THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES Suggested Answers Level : Professional Subject : Hong Kong Financial Accounting Diet : December 2006 The suggested answers are published for the purpose of assisting students in their understanding of what may be expected from a good candidate in the time allowed for each paper. They are in no way exhaustive nor model answer to the questions. They do not reflect the opinion of HKICS. 1
THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES HONG KONG FINANCIAL ACCOUNTING DECEMBER 2006 Suggested Answers SECTION A 1. (a) $ Segment sales 900,000 Less: Segment traceable expenses 400,000 Subtotal 500,000 Less: Allocated nontraceable expenses ($600,000 x 0.60) 360,000 Segment profit 140,000 So, the profit for Segment 1 is $140,000 (b) Benchmark treatment means that borrowing costs should be recognised as an expense in the period in which they are incurred. Allowed alternative treatment means that borrowing costs should be recognised as expenses in the period they are incurred, except that they are capitalised as part of the cost of the asset if the borrowing costs are directly attributable to the acquisition, construction or production of a qualifying asset. (c) (d) The travel agency should recognise $70 as its revenue in the period, because: The travel agency acts purely as an agent for the airline. Its revenue comes from rendering of services, earning a commission by selling the ticket on behalf of the airline. The ownership of the $930 belongs to the airline rather than the travel agency. Therefore, the $1,000 and $930 figures should not be reflected in the travel agent s income statement, although these figures might be important note disclosure items. Under the periodic system, the amount of inventory is determined periodically (normally annually) by conducting a physical count and multiplying the number of units by cost per unit to value the inventory on hand. This amount is then recognised as a current asset (closing inventory). The difference between the opening inventory plus purchases in the current period and the closing inventory will be accounted for as costs of goods sold in the current period. Under the perpetual system, inventory records are updated each time a transaction involving inventory takes place. Thus, at any one time, information about the quantity and cost of inventory on hand will be available enabling the enterprise to provide better customer service. The periodic system is relatively simple while the perpetual system is more complicated and expensive to operate. However the perpetual system provides an updated balance of inventory movement at any point of time and imposes better internal control over inventory shortage, thus providing more relevant information for management. 2
(e) Any change in accounting policy made voluntarily should be adjusted retrospectively. Any change in accounting policy required by a new accounting standard or interpretation should be recorded as required by the transitional provisions of that standard/interpretation; if not specified then it should be adjusted retrospectively. Any change in accounting estimate should normally be accounted for prospectively. Any material accounting error discovered should be accounted for retrospectively. (f) Preference shares [3 x (20,000 x $10 x 10%)] Ordinary shares ($100,000 - $60,000) Preference shares [(3 x $20,000) + ½($100,000 - $20,000 - $60,000)] Ordinary shares ($20,000 + ½ x $20,000 ) $60 000 $40 000 $70,000 $30,000 (g) Amount (FCUs) Exchange rates Amount ($) Doubtful accounts expense FCU 60,000 $0.20 $12,000 Patent amortisation expense 40,000 0.25 10,000 Rent expense 100,000 0.22 22,000 Totals FCU 200,000 $44,000 (h) Cheng Ltd 40% Wong Ltd 20% Ng Ltd 40% Lam Ltd Though the options are out of the money, they are currently exercisable and give Cheng Ltd the power to continue to set the operating and financial policies of Ng Ltd, because Cheng Ltd could exercise its options now. According to HKAS 27 Consolidated and Separate Financial Statements, it can be determined that Cheng Ltd controls Ng Ltd due to the existence of the potential voting rights of Cheng Ltd. Therefore Cheng Ltd is the parent of Ng Ltd. 3
(i) All three segments are reportable segments because each earns a majority of its revenues from external customers and each equals or exceeds at least one of the 10% thresholds set out in HKAS 14. Department Stores and Liquor Stores exceed all three and Toy Stores exceeds only the segment results threshold. Because total external revenue attributable to the reportable segments exceeds 75% of total consolidated revenue, there is no requirement to identify additional segments, in accordance with paragraph 37 of HKAS 14. (j) According to HKAS 37 Provisions, Contingent Liabilities and Contingent Assets, a contingent liability, if reasonably measurable, should be disclosed unless the possibility of an outflow in settlement is remote, which is not the case for Company A. However, HKAS 37 also requires that the estimate of the financial effect be measured based on the best estimate under the circumstances, rather than the amount claimed by the customer. Thus $500,000 of the potential loss, instead of $3 million, should be disclosed. 4
SECTION B 2. Hardcord Company Cash flow Statement for the year ended 30 June 2006 $ Cash flows from operating activities Profit before tax 161,000 (1) Increase in accounts receivable (25,000) (2) Increase in inventory (4,000) (3) Increase in prepayments (2,000) (4) Increase in accounts payable 3,000 (5) Interest 14,000 (6) Depreciation of plant 32,000 (7) Cash generated from 179,000 operations Interest paid (14,000) (6) Income tax paid (41,000) (8) Net cash from operating activities 124,000 Cash flows from investing activities Purchase of land (10,000) (9) Purchase of plant (40,000) (10) Net cash used in investing activities (50,000) Cash flows from financing activities Proceeds from borrowings 70,000 (11) (12) Dividends paid (73,000) (13) Net cash from financing (3,000) activities Net increase in cash and cash equivalents 71,000 Cash and cash equivalents at beginning of year 20,000 Cash and cash equivalents at end of year 91,000 Workings: (1) Profit before tax $161,000, ($120,000 + $41,000). (2) Increase in accounts receivable $25,000 ($90,000 - $65,000). (3) Increase in inventory $4,000 ($62,000 - $58,000) (4) Increase in prepayments $2,000 ($12,000 - $10,000). (5) Increase in accounts payable $3,000 ($48,000 - $45,000). (6) Interest expense $14,000, which in the absence of other information is assumed to equal interest paid. 5
(7) There were no disposals of plant; hence the increase in accumulated depreciation must represent the depreciation for the year $32,000 ($92,000 - $60,000). (8) Tax expense $41,000; in the absence of other information, it is assumed to also equal income tax paid. (9) There were no disposals of land; hence the increase in the carrying value of land must represent the purchase of land $10,000 ($90,000 - $80,000), (10) There were no disposals of plant, hence the increase in the carrying value of plant must represent the purchase of plant $40,000 ($320,000 - $280,000). (11) Borrowing of $30,000 settled through the issue of shares. This transaction does not involve a cash flow. (12) Proceeds from borrowings $70,000 is determined by as the difference in borrowings after adjusting for the $30,000 settlement ($200,000 - $160,000 + $30,000). (13) Dividend paid $73,000 (refer to additional information). 6
3. Mountain Ltd (a) Asset impairment Abes Buel $ 000 $ 000 Plant 850 825 Patent 240 0 Inventory 54 75 Receivables 75 82 Goodwill 25 20 1,244 1,002 Value in use 1,044 990 Impairment loss (200) (12) In relation to Buel, write goodwill down by $12,000: Dr Impairment loss 12,000 Cr Accumulated impairment losses - Goodwill 12,000 (1 mark) In relation to Abes, reduce goodwill by $25,000: Dr Impairment loss 25,000 Cr Accumulated impairment losses - Goodwill 25,000 (1 mark) Then, allocate the remaining $175,000 impairment loss to applicable assets: Carrying Proportion Allocation Net carrying amount of excess amount $ 000 $ 000 $ 000 Plant 850 850/1090 136 714 Patent 240 240/1090 39 201 1,090 175 As the patent has a fair value less costs to sell of $220,000, only $20,000 of the impairment loss can be allocated to it, so the plant must be reduced by a further $19,000, to $695,000. So the carrying amounts of assets for the two divisions at 31 December 2005 are: Abes Buel $ 000 $ 000 Plant 695 825 Patent 220 0 Inventory 54 75 Receivables 75 82 Goodwill 0 8 -------- ------- Total 1,044 990 7
3.(b) The maximum amounts of reversal of the impairment in relation to plant and patent in the two divisions are calculated as follows: (1) At 31 December 2006, for Buel, there can be no reversal of the prior goodwill impairment. (2) At 31 December 2006, for Abes, the plant and patent are recorded as follows: $ 000 Plant 1,500 Accumulated depreciation and impairment losses 1,155 [650 +136 +19 +350] 345 Patent 240 Accumulated impairment losses 20 220 The plant would have had the following carrying amount if the impairment loss had not occurred: $ 000 Plant 1,500 Accumulated depreciation and impairment losses 950 [650 + 300] 550 Hence, the maximum reversal of impairment in relation to plant is $205,000 (i.e., $550,000 - $345,000). As the patent write-off was $20,000 at 31 December 2005, the maximum reversal for the patent in 2006 is $20,000. 8
4.(a) Classification of the lease for both the lessor and the lessee Both companies will classify the transaction as a finance lease because, under the terms of the agreement, substantially all of the risks and rewards incident to ownership of the photocopier have been transferred from the lessor to the lessee. This conclusion can be supported by the fact that: the lease is non-cancellable (by definition); the lease term is, at 75%, a major part of the economic life of the copier, and the PV of MLP is, at 97%, substantially all of the fair value of the copier at the inception of the lease. PV of MLP = $12 000 + $12 000 x 0.9093 + $12 000 x 0.0.8262 + $1 500 x 0.7513 = $12 000 + $10 913 + $ 9 914 + $1 127 =$33 953 $33 953/$35 080 = 96.8% (b)(i) Payment schedule and the journal entries for Company X (the lessee) for the year ended 30 June 2006 are as follows : Lease payment schedule MLP Interest expense* Reduction in liability Balance of liability 1 July 2003 33,953 1 July 2003 12,000-12,000 21,953 1 July 2004 12,000 2,195 9,805 12,148 1 July 2005 12,000 1,215 10,785 1,363 30 June 2006 1,500 137 1,363-37,500 3,547 33,953 * Carrying amount at the beginning of the year x 10% Journal entries for the year ended 30 June 2006: $ $ 1 July 2005 Dr Lease liability 10,785 Dr Interest payable 1215 Dr Executory costs 2,500 Cr Cash 14,500 (Initial payment for lease of photocopier) 30 June 2006 Dr Depreciation expense 10,817 Cr Accumulated depreciation 10,817 [($33,953- $1,500)/3] (Annual depreciation for leased photocopier) Dr Lease liability 1,363 Dr Interest expense 137 Cr Leased asset 1,500 (Amortisation of leased lease liabilities) Dr Accumulated depreciation 32,453 Cr Leased asset 32,453 9
(Return of leased photocopier) (b)(ii) Receipt schedule and the journal entries for Company Y (the lessor) for the year ended 30 June 2006 are as follows Lease receipt schedule MLR Interest revenue* Reduction in receivable Balance of receivable 1 July 2003 35,080 1 July 2003 12,000-12,000 23,080 1 July 2004 12,000 2,308 9,692 13,388 1 July 2005 12,000 1,339 10,661 2,727 30 June 2006 3 000 273 2,727-39,000 3,920 35,080 * Carrying amount at the beginning of the year x 10% Journal entries for the year ended 30 June 2004: 1 July 2003 Dr Lease receivable 35,080 Dr Cost of goods sold * 28,873 Cr Sales revenue ** 33,953 Cr Inventory 30,000 (Recognition of lease receivable and recording sale of copier) * Cost less PV of unguaranteed residual ($30,000 - $1,500 x 0.7513) ** PV of MLP Dr Lease costs 1,365 Cr Cash 1,365 (Payment of initial direct costs) Dr Cash 14,500 Cr Lease receivable 12,000 Cr Reimbursement revenue 2,500 (Receipt of first payment) 30 June 2004 Dr Paper and toner expense 2,500 Cr Cash 2,500 (Payment of executory costs) Dr Interest receivable 2,308 Cr Interest revenue 2,308 (Interest expense accrual) 10
5. First Co and Second Co First Co Second Co $ $ (a) Dr Plant 500 Dr Proceeds on sale 1,000 Cr Carrying amount of asset sold 1,500 Dr Income tax expense 150 Cr Deferred tax liability 150 Dr Depreciation expense 25 Cr Accumulated depreciation 25 Dr Deferred tax liability 7.5 Cr Income tax expense 7.5 (b) Dr Inventory 200 Dr Proceeds on sale 800 Cr Carrying amount of asset sold 1,000 Dr Income tax expense 60 Cr Deferred tax liability 60 (c) Dr Sales revenue 400 Cr Cost of sales 300 Cr Inventory 100 Dr Deferred tax asset 30 Cr Income tax expense 30 Dr Creditors 100 Cr Debtors 100 (d) Dr Dividend payable 3,000 Cr Dividend declared 3,000 Dr Dividend revenue 3,000 Cr Dividend receivable 3,000 (e) Dr Dividend revenue 1,500 Cr Dividend paid 1,500 (f) Dr Retained earnings (1/7/05) 175 Dr Income tax expense 75 Cr Cost of sales 250 (g) Dr Retained earnings (1/7/05) 2,800 Dr Deferred tax asset 1,200 Cr Tractors 4,000 11
Dr Accumulated depreciation 922 Cr Depreciation expense 342 Cr Retained earnings (1/7/05) 580 Dr Income Tax expense 103 Dr Retained earnings (1/7/05) 174 Cr Deferred tax asset 277 (h) Dr Rent revenue 150 Cr Rent expense 150 12
6. 75% Nanshan Ltd Futing Ltd Nanshan Ltd 75% MI 25% (a) Net fair value of identifiable assets, liabilities and contingent liabilities of Futing Ltd = ($100,000 + $60,000 + $40,000) (equity) + $40,000 (1 30%) (plant) + $50,000 (1 30%) (land) + $30,000 (1 30%) (inventory) = $284,000 Net fair value acquired = 75% x $284,000 = $213,000 Cost of the combination = $250,000 Goodwill = $250,000 - $213,000 = $37,000 (b) Nanshan Ltd Consolidated income statement for the year ended 30 June 2006 Revenues: Sales revenue ($510 600 + $80 000) $590,600 Expenses: Cost of sales ($225 000 + $35 000) 260,000 Other expenses ($65 000 +$7 000 + $40 000 x 10%) 76,000 336,000 Profit before income tax 254,600 Income tax expense ($50 000 + $5 000 - $1 200) 53,800 Profit for the period 200,800 Attributable to: Parent shareholders ($200 800 - $7 550) 193,250 Minority interest [$33 000 ($4 000 - $1 200)] x 25% 7,550 $200,800 13
(c) Nanshan Ltd Consolidated balance sheet as at 30 June 2006 Assets Current assets ($162 000 + $84 000) $246,000 Non-current assets: Property, plant and equipment Plant ($425 500 + $190 000 + ($190 000 - $170 000) $635,500 Accumulated depreciation ($124 000 + $24 000 -$20 000 + $24 000) (152,000) Land [$110 000 + $50 000 + ($100 000 - $ 50 000) 210,000 Total non-current assets 693,500 Total assets $939,500 Equity and liabilities Equity attributable to equity holders of the parent: Share capital $400,000 Other reserves: General reserve ($60 000 + $80 000 -$45 000 -$15 000 - $5 000) 75,000 Retained earnings ($193 250 + $83 000) 276,250 Parent entity interest 751,250 Minority interest ($71 000 +$5 000 + $7 550) 83,550 Total equity 834, 800 Current liabilities Payables ($72 900 + $12 000) 84,900 Non-current liabilities Deferred tax liability ($12 000 + $15 000 - $7 200) 19,800 Total liabilities 104,700 Total equity and liabilities $939,500 14