SECTION A – CASE QUESTIONS (Total: 50 marks)

Answer the following ONE compulsory question which relates to the Case below. Marks
will be awarded for logical argumentation and appropriate presentation of the answers.

CASE

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 (HKD7,000,000), 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 HKD20,000,000, and the
carrying amount of those assets was HKD15,200,000. STL had no liabilities or contingent
liabilities at that date. The following shows STL’s balance sheet at 31 March 2005 together
with the fair values of the identifiable assets:

Carrying Fair
amounts values
HKD’000 HKD’000
Plant and equipment (net) 11,200 16,000
Net current assets 4,000 4,000
15,200 20,000
Issued equity:
1,000,000 ordinary shares 10,000
Retained earnings 5,200
15,200

During the year ended 31 March 2006, STL reported a profit of HKD12,000,000 but did not
pay any dividends. In addition, the fair value of STL’s plant and equipment further
increased to HKD20,000,000.

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
(HKD30,000,000), 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.

Module A (September 2006 Session) Page 1 of 7

The following shows the balance sheets of UHL and STL at 31 March 2006 together with the
fair values of STL’s identifiable assets at that date:

UHL STL STL

Carrying Fair
amounts values
HKD’000 HKD’000 HKD’000
Land lease premium 10,000 - -
Property, plant and equipment (net) 21,000 9,800 20,000
Investment in a subsidiary 37,000 - -
Net current assets 9,000 17,400 17,400
77,000 27,200 37,400
Issued equity:
Ordinary shares 65,000 10,000
Retained earnings 12,000 17,200
77,000 27,200

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.

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.

Module A (September 2006 Session) Page 2 of 7

You have a draft 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: David LEE, Accounting Manager, UHL

From: Danielle WONG (Director)
c.c.: 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 balance
sheets 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 balance sheet?

(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 balance sheet. This item disappeared in the current
year’s “consolidated” balance sheet 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?

(C) In your notes to the consolidated cash flow statement 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?

(D) What is “Goodwill”?

I would appreciate your clarification in time for the upcoming board meeting.

Best regards,

Danielle

Module A (September 2006 Session) Page 3 of 7

Required:

Question 1 (50 marks – approximately 90 minutes)

(a) Prepare a memorandum in response to the issues raised by

Ms. Danielle WONG. In your memorandum, you should:

(i) discuss the reasons for the item “Land lease premium” in the
consolidated balance sheet;
(5 marks)

(ii) 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% interest in STL in UHL’s balance sheet at
31 March 2005; (2) the effect of the 50% interest acquired at
31 March 2006 on the status of STL and (3) the meaning of
“consolidated” financial statements;
(10 marks)

(iii) determine the carrying amount of the 20% interest in STL at

31 March 2006 (i.e. before the acquisition of the 50% interest at
31 March 2006);
(5 marks)

(iv) discuss why the “contingent liability” is recognised as a liability in

UHL’s consolidated balance sheet; and
(5 marks)

(v) why goodwill is recognised in UHL’s consolidated balance sheet 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)

(b) Prepare an annex to your memorandum showing the consolidated balance

sheet as at 31 March 2006. Ignore deferred taxation. [Alternatively, you may
list the consolidation journals necessary for the purpose of drafting the
consolidated balance sheet.]

(15 marks)

* * * END OF SECTION A * * *
(QUESTIONS)

Module A (September 2006 Session) Page 4 of 7

SECTION B – ESSAY / SHORT QUESTIONS (Total: 50 marks)

Answer ALL of the following questions. Marks will be awarded for logical argumentation
and appropriate presentation of the answers.

Question 2 (10 marks – approximately 18 minutes)

Discuss the following statement:

“All errors in prior years’ financial statements must be corrected in the current year’s
financial statements.”
(10 marks)

Question 3 (14 marks – approximately 25 minutes)

Sloan Limited (“Sloan”) is considering the following three alternatives in obtaining external
funds:

(a) The issue of a financial instrument for a principal amount of HK$500,000,000. The
interest rate would be 16% per annum for the first ten years payable in arrears and
zero per cent in subsequent periods. Sloan would have no obligation to repay the
principal amount.

(b) The issue of redeemable convertible preference shares (“PS”) with a principal amount
of HK$500,000,000. By the end of the fourth year from the date of issue of the PS,
Sloan would have to redeem the PS. Sloan would pay a fixed dividend at 8% per
annum cumulative. At any time during the four years, the PS could be converted into
100,000,000 ordinary shares of Sloan if the holders exercised the conversion option,
without which Sloan would have to pay a dividend at 10% per annum cumulative.

(c) The issue of 100,000,000 ordinary shares for HK$500,000,000. At the same time,
Sloan would write a put option to repurchase the 100,000,000 ordinary shares at
HK$6.6 per share at the end of the fourth year from the date of issue of the ordinary
shares. The put option would necessitate gross physical settlement. The fair value
of the put option at the contract date is estimated at HK$15,000,000.

Required:

Determine how Sloan should account for the financial instruments to be issued under
these three investment options. Explain your answer by reference to relevant
accounting standards.
(14 marks)

Module A (September 2006 Session) Page 5 of 7

Question 4 (12 marks – approximately 22 minutes)

Phoenix Real Estate Limited (“Phoenix”) is a property developer in China. In 2003, 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 2005 when the development is completed and the hotel is available for its
intended use. The hotel’s grand opening took place on 1 July 2005.

Property Two - Since the date of the acquisition of the land, the board of Phoenix decided to
lease the whole property to earn rental. 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. According to the lease agreement, in addition to the minimum annual
rental, Phoenix is entitled to receive a turnover rent which represents the excess of 5%
annual revenue of the hotel operation over the minimum rental. 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 RMB’000
Cost of land use right 45,000 48,000
Cost of construction (excluding the
amortisation of land use right) 303,000 267,000
Fair value of the land use right as at
31 December 2005 60,000 100,000
Fair value of the building at existing
status as at 31 December 2005 560,000 340,000
Date of purchase of land use right 1 July 2003 1 October 2003
Term of land use right (from date of 75 years 60 years
purchase by Phoenix)
Estimated useful life of the property 50 years 40 years
Completion of construction of the December 2004 June 2005
building

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:

(a) Calculate the amount of (1) land use right and (2) carrying amount of the building
for each property to be reflected in Phoenix’s balance sheet as at
31 December 2005.
(9 marks)

(b) Explain the accounting treatment for the turnover rent under the lease
agreement entered into with the Tenant for Property Two in Phoenix’s financial
statements.
(3 marks)

Module A (September 2006 Session) Page 6 of 7

Question 5 (14 marks – approximately 25 minutes)

Mini Automobile Limited (“MAL”) signed a firm sales contract with Car Trading Inc. (“CTI”) on
1 May 2006. The contract specifies that 300 units of Mini Wagon II (“MW II”) have to be
delivered before 28 February 2007 at a fixed price of HK$380,000 per unit. If the delivery is
more than one month late, MAL will grant CTI a discount of 30 per cent on each delayed unit.
The costs of production are HK$288,000 per unit. Up to 31 December 2006, MAL was only
able to deliver 260 units. MAL will only be able to deliver another 20 units before
28 February 2007. The unexpected delay is due to a strike in one of the production plants.

MAL signed an agreement to lease premises for its show room for three years. According
to the lease agreement, MAL is responsible for restoration of the premises to the original
condition at the expiry of the lease term. As at 31 December 2006, MAL had already
incurred HK$10,000,000 in renovating and decorating the showroom. MAL estimates that it
will incur HK$800,000 to restore the premises to the original condition.

As at 31 December 2006, MAL was a defendant in a patent infringement lawsuit of its driving
control system (“DCS”) that has a high probability of making a loss of HK$120,000,000. If
MAL loses the case, the management will take legal action to claim the loss from the DCS
developer. The Company’s lawyers advise that it is also highly probable that MAL will be
successful in recovery of HK$100,000,000 from the DCS developer.

Required:

For each of the above situations, determine (i) whether a provision should be made; (ii)
the amount of the provision, if any, in MAL’s balance sheet at 31 December 2006; and
(iii) the required disclosure by reference to the relevant accounting standards.

(14 marks)

* * * END OF EXAMINATION PAPER * * *

(QUESTIONS)

Module A (September 2006 Session) Page 7 of 7