast EPS can, through the P/E ratio, have a significant effect on a company's share price. Thus, a share price might fall if it looks as if EPS is going to be low. This is not very rational, as EPS can depend on many, often subjective, assumptions used in preparing the statement of comprehensive income. It does not necessarily bear any relation to the value of a company, and of its shares. Nevertheless, in practice the market is sensitive to EPS. EPS is commonly used as a means of assessing the stewardship and management role performed by company directors and managers. Remuneration packages are often linked to EPS growth, thereby increasing the pressure on management to improve EPS. The danger of this, however, is that management effort may go into distorting results to produce a favourable EPS.
1.10 Limitations of EPS

Although EPS is an important ratio, it does have a number of limitations. Users of the ratio should be aware of these limitations and the opportunities for manipulation: Its calculation is complex and may not be understood by non-accountants. It is based on historic profits, which may not be indicative of future profits. It is affected by accounting policy and changes in policy. It ignores risk; the maximisation of EPS does not guarantee benefits or capital growth to shareholders. It does not take account of the capital structure of an entity, so is not directly comparable between two companies. It is open to manipulation by share buy-backs which increase EPS, but also increase a company's risk by increasing its borrowings.
511
Financial Reporting
Topic recap

Earnings per share is a measure of the amount of profits earned by a company for each ordinary share. Earnings are profits after tax and preference dividends. Basic EPS is calculated by dividing the net profit or loss for the period attributable to ordinary shareholders by the weighted average number of ordinary shares outstanding during the period. Diluted EPS is calculated by adjusting the net profit attributable to ordinary shareholders and the weighted average number of shares outstanding for the effects of all dilutive potential ordinary shares.
512
Answer 1
(a)
20X1
1 Jan 20X1 30 April 20X1 Bonus issue 5m/5 1 May 20X1 30 Sept 20X1 Part paid cash issue 1m 60% 1 Oct 20X1 31 Dec 20X1
5,000,000 1,000,000 6,000,000
x 6/5 x 4/12 months
2,000,000
x 5/12 months
2,500,000
600,000 6,600,000 x 3/12 months 1,650,000 6,150,000
Therefore earnings per share is

20X2
4,981,500 = 81.00c 6,150,000
NB the part paid shares are now fully paid and therefore the opening balance of shares is 7m rather than 6.6m 1 Jan 20X2 31 July 20X2 Rights issue 7m/7 1 August 20X2 31 Dec 20X2 7,000,000 1,000,000 8,000,000 x 5/12 months 3,333,333 7,427,884 Computation of theoretical ex-rights price
Fair value of all outstandin g shares + total received from exercise of rights Number of shares outstandin g prior to exercise + number of shares issued in exercise Therefore earnings per share is (b)
Restated 20X1 basic EPS
($3.65 7) + ($3.55 1) = $3.64 8
x 3.65/3.64 x 7/12 months
4,094,551
6,165,200 = 83.00c 7,427,884
81c x
3.64 = 80.78c 3.65
513
Financial Reporting
Answer 2
Basic EPS =
$29,295,000 = 63 cents 46.5 million
Consider dilutive effects of options: Proceeds raised on exercise: Therefore, shares issued at market value: Free shares: 100,000 76,190 Consider dilutive effect of loan stock: Post tax interest saving ($10m x 6% x 75%) Additional shares ($10m/$100 x 22) (note that the worst case conversion scenario is assumed) EPS of this instrument is therefore 20.45 cents. As this is less than basic EPS, the instrument is dilutive and should be taken into account in the calculation of diluted EPS. Diluted EPS is therefore 61.05c: Basic With options With loan stock
29,295,000 46,500,000 29,295,000 46,500,000 + 23,810 29,295,000+450,000 46,500,000+23,810+2,200,000
100,000 $3.20 = $320,000/$4.20 = = = =
$320,000 76,190 23,810 $450,000 2,200,000
63.00c 62.97c 61.05c
514
Exam practice
Silver Coin Holdings Limited

Year ended 30 June Profit for the year (before interest expense) Equity structure: Ordinary shares, $1 par ('OS') Redeemable, convertible preference shares, $10 par ('PS') issued on 1 July 20X7 Cumulative annual dividend of $0.3 per share Convertible into eight ordinary shares per preference share Outstanding share options Average market price of one ordinary share during the year
20X8 $32,800,000
23 minutes
20X9 $8,000,000
Silver Coin Holdings Limited reported the following information in relation to the results and equity structure for each of the years ended 30 June 20X8 and 20X9:
220,000,000 3,000,000
228,500,000 2,000,000
1,000,000 $1.8
1,000,000 $1.65
The PS were issued at par, which represented the then market price on the date of issue. 1,000,000 PS were converted into OS on 1 January 20X9. 500,000 ordinary shares were issued to new investors at $1.4 per share on 1 October 20X8. No dividend was declared by the company during the year ended 30 June 20X8, $0.45 dividend was declared to PS holders on 31 December 20X8. All 1,000,000 share options, with exercise price for one ordinary share at $1.5 per option, were granted to employees on 1 July 20X6. Each grant is conditional upon the employee working for the company over two years. The company did not have other borrowings outstanding during both the two years ended 30 June 20X9.
Required
(a) (b)
Calculate the basic earnings per share for each of the years ended 30 June 20X8 and 20X9. (7 marks) Calculate the diluted earnings per share for the year ended 30 June 20X9. (6 marks)
(Total = 13 marks)
(Note: Tax effect is ignored and a reasonable approximation of the weighted average number of shares by the number of months that the shares are outstanding as a proportion of the total months in a year is adequate.) HKICPA February 2010 (amended)
515
Financial Reporting
516
chapter 24
Operating segments
Topic list
1 HKFRS 8 Operating Segments
Learning focus
Listed companies are required to apply HKFRS 8 Operating Segments and you must be able to identify reportable operating segments and the required disclosures.
517
Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.23 Operating segments 3.23.01 3.23.02 3.23.03 Identify and discuss the nature of segmental information to be disclosed in accordance with HKFRS 8 Explain when operating segments should be aggregated and disaggregated Disclose the relevant information for operating segments and appropriate entity-wide information
518
24: Operating segments | Part C Accounting for business transactions
1 HKFRS 8 Operating Segments

Topic highlights
HKFRS 8 Operating Segments requires that a listed entity identifies reportable operating segments and discloses financial information in respect of them. Many entities now operate on a multinational basis in a number of different geographical and product markets. These distinct markets may operate very differently from one another and be subject to different levels of risks and returns, and differing future prospects. The reason for segment reporting is to provide users of accounts with information on such segments so that they can make a better assessment of an entitys past performance and position, and identify which segments of an entity are successful and which are less so. HKFRS 8 Operating Segments replaced HKAS 14 Segment Reporting in November 2006 and provides guidance on identifying segments and disclosing information in relation to them.
1.1 Objective of HKFRS 8

An entity should disclose information to enable users of its financial statements to evaluate the nature and financial effects of the business activities in which it engages and the economic environments in which it operates.
HKFRS 8.2
1.2 Scope of HKFRS 8

HKFRS 8 applies only to entities: whose equity or debt securities are traded in a public market (ie on a stock exchange); or which is in the process of listing securities in a public market.
It also applies to group financial statements where the parent meets the above criteria. In group accounts, only consolidated segmental information needs to be shown.
HKFRS 8.5,7
1.3 Definitions
HKFRS 8 provides one definition:
Key term
An operating segment is a component of an entity: (a) That engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity), Whose operating results are regularly reviewed by the entity's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and For which discrete financial information is available. (HKFRS 8)
(b)
(c)
The term 'chief operating decision maker' identifies a function, not necessarily a manager with a specific title. That function is to allocate resources and to assess the performance of the entity's operating segments.
519
Financial Reporting
1.4 Identifying reportable segments

Topic highlights
Reportable segments are operating segments or aggregation of operating segments that meet the 10 per cent test. HKFRS 8 requires entities within its scope to report financial and descriptive information about its reportable segments, so the first task is to understand which segments are reportable. Reportable segments are either individual operating segments or aggregations of operating segments (see below) that meet the specified criteria (the '10 per cent test' explained below).
HKFRS 8.12
1.4.1 Aggregation of operating segments

Two or more operating segments below the thresholds may be aggregated to produce a reportable segment if the segments have similar economic characteristics, and the segments are similar in: the nature of the products and services the nature of the production processes the type or class of customer for their products and services the methods used to distribute their products or provide their services if applicable, the nature of the regulatory environment (eg banks).
HKFRS 8.13,15,19
1.4.2 Quantitative thresholds

An entity should report separate information about each operating segment that: (a) (b) has been identified as meeting the definition of an operating segment, and segment total is 10 per cent or more of total: (i) (ii) (iii) revenue (internal and external) profits for all segments reporting a profit (or all segments in loss if greater), or assets
At least 75 per cent of total external revenue must be reported by operating segments. Where this is not the case, additional segments must be identified (even if they do not meet the 10 per cent thresholds). Operating segments that do not meet any of the quantitative thresholds may be reported separately if management believes that information about the segment would be useful to users of the financial statements. HKFRS 8 suggests that there may be a limit to the number of reportable segments that an entity separately discloses before information becomes too detailed. It suggests that when the number of reportable segments increases above ten, the entity should consider whether a practical limit has been reached.

Styledesign, a listed clothing manufacturer, trades in five business areas which are reported separately in its internal accounts provided to the chief operating decision maker. The results of these segments for the year ended 31 December 20X1 are as follows.
520
OPERATING SEGMENT INFORMATION AS AT 31 DECEMBER 20X1 External $m 14 56 59 22 12 18 181 Revenue Internal $m 7 3 8 0 3 24 45 Total $m 21 59 67 22 15 42 226 Segment profit/(loss) $m 1 13 9 (2) 2 (1) 22 Segment assets $m 31 778788 104 30 18 54 315 Segment liabilities $m 14 34 35 12 10 19 124
Ladies' fashion: Asia Rest of world Mens fashion Childrens fashion Sportswear Uniforms Required
Which of the operating segments of Styledesign constitute a reportable operating segment under HKFRS 8 Operating Segments for the year ending 31 December 20X1? (The answer is at the end of the chapter)
1.4.3 Decision tree to assist in identifying reportable segments

The following decision tree will assist in identifying reportable segments.
Management to identify operating segments reporting
Any operating segments meet all aggregation criteria? No Yes Any operating segments meet the quantitative threshold? No Aggregate segments if desired Yes Any remaining operating segments meet a majority of aggregation criteria? No Do identified reportable segments account for 75 per cent of the total external revenue? No Report additional segment
Yes
Aggregate segments if desired
Yes
These are reportable segments to be disclosed
Aggregate remaining segments into 'all other segments'
521
Financial Reporting
HKFRS 8.29,30
1.4.4 Restatement of previously reported information

If an entity changes the structure of its internal organisation in a manner that causes the composition of its reportable segments to change, the corresponding information for earlier periods, including interim periods, shall be restated unless the information is not available and the cost to develop it would be excessive. The determination of whether the cost is excessive shall be made for each individual item of disclosure. Following a change in the composition of its reportable segments, an entity shall disclose whether it has restated the corresponding items of segment information for earlier periods. If an entity has changed the structure of its internal organisation in a manner that causes the composition of its reportable segments to change and if segment information for earlier periods, including interim periods, is not restated to reflect the change, the entity shall disclose in the year in which the change occurs segment information for the current period on both the old basis and the new basis of segmentation, unless the necessary information is not available and the cost to develop it would be excessive.
HKFRS 8.2024,28,33,34
1.5 Disclosures
Topic highlights
HKFRS 8 disclosures are of: general information about segments financial information about segments segment profit or loss segment assets segment liabilities basis of measurement
Disclosures are also required about the revenues derived from products or services and about the countries in which revenues are earned or assets held, even if that information is not used by management in making decisions.
Disclosures required by the HKFRS are extensive, and best learned by looking at the example and proforma, which follow the list. (a) General information (i) (ii) (b) Factors used to identify the entity's reportable segments Types of products and services from which each reportable segment derives its revenues
Financial information; for each reportable segment the entity must disclose: (i) (ii) (iii) profit or loss total assets total liabilities
522
The following further items must also be disclosed if they are reported to the chief operating decision maker: External Revenue Interest revenue Interest expense Depreciation and amortisation Other material non-cash items Material items of income/expense (HKAS 1) Profit, assets and liabilities Share of profit of associates/jointly controlled entities equity accounted Profit or loss (as reported to chief operating decision maker) Income tax expense Non-current assets
(1)
Inter-co segment
Investments in associates/jointly controlled entities A reconciliation of the total of each of the above material items to the entity's reported figures is required. (c) (d) External revenue from external customers for each product and service (unless the cost of developing this information would be excessive). Geographical information External revenue Geographical areas Non-current assets Notes (1) (2) (e) Non-current assets excludes financial instruments, deferred tax assets, postemployment benefit assets, and rights under insurance contracts. External revenue is allocated based on the customer's location.
(1) (2)
By: Entity's country of domicile, and All foreign countries (subdivided if material)
Information about reliance on major customers (ie those who represent more than 10 per cent of external revenue).
1.5.1 Disclosure example from HKFRS 8

The following example is adapted from the HKFRS 8 Implementation Guidance, which emphasises that this is for illustrative purposes only and that the information must be presented in the most understandable manner in the specific circumstances. The hypothetical company does not allocate tax expense (tax income) or non-recurring gains and losses to reportable segments. In addition, not all reportable segments have material non-cash items other than depreciation and amortisation in profit or loss. The amounts in this illustration, denominated in thousands of dollars, are assumed to be the amounts in reports used by the chief operating decision maker.
523
Financial Reporting
Illustration: Disclosure example from HKFRS 8

Car parts $'000 Revenues from external customers Intersegment revenues Interest revenue Interest expense (b) Net interest revenue Depreciation and amortisation Reportable segment profit Other material non-cash items: Impairment of assets Reportable segment assets Expenditure for reportable segment non-current assets Reportable segment liabilities Notes (a) Revenues from segments below the quantitative thresholds are attributable to four operating segments of the company. Those segments include a small property business, an electronics equipment rental business, a software consulting practice and a warehouse leasing operation. None of those segments has ever met any of the quantitative thresholds for determining reportable segments. The finance segment derives a majority of its revenue from interest. Management primarily relies on net interest revenue, not the gross revenue and expense amounts, in managing that segment. Therefore, as permitted by HKFRS 8, only the net amount is disclosed. 8,000 1,250 950 300 270 200 7,000 1,000 4,050 Software $'000 21,500 4,500 2,500 1,800 1,550 3,200 15,000 1,300 9,800 Finance $'000 5,000 1,000 1,100 500 57,000 600 30,000 All other $'000 1,000 100 2,000
(a)
Totals $'000 35,500 4,500 3,750 2,750 1,000 2,950 4,070 200 81,000 2,900 43,850
(b)
1.5.2 Suggested proforma

Information about profit or loss, assets and liabilities
Segment A Segment B Segment C
All other segments X X X X (X) (X) X/(X) X/(X) X X (X)
Inter segment X (X) (X) X X/(X) X/(X) (X)
Entity total X X X (X) (X) X/(X) X/(X) X X (X)
Revenue external customers Revenue inter segment Interest revenue Interest expense Depreciation and amortisation Other material non-cash items Material income/expense (HKAS 1) Share of profit of associate/JVs Segment profit before tax Income tax expense
X X X X (X) (X) X/(X) X/(X) X X (X)
X X X X (X) (X) X/(X) X/(X) X X (X)
X X X X (X) (X) X/(X) X/(X) X X (X)
524
Segment A
Segment B
Segment C
All other segments
Inter segment
Unallocated items Profit for the year Segment assets Investments in associate/JVs Unallocated assets Entity's assets Expenditures for reportable assets Segment liabilities Unallocated liabilities Entity's liabilities X X X X X X X X (X)
Entity total X/(X) X X X X X
X X
X X
X X
X X
(X) (X)
X X X X
Information about geographical areas

Country of domicile
Revenue external customers Non-current assets X X
Foreign countries
X X
Total
X X
1.6 Key criticisms of HKFRS 8

(a) (b) (c) (d) Some commentators have criticised the 'managerial approach' as leaving segment identification too much to the discretion of the entity. The managerial approach may mean that financial statements of different entities are not comparable. The segments may include operations with different risks and returns. There is no defined measure of segment profit or loss.
1.7 Summary of HKFRS 8

HKFRS 8 is a disclosure standard which applies only to listed companies: Segment reporting is necessary for a better understanding and assessment of: past performance the economic environment informed judgments
HKFRS 8 adopts the managerial approach to identifying segments. The standard gives guidance on how segments should be identified and what information should be disclosed for each.
It also sets out requirements for related disclosures about products and services, geographical areas and major customers.
525
Financial Reporting
Topic recap
HKFRS 8 Operating Segments requires that a listed entity identifies reportable operating segments and discloses financial information in respect of them. Reportable segments are operating segments or aggregation of operating segments that meet the 10% test. HKFRS 8 disclosures are of: Operating segment profit or loss Segment assets Segment liabilities Certain income and expense items
Disclosures are also required about the revenues derived from products or services and about the countries in which revenues are earned or assets held, even if that information is not used by management in making decisions.
526
Answer to self test question
Answer 1
Revenue as % of total revenue ($226m) Ladies fashion * Mens fashion Childrens fashion Sportswear Uniforms 35.4% 29.6% 9.7% 6.6% 18.6% Profit or loss as % of profit of all segments in profit ($25m) 56% 36% 8% 8% 4% Assets as % of total assets $315m 34.6% 33.0% 9.5% 5.7% 17.1%
* The ladies fashion segments are aggregated due to their similar economic characteristics At 31 December 20X1 three of the five operating segments are reportable operating segments: Ladies fashion All size criteria are met Mens fashion All size criteria are met Children's fashion The children's fashion segment is not separately reportable as it does not meet the quantitative thresholds. It can, however, still be reported as a separate operating segment if management believes that information about the segment would be useful to users of the financial statements. Alternatively, the group could consider amalgamating it with another segment, providing the two operating segments have similar economic characteristics and share a majority of the aggregation criteria, which may be the case, particularly if uniforms refers to school uniforms. Otherwise it would be disclosed in an All other segments column. Sportswear The sportswear segment does not meet the quantitative thresholds and therefore is not separately reportable. It can also be reported separately if management believes the information would be useful to users. Alternatively, the group may be able to amalgamate it with another segment, providing the operating segments have similar economic characteristics and share a majority of the aggregation criteria. Otherwise it would also be disclosed in an All other segments column. Uniforms The uniforms segment meets the quantitative threshold in respect of revenue and assets and so is reported separately. Note: HKFRS 8.15 states that at least 75 per cent of total external revenue must be reported by operating segments. This condition has been met as the reportable segments (excluding children's wear and sports wear) account for 81 per cent of total external revenue (147/181).
527
Financial Reporting
Exam practice
HKFRS 8
18 minutes
Ms Li, the finance manager of a company listed on The Stock Exchange of Hong Kong Limited, is assessing the segment reporting requirements under HKFRS 8 Operating Segments included in the financial statements of the company and has tentatively concluded that: (a) (b) (c) (d) the company has a free choice in determining a business activity or business activities as an operating segment; the company can have 12 reportable segments; segment information should be prepared in conformity with the accounting policies adopted for preparing and presenting the financial statements of the company; and during the financial year, the company disposed of the businesses of one of its reportable segments. The company is required to restate the comparatives segment information in the financial statements for the current year.
Required Please comment on the above conclusions with reference to HKFRS 8 Operating Segments. (10 marks) HKICPA May 2007
528
chapter 25
Interim financial reporting

Topic list
1 HKAS 34 Interim Financial Reporting
Learning focus
The preparation of interim financial statements is relevant for evaluating the performance of a listed entity. Therefore, the application of accounting standards is very important to measure the performance in a consistent manner.
529
Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Account for transactions in accordance with Hong Kong Financial Reporting Standards 3.24 Interim financial reporting 3.24.01 3.24.02 3.24.03 3.24.04 Identify the circumstances in which interim financial reporting is required in accordance with HKAS 34 Explain the purpose and advantages of interim financial reporting Explain the recognition and measurement principles of interim financial statements and apply them Disclose the relevant information for interim financial statements including seasonality
530
25: Interim financial reporting | Part C Accounting for business transactions
1 HKAS 34 Interim Financial Reporting

Topic highlights
HKAS 34 does not mandate which entities should publish an interim financial report. For entities that do publish such reports, it lays down principles and guidelines for their production. However, it is up to government and regulators to decide what specific rules should apply to Hong Kong.
1.1 Objective
The objective of HKAS 34 is to prescribe the minimum content of an interim financial report and to prescribe the principles for recognition and measurement in complete or condensed financial statements for an interim period. Relevant and reliable interim financial reporting enhances users' understanding of the performance and position of an entity. In addition, it may be a requirement for some companies. The advantages of interim reporting are: (a) (b) (c) (d) (e) financial information is more useful if provided more frequently and in a timely manner. it provides up to date information, since investors do not only make investment and divestment decisions at period ends. investors can see the impact of events soon after they occur. interim information may help to project financial amounts for the full year. interim results can provide evidence of trends and seasonality which is not evident from annual results.
HKFRS 34.1
1.2 Scope
The standard does not make the preparation of interim financial reports mandatory for any company, taking the view that this is a matter for governments, securities regulators, stock exchanges or professional accountancy bodies to decide within each country. HKICPA encourages publicly traded entities to provide interim financial reports that conform to the recognition, measurement, and disclosure principles set out in this standard. The standard recommends that in respect of public listed companies, (a) (b) an interim financial report should be produced by such companies for at least the first six months of their financial year (ie a half year financial report) the report should be available no later than 60 days after the end of the interim period.
Thus, a company with a year ending 31 December should prepare an interim report for the half year to 30 June and this report should be available before the end of August.
531
Financial Reporting
HKFRS 34.4
1.3 Definitions
The following definitions are used in HKAS 34.
Key terms
Interim period is a financial reporting period shorter than a full financial year. Interim financial report means a financial report containing either a complete set of financial statements (as described in HKAS 1) or a set of condensed financial statements (as described in this standard) for an interim period. (HKAS 34)
HKFRS 34.6,8
1.4 Minimum components

The standard specifies the minimum component elements of an interim financial report: Condensed statement of financial position Condensed statement of comprehensive income Condensed statement of changes in equity Condensed statement of cash flows Selected explanatory notes
The rationale for requiring only condensed statements and selected note disclosures is that entities need not duplicate information in their interim report that is contained in their report for the previous financial year. Interim statements should focus more on new events, activities and circumstances.
HKFRS 34. 9-11
1.5 Form and content

HKAS 1 should be followed when full financial statements are given as interim financial statements, otherwise HKAS 34 states the minimum contents that should be disclosed. Where condensed financial statements are given instead, they should include, at least, those headings and subtotals that appeared in its most recent annual financial statements and selected explanatory notes. Additional items or notes should be presented if their omission results in misleading condensed interim financial statements. Where an entity is within the scope of HKAS 33 Earnings per Share it should present basic and diluted EPS for the interim period.
HKFRS 34.15,15A, 16A,19
1.5.1 Selected explanatory notes

According to HKAS 34, an entity should include in its interim report an explanation of events and transactions that are significant to an understanding of changes in financial position and performance since the end of the last reporting period. Information disclosed in relation to those events and transactions should update the relevant information presented in the most recent annual financial report. It is not necessary for the notes to the interim accounts to provide relatively insignificant updates to the information provided in the most recent annual financial report. In addition to disclosing significant events and transactions, an entity should include the following in its interim financial statements: (a) A statement that the same accounting policies and methods of computation are followed in the interim statements as compared with the most recent annual financial statements. If any policy or method has changed, a description of the nature and effect of the change is required. Explanatory comments on the seasonality or 'cyclicality' of operations.
(b)
532
(c) (d) (e) (f) (g)
The nature and amount of items affecting assets, liabilities, equity, net income or cash flows, that are unusual, because of their nature, size or incidence. Nature and amount of changes in estimates of amounts reported in earlier interim reports of the same financial year, or prior financial years. The issue, repayment and repurchase of equity or debt securities. Dividends paid on ordinary shares and dividends paid on other shares. Where segment information is provided in the annual financial statements, the following should be disclosed in the interim financial statements: (i) (ii) (iii) (iv) (v) (vi) Revenues from external customers (if included in the measure of profit reviewed by the chief operating decision maker); Intersegment revenues (if included in the measure of profit reviewed by the chief operating decision maker); A measure of segment profit or loss; Total assets for which there has been a material change from the amount disclosed in the last financial statements; A description of differences in the basis of segmentation or measurement of profit or loss from the last annual financial statements; A reconciliation of total profit or loss of reportable segments to the entitys profit or loss before tax and discontinued operations.
(h) (i) (j)
Events after the interim period that have not been reflected in the financial statements for the interim period; The effect of the acquisition or disposal of subsidiaries during the interim period. For financial instruments, the disclosures about fair value required by HKFRS 13 Fair Value Measurement and HKFRS 7 Financial Instruments: Disclosures.
The kinds of disclosure required may include corrections of prior period errors, inventory write downs and the acquisition and disposal of items of property, plant and equipment. Except as required above, the disclosures required by other HKFRS are not required if an entity's interim financial report includes only condensed financial statements and selected explanatory notes rather than a complete set of financial statements. The entity should also disclose the fact that the interim report has been produced in compliance with HKAS 34 on interim financial reporting.
Give some examples of the type of disclosures required according to the above list of explanatory notes. (The answer is at the end of the chapter)
HKFRS 34.20
1.6 Periods covered

As required by the standard, financial information for the following periods or as at the following dates should be provided in interim financial reports: (a) Statement of financial position data as at the end of the current interim period, and comparative data as at the end of the most recent financial year.
533
Financial Reporting
(b)
Statement of comprehensive income data for the current interim period and cumulative data for the current year to date, together with comparative data for the corresponding interim period and cumulative figures for the previous financial year. Statement of changes in equity data should be for both the current interim period and for the year to date, together with comparative data for the corresponding interim period, and cumulative figures, for the previous financial year. Statement of cash flows data should be cumulative for the current year to date, with comparative cumulative data for the corresponding interim period in the previous financial year.
(c)
(d)
HKFRS 34.23
1.7 Materiality
In deciding how to account for an item in an interim financial report, materiality should be assessed in relation to the interim period financial data. It should be recognised that interim measurements may rely to a greater extent on estimates than annual financial data.
HKFRS 34.28
1.8 Recognition and measurement principles

HKAS 34 strongly emphasises the recognition and measurement principles and the guidelines for their practical application. The guiding principle is that identical recognition and measurement principles should be used in an entity's interim and annual financial statements. To illustrate, a cost that is not regarded as an asset in the year-end statement of financial position should not be treated so in the statement of financial position for an interim period, Likewise, an accrual of income or expense for a transaction that has not been incurred (or a deferral of income or expense) is not suitable for interim reporting, just as it is for year-end reporting. A remeasurement of the amounts that were reported in a financial statement of a previous interim period may have to be carried out in a later interim period or at the year-end because of the application of this recognition and measurement principle. Disclosure of the nature and amount of any significant reassessments is required.
HKFRS 34.37
1.8.1 Revenues received occasionally, seasonally or cyclically

The revenue recognition principle should be applied consistently in both interim and year-end reports. Revenue which is not recurring ie received as an occasional item, or of seasonal or cyclical nature, should not be anticipated or deferred in the annual financial statements, as well as in the interim financial statements.
HKFRS 34.39
1.8.2 Costs incurred unevenly during the financial year

Anticipation or deferral of these costs (ie recorded as accruals or prepayments) is done only if it would be appropriate to do so in the annual financial statements. To illustrate, it would not be appropriate to anticipate expenses which have not yet been incurred eg part of the cost of a major advertising campaign happening later in the reporting year, where no expenses have been incurred. On the other hand, it would be necessary to anticipate a rental cost of a property where the rental is paid in arrears.
1.9 Applications of the recognition and measurement principles

Specific applications of the recognition and measurement principles are provided in an appendix to the standard. Some of these examples are explained below, by way of explanation and illustration.
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1.9.1 Payroll taxes and insurance contributions paid by employers

The assessment of these costs are done annually in some countries, though they are paid at an uneven rate during the year. A large portion of the taxes is paid in the earlier phase of the year while a much smaller portion is paid in the later part of the year. This situation thus entails the use of an estimated average annual tax rate in an interim statement, not the actual tax paid since the taxes are assessed on an annual basis, even though the payments pattern is uneven.
1.9.2 Cost of a planned major periodic maintenance or overhaul

In the absence of a legal or constructive obligation to carry out major periodic maintenance or overhaul, the cost of this kind of work in the later phase of the year must not be anticipated in an interim financial statement. The fact that a maintenance or overhaul is planned and is carried out annually is not a justification for the anticipation of the cost in an interim financial report.
1.9.3 Other planned but irregularly-occurring costs

Likewise, no accrual is to be made in an interim report for costs such as charitable donations or employee training costs which are planned to be incurred later in the year. These costs are considered as discretionary, even if they occur regularly and are planned.
1.9.4 Year-end bonus

Unless there is a legal or constructive obligation to pay a year-end bonus (eg a contractual obligation, or a regular past practice) and a reliable measure on the size of the bonus, such a bonus should not be provided for in an interim financial statement.
Example: Bonus
BlueBears year end is 31 December and it is currently preparing interim financial statements for the six months to 30 June 20X1. It has a contractual agreement with its staff that it will pay them an annual bonus equal to 8 per cent of their annual salary if the full years output exceeds 5,000,000 units. Budgeted output is 5,500,000 units and the entity has achieved budgeted output during the first six months of the year. Annual salaries are estimated to be $80 million, with the salary cost in the first half year to 30 June being $35 million. Required How should the bonus be reflected in the interim financial statements?
Solution
It is probable that the bonus will be paid, given that the actual output already achieved in the year is in line with budgeted figures, which exceed the required level of output. So a bonus of $2.8 million (8% x $35m) should be recognised in the interim financial statements at 30 June 20X1.
1.9.5 Holiday pay

The same principle is to be applied to holiday pay. An accrual must be made for any unpaid accumulated holiday pay in the interim financial report if the holiday pay is an enforceable obligation on the employer.
1.9.6 Non-monetary intangible assets

Expenses might be incurred during an interim period on items that might or will generate nonmonetary intangible assets. According to HKAS 38 Intangible Assets, with the exception of those costs that constitute part of the cost of an identifiable intangible asset, other costs relating to the
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Financial Reporting
generation of non-monetary intangible assets (eg development expenses) should be recognised as an expense when incurred. Costs that were initially recognised as an expense cannot be treated as part of the cost of an intangible asset in a later period. The same approach should be adopted in interim financial statements as mentioned in HKAS 34. That is to say, unless a cost will eventually be part of a non-monetary intangible asset that has not yet been recognised, it would not be appropriate to have it 'deferred'; it should be expensed in the interim report.
1.9.7 Depreciation
Depreciation and amortisation should be calculated and charged in an interim statement only on non-current assets already acquired. No such calculation is required for those non-current assets to be acquired later in the financial year.
1.9.8 Foreign currency translation gains and losses

HKAS 21 should be applied and the amounts should be computed based on the same principles as at the financial year end.
1.9.9 Tax on income

An income tax expense (tax on profits), calculated based on an estimated average annual tax rate for the year, should be included in the interim statements of an entity. To illustrate, suppose a tax rate of 20 per cent is to be applied on the first $500,000 of a company's profit and 22 per cent on profits above $500,000. A company which makes a profit of $500,000 in its first half year, and expects to make $500,000 in the second half year should apply an expected annual average tax rate of 21 per cent in the interim financial report, not 20 per cent. Since income tax on company profits is charged on an annual basis, an effective annual rate is therefore considered as appropriate for each interim period. Suppose a company earns pre-tax income of $300,000 in the first quarter of the year, but expects a loss of $100,000 in each of the following three quarters, so that net income before tax for the whole year is zero. Assume also that the tax rate for the current year is 20 per cent. The loss will not be anticipated in this case and thus a tax charge of $60,000 should be recorded for the first quarter of the year (20 per cent of $300,000) and a negative tax charge of $20,000 for each of the next three quarters, if actual losses are the same as anticipated. Where the tax year and the financial year of a company do not coincide, a separate estimated weighted average annual tax rate should be used in the interim periods that fall within the tax year. Tax credits are given, based on amounts of capital expenditure or research and development and so on, to set off against the tax payable in some countries. If these credits are calculated and granted annually, it is appropriate to include anticipated tax credits within the calculation of the estimated average tax rate for the year. This average tax rate is then applied to calculate the income tax for interim periods. However, in the case of a tax benefit relating to a specific one-time event, it should be recognised within the tax expense for the interim period in which the event occurs.

Flyman is currently preparing interim financial statements for the six months to 30 June 20X1. Its profit before tax for the six month period to 30 June 20X1 is $5 million. The business is seasonal and the profit before tax for the six months to 31 December 20X1 is almost certain to be $9 million. Income tax is calculated as 14 per cent of reported annual profit before tax if it does not exceed $10 million. If annual profit before tax exceeds $10 million the tax rate on the whole amount is 16%. Required Under HKAS 34 what should the taxation charge be in the interim financial statements? (The answer is at the end of the chapter)
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1.9.10 Inventory valuations

Inventories should be valued in the same manner in both interim reports and final accounts, though the valuation in interim reports may rely more heavily on estimates. The net realisable value of inventories should be estimated from selling prices and the related costs to complete and dispose of at interim dates.
Example: Inventory valuation

Callcut is currently preparing interim financial statements for the half year to 30 June 20X1. The price of its products tends to vary. At 30 June 20X1, it has inventories of 500,000 units, at a cost per unit of $5.00. The net realisable value of the inventories is $4.50 per unit at 30 June 20X1. The expected net realisable value of the inventories at 31 December 20X1 is $5.10 per unit. Required How should the value of the inventories be reflected in the interim financial statements?
Solution
The value of the inventories in the interim financial statements at 30 June 20X1 is the lower of cost and NRV at 30 June 20X1. This is: 500,000 $4.50 = $2.25m
HKFRS 34.41
1.10 Use of estimates

It is vital that accounting information must be reliable and free from material error. However a certain degree of accuracy and reliability might have to be sacrificed for the sake of timeliness and cost-benefits. This is particularly true where much less time can be devoted to the preparation of interim financial statements than at the financial year end. The standard therefore recognises that estimates for assessing values or even some costs will have to be used, to a greater extent, in interim financial reporting than in year-end reporting. An appendix to HKAS 34 gives some examples of the use of estimates. (a) (b) Inventories. An entity might not need to carry out a full inventory count at the end of each interim period. Instead, it may be sufficient to estimate inventory values using sales margins. Provisions. An entity might employ outside experts or consultants to advise on the appropriate amount of a provision, as at the year end (for example, a provision for environmental or site restoration costs). It will probably be inappropriate to employ an expert to make a similar assessment at each interim date. Similarly, an entity might employ a professional valuer to revalue non-current assets at the year end, whereas at the interim date(s) the entity will not rely on such experts. Income taxes. The rate of income tax (tax on profits) will be calculated at the year end by applying the tax rate in each country/jurisdiction to the profits earned there. At the interim stage, it may be sufficient to estimate the rate of income tax by applying the same 'blended' estimated weighted average tax rate to the income earned in all countries/jurisdictions.
(c)
The principle of materiality applies to interim financial reporting, as it does to year-end reporting. In assessing materiality, it needs to be recognised that interim financial reports will rely more heavily on estimates than year-end reports. Materiality should be assessed in relation to the interim financial statements themselves, and should be independent of 'annual materiality' considerations. If an estimate of an amount reported in an interim period changes significantly during the second period of the financial year but a separate financial report is not published for that second period, the nature and amount of that change in estimate should be disclosed in a note to the annual financial statements for that financial year.
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Financial Reporting
1.11 HK(IFRIC) Int-10 Interim Financial Reporting and Impairment

There is a prominent conflict about the recognition and reversal in financial statements of impairment losses on goodwill and certain financial assets between the requirements of HKAS 34 Interim Financial Reporting and those in other standards. HK(IFRIC) Int-10 concludes the following: (a) An entity must not reverse an impairment loss recognised in a previous interim period in respect of goodwill or an investment in either an equity instrument or a financial asset carried at cost. An entity must not extend this consensus by analogy to other areas of potential conflict between HKAS 34 and other standards.
(b)
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Topic recap
HKAS 34 recommends that entities should produce interim financial reports and for entities that do publish such reports, it lays down principles and guidelines for their production. In concept, HKAS 34 makes straightforward rules in respect of the production of interim financial reports by entities. The principles of recognition and measurement must be applied to avoid the 'massaging' of interim figures by the entities. It is of ultimate importance to understand the details in the guidelines and the application of the recognition and measurement principles to particular valuations and measurements.
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Financial Reporting
Answer 1
HKAS 34 provides the following list of events and transactions for which disclosures would be required if they were significant: (a) (b) (c) (d) (e) (f) (g) The write-down of inventories to net realisable value and the reversal of such a write-down Recognition of a loss from the impairment of financial assets, property, plant and equipment, intangible assets, or other assets, and the reversal of such a loss Reversal of any provisions for the costs of restructuring Acquisitions and disposals of items of property, plant and equipment Litigation settlements Corrections of prior period errors Changes in the business or economic circumstances that affect the fair value of the entitys financial assets and financial liabilities, whether those assets and liabilities are recognised at fair value or amortised cost Any loan default or breach of a loan agreement that has not been remedied on or before the end of the reporting period Related party transactions Transfers between levels of the fair value hierarchy used in measuring the fair value of financial instruments. Changes in the classification of financial assets as a result of a change in the purpose or use of those assets, and Changes in contingent liabilities or contingent assets.
(h) (i) (j) (k) (l)
This list is not exhaustive. Individual HKFRS provide guidance regarding disclosure requirements for many of the items listed above. When the events or transactions listed are significant, the interim report should provide an explanation of and update to the relevant information included in the financial statements of the last annual reporting period.
Answer 2
The taxation charge in the interim financial statements is based upon the weighted average rate for the year. In this case the entitys tax rate for the year is expected to be 16 per cent. The taxation charge in the interim financial statements will be $5m 16% = $800,000.
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Exam practice
Hintrim
18 minutes
Hintrim's accounting year ends on 31 December each year and it is currently preparing interim financial statements for the half year to 30 June 20X4. The financial controller is unsure about how to deal with three issues relating to HKAS 34 Interim Financial Reporting, and has asked for your help. (a) Hintrim has a contractual agreement with its staff that it will pay them an annual bonus equal to 10% of their annual salary if the full year's output exceeds one million units. Budgeted output is 1.4 million units and the entity has achieved budgeted output during the first six months of the year. Annual salaries are estimated to be $100 million, with the cost in the first half year to 30 June being $45 million. How should the bonus be reflected in the interim financial statements? (b) The price of Hintrim's products tends to vary. At 30 June 20X4, it has inventories of 100,000 units, at a cost per unit of $1.40. The net realisable value of the inventories is $1.20 per unit at 30 June 20X4. The expected net realisable value of the inventories at 31 December 20X4 is $1.55 per unit. How should the value of the inventories be reflected in the interim financial statements? (c) Hintrim's profit before tax for the six-month period to 30 June 20X4 is $6 million. The business is seasonal and the profit before tax for the six months to 31 December 20X4 is almost certain to be $10 million. Income tax is calculated as 25% of reported annual profit before tax if it does not exceed $10 million. If annual profit before tax exceeds $10 million the tax rate on the whole amount is 30%. (10 marks)
Advise the financial controller.
541
Financial Reporting
542
chapter 26
Presentation of financial statements

Topic list
1 2 Reporting financial performance Current developments
Learning focus
HKAS 1 has recently been revised, resulting in changes to the way in which performance is reported. These changes will affect all entities and you must be familiar with their application.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Prepare the financial statements for an individual entity in accordance with Hong Kong Financial Reporting Standards and statutory reporting requirements 4.01 Primary financial statement preparation 4.01.01 Prepare the statement of financial position, the statement of comprehensive income, the statement of changes in equity and of an entity in accordance with Hong Kong accounting standards Explain the minimum line items that should be presented in the financial statements and criteria for additional line items Financial statement disclosure requirements Disclose accounting policy and items required by the HKFRS, Companies Ordinance and other rules and regulations Explain the importance to disclose significant judgment and estimates 3
4.01.02 4.02 4.02.01 4.02.02
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26: Presentation of financial statements | Part C Accounting for business transactions
1 Reporting financial performance

Topic highlights
HKAS 1 was revised in 2007, with the effect that the way in which performance is reported has changed significantly. There have also been changes to terminology.
1.1 Revision of HKAS 1 Presentation of Financial Statements

HKAS 1 was revised in December 2007; this chapter explains the changes from the old standard, including new formats and terminology. The main changes to the previous version of the standard can be summarised as: changes to terminology enhanced performance reporting a change in focus of the statement of changes in equity the requirement for an additional statement of financial position in some circumstances
1.1.1 Changes to terminology

There have been a number of changes to terminology as follows: Old Balance sheet Income statement Cash flow statement Balance sheet date Equity holders Recycled to profit or loss New Statement of financial position Statement of comprehensive income Statement of cash flows End of the reporting period Owners Reclassified from equity to profit or loss
The use of these terms in practice is not mandatory; for example an entity may continue to use the title balance sheet'. As a result of the changes in terminology, there have been two consequential changes to titles of HKFRS: Old HKAS 7 Cash Flow Statements HKAS 10 Events after the Balance Sheet Date
HKAS 1.7
New HKAS 7 Statement of Cash Flows HKAS 10 Events after the Reporting Period
1.1.2 Performance reporting

Before the revision to HKAS 1 profit or loss for the period was presented in the income statement and all other changes in equity, including dividends, share issues and amounts recognised directly in equity, such as revaluation gains, were presented in the statement of changes in equity. HKAS 1 revised focuses on aggregating transactions with similar characteristics and therefore requires that changes in equity are classified as one of two types, and reported accordingly: (a) (b) Changes in equity arising from transactions with owners in their capacity as owners (eg dividends and share issues) are reported in the statement of changes in equity. Changes in equity arising from all other transactions are reported in the statement of comprehensive income. 545
Financial Reporting
The statement of comprehensive income therefore includes both: the profit or loss for the period and other comprehensive income.
Other comprehensive income is defined by HKAS 1 as income and expense (including reclassification adjustments) that are not recognised in profit or loss as required or permitted by other HKFRSs. The standard goes on to list the components of other comprehensive income as: (a) (b) (c) (d) (e) changes in the revaluation surplus those actuarial gains and losses on defined benefit plans not recognised in profit or loss gains and losses arising from translating the financial statements of a foreign operation gains and losses from investments in equity instruments measured at fair value through other comprehensive income the effective portion of gains and losses on hedging instruments in a cash flow hedge
1.1.3 Statement of changes in equity

As mentioned in the previous section, the statement of changes in equity focuses on reporting changes in equity as a result of transactions with owners in their capacity as owners. Elements of profit or loss and other comprehensive income do make up part of the overall change in equity in a period, and are therefore reported in the statement of changes in equity, however it is not the primary purpose of the statement of changes in equity to report these items.
HKAS 1.10
1.1.4 Additional statement of financial position

The revised HKAS 1 introduces a requirement to include a statement of financial position as at the beginning of the earliest comparative period when an entity: retrospectively applies an accounting policy retrospectively restates items in the financial statements, or reclassifies items in the financial statements.
In effect, this will result in the presentation of three statements of financial position when there is a prior period adjustment.
1.1.5 Other changes

Other changes introduced by HKAS 1 (revised) include the following: (a) Entities must disclose reclassification adjustments relating to each component of other recognised income and expense. These are amounts reclassified in the current period from other recognised income and expense to profit or loss. Tax effects of each item of comprehensive income must be shown. Entities should disclose income tax relating to each component of other recognised income and expense. This information will be useful, because often different tax rates are applied to these items than are applied to profit or loss. Dividends cannot be shown in profit or loss (income statement). Dividends must be presented on the face of the statement of changes in equity or in the notes. This change reflects the fact that a dividend distribution is an owner change in equity, which must be presented separately from non-owner changes in equity.
(b)
(c)
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HKAS 1.10
1.2 A complete set of financial statements

HKAS 1 revised states that a complete set of financial statements includes the following: (a) (b) (c) (d) (e) (f) A statement of financial position as at the end of the period. A statement of comprehensive income for the period. A statement of changes in equity for the period. A statement of cash flows for the period. Notes, comprising a summary of significant accounting policies and other explanatory information. A statement of financial position as at the beginning of the earliest comparative period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements.
These financial statements must be clearly identified and distinguished from other information in the same published document. The statement of cash flows is dealt with in Chapter 20 of this Learning Pack; the statements of financial position, comprehensive income and changes in equity are considered in more detail in the following sections of this chapter.
1.3 Statement of financial position

1.3.1 Proforma
The new HKAS 1 format is given below. ABC GROUP STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X9 $'000 ASSETS Non-current assets Property, plant and equipment 350,700 Goodwill 80,800 Other intangible assets 227,470 Investments in associates 100,150 Investments in equity investments measured at fair value through other comprehensive income 142,500 901,620 Current assets Inventories 135,230 Trade receivables 91,600 Other current assets 25,650 Cash and cash equivalents 312,400 564,880 Total assets 1,466,500 20X8 $'000 360,020 91,200 227,470 110,770 156,000 945,460 132,500 110,800 12,540 322,900 578,740 1,524,200
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Financial Reporting
20X9 $'000 EQUITY AND LIABILITIES Equity attributable to owners of the parent Share capital Retained earnings Other components of equity Non-controlling interests* Total equity Non-current liabilities Long-term borrowings Deferred tax Long-term provisions Total non-current liabilities Current liabilities Trade and other payables Short-term borrowings Current portion of long-term borrowings Current tax payable Short-term provisions Total current liabilities Total liabilities Total equity and liabilities
20X8 $'000
650,000 243,500 10,200 903,700 70,050 973,750 120,000 28,800 28,850 177,650 115,100 150,000 10,000 35,000 5,000 315,100 492,750 1,466,500
600,000 161,700 21,200 782,900 48,600 831,500 160,000 26,040 52,240 238,280 187,620 200,000 20,000 42,000 4,800 454,420 692,700 1,524,200
* Non-controlling interests is the new name for minority interest. The name was changed in HKFRS 3, which was issued after HKAS 1 (revised).
HKAS 1.54,55,58,59
1.3.2 Disclosure requirements

As a minimum HKAS 1 requires that the statement of financial position (balance sheet) includes the following: (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) Property, plant and equipment Investment property Intangible assets Financial assets (excluding amounts shown under (e), (h) and (i)) Investments accounted for using the equity method Biological assets Inventories Trade and other receivables Cash and cash equivalents The total of assets classified as held for sale and assets included in disposal groups classified as held for sale in accordance with HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations Trade and other payables Provisions Financial liabilities (excluding amounts shown under (k) and (l)) Liabilities and assets for current tax, as defined in HKAS 12 Income Taxes Deferred tax liabilities and deferred tax assets, as defined in HKAS 12
(k) (l) (m) (n) (o)
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(p) (q) (r)
Liabilities included in disposal groups classified as held for sale in accordance with HKFRS 5 Non-controlling interests, presented within equity, and Issued capital and reserves attributable to owners of the parent
Additional line items should be presented when they are relevant to an understanding of an entity's position. In deciding whether additional items should be presented separately, HKAS 1 (revised) requires that assessment is made of: the nature and liquidity of assets the function of assets within the entity, and the amounts, nature and timing of liabilities.
Where different measurement bases are used for different classes of assets (eg historic cost or revalued amount), the standard suggests that their nature or function differs and they should be presented separately. In addition, HKAS 1 (revised) requires that the line items presented in the statement of financial position are further sub-classified in a manner appropriate to the entity's operations either in the statement of financial position or in the notes.
HKAS 1.60,66,69,72, 74,75
1.3.3 Current / non-current classification

An entity must present current and non-current assets, and current and non-current liabilities, as separate classifications in the statement of financial position except where a presentation based on liquidity provides more relevant and reliable information. In this case, all assets and liabilities should be presented broadly in order of liquidity. HKAS 1 provides the criteria for classification of an asset or liability as current. Any other items are classified as non-current: Current asset (a) The entity expects to realise, sell or consume the asset in its normal operating cycle The asset is held primarily for trading The entity expects to realise the asset within 12 months after the reporting period The asset is cash or a cash equivalent unless the asset is restricted from being exchanged or used to settle a liability for at least the 12 months after the reporting period Current liability (a) The entity expects to settle the liability in its normal operating cycle The liability is held primarily for trading The liability is due to be settled within 12 months after the reporting period The entity does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period. Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect the classification
(b) (c)
(b) (c)
(d)
(d)
A long-term financial liability due to be settled within twelve months of the end of reporting period should be classified as a current liability, even if an agreement to refinance, or to reschedule payments, on a long-term basis is completed after the reporting period and before the financial statements are authorised for issue.
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Financial Reporting
End of reporting period
Agreement to refinance on longterm basis
Date financial statements authorised for issue
Settlement date <12 months after the reporting period
A long-term financial liability that is payable on demand because the entity breached a condition of its loan agreement should be classified as current at the end of reporting period even if the lender has agreed after the reporting period, and before the financial statements are authorised for issue, not to demand payment as a consequence of the breach.
Condition of loan agreement breached. Longterm liability becomes payable on demand
End of reporting period
Lender agrees not to enforce payment resulting from breach
Date financial statements approved for issue
However, if the lender has agreed by the end of reporting period to provide a period of grace ending at least twelve months after the reporting period within which the entity can rectify the breach and during that time the lender cannot demand immediate repayment, the liability is classified as non-current. HK Interpretation 5 was issued in November 2010. It sets out the conclusions of the HKICPA in relation to whether a term loan subject to a repayment on demand clause should be classified as current or non-current. HKICPA concludes that the classification depends on the rights and obligations of the lender and borrower as contractually agreed and in force at the reporting date. Where a lender has an unconditional right to call the loan at any time, it must be classified by the borrower as current, regardless of the probability of the lender exercising their right within 12 months.
HKAS 1.79
1.3.4 Disclosure of share capital and reserves

HKAS 1 requires that the following information is disclosed either in the statement of financial position or statement of changes in equity or notes to the accounts: (a) For each class of share capital: (i) (ii) (iii) (iv) (v) (vi) (vii) (b) the number of shares authorised the number of shares issued and fully paid, and issued but not fully paid par value per share, or that the shares have no par value a reconciliation of the number of shares outstanding at the beginning and end of the period the rights of each class of shares shares held by the entity itself or a subsidiary or an associate, and shares reserved for issue under options and contracts for the sale of shares, including terms and amounts, and
A description of the nature and purpose of each reserve within equity.
550
HKAS 1.81
1.4 Statement of comprehensive income

HKAS 1 (revised) allows the presentation of the statement of comprehensive income in one of two ways: (a) (b) As a single statement (the statement of comprehensive income) As two statements: (i) (ii) An income statement showing profit or loss A statement of comprehensive income which details other comprehensive income
1.4.1 Proforma: single statement

The following proforma shows the format of the statement of comprehensive income where a single statement is used. ABC GROUP STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X9 (SINGLE STATEMENT) 20X9 $'000 390,000 (245,000) 145,000 20,667 (9,000) (20,000) (2,100) (8,000) 35,100 161,667 (40,417) 121,250 121,250 5,334 (24,000) (667) 933 (667) 400 4,667 (14,000) 107,250 97,000 24,250 121,250 85,800 21,450 107,250 0.46 20X8 $'000 355,000 (230,000) 125,000 11,300 (8,700) (21,000) (1,200) (7,500) 30,100 128,000 (32,000) 96,000 (30,500) 65,500 10,667 26,667 (4,000) 3,367 1,333 (700) (9,334) 28,000 93,500 52,400 13,100 65,500 74,800 18,700 93,500 0.30
Revenue Cost of sales Gross profit Other income Distribution costs Administrative expenses Other expenses Finance costs Share of profit of associates Profit before tax Income tax expense Profit for the year from continuing operations Loss for the year from discontinued operations Profit for the year Other comprehensive income: Exchange differences on translating foreign operations Investments in equity investments measured at fair value through other comprehensive income Cash flow hedges Gains on property revaluation Actuarial gains (losses) on defined benefit pension plans Share of other comprehensive income of associates Income tax relating to components of other comprehensive income Other comprehensive income for the year, net of tax Total comprehensive income for the year Profit attributable to Owners of the parent Non-controlling interests Total comprehensive income attributable to Owners of the parent Non-controlling interests Earnings per share (in currency units) Basic and diluted
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Financial Reporting
1.4.2 Proforma: two statements

The two statement approach to the statement of comprehensive income is shown in the following illustration:
Illustration: Statement of comprehensive income (in two statements) given in HKAS 1

ABC GROUP INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 20X9 20X9 $'000 390,000 20,667 (115,100) 16,000 (96,000) (45,000) (19,000) (4,000) (6,000) (15,000) 35,100 161,667 (40,417) 121,250 121,250 97,000 24,250 121,250 0.46 20X9 $'000 121,250 5,334 (24,000) (667) 933 (667) 400 4,667 (14,000) 107,250 85,800 21,450 107,250 20X8 $'000 355,000 11,300 (107,900) 15,000 (92,000) (43,000) (17,000) (5,500) (18,000) 30,100 128,000 (32,000) 96,000 (30,500) 65,500 52,400 13,100 65,500 0.30 20X8 $'000 65,500 10,667 26,667 (4,000) 3,367 1,333 (700) (9,334) 28,000 93,500 74,800 18,700 93,500
Revenue Other income Changes in inventories of finished goods and work in progress Work performed by the entity and capitalised Raw material and consumables used Employee benefits expense Depreciation and amortisation expense Impairment of property, plant and equipment Other expenses Finance costs Share of profit of associates Profit before tax Income tax expense Profit for the year from continuing operations Loss for the year from discontinued operation PROFIT FOR THE YEAR Profit attributable to Owners of the parent Non-controlling interests Earnings per share (in currency units) Basic and diluted ABC Group Statement of comprehensive income PROFITS FOR THE YEAR Other comprehensive income Exchange differences on translating foreign operations Investments in equity investments measured at fair value through other comprehensive income Cash flow hedges Gains on property revaluation Actuarial gains (losses) on defined benefit pension plans Share of other comprehensive income of associates Income tax relating to components of other comprehensive income Other comprehensive income for the year, net of tax TOTAL COMPREHENSIVE INCOME FOR THE YEAR Total comprehensive income attributable to Owners of the parent Non-controlling interests
We have referred to the 'income statement' where the statement goes from revenue to profit for the year. Strictly speaking, the 'income statement' is often the 'income statement section of the statement of comprehensive income', but this is rather long-winded!
552
HKAS 1.82,83,8587,99
1.4.3 Disclosure requirements

Minimum items in the statement of comprehensive income should include the following: (a) Revenue Gains and losses arising from the derecognition of financial assets measured at amortised cost; (b) (c) Finance costs Share of the profit or loss of associates and joint ventures accounted for using the equity method If a financial asset is reclassified so that it is measured at fair value, any gain or loss arising from a difference between the previous carrying amount and its fair value at the reclassification date (d) (e) Tax expense A single amount comprising the total of the post-tax profit or loss of discontinued operations and the post-tax gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of the assets or disposal group(s) constituting the discontinued operation
(f) (g) (h) (i)
Profit or loss Each component of other comprehensive income classified by nature (excluding amounts in (h)) Share of the other comprehensive income of associates and joint ventures accounted for using the equity method, and Total comprehensive income.
The following items must also be disclosed in the statement of comprehensive income (income statement) as allocations of profit or loss for the period: (a) Profit or loss for the period attributable to: (i) (ii) (b) non-controlling interests owners of the parent
Total comprehensive income for the period attributable to: (i) (ii) non-controlling interests owners of the parent
Additional line items, headings and subtotals should also be presented when such presentation is relevant to an understanding of the entity's financial performance. In order to determine whether additional lines are necessary, an entity should consider materiality and the nature and function of items of income and expense. When items of income or expense are material, their nature and amount must be disclosed separately, either in the statement of comprehensive income or in the notes to the accounts. An analysis of expenses by either nature or function, whichever provides information that is reliable and more relevant, should also be disclosed either in the statement of comprehensive income or in the notes to the accounts. HKAS 1 does not permit the following in the statement of comprehensive income: The offsetting of income and expenses (unless required or permitted by an HKFRS) The presentation of any items of income or expense as extraordinary items.
553
Financial Reporting
HKAS 1.9093
1.4.4 Presentation of other comprehensive income

Income tax relating to each item of other comprehensive income must be disclosed, either in the statement of comprehensive income or in the notes. This disclosure is required because the tax rate applied to other comprehensive income may be different from that applied to profit or loss. Components of other comprehensive income may be shown either: net of the related tax effects, or before the related tax effects with one amount shown for the aggregate amount of income tax relating to other comprehensive income.
Reclassification adjustments relating to components of other comprehensive income should be disclosed. These are amounts reclassified to profit or loss in the current period that were recognised in other comprehensive income in previous periods. Users can use this information to assess the impact of reclassifications on profit or loss.
HKAS 1.106,106A
1.5 Statement of changes in equity

The statement of changes in equity provides a reconciliation of the shareholders' funds brought forward and shareholders' funds carried forward. Shareholders' funds consist of ordinary share capital, share premium, revaluation reserve, retained earnings and any other components of equity. The following should be disclosed: (a) (b) (c) Total comprehensive income for the period, showing separately the total amounts attributable to owners of the parent and to the non-controlling interests. For each component of equity, the effects of retrospective application or retrospective restatement recognised in accordance with HKAS 8, and For each component of equity, a reconciliation between the carrying amount at the beginning and the end of the period, separately disclosing changes resulting from: (i) (ii) (iii) profit or loss; other comprehensive income; and transactions with owners in their capacity as owners, showing separately contributions by and distributions to owners, and changes in ownership interests in subsidiaries that do not result in a loss of control.
An analysis of the other comprehensive income reported in the statement of changes in equity must be provided either: within the statement of changes in equity itself, or in the notes to the accounts.
The analysis should identify, for each balance within shareholders funds, individual items of other comprehensive income aggregated within it. This enables users of the accounts to see in which reserve each type of other comprehensive income is accumulated.
554
1.5.1 Proforma
ABC GROUP STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20X9
Translation Retained of foreign earnings operations Available for-sale financial assets Cash flow hedges Non controlling interests
Share capital
Revaluation surplus
Total
Total equity
Balance at
1 January 20X8 Changes in accounting policy Restated balance Changes in equity for 20X8 Dividends Total comprehensive income for the year Balance at 31 December 20X8 Changes in equity for 20X9 Issue of share capital Dividends Total comprehensive income for the year Transfer to retained earnings Balance at 31 December 20X9
$'000 600,000
$'000 118,100
$'000 (4,000)
$'000 1,600
$'000 2,000
$'000
$'000 717,700
$'000 29,800
$'000 747,500
600,000
400 118,500
(4,000)
1,600
2,000
400 718,100
100 29,900
500 748,000
(10,000)
(10,000)
(10,000)
53,200
6,400
16,000
(2,400)
1,600
74,800
18,700
93,500
600,000
161,700
2,400
17,600
(400)
1,600
782,900
48,600
831,500
50,000
(15,000)
50,000 (15,000)
50,000 (15,000)
96,600
3,200
(14,400)
(400)
800
85,800
21,450
107,250
200
(200)
650,000
243,500
5,600
3,200
(800)
2,200
903,700
70,050
973,750
The accountant of Chinatea Co has returned to work after a sabbatical break of some years. She is unaware of the issue of HKAS 1 (Revised) and has prepared draft financial statements as follows in accordance with what she remembers of HKAS 1 prior to the revision:
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Financial Reporting
BALANCE SHEET AT 31 DECEMBER 20X9 Non-current assets Long term receivable Current assets Inventories Receivables Cash
$ 525,000 10,000 535,000
31,200 56,450 10,900 98,550 633,550
Share capital and reserves Ordinary share capital ($1 nominal value) Share premium Profits reserve Liabilities Current liabilities Loan stock 20Y6
40,000 10,000 369,540 419,540 114,010 100,000 214,010 633,550
INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X9 Turnover Cost of sales Administrative expenses Distribution and other expenses Operating profit Interest payable Profit before tax Tax Profit after tax Dividends Retained profit The following information is also relevant: (a)
$ 1,235,000 (740,000) (267,020) (115,230) 112,750 (7,400) 105,350 (33,700) 71,650 (25,000) 46,650
The accountant has prepared a working schedule of non-current assets as follows: Land and buildings $ 700,000 700,000 337,500 12,500 350,000 350,000 Fixtures and fittings $ 200,000 15,000 215,000 60,000 5,000 65,000 150,000 Patent $ 30,000 30,000 2,500 2,500 5,000 25,000 Total $ 930,000 15,000 945,000 400,000 20,000 420,000 525,000
Cost b/f Additions Cost c/f Depreciation b/f Charge for year Depreciation c/f Carrying value
There have been no disposals of non-current assets in the period. (b) A property was to be revalued at the end of the reporting period to $600,000. The property had cost $400,000 including $80,000 in respect of land. Depreciation on the property at the end of the reporting period was $180,000. This has not been reflected in the financial statements. Deferred tax relating to the revaluation amounts to $95,000. Current liabilities include a short term provision of $20,000 and tax liability of $33,700.
(c)
556
(d) (e)
There was a 1 for 3 bonus issue of shares in the year which was funded by the share premium account. The long term receivable balance relates to a customer who has been given an extended two year credit period.
Required Re-draft the financial statements of Chinatea Co, including a statement of changes in equity in accordance with HKAS 1 (revised). Comparatives are not required. (The answer is at the end of the chapter)
1.6 Other aspects of HKAS 1

As well as prescribing the format and content of the financial statements, HKAS 1 provides guidance on the general features of financial statements.
HKAS 1.15,16,18,19, 20,23
1.6.1 True and fair view and compliance with HKFRSs

Financial statements must present a true and fair view of the financial position, performance and cash flows of an entity. In other words, they must faithfully represent the effects of transactions and other events in accordance with the basic principles of the Framework. The application of HKFRS and additional disclosure where necessary is presumed to result a true and fair view, and an entity which complies with HKFRS should state this fact in the notes to the accounts. Inappropriate accounting treatments are not rectified either by disclosure of the accounting policies used or by notes or explanatory material. In extremely rare circumstances, compliance with a requirement of an HKFRS or HK(IFRIC) may be so misleading that it would conflict with the objective of financial statements set out in the Framework, in which case the entity shall depart from that specific requirement. In the case of such a departure, the entity must disclose the following: (1) (2) (3) (4) That management has concluded that the financial statements present fairly the entity's financial position, financial performance and cash flows. That it has complied with applicable HKFRSs except that it has departed from a particular requirement to achieve a true and fair view. Full details of the departure, and The impact on the financial statements for each item affected and for each period presented.
If the relevant regulatory framework prohibits departure from the requirement, the entity shall, to the maximum extent possible, reduce the perceived misleading aspects of compliance by disclosing: (1) (2) The relevant HKFRS, the nature of the requirement and the reason why complying with the requirement is misleading. For each period presented, the adjustments to each item in the financial statements that would be necessary to achieve a true and fair view.
HKAS 1.25
1.6.2 Going concern

As part of the process of preparing financial statements, the management of an entity should assess the entity's ability to continue as a going concern. Where doubt exists as to this ability, any uncertainties should be disclosed. Where an entity is not a going concern, the financial statements should not be prepared on a going concern basis and this fact should be disclosed together with:
557
Financial Reporting

HKAS 1.29,30
the basis on which the financial statements have been prepared the reason why the entity is not regarded as a going concern.
1.6.3 Materiality and aggregation

HKAS 1 provides the following definition of material:
Key term
Material. Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. (HKAS 1 (revised)) The standard requires that: (a) (b) each material class of similar items is presented separately items of a dissimilar nature or function should be presented separately unless they are immaterial
If a line item in the financial statements is not individually material, it is aggregated with other items; an item which is not sufficiently material to warrant separate presentation in an individual statement may warrant separate presentation in the notes.
HKAS 1.117,122
1.6.4 Disclosure of accounting policies

An entity must provide a summary of accounting policies and within it disclose the following: (a) (b) The measurement basis (or bases) used in preparing the financial statements, and The other accounting policies used that are relevant to an understanding of the financial statements.
An entity must disclose, in the summary of significant accounting policies and/or other notes, the judgments made by management in applying the accounting policies that have the most significant effect on the amounts of items recognised in the financial statements.
HKAS 1.125
1.6.5 Estimation uncertainty

An entity must disclose in the notes information regarding key assumptions about the future, and other sources of measurement uncertainty, that have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year.
HKAS 1.107,137
1.6.6 Dividends
Entities no longer have the choice previously allowed in HKAS 1 of presenting dividends on the face of the income statement, the statement of changes in equity or the notes. Dividends must be presented on the face of the statement of changes in equity or in the notes. This change reflects the fact that a dividend distribution is an owner change in equity, which must be presented separately from non-owner changes in equity. The previous version of HKAS 1 permitted disclosure of the amount of dividends recognised as distributions to equity holders (now referred to as 'owners') and the related amount per share in the income statement, in the statement of changes in equity or in the notes. HKAS 1 revised requires dividends recognised as distributions to owners and related amounts per share to be presented in the statement of changes in equity or in the notes. The presentation of such disclosures in the statement of comprehensive income is not permitted.
558
The purpose is to ensure that owner changes in equity (in this case, distributions to owners in the form of dividends) are presented separately from non-owner changes in equity (presented in the statement of comprehensive income). Equity dividends declared after the reporting date but before the financial statements are authorised for issue should be considered as a non-adjusting event after the reporting period. HKAS 1 permits an entity to make this disclosure either: (1) (2) on the face of the statement of financial position as a separate component of equity in the notes to the financial statements
1.6.7 Other matters

As well as those matters covered above, HKAS 1 also requires the following: (a) (b) (c) (d) The accrual basis of accounting is used in the preparation of all financial statements except for the statement of cash flows. Assets and liabilities and income and expenses are not offset unless permitted or required by another HKFRS. A complete set of financial statements including comparative is presented at least annually. The presentation and classification of items in the financial statements is consistent from one period to the next unless another presentation or classification becomes more appropriate or an HKFRS requires another presentation or classification. Except when HKFRSs permit or require otherwise, an entity shall disclose comparative information in respect of the previous period for all amounts reported in the current period's financial statements.
(e)
The IASB is currently involved in two projects with respect to financial statement presentation: 1 In June 2011 a limited scope amendment to IAS 1 was issued, dealing in particular with other comprehensive income. This amendment is highly likely to be applied to HKAS 1 in due course. As a result of the amendment: other comprehensive income, and the related tax effect, is grouped for presentation purposes on the basis of whether it will eventually be recycled into profit or loss. Together with FASB, the IASB is also developing a standard which will replace both IAS 1 Presentation of Financial Statements and IAS 7 Statement of Cash Flows. The Boards goal is to reassess the layout of the main financial statements, together with how information is aggregated in order to improve the usefulness of the information provided in an entitys financial statements to help users make decisions in their capacity as capital providers.
559
Financial Reporting
Topic recap
HKAS 1 has been revised with the effect that the way in which performance is reported has changed significantly. There have also been changes to terminology. The revised standard provides guidance on the format and minimum contents of the statement of financial position, statement of comprehensive income and statement of changes in equity. HKAS 1 also provides general guidance with regard to achieving fair presentation, going concern, materiality and aggregation and the disclosure of accounting policies.
560
Answer 1
Statement of financial position of Chinatea Co at 31 December 20X9 ASSETS Non-current assets Property, plant and equipment (905,000 25,000 (W1)) Other intangible assets (W1) Current assets Inventories Trade receivables (56,450 + 10,000) Cash and cash equivalents Total assets EQUITY AND LIABILITIES Share capital Share premium Retained earnings Revaluation surplus Non-current liabilities Loan notes Deferred tax (on revaluation) Current liabilities Trade and other payables (114,010 33,700 20,000) Current tax payable Short term provisions Total current liabilities Total liabilities Total equity and liabilities $
880,000 25,000 905,000 31,200 66,450 10,900 108,550 1,013,550 40,000 10,000 369,540 285,000 704,540 100,000 95,000 195,000 60,310 33,700 20,000 114,010 309,010 1,013,550
Statement of comprehensive income for Chinatea Co for the year ended 31 December 20X9 Revenue Cost of sales Gross profit Distribution costs Administrative expenses Finance costs Profit before tax Income tax expense Profit for the year Other comprehensive income: Gains on property revaluation (W1) Income tax relating to components of other comprehensive income Other comprehensive income for the year, net of tax Total comprehensive income for the year $ 1,235,000 (740,000) 495,000 (115,230) (267,020) (7,400) 105,350 (33,700) 71,650 380,000 (95,000) 285,000 356,650
561
Financial Reporting
Statement of changes in equity for Chinatea Co for the year ended 31 December 20X9 Share capital $ 30,000 10,000 40,000 Share premium $ 20,000 (10,000) 10,000 Retained earnings $ 322,890 (25,000) 71,650 369,540 Revaluation surplus $ 285,000 285,000
At 1 January 20X9 Share issues (W2) Dividends Total comprehensive income at 31 December 20X9 WORKINGS (W1) Non-current assets Land and buildings $ 700,000 200,000 900,000 337,500 12,500 (180,000) 170,000 730,000
Cost b/f Additions Revaluation Cost c/f Depreciation b/f Charge for year Revaluation Depreciation c/f Carrying value
Fixtures and fittings $ 200,000 15,000 215,000 60,000 5,000 65,000 150,000
Patent $ 30,000 30,000 2,500 2,500 5,000 25,000
Total $ 930,000 15,000 200,000 1,145,000 400,000 20,000 (180,000) 240,000 905,000
The revaluation surplus recognised as other comprehensive income is therefore $380,000 ($200,000 + $180,000). (W2) New shares issued After share issue Share issue was 1 for 3 therefore x 40,000 shares = 40,000 shares at 31 December 20X9 30,000 shares at 1 January 20X9
Therefore $10,000 is charged to share premium meaning that the share premium balance at 1 January 20X9 must have been $20,000.
562
Exam practice
AZ
27 minutes
AZ is a listed manufacturing company. Its finished products are stored in a nearby warehouse until ordered by customers. AZ has performed very well in the past, but has been in financial difficulties in recent months and has been re-organising the business to improve performance. The trial balance for AZ at 31 March 20X3 was as follows: $'000 Sales Cost of goods manufactured in the year to 31 March 20X3 (excluding depreciation) Distribution costs Administrative expenses Restructuring costs Interest received Loan interest paid Land and buildings (including land $20,000,000) Plant and equipment Accumulated depreciation at 31 March 20X2: Buildings Plant and equipment Investment properties (at market value) Inventories at 31 March 20X2 Trade receivables Bank and cash Ordinary shares of $1 each, fully paid 6% redeemable $1 preference shares Share premium Revaluation surplus Retained earnings at 31 March 20X2 Ordinary dividends paid Preference dividends paid 7% loan stock 20X7 Trade payables Proceeds of share issue 94,000 9,060 16,020 121 1,200 639 50,300 3,720 6,060 1,670 24,000 4,852 9,330 1,190 20,000 1,000 430 3,125 27,137 1,000 60 18,250 8,120 2,400 214,292 $'000 124,900
214,292 Additional information provided: (i) The property, plant and equipment are being depreciated as follows: Buildings 5% per annum straight line Plant and equipment 25% per annum diminishing balance
Depreciation of buildings is considered an administrative cost while depreciation of plant and equipment should be treated as a cost of sale. (ii) (iii) (iv) On 31 March 20X3 the land was revalued to $24,000,000. Income tax for the year to 31 March 20X3 is estimated at $161,000. Ignore deferred tax. The closing inventories at 31 March 20X3 were $5,180,000. An inspection of finished goods found that a production machine had been set up incorrectly and that several production batches, which had cost $50,000 to manufacture, had the wrong packaging. The goods cannot be sold in this condition but could be repacked at an additional cost of $20,000.
563
Financial Reporting
They could then be sold for $55,000. The wrongly packaged goods were included in closing inventories at their cost of $50,000. (v) (vi) (vii) (viii) (ix) The preference shares will be redeemed at their par value ($1,000,000) in 20X9. Preference dividends are paid on 31 March each year. The 7% loan is a 10-year loan due for repayment by 31 March 20X7. Interest on this loan needs to be accrued for the six months to 31 March 20X3. The restructuring costs in the trial balance represent the cost of a major restructuring of the company to improve competitiveness and future profitability. No fair value adjustments were necessary to the investment properties during the period. During the year the company issued 2m new ordinary shares for cash at $1.20 per share. The proceeds have been recorded as 'Proceeds of share issue'.
Required Prepare the statement of comprehensive income and statement of changes in equity for AZ for the year to 31 March 20X3 and a statement of financial position at that date. Notes to the financial statements are not required, but all workings must be clearly shown. (15 marks)
564
Part D
Group financial statements
The emphasis in this section is on the application of accounting standards relating to consolidation. As future certified public accountants, it is important for you to be equipped with sound professional knowledge and skills in resolving consolidation issues. The purpose of this section is to develop your knowledge about the application of the relevant accounting standards to prepare consolidated financial statements, to account for associates and joint ventures and to handle difficult situations like acquisitions and the disposal of subsidiaries.
565
Financial Reporting
566
chapter 27
Principles of consolidation
Topic list
1 2 3 4 5 Introduction to group accounting Principles of consolidation Disclosure of interests in other entities HKFRS 3 (revised) Business Combinations Goodwill
Learning focus
You are very likely to come across groups of companies in practice and in your exam. It is important that you can identify different types of group companies and know how to account for them. The goodwill calculation (including gain on bargain purchase) and the related treatment are also vital for the preparation of group financial statements.
567
Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Prepare the financial statements for a group in accordance with Hong Kong Financial Reporting Standards and statutory reporting requirements 4.03 Principles of consolidation 4.03.01 4.03.02 4.03.03 4.03.04 Identify and describe the concept of a group as a single economic entity Define a subsidiary and when a group should start and stop consolidating a subsidiary Explain what constitutes control and the impact of potential voting rights Describe the reasons why the directors of a company may not want to consolidate a subsidiary and the circumstances in which nonconsolidation is permitted Explain the purpose of consolidated financial statements Explain the importance of eliminating intra-group transactions Explain the importance of uniform accounting policies and coterminous year ends in the preparation of consolidated accounts Apply the appropriate accounting treatment of consolidated goodwill Business combinations Explain the scope of business combinations in accordance with HKFRS 3 Identify business combination and the difference between acquisition of asset and business Determine the acquisition date of an acquisition Identify the identifiable assets (including intangibles) and liabilities acquired in a business combination Explain the recognition principle and measurement basis of identifiable assets and liabilities and the exception Explain what contingent consideration is and how to account for it initially and subsequently Explain how to account for acquisition-related costs, including those related to issue debt or equity securities Determine what is part of the business combination transaction and the consideration Calculate goodwill (including bargain purchase) and account for it Account for non-controlling interest when the subsidiary has negative equity balance Explain and account for measurement period adjustments Financial statement disclosure requirement Disclose the relevant information for business combinations occurred during and subsequent to the reporting period 3 3
4.03.05 4.03.06 4.03.07 4.03.08 4.06 4.06.01 4.06.02 4.06.03 4.06.04 4.06.05 4.06.06 4.06.07 4.06.08 4.06.09 4.06.11 4.06.12 4.10 4.10.01
568
27: Principles of consolidation | Part D Group financial statements
1 Introduction to group accounting

Topic highlights
A group of companies develops when a parent company buys one or more subsidiaries. The group should be regarded as a single economic entity for the purposes of accounting.
A group of companies is the result of one company (the parent company) buying a controlling share in one or more other companies (subsidiaries). This situation is very common where a parent company: buys a customer in order to secure custom buys a supplier in order to secure supplies buys a competitor in order to increase market share buys an overseas company in order to gain entry to a new geographical market, or buys another company in order to diversify.
1.1 Single economic entity and purpose of consolidated accounts

As groups grow, there is likely to be a very high level of buying and selling activity between group companies (intra-group sales). Often such sales do not take place at market prices. Similarly one group company may lend to another without charging interest or one company may provide management services to another free of charge. These group transactions distort the individual financial statements of each group company, making it difficult for a user of the accounts to understand the performance and position of the group as a whole. Furthermore, where there are a large number of group companies, there may be many individual sets of financial statements. Shareholders in the parent company (and so, by definition, the group) cannot be expected to digest each individual set of financial statements in order to gain an understanding of the group overall. Therefore, financial statements are prepared for the group as a single economic entity. In other words a single statement of financial position is prepared which combines the position of the parent and all its subsidiaries and a single statement of comprehensive income is prepared which combines the performance of the parent and all its subsidiaries. Since a single entity cannot transact with itself, the effects of any intra-group transactions are stripped out of these consolidated financial statements. Users of the accounts are therefore able to understand the position and performance of the group as a result only of its transactions with parties outside the group. The single economic entity concept and production of consolidated accounts is an example of the concept of substance over form, whereby the commercial substance of the group of companies as a whole has more relevance from an accounting perspective than the position of the individual companies as legal entities.
1.2 Group companies

Above we have considered a group of companies to consist of a parent company and one or more subsidiary companies which are controlled by the parent company. It is true that consolidated financial statements are only prepared where a parent company has at least one subsidiary, however other group entities, including associates and joint ventures may also be identified and must be represented in the consolidated financial statements.
569
Financial Reporting
HKAS 28.3, HKFRS 10, Appendix A, HKFRS 11, Appendix A
1.3 Definitions
A number of definitions are given in the standards listed above, including the following relating to group entities:
Key terms
Group. A parent and its subsidiaries. Parent. An entity that controls one or more entities. Subsidiary. An entity that is controlled by another entity. (HKFRS 10) (HKFRS 10) (HKFRS 10)
Control. An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through power over the investee. (HKFRS 10) Consolidated financial statements are the financial statements of a group in which the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity. (HKFRS 10) Power. Existing rights that give the current ability to direct the relevant activities. (HKFRS 10) Relevant activities. Activities of the investee that significantly affect the investees returns. (HKFRS 10) Associate. An entity over which the investor has significant influence. (HKAS 28)
Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control of those policies. (HKAS 28) Joint arrangement. An arrangement of which two or more parties have joint control. (HKFRS 11) Joint operation. A joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets, and obligations for the liabilities, relating to the arrangement. (HKFRS 11) Joint venture. A joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement. (HKFRS 11) Some of these definitions are considered in more detail later in this and subsequent chapters.
1.4 Levels of investment

Before we move on to discuss the principles of consolidation, the following table is useful in summarising different types of group investment and how they are accounted for. Investment Subsidiary Associate Joint arrangement (joint venture) Investment which is none of the above Criteria Control Significant influence Contractual arrangement Asset held for accretion of wealth Required treatment in group accounts Full consolidation (HKFRS 3/HKFRS 10) Equity accounting (HKAS 28) Equity accounting (HKFRS 11/HKAS 28) As for single company accounts per HKFRS 9
We will be looking at six accounting standards in this and the next three chapters. HKFRS 10 to 12 and the revised versions of HKAS 27 and 28 (known as HKAS 27 (2011) and HKAS 28 (2011)) 570
were issued in June 2011 as a package of five standards. They are applicable together and must be applied to periods beginning on or after 1 January 2013, although may be applied earlier: HKFRS 3 (revised) Business Combinations HKFRS 10 Consolidated Financial Statements HKFRS 11 Joint Arrangements HKFRS 12 Disclosure of Interests in Other Entities HKAS 27 (2011) Separate Financial Statements HKAS 28 (2011) Investments in Associates and Joint Ventures
HKFRS 9 was covered in Chapter 18. Note that this chapter includes mention of HKAS 27(revised). Before 2011, HKAS 27 was entitled Consolidated and Separate Financial Statements, and HKAS 27 (revised) refers to this standard rather than HKAS 27 (2011) Separate Financial Statements. The old HKAS 27 is included in order to provide some detail of the original definition of control, now superseded by that provided in HKFRS 10.
2 Principles of consolidation
Topic highlights
Consolidated financial statements are prepared where a parent controls another entity. The definition of control includes three elements.
HKFRS 10 Consolidated Financial Statements is applied in the preparation and presentation of consolidated financial statements. It provides guidance on establishing a parent-subsidiary relationship and prescribes the principles of consolidation.
2.1 Control
As we have already seen, a parent-subsidiary relationship is established when one entity controls another. The definition of control provided in HKAS 27 (revised) has now been superseded by that provided in HKFRS 10.
HKAS 27.1415
2.1.1 HKAS 27 (revised) definition of Control

Control is defined in HKAS 27 (revised) as the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. The standard expanded on this definition to state that a control relationship is presumed to exist where the parent owns, directly or indirectly through subsidiaries, more than half the voting power of an entity, unless it can be demonstrated that such ownership does not constitute control. In other words a company which holds more than 50 per cent of voting shares in another company controls that company. The standard also lists the following situations where control exists, even when the parent owns only 50 per cent or less of the voting power of an entity. (a) (b) (c) The parent has power over more than 50 per cent of the voting rights by virtue of agreement with other investors. The parent has power to govern the financial and operating policies of the entity by statute or under an agreement. The parent has the power to appoint or remove a majority of members of the board of directors (or equivalent governing body).
571
Financial Reporting
(d)
HKFRS 10.7, 8
The parent has power to cast a majority of votes at meetings of the board of directors (or equivalent governing body).
2.1.2 HKFRS 10 definition of Control

HKFRS 10, issued in June 2011 provides an amended definition, and identifies three separate elements of control. HKFRS 10 states that an investor controls an investee if and only if it has all of the following: (i) (ii) (iii) power over the investee (see below) exposure, or rights, to variable returns from its involvement with the investee (see below), and the ability to use its power over the investee to affect the amount of the investors returns (see below).
If there are changes to one or more of these three elements of control, then an investor should reassess whether it controls an investee.
HKFRS 10.10-12, 14, B11, B15, B18
2.1.3 Power
Power is defined as existing rights that give the current ability to direct the relevant activities of the investee. There is no requirement for that power to have been exercised. Relevant activities may include: selling and purchasing goods or services managing financial assets selecting, acquiring and disposing of assets researching and developing new products and processes determining a funding structure or obtaining funding.
In some cases assessing power is straightforward, for example, where power is obtained directly and solely from having the majority of voting rights or potential voting rights, and as a result the ability to direct relevant activities. In other cases, assessment is more complex and more than one factor must be considered. HKFRS 10 gives the following examples of rights, other than voting or potential voting rights, which individually, or alone, can give an investor power: Rights to appoint, reassign or remove key management personnel who can direct the relevant activities Rights to appoint or remove another entity that directs the relevant activities Rights to direct the investee to enter into, or veto changes to transactions for the benefit of the investor Other rights, such as those specified in a management contract.
HKFRS 10 suggests that the ability rather than contractual right to achieve the above may also indicate that an investor has power over an investee. An investor can have power over an investee even where other entities have significant influence or other ability to participate in the direction of relevant activities.
572
HKFRS 10.15, B57
2.1.4 Returns
An investor must have exposure, or rights, to variable returns from its involvement with the investee in order to establish control. This is the case where the investors returns from its involvement have the potential to vary as a result of the investees performance. Returns may include: dividends remuneration for servicing an investees assets or liabilities fees and exposure to loss from providing credit support returns as a result of achieving synergies or economies of scale through an investor combining use of their assets with use of the investees assets
HKFRS 10.17, B59
2.1.5 Link between power and returns

In order to establish control, an investor must be able to use its power to affect its returns from its involvement with the investee. This is the case even where the investor delegates its decision making powers to an agent.
HKFRS 10.19
2.2 Consolidated accounts

Where a parent controls one or more subsidiaries, HKFRS 10 requires that consolidated financial statements are prepared to include all subsidiaries, both foreign and domestic other than: those held for sale in accordance with HKFRS 5 those held under such long-term restrictions that control cannot be operated.
The rules on exclusion of subsidiaries from consolidation are necessarily strict, because this is a common method used by entities to manipulate their results. If a subsidiary which carries a large amount of debt can be excluded, then the gearing of the group as a whole will be improved. In other words, this is a way of taking debt out of the consolidated statement of financial position. HKFRS 10 is clear that a subsidiary should not be excluded from consolidation simply because it is loss making or its business activities are dissimilar from those of the group as a whole. HKFRS 10 rejects the latter argument: exclusion on these grounds is not justified because better information can be provided about such subsidiaries by consolidating their results and then giving additional information about the different business activities of the subsidiary, eg under HKFRS 8 Operating Segments.
HKFRS 10.4
2.2.1 Exemption from preparing group accounts

A parent need not present consolidated financial statements if and only if the following apply: (a) It is a wholly-owned subsidiary or it is a partially owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consolidated financial statements. Its securities are not publicly traded. It is not in the process of issuing securities in public securities markets, and The ultimate or intermediate parent publishes consolidated financial statements that comply with International Financial Reporting Standards.
(b) (c) (d)
573
Financial Reporting
A parent that does not present consolidated financial statements must comply with the HKAS 27 (2011) rules on separate financial statements.
2.3 Consolidation procedures

Topic highlights
Consolidated financial statements are prepared by combining the assets; liabilities, income and expenses of a parent and its subsidiaries on a line by line basis and cancelling any intra-group amounts. Financial statements prepared to the same date should be used.
HKFRS 10 does not deal with methods of accounting for business combinations and the calculation of goodwill (this is covered by HKFRS 3 (revised)), but it does provide guidance on consolidation procedures.
HKFRS 10. 22, B86
2.3.1 Preparation of consolidated financial statements

Consolidated financial statements are prepared by combining the financial statements of the parent and its subsidiaries on a line by line basis. Practically this involves adding together the parent's and its subsidiaries' assets, liabilities, income and expenses. In addition: the carrying amount of the parent's investment in each subsidiary and the parent's proportion of equity in each subsidiary are eliminated. non-controlling interests representing the equity of subsidiaries which does not belong to the parent are recognised.
The application of these procedures is considered in more detail in the next chapter.
HKFRS 10.B86
2.3.2 Intra-group transactions

As the consolidated financial statements are prepared for a group as a single economic entity, intra-group balances and transactions should be eliminated as part of the consolidation process. As we have already said, these amounts may be distorted due to the group relationship, and so may result in the presentation of misleading group performance or position. To take an example, assume that a group company bought an asset from a non-group company paying the market price of $100 and sold this to another group company for $300, so making a $200 profit. The second company then sold the asset to a third group company for $600, so making a $300 profit. If the effects of this intra-group transaction were not eliminated from the consolidated accounts, assets and profits would both be overstated by $500.
HKRS 10, B92,93
2.3.3 Coterminous year end

In most cases, all group companies will prepare accounts to the same reporting date. One or more subsidiaries may, however, prepare accounts to a different reporting date from the parent and the bulk of other subsidiaries in the group. In such cases the subsidiary may prepare additional statements to the reporting date of the rest of the group, for consolidation purposes. If this is not possible, the subsidiary's accounts may still be used for the consolidation, provided that the gap between the reporting dates is three months or less. Where a subsidiary's accounts are drawn up to a different accounting date, adjustments should be made for the effects of significant transactions or other events that occur between that date and the parent's reporting date.
574
HKFRS 10.B87
2.3.4 Uniform accounting policies

Consolidated financial statements should be prepared using uniform accounting policies for like transactions and other events in similar circumstances. Adjustments must be made where members of a group use different accounting policies, so that their financial statements are suitable for consolidation.
HKFRS 10.20, B88, HKFRS 3, Appendix A
2.3.5 Date of inclusion/exclusion

The results of subsidiary undertakings are included in the consolidated financial statements from the acquisition date, defined as the date on which the investor obtains control of the investee. Income and expenses of the subsidiary should be based on the asset and liability values recognised in the consolidated financial statements at this date. For example, future depreciation should be calculated based upon the fair value of the related asset at the acquisition date. The results of subsidiary undertakings should cease to be included within the consolidated financial statements on the date on which the parent ceases to control the subsidiary. From this date the investment is accounted for as an associate in accordance with HKAS 28 or a financial asset in accordance with HKFRS 9.
HKAS 27.38
2.3.6 Accounting for subsidiaries, jointly controlled entities and associates in the parent's separate financial statements
A parent company will usually produce its own, single company financial statements. HKAS 27 (2011) Separate Financial Statements provides accounting guidance to be applied in the preparation of these single company statements. In these statements, investments in subsidiaries, joint ventures and associates included in the consolidated financial statements should be either: (a) (b) accounted for at cost, or in accordance with HKFRS 9
Where subsidiaries are classified as held for sale in accordance with HKFRS 5 they should be accounted for in accordance with HKFRS 5 in the parents separate financial statements.
3 Disclosure of interests in other entities

HKFRS 12.7
HKFRS 12 Disclosure of Interests in Other Entities was issued in June 2011 as part of the package of five standards relating to consolidation. It removes all disclosure requirements from other standards relating to group accounting and provides guidance applicable to consolidated financial statements. The standard requires disclosure of: (a) the significant judgments and assumptions made in determining the nature of an interest in another entity or arrangement, and in determining the type of joint arrangement in which an interest is held information about interests in subsidiaries, associates, joint arrangements and structured entities that are not controlled by an investor.
(b)
HKFRS 12.10-19
3.1 Disclosure of subsidiaries

The following disclosures are required in respect of subsidiaries: (a) The interest that non-controlling interests have in the groups activities and cash flows, including the name of relevant subsidiaries, their principal place of business, and the interest and voting rights of the non-controlling interests Nature and extent of significant restrictions on an investors ability to use group assets and liabilities
(b)
575
Financial Reporting
(c) (d)
Nature of the risks associated with an entitys interests in consolidated structured entities, such as the provision of financial support Consequences of changes in ownership interest in subsidiary (whether control is lost or not)
HKFRS 12.20-23
3.2 Disclosure of associates and joint arrangements

The following disclosures are required in respect of associates and joint arrangements: (a) Nature, extent and financial effects of an entitys interests in associates or joint arrangements, including name of the investee, principal place of business, the investors interest in the investee, method of accounting for the investee and restrictions on the investees ability to transfer funds to the investor Risks associated with an interest in an associate or joint venture
(b)
4 HKFRS 3 (revised) Business Combinations

Topic highlights
HKFRS 3 (revised) provides guidance on the measurement of net assets acquired in a business combination, the non-controlling interest and goodwill arising on a business combination.
We have seen that HKFRS 10 defines control and prescribes procedures for the preparation of consolidated financial statements. HKFRS 3 Business Combinations, revised in 2008, is the second relevant standard on group accounting, and provides guidance on the following: (a) (b) (c) (d)
HKFRS 3.2
The recognition and measurement of the assets and liabilities acquired when a parent company achieves control over a subsidiary or other business The recognition and measurement of any non-controlling interest in the subsidiary or business The recognition and measurement of goodwill arising on the acquisition of a subsidiary or business Necessary disclosures to provide information to evaluate a business combination
4.1 Scope of HKFRS 3 (revised)

HKFRS 3 (revised) applies to business combinations, defined as transactions in which an acquirer obtains control of one or more businesses. It does not apply to: the formation of a joint venture the acquisition of an asset or group of assets that does not constitute a business a combination between entities or businesses under common control
Where a group of assets and liabilities is purchased which does not constitute a business, the assets and liabilities are recognised in the purchaser's financial statements in accordance with relevant standards including HKAS 16 and HKAS 38. The cost of the group is allocated to the individual identifiable assets and liabilities on the basis of their fair values at the date of acquisition. Goodwill does not arise on such a purchase.
HKFRS 3, Appendix A
4.2 Definitions
In addition to those definitions seen earlier in the chapter, HKFRS 3 (revised) provides the following:
576
Key terms
Acquirer is the entity that obtains control of the acquiree. Acquiree is the business or businesses that the acquirer obtains control of in a business combination. Non-controlling interest is the equity in a subsidiary not attributable, directly or indirectly, to a parent. Contingent consideration. Usually, an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually indentified and separately recognised. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Identifiable. An asset is identifiable if it either: (a) is separable, ie capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability, regardless of whether the entity intends to do so, or arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations. (HKFRS 3 (revised))
HKFRS 3.4-5 and B7-B12
(b)
4.3 Accounting for a business combination

An entity shall determine whether a transaction or other event is a business combination which requires that the assets acquired and liabilities assumed constitute a business. If the assets acquired are not a business, the reporting entity shall account for the transaction or other event as an asset acquisition. Definition of a business A business consists of inputs and processes applied to those inputs that have the ability to create outputs. Although businesses usually have outputs, outputs are not required for an integrated set to qualify as a business. The three elements of a business are defined as follows: (a) Input: Any economic resource that creates, or has the ability to create, outputs when one or more processes are applied to it. Examples include non-current assets (including intangible assets or rights to use non-current assets), intellectual property, the ability to obtain access to necessary materials or rights and employees. Process: Any system, standard, protocol, convention or rule that when applied to an input or inputs, creates or has the ability to create outputs. Examples include strategic management processes, operational processes and resource management processes. These processes typically are documented, but an organised workforce having the necessary skills and experience following rules and conventions may provide the necessary processes that are capable of being applied to inputs to create outputs. (Accounting, billing, payroll and other administrative systems typically are not processes used to create outputs.) Output: The result of inputs and processes applied to those inputs that provide or have the ability to provide a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants. To be capable of being conducted and managed for the purposes defined, an integrated set of activities and assets requires two essential elements inputs and processes applied to
(b)
(c)
577
Financial Reporting
those inputs, which together are or will be used to create outputs. However, a business need not include all of the inputs or processes that the seller used in operating that business if market participants are capable of acquiring the business and continuing to produce outputs, for example, by integrating the business with their own inputs and processes. The nature of the elements of a business varies by industry and by the structure of an entity's operations (activities), including the entity's stage of development. Established businesses often have many different types of inputs, processes and outputs, whereas new businesses often have few inputs and processes and sometimes only a single output (product). Nearly all businesses also have assets, but a business need not have liabilities. An integrated set of activities and assets in the development stage might not have outputs. If not, the acquirer should consider other factors to determine whether the set is a business. Those factors include, but are not limited to, whether the set: (a) (b) (c) (d) has begun planned principal activities; has employees, intellectual property and other inputs and processes that could be applied to those inputs; is pursuing a plan to produce outputs; and will be able to obtain access to customers that will purchase the outputs
HKFRS 3 (revised) requires that business combinations are accounted for by applying the acquisition method. This involves: (a) (b) (c) (d)
HKFRS3.6-7
identifying the acquirer determining the acquisition date recognising and measuring the identifiable assets acquired, liabilities assumed and non controlling interests in the acquiree recognising and measuring goodwill
4.3.1 Identifying the acquirer

For each business combination, one of the combining entities must be identified as the acquirer, in other words a business combination is not considered to be a merger.
HKFRS 3.8-9
4.3.2 Determining the acquisition date

The acquisition date is the date on which the acquirer gains control of the acquiree. This is normally the date on which consideration is transferred and assets and liabilities are acquired. The date may, however, be earlier or later, for example where written agreement provides for this.
HKFRS 3.10,11,18
4.3.3 Recognising and measuring assets, liabilities and the non-controlling interests
The acquirer should recognise at the acquisition date: Identifiable assets acquired Liabilities assumed Non-controlling interest Goodwill
In doing so, the acquirer should apply the recognition criteria of the Framework. This may result in the acquirer recognising some assets and liabilities that the acquiree had not previously recognised, for example intangible assets generated internally by the acquiree. The identifiable assets recognised should be measured at fair value at the acquisition date. The application of these principles is seen in more detail in Section 5 of this chapter.
578
HKFRS 3.32
4.3.4 Recognising and measuring goodwill

Goodwill is measured as the excess of the fair value of consideration transferred plus the amount of non-controlling interests over the fair value of identifiable net assets of the acquiree on the acquisition date. In some cases this will result in a positive amount of goodwill; in others a negative amount is calculated, referred to as a gain on a bargain purchase. The elements of the calculation of goodwill are considered in more detail in the next section of this chapter. Where an acquisition is achieved in steps, there may be an extra element to the calculation; step acquisitions are considered in a later chapter.
5 Goodwill
Topic highlights
Goodwill is calculated as the excess of consideration plus the non-controlling interests over the fair value of identifiable net assets acquired. The non-controlling interests can be measured as a proportion of the net assets of the acquiree or at fair value.
As we saw in Chapter 8, goodwill is created by good relationships between a business and its customers, a good reputation, customer base, and other intangible elements. It is not usually valued in the accounts of a business at all, however it is likely to arise in: the financial statements of an individual company where that company buys an unincorporated business consolidated financial statements where a parent company buys a subsidiary. $ X X (X) X
As we saw earlier, goodwill arising on a business combination is calculated as: Consideration transferred Amount of any non-controlling interests Less: net acquisition-date fair value of identifiable assets acquired and liabilities assumed We shall consider each of the elements of the calculation in turn.
HKFRS 3.37
5.1 Consideration transferred

Consideration or payment transferred to achieve a controlling share in another business may take a number of forms including: cash other assets ordinary or preference instruments debt instruments
Consideration may be immediate or deferred. Where it is deferred, payment may be contingent upon an event, or upon the acquiree attaining certain financial or non-financial goals. The basic principle of HKFRS 3 (revised) is that consideration transferred in a business combination should be measured at fair value.
579
Financial Reporting
HKFRS 3.3940
5.1.1 Contingent consideration

Contingent consideration is defined by HKFRS 3 (revised) as an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. However, contingent consideration also may give the acquirer the right to the return of previously transferred consideration if specified conditions are met. HKFRS 3 (revised) recognises that, by entering into an acquisition, the acquirer becomes obliged to make additional payments. Not recognising that obligation means that the consideration recognised at the acquisition date is not fairly stated. HKFRS 3 (revised) requires recognition of contingent consideration, measured at fair value, at the acquisition date. This is consistent with how other forms of consideration are fair valued. The acquirer may be required to pay contingent consideration in the form of equity or of a debt instrument or cash. Debt instruments are presented in accordance with HKAS 32. Contingent consideration may occasionally be an asset, for example if the consideration has already been transferred and the acquirer has the right to the return of part of it, an asset may occasionally be recognised in respect of that right.
HKFRS 3.51
5.1.2 Pre-existing relationships

All consideration transferred will need to be carefully analysed to determine whether it is really part of the business combination transaction. Pre-existing relationships between the acquirer and the acquiree will need to be accounted for separately from the business combination. For example, the acquirer may have a payable balance due to the acquiree, which is effectively settled through the business combination. Where the former owners or employees receive payments, a number of factors have been included to assist the identification of whether this is for future services or not, and should be accounted for as compensation.
HKFRS 3.53
5.1.3 Acquisition-related costs

The original HKFRS 3 required fees (legal, accounting, valuation etc) paid in relation to a business acquisition to be included in the cost of the acquisition, which meant that they were measured as part of goodwill. Under HKFRS 3 (revised) costs relating to the acquisition must be recognised as an expense at the time of the acquisition. They are not regarded as an asset. Costs of issuing debt or equity are to be accounted for under the rules of HKFRS 9.
HKFRS 3.19
5.2 Non-controlling interests

The revised HKFRS 3 views the group as an economic entity. This means that it treats all providers of equity including non-controlling interests as shareholders in the group, even if they are not shareholders in the parent. It is for this reason that the non-controlling interests form part of the calculation of goodwill. The question now arises as to how it should be valued. HKFRS 3 (revised) applies a different rule to the measurement of the non-controlling interest depending on whether or not the relevant shareholders are entitled to a proportionate share of the entitys net assets in the event of liquidation. Where holders of the non-controlling interest are entitled to a proportionate share of the net assets on a liquidation, HKFRS 3 (revised) requires that the non-controlling interest in the acquiree is measured either at: fair value or the non-controlling interests' proportionate share of the acquiree's identifiable net assets.
580
Where holders of the non-controlling interest are not entitled to a proportionate share of the net assets on a liquidation, the non-controlling interest should be measured at fair value. The non-controlling interests measured at fair value will be different from the non-controlling interests measured at proportionate share of the acquiree's net assets. The difference is goodwill attributable to the non-controlling interests. This will become more apparent when we see some examples.
HKFRS 3.B44-45
5.2.1 Measurement at fair value

The non-controlling interest is measured at its fair value, determined on the basis of a quoted price in an active market for equity shares not held by the acquirer or, if this is not available, by using another valuation technique. The amount of consideration transferred by an acquirer is not usually indicative of the fair value of the non-controlling interests, because consideration transferred by the acquirer will generally include a control premium. Therefore, it is not normally appropriate to determine the fair value of the acquired business as a whole or that of the non-controlling interests by extrapolating the fair value of the acquirer's interest. Hence, adopting this option means that additional time and expertise may be needed to determine the fair value of the non-controlling interests. The result of the application of the fair value method is that recognised goodwill represents all of the goodwill of the acquired business, not just the acquirer's share.
Example: Fair value option

Entity B has 40 per cent of its shares publicly traded on an exchange. Entity A purchases the 60 per cent non-publicly traded shares in one transaction, paying $630,000. Based on the trading price of the shares of entity B at the date of gaining control, a fair value of $400,000 is assigned to the 40 per cent non-controlling interests, indicating that entity A has paid a control premium of $30,000. The fair value of entity B's identifiable net assets is $700,000. Calculate goodwill measuring the non-controlling interests (a) (b) as a proportion of the net assets of the acquiree at fair value
Solution
(a) Non-controlling interests measured as a proportion of the net assets of the acquiree Goodwill: Consideration Non-controlling interests ($700 x 40%) Fair value of identifiable net assets (100%) Goodwill (b) Non-controlling interests measured at fair value Goodwill: Consideration Non-controlling interests Fair value of identifiable net assets (100%) Goodwill $'000 630 400 1,030 (700) 330 $'000 630 280 910 (700) 210
The first method calculates only the amount of goodwill associated with the controlling interests. The second method calculates goodwill to be $120,000 higher. This $120,000 is the goodwill associated with the non-controlling interests. The second calculation could be stripped out into the two elements as:
581
Financial Reporting
Consideration / fair value Share of identifiable net assets (60%/40%) Goodwill
Controlling interests $'000 630 (420) 210
Non-controlling interests $'000 400 (280) 120
Note that goodwill is not proportionate. If the total goodwill were split proportionately in the ratio 60:40, then the controlling interests would be allocated $198,000 and the non-controlling interests $132,000. This is not the case due to the control premium associated with a controlling interest. The premium to acquire control may reflect the value of synergies between the parent and subsidiary.
5.2.2 Future intention

Where available, the choice of measurement method for the non-controlling interests is made for each business combination (rather than being an accounting policy choice), and will require management to carefully consider their future intentions regarding the acquisition of the noncontrolling interests, as the two methods will potentially result in significantly different amounts of goodwill.
HKFRS 3.11,12,18, HKFRS 13. 933,76, 81, 86
5.3 Fair value of identifiable assets acquired

HKFRS 3 (revised) requires that the net assets of the acquiree on the acquisition date are measured at fair value for inclusion within the consolidated financial statements and the goodwill calculation except in limited, stated cases. The assets and liabilities must: (a) (b) meet the definitions of assets and liabilities in the Framework. be part of what the acquiree (or its former owners) exchanged in the business combination rather than the result of separate transactions.
HKFRS 13 Fair Value Measurement provides extensive guidance on how the fair value of assets and liabilities should be established. This standard requires that the following are considered in determining fair value: 1 2 The asset or liability being measured The principal market (ie that where the most activity takes place) or where there is no principal market, the most advantageous market (ie that in which the best price could be achieved) in which an orderly transaction would take place for the asset or liability. The highest and best use of the asset or liability and whether it is used on a standalone basis or in conjunction with other assets or liabilities. Assumptions that market participants would use when pricing the asset or liability.
3 4
582
Fair values may be incorporated into the books of the acquiree in either of the following ways: (a) The subsidiary company might incorporate any necessary revaluations in its own books of account. In this case, we can proceed directly to the calculation of goodwill and in turn the consolidation, taking asset values and reserves figures straight from the subsidiary company's statement of financial position. The revaluations may be made as a consolidation adjustment without being incorporated in the subsidiary company's books. In this case, we must make the necessary adjustments to the subsidiary's statement of financial position as a working. Only then can we proceed to the consolidation. Such adjustments are normally incorporated into the goodwill working, as shown in the following example.
(b)
Example: Fair value adjustments

Polly Co acquired 75 per cent of the 20,000 $1 ordinary shares of Surrey Co on 1 September 20X8 for $51,000. At that date the fair value of Surrey Co's non-current assets was $23,000 greater than their carrying amount, and the balance of retained earnings was $21,000. The non-controlling interests are measured as a proportion of the net assets of the acquiree. Calculate the goodwill arising on the business combination.
Solution
Goodwill Consideration transferred Non-controlling interests (64,000 (below) 25%) Share of net assets acquired as represented by Ordinary share capital Retained earnings Fair value adjustment Goodwill 20,000 21,000 23,000 (64,000) 3,000 $ $ 51,000 16,000 67,000
Large Co acquired 90 per cent of the ordinary shares in Small Co on 31 May 20X8, transferring $300,000 cash immediately, $100,000 in one year's time and 20,000 Large Co shares to the shareholders of Small Co. At the acquisition date the equity and reserves section of Small Co's statement of financial position included the following balances: $ Share capital ($1 shares) 100,000 Retained earnings 249,000 Revaluation reserve 50,000 The following information is also relevant: 1 2 3 The fair value of Small Co's land was $60,000 in excess of its book value, however Small Co had not yet completed a revaluation exercise for the year. Small Co had not included a provision for legal costs of $40,000 in the accounts, despite the recognition criteria of HKAS 37 being met. The share price of Large Co shares on the acquisition date was $1.60
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Financial Reporting
4 5
The share price of Small Co shares on the acquisition date was $1.25 An appropriate discount rate is 6 per cent
What goodwill arises on the acquisition of the controlling interests in Small Co, assuming that the non-controlling interests is measured at fair value? (The answer is at the end of the chapter)
The following sections consider specific guidance on establishing the fair value of specific assets and liabilities in the case of a business combination.
HKFRS 3.11
5.3.1 Restructuring and future losses

An acquirer should not recognise liabilities for future losses or other costs expected to be incurred as a result of the business combination. HKFRS 3 (revised) explains that a plan to restructure a subsidiary following an acquisition is not a present obligation of the acquiree at the acquisition date. Neither does it meet the definition of a contingent liability. Therefore an acquirer should not recognise a liability for such a restructuring plan as part of allocating the cost of the combination unless the subsidiary was already committed to the plan before the acquisition. This prevents creative accounting. An acquirer cannot set up a provision for restructuring or future losses of a subsidiary and then release this to profit or loss in subsequent periods in order to reduce losses or smooth profits.
HKFRS 3.B31
5.3.2 Intangible assets

The acquiree may have intangible assets, such as development expenditure. These can be recognised separately from goodwill only if they are identifiable. An intangible asset is identifiable only if it: (a) (b) is separable, ie capable of being separated or divided from the entity and sold, transferred, or exchanged, either individually or together with a related contract, asset or liability arises from contractual or other legal rights
HKFRS 3.23,56
5.3.3 Contingent liabilities

Contingent liabilities of the acquiree are recognised if their fair value can be measured reliably. A contingent liability must be recognised even if the outflow is not probable, provided there is a present obligation. This is a departure from the normal rules in HKAS 37; contingent liabilities are not normally recognised, but only disclosed. After their initial recognition, the acquirer should measure contingent liabilities that are recognised separately at the higher of: (a) (b) the amount that would be recognised in accordance with HKAS 37 the amount initially recognised
HKFRS 3.29
5.3.4 Reacquired rights

If the acquirer reacquires a right that it had previously granted to an acquiree (for example, the use of a trade name), the right will be recognised as an identifiable intangible asset, separately from goodwill.
HKFRS 3.27
5.3.5 Indemnification assets

Indemnification assets, such as an indemnity for an uncertain tax position or contingent liability, are recognised and measured based on the same measurement principles and assumptions as the related liability.
584
HKFRS 3.24,26,30,31
5.3.6 Other exceptions to the recognition or measurement principles

HKFRS 3 (revised) requires that the relevant standard is applied in measuring and recognising the following: (a) (b) (c) (d) Deferred tax: use HKAS 12 values. Employee benefits: use HKAS 19 values. Share-based payment: use HKFRS 2 values. Assets held for sale: use HKFRS 5 values.
HKFRS 3.4550
5.4 Measurement period adjustments

Sometimes the fair values of the acquiree's identifiable assets, liabilities or contingent liabilities or the cost of the combination can only be determined provisionally by the end of the period in which the combination takes place. In this situation, the acquirer should account for the combination using those provisional values. The acquirer should recognise any adjustments to those provisional values as a result of completing the initial accounting: (a) within twelve months of the acquisition date from the acquisition date (ie, retrospectively) the carrying amount of an item that is recognised or adjusted as a result of completing the initial accounting shall be calculated as if its fair value at the acquisition date had been recognised from that date. goodwill should be adjusted from the acquisition date by an amount equal to the adjustment to the fair value of the item being recognised or adjusted.
This means that:
(b)
Any further adjustments after the initial accounting is complete should be recognised only to correct an error in accordance with HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. Any subsequent changes in estimates are dealt with in accordance with HKAS 8 (ie the effect is recognised in the current and future periods). HKAS 8 requires an entity to account for an error correction retrospectively, and to present financial statements as if the error had never occurred by restating the comparative information for the prior period(s) in which the error occurred.
5.5 Subsequent accounting

Topic highlights
Purchased positive goodwill is retained in the statement of financial position as an intangible asset under the requirements of HKFRS 3 (revised). It must then be reviewed for impairment annually. A bargain purchase is reassessed. If a bargain purchase remains, it is recognised as a gain in profit or loss.
5.5.1 Positive goodwill

Positive goodwill acquired in a business combination is recognised as an asset and is initially measured at cost. Cost is the excess of the cost of the combination over the acquirer's interest in the net fair value of the acquiree's identifiable assets, liabilities, and contingent liabilities. After initial recognition goodwill acquired in a business combination is measured at cost less any accumulated impairment losses. It is not amortised. Instead it is tested for impairment at least annually, in accordance with HKAS 36 Impairment of Assets.
585
Financial Reporting
HKFRS 3.3436
5.5.2 Bargain purchase

A bargain purchase arises when the net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed exceeds the consideration transferred. It may also be referred to as negative goodwill. Before recognising a gain on a bargain purchase, the acquirer must reassess whether it has correctly identified all of the assets acquired and all of the liabilities assumed and must recognise any additional assets or liabilities that are identified in that review. The acquirer must then review the procedures used to measure the amounts this HKFRS requires to be recognised at the acquisition date for all of the following: (a) (b) (c) The identifiable assets acquired and liabilities assumed The non-controlling interests in the acquiree, if any The consideration transferred
The purpose of this review is to ensure that the measurements appropriately reflect all the available information as at the acquisition date.
5.5.3 Non-controlling interests at the end of reporting period

It is important to realise that the measurement of the non-controlling interests (NCI) only applies at the date of acquisition. Subsequent to acquisition, the fair value of the subsidiary's net assets will have changed. The non-controlling interests at a given reporting date can therefore be calculated either by: (a) (b) calculating the NCI proportion of the net assets of the acquiree at the reporting date. Where the fair value method is used the NCI goodwill must be added to this, or calculating the NCI share of post-acquisition reserves movement and adding this to NCI as measured at the acquisition date.
Example: Goodwill
On 1 January 20X9, Flatley Co acquired 70 per cent of the ordinary shares of Gringo Co at a cost of $700,000. The net assets of Gringo Co at this date were $740,000. The non-controlling interests had a fair value of $250,000. In the year to 31 December 20X9, Gringo retained profits of $100,000. What goodwill arises on the acquisition of Gringo, and what is the value of the non-controlling interests at 31 December 20X9 assuming that the non-controlling interests is measured: (a) (b) as a proportion of the net assets of the acquiree at fair value?
Solution
Goodwill Proportion of net assets method $ 700,000 222,000 922,000 (740,000) 182,000 222,000 30,000 252,000 Fair value method $ 700,000 250,000 950,000 (740,000) 210,000 250,000 30,000 280,000
Consideration NCI (30% x $740,000)/fair value Net assets of acquiree Goodwill Non-controlling interests at 31 December 20X7 Non-controlling interests at acquisition Share of retained profits (30% x $100,000)
586
Proportion of net assets method $ Or Share of net assets at reporting date 30% x ($740,000 + $100,000) Goodwill ($250,000 (30% x $740,000))
Fair value method $
252,000 252,000
252,000 28,000 280,000
In rare cases a subsidiary may have a negative equity balance. In this case the non-controlling interests is reported as a deficit balance in the consolidated statement of financial position in accordance with HKFRS 10. In other words, a group does not cease to allocate the non-controlling interests' share of losses to them simply because this would result in a negative balance.
HKFRS 3.58
5.5.4 Post acquisition changes in the fair value of contingent consideration

The treatment depends on the circumstances: (a) (b) If the change in fair value is due to additional information obtained that affects the position at the acquisition date, goodwill should be re-measured. If the change is due to events which took place after the acquisition date, for example, meeting earnings targets: (i) (ii) (iii) Account for under HKFRS 9 if the consideration is in the form of a financial instrument, for example loan notes. Account for under HKAS 37 if the consideration is in the form of cash. An equity instrument is not remeasured.
Abacus prepares accounts to 31 December. On 1 September 20X7 Abacus acquired 6 million $1 shares in Knowledge Co (KC) at $2.00 per share. At that date KC produced the following interim statement of financial position: Non-current assets Property, plant and equipment (Note 1) Current assets Inventories (Note 2) Receivables Cash in hand Current liabilities Trade payables Provision for taxation Bank overdraft Non-current liabilities Long-term loans Net assets Equity Share capital ($1 shares) Reserves $'000 $'000 16.0 4.0 2.9 1.2 8.1 3.2 0.6 3.9 (7.7) (4.0) 12.4 8.0 4.4 12.4
587
Financial Reporting
Notes (1) The following information relates to the property, plant and equipment of KC at 1 September 20X7. $m Gross replacement cost 28.4 Net replacement cost 16.6 Economic value 18.0 Net realisable value 8.0 The property, plant and equipment of KC at 1 September 20X7 had a total purchase cost to KC of $27.0 million. They were all being depreciated at 25 per cent per annum pro rata on that cost. This policy is also appropriate for the consolidated financial statements of Abacus. No non-current assets of KC which were included in the interim financial statements drawn up as at 1 September 20X7 were disposed of by KC prior to 31 December 20X7. No noncurrent asset was fully depreciated by 31 December 20X7. (2) The inventories of KC which were shown in the interim financial statements are raw materials at cost to KC of $4 million. They would have cost $4.2 million to replace at 1 September 20X7. Of the inventory of KC in hand at 1 September 20X7, goods costing KC $3.0 million were sold for $3.6 million between 1 September 20X7 and 31 December 20X7. On 1 September 20X7 Abacus took a decision to rationalise the group so as to integrate KC. The costs of the rationalisation were estimated to total $3.0 million and the process was due to start on 1 March 20X8. No provision for these costs has been made in any of the financial statements given above. The non-controlling interests are measured as a proportion of the net assets of the acquiree.
(3)
(4)
Required Compute the goodwill on consolidation of KC that will be included in the consolidated financial statements of the Abacus group for the year ended 31 December 20X7, explaining your treatment of the items mentioned above. You should refer to the provisions of relevant accounting standards. (The answer is at the end of the chapter)
HKFRS 3.5963
5.6 Disclosures
HKFRS 3 (revised) requires that an acquirer discloses information to enable the users of its financial statements to evaluate the nature and financial effect of a business combination that occurs during the current period or after the end of the period but before the financial statements are authorised for issue. This information should include: the name and a description of the acquiree the acquisition date the percentage of voting equity interests acquired the reasons for the business combination a qualitative description of the factors that make up the goodwill recognised the acquisition date fair value of the total consideration transferred and each major class of consideration for contingent consideration: the amount recognised at acquisition a description of the arrangement an estimate of the range of outcomes
details of acquired receivables
588
amounts recognised for each class of assets and liabilities acquired disclosure in accordance with HKAS 37 for contingent liabilities recognised the amount of a gain in a bargain purchase and a description of reasons why the transaction resulted in a gain the amount of any non-controlling interests and the measurement basis applied valuation techniques used to determine the fair value of the non-controlling interests where relevant.
589
Financial Reporting
Topic recap
A group of companies develops when a parent company buys one or more subsidiaries. The group should be regarded as a single economic entity for the purposes of accounting. Consolidated financial statements are prepared where a parent controls another entity. The definition on control includes three elements: where an investor has power over the investee, exposure or rights to variable returns from its involvement with the investee and the ability to use its power to affect those returns. Consolidated financial statements are prepared by combining the assets, liabilities, income and expenses of a parent and its subsidiaries on a line by line basis and cancelling any intragroup amounts. Financial statements prepared to the same date should be used. HKFRS 3 (revised) provides guidance on the measurement of net assets acquired in a business combination, the non-controlling interests and goodwill arising on a business combination. Goodwill is calculated as the excess of consideration plus the non-controlling interests over the fair value of identifiable net assets acquired. The non-controlling interests can be measured as a proportion of the net assets of the acquiree or at fair value. Purchased positive goodwill is retained in the statement of financial position as an intangible asset under the requirements of HKFRS 3 (revised). It must then be reviewed for impairment annually. A bargain purchase is reassessed. If a bargain purchase remains it is recognised as a gain in profit or loss.
590
Answer 1
Cash consideration Deferred cash consideration ($100,000 1/1.06) Equity consideration (20,000 $1.60) Non-controlling interests (10,000 $1.25) Fair value of net assets Book value Land Provision Goodwill
$ 300,000 94,340 32,000 426,340 12,500 438,840
399,000 60,000 (40,000) (419,000) 19,840
Answer 2
Goodwill on consolidation of Knowledge Co Consideration ($2.00 6m) Non-controlling interests ($13.2m 25%) Group share of fair value of net assets acquired Share capital Pre-acquisition reserves Fair value adjustments Property, plant and equipment ($16.6m $16.0m) Inventories ($4.2m $4.0m) Goodwill Notes on treatment (1) Share capital and pre-acquisition profits represent the book value of the net assets of KC at the date of acquisition. Adjustments are then required to this book value in order to give the fair value of the net assets at the date of acquisition. For short-term monetary items, fair value is their carrying value on acquisition. The fair value of property, plant and equipment should be determined by market value or, if information on a market price is not available (as is the case here), then by reference to depreciated replacement cost, reflecting normal business practice. The net replacement cost (ie $16.6m) represents the gross replacement cost less depreciation based on that amount, and so further adjustment for extra depreciation is unnecessary. Raw materials should be valued at replacement cost. In this case that amount is $4.2 million. The rationalisation costs cannot be reported in pre-acquisition results under HKFRS 3 (revised) as they are not a liability of KC at the acquisition date. 8.0 4.4 0.6 0.2 (13.2) 2.1 $m $m 12.0 3.3 15.3
(2)
(3) (4)
591
Financial Reporting
Exam practice
XYZ
18 minutes
XYZ is a listed entity engaged in the provision of recruitment services, preparing financial statements to 30 June each year. Part of the directors' long term strategy is to identify opportunities for the takeover of other related businesses. In 20X1, the directors decided to expand their operations into the second major city of the country in which XYZ operates by taking over an existing recruitment agency. On 1 July 20X1, XYZ paid $14,700,000 for 80 per cent of the shares in the successful AB Agency. At that date, AB had 1,000,000 shares in issue at a nominal value of $1 each, and retained earnings were $2,850,000. At the date of acquisition, AB's brand name was valued by specialists at $2,900,000 and following the acquisition it has been recognised in the consolidated financial statements of XYZ. Apart from retained earnings, AB has no other reserves. AB has continued to be very successful and, therefore XYZ's directors have been seeking further acquisitions. On 1 April 20X7, XYZ gained control of a small on-line recruitment business, paying $39.60 per share to acquire 60,000 out of 100,000 issued shares in the CD Agency. The nominal value of each share in CD is $1. CD's retained earnings at 1 July 20X6 were $700,000; at 30 June 20X7, they were $780,000. CD paid no dividends during the year ended 30 June 20X7. CD's profits can be assumed to accrue evenly over time. Since acquisition CD has continued to produce growth in both profit and market share. The directors follow the accounting treatment required for goodwill arising on consolidation by HKFRS 3 Business Combinations (revised). It is group policy to measure NCI at acquisition at full fair value. The fair value of the NCI shares at acquisition was $17 per share for AB and $35 per share for CD. XYZ has no investments other than those in AB and CD. Required Calculate the balance of goodwill on acquisition to be included in the consolidated financial statements of XYZ for the year ended 30 June 20X8. (10 marks)
592
chapter 28
Consolidated accounts: accounting for subsidiaries

Topic list
1 2 3 4 5 Consolidated financial statements Consolidated statement of financial position Consolidated statement of comprehensive income Recap of simple consolidation techniques Complex groups
Learning focus
Group accounting is relevant to many entities. You should be able to perform a simple consolidation.
593
Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level 4.04 4.04.01 Acquisition of subsidiaries Prepare a consolidated statement of financial position for a simple/complex group structure including pre and post acquisition profits, non-controlling interests and goodwill Prepare a consolidated statement of comprehensive income for a simple/complex group structure, dealing with an acquisition and the non-controlling interest Consolidated financial statement preparation Prepare a consolidated statement of financial position in compliance with HKFRS 10 Prepare a consolidated statement of comprehensive income 3 3
4.04.02
4.09 4.09.01 4.09.02
594
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
1 Consolidated financial statements

Topic highlights
Consolidated financial statements are prepared by adding together the parent and subsidiary's assets, liabilities, income and expenses and eliminating the cost of the investment in the subsidiary against the parent's equity in the subsidiary.
As we saw in the last chapter, HKFRS 10 requires a parent to present consolidated financial statements, in which the accounts of the parent and subsidiary (or subsidiaries) are combined and presented as a single entity.
1.1 Mechanics of consolidation

The basic mechanics of consolidation seen in the last chapter were as follows: (a) (b) (c) Add together the parent's and subsidiaries' assets, liabilities, income and expenses on a line by line basis, eliminating any intra-group balances or transactions. Eliminate the carrying amount of the parent's investment in each subsidiary and the parent's proportion of equity in each subsidiary. Recognise non-controlling interests representing the equity of subsidiaries which does not belong to the parent where relevant.
In this chapter we shall apply these rules to both the consolidated statement of financial position and consolidated statement of comprehensive income in turn.
2 Consolidated statement of financial position

Topic highlights
The consolidated statement of financial position includes only the parent's share capital. The basic principles of the consolidated statement of financial position require that the assets and liabilities of a parent and subsidiary company are added together, and the parent's investment in the subsidiary is eliminated against the equity of that subsidiary. Therefore, only the parent company's share capital is shown in the consolidated accounts. The following example illustrates this. Let us assume that the parent company buys all of the ordinary shares in the subsidiary for $100,000: STATEMENTS OF FINANCIAL POSITION AT ACQUISITION DATE Parent $ 160,000 100,000 58,000 318,000 100,000 180,000 38,000 318,000 Subsidiary $ 90,000 30,000 120,000 30,000 70,000 20,000 120,000 Consolidated $ 250,000 88,000 338,000 100,000 180,000 58,000 338,000
Non-current assets Investment in subsidiary Current assets Share capital Retained earnings Liabilities
595
Financial Reporting
In this instance only the parent's retained earnings are included in the consolidated statement of financial position. This is because the $70,000 retained earnings of the subsidiary must have been made pre-acquisition and therefore are not available to the group.
2.1 Goodwill
Topic highlights
Goodwill is recognised as an asset in the consolidated statement of financial position and tested for impairment annually.
In the illustration above, the 100 per cent investment in the subsidiary was purchased for $100,000 on a date when the net assets of the subsidiary were $100,000. Therefore no goodwill arose. As we saw in the last chapter, however, this is an unusual situation. We shall now introduce goodwill into the consolidation process.
Example: Goodwill
The following statement of financial position relates to A Co and B Co as at 31 December 20X7. A Co $ 4,000 3,800 2,400 10,200 8,000 1,900 9,900 300 10,200 B Co $ 3,200 500 3,700 3,000 500 3,500 200 3,700
Non-current assets Investment in B Co Current assets Represented by: Share capital (ordinary shares of $1.0 each) Reserves Current liabilities
A Co acquired all of the share capital of B Co on 31 December 20X7. The consolidation process now involves: 1 2 3 adding together the assets and liabilities of A and B eliminating the investment in B shown in A's books against B's equity calculating and including goodwill in the consolidated statement of financial position $ 3,800 (3,500) 300
Goodwill is calculated as: Consideration Net assets of B Co
CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO AS AT 31 DECEMBER 20X7 Eliminate investment Consolidated A Co B Co in B Co A Co $ $ $ $ Non-current assets 4,000 3,200 7,200 Investment in B Co 3,800 (3,800) Goodwill 300 300 Current assets 2,400 500 2,900 10,200 3,700 10,400
596
A Co $ Represented by: Share capital (ordinary shares of $1.0 each) Reserves Current liabilities 8,000 1,900 9,900 300 10,200
B Co $ 3,000 500 3,500 200 3,700
Eliminate investment in B Co $ (3,000) (500)
Consolidated A Co $ 8,000 1,900 9,900 500 10,400
Note. Consolidation adjustments are memoranda only, they are not part of bookkeeping procedures in the individual company's accounting records. Consolidation adjustment DEBIT Share capital Pre-acquisition reserves (B Co) Goodwill on consolidation Cost of investment $3,000 $500 $300 $3,800
CREDIT
being elimination of cost of investment in subsidiary on consolidation
2.2 Group reserves

Topic highlights
Group reserves are calculated as all of the parent company's reserves plus the group share of the post-acquisition reserves in the subsidiary.
In both of the examples seen so far, the consolidation is performed on the date of the acquisition and therefore group reserves are equal to the parent company's reserves. In the following example, we shall see how the post-acquisition profits of a subsidiary are taken into account in calculating group reserves.
Example: Group retained earnings

This example continues from the previous example (Goodwill) but has moved on a year, during which time B Co has made post-acquisition profits of $200. STATEMENTS OF FINANCIAL POSITION OF A CO AND B CO AT 31 DECEMBER 20X8 A Co $ 5,000 3,800 2,000 10,800 8,000 1,900 9,900 900 10,800 B Co $ 3,500 800 4,300 3,000 700 3,700 600 4,300
597
Financial Reporting
CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO AS AT 31 DECEMBER 20X8 Eliminate investment in B Co $ (3,800) 300 Consolidated A Co $ 8,500 300 2,800 11,600 8,000
Non-current assets Investment in B Co Goodwill (assuming no impairment of goodwill) Current assets Represented by: Share capital (ordinary shares of $1.0 each) Reserves ($1,900 of A Co + $200 post-acquisition profits of B Co) Current liabilities
A Co $ 5,000 3,800 2,000 10,800 8,000
B Co $ 3,500 800 4,300 3,000
(3,000)
1,900 9,900 900 10,800
700 3,700 600 4,300
(500)
2,100 10,100 1,500 11,600
This example shows how group retained earnings are comprised of all of the parent company's retained earnings plus the group share (100 per cent in this case) of the subsidiary's post acquisition retained earnings.

Topic highlights
The non-controlling interests are shown in the equity and liabilities section of the consolidated statement of financial position. The acquisition date measurement (fair value or a proportion of net assets) increases by the non-controlling interest's share of post-acquisition reserves.
So far we have only dealt with situations where the parent company owns all of the share capital in the subsidiary. As we saw in the last chapter, however, there may be a non-controlling interests in the subsidiary. This may be measured at fair value or as a proportion of the net assets in the subsidiary, and the next two examples consider each of these situations.
Example: Non-controlling interests (1)

This example is based on the same information as that previously, but we shall assume that A Co acquires only 2,400 shares of B Co, and that the non-controlling interests are measured as a proportion of the net assets of the subsidiary. Note that in this example the statement of financial position is being prepared at the acquisition date. A Co B Co $ $ Non-current assets 4,000 3,200 Investment in B Co 3,800 Current assets 2,400 500 10,200 3,700
598
A Co $ Represented by: Share capital (ordinary shares of $1 each) Reserves Current liabilities Goodwill working Consideration Non-controlling interests at date of acquisition ($3,500 x 20%) Less: net assets of B Co Share capital Reserves Goodwill 3,000 500 8,000 1,900 9,900 300 10,200
B Co $ 3,000 500 3,500 200 3,700 3,800 700 4,500
(3,500) 1,000
CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO AS AT 31 DECEMBER 20X7 Eliminate investment in B Co $ (3,800) 1,000 Consolidated A Co $ 7,200 1,000 2,900 11,100 8,000 1,900 9,900 700 500 11,100
Non-current assets Investment in B Co Goodwill Current assets Represented by: Share capital (ordinary shares of $1.0 each) Reserves (exclude preacquisition reserves of B Co) Non-controlling interests Current liabilities Consolidation adjustment DEBIT
A Co $ 4,000 3,800 2,400 10,200 8,000 1,900 9,900 300 10,200
B Co $ 3,200 500 3,700 3,000 500 3,500 200 3,700
(3,000) (500) 700
CREDIT
Share capital Pre-acquisition reserves (B Co) Goodwill on consolidation Cost of investment Non-controlling interests
$3,000 $500 $1,000 $3,800 $700
The non-controlling interests in net assets are shown within the equity and liabilities section of the statement of financial position. This amount represents the net assets of the subsidiary which legally belong to its non-controlling shareholders.
Example: Non-controlling interests (2)

Again, this example is based on the same information as previous worked examples but this time we'll assume that A Co acquires only 2,400 shares of B Co and the fair value of the 20 per cent non-controlling interests was $950. The non-controlling interest is measured at fair value at the acquisition date.
599
Financial Reporting
Non-current assets Investment in B Co Current assets Represented by: Share capital (ordinary shares of $1 each) Reserves Current liabilities Goodwill working Consideration Non-controlling interests (at fair value) Less: Net assets of B Co Share capital Reserves
A Co $ 4,000 3,800 2,400 10,200 8,000 1,900 9,900 300 10,200
B Co $ 3,200 500 3,700 3,000 500 3,500 200 3,700 3,800 950 4,750
3,000 500 (3,500) 1,250
Goodwill
CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO AS AT 31 DECEMBER 20X7 Eliminate investment Consolidated A Co B Co in B Co A Co $ $ $ $ Non-current assets 4,000 3,200 7,200 Investment in B Co 3,800 (3,800) Goodwill 1,250 1,250 Current assets 2,400 500 2,900 10,200 3,700 11,350 Represented by: Shares capital (ordinary shares of $1.0 each) 8,000 3,000 (3,000) 8,000 Reserves (exclude preacquisition reserves of B Co) 1,900 500 (500) 1,900 9,900 3,500 9,900 Non-controlling interests 950 950 Current liabilities 300 200 500 10,200 3,700 11,350 Consolidation adjustment DEBIT Share capital Pre-acquisition reserves (B Co) Goodwill on consolidation Cost of investment Non-controlling interests $3,000 $500 $1,250 $3,800 $950
CREDIT
Again the non-controlling interests is represented in the bottom half of the consolidated statement of financial position, however this time at fair value. The goodwill calculated in this example of $1,250 is 'full goodwill' being the goodwill attributable to both A Co and the non-controlling interests.
600
2.3.1 Non-controlling interests and post acquisition profits

Now we shall consider how a non-controlling interests impacts the mechanics of the consolidation when we also have post acquisition retained earnings to consider.
Example: NCI and post acquisition profits (1)

This example is based on the same information as previous worked examples but now assume that: A Co acquires only 2,400 shares of B Co The non-controlling interests are measured as a proportion of the net assets of the subsidiary B Co has made post-acquisition profits of $200. A Co $ 5,000 3,800 2,000 10,800 8,000 1,900 9,900 900 10,800 B Co $ 3,500 800 4,300 3,000 700 3,700 600 4,300
On 31 December 20X8, the statements of financial position of A Co and B Co are as follows:
CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO AS AT 31 DECEMBER 20X8 Eliminate investment in B Co $ (3,800) 1,000 Non-controlling interests post Consolidated reserve A Co $ $ 8,500 1,000 2,800 12,300 8,000 2,060 10,060 740 1,500 12,300
Non-current assets Investment in B Co Goodwill (assuming no impairment on goodwill) Current assets Represented by: Share capital (ordinary shares of $1 each) Reserves Non-controlling interests Current liabilities
A Co $ 5,000 3,800 2,000 10,800 8,000 1,900 9,900 900 10,800
B Co $ 3,500 800 4,300 3,000 700 3,700 600 4,300
(3,000) (500) 700
(40) 40
601
Financial Reporting
Goodwill working Consideration Non-controlling interests at date of acquisition ($3,500 20%) Less: net assets of B Co Share capital Reserves Goodwill Group reserves working Reserves of A Co Group share of post acquisition reserves of B Co (80% $200) Non-controlling interests working Non-controlling interests at acquisition (goodwill working) NCI share of post acquisition reserves of B Co (20% $200) Consolidation adjustment DEBIT Share capital Pre-acquisition reserves (B Co) Goodwill on consolidation Cost of investment Non-controlling interests
$ 3,800 700 4,500
3,000 500 (3,500) 1,000 $ 1,900 160 2,060 700 40 740 $3,000 $500 $1,000 $3,800 $700
CREDIT
Being elimination of investment in B Co DEBIT CREDIT Reserve Non-controlling interests $40 $40
being non-controlling interests share of post-acquisition reserve
The following example again includes post-acquisition profits in the subsidiary, but this time the non-controlling interests is measured at fair value at the acquisition date.
Example: NCI and post acquisition profits (2)

Use the same information as the previous examples but this time assume that: A Co acquires only 2,400 shares of B Co the non-controlling interests at acquisition is measured at fair value of $950 B Co has made a post-acquisition profit of $200. A Co $ 5,000 3,800 2,000 10,800 8,000 1,900 9,900 900 10,800 B Co $ 3,500 800 4,300 3,000 700 3,700 600 4,300
On 31 December 20X8, the statements of financial position of A Co and B Co are as follows:
602
Consolidated statement of financial position of A Co as at 31 December 20X8

Eliminate investment in B Co Non-controlling post acquisition reserve Consolidated A Co
A Co
B Co
Non-current assets Investment in B Co Goodwill (assuming no impairment on goodwill) Current assets Represented by: Share capital (ordinary shares of $1.0 each) Reserves Non-controlling interest Current liabilities
$ 5,000 3,800 2,000 10,800 8,000 1,900 9,900 900 10,800
$ 3,500 800 4,300 3,000 700 3,700 600 4,300
$ (3,800) 1,250
$ 8,500 1,250 2,800 12,550 8,000 2,060 10,060 990 1,500 12,550
(3,000) (500) 950 -
(40) 40
Goodwill working $ Cost of investment Non-controlling interests (fair value) Less: net assets of B Co Share capital Reserves Goodwill Group reserves working Reserves of A Co Group share of post acquisition reserves of B Co 80% $200 Non-controlling interests working Non-controlling interests at acquisition (goodwill working) NCI share of post acquisition reserves of B Co 20% $200 Consolidation adjustment DEBIT Share capital Pre-acquisition reserves (B Co) Goodwill on consolidation Cost of investment Non-controlling interests $3,000 $500 $1,250 $3,800 $950 3,000 500 (3,500) 1,250 $ 1,900 160 2,060 950 40 990 $ 3,800 950 4,750
CREDIT
being elimination of investment in B Co DEBIT CREDIT Reserve Non-controlling interests $40 $40
being non-controlling interests share of post-acquisition reserve
603
Financial Reporting
2.4 Fair value adjustments

Topic highlights
Where the book value of the subsidiary's assets and liabilities at the acquisition date is not equal to fair value, adjustment must be made on consolidation.
As we saw in the last chapter, HKFRS 3 (revised) requires that for the purposes of consolidation and the calculation of goodwill the assets and liabilities of the subsidiary are measured at fair value. This may mean that adjustments are required as part of the consolidation process.
Example: Fair value adjustments

A Co acquired 80 per cent of the share capital of B Co on 1 January 20X7 when B Co's reserves were $300. The statements of financial position of A Co and B Co as at 31 December 20X7 were as follows: A Co B Co $ $ Non-current assets, at cost 3,200 1,500 Less: Accumulated depreciation (1,000) (400) 2,200 1,100 Investment in B Co 1,300 Current assets 800 500 4,300 1,600 Represented by: Share capital (ordinary shares of $1 each) 3,000 1,000 Reserves 700 400 3,700 1,400 Current liabilities 600 200 4,300 1,600 The non-current assets of B Co were valued at $1,400 on 1 January 20X7, and were estimated to have a remaining useful life of seven years. The revaluation was not recorded in the books of B Co. B Co provides depreciation at 10 per cent per annum on cost of non-current assets. There have been no additions or disposal of non-current assets since 1 January 20X7. The non-controlling interests are measured as a proportion of the net assets of the subsidiary. WORKINGS (1) The revaluation surplus is calculated as follows: Cost Less: accumulated depreciation as at 1 January 20X7 ($400 $150) Fair value of non-current assets at date of acquisition Fair value adjustment at date of acquisition (2) Fair value adjustment on depreciation upon consolidation Depreciation provided in the books of B Co ($1,500 x 10%) Depreciation based on fair value $1,400 7 years Depreciation adjustment on consolidation $ 1,500 (250) 1,250 (1,400) (150) $ 150
(200) (50)
604
(3)
Goodwill on consolidation: Consideration Non-controlling interests at date of acquisition ($1,450 20%) Less: net assets of B Co Share capital Reserves Fair value adjustment Goodwill
$ 1,300 290 1,590
1,000 300 150 1,450 140 $ 400 (50) (300) 50 $ 700
(4)
Group reserves A Co's reserves at 31 December 20X7 Group share of post acquisition reserves in B @ reporting date Fair value adjustment depreciation @ acquisition date 80%
40 740 $ 290 10 300
(5)
Non-controlling interests NCI @ acquisition NCI share of post acquisition reserves (20% 50)
Consolidation adjustment
DEBIT
CREDIT
Share capital $1,000 Reserve (pre-acquisition reserve of B Co) (300 + 150) $450 Goodwill $140 Investment in B Co Non-controlling interests Non-current assets (depreciation) Non-current assets (cost) Revaluation reserve Depreciation charge Accumulated depreciation $250
$1,300 $290
being elimination of pre-acquisition reserves on consolidation DEBIT CREDIT $100 $150 $50 $50
being revaluation of non-current assets to fair value DEBIT CREDIT
being provision of depreciation on consolidation
605
Financial Reporting
CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO AS AT 31 DECEMBER 20X7

Eliminate investment in B Co Adjustments Consolidated A Co
A Co
B Co
Non-current assets
$ 3,200
$ 1,500
Accumulated depreciation
(1,000)
(400)
$ (100) (50) Additional depreciation 250 Reversal of depreciation prior to FV exercise 140
$ 4,600
(1,200)
Investment in B Co Goodwill Current assets Represented by: Share capital (Ordinary shares of $1 each)
2,200 1,300 800 4,300
1,100 500 1,600
(1,300)
3,400 140 1,300 4,840
3,000
1,000
(1,000) (300) Preacquisition (10) Postacquisition to NCI 50 Postacquisition FV adjustment 300
3,000
Reserves
700
400
740
Non-controlling interests Current liabilities
600 4,300
200 1,600
300 800 4,840
Note that there is no revaluation reserve in the consolidated statement of financial position since there is none in A Co's books, and that in B Co's books is a fair value adjustment on acquisition with no post-acquisition movement.
2.5 Intra-group transactions

Topic highlights
Intra-group balances and any unrealised profits must be eliminated on consolidation.
One of the basic principles underlying consolidation is that of viewing a group as a single economic entity. Therefore any intra-group (intercompany) transactions must be eliminated on consolidation so that the consolidated financial statements show only transactions with third parties outside the group.
606
Common intra-group transactions include:

one company lending money to another group company trading between group companies one company selling a non-current asset to another company.
We shall consider each of these in turn.
2.5.1 Intra-group lending

As a result of intra-group lending one group company will show a loan in their statement of financial position and another group company will show an investment (or receivable). On consolidation these should be eliminated against each other and are therefore not added across to form part of group borrowings or group investments.
2.5.2 Intra-group trading

Intra-group trading may result in one group entity recognising a receivable at the period end and another recognising a payable. These may be referred to as 'current accounts'. Again they should be cancelled against each other prior to the consolidation. Where the amounts outstanding are not equal due to cash in transit, the recipient company should account for the cash in transit as if it had been received prior to the period end. The receivable and payable amounts will then be equal and may be cancelled. A further result of intra-group trading is that of unrealised profits in stock. These are profits made by one group company selling to another. Until such time as the inventory in question is sold outside the group, the profit is not realised. Therefore, on consolidation, the unrealised profit in closing stock should be eliminated from the selling company's profits as part of the consolidation, and the closing inventory of the group should be recorded at cost to the group.
Example: Unrealised profit in stock

A Co acquired 100 per cent of the share capital of B Co on 1 January 20X7 when the reserves of B Co were $40. During the year ended 31 December 20X7, B Co sold goods to A Co at a price of $40 to include a 25 per cent margin. At 31 December 20X7, A Co had half of these goods in stock. The inventory and reserves reported in the accounts of A Co and B Co as at 31 December 20X7 were: A Co B Co $ $ Inventory 54 42 Reserves 100 50 The profit recorded by B Co on sale of the goods to A Co is $40 x 25% = $10. From the viewpoint of the group, $5 is unrealised and should be eliminated from B Co's profits prior to consolidation.
Consolidation adjustment
DEBIT CREDIT
B Co's Reserves Inventory
$5 $5
Consolidated inventory = $54 + $42 $5 = $91 Consolidated reserves = $100 + ($50 $40 $5) x 100% = $105 Note that in this case there is no non-controlling interests. If there had been, the group share of unrealised profits is deducted from group reserves and the non-controlling interests share is deducted from the non-controlling interests in the statement of financial position. Had A Co been the selling company, this is not an issue, and all of the unrealised profit is deducted from group reserves.
607
Financial Reporting
2.5.3 Intra-group transfers of non-current assets

It is common for group companies to transfer non-current assets from one to another depending on where they are needed. Often the transferor makes a profit on such a transaction. As above, this profit is unrealised until such time as the non-current asset is sold outside the group and therefore it must be eliminated on consolidation. Here there is also the extra complication of depreciation, which must, for the purpose of the consolidated accounts, be based on the original cost of the asset to the group.
Example: Intra-group transfers of non-current assets

A Co acquired 80 per cent of the share capital of B Co on 1 January 20X6. On 1 January 20X8, A Co sold non-current assets which were acquired on 1 January 20X7 at $80,000 to B Co for $90,000. Both A Co and B Co provide depreciation at 10 per cent on cost per annum. $ Original cost 80,000 Less: accumulated depreciation (8,000) 72,000 Carrying amount at date of transfer Selling price to B Co (90,000) 18,000 Profit recorded in A Co books On 31 December 20X8, the consolidation adjustment on excess depreciation charge by B Co from the viewpoint of the group is: $ 9,000 Accumulated depreciation provided in the books of B Co ($90,000 x10%) Accumulated depreciation since transfer based on cost of non-current assets (8,000) of the group ($80,000 10%) Excess depreciation charge 1,000 Therefore, relevant consolidation adjustments are: DEBIT CREDIT DEBIT CREDIT Consolidated reserves Consolidated non-current assets Consolidated accumulated depreciation Consolidated reserves $18,000 $18,000 $1,000 $1,000
3 Consolidated statement of comprehensive income

Topic highlights
A consolidated statement of comprehensive income is prepared by adding across income and expenses on a line by line basis. Profit and total comprehensive income are allocated to the noncontrolling interests and owners of the group.
A consolidated statement of comprehensive income is prepared by adding all the individual items in the subsidiary's statement of comprehensive income to those in the parent company's accounts. Similar complications as those seen in relation to the statement of financial position are relevant.
608

Where a subsidiary is partially owned, the relevant proportion of its profits and other comprehensive income must be allocated to the non-controlling interests. Both the profit or loss and total comprehensive income attributable to the non-controlling interests and the owners of the parent should be shown separately at the end of the consolidated statement of comprehensive income.
3.2 Intra-group transactions

Topic highlights
Intra-group income and expenditure is cancelled on consolidation. Any unrealised profits must also be eliminated.
The effects of intra-group lending, trading and transfers of assets will all need to be eliminated from the consolidated statement of financial position. In the case of intra-group lending, interest receivable in the lender's books is cancelled against interest payable in the borrower's books prior to consolidation. In the case of intra-group trading, sales in one group company's books is cancelled against cost of sales in another group company's books prior to consolidation. Where there is an unrealised profit in inventory this must also be eliminated. The following example illustrates this.
Example: Intra-group trading

The following information relates to A Co and its 70% owned subsidiary, B Co, for the year ended 31 December 20X7. A Co B Co $ $ Revenue 300 200 (120) Cost of sales (180) 80 Gross profit 120 During the year 20X7, B Co sold goods to A Co for $40, making a profit of $10. At the year end half of the goods remained in inventory, therefore there is an unrealised profit of $5. The consolidated statement of comprehensive income should be: Revenue ($300 + $200 $40) Cost of sales ($180 + $120 $40 + $5) Gross profit $ 460 (265) 195
In the case of intra-group transfers of assets, any profit or loss arising in the year must be eliminated from the consolidated profit or loss. In addition, in the year of transfer and subsequent years, adjustment must be made so that the depreciation charge recorded in the consolidated statement of comprehensive income is based on the cost of the asset to the group.
609
Financial Reporting
Example: Intra-group transfer of assets

The following information relates to A Co and its 70 per cent owned subsidiary, B Co, for the year ended 31 December 20X7. A Co B Co $ $ Revenue 500 400 (140) Cost of sales (220) Gross profit 280 260 30 Other income 90 (180) (270) Operating expenses 110 Operating profit 100 During the year, A Co transferred an asset used for administrative purposes to B Co making a profit of $80. As a result of the transfer depreciation has increased by $8 per annum. The consolidated statement of comprehensive income should be: Revenue ($500 + $400) Cost of sales ($220 + $140) Gross profit Other income ($90 + $30 $80) Operating expenses ($270 + $180 $8) Operating profit $ 900 (360) 540 40 (442) 138
3.3 Mid-year acquisitions

Topic highlights
Where a subsidiary is acquired mid-year, its results must be pro-rated prior to consolidation.
Where a subsidiary is acquired mid-year, care must be taken to ensure that the subsidiary's results are included in the consolidation only from the date of acquisition. Practically, this will involve prorating the subsidiary's results prior to adding across.
Example: Mid-year acquisitions

The income statements of A Co and B Co for the year ended 31 December 20X7 are given below:
A Co $ 300 (180) 120 (40) 80 (15) 65 B Co $ 200 (120) 80 (30) 50 (8) 42
Revenue Cost of sales Gross profit Administrative and distribution expenses Profit before taxation Taxation Profit after tax
A Co acquired 70 per cent of the ordinary share capital of B Co on 1 April 20X7. The consolidated income statement for the year ended 31 December 20X7 is:
610
A Co
B Co
Calculation
Revenue Cost of sales Gross profit Administrative and distribution expenses Profit before taxation Taxation Profit after tax Profit attributable to the noncontrolling interests Profit attributable to the group
$ 300 (180) 120
$ 200 (120) 80
($300 + $200 9/12) ($180 + $120 9/12)
Consolidated A Co $ 450 (270) 180
(40) 80 (15) 65
(30) 50 (8) 42
($40 + $30 9/12) ($15 + $8 9/12) ($42 9/12 30%)
(63) 117 (21) 96 9 87
4 Recap of simple consolidation techniques

The summary given below is very brief but it encompasses all the major rules which must be applied when preparing consolidated financial statements.
Consolidated statement of financial position Net assets: 100% P plus 100% S Share capital: P only. Reserves: 100% P plus group share of post-acquisition retained reserves of S less consolidation adjustments. Non-controlling interests:
Proportion of net assets method: NCI share of S's consolidated net assets Fair value method: NCI share of S's consolidated net assets plus NCI share of goodwill
The method of consolidation is as follows.
Determine the group structure. Draw chart showing the percentages holdings and dates of acquisition. Consider adjustments for: Provisions for unrealised profits (PUP) Revaluations to fair value Intragroup inventory and cash in transit Intangible assets Depreciation / amortisation on fair valued items
Combine net assets, cancelling any intra-group balances. Current accounts Loan stock
Share capital of P only
611
Financial Reporting
Calculate the non-controlling interests in net assets NCI % of share capital NCI % of reserves NCI % of revaluations to fair value NCI % of unrealised profit X X X (X) X
If measuring NCI at FV, include NCI share of goodwill.
Calculate the goodwill (positive or negative) Consideration transferred NCI Assets acquired: Share capital Pre-acquisition reserves Revaluation to fair value Goodwill X X (X) (X) (X) X
If cost is greater than the share of net assets acquired then the difference is positive goodwill, which should be capitalised and retained in the statement of financial position, subject to annual impairment reviews. If cost is less than the share of net assets acquired then the difference is a gain on bargain purchase. This should be reassessed and credited to profit.
Calculate retained earnings reserve

Per question Adjustments Fair value adjustment (% adj) Accumulated profits at acquisition Share of post acquisition profits of subsidiary (% X) Share of post acquisition profits reserves of associate/JCE (% X) P X X(X) X X X X S X X(X) X/X) (X) X A X X(X) X/(X) (X) X
Consolidated statement of comprehensive income Adjustments required for consolidation of a subsidiary are as follows.
Eliminate intra-group sales and purchases. Eliminate any unrealised profits on intra-group purchases still in inventory at the year end. Eliminate any intra-group dividends received and paid. Analyse profit for the year between owners of the parent and NCI.
For the inclusion of a subsidiary carry out the following.

Combine all P and S results (where the acquisition is mid-year, use a time-apportioned basis).
Exclude any investment income that is intra-group.
612
Calculate NCI
Pre-acquisition dividends
There are two ways to calculate the pre-acquisition element of a dividend.
To the extent that post-acquisition profits are insufficient to cover the dividend, the distribution must be out of pre-acquisition profits. This method is more commonly used in practice.
Apportion the dividend on a time basis between the pre- and post-acquisition periods, so that only post-acquisition dividends are taken to P's reserves.
For pre-acquisition dividends: Debit Dividend receivable/cash, Credit Cost of investment. For post-acquisition dividends: Debit Dividend receivable/cash, Credit Reserves.
Unrealised profits/losses
Only where S sells to P, allocate the unrealised profit between NCI and P: Debit Group reserves, Debit Non-controlling interests, Credit Inventory. Now try the following questions to practise the topics listed above.
Bootie Co has owned 80 per cent of Goose Co's equity since its incorporation. On 31 December 20X8 it despatched goods which cost $80,000 to Goose, at an invoiced cost of $100,000. Goose received the goods on 2 January 20X9 and recorded the transaction then. The two companies' draft accounts as at 31 December 20X8 are shown below: STATEMENTS OF COMPREHENSIVE INCOME Revenue Cost of sales Gross profit Other expenses Net profit Income tax Profit for the year STATEMENT OF CHANGES IN EQUITY Opening balance Total comprehensive income (profit) for the year Dividends Closing balance
Bootie $'000 5,000 2,900 2,100 1,700 400 130 270 Goose $'000 1,000 600 400 320 80 25 55
$'000 2,260 270 (130) 2,400
$'000 285 55 (40) 300
613
Financial Reporting
STATEMENTS OF FINANCIAL POSITION $'000 ASSETS Non-current assets Property, plant and equipment Investment in Goose
Current assets Inventory Trade receivables Bank and cash Bootie
$'000 1,920 80 2,000
$'000
Goose
$'000 200 200
500 650 390 1,540 3,540
120 40 35 195 395 100 200 300 30 40 25 1,140 3,540 95 395
EQUITY AND LIABILITIES Equity Share capital Retained earnings

Current liabilities Trade payables Dividend payable Tax
2,000 400 2,400 910 100 130
Required
Prepare draft consolidated financial statements (ignoring tax).

The draft statements of financial position of Okay and its subsidiary Chestnut at 30 September 20X8 are as follows: Okay Chestnut $ $ $ $ Non-current assets Tangible assets, carrying amount Land and buildings 225,000 270,000 157,500 Plant 202,500 427,500 427,500 Investment Shares in Chestnut at cost 562,500
Current assets Inventory Receivables Bank
255,000 375,000 112,500 742,500 1,732,500
180,000 90,000 22,500 292,500 720,000
614
Okay $ Equity Share capital issued and fully paid $1 ordinary shares Retained earnings Current liabilities
Chestnut $
1,125,000 450,000 1,575,000 157,500 1,732,500
450,000 202,500 652,500 67,500 720,000
The following information is also available: (a) Okay purchased 360,000 shares in Chestnut some years ago when that company had a credit balance of $105,000 in retained earnings. The goodwill had been impaired and was fully written off through profit or loss by 30 September 20X7. For the purpose of the acquisition, the land of Chestnut was revalued at $120,000 in excess of its book value. This was not reflected in the accounts of Chestnut. Land is not depreciated. At 30 September 20X8 Chestnut owed Okay $15,000 for goods purchased. The inventory of Chestnut includes goods purchased from Okay at a price which includes a profit to Okay of $10,500. It is the group's policy to value the non-controlling interests at its proportionate share of the fair value of the subsidiary's identifiable net assets.
(b)
(c) (d) (e)
Required
Prepare the consolidated statement of financial position for Okay as at 30 September 20X8 (ignoring tax). (The answer is at the end of the chapter)
You are provided with the following statements of financial position for Shakier and Minoa. STATEMENTS OF FINANCIAL POSITION AS AT 31 OCTOBER 20X0 Shakier $'000 $'000 Non-current assets, at carrying amount Plant 325 Fixtures 200 525 Investment Shares in Minoa at cost 200
Current assets Inventory at cost Receivables Bank Equity $1 Ordinary shares Retained earnings Current liabilities Payables Bank overdraft Minoa
$'000
$'000 70 50 120
220 145 100 465 1,190 700 215 915 275 275 1,190
70 105 175 295 170 50 220 55 20 75 295
615
Financial Reporting
The following information is also available: (1) Shakier purchased 70 per cent of the issued ordinary share capital of Minoa four years ago, when the retained earnings of Minoa were $20,000. There has been no impairment of goodwill. For the purposes of the acquisition, plant in Minoa with a book value of $50,000 was revalued to its fair value of $60,000. The revaluation was not recorded in the accounts of Minoa. Depreciation is charged at 20 per cent using the straight-line method. Shakier sells goods to Minoa at a mark up of 25 per cent. At 31 October 20X0, the inventories of Minoa included $45,000 of goods purchased from Shakier. Minoa owes Shakier $35,000 for goods purchased and Shakier owes Minoa $15,000. It is the group's policy to value the non-controlling interests at fair value. The market price of the shares of the non-controlling shareholders just before the acquisition was $1.50.
(2)
(3) (4) (5) (6)
Required
Prepare the consolidated statement of financial position of Shakier as at 31 October 20X0 (ignoring tax). (The answer is at the end of the chapter)
5 Complex groups
A parent company must prepare consolidated financial statements for all subsidiaries within its control, whether that control is direct or indirect. So far, we have considered only direct control, for example a situation where P owns 80 per cent of S. This section of the chapter considers two types of complex groups in which indirect control is also evident:

Vertical groups D-shaped groups
5.1 Vertical groups

Vertical groups are those where there is a sub-subsidiary, for example: P 90% S1 75% S2 Here:

P owns 90 per cent of S1, and therefore S1 is a subsidiary of P S1 owns 75 per cent of S2 and therefore S2 is a subsidiary of S1 As P controls S1 which in turn controls S2, S2 is within the control of P (referred to as a subsubsidiary)
616
In this case the consolidated financial statements of P should include the assets, liabilities and results of both S1 and S2. The consolidation is performed in the same way as the simple consolidations seen earlier in the chapter, however the calculation of goodwill becomes more complex, and is based on:

an effective group interest of P in S2 of 67.5% (90% x 75%) an effective non-controlling interest in S2 of 32.5%, being 25% owned directly by other shareholders in S2 7.5% (10% x 75%) owned indirectly by other shareholders in S1
5.1.1 Goodwill calculation

Goodwill in the sub-subsidiary is calculated from the perspective of the parent company, and therefore includes only the parents share of the cost of the investment in the sub-subsidiary and calculations based on the effective shareholdings.
Example: NCI as proportion of net assets

Tremendous owns 80 per cent of the shares in Fabulous, and has done for many years. On 1 January 20X1, Fabulous acquired a 70 per cent holding in Excellent at a cost of $9 million. On that date the fair value of the net assets of Excellent was $8 million (made up of $3m ordinary shares and $5m retained earnings). What goodwill arises in the Tremendous consolidated financial statements at 31 December 20X1 on the acquisition of Excellent, assuming that the non-controlling interest is measured as a proportion of net assets of the acquiree?
Solution

The group effective shareholding is 56% (80% x 70%) Therefore the effective non-controlling interest is 44% $'000 7,200 3,520 (8,000) 2,720
Cost of investment (80% x $9m) NCI (44% x $8m) Net assets of acquiree Goodwill
Note that the goodwill arising on the acquisition of Fabulous would be calculated in the normal way, separately from the goodwill arising on the acquisition of Excellent.
Example: NCI at fair value

The facts are as for the example above, however the NCI in Excellent is now measured at fair value based on a share price of $3.50.
Solution
Cost of investment (80% x $9m) NCI (44% x 3m x $3.50) Net assets of acquiree Goodwill $'000 7,200 4,620 (8,000) 3,820
617
Financial Reporting
In both of these examples the sub-subsidiary is acquired after the subsidiary. It may be the case that a vertical group develops where a parent company buys a subsidiary which itself already holds a sub-subsidiary. In this case separate calculations are still required for the goodwill arising in both the subsidiary and sub-subsidiary, but the acquisition date for both is the same, being the date on which the parent company acquired the subsidiary (and so the sub-subsidiary). The date on which the subsidiary acquired the sub-subsidiary is irrelevant.
5.1.2 Non-controlling interest and group reserves

Both non-controlling interests and group reserves are based on the respective effective shareholdings of the non-controlling interest and group.

The facts are as in the first example above (NCI measured as a proportion of net assets), and the retained earnings of Excellent as at 31 December 20X1 are $6.2 million. (a) (b) What is the non-controlling interest in respect of Excellent in both the statement of financial position at 31 December 20X1 and statement of comprehensive income then ended? What share of Excellents retained earnings are included in the group retained earnings calculation?
Solution
(a)
Statement of financial position
$'000 3,520 528 4,048 528 672
Non-controlling interest at acquisition Share of post acquisition profits 44% (6.2m-5m) Non-controlling interest
Statement of comprehensive income
Non-controlling interest in profit (b)

Retained earnings
Share of Excellents retained earnings 56% (6.2m-5m)

Below are the statements of financial position of three companies, Alpha, Beta and Gamma as at 31 December 20X5:
Alpha $'000 Beta $'000 Gamma $'000
Investments 300,000 shares in Beta 240,000 shares in Gamma Current assets
450 890 1,340 320 610 930 400 300 700 230 930 670 670 300 100 400 270 670
Share capital ($1 ordinary shares) Reserves Current liabilities
600 400 1,000 340 1,340
618
(1) (2)
Alpha acquired its interest in Beta on 1 January 20X2. Beta acquired its interest in Gamma on 1 January 20X3. The retained earnings of Beta and Gamma were:
1 January 20X3 1 January 20X2
Beta Gamma (3)
$'000 100 60
$'000 80 50
Alpha Group's policy is to value non-controlling interests at the date of acquisition at the proportionate share of the fair value of the acquiree's identifiable assets acquired and liabilities assumed. The fair values of the identifiable net assets of Beta and Gamma were equivalent to their book values at the respective date of acquisition. Beta and Gamma form separate cash-generating units. An impairment review carried out at 31 December 20X5 revealed that Beta had a recoverable amount of $780,000 (including its investment in Gamma) and that no impairment losses were required in respect of the group's investment in Gamma.
(4)
Required
(a) (b)
Prepare the consolidated statement of financial position of Alpha and its subsidiary companies as at 31 December 20X5. Calculate the goodwill and consolidated reserves at 31 December 20X5 on the assumption that Alpha acquired Beta on 1 January 20X3 and that Beta had acquired Gamma on 1 January 20X2 (ignoring impairment losses).
5.2 D-shaped groups

D-shaped groups are those where a parent company controls a subsidiary and the parent company and subsidiary together control a further subsidiary: P 80%
40%
S1
40% S2 Here:

P owns 80 per cent of S1 and therefore S1 is a subsidiary of P P owns 40 per cent of S2 directly and another 40 per cent indirectly through S1. S2 is therefore a sub-subsidiary of P.
As with vertical groups, an effective interest is calculated in S2 and the consolidation is based on this percentage. In this case the relevant percentage is 72 per cent (being a 40 per cent direct
619
Financial Reporting
holding and a 32 per cent indirect holding calculated as 80% x 40%). The non-controlling interest effective percentage is therefore 28 per cent.
5.2.1 Goodwill, non-controlling interest and retained earnings

The calculations for goodwill, the non-controlling interest and retained earnings are the same as those seen in the case of vertical groups, with one exception. Goodwill arising in the sub-subsidiary must include two elements to cost, being:

the cost of the parents direct holding the parents share of the subsidiarys holding in the sub-subsidiary (ie the indirect holding)
Example: Goodwill
Goose acquired 90 per cent of Duck a number of years ago. On 1 January 20X1, Duck and Goose both acquired 30 per cent of Gander, each paying $4million for their 30 per cent share. On this date the net assets of Gander amounted to $10 million.
Required
What goodwill arises on the acquisition assuming that the non-controlling interest is measured as a proportion of net assets?
Solution

Group effective holding is 57% (30% + (90% x 30%)) Therefore the NCI share is 43% $'000 4,000 3,600 4,300 (10,000) 1,900
Cost of direct holding Cost of indirect holding ($4m x 90%) NCI (43% x $10m) Net assets of acquiree Goodwill

Below are the statements of financial position of Sigma, Pi and Delta as at 31 December 20X5.
Sigma $'000 Pi $'000 Delta $'000
Investments 300,000 shares in Pi 25,600 shares in Delta 230,400 shares in Delta Current assets
450 35 316 869 1,354 600 400 1,000 354 1,354 660 976 400 356 756 220 976 574 574 320 180 500 74 574
Share capital ($1 ordinary shares) Retained earnings Current liabilities
620
(1) (2) (3)
Sigma acquired its interest in Pi on 1 January 20X2 when the balance on the retained earnings was $140,000. Sigma and Pi acquired their respective interests in Delta on 1 January 20X4 when the balance on the retained earnings was $80,000. It is group policy to value the non-controlling interests at fair value at the date of acquisition. The fair value of the non-controlling interests in Pi on 1 January 20X2 was $145,000. The fair value of the 38% non-controlling interests in Delta on 1 January 20X4 was $160,000. Sigma, Pi and Delta constitute separate cash-generating units. The year end impairment test revealed impairment losses of $15,000 re Delta's recognised goodwill, but none of the other CGUs were affected.
(4)
Required
Prepare the consolidated statement of financial position as at 31 December 20X5.

621
Financial Reporting
Topic recap
Consolidated financial statements are prepared by adding together the parent and subsidiary's assets, liabilities, income and expenses and eliminating the cost of the investment in the subsidiary against the parent's equity in the subsidiary. The consolidated statement of financial position includes only the parent's share capital. Goodwill is recognised as an asset in the consolidated statement of financial position and tested for impairment annually. Group reserves are calculated as all of the parent company's reserves plus the group share of the post-acquisition reserves in the subsidiary. The non-controlling interests are shown in the equity and liabilities section of the consolidated statement of financial position. The acquisition date measurement (fair value or a proportion of net assets) increases by the NCI share of post acquisition reserves each year. Where the book value of the subsidiary's assets and liabilities at the acquisition date is not equal to fair value adjustment must be made on consolidation. Intra-group balances and any unrealised profits must be eliminated on consolidation. A consolidated statement of comprehensive income is prepared by adding across income and expenses on a line by line basis. Profit and total comprehensive income are allocated to the non-controlling interests and owners of the group. Intra-group income and expenditure is cancelled on consolidation. Any unrealised profits must also be eliminated. Where a subsidiary is acquired mid year its results must be pro-rated prior to consolidation.
622
Answer 1
BOOTIE GROUP CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X8 $'000 5,900 Revenue (5,000 + 1,000 100) 3,420 Cost of sales (2,900 + 600 100+20) Gross profit 2,480 Other expenses (1,700 + 320) 2,020 Net profit 460 Income tax (130 + 25) 155 305 Profit for the year Profit attributable to: Owners of the parent Non-controlling interests (55 20%) 294 11 305
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20X8 $'000 Opening balance (balancing figure) 2,408 294 Group profit for the year Dividends (130) Closing balance 2,572 CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X8 $'000
Assets Non-current assets (1,920 + 200) Current assets Inventory (500 + 120 + 80) Trade receivables (650 100 + 40) Bank and cash (390 + 35)
$'000 2,120
700 590 425 1,715 3,835
EQUITY AND LIABILITIES Equity Share capital (Bootie only) Retained earnings (W) Shareholders' funds Non-controlling interests (20% 300)
Current liabilities Trade payables (910 + 30) Dividend payable: Bootie Co to non-controlling interests in Goose Co (40 20%) Income tax (130 + 25)
2,000 572 2,572 60 2,632 940 100 8 155 1,203 3,835
623
Financial Reporting
WORKING
Group retained earnings Bootie $'000 400 80 (100) 32 160 572 Goose $'000 200
Per question Closing inventory in transit (at cost) Inter company sale Dividend receivable ($40 80%) Share of Gooses profit ($200 80%) Group net owned profits
This working is, of course, only necessary when you are not required to prepare the consolidated statement of comprehensive income. Here, it serves as a proof of the consolidated statement of comprehensive income as well as of the reserves figure in the statement of financial position.
Answer 2
OKAY CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER 20X8 $
Non-current assets Land and buildings (W5) Plant (202,500 + 157,500) Current assets Inventory (W6) Receivables (W7) Bank (112,500 + 22,500)
$ 615,000 360,000 975,000
424,500 450,000 135,000 1,009,500 1,984,500
Equity Ordinary $1 shares Retained earnings (W3)
Non-controlling interests (W4) Current liabilities (W8) WORKINGS (1) (2) Group structure:
Goodwill
360,000 = 80% 450,000
1,125,000 495,000 1,620,000 154,500 210,000 1,984,500
Consideration transferred Non-controlling interests (675,000 20%) Less: net assets acquired Share capital Reserves Revaluation reserve Goodwill
$ 562,500 135,000 697,500
450,000 105,000 120,000 (675,000) 22,500
624
(3)
Retained earnings
Okay Chestnut (202,500 105,000) 80% Goodwill written off as impaired Unrealised profit for inventory (4)
$ 450,000 78,000 (22,500) (10,500) 495,000 $ 450,000 202,500 120,000 772,500
Share capital Retained earnings Revaluation 20% $772,500 = $154,500 (5)

Land and buildings
Okay Chestnut Net book value Revaluation
$ 225,000
270,000 120,000 390,000 615,000
(6)
Inventory
Okay Chestnut Less unrealised profit (7)

Receivables
$ 255,000 180,000 (10,500) 424,500 $ 375,000 90,000 (15,000) 450,000 $ 157,500 67,500 (15,000) 210,000
Okay Chestnut Less: intragroup (8)

Current liabilities
Okay Chestnut Less: intragroup
625
Financial Reporting
Answer 3
SHAKIER CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 OCTOBER 20X0 $'000
Non-current assets Plant (W4) Fixtures (200 + 50)
$'000
397 250 647 77 724 281 200 100 581 1,305
Intangible asset: goodwill (W1)

Current assets Inventory (W5) Receivables (W6) Bank
Equity and liabilities Share capital Retained earnings (W2)
Non-controlling interests (W3)

Current liabilities Payables (W7) Bank overdraft
700 221 921 84 1,005 280 20 300 1,305
WORKINGS (1)
Goodwill
$'000
Consideration transferred Fair value of the non-controlling interest (30% 170,000 $1.50) Net assets acquired Share capital Retained earnings Revaluation surplus (60 50) Goodwill in parent (2)
Retained earnings
$'000 200.0 76.5 276.5
170 20 10 (200.0) 76.5 $'000 9.0 5.6 (14.6) 200.4 21.0 221.4 $'000 215.0
Shakier PUP (W5) Additional depreciation on plant (8 (W4) 70%) Minoa: 70% (50 20)
626
(3)
$'000 10 (8)
Share capital Revaluation Less: excess depreciation Retained earnings Non-controlling interest in subsidiarys identifiable net assets: 30% $222,000 Goodwill attributable to NCI (76.5 200 30%) Non-controlling interests (4)
Plant
$'000 170
2 50 222 67 17 84 $'000 $'000 325
Shakier Minoa Per question Revalued (60 50) Depreciation on revalued plant (10 20% 4)
70 10 (8) 72 397
(5)
Inventory
$'000 70 (9)
Shakier Minoa 25 Less: PUP (45 /125) (6)

Receivables
$'000 220
61 281 $'000 $'000 145 35 110
Shakier Less: intragroup Minoa Less: intragroup 105 15
90 200 (7)
Payables
$'000
Shakier Less: intragroup Minoa Less: intragroup 55 35
$'000 275 15 260
20 280
627
Financial Reporting
Answer 4
(a) ALPHA GROUP CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X5 Goodwill (W2) Current assets (890 + 610 + 670) Share capital Reserves (W3) Non-controlling interests (W4) Current liabilities (340 + 230 + 270) WORKINGS 1
Group structure
$'000 84 2,170 2,254 600 559 1,159 255 1,414 840 2,254
Alpha
1.1.X2 300,000= 75% 400,000
Beta
1.1.X3
25%
240,000= 80% 300,000
Gamma
Group effective interest (80% 75%) ... Non-controlling interests
60% 40% 100%

Gamma $'000
Goodwill Beta
$'000 Consideration transferred Non-controlling interests (480 25%)/(360 40%) Fair value of identifiable net assets at acquisition: Share capital Reserves at 1.12.20X2/1.12.20X3
$'000 450 120
$'000
(320 x 75%)
240 144
400 80 (480) 90 (30) 60
300 60 (360) 24 24 84
Impairment losses (see below)
Impairment losses - Beta
'Notional' goodwill (gross*) (90 Net assets
100
75
$'000 120 700 820 (780) 40 30
Recoverable amount Impairment loss (gross) Impairment loss recognised (net) (40 75%)
628
Where non-controlling interests are measured at the date of acquisition at the proportionate share of the fair value of the acquiree's identifiable assets acquired and liabilities assumed (i.e. not at 'full' fair value), part of the calculation of the recoverable amount of the CGU relates to the unrecognised non-controlling interest share of the goodwill. For the purpose of calculating the impairment loss, the carrying amount of the CGU is therefore notionally adjusted to include the non-controlling interests in the goodwill by grossing it up. The resulting impairment loss calculated is only recognised to the extent of the parent's share. This adjustment is not required where non-controlling interests are measured at fair value at acquisition.
Consolidated reserves Alpha $'000 400 Beta $'000 300 (80) 220 Gamma $'000 100 (60) 40
Per question Reserves at acquisition (W2) Group share of post acquisition reserves: Beta (220 75%) Gamma (40 60%) Group impairment losses to date (W2) 4
165 24 (30) 559

Beta $'000 120 Gamma $'000 144
NCI at acquisition (W2) NCI share of post acquisition reserves: Beta ((W3) 220 25%) Gamma ((W3) 40 40%) Less: NCI share of investment in Gamma (320 25%)
55 16 (80) 95 255 160
629
Financial Reporting
(b)
Alpha acquired Beta on 1 January 20X3 and Beta acquired Gamma on 1 January 20X2
Revised workings:
Goodwill Beta
$'000 Consideration transferred Non-controlling interests (500 25%)/(360 40%) FV of identifiable net assets at acq'n: Share capital Reserves at 1.12.20X3
$'000 450 125
Gamma $'000 $'000
(320
75%)
240 144
400 100 (500) 75
300 60 (360) 24 99
Consolidated reserves Alpha $'000 400 Beta $'000 300 (100) 200 Gamma $'000 100 (60) 40
Per question Reserves at acquisition (W2) Group share of post acq'n reserves: Beta (200 75%) Gamma (40 60%)
Note:
150 24 574
All other figures in the consolidated statement of financial position would be the same as in part (a). The consolidated statement of financial position would appear as follows: ALPHA GROUP CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X5 Goodwill (from above) Current assets (890 + 610 + 670) Share capital Reserves (from above) Non-controlling interests (W4) Current liabilities (340 + 230 + 270) $'000 99 2,170 2,269 600 574 1,174 255 1,429 840 2,269
630
Non-controlling interests working same result, figures in bold have changed Beta $'000 125 50 Gamma $'000 144
NCI at acquisition (W2) NCI share of post acquisition reserves: Beta ((W3) 200 25%) Gamma ((W3) 40 40%) Less: NCI share of investment in Gamma (320 25%)
16 (80) 95 255 160
Answer 5
SIGMA CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X5 Goodwill (W2) Current assets (869 + 660 + 574) $'000 72 2,103 2,175 600 615 1,215 312 1,527 648 2,175
Share capital Retained earnings (W3) Non-controlling interests (W4) Current liabilities (354 + 220 + 74) WORKINGS 1
Group structure
1.1.X2
Sigma 75% Pi 25,600 320,000 1.1.X4 = 8%
300,000 400,000
1.1.X4
72% 230,400 320,000 Delta
Sigma's effective interest in Delta [(75% 72% = 54%) indirect + 8% direct] 62% ... Non-controlling interests 38% 100%
631
Financial Reporting
Goodwill Pi
$'000 Consideration transferred - Sigma Consideration transferred - Pi Non-controlling interests (at 'full' fair value) Fair value of identifiable NA at acq'n: Share capital Retained earnings
$'000 450 145
$'000
Delta $'000 35 (316 x 237 75%) 160
400 140 (540) 55 (-) 55
320 80 (400) 32 (15) 17 72
Impairment losses to date
Total goodwill 3
Retained earnings Sigma $'000 400
Per question Retained earnings at acquisition (W2) Group share of post acquisition retained earnings: Pi (216 75%) Delta (100 62%) Group share of impairment losses to date (W2) (15 62%) 4
Pi $'000 356 (140) 216
Delta $'000 180 (80) 100
162 62 (9) 615

Pi $'000 145 54 Delta $'000 160
NCI at acquisition (W2) NCI share of post acquisition retained earnings: Pi ((W3) 216 25%) Delta ((W3) 100 38%) Less: NCI in investment in Delta (316 25%) NCI share of impairment losses to date (W2) (15 38%)
38 (6) 192 312
(79) 120
632
Exam practice
Smart Computer Limited
22 minutes
On 1 October 2009, Smart Computer Limited (SCL) acquired an 80 per cent interest in Breakthrough Disc Company (BDC) at a consideration of HK$72 million. Fair value of BDC shares at that date was HK$45 each. The carrying amount of identifiable net assets of BDC reported on its statement of financial position at the date of acquisition was HK$42 million. Other than the property, plant and equipment with a carrying amount of HK$60 million and fair value of HK$76 million, there were no differences between the carrying amount and the fair value for all other reported assets and liabilities. An internally generated intangible asset with fair value of HK$8 million was identified. Both the property, plant and equipment and the intangible asset have an estimated useful life of 10 years from the date of acquisition. Post-acquisition profit reported by BDC before adjustment of depreciation and amortisation attributable to fair value up to 1 April 2010 was HK$8 million. SCL adopts the accounting policy to measure any non-controlling interests in the acquiree at fair value.
Required Assuming that BDC is not subject to income tax in any jurisdiction,
(a) (b)
calculate the amount of goodwill recognised for the acquisition.
(7 marks)
calculate the amount of non-controlling interests in BDC as at 1 April 2010 to be reflected in the consolidated statement of financial position of SCL. (5 marks)
(Total = 12 marks) HKICPA December 2010 (amended)
Bailey
45 Minutes
Bailey, a public limited company, has acquired shares in two companies. The details of the acquisitions are as follows: Ordinary Fair value Ordinary share of net Reserves share capital of Cost of assets at at capital of Date of investment $1 acquired acquisition acquisition $1 acquisition Company $m $m $m $m $m Hill 1 January 20X6 500 440 1,040 720 300 Campbell 1 May 20X9 240 270 510 225 72 The draft financial statements for the year ended 31 December 20X9 are:
633
Financial Reporting
STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER 20X9

Non-current assets Property, plant and equipment Investment in Hill Investment in Campbell Current assets Bailey $m 2,300 72720 225 3,245 3,115 6,360 Hill $m 1,900 1,900 1,790 3,690 Campbell $m 700 700 1,050 1,750
Equity Share capital Reserves Non-current liabilities Current liabilities
1,000 3,430 4,430 350 1,580 66,360

Bailey $m 5,000 (4,100) 900 (320) 36 616 (240) 376
500 1,800 2,300 290 1,100 3,690

Hill $m 4,200 (3,500) 700 (175) 525 (170) 355
240 330 570 220 960 1,750

Campbell $m 2,000 (1,800) 200 (40) 160 (50) 110
STATEMENTS OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X9
Revenue Cost of sales Gross profit Distribution and administrative expenses Dividend income from Hill and Campbell Profit before tax Income tax expense PROFIT FOR THE YEAR Other comprehensive income: Gain on revaluation of property (net of deferred tax) TOTAL COMPREHENSIVE INCOME FOR THE YEAR
50 426 250
20 375 50
10 120 20
Dividends paid in the year (from post-acquisition profits)
The following information is relevant to the preparation of the group financial statements of the Bailey group: (1) (2) The fair value difference in Hill relates to property, plant and equipment being depreciated through cost of sales over a remaining useful life of 10 years from the acquisition date. During the year ended 31 December 20X9, Hill sold $200 million of goods to Bailey. Three quarters of these goods had been sold by the year end. The profit on these goods was 40 per cent on sales price. There were no opening inventories of intragroup goods nor any intragroup balances at the year end. It is the group's policy to value non-controlling interests at fair value at the date of acquisition. The fair value of the non-controlling interests in Hill at 1 January 20X6 was $450 million. Cumulative impairment losses on recognised goodwill in Hill at 31 December 20X9 amounted to $20 million, of which $15 million arose during the year. It is the group's policy to recognise impairment losses on positive goodwill in administrative expenses. No impairment losses have been necessary on the investment in Campbell.
(3) (4)
Required
Prepare the consolidated statement of financial position for the Bailey group as at 31 December 20X9 and the consolidated statement of comprehensive income for the year then ended. (25 marks)
634
chapter 29
Consolidated accounts: accounting for associates and joint arrangements

Topic list
1 2 Associates Joint arrangements
Learning focus
This here Typechapter builds on the basic principles of consolidated accounts seen in the previous chapters. Associates and joint arrangements are common and you should know how to account for them.
635
Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level 4.07 4.07.01 4.07.02 4.07.03 Investments in associates Define an associate in accordance with HKAS 28 (2011) Explain what significant influence is and apply the principle Explain the reasons for and impact of equity accounting, including notional purchase price allocation on initial acquisition, fair value adjustments, upstream and downstream transactions, and uniform accounting policies Account for investors' share of losses of an associate in excess of its investments in associates Explain the impairment test and related treatments for investments in associates Prepare the disclosure in respect of associates Joint arrangements Define a joint arrangement Explain the difference among joint operations and joint ventures Explain how an entity should account for a joint venture Account for the transactions between a venturer and a joint venture Disclose the relevant information in the venturer's financial statements 3 3
4.07.04 4.07.05 4.07.07 4.08 4.08.01 4.08.02 4.08.03 4.08.04 4.08.05
636
29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
1 Associates
Topic highlights
An associate is an entity over which an investor has significant influence. This is assumed where at least 20 per cent of the voting power is held by an investor but may be achieved in other ways.
As we saw in Chapter 27, an associate is something less than a subsidiary, but more than a simple investment. HKAS 28 (2011) provides guidance on which entities meet the definition of an associate and how they should be accounted for within the consolidated financial statements. HKAS 28 (2011) does not apply to investments in associates or joint ventures held by venture capital organisations, mutual funds, unit trusts, and similar entities that are measured at fair value in accordance with HKFRS 9. Note that in the separate financial statements of the investor, an interest in an associate is accounted for either:
HKAS 28
at cost, or in accordance with HKFRS 9
1.1 Definitions
HKAS 28 (2011) provides a number of definitions:
Key terms
Associate. An entity, including an unincorporated entity such as a partnership, over which an investor has significant influence and which is neither a subsidiary nor an interest in a joint venture. Significant influence is the power to participate in the financial and operating policy decisions of the investee but is not control or joint control over those policies. Equity method. A method of accounting whereby the investment is initially recorded at cost and adjusted thereafter for the post acquisition change in the investor's share of the investees net assets. The investors profit or loss includes its share of the profit or loss of the investees profit or loss and the investors other comprehensive income includes its share of the investees other comprehensive income. (HKAS 28 (2011))
HKAS 28 (2011).5-6
1.1.1 Significant influence

Significant influence is defined as the 'power to participate', but not to 'control' (which would make the investment a subsidiary). Significant influence can be determined by the holding of voting rights (usually attached to shares) in the entity. HKAS 28 (2011) states that if an investor holds 20 per cent or more of the voting power of the investee, it can be presumed that the investor has significant influence over the investee, unless it can be clearly shown that this is not the case. Significant influence can be presumed not to exist if the investor holds less than 20 per cent of the voting power of the investee, unless it can be demonstrated otherwise. The existence of significant influence is evidenced in one or more of the following ways: (a) (b) (c) Representation on the board of directors (or equivalent) of the investee Participation in the policy making process Material transactions between investor and investee
637
Financial Reporting
(d) (e)
HKAS 28 (2011).17
Interchange of management personnel Provision of essential technical information
1.2 Excluded associates

HKAS 28 (2011) applies to all investments in associates unless the investment is classified as 'held for sale' in accordance with HKFRS 5 in which case it should be accounted for under HKFRS 5. An investor is exempt from applying HKAS 28 (2011) accounting procedures under the following circumstances: (a) (b) If it is a parent exempt from preparing consolidated financial statements under HKFRS 10 All of the following apply: (i) The investor is a wholly-owned subsidiary or it is a partially owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the investor not applying the equity method. Its securities are not publicly traded. It is not in the process of issuing securities in public securities markets. The ultimate or intermediate parent publishes consolidated financial statements that comply with HKFRS.
(ii) (iii) (iv)
Even where an investee operates under severe long-term restrictions that significantly impair its ability to transfer funds to the investor, the accounting requirements of HKAS 28 (2011) must be applied. Significant influence must be lost before the equity method ceases to be applicable.
HKAS 28 (2011).10-11, 22, 27,33
1.3 The equity method

HKAS 28 (2011) requires that associates are accounted for using the equity method in consolidated financial statements. Note that consolidated financial statements will only be prepared where there is also at least one subsidiary. Under the equity method: (a) The investment in an associate is initially recognised at cost and the carrying amount is increased or decreased to recognise the investor's share of the profit or loss of the investee after the date of acquisition. The investor's share of the profit or loss of the investee is recognised in the investor's profit or loss and their share of the other comprehensive income of the investee is recognised in other comprehensive income.
(b)
Therefore the investment in associate is shown in the consolidated financial statements in just one line in the statement of financial position and a maximum of two in the statement of comprehensive income. This treatment reflects the fact that the associate and its income streams are not controlled. The use of the equity method should be discontinued from the date that the investor ceases to have significant influence. When preparing the consolidated financial statements, the most recent available financial statements of the associate should be used. Where practicable these should be prepared to the same reporting date as the financial statements of the investor. Where this is not practicable, the difference between the end of the reporting period of the associate and that of the investor shall be no more than three months, and adjustment should be made for transactions during this time. Uniform accounting policies should be applied in the investor's and associate's accounts and where this is not the case, the associate's accounts should be adjusted.
638
1.4 Application of the equity method

Topic highlights
The equity method should be applied in the consolidated accounts:
HKAS 28.3839
Statement of financial position: include investment in associate at cost plus (or minus) the group's share of the associate's post-acquisition retained total comprehensive income Statement of comprehensive income: include group share of associate's profit after tax and other comprehensive income
The application of the equity method results in the following line items being included in the consolidated financial statements: Statement of financial position Investment in associate shown as a non-current asset
Statement of comprehensive income Share of profit (loss) of associate Share of associate's other comprehensive income
1.4.1 Consolidated statement of financial position

The investment in associates recognised in the consolidated statement of financial position is initially measured at cost. This amount will increase (decrease) each year by the amount of the group's share of the associate's total comprehensive income retained for the year. The group share of the associate's reserves is also included within the group reserves figure in the equity section of the consolidated statement of financial position.
Example: Associate
Panda Co acquires 30,000 of the 120,000 $1 ordinary shares in Aardvark for $100,000 cash on 1 January 20X1. In the year to 31 December 20X1, Aardvark earns profits after tax of $80,000, from which it declares a dividend of $20,000. Aardvark reports no other comprehensive income. How will Aardvark's results be accounted for in the individual and consolidated accounts of Panda Co for the year ended 31 December 20X1?
Solution
Individual accounts 1 record at cost on 1 January 20X1 DEBIT CREDIT 2 Investment in associate Cash $100,000 $100,000
record dividend income DEBIT CREDIT Cash (25% x $20,000) $5,000 $5,000
Investment income from shares in associates
Unless there is an impairment the investment remains held at cost of $100,000 in Pandas statement of financial position permanently.
639
Financial Reporting
Consolidated accounts
In the consolidated accounts of Panda Co equity accounting principles will be applied, and therefore: In the consolidated statement of financial position the investment is carried at cost plus Pandas share of Aardvarks retained profits Pandas share of Aardvarks profits is included in the consolidated statement of comprehensive income (25% x $80,000 = $20,000) Pandas share of the dividend paid by Aardvark (25% x $20,000 = $5,000) is already included in Pandas profits and therefore only $15,000 is brought in as a consolidation adjustment by:
Investment in associates Investment income CREDIT Share of profits of associates $15,000 $5,000 $20,000
DEBIT
The asset 'Investment in associates' is then stated at $115,000, being cost plus the group share of post-acquisition retained profits.
On acquisition of the associate shareholding, although the investment is always initially carried at cost, the consideration paid is notionally allocated to the fair value of the net assets acquired. (a) Where the cost of the investment exceeds the fair value of net assets acquired, notional goodwill exists within the carrying value of the investment in the statement of financial position. This is not recognised separately as goodwill and is not amortised. Where the cost of the investment is less than the fair value of net assets acquired, the difference is included as income in the determination of the investor's share of the associate's profit or loss in the period in which the investment is acquired.
(b)
1.4.2 Consolidated statement of comprehensive income

Under equity accounting, the associate's revenue, cost of sales and so on are not aggregated with those of the group. Instead the consolidated statement of comprehensive income will only include the group share of the associate's profit after tax and other comprehensive income for the year. In effect, this is the corresponding treatment to the associate's parent company's treatment: the investing company is the non-controlling interests here. PRO-FORMA CONSOLIDATED INCOME STATEMENT (FOR ILLUSTRATION) Revenue Cost of sales Gross profit Distribution costs and administrative expenses Interest and similar income receivable Finance costs Share of profit (after tax) of associate Profit before taxation Income tax expense parent company and subsidiaries Profit for the year $'000 2,000 800 1,200 500 700 50 750 (40) 710 30 740 240 505500
640
$'000 Profit attributable to: Owners of the parent Non-controlling interests 480 20 500
Set out below are the draft accounts of Parent Co and its subsidiaries and of Associate Co. Parent Co acquired 20 per cent of the equity capital of Associate Co five years ago when the latter's retained earnings stood at $60,000. SUMMARISED STATEMENT OF FINANCIAL POSITION Parent Co and subsidiaries $'000 400 80 30 190 700 200 500 700
Property, plant and equipment Investment in Associate at cost Loan to Associate Co Current assets Loan from Parent Co Share capital ($1 shares) Retained earnings
Associate Co $'000 180 70 (30) 220 100 120 220
SUMMARISED STATEMENTS OF COMPREHENSIVE INCOME Parent Co and subsidiaries $'000 Profit before tax 120 Taxation 30 90 Required Prepare the summarised consolidated accounts of Parent Co.
Associate Co $'000 100 20 80
Note. Assume that there are no non-controlling interests in the subsidiary companies. (The answer is at the end of the chapter)
Peter Co bought 30,000 ordinary shares on 31 December 20X6 in Agnes Co at a cost of $60,000 when the statement of financial position of Agnes was as follows:
641
Financial Reporting
Agnes Co DRAFT STATEMENT OF FINANCIAL POSITION AT DATE OF SHARE PURCHASE ASSETS Non-current assets Goodwill Tangible assets Current assets Total assets EQUITY AND LIABILITIES Equity Share capital in ordinary shares of $1 Retained earnings Non-current liabilities: 7% loan notes Total equity and liabilities
50,000 200,000 250,000 80,000 330,000
100,000 110,000 120,000 330,000
During the year to 31 December 20X7 Agnes Co made a profit before tax of $90,000 and the taxation charge on the year's profits was $20,000. A dividend of $30,000 was paid on 31 December out of these profits. The statement of financial position of Agnes Co on 31 December 20X7 was as follows: $ ASSETS Non-current assets Goodwill Tangible assets Current assets Total assets EQUITY AND LIABILITIES Equity Share capital in ordinary shares of $1 Retained earnings Non-current liabilities: 7% loan notes Total equity and liabilities 50,000 210,000 260,000 110,000 370,000
100,000 150,000 120,000 370,000
Calculate the entries for the associate which would appear in the consolidated accounts of the Peter group, in accordance with the requirements of HKAS 28 (2011). (The answer is at the end of the chapter)
1.5 Consolidation adjustments

Topic highlights
Intra-group transactions with an associate are not cancelled but the group share of any unrealised profit is eliminated. Fair value adjustments may also be required.
An associate is not deemed to be part of the single economic entity that is the group. That is because its assets and liabilities and therefore resulting income and expenditure are not controlled within the group. Since an associate is not considered to be part of the group, there is no need to eliminate intragroup transactions. 642
Certain consolidation adjustments do, however, remain relevant, in particular unrealised profits, referred to by HKAS 28 (2011) as the effect of upstream and downstream transactions, and fair value adjustments.
HKAS 28 (2011).28
1.5.1 'Upstream' and 'downstream' transactions

'Upstream' transactions are sales made by an associate to the parent company or a group subsidiary. 'Downstream' transactions are sales made by the parent company or a group subsidiary to an associate. The group share of unrealised profits and losses resulting from 'upstream' and 'downstream' transactions are eliminated. The double entry is as follows, where A per cent is the parent's holding in the associate, and PUP is the provision for unrealised profit. DEBIT CREDIT Cost of sales of parent Group inventories PUP A% PUP A%
For upstream transactions (associate sells to parent/subsidiary) where the parent holds the inventories. OR DEBIT CREDIT Cost of sales of parent/subsidiary Investment in associate PUP A% PUP A%
For downstream transactions (parent/subsidiary sells to associate) where the associate holds the inventory.
Example: Downstream transaction

P Co, a parent with subsidiaries, holds 30 per cent of the equity shares in A Co. During the year, P Co makes sales of $100,000 to A Co at cost plus a 25 per cent mark-up. At the year-end, A Co has all these goods still in inventories. P Co has made an unrealised profit of $20,000 ($100,000 /125) on its sales to the associate A. The group's share of this is 30 per cent, ie $6,000. This must be eliminated. The double entry is: DEBIT CREDIT P: Cost of sales Investment in associate (A) $6,000 $6,000
25
Because the sale was made to the associate, the group's share of the unsold inventories forms part of the investment in associate at the year end. If the sale had been from the associate A to P, ie an upstream transaction, the double entry would have been: DEBIT CREDIT P: Cost of sales P: Inventories $6,000 $6,000
If preparing the consolidated statement of comprehensive income, you would deduct the $6,000 from the group share of the associate's profit. Note. In the examples above, the debit could be to items other than cost of sales, depending on the subject of the intra-group transaction.
HKAS 28 (2011).32
1.5.2 Fair value adjustments

As we have already said, on acquisition of an associate, the cost of the investment is notionally allocated to the fair value of the net assets acquired.
643
Financial Reporting
Where a fair value adjustment is made for the purposes of this exercise, appropriate adjustments to the investor's share of the associate's profits or losses after acquisition are also made to account, for example, for depreciation of the depreciable assets based on their fair values at the acquisition date.
HKAS 28 (2011).38-39
1.6 Losses in an associate

Where an investor is loss making and the parent company's share of losses equals or exceeds its interest in the associate, the parent must discontinue recognising its share of further losses. For this purpose the investment in the associate includes: initial cost the group share of the associate's post-acquisition retained total comprehensive income other long term interests such as long-term loans or preference shares.
After the interest in the associate is reduced to zero, additional losses are provided for and a liability recognised to the extent that the investor has incurred legal or constructive obligations or made payments on behalf of the associate. Should the associate return to profit, the parent may resume recognising its share of profits only after they equal the share of losses not recognised.
Example: Carrying amount

The Letters Group has a 40 per cent associate investment in Alpha Co which cost $500,000 on 1 January 20X2, including a premium representing notional goodwill. The results of Alpha Co in recent years have been as follows: Year ended 31 December 20X2 20X3 20X4 20X5 20X6 Retained total comprehensive income $100,000 ($1,000,000) ($500,000) $100,000 $500,000
What is the carrying amount of the investment in Alpha Co in each of these years in the consolidated financial statements of the Letters Group?
Solution
31 December 20X2 31 December 20X3 31 December 20X4 31 December 20X5 $500,000 + (40% $100,000) $540,000 + (40% ($1m)) $140,000 + (40% ($500,000)) $60,000 + (40% $100,000) $20,000 + (40% $500,000) $540,000 $140,000 Nil ($60,000 losses unrecognised) Nil ($20,000 losses unrecognised and unrecovered) $180,000
31 December 20X6
1.7 Impairment losses

HKAS 39 sets out a list of indications that a financial asset (including an associate) may have become impaired (see chapter 18). Any impairment loss is recognised in accordance with HKAS 36 Impairment of Assets for each associate individually. An impairment loss is not allocated to any asset, including goodwill, that forms part of the carrying amount of the investment in associate.
644
Accordingly any reversal of that impairment loss is recognised in accordance with HKAS 36 to the extent that the recoverable amount of the investment subsequently increases.
1.8 Indirect investment in an associate

Where the investment in an associate is held by a subsidiary in which there is a non-controlling interest, the non-controlling interests shown in the consolidated financial statements of the group should include the non-controlling interests of the subsidiary's interest in the results and net assets of the associated company. This means that the group accounts must include the 'gross' share of net assets and total comprehensive income in accounting for the non-controlling interests separately. For example, we will suppose that P Co owns 80 per cent of S Co which owns 25 per cent of A Co, an associate of P Co. The relevant amounts for inclusion in the consolidated financial statements would be as follows: CONSOLIDATED INCOME STATEMENT Operating profit (P 100% + S 100%) Share of profit after tax of associate (A 25%) Tax (P 100% + S 100%) Non-controlling interests (S 20% + A 5%*) Retained profits (P 100% + S 80% + A 20%) CONSOLIDATED STATEMENT OF FINANCIAL POSITION Investment in associated company (figures based on 25% holding) Non-controlling interests ((20% shareholders' funds of S) + (5%* post-acquisition retained earnings of A)) Group retained earnings ((100% P) + (80% post-acquisition of S) + (20% post-acquisition of A)) * 20% 25% = 5%
1.9 Disclosures
Disclosures for both associates and joint arrangements are contained in HKFRS 12 Disclosure of interests in other entities. This was covered in Chapter 27.
2 Joint arrangements
Topic highlights
A joint venture is a contractual arrangement where two or more parties jointly control an economic activity.
When two or more entities wish to enter into a business arrangement together, however do not want to create a formal long-term partnership, it is common to form a joint venture. This type of business vehicle generally exists to fulfil short term projects, such as the construction of a building or structure. When the project is complete, the joint venture ceases to exist. There are different forms of joint venture, as we shall see, but essentially, entities which form the joint venture (venturers) contribute assets, expertise and in some cases equity to the venture. In return they are entitled to a share of the profits of the joint venture.
645
Financial Reporting
HKFRS 11 Joint Arrangements was issued in June 2011 and replaced HKAS 31 Interests in Joint Ventures. Both standards consider the different forms of joint venture which may be undertaken and how each form should be accounted for. This section of the chapter considers definitions in relation to joint arrangements and then explains in brief the requirements of HKAS 31 before concentrating on the new standard, HKFRS 11 for you to understand the key changes in the accounting standard.
HKFRS 11, Appendix A
2.1 Definitions
Before thinking about the different types of joint venture and how they are accounted for, we must consider the definitions provided by HKFRS 11.
Key terms
Joint arrangement. An arrangement of which two or more parties have joint control. Joint control. 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. Joint operation. A joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets and obligations for the liabilities relating to the arrangement. Joint venture. A joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement. (HKFRS 11)
HKFRS 11.713
2.1.1 Joint control

The definition above specifically refers to a contractually agreed sharing of control and states that this exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control. Where there is no contractual arrangement to establish joint control, or where there is a contractual arrangement but unanimous consent is not required to make decisions, then there is no joint control. HKFRS 11 makes additional points about joint control: No single party controls the arrangement on its own A party with joint control of an arrangement can prevent any of the other parties from controlling the arrangement An arrangement can be a joint arrangement even if not all parties have joint control; some parties to a joint arrangement may participate but not have joint control Judgment should be applied when assessing whether a party has joint control of an arrangement.
Example: Joint control

Three parties establish an arrangement. Abacus has 50 per cent of the voting rights in the arrangement, Bacchus has 30 per cent and Cornelius has 20 per cent. The contractual arrangement between the parties specifies that at least 75 per cent of votes are required to make decisions about relevant activities of the arrangement. In this case, Abacus can block a decision, however does not control the arrangement alone as it needs the agreement of Bacchus. Therefore, Abacus and Bacchus have joint control of the arrangement as decisions about relevant activities cannot be made without them agreeing. Cornelius is a participating party to the arrangement, however does not have joint control.
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Contractual arrangement
HKFRS 11, B2, B4
HKFRS 11 states that the contractual arrangement may be evidenced in a number of ways including: (a) (b) (c) (d) a written contract between the controlling parties minutes of discussions between controlling parties incorporation of the arrangement in the articles or by-laws of the joint arrangement. the purpose, activity and duration of the joint venture the appointment of the board of directors and voting rights of the controlling parties capital contributions by the controlling parties the sharing by the controlling parties of the output, income, expenses or results of the joint venture.
The contractual arrangement will deal with issues such as:
One party may be identified in the contractual arrangement as the operator or manager of the joint venture. This does not indicate that that party controls the joint arrangement, simply that they are acting within the financial and operating policies agreed by the controlling parties in accordance with the contractual arrangement. If it is evident that the operator does have control of the activity then the arrangement is a subsidiary of the operator rather than a joint operation or venture.
2.2 HKAS 31 Interests in Joint Ventures

Topic highlights
HKAS 31 specifies three types of joint venture: jointly controlled operations, jointly controlled assets and jointly controlled entities.
HKAS 31 specifies three main types of joint venture: Jointly controlled operations Jointly controlled assets Jointly controlled entities Two (or more) venturers are bound by a contractual arrangement The contractual relationship establishes joint control
The following characteristics are common to all types of joint venture:
The following table summarises the differences between these types of joint venture, and details the accounting treatment required by HKAS 31 in each case:
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Financial Reporting
Type of joint venture Jointly controlled operations (JCOs)
Characteristics No separate entity established Venturers provide own assets and resources and incur own expenses and liabilities Revenues and expenses of the JCO are shared among the venturers. No separate entity established Venturers jointly control assets purchased / contributed for use within the joint venture. Each venturer may take a share of the output from the assets and each bears an agreed share of expenses. Separate entity is established This JCE controls the joint ventures assets, incurs liabilities and expenses and earns income. Venturers share the results and sometimes the output of the JCE.
Accounting treatment In its own financial statements a venturer recognises: Assets it controls Liabilities it incurs Expenses it incurs Its share of income earned from the JCO.
Jointly controlled assets (JCAs)
In its own financial statements a venturer recognises: Its share of the jointly controlled assets Its share of liabilities incurred with other venturers in relation to the JCA Its share of income generated by the JCA and expenses incurred.
Jointly controlled entities (JCEs)
Separate financial statements are maintained for the JCE In venturers separate financial statements the investment is accounted for in accordance with HKAS 27 (2011). In venturers consolidated financial statements, the investment is accounted for using either one of two methods: equity accounting (HKAS 28 (2011)) proportionate consolidation (see below)
2.2.1 Proportionate consolidation

Proportionate consolidation differs from normal consolidation in that only the group share of assets and liabilities, income and expenses are brought into the financial statements. There is therefore no non-controlling interest. According to HKAS 31, this treatment reflects the substance and economic reality of the arrangement, being that the venturer has control over its share of future economic benefits through its share of the assets and liabilities of the venture.
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2.3 HKFRS 11 Joint Arrangements

Topic highlights
Joint arrangements are classified as either joint operations or joint ventures. HKFRS 11 classes joint arrangements as either joint operations or joint ventures. The classification of a joint arrangement as a joint operation or a joint venture depends upon the rights and obligations of the parties to the arrangement.
A joint operation is a joint arrangement whereby the parties that have joint control (the joint operators) have rights to the assets, and obligations for the liabilities, of that joint arrangement. This type of arrangement essentially combines the HKAS 31 concepts of jointly controlled operations and jointly controlled assets. A joint arrangement that is not structured through a separate entity is always a joint operation. A joint venture is a joint arrangement whereby the parties that have joint control (the joint venturers) of the arrangement have rights to the net assets of the arrangement. A joint arrangement that is structured through a separate entity may be either a joint operation or a joint venture. In order to ascertain the classification, the parties to the arrangement should assess the terms of the contractual arrangement together with any other facts or circumstances to assess whether they have: rights to the assets, and obligations for the liabilities, in relation to the arrangement (indicating a joint operation) rights to the net assets of the arrangement (indicating a joint venture)
Detailed guidance is provided in the appendices to HKFRS 11 in order to help this assessment, giving consideration to, for example, the wording contained within contractual arrangements.
Can you think of any examples of situations where the following may occur? (a) joint operation not structured through a separate entity (b) joint venture structured through a separate entity (The answer is at the end of the chapter)
HKFRS 11.20, 26
2.3.1 Accounting for joint operations

HKFRS 11 requires that a joint operator recognises line-by-line the following in relation to its interest in a joint operation: (a) (b) (c) (d) (e) its assets, including its share of any jointly held assets its liabilities, including its share of any jointly incurred liabilities its revenue from the sale of its share of the output arising from the joint operation its share of the revenue from the sale of the output by the joint operation, and its expenses, including its share of any expenses incurred jointly.
This treatment is applicable in both the separate and consolidated financial statements of the joint operator.
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Financial Reporting
HKFRS 11.24, 26
2.3.2 Accounting for joint ventures

In its consolidated financial statements, HKFRS 11 requires that a joint venturer recognises its interest in a joint venture as an investment and accounts for that investment using the equity method in accordance with HKAS 28 (2011) Investments in Associates and Joint Ventures unless the entity is exempted from applying the equity method (see Section 1.2 which is also applicable to joint ventures). In its separate financial statements, a joint venturer should account for its interest in a joint venture in accordance with HKAS 27 (2011) Separate Financial Statements (see Chapter 27).
2.3.3 Application of HKAS 28 (2011) to joint ventures

The consolidated statement of financial position is prepared by: including the interest in the joint venture at cost plus share of post-acquisition total comprehensive income including the group share of the post-acquisition total comprehensive income in group reserves
The consolidated statement of comprehensive income will include: the group share of the joint ventures profit or loss the group share of the joint ventures other comprehensive income.
The use of the equity method should be discontinued from the date on which the joint venturer ceases to have joint control over, or have significant influence on, a joint venture.
HKAS 28 (2011), 28-29
2.3.4 Transactions between a joint venturer and a joint venture

Upstream transactions A joint venturer may sell or contribute assets to a joint venture so making a profit or loss. Any such gain or loss should, however, only be recognised to the extent that it reflects the substance of the transaction. Therefore: Only the gain attributable to the interest of the other joint venturers should be recognised in the financial statements. The full amount of any loss should be recognised when the transaction shows evidence that the net realisable value of current assets is less than cost, or that there is an impairment loss.
Downstream transactions When a joint venturer purchases assets from a joint venture, the joint venturer should not recognise its share of the profit made by the joint venture on the transaction in question until it resells the assets to an independent third party, ie until the profit is realised. Losses should be treated in the same way, except losses should be recognised immediately if they represent a reduction in the net realisable value of current assets, or a permanent decline in the carrying amount of non-current assets.
2.4 Disclosures
Disclosures for both associates and joint arrangements are contained in HKFRS 12 Disclosure of interests in other entities. This was covered in Chapter 27.
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AB Co contributes inventories to a 50:50 joint venture it has undertaken with CD Co. The historical cost of the inventories is recorded in AB Co's books of account at $1m. What gain or loss should AB Co recognise in its financial statements when the fair value (net realisable value) of the inventories is estimated at the date of transfer and recorded by the joint venture as: (a) (b) $1.2 million? $0.8 million? (The answer is at the end of the chapter)
651
Financial Reporting
Topic recap
An associate is an entity over which an investor has significant influence. This is assumed where at least 20 per cent of the voting power is held by an investor but may be achieved in other ways. The equity method should be applied in the consolidated accounts: Statement of financial position: include investment in associate at cost plus (or minus) the group's share of the associate's post-acquisition retained total comprehensive income Statement of comprehensive income: include group share of associate's profit after tax and other comprehensive income
Intra-group transactions are not cancelled but the group share of any unrealised profit is eliminated. Fair value adjustments may also be required. A joint arrangement is a contractual arrangement of which two or more parties have joint control. HKAS 31 specifies three types of joint venture: jointly controlled operations, jointly controlled assets and jointly controlled entities. Joint arrangements are classified as with joint operations or joint ventures. HKFRS 11 classes joint arrangements as either joint operations or joint ventures. The classification of a joint arrangement as a joint operation or a joint venture depends upon the rights and obligations of the parties to the arrangement. Joint operations are those joint arrangements where the controlling party has rights to the assets and obligations for the liabilities relating to the arrangement. Joint ventures are those joint arrangements where the controlling party has rights to the net assets of the arrangement. Joint arrangements which are not structured through a separate vehicle are always joint operations; joint arrangements which are structured through a separate vehicle may be joint operations or joint ventures. In their own separate or consolidated financial statements, joint operators recognise their share of the assets, liabilities, revenues and expenses of a joint operation. Financial statements are prepared for joint ventures and they are included in the consolidated financial statements of the joint venturers using the equity method.
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Answer 1
PARENT CO CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME Net profit Share of profits of associate (20% 80) Profit before tax Income tax expense Profit attributable to the owners of Parent Co PARENT CO CONSOLIDATED STATEMENT OF FINANCIAL POSITION Assets Property, plant and equipment Interest in an associate (see note) Current assets Total assets Equity and liabilities Share capital Retained earnings (W) Total equity and liabilities Note. Interest in an associate Cost Share of post-acquisition retained earnings 20% (120 60) Loan to an associate WORKING Retained earnings Parent and subsidiaries $'000 500 12 512 $'000 120 16 136 30 106
$'000 400 122 190 712 200 512 712 $'000 80 12 30 122
Per question Pre-acquisition Post-acquisition Group share in associate (20% 60) Group retained earnings
Associate $'000 120 60 60
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Financial Reporting
Answer 2
CONSOLIDATED INCOME STATEMENT Group share of associate's profit after tax 30% x (90,000 20,000) CONSOLIDATED STATEMENT OF FINANCIAL POSITION Interest in associate The asset 'interest in associate' comprises: Cost Share of post-acquisition retained earnings 30% (150,000 110,000) 60,000 12,000 72,000 $ 21,000 $ 72,000
Answer 3
(a) An example of a joint operation may involve building an aircraft. Say that Boeing is to build the body of the aircraft and the engines are to be built by Rolls Royce as specified by the airline customer for the aircraft. You can see that different parts of the manufacturing process are carried out by each of the joint operators. In the Rolls Royce factory, workers will work on the engines for the Boeing plane alongside others working on engines for different aircraft. Each operator, Boeing and Rolls Royce, bears its own costs and takes a share of revenue from the aircraft sale. That share is decided in the contractual arrangement between the venturers. Other examples may arise in the oil, gas and mineral extraction industries. In such industries companies may, say, jointly control and operate an oil or gas pipeline. Each company transports its own products down the pipeline and pays an agreed proportion of the expenses of operating the pipeline (perhaps based on volume). A further example is a property which is jointly controlled, each operator taking a share of the rental income and bearing a portion of the expense. In each case, the key issue is that the joint controller is entitled to a share of assets and liabilities of the joint arrangement, rather than a share of net assets. (b) A common situation is where two or more entities transfer the relevant assets and liabilities to a joint venture in order to combine their activities in a particular line of business. In other situations, an entity wishing to start operations in a foreign country will set up a joint venture with the government of the foreign country (or an agency of it).
Answer 4
(a) AB Co has made a profit of $0.2 million, but only 50 per cent of this can be considered as realised, ie that part attributable to the other venturer. AB Co should therefore recognise a gain of $0.1 million. A loss of $0.2 million has been made on the inventories, the entire amount of which should be recognised by AB Co. It is known that the loss will be made, even though the inventories have not yet been sold, and the standard requires that the full loss should be recognised immediately when they represent a reduction in the net realisable value.
(b)
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Exam practice
Sun Tech Limited
54 minutes
Assume that you are Mr. Ricky Lam, the accounting manager of Sun Tech Limited ('STL'). STL is a company incorporated and listed in Hong Kong and is principally engaged in the manufacturing of electronic products. In June 20X8, STL made an offer to the shareholders of Moon-night Limited ('MNL') to acquire a controlling interest in MNL. STL was prepared to pay $1.50 cash per share, provided that 70 per cent of the shares could be acquired. The directors of MNL recommended that the offer be accepted. By 1 July 20X8, when the offer expired, 75 per cent of the shares had changed hands and were now in the possession of STL. STL also acquired 25 per cent of the shares of Earth-ray Limited ('ERL') on 1 July 20X8 for a cash consideration of $145 million. A summary of the acquisition of the shares of MNL and ERL by STL is as follows: Share capital (par value Retained of $1) at earnings at acquisition date acquisition date $'000 $'000 400,000 160,000 400,000 180,000
Date of acquisition MNL 1 July 20X8 ERL 1 July 20X8
% acquired 75 25
Cost of investment $'000 450,000 145,000
Net assets at acquisition date $'000 560,000 580,000
The following table summarises information from the three companies' income statements for the year ended 30 June 20X9: STL MNL ERL $'000 $'000 $'000 Revenue 878,900 388,900 300,000 Cost of sales (374,400) (112,400) (120,000) Gross profit 504,500 276,500 180,000 Other income 14,000 16,000 15,000 Distribution and administrative costs (216,200) (115,800) (120,000) Depreciation and amortisation (30,000) (10,000) (10,000) Profit before tax 272,300 166,700 65,000 Tax (112,400) (50,000) (24,000) Profit for the year 159,900 116,700 41,000 The fair value of the identifiable net assets of MNL and ERL at the date of acquisition was the same as the carrying amount of those assets. Both companies did not have any reserves other than retained earnings. During the year ended 30 June 20X9, STL sold goods to MNL and ERL at an invoiced value of $100 million and $15 million respectively. STL invoiced goods to its subsidiary and associated company at cost plus 20 per cent. One-third (1/3) of the goods and half (1/2) of the goods were still held in MNL's inventory and in ERL's inventory respectively at 30 June 20X9. On 1 July 20X8, MNL sold equipment to STL for $60 million. At that date, the carrying amount of the equipment was $52 million and the equipment was estimated to have a remaining useful life of 10 years. The resulting gain was recorded as other income by MNL. STL has adopted an accounting policy which depreciates plant and equipment using the straight-line method with no residual value. It is also the group policy that non-controlling interest shall be measured at the noncontrolling interest's proportionate share of the subsidiary's identifiable net assets.
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Financial Reporting
Joint venture STL is considering a joint venture with Johnson Limited ('JSL'). STL and JSL will have equal interests in the joint venture, which will be set up as a separate legal entity. JSL will contribute $10 million in cash while STL will contribute machinery which is stated in its statement of financial position at a cost of $12 million and a carrying amount of $8 million. The machinery has a fair value assessed as $10 million on the basis of its depreciated replacement cost. It is noted that the significant risks and rewards of ownership of the contributed machinery can be transferred to the joint venture and the resulting gain can be reliably measured. You have prepared draft consolidated financial statements of STL for the year ended 30 June 20X9. After you sent these draft consolidated financial statements to STL's directors for review, one of the directors, who is not a certified public accountant, sent you an e-mail as follows: To: Ricky Lam, Accounting Manager, STL From: Sunny Sun (Director) c.c.: Susan Chow, Emily Tsim, Rachael Lau (Directors) Date: 18 September 20X9 Consolidated financial statements of STL as at 30 June 20X9 Could you please clarify the following points relating to STL's draft consolidated financial statements which I have just reviewed. (a) (b) (c) (d) I have not found any goodwill in either of the financial statements of STL and MNL. Why is there such an item in the consolidated statement of financial position? It seems to be a good idea to invest in the joint venture. By contributing our machinery to the joint venture, a gain on disposal will be recorded. Do you agree? I note that you have made tax-effect entries for adjustments for intragroup transactions. As tax is charged on individual entities, why have these tax effect entries been made? I note that the amount of sales from STL to ERL has not been eliminated. Why don't we eliminate all these sales as ERL is our investee? Did we overstate our profit, particularly when ERL has not resold all the inventory transferred from STL?
I would appreciate your clarification in time for the next board meeting. Best regards, Sunny Required Prepare a memorandum in response to the issues raised by Mr. Sunny Sun. In your memorandum, you should: (a) (b) briefly discuss the reason for the goodwill and calculate the amount of goodwill as shown in the consolidated statement of financial position; (5 marks) discuss how STL should account for its contribution to the joint venture and prepare the relevant journal entries in STL's separate financial statements and in the consolidated financial statements; (10 marks) discuss why tax effects of adjustments for intragroup transactions are needed. Illustrate, with appropriate calculation, by using the intragroup sales of goods from STL to MNL as an example (assume a tax rate of 16 per cent); (7 marks) explain why the amount of sales from STL to ERL has not been eliminated in the consolidated income statement. Discuss and calculate the amount of ERL's profit that STL should share (assume a tax rate of 16 per cent). (8 marks) (Total = 30 marks) HKICPA May 2009 (amended)
(c)
(d)
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chapter 30
Changes in group structures

Topic list
1 2 3 4 Disposals Step acquisitions Merger accounting for common control combinations HK(IFRIC) Int-17 Distributions of Non-cash Assets to Owners
Learning focus
The acquisition and disposal of investments in group companies is a common occurrence in business. The 'clean' transactions that we have already seen where a controlling shareholding is purchased on one date are not always how an acquisition is achieved. Gradual (or step) acquisitions are common and you must be able to deal with both these and disposals either of a whole investment or part of an investment.
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Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes: Competency level Prepare the financial statements for a group in accordance with Hong Kong Financial Reporting Standards and statutory reporting requirements 4.03 4.03.09 4.05 4.05.01 4.05.02 4.06 4.06.10 4.07 4.07.06 4.11 4.11.01 4.11.02 Principles of consolidation Explain how to account for changes in parent's ownership interest in a subsidiary without losing control Disposal of subsidiaries Account for the disposal of a subsidiary by a group Account for the change of ownership in subsidiaries without loss of control Business combinations Explain the accounting for step acquisition Investments in associates Account for the disposal of an associate Merger accounting for common control combinations Describe the principles and practices of merger accounting Apply merger accounting to a common control combination 2 3 3 3 3
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30: Changes in group structures | Part D Group financial statements
1 Disposals
Topic highlights
A subsidiary or associate may be disposed of in its entirety or in part, so that the status of the investment changes.
A parent company may choose to dispose of all or part of its investment in a subsidiary or associate. A gain or loss on disposal is normally calculated and included in the consolidated financial statements as well as the parent company's individual accounts. The treatment of the disposal and calculation of any gain or loss depends upon the type of disposal.
1.1 Types of disposal

The type of disposal may be categorised as one of the following, each of which we shall deal with in turn in this chapter: Full disposal of a subsidiary Partial disposal of a subsidiary such that the investment remains a subsidiary Partial disposal of a subsidiary such that the investment becomes an associate Partial disposal of a subsidiary such that the investment becomes a financial asset Full disposal of an associate Partial disposal of an associate such that the investment becomes a financial asset
Before considering each type of disposal in turn, we must consider the issue of loss of control. HKFRS 3 (revised) and HKFRS 10 do not consider the second situation above to be a disposal, as control is not lost. This situation is therefore accounted for in a different way from other partial disposals.
1.1.1 Loss of control or significant influence

HKFRS consider a disposal to involve the loss of control or significant influence; this has been referred to as 'crossing an accounting boundary'. The date of disposal is therefore the date on which control or significant influence is lost.
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Financial Reporting
The diagram below may help you visualise the boundary: HKFRS 9 HKAS 28 (2011) / HKFRS 11 HKFRS 10
10%
Loss of control but retaining financial asset 40% Loss of control but retaining an associate or a jointly controlled entity
10%
Loss of significant influence or joint control but retaining a financial asset
0%
Passive
20%
Significant influence / joint control
50%
Control
100%
As you will see from the diagram, where an interest in a subsidiary is reduced from say 80 per cent to 60 per cent, this does not involve crossing that all-important 50 per cent threshold.
HKAS 27.10
1.1.2 Subsidiary held for sale

HKAS 27 (2011) requires that in the separate financial statements of the investor, a subsidiary, jointly controlled entity or associate is held either at cost or in accordance with HKFRS 9. HKAS 27 (2011) is aligned with HKFRS 5 by clarifying that a parent entity that accounts for an investment in a subsidiary in accordance with HKFRS 9 (in its separate financial statements) and subsequently classifies the investment as held for sale (or held in a disposal group classified as held for sale) would continue to account for the investment in accordance with HKFRS 9. HKFRS 5 measurement requirements only apply to investments that are held at cost.
HKFRS 10.25
1.2 Full disposal of a subsidiary

Topic highlights
Where a subsidiary is disposed of in full a gain or loss on disposal is recognised in the parent's individual and the consolidated accounts. The amount of the gain or loss will be different in the individual and the consolidated accounts. The results of the subsidiary are consolidated to the date of disposal.
Where a subsidiary is disposed of, a profit or loss on disposal will be recognised in both the parent's individual and the consolidated financial statements. The calculation of each of these amounts will be different.
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1.2.1 Gain or loss in parent company's accounts

The gain or loss on disposal in the parent company's individual accounts is relatively straightforward. Proceeds are compared with the carrying value of the investment sold: Fair value of consideration received Less: carrying value of investment disposed of Profit/(loss) on disposal $ X (X) X/(X)
The profit on disposal may be taxable and where it is, the tax is based on the parent's gain rather than the group's.
1.2.2 Gain or loss in consolidated accounts

The calculation of the gain or loss in the consolidated accounts is a little more complex: $ Fair value of consideration received Less: net assets of subsidiary at disposal date goodwill at disposal date non-controlling interests at disposal date Group profit/(loss) This gain may need to be disclosed separately if it is material. X X (X) (X) X/(X) $ X
1.2.3 Preparation of the consolidated financial statements

Where there has been a full disposal of a subsidiary during the accounting period: (a) (b) (c) That subsidiary is not recognised in the statement of financial position at the period end, nor is any non-controlling interests The results of the subsidiary are included in the consolidated statement of comprehensive income only until the date on which control is lost The non-controlling interests in profit and total comprehensive income represents the NCI share of these amounts only until control is lost
If the subsidiary is classified as a discontinued operation per HKFRS 5 the consolidated statement of comprehensive income should include in one line 'Profit for the period from discontinued operations', being the group profit on disposal plus the subsidiary's profit for the year to disposal.
Land Co has owned 80 per cent of the ordinary share capital in Rover Co for a number of years. The investment cost $980,000 and goodwill of $45,000 arose on acquisition, $5,000 relating to the non-controlling interests which was measured at fair value. Goodwill has not been impaired. On 30 June 20X9 Land Co disposed of the whole shareholding in Rover Co for $1.2 million. At the date of disposal Rover Co had net assets of $1 million and non-controlling interests of $205,000. What gain is reported (a) (b) in Land Co's individual accounts? in the Land Group consolidated accounts? (The answer is at the end of the chapter)
661
Financial Reporting
HKFRS 10.23
1.3 Partial disposal of subsidiary: subsidiary to subsidiary

Topic highlights
Where control is not lost on the disposal of shares there is no gain or loss in the consolidated accounts; instead the transaction results in an adjustment to shareholders' funds. As we have already said, where a controlling shareholding is retained, the 'accounting boundary' is not crossed and HKFRS 3 (revised) and HKFRS 10 do not consider the transaction to be a disposal. In the parent company's individual accounts a profit or loss is recognised on the disposal of the investment calculated in the same way as we saw earlier, being proceeds less carrying amount of the investment. In the consolidated financial statements, however: no gain or loss on disposal is calculated goodwill is not re-calculated the transaction is accounted for through shareholders' equity.
1.3.1 Adjustment to shareholders' equity

The adjustment to shareholders' equity is calculated as the difference between the proceeds received and the change in the non-controlling interests as a result of the transaction.
Example: Adjustment on disposal

Manta Co acquired 90 per cent of Ray Co in 20X6 and at this time goodwill was calculated as $65,000 using the proportion of net assets method to value the non-controlling interests. Goodwill has been impaired by $15,000 since acquisition. On 31 August 20X9 Manta Co disposed of a 20 per cent holding in Ray Co for $120,000; on this date the net assets of Ray Co were $560,000. What adjustment is required as a result of the disposal?
Solution
1 Adjustment required to the non-controlling interests: At disposal date: NCI based on old shareholding (10% x $560,000) NCI based on new shareholding (30% x $560,000) Adjustment required The non-controlling interests must be increased by $112,000. 2 Journal adjustment is therefore: DEBIT Proceeds CREDIT NCI Shareholders' equity ($120,000 - $112,000) $ 120,000 112,000 8,000 $ 56,000 168,000 112,000
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In 20X8, A acquired a 100 per cent equity interest in B for cash consideration of $125,000. B's identifiable net assets at fair value were $100,000. Goodwill of $25,000 was identified and recognised. In the subsequent years, B increased net assets by $20,000 to $120,000. This is reflected in equity attributable to the parent. A then disposed of 30 per cent of its equity interest to non-controlling interests for $40,000. What adjustment is required to shareholders' equity on the disposal? (The answer is at the end of the chapter)
1.3.2 Preparation of the consolidated financial statements (subsidiary to subsidiary)

In the statement of financial position:
HKFRS 10.25
the non-controlling interests are based on the year end percentage goodwill on acquisition is unchanged as a result of the partial sale of the shareholding parent's equity is adjusted as above
In the statement of comprehensive income: the subsidiary's results are included for the whole accounting period the non-controlling interests are based on pro-rated profits and total comprehensive income there is no profit or loss on disposal.
1.4 Partial disposal of subsidiary: subsidiary to associate

Topic highlights
Where a subsidiary becomes an associate or financial asset, a gain or loss is recognised in the consolidated accounts. This includes the gain on the shares disposed of and the revaluation of the shares retained.
In this instance control is lost and therefore a gain or loss on disposal must be calculated in both the parent company's and the consolidated financial statements. The gain or loss in the parent company's accounts is again calculated as proceeds less carrying amount of investment, and any tax due will be based on this figure.
1.4.1 Gain in the consolidated accounts

Where control is lost, the gain in the consolidated accounts is calculated as: Proceeds Fair value of interest retained Less: net assets of subsidiary recognised prior to disposal: Net assets Goodwill Non-controlling interests Profit / loss X X (X) (X) X/(X) $ $ X X X
It may seem odd that the fair value of the interest retained forms part of this calculation, but this is because the gain is essentially made up of two parts:
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Financial Reporting
A realised gain on the shares disposed of An unrealised gain on the revaluation of the shares retained to fair value.
The following example will help you to see this.
Example: Gain or loss

Ives Group acquired 95 per cent holding in Hunt Co in 20X6, which it held until 31 May 20X9 when a 55 per cent shareholding was sold for $670,000, so reducing Ives Group's investment to 40 per cent. At the disposal date the net assets of Hunt Co were $900,000, goodwill arising on acquisition had been fully impaired and the fair value of a 40 per cent interest in Hunt was $390,000. The non-controlling interests are valued using the proportion of net assets method. Required What gain or loss arises on the disposal? Proceeds Fair value of interest retained Less: Amounts recognised prior to disposal Net assets of Hunt Goodwill (fully impaired) NCI at disposal (5% $900,000) Gain on disposal The gain can be analysed as follows: Gain on disposal Proceeds Net assets disposed of ($900,000 55%) Gain on revaluation of retained interest Fair value of retained interest Net assets retained ($900,000 40%) $ 670,000 (495,000) 175,000 390,000 (360,000) 30,000 $ $ 670,000 390,000 1,060,000
900,000 (45,000) (855,000) 205,000
1.4.2 Preparation of the consolidated financial statements (subsidiary to associate)

In the statement of financial position: The interest in the associate is equity accounted for based on the year end shareholding. For this purpose, the cost of the investment is taken to be the fair value of the interest retained at the date the investment became an associate holding.
In the statement of comprehensive income: The results of the investment are pro-rated and: Consolidated until the disposal date Equity accounted thereafter
The gain or loss on disposal, calculated as above is recognised.
664
Example: Partial disposals

Linda Co bought 100 per cent of the voting share capital of Vivi Co on its incorporation on 1 January 20X2 for $160,000. Vivi Co earned and retained $240,000 from that date until 31 December 20X7. At that date the statements of financial position of the company and the group were as follows: Linda Co Vivi Co Consolidated $'000 $'000 $'000 Investment in Vivi 160 Other net assets 1,000 500 1,500 1,160 500 1,500 Share capital Reserve Current liabilities 400 560 200 1,160 160 240 100 500 400 800 300 1,500
It is the group's policy to value the non-controlling interests at its proportionate share of the fair value of the subsidiary's identifiable net assets. On 1 January 20X8 Linda Co sold 40 per cent of its shareholding in Vivi Co for $280,000. The profit on disposal (ignoring tax) in the financial statements of the parent company is calculated as follows: Linda $'000 Fair value of consideration received 280 (64) Carrying value of investment (40% 160) Profit on sale 216 We now move on to calculate the adjustment to equity for the group financial statements. Because only 40 per cent of the 100 per cent subsidiary has been sold, leaving a 60 per cent subsidiary, control is retained. This means that there is no group profit on disposal in profit or loss for the year. Instead, there is an adjustment to the parent's equity, which affects group reserve. Point to note The adjustment to parent's equity is calculated as follows: Fair value of consideration received Increase in non-controlling interests in net assets at the date of disposal (40% 400)* Adjustment to parent's equity *Share capital Reserve $'000 280 (160) 120 160 240 400
This increases group reserve and does not go through group profit or loss for the year. (Note that there is no goodwill in this example, as the subsidiary was acquired on incorporation.)
665
Financial Reporting
Solution: Subsidiary status

The statements of financial position immediately after the sale will appear as follows: Linda Co $'000 96 1,280 1,376 400 776 200 1,376 Vivi Co $'000 500 500 160 240 100 500 Consolidated $'000 1,780 1,780 400 920 300 1,620 160 1,780
Investment in Vivi (160 64) Other assets Share capital Retained earnings (Note) Current liabilities Non-controlling interests
Note. Linda's reserves are $560,000 + $216,000 profit on disposal. Group reserves are increased by the adjustment above: $800,000 + $120,000 = $920,000.
Solution: Associate status

Using the above example, assume that Linda Co sold 60 per cent of its holding in Vivi Co for $440,000. The fair value of the 40 per cent holding retained was $200,000. The gain or loss on disposal in the books of the parent company would be calculated as follows: Parent company $'000 Fair value of consideration received 440 (96) Carrying value of investment (60% 160) Profit on sale 344 This time control is lost, so there will be a gain in group profit or loss, calculated as follows: Fair value of consideration received Fair value of investment retained Less: Net assets of Vivi Co at date control lost Group profit on sale $'000 440 200 (400) 240
(Note that there was no goodwill arising on the acquisition, otherwise this goodwill would be deducted in the calculation.) The statements of financial position would now appear as follows: Linda Co $'000 64 1,440 1,504 400 904 200 1,504 Vivi Co $'000 - 500 500 160 240 100 500 Consolidated $'000 200 1,440 1,640 400 1,040 200 1,640
Investment in Vivi (Note 1) Other assets Share capital Retained earnings (Note 2) Current liabilities
666
Notes (1) The investment in Vivi is at fair value in the group accounts. It is equity accounted based on the fair value at the date control was lost plus the share of post-acquisition retained earnings. As yet there are no retained earnings because control has only just been lost at 31 December 20X7. Linda's reserves are $560,000 + the profit on sale of $344,000 ie $904,000. Group retained earnings are $800,000 (per question) plus group profit on the sale of $240,000, ie $1,040,000.
(2)
HKFRS 10.25
1.5 Partial disposal of subsidiary: subsidiary to financial asset

As in the case of a partial disposal which results in a subsidiary holding becoming an associate, where a subsidiary becomes a financial asset, control is lost. Therefore a gain or loss on disposal is recognised in the consolidated financial statements. This is calculated using the same method as that shown in Section 1.4.1. In other words, the retained investment is revalued to fair value and the gain or loss on this revaluation forms part of the overall gain or loss on disposal. Again, the gain or loss for inclusion in the parent company's own financial statements is the difference between the proceeds and the carrying amount of the investment sold.
1.5.1 Preparation of the consolidated financial statements (subsidiary to financial asset)

In the statement of financial position:
HKFRS 10.B98-99
the investment is recognised at its fair value at the date of disposal thereafter it is accounted for in accordance with HKFRS 9 the results of the investment are pro-rated and consolidated until the date of disposal thereafter only dividend income is included a gain or loss on disposal is recognised
In the statement of comprehensive income:
1.6 Reclassification adjustments

Where control of a subsidiary is lost, any amounts recognised in other comprehensive income at the date of disposal in relation to the subsidiary should be accounted for in the same way as if the parent company had directly disposed of the assets that they relate to. Therefore where the subsidiary holds financial assets at fair value through other comprehensive income then on disposal, the amounts of other comprehensive income recorded in the consolidated accounts in relation to these are reclassified to profit or loss (recycled) and form part of the gain on disposal. If the subsidiary holds revalued assets, the revaluation surplus previously recognised in consolidated other comprehensive income should be transferred to group retained earnings.
Example: Reclassification adjustments on loss of control

In 20X7, A acquired a 100 per cent equity interest in B for cash consideration of $125,000. B's identifiable net assets at fair value were $100,000. Goodwill of $25,000 was identified and recognised.
667
Financial Reporting
In the subsequent years, B increased net assets by $20,000 to $120,000. Of this, $15,000 was reported in profit or loss and $5,000, relating to financial assets held at fair value through other comprehensive income, was reported within other comprehensive income. A then disposed of 75 per cent of its equity interest for cash consideration of $115,000. The resulting 25 per cent equity interest is classified as an associate under HKAS 28 (2011) and has a fair value of $38,000. The gain recognised in profit or loss on disposal of the 75 per cent equity interest is: Fair value of consideration received Fair value of residual interest Gain previously reported in other comprehensive income Less: net assets and goodwill derecognised Gain $ 115,000 38,000 5,000 158,000 (145,000) 13,000
Noel Co bought 80 per cent of the share capital of Fanny Co for $324,000 on 1 October 20X5. At that date Fanny Co's retained earnings balance stood at $180,000. The statements of financial position at 30 September 20X8 and the summarised statements of comprehensive income (income statements) to that date are given below: Noel Co Fanny Co $'000 $'000 Non-current assets 360 270 Investment in Fanny Co 324 Current assets 370 370 1,054 640 Equity $1 ordinary shares 540 180 Reserve 414 360 Current liabilities 100 100 1,054 640 Profit before tax Tax Profit for the year 153 (45) 108 126 (36) 90
No entries have been made in the accounts for any of the following transactions. Assume that profits accrue evenly throughout the year. It is the group's policy to value the non-controlling interests at its proportionate share of the fair value of the subsidiary's identifiable net assets. Ignore tax on the disposal. Required Prepare the consolidated statement of financial position and income statement at 30 September 20X8 in each of the following circumstances. (Assume no impairment of goodwill.) (a) (b) (c) (d) Noel Co sells its entire holding in Fanny Co for $650,000 on 30 September 20X8. Noel Co sells one quarter of its holding in Fanny Co for $160,000 on 30 June 20X8. Noel Co sells one half of its holding in Fanny Co for $340,000 on 30 June 20X8, and the remaining holding (fair value $250,000) is to be dealt with as an associate. Noel Co sells one half of its holding in Fanny Co for $340,000 on 30 June 20X8, and the remaining holding (fair value $250,000) is to be dealt with as a financial asset at fair value through other comprehensive income. (The answer is at the end of the chapter)
668
1.7 Full disposal of associate

Topic highlights
Where an associate is fully or partially disposed of, a gain or loss is recognised in the consolidated financial statements. The gain or loss on a partial disposal includes the revaluation of the retained investment.
Where an associate is disposed of in full, a gain arises in both the parent and group financial statements. The gain in the parent's financial statements is calculated in the same way as we have seen previously: proceeds less carrying amount of investment. In the consolidated financial statements, the gain or loss is calculated as: Proceeds Less: Cost of investment Share of post-acquisition profits retained by associate at disposal Impairment of investment to date Profit/(loss) In the consolidated financial statements in the year of disposal: No investment is recognised in the statement of financial position The group share of the associate's results is included in the statement of comprehensive income to the date of disposal $ X X (X) (X) X/(X) $ X
1.8 Partial disposal of associate: associate to financial asset

Where part of an associate shareholding is disposed of such that it becomes a financial asset (for example, a 40 per cent holding becomes a 10 per cent holding), then significant influence is lost. In this case a gain arises in the parent company's financial statements, calculated as before, and a gain is also calculated in the consolidated financial statements, calculated as: $ $ Proceeds X Fair value of interest retained X X Less: Cost of investment X Share of post-acquisition profits retained by associate at disposal X Impairment of investment to date (X) (X) Profit/(loss) X/(X) Note that like the gain calculation in respect of part disposals of subsidiaries, this calculation includes the fair value of the financial asset retained. Therefore, once again, the gain is made up of two elements: A gain on disposal, and A gain on the revaluation of the financial asset.
669
Financial Reporting
1.8.1 Preparation of the consolidated financial statements (associate to financial asset)

In the statement of financial position: the investment is recognised at its fair value at the date of disposal thereafter it is accounted for in accordance with HKFRS 9
In the statement of comprehensive income: the group share of the associate's results is included to the date of disposal thereafter only dividend income is included a gain or loss on disposal is recognised.
2 Step acquisitions
Topic highlights
The acquisition method is only applied when control is achieved. Therefore goodwill only arises on the acquisition of a subsidiary, either in one or a number of transactions.
When a parent company gradually builds up an investment in another company to a stage where it controls that company, this is referred to as a step acquisition. For example a company may initially purchase a 10 per cent share in a company, so achieving a financial asset accounted for in accordance with HKFRS 9 then increase the shareholding to 40 per cent, so achieving an associate investment accounted for in accordance with HKAS 28 (2011) finally increase the shareholding to 75 per cent, so achieving a subsidiary investment accounted for in accordance with HKFRS 10 and HKFRS 3 (revised).
2.1 Application of acquisition accounting

It is important to realise acquisition accounting is only applied on the date that control is achieved and therefore goodwill does not arise until this time. The date on which subsidiary status is achieved is therefore referred to as the acquisition date. Earlier in the chapter we looked at 'crossing the accounting boundary' in the context of disposals. The same 'accounting boundary' principle applies to acquisition accounting:
670
HKFRS 9
HKAS 28 (2011) / HKFRS 11
HKFRS 10
10%
40%
0% Passive
20%
Significant influence/ joint control
50%
Control
100%
Goodwill is identified and net assets remeasured to fair value only in respect of the transaction that achieved control, and not in respect of any earlier or subsequent acquisitions of equity interests. When more shares are acquired in an existing subsidiary, goodwill is not recalculated; we shall consider this situation later in the chapter.
HKFRS 3.32,41,42
2.2 Calculation of goodwill when control is acquired

Topic highlights
Where control is achieved any previously held interest is revalued to fair value; the gain or loss is recognised in profit or loss.
On the date on which control is achieved, previously held interests (measured in accordance with HKFRS 9 or HKAS 28 (2011)) are remeasured to fair value and this value is included in calculating goodwill. Any gain or loss arising from the remeasurement will be recognised in profit or loss. The calculation of goodwill now becomes: Consideration transferred Non-controlling interests Fair value of previously held interest Fair value of net assets of acquiree Goodwill $ X X X X (X) X
Example: Financial asset under HKFRS 9 becomes a subsidiary

A acquired a 75 per cent controlling interest in B in two stages. (1) In 20X3, A acquired a 15 per cent equity interest for cash consideration of $10,000. A classified the interest as financial assets at fair value through other comprehensive income in accordance with HKFRS 9. From 20X3 to the end of 20X7, A reported fair value increases of $2,000 in other comprehensive income (OCI).
671
Financial Reporting
In 20X8, A acquired a further 60 per cent equity interest for cash consideration of $60,000. A identified net assets of B with a fair value of $80,000. A elected to measure non-controlling interests at their share of net assets. On the date of acquisition, the previously-held 15 per cent interest had a fair value of $12,500. $ In 20X8, A will include $2,500 in profit or loss, being: Gain on 'disposal' re-measurement of 15% investment to fair value ($12,500 500 $12,000) Gain previously reported in OCI ($12,000 $10,000) 2,000 Total 2,500 In 20X8, A will measure goodwill as follows: Fair value of consideration given for controlling interests Non-controlling interests (25% $80,000) Fair value of previously-held interest Less: fair value of net assets of acquiree Goodwill 60,000 20,000 12,500 92,500 (80,000) 12,500
(2)
Example: Associate becomes a subsidiary

C acquired a 75 per cent controlling interest in D in two stages. (1) In 20X3, C acquired a 40 per cent equity interest for cash consideration of $40,000. C classified the interest as an associate under HKAS 28 (2011). At the date that C acquired its interest, the fair value of D's identifiable net assets was $80,000. From 20X3 to 20X7, C equity accounted for its share of undistributed profits totalling $5,000, and included its share of revaluation gain of $3,000 in other comprehensive income (OCI). Therefore, in 20X7, the carrying amount of C's interest in D was $48,000. In 20X8, C acquired a further 35 per cent equity interest for cash consideration of $55,000. C identified net assets of D with a fair value of $110,000. C elected to measure noncontrolling interests at fair value of $30,000. On the date of acquisition, the previously-held 40 per cent interest had a fair value of $50,000.
(2)
In 20X8 (ignoring any profits earned prior to the acquisition), C will include $2,000 in profit or loss, being: $ Fair value of previously-held interest 50,000 Less: carrying amount under HKAS 28 (2011) 48,000 Gain on disposal of investment in associate 2,000 The revaluation gain of $3,000 previously recognised in OCI is not reclassified to profit or loss because it would not be reclassified if the interest in D were disposed of. In 20X8, C will measure goodwill as follows: Fair value of consideration given for controlling interests Non-controlling interests (fair value) Fair value of previously-held interest Sub-total Less: fair value of net assets of acquiree Goodwill $ 55,000 30,000 50,000 135,000 (110,000) 25,000
672
2.3 Preparation of the consolidated financial statements

As we saw earlier in the chapter, a mid-year change in the status of an investment requires that its results are pro-rated and accounted for accordingly.
2.3.1 Financial asset to subsidiary

When a financial asset becomes a subsidiary: In the consolidated statement of financial position the investment is consolidated based upon the year end shareholding; goodwill is recognised on the acquisition. In the consolidated statement of comprehensive income: Until the date on which control was achieved, only dividend income is shown After the date on which control was achieved, results are consolidated
2.3.2 Associate to subsidiary

When an associate becomes a subsidiary: Again, in the consolidated statement of financial position the investment is consolidated based upon the year end shareholding; goodwill is recognised on the acquisition. In the consolidated statement of comprehensive income:
HKFRS 10.B96
Until the date on which control was achieved, the investment's results are equity accounted After the date on which control was achieved the results are consolidated.
2.4 Increased shareholding in subsidiary

Topic highlights
An increase in shareholding in an existing subsidiary is treated as a transaction between owners with an adjustment made to reserves; goodwill is not recalculated.
Where an investment goes from, for example, a 60 per cent subsidiary to an 80 per cent subsidiary, the 50 per cent threshold has not been crossed, so there is no re-measurement to fair value and no gain or loss to profit or loss for the year. The increase is treated as a transaction between owners. As with disposals, ownership has been reallocated between parent and noncontrolling shareholders. Accordingly the parent's equity is adjusted. HKFRS 10 does not give detailed guidance as to how to measure the amount to be allocated to the parent and non-controlling interests to reflect a change in their relative interests in the subsidiary. In most cases, however, the best approach is to recognise the change as the difference between the fair value of consideration paid and the decrease in non-controlling interests. (As the parent's share has increased, the NCI share has decreased.) $ Fair value of consideration paid (X) Decrease in NCI in net assets at date of transaction X Decrease in NCI in goodwill at date of transaction (Note) X Adjustment to parent's equity (X) Note. This line is only required where non-controlling interests are measured at fair value at the date of acquisition.
673
Financial Reporting
Example: Increase of shareholding in subsidiary

A parent owns an 80 per cent interest in a subsidiary which has net assets of $4,000. The carrying amount of the non-controlling interests is $800. The parent acquires an additional 10 per cent interest from the non-controlling interests for $500. The adjustment required is: $ Fair value of consideration paid (500) 400 Decrease in NCI in net assets at date of transaction (10% $4,000) Adjustment to parent's equity (100) The parent accounts for this directly in consolidated equity as follows: DEBIT CREDIT Equity non-controlling interests Equity controlling interests Cash $400 $100 $500
Example: Parent acquires non-controlling interest

In 20X8, A acquired a 75 per cent equity interest in B for cash consideration of $90,000. B's identifiable net assets at fair value were $100,000. The fair value of the 25 per cent non-controlling interests (NCI) was $28,000. Goodwill, on the two alternative bases for measuring non-controlling interests at acquisition, is calculated as follows: NCI at % of net assets $ 90,000 25,000 115,000 100,000 15,000 NCI at fair value $ 90,000 28,000 118,000 100,000 18,000
Fair value of consideration Non-controlling interests Fair value of net assets Goodwill
In the subsequent years, B increased net assets by $20,000 to $120,000. This is reflected in the carrying amount within equity attributed to non-controlling interests as follows: NCI at % of net assets $ 25,000 5,000 30,000 NCI at fair value $ 28,000 5,000 33,000
Non-controlling interests at acquisition Increase (25% $20,000) Carrying amount
In 20X8, A then acquired the 25 per cent equity interest held by non-controlling interests for cash consideration of $35,000. The adjustment to equity will be: NCI at NCI at % of net assets fair value $ $ Fair value of consideration 35,000 35,000 Carrying amount of non-controlling interests 30,000 33,000 Negative movement in parent equity 5,000 2,000 As indicated in HKFRS 3 (Revised 2008), the reduction in equity is greater where the option was taken to measure non-controlling interests at acquisition date as a proportionate share of the acquiree's identifiable net assets. The treatment has the effect of including the non-controlling interest's share of goodwill directly in equity. This outcome will always occur where the fair value basis is greater than the net asset basis at acquisition date.
674
Example: Parent acquires part of a non-controlling interest

The facts are as in the previous example: Parent acquires non-controlling interests above except that, rather than acquire the entire non-controlling interests, A acquires an additional 15 per cent equity interest held by non-controlling interests for cash consideration of $21,000. The adjustment to the carrying amount of non-controlling interests will be: NCI at NCI at % of net assets fair value $ $ Balance as in the previous example 30,000 33,000 Transfer to parent (15/25) 18,000 19,800 10% interest carried forward 12,000 13,200* The adjustment to equity will be: Fair value of consideration Change to non-controlling interests (as above) Negative movement 21,000 18,000 3,000 21,000 19,800 1,200
* It is assumed that non-controlling interests are reduced proportionately. Under the fair value 10 th option, the closing balance represents /25 of the acquisition date fair value (11,200) plus 10 per cent of the change in net assets since acquisition (2,000).
Good, whose year end is 30 June 20X9 has a subsidiary, Will, which it acquired in stages. The details of the acquisition are as follows: Holding Retained earnings Purchase Date of acquisition acquired at acquisition consideration % $m $m 1 July 20X7 20 270 120 1 July 20X8 60 450 480 The share capital of Will has remained unchanged since its incorporation at $300 million. The fair values of the net assets of Will were the same as their carrying amounts at the date of the acquisition. Good did not have significant influence over Will at any time before gaining control of Will. The group policy is to measure non-controlling interests at its proportionate share of the fair value of the subsidiary's identifiable net assets. The fair value of a 20 per cent interest on 1 July 20X8 was $130m. Required (a) (b) Calculate the goodwill on the acquisition of Will that will appear in the consolidated statement of financial position at 30 June 20X9. Calculate the profit on the derecognition of any previously held investment in Will to be reported in group profit or loss for the year ended 30 June 20X9. (The answer is at the end of the chapter)
675
Financial Reporting
Example: Step acquisition of a subsidiary

Happy acquired 25 per cent of Frankie on 1 January 20X8 for $2,020,000 when Frankie's reserves were standing at $5,800,000. The fair value of Frankie's identifiable assets and liabilities at that date was $7,200,000. Both Happy and Frankie are stock market listed entities. At 31 December 20X8, the fair value of Happy's 25 per cent stake in Frankie was $2,440,000. A further 35 per cent stake in Frankie was acquired on 30 September 20X9 for $4,025,000 (equivalent to the fair value of $14.375 per share acquired on that date) giving Happy control over Frankie. The fair value of Frankie's identifiable assets and liabilities at that date was $9,400,000, and Frankie 's reserves stood at $7,800,000. For consistency with the measurement of other shares, Happy holds all investments in subsidiaries and associates as financial assets at fair value through other comprehensive income in its separate financial statements as permitted by HKAS 27 (2011). At 31 December 20X9, the fair value of Happy's 60 per cent holding in Frankie was $7,020,000 (and total cumulative gains recognised in other comprehensive income in Happy's separate financial statements amounted to $975,000). Summarised statements of financial position of the two companies at that date show: Happy $'000 Non-current assets Property, plant and equipment Investment in Frankie Current assets Equity Share capital Reserves Liabilities 38,650 7,020 45,670 12,700 58,370 10,200 40,720 50,920 7,450 58,370 Frankie $'000 7,600 7,600 2,200 9,800 800 7,900 8,700 1,100 9,800
The difference between the fair value of the identifiable assets and liabilities of Frankie and their book value relates to the value of a plot of land. The land had not been sold by 31 December 20X9. Income and expenses are assumed to accrue evenly over the year. Neither company paid dividends during the year. Group policy is to measure non-controlling interests at the date of acquisition at their proportionate share of the net fair value of the identifiable assets acquired and liabilities assumed. No impairment losses on recognised goodwill have been necessary to date. Required (a) Prepare the consolidated statement of financial position of Happy Group as at 31 December 20X9 in the following circumstances: (i) (ii) (b) The 25 per cent interest in Frankie allowed Happy significant influence over the financial and operating policy decisions of Frankie. The other 75 per cent of shares were held by a single shareholder and Happy was allowed no influence in the running of Frankie until acquiring control.
Show the consolidated current assets, non-controlling interests and reserves figures if Happy acquired an additional 10 per cent interest in Frankie on 1 January 20Y0 for $1,200,000.
676
Solution
Parts (a)(i) and (a)(ii) to the example would generate the same overall answer. (a) HAPPY GROUP CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X9 $'000 Non-current assets Property, plant and equipment (38,650 + 7,600 + (W6) 800) 47,050 Goodwill (W2) 1,260 48,310 Current assets (12,700 + 2,200) 14,900 63,210 Equity attributable to owners of the parent Share capital 10,200 Reserves (W3)/(W4) 40,660 50,860 Non-controlling interests (W5) 3,800 54,660 Liabilities (7,450 + 1,100) 8,550 63,210 WORKINGS (1) Group structure Part (i) 1 January 20X9 SOCI 30 September 20X9 31 December 20X9
Associate Equity account /12
Consolidate 3 /12 Acquired 35% 25% + 35% = 60% Subsidiary 30 September 20X9 Consol in SOFP with 40% NCI 31 December 20X9
Had 25% associate
Part (ii) 1 January 20X9 SOCI
Consolidate 3 /12
Had 25% financial asset
Acquired 35% 25% + 35% = 60% Subsidiary
Consol in SOFP with 40% NCI
677
Financial Reporting
(2)
Goodwill Consideration transferred Non-controlling interests (9,400 x 40%) FV of P's previously held equity interest (800,000 25% $14.375) Less: Fair value of identifiable assets acq'd and liabilities assumed: Share capital Reserves Fair value adjustments (W6)
$'000
$'000 4,025 3,760 2,875 10,660
800 7,800 800 (9,400) 1,260
(3)
Consolidated reserves (if previously held as an associate) (i) Happy $'000 Per question Profit on derecognition of investment (note) Fair value movement (W6) Reserves at acquisition Share of post acqn reserves Frankie 25% (2,000 25%) Frankie 60% (100 60%) Less: Fair value gain recognised in Happy's separate FS 40,720 355 (5,800) 2,000 500 60 (975) 40,660 $'000 2,875 (2,520) 355 Frankie $'000 7,900 (7,800) 100 (7,800) 100 Frankie $'000 25% 7,800 Frankie $'000 60% 7,900
Note. Profit on derecognition of 25% associate Fair value at date control obtained (200,000 shares $14.375) P's share of carrying value [2,020 + ((7,800 5,800) 25%] (4) Consolidated reserves (if previously held as an AFSFA) (ii) Happy $'000 40,720 855 -
Per question Profit on derecognition of investment* Fair value movement (W6) Reserves at acquisition Frankie share of post acquisition reserves (100 60%) Less: Fair value gain recognised in Happy's separate FS * Profit on derecognition of 25% investment
60 (975) 40,660 $'000 2,875 (2,020) 855
Fair value at date control obtained (200,000 shares $14.375) Cost
678
Note. The profit would be the same whether the available-for-sale financial asset had been revalued or not, as any revaluation above original cost previously recognised in other comprehensive income is transferred to profit or loss. (5) Non-controlling interests Net assets at year end per question Fair value adjustment (W6) NCI share 40% = $3,800,000 (6) Fair value adjustments Measured at date control achieved (only) Land (9,400 (800 + 7,800)) (b) (i) (ii) Current assets (14,900 1,200) = $13,700 Non-controlling interests Net assets at year end per question Fair value adjustment (W8) 30% = $2,850,000 $'000 40,660 (250) 40,410 Note. No other figures in the statement of financial position are affected. Per part (a) Adjustment to parent's equity on acq'n of 10% (W) WORKING Adjustment to parent's equity on acquisition of additional 10% of Frankie $'000 Fair value of consideration paid (1,200) 950 Decrease in NCI in net assets at acq'n (9,500 10%) (250) Consolidated reserves $'000 8,700 800 9,500 At acquisition 30 September 20X9 $'000 800 Movement $'000 At year end 31 December 20X9 $'000 800 $'000 8,700 800 9,500
Example: Step acquisition of a subsidiary with non-controlling interest at fair value

The facts are the same as in the previous example, except that group policy is to measure noncontrolling interests at the date of acquisition at fair value. The fair value of the non-controlling interests at acquisition was $4,600,000.
679
Financial Reporting
Solution
Parts (a)(i) and (a)(ii) to the example would generate the same overall answer. (a) HAPPY GROUP CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X9 $'000 Non-current assets Property, plant and equipment (38,650 + 7,600 + (W2) 800) 47,050 Goodwill (W2) 2,100 49,150 Current assets (12,700 + 2,200) 14,900 64,050 Equity attributable to owners of the parent Share capital 10,200 Reserves (W3)/(W4) 40,660 50,860 Non-controlling interests (W5) 4,640 55,500 Liabilities (7,450 + 1,100) 8,550 64,050 WORKINGS (1) Group structure Part (i) 1 January 20X9 SOCI 30 September 20X9 31 December 20X9
Associate Equity account /12
Consolidate 3 /12 Acquired 35% 25% + 35% = 60% Subsidiary Consol in SOFP with 40% NCI
Had 25% associate
Part (ii) 1 January 20X9 SOCI 30 September 20X9 31 December 20X9
Consolidate 3 /12 Acquired 35% 25% + 35% = 60% Subsidiary Consol in SOFP with 40% NCI
Had 25% financial asset
680
(2)
Goodwill $'000 Consideration transferred FV NCI FV P's previously held equity interest Fair value of identifiable assets acq'd and liabilities assumed: Share capital Reserves Fair value adjustments (W6) x 60%/40%
Group $'000 4,025
NCI $'000 4,600
2,875 800 7,800 800 9,400 (5,640) 1,260 2,100 (3,760) 840
(3)
Consolidated reserves (if previously held as an associate) (i) Happy $'000 Per question Profit on derecognition of investment (Note) Fair value movement (W6) Reserves at acquisition Share of post acqn reserves Frankie 25% (2,000 x 25%) Frankie 60% (100 x 60%) Less: fair value gain recognised in Happy's separate FS 40,720 355 Frankie $'000 25% 7,800 (5,800) 2,000 500 60 (975) 40,660 $'000 2,875 (2,520) 355 Frankie $'000 60% 7,900 (7,800) 100
Note. Profit on derecognition of 25% associate Fair value at date control obtained (200,000 shares x $14.375) P's share of carrying value [2,020 + ((7,800 5,800) x 25%)] (4) Consolidated reserves (if previously held as financial assets) (ii) Happy $'000 40,720 855 -
Per question Profit on derecognition of investment (Note) Fair value movement (W6) Reserves at acquisition Frankie share of post acquisition reserves (100 60%) Less: fair value gain recognised in Happy's separate FS
Frankie $'000 7,900 (7,800) 100
60 (975) 40,660
681
Financial Reporting
Note. Profit on derecognition of 25% investment Fair value at date control obtained (200,000 shares x $14.375) Cost
$'000 2,875 (2,020) 855
Note. The profit would be the same whether the financial asset had been revalued or not, as any revaluation above original cost previously recognised in other comprehensive income is transferred to profit or loss. (5) Non-controlling interests Net assets at year end per question Fair value adjustment (W6) 40% NCI in goodwill (W2) (6) Fair value adjustments Measured at date control achieved (only) Land (9,400 (800 + 7,800)) At acquisition 30 September 20X9 $'000 800 Movement $'000 At year end 31 December 20X9 $'000 800 $'000 8,700 800 9,500 $'000
3,800 840 4,640
3 Merger accounting for common control combinations

3.1 Introduction
Topic highlights
A key issue involved in a business combination is to determine whether a particular arrangement should be classified as an acquisition or a merger (pooling of interests or uniting of interests). HKFRS 3 (revised) Business Combinations applies to all business combinations except where a combination is specifically excluded from its scope. For those business combinations outside the scope of HKFRS 3 (revised), for example, business combinations involving entities or businesses under common control, there is no specific accounting standard addressing the appropriate accounting treatment. HKFRS 3 (revised) defines a business combination involving entities or businesses under common control as 'a business combination in which all of the combining entities or businesses are ultimately controlled by the same party or parties both before and after the business combination, and that control is not transitory'. HKICPA has issued Accounting Guideline 5 (AG5) to give guidance on how such combinations should be accounted for, given that they fall outside the scope of HKFRS 3 (revised). AG5 refers to these combinations as 'common control combinations' to distinguish them from other business combinations which fall within or outside the scope of HKFRS 3 (revised). HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, contains requirements for the selection of accounting policies in the absence of a HKFRS that specifically applies to an issue. Common control combinations fall outside the scope of HKFRS 3 (revised). Accordingly, an entity selects an appropriate accounting policy in accordance with the requirements set out in
682
HKAS 8 and many entities consider that merger accounting is an appropriate accounting policy for common control combinations. AG5 sets out the basic principles and procedures of merger accounting when recognising a common control combination. It should be noted that interspersing a shell entity between a parent entity and a single subsidiary does not represent the combination of two businesses and accordingly is not addressed in AG5. In practice, these transactions may be accounted for by applying a principle similar to that for a reverse acquisition. An essential difference exists between a business combination effected by the purchase of a company's shares for cash and that executed by an exchange of shares. A business combination involving a share exchange which is characterised by a continuity of ownership is regarded as a pooling of interests of both parties rather than an acquisition, and should be accounted for differently.
3.2 The principles

The concept underlying the use of merger accounting to account for a common control combination is that no acquisition has occurred and there has been a continuation of the risks and benefits to the controlling party (or parties) that existed prior to the combination. Use of merger accounting recognises this by accounting for the combining entities or businesses as though the separate entities or businesses were continuing as before. In applying merger accounting, financial statement items of the combining entities or businesses for the reporting period in which the common control combination occurs, and for any comparative periods disclosed, are included in the consolidated financial statements of the combined entity as if the combination had occurred from the date when the combining entities or businesses first came under the control of the controlling party or parties. Where the combining entities or businesses include an entity or a business previously acquired from a third party, the financial statement items of such entity or business are only included in the consolidated financial statements of the combined entity from the date of the previous acquisition using the acquisition values recognised at that date. A single uniform set of accounting policies is adopted by the combined entity. Therefore, the combined entity recognises the assets, liabilities and equity of the combining entities or businesses at the carrying amounts in the consolidated financial statements of the controlling party or parties prior to the common control combination. If consolidated financial statements were not previously prepared by the controlling party or parties, the carrying amounts are included as if such consolidated financial statements had been prepared, including adjustments required for conforming the combined entity's accounting policies and applying those policies to all periods presented. These carrying amounts are referred to below as existing book values from the controlling parties' perspective. There is no recognition of any additional goodwill or excess of the acquirer's interest in the net fair value of the acquiree's identifiable assets, liabilities and contingent liabilities over cost at the time of the common control combination to the extent of the continuation of the controlling party or parties' interests. Similarly, in accordance with HKFRS 10, the effects of all transactions between the combining entities or businesses, whether occurring before or after the combination, are eliminated in preparing the consolidated financial statements of the combined entity.
3.3 The procedures

In the consolidated financial statements under merger accounting: (1) No adjustment is required to the carrying values of the assets and liabilities of the acquired company on consolidation, except to achieve uniformity of accounting policies of the combining companies.
683
Financial Reporting
(2) (3)
There is no distinction between pre- and post-acquisition reserves. The distributable reserves of the acquired company are not capitalised and remain distributable. The consolidated income statement includes the results of each of the combining entities or businesses from the earliest date presented (ie. including the comparative period) or since the date when the combining entities or businesses first came under the control of the controlling party or parties, where this is a shorter period, regardless of the date of the common control combination. The consolidated income statement also takes into account the profit or loss attributable to the non-controlling interests recorded in the consolidated financial statements of the controlling party. Comparative figures should be presented as if the companies had been combined throughout the previous period and at the previous reporting date unless the combining entities or businesses first came under common control at a later date. No amount is recognised as consideration for goodwill or excess of acquirer's interest in the net fair value of acquiree's identifiable assets, liabilities and contingent liabilities over cost at the time of common control combination, to the extent of the continuation of the controlling party or parties' interests. Expenditure incurred in relation to a common control combination that is to be accounted for by using merger accounting is recognised as an expense in the period in which it is incurred. Such expenditure includes professional fees, registration fees, costs of furnishing information to shareholders, and salaries and other expenses involved in achieving the common control combination. It also includes any costs or losses incurred in combining operations of the previously separate businesses. Consolidation is performed in accordance with HKFRS 10. The principal consolidation entries are as follows: (a) (b) the effects of all transactions between the combining entities or businesses, whether occurring before or after the common control combination, are eliminated; and since the combined entity will present one set of consolidated financial statements, a uniform set of accounting policies is adopted which may result in adjustments to the assets, liabilities and equity of the combining entities or businesses.
(4)
(5)
(6)
(7)
3.4 Accounting period covered by a newly formed parent

A common control combination may be effected by setting up a new parent which acquires the issued shares or equity of the combining entities or businesses in exchange for the issue of its own shares. In such cases, the first accounting period of the new parent will frequently be a period of less than a year, ending on the reporting date chosen for the group. This will normally be the existing reporting date of one or more of the combining entities or businesses. Frequently, the date of formation of the new parent will not coincide with the beginning or end of the group's accounting periods. Strictly, if the parent is a Hong Kong incorporated company, the Companies Ordinance requires the consolidated financial statements to cover the accounting period of the parent. It could be argued that this requirement prevents the disclosure of comparative information. In substance, however, where the combining entities or businesses are continuing to trade as before, but with a new legal parent, it is appropriate to prepare consolidated financial statements as if the parent had been in existence throughout the reported periods presented with a prominent footnote explaining the basis on which consolidated financial statements are prepared.
684
3.5 Disclosures in addition to those required by applicable HKFRSs

Entities applying AG5 in accounting for a common control combination using the principles of merger accounting shall disclose in their consolidated financial statements the fact that this Guideline has been used. Entities shall disclose the accounting policy applied in accounting for a common control combination by using the principles of merger accounting. Details of the accounting policy shall include, but not be limited to, a discussion of the specific principles and bases applied under merger accounting. Bearing in mind the necessity of showing a true and fair view, entities applying AG5 shall disclose in their consolidated financial statements significant details of the common control combinations. For each common control combination accounted for by using merger accounting, the following information shall be disclosed: (a) (b) (c) (d) the names of the combining entities (other than the reporting entity); the date of the common control combination; the composition of the consideration and fair value of the consideration other than shares issued; the nature and amount of significant accounting adjustments made to the net assets and net profit or loss of any entities or businesses to achieve consistency of accounting policies, and an explanation of any other significant adjustments made to the net assets and net profit or loss of any entity or business as a consequence of the common control combination; and a statement of the adjustments to consolidated reserves.
(e)
3.6 Earnings per share

Ordinary shares issued as part of a common control combination which is accounted for using merger accounting are included in the calculation of the weighted average number of shares for all periods presented because the consolidated financial statements of the combined entity are prepared as if the combined entity had always existed. Therefore, the number of ordinary shares used for the calculation of basic earnings per share in a common control combination which is accounted for using merger accounting is the aggregate of the weighted average number of shares of the entity whose shares are outstanding after the combination.
Example: Merger Accounting

Pear has three subsidiaries, Xero, Yoho and Apex. Pear acquired 100 per cent of Xero for $28,000 many years ago. At that time, Pear recorded goodwill of $13,000 and fair value of identifiable assets acquired of $15,000 (which is equal to the then carrying amounts of the assets acquired). Pear set up Yoho with a party outside the group, Shareholder S, many years ago. Pear's cost of investment in Yoho was $15,000, being 75 per cent of the share capital of Yoho. On 1 January 20X0, Pear formed a new entity, Apex, through share capital injection of $20,000. On 31 December 20X1, Apex acquired 100 per cent shareholdings in Xero and Yoho from Pear and Shareholder S. In return, Apex issued 14,000 and 6,000 ordinary shares with par value of $1 each to Pear and Shareholder S, respectively. Apex, Xero and Yoho have financial year ends of 31 December. The fair values of assets and liabilities of Yoho as at 31 December 20X1 are equal to their carrying values. Ignore any tax effect arising from the business combination.
685
Financial Reporting
Before the business combination Pear New parent entity
After the business combination Pear 85% Apex
100% Apex
100% Xero
75% Yoho
100% Xero
100% Yoho
The income statements of Apex, Xero and Yoho for the year ended 31 December 20X1 are: Apex $ Revenue Profit or loss 3,000 (5,000) Xero $ 40,000 20,000 Yoho $ 50,000 20,000
The statements of financial position of Apex, Xero and Yoho as at 31 December 20X1 are: Apex (before issue of shares) $ 13,000 13,000 20,000 (7,000) 13,000 * Apex (after issue of shares*) $ 233,000 13,000 246,000 253,000 (7,000) 246,000 Xero Yoho
Investment in subsidiaries Other assets Net assets Capital (including share premium) Accumulated profits (losses)
100,000 100,000 10,000 90,000 100,000
120,000 120,000 20,000 100,000 120,000
The 20,000 new shares issued by Apex as consideration are recorded at a value equal to the deemed cost of acquiring Xero and Yoho ($233,000). The deemed cost of acquiring Xero is $113,000, being the existing book values of net assets of Xero as at 31 December 20X1 ($100,000) plus remaining goodwill arising on the acquisition of Xero by Pear ($13,000). The deemed cost of acquiring Yoho is $120,000, being the existing book values of net assets of Yoho as at 31 December 20X1. The deemed cost used in this example is for illustrative purposes only and does not necessarily represent the value to be reported in the individual financial statements of Apex as the cost of acquiring the subsidiaries. Apex $ 2,000 (3,000) Xero $ 38,000 15,000 Yoho $ 45,000 12,000
The income statements of Apex, Xero and Yoho for the year ended 31 December 20X0 are:
Revenue Profit or loss
686
The statements of financial position of Apex, Xero and Yoho as at 31 December 20X0 are: Apex $ 18,000 20,000 (2,000) 18,000 Xero $ 80,000 10,000 70,000 80,000 Yoho $ 100,000 20,000 80,000 100,000
Net assets Capital (including share premium) Accumulated profits (losses)
Required Prepare the consolidated financial statements of Apex for the year ending 31 December 20X1 (including the comparative figures, which would be presented for 20X0).
Solution
As Apex, Xero and Yoho are under the common control of Pear before and after the business combination, the business combination is specifically excluded from the scope of HKFRS 3 (revised). The directors of Apex choose to account for the acquisition of the shareholdings in Xero and Yoho using the principles of merger accounting. Under the principles of merger accounting, the assets and liabilities of Xero and Yoho are consolidated in the financial statements of Apex using the existing book values as stated in the consolidated financial statements of Pear immediately prior to the combination. This procedure requires recording of goodwill arising on the original acquisition of Xero by Pear and non-controlling interests in Yoho as stated in the consolidated financial statements of Pear immediately prior to the combination. There is no recognition of any additional goodwill or excess of the acquirer's interest in the net fair value of the acquiree's identifiable assets, liabilities and contingent liabilities over cost at the time of this combination. The consolidated income statement of Apex for the year ended 31 December 20X1 is: Apex $ Revenue Profit or loss Attributable to the former non-controlling interests in Yoho Attributable to the equity holders of Apex Adjustment Y1 Being an adjustment to reflect the profit attributable to the non-controlling interests in Yoho prior to the combination. ($20,000 25%) 3,000 (5,000) Xero $ 40,000 20,000 Yoho $ 50,000 20,000 5,000 (Y1) Adjustments $ Adj Consolidated $ 93,000 35,000 (5,000)
30,000
687
Financial Reporting
The consolidated statement of financial position of Apex as at 31 December 20X1 is: Apex $ Goodwill Investment in Xero and Yoho Other assets Net assets Capital (including share premium) Other reserve Retained earnings Xero $ Yoho $ Adjustments Consolidated $ Adj $ 13,000 (X1) 13,000 (113,000) (X3) (120,000) (Y5) 233,000 246,000 (10,000) (20,000) (85,000) (75,000) (5,000) (25,000) (X3) (Y5) (X3) (Y5) (X2) (Y4) 253,000
233,000 13,000 246,000 253,000
100,000 100,000 10,000
120,000 120,000 20,000
(7,000) 246,000
90,000 100,000
100,000 120,000
(160,000) 153,000 246,000
Adjustments Relating to Xero: X1 Being an adjustment to record goodwill arising on the original acquisition of Xero by Pear as stated in the consolidated financial statements of Pear immediately prior to the combination ($13,000). Being an adjustment to eliminate the accumulated profits of Xero generated prior to the original acquisition of Xero by Pear ($5,000). Being an adjustment to eliminate the share capital of Xero against the related investment cost of Apex. An adjustment of $85,000 has been made to a separate reserve in the consolidated financial statements of Apex ($113,000 $28,000).
X2 X3
Relating to Yoho: Y4 Y5 Being an adjustment to reflect the profits attributable to the non-controlling interests in Yoho prior to the combination ($100,000 25%). Being an adjustment to eliminate the share capital of Yoho against the related investment cost of Apex. An adjustment of $75,000 has been made to a separate reserve in the consolidated financial statements of Apex ($120,000 75% $15,000).
The consolidated income statement of Apex for the year ended 31 December 20X0 is: Apex $ 2,000 (3,000) Xero $ 38,000 15,000 Yoho $ 45,000 12,000 3,000 (Y1) Adjustments $ Adj Consolidated $ 85,000 24,000) (3,000)
Revenue Profit or loss Attributable to the non-controlling interests Attributable to the equity holders of Apex Adjustment Y1
21,000
Being an adjustment to reflect the profit attributable to the non-controlling interests in Yoho prior to the combination ($12,000 25%).
688
The consolidated statement of financial position of Apex as at 31 December 20X0 is: Apex $ Goodwill Investment in Xero and Yoho Other assets Net assets Capital (including share premium) Xero $ Yoho $ Adjustments Consolidated $ Adj $ 13,000 (X2) 13,000 203,000 (1) (113,000) (X4) (90,000) (Y5) 198,000 211,000 203,000 (10,000) (20,000) (85,000) (75,000) 25,000 (5,000) (20,000) (1) (X4) (Y5) (X4) (Y5) (Y5) (X3) (Y5) 223,000
18,000 18,000 20,000
80,000 80,000 10,000
100,000 100,000 20,000
Other reserve
(160,000) 25,000 123,000 211,000
Non-controlling interests Retained earnings (2,000) 18,000
70,000 80,000
80,000 100,000
Note: The comparative figures are restated as if the entities had been combined at the previous end of reporting period. The consolidated share capital represents the share capital of Apex adjusted for the share capital issued for the purposes of the business combination. Adjustments (1) Being an adjustment to push back the capital issued for the purposes of the business combination ($203,000, of which $113,000 relating to Xero and $90,000 relating to Yoho). The aim of the consolidated financial statements in merger accounting is to show the combining entities' results and financial positions as if they had always been combined. Consequently, the share capital in respect of 14,000 shares issued for the purposes of the business combination has to be shown as if it had always been issued. Being an adjustment to record goodwill arising on the original acquisition of Xero by Pear as stated in the consolidated financial statements of Pear immediately prior to the combination ($13,000). Being an adjustment to eliminate the accumulated profits of Xero generated prior to the original acquisition of Xero by Pear ($5,000). Being an adjustment to eliminate the share capital of Xero against the related investment cost of Apex. An adjustment of $85,000 has been made to a separate reserve in the consolidated financial statements of Apex. Being an adjustment to eliminate the share capital of Yoho against the related investment cost of Apex. Prior to the business combination, Pear only had 75 per cent equity interest in Yoho. Non-controlling interests of $25,000 were recorded as at 31 December 20X0. An adjustment of $75,000 has been made to a separate reserve in the consolidated financial statements of Apex.
Relating to Xero: X2
X3 X4
Relating to Yoho: Y5
Earnings per share Based on the same facts as per the above example, the calculation of basic earnings per share for each period presented in the consolidated financial statements of Apex is based on the consolidated profit (excluding the profit attributable to the non-controlling interests), and on the 40,000 shares (comprising 20,000 shares of Apex in issue throughout the two years ended 31 December 20X1 and 20,000 shares of Apex issued on 31 December 20X1 as consideration for the equity interests in Xero and Yoho).
689
Financial Reporting
4 HK(IFRIC) Int-17 Distributions of Non-cash Assets to Owners

4.1 The issue
Topic highlights
When an entity declares a distribution and has an obligation to distribute the assets concerned to its owners, it must recognise a liability for the dividend payable. Consequently, this Interpretation addresses the following issues: (a) (b) (c) When should the entity recognise the dividend payable? How should an entity measure the dividend payable? When an entity settles the dividend payable, how should it account for any difference between the carrying amount of the assets distributed and the carrying amount of the dividend payable?
4.2 Key provisions

4.2.1 When to recognise a dividend payable
The liability to pay a dividend shall be recognised when the dividend is appropriately authorised and is no longer at the discretion of the entity, which is the date: (a) (b) when declaration of the dividend, eg by management or the board of directors, is approved by the relevant authority, eg the shareholders, if the jurisdiction requires such approval, or when the dividend is declared, eg by management or the board of directors, if the jurisdiction does not require further approval.
4.2.2 Measurement of a dividend payable

An entity shall measure a liability to distribute non-cash assets as a dividend to its owners at the fair value of the assets to be distributed. If an entity gives its owners a choice of receiving either a non-cash asset or a cash alternative, the entity shall estimate the dividend payable by considering both the fair value of each alternative and the associated probability of owners selecting each alternative. At the end of each reporting period and at the date of settlement, the entity shall review and adjust the carrying amount of the dividend payable, with any changes in the carrying amount of the dividend payable recognised in equity as adjustments to the amount of the distribution.
4.2.3 Accounting for any difference between the carrying amount of the assets distributed and the carrying amount of the dividend payable when an entity settles the dividend payable
When an entity settles the dividend payable, it shall recognise the difference, if any, between the carrying amount of the assets distributed and the carrying amount of the dividend payable in profit or loss.
4.2.4 Presentation and disclosures

An entity shall present the difference as a separate line item in profit or loss. An entity shall disclose the following information, if applicable: (a) the carrying amount of the dividend payable at the beginning and end of the period; and
690
(b)
the increase or decrease in the carrying amount recognised in the period as result of a change in the fair value of the assets to be distributed.
If, after the end of a reporting period but before the financial statements are authorised for issue, an entity declares a dividend to distribute a non-cash asset, it shall disclose: (a) (b) (c) the nature of the asset to be distributed; the carrying amount of the asset to be distributed as of the end of the reporting period; and the estimated fair value of the asset to be distributed as of the end of the reporting period, if it is different from its carrying amount, and the information about the method used to determine that fair value required by HKFRS 7.
691
Financial Reporting
Topic recap
A subsidiary or associate may be disposed of in its entirety or in part, so that the status of the investment changes. Where a subsidiary is disposed of in full a gain on disposal is recognised in the parent's individual and the consolidated accounts. The amount of the gain is different. The results of the subsidiary are consolidated to the date of disposal. Where control is not lost on the disposal of shares there is no gain or loss in the consolidated accounts; instead the transaction results in an adjustment to shareholders' funds. Where a subsidiary becomes an associate or financial asset, a gain or loss is recognised in the consolidated accounts. This includes the gain on the shares disposed of and the revaluation of the shares retained. Where an associate is fully or partially disposed of, a gain or loss is recognised in the consolidated financial statements. The gain or loss on a partial disposal includes the revaluation of the retained investment. The acquisition method is only applied when control is achieved. Therefore goodwill only arises on the acquisition of a subsidiary, either in one or a number of transactions. Where control is achieved any previously held interest is revalued to fair value; the gain or loss is recognised in profit or loss. An increase in shareholding in an existing subsidiary is treated as a transaction between owners with an adjustment made to reserves; goodwill is not recalculated. A key issue involved in a business combination is to determine whether a particular arrangement should be classified as an acquisition or a merger (pooling of interests or uniting of interests). When an entity declares a distribution and has an obligation to distribute the assets concerned to its owners, it must recognise a liability for the dividend payable.
692
Answer 1
Land Co's accounts Fair value of consideration received Less: carrying value of investment disposed of Profit on disposal Consolidated accounts Fair value of consideration received Less: net assets of subsidiary at disposal date goodwill at disposal date non-controlling interests at disposal date (20% $1m) + $5,000 Group profit $000 1,000 45 (205) (840) 360 $000 1,200 (980) 220 $000 1,200
Answer 2
The adjustment to equity will be: Fair value of consideration received Amount recognised as non-controlling interests (30% 120,000) Positive movement in parent equity DEBIT CREDIT Cash Non-controlling interests Parent's equity $40,000 $36,000 $4,000 $ 40,000 36,000 4,000
Note that there is no adjustment to the carrying amount of goodwill of $25,000 because control has been retained.
Answer 3
(a) Complete disposal at year end (80 per cent to 0 per cent) CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER 20X8 $000 Non-current assets 360 Current assets (370 + 650) 1,020 1,380 Equity $1 ordinary shares 540 Reserve (W2) 740 Current liabilities 100 1,380
693
Financial Reporting
CONSOLIDATED INCOME STATEMENT FOR THE YEAR ENDED 30 SEPTEMBER 20X8 $'000 279 Profit before tax (153 + 126) 182 Profit on disposal (W1) (81) Tax (45 + 36) 380 Profit attributable to: Owners of the parent 362 18 Non-controlling interests (20% 90) 380 WORKINGS (1) Profit on disposal of Fanny Co Fair value of consideration received Less: net assets at disposal Goodwill (note) NCI (540 20%) $'000 540 36 (108) (468) 182 Note. Goodwill Consideration transferred NCI: 20% (180 + 180) Net assets 180 + 180 (2) Reserve carried forward Noel per question Fanny: 80% (360 180) Profit on disposal (W1) (b) Partial disposal: subsidiary to subsidiary (80 per cent to 60 per cent) CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER 20X8 $'000 Non-current assets (360 + 270) 630 Goodwill (part (a)) 36 Current assets (370 + 160 + 370) 900 1,566 Equity $1 ordinary shares 540 Reserve (W2) 610 1,150 216 Non-controlling interests (40% 540*) Current liabilities (100 + 100) 200 1,566 * Net assets of Fanny Co $'000 Share capital 180 Reserve 360 540 $'000 324 72 396 (360) 36 $'000 414 144 182 740 $'000 650
694
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 30 SEPTEMBER 20X8 $'000 Profit before tax (153 + 126) Tax (45 + 36) Profit for the period Profit attributable to: Owners of the parent Non-controlling interests 9 20% x 90 x /12 40% x 90 x 3/12 WORKINGS (1) Adjustment to parent's equity on disposal of 20% of Fanny Fair value of consideration received Less: increase in NCI in net assets at disposal 20% (540 (3/12 90)) (2) Group retained earnings Noel Co's Reserve Adjustment to parent's equity on disposal (W1) 80% Fanny: share of post acq'n. earnings (157.5 80%) 60% Fanny: share of post acq'n. earnings (22.5 60%) $'000 414.0 56.5 126.0 13.5 610.0 Fanny 60% retained $'000 360.0 (337.5) 22.5 $'000 160.0 (103.5) 56.5 $'000 279 (81) 198 175.5 13.5 9.0 22.5 198.0 19
At date of disposal (360 (90 3/12)) Reserve at acquisition/on disposal (c)
Fanny 80% $'000 337.5 (180.0) 157.5
Partial disposal: subsidiary to associate (80 per cent to 40 per cent) CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER 20X8 Non-current assets Investment in associate (W3) Current assets (370 + 340) Equity $1 ordinary shares Reserve (W2) Current liabilities $'000 360 259 710 1,329 540 689 100 1,329
695
Financial Reporting
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 30 SEPTEMBER 20X8 Profit before tax (153 + 9/12 126) Profit on disposal (W1) Share of profit of associate (90 3/12 40%) Tax 45 + (9/12 36) Profit for the period Profit attributable to: Owners of the parent Non-controlling interests (20% 90 9/12) WORKINGS (1) Profit on disposal in Noel Co Fair value of consideration received Fair value of 40% investment retained Less: Net assets when control lost ((540 (90 3/12)) Goodwill (part (a)) NCI (517.5 20%) $'000 $'000 340 250 $'000 247.5 140.0 9.09 (72.0) 324.5 311.0 13.5 324.5
517.5 36 (103.5) (450) 140
(2)
Group reserve
At date of disposal Group profit on disposal (W1) Fanny: share of post acquisition earnings (157.5 80%) Fanny: share of post acquisition earnings (22.5 40%) At date of disposal (360 (90 3/12))/per question Retained earnings at acquisition/ on disposal (3) Investment in associate
Noel Reserve $'000 414 140 126 9 689 414 414
Fanny $'000
Fanny 40% Reserve $'000
337.5 (180.0) 157.5
360.0 (337.5) 22.5 $'000 4250 9 259
Fair value at date control lost (new 'cost') Share of post acquisition reserves (90 3/12 40%)
696
(d)
Partial disposal: subsidiary to financial asset (80 per cent to 40 per cent) CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER 20X8 $'000 Non-current assets 360 Investment 250 Current assets (370 + 340) 710 1,320 Equity $1 ordinary shares 540 Reserve (W) 680 Current liabilities 100 1,320 CONSOLIDATED INCOME STATEMENT FOR THE YEAR ENDED 30 SEPTEMBER 20X8 $'000 247.5 Profit before tax (153 + (9/12 126)) Profit on disposal (See (c) above) 140.0 9 (72.0) Tax (45 + ( /12 36)) Profit for the period 315.5 Profit attributable to: Owners of the parent Non-controlling interests WORKING Reserve Noel Co's reserve Group profit on disposal (W1) Fanny: share of post acquisition reserve (157.5 80%) $'000 414 140 126 680 Fanny $'000 337.5 (180.0) 157.5 302.0 13.5 315.5
At date of disposal (360 (90 3/12)) Reserve at acquisition
Answer 4
(a) Goodwill (at date control obtained) Consideration transferred Non-controlling interests (750 20%) Fair value of previously held equity interest Less: Fair value of identifiable assets acquired and liabilities assumed Share capital Retained earnings $m $m 480 150 130 760
300 450 7
(750) 10 $m 130 (120) 10
(b)
Profit on derecognition of investment Fair value at date control obtained Cost
697
Financial Reporting
Exam practice
Most Capital Limited
54 minutes
Assume that you are Ms. Pindy Lee, the accounting manager of Most Capital Limited ('MCL'). MCL is a company incorporated and listed in Hong Kong and is principally engaged in the manufacturing of sanitary ware. As at 1 April 20X7, MCL had two subsidiaries, First Successful Limited ('FSL') and Second Winning Limited ('SWL'). A summary of the acquisitions of these subsidiaries by MCL is as follows: % acquired 70 60 Cost of investment $'000 20,000 10,000 Retained earnings at acquisition date $'000 15,000 7,000 Net assets at acquisition date $'000 25,000 15,000
Date of acquisition FSL SWL 31 March 20X6 31 March 20X6
The fair value of the identifiable net assets of these subsidiaries at the respective date of acquisition was the same as the carrying amount of those assets. All goodwill arising on the acquisitions was found to be fully impaired so was written off in the consolidated financial statements for the year ended 31 March 20X7. The retained earnings of MCL, FSL and SWL, as at 31 March 20X7, were $32 million, $20 million and $8 million respectively. The companies did not have any reserves other than retained earnings. The details of the issued share capital of MCL, FSL and SWL as at 31 March 20X7 are as follows: Issued capital $ million 60 10 8 Number of shares million 10 5 8 Par value per share $ 6 2 1
MCL FSL SWL
MCL made a rights issue of one share for every two ordinary shares that was fully exercised on 1 January 20X8. The exercise price was $9 per share and the fair value of one ordinary share of MCL immediately before the rights issue was $12. The issued share capital of FSL and SWL has not changed since their acquisition by MCL. The following table summarises information from the three companies' income statements for the year ended 31 March 20X8:
698
Revenue Cost of sales Gross profit Distribution costs Administrative expenses Depreciation and amortisation Profit from operations Finance costs Profit before tax Tax Profit for the year
MCL $'000 300,000 (243,000) 57,000 (15,000) (10,000) (3,000) 29,000 (4,000) 25,000 (7,000) 18,000
FSL $'000 140,000 (112,000) 28,000 (7,500) (5,000) (1,500) 14,000 (2,000) 12,000 (5,000) 7,000
SWL $'000 72,500 (58,000) 14,500 (4,000) (2,500) (1,000) 7,000 (1,000) 6,000 (2,000) 4,000
On 30 September 20X7, MCL sold 2.4 million shares in SWL for $8 million. The gain on this disposal has not been included in the above income statements. The fair value of the remaining holding was $5 million at the date of disposal. On 31 March 20X8, MCL sold all its plant and equipment, with an original purchase cost of $20 million and a carrying amount of $12 million, to a bank for its fair value of $16 million cash. MCL then leased the plant and equipment back from the bank under a finance lease over four years. The lease arrangement called for annual year-end payments of $1.6 million. At the end of the lease term, the bank is obligated to return the plant and equipment to MCL at an amount that has the overall effect, taking into account the lease payments, of providing the bank with a yield of the best lending rate minus 1 per cent per annum. The remaining useful lives of the plant and equipment at 31 March 20X8 ranged from 8 to 10 years. No entries relating to the disposal have been recorded by MCL and the group. During the year ended 31 March 20X8, FSL sold goods to MCL at an invoiced value of $1 million. FSL usually sold goods at cost plus 25 per cent. Half of the goods were still held in MCL's inventory at 31 March 20X8. MCL has adopted an accounting policy which depreciates plant and equipment using the straightline method over a 10-year life with no residual value. It is also the group's policy that interests in subsidiaries and associates are carried at cost in the separate financial statements and noncontrolling interests are valued using the proportion of net assets method. SWL's results for the six months ended 30 September 20X7 were exactly half of its annual results in the year ended 31 March 20X8. You have then added the gain on disposal of investment in SWL into MCL's financial statements and prepared draft consolidated financial statements of MCL for the year ended 31 March 20X8. After you sent these draft consolidated financial statements to MCL's directors for review, one of the directors, who is not a certified public accountant, sent you an e-mail as follows:
699
Financial Reporting
To: Pindy LEE, Accounting Manager, MCL From: Faria LEE (Director) c.c.: Beverly CHOW, Emily WILSCON, Charmaine YUEN (Directors) Date: 18 May 20X8 Consolidated financial statements of MCL as at 31 March 20X8 Could you please clarify the following points relating to MCL's draft consolidated financial statements which I have just reviewed. (a) So far as I understand, we have already disposed of all our plant and equipment. I am not aware that we have purchased any new plant and equipment. Why is there still an amount of HK$12 million of plant and equipment in the consolidated statement of financial position? I find two new items, namely an 'Investment in an associate' in the consolidated balance sheet and a 'Share of profit of an associate' in the consolidated income statement for the year ended 31 March 20X8. Why are these items with the consolidated financial statements? I note that the amount of gain on disposal of our investment in SWL as shown in our separate income statement and that in the consolidated income statement are different. Why is there such a difference? I note that MCL made a rights issue during the year. Will this have any impact on the EPS of MCL for the year?
(b)
(c)
(d)
I would appreciate your clarification in time for the upcoming board meeting. Best regards, Faria Required Prepare a memorandum in response to the issues raised by Ms. Faria LEE. In your memorandum, you should: (a) (b) (c) discuss the reasons for the amount of HK$12 million of plant and equipment as shown in the consolidated statement of financial position; (5 marks) discuss how MCL should account for its interest in SWL before and after the disposal of the 2.4 million shares in SWL (no computation is expected in this part); (10 marks) discuss why the amount of the gain on disposal of the investment in SWL as shown in the separate income statement and in the consolidated income statement is different; and (5 marks) discuss with appropriate calculation, the impact of the rights issue on the earnings per share of MCL for the year ended 31 March 20X8. (10 marks) (Total = 30 marks) HKICPA February 2008 (amended)
(d)
700
Answers to exam practice questions
701
Financial Reporting
702
Chapter 1 Legal environment

The statement given by the executive director is incorrect. Section 123 of the Companies Ordinance requires every company to prepare a statement of financial position which gives a true and fair view of the state of affairs of the company as at the end of its financial year and a statement of comprehensive income which gives a true and fair view of the company for the financial year. Directors are responsible for ensuring that the financial statements are accurate and presented in accordance with the laws and regulations (eg Companies Ordinance and Rules governing the Listing of Securities of The Stock Exchange of Hong Kong Limited) that apply to the company. Directors of a company must take all reasonable steps to ensure that proper books and accounts are kept so as to give a true and fair view of the state of affairs of the company, and explain its transactions. The role of the directors carries a high level of responsibility in respect of financial reporting although they can employ a professional accountant and delegate the task to the professional accountant. The statement given by the financial controller is incorrect. The financial controller, being a professional accountant in business, involved in the preparation and reporting of the financial or management information made public and used by others inside or outside the listed company is expected to observe the same fundamental principles set out in the Code of Ethics for Professional Accountants (the 'Code') and the same standards of behaviour and competence as applied to other certified public accountants who work in practising offices. Section 320.1 of the Code states that a professional accountant in business should prepare or present the financial information fairly, honestly and in accordance with relevant professional standards so that the information will be understood in its context. Section 320.2 states that a professional accountant in business who has responsibility for the preparation or approval of the general purpose financial statements of an employing organisation should ensure that those financial statements are presented in accordance with the applicable financial reporting standards. HKAS 36.10 requires that irrespective of whether there is any indication of impairment, an entity shall test goodwill acquired in a business combination for impairment annually. A failure to perform such impairment tests for the purpose of the preparation of the financial statements constitutes non compliance with financial reporting standards. If the failure was due to the threats to compliance with the fundamental principles, section 320.6 of the Code states that where it is not possible to reduce the threat to an acceptable level, a professional accountant in business should refuse to remain associated with information they consider is, or may be, misleading.
Chapter 2 Financial reporting framework

(a) Hong Kong Financial Reporting Standards (HKFRSs) includes all Hong Kong Financial Reporting Standards, Hong Kong Accounting Standards (HKASs) and Interpretations issued by the Hong Kong Institute of Certified Public Accountants (the HKICPA) and currently in issue. HKFRSs set out recognition, measurement, presentation and disclosure requirements for transactions and events that are important for all general purpose financial statements. They may also set out requirements for transactions and events that arise in specific industries. The application of HKFRSs, with additional disclosure when necessary, is presumed to result in financial statements that give a true and fair view. 703
Financial Reporting
Accounting Guidelines (AGs) have effect as guidance statements and indicators of best practice. They are persuasive in intent. Unlike HKFRSs, AGs are not mandatory, but are consistent with the purpose of HKFRSs in that they help define accounting practice in the particular area or sector to which they refer. Therefore, they should normally be followed, and members of the HKICPA should be prepared to explain departures if called upon to do so. (b) Relevance is one of the fundamental qualitative characteristics that make the information provided in the financial statements useful to users. The relevance of information is affected by its materiality. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. It is immaterial and, therefore, irrelevant if it would have no impact on a decision maker. In short, it must make a difference or it need not be disclosed. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. It is difficult to provide firm guidance to judge when a given item is or is not material. Materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.
Chapter 3 Small company reporting

(a) Advantages Although originally designed to be suitable for all types of entity, Hong Kong Financial Reporting Standards (HKFRSs) have in recent years become increasingly complex. They are now designed primarily to meet the information needs of institutional investors in large listed entities. In contrast the shareholders of smaller private entities are often also directors. Through managing the company and maintaining the financial records, they are already aware of the companys financial performance and position and so do not need the level of detail in financial statements required by external institutional investors of larger companies. The main external users of SMEs tend to be lenders, trade suppliers and the tax authorities. They have different needs from institutional investors and are more likely to focus on shorter-term cash flows, liquidity and solvency. It can be argued that full HKFRS are too complex for the preparers of private entity accounts to understand. In particular, they tend to include a sizeable amount of implementation guidance and disclosure requirements appropriate for public companies. Unlike full HKFRS, choice is largely omitted from the HKFRS for Private Entities, so making financial statements prepared under it more comparable. The management of many private entities feel that following full HKFRS places an unacceptable burden on them a burden that has been growing as HKFRS become more detailed and more countries adopt them. The cost of following full HKFRS often appears to outweigh the benefits. The disclosure requirements of full HKFRS are very extensive and as such, can result in information overload for the users of unlisted company accounts, reducing the understandability of financial statements. The disclosure requirements of the HKFRS for Private Entities are greatly reduced in comparison.
704
Disadvantages From a practical perspective, the changeover from full HKFRS to the simplified HKFRS for Private Entities, will require training and possible changes in systems. This will place both a time and cost burden on entities choosing to make the change. If eligible entities adopt the simplified HKFRS for private entities, their accounts will no longer be comparable with other companies following full HKFRS, whether they are listed companies or private entities choosing not to switch to the HKFRS for PEs. This may make it harder to attract investors. Full HKFRS are well established and act as a form of quality control where financial statements are prepared in accordance with them. It could therefore be argued that financial statements which do not comply with full HKFRS will lose their credibility. The HKFRS for Private Entities reduces disclosures required by full HKFRS substantially. Although this has many benefits, there is a risk that the omission of certain key information might actually make the financial statements harder to understand.
Conclusion The board believes that the advantages for private entities of having a separate simplified set of HKFRSs outweigh the disadvantages. They believe that both preparers and users of private entity accounts will benefit. (b) Examples of full HKFRS with choice 1 HKFRS 3 (revised) Business Combinations requires goodwill to be calculated as the excess of consideration plus the non-controlling interest over the fair value of the net assets of the acquiree. It allows an entity to measure the non-controlling interest at either fair value or as a share of net assets at acquisition. This choice of measurement method impacts the value of goodwill calculated, with measurement of the NCI at fair value resulting in full goodwill, and measurement of the NCI as a proportion of net assets resulting in partial goodwill. The HKFRS for Private Entities requires that goodwill is calculated as the excess of cost over the share of the fair value of net assets acquired ie the non-controlling interest is excluded from the calculation. Therefore goodwill recognised is always partial goodwill. This avoids the need for private entities to determine the fair value of the non-controlling interests not purchased when undertaking a business combination. 2 HKAS 16 Property, Plant and Equipment allows assets to be held under the cost or revaluation model. The HKFRS for Private Entities does not permit the application of the revaluation model. 3 HKAS 19 Employee Benefits allows three possible treatments for the recognition of actuarial gains and losses on defined benefit pension plans: (1) (2) (3) Immediate recognition in profit or loss Immediate recognition in other comprehensive income Deferred recognition using the 10 per cent corridor method
The HKFRS for Private Entities allows either of the first two methods, however does not allow the deferral option. The recognition of actuarial gains and losses in other comprehensive income is one of the rare uses of other comprehensive income in the HKFRS for Private Entities. 4 HKAS 38 Intangible Assets allows either the cost model or revaluation model (where there is an active market). The HKFRS for Private Entities does not permit the revaluation model to be used.
705
Financial Reporting
HKAS 40 allows either the cost model or fair value model (through profit or loss) to be applied to investment properties. The HKFRS for Private Entities requires the fair value model (through profit or loss) to be used as long as fair value can be measured without undue cost or effort. This promotes consistency in the treatment of investment properties between private entities financial statements.
Examples of HKFRSs with complex recognition and measurement requirements 1 HKFRS 3 Business Combinations requires goodwill to be tested annually for impairment. This requires the assets of the business to be combined into cash-generating units or even a group of cash-generating units in order to determine any impairment loss. The impairment must then be allocated to goodwill and the other individual assets. This is a complex exercise. The HKFRS for Private Entities requires goodwill to be amortised instead. This is a much simpler approach and the HKFRS for Private Entities specifies that if an entity is unable to make a reliable estimate of the useful life, it is presumed to be ten years, simplifying things even further. 2 HKAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires grants to be recognised only when it is reasonably certain that the entity will comply with the conditions attached to the grant and the grants will be received. Grants relating to income are recognised in profit or loss over the period the related costs are recognised in profit or loss. Grants relating to assets are either netted off the cost of the asset (reducing depreciation by the amount of the grant over the asset's useful life) or presented as deferred income (and released to profit or loss as income over the useful life of the asset). The HKFRS for Private Entities simplifies this and specifies that where there are no specified future performance conditions, the grant should be recognised as income when it is receivable. Otherwise, it should be recognised as income when the performance conditions are met. 3 HKAS 23 Borrowing Costs requires borrowing costs relating to qualifying assets to be capitalised for the period of construction. Where general borrowings are used to fund construction, a complex calculation to establish the weighted average cost of capital is required. The HKFRS for Private Entities requires all borrowing costs to be expensed, so removing the need for such a complex calculation. 4 HKAS 36 Impairment of Assets requires annual impairment tests for goodwill, intangible assets with an indefinite life, and intangible assets not yet available for use. This is a complex, time-consuming and expensive test. The HKFRS for Private Entities only requires impairment tests where there are indicators of impairment. The full HKFRS also requires impairment losses to be charged firstly to other comprehensive income for revalued assets then to profit or loss. The HKFRS for Private Entities requires all impairment losses to be recognised in profit or loss, given that tangible and intangible assets cannot be revalued under the HKFRS for Private Entities. 5 HKAS 38 Intangible Assets requires internally generated assets to be capitalised if certain criteria (proving future economic benefits) are met. Testing these criteria for each type of internally generated asset is both onerous and judgemental, and in practice leads to inconsistency with some items being expensed and some capitalised. The HKFRS for Private Entities removes these capitalisation criteria and requires all internally generated research and development expenditure to be expensed through profit or loss.
706
Chapter 4 Non-current assets held for sale and discontinued operations

HKAS 36.18 defines the recoverable amount as the higher of an assets or cash-generating unit's fair value less costs to sell and its value in use. Rocket Running Limited ('RR') as a disposal group with an estimated fair value less costs to sell of HK$85,000,000 HKFRS 5.23 requires an impairment loss recognised for a disposal group to reduce the carrying amount of the assets in the group that are within the scope of the measurement requirements of the HKFRS, in order of allocation set out in HKAS 36.104 and 122. The allocation of the impairment loss is as follows: Carrying amount reported immediately before classification as held for sale Goodwill Intangible assets Property, plant and equipment Inventories Trade receivables Financial assets held for trading TOTAL HK$000 2,400 12,500 48,300 16,600 4,500 8,000 92,300 Allocation of impairment loss Carrying amount after allocation of impairment loss HK$000 -11,493 44,407 16,600 4,500 8,000 85,000
HK$000 (2,400) (1,007) (3,893)
(7,300)
An impairment loss of HK$7,300,000 (HK$92,300,000 less HK$85,000,000) should be recognised when the group is initially classified as held for sale. The impairment loss reduces the amount of goodwill first. The residual loss is allocated to other non-current assets to which the measurement requirements of HKFRS 5 are applicable pro rata based on the carrying amounts of these assets (i.e. intangible assets and property, plant and equipment). Closure of the retailing operation of Soft Walking Limited ('SW') and abandonment of noncurrent assets Super Shoes Limited should not classify the non-current assets of SW as held for sale that are to be abandoned as their carrying amount would be recovered principally through continuing use. There is an indication that the assets of SW may be impaired and the recoverable amount should be estimated in accordance with HKAS 36.18 to 23. Irrespective of whether there is any indication of impairment, goodwill should be tested for impairment annually in accordance with HKAS 36.80 to 99.
707
Financial Reporting
The recognition of impairment loss is as follows: Carrying amount reported immediately before impairment HK$000 2,700 18,800 6,400 1,300 29,200 Impairment loss recognised Carrying amount after allocation of impairment loss HK$000 --3,840 1,300 5,140
Goodwill Property, plant and equipment Inventories Trade receivables TOTAL
HK$000 (2,700) (18,800) (2,560) (24,060)
Goodwill and property, plant and equipment are considered fully impaired as both the fair value less costs to sell and value in use are nil. Inventories are stated at net realisable value of 60 per cent of the cost in accordance with HKAS 2.9.
Chapter 5 Property, plant and equipment

Hotel Property One Land use right is accounted for as an operating lease under HKAS 17. Carrying amount as at 31 December 20X5 = RMB45,000,000 (1 2.5/75) = RMB43,500,000. An owner-managed hotel is owner-occupied property, rather than investment property. Accordingly, the building is treated as property, plant and equipment under HKAS 16 and measured by the cost model. Cost of the building (capitalised the amortisation of land cost over the development period) = RMB303,000,000 + [45,000,000 1.5/75] = RMB303,900,000. Accumulated depreciation up to 31 December 20X5 (1 full year) = RMB303,900,000/ 50 1 = RMB6,078,000. Carrying amount as of 31 December 20X5 = RMB303,900,000 6,078,000 = RMB297,822,000. Hotel Property Two The land use right is accounted for as an operating lease under HKAS 17.
708
Carrying amount as of 31 December 20X5 = RMB48,000,000 (1 2.25/60) = RMB46,200,000. The building is held to earn rental without provision of any ancillary services to the occupant. Accordingly, the building is treated as investment property under HKAS 40 and stated at fair value as of 31 December 20X5. Carrying amount = fair value = RMB340,000,000. Under HKAS 17, separate measurement of the land and buildings elements is not required when the lessee's interest in both land and buildings is classified as an investment property in accordance with HKAS 40 and the fair value model is adopted. Accordingly, there is an alternative treatment to state the whole property, ie both land and building, at RMB440,000,000 (RMB100,000,000 + 340,000,000).
Chapter 6 Investment property

Building A Warehouse As a warehouse for storage of inventories, it was accounted for as property, plant and equipment under HKAS 16 prior to the vacating of the warehouse. At 31 December 20X7, this building should continue to be classified as property, plant and equipment after removal of the inventories to the new production plant in Shenzhen as CLL has no intention of selling it. Accordingly, the building is carried at cost less any accumulated depreciation and any accumulated impairment loss. Cost less accumulated depreciation: $20 million (1 (8/30)) = $14.67 million. As the fair value of the building ($28 million) is higher than the cost less accumulated depreciation ($14.67 million), no impairment is recognised. Building B Director's quarter As a director's quarter, it was formerly accounted for as property, plant and equipment under HKAS 16 prior to being vacated. At 31 December 20X7, this building should be classified as a non-current asset held for sale under HKFRS 5 as its carrying amount will be recovered principally through a sale transaction rather than through continuing use. The building was available for immediate sale in its present condition subject only to the terms that are usual and customary for sales of such assets as it had already been vacated. Also, as the management of CLL had made the decision to sell the building in a board meeting and appointed a property agent to actively identify potential buyers, it can assume that a sale is highly likely. At 31 December 20X7, the building should be measured at the lower of carrying amount and fair value less costs to sell. Carrying amount = $36 million (1 (10/30)) = $24 million. Fair value less costs to sell = $22 million (1 0.5%) = $21.89 million. Accordingly, Building B is stated at $21.89 million on the statement of financial position as at 31 December 20X7. Building C Earning rental income As a building held for earning rental income, it was accounted for as investment property under HKAS 40 prior to being vacated.
709
Financial Reporting
As in the case of Building B, this building should be classified as a non-current asset held for sale under HKFRS 5. According to HKFRS 5.5, the measurement provisions of HKFRS 5 do not apply to the non-current assets that are accounted for in accordance with the fair value model in HKAS 40. Since CLL accounts for investment property at fair value model, Building C will continue to be measured in accordance with HKAS 40. The fair value of Building C at 31 December 20X7 is $22 million.
Chapter 7 Government grants

The $10,000,000 government grant falls under the requirements of HKAS 20 Accounting for Government Grants and Disclosure of Government Assistance, which defines government grants as assistance by government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. According to HKAS 20, PMT should not recognise the grant until there is reasonable assurance that it will comply with the conditions attaching to them and the grants will be received. That is, if PMT has no plan, or it is unlikely that PMT will meet the employment targets within the next four years, PMT should not recognise the government grant. If there is reasonable assurance that PMT will comply with the conditions, PMT should recognise the government grant as income over the periods necessary to match the grant with the related costs which it is intended to compensate, ie the $25,000,000 acquisition cost of the equipment, on a systematic basis. PMT may either set up the government grant as deferred income of $10,000,000 and amortise it over eight years on a straight-line basis; or PMT may deduct the government grant of $10,000,000 in arriving at the carrying amount of the equipment for its research and development centre, ie the initial carrying amount of the equipment would be $15,000,000.
Chapter 8 Intangible assets and impairment of assets

20X220X3 HKAS 38 would require the $15m expenditure to be written off as an expense. It is original investigation into the prospect of developing a new engine. Once written off the expenditure cannot then be capitalised in future. 20X4 All indications are that there is a commercially viable project; in that (HKAS 38): it appears technically feasible, Revolution Co. intends to complete and sell the design, future economic benefits appear probable, the board made resources available to complete the design, and expenditure can be reliably measured. Only $45m would be capitalised. The remaining $10m (overheads and staff training) must be written off as an expense. No amortisation will be provided as the project is not complete. 20X5 The extra $5m staff costs will be capitalised. As the project is complete and has been marketed the company may amortise over five years; ie $50m/5 = $10m pa. The launch party costs of $1m will be written off. The event on April 1 20X6 will not affect the financial statements as it happened after the date the accounts were published (and therefore signed). Therefore HKAS 10 does not apply.
710
20X6
This is not, as the technical director suggests, a change in accounting policy as it is not the result of a decision to provide more relevant and reliable information (HKAS 8). However, it could be looked upon as the correction of a prior period error under HKAS 8; in that such an error arises from 'failure to use, or misuse of, reliable information thatcould reasonably be expected to have been obtained and taken into account' . The fact that the manufacturer and independent engineer could spot the flaw seems to suggest that reliable information could have been obtained. If this view is accepted then the opening comparative figure for retained earnings have been overstated and will have to be reduced by the asset's carrying value of $40m ($50m $10m).
However, if the intention in HKAS 8 is that an error occurs only in the 'use... or misuse...' of information that is first and foremost reliable, then the April 1 event will result in the carrying value of the design ($40m) being impaired and therefore must be written down to zero (via income) under HKAS 36.
Chapter 9 Leases
(a) Purchase option regarding classification of the lease by SRC According to HKAS 17.10, if the lessee (SRC) has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised, it would normally lead to a lease being classified as a finance lease. The option price is $10,000. In view of the fact that SRC estimated the economic useful life of the leased equipment to be eight years while the lease term is just five years, plus the fair value of the leased equipment at 1 January 20X7 is $227,500, it is reasonable to expect that the option price is sufficiently lower than the then fair value after five years. Therefore, SRC should classify the lease as a finance lease. (b) 12.93 per cent is the implicit rate that, at the inception of the lease, causes the aggregate present value of the minimum lease payment and the unguaranteed residual value to be equal to the fair value of the leased asset: Present Annual Unguaranteed value lease residual at implicit rate Date payment value 12.93% $ $ $ 01/01/20X7 53,069 53,069 = 53,069 / (1.1293)1 01/01/20X8 53,069 46,993 01/01/20X9 01/01/20Y0 01/01/20Y1 31/12/20Y1 53,069 53,069 53,069 30,000 41,612 36,848 32,629 16,333 227,484 Year Balance of lease net investment at 1 Jan $ 227,500 196,985 162,524 123,608 79,660 Annual lease payment at 31 Dec $ 53,069 53,069 53,069 53,069 53,069 Interest 12.93% $ 22,554 18,608 14,153 9,121 3,438 Balance of lease net investment at 31 Dec $ 196,985 162,524 123,608 79,660 30,029
= 53,069 / (1.1293)2 = 53,069 / (1.1293)3 = 53,069 / (1.1293)4 = 30,000 / (1.1293)5
20X7 20X8 20X9 20Y0 20Y1
711
Financial Reporting
(c)
Journal entries that TMI should make for each of the years ended 31 December 20X7 and 20X8: 20X7 DEBIT Lease payment receivable CREDIT Revenue to record the revenue and the lease payment receivable for the finance lease of the equipment. DEBIT Cost of sales CREDIT Inventory to record the cost of sales for the finance lease of the equipment. DEBIT Cash CREDIT Lease payment receivable to record the receipt of the lease payment. DEBIT Lease payment receivable CREDIT Interest income to record the interest income for the year recognised at the implicit rate. 20X8 DEBIT Cash CREDIT Lease payment receivable to record the receipt of the lease payment. DEBIT Lease payment receivable CREDIT Interest income to record the interest income for the year recognised at the implicit rate. $ 227,500 $ 227,500
200,000 200,000 53,069 53,069 22,554 22,554
53,069 53,069 18,608 18,608
712
Chapter 10 Inventories
Adjustment Add to inventory value $ Subtract from inventory value $ 206
Item (a)
Explanation Cost $2,885. Net realisable value $(3,600 921) = $2,679. The inventory should be valued at the lower of cost and NRV. Since NRV is lower, the original valuation of inventories (at cost) will be reduced by $(2,885 2,679) Inventory issued on sale or return and not yet accepted by the customer should be included in the valuation and valued at the lower of cost and NRV, here at $5 each (cost) The cost ($7.30) is below the current and foreseeable selling price ($10 or more) which is assumed to be the NRV of the item. Since the current valuation is at the lower of cost and NRV, no change in valuation is necessary
(b)
1,500
(c)
1,500 $
206 $ 153,699
Original valuation of inventories, at cost Adjustments and corrections: To increase valuation To decrease valuation Valuation of inventories for the annual accounts
1,500 (206) 1,294 154,993
Chapter 11 Provisions, contingent liabilities and contingent assets

(a) Under HKAS 37, a provision should be recognised when and only when: An entity has a present obligation (legal or constructive) as a result of a past event, and it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and a reliable estimate can be made of the amount of the obligation. According to HKAS 37.19, it is only those obligations arising from past events that exist independently of the reporting entity's future actions that are recognised as provisions. The provision for the late delivery penalty is a provision for future operating losses as the delivery date of the 7,000,000 units of rechargeable battery is 31 August 20X8. Since the delivery will be expected on 10 September 20X8, the compensation per unit will be $0.1 per unit (10 days $0.01) and the total compensation will be $700,000. This compensation will reduce the expected gross profit, but will not result in an onerous contract for DCL. Accordingly, no provision is required for this late delivery penalty as at 30 June 20X8. (b) As at 30 June 20X8, DCL has no obligation to perform the safety inspection of the production line, accordingly no provision should be recognised. The cost for the inspection should be recognised as expense when incurred.
713
Financial Reporting
OR The information provided in the question has not stated whether DCL, by an established pattern of past practice, published policies or a sufficiently specific current statement, has indicated to other parties that it must carry out the safety inspection on an annual basis and therefore, it has created a valid expectation on the other parties in respect of this activity. If there is evidence to prove the above, this can be considered as a constructive obligation and therefore a provision should be provided. (c) Any future loss on sales of aged finished goods should be considered in the measurement of the net realisable value of the inventory under HKAS 2 instead of HKAS 37. The net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Sales of finished goods at a price below the cost immediately after the date of the statement of financial position (July 20X8) is a strong indicator of the amount of net realisable value at 30 June 20X8. Accordingly, this should be recorded as a write down of inventories and no separate provision should be recognised in the current liabilities. (d) DCL has an obligation to pay the bonus to two executive directors in accordance with the directors' service contract. It should be possible to make a reliable estimate of the provision amount based on the amount of profit before tax and the accrued bonus. Accordingly, a provision should be recognised as at 30 June 20X8.
Chapter 12 Construction contracts

(a) The statement is incorrect. HKAS 11.22 states that when the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract shall be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the end of reporting period. HKAS 11.25 states that the recognition of revenue and expenses by reference to the stage of completion of a contract is often referred to as the percentage of completion method. Under this method, contract revenue is matched with the contract costs incurred in reaching the stage of completion, resulting in the reporting of revenue, expenses and profit which can be attributed to the proportion of work completed. This method provides useful information on the extent of contract activity and performance during a period. Even when the outcome of a construction contract cannot be estimated reliably, revenue shall be recognised only to the extent of contract costs incurred that it is probable will be recoverable and contract costs shall be recognised as an expense in the period in which they are incurred. (HKAS 11.32) Under both circumstances, an expected loss on the construction contract shall be recognised as an expense immediately when it is probable that total contract costs will exceed total contract revenue. (HKAS 11.22, 32 and 36) (b) It is considered that the outcome of the Waterfall Golf Villa construction contract can be estimated reliably as: (i) (1) (2) the total contract revenue can be measured reliably. evidence/indicator: contract sum has been agreed upfront between VC and the employer.
714
(ii)
(1) (2)
it is probable that the economic benefits associated with the contract will flow to the entity. evidence/indicator: VC has collected the contracted instalment from the employer on time. both the contract costs to complete the contract and the stage of contract completion at the end of reporting period can be measured reliably. evidence/indicator: the information given indicated that VC has reassessed the total costs against with the original bid estimate and forecast that the total cost would increase because the price of construction material has been 15 per cent higher than the price in the budget. Besides, it is stated that 60 units have been completed and the remaining 20 units are expected to be completed in the last quarter of 20X9. the contract costs attributable to the contract can be clearly identified and measured reliably so that actual costs incurred can be compared with prior estimates. evidence/indicator: same as (iii).
(iii)
(1) (2)
(iv)
(1)
(2) (i) (ii)
The stage of completion of the contract may be determined by reference to: the proportion that contract costs incurred for work performed to date bear to the revised estimated total contract costs. completion of a physical proportion of the contract work (ie 60 units completed and 20 units in progress).
For the year ended 30 June 20X9, the contract revenue and contract costs shall be recognised as revenue and expenses respectively by reference to the stage of completion as determined above at 30 June 20X9 less the contract revenue and contract costs that were recognised in the prior year. For the year ended 30 June 20X8, revenue should have been recognised only to the extent of contract costs incurred that it is probable will be recoverable and contract costs should have been recognised as an expense in the prior year in which they were incurred. For financial statements presentation, where contract costs incurred to 30 June 20X9 plus recognised profits exceed (less than) progress billings, the surplus is shown as amounts due from (to) customers for contract work. Amounts billed for work performed but not yet settled by the customer are included in the statement of financial position as receivable, while amounts received before the related work is performed are included as a liability, as advances received.
Chapter 13 Share-based payment

The financial statements of Fortune Limited Payment for redundancy of staff of $1,850,000 Under HKAS 19.133, a redundancy payment is a termination benefit which should be recognised as a liability and an expense when, and only when, an entity is demonstrated to be committed to either: (i) (ii) terminating the employment of an employee or group of employees before the normal retirement date; or providing termination benefits, as a result of an offer made in order to encourage voluntary redundancy.
Under HKAS 19.134, an entity is demonstrably committed to a termination when, and only when, the entity has a detailed formal plan for the termination, and is without realistic possibility of withdrawal.
715
Financial Reporting
The issue of redundancy notices to the staff of Fortune Limited immediately after the date when Broom Limited has taken control over Fortune Limited has given rise to a constructive obligation since that day and as at 31 December 20X6. Accordingly, a provision of $1,850,000 should be recognised as an expense in the statement of comprehensive income for 20X6 and a liability in the statement of financial position as at 31 December 20X6 of Fortune Limited. Payment to two directors for retrenchment $2,400,000 (2 $1,200,000) is recognised as an expense in the income statement of 20X6. Payment for cancellation of options granted to managing director According to HKFRS 2.28, if the entity cancels or settles a grant of equity instruments during the vesting period (other than a grant cancelled by forfeiture when the vesting conditions are not satisfied): (i) The entity shall account for the cancellation or settlement as an acceleration of vesting, and shall therefore recognise immediately the amount that otherwise would have been recognised for services received over the remainder of the vesting period. Unrecognised share compensation expense as at 31 October 20X6: = $180,000 / 36 (36 14) = $110,000 DEBIT Expense CREDIT Equity (ii) $110,000 $110,000
Any payment made to the employee on the cancellation or settlement of the grant shall be accounted for as the repurchase of any equity interest, ie as a reduction from equity, except to the extent that the payment exceeds the fair value of the equity granted, measured at the repurchase date. Any such excess shall be recognised as an expense. As the consideration paid for the cancellation, ie $210,000, is higher than the fair value of the equity granted as at 31 October 20X6 of $200,000, $10,000 is recognised as an expense while $200,000 is deducted from equity. DEBIT Expense Equity CREDIT Cash $10,000 $200,000 $210,000
The consolidated financial statements of Broom Limited Payment for redundancy of staff of $1,850,000 Redundancy of staff by Fortune Limited whose execution is conditional upon its being acquired by Broom Limited, is not, immediately before the business combination, a present obligation of Fortune Limited. Nor is it a contingent liability of Fortune Limited immediately before the combination. Accordingly, Broom Limited should not recognise a liability for such redundancies as part of allocating the cost of the combination. The provision of $1,850,000 should be recognised as a post acquisition expense in Broom Limited's consolidated income statement of 20X6 and a liability in their consolidated statement of financial position as at 31 December 20X6. Payment to two directors for retrenchment The payment that Fortune Limited is contractually required to make to its two directors in the event that it is acquired in a business combination is a present obligation of Fortune Limited that is regarded as a contingent liability until it becomes probable that a business combination will take place.
716
In accordance with HKFRS 3.42, when the business combination is effected, that liability of Fortune Limited is recognised by Broom Limited as part of allocating the cost of the combination. The payment of $2,400,000 should not be recognised as a post acquisition expense in Broom Limited's consolidated income statement of 20X6. Payment for cancellation of options granted to managing director The cancellation on 31 October 20X6 of share options granted to the managing director was carried out prior to the acquisition date, ie 1 November 20X6, and therefore, the agreed payment of $210,000 was an existing liability of Fortune Limited at the acquisition date. Accordingly, Broom Limited should recognise the liability of $210,000 as part of allocating the cost of the combination. The payment of $210,000 should not be recognised as a post-acquisition expense in Broom Limited's consolidated income statement of 20X6. Payment for due diligence exercise The fee for the due diligence exercise on Fortune Limiteds financial statements is an acquisitionrelated cost. Accordingly, Broom Limited should recognise $300,000 as an expense in the consolidated income statement for 20X6 in accordance with the requirements of HKFRS 3.
Chapter 14 Revenue
Research and development contract Under HKAS 18.20, when the outcome of a transaction involving the rendering of services (in this case, PMT is to provide research and development services to WY) can be estimated reliably, revenue associated with the transaction shall be recognised by reference to the stage of completion of the transaction at the date of the statement of financial position. Under HKAS 18.26, when the outcome of a transaction involving the rendering of services cannot be estimated reliably, revenue shall be recognised only to the extent of the expenses recognised that are recoverable. The non-refundable up-front payment received without any corresponding performance or delivery should be treated as an advance from WY and recognised as performance occurring over the term of the contract. Milestone payments received are recognised as revenue over the period from the achievement of the milestone to the end of the contract, similar to the treatment of the non-refundable up-front fee. To estimate the stage of completion, PMT may use one of the following methods to measure the proportion of the services performed: (i) (ii) (iii) surveys of work performed; services performed to date as a percentage of total services to be performed; or the proportion that costs incurred to date bear to the estimated total costs of the transaction.
PMT may also take the view that successful completion of the clinical trials and delivery of the first pilot unit are specific acts that are much more significant than any other acts. In such a case, the recognition of revenue is postponed until the significant act is executed. That is, PMT should recognise $3,500,000 (less any amount previously recognised when the outcome could not be reliably estimated) as revenue upon successful completion of the clinical trials, and $1,500,000 upon the delivery of the first pilot unit.
717
Financial Reporting
Chapter 15 Income taxes

(a) Deferred tax position at 31 December 20X7 accounted for in GP's consolidated financial statements: Carrying amount of the printing machine at 31 December 20X7: $20,000,000 [1 (4.5 years/16 years)] = $14,375,000 Tax base at 31 December 20X7: $20,000,000 [1 (1 0.1) (4.5 years/10 years)] = $11,900,000 Taxable temporary difference: Carrying amount tax base = $14,375,000 $11,900,000 = $2,475,000 Deferred tax liability: $2,475,000 25% = $618,750 (1) Deferred tax assets and liabilities shall be measured at the tax rates that are expected to apply to the period when the asset is realised or the liability is settled, based on tax rates (and tax laws) that have been enacted or substantively enacted by the reporting date. 20X3 is the first profit-making year for GP, the company will have full tax exemption for 20X3 and 20X4, and then be subject to 50 per cent reduction for 20X5 to 20X7 (ie 12%). Afterward, the tax rate is 25 per cent. As the taxable temporary difference will be reversed after 20X7, the tax rate applied for deferred tax computation is 25 per cent.
(1)
(b)
Journal entries to record the deferred income taxes at 31 December 20X8 for GP's consolidated financial statements: $ $ DEBIT Deferred tax Income statement 137,500 CREDIT Deferred tax liability 137,500 Carrying amount of the printing machine at 31 December 20X8: $20,000,000 [1 (5.5 years/16 years)] = $13,125,000 Tax base at 31 December 20X8: $20,000,000 [1 (1 0.1) (5.5 years/10 years)] = $10,100,000 Taxable temporary difference: Carrying amount tax base = $13,125,000 $10,100,000 = $3,025,000 Deferred tax liability: $3,025,000 25% = $756,250 Increase in deferred tax liability in 20X8: = $756,250 $618,750 = $137,500
(c)
Amount of deferred taxes to be shown on GP's consolidated statement of financial position at 31 December 20X8: Deferred tax asset Deferred tax liability $500,000 $756,250
GP's deferred tax asset cannot be offset against the deferred tax liability of BP as the two entities' income taxes are NOT levied by the same taxation authority.
718
Chapter 16 Employee benefits

(a) Actuarial gains and losses are caused by unexpected movements in asset and liability values in defined benefit employee compensation plans. The 'corridor' approach recognises actuarial gains and losses only if they fall outside a 10 per cent corridor, ie net cumulative unrecognised actuarial gains and losses as at the end of the previous reporting period exceeded the greater of: (i) (ii) 10 per cent of the present value of the defined benefit obligation as at that date, and 10 per cent of the fair value of any plan assets as at that date.
Actuarial gains and losses are recognised through profit or loss in the statement of comprehensive income over a period not exceeding the average expected remaining working life of employees. The corridor approach has always been available under HKAS 19. The effect is to defer recognition of actuarial gains and losses. Gains and losses are not recognised until they exceed the corridor and even then recognised over a number of years. Alternatively, actuarial gains and losses may be recognised immediately, either in profit or loss or other comprehensive income. (b) (i) Present value of obligation Present value of obligation at start of year Interest cost thereon at 8% Current service cost Benefits paid Actuarial gain/(loss) Present value of obligation at end of the year (ii) Market value of plan assets Market value of plan assets at start of year Expected return thereon at 10% Contributions Benefits paid Actuarial loss on plan assets Market value of plan assets at end of the year (iii) 10 per cent corridor Limit of corridor (10% of higher of each year's opening amounts) Unrecognised actuarial gains/(losses) b/f Actuarial gain/(loss) for the year: obligation Actuarial gain/(loss) for the year: plan assets Actuarial gain/(loss) recognised Unrecognised actuarial gains c/f 20X8 $000 20,000 1,600 1,250 (987) 1,137 23,000 20X8 $000 20,000 2,000 1,000 (987) (513) 21,500 20X8 $000 2,000 (1,137) (513) (1,650) (1,650) 20X9 $000 23,000 1,840 1,430 (1,100) 330 25,500 20X9 $000 21,500 2,150 1,100 (1,100) (1,350) 22,300 20X9 $000 2,300 (1,650) (330) (1,350) (3,330) 1,030 (2,300)
719
Financial Reporting
Chapter 17 Borrowing costs

HKAS 23 (revised) Borrowing costs specifies that borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset form part of the cost of that asset. Other borrowing costs are recognised as an expense. Since PPY has borrowed the funds specifically for the purpose of obtaining the qualifying asset (the plant), PPY shall determine the amount of borrowing costs eligible for capitalisation as the actual borrowing costs incurred on that borrowing during the period less any investment income on the temporary investment of those borrowings. In this case, since the expenditure on the qualifying asset (HK$18 million), i.e. the plant, is higher than the funds borrowed (HK$10 million), it is expected that there is no investment income on temporary investment. An entity shall cease capitalising borrowing costs when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete. Therefore, during the year ended 31 March 2010, the interest should be capitalised only for the period from 1 April 2009 to 30 November 2009, i.e. 8 months. Borrowing costs that should have been capitalised in the current year: = HK$10,000,000 x 9% x 8/12 = HK$600,000
Chapter 18 Financial instruments

Classification of financial assets GIIs investments are both financial assets. According to HKFRS 9, financial assets are classified as measured at either amortised cost or fair value depending on: 1. 2. the entitys business model for managing the financial assets and the contractual cash flow characteristics of the financial assets.
In particular, a financial asset is measured at amortised cost where: 1. 2. the asset is held within a business model where the objective is to hold assets in order to collect contractual cash flows the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal outstanding.
For this purpose, interest is consideration for the time value of money and for the credit risk associated with the principal amount. Embedded derivatives Derivatives embedded within a host which is a financial asset within the scope of HKFRS 9 are not separated out for accounting purposes; instead the entire hybrid contract is accounted for as one and classified as measured at amortised cost or fair value through profit or loss in accordance with the guidelines above. Application: convertible bonds For the holder, convertible bonds are a financial asset within the scope of HKFRS 9. The standard requires that the holder analyses the instrument in its entirety (rather than split it into the host contract and conversion option, as was required under HKAS 39). GII will be entitled to receive a contracted interest payment of $450,000 ($15 million 6% / 2) on 31 December 20X8, 30 June 20X9, 31 December 20X9, 30 June 20Y0 and 31 December 20Y0 from the listed company. These contractual interest payments are not only consideration for the
720
time value of money and credit risk; they are also linked to the value of the equity of the issuer of the bonds. Therefore the bonds should be classified as at fair value through profit or loss. At initial recognition at 1 July 20X8, the financial asset will be measured at fair value. After initial recognition, the asset will be measured at fair value with gains or losses recognised in profit or loss. Deposit with commercial bank The deposit is considered a financial asset classified as held at amortised cost. The additional 3 per cent interest is an example of an embedded derivative, however, as the host contract is a financial asset, the derivative is not separated out for the purposes of accounting and the entire hybrid contract is accounted for together.
Chapter 19 Foreign currency transactions

(a) Journal entries to be made for the year ended 31 December 20X8 (all in $ million): On 1 February 20X8: DEBIT Deposit/prepayment [3 x 11.7] CREDIT Bank to record the payment of the deposit of EURO 3 million 35.1 35.1
On 1 April 20X8: DEBIT Equipment 115.6 CREDIT Deposit/prepayment [3 x 11.7] CREDIT Payable [7 x 11.5] to record the recognition of the equipment and the corresponding payable On 30 September 20X8: DEBIT Payable 80.5 CREDIT Bank [7 x 11.3] CREDIT Exchange gain to record the settlement of the payable and recognition of the exchange gain On 31 December 20X8: DEBIT Depreciation charge [($115.6/10) x 9/12] 8.67 CREDIT Accumulated depreciation to record the 9 months' depreciation charge up to 31 December 20X8 (b)
35.1 80.5
79.1 1.4
8.67
HKAS 21.39 sets out the requirements for translation of results and financial position of an entity from its functional currency to the presentation currency. At 31 December 20X8, the equipment is carried at cost less deprecation of $106.93 million ($115.6 million less $8.67 million). This amount shall be translated at the exchange rate at this date, ie $11.8 = EURO 1. Accordingly, the equipment would be presented at EURO 9.06 million ($106.93 million / $11.8). The depreciation charge for the nine months ended 31 December 20X8 of total $8.67 million shall be translated at the dates of the transactions. HKAS 21.40 states that for practical reasons, a rate that approximates the exchange rates at the dates of the transactions, for example an average rate for the period, is often used to translate income and expense items. Accordingly, the depreciation charge shall be translated at $11.4 = EURO 1 and presented at EURO 0.76 million ($8.67 million / $11.4).
721
Financial Reporting
An exchange gain of $1.4 million results from the change in exchange rates from 1 April to 30 September 20X8. Accordingly, the exchange gain shall be translated at $11.35 = EURO 1 and presented at EURO 0.12 million. All exchange differences arising from the translation from $ to EURO shall be recognised as a separate component of equity.
Chapter 20 Statements of cash flows

(a) Chong Co. EXTRACT FROM THE STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 OCTOBER 20X7 $'000 Cash flows from operating activities Profit before tax (W1) Depreciation charge for the year (W2) Loss on disposal of assets (W3) Finance charge Redemption penalty Operating profit before changes in working capital Increase in receivables Increase in payables Cash generated from operations Interest paid Income tax paid (W4) Net cash flow from operating activities (b) 266 76 4 15 8 369 (61) 66 374 (12) (52) 310
To examine whether the net cash flow from operating activities is sufficient to support the proposed relocation and expansion we must first consider the other uses to which the cash flow has been put: $'000 Net capital expenditure (W5) 260 Bond repayment (W6) 171 431 Extent to which financed by new issue of shares 280 Net cash requirement to finance capital expenditure and bond 151 Dividend 40 Overall net cash requirement 191 Net cash flow from operating activities 310 Increase in cash at bank 119 The above shows that the company's overall net cash requirement during the year was easily met by available cash flow from operations. However, the company would have to forecast future cash flow and consider relocation costs and any likely future capital commitments before deciding whether future cash flows would be sufficient to fund the relocation. Also, the above shows that net capital expenditure was financed by a new issue of shares and that much of the net cash flow from operating activities was used to repay part of the bond. The company would have to balance the likelihood of these events recurring* with the need to fund the above relocation costs. * The company would also need to consider the likely impact of this on the equity/debt gearing ratio (down from 1.95:1 to 8:1).
722
W1
Calculation of profit before tax' Retained profit at 31.10.X7 Retained profit at 31.10.X6 Increase in retained profit during the year Add dividend paid Profit for the year Tax charge in income statement Profit for the year before tax
$'000 224 86 138 40 178 88 266 $'000 276 232 44 32 76 16 52 32 20 4
W2
Calculation of depreciation charge for the year Accumulated depreciation: at 31.10.X7 at 31.10.X6
Net increase for the year Depreciation on disposals Depreciation charge for the year W3 Calculation of profit or loss on disposal Proceeds from disposal Cost of assets Less depreciation Loss on disposal W4 Tax paid calculation Opening balances: Deferred tax Income tax Tax charge Closing balances: Deferred tax Income tax Tax paid W5 Calculation of net capital expenditure Closing balance 31.10.X7 Opening balance 31.10.X6 Cost of disposals Capital expenditure during year Less proceeds from disposal of assets W6 Calculation of bond repayment Liability at start of year Add amortised interest (Finance charge $15,000 cash paid $12,000) Redemption penalty Liability at year end
$'000 44 32 76 88 164 72 40 112 52 $'000 1,240 1,016 224 52 276 16 260 $'000 280 3 283 8 291 120 171
723
Financial Reporting
Chapter 21 Related party transactions

XC XC is not a related party of EI. The discount represents no more than a normal commercial arrangement with a favoured customer. Property Elaine is one of the key management personnel of the company and thus a related party, and the sale of the property to her at a discount of $250,000 must be disclosed in the financial statements. FC As a provider of finance, FC is not itself a related party. However, Johnson is close family of Elaine and therefore a related party to EI, and the loan does not appear to have been advanced at normal commercial terms. The loan and the involvement of Johnson will need to be disclosed.
Chapter 22 Accounting policies, changes in accounting estimates and errors; events after the reporting period
The statement is incomplete, incorrect and misleading. HKAS 8 requires that (except to the extent that it is impracticable to determine either the periodspecific effects or the cumulative effect of the error) an entity shall correct material prior period errors retrospectively in the first set of financial statements authorised for issue after their discovery by: restating the comparative amounts for the prior period(s) presented in which the error occurred; or if the error occurred before the earliest prior period presented, restating the opening balances of assets, liabilities and equity for the earliest prior period presented.
Retrospective restatement corrects the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior period error had never occurred. The correction of a prior period error is excluded from profit or loss for the period in which the error is discovered. Any information presented about prior periods, including any historical summaries of financial data, is restated as far back as is practicable. For a particular prior period, it is impracticable to make a retrospective restatement to correct an error if: the effects of the retrospective restatement are not determinable; the retrospective restatement requires assumptions about what management's intent would have been in that period; or the retrospective restatement requires significant estimates of amounts and it is impossible to distinguish other information objectively from the information about those estimates that: provides evidence of circumstances that existed on the date(s) as at which those amounts are to be recognised, measured or disclosed; and would have been available when the financial statements for that prior period were authorised for issue.
When it is impracticable to determine the period-specific effects of an error on comparative information for one or more prior periods presented, the entity shall restate the opening balances of
724
assets, liabilities and equity for the earliest period for which retrospective restatement is practicable (which may be the current period). When it is impracticable to determine the cumulative effect, at the beginning of the current period, of an error on all prior periods (eg a mistake in applying an accounting policy), the entity shall restate the comparative information to correct the error prospectively from the earliest date practicable. It therefore disregards the portion of the cumulative restatement of assets, liabilities and equity arising before that date.
Chapter 23 Earnings per share

(a) Year ended 30 June 20X8: Profit attributable to ordinary shareholders = $32,800,000 (3,000,000 $0.3) = $31,900,000 Weighted average number of ordinary shares outstanding for the year = 220,000,000 Basic earnings per share = $31,900,000 / 220,000,000 = 14.5 cents Year ended 30 June 20X9: Profit attributable to ordinary share holders = $8,000,000 (3,000,000 $0.15 + 2,000,000 $0.15) = $7,250,000 (Or Profit attributable to ordinary shareholders = $8,000,000 (1,000,000 $0.15 + 2,000,000 $0.3) = $7,250,000) Weighted average number of ordinary shares outstanding for the year = (220,000,000 3/12) + (220,500,000 3/12) + (228,500,000 6/12) = 224,375,000 (Or Weighted average number of ordinary shares outstanding for the year = (220,000,000 12/12) + (500,000 9/12) + (8,000,000 6/12) = 224,375,000) Basic earnings per share = $7,250,000 / 224,375,000 = 3.231 cents (b) Year ended 30 June 20X9: The potential impact of preference share conversion on earnings: $750,000/ (1,000,000 8 6/12 + 2,000,000 8) = $0.0375 No adjustment to the preference share dividend as the earnings per incremental share is higher than the basic earnings per share (3.231 cents) and therefore considered anti-dilutive. Adjusted profit attributable to ordinary shareholders = $7,250,000 Adjusted weighted average number of ordinary shares: No adjustment for the conversion of the preference shares Weighted average number of shares under option = 1,000,000 Weighted average number of shares that would have been issued at average market price: (1,000,000 $1.5) / $1.65 = 909,091
725
Financial Reporting
Weighted average number of shares assumed to be issued for nil consideration: (1,000,000 909,091) = 90,909 Weighted average number of ordinary shares used to calculate diluted earnings per share: 224,375,000 + 90,909 = 224,465,909 Diluted earnings per share = $7,250,000 / 224,465,909 = 3.230 cents
Chapter 24 Operating segments

(a) The conclusion is incorrect. The entity does not have a free choice. HKFRS 8.5 states an operating segment is a component of an entity: (i) that engages in business activities from which it may earn revenue and incur expenses (including revenues and expenses relating to transactions with other components of the same entity), whose operating results are regularly reviewed by the entity's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial information is available.
(ii)
(iii) (b)
A reportable segment consists of an operating segment, or an aggregation of two or more operating segments, that exceed the quantitative thresholds specified in HKFRS 8.13. In general, an entity shall report separately information about an operating segment that meets any of the following quantitative thresholds: (i) Its reported revenue, including both sales to external customers and intersegment sales or transfers, is 10 per cent or more of the combined revenue, internal and external, of all operating segments. The absolute amount of its reporting profit or loss is 10 per cent or more of the greater, in absolute amount, of (i) the combined reported profit of all operating segments that did not report a loss and (ii) the combined reported loss of all operating segments that reported a loss. Its assets are 10 per cent or more of the combined assets of all operating segments.
(ii)
(iii)
Operating segments that do not meet any of the quantitative thresholds may be considered reportable, and separately disclosed, if management believes that information about the segment would be useful to users of the financial statements. HKFRS 8.19 states that there may be a practical limit to the number of reportable segments that an entity separately discloses beyond which segment information may become too detailed. Although no precise limit has been determined, as the number of segments that are reportable increases above ten, the entity should consider whether a practical limit has been reached. An evaluation should be made of the criteria adopted by the management for aggregation to determine if an appropriate aggregation of operating segments has been performed. Accordingly, it is possible for an entity to report 12 reportable segments. (c) The conclusion is incorrect. HKFRS 8 does not require that segment information be provided in accordance with the same generally accepted accounting principles used to prepare the financial statements. According to HKFRS 8.25, the amount of each segment item reported shall be the measure reported to the chief operating decision maker for the purposes of making decisions about allocating resources to the segment and assessing its performance. Adjustments and elimination made in preparing an entity's financial statements and allocations of revenues, expenses and gains or losses shall be included in determining
726
reported segment profit or loss only if they are included in the measure of the segment profit or loss that is used by the chief operating decision maker. Similarly, only those assets and liabilities that are included in the measures of the segment assets and segment liabilities that are used by the chief operating decision maker shall be reported for that segment. (d) The conclusion is incorrect. The company is not required to remove from the prior year amounts the portion of the operating segment that was disposed of prior to the end of the current year. The disposal of a portion of an operating segment is not considered a change of the structure of an entity's internal organisation in a manner that causes the composition of its reportable segments to change, which would require restatement of prior periods in accordance with HKFRS 8.29. Furthermore, if management judges that an operating segment identified as a reportable segment in the immediately preceding period is of continuing significance, information about that segment shall continue to be reported separately in the current period even if it no longer meets the criteria for reportability in HKFRS 8.13.
Chapter 25 Interim financial reporting

(a) It is probable that the bonus will be paid, given that the actual output already achieved in the year is in line with budgeted figures, which exceed the required level of output. So a bonus of $4.5 million should be recognised in the interim financial statements at 30 June 20X4. The value of the inventories in the interim financial statements at 30 June 20X4 is the lower of cost and NRV at 30 June 20X4. This is: 100,000 $1.20 = $120,000 (c) The taxation charge in the interim financial statements is based upon the weighted average rate for the year. In this case the entity's tax rate for the year is expected to be 30 per cent. The taxation charge in the interim financial statements will be $1.8 million.
(b)
Chapter 26 Presentation of financial statements

AZ CO STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 MARCH 20X3 Revenue Cost of sales (W1) Gross profit Distribution costs (W1) Administrative expenses (W1) Other expenses (W1) Finance income Finance costs [60 + (18,250 7%)] Profit before tax Income tax expense PROFIT FOR THE YEAR Other comprehensive income: Gain on land revaluation TOTAL COMPREHENSIVE INCOME FOR THE YEAR $'000 124,900 (94,200) 30,700 (9,060) (17,535) (121) 1,200 (1,338) 3,846 (161) 3,685 4,000 7,685
Other expenses represent the cost of a major restructuring undertaken during the period.
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Financial Reporting
AZ CO STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X3 Non-current assets Property, plant and equipment (W2) Investment properties Current assets Inventories (5,180 (W3) 15) Trade receivables Cash and cash equivalents Equity Share capital (20,000 + (W4) 2,000) Share premium (430 + (W4) 400) Retained earnings (27,137 1,000 + 3,685) Revaluation surplus (3,125 + 4,000) Non-current liabilities Redeemable preference shares 7% debentures 20X7 Current liabilities Trade payables Income tax payable Interest payable (1,278 639) AZ CO STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 MARCH 20X3 Share capital $'000 20,000 2,000 Share premium $'000 430 400 Retained earnings $'000 27,137 (1,000) 3,685 29,822
$'000 48,262 24,000 72,262 5,165 9,330 1,190 15,685 87,947 22,000 830 29,822 7,125 59,777 1,000 18,250 19,250 8,120 161 639 8,920 87,947
Balance at 1 April 20X2 Issue of share capital Dividends Total comprehensive income for the year 22,000 Balance at 31 March 20X3 WORKINGS 1 Expenses Per TB Opening inventories Depreciation on buildings (W2) Depreciation on P&E (W2) Closing inventories (5,180 (W3) 15)
Revaluation surplus $'000 3,125
Total $'000 50,692 2,400 (1,000) 7,685 59,777
830
4,000 7,125
Cost of sales $'000 94,000 4,852 513 (5,165) 94,200
Distribution $'000 9,060
Admin $'000 16,020 1,515
Other $'000 121
9,060
17,535
121
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Property, plant and equipment Cost b/d Acc'd depreciation b/d Depreciation charge for year: $30,300 5% ($3,720 $1,670) 25% Revaluation (balancing figure) NBV c/d
Land $'000 20,000 20,000 20,000 4,000 24,000
Buildings $'000 30,300 (6,060) 24,240 (1,515) 22,725 22,725
P&E $'000 3,720 (1,670) 2,050
Total $'000 54,020 (7,730) 46,290 (1,515) (513) 44,262 4,000 48,262
(513) 1,537 1,537
Inventories Defective batch: Selling price Cost to complete: repackaging required NRV Cost Write off required
$'000 55 (20) 35 (50) (15)
Share issue The proceeds have been recorded separately in the trial balance. This requires a transfer to the appropriate accounts: $'000 $'000 DEBIT Proceeds of share issue 2,400 CREDIT Share capital (2,000 $1) Share premium (2,000 $0.20) 2,000 400
Chapter 27 Principles of consolidation

Consolidated goodwill AB (W1) CD (W2) WORKINGS (1) Goodwill on acquisition of AB Purchase consideration NCI share (W3) Less: Net fair value of identifiable assets and liabilities acq'd: Net tangible assets (1,000 + 2,850) Brand name Goodwill on acquisition (2) Goodwill on acquisition of CD Purchase consideration (39.6 60,000) NCI share (W4) Net assets acquired at 1 April 20X3 (100 + (700 + (80 9/12))) Goodwill on acquisition $'000 $'000 14,700 3,400 $'000 11,350 2,916 14,266
3,850 2,900 (6,750) 11,350 $'000 2,376 1,400 (860) 2,916
729
Financial Reporting
(3)
NCI at acquisition of AB Number of shares Fair value = 20% 1m = 200,000 = 200,000 $17 = $3,400,000
(4)
NCI at acquisition of CD Number of shares Fair value = 100,000 60,000 = 40,000 = 40,000 $35 = $1,400,000
Chapter 28 Consolidated accounts: accounting for subsidiaries

Smart Computer Limited (a) The amount of goodwill is calculated as follows: Consideration transferred: HK$72 million Amount of non-controlling interests: HK$45 x 2,000,000 20% = HK$18 million Identifiable net assets of BDC acquired: Net carrying amount in the books of BDC = HK$42 million Fair value adjustments: Property, plant and equipment = HK$76 - HK$60 million = HK$16 million Intangible asset = HK$8 million Net of the acquisition-date amounts of the identified assets acquired and the liabilities assumed = HK$[42 + 16 + 8] million = HK$66 million Goodwill acquired = HK$[72 + 18 66] million = HK$24 million (b) Non-controlling interests in BDC as at 1 April 2010 to be reflected in the consolidated statement of financial position of SCL: Net of the acquisition-date amounts of the identified assets acquired and the liabilities assumed (as above) = HK$66 million Post acquisition profit reported by BDC before adjustment of depreciation and amortisation attributable to fair value up to 1 April 2010 = HK$8 million Additional depreciation for the period from 1 October 2009 to 31 March 2010: = HK$16 million / 10 0.5 = HK$0.8 million Additional amortisation for the period from 1 October 2009 to 31 March 2010: = HK$8 million / 10 0.5 = HK$0.4 million Adjusted post acquisition profit of BDC incorporated into the consolidated financial statements of SCL up to 1 April 2010 = HK$[8 0.8 0.4] million = HK$6.8 million
730
Non-controlling interest of 20% = HK$18 million + [HK$6.8 million x 20%] = HK$19.36 million Bailey BAILEY GROUP CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X9 Non-current assets Property, plant and equipment (2,300 + 1,900 + (W7) 60) Goodwill (W2) Investment in associate (W3) Current assets (3,115 + 1,790 (W8) 20) Equity attributable to owners of the parent Share capital Reserves (W4) Non-controlling interests (W5) Non-current liabilities (350 + 290) Current liabilities (1,580 + 1,100) $m 4,260 110 243 4,613 4,885 9,498 1,000 4,216 5,216 962 6,178 640 2,680 9,498
BAILEY GROUP CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X9 $m Revenue (5,000 + 4,200 (W8) 200) 9,000 Cost of sales (4,100 + 3,500 + (W7) 10 (W8) 200 + (W8) 20) (7,430) Gross profit 1,570 Distribution costs and administrative expenses (320 + 175 + (W2) 15) (510) Share of profit of associate (110 30% 8/12) 22 Profit before tax 1,082 Income tax expense (240 + 170) (410) PROFIT FOR THE YEAR 672 Other comprehensive income: Gain on revaluation of property (net of deferred tax) (50 + 20) 70 Share of other comprehensive income of associate (10 30% 8/12) 2 Other comprehensive income, net of tax 72 TOTAL COMPREHENSIVE INCOME FOR THE YEAR 744 Profit attributable to: Owners of the parent 548 Non-controlling interests (W6) 124 672 Total comprehensive income attributable to: Owners of the parent 612 Non-controlling interests (W6) 132 744
731
Financial Reporting
WORKINGS 1 Group structure Bailey 1.1.X6 (4 years ago) 1.5.X9 (current year)
300 = 60% 500
72 = 30% 240
Hill Pre-acqn reserves $440m 2 Goodwill (Hill)
Campbell $270m
$m Consideration transferred Non-controlling interests (at 'full' fair value) Fair value of net assets at acquisition Share capital Reserves Fair value adjustment (W7) 500 440 100
$m 720 450
Impairment losses to date

Note: add impairment loss for year of $15m to administrative expenses.
(1,040) 130 (20) 110
Investment in associate (Campbell)
Cost of associate Share of post acquisition reserves (W4) 4

Reserves
$m 225 18 243
Bailey $m 3,430 Hill $m 1,800 (40) (20) (440) 1,300 Campbell $m 330
Per question Fair value movement (W7) Provision for unrealised profit (W8) Pre-acquisition Group share of post-acquisition reserves: Hill (1,300 60%) Campbell (60 30%) Impairment losses: Hill ((W2) 20 60%) 5
Non-controlling interests (SOFP)
(270) 60
780 18 (12) 4,216 $m 450 520 (8) 962
NCI at acquisition (W2) NCI share of post acquisition reserves ((W4) 1,300 40%) NCI share of impairment losses ((W2) 20 40%)
732
Non-controlling interests (SOCI) PFY $m 355 (10) (20) (15) 310 40% = 124 TCI $m 375 (10) (20) (15) 330 40% = 132
Hill's profit/TCI per question Fair value adjustment movement (W7) Provision for unrealised profit (W8) Impairment loss on goodwill for year (W2) NCI share 7
Fair value adjustment (Hill) At acquisition 1/1/X6 $m 100 Movement X6, X7, X8, X9 $m * (40) Year end 31/12/X9 $m 60
Property, plant and equipment (W2) (1,040 500 440)
Goodwill (W2)
Reserves (W4) Add 1 year to cost of sales
Add to PPE
* additional depreciation = 100 4/10 = 40 8

Intragroup trading (Hill Bailey)
Eliminate intragroup revenue and cost of sales: DEBIT ( ) Revenue CREDIT ( ) Cost of sales $200m $200m
Eliminate unrealised profit on goods left in inventories at year end: = $200m 1/4 in inventories x 40%/100% margin = $20m DEBIT ( ) Hill's reserves/( ) Hill's cost of sales CREDIT ( ) Inventories $20m (affects NCI in SOCI) $20m
Chapter 29 Consolidated accounts: accounting for associates and joint arrangements

To: Sunny Sun (Director), STL From: Ricky Lam, Accounting Manager, STL c.c.: Susan Chow, Emily Tsim, Rachael Lau (Directors) Date: dd/mm/yyyy I refer to your e-mail dated 18 September 20X9 regarding your queries about the draft consolidated financial statements for STL as at 30 June 20X9.
Goodwill
Goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised.
HKFRS 3 (revised) requires the acquirer, having recognised the identifiable assets, the liabilities and any non-controlling interests, to identify any difference between:
733
Financial Reporting
the aggregate of the consideration transferred, any non-controlling interest in the acquiree and, in a business combination achieved in stages, the acquisition-date fair value of the acquirer's previously held equity interest in the acquiree; and the net identifiable assets acquired.
The difference is generally recognised as goodwill. The amount of goodwill is calculated as follows: Consideration transferred ($1.50 75% 400 million shares) = $450 million Amount of non-controlling interest in MNL ($560 million 25%) = $140 million Total = $450 million + $140 million = $590 million Identifiable net assets of MNL acquired = $560 million Goodwill acquired = $30 million
Contribution to joint venture
In accordance with HKAS 28 (2011), when a venturer contributes assets to a joint venture, recognition of any portion of a gain or loss from the transaction shall reflect the substance of the transaction. In applying to non-monetary contributions to a joint venture in exchange for an equity interest in the joint venture, HKAS 28 (2011) states that a venturer shall recognise in profit and loss for the period the portion of a gain or loss attributable to the equity interests of the other venturers except when the contribution transaction lacks commercial substance. If the above mentioned exception applies, the gain or loss is regarded as unrealised and therefore is not recognised in profit and loss. In this case, it is reasonable to assume that the exception does not apply and therefore the gain should be recognised in profit or loss. Therefore STL shall recognise that portion of the gain that is attributable to the interests of the other venturer, ie 50 per cent. The journal entries for STL, in its separate financial statements, to record its contribution to the joint venture, are: $m $m DEBIT CREDIT Interests in JV capital contribution Accumulated depreciation machinery Interests in JV unrealised gain on contribution of machinery Other income gain on contribution of machinery to JCE Machinery 10 4 1 1 12
According to HKAS 28 (2011), in the consolidated financial statements of the venturer, unrealised gains or losses on non-monetary assets contributed to joint ventures shall be eliminated against the investment under the equity method. Such unrealised gains or losses shall not be presented as deferred gains or losses in the venturer's consolidated statement of financial position. It is not appropriate to present unrealised gains or losses on non-monetary assets contributed to joint ventures as deferred items since such items do not meet the recognition criteria for assets or liabilities as defined in the Framework. Therefore, STL shall make the following adjustment under the equity method, in addition to the above adjustment, in its consolidated financial statements: $m $m DEBIT Interests in JV unrealised gain on contribution of machinery 1 CREDIT Machinery held in JV 1
734
Tax effect of consolidation adjustments for intragroup transactions
Since taxes are being charged on the individual entities, the consolidation adjustments will not affect the current tax liability, ie the amount that is expected to be paid in tax. However, tax-effect adjustments are necessary when, during the consolidation, adjustments are made to the carrying amounts of assets. The consolidation adjustments relating to the carrying amount of assets will affect the differences between the tax base and the carrying amount of an asset. This then affects future tax (deferred tax amounts) rather than current tax payable. HKAS 12 provides examples of circumstances that give rise to deductible temporary differences eg: 'unrealised profits resulting from intragroup transactions are eliminated from the carrying amount of assets, such as inventory or property, plant or equipment, but no equivalent adjustment is made for tax purposes'. In this case, to eliminate intragroup sales and unrealised profit on inventory on downstream sales, inventory is to be reduced by ($100,000,000 20/120 1/3) = $5,555,555 as the cost to the consolidated group differs from that to the subsidiary (MNL). In MNL's accounts, the inventory is carried at $100,000,000 and has a tax base of $100,000,000, giving rise to no temporary differences. From the group's point of view, the inventory has a carrying amount of $94,444,445, giving a temporary difference of $5,555,555. As the expected future deduction is greater than the assessable amount, a deferred tax asset exists for the group, though there is no effect on the amount of tax payable in the current period. Deferred tax asset thereof = $5,555,555 16% = $888,888
STL's share of ERL's current year profit
According to HKAS 28 (2011), if an investor holds, directly or indirectly, 20 per cent or more of the voting power of the investee, it is presumed that the investor has significant influence. Thus ERL would be regarded as an associate of STL. The equity method would be applicable whereby the investment in ERL would be initially recognised at cost and adjusted thereafter for the post-acquisition change in STL's share of ERL's net assets. STL's profit or loss will include STL's share of the profit or loss of ERL. Since STL has transferred the significant risks and rewards of ownership of the inventories to the associate, the transaction should be recognised as sales. Thus no elimination of sales is required. Nonetheless, HKAS 28 (2011) requires that profits and losses resulting from 'upstream' (sales of assets from an associate to the investor) and 'downstream' (sales of assets from the investor to an associate) transactions between an investor (including its consolidated subsidiaries) and an associate are recognised in the investor's financial statements only to the extent of unrelated investors' interests in the associate. Therefore, the investor's share in the profits and losses resulting from these transactions should be eliminated. When STL sells goods to ERL (an associate), STL should not recognise its share of the profit or loss from the transaction in its consolidated financial statements until the goods or assets have been resold to an independent party. STL's share of any unrealised profit or loss in the inventories that were retained by ERL at the end of the reporting period is eliminated as follows: ERL's profit for the year ended 30 June 20X9 = $41,000,000 STL's share = $41,000,000 25% = $10,250,000 Less: Elimination of unrealised profit (after tax) on intercompany transaction
735
Financial Reporting
Total unrealised profit: STL's share = Less: Tax effect Elimination of unrealised profit (after tax)
$15,000,000 20/120 1/2 = $1,250,000 25% = $312,500 16% = $312,500 $50,000 =
$1,250,000 $312,500 $50,000 $262,500
Thus STL's share of ERL's adjusted profit = $10,250,000 $262,500 = $9,987,500 I hope the above explanation has answered your questions. Please feel free to contact me if you have further queries. Best regards Ricky Lam
Chapter 30 Changes in group structures

To: Faria LEE (Director), MCL From: Pindy LEE, Accounting Manager, MCL c.c.: Beverly CHOW, Emily WILSCON, Charmaine YUEN (Directors) Date: dd/mm/yyyy I refer to your e-mail dated 18 May 20X8 regarding your queries about the draft consolidated financial statements for MCL as at 31 March 20X8. (a)
Plant and equipment
In accordance with HK(SIC)-Int 27, we are required to evaluate the substance of the transaction with the bank which involves the legal form of a lease. Since the overall economic effect of the transactions cannot be understood without reference to the series of transactions as a whole, it is concluded that the series of the sale and the lease is linked and shall be accounted for as one transaction. The sale and leaseback arrangement with the bank does not, in substance, involve a sale as MCL retains substantially all the risks and rewards incident to ownership of the underlying asset and enjoys substantially the same rights to its use as before the arrangement. If the legal form is ignored, the substance of the arrangement is a financing arrangement in which the seller-lessee (MCL) borrows money from the lessor (the bank) using the asset as security. Since MCL's risks and rewards incident to owning the plant and equipment have not substantively changed, the amount of $12 million of plant and equipment should remain in the consolidated statement of financial position. (b)
The Investment in SWL from 31 March 20X7 to 31 March 20X8
(1)
Status before and after the disposal
Before the disposal, MCL held 60 per cent of the issued shares of SWL. In accordance with HKFRS 10, control is presumed to exist:

power is achieved through holding the majority of votes MCL has exposure to variable returns from the investment (such as dividends) it is assumed that voting power can be used to affect these returns.
Therefore, SWL was a subsidiary of MCL at 31 March 20X7, and MCL was a parent at that date.
736
After the disposal of 2,400,000 shares in SWL, MCL held a 30 per cent interest in SWL in total. MCL had significant influence, but not control, over SWL from the date of the disposal, ie 30 September 20X7. Thereafter, SWL was classified as an associate under HKAS 28 Investments in Associates and Joint Ventures from the date that it ceased to be a subsidiary. (2)
The effect of disposal on MCL's financial statements
MCL's remaining 30 per cent investment in SWL should be accounted for using the equity method in MCL's consolidated financial statements under which the investment would initially be recognised at cost as of 30 September 20X7. The fair value of the investment at the date that SWL ceased to be a subsidiary, ie 30 September 20X7, shall be regarded as the cost on initial measurement. During the period from 1 October 20X7 to 31 March 20X8 (after the disposal of the 2,400,000 shares), the investment in 30 per cent equity interest in SWL shall be accounted for by the equity method. Under the equity method, the investment should be initially recognised at cost and the carrying amount increased or decreased to recognise MCL's share of SWL's profit or loss after the date SWL became an associate. MCL's share of SWL's profit or loss will be recognised in MCL's consolidated profit or loss. HKFRS 10 states that the income and expenses of a subsidiary are included in the consolidated financial statements from the acquisition date, ie the date on which the acquirer effectively obtains control of the acquiree, until the date on which the parent ceases to control the subsidiary. Thus, SWL's income and expenses from 1 April 20X7 to 30 September 20X7 should be included in the consolidated financial statements for the year ended 31 March 20X8. The difference between the proceeds from the disposal of the subsidiary plus the fair value of the interest retained and the carrying amount of the net assets as of the date of disposal is recognised in the consolidated income statement as the gain or loss on the disposal of the subsidiary. In MCL's separate financial statements for the year ended 31 March 20X8, the investment in SWL would continue to be accounted for at cost. (c)
Difference in gains on disposal at entity and consolidated level
During the period from 1 April 20X7 to 30 September 20X7 (before the disposal of the 2,400,000 shares), the investment in 60 per cent equity interest in SWL shall be accounted for as a subsidiary. The difference between the proceeds from the disposal of a 30 per cent equity interest in SWL plus the fair value of the 30 per cent equity interest retained and the carrying amount of the net assets in the consolidated financial statements as of the date of disposal is recognised in the consolidated income statement as the gain or loss on the disposal of the subsidiary. The relevant carrying amount as of the date of disposal to be recognised in the consolidated income statement should have already been increased or decreased to recognise MCL's share of SWL's profit or loss after the date of acquisition since MCL's share of SWL's profit or loss will be recognised in MCL's consolidated profit or loss. However, when separate financial statements are prepared, investments in subsidiaries shall be accounted for either at cost, or in accordance with HKFRS 9. In this case, MCL stated the investment at cost. Thus the calculation of gain or loss on disposal will be based simply on the difference between proceeds from the disposal and the cost of the investment.
737
Financial Reporting
(d)
Impact of rights issue on EPS of MCL for 20X8
In this rights issue, the exercise price ($9) of the rights issue is less than the fair value of the shares ($12). Therefore such a rights issue includes a bonus element. In calculating the basic EPS for the current year, the number of ordinary shares from 1 April 20X7 to 31 December 20X7 to be used in calculating basic earnings per share would be adjusted by the following bonus factor:
Fair value per share immediately prior to the exercise of rights Theoretical ex - rights fair value per share
Theoretical ex-rights price to identify the bonus factor:
The theoretical ex-rights fair value per share is calculated by adding the aggregate fair value of the shares immediately prior to the exercise of the rights to the proceeds from the exercise of the rights, and dividing by the number of shares outstanding after the exercise of the rights.

2 shares at fair value of $12 prior to rights issue = $24 1 share at discounted rights issue price of $9 = $9 Ex-rights price (3 shares at fair value of $33 after issue) = $33/3 = $11
The bonus factor = $12 / $11 = 1.09 Since the rights issue is made part way through the year (1 January 20X8), a timeapportionment is required. Thus, weighted average number of ordinary shares outstanding:

10,000,000 shares 12/11 9/12 = 8,181,818 plus (10,000,000 + 5,000,000) shares 3/12 = 3,750,000 = 11,931,818
The comparative basic EPS ie basic EPS for the year ended 31 March 20X7, should be adjusted accordingly by dividing by the factor of 1.09. I hope the above explanation has answered your questions. Please feel free to contact me if you have further queries. Best regards Pindy Lee
738
Question bank - questions
739
Financial Reporting
740
Question 1
90 minutes
Assume that you are Mr Ricky Cheung, the accounting manager of Pacific Limited ('PCF'). PCF is a conglomerate listed on the Stock Exchange of Hong Kong with many subsidiaries. PCF acquired the equity interest in Sanata Limited ('SNT') by two successive purchases with details as follows: Date 1 April 2009 31 March 2010 Acquisition cost paid HK$ 6,000,000 26,000,000 Fair value of SNT as an entity HK$ 24,000,000 40,000,000 % acquired 25% 65%
The financial year of both PCF and SNT ends on 31 March. The fair value of non-controlling interests is measured as a proportionate interest in the fair value of the subsidiary as an entity. Information relating to SNT is as follows: 1 April 2009 Book value HK$ Intangibles Inventory Other net assets Net identifiable assets Share capital Retained earnings 2,000,000 18,000,000 20,000,000 8,000,000 12,000,000 20,000,000 1 April 2009 Fair value HK$ 3,600,000 2,400,000 18,000,000* 24,000,000* 31 March 2010 Book value HK$ 4,000,000 24,000,000 28,000,000 8,000,000 20,000,000 28,000,000 31 March 2010 Fair value HK$ 3,200,000 4,800,000 24,000,000* 32,000,000*
* The fair values of other net assets and net identifiable assets are stated before considering the impact of deferred tax. Following the business combination, the tax bases of the assets and liabilities of SNT remain unchanged. The net profit of SNT for the year ended 31 March 2010 was HK$8,000,000. The intangibles of SNT had a remaining useful life of 6 years from 1 April 2009 and all inventories were sold within two months from the year-end. Both PCF and SNT did not declare any dividends during the year ended 31 March 2010. The accounting policy of PCF is to account for the investment in associates at cost in its separate financial statements. Customer loyalty programme SNT is a regional chain of convenience stores. It operates a customer loyalty programme and it grants programme members loyalty points when they spend a specified amount on foodstuffs. Programme members can redeem the points for further foodstuffs. The points have no expiry date. Before 1 April 2008, the entity granted 200,000 points. Management expected 180,000 of these points to be redeemed. Management has measured the fair value of each loyalty point to be HK$1. During the year ended 31 March 2009, 81,000 of the points were redeemed in exchange for foodstuffs. In the year ended 31 March 2010, management revised its expectations. It expected 190,000 points to be redeemed altogether. During the year, 90,000 points were redeemed. You have prepared the draft consolidated financial statements of PCF for the year ended 31 March 2010. After you sent these draft consolidated financial statements to PCF's directors for review, one of the directors, who is not a certified public accountant, sent you an e-mail as follows:
741
Financial Reporting
To: From: cc:
Ricky Cheung, Accounting Manager, PCF Emily Chen (Director) David Ip, Susan Tse, Richard Chung (Directors) Date: 18 May 2010
Consolidated financial statements of PCF as at 31 March 2010 Could you please clarify the following points relating to PCF's draft consolidated financial statements which I have just reviewed. (A) I find that there is an item called 'gain on step acquisition' in the consolidated financial statements. You told me that it is somewhat related to the remeasurement of the previously held equity interest in SNT at its acquisition-date fair value. What is it all about? I find that there are intangibles in the consolidated financial statements that I cannot find in the financial statements of PCF and SNT. It seems to me that goodwill is the difference between the amount that I paid and the value that I obtained from the investment. However, I cannot obtain the goodwill figure that you computed in the consolidated financial statements. I know that there will be tax-effect entries for fair value adjustments. However, why is this tax effect affecting the value of the goodwill? I find that portion of the revenue from the sales of foodstuffs by SNT has not been recognised in the same period as the sales are made. You told me that it is due to the customer loyalty programme. What is it all about?
(B) (C)
(D) (E)
I would appreciate your clarification for the upcoming board meeting. Best regards, Emily Required Assume that you are the accounting manager, and you are required to draft a memorandum to Ms Chen, a Director of PCF. In your memorandum, you should: (a) discuss and calculate the effect of the business combination, at 31 March 2010, on the 25 per cent equity interests in SNT held by PCF in the separate financial statements of PCF and at consolidated level (ignore taxation); (14 marks) discuss the rationale for the recognition of the intangibles in the consolidated financial statements that are not recognised in the financial statements of SNT; (10 marks) calculate the amount of goodwill as at 31 March 2010 if deferred tax implications are ignored; (5 marks) discuss the rationale and calculate the effect on goodwill if deferred tax implications follow from recognising the difference between the fair values and book values of the identifiable net assets is taken into consideration (assuming a tax rate of 16 per cent); and (10 marks) discuss and calculate the amount of revenue in relation to 200,000 loyalty points, granted before 1 April 2008, to be recognised for the year ended 31 March 2009 and 31 March 2010. (11 marks) (Total = 50 marks) HKICPA February 2010
(b) (c) (d)
(e)
742
Question 2
90 minutes
Assume that you are Mr David Li, the accounting manager of City Limited ('City'). City is a company incorporated and listed in Hong Kong and is principally engaged in the manufacturing of electronic products. The draft consolidated financial statements for the year ended 31 March 2008 are shown as follows: CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 MARCH 2008 Notes HK$'000 Revenue 2,348,314 Cost of sales (2,044,510) Gross profit 303,804 Interest income 5,306 Selling and distribution costs (44,868) Administrative expenses (136,085) Loss on disposal of an associate (e) (7,888) Finance costs (4,974) Profit before tax (a) 115,295 Income tax expense (14,758) Profit for the year 100,537 Other comprehensive income: Exchange differences on translating foreign operations (g) 310 Total comprehensive income for the year 100,847 CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 2008 2008 Notes HK$'000 Non-current assets Property, plant and equipment (b) 115,568 Investment in an associate (e) Club membership (d) 1,956 Pledged bank deposits (f) 6,582 124,106 Current assets Inventories 270,726 Trade receivables, deposits and prepayments 719,128 Pledged bank deposits (f) 2,322 Bank balances and cash 234,026 1,226,202 Current liabilities Trade payables and accrued charges 675,602 Amount due to a related party 48,634 Tax liabilities 7,898 Obligations under finance leases due within one year 220 Bank borrowings due within one year 76,482 808,836 417,366 Net current assets Total assets less Current liabilities 541,472 Equity Share capital Reserves Total equity Non-current liabilities Obligations under finance leases due after one year Bank borrowings due after one year Deferred tax liabilities (c) 6,068 518,706 524,774 10,412 6,286 16,698 541,472 2007 HK$'000 114,170 11,748 1,956 6,232 134,106 346,984 670,522 13,522 143,472 1,174,500 708,524 37,862 10,580 2,690 83,006 842,662 331,838 465,944 6,000 443,618 449,618 216 8,908 7,202 16,326 465,944
743
Financial Reporting
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 MARCH 2008
Share capital $'000 6,000 68 6,068 Share premium $'000 154,490 4,050 158,540 Retained profits $'000 284,821 100,537 (16,990) (9,102) 359,266 Translation of foreign operations $'000 590 310 900 Share option reserve $'000 3,717 (4,050) 333 Total equity $'000 449,618 100,847 68 333 (16,990) (9,102) 524,774
At 31 March 2007 Total comprehensive income for the year Exercise of share options Recognition of equity-settled share-based payment Final dividend paid in respect of 2007 Interim dividend paid in respect of 2008 At 31 March 2008
Additional information (a) Profit before tax 2008 HK$'000 Profit before tax has been arrived at after charging: Depreciation Equity-settled share-based payment expense Loss on disposal of property, plant and equipment Impairment loss recognised on trade receivables (b) Property, plant and equipment Cost At 31 March 2007 Additions Disposals At 31 March 2008 Depreciation At 31 March 2007 Charge for the year Eliminated on disposals At 31 March 2008 Carrying amounts At 31 March 2008 At 31 March 2007 (c) 32,036 333 802 210 2007 HK$'000 26,748 3,717 436 HK$'000 219,792 34,240 (2,898) 251,134 105,622 32,036 (2,092) 135,566 115,568 114,170
Pursuant to the service agreement between City and a director of City dated 1 May 2006, an option to subscribe for 6,800,000 shares in the Company at an exercise price equal to the par value of HK$0.01 per share (the 'Pre-IPO Share Option') was granted to the director. The Pre-IPO Share Option, which serves as an incentive for the director, shall be exercised during the period from 1 May 2007 to 31 December 2008 and the option holder has to be in employment with City when he exercises the options. The estimated fair value of the PreIPO Share Option at the date of grant is HK$4,050,000. The club membership represents entrance fees paid to golf clubs held on a long-term basis. It is considered by the management of City as having an indefinite useful life.
(d)
744
(e) (f) (g)
On 1 April 2007, City disposed of its entire 20% interest in an associate for a cash consideration of HK$3,860,000, resulting in a loss on disposal of HK$7,888,000. As at 31 March 2008, bank deposits of HK$8,904,000 had been pledged to secure City's banking facilities in terms of short-term bank borrowings and long-term borrowings. Exchange differences arising on translation of foreign operations recognised directly in equity for the year ended 31 March 2008 were made on the translation of the financial statements of the 100 per cent owned foreign subsidiaries. The exchange gains/(losses) were found to be made up as follows: Inventories Trade receivables Trade payables Cash HK$'000 120 140 (40) 90
After you sent these draft consolidated financial statements to City's directors for review, a new director who has just joined the board sent you an e-mail as follows: To: From: cc: David LI, Accounting Manager Janice CHEUNG (Director) Michelle CHOW, Julian LIN, Fiona MERRILL (Directors) Date: 18 May 2008 Consolidated financial statements of City as at 31 March 2008 Could you please clarify the following points relating to City's draft consolidated financial statements which I have just reviewed? (A) So far as I understand, cash is cash. Why is there a total of three items showing our bank deposits and cash in the consolidated statement of financial position? Also, I cannot find the consolidated statement of cash flows. Please send it to me again. I note that the amount of the item 'Club membership' has remained the same throughout the two years in the consolidated statement of financial position. I believe that non-current assets should be subject to depreciation and amortisation. Why does the amount of this item remain the same? I have also found an item 'Equity-settled share-based payment expense' in the note to profit before tax. As we are only issuing equity to the employees, how would it affect the profit before tax? Why is HK$333,000 recognised as an expense in 2008 while the total estimated fair value is HK$4,050,000?
(B)
(C)
I would appreciate your clarification in time for the upcoming board meeting. Best regards, Janice Required (a) Prepare a memorandum in response to the issues raised by Ms Janice Cheung. In your memorandum, you should: (i) (ii) (iii) (b) discuss the reasons for the classification of bank deposits and cash into three items as shown in the consolidated statement of financial position; (8 marks) discuss the accounting treatment of the 'Club membership'; and (7 marks) discuss, with appropriate calculations, the accounting treatment of the 'Equity-settled share-based payment expense'. (8 marks)
Prepare an annex to your memorandum showing the consolidated statement of cash flows for the year ended 31 March 2008. (27 marks) (Total = 50 marks) HKICPA September 2008 (amended)
745
Financial Reporting
Question 3
90 minutes
You are the accounting manager of Pass Holdings Limited ('PHL'), a listed company in Hong Kong, engaged in the trading of construction materials. The statements of financial position of PHL and its investee companies, Success Insight Limited ('SIL') and Outstanding Achievement Limited ('OAL'), at 31 March 2007 are shown below: SUMMARY STATEMENTS OF FINANCIAL POSITION AT 31 MARCH 2007 PHL $'000 Non-current assets Investment property Equipment Investments Current assets Inventories Receivables Cash $'000 54,900 5,000 30,000 89,900 11,500 1,800 800 14,100 104,000 Capital and reserves Issued capital Retained profit opening Profit for the year Non-current liabilities Additional information PHL acquired 60 per cent of the ordinary shares of SIL on 1 April 2006 for $20 million when the issued ordinary share capital and the reserves of SIL were $20 million and $4 million respectively. At the date of acquisition of SIL, the fair value of its equipment was considered to be $2 million greater than its carrying amount in SIL's statement of financial position though the economic useful life remains unchanged. SIL had acquired the equipment on 1 April 2004 and the equipment is depreciated on cost over 10 years. Non-controlling interest is measured using the proportion of net assets method. PHL acquired 30 per cent of the ordinary shares of OAL on 1 April 2006 for $10 million when the issued ordinary share capital and the reserves of OAL were $15 million and $3 million respectively. During the year ended 31 March 2007, SIL sold construction materials to both PHL and OAL. Transfers were made by SIL at cost plus 25 per cent. PHL held $2 million inventories of these components at 31 March 2007 and OAL held $0.5 million at the same date. PHL holds a property which was let out, charging arm's length rentals, to SIL who uses it as an office and a showroom. PHL acquired this property on 1 April 2006 at a price of $54.9 million. The estimated useful life of the property was 50 years from 1 April 2006. The fair value of the property at 31 March 2007 remains at $54.9 million and the rental income to PHL for the year amounts to $3 million. This property is included in PHL's statement of financial position at its fair value as an investment property. PHL adopts the cost model and uses the straight-line method to depreciate property, plant and equipment. After you sent a summary of the consolidated financial results of the PHL Group to PHL's directors for review, one of the directors, who is not a certified public accountant, sends you an e-mail as follows: 40,000 15,000 14,200 69,200 34,800 104,000 20,000 4,000 13,700 37,700 9,000 46,700 6,000 4,200 4,000 14,200 46,700 15,000 3,000 4,800 22,800 6,000 28,800 $'000 SIL $'000 32,500 32,500 5,300 4,800 3,000 13,100 28,800 OAL $'000 $'000 15,700 15,700
746
To: Accounting Manager, PHL From: Peter CHAN (Director) c.c.: L.P. LEE, Mary CHEUNG, Paul WONG (Directors) Date: 18 June 2007 Financial summary of PHL for the year ended 31 March 2007 Could you please clarify the following points relating to PHL's draft financial summary which I have just reviewed? (1) In your cover note you mentioned that part of the profit from the sales made by SIL to OAL has been eliminated. I am puzzled about this elimination. Why is there such an elimination of profit? Since PHL has not sold anything to OAL, what has caused this elimination in PHL's accounts? I am also puzzled about the investment property that was found in the statement of financial position of PHL but not in the consolidated statement. What has happened to this investment property?
(2)
I would appreciate clarification in time for the upcoming board meeting. Best regards, Peter Required (a) (b) Prepare a memorandum in response to the issues raised by Mr Peter Chan. (15 marks)
Prepare an annex to your memorandum showing the consolidation journal entries for the consolidated statement of financial position as at 31 March 2007 regarding the following (alternatively, you may show the consolidation adjustments in the form of a worksheet): (i) (ii) acquisition of SIL at 1 April 2006 (ignore taxation); (7 marks)
consolidation adjustments for the year ended 31 March 2007, including but not limited to fair value adjustment, re-classification of assets, elimination of intragroup transactions, equity accounting and non-controlling interests (ignore taxation); and (21 marks) the deferred taxation effect (assume a tax rate at 15 per cent). (7 marks) (Total = 50 marks) HKICPA May 2007 (amended)
(iii)
Question 4
90 minutes
Assume that you are Mr David Lee, the accounting manager of Ultimate Holdings Limited ('UHL'). UHL is a company incorporated in Hong Kong and is principally engaged in the trading of toys in Hong Kong. On 31 March 2005, UHL acquired 20 per cent of the issued share capital of Successful Toys Limited ('STL'), a retail chain store incorporated in Hong Kong. The cost of the investment was seven million Hong Kong Dollars (HK$7,000,000), which UHL paid all in cash. This 20 per cent shareholding enables UHL to exercise significant influence on STL. On 31 March 2005, the fair value of STL's identifiable assets was HK$20,000,000, and the carrying amount of those assets was HK$15,200,000. STL had no liabilities or contingent liabilities at that date. The following shows STL's statement of financial position at 31 March 2005 together with the fair values of the identifiable assets:
747
Financial Reporting
Plant and equipment (net) Net current assets Issued equity: 1,000,000 ordinary shares Retained earnings
Carrying amounts HK$'000 11,200 4,000 15,200 10,000 5,200 15,200
Fair values HK$'000 16,000 4,000 20,000
During the year ended 31 March 2006, STL reported a profit of HK$12,000,000 but did not pay any dividends. In addition, the fair value of STL's plant and equipment further increased to HK$20,000,000. On 31 March 2006 the fair value of the 20 per cent stake in STL was HK$10,000,000. On 31 March 2006, UHL acquired a further 50 per cent of the issued share capital of STL thereby obtaining control. The cost of investment was thirty million Hong Kong Dollars (HK$30,000,000), which UHL paid all in cash. At 31 March 2006, STL had a contingent liability of HK$1,000,000 regarding a lawsuit with a supplier. STL expects to settle the case by March 2007 by paying around the amount claimed. The following shows the statements of financial position of UHL and STL at 31 March 2006 together with the fair values of STL's identifiable assets at that date: UHL Land lease premium Property, plant and equipment (net) Investment in a subsidiary Net current assets Issued equity: Ordinary shares Retained earnings HK$'000 10,000 21,000 37,000 9,000 77,000 65,000 12,000 77,000 STL Carrying amounts HK$'000 9,800 17,400 27,200 10,000 17,200 27,200 STL Fair values HK$'000 20,000 17,400 37,400
UHL has adopted an accounting policy to depreciate and amortise plant and equipment using the straight-line method over a 10-year life with no residual value. Non-controlling interests are measured using the proportion of net assets method. UHL has no investment other than STL. The fair values of STL's assets at 31 March 2005 and subsequent changes in the fair values have not been reflected in STL's financial statements. You have a draft set of consolidated financial statements of UHL for the year ended 31 March 2006. After you have sent them to UHL's directors for review, one of the directors, who is not a certified public accountant, sends you an e-mail as follows: To: From: c.c.: David Lee, Accounting Manager, UHL Danielle Wong (Director) Crystal Ho, Stephen Lee, Christopher Yung (Directors) Date: 18 May 2006 Consolidated financial statements of UHL as at 31 March 2006 Could you please clarify the following points relating to UHL's draft consolidated financial statements which I have just reviewed. (A) So far as I understand, the company owns a warehouse in the New Territories and an office in Kowloon. I am not aware that we have purchased or leased any land. Why is there an item 'Land lease premium' in the consolidated statement of financial position?
748
(B)
In last year's financial statements, I see an item 'Investment in an associate' of an amount of HK$7,000,000 in the statement of financial position. This item disappeared in the current year's 'consolidated' statement of financial position as at 31 March 2006. Interestingly, I find an item 'Share of profit of an associate' in the 'consolidated' income statement for the current year. Is there something wrong with the financial statements? What does the term 'consolidated' mean? In your notes to the consolidated statement of cash flows describing assets and liabilities acquired in business combination, there is an item 'Provision for contingent liabilities' of HK$1,000,000 under current liabilities assumed. I recall that in the financial statements of some listed companies I have read, contingent liabilities are in fact not liabilities. They are only disclosed in the notes. Why do we treat them as a liability in our accounts? What is 'Goodwill'?
(C)
(D)
I would appreciate your clarification in time for the upcoming board meeting. Best regards, Danielle Required (a) Prepare a memorandum in response to the issues raised by Ms Danielle Wong. In your memorandum, you should: (i) (ii) discuss the reasons for the item 'Land lease premium' in the consolidated statement of financial position; (5 marks) discuss how UHL should account for its interest in STL from 31 March 2005 to 31 March 2006. For this purpose, you should explain (1) the treatments of the 20 per cent interest in STL in UHL's statement of financial position at 31 March 2005; (2) the effect of the 50 per cent interest acquired at 31 March 2006 on the status of STL and (3) the meaning of 'consolidated' financial statements; (10 marks) determine the carrying amount of the 20 per cent interest in STL at 31 March 2006 (ie before the acquisition of the 50 per cent interest at 31 March 2006); (5 marks) discuss why the 'contingent liability' is recognised as a liability in UHL's consolidated statement of financial position; and (5 marks) discuss why goodwill is recognised in UHL's consolidated statement of financial position and its implications for financial statements in future. You should also demonstrate the calculation of the carrying amount of the goodwill as at 31 March 2006. (10 marks)
(iii) (iv) (v)
(b)
Prepare an annex to your memorandum showing the consolidated statement of financial position as at 31 March 2006. Ignore deferred taxation. (Alternatively, you may list the consolidation journals necessary for the purpose of drafting the consolidated statement of financial position.) (15 marks) (Total = 50 marks) HKICPA September 2006 (amended)
749
Financial Reporting
Question 5
(a)
18 minutes
Mr. K Chow is a member of the Hong Kong Institute of Certified Public Accountants ('HKICPA'). His brother, Mr. V Chow, is also a member of HKICPA and acts as an independent non-executive director and the chairman of the audit committee of a company listed on the Stock Exchange of Hong Kong Limited. For the audit committee meeting to be held next week, Mr. V Chow received a copy of draft audited annual financial statements for the year ended 30 June 2009 (the 'Accounts') which reported a significant increase in profit. They discussed the company's financial performance and position with reference to the information shown in the Accounts. Mr. K Chow acquired shares in the company on the following day. Required Discuss the appropriateness of behaviours of both Mr. K Chow and his brother, Mr. V Chow in the context of Code of Ethics for Professional Accountants of HKICPA. (5 marks)
(b)
No goodwill is recognised in the financial statements prepared under merger accounting for a business combination under common control. However, goodwill can still appear in the consolidated financial statements after applying merger accounting for business combination under common control. Discuss. (5 marks) (Total = 10 marks) HKICPA February 2010
Question 6
27 minutes
Howard Development Limited ('HDL') has financial difficulties and successfully renegotiated the contractual terms of a bank loan of principal HK$200 million on 30 June 2009, the date of the statement of financial position: Original Term of interest Date of repayment 8 per cent payable yearly in arrears 30 June 2010 Modified 6 per cent payable yearly in arrears since 1 July 2009 30 June 2013
The original effective interest rate is 8 per cent. No fees for renegotiating the finance are payable. The holders of 100 units of HK$1 million, 4 per cent convertible bonds (the 'Bonds') of HDL have agreed to convert the Bonds into 250 million ordinary shares of HK$0.1 par on 30 June 2009 and waive the payment of interest. Each unit of the Bonds was originally convertible into 2 million ordinary shares and with a maturity date of 30 June 2010. Interest is payable yearly in arrears. The carrying amount of the Bonds as at 30 June 2009 is as follows: HK$ Current liabilities: The Bonds (effective interest rate: 8 per cent) Bonds interest payable Equity: Convertible bonds equity reserve 96,296,296 4,000,000 7,133,058
The market price of the ordinary shares of HDL on 30 June 2009 was HK$0.45. Required (a) Discuss the accounting treatment for HDL in relation to the modification of the terms of the bank loan. (8 marks)
750
(b)
Prepare the journal entries that HDL should make on 30 June 2009 in relation to the conversion of the Bonds. (7 marks) (Total = 15 marks) HKICPA February 2010
Question 7
25 minutes
Modern Department Store (MDS) adopted a share option scheme which allows the board of directors of the company to award share options to employees at nil consideration. On 1 April 2008, 2,000,000 share options were granted to the chief operating officer ("the COO"). Subject to the continued employment of the COO with the company, one-fourth of the awarded share options shall become vested at the end of each anniversary from the date of grant. MDS expects that all the awarded share options will vest. On 1 April 2010, MDS entered into an agreement with the COO to cancel the unvested awarded share options at a consideration of HK$5,500,000. Fair value of the share options of MDS (assuming same for different vesting dates): 1 April 2008 31 March 2009 31 March 2010 1 April 2010 Required (a) (b) Calculate the amount of compensation expense in relation to the share options awarded by MDS for the years ended 31 March 2009 and 31 March 2010 respectively. (4 marks) Explain the accounting implication of and calculate the compensation expense upon the cancellation of the unvested awarded share options on 1 April 2010 to the financial statements of MDS for the year ending 31 March 2011. (7 marks) Assuming that the share options were awarded to the director of Bargain Store (BS), a subsidiary of MDS, instead of the COO of the company, without any intra-group charge for such share-based payment arrangement, explain the accounting implication for the financial statements of BS for the year ended 31 March 2010. (3 marks) (Total = 14 marks) HKICPA December 2010 HK$8 HK$3 HK$5 HK$5
(c)
Question 8
25 minutes
Anna Manufacturing Limited (AML), a company listed on the Hong Kong Stock Exchange, had a convertible bond (CB) with a principal amount of HK$800 million issued on 1 December 2008. Fixed interest at 6 per cent per annum is payable annually in arrears. The holders are entitled to convert the CB into 50 million ordinary shares of HK$2 par value each of AML at any time before the redemption by AML at 30 November 2012 at principal amount. On 1 April 2010, the holders of CB exercised their options to convert into shares in AML. On the same date, AML borrowed an interest-free loan of HK$500 million from its major shareholder for a term of two years. Effective interest rate of AML's other external borrowings was 8 per cent and 6 per cent per annum on 1 December 2008 and 1 April 2010 respectively. The functional currency of AML is the Hong Kong dollar.
751
Financial Reporting
Required (a) (b) (c) Prepare journal entries for the issue of CB on 1 December 2008. Prepare journal entries for the conversion of CB into shares on 1 April 2010. (5 marks) (5 marks)
Prepare journal entries for the recognition of the interest-free loan on 1 April 2010. (4 marks) (Total = 14 marks)
(Note: Tax effect is ignored.) HKICPA December 2010
Question 9
11 minutes
Cleantech Motor Limited ('CML') was an overseas company incorporated in the British Virgin Islands and registered under the Hong Kong Companies Ordinance in October 2008 with a share capital of HK$60 million contributed by two shareholders in cash. During 2009, CML incurred approximately HK$28 million for the development activities for an electrical vehicle project, out of which approximately HK$5 million is not yet paid at the end of financial period. A letter of intent has been signed with an automobile manufacturing company for licensing the technology from CML at a consideration of not less than HK$50 million if it is successfully developed. It was so far unable to complete the technical feasibility study on the computerised energy saving monitoring system and no module is available for testing. The other asset of the entity is cash kept at a bank. CML has 100 employees. The management does not have intention to raise funds publicly at this moment. Required You are the auditors of CML. Advise the directors of CML whether they can prepare the financial statements in accordance with the Small and Medium-sized Entity Financial Reporting Standard. (6 marks) HKICPA December 2010
Question 10
81 minutes
Assume that you are Mr. Tommy Lau, the accounting manager of Papaya Limited (PPY). PPY is a company incorporated in Hong Kong and is principally engaged in the manufacturing of consumer products. PPY acquired 80 per cent of the ordinary shares of Sheffield Limited (SFL) for HK$25,600,000 on 1 April 2007. At the acquisition date, SFL reported retained earnings of HK$12,000,000 and no revaluation reserve. The carrying amount of all assets and liabilities approximated the fair value except for intangible assets. The fair and book values of the intangible assets of SFL (with a remaining life of ten years), excluding deferred tax liability on fair value adjustments, is HK$18,500,000 and HK$16,000,000 respectively at the date of acquisition. Non-controlling interests are measured as the non-controlling interests proportionate share of the acquirees net identifiable assets as at acquisition date. Investment in SFL was carried at cost. Both companies did not have any reserves other than retained earnings and revaluation reserves. On 1 April 2007, PPY commenced construction of a plant which was expected to take three years to complete. In the year ended 31 March 2010, HK$600,000 interest which qualified for capitalisation had not been capitalised in the draft accounts. On 1 April 2009, PPY held inventory purchased from SFL during the year ended 31 March 2009 for HK$1,200,000 which had been manufactured by SFL at a cost of HK$800,000. During the year ended 31 March 2010, SFL sold goods costing HK$3,200,000 to PPY for HK$4,800,000. PPY sold the inventory on hand at the beginning of the year, but continued to hold 40 per cent of its 2009 purchases from SFL on 31 March 2010. It is the groups accounting policy to allocate to noncontrolling interests the adjustments to unrealised profits from upstream transactions. The tax rate for the years of assessment from 2007 / 08 to 2009 / 10 was 16.5 per cent. 752
PPY holds an investment property which was let out, charging arms length rentals, to a senior manager of SFL. PPY acquired this property on 1 April 2009 at a price of HK$6,000,000. The estimated useful life of the property was 50 years from 1 April 2009. The fair value of the property at 31 March 2010 remains at HK$6,000,000 and the rental income to PPY for the year ended 31 March 2010 amounts to HK$300,000. This property is included in PPYs statement of financial position at its fair value as an investment property. PPY adopts the revaluation model for property, plant and equipment, except for construction in progress, which is stated at cost. Intangible assets are carried at cost. Depreciation is provided using the straight-line method. The draft financial data of the two companies for the year ended 31 March 2010 are shown below: PPY HK$ Sales Cost of sales* Gross profit Other income (Dividend income) Distribution costs Administrative expenses Finance costs Profit before tax Income tax expense Profit for the year Other comprehensive income: revaluation surplus Total comprehensive income for the year Retained earnings HK$ 36,400,000 12,800,000 (3,200,000) 46,000,000 80,000,000 (51,200,000) 28,800,000 1,280,000 (3,000,000) (5,000,000) (5,760,000) 16,320,000 (3,520,000) 12,800,000 6,000,000 18,800,000 Revaluation surplus HK$ 4,000,000 6,000,000 -10,000,000 SFL HK$ 38,400,000 (25,600,000) 12,800,000 -(2,300,000) (2,500,000) (1,120,000) 6,880,000 (2,080,000) 4,800,000 1,200,000 6,000,000
Share capital HK$ PPY Balance, 1 April 2009 Total comprehensive income Dividends Balance, 31 March 2010 SFL Balance, 1 April 2009 Total comprehensive income Dividends Balance, 31 March 2010 32,000,000 --32,000,000
Total equity HK$ 72,400,000 18,800,000 (3,200,000) 88,000,000
16,000,000 --16,000,000
21,800,000 4,800,000 (1,600,000) 25,000,000
1,000,000 1,200,000 -2,200,000
38,800,000 6,000,000 (1,600,000) 43,200,000 SFL HK$ 7,600,000 12,000,000 -11,200,000 21,600,000 14,000,000 10,400,000 76,800,000
Property, plant and equipment, net Investment property Investment in SFL, at cost Intangible assets, net Inventories Trade and other receivables Cash and cash equivalents
PPY HK$ 40,000,000 20,800,000 25,600,000 -51,200,000 25,000,000 23,000,000 185,600,000
753
Financial Reporting
Share capital Retained earnings Revaluation surplus Trade and other payables Long term loan
PPY HK$ 32,000,000 46,000,000 10,000,000 88,000,000 47,600,000 50,000,000 185,600,000
SFL HK$ 16,000,000 25,000,000 2,200,000 43,200,000 13,600,000 20,000,000 76,800,000
* Cost of sales includes the depreciation of the plant and amortisation of intangible assets You have prepared the draft consolidated financial statements of PPY for the year ended 31 March 2010. After you sent these draft consolidated financial statements to PPYs directors for review, one of the directors, who is not a certified public accountant, sent you an e-mail as follows: To: Tommy Lau, Accounting Manager, PPY From: Gabriel Wong (Director) c.c.: Renee Ho, Chris Wong, Adrian Cheung (Directors) Date: 8 May 2010 Consolidated financial statements of PPY as at 31 March 2010 Could you please clarify the following points relating to PPYs draft consolidated financial statements which I have just reviewed. (A) (B) I am puzzled about the investment property. The figure that was found in the PPYs statement of financial position was not the same as that in the consolidated one. I find that it is difficult to obtain the figures in the consolidated statement of financial position. Can you tell me more about how you arrived at each figure? I would appreciate your clarification for the upcoming board meeting. Best regards, Gabriel Assume that you are Tommy Lau, the accounting manager, and you are required to draft a memorandum to Gabriel Wong, a Director of PPY. In your memorandum, you should: (a) (b) discuss the reason for the different figures for the investment property in the consolidated financial statements and in the financial statements of PPY; and (7 marks) prepare an annex to your memorandum showing worksheets for: (i) (ii) the consolidated statement of comprehensive income, and the consolidated statement of financial position. (12 marks) (26 marks) (Total = 45 marks) (Consolidation adjustments are to be shown in the form of a worksheet. You have to show the detailed calculations of each figure though journal entries are not required.) HKICPA December 2010 (adapted)
754
Question bank - answers
755
Financial Reporting
756
Answer 1
To: From: c.c.: Ms Chen, Director of PCF Ricky Cheung, Accounting Manager, PCF David Ip, Susan Tse, Richard Chung (Directors) Date: dd/mm/yyyy Subject: Report on business combination I refer to your e-mail dated 18 May 2010 regarding your queries about the draft consolidated financial statements for PCF as at 31 March 2010. (a) Effect of business combination on the 25 per cent equity interest in SNT On 1 April 2009, PCF acquired the 25 per cent equity interest in SNT at a cost of $6,000,000. Thus the investment in SNT would be stated initially at cost, ie $6,000,000. On 31 March 2010, PCF obtained control of SNT in which it held an equity interest immediately before the acquisition date. HKFRS 3 (revised) Business Combinations refers to such a transaction as a 'business combination achieved in stages', sometimes also referred to as a 'step acquisition'. In accordance with paragraph 42 of HKFRS 3 (revised), in a business combination achieved in stages, the acquirer shall remeasure its previously held equity interest in the acquiree at its acquisition-date fair value and recognise the resulting gain or loss, if any, in profit and loss. On consolidation, PCF should then remeasure this 25 per cent equity interest at its acquisition-date fair value and recognise the resulting gain or loss in profit and loss. A business combination should not have any effect at the level of separate financial statements. The investment in SNT should simply be accounted for at cost in the separate financial statements of PCF, ie $6,000,000 + $26,000,000 = $32,000,000. Gain on step acquisition at consolidation level Since PCF had a 25 per cent equity interest in SNT during the year ended 31 March 2010, PCF had significant influence over SNT and thus PCF had to account for SNT's profit for the year ended 31 March 2010 using the equity method at consolidation level (HKAS 28 (2011) Investments in Associates and Joint Ventures): Net profit of SNT for the year ended 31 March 2010 Less: amortisation of intangibles ($3.6m / 6 years) Less: cost of sales from revalued inventory Adjusted net profit for SNT $ 8,000,000 (600,000) (400,000) 7,000,000
The carrying amount of the previously held equity interests at consolidated level would be equal to: The original acquisition cost for the 25% interest Plus: share of profit after acquisition (25% $7,000,000) The carrying amount of previously held interests at consolidated level $ 6,000,000 1,750,000 7,750,000
Gain on step acquisition on previously held interest at consolidated level would be equal to: The remeasured acquisition-date fair value of the 25% equity interest (25% $40,000,000) Less: carrying amount of the 25% equity interest at consolidated level Thus, gain on step acquisition at consolidated level would be $ 10,000,000 ( 7,750,000) 2,250,000
757
Financial Reporting
(b)
Recognition of intangibles The recognition principle under HKFRS 3 (revised) states that 'as of the acquisition date, the acquirer shall recognise, separately from goodwill, the identifiable assets acquired, the liabilities assumed and any non-controlling interest in the acquiree'. Accordingly, the acquirer should recognise an acquiree's intangible assets separately from goodwill, if the recognition criteria are met, ie: to qualify for recognition as part of applying the acquisition method, the identifiable assets acquired and liabilities assumed must meet the definitions of assets and liabilities in the Conceptual Framework for Financial Reporting at the acquisition date. in addition, to qualify for recognition as part of applying the acquisition method, the identifiable assets acquired and liabilities assumed must be part of what the acquirer and the acquiree (or its former owners) exchanged in the business combination transaction rather than the result of separate transactions.
Paragraph 13 of HKFRS 3 (revised) states that 'the acquirer's application of the recognition principle and conditions may result in recognising some assets and liabilities that the acquiree had not previously recognised as assets and liabilities in its financial statements'. For example, the acquirer recognises the acquired identifiable intangible assets, such as a brand name, a patent or a customer relationship, that the acquiree did not recognise as assets in its financial statements because it developed them internally and charged the related costs to expense. An intangible asset is identifiable if it meets either the separability criterion or the contractuallegal criterion. An intangible asset that meets the contractual-legal criterion is identifiable even if the asset is not transferable or separable from the acquiree or from other rights and obligations. The separability criterion means that an acquired intangible asset is capable of being separated or divided from the acquiree and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability.
An intangible asset that the acquirer would be able to sell, license or otherwise exchange for something else of value meets the separability criterion even if the acquirer does not intend to sell, license or otherwise exchange it. An acquired intangible asset meets the separability criterion if there is evidence of exchange transactions for that type of asset or an asset of a similar type, even if those transactions are infrequent and regardless of whether the acquirer is involved in them. An intangible asset that is not individually separable from the acquiree or combined entity meets the separability criterion if it is separable in combination with a related contract, identifiable asset or liability. Since goodwill is a payment for anticipated benefits that are not capable of being individually identified and separately recognised, it is inappropriate for an identifiable intangible asset to be subsumed in goodwill. Thus an acquirer should recognise an intangible asset of the acquiree in the consolidated financial statements if it meets the definition of an intangible asset and its fair value is included in the exchange transaction relating to the business combination.
758
(c)
Amount of goodwill as at 31 March 2010 Fair value of consideration transferred Amount of non-controlling interest (10% $40,000,000) Fair value of the previously held interest (25% $40,000,000) Less: Fair value of SNT's recognised net identifiable assets Goodwill
$ 26,000,000 4,000,000 10,000,000 40,000,000 (32,000,000) 8,000,000
(d)
Deferred tax HKAS 12 requires the recognition of deferred tax liabilities or deferred tax assets on taxable or deductible temporary differences. Temporary differences arise when the tax bases of the identifiable assets acquired and liabilities assumed are not affected by the business combination or are affected differently (paragraph 19). Paragraph 18 of HKAS 12 states that temporary differences arise when the identifiable assets acquired and liabilities assumed in a business combination are recognised at their fair values in accordance with HKFRS 3 (revised) Business Combinations, but no equivalent adjustment is made for tax purposes. When the carrying amount of an asset is increased to fair value but the tax base of the asset remains at cost to the previous owner, a taxable temporary difference arises which results in a deferred tax liability. The resulting deferred tax liability increases goodwill. In Hong Kong, the Inland Revenue Department does not allow reductions in the carrying amount of goodwill as a deductible expense in determining taxable profit. Moreover, the cost of goodwill is often not deductible when a subsidiary disposes of its underlying business. Therefore, goodwill has a tax base of nil. Any difference between the carrying amount of goodwill and its tax base of nil is a taxable temporary difference. However, HKAS 12 does not permit the recognition of the resulting deferred tax liability because goodwill is measured as a residual. In this case: the carrying amount of the inventory ($4,000,000) is increased to its fair value ($4,800,000) but the tax base will remain at cost, a taxable temporary difference ($800,000) arises, which results in a deferred tax liability of 16% $800,000 = $128,000 and this affects the amount of goodwill.
A temporary difference may also arise on initial recognition of an asset or liability, for example if part or all of the cost of an asset is not deductible for tax purposes (paragraph 22). In this case: intangibles are recognised at $3,200,000 which will not be deductible for tax purposes, a taxable temporary difference of $3,200,000 arises. Thus in accounting for the business combination, a deferred tax liability of 16% $3,200,000 = $512,000 should be recognised and this affects the amount of goodwill.
Thus the goodwill, after considering the deferred tax implication of the fair value differences will be:
759
Financial Reporting
Original goodwill amount + deferred tax liability for inventory + deferred tax liability for intangibles Or:
$ 8,000,000 128,000 512,000 8,640,000
In this case, the carrying amount of net identifiable assets ($28,000,000) is increased to its fair value ($32,000,000) but the tax base will remain at cost, a taxable temporary difference of $4,000,000 arises, which results in a deferred tax liability of 16% $4,000,000 = $640,000 and this affects the amount of goodwill. $ 8,000,000 640,000 8,640,000 $ 40,000,000 31,360,000 8,640,000
Original goodwill amount + deferred tax liability for inventory and intangibles or Total fair value Fair value of SNT's recognised net identifiable assets, after tax ($32,000,000 $128,000 $512,000) (e) Customer loyalty programme
According to the HK(IFRIC)-Int 13, SNT should apply paragraph 13 of HKAS 18 and account for points of the loyalty programme as a separately identifiable component of the sales transactions in which they are granted (the 'initial sales'). The fair value of the consideration received or receivable in respect of the initial sales shall be allocated between the award credits (the loyalty points) and the other component of the sale. Since SNT supplies the awards itself, SNT shall recognise the consideration allocated to loyalty points as revenue only when loyalty points are redeemed and it fulfils its obligations to supply awards. In other words, a portion of the consideration shall be allocated to loyalty points and recognition of revenue thereof shall be deferred. In this case, since SNT's management has measured the fair value of each loyalty point to be $1, SNT shall recognise $200,000 ($1 200,000) as revenue only when the loyalty points are redeemed and thus the recognition of revenue of this portion of consideration amounting to $200,000 has been deferred to a period after 1 April 2008. The amount of revenue recognised shall be based on the number of award credits that have been redeemed in exchange for awards, relative to the total number expected to be redeemed. Year ended 31 March 2009 As at 31 March 2009, 81,000 of the points have been redeemed in exchange for foodstuffs. Thus the amount of revenue to be recognised for the year ended 31 March 2009 = = = (number of points redeemed / total number of points expected to be redeemed) $200,000 (81,000 points / 180,000 points) $200,000 $90,000
760
Year ended 31 March 2010 In the year ended 31 March 2010, the management of SNT revised its expectations. It expected 190,000 points to be redeemed altogether. This revised estimate of the total number of points expected to be redeemed shall be used. During this year, 90,000 points are redeemed, bringing the total number redeemed to 81,000 + 90,000 = 171,000 points. The cumulative revenue to date = (cumulative number of points redeemed / revised estimate of total number of points expected to be redeemed) $200,000. Thus, the cumulative revenue that SNT recognises is (171,000 points / 190,000 points) $200,000 = $180,000. SNT has recognised revenue of $90,000 in the year ended 31 March 2009, so the amount of revenue to be recognised in the year ended 31 March 2010 = cumulative revenue to date cumulative revenue recognised to date = $180,000 $90,000 = $90,000 I hope the above explanation has answered your questions. Please feel free to contact me if you have further queries. Best regards, Ricky Cheung
Answer 2
To: From: cc: Janice Cheung (Director) David Li, Accounting Manager Michelle Chow, Julian Lin, Fiona Merrill (Directors) Date: dd/mm/yyyy I refer to your e-mail dated 18 May 2008 regarding your queries about the draft consolidated financial statements for City as at 31 March 2008. (a) (i) Pledged bank deposits HKAS 1 requires the face of the statement of financial position to include a line item that presents the cash and cash equivalents. HKAS 7 states that cash comprises cash on hand and demand deposits while cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. Since pledged bank deposits are not readily convertible to known amounts of cash without an insignificant risk of changes in value, they are not included in the cash and cash equivalents. HKAS 1 also specifies that additional line items, headings and subtotals shall be presented on the face of the statement of financial position when such presentation is relevant to an understanding of the entity's financial position. Paragraph 14 of HKFRS 7 requires an entity to disclose: the carrying amount of financial assets it has pledged as collateral for liabilities or contingent liabilities, including amounts that have been reclassified in accordance with HKFRS 9; and the terms and conditions relating to its pledge.
761
Financial Reporting
Paragraph 31 of HKFRS 7 requires an entity to disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from financial instruments to which the entity is exposed at the reporting date. Pledged bank deposits and their relevant financial liability create a potentially significant exposure to risks and hence their terms and conditions warrant disclosure. The amounts represent deposits pledged to banks to secure banking facilities granted to the Group. This denotes that as at 31 March 2008, bank deposits of HK$8,904,000 (2007: HK$19,754,000) had been pledged to secure City's banking facilities. HKAS 1 requires that an asset shall be classified as current when it satisfies any of the following criteria: (a) (b) (c) (d) it is expected to be realised in, or is intended for sale or consumption in, the entity's normal operating cycle; it is held primarily for the purpose of being traded; it is expected to be realised within twelve months after the end of the reporting period; or it is cash or a cash equivalent (as defined in HKAS 7 Statement of Cash Flows) unless it is restricted from being exchanged or used to settle a liability for at least twelve months after the end of the reporting period.
All other assets shall be classified as non-current. Therefore, the bank deposits and cash should be classified into three items in accordance with the nature of the amount, ie cash and cash equivalents, pledged bank deposits classified as current assets and pledged bank deposits classified as non-current assets. The amounts denote that deposits amounting to HK$2,322,000 (2007: HK$13,522,000) have been pledged to secure short-term bank borrowings and are therefore classified as current assets; and the remaining deposits amounting to HK$6,582,000 (2007: HK$6,232,000) have been pledged to secure long-term borrowings and are therefore classified as non-current assets. The pledged bank deposits will be released and reclassified from 'Pledged bank deposits' to 'Bank balances and cash' upon settlement of the relevant bank borrowings. (ii) Club membership The club membership represents entrance fees paid to clubs held on a long-term basis. Typically, it is recognised as an intangible asset since it is an identifiable nonmonetary asset without physical substance. The accounting for an intangible asset is based on its useful life. An intangible asset with a finite useful life is amortised, and an intangible asset with an indefinite useful life is not. Therefore, an entity shall assess whether the useful life of an intangible asset is finite or indefinite. HKAS 38 requires an intangible asset to be regarded as having an indefinite useful life when, based on an analysis of all of the relevant factors, there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity. The term 'indefinite' does not mean 'infinite'. The useful life of an intangible asset reflects only that level of future maintenance expenditure required to maintain the asset at its standard of performance assessed at the time of estimating the asset's useful life, and the entity's ability and intention to reach such a level. A conclusion that the useful life of an intangible asset is indefinite should not depend on planned future expenditure in excess of that required to maintain the asset at that standard of performance.
762
Since there is no foreseeable limit to the period over which the club membership is expected to generate net cash inflows for City, the management of City considered the club membership as having an indefinite useful life. An intangible asset with an indefinite useful life should not be amortised. Therefore the club membership, which is considered by the management of the Group as having an indefinite useful life, will not be amortised until the useful life is determined to be finite upon reassessment of the useful life annually by the management. The useful life of the club membership should be reviewed each reporting period to determine whether events and circumstances continue to support an indefinite useful life assessment for that asset. If they do not, the change in the useful life assessment from indefinite to finite should be accounted for as a change in an accounting estimate. As a result, the club membership with indefinite useful life is carried at cost less any identified impairment loss and is tested for impairment annually. During the year ended 31 March 2008, the club membership shall be tested for impairment by comparing its carrying amount with its recoverable amount. If the recoverable amount exceeds the carrying amount, the management can conclude that no impairment loss needed to be charged for the current year and hence the carrying amount of the club membership remains the same throughout the two years. As an intangible asset assessed as having an indefinite useful life, HKAS 38 requires City to disclose the carrying amount of the club membership and the reasons supporting the indefinite useful life assessment. (iii) Equity-settled share-based payment transactions Share options granted to employees of the Group HKFRS 2 defines equity-settled share-based payment transactions as transactions in which the reporting entity receives goods or services as consideration for equity instruments of the entity, which equity instruments can include shares or share options. For equity-settled share-based payment transactions, the entity shall measure the goods or services received, and the corresponding increase in equity, directly, at the fair value of the goods or services received, unless that fair value cannot be estimated reliably. If the entity cannot estimate reliably the fair value of the goods or services received, the entity shall measure their value, and the corresponding increase in equity, indirectly, by reference to the fair value of the equity instruments granted. There is a general assumption that transactions with employees cannot be reliably measured on the basis of the value of the services being provided. Therefore, transactions with employees are typically measured at the fair value of the equity instruments being granted. The grant date is 1 May 2006. The requirement for the holder to be in employment with City when he exercises the options is effectively a vesting condition. The vesting date should be 1 May 2007, which is the first date that the option holder is entitled to exercise the options. The options vest over the one year ending 1 May 2007. Since the options vest over the one year ending 1 May 2007, it is presumed that the services to be rendered by the director as consideration for the options will be received in the one year vesting period. Therefore, City should recognise 335/365 (335 days out of 365 days) of the services to be received as an expense during the year ended 31 March 2007 with a corresponding increase in equity (share option reserve).
763
Financial Reporting
The amount should be measured by reference to the fair value of the options as at 1 May 2006, ie the fair value of services received determined by reference to the fair value of share options granted at the grant date is expensed on a straight-line basis over the vesting period, with a corresponding increase in equity (share option reserve). Therefore, City recognised the total expense of HK$333,000 (HK$4,050,000 30/365) for the year ended 31 March 2008 (2007: HK$3,717,000 (HK$4,050,000 335/365)) in relation to share options granted by the Company. At the end of each reporting period, City should revise its estimates of the number of options that are expected to ultimately vest. The impact of the revision of the estimates is recognised in profit or loss, with a corresponding adjustment to share option reserve. At the time when the share options are exercised, the amount previously recognised in share option reserve shall be transferred to share premium. Thus, HK$4,050,000 has been transferred from the share option reserve to the share premium account as shown in the consolidated statement of changes in equity. I hope the above explanation has answered your questions. Please feel free to contact me if you have further queries. Best regards David LI (b) CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 MARCH 2008 HK$'000 Operating activities Profit before tax 115,295 Adjustments for: Finance costs 4,974 Share-based payment expense 333 Depreciation 32,036 Impairment loss recognised on trade receivables 210 Interest income (5,306) Loss on disposal of property, plant and equipment 802 Loss on disposal of an associate 7,888 Operating cash flows before movements in working capital 156,232 Decrease in inventories (270,726 exchange difference 120) 346,984 76,378 Increase in trade receivables, deposits and prepayments (719,128 exchange difference 140) + impairment 210 670,522 (48,676) Decrease in trade payables and accrued charges (675,602 exchange difference 40) 708,524 (32,962) Increase in amount due to a related party (48,634 37,862) 10,772 Cash generated from operating activities 161,744 Tax paid (current 10,580 + deferred 7,202 + I/S 14,758 closing current 7,898 closing deferred 6,286) (18,356) Net cash generated from operating activities Investing activities Purchases of property, plant and equipment Proceeds on disposal of property, plant and equipment (2,898 2,092) 802 Proceeds on disposal of an associate (Note e) Decrease in pledged bank deposits (6,582 + 2,322) (6,232 + 13,522) Interest received Net cash used in investing activities 143,388 (34,240) 4 3,860 10,850 5,306 (14,220)
764
HK$'000 Financing activities Repayment of obligations under finance leases (2,690 + 216) 220 Proceeds on issue of shares (6,068 6,000) Repayment of bank borrowings (83,006 + 8,908) (76,482 + 10,412) Dividends paid (16,990 + 9,102) Interest paid Net cash used in financing activities Net increase in cash and cash equivalents Effect of foreign exchange rate changes (Note g) Cash and cash equivalents at the beginning of the year Cash and cash equivalents at the end of the year representing bank balances and cash (2,686) 68 (5,020) (26,092) (4,974) (38,704) 90,464 90 143,472 234,026
Alternatively, candidates may present Statement of Cash Flows by using direct method: HK$'000 Cash generated from operating activities: Cash receipts from customers (670,522 + 2,348,314 (719,128 exchange gain 140 + impairment loss 210)) Cash paid to suppliers and employees (Note 1) Cash generated from operating activities Note 1 Cash paid to suppliers and employees Opening inventories + purchases closing inventories = cost of sales 346,984 + purchases (270,726 exchange gain 120) = 2,044,510 thus purchases = 1,968,132 Opening trade payables and accrued charges Opening amount due to a related party Purchases Selling and distribution costs Administrative expenses less: share-based payment expense less: depreciation less: impairment loss recognised on trade receivables less: loss on disposal of property, plant and equipment less: closing trade payables and accrued charges add: exchange difference less: closing amount due to a related party HK$'000 708,524 37,862 1,968,132 44,868 136,085 (333) (32,036) (210) (802) (675,602) 40 (48,634) 2,137,894
2,299,638 (2,137,894) 161,744
Answer 3
(a) To: From: cc: Mr Peter Chan, Director, PHL Accounting Manager, PHL LP Lee, Mary Cheung, Paul Wong (Directors) Date: dd/mm/yyyy I refer to your e-mail dated 18 June 2007 regarding your queries about the summary consolidated financial statements for PHL for the year ended 31 March 2007. The explanation for the accounting treatment of the sales of materials from SIL to OAL and the investment property held by PHL is as follows:
765
Financial Reporting
Elimination of the profit arising from the sales made by SIL to OAL The objective of preparing consolidated financial statements is to give a true and fair view of the state of affairs and results of the group of companies, ie PHL and SIL, as if it were a single economic entity. In order to achieve this objective, the financial statements of member companies of our Group, ie PHL and SIL, are combined and certain adjustments are made to the combined statements. OAL is an associate of the Group since PHL holds 30 per cent interest in OAL. For the purpose of PHL's consolidated financial statements, the Group should use the equity method of accounting to account for its investment in OAL. HKAS 28 (2011) Investments in Associates and Joint Ventures requires that the profits resulting from the transactions between the Group and OAL are recognised in PHL's financial statements only to the extent of unrelated investors' interests in OAL. The Group should not recognise its share of the profit (ie 30 per cent) for the sales made by SIL to OAL until OAL resells the goods to an independent party. Therefore, the Group's (PHL and SIL as a group) 30 per cent share in the unrealised profits resulting from those transactions between SIL and OAL included in OAL's inventory at 31 March 2007 should be eliminated from PHL's consolidated financial statements. Since SIL is a member of the Group, the elimination is still required even though PHL did not take part in the transactions directly. Property occupied by SIL HKAS 40 defines an investment property as a property held to earn rentals or for capital appreciation or both, rather than for: use in the production or supply of goods or services or for administrative purposes; or sale in the ordinary course of business.
From the perspective of PHL alone (ie not from the perspective of PHL and SIL as a group), the property leased by PHL to SIL is investment property since it meets the definition of an investment property. Therefore, the property should be classified and accounted for as an investment property in the statement of financial position of PHL. However, in the consolidated financial statements of PHL, the property does not qualify as investment property because, from the perspective of the group as a whole, the property is owner-occupied. The property is an owner-occupied property from the perspective of the group as a whole since it is held for use by SIL in supply of goods and for administrative purposes. Therefore, the property has been reclassified as property, plant and equipment in PHL's consolidated financial statements. Please refer to the annex for detailed calculation of the balance of investment in OAL as shown in the consolidated statement of financial position and also the worksheet for the consolidated statement of financial position as at 31 March 2007. I hope the above explanation has answered your questions. Please feel free to contact me if you have further queries. Best regards XXX
766
(b)
(i)
(Figures are in $'000 unless otherwise specified) CJ1 DEBIT Share capital Reserves Property, plant and equipment Goodwill (20,000 + 10,400 (20,000 + 4,000 + 2,000) Investment in subsidiary Non-controlling interest [(20,000 + 4,000 + 2,000) 40%] 20,000 4,000 2,000 4,400 20,000 10,400
CREDIT
being elimination of investment in subsidiary against the subsidiary's share capital and pre-acquisition reserves at the date of acquisition and recognition of goodwill and noncontrolling interest in assets and liabilities. (ii) Additional depreciation due to fair value adjustment of equipment at acquisition of SIL CJ2 DEBIT CREDIT Profit or loss depreciation [2,000/8] Property, plant and equipment accumulated depreciation 250 250
being additional depreciation charge on the equipment for the year ($2,000,000/8) as a result of revaluation of the assets to fair value on acquisition. Reclassification of investment property to property, plant and equipment CJ3A DEBIT CREDIT Property, plant and equipment Investment property 54,900 54,900
being reclassification of investment property to owner-occupied property from the perspective of a group. CJ3B DEBIT CREDIT Profit or loss depreciation [54,900/50] Property, plant and equipment accumulated depreciation 1,098 1,098
being depreciation of the owner-occupied property from the perspective of a group. Equity accounting of interest in OAL CJ4 DEBIT CREDIT Investment in associate Profit or loss share of profit in associate [(7,800 - 3,000) 30%] 1,440 1,440
being recognition of the group's share of post-acquisition profit in associate. Elimination of unrealised profit in inventories CJ5A DEBIT CREDIT Profit or loss share of profit in associate Investment in associate [($500,000 25/125) 30%] 30 30
being elimination of unrealised profit on inventories of OAL at reporting date.
767
Financial Reporting
CJ5B DEBIT CREDIT Profit or loss cost of sales Inventory [$2,000,000 25/125] 400 400
being elimination of unrealised profit on inventories of PHL at reporting date. Non-controlling interest Profit of SIL for the year Fair value adjustment 40% non-controlling interest CJ6 DEBIT CREDIT Retained profit profit or loss Non-controlling interest 5,380 5,380 13,700* (250) 13,450 5,380
being classification of retained profit as non-controlling interest. * This includes non-controlling interest's share of profit of sales from SIL to PHL and OAL. The elimination of unrealised profit of inventories held by PHL and OAL at the reporting date will not affect the non-controlling interest. Intragroup rental transaction DEBIT CREDIT Profit or loss rental income Profit or loss rental expenses 3,000 3,000
being elimination of intragroup rental transaction. (iii) Deferred tax liabilities arising from valuation adjustment of equipment of SIL At 1 April 2006 CJ7A DEBIT CREDIT Goodwill (300 60%) Non-controlling interest (300 40%) Deferred tax liabilities (2,000 15%) 180 120 300
being deferred tax liabilities arising on the valuation adjustment of assets acquired in a business combination, allocated to the group as goodwill and to the non-controlling interest. For the year ended 31 March 2007 CJ7B DEBIT CREDIT Deferred tax liabilities (250 15%) Profit or loss - tax expenses 37.5 37.5
being reversal of deferred tax liabilities on the valuation adjustment of assets acquired in a business combination. CJ7C DEBIT CREDIT Retained profit profit or loss (37.5 40%) Non-controlling interest 15 15
being classification of retained profit as non-controlling interest. CJ7D DEBIT CREDIT Deferred tax asset (400 15%) Profit or loss - tax expenses 60 60
being deferred tax asset arising from the elimination of the unrealised profit on inventories of PHL. 768
For the purpose of this suggested solution, it is assumed that elimination of unrealised profit in the associate OAL will not result in deferred taxation (or that the amount is not material).
769
Financial Reporting
Answer 4
To: From: cc: Danielle WONG (Director), UHL David LEE, Accounting Manager, UHL Crystal HO, Stephen LEE, Christopher YUNG (Directors) Date: dd/mm/yyyy I refer to your e-mail dated 18 May 2006 regarding your queries about the draft consolidated financial statements for UHL as at 31 March 2006 and the proforma consolidated statement of financial position as at 31 March 2005. (a) (i) Land lease premium The 'Land lease premium' refers to the land element of our warehouse and office. Although we have purchased the warehouse and the office, a significant amount of the purchase considerations was paid for the land element. With very few exceptions, all lands in Hong Kong are owned by the Government and leased out for a limited period. That is, the warehouse and office were built on land under a government lease. For the purpose of lease classification, the land and buildings elements of a lease of land and buildings are considered separately. A characteristic of land is that it normally has an indefinite economic life. Since the land title will not pass to the leasing company by the end of the lease term, the company normally does not receive substantially all of the risks and rewards incidental to ownership of the land. When the land has an indefinite economic life, the land element is normally classified as an operating lease unless the title is expected to pass to the lessee by the end of the lease term. The lease of land is therefore classified as an operating lease. The 'Land lease premium' of HK$10,000,000, which represents a part of the payments made for the acquisition of the warehouse and office, is accounted for as an operating lease of the land, representing prepaid lease payments that are amortised over the lease term. (ii) The investment in STL from 31 March 2005 to 31 March 2006 (1) At 31 March 2005 At 31 March 2005, UHL held only 20 per cent of the issued shares of STL. UHL had significant influence, but not control over STL. Therefore, STL was classified as an associate under HKAS 28 (2011) Investments in Associates and Joint Ventures. UHL's 20 per cent investment in STL should be accounted for using the equity method under which the investment would initially be recognised at cost of HK$7,000,000 at 31 March 2005. (2) The effects of acquiring a further 50 per cent interest in STL at 31 March 2006 After the acquisition of a further 50 per cent interest in STL, UHL holds a total of 70 per cent interest in STL. HKFRS 10 defines a subsidiary as an entity that is controlled by another entity. The key element is 'control' which means power over the investee, exposure or rights to variable returns from the investee and the ability to use power to affect the returns. In accordance with HKFRS 10, the elements of control are presumed to exist since UHL directly owns more than one half of the voting rights of STL.
770
Therefore, STL was a subsidiary of UHL at 31 March 2006, and UHL was a parent at that date. In accordance with HKFRS 10 and the Companies Ordinance, UHL, as a parent company, shall present consolidated financial statements for the year ended 31 March 2006 in addition to its separate financial statements. (3) The meaning of 'consolidated' financial statements Consolidated financial statements are the financial statements of a group presented as those of a single economic entity. In preparing the consolidated financial statements, UHL combines the financial statements of UHL and STL line by line by adding together like items of assets, liabilities, equity, income and expenses. In order that the consolidated financial statements present financial information about the group as that of a single economic entity, a number of consolidation adjustments are made to the combined financial statements. For example, the carrying amount of UHL's investment in STL is eliminated against STL's equity at the date of acquisition, resulting in, among other items, a goodwill balance in the consolidated statement of financial position. Moreover, UHL's 20 per cent investment in STL from 1 April 2005 to 31 March 2006 should be accounted for using the equity method in the consolidated financial statements for the year ended 31 March 2006. In UHL's separate financial statements for the year ended 31 March 2006, the investment in STL would continue to be accounted for at cost. (iii) Carrying amount of the 20 per cent interest in STL in the consolidated statement of financial position of UHL at 31 March 2006 During the period from 1 April 2005 to 31 March 2006 (before the acquisition of the further 50 per cent), the investment in 20 per cent equity interest in STL shall be accounted for by the equity method. Under the equity method, the investment should be initially recognised at cost and the carrying amount increased or decreased to recognise UHL's share of STL's profit or loss after the date of acquisition. UHL's share of STL's profit or loss will be recognised in UHL's consolidated profit or loss. The carrying amount of the 20 per cent interest in STL at 31 March 2006 was determined as follows: HKD'000 Cost of investment at 1 April 2005 7,000 Share of profits for the year ended 31 March 2006 2,400 (20% HKD12,000,000) Depreciation adjustment for the year (96) [20% (HKD16,000,000 HKD11,200,000)]/10 years Carrying amount of investment in associate (STL) at 31 March 2006 9,304* * Alternatively: Share of net assets at 31 March 2006 (20% HKD27,200,000) Balance of fair value adjustment (20% (HKD16,000,000 HKD11,200,000) 9 / 10) Balance of goodwill at 31 March 2006 (HKD7,000,000 20% HKD20,000,000) Carrying amount of investment in associate (STL) at 31 March 2006 HKD'000 5,440 864 3,000 9,304
771
Financial Reporting
(iv)
According to HKAS 37 Provisions, Contingent Liabilities and Contingent Assets, a contingent liability is: (1) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or a present obligation that arises from past events but is not recognised because: it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or the amount of the obligation cannot be measured with sufficient reliability.
(2)
It is right that, in accordance with HKAS 37, UHL should not recognise a contingent liability. A contingent liability should be disclosed, unless the possibility of an outflow of resources embodying economic benefits is remote. However, since the further acquisition of the 50 per cent of STL constitutes a business combination, which is defined by HKFRS 3 (revised) Business Combinations as the bringing together of separate entities or businesses into one reporting entity, UHL should also apply HKFRS 3. In accordance with HKFRS 3 (revised), UHL (as the acquirer) should recognise STL's contingent liabilities separately at the acquisition date if, at that date, the fair value of the contingent liabilities can be measured reliably. Although STL's contingent liability of HK$1,000,000 was not recognised by STL before the business combination, that contingent liability has a fair value, the amount of which reflects market expectations about any uncertainty surrounding the possibility that an outflow of resources embodying economic benefits will be required to settle the possible or present obligation. As a result, the existence of STL's contingent liabilities has the effect of lowering the price that UHL is prepared to pay for the controlling interest in STL. UHL has, in effect, been paid to assume an obligation in the form of a reduced purchase price for the controlling interest in STL. (v) Goodwill on consolidation The 'goodwill' in the consolidated financial statements represents the payment made by UHL on acquisition of the controlling interest in STL in anticipation of future economic benefits from assets that are not capable of being individually identified and separately recognised. It is measured as the residual cost of the business combination after recognising STL's identifiable assets, liabilities and contingent liabilities. In accordance with HKFRS 3, UHL should, at the acquisition date, recognise the goodwill acquired in the business combination with STL as an asset; and initially measure that goodwill at its cost. The investment in STL is a business combination involving more than one exchange transaction since it occurred in stages by successive share purchases. However, goodwill is only calculated when control is first achieved, in this case on 31 March 2006. After initial recognition at 31 March 2006, UHL should measure goodwill at cost less any accumulated impairment losses. UHL should test the goodwill for impairment annually, or more frequently if events or changes in circumstances indicate that it might be impaired, in accordance with HKAS 36 Impairment of Assets. Since UHL acquired the goodwill at 31 March 2006, no impairment loss need to be recognised as at that date.
772
The calculation of the goodwill at 31 March 2006 is as follows: Cost of investment for the 50% acquired at 31 March 2006 Non-controlling interest (30% (37,400,000 1,000,000)) Fair value of previously held 20% stake Net assets at 31 March 2006 Goodwill
HKD'000 30,000 10,920 10,000 50,920 (36,400) 14,520
I hope the above explanation has answered your queries. Please feel free to contact me if you have further queries. Best regards David Lee (b) CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF UHL AS AT 31 MARCH 2006 UHL HKD'000 Net assets Land lease premium Property, plant and equipment Investment in a subsidiary Goodwill Net current assets Issued equity Retained earnings Non-controlling interest Notes (1) (2) (3) HK$20,000,000 9,800,000 Answer 4 (a)(v) + + Pre-acquisition retained earnings of STL = HK$17,200,000 equity method profits HK$2,400,000 HK$96,000 gain on fair value of 20% stake HK$696,000 (HK$10,000,000 HK$9,304,000) 10,000 21,000 37,000 9,000 77,000 65,000 12,000 77,000 STL HKD'000 9,800 17,400 27,200 10,000 17,200 27,200 Adjust HKD'000 10,200 (37,000) 14,520 (1,000) (13,280) (10,000) (14,200) 10,920 (13,280) 1 Note Consolidated HKD'000 10,000 41,000 14,520 25,400 90,920 65,000 15,000 10,920 90,920
3 4
(4) CJ 1
30% (HK$37,400,000 HK$1,000,000)
No consolidation adjustment is required at 31 March 2005. However, it is possible to analyse the balance of investment in an associate by putting through a consolidation journal as follows: HK$'000 HK$'000 DEBIT Investment in an associate share of equity at date of acquisition Investment in an associate fair value adjustments (HK$16,000,000 HK$11,200,000) 20% Investment in an associate goodwill CREDIT Investment in an associate costs of acquisition being analysis of investment in an associate for consolidation purposes.
3,040 960 3,000 7,000
773
Financial Reporting
CJ 2 HK$'000 DEBIT Investment in an associate share of post acquisition profit of an associate (HK$12,000,000 20%) HK$'000
2,400 2,400
CREDIT Profit or loss share of post acquisition profit of an associate being recognition of UHL's share of STL's profit for the year. CJ 3 DEBIT Profit or loss share of post acquisition profit of an associate (HK$960,000/10 years) 96
CREDIT Investment in an associate being recognition of depreciation adjustment for the year. CJ 4 DEBIT Share capital Retained earnings Property, plant and equipment (HK$20,000,000 9,800,000) Goodwill CREDIT Net current assets (Provision for STL's contingent liability) Non-controlling interests (HK$36,400,000 30%) Investment in an associate [See Answer 4 (a)(iii)] Retained earnings (HK$10,000,000 HK$9,304,000) Investment in a subsidiary DEBIT Investment in an associate** 7,000 10,000 17,200 10,200 14,520
96
1,000 10,920 9,304 696 30,000
CREDIT Investment in a subsidiary**
7,000
being elimination of share capital, pre-acquisition reserves against cost of investment and recognition of goodwill and non-controlling interest in assets and liabilities. **This eliminates the effect of the transfer from the cost of the 20 per cent investment in STL as investment in an associate to an investment in a subsidiary made at the entity level of UHL.
774
Answer 5
(a) In accordance with the Code of Ethics for Professional Accountants of HKICPA (the 'Code'): Mr. V Chow, as the independent non-executive director of the listed company, should consider the need to maintain confidentiality of information within the listed company. Mr. V Chow should not disclose the confidential information contained in the draft audited financial statements of the listed company to Mr. K Chow without proper and specific authority. Both Mr. K Chow and Mr. V Chow should not use confidential information acquired as a result of professional and business relationships to their personal advantage or the advantage of third parties. Both Mr. K Chow and Mr. V Chow should comply with relevant laws and regulations and should avoid any action that discredits the profession. The trading of shares by Mr. K Chow would constitute insider dealing under the Securities and Futures Ordinance. Insider dealing in relation to the listed securities of a corporation takes place when, inter alia, a person who is connected with the corporation and who is knowingly in possession of relevant information deals in listed securities of the corporation or counsels or procures another person to do so knowing or having reasonable cause to believe that such person would deal in them. Relevant information is specific information about a corporation which is not generally known to persons accustomed or likely to deal in the listed securities of that corporation but which would materially affect the price of the securities if it were. (b) Goodwill can still be recognised in the financial statements prepared under merger accounting for a business combination under common control. The concept underlying the use of merger accounting to account for a common control combination is that no acquisition has occurred and there has been a continuation of the risks and benefits to the controlling party (or parties) that existed prior to the combination. The net assets of the combining entities or businesses are consolidated using the existing book value from the controlling parties perspective. The assets and liabilities of the acquired entity or business should be recorded at the book values as stated in the financial statements of the controlling party. That is, it will require recording of: the fair value of the identifiable assets and liabilities of the acquired entity or business at the date of original acquisition from third parties by the controlling party. any remaining goodwill arising on the previous acquisition and non-controlling interest recorded in the consolidated financial statements of the controlling party.
There is no recognition of any additional goodwill or excess of acquirers interest in the net fair value of the acquirees identifiable assets, liabilities and contingent liabilities over cost at the time of common control combination to the extent of the continuation of the controlling party or parties interest.
775
Financial Reporting
Answer 6
(a) HDL must determine whether the modification is considered to be an extinguishment of the original bank loan in accordance with HKFRS 9. HKFRS 9, 3.3.2 requires an exchange between an existing borrower and lender of debt instruments with substantially different terms to be accounted for as extinguishment of the original financial liability and the recognition of a new financial liability. Similarly, a substantial modification of the terms of an existing financial liability is accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. B3.3.6 of HKFRS 9 states that the terms are substantially different if the discounted present value of the cash flows under the new terms, including any fees paid net of any fees received and discounted using the original effective interest rate, is at least 10 per cent different from the discounted present value of the remaining cash flows of the original financial liability. The modified cash flow of the bank loan is as follows: Year ended 30 June 2010 30 June 2011 30 June 2012 30 June 2013 Payments HK$ million 12.00 12.00 12.00 212.00
Present value at 30 June 2009 discounting at original effective interest rate of 8% is HK$186.75 million. As the difference between the amortised cost of the bank loan at the date of modification, 30 June 2009 (HK$200 million) and the present value of the new bank loan, discounted by the original effective interest rate (HK$186.75 million), is less than 10 per cent ([HK$200 million HK$186.75 million]/ HK$200 million x 100% = 6.625%), the modification is not considered as extinguishment of the original bank loan. No gain or loss is recognised for the modification and the carrying amount of the bank loan is still HK$200 million. The bank loan was originally repayable on 30 June 2010 and classified as current liability. The modification of the maturity date of the bank loan results in such liability to be settled more than twelve months after the reporting period. Accordingly, it is classified as noncurrent liability in the statement of financial position as at 30 June 2010. (b) In accordance with AG35 of HKAS 32, an entity may amend the terms of a convertible instrument to induce early conversion, for example by offering a more favourable conversion ratio or paying other additional consideration in the event of conversion before a specific date. The difference, at the date the terms are amended, between the fair value of the consideration the holder receives on conversion of the instrument under the revised terms and the fair value of the consideration the holder would have received under the original terms is recognised as a loss in profit or loss.
776
Journal entries that HDL should make on 30 June 2009: HK$ DEBIT CREDIT Expense Convertible bonds equity reserve 18,500,000 18,500,000 HK$
To record the amendment of the terms of conversion (100 x (2,500,000 2,000,000) x HK$0.45) HK$4,000,000. DEBIT Convertible bonds Interest payable Convertible bonds equity reserve Share capital Share premium 96,296,296 4,000,000 25,633,058 25,000,000 100,929,354
CREDIT
To record the conversion of the bonds under the amended terms of conversion and waive interest payable.
Answer 7
(a) Share-based compensation expense for the year ended 31 March 2009: = [(2,000,000 / 4 x HK$8)] + [(2,000,000 / 4 x HK$8) / 2] + [(2,000,000 / 4 x HK$8) / 3] + [(2,000,000 / 4 x HK$8) / 4] = HK$4,000,000 + HK$2,000,000 + HK$1,333,333 + HK$1,000,000 = HK$8,333,333 Share-based compensation expense for the year ended 31 March 2010: = [(2,000,000 / 4 x HK$8) / 2] + [(2,000,000 / 4 x HK$8) / 3] + [(2,000,000 /4 x HK$8) / 4] = HK$2,000,000 + HK$1,333,333 + HK$1,000,000 = HK$4,333,333 (b) Accounting implication of cancellation of unvested awarded share options on 1 April 2010: According to HKFRS 2.28, if a grant of equity instruments is cancelled or settled during the vesting period (other than a grant cancelled by forfeiture when the vesting conditions are not satisfied): (a) the entity shall account for the cancellation or settlement as an acceleration of vesting, and shall therefore recognise immediately the amount that otherwise would have been recognised for services received over the remainder of the vesting period. any payment made to the employee on the cancellation or settlement of the grant shall be accounted for as the repurchase of an equity interest, i.e. as a deduction from equity, except to the extent that the payment exceeds the fair value of the equity instruments granted, measured at the repurchase date. Any such excess shall be recognised as an expense.
(b)
Share-based compensation expense originally to be recognised from 1 April 2010 to 31 March 2012: = [(2,000,000 / 4 x HK$8) / 3] + [(2,000,000 / 4 x HK$8) / 4 x 2] = HK$1,333,334 + HK$2,000,000 = HK$3,333,334 OR Accumulated compensation expense recognised up to 31 March 2010: HK$8,333,333 + HK$4,333,333 = HK$12,666,666 [(2,000,000 x HK$8) HK$12,666,666] = HK$3,333,334
777
Financial Reporting
Payment exceeds the fair value of the share options granted and cancelled, measured at 1 April 2010: = HK$5,500,000 [(2,000,000 / 4 x 2) x HK$5] = HK$500,000 Total compensation expense recognised upon cancellation of unvested awarded share options on 1 April 2010 = HK$3,333,334 + HK$500,000 = HK$3,833,334 According to HK(IFRIC) Int 11 para. 8, provided that the share-based arrangement is accounted for as equity-settled in the consolidated financial statements of the parent, the subsidiary shall measure the services received from its employees in accordance with the requirements applicable to equity-settled share-based payment transactions, with a corresponding increase recognised in equity as a contribution from the parent. The journal entries to be recorded by BS for the year ended 31 March 2010 were: DEBIT Share compensation expense CREDIT Contribution from MDS HK$4,333,333 HK$4,333,333
(c)
778
Answer 8
(a) The value of the financial liability component of the CB at initial recognition: [(6% x HK$800 / 1.08) + (6% x HK$800 / 1.08 ) + (6% x HK$800 / 1.08 ) + (6% x HK$800 / 4 4 1.08 ) + (HK$800 / 1.08 )] million = HK$[44.4 + 41.2 + 38.1 + 35.3 + 588] million = HK$747 million The initial carrying amount of the equity component of the CB: = HK$(800 747) million = HK$53 million Journal entries for the issue of the convertible bond (CB) on 1 December 2008: DEBIT Cash CREDIT Convertible Bond liability CREDIT Equity conversion option (b) HK$800 million HK$747 million HK$53 million
2 3
Carrying amount of the financial liability component of the CB at 1 April 2010: HK$[(747 million x 1.08) - (800 million x 6%)] x [1 + (0.08 x 4/12)] = HK$(806.76 48) million x 1.027 = HK$779 million Journal entries for the conversion of CB into shares on 1 April 2010: DEBIT DEBIT CREDIT CREDIT Convertible Bond liability Equity conversion option Share capital Share premium HK$779 million HK$53 million HK$100 million HK$732 million
(c)
HKFRS 9 requires an entity to measure the financial liability at fair value, plus transaction costs that are directly attributable to the issue of the financial liabilities, at initial recognition. Measurement of the fair value of the interest-free loan of HK$500 million based on the effective interest rate of other borrowings of AML, i.e. 6 per cent: HK$500 million / 1.062 = HK$445 million The journal entries for the recognition of the interest-free loan on 1 April 2010: DEBIT CREDIT CREDIT Bank or Cash Loan from a shareholder Equity contribution from a shareholder HK$500 million HK$445 million HK$55 million
779
Financial Reporting
Answer 9
CML did not have public accountability as it was not an issuer of securities and it was not in the process of issuing publicly traded equity or debt securities. In terms of size test, CML met the following two quantitative conditions: The entity had no revenue, i.e. annual revenue did not exceed HK$50 million, for the year. The entity did not have assets in excess of HK$50 million at 31 December 2009.
Under SME-FRS s.4 Intangible assets, an intangible asset arising from development phase of an internal project should be recognised if, and only if, an entity can demonstrate all the conditions set out in 4.7 are fulfilled. One of these conditions is the technical feasibility of completing the intangible asset so that it will be available for use or sale. Based on the information stated, CML did not demonstrate that this condition has been met. Accordingly, the HK$28 million expenditure cannot be recognised as an intangible asset, but charged to profit or loss. As a result, the total assets of CML at 31 December 2009 was estimated to be approximately HK$37 million [= 60 (28 5) million]. Provided that both shareholders of CML agree to prepare the financial statements in accordance with the SME-FRS, CML qualifies for reporting under the SME-FRS for the year ended 31 December 2009.
Answer 10
(a) Investment property HKAS 40 defines an investment property as a property held to earn rentals or for capital appreciation or both, rather than for use in the production or supply of goods or services or for administrative purposes; or sale in the ordinary course of business. From the perspective of PPY, the property is an investment property because it meets the definition stated above by leasing it to another party (a senior manager of SFL). Therefore, PPY correctly treats the property as an investment property in its separate financial statements. However, PPYs property is leased to, and occupied by, an employee of its subsidiary (SFL). Paragraph 9(c) of HKAS 40 specifies that owner-occupied property includes property occupied by employees (whether or not the employees pay rent at market rates) and it is one of the examples of items that are not investment property and are therefore outside the scope of HKAS 40. From the perspective of the group, an employee of SFL is an employee of the group. Thus the property does not qualify as an investment property in the consolidated financial statements, because the property is owner-occupied from the perspective of the group.
780
Therefore, the relevant investment property, with a fair value of HK$6 million, has to be reclassified as property, plant and equipment in the consolidated financial statements. Nonetheless, the rent paid by the senior manager of SFL to PPY is not an intragroup income and expense and thus the relevant rental income is not eliminated in preparing the consolidated financial statements. I hope the above explanation has answered your questions. For the details, please refer to the annex. Please feel free to contact me if you have further queries. Best regards, Tommy Lau (b) Annex (i) Worksheet for the consolidated statement of comprehensive income
PPY HK$ Sales Cost of sales Gross profit Other income (Dividend income) Distribution costs Administrative expenses Finance costs Profit before tax Income tax expense Profit for the year Other comprehensive income: revaluation surplus Total comprehensive income 80,000,000 (51,200,000) 28,800,000 SFL HK$ 38,400,000 (25,600,000) 12,800,000 DEBIT (HK$) 4,800,000 640,000 250,000 Eliminations working(s) W7 W7 W2/W6 4,800,000 400,000 41,110,000 CREDIT (HK$) Consolidated HK$ 113,600,000 (72,490,000)
1,280,000 (3,000,000) (5,000,000) (5,760,000) 16,320,000 (3,520,000) 12,800,000
-(2,300,000) (2,500,000) (1,120,000) 6,880,000 (2,080,000) 4,800,000
1,280,000
W3
-(5,300,000) (7,500,000)
(a)
600,000
(6,280,000) 22,030,000
66,000
W6/W7 W2
105,600 41,250
(5,519,150) 16,510,850
6,000,000
1,200,000
7,200,000
18,800,000
6,000,000
23,710,850
781
Financial Reporting
Profit attributable to: Owners of the parent Non-controlling interests Total comprehensive income attributable to: Owners of the parent Non-controlling interests 878,170 240,000 W4 W4a 22,592,680 1,118,170 23,710,850 878,170 W4 15,632,680 878,170 16,510,850
(ii)
Worksheet for consolidated statement of financial position

PPY HK$ SFL HK$ DEBIT (HK$) Eliminations working(s) CREDIT (HK$) Consolidated HK$
Property, plant and equipment, net Investment properties Investment in SFL, at cost Goodwill Other intangible assets, net Deferred tax asset Inventories Trade and other receivables Cash and cash equivalents
40,000,000
7,600,000
600,000 6,000,000
(a) (b) (b) W1 6,000,000 25,600,000
54,200,000
20,800,000 12,000,000 25,600,000 ---1,530,000 2,500,000 105,600
26,800,000 -1,530,000
W1 W1/W2 W7 W7 640,000 750,000
-- 11,200,000 ---
12,950,000 105,600 72,160,000 39,000,000 33,400,000 240,145,600
51,200,000 21,600,000 25,000,000 14,000,000 23,000,000 10,400,000 185,600,000 76,800,000
Share capital Retained earnings Revaluation surplus Non-controlling interests
32,000,000 16,000,000 46,000,000 25,000,000 10,000,000 2,200,000
16,000,000
W1
32,000,000 56,071,480 11,760,000 99,831,480
88,000,000 43,200,000 --100,000 320,000 W1 W2 W3/W4 W4a W5 W5a 80,000 W6 6,017,500 16,500 878,170 240,000 1,960,000 200,000 13,200
8,825,370
782
Deferred tax liability Trade and other payables Long term loan 47,600,000 13,600,000 50,000,000 20,000,000 185,600,000 76,800,000 WORKING:
123,750
W2/W1
412,500
288,750 61,200,000 70,000,000
49,816,020
49,816,020
240,145,600
Reconciling consolidated retained earnings and consolidated revaluation surplus PPY HK$ Retained earnings, 1 April 2009 SFL HK$ DEBIT (HK$) Eliminations working CREDIT (HK$) Consolidated HK$
36,400,000 21,800,000
400,000 320,000 12,000,000 1,960,000
W2 W6 W1 W5
66,000 52,800
43,638,800
Profit for the year attributable to the owners of the parent Dividends declared Retained earnings, 31 March 2010
12,800,000 4,800,000 (3,200,000) (1,600,000) W3 1,600,000
15,632,680 (3,200,000)
46,000,000 25,000,000 PPY HK$ SFL HK$ Dr(HK$) Eliminations working Cr(HK$)
56,071,480 Consolidated HK$
Revaluation surplus, 1 April 2009 Revaluation for the year Revaluation surplus, 31 March 2010
4,000,000 1,000,000 6,000,000 1,200,000
200,000
W5a
4,800,000 6,960,000
10,000,000 2,200,000
11,760,000
Note: The journal entries are for illustrative purpose only. They are not required by the question. HK$ HK$
783
Financial Reporting
W1 - Elimination of investment in subsidiary DEBIT DEBIT DEBIT DEBIT Share capital Retained earnings Goodwill Intangible assets 16,000,000 12,000,000 1,530,000 2,500,000 412,500 25,600,000 (30,087,500 x 20%) 6,017,500
CREDIT Deferred tax liability CREDIT Investment in SFL CREDIT Non-controlling interests
W2 - Past and current amortisation on revalued intangible assets DEBIT DEBIT DEBIT Opening retained earnings Non-controlling interests Amortisation (2.5m/10 2 80%) (2.5m/10 2 20%) (2.5m/10) 400,000 100,000 250,000 750,000 (750,000 x 16.5%) (400,000 x 16.5%) (100,000 x 16.5%) (250,000 x 16.5%) 123,750 66,000 16,500 41,250
CREDIT Accumulated amortisation DEBIT Deferred tax liability
CREDIT Opening retained earnings CREDIT Non-controlling interests CREDIT Tax expense W3 - Eliminate dividend income DEBIT DEBIT Dividend income Non-controlling interests
(1,600,000 x 80%) (1,600,000 x 20%)
1,280,000 320,000 1,600,000
CREDIT Dividends declared
784
HK$ W4 - Current income to Non-controlling interests DEBIT Non-controlling interests (IS) 878,170 CREDIT Non-controlling interests (SOFP) Profit of SFL before adjustment Add: previous years unrealised profit now realised (1.2m - 0.8m) Tax effects on previous years unrealised profit (400,000 16.5%) Less: current years unrealised profit Tax effects on current year unrealised profit Less: amortisation on revalued intangible assets Tax effects on amortisation on revalued intangible assets (250,000 16.5%) Adjusted profit Non-controlling interests share (20%) W4a - Current revaluation surplus to Non-controlling interests DEBIT Non-controlling interests (IS) (1,200,000 20%) 240,000 CREDIT Non-controlling interests (SOFP) W5 - Assign post-acquisition Retained Earnings to Non-controlling interests DEBIT Opening retained earnings (from 1 April 2007 to 31 March 2009) [20% (21.8m-12m)] 1,960,000 (40% (4.8m - 3.2m)) (640,000 16.5%) 4,800,000 400,000 (66,000) (640,000) 105,600 (250,000) 41,250 4,390,850 878,170
HK$
878,170
240,000
CREDIT Non-controlling interests (SOFP) W5a - Assign post-acquisition revaluation surplus to Non-controlling interests DEBIT Opening revaluation surplus (from 1 April 2007 to 31 March 2009) [20% (1m-0m)] 200,000
1,960,000
CREDIT Non-controlling interests W6 - Realisation of opening unrealised profit in inventory DEBIT DEBIT Opening retained earnings Non-controlling interests 320,000 80,000
200,000
CREDIT Cost of sales DEBIT Tax expense (400,000 16.5%) 66,000
400,000
CREDIT Opening retained earnings (320,000 16.5%) CREDIT Non-controlling interests (80,000 16.5%)
52,800 13,200
W7 - Elimination of intercompany sale of inventory DEBIT DEBIT Sales Cost of sales (1.6m 40%) 4,800,000 4,800,000 640,000 640,000 CREDIT Cost of sales CREDIT Inventory
785
Financial Reporting
HK$ DEBIT Deferred tax asset (640,000 16.5%) 105,600 CREDIT Tax expense Reconciliation of Non-controlling interests in SOFP: Shareholders equity of SFL at 31 March 2010 Fair value adjustment of intangible assets Tax on fair value adjustment of intangible assets (2.5m 16.5%) Accumulated amortisation on fair value adjustment of intangible assets (2.5m/10 3) Tax on acc. amortisation on fair value adjustment of intangible assets Unrealised profit on upstream sale Tax on unrealised profit on upstream sale Adjusted shareholders equity of SFL at 31 March 2010 NCIs share @ 20% or Shareholders equity of SFL at 31 March 2010 Fair value adjustment of intangible assets Tax on fair value adjustment of intangible assets (2.5m 16.5%) Accumulated amortisation on fair value adjustment of intangible assets (2.5m/10 3) Tax on acc. amortisation on fair value adjustment of intangible assets Unrealised profit on upstream sale Tax on unrealised profit on upstream sale Adjusted shareholders equity of SFL at 31 March 2010 43,200,000 2,500,000 (412,500) (750,000) 123,750 (640,000) 105,600 44,126,850 43,200,000 2,500,000 (412,500) (750,000) 123,750 (640,000) 105,600 44,126,850 8,825,370 20% NCI 8,640,000 500,000 (82,500) (150,000) 24,750 (128,000) 21,120 8,825,370
HK$ 105,600
786
Glossary of terms
787
Financial Reporting
788
Glossary of terms
Accounting policies. The specific principles, bases, conventions, rules and practices adopted by an entity in preparing and presenting financial statements. Accounting profit. Profit or loss for a period before deducting tax expense. Accrual basis. The effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Acquiree. The business or businesses that the acquirer obtains control of in a business combination. Referred to in HKFRS 10 as the investee. Acquirer. The entity that obtains control of the acquiree. Referred to in HKFRS 10 as the investor. Active market. A market in which all the following conditions exist: (a) (b) (c) The items traded in the market are homogenous Willing buyers and sellers can normally be found at any time; and Prices are available to the public
Actuarial gains and losses comprise: (a) (b) Experience adjustments (the effects of differences between the previous actuarial assumptions and what has actually occurred) The effects of changes in actuarial assumptions
Amortised cost of a financial asset or financial liability. The amount at which the financial asset or liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectability. Antidilution. An increase in earnings per share or a reduction in loss per share resulting from the assumption that convertible instruments are converted, that options or warrants are exercised, or that ordinary shares are issued upon the satisfaction of certain conditions. Asset. Any tangible or intangible possession which has value. A resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity. Assets. Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Assets are rights or other access to future economic benefits controlled by an entity as a result of past transactions or events. Associate. An entity, including an unincorporated entity such as a partnership, over which the investor has significant influence and that is neither a subsidiary nor an interest in a joint venture. Borrowing costs. Interest and other costs incurred by an entity in connection with the borrowing of funds. Carrying amount. The amount at which an asset is recognised after deducting any accumulated depreciation (amortisation) and accumulated impairment losses thereon. Cash. Comprises cash on hand and demand deposits. Cash equivalents. Short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. Cash flow hedge. Hedge of the exposure to variability in cash flows that: (a) Is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction (such as an anticipated purchase or sale), and that Could affect profit or loss.
(b)
Cash flows. Inflows and outflows of cash and cash equivalents.
789
Financial Reporting
Cash generating unit. The smallest identifiable group of assets for which independent cash flows can be identified and measured. Change in accounting estimate. An adjustment of the carrying amount of an asset or a liability, or the amount of the periodic consumption of an asset, that results from the assessment of the present status of, and expected future benefits and obligations associated with, assets and liabilities. Changes in accounting estimates result from new information or new developments and, accordingly, are not corrections of errors. Close members of the family of a person. Those family members who may be expected to influence, or be influenced by, that person in their dealings with the entity and include: (a) (b) (c) that persons children and spouse or domestic partner children of that persons spouse or domestic partner; and dependants of that person or that persons spouse or domestic partner
Closing rate. The spot exchange rate at the end of the reporting period. Comparability. An enhancing qualitative characteristic. Information is more useful if it can be compared with similar information about other entities or the same entity for another period. Consolidated financial statements. The financial statements of a group in which the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity. Construction contract. A contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use. Constructive obligation. 'An obligation that derives from an entity's actions where: By an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities, and As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.' Contingent asset. A possible asset that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity. Contingent consideration. Usually, an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met. Contingent liability (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity, or (b) a present obligation that arises from past events but is not recognised because: (i) (ii) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or the amount of the obligation cannot be measured with sufficient reliability.
Contingent rent. That portion of the lease payments that is not fixed in amount but is based on a factor other than just the passage of time (eg percentage of sales, amount of usage, price indices, market rates of interest). Contingent share agreement. An agreement to issue shares that is dependent on the satisfaction of specified conditions. Contingently issuable ordinary shares. Ordinary shares issuable for little or no cash or other consideration upon the satisfaction of specified conditions in a contingent share agreement.
790
Glossary of terms
Control. An investor controls an investee when the investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through power over the investee. Corporate governance. The system by which companies are directed and controlled. Cost. The amount of cash or cash equivalents paid or the fair value of other consideration given to acquire an asset at the time of its acquisition or construction. Cost plus contract. A construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee. Costs to sell. The incremental costs directly attributable to the disposal of an asset (or disposal group), excluding finance costs and income tax expense. Current cost. 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 obligation currently. Current service cost. The increase in the present value of the defined benefit obligation resulting from employee service in the current period. Current tax. The amount of income taxes payable (recoverable) in respect of the taxable profit (tax loss) for a period. Deferred tax assets. The amounts of income taxes recoverable in future periods in respect of: Deductible temporary differences The carry forward of unused tax losses The carry forward of unused tax credits
Deferred tax liabilities. The amounts of income taxes payable in future periods in respect of taxable temporary differences. Defined benefit plans. Post-employment benefit plans other than defined contribution plans. Defined contribution plans. Post-employment benefit plans under which an entity pays fixed contributions into a separate entity (a fund) and will have no legal or constructive obligation to pay further contributions if the fund does not hold sufficient assets to pay all employee benefits relating to employee service in the current and prior periods. Depreciable amount. The cost of an asset, or other amount substituted for cost, less its residual value. Depreciable assets. Assets which: Are expected to be used during more than one accounting period. Have a limited useful life. Are held by an entity for use in the production or supply of goods and services, for rental to others, or for administrative purposes.
Depreciation. The systematic allocation of the depreciable amount of an asset over its useful life. Derivative. A financial instrument or other contract with all three of the following characteristics: (a) Its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable (sometimes called the 'underlying') It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors It is settled at a future date 791
(b)
(c)
Financial Reporting
Development. The application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use. Dilution. A reduction in earnings per share or an increase in loss per share resulting from the assumption that convertible instruments are converted, that options or warrants are exercised, or that ordinary shares are issued upon the satisfaction of specified conditions. Discontinued operation. A component of an entity that either has been disposed of or is classified as held for sale and: (a) (b) (c) represents a separate major line of business or geographical area of operations is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations or is a subsidiary acquired exclusively with a view to resale.
Disposal group. Group of assets to be disposed of, by sale or otherwise, together as a group in a single transaction, and liabilities directly associated with those assets that will be transferred in the transaction. (In practice, a disposal group could be a subsidiary, a cash-generating unit or a single operation within an entity.) Dividends. Distributions of profit to holders of equity investments, in proportion with their holdings, of each relevant class of capital. Economic life. Either the: (a) (b) Period over which an asset is expected to be economically usable by one or more users, or Number of production or similar units expected to be obtained from the asset by one or more users
Effective interest method. A method of calculating the amortised cost of a financial instrument and of allocating the interest income or interest expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount of the financial asset or liability. Employee benefits. All forms of consideration given by an entity in exchange for service rendered by employees. Entity specific value. The present value of the cash flows an entity expects to arise from the continuing use of an asset and from its disposal at the end of its useful life, or expects to incur when settling a liability. Equity. The residual interest in the assets of the entity after deducting all its liabilities. Equity instrument granted. The right (conditional or unconditional) to an equity instrument of the entity conferred by the entity on another party, under a share-based payment arrangement. Equity instrument. A contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Equity method. A method of accounting whereby an interest in a jointly controlled entity is initially recorded at cost and adjusted thereafter for the post acquisition change in the venturer's share of net assets of the jointly controlled entity. The profit or loss of the venturer reflects the venturer's share of the profit or loss of the jointly controlled entity. Event after the reporting period. Those events, favourable and unfavourable, that occur between the end of the reporting period and the date when the financial statements are authorised for issue. Exchange difference. The difference resulting from translating a given number of units of one currency into another currency at different exchange rates. Exchange rate. The ratio of exchange for two currencies.
792
Glossary of terms
Expenses. Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Fair value. The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value hedge. A hedge of the exposure to changes in the fair value of a recognised asset or liability, or an identified portion of such an asset or liability, that is attributable to a particular risk and could affect profit or loss. Fair value less costs to sell. The amount obtainable from the sale of an asset or cash-generating unit in an arm's length transaction between knowledgeable, willing parties, less the costs of disposal. Faithful representation. A fundamental qualitative characteristic. Financial information should faithfully represent the phenomena it purports to represent. To be a perfectly faithful representation, a depiction should be complete, neutral and free from error. Finance lease. A lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. Financial asset. Any asset that is: (a) (b) (c) Cash; An equity instrument of another entity; A contractual right to receive cash or another financial asset from another entity; or to exchange financial instruments with another entity under conditions that are potentially favourable to the entity; or A contract that will or may be settled in the entity's own equity instruments and is a: (i) (ii) Non-derivative for which the entity is or may be obliged to receive a variable number of the entity's own equity instruments Derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments
(d)
Financial instrument. Any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial liability. Any liability that is a: (a) Contractual obligation to: (i) (ii) (b) Deliver cash or another financial asset to another entity Exchange financial instruments with another entity under conditions that are potentially unfavourable
Contract that will or may be settled in the entity's own equity instruments and is a: (i) (ii) Non-derivative for which the entity is or may be obliged to deliver a variable number of the entity's own equity instruments Derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instruments
Financing activities. Activities that result in changes in the size and composition of the contributed equity and borrowings of the entity. Fixed price contract. A construction contract in which the contractor agrees to a fixed contract price, or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses.
793
Financial Reporting
Fixed production overheads. Defined by the standard as those indirect costs of production that remain relatively constant regardless of the volume of production such as depreciation and maintenance of factory buildings and equipment and the cost of factory management and administration. Fixed production overheads must be allocated to items of inventory on the basis of the normal capacity of the production facilities. Normal capacity is the expected achievable production based on the average over several periods/seasons, under normal circumstances, and taking into account the capacity lost through planned maintenance. Foreign currency. A currency other than the functional currency of the entity. Foreign operation. An entity that is a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity. Forgivable loans. Loans which the lender undertakes to waive repayment of under certain prescribed conditions. Functional currency. The currency of the primary economic environment in which the entity operates. Future economic benefit. The potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. The potential may be a productive one that is part of the operating activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce cash outflows, such as when an alternative manufacturing process lowers the cost of production. Gains. Increases in economic benefits. As such they are no different in nature from revenue. Going concern. The entity is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future. It is assumed that the entity has neither the intention nor the necessity of liquidation or of curtailing materially the scale of its operations. Goodwill. An asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually indentified and separately recognised. Government. Government, government agencies and similar bodies whether local, national or international. Government assistance. Action by government designed to provide an economic benefit specific to an entity or range of entities qualifying under certain criteria. Government grants. Assistance by government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. They exclude those forms of government assistance which cannot reasonably have a value placed upon them and transactions with government which cannot be distinguished from the normal trading transactions of the entity. Grant date. The date at which the entity and another party (including an employee) agree to a share-based payment arrangement, being when the entity and the other party have a shared understanding of the terms and conditions of the arrangement. At grant date the entity confers on the other party (the counterparty) the right to cash, other assets, or equity instruments of the entity, provided the specified vesting conditions, if any, are met. If that agreement is subject to an approval process (for example, by shareholders), grant date is the date when that approval is obtained. Grants related to assets. Government grants whose primary condition is that an entity qualifying for them should purchase, construct or otherwise acquire non-current assets. Subsidiary conditions may also be attached restricting the type or location of the assets or the periods during which they are to be acquired or held. Grants related to income. Government grants other than those related to assets.
794
Glossary of terms
Gross investment in the lease. The aggregate of: (a) (b) The minimum lease payments receivable by the lessor under a finance lease Any unguaranteed residual value accruing to the lessor
Group. A parent and all its subsidiaries. Guaranteed residual value. (a) For a lessee, that part of the residual value which is guaranteed by the lessee or by a party related to the lessee (the amount of the guarantee being the maximum amount that could, in any event, become payable). For a lessor, that part of the residual value which is guaranteed by the lessee or by a third party unrelated to the lessor who is financially capable of discharging the obligations under the guarantee.
(b)
Hedge effectiveness. The degree to which changes in the fair value or cash flows of the hedged item attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument. Hedge of a net investment in a foreign operation. HKAS 21 defines a net investment in a foreign operation as the amount of the reporting entity's interest in the net assets of that operation. Hedged item. An asset, liability, firm commitment, or forecasted future transaction that: (a) (b) Exposes the entity to risk of changes in fair value or changes in future cash flows, and that Is designated as being hedged.
Hedging. For accounting purposes, means designating one or more hedging instruments so that their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item. Hedging instrument. A designated derivative or (in limited circumstances) another financial asset or liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. (A non-derivative financial asset or liability may be designated as a hedging instrument for hedge accounting purposes only if it hedges the risk of changes in foreign currency exchange rates.) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. Identifiable. An asset is identifiable if it either: (a) is separable, ie capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability, regardless of whether the entity intends to do so. arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.
(b)
Impairment loss. The amount by which the carrying amount of an asset exceeds its recoverable amount. Impracticable. Applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so. Inception of the lease. The earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. As at this date: (a) (b) A lease is classified as either an operating lease or a finance lease In the case of a finance lease, the amounts to be recognised at the lease term are determined.
795
Financial Reporting
Income. Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Initial direct costs. Incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors. Examples of initial direct costs include amounts such as commissions, legal fees and relevant internal costs. Intangible asset. An identifiable non-monetary asset without physical substance. Interest. The charge for the use of cash or cash equivalents or amounts due to the entity. Interest cost. The increase during a period in the present value of a defined benefit obligation which arises because the benefits are one period closer to settlement. Interest rate implicit in the lease. The discount rate that, at the inception of the lease, causes the aggregate present value of the: (a) (b) Minimum lease payments Unguaranteed residual value
to be equal to the sum of: (a) (b) The fair value of the leased asset Any initial direct costs
Interim financial report. A financial report containing either a complete set of financial statements (as described in HKAS 1) or a set of condensed financial statements (as described in this standard) for an interim period. Interim period. A financial reporting period shorter than a full financial year. Intrinsic value. The difference between the fair value of the shares to which the counterparty has the (conditional or unconditional) right to subscribe or which it has the right to receive, and the price (if any) the other party is (or will be) required to pay for those shares. For example, a share option with an exercise price of $15 on a share with a fair value of $20, has an intrinsic value of $5. Inventories. Assets: Held for sale in the ordinary course of business In the process of production for such sale In the form of materials or supplies to be consumed in the production process or in the rendering of services
Investing activities. The acquisition and disposal of long-term assets and other investments not included in cash equivalents. Investment property. Property (land or a building or part of a building or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for: (a) (b) use in the production or supply of goods or services or for administrative purposes sale in the ordinary course of business.
Joint arrangement. An arrangement of which two or more parties have joint control. Joint control. 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. Joint operation. A joint arrangement whereby the parties that have joint control of the arrangement have rights to the assets and obligations for the liabilities relating to the arrangement. Joint operator. A party to a joint operation that has joint control of that joint operation.
796
Glossary of terms
Joint venture. A joint arrangement whereby the parties that have joint control of the arrangement have rights to the net assets of the arrangement. Joint venturer. A party to a joint venture that has joint control of that joint venture. Key management personnel. Those persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity. Lease. An agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. Lease term. The non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option. Lessee's incremental borrowing rate of interest. The rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset. Liability. A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Liquidation. The 'end of the road' for the company. It occurs when it is certain that the life of the company will come to an end. The process by which this occurs is called winding up. You can use the terms 'liquidation' and 'winding up' to mean broadly the same thing. However, the company does not have to be in financial difficulties to be wound up. The members of the company may decide at any time to take such action, and in some cases are obliged to do so (for example, if the company were set up to achieve a specific purpose and this has been fully achieved, there is no reason for the company to go on trading). Liquidity. The availability of sufficient funds to meet deposit withdrawals and other short-term financial commitments as they fall due. Losses. Decreases in economic benefits. As such they are no different in nature from other expenses. Material. Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. Materiality. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Measurement. The process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the statement of financial position and statement of comprehensive income. Measurement date. The date at which the fair value of the equity instruments granted is measured. For transactions with employees and others providing similar services, the measurement date is grant date. For transactions with parties other than employees (and those providing similar services), the measurement date is the date the entity obtains the goods or the counterparty renders service. Minimum lease payments. The payments over the lease term that the lessee is or can be required to make, excluding contingent rent, costs for services and taxes to be paid by and be reimbursable to the lessor, together with: (a) (b) For a lessee, any amounts guaranteed by the lessee or by a party related to the lessee. For a lessor, any residual value guaranteed to the lessor by one of the following:
797
Financial Reporting
(i) (ii) (iii)
The lessee A party related to the lessee An independent third party financially capable of meeting this guarantee.
Monetary items. Units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency. Multi-employer plans. Defined contribution plans (other than state plans) or defined benefit plans (other than state plans) that: (a) (b) Pool the assets contributed by various entities that are not under common control Use those assets to provide benefits to employees of more than one entity, on the basis that contribution and benefit levels are determined without regard to the identity of the entity that employs the employees concerned
Net investment in a foreign operation. The amount of the reporting entity's interest in the net assets of that operation. Net investment in the lease. The gross investment in the lease discounted at the interest rate implicit in the lease. Net realisable value. The estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Non-cancellable lease. A lease that is cancellable only in one of the following situations: (a) (b) (c) (d) Upon the occurrence of some remote contingency. With the permission of the lessor. If the lessee enters into a new lease for the same or an equivalent asset with the same lessor. Upon payment by the lessee of an additional amount such that, at inception, continuation of the lease is reasonably certain.
Non-controlling interest. The equity in a subsidiary not attributable, directly or indirectly, to a parent. Non-current asset. An asset intended for use on a continuing basis in the entity's activities, ie it is not intended for resale. Obligation. A duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise, however, from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. Off-balance sheet finance. The funding or refinancing of a company's operations in such a way that, under legal requirements and traditional accounting conventions, some or all of the finance may not be shown in its statement of financial position. Onerous contract. A contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. The unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it. Operating activities. The principal revenue-producing activities of the entity and other activities that are not investing or financing activities. Operating lease. A lease other than a finance lease. Operating segment. A component of an entity: (a) That engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same entity),
798
Glossary of terms
(b)
Whose operating results are regularly reviewed by the entity's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance, and For which discrete financial information is available.
(c)
Options, warrants and their equivalents. Financial instruments that give the holder the right to purchase ordinary shares. Ordinary share. An equity instrument that is subordinate to all other classes of equity instruments. Other long-term employee benefits. Employee benefits (other than post-employment benefits and termination benefits) that are not due to be settled within twelve months after the end of the period in which the employees render the related service. Owner-occupied property. Property held by the owner (or by the lessee under a finance lease) for use in the production or supply of goods or services or for administrative purposes. Parent. An entity that controls one or more entities. Past service cost. The change in the present value of the defined benefit obligation for employee service in prior periods, resulting in the current period from the introduction of, or changes to, postemployment benefits or other long-term employee benefits. Past service cost may be either positive (when benefits are introduced or changed so that the present value of the defined benefit obligation increases) or negative (when existing benefits are changed so that the present value of the defined benefit obligation decreases). Plan assets comprise: (a) (b) Assets held by a long-term employee benefit fund Qualifying insurance policies
Post-employment benefit plans. Formal or informal arrangements under which an entity provides post-employment benefits for one or more employees. Post-employment benefits. Employee benefits (other than termination benefits) which are payable after the completion of employment. Potential ordinary share. A financial instrument or other contract that may entitle its holder to ordinary shares. Power. Existing rights that give the current ability to direct the relevant activities. Present value of a defined benefit. The present value, without deducting any plan assets, of expected future payments required to settle the obligation resulting from employee service in the current and prior periods. Present value. The present discounted value of the future net cash flows in the normal course of business. Presentation currency. The currency in which the financial statements are presented. Prior period errors. Omissions from, and misstatements in, the entity's financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that: Was available when financial statements for those periods were authorised for issue Could reasonably be expected to have been obtained and taken into account in the preparation and presentation of those financial statements
Property, plant and equipment. Tangible items that are: Held for use in the production or supply of goods or services, for rental to others, or for administrative purposes Expected to be used during more than one period
799
Financial Reporting
Prospective application of a change in accounting policy and of recognising the effect of a change in an accounting estimate, respectively, are: Applying the new accounting policy to transactions, other events and conditions occurring after the date as at which the policy is changed Recognising the effect of the change in the accounting estimate in the current and future periods affected by the change
Provision. A liability of uncertain timing or amount. A present obligation which satisfies the rest of the definition of a liability, even if the amount of the obligation has to be estimated. Qualifying asset. An asset that necessarily takes a substantial period of time to get ready for its intended use or sale. Realisable (settlement) value Realisable value. The amount of cash or cash equivalents that could currently be obtained by selling an asset in an orderly disposal. Settlement value. The undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.
Recognition. The process of incorporating in the statement of financial position or statement of comprehensive income an item that meets the definition of an element and satisfies the following criteria for recognition: (a) (b) It is probable that any future economic benefit associated with the item will flow to or from the entity. The item has a cost or value that can be measured with reliability.
Recoverable amount. The higher of an asset's fair value less costs to sell and its value in use. Recoverable amount of an asset. The higher of its fair value less costs to sell and its value in use. Related party. A person or entity that is related to the entity that is preparing its financial statements. Related party transaction. A transfer of resources, services or obligations between a reporting entity and a related party, regardless of whether a price is charged. Relevance. Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations. Relevant activities. Activities of the investee that significantly affect the investees returns. Reporting entity. An entity for which there are users who rely on the financial statements as their major source of financial information about the entity. Research. Original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Residual value. The estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life. Restructuring. A programme that is planned and controlled by management and materially changes either: the scope of a business undertaken by an entity, or the manner in which that business is conducted
Retrospective application. Applying a new accounting policy to transactions, other events and conditions as if that policy had always been applied. 800
Glossary of terms
Retrospective restatement. Correcting the recognition, measurement and disclosure of amounts of elements of financial statements as if a prior period error had never occurred. Return on plan assets. Interest, dividends and other revenue derived from the plan assets, together with realised and unrealised gains or losses on the plan assets, less any cost of administering the plan (other than those included in the actuarial assumptions used to measure the defined benefit obligation) and less any tax payable by the plan itself. Revaluation. Restatement of assets and liabilities. Revenue. The gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants. Royalties. Charges for the use of non-current assets of the entity, eg patents, computer software and trademarks. Service concession arrangements. Arrangements whereby a government or other body grants contracts for the supply of public services such as roads, energy distribution, prisons or hospitals to private operators. The objective of this project of the HK(IFRIC) is to clarify how certain aspects of existing HKICPA literature are to be applied to service concession arrangements. Share option. A contract that gives the holder the right, but not the obligation, to subscribe to the entity's shares at a fixed or determinable price for a specified period of time. Share-based payment arrangement. An agreement between the entity (or another group entity) and another party (including an employee) that entitles the other party to receive: (a) (b) cash or other assets of the entity for amounts that are based on the price (or value) of equity instruments (including shares or share options) of the entity or another group entity, or equity instruments (including shares or share options) of the entity or another group entity
provided the specified vesting conditions are met. Share-based payment transaction. A transaction in which the entity: (a) (b) receives goods or services from the supplier of those goods or services (including an employee) in a share-based payment arrangement, or incurs an obligation to settle the transaction with the supplier in a share-based payment arrangement when another group entity receives those goods or services.
Short-term employee benefits. Employee benefits (other than termination benefits) that are due to be settled within twelve months after the end of the period in which the employees render the related service. Significant influence. The power to participate in the financial and operating policy decisions of an entity, but is not control or joint control over those policies. Significant influence may be gained by share ownership, statute or agreement. Solvency. The availability of cash over the longer term to meet financial commitments as they fall due. Spot exchange rate. The exchange rate for immediate delivery. Subsidiary. An entity, including an unincorporated entity such as a partnership, that is controlled by another entity (known as the parent). Substance over form. The principle that transactions and other events are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. Tax base of an asset or liability. The amount attributed to that asset or liability for tax purposes. Tax expense/(tax income). The aggregate amount included in the determination of profit or loss for the period in respect of current tax and deferred tax.
801
Financial Reporting
Taxable profit/(tax loss). The profit (loss) for a period, determined in accordance with the rules established by the taxation authorities, upon which income taxes are payable (recoverable). Temporary differences. Differences between the carrying amount of an asset or liability in the statement of financial position and its tax base. Temporary differences may be either: Taxable temporary differences, which are temporary differences that will result in taxable amounts in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled; or Deductible temporary differences, which are temporary differences that will result in amounts that are deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled. Entity's decision to terminate an employee's employment before the normal retirement date Employee's decision to accept voluntary redundancy in exchange for those benefits
Termination benefits. Employee benefits payable as a result of either an: (a) (b)
Timeliness. An enhancing characteristic which means having information available in time to be capable of influencing decisions. Understandability. An enhancing qualitative characteristic. Classifying, characterising and presenting information clearly and concisely makes it understandable. Unearned finance income. The difference between the: (a) (b) Gross investment in the lease Net investment in the lease
Unguaranteed residual value. That portion of the residual value of the leased asset, the realisation of which by the lessor is not assured or is guaranteed solely by a party related to the lessor. Useful life. One of two things. The period over which an asset is expected to be available for use by an entity. The number of production or similar units expected to be obtained from the asset by an entity.
Useful life. The estimated remaining period, from the beginning of the lease term, without limitation by the lease term, over which the economic benefits embodied in the asset are expected to be consumed by the entity. Value in use. The present value of estimated future cash flows expected to arise from the continuing use of an asset and from its disposal at the end of its useful life. Variable production overheads. Those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and labour. Verifiability. An enhancing qualitative characteristic. Different knowledgeable and independent observers could reach consensus that a depiction is a faithful representation. Vest. To become an entitlement. Under a share-based payment arrangement, a counterparty's right to receive cash, other assets, or equity instruments of the entity vests when the counterpartys entitlement is no longer conditional on the satisfaction of any vesting conditions. Vested employee benefits. Employee benefits that are not conditional on future employment. Vesting conditions are the conditions that determine whether the entity receives the services that entitle the counterparty to receive cash, other assets or equity instruments of the entity, under a share-based payment arrangement. Vesting conditions are either service conditions or performance conditions. Service conditions require the counterparty to complete a specified period of service. Performance conditions require the counterparty to complete a specified period of service and specified performance targets to be met (such as a specified increase in the entitys profit over a specified period of time). A performance condition might include a market condition. Vesting period. The period during which all the specified vesting conditions of a share-based payment arrangement are to be satisfied. 802
Index
803
Financial Reporting
804
Index
Note: Key Terms and their page references are given in bold.
A
Accounting Bulletins (ABs), 28, 33 Accounting Guideline 5 (AG5), 682 Accounting Guidelines (AGs), 28, 33 Accounting policies, 481 Accounting profit, 303 Accounting standards and choice, 31 Acquiree, 577 Acquirer, 577 Acquisition, 484 Active market, 146 Actuarial gains and losses, 339 Amortised cost, 391 Antidilution, 497 Approved share registrars, 25 Asset, 49 Assets, 49 Assets held for sale, 80 Associate, 324, 570, 637 Associates and joint ventures, 458 Conceptual framework, 38 Conceptual nature of employee benefit costs, 337 Confidentiality, 36 Consolidated financial statements, 570 Construction contract, 238 Constructive obligation, 221 Contingent asset, 219 Contingent consideration, 577 Contingent liability, 219 Contingent rent, 181 Contingent rights and obligations, 377 Contingent share agreement, 497 Contingently issuable ordinary shares, 497 Control, 470, 570 Corporate governance, 8 Corporate Governance Committee of the Hong Kong Institute of CPAs, 9 Corporate Governance Disclosure in Annual Reports A Guide to Current Requirements and Recommendations for Enhancement, 9 Cost, 95, 115, 429, 484, 485 Cost model, 98, 119 Cost plus contract, 238 Costs to sell, 81 Current cost, 54 Current developments, 56, 414 Current service cost, 339 Current tax, 303 Curtailment, 352
B
Basis of provision of deferred tax, 318 Borrowing costs, 363, 369 Business combinations, 571
C
Capital maintenance, 51 Carrying amount, 95, 115, 156 Cash, 445 Cash and cash equivalents, 445 Cash equivalents, 445 Cash flow hedge, 401 Cash flows, 443, 445 Cash generating unit, 161 Change in accounting estimate, 481 Classification as assets held for sale, 80 Close members of the family of a person, 471 Closing rate, 424 Code of Ethics for Professional Accountants, 36, 37 Companies listed on GEM, 35 Companies listed on the Main Board, 34 Companies Ordinance, 7, 9, 12, 28, 34 Company secretary, 11 Compliance with HKFRS, 54 Compound financial instruments, 381
D
Debt instruments, 12 Deductible temporary differences, 308, 314 Deferred tax, 306 Deferred tax assets, 308, 310 Deferred tax liabilities, 308 Deferred taxation and business combinations, 321 Defined benefit liability, 353 Defined benefit plans, 338 Defined contribution plans, 338 Depreciable amount, 99 Depreciable assets, 99 Depreciation, 99, 536 Derecognition, 105
805
Financial Reporting
Derivative, 376 Derivative instruments, 375 Diluted EPS, 504 Dilution, 497 Direct method, 448 Directors' responsibilities, 9 Disclosure requirements for companies listed on the GEM, 35 Disclosure requirements for companies listed on the Main Board, 34 Discontinued operations, 85 Disposal group, 79 Disposal of foreign entity, 433 Dividends, 279
Foreign currency, 423, 536 Foreign operation, 424 Forgivable loans, 129 Framework, 278 Framework for Preparation and Presentation of Financial Statements (the Framework), 32 Functional currency, 423 Future economic benefits, 53
G
Generally Accepted Accounting Principles (GAAP), 39 GAAP for Small and Medium-sized Entities, 41 Gains, 51 Goodwill, 154, 577 Goodwill (HKFRS 3), 152 Goodwill and fair value adjustments, 431 Government, 129 Government assistance, 129 Government grants, 129 Grant date, 256 Grants related to assets, 129 Grants related to income, 129 Gross investment in the lease, 180 Group, 570 Guaranteed residual value, 180
E
Economic life, 180 Effective interest method, 391 Effective interest rate, 391 Effectiveness, 402 Elements of financial statements, 48 Employee benefits, 338 Entity specific value, 95 Equity, 49, 50 Equity instrument, 256, 376 Equity instrument granted, 256 Equity method, 637, 639 Ethics, 37 Exchange difference, 423 Exchange differences, 426 Exchange rate, 423 Exemption from preparing group accounts, 573 Expenses, 51
H
Hedge effectiveness, 400 Hedge of a net investment in a foreign operation, 401 Hedged item, 400 Hedging, 400 Hedging instrument, 400 Held for sale, 80, 89 Highly probable sale, 80 Historical cost, 54 HK(IFRIC) Int-1 Changes in Existing Decommissioning, Restoration and Similar Liabilities, 229 HK(IFRIC) Int-4 Determining whether an Arrangement contains a Lease, 196 HK(IFRIC) Int-5 Rights to Interests from Decommissioning Restoration and Environmental Rehabilitation Funds, 230 HK(IFRIC) Int-10 Interim Financial Reporting and Impairment, 538 HK(IFRIC) Int-12 Service Concession Arrangements, 286 HK(IFRIC) Int-13 Customer Loyalty Programmes, 289
F
Fair presentation, 54 Fair value, 81, 95, 115, 129, 205, 256, 279, 376, 484 Fair value hedge, 401 Fair value less costs to sell, 156 Fair value model, 115, 118, 119 Finance lease, 178 Financial asset, 376 Financial instrument, 376 Financial liability, 376 Financial position, 49 Financial Reporting Council (FRC), 26 Financial Reporting Standards Committee ('FRSC') of the Hong Kong Institute of CPAs, 29, 58 Financing activities, 445, 447 Fixed price contract, 238 Fixed production overheads, 206 806
Index
HK(IFRIC) Int-15 Agreements for the Construction of Real Estate, 291 HK(IFRIC) Int-17 Distributions of Non-cash Assets to Owners, 690 HK(IFRIC) Interpretations, 32 HK(SIC) Int-10 Government Assistance no specific relation to operating activities, 133 HK(SIC) Int-15 Operating Leases Incentives, 182 HK(SIC) Int-21 Income Taxes Recovery of Revalued Non-depreciable Assets, 327 HK(SIC) Int-25 Income taxes Changes in the Tax Status of an Entity or its Shareholders, 328 HK(SIC) Int-27 Evaluating the Substance of Transactions in the Legal Form of a Lease, 196 HK(SIC) Int-32 Intangible Assets Website Costs, 150 HK(SIC) Interpretations, 32 HKAS 1 Presentation of Financial Statements, 384, 414, 545 HKAS 2 Inventories, 205 HKAS 7 Statement of Cash Flows, 444 HKAS 8, 305 HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, 305, 481, 485, 585, 682 HKAS 10 Events after the Reporting Period, 488 HKAS 11 Construction Contracts, 237, 291 HKAS 12 Income Taxes, 303, 384, 430 HKAS 16 Property, Plant and Equipment, 95 HKAS 17 Leases, 177, 194 HKAS 18 Revenue, 278, 291, 293 HKAS 19 Employee Benefits, 337 HKAS 20 Government Grants, 129 HKAS 21 The Effects of Changes in Foreign Exchange Rates, 423 HKAS 23 Borrowing Costs, 363 HKAS 28 Investments in Associates and Joint Ventures, 637 HKAS 32 Financial Instruments: Presentation, 375, 378 HKAS 33 Earnings Per Share, 497, 532 HKAS 34 Interim Financial Reporting, 531 HKAS 36 Impairment of Assets, 155, 585 HKAS 37 Provisions, Contingent Liabilities and Contingent Assets, 219 HKAS 38 Intangible Assets, 139 HKAS 39 Financial Instruments: Recognition and Measurement, 375, 398, 400 HKAS 40 Investment Property, 115 HKFRS 2 Share Based Payment, 255 HKFRS 3 (Revised) Business Combinations, 153
HKFRS 3 Business Combinations, 324, 576, 682 HKFRS 7, 407, 414 HKFRS 7 Financial instruments: Disclosures, 375 HKFRS 8 Operating segments, 519, 526 HKFRS 8 Operating Segments, 519 HKFRS 9 Financial Instruments, 375, 385 HKFRS 10, 31, 230, 431, 457, 469, 570, 571, 572, 573, 574, 576, 587, 594, 595, 659, 662, 670, 673, 683, 684 HKFRS 11, 31, 230, 570, 571, 646, 647, 649, 650, 652, 660 HKFRS 12, 31, 571, 575, 645, 650 HKFRS 13, 31, 102, 103, 107, 118, 119, 183, 257, 346, 394, 402, 407, 409, 483, 533, 582 HKICPA's Framework, 41 Hong Kong Accounting Standards, 30 Hong Kong Exchanges and Clearing Limited (HKEx), 25 Hong Kong Financial Reporting Standards, 29, 30, 33 Hong Kong Institute of CPAs (HKICPA), 23 Hong Kong Insurance Authority (HKIA), 27 Hong Kong Interpretations, 32 Hong Kong legal framework, 5 Hong Kong Monetary Authority (HKMA), 28 Hong Kong Partnerships Ordinance, 5
I
Impaired asset, 156 Impairment, 155 Impairment loss, 95, 155 Impracticable, 482 Inception of the lease, 180 Income, 51 Income statement, 404 Incremental costs, 179 Indirect method, 448 Indirect versus direct, 450 Initial direct costs, 179 Inland Revenue Department, 5 Intangible asset, 139 Integrity, 36 Interest, 279 Interest cost, 339 Interest rate implicit in the lease, 179 Interest, royalties and dividends, 283 Interim financial report, 532 Interim period, 532 Interim reports, 34 Intrinsic value, 256 Inventories, 205 Investing activities, 445, 446
807
Financial Reporting
Investment, 570 Investment products offered to the public, 25 Investment property, 115 Investor Compensation Company Limited (ICC), 25
O
Objectivity, 36 Obligation, 50 Off-balance sheet finance, 195 Officers of companies, 11 Offsetting a financial asset and a financial liability, 384 Onerous contract, 224 Operating activities, 445, 446 Operating lease, 115, 178, 182 Operating segment, 519 Options, warrants and their equivalents, 497 Ordinary shares, 497 Originating timing differences, 309 Other long-term employee benefits, 338 Owner-occupied property, 115
J
Joint arrangement, 570 Joint control, 470, 646 Joint venture, 324, 570, 646 Joint ventures, 7
K
Key management personnel, 471
L
Lease, 178 Lease term, 179 Leasing, 177 Lessee's incremental borrowing rate of interest, 180 Lessor accounting, 189 Liabilities, 49, 54 Liability, 49, 219 Liquidation, 15 Listed companies, 25, 34 Losses, 51
P
Parent, 570 Past service cost, 339 Performance, 50 Permanent differences, 309 Plan assets, 339 Post-employment benefit plans, 338 Post-employment benefits, 338, 342 Potential ordinary share, 497 Present value, 54 Present value of a defined benefit, 339 Presentation currency, 423 Presentation of assets held for sale, 84 Prior period errors, 481 Professional Accountants Ordinance, 23 Professional behaviour, 37 Professional competence and due care, 36 Pronouncements of the International Accounting Standards Board (IASB), 28 Property, plant and equipment, 95 Proportionate consolidation, 459 Prospective application, 482 Provision, 50, 219 Provisions, 50 Purchased goodwill, 153
M
Manufacturer or dealer lessors, 192 Material, 481, 558 Materiality, 534 Measurement, 53, 54 Measurement date, 257 Measurement of assets held for sale, 81 Measurement of revenue, 279 Merger accounting for common control combinations, 682 Minimum lease payments, 179 Monetary items, 424 Multi-employer plans, 338
N
Net investment in a foreign operation, 424 Net investment in the lease, 180 Net realisable value, 205 Non-cancellable lease, 180
Q
Qualifying asset, 363
R
Realisable (settlement) value, 54 Realisable value, 54
808
Index
Receivership, 15 Recognition, 52 Recognition of items, 53 Recognition of the elements of financial statements, 52 Recoverable amount, 82 Recoverable amount of an asset, 156 Registrar of Companies, 6 Registration of charges, 12 Related party transaction, 470 Rendering of services, 282 Reporting entity, 43 Research and development costs, 143 Residual value, 95, 100 Restructuring, 14, 224 Retrospective application, 482 Retrospective restatement, 482 Return on plan assets, 339 Revaluation, 52 Revaluation model, 98 Revenue, 279 Reversal of an impairment loss, 168 Rights issue, 502 Royalties, 279
Transactions between a venturer and a joint venture, 650 Treasury shares, 382
U
Unearned finance income, 180 Unguaranteed residual value, 180 Useful life, 99, 180 Users and their information needs, 43
V
Value in use, 82, 156 Variable production overheads, 206 Vest, 257 Vested employee benefits, 338 Vesting conditions, 257 Vesting period, 257
W
Winding up, 15
S
Sale and leaseback transactions, 193 Securities and Futures Commission (SFC), 24 Service concession arrangements, 286 Settlement, 352 Settlement value, 54 Share option, 256 Share split/reverse share split, 501 Share-based payment arrangement, 256 Share-based payment transaction, 256 Short-term employee benefits, 338 Significant influence, 470, 570, 637 Sole trader business, 5 Spot exchange rate, 423 Statutory reporting, 13 Stock Exchange of Hong Kong, 23 Subsidiary, 570
T
Tax, 536 Tax base, 308, 321 Tax expense/(tax income), 303 Tax planning opportunities, 316 Taxable profit/(tax loss), 303 Taxable temporary differences, 308 Temporary differences, 308 Termination benefits, 338 809
Financial Reporting
810
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LEARNING PACK

Module A Financial Reporting

HKICPA and BPP Learning Media Ltd 2011

Module A Financial Reporting

Part B Financial reporting framework

Part C Accounting for business transactions

II Statements of cash flows

III Disclosure and reporting

Part D Group financial statements

701 739 755 787 803

Overall Structure of Module A (Financial Reporting)

Learning Outcomes Topic highlights

Topic recap Exam practice

Chapter where covered

Chapter where covered

Chapter where covered

Chapter where covered

Chapter where covered

Chapter where covered

Chapter where covered

Chapter where covered

Chapter where covered

Chapter where covered

Chapter where covered

Chapter where covered

Chapter where covered

List of Accounting Standards

* These standards are not examinable at the examination.

1: Legal environment | Part A Legal environment

1 Hong Kong legal framework

1.1 Types and relative advantages of alternative forms of organisation

1.1.1 Sole trader business

1: Legal environment | Part A Legal environment

1.1.4 Joint ventures

1.2 Legal procedures for establishment of companies

1.3 Corporate governance

1: Legal environment | Part A Legal environment

2 Obligations of directors and officers of companies

2.1 Directors' responsibilities

2.1.1 Duties and responsibilities

2.1.2 Powers and obligations

1: Legal environment | Part A Legal environment

2.2 Officers of companies

2.2.1 The role of the secretary

2.2.2 Powers and duties of the company secretary

3.1 Share issues and prospectus requirements

3.2 Debt instruments and registration of charges

3.2.1 Registration of charges

1: Legal environment | Part A Legal environment

3.3 Statutory reporting and documentation requirements

3.4 Appointment and removal of auditors

3.4.1 New auditors

3.4.2 Removal and resignation of auditors

3.5 Restructuring, including appointment of receivers and liquidators

1: Legal environment | Part A Legal environment

1: Legal environment | Part A Legal environment

Preparing financial statements

Financial reporting framework

Financial reporting framework

2: Financial reporting framework | Part B Financial reporting framework

1 Regulatory bodies and their impact on accounting

1.1 The role of the Hong Kong Institute of CPAs (HKICPA)

(b) (c) (d)

1.3 Securities and Futures Commission (SFC)