Reference to HKALE Principles of Accounts Prepared by T.C.

Ng
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Text-Type Questions in Past Papers

Text-Type Questions in Past Papers

I. Purposes of Financial Accounting
Purposes of accounting that would facilitate business management [2007-2(c)]

Reporting: a properly prepared set of financial statements might be required by users including the tax
authority, creditors, bankers, etc

Controlling: proper accounting records facilitate debts collection as well as time payment of debts

Evaluating: properly presented trading results and financial position in accordance with generally accepted
accounting principles facilitate results comparison across years and between firms

Planning: proper books of accounts would facilitate owners’ decision-making with respect to manpower
planning, future expansion, etc

A true and fair view [2004-I-2(C)(a)]

Truth: facts and reality which are NOT false or erroneous

Fairness: the impression/perception of users of financial statements that the info. contained in the financial
statements is fairly represented

In virtually all circumstances, a true and fair view is achieved by compliance with applicable accounting
standards and relevant sections of the Companies Ordinance

A true and fair view requires:
 selecting and applying accounting policies so that the financial statements comply with all
requirements of applicable accounting standards.
 presenting information in a manner that is relevant, reliable, comparable and understandable.
 providing additional disclosures when the requirements in the accounting standards are insufficient
to enable users to understand the impart of particular transactions or events on the enterprise’s
financial position and performance.

Departure from accounting standards is only allowed in extremely rare circumstances when the treatment
required is clearly inappropriate and thus a true and fair view cannot be given either by applying the
standards or through additional disclosures alone. Disclosure of reasons and financial effect MUST be made
in the financial statement.

II. Financial Accounting

Purpose of depreciation [2001-II-5(c), 2007-I-5(a)]

Allocation of the cost/depreciable amount of an asset over its useful life in a systematic manner

If the value of the noncurrent asset is revalued upward, depreciation is still required. Depreciation is
calculated to allocate the depreciable amount (on revalued basis) of the asset over its remaining useful life.

A depreciation method should reflect the pattern in which the asset’s economic benefits are consumed by
the company through production

Straight-line method: (assumption) there is an even usage of the asset throughout its useful life

Reducing balance method: (assumption) the asset falls in value at a faster rate in earlier years
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Text-Type Questions in Past Papers

Sum of the years’ digit method: accelerated depreciation method which assumes a higher usage in earlier
years than in later years

For assets which fall in value at a faster rate in earlier years, the reducing balance method will be a fairer
method of allocating costs

The decreasing deprecation over the years, together with the increasing maintenance charge, will result in
a stable level of expenses on the asset

On the basis the usage of the asset will be gradually decreasing, the sum of the years’ digit method will be
more appropriate

Advantages for maintaining both current and capital accounts in partnership [2008-I-3(b)]

Maintaining fixed capital accounts helps to distinguish the fund contributed by partners from that
generated from recurrent operations

Fixed capitals help to ensure the capital base is NOT eroded by excessive drawings, which will be revealed
by a negative balance in the current account

Reasons for not maintaining goodwill account [2006-I-2(c)]

Valuation may be subjective; estimated value may NOT be reliable

Not arise from arms’ length transaction

Intangible nature of the asset

Relationship will future economic benefit NOT easily identifiable or measurable

Purpose of making revaluation adjustment upon a change in profit & loss sharing ratio among partners
[2005-I-4(d)]


in P/L sharing ratio among partners  assets revaluation needed to reflect their fair values

There may be unrealised holding gains/losses which have NOT been accounted for in the books as at the
date of
in P/L sharing ratio

Through revaluation, partners’ capital accounts are credited with their respective share of gains (or debited
with the share of losses) using the OLD P/L sharing ratio

If revaluation is NOT done, the partners would be entitled to a share of these gains (or losses) using the
new P/L sharing ratio when the assets are EVENTUALLY realised, even though they arouse prior to

in the ratio

Reasons for paying a premium to take-over a business incurring a heavy loss [2007-I-3(c)]

The purchase consideration has taken into account earning potential of assets in the partnership

The heavy loss only temporary  profitability may improve after restructuring/business take-over

The premium could have been paid for the existing customer and supplier network

The purchase consideration has taken into account the business owners’ expertise in the area, i.e. specialist
knowledge

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Text-Type Questions in Past Papers

Comparison between equity capital and loan capital [2008-I-1(a)]

Equity Capital

Shareholders have voting rights

Dividend is an appropriation of profit, with

rate NOT fixed

No stipulated date for repayment of capital

In case of liquidation, shareholders rank the

last to receive back the fund invested
Loan Capital

Debenture holders have NO voting rights
Interest is an expense, with fixed rate

Stipulated date for redemption of debentures
In case of liquidation, debenture holders rank
before shareholders

Purpose of preparing consolidated financial statements [2004-I-1(A)(a)]

To present the group’s operating performance AND financial position from the perspective of the group
as a whole

Group accounts are legally required

III. Analysis and Interpretation of Financial Statements

Comparison between liquidity ratios and cash flow statements [2006-I-1(c)(ii)]

Sources and uses of cash are given in the cash flow statement.

The cash flow statement presents both the current cash position AND an indication of the future cash
position. These sources of fund affect the company’s future cash position, but they are NOT included in
the liquidity ratios.

Each ratio focuses on just one aspect of liquidity and NOT a comprehensive view as given in the cash flow
statement.

Circumstances in which cash flows from operating activities offer a clearer picture of operating performance
than earnings [2007-I-4(c)]

A company reports large non-cash expenses, such as write-offs, depreciation, and provisions for future
obligations. Earnings may give an overly pessimistic view of the firm.

A company is growing rapidly. Reported earnings may be positive, but operations are actually consuming
rather than generating cash.

A company purposely shows a more favourable position than the actual, e.g. when applying for a major loan.
In such cases, cash flow from operations provides a better reality check for reported earnings.

Common remarks used in analysis of cash flows (revealed by the cash flow statement) [2003-I-1(c),
2005-I-2(b), 2006-I-1(c)(i), 2008-I-2(c)]

Positive and recurrent cash flow from operating activities (crucial to survival of company)  current cash
flow position considered promising

Strong cash generating power from operations relative to regular short-term and long-term
commitments/regular cash payments  no problem in interest payments

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Text-Type Questions in Past Papers

(A substantial amount of ) Fixed deposits will mature next year  enhance the short-term ability to repay

Major use of cash is fixed assets acquisition (non-recurring)  expand business / increase production
capacity, hence generating future cash inflow

Funds can be generated upon disposal of noncurrent assets

Debentures is only repayable after 6 years  NOT impose pressing demand for short-term liquidity

There should be sufficient cash in near future to pay off bank overdraft

Negative cash flow in operating activities + cash inflow mainly from sale of fixed assets  difficulty in
sustaining daily operations

A large portion of assets sold (which could generate future economic benefits)  company’s ability to
generate future profit in doubt

New bank loan obtained and new asset financed by finance lease  has to repay loan and bear high interest
expenses in future

Surplus cash should be used to finance expansion of production capacity and/or operations; if not, repayment
difficulty when bank loan is due 2 years later

Uses and limitations of financial statements and ratio analysis [1999-II-4(a)]

Uses:

Financial statements interpretation/analysis is a process of evaluating relationship between component
parts of financial statements to obtain a better understanding of a firm’s financial position and
operating performance

By ratio analysis, the performance of the firm can be evaluated in terms of its profitability,
solvency/liquidity and capital structure (gearing)

Main purpose: to help users appraise a firm’s past performance and from that appraisal, to make
predictions about its likely future performance

Ratios are used as they can eliminate the effects of scale and size of different firms or different years of
the same firm, so that comparison can be made
Limitations:

Financial statements are usually prepared on a historical cost basis  may NOT be relevant for predicting
future performance

Different firms may adopt different accounting policies which make comparisons difficult

The uniqueness (e.g. the environment where the firm is operated) of a particular year or a particular firm
has to be considered before a meaningful comparison can be made

III. An Introduction to Managerial Accounting

Types of costs [2004-II-4(B) & 5(A), 2007-II-2(b)]

Fixed cost does NOT change regardless of production level; beyond relevant range
of output and time period, even total fixed cost may change
(*increase in volume  UNIT fixed cost, NOT total fixed cost, will

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Text-Type Questions in Past Papers

decrease)

Stepped cost / semi-fixed cost does NOT change within a range of activity

Semi-variable cost consists of fixed and variable elements; the variable cost changes in
DIRECT proportion with production level

Sunk cost cost that has been incurred by a decision made in the past and that
CANNOT be changed by any decision that will be made in future

Opportunity cost measures the best opportunity that is lost or sacrificed when the choice
of one course of action requires an alternative course of action be given
up

Job Costing Method versus of Process Costing Method [2005-II-4(A)(a)]

Job Costing Method Process Costing

Costs attributable to individual jobs and
NO specific costs assigned to individual units;
calculated on job basis unit cost calculated on average cost basis

Commonly used for customised or one-off
Commonly applied to mass produced, similar
products that are tailor-made to meet the products going through a sequence of
customers’ specifications continuous or repetitive operations incurring
direct costs and overheads from process to
process

Reasons for Increasing Trend to Adopt ABC systems [2004-II-2(B)]

To allow for allocation of non-manufacturing overheads to products

To eliminate cross-subsidisation when more than one product is manufactured

To provide more accurate cost information available for various products and hence flexible pricing is
possible

To help to monitor the production efficiency of various production activities

Sophisticated overhead allocation methods enabled by lower information processing costs

Advantages of using standard absorption costing approach for stock valuation [2008-II-4(c)]

The use of absorption costing (rather than marginal costing) for stock valuation is recommended as
production overheads, whether fixed or variable, are necessary costs for manufacturing process

For cost control on producing standardised products, standard costing for stock valuation is more
appropriate than actual costing as variance could be identified

It helps alert management of deviations from standards or planned estimates

Definition of margin of safety [2005-II-5(a)(ii)]

Amount of sales that can be reduced before a loss occurs

Difference between actual sales revenue and sales revenue at break-even point

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Text-Type Questions in Past Papers

Reasons for opening a provision for unrealised profit account and how it would be disclosed in the balance
sheet [1999-I-5(b)]

Internal (manuf.) profit may arise as a result of the transfer of finished goods at loaded price from manuf.
section to the trading section. The manuf. section then turns from a cost centre to a profit centre.

Where some of the finished goods produced during the year have not been sold at period end, provision
for unrealised profit is required to account for the unrealised profit element in the closing stock of
finished goods.

Provision for unrealised profits is an adjustment for unsold finished stock in the trading section under the
profit and loss account. It is necessary because until the goods are sold there is NO real profit earned by
the company.

When there is opening stock of finished goods, the adjustment shown in the profit and loss account would be
the increase (debited to the profit and loss account) or decrease (credited to the profit and loss account) in the
provision for realised profit during the period.

In preparing the balance sheet at period end, any closing balance of provision for unrealised profit on finished
goods MUST be deducted from the gross value of the stock of finished goods to arrive at the cost of the
stock of the finished goods.

Purposes of Cash Flow Statements [2006-II-2(b), 2008-II-1(c)]

To direct and coordinate cash inflows and outflows

To facilitate the planning and coordination of business activities to match with sources of fund

To provide advance notice of future cash positions

To evaluate actual performance against budgeted flows

To alert the management of any need to deal with potential cash shortages problems or cash surplus
opportunities and to decide on any necessary action

Ways of incorporating risk in investment appraisal calculations [2006-II-5(d)]

Risk-adjusted discount rate: Higher rate used for discounting to include the risk incurred in the investment 
discounting cash flows in future more heavily, i.e. smaller NPV

Higher payback period/IRR requirement: Earlier pay-back of investment  lower risk incurred as the firm
can recoup the initial amount of investment earlier

Sensitivity analysis

Scenario analysis

Examples of non-financial factors in decision-making [2004-II to 2008-II]

* When attempting examination questions of this type, it is reminded that ALL factors suggested should be
specifically related to the scenario in question. The factors provided below are common suggestions only.

General factors
Accuracy/reliability of the estimates that should be ascertained

Availability of spare production capacity

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Text-Type Questions in Past Papers

Possibility of improving profitability, e.g. making similar deals with other

corporate clients, raising the price on all future sales

Concern over whether demand is a short-term upsurge

Impact on staff morale; skills and expertise of staff

Strategy of competitors
Taking special orders,
Policy/management implications on different mark-ups for different products
e.g. bulk order with Feedback from
The order should be one-off or clearly differentiated
discounts offered ordinary customers from the general retail sales  no expectation of price
reduction by individual customers aroused

Their dissatisfaction
Feedback from the
Possibility of starting up a long-term business
special client relationship with the client, i.e. his/her future purchase
volume
Deciding on the use of
Stakeholders’ risk preference on suggested proposals
the vacant factory space,
Creditworthiness of the new tenant, customers and relevant parties
e.g. using it to facilitate
Matching cash flow pattern from the proposals with uses and sources of fund or
production, selling it, those of other projects
signing a tenancy
Medium-term business direction requiring the use of space, e.g. new market
agreement with a client, segments, new products/services, new technology, system or logistic
re-engineering

IV. Accounting Theory

Cash basis versus Accrual basis [2006-I-4(b)]

Cash basis: all transactions are recorded on the dates of receipt or payment

Accrual basis: all amounts are analysed and recorded according to their dates of incurrence, NOT receipts
or payments

Capital expenditure versus Revenue expenditure [1998-II-4(a)]

Capital expenditure: amount spent on the acquisition of long-term assets and not assets for resale,
including the addition of value to the existing assets (e.g. purchase of furniture)

Revenue expenditure: amount spent on the acquisition of assets for resale or for the purpose of earning
revenue income (e.g. purchase of trading stock)

Characteristics of operating lease [2006-II-5(c)]

The lessor retains most of the risks and rewards of the ownership of an asset

the NPV under leasing arrangement is less than 90% of the fair market value of the asset (*** in the NEW
accounting standard, NO numerical thresholds are specified with the intention to draw attention away from
such strict criterion)

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Text-Type Questions in Past Papers

Development cost capitalisation [2005-I-2(c)]

Development cost should NOT be capitalised when:

Project NOT clearly defined, technically feasible OR commercially viable

Future benefits NOT reasonably certain or CANNOT recover costs

NOT enough resources to complete the project

Costs attributable to the project CANNOT be separately identified or measured reliably

Normal identification of stock loss under perpetual and periodic inventory systems [2005-I-5(C)]

Perpetual: quantity of goods that should be in stock are kept up-to-date  stock loss can be identified
quite easily by comparing it with physical stock count

Periodic: stock loss cannot be identified UNLESS all sales are made at a standard mark-up; and is
ascertained ONLY upon the end-of-period stocktaking

Advantages of using IT in operating perpetual inventory system [2005-I-5(D)]

Perpetual inventory made more feasible in a business environment supported with good computer systems,
esp. when a large volume of data is involved

Tedious data recording work performed by computers accurately and quickly involving less manpower

IT permits instantly and/or continually perpetual inventory record

IT permits tracking of stock movements between different locations

FIFO Method versus LIFO Method in stocktaking [2007-II-1(f)]

FIFO Method

Assumes that stock items purchased first are

issued first  stock value at year end will carry
the more recent purchase cost  more realistic
asset valuation

More realistic assumption whereby the oldest

items of stock are assumed to be sold first and
those remaining are the newer items  better
representation of actual stock flows
LIFO Method
Could distort current period’s profit/loss when
preserved old layers of stock are presumed to
be used when the prevailing physical stock is
substantially reduced
Disallowed in professional practice

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