CASE

Miami Global Holdings Inc (“MGHI”), a company incorporated in the United States (“US”),
owns the brand of “Miami Health Club” and operates worldwide. Nevertheless, there is no
shareholding relationship across the groups of entities in different countries. Every group of
entities in each jurisdiction operates independently. They are, however, linked up by an
international cooperation agreement with the headquarters in the US through the following
key terms:

1. MGHI shall license the use of the brand “Miami Health Club” to the entity in the
jurisdiction which operates under the brand of “Miami Health Club” (the “User”);

2. MGHI shall provide a trainer to the User in the User country to promote the corporate
objective, to teach the selling strategy, to train up and update fitness trainers with the
latest technology;

3. MGHI shall provide software for use by the User to keep track of the fitness status of the
trainees where the User does not have the source code to change the software and is
not allowed to modify, adapt or copy the software;

4. The trainer is an employee of MGHI who would render services in the User country for
not more than three months in every calendar year.

5. The fee payable by the User to MGHI is US$1 million per annum.

The User in Hong Kong is Miami HK Holdings Ltd (“MHK”), and it has a wholly owned
Hong Kong subsidiary, Miami Health Club HK Ltd (“MHC”) which is the Hong Kong operating
company housing all the staff and recording all the subscription income and operating
expenses generated from the fitness operation.

MHK is 80% owned by Mr Joe Yeung and 20% owned by Mr Peter Chu. Joe is the sole
director of MHK and MHC.

On 1 September 2014, a three-year contract was entered into between MHK and MGHI in
which MGHI agreed to license the right of use of the brand name “Miami Health Club” in
Hong Kong to MHK from 1 October 2014 to 30 September 2017. Based on the contract, the
payment of the annual fee of US$1 million would be payable by MHK to MGHI on
30 June 2015, 2016 and 2017.

Since the international cooperation agreement is signed between MGHI and MHK, MHK
recharged the fee to MHC at a mark-up of 10%.

Final Examination (June 2017 Session) – Paper II 1 of 10

Below is an extract of the separate financial statements of MHK for the years ended
30 September 2015 and 2016:

Statement of financial position of MHK as at 30 September 2016

2016 2015
HK$’000 HK$’000
Non-current asset
Investment in a subsidiary (MHC) 10,000 10,000

Current asset
Trade receivable 5,000 6,000
Total assets 15,000 16,000

Current liability
Bank loan (1,000) (1,000)
Total assets less current liability 14,000 15,000

Shareholders’ equity
Share capital (1,000) (1,000)
Retained earnings (1,000) (1,000)
Total equity (2,000) (2,000)

Non-current liability
Bank loan (12,000) (13,000)
Total equity and non-current liability (14,000) (15,000)

Statement of profit or loss of MHK for the year ended 30 September 2016:

Income HK$’000
Management fee 8,536

Expense
International fee (7,760)
Interest expense (870)
Loss for the year (94)

Operation of the fitness centres

The fitness centres operated by MHC are mainly located in urban areas. In order to satisfy
the increase in the demand of customers, MHC decided to open a new fitness centre in the
New Territories. Joe has received a proposal from a landlord for the new location and
details are as follows:

Non-cancellable lease period: 1 April 2017 to 31 March 2020

Monthly rental: HK$200,000 or 28% of the turnover of MHC, whichever
is higher
Rent-free period: 1 April 2017 to 31 May 2017
Final Examination (June 2017 Session) – Paper II 2 of 10
In addition, an interest-free deposit of HK$600,000 would be required to be paid upon the
signing of the contract and would be repaid in cash upon the end of the lease period.

Based on management estimation, the fair value of the interest-free deposit as at the date of
lease inception was HK$520,000 and the projected turnover and rental expenses of MHC for
each of the six months ending 30 September 2017 are as follows:

Month Projected turnover Rental expenses

(in HK$) (in HK$)
April 2017 600,000 Nil
May 2017 700,000 Nil
June 2017 750,000 210,000
July 2017 850,000 238,000
August 2017 650,000 200,000
September 2017 700,000 200,000
Total 4,250,000 848,000

MHC has been marginally profitable until the last three years, when it began suffering losses
and facing funding difficulties. MHC attempted to increase its line of credit with Lion Bank in
October 2016. The credit manager of the Lion Bank used the revised Z-score model and
MHC’s 2015 and 2016 financial information to determine creditworthiness. Finally, Lion
Bank rejected MHC’s credit application. MHC’s statements of financial position for the years
ended 30 September 2015 and 2016 are given below and its 2015 and 2016 “Profits before
Interest and Tax” were HK$ 0.8 million and HK$ 0.6 million respectively.

Statement of financial position of MHC as at 30 September 2016

2016 2015
HK$’000 HK$’000
Non-current assets
Property, plants and equipment 19,300 18,600
Intangible assets and others 2,200 2,300
21,500 20,900
Current assets
Trade receivable 2,900 2,700
Other receivables 1,800 1,500
Bank and cash 3,400 1,900
8,100 6,100
Total assets 29,600 27,000

Current liabilities
Trade payable 4,100 2,900
Accrued expenses 3,300 2,100
7,400 5,000
Total assets less current liabilities 22,200 22,000

Final Examination (June 2017 Session) – Paper II 3 of 10

 2016 2015
HK$’000 HK$’000
Shareholders’ equity
Share capital 6,000 6,000
Retained earnings 1,600 1,800
Total equity 7,600 7,800

Non-current liabilities
Deferred tax liabilities 600 200
Secured bank loan 10,000 10,000
Other long-term loan 4,000 4,000
14,600 14,200
Total equity and non-current liabilities 22,200 22,000

Audit of MHK and MHC

Fins & Co has been the auditor of MHK and MHC for many years. For the preparation of the
financial statements of MHK and MHC for the year ended 30 September 2016, the
management have performed a going concern assessment and prepared the financial
statements of MHK and MHC based on the going concern assumptions.

MHK’s shareholders and MHK confirmed to Fins & Co that they will provide financial support
for the continuing operations of MHK and MHC, respectively, so as to enable MHK and MHC
to meet their liabilities as they fall due and carry on its business without a significant
curtailment of operations in the twelve months from 30 September 2016.

Litigation

Subsequent to the financial year-end, there were many news reports that after prepaying the
subscription fees, many trainees could not reserve the training sections before the expiry
dates of their subscription payments. They felt they were cheated and would take legal
action against MHC. In addition, since the staff of MHC did not sell the services packages
according to the directions provided by MGHI, MGHI was taking legal action against MHK.

Before the case has been put to the court, Mr Joe Yeung transferred all the assets of MHC
to a company controlled by his relative at a nominal value of HK$1 million, notwithstanding
that the fair value of the assets was HK$50 million.

Final Examination (June 2017 Session) – Paper II 4 of 10

SECTION A – CASE QUESTIONS (Total: 75 marks)

Answer ALL of the following questions. Marks will be awarded for logical argumentation /
calculation and appropriate presentation of the answers.

Question 1 (10 marks – approximately 18 minutes)

You are the financial controller of Miami Global Holdings Inc (“MGHI”) and are
currently preparing the financial statements for the year ended 30 September 2016.

(a) Analyse whether the international cooperation agreement entered into between
MHK and MGHI falls within the scope of HKFRS 15 Revenue from Contracts with
Customers and also state the timing in which such an analysis should be
performed.
(6 marks)

(b) Assume the litigation against MHK is in a very preliminary stage and it is not
clear if MGHI will win the case at the moment. MGHI has incurred legal and
professional expenses of US$0.3 million on the case. Explain to the directors of
MGHI the impact of the litigation against MHK on the financial statements.

(4 marks)

Question 2 (9 marks – approximately 16 minutes)

You are the accounting manager of MHC. Advise the director of MHC, as to the
accounting implication of all the applicable items (in particular but not limited to the
rental expenses to be charged to the profit or loss) as well as the disclosure
requirement in relation to entering into the new lease on the separate financial
statements of MHC for the year ending 30 September 2017, with reference to the
relevant accounting standards.
(9 marks)

Question 3 (5 marks – approximately 9 minutes)

Fins & Co is the auditor of MHK and MHC. State the areas that Fins & Co has to
consider in assessing whether to continue the existing engagements with MHK and
MHC.
(5 marks)

Question 4 (5 marks – approximately 9 minutes)

Discuss how the news reported on MHK and MHC would impact the overall audit plan.

(5 marks)

Final Examination (June 2017 Session) – Paper II 5 of 10

Question 5 (15 marks – approximately 27 minutes)

(a) State four possible events that may cause doubt about the going concern of
MHK and MHC.
(4 marks)

(b) State the auditor’s objectives in relation to going concern.

(2 marks)

(c) Comment on whether:

(i) it is appropriate for MHK’s shareholders and MHK to only confirm to

Fins & Co that they will provide financial support to MHK and MHC,
respectively.

(ii) it is sufficient for Fins & Co to only rely on the financial support for the
twelve months from 30 September 2016 in assessing the going concern of
MHK and MHC.

(2 marks)

(d) In relation to the financial support provided to MHK by the shareholders of MHK,
and the financial support provided to MHC by MHK,

(i) suggest the possible audit procedures that could be performed for each of
the financial support and

(ii) assess whether the shareholders of MHK and MHK can honour the
financial support. Also, discuss its possible implication (if any) to the
audit opinion.

(7 marks)

Question 6 (7 marks – approximately 13 minutes)

(a) Lion Bank rejected MHC’s credit application to increase its line of credit. Based
on the Altman’s revised Z-score model, analyse whether MHC exposed a default
risk, so its credit application was rejected?
(Revised Z–score model: Z-score = 6.56(NWC/Total assets) + 3.26(Accumulated
retained earnings/Total assets) + 1.05(EBIT/Total assets) + 6.72(Book value of
equity/Total liabilities))
(4 marks)

(b) Identify the relevant financial ratios to be used by Lion Bank to assess MHC’s
financial health.

(3 marks)

Final Examination (June 2017 Session) – Paper II 6 of 10

Question 7 (14 marks – approximately 25 minutes)

Assuming Mr Joe Yeung did not transfer the assets of MHC to his relative’s company.

MHC has been marginally profitable until the last three years, when it began suffering losses.
The self-owned fitness centres are located on reasonably valuable real estate. MHC’s
properties (fitness centres) have an estimated liquidation value of $25million. After a lot of
discussion with MHC’s bankers and creditors, management has agreed to a voluntary
liquidation. A trustee, who is appointed by the various parties to liquidate the real estate, will
charge HK$1 million for his services. In addition to the trustee, a liquidator has been
appointed and his fee is expected to be HK$1 million. MHC owes $5 million in property
taxes. It has a HK$10 million bank loan secured on its property. The other long-term loan is
not secured. Creditors’ claims are summarized as follows:

(30 November 2016)

Claims
Book value of claims (HK$)
Trade payable 2,000,000
Owing to employees 3,000,000
Secured bank loan 10,000,000
Other long term loan 4,000,000
Ordinary shareholders 6,000,000

Required:

(a) Analyse the situation and calculate the amount each claim is likely to receive
upon liquidation.
(5 marks)

(b) Are there any benefits of an early indication of financial distress to the company?

(4 marks)

(c) Consider any important matters the management need to take into consideration
before entering into the bankruptcy.
(5 marks)

Final Examination (June 2017 Session) – Paper II 7 of 10

Question 8 (4 marks – approximately 7 minutes)

York Fitness Ltd (“York”) wants to acquire MHC to expand its fitness business in Hong Kong.
According to its CFO’s forecast, the project will provide a net cash flow of HK$ 250,000 for
the company at the first year and the future cash flow is projected to grow at a constant rate
of 5% per year indefinitely. The project requires an initial investment of HK$ 3,500,000.

Required:

(a) If York requires a return of 11% on such an investment, should the project start?

(2 marks)

(b) The CFO of York is not very sure about the assumption of a growth rate of 5% in
its cash flows. Determine the constant growth rate so that the company will
break even if it still requires an 11% return on the project.
(2 marks)

Question 9 (6 marks – approximately 11 minutes)

State the fiduciary duties of the directors and explain how Joe breached his fiduciary
duties as the director of MHK.
(6 marks)

* * * * * * * *

Final Examination (June 2017 Session) – Paper II 8 of 10

End of Section A
SECTION B – ESSAY QUESTIONS (Total: 25 marks)

Answer ALL of the following questions. Marks will be awarded for logical argumentation /
calculation and appropriate presentation of the answers.

Refer to the Case information.

Question 10 (17 marks – approximately 31 minutes)

You are the tax advisor to MGHI. Please write a letter to the Board of Directors of
MGHI about the potential Hong Kong tax exposure, if any, to it as well as its
employees in relation to its arrangement with MHK under the general charging section
and deeming provision(s). Suggest recommendations to mitigate such exposure.
Quote the relevant tax cases and statutory provisions for support.
(17 marks)

The following mark allocation is provided as guidance for this requirement:

- Profit tax exposure (11 marks)

- Salaries tax exposure (6 marks)

[Mark(s) will be awarded for proper letter format used with logical presentation.]

Question 11 (8 marks – approximately 14 minutes)

Regarding the bank loan to MHK, is there a risk that part of the interest expense of
HK$870,000 for the year ended 30 September 2016 would be disallowed by the IRD?
Explain the reason(s) and calculate the amount of the disallowable portion. State
your assumptions, if any.
(8 marks)

* * * END OF EXAMINATION PAPER * * *

Final Examination (June 2017 Session) – Paper II 10 of 10