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

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1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination HONG KONG FINANCIAL ACCOUNTING DECEMBER 2010 Suggested Answers The suggested answers are published for the purpose of assisting students in their understanding of the possible principles, analysis or arguments that may be identified in each question 0

2 SECTION A 1. (a) Conglomerate Group is involved in two industries: a publisher receiving annual magazine subscriptions in advance a car dealer selling cars on credit terms of up to five years Advise the appropriate revenue recognition policies for the above two industries. 1. (a) According to HKAS 18 Revenue, the primary issue in accounting for revenue is determining when to recognise revenue. Revenue is recognised when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably. Since the annual magazine subscriptions are received in advance, the revenue is only partially earned when each magazine is supplied. A proportion of the subscriptions should thus be deferred. For magazines, the items involved are of similar value in each time period. Thus revenue should be recognised on a straightline basis over the period in which the items are despatched. The sale of a car on substantial credit terms gives rise to two different types of revenue trading profit and finance income. If the credit agreement is such that the user of the car becomes immediately or eventually the legal owner, then the trading profit can be regarded as being earned at the date the agreement is signed. The finance income will be spread over the duration of the agreement. 1. (b) Principled Limited has previously depreciated vehicles using the reducing-balance method at 20% per year. It now uses the straight-line method over a period of five years. It had previously shown a portion of overheads within cost of sales. It now shows those overheads within administrative expenses. Evaluate whether the above two changes should be accounted for as a change in accounting policy or a change in accounting estimate. (b) According to HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, 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. A change to any of the recognition, presentation or measurement basis should be accounted for as a change in accounting policy. A change from the reducing-balance method to straight-line method of depreciation does not change any of the recognition, presentation or measurement basis. Thus it should be accounted for as a change in accounting estimate. A change from showing a portion of overheads in cost of sales to administrative expenses is a change in the presentation and therefore it should be accounted for as a change in accounting policy. 1

3 1. (c) Some accounting standards apply only to an entity: whose debt or equity instruments are traded in a public market; or which files, or is in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market. List TWO of these accounting standards and briefly describe their scope. (c) HKFRS 8 Operating Segments shall apply to the financial statements of an entity whose debt or equity instruments are traded in a public market or that files, or is in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market. HKAS 14 Segment Reporting shall be applied by entities whose equity or debt securities are publicly traded and by entities that are in the process of issuing equity or debt securities in public securities markets. HKAS 33 Earnings Per Share shall be applied by entities whose ordinary shares or potential ordinary shares are publicly traded and by entities that are in the process of issuing ordinary shares or potential ordinary shares in public markets. HKAS 34 Interim Financial Reporting does not mandate which entities should be required to publish interim financial reports. However, governments, securities regulators, stock exchanges, and accountancy bodies often require entities whose debt or equity securities are publicly traded to publish interim financial reports. 1. (d) On 1 April 2009, Forever Limited decided to revalue its property. Extracts from the statement of financial position at 31 March 2009 shows that the plant has a cost of $30 million and an accumulated depreciation of $9 million. Depreciation has been provided on a straight line basis over 40 years. The property was revalued on 1 April 2009 to its market value of $28 million. There has been no change to its remaining estimated useful life. Determine the depreciation charge, giving appropriate explanations, and show the movements on the revaluation reserve for the year ended 31 March (d) The revaluation took place on 1 April Thus the property is revalued from $21 million to $28 million, resulting in a revaluation reserve of $7 million. Up to 31 March 2009, the depreciation on the property has been $9 million, thus representing 12 years (i.e. $9,000,000 / $750,000 per year). On 1 April 2009, the property has a further 28 years useful life remaining. The revised annual depreciation charge based on the revalued amount will be $28 million/28 years = $1,000,000. Movements on the revaluation reserve: $ Opening revaluation reserve nil Revaluation ($28m ($30m - $9m)) 7,000,000 Transfer to retained earnings ($7m/28 years) ( 250,000) Closing revaluation reserve 6.750,000 2

4 1. (e) On 1 April 2009, Infinity Limited entered into a factoring agreement with Lancaster Limited whereby it assigned its receivables to Lancaster. Infinity received a payment of 95% of the net receivables. Infinity received the balance when the customer paid Lancaster. Lancaster had the right of recourse against Infinity for any loss up to an agreed maximum amount. At 31 March 2010, Infinity assigned to Lancaster receivables with an invoice value of $20 million. Infinity was subject, under the agreement, to a maximum potential recourse of $200,000. Explain how this transaction should be accounted for, and show the relevant extract from Infinity s statement of financial position as at 31 March (e) Since Infinity retains the risk of slow payment and unpaid receivables, the substance of the transaction is that of a financing arrangement and Infinity has not disposed of the receivables. Under the terms of the factoring agreement, there is recourse only for loss up to an agreed maximum amount. This indicates that linked presentation is appropriate for the finance over and above that for which the factor has limited recourse ($200,000). The relevant extract from Infinity s statement of financial position as at 31 March 2010 would show: Current assets Accounts receivable 20,000,000 Less: non-returnable proceeds (95% x $20m) - $200,000 (18,800,000) 1,200,000 Cash 19,000,000 20,200,000 Current liabilities Recourse under factored debts 200, (f) Success Ltd is a Hong Kong company that is listed on the Hong Kong and New York stock exchanges. The company has established a number of factories in Malaysia, Brunei and China. Materials and labour are usually purchased in local currencies. However, all purchases of plant and machinery are denominated in US dollars. All sales are denominated in US dollars and all borrowing tends to be done in US dollars and come from US-based banks. Most equity capital has been raised within Hong Kong, though in recent years there has been a trend towards issuing new shares on the New York Stock Exchange. Determine the functional currency of Success Ltd. 3

5 (f) According to HKAS 21 The Effects of Changes in Foreign Exchange Rates, the functional currency is the currency of the primary economic environment in which the entity operates. The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity considers the following factors in determining its functional currency: (a) the currency: (i) that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled); and (ii) of the country whose competitive forces and regulations mainly determine the sales price of its goods and services (b) the currency that mainly influences labour, material and other costs of providing goods or services (this will often be the currency in which such costs are denominated and settled). It would appear that US is the primary economic environment in which Success Limited operates and thus the functional currency should be US dollars, because: Sales are denominated in US dollars Plant and machinery are acquired in US dollars Bank finance is denominated in US dollars Recent share issues have been undertaken within the US 1. (g) Eagle Limited is an investment holding company and considers the holding of equity investments to be part of its business operations. Discuss how Eagle should present the dividends received from its equity investments in the statement of cash flows. (g) Paragraph 33 of HKAS 7 Statement of Cash Flows states that for a financial institution, interest received, interest paid and dividends received are usually classified as operating cash flows. However, for other entities, there is no consensus on the classification of these cash flows. Eagle Limited, being an investment holding company, is not a financial institution. Thus there is no consensus on how Eagle should classify the dividend received from its equity investments. On one hand, dividends received by Eagle may be classified as operating cash flows because they enter into the determination of profit or loss. On the other hand, such cash flows may be classified as investing cash flows because they are returns on investments. 4

6 1. (h) Forever Young Limited (FYL) issued convertible bonds on 1 April The bonds have a three-year term and each bond is convertible at any time up to maturity into 250 ordinary shares. Describe a convertible bond and advise the appropriate accounting treatment of the convertible bonds for FYL. (h) A convertible bond is a type of bond that the holder can convert into ordinary shares in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with both debt- and equity-like features. According to HKAS 32 Financial Instruments: Presentation, FYL, the issuer of the convertible bonds (a non-derivative financial instrument) is required to evaluate the terms of the financial instrument to determine whether it contains both a liability and an equity component. The liability component should be measured first, and the difference between the proceeds of the bond issue and the fair value of the liability should be assigned to the equity component. The present value of the liability component should be calculated using a market interest rate for similar bonds having no conversion rights. 1. (i) TVX Ltd holds a licence which has enabled the company to be a market leader in its area. The legal life of the licence is 10 years, but the licence is renewable by TVX at little cost. The licence has been held by TVX for a period of 29 years and it has been renewed twice already. Discuss how TVX should determine the useful life of the licence and what form of evidence TVX should collect to justify its selection of the useful life. (i) Paragraph 88 of HKAS 38 Intangible Assets states that an intangible asset shall be regarded by the entity 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. Since the licence may be renewed at little cost and it has been renewed twice before, the licence may be treated as having an indefinite useful life. TVX needs to collect evidence to support its ability to renew the licence indefinitely. TVX has to demonstrate that there is no compelling challenge to the licence renewal and that the licence is expected to contribute to TVX s net cash inflows indefinitely. In particular, TVX has to demonstrate there are expected future benefits beyond the legal life and that TVX is able to control those benefits. 5

7 1. (j) HKAS 33 Earnings Per Share specifies that potential ordinary shares shall be treated as dilutive when, and only when, their conversion to ordinary shares would decrease earnings per share or increase loss per share from continuing operations. Explain how an entity should determine whether its potential ordinary shares are dilutive or anti-dilutive. (j) HKAS 33 Earnings Per Share states that an entity should use profit or loss from continuing operations attributable to the parent entity as the control number to establish whether potential ordinary shares are dilutive or anti-dilutive. Profit or loss from continuing operations attributable to the parent entity should be adjusted for the after-tax amounts of preference dividends, differences arising on the settlement of preference shares, and other similar effects of preference shares classified as equity, and it excludes items relating to discontinuing operations. Potential ordinary shares are anti-dilutive when their conversion to ordinary shares would increase earnings per share or decrease loss per share from continuing operations. The calculation of diluted earnings per share does not assume conversion, exercise, or other issue of potential ordinary shares that would have an anti-dilutive effect on earnings per share. In determining whether potential ordinary shares are dilutive or anti-dilutive, each issue or series of potential ordinary shares is considered separately rather than in aggregate. The sequence in which potential ordinary shares are considered may affect whether they are dilutive. Therefore, to maximise the dilution of basic earnings per share, each issue or series of potential ordinary shares is considered in sequence from the most dilutive to the least dilutive, i.e. dilutive potential ordinary shares with the lowest earnings per incremental share are included in the diluted earnings per share calculation before those with a higher earnings per incremental share. Options and warrants are generally included first because they do not affect the numerator of the calculation. 6

8 Section B 2. Peru Limited acquired 75% of the shares of South Limited for $460,000 on 1 April At the acquisition date, South reported retained earnings of $225,000. The excess of Peru s acquisition cost over its share of South s book value was assigned to plant and equipment that had a fair value of $30,000 greater than book value and a remaining life of five years at the acquisition date, and the balance to goodwill. Non-controlling interests are to be measured at their fair value at the acquisition date, i.e. $145,000. The investment in South is carried at cost. There has been no change in the share capital of South since the date of acquisition. The financial statements of the two companies for the year ended 31 March 2010 are shown below. Peru South $ $ Sales 1,500, ,000 Cost of goods sold (960,000) (480,000) Dividend income (including South s dividend) 24,000 1,000 Depreciation expense (150,000) (15,000) Interest expense (108,000) (22,000) Other expenses (66,000) (114,000) Profit for the year 240,000 90,000 Retained earnings, 1 April 870, ,000 Dividends declared (60,000) (30,000) Retained earnings, 31 March 1,050, ,000 Plant and equipment, net 750, ,000 Investment in South, cost 460,000 - Other investments 515, ,000 Inventory 825, ,000 Cash and receivables 930, ,000 3,480,000 1,440,000 Share capital 600, ,000 Retained earnings 1,050, ,000 Payables 1,830, ,000 3,480,000 1,440,000 On 1 April 2009, Peru held inventory purchased from South during the year ended 31 March 2009 of $25,000; these goods had been manufactured by South at a cost of $15,000. During the year ended 31 March 2010, South sold goods costing $60,000 to Peru for $90,000. Peru sold the inventory on hand at the beginning of the year, but held 30% of its current year s purchases from South on 31 March REQUIRED: Prepare the worksheets for the consolidated financial statements of the Peru Limited and South Limited group for the year ended 31 March 2010 (ignore taxation). 7

9 2. Worksheets for the consolidated financial statements for the year ended 31 March 2010 Peru South Dr Ref Cr Consolidated $ $ $ $ $ Sales 1,500, ,000 90, ,130,000 Cost of goods sold (960,000) (480,000) 5 10,000 (1,349,000) 6 81,000 Dividend income (including South s dividend) 24,000 1,000 22, ,500 Depreciation expense (150,000) (15,000) 6,000 2 (171,000) Interest expense (108,000) (22,000) (130,000) Other expenses (66,000) (114,000) (180,000) Profit for the year 240,000 90, ,500 Income to noncontrolling interests 21,250 7 (21,250) Profit for the group 281,250 Retained earnings, 1 April 870, , , ,022,250 9, , ,500 5 Dividends declared (60,000) (30,000) 3 30,000 (60,000) Retained earnings, 31 March 1,050, ,000 1,243,500 Plant and equipment, net 750, ,000 30,000 1,2 18, ,000 Investment in South, cost 460, ,000 - Goodwill 50, ,000 Other investments 515, , ,000 Inventory 825, , ,000 1,231,000 Cash and receivables 930, ,000 1,550,000 3,480,000 1,440,000 4,513,000 Share capital 600, , , ,000 Retained earnings 1,050, ,000 1,243,500 Non-controlling interests 3,000 2,1 145, ,500 7,500 3,4 56,250 2,500 5,7 21,250 Payables 1,830, ,000 2,460,000 3,480,000 1,440,000 4,513, , ,500 8

10 The journal entries are not required CJE 1 Elimination of investment in subsidiary Dr Share capital 300,000 Dr Retained earnings 225,000 Dr Goodwill 50,000 Dr Plant and equipment 30,000 Cr Investment in South 460,000 Cr Non-controlling interests (BS) 145,000 CJE 2 Past and current depreciation on undervalued plant and equipment =30,000/5 years *2 years Dr Opening retained earnings * 75% 9,000 Dr Non-controlling interests (BS) =30,000/5 years *2 years * 25% NCI 3,000 Dr Depreciation =30,000/5 years 6,000 Cr Accumulated depreciation 18,000 CJE 3 Eliminate dividend income Dr Dividend income (30,000 x 75%) 22,500 Dr Non-controlling interests (BS) (30,000 x 25% NCI) 7,500 Cr Dividends declared 30,000 CJE 4 Assign post-acquisition RE to NCI Dr Opening retained earnings (from 1/4/2007 to beginning 31/3/2009) 56,250 Cr Non-controlling interests (BS) 56,250 25%*(RE 31/3/ K Assign post-acquisition RE to NCI pre-acq 225K) CJE 5 Realisation of opening unrealised profit in inventory Dr Opening retained earnings 75% 7,500 Dr Non-controlling interests (BS) 25% NCI 2,500 Cr Cost of goods sold (25K 15K) 10,000 Note: Opening retained earnings after NCI = (450,000 pre-acq 225,000) assigned to NCI 56,250 past depreciation on undervalued plant and equipment (9,000) last year s unrealised profit (7,500) = 152,250. CJE 6 Elimination of intercompany sale of inventory Dr Sales 90,000 Cr Cost of goods sold 81,000 Cr Inventory 30% unsold x (90K 60K) 9,000 9

11 CJE 7 Allocate current profit for the year to non-controlling interests Dr Non-controlling interests (PL) 21,250 Cr Non-controlling interests (BS) 21,250 Profit for the year before adjustment 90,000 Less: depreciation on undervalued plant and equipment CJE 2 (6,000) Add: previous year s unrealised profit now realised CJE 5 (25,000-15,000) 10,000 Less: current year's unrealised profit CJE 6 [30%*(90k-60k)] (9,000) Adjusted profit 85,000 NCI's share 25% 21,250 Profits retained 63,750 Tutorial note: NCI = 145,000 3,000 7, ,250-2, ,250 = 209,500 Analytical check to NCI as at 31 March 2010 $ NCI s share of S s net assets at book value 202,500 (300K + 510K) x 25% NCI s share of South s FV adjustment (unamortized) 3,000 (30K x 2/5) x 25% NCI s share of implicit goodwill 6,250 (145,000 25% x 555,000) Less: NCI s share of unrealised profit of upstream sale _(2,250) (90K 60K) x 30% x 25% NCI 209,500 10

12 3. Phoenix Limited is a milk-bottle manufacturer. During the year ended 31 March 2010, the following events occurred: Litigation against a supplier Phoenix filed a litigation case against its supplier for a breach of contract. Phoenix s lawyer estimates that a favourable settlement is highly probable. In fact, Phoenix has had several similar lawsuits in the past few years. Contamination Phoenix s milk-bottle industry causes contamination. Its operations take place in a country where there is no environmental legislation to prevent or penalise the company. However, since Phoenix is well-known for practising good corporate social responsibility, it has a widely published sustainability policy in which it undertakes to clean up all contamination that it causes, and it has a record of honouring this published policy. Reorganisation On 15 January 2010, the board of directors of Phoenix voted to proceed with a reorganisation scheme. The costs will amount to $9 million (after crediting $21 million gains on disposal of certain plant and machinery). The reorganisation will take place in June 2010, but related redundancy negotiations with staff began in March REQUIRED: (a) What are provisions, contingent liabilities and contingent assets? (b) Discuss and calculate the amount of provisions, contingent liabilities and contingent assets to be recognised, if necessary, in the above three cases. 3. (a) HKAS 37 Provisions, Contingent Liabilities and Contingent Assets defines a provision as a liability of uncertain timing or amount. Provisions can be distinguished from other liabilities such as trade payables and accruals because there is uncertainty about the timing or amount of the future expenditure required in settlement. A contingent liability is defined as: 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. 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. 11

13 In a general sense, all provisions are contingent because they are uncertain in timing or amount. However, HKAS 37 uses the term contingent for liabilities and assets that are not recognised because their 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. Thus, the term contingent liability is used for liabilities that do not meet the recognition criteria. (b) Litigation against a supplier Paragraph 31 of HKAS 37 specifies that an entity should not recognise a contingent asset. Contingent assets are not recognised in financial statements since this may result in the recognition of income that may never be realised. However, when the realisation of income is virtually certain, the related asset is not a contingent asset. Therefore, the contingent asset (from the favourable settlement) should not be accrued in the financial statements. Material contingent assets that are probable should be disclosed in the financial statements. Contamination In this case, there is a present obligation as a result of a past obligating event. An obligating event is an event that creates a legal or constructive obligation that results in an entity having no realistic alternative to settling that obligation. The obligating event is the contamination of the land, which gives rise to a constructive obligation because the conduct of Phoenix has created a valid expectation on the part of those affected by it that Phoenix will clean up the contamination. Besides, it is probable that there will be an outflow of resources embodying economic benefits in settlement. As a result, a provision should be recognised for an objective estimate of the costs of clean-up. Reorganisation Although the closure will not begin until June, the employees will have had a valid expectation that it would happen when the redundancy negotiations began in March Therefore a provision should be recognised. A constructive obligation to restructure arises since Phoenix has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan and by announcing its main features to those affected by it. The provision will be for $30 million because the expected gain on disposal ($21 million) cannot be netted off against the expected costs. According to HKAS 37, an entity should not consider gains on the expected disposal of assets in measuring a provision, even if the expected disposal is closely linked to the event giving rise to the provision. 12

14 4. Anita Holdings is a conglomerate incorporated in and operating in Africa. It has decided to list its shares on the Stock Exchange of Hong Kong. The Listing Rules require Anita to restate its financial statements, which have been prepared based on African accounting standards, in accordance with Hong Kong Accounting Standards (HKASs) or International Accounting Standards (IASs). Below are extracts from Anita s group financial statements for the years ended 31 March 2010 and 31 March 2009 as drawn up under African accounting standards. Any differences between these rules and HKASs have been noted. Extracts from the financial statements for the years ended 31 March 2010 and 31 March 2009: $ million $ million Revenues 2,010 1,810 Expenses (1,784) (1,550) Profit before interest Interest expenses (10) (10) Profit for the year Opening retained earnings 1,300 1,840 Profit for the year Goodwill written off (640) Dividends (160) (150) Retained earnings 1,356 1,300 Assets 4,820 4,500 Current liabilities (2,664) (2,400) Net assets 2,156 2,100 Ordinary share capital Preference shares Retained earnings 1,356 1,300 2,056 2,000 10% debentures ,156 2,100 Additional information: Preference shares The preference shares were issued on 1 April 2008 at their par value of $600 million. They pay no dividend and they will be mandatorily redeemed by Anita on 31 March 2012 at $ million. The implicit rate of interest is 8% per annum. Goodwill On 1 April 2009, Anita acquired a new wholly-owned subsidiary and goodwill of $640 million arose on the acquisition. This was written off to retained earnings on the date of acquisition in accordance with the domestic accounting standard. The goodwill has not been impaired. At the date of acquisition, the fair value of identifiable net assets approximates to their book value. Debentures The debentures were issued on 1 April 2008 at their par value of $100 million. The 13

15 interest expenses as shown in the income statement are solely attributed to their interest calculated as $100 million x 10% per annum. The return on capital employed (ROCE) and interest cover are calculated as: ROCE (profit for the year/equity and loan capital) 10.02% 11.90% Interest cover (profit before interest/interest expenses) REQUIRED: (a) Advise the appropriate accounting treatment of the preference shares and goodwill in accordance with HKASs. (b) Prepare revised extracts of the financial statements in accordance with HKASs. (c) Calculate the revised return on capital employed and interest cover. Comment on the reported results. 4. (a) Preference shares Paragraph 18 of HKAS 32 Financial Instruments: Presentation states that a preference share that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date, or which gives the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount, is a financial liability. Anita s preference shares provide for redemption on a specific date and so represent a financial liability because Anita has an obligation to transfer financial assets to the holder of the shares. Thus Anita should account for the preference shares as a financial liability. The unwinding of the discount on the preference shares, based on the implicit interest rate of 8%, should be recognised in profit or loss and classified as interest expense. The opening accumulated profits will need to be recalculated to take into account the one-year finance cost. Balance b/f Finance cost 8% Balance c/f $ million $ million $ million 1/4/ /3/ /4/ /3/ /4/ /3/ /4/ /3/ For the year ended 31 March 2009: Dr Interest expenses $48 million Cr Preference shares $48 million For the year ended 31 March 2010 Dr Interest expenses $51.84 million Cr Preference shares $51.84 million 14

16 Goodwill HKFRS 3 (Revised) Business Combinations requires the acquirer to recognise goodwill as of the acquisition date. HKAS 36 Impairment of Assets requires goodwill to be tested for impairment annually. However, the goodwill is not subject to amortisation and it cannot be written off to retained earnings at the date of acquisition. Anita should recognise the goodwill as an asset in its statement of financial position. Since there is no impairment of goodwill, the whole amount $640 million should be written back, i.e. for the year ended 31 March 2009: Dr Goodwill $640 million Cr Goodwill written off $640 million (b) Revised extracts from financial statement for the years ended 31 March 2010 and 31 March $ million $ million Revenues 2,010 1,810 Expenses (1,784) (1,550) Profit before interest Interest expenses ( and +48) (61.84) (58) Profit for the year Opening retained earnings 1,892 1,840 Profit for the year Dividends (160) (150) Retained earnings 1, ,892 Assets 4,820 4,500 Goodwill Current liabilities (2,664) (2,400) Net assets 2,796 2,740 Ordinary share capital Retained earnings 1, ,892 1, ,992 10% debentures Preference shares ( and +48) ,796 2,740 (c) Revised return on capital employed (ROCE) and interest cover are calculated as: ROCE (164.16/2,796) and (202/2,740) 5.87% 7.37% Interest cover (226/61.84) and (260/58)

17 Under African accounting standards, Anita was reasonably profitable, showing ROCE of 11.90% and 10.02%. At the same time, it was relatively low-risk, as shown by the high interest cover (22.6 and 26). Under HKASs, the ROCE is fairly small and is getting worse; also the low interest cover makes Anita look quite high risk. 16

18 5. (a) Kangaroo s Construction Company reports its income for financial statement purposes on a percentage-of-completion basis. The price for one of its contracts is $6,800,000. A record of construction activities for 2009 and 2010 is as follows: Costs incurred during the year Estimated further costs to completion Billings and collections during the year $ $ $ ,880,000 3,520,000 2,920, ,566,000 2,394,000 1,500,000 REQUIRED: Calculate Kangaroo s contract revenue, contract profits or losses and amounts due from/ (to) the customer for the 2009 and (b) Good Service Limited (GSL) is a solution provider conducting research and development services for other companies. During the year ended 31 December 2008, GSL began working on a new project and costs of $3,000,000 were incurred on this project. On 1 October 2009, promising results were obtained, and the newly developed product was named ProductX. The costs from 1 January 2009 to 30 September 2009 were $1,400,000. GSL attempted to sell the legal rights to ProductX to Profit Gain Limited (PGL) for $40,000,000. PGL was not convinced that it should purchase the legal rights to ProductX, and asked for further testing and investigation. However, PGL did pay GSL $1,000,000 in October 2009 for an option to be the sole purchaser. This option would expire on 31 May 2010, and was non-refundable. The results of further tests were encouraging. The costs of these tests were $1,800,000 for the period from 1 October 2009 to 31 December On 31 May 2010, PGL exercised its option and agreed to buy the legal rights to ProductX for $40,000,000 REQUIRED: Discuss how GSL should account for the development costs incurred arising from its work on ProductX for the years ended 31 December 2008 and

19 5. (a) Checking Contract price 6,800,000 6,800,000 6,800,000 (1) Actual cost incurred to date 2,880,000 4,446,000 Estimated cost to completion 3,520,000 2,394,000 (2) Total estimated cost 6,400,000 6,840,000 6,840,000 Total estimated gross profit 400,000 (40,000) (40,000) Percentage completed 45% 65% 100% Recognised revenue to date 3,060,000 4,420,000 6,800,000 Revenue recognised in prior - 3,060,000 4,420,000 years Revenue recognised for current year (I/S) 3,060,000 1,360,000 2,380,000 Cost to date 2,880,000 4,446,000 6,840,000 Cost previously recognised - 2,880,000 4,446,000 2,880,000 1,566,000 2,394,000 Unrecoverable loss (bal.) - 14,000 (14,000) Costs for the current year (I/S) (bal.) 2,880,000 1,580,000 2,380,000 Gross profit (loss) 180,000 (220,000) - Amount due from customer Contract cost-to-date 2,880,000 4,446,000 Profits/(losses) recognised to 180,000 (40,000) date Less: progress billings to date (2,920,000) (4,420,000) Amount due from/(to) customers 140,000 (14,000) 18

20 (b) Research and development HKAS 38 Intangible Assets states that an intangible asset arising from development shall be recognised if, and only if, an entity can demonstrate all of the following: 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 the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset its ability to measure reliably the expenditure attributable to the intangible asset during its development In this case, the development costs of $3,000,000 incurred during the year ended 31 December 2008 should be expensed in the period in which they were incurred because of the uncertainty associated with the ultimate recoverability of the costs. Although promising results were obtained on 1 October 2009, the fact that PGL was not convinced that it should purchase ProductX shows that the ultimate recoverability was uncertain. Therefore the costs from 1 January 2009 to 30 September 2009 amounting to $1,400,000 should be expensed. GSL could not demonstrate that the asset would generate probable further economic benefits until the point when PGL decided to exercise its option to purchase the legal rights to ProductX, i.e. on 31 May Thus the costs of the tests amounting to $1,800,000 for the period from 1 October 2009 to 31 December 2009 should also be expensed. Expenditure on an intangible item that was initially recognised as an expense shall not be recognised as part of the cost of an intangible asset at a later date. Thus, only costs incurred starting from 31 May 2010 can be capitalised. 19

21 6. On 1 April 2008, Daisy Limited granted 1,000,000 share options with an exercise price of $6 to its chief executive officer. The fair value of the options was $4.50 at the date of the grant. The following conditions relate to the grant: (a) The vesting date was 1 April (b) The vesting condition is that the grantee must remain an employee at the vesting date. (c) Another condition is that the share options will not vest until the share price had increased to above $7. The chief executive officer was not expected to leave the company after 1 April Daisy Limited s year end is 31 March. Meanwhile, Daisy is considering whether it should grant an equity-settled sharebased instrument or a cash-settled share-based instrument in future. (Note: Candidates should ignore taxation.) REQUIRED: (a) Explain the differences in accounting treatment between an equity-settled share-based instrument and a cash-settled share-based instrument. (b) What are the vesting date and vesting conditions? What vesting assumptions need to be made in calculating remuneration expenses? Should Daisy Ltd recognise any remuneration expenses? (c) Prepare the journal entries for the years ended 31 March 2009 and Assuming that the share price of Daisy Limited on 1 April 2010 was $7.50 and that the chief executive officer exercised his share options on that day, prepare the journal entries for 1 April (a) In equity-settled share-based payment transactions, an entity receives goods or services as consideration for equity instruments of the entity. According to HKAS 2 Share-based Payments, the goods or services received and the corresponding increase in equity must be measured at the fair value of goods or services unless the fair value cannot be reliably estimated. In cash-settled share-based payment transactions, the entity acquires goods or services by incurring liabilities to the supplier of those goods or services for amounts that are based on the price (or value) of the entity s shares or other equity instruments of the entity. The fair value of the liability has to be remeasured at each reporting date and at the date of settlement. Any change in the fair value is recognised in the profit or loss for the period. There is no such remeasurement for equity-settled transactions. 20

22 (b) HKFRS 2 Share-based Payments defines the vesting date as the date at which the counterparty satisfied the vesting conditions of a share-based payment transaction. Vesting conditions are the conditions in a share-based payment transaction that must be satisfied by the counter-party before the latter is entitled to receive equity instruments of the firm or cash under the share-based payment transaction. There are two types of vesting conditions: service conditions and performance conditions. Service conditions pertain to the stipulated service period that must be served before the vesting condition is satisfied. Performance conditions usually incorporate a service condition as well as a performance target such as the achievement of a certain level of sales or profit. In respect of service conditions, if the equity instruments have not vested because the counterparty has not completed the specified period of services, HKFRS 2 requires that the firm assumes that the services are rendered during the vesting period. The firm should recognise an expense as the services are being rendered with a corresponding increase in equity. In this case, the share option carries a vesting condition which is a market condition since it has a target share price. HKFRS 2 requires the recognition of an expense for services provided regardless of whether the market condition is satisfied so long as other vesting conditions are satisfied. (c) As the chief executive officer was not expected to forfeit the share options, Daisy Limited should record the following journal entries: 31 March 2009 Dr Remuneration expense 2,250,000 Cr Share options reserve 2,250,000 (Recognising remuneration expense: 1,000,000 options x $4.50 x 1/2) 31 March 2010 Dr Remuneration expense 2,250,000 Cr Share options reserve 2,250,000 (Recognising remuneration expense: 1,000,000 options x $ $2,250,000) If the share price of Daisy Limited on 1 April 2010 was $7.50 and the chief executive officer exercised his share options on that day, Daisy Limited should record the following journal entry: 1 April 2010 Dr Cash 6,000,000 Dr Share option reserves 4,500,000 Cr Share capital 10,500,000 (Recording exercise of share options by chief executive officer and increase in share capital) Cash = 1,000,000 share with an exercise price of $6 = $6,000,000 END 21

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