Advanced Corporate Reporting

(Hong Kong)
PART 3 TUESDAY 14 DECEMBER 2004

QUESTION PAPER Time allowed 3 hours This paper is divided into two sections Section A This ONE question is compulsory and MUST be answered THREE questions ONLY to be answered

Section B

Do not open this paper until instructed by the supervisor This question paper must not be removed from the examination hall

The Association of Chartered Certified Accountants

Paper 3.6(HKG)

This is a blank page. Question 1 begins on page 3.

4DINTPA Paper 3.6INT

Section A This ONE question is compulsory and MUST be attempted 1 AAP, a public limited company, is considering whether to invest in an overseas group, Beel. The current years cash flow statement of Beel does not conform with Hong Kong Accounting Standards and is set out below. Beels presentation currency is the dollar. Beel Group Cash Flow Statement for the year ended 30 November 2004 $m $m Net cash flow from operating activities 1,895 Extraordinary cash flow environmental damage (80) Dividends from associates (note v) (10) Interest paid (150) Interest received 110 (40) Taxation (1,500) Capital expenditure and financial investment (note iv) (75) Acquisitions and disposals (note ii) (250) Equity dividends paid including minority interest (note v) (20) Cash outflow before management of liquid resources and financing (80) Management of liquid resources (note i) (26) Financing issue of ordinary shares (note ii) 130 Financing proceeds from long term borrowing (note ii) 35 Financing payment of zero dividend bond (note iii) (45) 120 Increase in cash in the period 14 Analysis of net cash flow from operating activities $m Net profit before tax and extraordinary item from income statement 2,385 Adjustments to operating activities for: Investment income (20) Interest expense 30 2,395 Increase in inventory (400) Decrease in trade receivables 300 Decrease in trade payables (500) Increase in insurance claims provision 100 Net cash flow from operating activities 1,895

4DINTAA Paper 3.6INT

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4DINTAA Paper 3.6INT

The following information is relevant to the group cash flow statement: (i) The amount for the management of liquid resources has been derived from the following balance sheet amounts: 2004 $m 190 181 171 2003 $m 170 175 145

Cash with banks on short term deposit (one weeks notice) Investments in money market instruments

There have been no sales of money market instruments in the year but there have been purchases of $6 million. Cash at bank at 30 November 2003 was $30 million and at 30 November 2004 was $44 million. (ii) Beel had purchased a subsidiary company in the year. The figure in the cash flow statement for the acquisition of the subsidiary comprises the following: $m Cash 160 Loan notes 20 Ordinary Shares in Beel 100 Purchase consideration 280 less cash balance of subsidiary (30) Cash flow 250 The issue of the loan notes and ordinary shares in Beel, above, has also been included in cash flows from Financing. The other net assets acquired have been adjusted in the cash flow statement. (iii) Beel had issued a ten year zero dividend bond at a discount. The bond matured in the year and it had been treated in the cash flow statement as follows: $m Issue price 19 Premium on redemption 31 Face value at issue date 50 less interest charge for year at effective yield of 10% (rounded) 1(5) Net cash flow 45 (iv) The cash flow attributed to purchases of property, plant and equipment was calculated by reference to the movement in the balance sheet values from 2003 to 2004 as adjusted for the purchase of the subsidiary. The actual movement on property, plant and equipment in the period is as follows: $m Net book value at 30 November 2003 1,600 New subsidiary addition 45 Other additions 265 Disposals (125) Depreciation (65) Net book value at 30 November 2004 1,720 The disposal proceeds relating to property, plant and equipment were $80 million.

4DINTBA Paper 3.6INT

$m Cash flow statement entry Net book value at 30 November 2004 Net book value at 30 November 2003 1,720 (1,600) 120 (45) 75

less addition from subsidiary Net purchases of property, plant and equipment

(v) The entries in the cash flow statement for dividends paid to/from the minority interest and the associated company are as follows: Minority Associated Interest Company $m $m Balance at 30 November 2004 in group balance sheet 346 65 Balance at 30 November 2003 in group balance sheet (355) (55) Shown in cash flow as dividend paid 11(9) 10 The loss attributable to the minority interest in the year was $7 million and the share of the associated companys profit after tax was $16 million. Required: Redraft the group cash flow statement for Beel in accordance with Hong Kong SSAP 15 Cash flow statements using the indirect method after taking into account the information set out above. (25 marks)

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4DINTAPB Paper 3.6INT

Section B THREE questions ONLY to be attempted 2 The following balance sheets relate to A, B, C and D, all public limited companies, as at 30 November 2004. A $m 1,700 1,250 1,800 1,450 1,400 5,600 1,000 1,950 2,650 5,600 B $m 1,000 C $m 500 D $m 300

4DINTABA Paper 3.6INT

Tangible non-current assets Investment in B at cost Investment in C at cost Investment in D at cost Net current assets

1,800 1,800 1,500 1,200 1,100 1,800

350 850 300 150 400 850

100 400 200 125 175 400

Equity Share capital of $1 Share premium account Retained earnings

The directors of A have decided to restructure the group at 30 November 2004 and have agreed upon the following plan: (i) A is to dispose of its holding in D to B in exchange for 110 million shares of B, plus a cash consideration of $50 million. The current value of the shares of the four companies is as follows as at 29 November 2004: A B C D $ 6 385 290 210

(ii) C is to be demerged from the group and a new public limited company E formed. E will issue shares to the shareholders of A in exchange for As investment in C. E issued 300 million ordinary shares of $1 to the shareholders of A. (iii) Goodwill arising on consolidation was impairment tested at 30 November 2004. The impairment loss when allocated only affected goodwill. Goodwill is currently amortised over five years. (iv) The following information is also relevant to the group reconstruction. The subsidiaries were all 100% owned by A at the date of the reconstruction and the acquisition details are set out below: Retained earnings at acquisition $m 450 250 150 Date of acquisition Fair value of net assets at acquisition $m 1,200 1,700 1,420 Carrying value of goodwill at 30 November 2004 after impairment test $m 30 20 15

Subsidiary

B C D

01/12/02 01/12/02 01/12/03

(v) Any increase in the fair value of the net assets at acquisition is attributable to non-depreciable land. B, C and D have not issued any shares since acquisition other than the share issues proposed in the restructuring plan. (vi) Local legislation requires shares issued on a reconstruction to be valued at nominal value and shares cannot be issued at a value that is less than their nominal value. Inter group transfers of investments should be made at their carrying value.

4DINTBA Paper 3.6INT

Required (a) (i) Explain the impact of the group reconstruction on the individual accounts of A, B, C and D, showing suitable computations. (7 marks)

(ii) Prepare the individual balance sheets of A, B and D and a consolidated balance sheet of the A group after the group reconstruction at 30 November 2004. (14 marks) (b) Prepare an analysis showing the composition of the group retained earnings of A at 30 November 2004 after the reconstruction, showing the impact of the demerging of C. (4 marks) (25 marks)

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4DINTBC Paper 3.6INT

Artright, a public limited company, produces artefacts made from precious metals. Its customers vary from large multinational companies to small retail outlets and mail order customers. (i) On 1 December 2003, Artright has a number of finished artefacts in inventory which are valued at cost $4 million (selling value $506 million) and whose precious metal content was 200,000 ounces. The selling price of artefacts produced from a precious metal is determined substantially by the price of the metal. The inventory value of finished artefacts is the metal cost plus 5% for labour and design costs. The selling price is normally the spot price of the metal content plus 10% (approximately). The management were worried about a potential decline in the price of the precious metal and its effect on the selling price of the inventory. Therefore it sold futures contracts for 200,000 ounces in the metal at $24 an ounce at 1 December 2003. The contracts mature on 30 November 2004. The management have designated the futures contracts as cash flow hedges of the anticipated sale of the artefacts. Historically this has proved to be highly effective in offsetting any changes in the selling price of the artefacts. The finished artefacts were sold for $228 per ounce on 30 November 2004. The costs of setting the futures contracts in place were negligible. The metals spot and futures prices were as follows: Spot price $ per ounce 11 December 2003 30 November 2004 23 21 Futures price per ounce for delivery 30 November 2004 $ 24 21

(ii) The artefacts produced by the company require special packaging materials in order to store and deliver the product. Artright has entered into a one year contract with a local supplier to deliver these materials on a quarterly basis until the end of the contract on 30 November 2005. The agreed price of each delivery is 100,000 sterling (UK pounds) payable quarterly. (iii) Artright has a mail order business. The customers pay for their goods on a loan basis over a period which varies from six months to 24 months. The average life of a loan is 12 months and the effective interest rate on the loans is 10% per annum. Most of the loans are repaid on time and of those that do not pay on time, any delay in payment is not penalised by extra interest payments. Artright currently has as at 30 November 2004 loans outstanding of $2 million (principal) on which interest of $150,000 is expected to be earned from 1 December 2004. The amounts due are $105 million on 31 May 2005 and $11 million on 30 November 2005. The company estimates that it will receive cash repayments of $1 million on 31 May 2005 and $104 million on 30 November 2005. Also one of Artrights customers had experienced financial difficulties and as at 1 December 2003, a receivable of $200,000 had been converted into a fixed interest loan of 10%. The loan was repayable over two years and at 30 November 2004, the customer had paid $100,000 to Artright. The accrued interest for the year was $16,500. Because of the continuing problems of the customer, at 30 November 2004 the loan was rescheduled over a further three years at an interest rate of 10%, and the annual repayments subsequently reduced. The management of Artright feel that the customer will be able to meet the payments under the restructured loan agreement. (iv) The company also trades with multi-national corporations. Artright often has cash flow problems and factors some of its trade receivables. On 1 November 2004 it sold trade receivables of $500,000 to a bank and received a cash settlement of $440,000 for these trade receivables. The portfolio of trade receivables sold is due from some of the companys best customers who always pay their debts but are quite slow payers. Because of the low risk of default, Artright has guaranteed 12% of the balance outstanding on each receivable and the fair value of this guarantee is thought to be $12,000.

4DINTBC Paper 3.6INT

Required: Using the principles of Hong Kong Accounting Standard 39 Financial Instruments: recognition and measurement: (a) Discuss whether the cash flow hedge of the sale of the inventory of artefacts is effective and how it would be accounted for in the financial statements for the year ended 30 November 2004. (6 marks) (b) Discuss the nature of the contracts to purchase packaging materials. (4 marks)

(c) Discuss, with suitable calculations, the potential impairment of the mail order receivables and the loan to the customer. (10 marks) (d) Discuss whether the sale of the trade receivables would result in them being derecognised in the balance sheet at 30 November 2004 and how the sale of the trade receivables would be recorded. (5 marks) (25 marks)

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4DINTBD Paper 3.6INT

The line of business of Pohler Speed, a public limited company, is global mail, logistics and financial services. The financial director wishes to prepare a report on the key points in the financial statements for the year ended 30 November 2004 in which the company has reported a net profit before tax of $500 million. The director has summarised these points as follows: (i) Employee share scheme the company has accounted for the costs of an executive stock option plan on the basis of a previous IASB exposure draft on share-based payment rather than HKFRS2 Share-based payment. This will result in an increase in staff costs of $20 million in the current year and $22 million for the comparative period to 30 November 2003. The company has decided not to apply HKFRS2 Share-based payment until the next accounting period. The increase in staff costs using HKFRS2 would have been $23 million for the current and $19 million for the comparative period. HKFRS2 applies from 1 January 2005. (5 marks)

(ii) Operating leases the company has leased electronic sorting systems to other companies on 30 November 2004. The beneficial and legal ownership remains with Pohler Speed and the assets remain available to Pohler Speed for its operating activities. The leased assets have been treated as operating leases with the net present value of the income stream of $100 million (including the deposit) being recognised in the income statement. Pohler Speed estimates that the fair value of the assets leased was $140 million at the inception of the leases. Deposits of $20 million were received by Pohler Speed on 30 November 2004. No depreciation is to be charged on the leased assets for the current year. (5 marks) (iii) Restructuring of the group a formal announcement for a further restructuring of the group was made after the year end on 5 December 2004. A provision has not been made in the financial statements as a public issue of shares is being planned and the company does not wish to lower the reported profits. Prior to the year end, the company has sold certain plant and issued redundancy notices to some employees in anticipation of the formal commencement of the restructuring. The company prepared a formal plan for the restructuring which was approved by the board and communicated to the trade union representatives prior to the year end. The directors estimate the cost of the restructuring to be $60 million, and it could take up to two years to complete the restructuring. The estimated cost of restructuring includes $10 million for retraining and relocating existing employees, and the directors feel that costs of $20 million (of which $5 million is relocation expenses) will have been incurred by the time the financial statements are approved. (5 marks) (iv) Fine for illegal receipt of a state subsidy the company was fined on 10 October 2004 for the receipt of state subsidies that were contrary to a supra-national trade agreement. The subsidies were used to offset trade losses in previous years. Pohler Speed has to repay to the government $300 million plus interest of $160 million. The total repayment has been treated as an intangible asset which is being amortised over twenty years with a full years charge in the current year. (4 marks) (v) Goodwill negative goodwill of $300 million arose on 1 December 2002 as a result of the expectation of future losses identified in a previous restructuring plan. The goodwill was being written back to the income statement over five years which represents the length of time it would take to turn the group into a profit making organisation. However, the negative goodwill of $240 million at 1 December 2003 has been recognised in the income statement to 30 November 2004. Additionally Pohler Speed had acquired a business on 30 November 2003. The initial accounting for the business combination could only determine provisional values for the net assets. This year a review of the fair values of the net assets acquired resulted in a reduction of the inventory value at acquisition by $4 million but no adjustments have yet been made to the value of the subsidiarys assets at acquisition. Unamortised goodwill at 30 November 2004 as regards this latter acquisition is $20 million. Goodwill is amortised currently over 5 years with a full years charge in the year of acquisition. The directors are aware that the principles of IFRS3 Business Combinations will soon be applicable in Hong Kong. However, they are unsure as to the accounting requirements of this standard in the above areas. (6 marks) The financial director wishes to prepare a report for submission to the Board of Directors which discusses the above accounting treatment of the key points in the financial statements.

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Required: (a) Draft a report explaining recommended accounting practice in each of the above areas and discussing whether the accounting practices used by the company are acceptable, the issues involved, and (b) Show in your report the potential impact on profit before tax of any revisions to the accounting practices that ought to be made. (Note: candidates should use Hong Kong Accounting Standards and IFRS3 Business Combinations when answering this question.) (25 marks)

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Trident, a public limited company just listed on the Hong Kong Stock Exchange, operates in the financial services sector and is planning to prepare its first financial statements under Hong Kong Financial Reporting Standards (HKFRSs) as at 31 December 2005. The Generally Accepted Accounting Practices (GAAP) used by Trident are very similar to HKFRS but there are some differences which are set out below. The Group is currently preparing its local GAAP financial statements for the year ending 31 December 2004. The company has two foreign subsidiaries, Spar and Mask, both public limited companies. Spar, a company incorporated in Hong Kong, is 80% owned by Trident and prepared its first HKFRS financial statements at 31 December 2003 in order to comply with local legislation. Trident acquired a 70% holding in Mask in 1999. Mask was consolidated from that date using purchase accounting practices that are similar but not the same as those used by HKFRS. However the local rules relating to the financial statements of Mask as regards, for example, the concept of substance over form are totally different to HKFRS. Mask had adopted the Hong Kong accounting standard relating to investment properties in its own financial statements for the year ended 31 December 2003 because this standard had been incorporated into the local legislation. Group policy is to amortise goodwill but some goodwill had been totally written off against retained earnings on the acquisition of certain subsidiaries. On the disposal or closure of the business to which the goodwill related, goodwill previously eliminated against retained earnings is charged to the income statement. The gains and losses on the translation of the financial statements of overseas subsidiaries have been charged to retained earnings for many years and not recycled to the income statement on the disposal of subsidiaries. On 30 October 2004, the Group revalued its tangible non-current assets and incorporated these values into its financial statements. The company uses a straight line method to depreciate its tangible non-current assets. Further Trident had been developing computer software which was to be used as a financial modelling tool. The software cost had not been capitalised but charged to the income statement. The Group has a separately administered defined benefit pension scheme. Contributions are charged to the income statement and the regular pension costs are attributed using the projected unit method. Variations in pension costs as a result of actuarial valuations are amortised over the average remaining service lives of employees. No actuarial gains and losses had been recognised in the financial statements. Trident has several financial instruments in issue. It has preference share capital which was originally redeemable on 1 January 2001. However if the preference shareholders so wish the capital can be converted into ordinary shares of Trident at any time up to 31 December 2007 at which time the preference shares will be converted compulsorily. Additionally Trident enters into foreign exchange contracts to hedge existing monetary assets and liabilities, and hedges against the effects of changes in exchange rates in the net investment in overseas subsidiaries. Hedge accounting is currently not used by Trident. Required: Based on the information above, draft a memorandum to the Directors of Trident setting out: (a) the general principles behind HKFRS1 First-time Adoption of Hong Kong Financial Reporting Standards, (5 marks) (b) whether the measurement criteria in HKFRS1 would be applied to the opening balances of Mask and Spar in the first HKFRS group financial statements, (5 marks) (c) the specific accounting implications of HKFRS1 First-time Adoption of Hong Kong Financial Reporting Standards for the Trident Group at the date of transition to HKFRS. (15 marks) (25 marks)

End of Question Paper

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