SECTION A – CASE QUESTIONS (Total: 50 marks)

To: Danielle WONG (Director), UHL

From: David LEE, Accounting Manager, UHL
c.c.: 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 balance sheet for UHL as at 31 March 2006 and the proforma consolidated
balance sheet as at 1 April 2006.

Answer 1(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.

Module A (September 2006 Session) Page 1 of 15

Answer 1(a)(ii)

The 20% Investment in STL from 31 March 2005 to 31 March 2006

(1) At 31 March 2005

At 31 March 2005, UHL held only 20% 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 Investments in

Associates.

UHL’s 20% 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% interest in STL at 31 March 2006

After the acquisition of a further 50% interest in STL, UHL holds a total of 70%
interest in STL.

HKAS 27 defines a subsidiary as an entity that is controlled by another entity. The

key element is “control” which means the power to govern the financial and
operating policies of an entity so as to obtain benefits from its activities.

In accordance with HKAS 27, control is presumed to exist since UHL directly owns
more than one half of the voting power of STL (and there is no indication that such
ownership does not constitute control).

Therefore, STL was a subsidiary of UHL at 31 March 2006, and UHL was a parent at
that date.

In accordance with HKAS 27 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.

Module A (September 2006 Session) Page 2 of 15

 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 in
the consolidated balance sheet.

Moreover, UHL’s 20% 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.

Answer 1(a)(iii)

Carrying amount of the 20% interest in STL in the consolidated balance sheet of UHL at
31 March 2006

During the period from 1 April 2005 to 31 March 2006 (before the acquisition of the further
50%), the investment in 20% 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% 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% x HKD12,000,000)
Depreciation adjustment for the year (96)
[20% x (HKD16,000,000 – HKD11,200,000)] / 10 years
Carrying amount of investment in associate (STL) at
31 March 2006 9,304*

* Alternatively:
HKD’000
Share of net assets at 31 March 2006 5,440
(20% x HKD27,200,000)
Balance of fair value adjustment 864
(20% x (HKD16,000,000 – HKD11,200,000) x 9 / 10
Balance of goodwill at 31 March 2006 3,000
(HKD7,000,000 – 20% x HKD20,000,000)
Carrying amount of investment in associate (STL) at
31 March 2006 9,304

Module A (September 2006 Session) Page 3 of 15

Answer 1(a)(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

(2) 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.

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% of STL constitutes a business
combination, which is defined by HKFRS 3 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, 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.

Module A (September 2006 Session) Page 4 of 15

Answer 1(a)(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.

Each exchange transaction shall be treated separately by UHL using the cost of the
transaction and fair value information at the date of each exchange transaction, to
determine the amount of any goodwill associated with that transaction.

This results in a step-by-step comparison of the cost of the individual investments with
UHL’s interest in the fair values of STL’s identifiable assets, liabilities and contingent
liabilities at each step.

HKFRS 3 requires that comparisons of the cost of the individual investments with the fair
values be made in order that changes in STL’s retained earnings and other equity
balances after each exchange transaction be included in the post-combination reserves of
UHL’s consolidated financial statements to the extent that they relate to the previously
held ownership interests. (See Note 1 below)

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.

Module A (September 2006 Session) Page 5 of 15

The calculation of the goodwill at 31 March 2006 is as follows:
HKD’000
Cost of investment for the 50% acquired at 31 March 2006 30,000
Carrying amount of the original 20% interest in STL at 31 March 2006 9,304
Share of post acquisition changes in fair value (Note 1) 976
[20%×36,400,000 – (9,304,000-3,000,000)].
40,280

Fair value of STL’s assets at 31 March 2006 37,400

Provision for contingent liability (1,000)
36,400
Minority interest in STL’s assets and liabilities at 31 March 2006 (10,920)
(HK$36,400,000 x 30%)
Fair value of net asset acquired at 31 March 2006 25,480
Goodwill (Note 2) 14,800

Note 1: Total post acquisition change in fair value was HK$3,280,000 [20% x (HK$36,400,000 –
HK$20,000,000)]. A part of these changes in fair value (HK$2,304,000) has already
been recognised in UHL’s consolidated reserves when STL was accounted for using the
equity method from 1 April 2005 to 31 March 2006. This figure of HK$976,000
represents the amount of changes in STL’s fair values from 1 April 2005 to 31 March 2006
that have not been recognised by UHL through STL’s equity accounting.

Note 2: The amount of goodwill at 31 March 2006 may be reconciled to the amounts of goodwill of
the two separate transactions arising at the two transaction dates.

HKD’000
Cost of investment for the 50% acquired at 31 March 2006 30,000

Fair value of STL’s assets at 31 March 2006 37,400

Provision for contingent liability (1,000)
36,400
Fair value of net asset acquired at 31 March 2006 (50%) 18,200

Goodwill for the 50% acquired at 31 March 2006 (30,000-18,200) 11,800

Goodwill for the 20% acquired at 1 April 2005 (available in Answer 1(a)(iii) 3,000
(HKD7,000,000 – 20% x HKD20,000,000)
Goodwill at 31 March 2006 14,800

I hope the above explanation has answered your queries. Please feel free to contact me
if you have further queries.

Best regards
David Lee

Module A (September 2006 Session) Page 6 of 15

Answer 1(b)

Consolidated balance sheet of UHL as at 31 March 2006

UHL STL Adjust Note Consolidated

HKD'000 HKD'000 HKD'000 HKD'000
Net assets
Land lease premium 10,000 -- -- 10,000
Property, plant and
equipment 21,000 9,800 10,200 1 41,000
Investment in a
subsidiary 37,000 -- (37,000) --
Goodwill -- -- 14,800 2 14,800
Net current assets 9,000 17,400 (1,000) 25,400
77,000 27,200 (13,000) 91,200

Issued equity 65,000 10,000 (10,000) 65,000

Retained earnings 12,000 17,200 (14,896) 3 14,304
Asset revaluation
reserves -- -- 976 976
Minority interest -- -- 10,920 4 10,920
77,000 27,200 (13,000) 91,200

Note:
(1)
HK$20,000,000-9,800,000
(2)
Answer 1(a)(v)
(3)
HK$17,200,000-HK$2,400,000+HK$96,000
(4)
30% x (HK$37,400,000-HK$1,000,000)

Module A (September 2006 Session) Page 7 of 15

 CJ 1

No consolidation adjustment is required at 31 March 2005 or 1 April 2005. However, it

may be good practice to analyse the balance of investment in an associate by putting
through a consolidation journal as follows:
HK$’000 HK$’000
DR Investment in an associate – share of equity at 3,040
date of acquisition
DR Investment in an associate – fair value 960
adjustments (HK$16,000,000 – HK$11,200,000) x
20%
DR Investment in an associate – goodwill 3,000
CR Investment in an associate – costs of 7,000
acquisition

Being analysis of investment in an associate for consolidation purposes.

CJ 2

DR Investment in an associate – share of post 2,400

acquisition profit of an associate (HK$12,000,000
x 20%)
CR Profit or loss – share of post acquisition 2,400
profit of an associate

Being recognition of UHL’s share of STL’s profit for the year.

CJ 3

DR Profit or loss – share of post acquisition profit of 96

an associate (HK$960,000/10 years)
CR Investment in an associate 96

Being recognition of depreciation adjustment for the year.

CJ 4

DR Share capital 10,000

DR Retained Earnings 17,200
DR Property, plant and equipment 10,200
(HK$20,000,000-9,800,000)
DR Goodwill 14,800
CR Net current assets (Provision for STL’s 1,000
contingent liability)
CR Minority Interests (HK$36,400,000 x 30%) 10,920
CR Investment in an associate [See Answer 9,304
1(a)(iii)]
CR Asset revaluation reserves [See Note 1 of 976
Answer 1(a)(v)]
CR Investment in a subsidiary 30,000
DR Investment in an associate** 7,000
CR Investment in a subsidiary** 7,000

Module A (September 2006 Session) Page 8 of 15

 Being elimination of share capital, pre-acquisition reserves against cost of investment
and recognition of goodwill and minority interest in assets and liabilities.

**This eliminates the effect of the transfer from the cost of the 20% investment in STL as
investment in an associate to an investment in a subsidiary made at the entity level of
UHL.

* * * END OF SECTION A * * *
(ANSWERS)

Module A (September 2006 Session) Page 9 of 15

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

Answer 2

The statement is incomplete, incorrect and misleading.

HKAS 8 requires that (except to the extent that it is impracticable to determine either the
period-specific 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:

(1) provides evidence of circumstances that existed on the date(s) as at which those
amounts are to be recognised, measured or disclosed; and

(2) 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 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 (e.g. 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.

Module A (September 2006 Session) Page 10 of 15

Answer 3(a)

The financial instrument is Sloan’s financial liability since it represents a contractual

obligation by Sloan to deliver cash to another entity.

The financial liability should not be classified as a financial liability at fair value through
profit or loss since it is not held for trading (and it is not likely that it satisfies the conditions
for designation as such).

The financial liability should be classified as financial liability at amortised cost, and initially
recognised at HK$500,000,000 (presumably the fair value of the instrument at issuance).

After initial recognition, Sloan should measure the financial liability at amortised cost using
the effective interest method.

The effective interest rate is 9.6% (The rate that exactly discounts the annual interest
payment of HK$80,000,000 for 10 years to the initial carrying amount of
HK$500,000,000).

Answer 3(b)

From the perspective of Sloan, the convertible preference shares (PS) comprise two
components:

- a financial liability (the repayment of the principal amount at the end of the fourth year
and the cumulative fixed dividends represent a contractual arrangement to deliver cash
or another financial asset); and

- an equity instrument (a call option granting the holder the right, for a specified period of
time, to convert it into a fixed number of Sloan’s ordinary shares).

Sloan should separately account for the two components and should allocate the initial
carrying amount of the PS to its equity and liability components.

The fair value of the financial liability is estimated to be HK$450,788,881

[(HK$500,000,000x132%)/(1.1)4, assuming that dividends would be paid cumulatively at
the end of the fourth year] or HK$468,301,346 [(HK$40,000,000/1.1)
+(HK$40,000,000/1.12)+(HK$40,000,000/1.13)+(HK$540,000,000/1.14), assuming that
dividends would be paid yearly] or other appropriate estimates.

The initial carrying amount of the equity instrument represented by the option to convert
the instrument into Sloan’s ordinary shares is then determined by deducting the fair value
of the financial liability from the fair value of the compound financial instrument as a whole.

That is, the equity component should be HK$49,211,119 or (HK$31,698,654 or other

reasonable estimates).

Module A (September 2006 Session) Page 11 of 15

Answer 3(c)

The 100,000,000 ordinary shares issues by Sloan are equity instruments, since the
ordinary shares represent a contract that evidences a residual interest in the assets of an
entity after deducting all of its liabilities (HKAS 32.11).

In accordance with HKAS 32.23, the put option, which contains an obligation for Sloan to
repurchase the 100,000,000 ordinary shares for cash (at HK$6.6 per share) gives rise to a
financial liability for the present value of the redemption amount.

When such financial liability is recognised initially under HKAS 39, its fair value (the
present value of the redemption amount) is reclassified from equity.

Subsequently, the financial liability is measured in accordance with HKAS39.

If the contract expires without delivery, the carrying amount of the financial liability is
reclassified to equity.

Answer 4(a)

Hotel Property One

Land use right is accounted for as an operating lease under HKAS 17.

Carrying amount as of 31 December 2005

= 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 2005 (1 full year)

= RMB303,900,000/ 50 x 1
= RMB6,078,000.

Carrying amount as of 31 December 2005

= 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.

Carrying amount as of 31 December 2005

= RMB48,000,000 * (1 - 2.25/60)
= RMB46,200,000.

Module A (September 2006 Session) Page 12 of 15

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 2005.

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, i.e. both land
and building, at RMB440,000,000 (RMB100,000,000 + 340,000,000).

Answer 4(b)

The turnover rent element is an embedded derivative in the host lease contract.

Under HKAS 39, an embedded derivative in a host lease contract is considered to be

closely related to the host contract if the embedded derivative is contingent rentals based
on related sales.

Accordingly, Phoenix is not required to account for the embedded derivative separately
from the host lease contract.

The turnover rent is a form of contingent rent governed by HKAS 17 Leases.

The turnover rent for each year calculated as the excess of 5% annual turnover of the
hotel over the minimum rental shall be recognised as income of the relevant year.

Answer 5

(i) Contract with CTI

According to the contract, the amount of the revenue from the remaining 40 units
would be HK$12,920,000 (HK$380,000x20+380,000x70%x20).

The total cost of the 40 units would be HK$11,520,000 (HK$288,000x40). Therefore,

a gross profit of HK$1,400,000 would be resulted when MAL completes the remaining
obligations under the contract.

Since the contract is not an onerous contract, no provision at 31 December 2006

should be made for the future completion of the contract according to HKAS 37
Provisions, Contingent Liabilities and Contingent Assets.

It is NOT appropriate to make a provision of HK$440,000 [(HK$380,000x70% -

HK$288,000)x 20] for the loss related to the delayed delivery of the 20 units, since the
unfinished part of the contract should be considered as a whole.

Module A (September 2006 Session) Page 13 of 15

(ii) Restoration of Showroom

The past event leading to the obligation to restore the premises was the renovation
and decoration that changed the premises from its original condition to the present
condition.

The obligation was a present obligation at 31 December 2006 since MAL had already
changed the condition of the premises.

Accordingly, a provision for restoration of the premises should be recognised at

31 December 2006.

Under HKAS 37.36, the amount recognised as a provision shall be the best estimate
of the expenditure required to settle the present obligation at the balance sheet date.

HK$800,000 is to be incurred at the end of the lease term, not at the balance sheet
date. Under HKAS 37.45, where the effect of the time value of money is material,
the amount of a provision shall be the present value of the expenditures expected to
be required to settle the obligation. Accordingly, an estimate of the present value of
HK$800,000 at 31 December 2006 should be calculated for the provision to be
recognised.

According to HKAS 16 “Property, Plant and Equipment”, the initial estimate of the
costs of restoring the showroom should be included as cost of the showroom, i.e.
leasehold improvement.

(iii) Patent infringement

The past event leading to the highly probable loss of HK$120,000,000 was the
alleged infringement of DCS.

The obligation was a present obligation at 31 December 2006 since MAL had already
committed the alleged infringement.

There were material uncertainties as to the timing and the amount of the obligation
until the settlement of the legal case, although MAL’s lawyers were of the view that
the loss of HK$120,000,000 was highly probable.

Therefore, MAL should recognise a provision of HK$120,000,000 at

31 December 2006, which represents the best estimate of the uncertain amount of
the loss.

MAL should disclose in the notes a brief description of the nature of the provision,
including:

- an estimate of its financial effect, i.e. HK$120,000,000;

- an indication of the uncertainties relating to the amount or timing of any outflow

(i.e. it was highly probable according to the lawyers’ opinion and the expected
date of settlement); and

- the possibility of any reimbursement from the DCS developer.

Module A (September 2006 Session) Page 14 of 15

 The potential recovery from the DCS developer is a contingent asset, which 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 MAL.

Although it is highly probable that MAL will succeed in recovery of HK$100,000,000

from the DCS developer, according to HKAS 37, MAL should not recognise any asset
until the realisation of the recovery is virtually certain.

* * * END OF EXAMINATION PAPER * * *

(ANSWERS)

Module A (September 2006 Session) Page 15 of 15