Professional Documents
Culture Documents
Programme
Qualification Programme
Module A
Financial
Module A
Reporting Financial Reporting
Qualification Programme
Module A
Financial Reporting
First edition 2010
Fifth edition 2015
Published by
www.bpp.com/learningmedia
Printed in China
©
HKICPA and BPP Learning Media Ltd
2015
ii
Contents
Page
Director's message v
Introduction vi
Module overview vii
Chapter features viii
Learning outcomes ix
Introduction iii
Page
II Statement of cash flows
20 Statements of cash flows 565
III Disclosure and reporting
21 Related party disclosures 601
22 Accounting policies, changes in accounting estimates and errors;
events after the reporting period 617
23 Earnings per share 639
24 Operating segments 663
25 Interim financial reporting 679
26 Presentation of financial statements 695
Part D Group financial statements
27 Principles of consolidation 725
28 Consolidated accounts: accounting for subsidiaries 765
29 Consolidated accounts: accounting for associates and joint arrangements 813
30 Changes in group structures 843
31 Consolidation of foreign operations 895
iv Financial Reporting
Director's message
Welcome to the Qualification Programme (QP) of the Hong Kong Institute of Certified Public
Accountants (HKICPA).
You have made the decision to complete the HKICPA's QP which entails completing the training
programme, passing professional examinations and acquiring practical experience under an
authorised employer or supervisor. This marks a further step on your pathway to a successful
business career as a CPA and becoming a valued member of the HKICPA.
The QP comprising four core modules and a final examination will provide you with a foundation for
life-long learning and assist you in developing your technical, intellectual, interpersonal and
communication skills. You will find this programme challenging with great satisfaction that will open
a wide variety of career opportunities bringing in attractive financial rewards.
A module of the QP involves approximately 120 hours of self-study over fourteen weeks,
participation in two full-day workshops and a three-hour open-book module examination at the
module end. We encourage you to read this Learning Pack which is a valuable resource to guide
you through the QP.
The four core modules of the QP are as follows:
Module A: Financial Reporting
Module B: Corporate Financing
Module C: Business Assurance
Module D: Taxation
Should you require any assistance at any time, please feel free to contact us on (852) 2287 7228.
May I wish you every success in your QP!
Shanice Tsui
Director of Education and Training
Hong Kong Institute of Certified Public Accountants
Introduction v
Introduction
This is the fifth edition of the Learning Pack for Module A Financial Reporting of the HKICPA
Qualification Programme.
The Institute is committed to updating the content of the Learning Pack on an annual basis to keep
abreast of the latest developments. This edition has been developed after having consulted and
taken on board the feedback received from different users of the previous edition. Some of the
examples and self-test questions have been rewritten to better reflect current working practices in
industry and facilitate the learning process for users of the Learning Pack.
The Learning Pack has been written specifically to provide a complete and comprehensive
coverage of the learning outcomes devised by HKICPA, and has been reviewed and approved by
the HKICPA Qualification and Examinations Board for use by those studying for the qualification.
The HKICPA Qualification Programme comprises two elements: the examinations and the
workshops. The Learning Pack has been structured so that the order of the topics in which you
study is the order in which you will encounter them in the workshops. There is a very close inter-
relationship between the module structure, the Learning Pack and the workshops. It is important
that you have studied the chapters of the Learning Pack relevant to the workshops before you
attend the workshops, so that you can derive the maximum benefit from them.
On page (ix) you will see the HKICPA learning outcomes. Each learning outcome is mapped to the
chapter in the Learning Pack in which the topic is covered. You will find that your diligent study of
the Learning Pack chapters and your active participation in the workshops will prepare you to
tackle the examination with confidence.
One of the key elements in examination success is practice. It is important that not only you fully
understand the topics by reading carefully the information contained in the chapters of the Learning
Pack, but it is also vital that you take the necessary steps to practise the techniques and apply the
principles that you have learned.
In order to do this, you should:
Work through all the examples provided within the chapters and review the solutions,
ensuring that you understand them;
Complete the self-test questions within each chapter, and then compare your answer with
the solution provided at the end of the chapter; and
Attempt the exam practice questions that you will find at the end of the chapter. Many of
these are HKICPA past examination questions, which will give an ideal indication of the
standard and type of question that you are likely to encounter in the examination itself. You
will find the solutions to exam practice questions at the end of the book.
In addition, you will find at the end of the Learning Pack a bank of past HKICPA case-study style
questions. These are past ‘Section A’ examination questions, which present a case study testing a
number of different topics within the syllabus. These questions will provide you with excellent
examination practice when you are in the revision phase of your studies, bringing together, as they
do, the application of a variety of different topics to a scenario.
Please note that the Learning Pack is not intended to be a 'know-it-all' resource. You are required
to undertake background reading including standards, legislations and recommended texts for the
preparation for workshop and examination.
vi Financial Reporting
Module Overview
This module will enable you to exercise judgment in selecting and applying accounting policies to
prepare financial statements (both at individual company and group levels) in compliance with the
relevant Hong Kong Financial Reporting Framework and Hong Kong Accounting Standards
('HKFRSs'). Please refer to the QP Learning Centre for the cut-off rule on examinable standards.
Overall Structure of Module A (Financial Reporting)
Statements of
Financial Position and
Profit or Loss and
Other Comprehensive
Income
Introduction vii
Chapter features
Each chapter contains a number of helpful features to guide you through each topic.
Topic list Tells you what you will be studying in the chapter. The topic items form the
numbered headings within the chapter.
Learning focus Puts the chapter topic into perspective and explains why it is important, both
within your studies and within your practical working life.
Learning The list of Learning Outcomes issued for the Module by HKICPA,
Outcomes referenced to the chapter in the Learning Pack within which coverage will be
found.
Topic recap Reviews and recaps on the key areas covered in the chapter.
Bold text Throughout the Learning Pack you will see that some of the text is in bold
type. This is to add emphasis and to help you to grasp the key elements
within a sentence or paragraph.
Topic highlights Summarise the key content of the particular section that you are about to
start. They are also found within sections, when an important issue is
introduced other than at the start of the section.
Key terms Definitions of important concepts. You really need to know and understand
these before the examination, and understanding will be useful at the
workshops too.
Case study/ An example or illustration not requiring a solution, designed to enrich your
Illustration understanding of a topic and add practical emphasis. Often based on real
world scenarios and contemporary issues.
Self-test questions These are questions that enable you to practise a technique or test your
understanding. You will find the answer at the end of the chapter.
Formula to learn You may be required to apply financial management formulae in Module B,
Corporate Financing.
Exam practice A question at the end of the chapter to enable you to practise the
techniques that you have learned. In most cases this will be a past HKICPA
examination question, updated as appropriate. You will find the answers in a
bank at the end of the Learning Pack entitled Answers to Exam Practice
Questions.
Further reading In Modules B and D you will find references to further reading that will help
you to understand the topics and put them into the practical context. The
reading suggested may be books, websites or technical articles.
HKICPA's learning outcomes for the Module are set out below. They are cross-referenced to the
chapter in the Learning Pack where they are covered.
Fields of competency
The items listed in this section are shown with an indicator of the minimum acceptable level of
competency, based on a three-point scale as follows:
1 Awareness
To have a general professional awareness of the field with a basic understanding of relevant
knowledge and related concepts.
2 Knowledge
The ability to use knowledge to perform professional tasks competently without assistance in
straightforward situations or applications.
3 Application
The ability to apply comprehensive knowledge and a broad range of professional skills in a
practical setting to solve most problems generally encountered in practice.
Topics
Chapter
where
Competency covered
Introduction ix
Chapter
where
Competency covered
x Financial Reporting
Chapter
where
Competency covered
Introduction xi
Chapter
where
Competency covered
Introduction xiii
Chapter
where
Competency covered
Introduction xv
Chapter
where
Competency covered
Introduction xvii
Chapter
where
Competency covered
Introduction xix
Chapter
where
Competency covered
xx Financial Reporting
Chapter
where
Competency covered
Prepare the financial statements for a group in accordance with
Hong Kong Financial Reporting Standards and statutory
reporting requirements
LO4.03 Principles of consolidation: 3
4.03.01 Identify and describe the concept of a group as a 27
single economic entity
4.03.02 Define a subsidiary and when a group should 27
start and stop consolidating a subsidiary
4.03.03 Explain what constitutes control and the impact of 27
potential voting rights
4.03.04 Describe the reasons why the directors of a 27
company may not want to consolidate a
subsidiary and the circumstances in which non-
consolidation is permitted
4.03.05 Explain the purpose of consolidated financial 27
statements
4.03.06 Explain the importance of eliminating intra-group 27
transactions
4.03.07 Explain the importance of uniform accounting 27
policies and coterminous year ends in the
preparation of consolidated accounts
4.03.08 Apply the appropriate accounting treatment of 27
consolidated goodwill
4.03.09 Explain how to account for changes in parent's 30
ownership interest in a subsidiary without losing
control
LO4.04 Acquisition of subsidiaries: 3
4.04.01 Prepare a consolidated statement of financial 28
position for a simple/complex group structure
including pre and post acquisition profits, non-
controlling interests and goodwill
4.04.02 Prepare a consolidated statement of profit or loss 28
and other comprehensive income for a
simple/complex group structure, dealing with an
acquisition and the non-controlling interest
LO4.05 Disposal of subsidiaries: 3
4.05.01 Account for the disposal of a subsidiary by a 30
group
4.05.02 Account for the change of ownership in 30
subsidiaries without loss of control
Introduction xxi
Chapter
where
Competency covered
Introduction xxiii
xxiv Financial Reporting
Part A
Legal environment
The emphasis in this section is on the legal environment in Hong Kong. The purpose of this
section is to develop your understanding of the Hong Kong legal environment, including the
legal framework and the related implications for business activities. This is considered as the
basic knowledge and foundation for a future certified public accountant.
1
Financial Reporting
2
chapter 1
Legal environment
Topic list
Learning focus
This chapter is partly background knowledge to set the scene about the legal environment
before you look at financial reporting standards. It also discusses the legal framework and
related implications for business activities. It is important that you are aware of these both for
exam purposes and in practice.
3
Financial Reporting
Learning outcomes
Competency
level
Describe the Hong Kong legal framework and related implications for
business activities
1.01 Types and relative advantage of alternative forms of 2
organisation
1.01.01 Identify the types and relative advantages of alternative forms of
organisation
1.02 Legal procedures for establishment and governance of 2
companies
1.02.01 Describe the legal procedures for the establishment and
governance of companies
Describe the obligations of directors and officers of companies
1.03 Powers, duties and obligations of directors and company 2
secretaries
1.03.01 Describe the powers, duties and obligations of company directors
1.03.02 Describe the powers, duties and obligations of the company
secretary
Describe the legal requirements associated with company structure,
share offerings, debt obligations and restructuring
1.04 Share issues and prospectus requirements 2
1.04.01 Describe the procedure for issuing shares and the requirement for a
prospectus
1.05 Debt instruments and registration of charges 2
1.05.01 Describe the procedure for the issue of debt instruments
1.05.02 Describe the procedure for the registration of charges over
company debt
1.06 Statutory reporting and documentation requirements 3
1.06.01 Explain the statutory registers that must be kept by a company
1.06.02 Identify the financial statements that a company must prepare
1.07 Appointment and removal of auditors 3
1.07.01 Describe the procedures for the appointment, removal and
resignation of company auditors
1.08 Restructuring, including appointment of receivers and 1
liquidators
1.08.01 Identify the reasons for which a company may restructure, including
the appointment of receivers and liquidators
4
1: Legal environment | Part A Legal environment
The liability of the members of companies can be unlimited or limited. We are mainly concerned
with limited companies in this section.
5
Financial Reporting
However, if this business entity fails to register with the Registrar of Companies, then it becomes a
general partnership as a default.
In a general partnership all partners are general partners so each one is liable for all debts and
obligations of the firm.
In a limited partnership the general partners are liable for all debts and obligations of the firm
while the limited partners are liable only for the capital they contributed to the firm.
In a limited partnership the general partners manage the firm while the limited partners may not
and should limited partners do so then they become personally liable for the debts of obligations of
the firm in the same manner as a general partner.
Unless a partnership agreement between the partners demand otherwise, (1) a majority of the
general partners decide ordinary business matters, (2) a limited partner may assign his partnership
interests, (3) a limited partner cannot dissolve a partnership, (4) the introduction of a new partner
does not require the consent of the existing limited partners.
A partnership business, in common with a sole trader business, is not required to make accounts
and other documents public. It also has the additional advantages of:
greater access to capital since more individuals contribute to the business
potentially a greater spread of skills provided by the partners
shared risk
The disadvantages of a partnership include the issue of disputes in the running of the business,
and unlimited liability. Additionally, partners are jointly and severally liable for their partners,
meaning that any one may be held responsible for losses of the business.
1.1.3 Companies
A company is bound by applicable rules and regulations. This regulated formal structure is a
reason why companies are such a popular business structure. It is a comparatively safe and stable
system for different groups of people to join together in business activities.
The liabilities of the shareholders of companies in Hong Kong can be either limited or unlimited.
Extracts from Part 1 Division 3 Subdivision 1 of the new Companies Ordinance explain the
differences between unlimited companies and companies limited by shares or guarantee:
(a) Limited by shares – the members of the company are liable to pay the company's debts
only to the extent of the nominal value of their shares.
(b) Limited by guarantee – the members of the company are liable to pay the company's
debts only to the extent of a stated guarantee. This structure is often used by non-profit
organisations which do not want to have share capital, but want the benefits of using the
structure of a company.
(c) Unlimited – the members of the company are personally responsible for the debts of the
company. This type is less common but may suit partnerships who want to
use the more formal company structure for their business operation but are restricted by
some professional organisation from limiting their liability. In Hong Kong, sole proprietors
operating small businesses may also use this form of company.
Advantages of operating as a limited liability company
Advantages of a limited liability company include the following:
(a) The liability of the members is limited so reducing their personal exposure to debts should
the company fail.
(b) The separation of ownership and management may result in the smoother running of the
business and easier resolution of problems.
(c) A company may have better access to finance than unincorporated businesses and can
create a floating charge by the way of security.
6
1: Legal environment | Part A Legal environment
(d) The ownership of the business is easily achieved through the transfer of shares.
Drawbacks of operating as a limited liability company
Drawbacks of a limited liability company include the following:
(a) The regulated formal operating structure comes at the cost of registration, secretarial and
audit fees.
(b) The stringent reporting requirements mean that details of the operation of the business are
made public and this increases the accountability of management.
(c) The process of operating is governed and sometimes inhibited by legal requirements. For
example, all limited companies are bound to compile accounts and to have their accounts
audited annually.
For these reasons, small business operators may prefer to operate as a sole trader or as a
partnership.
1.1.4 Joint ventures
A joint venture is a legal entity formed by two or more parties to undertake an economic activity
together. The entity formed (the joint venture) may be any type of legal structure including a
partnership or limited liability company.
Joint ventures are often the preferred, or required, method of entry into a new market. By forming a
joint venture with another company, entities can reduce the risks associated with accessing new
geographical or product markets. In certain jurisdictions, including Saudi Arabia, a foreign entity
cannot legally carry out business without forming an alliance with a national entity.
7
Financial Reporting
The AA of companies incorporated under the new CO must contain the following mandatory
clauses (the “Mandatory Articles”) :
Company name (section 81)
Members' liabilities (section 83)
Liabilities or contribution of members (for limited companies) (section 84)
Capital and initial shareholdings (for companies with a share capital) (section 85(1) and
section 8 of Part 5 of Schedule 2 to the new CO)
For an association to be incorporated with a licence granted under section 103 or a limited
company granted with such a licence, its AA must state the company’s objects whilst the
licence remains in force (section 82).
Conditions contained in the memorandum of existing companies will be deemed to be provisions of
their articles, except those relating to authorized share capital and par value, which are regarded
as deleted under the new CO.
The new CO adopts a mandatory system of no-par value for all local companies with a share
capital and retires the par value of shares, as par value is an antiquated concept that may give rise
to practical problems, such as inhibiting the raising of new capital and unnecessarily complicating
the accounting regime. Now that the par value for shares has been abolished, it is now more in line
with international trends and to provide companies with greater flexibilities in structuring their share
capital.
Par value (also known as "nominal value") is the minimum price at which shares can generally be
issued. Before the implementation of the new CO, companies incorporated in Hong Kong and
having a share capital were required to have a par value ascribed to their shares. The
Administration has legislated for the migration to mandatory no-par. Relevant concepts such as
nominal value, share premium, and requirement for authorised capital will no longer be necessary
and will be abolished.
Schedule 11 part 4 Division 2 of the new CO contains transitional provisions in relation to the
abolition of par value. These state that at the beginning of the commencement date of the new
legislation, any amount standing to the credit of the company’s share premium account and capital
redemption reserve becomes part of the company’s share capital. Additionally, any amount that
would be required by a continuing provision to be transferred to a company’s share premium
account or capital redemption reserve on or after the commencement date of section 135 becomes
part of the company’s share capital.
Once registered with the Registrar of Companies, a company is issued with a certificate of
incorporation as evidence that all the requirements of the new CO have been met with respect to
the registration.
The most common form of business structure in Hong Kong is the limited liability company. Limited
companies can be private limited companies or public limited companies. Any company that
cannot meet the legal requirements to remain a private company must register as a public
company.
Private companies are devised for the small business and are intended for situations where the
members are also the managers of the company.
A private company is defined by new CO Part One Division 3 Subdivision 2 section 11 as a
company which by its articles:
(a) restricts the right to transfer its shares; and
(b) limits the number of members to 50, not including employees of the company and former
employees who were members of the company whilst employed and who have continued to
be members; and
(c) prohibits any invitation to the public to subscribe for any shares or debentures in the
company; and
8
1: Legal environment | Part A Legal environment
9
Financial Reporting
Key term
Corporate governance is the system by which companies are directed and controlled.
(Cadbury Report)
Corporate governance may be defined as the system and processes by which companies are
directed and controlled in response to the rights and expectations of shareholders and other
stakeholders. Corporate governance therefore covers a very wide range of issues and disciplines
from the appointment and the remuneration of directors, the procedures of the directors' meetings
and the role of non-executive directors, to the company's objectives, business strategy and risk
management, and to investor relations, employee relations and social responsibilities and so on.
Corporate governance has been the subject of much debate in the business world in recent
years. The trigger for this debate was the collapse of major international companies during the
1980s, including Maxwell, BCCI and Polly Peck. These collapses were often unexpected, and
dubious (or even fraudulent) activities were sometimes attributed to their owners and managers.
These events represented a nasty shock for countries, such as the UK and the USA, that felt they
had well-regulated markets and strong company legislation. It became obvious, however, that part
of the problem was the way in which regulation was spread between different national
authorities for these global conglomerates, so that no one national authority had the whole picture
of the affairs of such companies, nor full powers over the whole of the business.
Individual countries began to develop better guidelines for the corporate governance, and efforts
have been made to produce an international standard on corporate governance.
Since 1995, the Corporate Governance Committee of the Hong Kong Institute of CPAs has made a
series of recommendations for enhanced corporate governance disclosure in Hong Kong. In the
committee's latest report, Corporate Governance Disclosure in Annual Reports – A Guide to
Current Requirements and Recommendations for Enhancement, which was published in March
2001, the Committee repeated certain of those recommendations which have not yet been adopted
in the Listing Rules and made further recommendations for enhancement.
Some of the recommendations are extracted as follows:
(a) To communicate to shareholders the strength of their corporate governance structure,
policies and practices, listed companies and public corporation are encouraged to include in
their annual report a statement of corporate governance;
(b) To enhance comparability and transparency of the way directors are compensated, directors'
remuneration should be analysed between 'performance based' and 'non-performance
based';
(c) Disclosure requirements in respect of directors' share options should be extended to include
disclosure by individual directors of the aggregate value realised. Aggregate value realised is
calculated as the excess of the market price on the day of exercise of the option over the
exercise price multiplied by the number of shares acquired as a result of the exercise of the
option;
(d) To aid communication with the reader of the financial statements, the directors should set
out in a separate statement their responsibilities in connection with the preparation of the
financial statements; and
10
1: Legal environment | Part A Legal environment
11
Financial Reporting
12
1: Legal environment | Part A Legal environment
These general principles involving duties and operation requirements are summarised further as
duties and powers below.
(a) Fiduciary duties
Directors must act honestly and in good faith for the benefit of the company.
In particular, directors must act in good faith in what they believe to be the best interests of
the company. Generally speaking, the interests of the company are to be equated with the
interests of its members as a whole. Directors must not act just for the economic advantage
of the majority of shareholders disregarding the interests of the minority. The position and
interests of creditors must be considered in any case where the company is not fully solvent.
The interests of the company's employees must also be taken into account.
Directors must act for a proper purpose. That is, directors must not abuse the powers
given to them by using those powers for purposes other than those for which they were
granted.
Directors must not obtain a personal profit from transactions entered into by the
company without the prior approval of the shareholders; otherwise such profits will be
regarded as being held in trust for the company and they may have to account for them.
Directors must agree not to fetter their discretion. As the powers delegated to directors
are held in trust by them for the company, they must not restrict their exercise of future
discretion.
Directors must act in such a way that there is no possibility of conflict between
personal interests and company interests. Directors should also avoid any conflict of
interest by not using corporate property, information or opportunity for any purpose other
than in the company's interests.
(b) Duty to exercise skill and care
Directors must exercise reasonable care and skill in the performance of their duties.
The wide range of skills required of directors has meant that there have been no precise
standards of skill and care established in case law. In the past the courts have required that
directors display the degree of skill and care which may reasonably be expected from a
person with that director's knowledge and experience. If employed as having particular skills,
for example, as being a certified public accountant, a director should display the skill or
ability expected from a person of that profession. A certified public accountant may,
depending on the circumstances, be held professionally responsible if he or she should be
found negligent in the discharge of his or her duties as a director.
However, the new CO has introduced a statutory responsibility on directors to
exercise reasonable care, skill and diligence (s.465) which should make it easier for
courts to determine whether the duty of care has been exercised.
Statutory duty – various company law statutes impose a number of duties on
directors, such as the preparation of annual accounts and duties in relation to auditors.
(c) Directors' responsibilities in respect of financial reporting
Directors are responsible for ensuring that all information contained in prospectuses,
financial statements and other financial documents is accurate and is presented in
accordance with the laws and regulations that apply to the company. In respect of
directors' liabilities, directors can be subject to fines and penalties under the Companies
Ordinance or subject to other penalties by regulatory bodies and, in the event of legal
proceedings, may be personally sued for negligence by investors, shareholders or other
parties affected by their actions.
The directors are responsible for ensuring that:
the company prepares financial statements that give a true and fair view of the
company’s financial positions and results
13
Financial Reporting
the financial statements are accurate and presented in accordance with law
(especially for example the Companies Ordinance) and regulations
proper books and accounts are kept.
14
1: Legal environment | Part A Legal environment
example, the chairman of a board cannot rescind a contract within his powers, signed by a
fellow director, on authority grounds, if he is also actively involved in the contract negotiation
together with that director.
The term "officer" is a generic one that can be applied to directors, the secretary and some other
senior managers. Officers are usually accountable in law for certain actions specified in legislation.
Furthermore, they may be accountable under the principles established in decided cases.
The secretary is the chief administrative officer of the company as regards relations with members
and the Companies Registry.
Every company must have a secretary. The position may be filled by an individual or a company.
It is permitted to have more than one secretary. Details of the secretary must be registered in
Chinese and English.
The secretary can be a director of the company unless the company has only one member who is
also the only director (s.475, new CO). Listed companies must segregate the roles of chairman and
secretary under the Listing Rules.
2.2.1 The role of the secretary
The secretary is the vital link between the company and the Companies Registry, and the company
and its members.
The secretary receives all formal communications from the Registry. The secretary is responsible
for submitting returns and registration of documents such as charges over assets, special
resolutions, loans to directors and so on (though it is the directors who are accountable for these
actions).
2.2.2 Powers and duties of the company secretary
The secretary:
makes arrangements for meetings of the board of directors
makes arrangements for annual and extraordinary general meetings
records the formal minutes of meetings and makes these available for signature
maintains the company's records, including the register of members
deals with matters relating to liaison with members
deals with formal communications between the company and the Companies Registry
15
Financial Reporting
However, in other companies, shareholders are not directors or employed to manage the business,
therefore, attendance at the Annual General Meeting (AGM) is an opportunity to understand the
management of the company.
Under the new CO, a company must hold its AGM by reference to its accounting reference period
as follows:
In the case of a company limited by guarantee or a private company that is not a
subsidiary of a public company, 9 months after the end of its accounting reference
period; and
In the case of any other company (e.g. public company, non-HK company) , 6 months
after the end of its accounting reference period.
The accounting reference period is the period by reference to which the financial year is to be
determined. Before holding an AGM, at least 21 days’ notice must be give to members.
If the accounting reference period is the first accounting reference period of the company and is
longer than 12 months, the company must hold a general meeting as its annual general meeting
within the following period:
if it is a private company or a company limited by guarantee:
– 9 months after the anniversary of the company’s incorporation; or
– 3 months after the end of that accounting reference period,
whichever is the later.
If it is any other company (e.g. public company, non-HK company):
– 6 months after the anniversary of the company’s incorporation; or
– 3 months after the end of that accounting reference period,
whichever is the later.
However, Under the new CO, a company can dispense with the AGM of each financial year if:
everything that is required to be completed at the meeting is instead achieved by a written
resolution and copies of the documents required to be laid or produced at the meeting are
provided to each member of the company on or before the circulation date of the written
resolution (section 612(1));
the company is a single member company (section 612(2)(a));
the company has dispensed with the holding of AGMs by a written resolution or a resolution
at a general meeting passed by all members under section 613. The company is required to
deliver a copy of the resolution to the Registrar of Companies within 15 days after it has
been passed (sections 622(1)(g) and (2)); or
the company is a dormant company (section 611).
16
1: Legal environment | Part A Legal environment
For a guarantee company, 9 months after the end of the company's accounting reference
period.
The accounting reference period is the period by reference to which the company's annual financial
statements are to be prepared. For example, if a company prepares its financial statements up to
31 March every year, the accounting reference period is from the 1 April of a year to 31 March of
the same year.
Further, section 2 of Schedule 6 to the new CO provides that a listed company is only required to
provide the particulars of members who held 5% or more of the issued shares in any class of the
company's shares as at the date of the return.
There is no change in the requirement to file annual returns of private companies. Pursuant to
sections 662(1) and (2) of the new CO, the annual return of a private company must be delivered
for registration within 42 days after the anniversary of the date of incorporation of the company.
The issued share capital is made up of the shares already held by members. It is sometimes called
subscribed share capital.
A company does not have to issue all of its authorised share capital at once, or even at all if it
chooses not to do so. Share capital not issued is called unissued share capital.
17
Financial Reporting
18
1: Legal environment | Part A Legal environment
19
Financial Reporting
Key term
Liquidation is the "end of the road" for the company. It occurs when it is certain that the life of the
company will come to an end. The process by which this occurs is called winding up. You can use
the terms "liquidation" and "winding up" to mean broadly the same thing. However, the company
does not have to be in financial difficulties to be wound up. The members of the company may
decide at any time to take such action, and in some cases are obliged to do so (for example, if the
company were set up to achieve a specific purpose and this has been fully achieved, there is no
reason for the company to go on trading).
The liquidator is the person appointed to wind up the company and is an insolvency practitioner
(usually an accountant or solicitor) with expertise in such matters. Where a company is insolvent,
the liquidator is appointed by the Official Receiver, a civil servant acting on instructions from the
court. The Official Receiver is sometimes called the provisional liquidator.
3.5.3 Receivership
A receiver is different to both a liquidator and the Official Receiver. A receiver is a person or firm
appointed by creditors to act if a company has broken the conditions of a debenture, such as not
making payments when contractually obliged to do so. The job of the receiver is to get the money
back for the creditor. If he does so and the company can still survive, it does not mean that the
receiver's actions will bring an end to the company.
The receiver is appointed under the provisions of the debenture. A receiver may also be appointed
by the court or on the statutory basis provided by the Conveyancing and Property Ordinance:
"... there shall be implied in any legal charge or equitable mortgage by deed, where the
money has become due, a power exercisable in writing by the mortgagee and any person
entitled to give a receipt for the mortgage money on its repayment to appoint a receiver... to
remove any receiver... and appoint another in his place."
The court appoints a receiver if the security is in jeopardy.
When a receiver is appointed it is necessary to inform the Companies Registry within seven days
of appointment. From this time, the company's letterhead must make specific reference to the
receiver.
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1: Legal environment | Part A Legal environment
21
Financial Reporting
s.380(6) – the financial statements must contain the reasons for, and the particulars and
effect of, the departure from the Ordinance requirements to give a true and fair view.
s.381 – the annual consolidated financial statements for a financial year must include all the
subsidiary undertakings of the company, exclusion of one or more subsidiaries may be
possible subject to reporting exemption or materiality.
s.387 – a statement of financial position that forms part of any financial statements must be
approved by the directors and signed by two directors on the directors' behalf.
The new CO defines accounting standards as statements of standard accounting practice issued or
specified by a body prescribed by its Regulations. However, the definition of a true and fair view
again is not provided.
22
1: Legal environment | Part A Legal environment
Topic recap
Legal environment
HongHong
KongKong
LegalLegal Hong
Directors
Kong and
Legal
officers of a company Hong Legal
Kong requirements
Legal
Framework Framework Framework
A company is established
under the provisions of the
Companies Ordinance.
Limited liability companies The company secretary is the chief Statutory reporting
are private or public. administrative officer. They: A company must:
Those which do not meet arrange board meetings maintain statutory registers
the conditions to remain arrange general meetings prepare statements of
private must register as record meeting minutes financial position and
public. maintain company records comprehensive income.
liaise with members
deal with formal
communications with the
Companies Registry
Corporate governance is Auditors
the system by which New auditors appointed at
companies are directed and AGM
controlled. Removal of auditors by
ordinary resolution
Resignation at any time in
writing
Restructuring
Debt restructuring
(renegotiate debts to
improve liquidity)
Capital restructuring
(reallocate assets to
improve liquidity)
Liquidation (winding
up the company)
Receivership
(recovery of money for
creditors)
23
Financial Reporting
Exam practice
24
Part B
Financial reporting
framework
The emphasis in this section is on the legal environment in Hong Kong. The purpose of this
section is to develop your understanding of the Hong Kong legal environment, including the
legal framework and the related implications for business activities. This is considered as the
basic knowledge and foundation for a future certified public accountant.
25
Financial Reporting
26
chapter 2
Financial reporting
framework
Topic list 8 The HKICPA’s Conceptual Framework
8.1 Preface
1 Regulatory bodies and their impact on 8.2 Introduction
accounting 8.3 Purpose and status
1.1 The role of the Hong Kong Institute of 8.4 Scope
CPAs (HKICPA) 8.5 Users and their information needs
1.2 The role of the Stock Exchange of Hong 8.6 The objective of financial statements
Kong (SEHK) Ltd 8.7 Information about economic resources, claims
1.3 Securities and Futures Commission (SFC) and changes in resources and claims
1.4 Financial Reporting Council (FRC) 8.8 The reporting entity
1.5 Hong Kong Insurance Authority (HKIA) 9 Qualitative characteristics of financial information
1.6 Hong Kong Monetary Authority (HKMA) 9.1 Fundamental qualitative characteristics
2 Financial reporting requirements under 9.2 Enhancing qualitative characteristics
HKFRS 9.3 The cost constraint on useful financial reporting
9.4 Underlying assumption
3 Hong Kong Financial Reporting Standards
3.1 The setting of HKFRS and due process 10 The elements of financial statements
3.2 Current Hong Kong FRS 10.1 Financial position
3.3 Scope of HKFRS 10.2 Performance
3.4 Accounting standards and choice 10.3 Capital maintenance
10.4 Section summary
4 Other sources of financial reporting guidance
4.1 HK(IFRIC) Interpretations, Hong Kong 11 Recognition of the elements of financial
Interpretations and HK(SIC) Interpretations statements
4.2 Conceptual Framework for Financial 11.1 Probability of future economic benefits
Reporting (the Conceptual Framework) 11.2 Reliability of measurement
4.3 Accounting Guidelines and implementation 11.3 Recognition of items
guidance 12 Measurement of the elements of financial
4.4 Accounting Bulletins statements
5 Additional requirements for listed companies 13 Fair presentation and compliance with HKFRS
5.1 Companies listed on the Main Board 13.1 Extreme case disclosures
5.2 Companies listed on the Growth 13.2 Break-up basis accounts
Enterprise Market (GEM)
5.3 Acceptance of Mainland Accounting and 14 Management commentary
Auditing Standards 14.1 Purpose
14.2 Contents
6 Code of Ethics for Professional Accountants 15 Integrated reporting
6.1 Fundamental principles 15.1 Development of integrated reporting
6.2 Obligation to comply with the Code of 15.2 Drivers of integrated reporting
Ethics 15.3 Benefits of integrated reporting
6.3 Revision to Code of Ethics 15.4 Integrated reporting framework
7 Conceptual Framework and GAAP 16 Current developments
7.1 A conceptual framework 16.1 Conceptual Framework
7.2 Advantages and disadvantages of a 16.2 Other IASB projects
conceptual framework
7.3 Generally Accepted Accounting Principles
(GAAP) 27
Financial Reporting
Learning focus
The content of the HKICPA's Conceptual Framework is vital as it underpins all HKFRS. Both in
exams and in practice, when an accounting standard does not appear to provide guidance on
a particular topic, you may be required to fall back on the basic principles of the Conceptual
Framework.
Learning outcomes
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2: Financial reporting framework | Part B Financial reporting framework
1.2 The role of the Stock Exchange of Hong Kong (SEHK) Ltd
The principal function of the SEHK is to provide a fair, orderly and efficient market for the trading of
securities, under the Stock Exchange Unification Ordinance.
To enhance the competitiveness of the Hong Kong securities market so as to meet the challenge of
an increasingly globalised market, there was a comprehensive market reform of the securities and
futures market in March 2000, under which the SEHK, the Hong Kong Futures Exchange Ltd
(HKFE) and the Hong Kong Securities Clearing Company Ltd (HKSCC) were amalgamated under
a holding company, Hong Kong Exchanges and Clearing Ltd (HKEx).
Currently, there are two established exchanges under the SEHK, the Main Board and the Growth
Enterprise Market (GEM) Board, on which companies are listed in Hong Kong.
Companies listed on the Main Board are required to comply with the Listing Rules whereas
companies listed on the GEM Board are required to comply with the GEM Rules.
The SEHK regulates the financial reporting compliance of listed companies through a Regulatory
Affairs Group and a GEM Department for companies listed on the Main Board and the GEM Board
respectively.
29
Financial Reporting
The SFC is responsible for administering the laws governing the securities and futures markets in
Hong Kong and facilitating and encouraging the development of these markets.
The statutory regulatory objectives as set out in the SFO are to:
maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness
of the securities and futures industry;
promote understanding by the public of the operation and functioning of the securities and
futures industry;
provide protection for members of the public investing in or holding financial products;
minimise crime and misconduct in the securities and futures industry;
reduce systemic risks in the securities and futures industry; and
assist the Financial Secretary in maintaining the financial stability of Hong Kong by taking
appropriate steps in relation to the securities and futures industry.
In carrying out their mission, the SFC aims to ensure Hong Kong's continued success and
development as an international financial centre.
The SFC is divided into four operational divisions: Corporate Finance, Intermediaries and
Investment Products, Enforcement, and Supervision of Markets. The Commission is supported by
the Legal Services Division and Corporate Affairs Division.
1.3.1 Whom, what and how: SFC regulation
Areas of regulation Methods
Licensed corporations and Set licensing standards to ensure that all practitioners are
individuals carrying out the fit and proper
following regulated activities:
Approve licenses and maintain a public register of
Dealing in securities licensees
Dealing in futures contracts Issue codes and guidelines to inform the industry of its
Leveraged foreign exchange expected standard of conduct and set financial resources
trading requirement
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2: Financial reporting framework | Part B Financial reporting framework
Investment products offered Set standards for the authorisation and regulation of
to the public investment products
Review and authorise investment products offered to the
public and their promotion (including advertisements and
marketing materials)
Listed companies Approve changes to the Listing Rules
Monitor announcements and vet listing application
materials under the Dual Filing regime
Directly regulate takeovers, mergers and privatisations
under the Codes on Takeovers and Mergers and Share
Buy-backs
Consider requests for exemptions from prospectus
requirements under the Companies Ordinance
Carry out active surveillance of listed companies,
enquiring into their suspected prejudicial or fraudulent
transactions or provision of false or misleading
information; and performing risk-based reviews of
particular companies and broader thematic reviews of
activities which may signal corporate misconduct
Automated trading service Grant licences or authorisations for the provision of ATS in
(ATS) providers Hong Kong
Oversee the operations of ATS providers
Hong Kong Exchanges and Oversee the performance of its role as the frontline
Clearing Limited (HKEx) regulator of listing related matters
Approve the creation of new markets, new products and
changes to its rules and regulations
Monitor HKEx's own compliance with the Listing Rules
Monitor the trading of shares, options and futures on its
markets
Approved share registrars Approve the Federation of Share Registrars as an
association whose members shall be approved share
registrars
Require approved share registrars to comply with the
requirements of the Code of Conduct for Share Registrars
Investor Compensation Recognise the ICC as an independent compensation
Company Limited (ICC) company
Approve the rules and any amendment of rules of the ICC
Require the ICC to prepare and regularly submit financial
statements, auditors' report and other documents to the
SFC
All participants in trading Monitor unusual market movements and direct trade
activities suspension of related stocks to maintain an informed and
orderly market
Investigate and take action against market misconduct
and other breaches of the law
31
Financial Reporting
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2: Financial reporting framework | Part B Financial reporting framework
Any person who possesses information and/or evidence which suggest that there are or may be
auditing and reporting irregularities or non-compliance with financial reporting requirements may
lodge a complaint with the FRC.
Any auditing or reporting irregularities identified by the FRC will be referred to the HKICPA for
follow-up action. Any non-compliance relevant to the Listing Rules will be referred to the Securities
and Futures Commission or The Stock Exchange of Hong Kong Limited for follow-up action. The
FRC is not empowered to discipline or prosecute.
33
Financial Reporting
The financial reporting regulations and requirements currently in place in Hong Kong applicable to
limited liability companies are derived from a number of sources, including those bodies mentioned
above. Some are mandatory and some are advisory.
Those sources which are mandatory include:
(a) Legal requirements set out in the Companies Ordinance.
(b) Hong Kong Financial Reporting Standards (HKFRS, taken for the purpose of this Learning
Pack to include both HKAS and HKFRS) and HKAS Interpretations (HKAS-lnt) issued by the
Hong Kong Institute of Certified Public Accountants (Hong Kong Institute of CPAs).
(c) For companies listed in Hong Kong, the requirements set out in the Rules Governing the
Listing of Securities (the Listing Rules) and the Rules Governing the Listing of Securities on
the Growth Enterprise Market (the GEM Rules), both issued by The Stock Exchange of Hong
Kong Ltd (SEHK) pursuant to section 34 (1) of the Stock Exchanges Unification Ordinance
(Cap. 361).
Those sources which are advisory in nature include:
(a) Accounting Guidelines (AGs) issued by the Hong Kong Institute of CPAs.
(b) Accounting Bulletins (ABs) issued by the Financial Accounting Standards Committee (FASC)
of the Hong Kong Institute of CPAs.
(c) Pronouncements of the International Accounting Standards Board (IASB), formerly known as
International Accounting Standards Committee (IASC), and leading national standard setting
bodies such as those from Australia, Canada, New Zealand, the United Kingdom and the
United States of America.
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2: Financial reporting framework | Part B Financial reporting framework
HKFRS are the most authoritative source of accounting principles generally accepted in Hong
Kong (HK GAAP).
Although HKFRS do not have any statutory backing, their authority is ensured by the requirement
of the Hong Kong Institute of CPAs that they should be observed by its members involved (either
as preparers or as auditors) with financial statements intended to give a true and fair view, unless
there are justifiable reasons for a departure in very exceptional circumstances.
For the purpose of this Learning Pack, the terms accounting standards, Standards and
Interpretations, Hong Kong Accounting Standards and Hong Kong Financial Reporting Standards
are used interchangeably and include all Hong Kong Financial Reporting Standards (HKFRS),
Hong Kong Accounting Standards (HKAS) and HKAS Interpretations (HKAS-Int) approved by the
Council and currently in issue unless otherwise specified.
Within this remit, the HKICPA Council permits the FRSC to work in whatever way it considers most
effective and efficient and this may include forming advisory subcommittees or other forms of
specialist advisory groups to give advice in preparing new and revised HKFRS. The process for the
development of an HKFRS normally involves the following steps:
(a) Identifying and reviewing all the issues associated with an Exposure Draft or a draft
Interpretation issued by the IASB for possible adoption in Hong Kong or any other topics and
considering the application of the Conceptual Framework to the issues, if needed.
(b) Studying pronouncements of the IASB and other standard-setting bodies and accepted
industry practices about the issues.
(c) Consulting the Standard Setting Steering Board of the HKICPA (SSSB) about the advisability
of adding the topic to the FRSC's agenda.
(d) Forming an advisory group to give advice to the FRSC on the project.
(e) Publishing for public comment a discussion document. (In the case of the IASB issuing a
discussion document, also issuing an invitation to comment in Hong Kong with an earlier
deadline than that imposed by the IASB, so as to allow the FRSC a reasonable time to
consider the comments before the Council makes a submission to the IASB.)
(f) Publishing for public comment an Exposure Draft or a draft Interpretation. (In the case of the
IASB issuing an Exposure Draft or a draft Interpretation, issuing an invitation to comment in
Hong Kong on that Exposure Draft or draft Interpretation with a request for comment before
the comment deadline imposed by the IASB so as to allow the FRSC a reasonable time to
consider the comments before the Council makes a submission to the IASB.)
(g) Publishing within an Exposure Draft a basis for conclusions.
(h) Considering all the comments received within the comment period on Discussion Papers and
Documents, Exposure Drafts and draft Interpretations and those received in response to the
Hong Kong invitation to comment on the IASB documents and, when appropriate, preparing
a comment letter to the IASB.
(i) Following publication of the finalised IFRS or Interpretation of IFRS, considering the changes
made, if any, by the IASB and adopting the finalised IFRS or Interpretation of IFRS in Hong
Kong with the same effective date.
35
Financial Reporting
(j) Approving a standard or an Interpretation, including those converged with the equivalent
IFRS or Interpretation of IFRS, by the Council.
(k) Publishing within a standard a basis for conclusions, if appropriate, explaining how the
conclusions were reached and giving background information that may help users of HKFRS
to apply them in practice or, in the case of a standard that is converged with IFRS, publishing
within the standard the IASB Basis for Conclusions with an explanation of the extent to which
the Council agrees with the IASB Basis for Conclusions so as to enable users to understand
any changes made to the IFRS.
HKAS 1
Presentation of Financial Statements
(Revised)
HKAS 2 Inventories
HKAS 7 Statement of Cash Flows
HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
HKAS 10 Events After the Reporting Period
HKAS 11 Construction Contracts
HKAS 12 Income Taxes
HKAS 16 Property, Plant and Equipment
HKAS 17 Leases
HKAS 18 Revenue
HKAS 19
Employee Benefits
(2011)
HKAS 20 Accounting for Government Grants and Disclosure of Government Assistance
HKAS 21 The Effects of Changes in Foreign Exchange Rates
HKAS 23
Borrowing Costs
(Revised)
HKAS 24
Related Party Disclosures
(Revised)
HKAS 26 Accounting and Reporting by Retirement Benefit Plans
HKAS 27
Separate Financial Statements
(2011)
HKAS 28
Investments in Associates and Joint Ventures
(2011)
HKAS 29 Financial Reporting in Hyperinflationary Economies
HKAS 32 Financial Instruments: Presentation
HKAS 33 Earnings Per Share
HKAS 34 Interim Financial Reporting
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2: Financial reporting framework | Part B Financial reporting framework
You need to keep yourself up to date with Hong Kong Accounting Standards as they are issued or
reviewed.
Various Exposure Drafts and Discussion Papers are currently at different stages within the HKFRS
process, and by the end of your financial reporting studies, you should know all the Standards,
Exposure Drafts and Discussion Papers.
37
Financial Reporting
In favour of accounting standards (both national and international), the following points can be
made:
(a) They reduce or eliminate confusing variations in the methods used to prepare accounts.
(b) They provide a focal point for debate and discussions about accounting practice.
(c) They oblige companies to disclose the accounting policies used in the preparation of
accounts.
(d) They are a less rigid alternative to enforcing conformity by means of legislation.
(e) They have obliged companies to disclose more accounting information than they would
otherwise have done if accounting standards did not exist, for example HKAS 33 Earnings
Per Share.
Many companies are reluctant to disclose information which is not required by national legislation.
However, the following arguments may be put forward against standardisation and in favour of
choice:
(a) A set of rules which give backing to one method of preparing accounts might be
inappropriate in some circumstances. For example, HKAS 16 on depreciation is
inappropriate for investment properties (properties not occupied by the entity but held solely
for investment), which are covered by HKAS 40 on investment property.
(b) Standards may be subject to lobbying or government pressure (in the case of national
standards). For example, in the USA, the accounting standard FAS 19 on the accounts of oil
and gas companies led to a powerful lobby of oil companies, which persuaded the SEC
(Securities and Exchange Commission) to step in. FAS 19 was then suspended.
(c) Many national standards are not based on a conceptual framework of accounting,
although HKFRS are.
(d) There may be a trend towards rigidity, and away from flexibility in applying the rules.
You should be able to discuss:
Due process of the HKICPA
Use and application of HKFRS
Future work of the HKICPA
One of the competencies you are required to demonstrate is to recognise and apply the external
legal and professional framework and regulations to financial reporting. The information in this
chapter will give you knowledge to help you demonstrate this competence.
38
2: Financial reporting framework | Part B Financial reporting framework
39
Financial Reporting
40
2: Financial reporting framework | Part B Financial reporting framework
Certified public accountants in business owe certain legal duties towards their employers.
Additionally, they have ethical duties towards the HKICPA. The Council of HKICPA requires
members of the Institute (and therefore certified public accountants) to comply with the Code of
Ethics for Professional Accountants (the Code). Apparent failures by certified public accountants to
41
Financial Reporting
comply with the Code are liable to be enquired into by the appropriate committee established under
the authority of the Institute, and disciplinary action may result. Disciplinary action may include an
order that the name of the certified public accountant be removed from the Institute's membership
register.
The Code of Ethics is likely to be taken into account when the work of a certified public accountant
is being considered in a court of law or in other contested situations.
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2: Financial reporting framework | Part B Financial reporting framework
43
Financial Reporting
44
2: Financial reporting framework | Part B Financial reporting framework
Prior to a review of the HKICPA's attempt to bring forth the conceptual framework, it is important to
consider the generally accepted accounting principles (or practice) or GAAP.
45
Financial Reporting
(c) Listing Rules. The Stock Exchange of Hong Kong Limited (SEHK) has adopted rules
governing the listing of securities on its Main Board (the Listing Rules) and on its Growth
Enterprise Market (the GEM Rules). These include some accounting and disclosure
requirements.
Other sources of GAAP
Hong Kong Accounting Standard 8 Accounting Policies, Changes in Accounting Estimates and
Errors (HKAS 8, which is identical to IAS 8) states:
10. In the absence of a HKFRS that specifically applies to a transaction, other event or
condition, management shall use its judgment in developing and applying an accounting
policy that results in information that is:
(a) relevant to the economic decision-making needs of users; and
(b) reliable, in that the financial statements:
(i) represent faithfully the financial position, financial performance and cash flows
of the entity;
(ii) reflect the economic substance of transactions, other events and conditions,
and not merely the legal form;
(iii) are neutral, i.e. free from bias;
(iv) are prudent; and
(v) are complete in all material respects.
11. In making the judgment described in paragraph 10, management shall refer to, and
consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in HKFRS dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities,
income and expenses in the Conceptual Framework.
12. In making the judgment described in paragraph 10, management may also consider the
most recent pronouncements of other standard-setting bodies that use a similar conceptual
framework to develop accounting standards, other accounting literature* and accepted
industry practices, to the extent that these do not conflict with the sources in paragraph 11.
*In the context of Hong Kong, other accounting literature includes Accounting Guidelines and
Accounting Bulletins.
The Accounting Guidelines and Accounting Bulletins referred to in the footnote to paragraph 12 of
HKAS 8 (above) are "best practice" guidance documents that have been published by the HKICPA
to assist its members in applying HKFRS. Accounting Guidelines, and Industry Accounting
Guidelines, are persuasive in intent and, while not mandatory, should normally be followed.
Accounting Bulletins are intended to assist members of the HKICPA in dealing with accounting
issues and to stimulate debate on subjects of topical interest.
TechWatch is a monthly publication prepared by the HKICPA to alert HKICPA members to topics
and issues that impact on accountants and their working environment. It is intended for general
guidance only.
7.3.2 GAAP for Small and Medium-sized Entities
The HKICPA released its own Small and Medium-sized Entity Financial Reporting Framework and
Financial Reporting Standard (SME-FRF & FRS) in August 2005. The SME-FRF and FRS became
effective for optional use by a qualifying entity's first financial statements that cover a period
beginning on or after 1 January 2005. Entities that qualify include Hong Kong incorporated
companies that meet certain legal requirements and overseas companies that have no public
accountability, meet size requirements and where the owners agree to use the SME-FRF and FRS.
Those entities which do not meet the criteria to use the SME-FRF and FRS may be able to use the
HKFRS for Private Entities, issued in 2010. Both of these options are discussed in more detail in
the next chapter.
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2: Financial reporting framework | Part B Financial reporting framework
In June 1997 the HKICPA produced a document, Framework for the Preparation and Presentation
of Financial Statements (the Framework). This is, in effect, the conceptual framework upon which
all HKFRS are based and hence it determines how financial statements are prepared and the
information they contain.
The Framework is currently being revised with the project taking place in several stages and
Exposure Drafts being issued as each progress stage approaches completion. The first
amendments to the Framework were issued in October 2010, and the HKICPA has decided to
amend the Framework on a piecemeal basis, so the revised parts of the Framework sit alongside
the old Framework. The Framework has been renamed the Conceptual Framework for Financial
Reporting.
The revised Conceptual Framework for Financial Reporting consists of several sections or
chapters, following on after a preface and introduction. These chapters are as follows:
The objective of general purpose financial reporting (issued October 2010)
The reporting entity (not yet issued)
Qualitative characteristics of useful financial information (issued October 2010)
The Framework (1997): The Remaining Text
– Underlying assumption
– The elements of financial statements
– Recognition of the elements of financial statements
– Measurement of the elements of financial statements
– Concepts of capital and capital maintenance
Much of the content of the chapters is also included in HKAS 1 (revised), and covered in sections
10 to 12 of this chapter. As you read through them, think about the impact the Conceptual
Framework has had on HKFRS, particularly the definitions.
8.1 Preface
Financial statements are prepared and presented for external users worldwide, and although they
may appear similar, differences are caused by social, economic and legal circumstances.
The HKICPA wishes to narrow these differences by harmonising all aspects of financial
statements, including the regulations governing their accounting standards and their preparation
and presentation.
The HKICPA believes that financial statements prepared for the purpose of providing information
that is useful in making economic decisions meet the common needs of most users. The types of
economic decisions for which financial statements are likely to be used include the following:
Decisions to buy, hold or sell equity investments
Assessment of management stewardship and accountability
Assessment of the entity's ability to pay employees
Assessment of the security of amounts lent to the entity
Determination of taxation policies
Determination of distributable profits and dividends
Inclusion in national income statistics
Regulations of the activities of entities
47
Financial Reporting
Any additional requirements imposed by national governments for their own purposes should not
affect financial statements produced for the benefit of other users.
The Conceptual Framework recognises that financial statements can be prepared using a variety
of models. Although the most common is based on historical cost and a nominal unit of currency
(such as the Hong Kong dollar), the Conceptual Framework can be applied to financial statements
prepared under a range of models.
8.2 Introduction
The introduction to the Conceptual Framework lays out the purpose, status and scope of the
document. It then looks at different users of financial statements and their information needs.
8.4 Scope
The Conceptual Framework deals with the following:
(a) The objective of financial reporting.
(b) The qualitative characteristics of useful information.
(c) The definition, recognition and measurement of the elements from which financial
statements are constructed.
(d) Concepts of capital and capital maintenance.
The Conceptual Framework is concerned with "general purpose" financial statements (that is, a
normal set of annual statements), but it can be applied to other types of accounts. A complete set
of financial statements includes:
(a) a statement of financial position
(b) a statement of profit or loss and other comprehensive income
(c) a statement of changes in financial position (e.g. a statement of cash flows)
(d) notes, other statements and explanatory material
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2: Financial reporting framework | Part B Financial reporting framework
Supplementary information may be included, but some items are not included in the financial
statements themselves, namely commentaries and reports by the directors, the chairman,
management and so on.
All types of financial reporting entities are included whether commercial, industrial, business;
public or private sector.
Key term
A reporting entity is an entity for which there are users who rely on the financial statements as
their major source of financial information about the entity. (Conceptual Framework)
Self-test question 1
What are the information needs of the users of financial information? Your answer should not be
restricted to the groups of users identified by the Conceptual Framework as the primary users.
(The answer is at the end of the chapter)
This section of the Conceptual Framework was amended in September 2010. As a result of the
amendments, there is a new emphasis on specific users of accounts, namely investors, potential
investors, lenders and creditors. They require information which is useful in making decisions about
buying, selling or holding equity and debt instruments, and providing or settling loans and other
forms of credit.
The type of information required by investors, creditors and lenders is that which provides an
indication of potential future net cash inflows. Such information includes that relating to:
the resources of the entity
claims against the entity
how efficiently and effectively the management have used the entity’s resources, protected
the entity’s resources from the unfavourable effects of factors such as price changes and
ensured that the entity complies with applicable laws and regulations.
Most investors, creditors and lenders cannot require entities to provide information directly to them,
and therefore rely on general purpose financial statements. Although such financial statements do
include a large amount of information, the Conceptual Framework states that general purpose
financial statements do not and they cannot provide all of the information that investors, lenders
49
Financial Reporting
and other creditors need. Therefore, these users must also consider information from other
sources, such as general economic conditions and expectations, political events and political
climate, and industry and company outlooks.
This section of the Conceptual Framework also clarifies that:
general purpose financial statements are not designed to show the value of an entity,
although information contained within them may aid a valuation
the management of an entity need not rely on general purpose financial statements as they
can obtain necessary financial information internally
other parties such as regulators and members of the public may also find general purpose
financial reports useful, however, these reports are not primarily directed to these groups.
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2: Financial reporting framework | Part B Financial reporting framework
This section of the Conceptual Framework was revised in September 2010 and as a result, two
fundamental and four enhancing qualitative characteristics replace the previous qualitative
characteristics of relevance, reliability, comparability and understandability.
The two fundamental qualitative characteristics are relevance and faithful representation; the four
enhancing characteristics are comparability, verifiability, timeliness and understandability.
If financial information is to be useful, it must be relevant and faithfully represent what it purports to
represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely
and understandable.
The revised Conceptual Framework states that the qualitative characteristics of useful financial
information apply not only to financial information provided in financial statements, but also to
financial information provided in other ways.
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report. It is impossible to specify a quantitative threshold for materiality or predetermine what could
be material in a particular situation as it depends on the individual entity.
9.1.2 Faithful representation
To be useful, in addition to being relevant, financial information must also faithfully represent the
phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would
have three characteristics – it would be complete, neutral and free from error.
Faithful representation does not mean accurate in all respects. Information that is complete means
all necessary information is included for the user to understand the item being depicted. Neutral
information is prepared without bias in the selection or presentation of the information. Free from
error means there are no errors or omissions in the description of the item, and the process used to
produce the reported information has been selected and applied with no errors in the process.
CF.QC17-18 9.1.3 Application of the fundamental qualitative characteristics
Useful information must be both relevant and faithfully represented; neither a faithful representation
of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps
users to make good decisions.
The most efficient and effective process for applying the fundamental qualitative characteristics
would usually be as follows:
(a) Identify an economic phenomenon that has the potential to be useful to users of an entity’s
financial information.
(b) Identify the type of information about that phenomenon that would be most relevant, if
available and can be faithfully represented.
(c) Determine whether that information is available and can be faithfully represented.
(d) If so, the process of satisfying the fundamental qualitative characteristics ends; if not, the
process is repeated with the next most relevant type of information.
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9.2.3 Timeliness
Timeliness means having information available to decision-makers in time to be capable of
influencing their decisions. Generally, the older the information is the less useful it is. However,
some information may continue to be timely long after the end of a reporting period because, for
example, some users may need to identify and assess trends.
9.2.4 Understandability
Classifying, characterising and presenting information clearly and concisely makes it
understandable.
Some transactions are inherently complex and cannot be made easy to understand. While
excluding information about those transactions from financial reports might make the information in
those financial reports easier to understand, this may mean that information would be incomplete
and therefore potentially misleading.
The revised Conceptual Framework states that financial reports are prepared for users who have a
reasonable knowledge of business and economic activities and who review and analyse the
information diligently. At times, even the well-informed, diligent users may need to seek the aid of
an adviser to understand information about complex economic phenomena.
CF.QC33-34 9.2.5 Application of the enhancing qualitative characteristics
Enhancing qualitative characteristics should be maximised to the extent possible. However, the
enhancing qualitative characteristics, either individually or as a group, cannot make information
useful if that information is irrelevant or not faithfully represented.
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Self-test question 2
The qualitative characteristics of financial information in the Conceptual Framework for Financial
Reporting are comparability, faithful representation, relevance, timeliness, understandability and
verifiability.
Required
Explain the meaning of these characteristics in the context of financial reporting, providing
examples of how they are or are not applied to different accounting standards.
(The answer is at the end of the chapter)
This chapter of the Conceptual Framework is taken from the 1997 Framework. It lays out these
elements as follows:
Elements of
financial statements
n Assets n Income
n Liabilities n Expenses
n Equity
A process of sub-classification then takes place for presentation in the financial statements, e.g.
assets are classified by their nature or function in the business to show information in the best way
for users to take economic decisions.
Key terms
Asset. A resource controlled by an entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
Liability. A present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
Equity. The residual interest in the assets of the entity after deducting all its liabilities.
(Conceptual Framework)
These definitions are important, but they do not cover the criteria for recognition of any of these
items, which are discussed in the next section of this chapter. This means that the definitions may
include items which would not actually be recognised in the statement of financial position because
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they fail to satisfy recognition criteria particularly, as we will see below, the probable flow of any
economic benefit to or from the business.
Whether an item satisfies any of the definitions above will depend on the substance and
economic reality of the transaction, not merely its legal form. For example, consider finance
leases (see Chapter 9).
CF.4.8-4.14 10.1.1 Assets
Key term
Future economic benefit. The potential to contribute, directly or indirectly, to the flow of cash and
cash equivalents to the entity. The potential may be a productive one that is part of the operating
activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a
capability to reduce cash outflows, such as when an alternative manufacturing process lowers the
cost of production. (Conceptual Framework)
Assets are usually employed to produce goods or services for customers; customers will then pay
for these and so contribute to the cash flow of the entity.
The existence of an asset is not reliant on:
physical form or
legal ownership
Non-physical items such as patents are assets provided that they are controlled and provide
probable future economic benefits; similarly non-owned items, such as machinery obtained under a
finance lease are assets, provided that they are controlled and provide probable future economic
benefits.
Transactions or events in the past give rise to assets; those expected to occur in the future do not
in themselves give rise to assets. For example, an intention to purchase a non-current asset does
not, in itself, meet the definition of an asset.
CF.4.15-4.18 10.1.2 Liabilities
An essential characteristic of a liability is that the entity has a present obligation.
Key term
Obligation. A duty or responsibility to act or perform in a certain way. Obligations may be legally
enforceable as a consequence of a binding contract or statutory requirement. Obligations also
arise, however, from normal business practice, custom and a desire to maintain good business
relations or act in an equitable manner. (Conceptual Framework)
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Financial Reporting
Key term
Provision. A present obligation which satisfies the rest of the definition of a liability, even if the
amount of the obligation has to be estimated. (Conceptual Framework)
Self-test question 3
Trainton Peach Co (TP) has recently acquired another company, Luton Sound (LS), in order to
access specific know how, TP has incurred a high level of external consultancy fees and spent a
large proportion of internal finance department time (and so cost) on the acquisition. The
Managing Director of TP has asked you, the Group Finance Manager, to capitalise the external
costs and a proportion of the internal costs and amortise them over the same period as goodwill on
the acquisition. The Managing Director’s rationale for the request is that this treatment should make
the financial statements more relevant.
Required
Prepare notes in reply to the Managing Director.
(The answer is at the end of the chapter)
Key terms
Income. Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants.
Expenses. Decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants. (Conceptual Framework)
Income and expenses can be presented in different ways in the statement of profit or loss and
other comprehensive income, to provide information relevant for economic decision-making. For
example, distinguish between income and expenses which relate to continuing operations and
those which do not.
Items of income and expense can be distinguished from each other or combined with each other.
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Key term
Gains. Increases in economic benefits. As such they are no different in nature from revenue.
(Conceptual Framework)
Gains include those arising on the disposal of non-current assets. The definition of income also
includes unrealised gains, for example, on revaluation of marketable securities.
CF.4.33-4.35 10.2.2 Expenses
As with income, the definition of expenses includes losses as well as those expenses that arise in
the course of ordinary activities of an entity.
Key term
Losses. Decreases in economic benefits. As such they are no different in nature from other
expenses. (Conceptual Framework)
Losses will include those arising on the disposal of non-current assets. The definition of expenses
will also include unrealised losses, for example, exchange rate effects on borrowings.
Key term
Revaluation. Restatement of assets and liabilities. (Conceptual Framework)
These increases and decreases meet the definitions of income and expenses. They are not
included in the statement of profit or loss under certain concepts of capital maintenance, however,
but rather in equity.
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Financial performance:
– Income
– Expenses
Key term
Recognition. The process of incorporating in the statement of financial position or statement of
profit or loss and other comprehensive income an item that meets the definition of an element and
satisfies the following criteria for recognition:
(a) It is probable that any future economic benefit associated with the item will flow to or from the
entity.
(b) The item has a cost or value that can be measured with reliability. (Conceptual Framework)
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Key term
Measurement. The process of determining the monetary amounts at which the elements of the
financial statements are to be recognised and carried in the statement of financial position and
statement of profit or loss and other comprehensive income. (Conceptual Framework)
This involves the selection of a particular basis of measurement. A number of these are used to
different degrees and in varying combinations in financial statements. They include the following:
Key terms
Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair
value of the consideration given to acquire them at the time of their acquisition. Liabilities are
recorded at the amount of proceeds received in exchange for the obligation, or in some
circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected
to be paid to satisfy the liability in the normal course of business.
Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be
paid if the same or an equivalent asset was acquired currently.
Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be
required to settle the obligation currently.
Realisable (settlement) value.
Realisable value. The amount of cash or cash equivalents that could currently be obtained by
selling an asset in an orderly disposal.
Settlement value. The undiscounted amounts of cash or cash equivalents expected to be
paid to satisfy the liabilities in the normal course of business.
Present value. The present discounted value of the future net cash flows in the normal course of
business. (Conceptual Framework)
Historical cost is the most commonly adopted measurement basis, but this is usually combined
with other bases, e.g. inventory is carried at the lower of cost and net realisable value.
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Financial Reporting
Most importantly, financial statements should present a true and fair view of the financial position,
financial performance and cash flows of an entity. Compliance with HKFRS is presumed to result
in financial statements that achieve a fair presentation and true and fair view.
The following points made by HKAS 1 expand on this principle:
(a) Financial statements should be prepared using the accrual basis, i.e. income and expenses
are recognised as they arise rather than when the related cash is received or paid.
(b) Financial statements should be prepared on a going concern basis unless it is planned for
the entity to cease trading.
(c) Compliance with HKFRS should be disclosed.
(d) All relevant HKFRS must be followed if compliance with HKFRS is disclosed.
(e) Use of an inappropriate accounting treatment cannot be rectified either by disclosure of
accounting policies or notes/explanatory material.
There may be (very rare) circumstances when management decides that compliance with a
requirement of an HKFRS would be misleading. Departure from the HKFRS is therefore required
to achieve a fair presentation.
The following should be disclosed in such an event:
(a) Management confirmation that the financial statements fairly present the entity's financial
position, performance and cash flows.
(b) Statement that all HKFRS have been complied with except departure from one HKFRS to
achieve a fair presentation.
(c) Details of the nature of the departure, why the HKFRS treatment would be misleading, and
the treatment adopted.
(d) Financial impact of the departure.
This is usually referred to as the "true and fair override".
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Financial Reporting
(e) It is sometimes said that all non-current assets should be reclassified as current assets in
break-up basis accounts. This would only be the case, however, if their use had changed.
If they were still held for use within the business (if only for a short time) then they are still
non-current assets.
Liabilities
(a) Liabilities are normally only recognised where an obligation exists at the reporting date and
the normal rules in HKAS 37 have been met. Therefore, legal and other costs related to an
insolvency are only recognised when incurred.
(b) Some non-current liabilities will be reclassified as current. A common example of this is
where the company is in breach of loan covenants at the year end meaning that the loan
facility will be withdrawn and so repayment is required in the short term.
13.2.2 Disclosure
When management is aware of material uncertainties related to events or conditions that may cast
significant doubt upon an entity’s ability to continue as a going concern, the entity should disclose
those uncertainties.
Where an entity does not prepare financial statements on a going concern basis, it must disclose
that fact together with the basis on which it prepared the financial statements and the reason why
the entity is not regarded as a going concern.
14 Management commentary
A management commentary (known as management discussion and analysis in Hong Kong) is a
narrative report that accompanies financial statements as part of an entity's financial reporting.
It explains the main trends and factors underlying the development, performance and position of the
entity's business during the period covered by the financial statements. It also explains the main
trends and factors that are likely to affect the entity's future development, performance and position.
An IFRS Practice Statement was issued on Management Commentary in December 2010. This is
a broad, non-binding framework for the presentation of narrative reporting to accompany financial
statements prepared in accordance with IFRS.
The Practice Statement is not an IFRS. Therefore, entities applying IFRS are not required to
comply with the Practice Statement, unless specifically required by their jurisdiction.
14.1 Purpose
The purpose of management commentary is to help investors to:
(a) interpret and assess the related financial statements in the context of the environment in
which the entity operates.
(b) assess what management views as the most important issues facing the entity and how it
intends to manage those issues.
(c) assess the strategies adopted by the entity and the potential for those strategies to succeed.
14.2 Contents
A number of principles and qualitative characteristics should underlie the preparation and
presentation of the management commentary.
In particular, the management commentary should:
supplement and complement financial statement information.
provide an analysis of the entity through the eyes of management.
have an orientation to the future.
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15 Integrated reporting
In recent years users of financial statements have become increasingly interested not only in the
financial performance of a company, but also in the social, environmental and ethical performance.
Understanding a company's approach to corporate social responsibility is relevant to these
users because they want assurance that the company that they have invested in or have dealings
with complies with legal requirements, ethical standards and other international norms.
Furthermore, investors and other parties increasingly expect companies to actively engage in
actions that have a positive impact on the environment, consumers, communities, employees and
other stakeholders.
Integrated reporting is the latest development in corporate social responsibility reporting.
Self-test question 4
The HKEx recommends that listed companies provide a sustainability report within their annual
reports.
Required
Explain the benefits to an organisation of providing a sustainability report within its annual report.
(The answer is at the end of the chapter)
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Financial Reporting
The relationship among the Capitals, Guiding Principles, and Content Elements can be
summarised in this diagram:
Guiding
principles
(Capitals) Inputs
Described by
Content
Operations Integrated
elements
report
(Goods/services)
outputs
Case study
Examples of integrated reports can be found in the integrated reporting database, maintained on
the IIRC’s website. This includes examples of emerging practice in integrated reporting.
http://examples.theiirc.org/home
16 Current developments
16.1 Conceptual Framework
As we saw earlier in this chapter, the IASB and FASB completed the first phase of their joint project
to develop a common Conceptual Framework for Financial Reporting in 2010. As a result, they
have issued a Conceptual Framework, which includes new chapters on the objective of financial
statements and qualitative characteristics together with the remaining chapters from the old
Framework. This revised Conceptual Framework has been adopted by the HKICPA.
The remaining phases of the project relate to:
elements and recognition
measurement
the reporting entity
presentation and disclosure
Subsequent to the completion of phase 1 of the project in 2010, remaining work was deferred. In
late 2012, however, the project was reactivated as an IASB-only project. A Conceptual Framework
discussion paper was issued in 2013 to obtain feedback from constituents on the remaining phases
of the project before the development of an exposure draft (expected in 2015). In particular the
discussion paper suggests:
Improvements to the existing definitions of assets and liabilities and additional guidance to
support those definitions
Improvements to the guidance on when assets and liabilities should be recognised
New guidance on when assets and liabilities should be derecognised
Guidance to assist standard setters in selecting the most appropriate measurement basis for
an asset or liability
Increased disclosure of information about different classes of equity
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Principles to assist standard setters in deciding which items of income and expense should
be recognised in profit or loss, and which should be recognised in other comprehensive
income, and when items of other comprehensive income should be reclassified to profit or
loss
The development of disclosure concepts for the Conceptual Framework.
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Topic recap
Hong
Financial
Kong Legal
Reporting
Framework
Hong Regulatory
Kong Legalbodies HongFinancial
Kong Legal
Reporting CodeLegal
Hong Kong of Ethics
Framework Framework
requirements Framework
HKICPA regulates the HKFRS set out recognition, Professional accountants must
accounting profession. The FR measurement, presentation comply with the Code
Standards Committee within and disclosure
the HKICPA issues HKFRS. requirements. They should
be observed to achieve a
true and fair view.
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Conceptual Framework
Measure at:
historical cost realisable (settlement)
current cost value
PV of future cash flows
Fair presentation
Presumed to be achieved by compliance with HKFRS
Departure from HKFRS is allowed if necessary to achieve fair presentation
“True and fair override” disclosures are necessary in the case of a departure
Integrated reporting
Links environmental, social and sustainability issues to financial strategy and results (triple bottom
line reporting)
Non-mandatory
Guidance is provided in the <IR> Framework
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Financial Reporting
Answer 1
(a) Investors are the providers of risk capital.
(i) Information is required to help make a decision about buying or selling shares, taking
up a rights issue and voting.
(ii) Investors must have information about the level of dividend, past, present and future
and any changes in share price.
(iii) Investors will also need to know whether the management has been running the
company efficiently.
(iv) As well as the position indicated by the statement of profit or loss and other
comprehensive income, statement of financial position and earnings per share (EPS),
investors will want to know about the liquidity position of the company, the company's
future prospects, and how the company's shares compare with those of its
competitors.
(b) Employees need information about the security of employment and future prospects for jobs
in the company, and to help with collective pay bargaining.
(c) Lenders need information to help them decide whether to lend to a company. They will also
need to check that the value of any security remains adequate, that the interest repayments
are secure, that the cash is available for redemption at the appropriate time and that any
financial restrictions (such as maximum debt/equity ratios) have not been breached.
(d) Suppliers need to know whether the company will be a good customer and pay its debts.
(e) Customers need to know whether the company will be able to continue producing and
supplying goods.
(f) Government's interest in a company may be one of creditor or customer, as well as being
specifically concerned with compliance with tax and company law, ability to pay tax and the
general contribution of the company to the economy.
(g) The public at large would wish to have information for all the reasons mentioned above, but
it could be suggested that it would be impossible to provide general purpose accounting
information which was specifically designed for the needs of the public.
Answer 2
Relevance
Relevant information helps users to make decisions by having either a predictive or confirmatory
value. Examples in practice include:
HKFRS 5 requires the separate disclosure of the results of discontinued operations; this
helps users to predict future results of continuing operations.
Recognising a provision in accordance with HKAS 37 aids users to predict future cash
outflows.
The use of a fair value measurement model for property helps to confirm users’ expectations
of its value.
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Faithful representation
Information must be complete, neutral and free from error and reflect the commercial substance of
a transaction rather than its legal form. Examples include:
HKAS 32 requires that redeemable preference shares are accounted for as debt since they
meet the definition of a liability.
HKAS 10 requires that consolidated financial statements are prepared for a group of
companies.
HKAS 17 requires that an asset acquired by way of a finance lease is accounted for in the
same way as an owned asset.
Comparability
Information about an entity must be comparable with other entities and the same entity in a
different period. Comparability is achieved by applying consistent accounting policies and
presenting information in the same way from year to year.
HKFRS 3 reduces comparability by allowing a non-controlling interest to be measured at
either fair value or as a proportion of the fair value of identifiable net assets acquired on a
case-by-case basis.
HKAS 40 and HKAS 16 increase comparability by requiring the same measurement policy to
be applied to all investment property / assets within the same class.
Where standards provide choice (e.g. HKAS 40), they reduce comparability
Verifiability
Verifiability means that different knowledgeable and independent observers would agree that a
depiction is a faithful representation. For example, where historical cost is used as a measurement
basis for property, this is highly verifiable; where fair value or revaluation is used, this is less
verifiable as appraisers may differ in their opinion of fair or market value.
Timeliness
Information is only useful where it is provided in a timely manner. There is however a balance
between timeliness and reliability: it is often better to take a longer time to provide more reliable
information.
In Hong Kong, companies listed on the Main Board are required to send their annual reports
and audited financial statements to every member and other holders of their listed securities
within three months after the end of the reporting period
Understandability
Financial information should be useful for users with a reasonable knowledge of business and
economic activities. Matters should not be left out of the financial statements on account of their
complexity. For example, the financial statements include complex items such as financial
instruments, pensions and deferred tax; users’ understanding of these items is aided by extensive
accounting policy, explanatory and numerical disclosures.
Answer 3
Although relevance is a fundamental characteristic of the Conceptual Framework, and must be
considered when preparing financial statements, the issue here is whether the costs meet the
definition of an asset.
An asset is ‘a resource controlled by an entity as a result of past events and from which future
economic benefits are expected to flow to the entity’.
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The Conceptual Framework states that an asset should be recognised only if:
It is probable that any future economic benefit associated with the item will flow to or from
the entity, and
The item has a cost or value that can be measured with reliability.
Arguably, the costs incurred result in TP gaining knowledge, which is a resource that it controls as
the result of a past event.
The question is therefore whether future economic benefits are expected to flow to TPas a result of
the transaction costs. It could be argued that the company will return profits to TP and therefore
the transaction costs would indirectly result in economic benefits.
It should however be noted that it is not as a result of incurring the transaction costs that such
profits would be returned to TP; in fact this would be as a result of paying the purchase price for
LS.
Therefore the costs of external consultants and a proportion of the costs of an internal department
do not meet the definition of an asset that can be recognised in the statement of financial position.
In addition, the argument that capitalisation of the costs would result in relevant information does
not hold. Relevance is a fundamental characteristic of the Conceptual Framework. Information is
relevant when it is capable of making a difference in the decisions made by users because it has
either a predictive or a confirmatory value or both. The capitalisation of costs incurred prior to an
acquisition does not have either a predictive or confirmatory value. Therefore capitalising such
costs will not increase relevance.
Answer 4
The provision of a sustainability report is not currently mandatory for listed companies in Hong
Kong, and therefore in providing one a company would demonstrate to stakeholders that it is a
forward-looking and proactive organisation.
In measuring, monitoring and reporting on sustainability performance, a company is likely to
improve it. The process will also help an organisation to set goals and manage change.
Other internal benefits of sustainability reporting include:
Fostering of employee loyalty
An increased understanding of risks and opportunities
A positive influence on long-term management strategy
Streamlining of processes, reduction of costs and improvement of efficiency
The avoidance of being implicated in publicised environmental and social corporate failures
The ability to compare performance with rest of an industry to assess competitiveness and
market position
External benefits include:
An improvement in reputation
Fostering investor confidence and trust.
Repeat custom and renewal of contracts
Acting as a differentiator to win new business from competition
Mitigation of negative social and environmental impacts
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Exam practice
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74
chapter 3
1 Background
2 Financial reporting in Hong Kong
2.1 Three financial reporting options
3 SME-FRF and SME-FRS
3.1 Companies which qualify for reporting under the SME-FRF and SME-FRS
3.2 The requirements of the SME-FRF and SME-FRS
3.3 SME-FRF and consolidated financial statements
4 Introduction to the HKFRS for Private Entities
4.1 Development of the HKFRS for Private Entities
4.2 Eligibility to use the HKFRS for Private Entities
5 Contents of the HKFRS for Private Entities
5.1 Overview
5.2 Simplified accounting
5.3 Simplified presentation
5.4 Omitted topics
5.5 Examples of options in full HKFRS not included in the HKFRS for Private Entities
5.6 Simplified disclosure
5.7 Updates and amendments to the HKFRS for Private Entities
6 Impact of the HKFRS for Private Entities
6.1 Key concerns
6.2 Comparison with full HKFRS
Learning focus
The HKFRS for Private Entities was issued in April 2010. It provides an option for non-publicly
accountable entities which do not qualify for the SME-FRS to use simplified accounting and
disclosure rules.
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Financial Reporting
Learning outcomes
Competency
level
LO2.03 Small and Medium-sized Entity Financial Reporting Framework 2
and Financial Reporting Standard:
2.03.01 Identify the conditions under which an entity may adopt the SME
Financial Reporting Framework and Financial Reporting Standard
2.03.02 Describe the requirements of the SME Financial Reporting
Framework and Financial Reporting Standard
LO2.04 Hong Kong Financial Reporting Standard for Private Entities 2
2.04.01 Identify the conditions under which an entity may adopt the HKFRS
for Private Entities
2.04.02 Describe the requirements of the HKFRS for Private Entities
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1 Background
Topic highlights
The SME-FRF and SME-FRS provide a framework for simplified reporting for smaller companies in
Hong Kong.
The HKFRS for Private Entities was issued in April 2010 and is based on the IASB’s International
Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs).
The objective of financial statements is to provide information about the financial position and
performance of an entity that is useful to users of such information. Financial statements show the
results of management's stewardship of, and accountability for, the resources entrusted to it.
For small and medium-sized entities (SMEs), the most significant users are likely to be owners,
government and creditors, who may have the power to obtain information additional to that
contained in the financial statements. These users do not generally require the detailed
disclosures required by full HKFRS, and indeed the preparing entities generally find the provision of
such disclosures onerous in terms of the time and cost of preparation.
In Hong Kong, there are therefore two options for simplified reporting for smaller, non-listed
entities:
1 the SME-FRF and SME-FRS
2 the HKFRS for Private Entities.
This chapter considers each of these options, including who can use them and what simplifications
are made compared to the use of full HKFRS.
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The options available to each type of entity are summarised in the following table:
Can apply:
SME-FRF sets out the conceptual basis and qualifying criteria for the preparation of financial
statements in accordance with the Small and Medium-sized Entity Financial Reporting Standard
(SME-FRS).
SME-FRS sets out the recognition, measurement, presentation and disclosure requirements for an
entity that prepares and presents the financial statements in accordance with the SME-FRS.
SME-FRS 16 3.1 Companies which qualify for reporting under the SME-FRF
and SME-FRS
Both Hong Kong incorporated and overseas unlisted companies may qualify for reporting under the
SME-FRF and preparing financial statements in accordance with the SME-FRS.
3.1.1 Qualifying Hong Kong companies
A company incorporated under the Hong Kong Companies Ordinance qualifies for reporting under
the SME-FRF and SME-FRS if it satisfies the reporting exemption criteria set out in section 359 of
the new Companies Ordinance. The qualifying categories are:
A private company that is not a Any size 100% written approval from
member of a group shareholders is required each
year
Small private company Must not exceed two of: No shareholder approval is
Total annual revenue of required
$100m
Total assets of $100m at
the reporting date
100 employees
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Where size limits apply, in general a company will be required to pass the size tests for two
consecutive years before becoming eligible in the third year. Similarly a company would have to fail
the tests for two consecutive years in order to become ineligible in the third year.
The following types of company are not eligible for the reporting exemption and may not apply the
SME-FRF and SME-FRS:
(a) Companies that are authorised under the Banking Ordinance to carry out banking business
(b) Companies that accept, by way of trade or business (other than banking business), loans of
money at interest or repayable at a premium other than on terms involving the issue of
debentures or other securities
(c) Companies that are licensed under Part V of the Securities and Futures Ordinance to carry
on a regulated business
(d) Companies that carry on an insurance business, other than solely as an agent
In addition, groups that contain such companies are not eligible for the reporting exemption and
cannot apply the SME-FRF and SME-FRS in the preparation of their consolidated financial
statements.
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3: Small company reporting | Part B Financial reporting framework
If an entity holds assets in a fiduciary capacity for a broad group of outsiders for reasons that are
incidental to its primary business, it is not considered to have public accountability. Such entities
may include schools, travel agents and charities.
4.2.3 Subsidiaries
A subsidiary of a group which applies full HKFRS may use the HKFRS for Private Entities provided
that the subsidiary itself meets the eligibility criteria.
It includes simplifications that reflect the needs of users of private companies' financial statements
and the cost-benefit considerations of preparers. It facilitates financial reporting by unlisted entities
by:
simplifying requirements for recognition and measurement;
eliminating topics and disclosure requirements that are not generally applicable to private
entities;
removing certain accounting treatments permitted under full HKFRS.
Note that entities are not permitted to mix and match the requirements of the HKFRS for Private
Entities and full HKFRS, except for the option to apply the recognition and measurement rules of
HKAS 39 (HKFRS 9) with regard to financial instruments.
The HKFRS for Private Entities became effective immediately upon its issuance on 30 April 2010.
Eligible entities are permitted to use HKFRS for Private Entities to prepare financial statements for
prior period(s) where the relevant financial statements have not been finalised and approved.
5.1.1 Cost-benefit considerations
In order to provide additional relief to preparers of financial statements under the HKFRS for
Private Entities, an "undue cost or effort" principle has been introduced in some sections of the
standard to replace the "impracticability" relief criterion in the full HKFRS (a requirement is
considered "impracticable" if an entity cannot apply it after making every reasonable effort to do
so).
Although the notion of "undue cost or effort" is not defined, it focuses on the concept of balancing
costs and benefits, which might in turn require management's judgment of when a cost is
considered excessive. In other words, the "undue cost or effort" principle implies that cost is always
considered.
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Financial Reporting
* Note. Entities are permitted to choose to apply HKAS 39 Financial Instruments: Recognition and
Measurement in its entirety rather than the financial instruments section of the HKFRS for Private
Entities. Note also that full HKFRS no longer allow these categories (HKFRS 9) and no longer
allows deferred recognition (HKAS 19).
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3: Small company reporting | Part B Financial reporting framework
The addition of a requirement to account for the liability component of a compound financial
instrument in the same way as a similar standalone financial liability (currently the IFRS for
SMEs requires that it is measured at amortised cost).
The final amendments are expected to be issued in 2015 and adopted by HKICPA as amendments
to the HKFRS for private entities.
Beyond this, the IASB anticipate that the IFRS for SMEs will be amended approximately once
every three years, with proposed changes issued in one go within an ‘omnibus Exposure Draft’.
Therefore, the number and frequency of amendments is reduced compared to those made to full
standards, and so the burden on companies to keep up to date is also reduced.
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Are there any long-term considerations that should be taken into account?
The PE's long-term plans need to be considered; where such plans include becoming publicly
accountable or a possible listing of debt or equity instruments, this could affect the choices made
by the PE. A PE with such plans would be precluded from using the HKFRS for Private Entities in
the future, as it would fail to meet the definition of a PE. This would then force the PE into a second
conversion to the full HKFRS.
Another consideration is whether a PE's holding company reports (or will report) under the full
HKFRS. In such cases, it may be easier for that PE to also report under the full HKFRS in order to
facilitate the consolidation process in its parent company – thereby avoiding the need for dual
reporting.
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Financial Reporting
Topic recap
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Exam practice
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Financial Reporting
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Part C
The emphasis in this section is on the legal environment in Hong Kong. The purpose of this
section is to develop your understanding of the Hong Kong legal environment, including the
legal framework and the related implications for business activities. This is considered as the
basic knowledge and foundation for a future certified public accountant.
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94
chapter 4
Learning focus
The measurement requirements for non-current assets and disposal groups held for sale are
particularly important both for exam and practical purposes.
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Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.21 Non-current assets held for sale and discontinued operations 3
3.21.01 Define non-current assets (or disposal groups) held for sale or held
for distribution to owners and discontinued operations within the
scope of HKFRS 5
3.21.02 Explain what assets are within the measurement provision of
HKFRS 5
3.21.03 Determine when a sale is highly probable
3.21.04 Measure non-current assets held for sale and discontinued
operations including initial measurement, subsequent measurement
and change of plan
3.21.05 How to account for impairment loss and subsequent reversals
3.21.06 Present the non-current asset held for sale and discontinued
operation in the financial statements (including the prior year
restatement)
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HKFRS 5,
Appendix A
1.1 Introduction and definitions
HKFRS 5 requires assets and groups of assets (‘disposal groups’) that are ‘held for sale’ to be
presented separately in the statement of financial position.
It also requires that the results of discontinued operations are presented separately in the
statement of profit or loss and other comprehensive income.
These requirements ensure that users of financial statements are better able to make projections
about the financial position, profits and cash flows of the entity.
Key terms
Disposal group. A group of assets to be disposed of, by sale or otherwise, together as a group in
a single transaction, and liabilities directly associated with those assets that will be transferred in
the transaction. (In practice, a disposal group could be a subsidiary, a cash-generating unit or a
single operation within an entity.)
Discontinued operation. A component of an entity that either has been disposed of or is classified
as held for sale and:
(a) Represents a separate major line of business or geographical area of operations; or
(b) Is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations; or
(c) Is a subsidiary acquired exclusively with a view to resale.
(HKFRS 5)
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Financial Reporting
Where a non-current asset forms part of a disposal group, the measurement requirements of
HKFRS 5 are applied to the group as a whole rather than to each asset within it on an individual
basis.
The classification, presentation and measurement requirements in this HKFRS applicable to a non-
current asset (or disposal group) that is classified as held for sale apply also to a non-current asset
(or disposal group) that is classified as held for distribution to owners acting in their capacity as
owners (held for distribution to owners).
Topic highlights
A non-current asset (or disposal group) should be classified as held for sale if its carrying amount
will be recovered principally through a sale transaction rather than through continuing use.
In order for this to be the case:
(a) the asset must be available for immediate sale in its present condition
(b) its sale must be highly probable (i.e., significantly more likely than not)
HKFRS 5
2.1 Available for immediate sale in present condition
Implementation
HKFRS 5 requires that to be classified as held for sale, an asset (or disposal group) must be
Guidance
available for immediate sale in its present condition subject only to terms that are usual and
customary for sales of such assets (or disposal group).
The standard does not expand on the meaning of this, however the Implementation Guidance that
accompanies the standard states that an asset (or disposal group) is available for immediate sale if
an entity currently has the intention and ability to transfer the asset (or disposal group) to a buyer in
its present condition.
Example: Available for immediate sale in present condition 1
Vaughan Co acquires a property that it intends to sell only after it has completed renovations to
increase the property’s sales value.
Required
Is the head office available for immediate sale in its present condition?
Solution
No, Vaughan Co intends to delay the sale of the property until renovations are complete. Therefore
until the renovation work is finished the property is not available for immediate sale in its present
condition.
Example: Available for immediate sale in present condition 2
Farrell Co is committed to a plan to sell its manufacturing facility and has begun work to identify a
buyer. The facility has a backlog of customer orders to complete and any of these that have not
been completed by the sale date will be transferred to the purchaser of the facility. This transfer will
not affect the timing of the sale.
Required
Is the manufacturing facility available for immediate sale in its present condition?
Solution
Yes, the facility is available for sale in its present condition because any outstanding customer
orders will be transferred to the purchaser.
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Financial Reporting
Sold
No
Available for sale in present
condition?
Yes
No
Sale expected within one year?
Yes
Yes
Self-test question 1
1 Should the following be classified as held for sale at 31 December 20X1?
(a) Lawnmo is committed to a plan to sell a manufacturing facility in its present condition
and classifies the facility as held for sale at 31 March 20X1. After a firm purchase
commitment is obtained, the buyer's inspection of the property identifies environmental
damage not previously known to exist. Lawnmo is required by the buyer to make good
the damage, and this is likely to mean that the sale will not be completed until the end
of August 20X2. Lawnmo has initiated actions to make good the damage, and
satisfactory rectification of the damage is highly probable.
(b) Ficus is committed to a plan to sell its head office building and has engaged the
services of an agent to locate a buyer. Ficus will use the building until the completion
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of its new premises, currently under construction. The existing head office will not be
transferred to a buyer until such time as Ficus vacates the property.
2 On 1 July 20X9, the board of directors of Clematis agreed to sell a division of the business.
The division currently has work planned until the end of September 20X9 so the board have
agreed to complete the work and then discontinue the operations of the division. There is an
interested buyer for the division but the Board of Clematis has stated that the purchase
cannot take place until after the work has been completed and realistically anticipate that a
transfer of the division cannot occur until 31 October 20X9.
Should the division be classified as 'held for sale' at 1 July 20X9?
(The answer is at the end of the chapter)
HKFRS
5.15,15A, 18
3.1 Initial measurement
Immediately before classification as held for sale, an asset (or the assets and liabilities of a
disposal group) must be remeasured in accordance with applicable HKFRS.
On transfer to the held for sale category, a non-current asset (or the net assets of a disposal group)
should be measured at the lower of carrying amount and fair value less costs to sell.
An entity shall measure a non-current asset (or disposal group) classified as held for distribution to
owners at the lower of its carrying amount and fair value less costs to distribute.
HKFRS 5.16 3.1.1 Carrying amount
HKFRS 5 clarifies that the carrying amount is that amount at which the asset or disposal group
would have been included in the financial statements had the classification to the held for sale
category not occurred. This carrying amount is measured in accordance with applicable HKFRS.
HKFRS 5.17 3.1.2 Fair value less costs to sell
HKFRS 13 Fair Value Measurement is applied in order to determine fair value (see Chapter 19).
When the sale is expected to occur beyond one year, the standard specifies that costs to sell
should be measured at present value. Any increase in the present value arising from the passage
of time is recognised in profit or loss as a financing cost.
HKFRS
5.19,25
3.2 Subsequent measurement
Once classified as held for sale (or part of a disposal group held for sale), a non-current asset is
not depreciated or amortised. Interest attributable to the liabilities of a disposal group does however
continue to be recognised.
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Financial Reporting
At each reporting date subsequent to classification as held for sale (or distribution), an asset or
disposal group must be remeasured at the lower of carrying amount and fair value less costs to sell
(distribute).
For a disposal group, the carrying amount of those assets which are part of the disposal group but
individually outside the scope of HKFRS 5 (see section 1.2) should be re-measured in accordance
with the relevant HKFRS before the fair value less costs to sell of the disposal group is re-
measured.
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At 15 February 20X9:
the inventory, which is carried at cost, could be sold for $13.7 million only after incurring
packaging costs of $700,000.
a property with a carrying amount of $12 million (being the valuation determined the last time
the property was revalued) has a fair value of $14 million.
The fair value of the disposal group is $400 million and costs to sell are $6 million.
Required
Show how HKFRS 5 measurement guidance is applied to the disposal group.
Solution
The assets of the disposal group are first remeasured at 15 February 20X9 in accordance with
relevant standards:
Carrying amount at
15 February Revised carrying
20X9 Remeasurement amount
$'000 $'000 $'000
Goodwill 45,000 - 45,000
Intangible asset 100,000 - 100,000
Property, plant and equipment 198,000 2,000 200,000
Inventory 13,200 (200) 13,000
Other current assets 90,000 90,000
Total 446,200 1,800 448,000
The fair value less costs to sell is $394 million ($400 million – $6 million) and the revised carrying
amount is $448 million. Therefore an impairment loss is recognised on transfer of the disposal
group to held for sale of $54 million, and this is allocated to the non-current assets which fall within
the scope of the measurement provisions of HKFRS 5.
Therefore, no impairment loss is allocated to inventory or the other current assets.
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Financial Reporting
The loss is allocated in the first place to goodwill and thereafter to other non-current assets on a
pro-rata basis:
Revised Carrying
carrying amount amount after
at allocation of
15 February Impairment impairment
20X9 loss loss
$'000 $'000 $'000
Goodwill 45,000 (45,000) –
Intangible asset 100,000 (3,000) 97,000
Property, plant and equipment 200,000 (6,000) 194,000
Inventory 13,000 – 13,000
Other current assets 90,000 – 90,000
Total 448,000 54,000 394,000
HKFRS 5.21-
22
3.4 Reversal of impairment losses
Where an asset or disposal group held for sale or distribution is measured at fair value less costs to
sell, any subsequent increase in fair value less costs to sell is recognised as follows:
In the case of an individual asset, a reversal of an impairment loss may not be recognised in
excess of the cumulative impairment loss previously recognised in accordance with either
HKAS 36 or HKFRS 5.
In the case of a disposal group, a reversal of an impairment loss is recognised:
– To the extent that it is not recognised on the remeasurement of the carrying amount of
assets and liabilities outside the scope of HKFRS 5
– For assets within the scope of HKFRS 5, not in excess of the cumulative impairment
loss previously recognised in accordance with either HKAS 36 or HKFRS 5.
An impairment loss recognised for goodwill is not allowed to be reversed in a subsequent period.
Self-test question 2
Collingwood Co (‘CC’) classified one of its divisions as a disposal group held for sale on 12 June
20X4 . On this date the fair value less costs to sell was determined to be $7 million less than its
carrying amount and this loss was allocated as follows:
Revised carrying
Carrying amount at amount at 12 June
12 June 20X4 Impairment loss 20X4
$'000 $'000 $'000
Goodwill 5,000 (5,000) -
Non-current assets 30,000 (2,000) 28,000
Current assets 13,750 13,750
Current liabilities (11,200) (11,200)
Total 37,550 (7,000) 30,550
The loss was recognised on 12 June 20X4 by:
DEBIT Impairment loss $7,000,000
CREDIT Assets held for disposal $7,000,000
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At the year end of 31 December 20X4, the division had not yet been sold. The current assets of the
division were measured at $12.9 million and the current liabilities at $10 million. The fair value less
costs to sell of the division was $33 million.
Required
Calculate amounts to be recognised in the statement of financial position of CC at 31 December
20X4 in respect of the disposal group and explain your answer. You should also state any journal
entries required at the year end.
(The answer is at the end of the chapter)
HKFRS 5.27 3.5 Measurement where assets are no longer classified as held
for sale or distribution
A non-current asset (or disposal group) that is no longer classified as held for sale (for example,
because the sale has not taken place within one year) is measured at the lower of:
(a) Its carrying amount before it was classified as held for sale, adjusted for any depreciation,
amortisation or revaluations that would have been charged had the asset not been classified
as held for sale
(b) Its recoverable amount at the date of the decision not to sell
HKFRS 5 was amended in 2014 to extend this treatment to apply to assets or disposal groups that
cease to be classified as held for distribution. The amendment is effective from 1 January 2016.
3.6 Reclassification
HKFRS 5.26A
HKFRS 5 was amended in 2014 (effective 1 January 2016) to address the situation where an asset
(or disposal group) classified as held for sale becomes held for distribution or vice versa.
In this situation, the change in classification is considered to be a continuation of the original plan of
disposal and the original date of classification as held for sale/distribution is not changed.
Therefore HKFRS 5’s classification, measurement and presentation requirements of the new
method of disposal apply:
If reclassified as held for sale the asset (or disposal group) is measured at the lower of
carrying amount and fair value less costs to sell.
If reclassified as held for distribution the asset (or disposal group) is measured at the lower
of carrying amount and fair value less costs to distribute.
Any reduction or increase in fair value less costs to sell (or distribute) are recognised as
discussed in sections 3.3 and 3.4.
Example: Reclassification
Reilly Co, a family owned-company, classified a property as held for sale in accordance with
HKFRS 5 at 31 December 20X4. The asset was measured at this date at $289,500, being its fair
value of $300,000 less costs to sell of $10,500. At 31 August 20X5, having been unable to locate a
buyer, the Board of the company agreed to distribute the property to the shareholders of Reilly Co.
At that date the fair value of the property was $295,000 and the costs to distribute it amounted to
$7,500.
Required
How is the reclassification of the property from held for sale to held for distribution accounted for?
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Financial Reporting
Solution
The property is measured at the lower of carrying amount and fair value less costs to
distribute.
The carrying amount of the property is $289,500 and the fair value less costs to distribute is
$287,500, therefore the property is measured at $287,500.
The decrease in the carrying amount of the property is recognised as an impairment loss in
profit or loss.
The journal to record the reclassification is therefore:
DEBIT Non-current asset held for $287,500
distribution
DEBIT Impairment loss $2,000
CREDIT Non-current asset held for sale $289,500
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Equity X X
Non-current liabilities X X
Current liabilities X X
Liabilities associated with non-current assets classified as
held for sale 260 X
Total equity and liabilities X X
HKFRS
5.41,42
4.2 Additional disclosures
The following disclosures are required when a non-current asset (or disposal group) is either
classified as held for sale or sold during a reporting period:
(a) A description of the non-current asset (or disposal group)
(b) A description of the facts and circumstances of the disposal
(c) Any gain or loss recognised when the item was classified as held for sale
(d) If applicable, the reportable segment in which the non-current asset (or disposal group) is
presented in accordance with HKFRS 8 Operating Segments
When an entity reclassifies an asset as no longer held for sale, it should disclose the facts and
circumstances leading to the decision and its resultant effect.
Example: Disclosure
Disposal Group held for sale
Part of a manufacturing facility within the Beverages segment is presented as a disposal group
held for sale following the commitment of the Company’s management on 18 August 20X6 to sell
part of the facility. Efforts to sell the disposal group have commenced and a sale is expected by
August 20X7.
An impairment loss of $12 million on the remeasurement of the disposal group to the lower of its
carrying amount and its fair value less costs to sell has been recognised in other expenses.
5 Discontinued operations
HKFRS 5.32 5.1 Definition of discontinued operations
A discontinued operation was defined at the start of this chapter as a component of an entity that
has either been disposed of, or is classified as held for sale, and:
(a) Represents a separate major line of business or geographical area of operations;
(b) Is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations; or
(c) Is a subsidiary acquired exclusively with a view to resale.
A component of an entity comprises operations and cash flows that can be clearly distinguished
from the rest of the entity, both operationally and for financial reporting purposes.
HKFRS 5 requires that the results of a discontinued operation are disclosed separately in order to
enable users of the financial statements to evaluate the financial effects of discontinued operations.
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Self-test question 3
Discuss whether these situations meet the definition of discontinued operations in HKFRS 5.
(i) Wong Co. had used two factories to manufacture office equipment. A general slump in the
economy has resulted in a reduced demand for such equipment and the company has
decided to move all the production facilities to one of the factories but keep the now empty
factory in the hope that there will be an upturn in demand and require the return to two
factory output.
(ii) In addition to the manufacture of office equipment, Wong Co. supplied office stationery to
private education establishments. In order to raise much needed cash the office stationery
supply business was sold. The office stationery supply business was operated separately
from the manufacturing activities.
(The answer is at the end of the chapter)
HKFRS 5.33-
35,37
5.2 Presentation of discontinued operations
An entity should disclose a single amount in the statement of profit or loss and other
comprehensive income comprising the total of:
(a) The post-tax profit or loss of discontinued operations; and
(b) The post-tax gain or loss recognised on the measurement to fair value less costs to sell
or on the disposal of the assets or disposal group(s) constituting the discontinued operation.
An entity should also disclose an analysis of the above single amount into:
(a) The revenue, expenses and pre-tax profit or loss of discontinued operations
(b) The related income tax expense
(c) The gain or loss recognised on the measurement to fair value less costs to sell or on the
disposal of the assets or the discontinued operation
(d) The related income tax expense
The analysis may be shown separately from continuing operations, in a section identified as
discontinued operations, in the statement of profit or loss and other comprehensive income. As an
alternative, it may also be presented in the notes to the financial statements. Such disclosure is not
necessary where the discontinued operation relates to a newly acquired subsidiary that has been
classified as held for sale.
Disclosures relating to the net cash flows attributable to the operating, investing and financing
activities of the discontinued operations may be presented on the face of the statement of cash
flows. Alternatively, they may be shown in the notes.
The required disclosures must be re-presented for prior periods presented in the financial
statements so that the disclosures relate to all operations that have been discontinued by the most
recent reporting date.
Any current year adjustments made to amounts previously presented in discontinued operations
and directly related to the disposal of a discontinued operation in a prior period are classified
separately in discontinued operations.
The gains or losses arising from the reassessment of a disposal group, which is held for sale and is
not a discontinued operation, should be incorporated in the profit or loss from continuing
operations.
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Illustration
The following illustration is taken from the implementation guidance to HKFRS 5. Profit for the year
from discontinued operations would be analysed in the notes.
Smart Group
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 DECEMBER 20X9
20X9 20X8
$'000 $'000
Continuing operations
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Other expenses (X) (X)
Finance costs (X) (X)
Share of profit of associates X X
Profit before tax X X
Income tax expense (X) (X)
Profit for the year from continuing operations X X
Discontinued operations
Profit for the year from discontinued operations X X
Profit for the year X X
Period attributable to:
Owners of the parent X X
Non-controlling interest X X
X X
The analysis of the profit from discontinued operations may also be presented in a separate
column in the statement of profit or loss and other comprehensive income.
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Financial Reporting
Self-test question 4
A&Z
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR
ENDED 31 DECEMBER 20X1
20X1 20X0
$'000 $'000
Revenue 3,000 2,200
Cost of sales (1,000) (700)
Gross profit 2,000 1,500
Distribution costs (400) (300)
Administrative expenses (900) (800)
Profit before tax 700 400
Income tax expense (210) (120)
Profit for the year 490 280
Other comprehensive income for the year, net of tax 40 30
Total comprehensive income for the year 530 310
During the year the company ran down a material business operation with all activities ceasing on
26 December 20X1. The results of the operation for 20X0 and 20X1 were as follows:
20X1 20X0
$'000 $'000
Revenue 320 400
Cost of sales (150) (190)
Gross profit 170 210
Distribution costs (120) (130)
Administrative expenses (100) (90)
Loss before tax (50) (10)
Income tax expense 15 3
Loss for the year (35) (7)
Other comprehensive income for the year, net of tax 5 4
Total comprehensive income for the year (30) (3)
The company recognised a loss of $30,000 on initial classification of the assets of the discontinued
operation as held for sale, followed by a subsequent gain of $120,000 on their disposal in 20X1.
These have been netted against administrative expenses. The income tax rate applicable to profits
on continuing operations and tax savings on the discontinued operation's losses is 30%.
Required
Prepare the statement of profit or loss and other comprehensive income for the year ended 31
December 20X1 for A&Z complying with the provisions of HKFRS 5.
(The answer is at the end of the chapter)
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Topic recap
Measurement Disclosure
Lower of carrying amount and fair value Disclose single amount in statement of profit
less costs to sell or distribute. or
comprehensive
loss and otherincome
comprehensive
comprising:income
comprising:
Post tax profit or loss of the
Postdiscontinued
tax profit or operations
loss of the discontinued
and
operations
Post taxand
gain or loss on
If FV less costs to sell/distribute < carrying Postdisposal/measurement
tax gain or loss on to fair
amount recognise impairment loss. In disposal/measurement
value less costs to sell.
to fair value less
disposal group set against: costs to sell.
1. goodwill
2. other assets on pro rata basis
Disclosure
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Financial Reporting
Answer 1
1 (a) The manufacturing facility should be classified as held for sale. Although the sale will
not be completed within 12 months of classification, the delay is caused by
circumstances beyond Lawnmo’s control and Lawnmo is clearly committed to the sale.
(b) The building should not be classified as held for sale. The delay in transferring the
building to a buyer demonstrates that it is not available for immediate sale. This is the
case even if a firm purchase commitment were obtained.
2 In order to be held for sale an asset must be available for immediate sale in its present
condition and a sale must be highly probable.
At 1 July 20X9 the division is not available for immediate sale in its present condition and
therefore it does not meet the criteria specified in HKFRS 5 as being held for sale.
The division will only meet be available for immediate sale in its present condition when the
planned work has been completed. It may meet the criteria on 31 October when the work
has been completed.
Answer 2
The statement of financial position of CC at 31 December 20X4 will include:
Assets held for sale of $42.9 million
Liabilities associated with assets held for sale of $10 million
WORKING
Carrying Carrying
amount at 12 amount at 31 Reversal of Revised
June 20X4 December 20X4 impairment loss carrying amount
$'000 $'000 $'000 $'000
Goodwill - - - -
Non-current assets 28,000 28,000 2,000 30,000
Current assets 13,750 12,900 - 12,900
Current liabilities (11,200) (10,000) - (10,000)
Total 30,550 30,900 2,000 32,900
The carrying amount of the disposal group at 31 December 20X4 is $30,900,000 (after
remeasuring the current assets and liabilities outside the scope of HKFRS 5 in accordance with
relevant standards).
The fair value less costs to sell is $33 million
The maximum impairment reversal is the lower of :
The initial impairment of $7 million
The $2.1million by which the fair value less costs to sell exceeds carrying amount.
Therefore the maximum impairment reversal is $2.1 million, however no reversal may be
recognised in respect of goodwill. Therefore $2 million is recognised in respect of non-current
assets by:
DEBIT Assets held for disposal $2,000,000
CREDIT Impairment loss $2,000,000
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Answer 3
(i) The closure of the factory does not result in the disposal of a separate major line of business
or geographical area of operation nor is the factory being held for sale. The closure therefore
does not appear to result in a need to classify any of the performance of Wong Co. as
discontinued in these circumstances. Nothing has been discontinued, merely production
reduced to a more competitive level until demand returns.
(ii) The office stationery supply business will probably be considered to represent a separate
major line of business and should therefore be classified as a discontinued operation with
separate disclosure of its activities in the statement of profit or loss as required by HKFRS 5.
Its disposal will probably have been a single co-ordinated plan, further confirming the
business as a discontinued operation.
Answer 4
A&Z
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 DECEMBER 20X1
20X1 20X0
$'000 $'000
Revenue (3,000 – 320)/(2,200 – 400) 2,680 1,800
Cost of sales (1,000 – 150)/(700 – 190) (850) (510)
Gross profit 1,830 1,290
Distribution costs (400 – 120)/(300 – 130) (280) (170)
Administrative expenses (900 – 100)/(800 – 90) (800) (710)
Profit before tax 750 410
Income tax expense (210 + 15)/(120 + 3) (225) (123)
Profit for the year from continuing operations 525 287
Loss for the year from discontinued operations (35) (7)
Profit for the year 490 280
Other comprehensive income for the year, net of tax 40 30
Total comprehensive income for the year 530 310
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Financial Reporting
Exam practice
Taking into consideration the range of the price offered by the potential buyer, the management
estimates that the fair value less costs to sell of the group of assets of RR amounts to
HK$85,000,000.
Almost all of the property, plant and equipment of SW are leasehold improvement of retailing shops
located at premises rented under operating leases which would be abandoned upon the early
termination of the lease terms. No proceeds are expected to be received even upon disposal.
SW would continue to sell its inventories but at an estimated discount of 40% of the cost. The
trade receivables are expected to be fully recovered.
Required
Explain and calculate the impairment loss to be made to each of the assets of RR and SW.
(12 marks)
HKICPA February 2010
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chapter 5
Learning focus
Non-current assets form a large part of many entities' statements of financial position.
Accounting for them is not necessarily straightforward and you may need to think critically and
deal with controversial issues. This chapter deals with property, plant and equipment; how to
account for transactions involving them, and the principles and methods of depreciation.
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Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.08 Property, plant and equipment 3
3.08.01 Identify the non-current assets which fall within or outside the scope
of HKAS 16
3.08.02 State and apply the recognition rules in respect of property, plant
and equipment
3.08.03 Determine the initial measurement of property, plant and
equipment, including assets acquired by exchange or transfer
3.08.04 Determine the accounting treatment of subsequent expenditure on
property, plant and equipment
3.08.05 Determine the available methods to measure property, plant and
equipment subsequent to initial recognition
3.08.06 Account for the revaluation of property, plant and equipment
3.08.07 Define 'useful life' and allocate an appropriate useful life for an
asset in a straightforward scenario
3.08.08 Explain the different methods of depreciation: straight line and
diminishing balance, and calculate the depreciation amount in
respect of different types of asset
3.08.09 Account for the disposal of property, plant and equipment
3.08.10 Disclose relevant information relating to property, plant and
equipment in the financial statements
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Key terms
Property, plant and equipment are tangible items that are:
Held for use in the production or supply of goods or services, for rental to others, or for
administrative purposes
Expected to be used during more than one period
A bearer plant is a living plant that:
(a) Is used in the production or supply of agricultural produce
(b) Is expected to bear produce for more than one period
(c) Has a remote likelihood of being sold as agricultural produce except for individual scrap sales.
Cost is the amount of cash or cash equivalents paid or the fair value of other consideration given to
acquire an asset at the time of its acquisition or construction.
Residual value is the estimated amount that an entity would currently obtain from disposal of the
asset, after deducting the estimated costs of disposal, if the asset were already of the age and in
the condition expected at the end of its useful life.
Entity specific value is the present value of the cash flows an entity expects to arise from the
continuing use of an asset and from its disposal at the end of its useful life, or expects to incur
when settling a liability.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Carrying amount is the amount at which an asset is recognised after deducting any accumulated
depreciation and accumulated impairment losses.
An impairment loss is the amount by which the carrying amount of an asset exceeds its
recoverable amount.
Recoverable amount is the higher of an asset's fair value less costs to sell and its value in use.
(HKAS 16)
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Financial Reporting
HKAS 16 was amended in 2014 to add the definition of a bearer plant, as listed above. Examples
of bearer plants include grapevines, fruit trees and tea bushes, all of which are used to produce
harvests that can be sold. As a result of the amendment, bearer plants are now within the scope of
HKAS 16 and accounted for as property, plant and equipment. Previously, such plants were within
the scope of HKAS 41 Agriculture.
HKAS 16.7
1.3 Recognition of non-current assets
An item of property, plant and equipment should be recognised in the statement of financial
position as an asset when:
(a) It is probable that future economic benefits associated with the asset will flow to the entity.
(b) The cost of the asset to the entity can be measured reliably.
1.3.1 First criterion: Future economic benefits
The degree of certainty attached to the flow of future economic benefits must be assessed. This
should be based on the evidence available at the date of initial recognition (usually the date of
purchase). The entity should thus be assured that it will receive the rewards attached to the asset
and it will incur the associated risks, which will only generally be the case when the rewards and
risks have actually passed to the entity. Until then, the asset should not be recognised.
1.3.2 Second criterion: Cost measured reliably
It is generally easy to measure the cost of an asset as the transfer amount on purchase, i.e. what
was paid for it. Self-constructed assets can also be measured easily by adding together the
purchase price of all the constituent parts (labour, materials and so on) paid to external parties.
HKAS 1.3.3 Application to specific types of asset
16.8,9,11,13,14
Small separate assets
Although HKAS 16 provides criteria that must be met in order for an item of property, plant or
equipment to be recognised as an asset, it does not prescribe a unit of measurement for
recognition i.e. what value an item should have in order to be recognised as an asset rather than
expensed. Smaller items, such as tools, dies and moulds, are sometimes classified as
consumables and written off as an expense. Where these are classified as property, plant and
equipment, it is usual to aggregate similar items together and treat them as one.
Spare parts and stand-by equipment
Spare parts, stand-by equipment and servicing equipment are recognised as property, plant and
equipment when they meet the definition of property, plant and equipment. Otherwise they are
classified as inventory.
Safety and environmental equipment
When items of safety and environmental equipment are acquired they will qualify for recognition
where they enable the entity to obtain future economic benefits from related assets in excess of
those it would obtain otherwise. The recognition will only be to the extent that the carrying amount
of the asset and related assets does not exceed the total recoverable amount of these assets.
Complex assets
For very large and specialised items, an apparently single asset should be broken down into its
composite parts. This occurs where the different parts have different useful lives and different
depreciation rates are applied to each part, e.g. an aircraft, where the body and engines are
separated as they have different useful lives. Expenditure incurred in replacing or renewing a
component of an item of property, plant and equipment must be recognised in the carrying amount
of the item (and then depreciated to the next replacement date).
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1.4 Measurement
HKAS 16.15- 1.4.1 Initial measurement
22
Once an item of property, plant and equipment qualifies for recognition as an asset, it will initially
be measured at cost.
The standard lists the components of the cost of an item of property, plant and equipment.
(a) Purchase price, less any trade discount or rebate
(b) Import duties and non-refundable purchase taxes
(c) Directly attributable costs of bringing the asset to working condition for its intended use,
for example:
(i) The cost of site preparation
(ii) Initial delivery and handling costs
(iii) Installation costs
(iv) Testing
(v) Professional fees (architects, engineers)
(d) Initial estimate of the unavoidable cost of dismantling and removing the asset and restoring the
site on which it is located (HKAS 37 Provisions, Contingent Liabilities and Contingent Assets)
(e) Any borrowing costs incurred related to building the asset may be capitalised within the
assets too (HKAS 23 Borrowing Costs)
Additional guidance is provided on directly attributable costs included in the cost of an item of
property, plant and equipment.
(a) These costs bring the asset to the location and working conditions necessary for it to be
capable of operating in the manner intended by management, including those costs to test
whether the asset is functioning properly.
(b) They are determined after deducting the net proceeds from selling any items produced when
bringing the asset to its location and condition.
The standard also states that income and related expenses of operations that are incidental to the
construction or development of an item of property, plant and equipment should be recognised in
profit or loss. These include:
Costs of opening a new facility
Costs of introducing a new product or service
Costs of conducting business in a new location or with a new class of customer
Administration and other general overhead costs
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In addition, the capitalisation of costs must cease when an asset is in the location and condition
necessary for it to be capable of normal operation. Therefore, the following may not be capitalised:
Costs incurred when an item is capable of normal use however is operating at less than full
capacity
Initial operating losses
The costs of relocating or reorganising the entity's operations
All of these will be recognised as an expense rather than an asset.
In the case of self-constructed assets, the same principles are applied as for acquired assets.
If the entity makes similar assets during the normal course of business for sale externally, then the
cost of the asset will be the cost of its production under HKAS 2 Inventories. This also means that
abnormal costs (wasted material, labour or other resources) are excluded from the cost of the asset.
An example of a self-constructed asset is when a building company builds its own head office.
Self-test question 1
As part of a plan to diversify its product range, Flame Imports Co (‘FIC’) began construction of a
new distribution warehouse near to one of the container terminals at the Port of Hong Kong on 1
November 20X3. The costs incurred in respect of this property were as follows:
$’000
Site selection 260
Legal costs of acquiring site 340
Site preparation 1,320
Architects’ Fees 450
Construction materials 2,720
Construction labour 2,400
Proportion of FIC administrative costs allocated to project 190
The amount billed by the architects includes $125,000 in relation to original blueprints drawn up.
These blueprints were scrapped when the directors of FIC instructed the architects to revise their
plans in order to make the building as environmentally friendly as possible.
In line with the green credentials of the new building, FIC have installed solar panels on the roof of
the warehouse at a cost of $ 350,000. A further $ 20,000 was spent on having the building certified
as eco-friendly by the Hong Kong Green Building Council (HKGBC). The directors of FIC decided
to obtain this certification in order to boost their credentials as a sustainable company and so that
they could refer to it within their sustainability report.
The solar panels are expected to last 20 years before they will require replacement; the HKGBC
certificate must be renewed every 5 years. The property was completed on 12 March 20X4 and
brought into use on 1 April 20X4.
FIC depreciates property over a 50 year useful life.
Required
Calculate and explain the initial measurement of the new warehouse.
(The answer is at the end of the chapter)
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Solution
The ship owner shall capitalise the ship at a value of $20m. The properties are deemed to be
disposed of at $15m ($20m – $5m), thus a gain of $5m ($15m – $10m) is recognised on disposal
of the properties.
Expressed as journal entries, we can see:
$m $m
DEBIT Property, plant and equipment (Ship) 20
CREDIT Gain on disposal 5
Property, plant and equipment (Properties) 10
Cash 5
1.5 Depreciation
Topic highlights
Where assets held by an entity have a limited useful life to that entity it is necessary to apportion
the value of an asset over its useful life.
With the exception of land held on freehold or very long leasehold, every non-current asset
eventually wears out over time. Machines, cars and other vehicles, fixtures and fittings, and even
buildings do not last for ever. When a business acquires a non-current asset, it will have some idea
about how long its useful life will be, and it might decide what to do with it.
(a) Keep on using the non-current asset until it becomes completely worn out, useless, and
worthless.
(b) Sell off the non-current asset at the end of its useful life, either by selling it as a
second-hand item or as scrap.
Since a non-current asset has a cost, and a limited useful life, and its value eventually declines, it
follows that a charge should be made in profit or loss to reflect the use that is made of the asset by
the business. This charge is called depreciation.
Depreciation must be charged even where an asset appears to be increasing in value over time.
Other than assets classified as held for sale, to which HKFRS 5 applies, the only type of asset for
which non-depreciation is permissible is freehold land.
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Key terms
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.
HKAS 16.6
Depreciable assets are assets which:
Are expected to be used during more than one accounting period
Have a limited useful life
Are held by an entity for use in the production or supply of goods and services, for rental to
others, or for administrative purposes.
Useful life is one of two things:
The period over which an asset is expected to be available for use by an entity.
The number of production or similar units expected to be obtained from the asset by an entity.
Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual
value.
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(due to technological advance, improvements in production, reduction in demand for the product or
service produced by the asset) and legal restrictions, for example, the length of a related lease,
also play a role in determining the useful life of an asset.
Self-test question 2
Waitco acquires a computer system for use in its administration office on 1 July 20X4. The supplier
of the computer system has asserted that it will continue to operate at its full potential for at least
five full years. Waitco expects to continue with its policy of renewing all IT equipment used in the
business after a three-year period. After three years, Waitco usually sells its computers and other
hardware back to the supplier, who refurbishes the items before selling them to education
establishments. Such establishments will ordinarily benefit from the equipment for a further eight
years.
Required
Determine an appropriate useful life for the purpose of the calculation of depreciation by Waitco,
and explain your conclusion.
(The answer is at the end of the chapter)
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Financial Reporting
Self-test question 3
A computer system cost $20,000 and is being depreciated at 10% using the diminishing balance
method.
Required
(a) What journal entries are required to record depreciation in the first two years of ownership?
(b) How does this asset appear in the statement of financial position in the first and second year
of ownership?
(c) Why is the diminishing balance method more appropriate for such an asset?
(The answer is at the end of the chapter)
Self-test question 4
DSyne Co acquired an item of plant for $1.8m on 1 January 20X1. It identified that the asset had
three major components as follows:
Component Useful life Cost
$'000
1 15 years 900
2 5 years 650
3 10 years 250
Under the terms of the 15-year licence agreement for the use of the plant, component 1 (but not
the other components) was to be dismantled at the end of the licence period.
Dismantling costs were initially estimated at a total cost of $280,000 payable in 15 years' time.
DSyne’s discount rate appropriate to the risk specific to this liability is 7% per annum.
Component 1 developed a fault on 1 January 20X2 and had to be sold for scrap for $140,000.
A replacement was purchased at a cost of $910,000 on 1 January 20X2, for use until the end of the
licence period, when dismantling costs on this component estimated at $250,000 would be
payable.
At a rate of 7% per annum the present value of $1 payable in 15 years' time is 0.3624 and of $1
payable in 14 years' time is 0.3878.
Required
Calculate
(a) The carrying amount of the machinery at 31 December 20X1
(b) The profit/loss on the disposal of the faulty component
(c) The carrying amount of the machinery at 31 December 20X2
(The answer is at the end of the chapter)
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Solution
$
Original cost 100,000
Depreciation 20X7 – 20X8 (100,000 2/10) (20,000)
Carrying amount at 1 January 20X9 80,000
Remaining life = 5 years
80,000
Depreciation charge years 20X9 – 20Y3 = $16,000
5
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Financial Reporting
revaluations are kept up to date and the revaluation of the entire class is accomplished in a short
period of time.
HKAS 1.6.4 Accounting for a revaluation
16.39,40
How should any increase in value be treated when a revaluation takes place? The debit will be
the increase in value in the statement of financial position, but what about the credit? HKAS 16
requires the increase to be credited to other comprehensive income and accumulated in a
revaluation surplus (i.e. part of owners' equity), unless the increase is reversing a previous
decrease which was recognised as an expense. Where this is the case, the increase is recognised
as income to the extent of the previous expense; any excess is then taken to the revaluation
surplus.
A decrease in value is recognised in the same way as an impairment loss (see section 1.7 below).
Example: Revaluation
Paddington has acquired numerous buildings and accounts for these using the revaluation model.
One particular piece of land is carried in Paddington’s statement of financial position at $560,000 at
1 January 20X1. At 31 December 20X1, further to a revaluation exercise, a fair value of $710,000
is identified in respect of this building.
How is this revaluation accounted for assuming that:
(a) The buildings have only ever risen in value
(b) Further to an economic downturn, at the time of the last revaluation exercise, an impairment
of $80,000 was identified and recognised in profit
Ignore depreciation.
Solution
(a) The double entry is:
$ $
DEBIT Buildings 150,000
CREDIT Other comprehensive income (revaluation surplus) 150,000
The case is similar for a decrease in value on revaluation. Any decrease should be recognised as
an expense, except where it offsets a previous increase taken as a revaluation surplus in owners'
equity. Any decrease greater than the previous upwards increase in value must be taken as an
expense in profit or loss.
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Solution
The double entry is:
$ $
DEBIT Other comprehensive income (revaluation surplus) 300,000
Administrative expenses (profit or loss) 500,000
CREDIT Building 800,000
Solution
(a) On 1 January 20X6 the carrying value of the property is $9m – (5 $9m 50) = $8.1m.
For the revaluation:
$ $
DEBIT Asset value 400,000
CREDIT Other comprehensive income (revaluation surplus) 400,000
(b) The depreciation for the year ended 31 December 20X6 will be $8.5m 45 = $188,889,
compared to depreciation on cost of $9m 50 = $180,000. So each year, the extra $8,889
can be treated as part of the surplus which has become realised:
$ $
DEBIT Revaluation surplus 8,889
CREDIT Retained earnings 8,889
This is a movement on owners' equity only, disclosed in the statement of changes in equity.
1.7 Impairment
An impairment loss should be treated in the same way as a revaluation decrease i.e. the
decrease should be recognised as an expense. However, a revaluation decrease (or impairment
loss) should be charged directly against any related revaluation surplus to the extent that the
decrease does not exceed the amount held in the revaluation surplus in respect of that same asset.
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A reversal of an impairment loss should be treated in the same way as a revaluation increase,
i.e. a revaluation increase should be recognised as income to the extent that it reverses a
revaluation decrease or an impairment loss of the same asset previously recognised as an
expense.
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$m
With revaluation of the asset
Gain on disposal (as above) 4.0
Revaluation surplus transferred to retained profits 23.2
27.2
Self-test question 5
A business purchased two rivet making machines on 1 January 20X5 at a cost of $15,000 each.
Each had an estimated life of five years and a nil residual value. The straight line method of
depreciation is used.
Owing to an unforeseen slump in market demand for rivets, the business decided to reduce its
output of rivets, and switch to making other products instead. On 31 March 20X7, one rivet making
machine was sold (on credit) to a buyer for $8,000.
Later in the year, however, it was decided to abandon production of rivets altogether, and the
second machine was sold on 1 December 20X7 for $2,500 cash.
Required
Prepare the machinery account, provision for depreciation of machinery account and disposal of
machinery account for the accounting year to 31 December 20X7.
(The answer is at the end of the chapter)
Self-test question 6
Otley Chevin Co ('OCC') acquired a new head office building on 30 September 20X3, and as a
result, the old head office was sold on this date for $39 million. A buyer had been identified some
months earlier and as a result the sale transaction was made immediately on 30 September 20X3.
Prior to this, the property had not been classified as held for sale as it had been occupied by a
subsidiary of OCC, which was itself awaiting the completion of a new property.
This old head office property had been owned since 1 July 20W2, had an original cost of $24
million and was depreciated over a period of 50 years. On 1 April 20X2 the company decided to
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change their accounting policy for property and adopt the revaluation model. The fair value of the
old head office at this date was $38 million. The total useful life of the property remained
unchanged. The fair value of the property had not changed substantially since the date of the
revaluation.
OCC has a policy of maximising distributable reserves, making an annual reserves transfer for
excess depreciation on revalued assets. Its reporting date is 31 March.
Required
(a) Explain the accounting treatment applied to the old head office building throughout the
period that it has been owned by OCC.
(b) Provide extracts from the statement of profit or loss and other comprehensive income and
the statement of changes in equity in the year ended 31 March 20X4 in respect of the
disposal of the old head office.
Note: You should work to the nearest $’000.
(The answer is at the end of the chapter)
HKAS
16.73,74,77,
1.9 Disclosure
79 The standard has a long list of disclosure requirements, for each class of property, plant and
equipment.
(a) Measurement bases for determining the gross carrying amount (if more than one, the gross
carrying amount for that basis in each category).
(b) Depreciation methods used.
(c) Useful lives or depreciation rates used.
(d) Gross carrying amount and accumulated depreciation (aggregated with accumulated
impairment losses) at the beginning and end of the period.
(e) Reconciliation of the carrying amount at the beginning and end of the period showing:
(i) Additions
(ii) Disposals
(iii) Acquisitions through business combinations (see Chapter 28)
(iv) Increases/decreases during the period from revaluations and from impairment losses
(v) Impairment losses recognised in profit or loss
(vi) Impairment losses reversed in profit or loss
(vii) Depreciation
(viii) Net exchange differences (from translation of statements of foreign entity)
(ix) Any other movements.
The financial statements should also disclose the following:
(a) Any recoverable amounts of property, plant and equipment
(b) Existence and amounts of restrictions on title, and items pledged as security for liabilities
(c) Accounting policy for the estimated costs of restoring the site
(d) Amount of expenditures on account of items in the course of construction
(e) Amount of commitments to acquisitions
Revalued assets require further disclosures, in addition to those required by HKFRS 13 Fair Value
Measurement (see Chapter 19):
(a) Basis used to revalue the assets
(b) Effective date of the revaluation
(c) Whether an independent valuer was involved
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(d) Carrying amount of each class of property, plant and equipment that would have been
included in the financial statements had the assets been carried at cost less accumulated
depreciation and accumulated impairment losses
(e) Revaluation surplus, indicating the movement for the period and any restrictions on the
distribution of the balance to shareholders
The standard also encourages disclosure of additional information, which the users of financial
statements may find useful.
(a) The carrying amount of temporarily idle property, plant and equipment
(b) The gross carrying amount of any fully depreciated property, plant and equipment that is still
in use
(c) The carrying amount of property, plant and equipment retired from active use and held for
disposal
(d) The fair value of property, plant and equipment when this is materially different from the
carrying amount
Illustration
The following illustration shows the format that is commonly used to disclose non-current assets
movements
Accounting policies
Land and buildings held for use in the production or supply of goods or services or for
administrative purposes are stated in the statement of financial position at their revalued amounts,
being the fair value at the date of the revaluation less any subsequent accumulated depreciation
and impairment losses. Revaluations are performed with sufficient regularity such that the carrying
amount does not differ materially from that which would be determined using fair values at the
reporting date.
Revaluation surpluses are recognised as other comprehensive income and accumulated in a
revaluation reserve, except to the extent that they reverse a previous impairment loss, in which
case they are recognised in profit or loss.
Plant and equipment are stated at cost less accumulated depreciation and any recognised
impairment loss.
Freehold land is not depreciated; depreciation is recognised so as to write off the cost or valuation
of assets (other than freehold land) less their residual values over their useful lives on the following
bases:
Buildings over 50 years
Plant and equipment over a period of 5 to 15 years
The gain or loss arising on the disposal of an asset is determined as the difference between the
sales proceeds and the carrying amount of the asset and is recognised in income.
Property, plant and machinery
Land and Plant and
buildings equipment Total
$’000 $’000 $’000
Cost or valuation
At 1 January 20X8 40,000 10,000 50,000
Revaluation surplus 12,000 – 12,000
Additions in year – 4,000 4,000
Disposals in year – (1,000) (1,000)
At 31 December 20X8 52,000 13,000 65,000
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Topic recap
HEADING
HKAS 16 Property, Plant and Equipment
Upwards revaluation
Carrying amount = Downwards
Carrying amount =
recognised as other
cost – accumulated revaluation
revalued amount –
comprehensive
depreciation – charged to
accumulated
income in revaluation
accumulated revaluation
depreciationsurplus
– to
surplus.
impairment losses. the extent it exists in
accumulated
respect of the
impairment asset
losses.
then as an expense.
Disclosure requirements:
Measurement bases Recoverable amounts
Depreciation methods and Restrictions on title
estimations Estimated costs of restoring site
Reconciliation of cost/revalued Expenditure on assets under
amount and accumulated construction
depreciation b/f to the same Capital commitments
amounts c/f Additional disclosure for revalued
assets
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Answer 1
The initial cost of an item of PPE includes its purchase price plus any costs directly attributable to
bringing the asset to the location and condition necessary for it to operate in the normal manner
intended by management.
Site selection costs are not directly attributable costs and are do not therefore form part of the
cost of the new warehouse; these are instead recognised in profit or loss as incurred. Site
preparation costs are, however, directly attributable to the completion of the warehouse and these
do form part of its cost.
HKAS 16 is clear that professional fees are part of the cost of an item of PPE and therefore both
legal costs and architects’ fees are included in the initial measurement. However, the architects’
fees include $ 125,000 relating to scrapped blueprints. This came about as a result of the directors’
decision to make the building environmentally friendly. These fees relate to wasted resources, and
as such HKAS 16 does not permit their inclusion in the initial measurement of the property.
Both construction materials and labour are directly attributable to the completion of the warehouse
and are included in the initial cost of the property. HKAS 16 does not allow the inclusion of a
proportion of general and administrative overheads in the cost of an asset; $190,000 is therefore
recognised in profit or loss.
The solar panels are an item of property, plant and equipment and their cost is capitalised as part
of the cost of the property. The cost of obtaining HKGBC certification is not a cost attributable to
bringing the warehouse into working condition. The warehouse would operate in the manner in
which it was intended to without this certification. Therefore this cost is recognised in profit or loss.
The initial measurement of the property is therefore:
$'000
Site preparation 1,320
Legal costs of acquiring site 340
Architects’ Fees (450 – 125) 325
Construction materials 2,720
Construction labour 2,400
Solar panels 350
7,455
Answer 2
Useful life is defined as either the period over which an asset is expected to be available for use by
an entity or the number of production or similar units expected to be obtained from the asset by an
entity.
As a computer system used for administrative purposes is unlikely to produce ‘units’, the first
definition is appropriate.
Here the computer system is expected to be available for use by Waitco for a period of 3 years.
After this time, Waitco expects to sell the system back to the supplier and replace it with a new
system. Therefore the useful life is 3 years.
The supplier’s claim as to the ‘full potential’ life of the asset is irrelevant to the determination of
useful life, as is the fact that the system can be used by a second owner for a further 8 years, so
giving a total economic life of 11 years.
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5: Property, plant and equipment | Part C Accounting for business transactions
Answer 3
(a) In year 1:
DEBIT Depreciation expense $2,000
$20,000 10%
CREDIT Accumulated depreciation $2,000
To recognise year 1 depreciation on the asset.
In year 2:
DEBIT Depreciation expense $1,800
($20,000 – $2,000) 10%
CREDIT Accumulated depreciation $1,800
To recognise year 2 depreciation on the asset.
(b) Year 1 Year 2
$ $
Cost 20,000 20,000
Accumulated depreciation
Yr 1 (2,000) (2,000)
Yr 2 – (1,800)
Carrying amount 18,000 16,200
(c) The diminishing balance method of depreciation is used instead of the straight line method
when it is considered fair to allocate a greater proportion of the total depreciable amount to
the earlier years and a lower proportion to the later years on the assumption that the benefits
obtained by the business from using the asset decline over time.
It may be argued that this method links the depreciation charge to the costs of maintaining
and running the computer system. In the early years these costs are low and the
depreciation charge is high, while in later years this is reversed.
Answer 4
(a)
Cost Depreciation Carrying amount
$ $ $
Component 1
Cost 900,000
Dismantling 101,472
($280,000 1,001,472 66,765 934,707
0.3624)
Component 2 650,000 130,000 520,000
Component 3 250,000 25,000 225,000
1,679,707
(b) Proceeds 140,000
CV at disposal (934,707)
Loss on disposal (794,707)
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Financial Reporting
(c)
Cost Depreciation Carrying amount
$ $ $
Component 1
Cost 910,000
Dismantling 96,950
($250,000 1,006,950 71,925 935,025
0.3878)
Component 2 650,000 260,000 390,000
Component 3 250,000 50,000 200,000
1,525,025
Answer 5
20X7
$ $
31 Mar DEBIT Loss on disposal 250
Accumulated depreciation* 6,750
Account receivable (sale price) 8,000
CREDIT Non-current asset (cost) 15,000
Being recording sales proceeds for disposal
31 Dec DEBIT Loss on disposal 3,750
Accumulated depreciation** 8,750
Cash (sale proceeds) 2,500
CREDIT Non-current asset (cost) 15,000
Being recording sales proceeds for disposal
* Depreciation at date of disposal = $6,000 + $750
** Depreciation at date of disposal = $6,000 + $2,750
You should be able to calculate that there was a loss on the first disposal of $250, and on the
second disposal of $3,750, giving a total loss of $4,000.
WORKINGS
(1) Accumulated depreciation
At 1 January 20X7, accumulated depreciation on the machines will be:
$15,000
2 machines 2 years per machine pa = $12,000, or $6,000 per machine
5
(2) Monthly depreciation
$3,000
Monthly depreciation is = $250 per machine per month
12
(3) Depreciation at date of disposal
The machines are disposed of in 20X7.
(a) On 31 March – after 3 months of the year.
Depreciation for the year on the machine = 3 months $250 = $750
(b) On 1 December – after 11 months of the year.
Depreciation for the year on the machine = 11 months $250 = $2,750
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5: Property, plant and equipment | Part C Accounting for business transactions
Answer 6
(a) The old head office was acquired on 1 July 20W2 at a cost of $24 million, with the acquisition
recorded by:
DEBIT Property $24,000,000
CREDIT Cash/payable $24,000,000
The property was depreciated over 50 years, giving an annual depreciation charge of $24
million/50 years = $480,000, recognised each year by:
DEBIT Depreciation expense $480,000
CREDIT Accumulated depreciation $480,000
Therefore at 1 April 20X2 when the property was revalued it had a carrying amount of:
$'000
Cost 24,000
Depreciation ($480,000 9.75 years) (4,680)
Carrying amount 19,320
At this date the property was revalued to $38 million. The journal to record this revaluation is
DEBIT Property (38,000 – 19,320) $18,680,000
CREDIT Other comprehensive income – $18,680,000
revaluation surplus
The credit entry is accumulated in a revaluation reserve in equity.
The property continued to be depreciated over the remaining 40.25 years of the total 50 year
useful life, giving an annual depreciation charge of $38,000,000/40.25 = $944,000 (to the
nearest $’000). The journal to recognise this depreciation is:
DEBIT Depreciation expense $944,000
CREDIT Accumulated depreciation $944,000
As OCC has a policy of maximising distributable reserves, the difference between the
$944,000 depreciation charge and the previous charge based on historic cost of $480,000 is
the subject of a reserves transfer:
DEBIT Revaluation reserve $464,000
CREDIT Retained earnings $464,000
Therefore at the disposal date the property had a carrying amount of:
$’000
Valuation 38,000
Depreciation y/e 31 March 20X3 (944)
Depreciation 1 April 20X3 – 30 September 20X3 (6 months) (472)
Carrying amount 36,584
The revaluation surplus has a carrying amount of:
$’000
Revaluation surplus at 1 April 20X2 18,680
Excess depreciation y/e 31 March 20X3 (464)
Balance 18,216
(Note the reserves transfer is annual and therefore no transfer will have been made for the 6
months ended 30 September 20X3).
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Financial Reporting
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Exam practice
RMB'000 RMB'000
Cost of land use right 45,000 48,000
Cost of construction (excluding the right 303,000 267,000
amortisation of land use right)
Fair value of land use right at 31 December 60,000 100,000
20X5
Fair value of the building at existing status as at 560,000 340,000
31 December 20X5
Date of purchase of land use right 1 July 20X3 1 October 20X3
Term of land use right of the property 75 years 60 years
Estimated useful life of the property 50 years 40 years
Completion of construction of the building December 20X4 June 20X5
Phoenix has adopted the cost model under HKAS 16 for property, plant and equipment and the fair
value model under HKAS 40 for investment property (buildings only). Depreciation is provided to
write off the cost of property, plant and equipment using the straight line method. The land use right
is considered as a lease and accounted for in accordance with the requirements under HKAS 17.
Amortisation of the cost of the land during the construction period is capitalised as part of the
development cost of the property.
Required
Calculate the amount of (1) land use right and (2) carrying amount of the building for each property
to be reflected in Phoenix's statement of financial position as at 31 December 20X5. (9 marks)
HKICPA September 2006 (amended)
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Financial Reporting
140
chapter 6
Investment property
Topic list
Learning focus
Some entities own land or buildings and treat them as an investment, i.e. in order to generate
income and cash flows independently of the other assets held by the entity. It is important that
you understand the difference between investment properties and other classes of assets,
and how to account for them.
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Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.10 Investment property 3
3.10.1 Identify an investment property within the scope of HKAS 40 and
situation when a property can be transferred in and out of the
investment property category
3.10.2 Distinguish investment property from other categories of property
holdings and describe the difference in accounting treatment
3.10.3 Apply the recognition and measurement rules relating to investment
property
3.10.4 Account for investment property
3.10.5 Disclose relevant information, including an accounting policy note,
for investment property
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6: Investment property | Part C Accounting for business transactions
HKAS 40 Investment Property was published in March 2000 with the objective of regulating the
accounting treatment for investment property and related disclosure requirements.
HKAS 40 does not deal with issues covered in HKAS 17. It includes investment property held
under a finance lease or leased out under an operating lease.
HKAS 40.5
1.1 Definitions
Key terms
Investment property is property (land or a building – or part of a building – or both) held (by the
owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both,
rather than for:
(a) Use in the production or supply of goods or services or for administrative purposes
(b) Sale in the ordinary course of business.
Owner-occupied property is property held by the owner (or by the lessee under a finance lease) for
use in the production or supply of goods or services or for administrative purposes.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Cost is the amount of cash or cash equivalents paid or the fair value of other consideration given to
acquire an asset at the time of its acquisition or construction.
Carrying amount is the amount at which an asset is recognised in the statement of financial
position.
A property interest that is held by a lessee under an operating lease may be classified and
accounted for as an investment property, if and only if the property would otherwise meet the
definition of an investment property and the lessee uses the HKAS 40 fair value model. This
classification is available on a property-by-property basis. (HKAS 40.5)
HKAS 40.8- The standard provides the following examples of investment properties:
12,
15 (a) Land held for long-term capital appreciation rather than for short-term sale in the ordinary
course of business.
(b) Land held for a currently undetermined future use.
(c) A building owned by the reporting entity (or held by the entity under a finance lease) and
leased out under an operating lease.
(d) A building that is vacant but held to be leased out under one or more operating leases.
(e) Property that is being constructed or developed for future use as investment property.
(f) A building held by an entity and leased to a parent or another subsidiary. Note, however,
that while this is regarded as an investment property in the individual entity's financial
statements, in the consolidated financial statements this property will be regarded as
owner-occupied (because it is occupied by the group) and will therefore be treated in
accordance with HKAS 16.
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Financial Reporting
The standard also clarifies that the following are not investment properties, but are instead within
the scope of the named standards:
(a) Property intended for sale in the ordinary course of business (HKAS 2)
(b) Property being constructed or developed for sale in the ordinary course of business
(HKAS 2)
(c) Property being constructed or developed on behalf of third parties (HKAS 11)
(d) Owner occupied property (HKAS 16), which includes:
(i) Property held for future owner-occupation
(ii) Property held for future development before owner-occupation
(iii) Property occupied by employees regardless of whether they pay market rent
(iv) Owner-occupied property awaiting disposal
(e) Property leased to another entity under a finance lease.
Where a property is partly owner-occupied and partly held to earn rentals or for capital
appreciation, its treatment depends on whether or not the portions of the property could be sold
separately (or leased out separately under a finance lease). If they could not be sold separately,
the property is only treated as investment property if an insignificant portion is held for owner-
occupier use.
Where an entity provides ancillary services to the occupants of a property it holds:
The property is treated as investment property where those ancillary services are
insignificant to the arrangement as a whole
The property is treated as owner-occupied where the ancillary services are significant, for
example the services provided to a hotel guest by the owner of the hotel indicate that a hotel
is owner-occupied.
1.1.1 Use of judgment
HKAS 40.14
HKAS 40 is clear that judgment should be applied in order to determine whether a property is an
investment property. Judgment should also be used to determine whether the acquisition of an
investment property is the acquisition of an asset/group of assets or a business combination within
the scope of HKFRS 3. In order to determine this, the guidance in both HKAS 40 and HKFRS 3
should be applied.
Self-test question 1
(a) Propex constructs properties, some of which are sold, some of which are occupied by the
company itself and some of which are let to tenants:
1 Tennant House is owned by Propex and let to its construction workers who pay
nominal rent.
2 Stowe Place which, until recently was Propex’s main administrative property. On 1
July 20X3, Propex acquired an alternative property and split Stowe Place into 20
separate units. Propex continues to use one of the units and rents the remainder out
to unconnected companies under finance leases. At 31 December 20X3, 8 of the units
are vacant.
3 Construction on Crocket Square began in August 20X3 and at 31 December it is two-
thirds complete. Propex intends to let this out to a company called Speedex in which it
has a controlling interest.
4 Smith Tower is an office complex let out to a number of commercial tenants. Propex
provides these tenants with security and maintenance services in the building.
Propex depreciates its buildings at 2% per annum on cost.
Required
Explain how each of these properties should be classified in the financial statements of
Propex in the year ended 31 December 20X3.
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(b) One of Propex’s subsidiaries, Robantic owns a large open plan warehouse in which it stores
excess stock. The warehouse offers significantly more space than Robantic requires and as
a result it rents out space to other companies that need to store goods on a short-term basis.
Required
Explain how the warehouse should be classified in the financial statements of Robantic.
(The answer is at the end of the chapter)
Below is the decision tree showing which HKFRS should be applied to various kinds of property:
Is the asset complete and
held for use in the production
or supply of goods or services
or for administrative purposes
i.e. wholly owner occupied
(including occupied by
another group entity in the Yes
case of consolidated
accounts)? Asset is accounted for as
PPE (HKAS 16)
No
Is the asset under
development for future owner
Yes
occupation?
No
Is the asset complete and
held for sale in the ordinary
Yes
course of business?
No Asset is accounted for as
inventories (HKAS 2)
Is the asset being constructed
or developed for sale in the
Yes
ordinary course of business?
No
Is the asset being constructed Yes Asset is accounted for as
or developed on behalf of construction contract
third parties? (HKAS 11)
No
Is the asset partly owner Can the part which is owner
occupied? occupied be sold or leased
Yes
under a finance lease in a
separate transaction?
No
Is the asset leased out under Yes Asset is accounted for
a finance lease? under HKAS 17
No Yes
No
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Financial Reporting
Asset should be recognised Yes Is the part of the asset Asset should be
as an investment property which is owner occupied separated into
under HKAS 40 insignificant? component parts. The
portion which is not
No
owner occupied is
Asset is recognised as investment property
property, plant and (HKAS 40); the portion
equipment under HKAS 16 which is owner occupied
is PPE (HKAS 16)
HKAS
40.20,25
1.3 Initial measurement
An investment property should be measured initially at its cost, including transaction costs.
A property interest held under a lease and classified as an investment property shall be accounted
for as if it were a finance lease. The asset is recognised at the lower of the fair value of the property
and the present value of the minimum lease payments. An equivalent amount is recognised as a
liability.
HKAS
40.30,34
1.4 Measurement subsequent to initial recognition
Topic highlights
Entities can choose between:
Fair value model, with changes in fair value being measured
Cost model – the treatment most commonly used under HKAS 16
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6: Investment property | Part C Accounting for business transactions
The journal entry required to recognise an increase in the fair value of an investment
property is therefore:
DEBIT Investment property X
CREDIT Profit or loss X
The journal entry required to recognise a decrease in the fair value of an investment property
is:
DEBIT Profit or loss X
CREDIT Investment property X
HKAS 40 was the first time that the HKICPA has allowed a fair value model for non-financial
assets. This is not the same as a revaluation of assets where increases in carrying amount above a
cost-based measure are recognised as revaluation surplus (i.e., as a reserve, in equity). Under the
fair value model all changes in fair value are recognised in profit or loss.
HKFRS 13 Fair Value Measurement, issued in May 2011, deleted much of the guidance provided
in HKAS 40 in respect of the determination of fair value. Instead the requirements of HKFRS 13
apply in measuring the fair value of investment properties.
HKFRS 13 is considered in detail in Chapter 19 of this Learning Pack.
The guidance which remains in HKAS 40 is as follows:
(a) Double counting should be prevented in deciding on the fair value of the assets. For
example, elevators or air conditioning, which form an integral part of a building should be
incorporated in the investment property rather than recognised separately.
(b) According to the definition in HKAS 36 Impairment of Assets, fair value is not the same as
‘value in use’. The latter reflects factors and knowledge as relating solely to the entity, while
the former reflects factors and knowledge applicable to the market.
(c) In those uncommon cases in which the fair value of an investment property cannot be
determined reliably by an entity, the cost model in HKAS 16 must be employed until the
investment property is disposed of. The residual value must be assumed to be zero.
1.4.2 Operating lease and investment property
In respect of leased property that qualifies as an operating lease, the lessee has the option to
classify the leased property as investment property provided that the lessee uses the fair value
model of HKAS 40 and the relevant criteria are met and all of the investment property must only be
accounted for under the fair value model. This means that the components of land and
buildings of the lease need not be split in order to calculate whether it is a finance lease or
operating lease.
Self-test question 2
Barnett Simpson Investments (BSI) acquired Mountain Square, a fifteen-storey office block, on 1
July 20X3 at a cost of $82.5 million. The property is divided into units of varying sizes and BSI rents
office space in it to small businesses on annual leases. The company occupies the top floor for its
own use, running its accounts department from this location. BSI provides its tenants in this
property with a number of additional services including a manned reception, provision of security
and property maintenance services. At 30 June 20X4 the property had a fair value of $91.5 million.
The company depreciates owner-occupied property over 50 years and measures it using the
historic cost model; investment property is measured using the fair value model.
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Financial Reporting
Required
Explain how Mountain Square should be classified in the financial statements of BSI at 30 June
20X4 and state the required journal entries in respect of Mountain Square in that year.
HKAS 40.31 1.4.4 Changing models
An entity should apply its chosen fair value model or cost model to all its investment property.
It should not change its model unless the change will result in a more appropriate
presentation. HKAS 40 states that it is very unlikely that a change from the fair value model to the
cost model will end up in a more appropriate presentation.
A change in model is accounted for as a change of accounting policy (HKAS 8) and should be
applied retrospectively.
HKAS 40.57-
65
1.5 Transfers
Transfers to or from investment property should be made when, and only when, there is a change
in the use of the property as follows:
Notes
1 Where an entity decides to sell an investment property without development, it is not
transferred to inventory but remains in investment property until the date of disposal.
2 Where an entity begins to redevelop an investment property for continued future use as an
investment property, it is not reclassified during the redevelopment, but remains an
investment property.
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6: Investment property | Part C Accounting for business transactions
Note
Where fair value is less than the carrying amount of the property, the decrease is recognised in
profit or loss (usually in the same account as that to which depreciation has been charged). To the
extent that an amount is included in revaluation surplus for that property, the decrease is first
recognised in other comprehensive income and reduces the revaluation surplus within equity.
The journal entries to record the transfer where fair value is less than carrying amount are
therefore:
(DEBIT Other comprehensive income X
(revaluation surplus)
DEBIT Profit or loss X
CREDIT Property, plant and equipment X
and
DEBIT Investment property X
CREDIT Property, plant and equipment X
Where fair value is greater than the carrying amount of the property:
(a) To the extent that the increase reverses a previous impairment loss for that property, the
increase is recognised in profit or loss (in the same account as that where the impairment
was initially recognised). The amount recognised in profit or loss cannot exceed the amount
needed to restore the carrying amount to the carrying amount that would have been
determined (net of depreciation) had no impairment loss been recognised; and
(b) Any remaining part of the increase is recognised in other comprehensive income and
increases the revaluation reserve within equity. On subsequent disposal of the investment
property, the revaluation surplus included in equity may be transferred to retained earnings.
The transfer from revaluation reserve to retained earnings is not made through the statement
of profit or loss and other comprehensive income.
The journal entries to record the transfer where fair value is greater than carrying amount are
therefore:
DEBIT Property, plant and equipment X
CREDIT Other comprehensive income X
(revaluation surplus)
CREDIT Profit or loss X
and
DEBIT Investment property X
CREDIT Property, plant and equipment X
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Financial Reporting
Self-test question 3
Golding Muirhead Property (GMP), a property construction company, completed the construction of
the M Building -a complex of 80 apartments in Shanghai – at the end of March 20X4. On 1 June
20X4, as a result of a lack of buyers in the market, and a recent fall in selling prices, GMP decided
to take the property off the market. Instead the company decided to rent out the individual
apartments in the M Building until the market improves. Rental arrangements were agreed
immediately on half of the apartments. The company expects an improvement in the market to take
four years. GMP cost $80million to develop and had a fair value on completion of $89million, and
fair values of $83.5million and $81.2 million on 1 June 20X4 and 30 June 20X4 respectively. GMP
measures investment properties using the fair value model.
Required
Explain how the M Building should be classified in the financial statements of GMP at 30 June
20X4 and what amounts are included in the financial statements for the year in respect of the
property, based on the information provided.
(The answer is at the end of the chapter)
1.6 Disposals
HKAS
40.66,69,72 An investment property should be derecognised (eliminated from the statement of financial
position) on disposal or when it is permanently withdrawn from use and no future economic
benefits are expected from its disposal.
A gain or loss on disposal arises when there is a difference between the net disposal proceeds and
the carrying amount of the asset. It should generally be recognised in profit or loss as income or
expense (in the same account as that where changes in fair value have been recorded).
Compensation from third parties for investment property that was impaired, lost or given up should
be recognised in profit and loss when the compensation becomes receivable.
HKAS 16 HKAS 40
HKAS 16 revaluation HKAS 40 fair value
cost model model HKAS 2 cost model model
Measurement Cost less Revalued Lower of cost Cost less Fair value
in statement depreciation amount less and net depreciation
of financial less depreciation realisable less
position impairment less value impairment
losses impairment losses (same
losses as cost model
in HKAS 16)
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6: Investment property | Part C Accounting for business transactions
151
Financial Reporting
Illustration
1 Significant accounting policies
Investment properties
Investment properties are investments in land and buildings that are held to earn rentals or
for capital appreciation or both. Such properties are carried in the statement of financial
position at their fair value as determined by professional valuation. Changes in fair values of
investment properties are recorded in the statement of profit or loss.
2 Critical accounting estimates and judgments
Investment properties valuation
Investment properties are carried in the statement of financial position at their fair value as
determined by professional valuation. In determining the fair value of the investment
properties, the valuers use assumptions and estimates that reflect, amongst other things,
comparable market transactions, rental income from current leases and assumptions about
rental income from future leases in the light of current market conditions. Judgment is
required to determine the principal valuation assumptions to determine the fair value of the
investment properties.
Investment properties
Fair value $’m
At 1 January 20X3 23.60
Increase in fair value during the year 0.15
At 31 December 20X3 23.75
Increase in fair value during the year 0.25
Transferred from property, plant and equipment 3.00
At 31 December 20X4 27.00
The fair value of the Group’s investment property at 31 December 20X4 has been arrived at
on the basis of valuation carried out at that date by Valuer Co, independent valuers not
connected with the Group.
The Group has pledged all of its investment property to secure general banking facilities
granted to the Group.
The property rental income earned by the Group from its investment property, all of which is
leased out under operating leases, amounted to $980,000 (20X3: $975,000). Direct
operating expenses arising on the investment property in the period amounted to $231,000
(20X3: $430,000).
The Group has entered into a contract for the maintenance of its investment property for the
next five years which will give rise to an annual charge of $150,000.
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6: Investment property | Part C Accounting for business transactions
Topic recap
Disclose
Land, building
singleoramount
part ofinbuilding
statement
heldofby Disclose
Whichsingle
measurement
amount inmodel
statement
is applied
of
comprehensive
the owner (or lessee
incomeunder
comprising:
finance lease) comprehensive
Criteria for classification
income comprising:
as investment property
to earn
Post
rentals/for
tax profit
capital
or loss
appreciation
of the rather UsePost
of independent
tax profit or valuer
loss of the
than fordiscontinued
use/sale in the
operations
ordinaryand course of Amounts
discontinued
recognised
operations
in profitand
or loss
business.
Post Includes:
tax gain or loss on Restrictions
Post tax gain
or obligations
or loss onassociated with the
Land disposal/measurement
held for undeterminedtofuturefair use property.
disposal/measurement to fair
Property
value being
less costs
constructed
to sell. for use as an value less costs to sell.
investment property
153
Financial Reporting
Answer 1
(a) 1 Tennant House
This property initially appears to meet the definition of investment property as it
is let to tenants.
HKAS 40 is, however, clear that where a property is let to employees, it is
owner occupied, regardless of whether those employees pay market rent.
Therefore Tennant House is within the scope of HKAS 40.
2 Stowe Place
Stowe place is part owner-occupied and part investment property.
HKAS 40 therefore requires that we consider whether the property is separable,
i.e. whether the units within the property could be sold or leased separately
under finance leases.
The answer to this is yes, as the units are already leased separately under
finance leases.
Therefore the one unit used by Propex is classified as property, plant and
equipment, and the remaining units are classified as investment property.
The fact that 8 units are not rented out at the reporting date is irrelevant as the
empty units still have the capacity to earn rentals.
1/20 of the property is therefore within the scope of HKAS 16 and the remaining
19/20 is within the scope of HKAS 40.
3 Crocket Square
Propex is constructing the property to let out to another company, Speedex.
During construction, and after completion, the property is therefore within the
scope ofHKAS 40 and should be accounted for as an investment property in
Propex’s individual accounts.
As Speedex is a subsidiary of Propex, the property will be owner-occupied from
a group perspective and therefore HKAS 16 is applied at a consolidation level.
4 Smith Tower
The service and maintenance services provided by Propex to its tenants would
be deemed not significant to the arrangement as a whole. Therefore, Propex
should treat Smith Tower as an investment property and apply the provisions of
HKAS 40.
(b) The warehouse is held by Robantic in part for its own use and in part in order to earn rentals.
In this case the different parts of the property are not separable; the part of the property that
is rented could not be sold separately or leased under a finance lease as it is not physically
separate from the part of the property used by Robantic. In this case HKAS 40 states that
the property is investment property in its entirety if only an insignificant part of the property
is used by Robantic itself. Insignificant is not defined by HKAS 40 and judgment is required
in order to apply this concept. It is likely that further information is required in this case in
order to establish the size of the area used by Robantic and, if relevant, the proportion of the
cost of the property that the owner occupied part represents.
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Answer 2
HKAS 40 defines owner-occupied property as property held for use in the production or supply of
goods or services or for administrative purposes. The top floor of Mountain Square is occupied by
BSI for administrative purposes and so meets this definition.
HKAS 40 defines investment property as property held to earn rentals or for capital appreciation or
both. The 14 floors of Mountain Square that are rented out would appear to meet this definition,
although the ancillary services provided must also be considered.
If ancillary services are significant to an arrangement as a whole, HKAS 40 concludes that the
property is owner-occupied; if the ancillary services are insignificant, it is investment property.
A degree of judgment must be applied but it would appear that the services provided by BSI are
insignificant and therefore the 14 floors do qualify as investment property.
HKAS 40 requires that where a property is part owner-occupied and part investment property, the
portions are accounted for separately if they could be sold separately or leased out separately
under a finance lease.
Although the leases over units in the 15 non-owner occupied floors are operating leases, they
could be equally be finance leases. Therefore it appears appropriate to split-account for the
property with 1/15 accounted for under HKAS 16 as owner occupied property and the remaining
14/15 under HKAS 40 as investment property.
Therefore the property is initially recognised on 1 July 20X3 by:
DEBIT Investment property $77,000,000
(14/15 $82,500,000)
DEBIT Property, plant and equipment $5,500,000
(1/15 $82,500,000)
CREDIT Bank $82,500,000
The owner-occupied portion is depreciated in the year ended 30 June 20X4 by:
DEBIT Depreciation expense $110,000
($5,500,000/50 years)
CREDIT Property, plant and equipment $110,000
At 30 June 20X4, the investment property portion is remeasured to its fair value of $85,400,000
(14/15 x $91,500,000) by:
DEBIT Investment property $8,400,000
($85.4m – $77m)
CREDIT Gain on investment property (profit $8,400,000
or loss)
Answer 3
The M Building was built as a property intended for sale in the ordinary course of business and
therefore it was classified as inventory. The issue is whether the property is still inventory after 1
June 20X4, or whether it should be transferred to investment property.
The property should continue to be inventory if this is consistent with GMP’s strategy for the
property; it should be transferred to investment property if there has been a change in the
management’s intentions and they intend to hold the property for future rentals or capital
appreciation.
The correct classification of the M Building requires the application of judgment. The fact that rental
agreements have been arranged does not in itself mean that reclassification to investment property
is required. It does, however, indicate that management intentions may have changed. This view is
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Financial Reporting
further reinforced by the decision to stop marketing the property. However, the transfer to inventory
is limited to the portion that have signed rental agreements, which is half. (The IASB has added a
project to its work plan to clarify whether this interpretation is valid, but for now it is.)
Therefore, on balance, half the property should be transferred to investment property at 1 June
20X4.
As inventory prior to transfer, the property is carried at cost of $80 million of which $40 million
relates to the properties on which rental agreements have been signed. Where there is a transfer
from inventory to investment property carried at fair value any difference between the fair value of
the property and its previous carrying amount is recognised in profit or loss.
Therefore on 1 June 20X4, the property is transferred to investment property at $41.75 million
($83.5 million × 50%) and $1.75 million ($3.5 million × 50%) is recognised as a gain in profit or loss
by:
DEBIT Investment property $41,750,000
CREDIT Inventory $40,000,000
CREDIT Other income (profit or loss) $1,750,000
On 30 June 20X4, the property is re-measured to $40.6 million ($81.2 million × 50%) and a loss of
$1.15 million is recognised in profit or loss by:
DEBIT Operating expense (profit or loss) $1,150,000
CREDIT Investment property $1,150,000
Therefore in the statement of financial position at 30 June 20X4, the applicable portion of M
Building is recognised as investment property, measured at $40.6 million
In the statement of profit or loss for the year ended 30 June 20X4, a net gain on investment
property of $0.6 million is recognised.
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6: Investment property | Part C Accounting for business transactions
Exam practice
In the board meeting held on 30 September 20X7, the management of CLL determined to sell
Buildings B and C. A property agency was appointed in the following month to identify potential
buyers. In addition, CLL moved the storage of its inventories in Building A to a new production plant
in Shenzhen. At 31 December 20X7, all three buildings were vacant.
CLL has accounted for (i) the building under property, plant and equipment at cost basis and
depreciated the cost with the estimated useful life of 30 years, (ii) the investment property at fair
value model, and (iii) the land cost as operating lease under HKAS 17. Cost and fair value of the
land are assumed to be zero. Cost to sell the buildings is estimated at 0.5% of the disposal value of
the asset.
Required
Determine the statement of financial position classification of these three buildings and calculate
the respective amounts to be recognised on the statement of financial position as at 31 December
20X7. (15 marks)
HKICPA February 2008 (amended)
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Financial Reporting
(b) Refurnished Tower C at a cost of HK$1.8 million in April and May 20X3 and then rented it
out to earn rental income since 1 June 20X3
(c) Completed the construction of Tower B by end of May 20X3 with additional expenditure of
HK$3.8 million
(e) Sold Tower D at HKD30 million to an independent third party and entered into a lease of the
premises for 2 years at a market rental of HK$80,000 per month on 1 May 20X3
An external valuer has been engaged to perform a valuation for all the properties except Tower D
and the estimated fair values at 31 March 20X3 and 30 June 20X3 are as follows:
31 March 20X3 30 June 20X3
HK$’m HK$’m
Tower A 26.4 27.2
Tower B 17.4 19.2
Tower C 38.0 40.0
Required
(a) Explain the implication of the activities occurred during the six months ended 30 June 20X3
on the classification and the effective date for each of the properties of RLC. (6 marks)
(b) Determine the carrying amount at 30 June 20X3 for each of the properties owned by RLC.
(5 marks)
(c) Identify the nature and quantify the amount of each income and expenses item to be
recognised in the statement of comprehensive income for the six months ended 30 June
20X3 of RLC in relation to each of these properties. (12 marks)
Note: Ignore tax effect and rental income from investment properties.
(Total = 23 marks)
HKICPA December 2013
158
chapter 7
Government grants
Topic list
Learning focus
Entities in many different countries receive government grants for all sorts of reasons, very
often to encourage growth and industry in certain areas, or to help them overcome external
difficulties, such as economic difficulties. This chapter covers how to account for government
grants.
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Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.03 Government grants and assistance 3
3.03.01 Accounting and presentation of government grants
3.03.02 Disclosure of government grants and assistance in accordance with
HKAS 20
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7: Government grants | Part C Accounting for business transactions
Key terms
Government. Government, government agencies and similar bodies whether local, national or
international.
Government assistance. Action by government designed to provide an economic benefit specific
to an entity or range of entities qualifying under certain criteria.
Government grants. Assistance by government in the form of transfers of resources to an entity in
return for past or future compliance with certain conditions relating to the operating activities of the
entity. They exclude those forms of government assistance which cannot reasonably have a value
placed upon them and transactions with government which cannot be distinguished from the
normal trading transactions of the entity.
Grants related to assets. Government grants whose primary condition is that an entity qualifying
for them should purchase, construct or otherwise acquire non-current assets. Subsidiary conditions
may also be attached restricting the type or location of the assets or the periods during which they
are to be acquired or held.
Grants related to income. Government grants other than those related to assets.
Forgivable loans. Loans which the lender undertakes to waive repayment of under certain
prescribed conditions.
Fair value. This is the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date.
(HKAS 20.3)
Government assistance can be of various forms since both the type of assistance and the
conditions related to it may differ. It may have the impact of encouraging an entity to undertake
something it otherwise would not have done.
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Financial Reporting
How will the financial statements be affected by the receipt of government assistance?
(a) Any resources transferred to an entity must be accounted for using an appropriate method.
(b) Disclosure in the notes to the accounts is required to show the magnitude to which an entity
has benefited from such assistance.
HKAS 20.7-
11
1.3 Government grants
Government grants (including non-monetary grants at fair value) should only be recorded when the
entity has reasonable assurance that:
The entity will comply with any conditions attached to the grant
The entity will actually receive the grant
The receipt of the grant does not mean that the conditions attached to it have been or will be
fulfilled.
The manner of receipt of the grant, whether it is in cash or as a reduction in a liability to the
government, is irrelevant in the treatment of the grant.
Once a grant has been recognised, any contingency associated with it should be accounted for
under HKAS 37 Provisions, Contingent Liabilities and Contingent Assets.
When a forgivable loan (as given in the key terms above) is received from the government and it
is reasonably assured that the entity will meet the appropriate terms for forgiveness, it should be
treated in the same way as a government grant. In addition, a loan at a below-market rate of
interest is to be dealt with as a government grant.
A benefit of a government loan at a below-market rate of interest is treated as a government
grant. The loan shall be recognised and measured in accordance with HKFRS 9 Financial
Instruments. The benefit of the below-market rate of interest shall be measured as the difference
between the initial carrying value of the loan determined in accordance with HKFRS 9 and the
proceeds received. The benefit is accounted for in accordance with this standard. The entity shall
consider the conditions and obligations that have been, or must be, met when identifying the costs
for which the benefit of the loan is intended to compensate.
Self-test question 1
What are the different arguments used in support of each method?
(The answer is at the end of the chapter)
HKAS 20 requires that the income approach should be adopted in the recognition of grants. In
other words, grants received should be recognised in profit or loss on a systematic basis over the
relevant accounting periods in which the entity recognises as expenses the related costs.
A systematic basis of matching should be used to avoid a violation of the accrual assumption to
treat grants in profit or loss on a receipts basis. This latter basis would only be acceptable when no
other basis was available.
The related cost to a government grant can easily be identified and thereby the period(s) in which
the grant should be recognised in profit or loss, i.e. when the costs are incurred by the entity.
Grants received relating to a depreciating asset will be recognised, in the same proportion, over the
periods in which the asset is depreciated.
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7: Government grants | Part C Accounting for business transactions
Self-test question 2
On 1 January 20X8, Xenon Co. purchased a non-current asset for cash of $100,000 and received
a grant of $20,000 towards the cost of the asset. Xenon Co.'s accounting policy is to treat the grant
as deferred income. The asset has a useful life of five years.
Required
Show the accounting entries to record the asset and the grant in the year ended 31 December
20X8.
(The answer is at the end of the chapter)
Certain obligations may have to be fulfilled for grants relating to non-depreciable assets. In such
a case, the grant should be recognised in profit or loss over the periods in which the cost of
meeting the obligation is incurred. For example, if a piece of land is granted on the condition that a
building is erected on it, then the grant should be recognised in profit or loss over the building's life.
If a series of conditions, in the form of a package of financial aid, are attached to the grant, then
the entity must be careful in identifying precisely those conditions which give rise to costs which in
turn determine the periods in which the grant will be earned. The grant may also be split into parts
and allocated on different bases.
Grants received as compensation for expenses or losses which an entity has already incurred
and grants given merely to provide immediate financial support where there are no foreseeable
related costs, should be recognised in profit or loss of the period in which they become receivable.
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Financial Reporting
Solution
The results of the company would be as follows:
(a) Reducing the cost of the asset
20X8 20X9 20Y0
$ $ $
Profits
Profit before depreciation 250,000 280,000 315,000
Depreciation* 12,000 12,000 12,000
Profit 238,000 268,000 303,000
*The depreciation charge on a straight line basis, for each year, is 2% × ($700,000
$100,000) = $12,000.
STATEMENT OF FINANCIAL POSITION AT YEAR END (EXTRACT)
$ $ $
Non-current asset at cost 600,000 600,000 600,000
Depreciation 12,000 24,000 36,000
Carrying amount 588,000 576,000 564,000
(b) Treating the government grant as deferred income
20X8 20X9 20Y0
$ $ $
Profits
Profit before grant
and depreciation 250,000 280,000 315,000
Depreciation (14,000) (14,000) (14,000)
Government grant 2,000 2,000 2,000
Profit 238,000 268,000 303,000
Whichever of these methods is used, the cash flows in relation to the purchase of the asset and
the receipt of the grant are often disclosed separately because of the significance of the
movements in cash flow.
HKAS 20.29- 1.3.4 Presentation of grants related to income
31
Grants related to income are a credit in the statement of profit or loss and other comprehensive
income. There are two alternative methods of disclosure.
(a) Present as a separate credit or under a general heading, e.g. 'other income'.
(b) Deduct from the related expense.
The disclosure has been a subject of controversy. Some would argue that it is not good practice to
offset income and expenses in the statement of profit or loss and other comprehensive income,
others would say that offsetting is acceptable since the expenses would not have been incurred
had the grant not been available. A proper understanding of the financial statements is required
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7: Government grants | Part C Accounting for business transactions
for the disclosure of the grant, particularly the effect on any item of income or expense which is to
be separately disclosed.
Self-test question 3
On 1 July 20X4, Dodds Plaice Co (‘DP’), an engineering company, received notification that it
would be awarded a grant of $60,000 conditional upon employing an apprentice for a two-year
period. DP received the grant on 1 August 20X4 and employed an apprentice on a two year
contract on 1 September 20X4. The apprentice’s salary is agreed at $36,000 in the first year of
employment and $40,000 in the second year. It is DP’s policy to present grant income separately in
the financial statements.
Required
(a) Explain how DP should recognise income from the grant.
(b) Show the accounting entries that DP should make to record the cost of the apprentice’s
salary and the grant in the year ended 31 December 20X4.
(c) Prepare extracts from DP’s financial statements for the year ended 31 December 20X4.
(The answer is at the end of the chapter)
Self-test question 4
On 1 January 20X5, The Welfare Corporation (‘TWC’) receives a grant of $1 million from the Hong
Kong government for the purpose of operating a drugs rehabilitation programme over a 2 year
period. 75% of the costs of operating the programme were expected to be incurred in its first year.
In February 20X6, the government realised that not all of the conditions stipulated in the grant
documentation were met by TWC, and asked for $600,000 to be refunded. TWC repaid this in
March 20X6
Required
Show the accounting entries required by TWC in the years ended 31 December 20X5 and 31
December 20X6.
(The answer is at the end of the chapter)
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Financial Reporting
HKAS 20.34-
36
1.4 Excluded government assistance
The definition of government grants does not include some forms of government assistance.
(a) Some forms of government assistance cannot reasonably have a value placed on them,
e.g. free technical or marketing advice, provision of guarantees.
(b) There are transactions with government which cannot be distinguished from the entity's
normal trading transactions, e.g. government procurement policy resulting in a portion of
the entity's sales. Any segregation would be arbitrary.
The government assistance may have to be disclosed because of its significance; nature, extent
and duration.
Solution
Accounting policy
Government grants are not recognised until there is reasonable assurance that the Company will
comply with the conditions attached to them and that the grants will be received.
Government grants towards research costs are recognised as income over the period necessary to
match them to the related costs and are deducted in reporting the related expense.
Government grants
A grant of $750,000 was received on 31 July 20X8. The grant was awarded by the Enterprise Zone
Grant Committee and is conditional upon Sunbeam conducting research activities over a three year
period. The company has, to date, set up the required research activities and completed four
months of work. Sunbeam expects these research activities to continue for the required period of
time.
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7: Government grants | Part C Accounting for business transactions
the entity. Examples of this kind of assistance are transfers of resources by governments to entities
which:
Operate in a specific industry
Continue to operate in newly privatised industries
Commence or continue to operate in underdeveloped areas
If the government assistance is considered as a ‘government grant’ within the scope of HKAS 20,
then it should be accounted for in accordance with this standard.
Even if there are no circumstances particularly relating to the operating activities of the entity other
than the requirement to operate in certain regions or industry sectors, government assistance to
entities still meets the definition of government grants in HKAS 20 and should not be credited
directly to equity.
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Financial Reporting
Topic recap
Transfer of
Disclose single
resources
amount from
in statement
government of Outside definition
Disclose single amount
of grants:
in statement of
comprehensive
to an entity in return
income
for comprising:
compliance comprehensive
1. Government income
assistance
comprising:
without
with certain
Post conditions.
tax profit or loss of the Post
valuetax
e.g.
profit or loss of the
discontinued operations and discontinued operations
Free technical adviceand
Includes:
Post tax gain or loss on Post
tax gain or
Provision of loss on
guarantees
disposal/measurement
Forgivable loans to fair disposal/measurement to fair
Below value less costs
market to loans
interest sell. 2. value
Transactions
less costs
withtogovernment
sell.
Non-monetary assets (grant = fair value that cannot be distinguished
of asset) from normal trading
Excludes government assistance without transactions.
value.
Disclose single
Recognise when amount
there in statement of
is reasonable Disclose if significant
comprehensive
assurance that: income comprising:
1. Postentity
the tax profit or loss with
will comply of the
conditions
discontinued
attached to theoperations
grant and
Post tax gain or loss on
disposal/measurement
2. the entity will receive the to fair
value less costs to sell.
grant.
Presentation
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7: Government grants | Part C Accounting for business transactions
Answer 1
The standard gives the following arguments in support of each method.
Capital approach
(a) The grants are a financing device, so should go through the statement of financial position.
In the statement of profit or loss and other comprehensive income they would simply offset
the expenses which they are financing. No repayment is expected by the government, so the
grants should be recognised outside profit or loss.
(b) Grants are not earned, they are incentives without related costs, so it would be wrong to
take them to profit or loss.
Income approach
(a) The grants are not received from shareholders so should not be recognised directly in
equity, but should be recognised in profit or loss in appropriate periods.
(b) Grants are not given or received for nothing. They are earned by compliance with
conditions and by meeting obligations. They should therefore be recognised in profit or loss
over the periods in which the entity recognises as expenses the related costs for which the
grant is intended to compensate.
(c) Grants are an extension of fiscal policies and so as income taxes and other taxes are
expenses, so grants should be recognised in profit or loss.
Answer 2
Acquisition of the asset and receipt of the grant on 1 January 20X8:
$ $
DEBIT Non current assets 100,000
CREDIT Bank 100,000
To record the asset at its cost
DEBIT Bank 20,000
CREDIT Deferred income 20,000
To record the receipt of the grant
In the year ended 31 December 20X8 the asset is depreciated and a portion of the grant is
released to the statement of profit or loss:
DEBIT Depreciation expense ($100,000 / 5 years) 20,000
CREDIT Accumulated depreciation 20,000
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Financial Reporting
Answer 3
(a) A grant is recognised as income when there is reasonable assurance that the entity will:
(i) comply with any conditions attached to the grant and
(ii) actually receive the grant.
The second condition is met on 1 August 20X4 when DP received the grant monies,
however at this date it is unclear whether the company will comply with the requirement to
employ an apprentice. Therefore the grant is initially recognised as a liability (deferred
income) rather than income. The first condition ie compliance with the requirement to
employ an apprentice is met on 1 September 20X4. From this date the grant is therefore
recognised as income over the two-year conditional period.
(b) Journal entries
1 August 20X4
$ $
DEBIT Bank 60,000
CREDIT Deferred income – grant 60,000
To record receipt of grant.
31 December 20X4
$ $
DEBIT Staff costs (4/12m x $36,000) 12,000
CREDIT Bank 12,000
To record payment of the apprentice’s salary for 4 months of 20X4
and
$ $
DEBIT Deferred income – grant (working) 9,474
CREDIT Grant income (profit or loss) 9,474
To record release of deferred grant income
Working
36
$60,000 4/12 months = $9,474
36 + 40
(c) Statement of profit or loss for the year ended 31 December 20X4
$
Staff costs 12,000
Grant income (9,474)
Statement of financial position as at 31 December 20X4
$
Current liabilities
Deferred grant income (working) 29,473
Long-term liabilities
Deferred grant income (working) 21,053
Working
Within 1 year $
36/(36+40) $60,000 8/12m 18,947
40/(36+40) $60,000 4/12m 10,526
29,473
After 1 year
40/(36+40) $60,000 8/12m 21,053
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7: Government grants | Part C Accounting for business transactions
Answer 4
1 January 20X5
$ $
DEBIT Bank 1,000,000
CREDIT Deferred income – grant 1,000,000
To record receipt of grant.
31 December 20X5
$ $
DEBIT Deferred income – grant (75% $1m) 750,000
CREDIT Grant income (profit or loss) 750,000
To record release of deferred grant income to match costs
March 20X6
$ $
DEBIT Deferred income – grant 250,000
DEBIT Operating expenses 350,000
CREDIT Bank 600,000
To record part-repayment of grant.
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Financial Reporting
Exam practice
MHL 11 minutes
MHL Group conducts research and development projects in Country X. It has invested $50 million
in equipment for its research and development centre. The equipment has an estimated useful life
of ten years and is depreciated on a straight-line basis. In the period of acquisition, MHL Group
received an interest free loan of $25 million from the provincial government in Country X towards
the purchase of the equipment, which is conditional on the employment targets to be achieved
within the next five years.
Required
Advise the appropriate accounting treatment and the presentation of the interest free loan form the
provincial government in the financial statements. (6 marks)
HKICPA December 2014 (amended)
172
chapter 8
Learning focus
Impairment of assets is particularly relevant in the current economic climate and several
companies are now having to apply the requirements with regard to accounting for impairment
for the first time.
173
Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.09 Intangible assets 3
3.09.01 Define an intangible asset and scope of HKAS 38
3.09.02 Apply the definition of an intangible asset to both internally-
generated and purchased intangibles
3.09.03 Account for the recognition and measurement of intangible assets
in accordance with HKAS 38
3.09.04 Describe the subsequent accounting treatment of intangible assets
including amortisation
3.09.05 Distinguish between research and development and describe the
accounting treatment of each
3.09.06 Explain how goodwill arises
3.09.07 Account for goodwill
3.09.08 Disclose relevant information in respect of intangible assets under
HKAS 38
3.13 Impairment of assets 3
3.13.01 Identify assets that are within the scope of HKAS 36
3.13.02 Identify an asset that may be impaired by reference to common
external and internal indicators
3.13.03 Identify the cash generating unit an asset belongs to
3.13.04 Calculate the recoverable amount with reference to value-in-use
and fair value less cost to sell
3.13.05 Calculate the impairment loss, including the loss relating to cash-
generating units
3.13.06 Allocate impairment loss and account for subsequent reversal
3.13.07 Disclose relevant information with regard to impairment loss,
including critical judgment and estimate
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8: Intangible assets and impairment of assets | Part C Accounting for business transactions
HKAS 38 Intangible Assets was issued in August 2004 and revised in May 2009 to reflect changes
introduced by HKFRS 3 (revised) Business Combinations.
HKAS 38.8-
10
1.3 Definition of an intangible asset
Key terms
An intangible asset is an identifiable non-monetary asset without physical substance.
An asset is a resource which is:
(a) Controlled by the entity as a result of events in the past
(b) Something from which the entity expects future economic benefits to flow
Examples of items that might be considered as intangible assets therefore include computer
software, patents, copyrights, motion picture films, customer lists, franchises, brands and fishing
rights.
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Financial Reporting
An item should not be recognised as an intangible asset, however, unless it meets this definition in
full. In other words it is:
(a) Identifiable
(b) Controlled by the entity as a result of past events
(c) Expected to result in future economic benefits
Each of these elements of the definition is considered in turn below.
HKAS 1.3.1 Identifiable
38.11,12
An asset is identifiable if it:
(a) Is separable, i.e. if it could be rented or sold either individually or together with a related
contract or asset; or
(b) Arises from contractual or other legal rights regardless of whether those rights are separable.
Goodwill, whether purchased or internally generated, is not identifiable and is therefore not
considered to be an intangible asset within the scope of HKAS 38.
Other internally generated intangible items, such as brands and customer lists do, however,
meet these criteria, however, they may not meet the remaining two criteria within the definition of
an intangible asset, or the recognition criteria (section 1.4).
Purchased intangible assets, such as a purchased patent or brand are normally identifiable.
HKAS 38.13- 1.3.2 Control by the entity
16
An entity controls an asset if the entity has the power to obtain the future economic benefits flowing
from the underlying resource and to restrict the access of others to those benefits.
Whereas the application of the control criteria to purchased assets is relatively simple, it is less
straightforward in the case of internally generated assets. Therefore, additional guidance is
provided as follows:
Market and technical knowledge
The following provide evidence that an entity can control access to the future economic benefits
arising from expenditure to develop market and technical knowledge:
The existence of copyrights
A legal duty of employees to maintain confidentiality with regard to the knowledge
If such a legal right exists, and provided that the knowledge is identifiable and is expected to result
in future economic benefits, it qualifies as an intangible asset.
Skilled staff
Expenditure on training results in more skilled staff, and often increased revenues and better
efficiency. The costs of such training, however, are very unlikely to qualify as an intangible asset
because an entity does not control the future actions of its staff. These staff may leave the
organisation at any time.
Market share/customer base
Expenditure on advertising and building customer relationships results in the growth of market
share and a loyal customer base. However, unless relationships with customers are protected by
legal rights, the entity can not control the actions of its customers, and they may change to a
different supplier. Therefore, such expenditure on creating market share does not qualify as an
intangible asset.
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8: Intangible assets and impairment of assets | Part C Accounting for business transactions
HKAS 38.21-
23
1.4 Recognition of an intangible asset
An intangible asset meeting the definition above should be recognised if, and only if, both the
following apply:
(a) It is probable that the future economic benefits that are attributable to the asset will flow to
the entity.
(b) The cost of the asset can be measured reliably.
Management has to exercise its judgment in assessing the degree of certainty attached to the flow
of economic benefits to the entity. External evidence is best.
HKAS 38.25 1.4.1 Separately acquired intangible assets
Normally, the fact that an entity purchases an intangible asset indicates an expectation that the
expected future economic benefits embodied in the asset will flow to the entity. In addition, the cost
can clearly be measured reliably.
Therefore, purchased intangible assets are normally recognised in the financial statements.
HKAS 38.33- 1.4.2 Intangible assets acquired as part of a business combination
34
In accordance with HKFRS 3 (revised), any intangible asset for which a fair value can be reliably
determined should be recognised separately. This is the case even where the purchased entity
does not recognise the asset in its own statement of financial position.
Sufficient information exists to measure the fair value of an asset reliably where it is separable or
arises from contractual or other legal rights.
HKAS 1.4.3 Internally generated assets
38.48,51,52,
63 Internally generated goodwill does not meet the definition of an intangible asset and therefore is
never recognised in the financial statements.
Other internally generated assets may meet the recognition criteria, however due to the difficulty of
assessing future economic benefits and determining a reliable cost of an internally generated
asset, HKAS 38 requires that all internal expenditure that may result in an intangible asset is
classified as research or development, and provides more detailed recognition guidance which is
applicable. This is considered in greater detail in section 2 of the chapter.
In any case, internally-generated brands, mastheads, publishing titles, customer lists and
items similar in substance shall not be recognised as intangible assets.
Self-test question 1
Trainor Clothing Co is a manufacturer of branded clothing that it sells to retailers on a wholesale
basis.
The company has an extensive customer list that it has built up for a new clothing range over the
year ended 31 December 20X4. Employee timesheets reveal that the marketing staff costs of
contacting new potential customers and compiling the list amounts to $120,000.
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The financial controller feels that the name ‘Trainor Clothing’ has an industry-wide reputation for
quality and that an element of goodwill should be capitalised in the statement of financial position.
He has suggested an amount of $500,000, being the amount recognised when a large
conglomerate acquired one of Trainor Clothing’s competitors recently.
In September 20X4, Trainor Clothing acquired a brand, Bonita Carina from a competitor at a cost of
$3 million. The brand has strong sales and a loyal customer base.
Required
Explain whether the items of expenditure listed may be recognised as an intangible asset in
accordance with HKAS 38.
(The answer is at the end of the chapter)
HKAS 38.24
1.5 Initial measurement of an intangible asset
An intangible asset is initially measured at cost.
HKAS 38.27- 1.5.1 Separately acquired intangible assets
29
The cost of a separately acquired intangible asset includes its purchase price and any directly
attributable costs of preparing the asset for its intended use.
Directly attributable costs may include professional fees and testing costs, but not advertising and
promotional expenditure or administration and general overhead costs.
HKAS 38.33 1.5.2 Intangible assets acquired as part of a business combination
When an intangible asset is acquired as part of a business combination (where one company
has acquired the shares of another company), the cost of the intangible asset is its fair value at the
date of the acquisition.
For example, if company A has acquired company B, and company B owns a drilling licence with a
fair value of $2m at the date of acquisition, then the cost of the licence in the consolidated accounts
will be $2m.
HKAS 38.44 1.5.3 Intangible assets acquired by way of government grant
According to HKAS 38, intangible assets acquired by way of government grant and the grant itself
may be recorded initially either at cost (which may be zero) or fair value.
HKAS 38.45 1.5.4 Exchanges of assets
Fair value is used to measure the cost of the intangible asset acquired if one intangible asset is
exchanged for another unless:
(a) The exchange lacks commercial substance; or
(b) The fair values of both the asset received and the asset given up cannot be measured
reliably.
In such cases, the cost of the intangible asset acquired is measured at the carrying amount of the
asset given up.
1.5.5 Internally generated assets
Internally generated intangible assets are recognised at cost. The elements of this are discussed in
more detail in section 2.
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Example
Anderson Gadd owns and operates a number of restaurants, half of which are operated under
franchise from a global company Allied Restaurant Company (ARC). Anderson Gadd has incurred
the following expenses in the year ended 31 July 20X3 and wishes to know which can be
recognised as intangible assets in the statement of financial position:
1. The $357,000 cost of a new stock management software package.
2. Franchise fees of $250,000 paid to ARC for the use of the trading name ‘Cowabunga’ for a
new outlet.
3. Training costs amounting to $130,000 for staff at the new Cowabunga outlet.
9. Advertising costs of $75,000 incurred prior to the opening of the new Cowabunga outlet.
Required
Advise the management of LDC at what amount any intangible asset is initially measured.
Solution
Accounting software is a separately acquired intangible asset. All recognition criteria are met and
the stock management software package is capitalised at its cost of $357,000 by:
DEBIT Intangible assets – software $357,000
CREDIT Cash/payable $357,000
Franchise fees meet the definition of an intangible asset as they are identifiable (evidenced by their
separate acquisition) and result in a benefit (a revenue stream) that is controlled by Anderson
Gadd as a result of a past event (the acquisition). It is assumed that Anderson Gadd would not
have paid the fees if economic benefit were not probable; the fee provides evidence of reliable
measurement. Therefore the $250,000 cost is capitalised as an intangible asset by:
DEBIT Intangible assets – franchise fees $250,000
CREDIT Cash/payable $250,000
Training costs must be expensed. The benefit of training costs is not controlled by Anderson Gadd
as the staff that it has trained may leave the company. Equally, advertising costs are the costs of
introducing a new product or service; HKAS 38 specifically prohibits these costs forming part of an
intangible asset. Therefore a total of $205,000 is recognised as an expense in the period by:
DEBIT Training costs $130,000
DEBIT Advertising costs $75,000
CREDIT Cash/payable $205,000
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HKAS 38 requires that internally generated assets are classified into research and development
phases.
2.1 Definitions
Key terms
Research is original and planned investigation undertaken with the prospect of gaining new
scientific or technical knowledge and understanding.
Development is the application of research findings or other knowledge to a plan or design for the
production of new or substantially improved materials, devices, products, processes, systems or
services before the start of commercial production or use.
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HKAS 38.65-
66, 71
2.3 Initial measurement
Topic highlights
Internally generated intangible assets are initially measured at cost
The costs allocated to an internally generated intangible asset should only be those costs that can
be directly attributed or allocated on a reasonable and consistent basis to creating, producing or
preparing the asset for its intended use. The principle here is similar to that applied to the cost of
non-current assets and inventory.
The cost of an internally operated intangible asset is the sum of the expenditure incurred from
the date when the intangible asset first meets the recognition criteria. If, as often happens,
considerable costs have already been recognised as expenses before management could
demonstrate that the criteria have been met, this earlier expenditure should not be retrospectively
recognised at a later date as part of the cost of an intangible asset.
Self-test question 2
Mountain Co. is developing a new production process. During 20X1, expenditure incurred was
$500,000, of which $310,000 was incurred before 1 December 20X1 and $190,000 between
1 December 20X1 and 31 December 20X1. Mountain can demonstrate that, at 1 December 20X1,
the production process met the criteria for recognition as an intangible asset. How should the
expenditure be treated?
(The answer is at the end of the chapter)
Self-test question 3
Light Drinks Company (LDC) owns and operates a number of beer and wine bars. The company
has incurred the following expenses in the year ended 31 July 20X3 and wishes to know which can
be recognised as intangible assets in the statement of financial position:
1. Costs incurred in developing a beer pumping process to ensure that the draught beer sold at
its outlets is not flat. This process is expected to be implemented by 20X5. Testing indicates
that it will cut wastage.
2. The costs of testing the beer pumping process.
3. The salaries of staff involved in the beer pumping process development project.
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4. A share of the general overheads (eg rent and depreciation) of the R&D department as an
allocation to the beer pumping process development project.
5. A share of administrative overheads as an allocation to the beer pumping process
development project.
Required
Explain which costs can be capitalised as an intangible asset at 31 July 20X3.
(The answer is at the end of the chapter)
At this stage it may be useful to summarise the rules seen for the recognition and initial
measurement of separately purchased intangibles, intangibles acquired as part of a business
acquisition and internally generated development expenditure.
Summary of the recognition and initial measurement requirements of HKAS 38
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HKAS
38.72,74,75,81
2.5 Measurement of intangible assets subsequent to initial
recognition
HKAS 38 allows two methods of measuring for intangible assets after they have been first
recognised:
1 Cost model: an intangible asset is carried at its cost, less any accumulated amortisation
and less any accumulated impairment losses.
2 Revaluation model: an intangible asset is carried at a revalued amount, which is its fair
value at the date of revaluation, less any subsequent accumulated amortisation and any
subsequent accumulated impairment losses.
The rules with regard to the application of the revaluation model are as follows:
(a) The fair value must be measured reliably with reference to an active market in that type of
asset.
(b) The entire class of intangible assets of that type must be revalued at the same time (to
prevent a business from choosing to revalue only those particular assets that have enjoyed
favourable price movements, and retaining the others at cost).
(c) If an intangible asset in a class of revalued intangible assets cannot be revalued because
there is no active market for this asset, the asset should be carried at its cost less any
accumulated amortisation and impairment losses.
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(d) Revaluations should be made with such regularity that the carrying amount does not differ
from that which would be determined using fair value at the end of the reporting period.
HKAS 2.5.1 Active market
38.8,78
Key term
An active market is a market in which all the following conditions exist:
(a) The items traded in the market are homogenous
(b) Willing buyers and sellers can normally be found at any time
(c) Prices are available to the public
Since an active market for an intangible asset will not usually exist, the revaluation model will
usually not be available. For example, intangible assets such as copyrights, publishing rights and
film rights are each sold at unique sale value, so a continuous active market is not accessible.
A revaluation to fair value would therefore be inappropriate. However, a fair value might be
obtainable for assets such as fishing rights, quotas or taxi cab licences.
HKAS 38.85- 2.5.2 Accounting for a revaluation
87
Where the carrying amount of an intangible asset is revalued upwards to its fair value, the amount
of the revaluation should be credited to other comprehensive income and accumulated in a
revaluation surplus in equity.
However, a revaluation surplus resulting from a reversal of a previous revaluation decrease that
has been charged to profit or loss can be recognised as income.
On the other hand, the amount of a downward revaluation on an intangible asset should be
charged as an expense against income, unless an upward revaluation has previously been
recorded on the same intangible asset. In such case, the revaluation loss should be first debited to
other comprehensive income against any previous revaluation surplus recorded for the asset.
Self-test question 4
A non-current asset with a carrying value of $160m was impaired and written down to its
recoverable value of $120m two years ago.
After an upturn in business, the asset has a market value of $135m. Had the impairment not taken
place, the carrying value of the asset would have been $130m.
Required
Consider how this impairment is reversed.
(The answer is at the end of the chapter)
When the revaluation model is adopted, the cumulative revaluation surplus of an intangible asset
may be transferred to retained earnings when the asset is disposed of and the surplus is
eventually realised. However, the surplus may also be realised over the period in which the
intangible asset is being used by the entity. The amount of the surplus realised each year is
calculated as the difference in amortisation charges based on the revalued amount of the asset
and the historical cost of the asset. The realised surplus should not be included in profit or loss,
instead it should be transferred from revaluation surplus directly to retained earnings and disclosed
in the statement of changes in equity.
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subsequent year based on the proportion of total revenue generated. This is not appropriate
because revenue generated is affected by factors other than the consumption of the asset, e.g.
price inflation, demand and sales and marketing activities. This amendment is effective for periods
beginning on or after 1 January 2016.
The amortisation method used for an intangible asset with a finite useful life should be reviewed at
each financial year end.
HKAS 38.99 2.6.5 Accounting for amortisation
The amortisation charge for a period is recognised in profit or loss in the same way as depreciation
on tangible non-current assets:
DEBIT Amortisation expense X
CREDIT Accumulated amortisation X
HKAS
38.107-109 2.6.6 Intangible assets with indefinite useful lives
An intangible asset with an indefinite useful life should not be amortised, instead HKAS 36
requires that such an asset is tested for impairment at least annually.
The useful life of an intangible asset that is not being amortised should be reviewed each year to
determine whether it is still appropriate to assess its useful life as indefinite. Reassessing the useful
life of an intangible asset as finite rather than indefinite is an indicator that the asset may be
impaired and in these circumstances it should be tested for impairment as well as being amortised
over its remaining life.
Self-test question 5
It can be difficult to establish the useful life of an intangible asset in practice. Write brief notes on
factors to consider when determining the useful life of a purchased brand name and how to
provide evidence that its useful life might, in fact, exceed 20 years.
(The answer is at the end of the chapter)
HKAS
38.118,122,
2.8 Disclosure requirements
124,126 Extensive disclosure is required for intangible assets as listed in the standard. The accounting
policies for intangible assets that have been adopted are to be disclosed in the financial
statements.
For each class of intangible assets, disclosure is required of the following:
(a) The method of amortisation used (e.g., straight line method).
(b) The useful life of the assets or the amortisation rate used.
(c) The gross carrying amount, the accumulated amortisation and the accumulated impairment
losses as at the beginning and the end of the period.
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(d) A reconciliation of the carrying amount as at the beginning and at the end of the period
(additions, retirements/disposals, revaluations, impairment losses, impairment losses reversed,
amortisation charge for the period, net exchange differences, other movements).
(e) The carrying amount of internally-generated intangible assets.
The financial statements should also disclose the following:
(a) In the case of intangible assets that are assessed as having an indefinite useful life, the
carrying amounts and the reasons supporting that assessment.
(b) For intangible assets acquired by way of a government grant and initially recognised at fair
value, the fair value initially recognised, the carrying amount, and whether they are
carried under the cost model or the revaluation model for subsequent remeasurements.
(c) The carrying amount, nature and remaining amortisation period of any intangible asset that
is material to the financial statements of the entity as a whole.
(d) The existence (if any) and amounts of intangible assets whose title is restricted and of
intangible assets that have been pledged as security for liabilities.
(e) The amount of any commitments for the future acquisition of intangible assets.
Where intangible assets are accounted for at revalued amounts, disclosure is required of the
following:
(a) The effective date of the revaluation (by class of intangible assets).
(b) The carrying amount of revalued intangible assets.
(c) The carrying amount that would have been shown (by class of assets) if the cost model
had been used, and the amount of amortisation that would have been charged.
(d) The amount of any revaluation surplus on intangible assets, as at the beginning and end of
the period, and movements in the surplus during the year (and any restrictions on the
distribution of the balance to shareholders).
The financial statements should also disclose the amount of research and development
expenditure that has been charged as an expense of the period.
Illustration
Accounting policies
Intangible assets
(i) Research and development
Expenditure on research activities is recognised as an expense in the period in which it is
incurred.
An internally generated intangible asset arising from the Group’s product development
activities is capitalised only if all of the following conditions are met:
An asset is created that can be identified
It is probable that the asset with generate future economic benefits
The development cost of the asset can be measured reliably
Internally generated intangible assets are amortised on a straight line basis over ten years
and measured at cost less accumulated amortisation and accumulated impairment losses.
Where no internally generated intangible asset can be recognised, development expenditure
is recognised as an expense in the period in which it is incurred.
(ii) Other intangible assets
Other intangible assets that are acquired by the Group and have finite useful lives are
measured at cost less accumulated amortisation and accumulated impairment losses.
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Intangible assets
Development Licences
costs Total
$’000 $’000 $’000
Cost
At 1 January 20X3 5,000 8,000 13,000
Additions in year 200 - 200
Disposals in year – - -
At 31 December 20X3 5,200 8,000 13,200
Amortisation
At 1 January 20X3 1,000 3,300 4,300
Charge for year 520 600 1,120
Eliminated on disposals – - -
At 31 December 20X3 1,520 3,900 5,420
Carrying amount
At 31 December 20X3 3,680 4,700 7,780
At 1 January 20X3 4,000 4,100 8,700
Internally generated intangible assets have a carrying amount of $3.68 million (20X2:
$4 million).
At 31 December 20X3, the Group had entered into contractual commitments for the
acquisition of licences amounting to $750,000.
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Self-test question 6
Stauffer is a public listed company reporting under HKFRS. It has asked for your opinion on the
accounting treatment of the following items:
(a) The Stauffer brand has become well known and has developed a lot of customer loyalty
since the company was set up eight years ago. Recently, valuation consultants valued the
brand for sale purposes at $14.6m. Stauffer's directors are delighted and plan to recognise
the brand as an intangible asset in the financial statements. They plan to report the gain in
the revaluation surplus as they feel that crediting it to profit or loss would be imprudent.
(b) On 1 October 20X5 the company was awarded one of six licences issued by the government
to operate a production facility for five years. A ‘nominal’ sum of $1m was paid for the
licence, but its fair value is actually $3m.
(c) The company undertook an expensive, but successful advertising campaign during the year
to promote a new product. The campaign cost $1m, but the directors believe that the extra
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sales generated by the campaign will be well in excess of that over its four year expected
useful life.
(d) Stauffer owns a 30-year patent which it acquired two years ago for $8m which is being
amortised over its remaining useful life of 16 years from acquisition. The product sold is
performing much better than expected. Stauffer's valuation consultants have valued its
current market price at $14m.
(e) On 1 August 20X6, Stauffer acquired a smaller company in the same line of business.
Included in the company's statement of financial position was an in-process research and
development project, which showed promising results (and was the main reason why
Stauffer purchased the other company), but was awaiting government approval. The project
was included in the company's own books at $3m at the acquisition date, while the
company's net assets were valued at a fair value of $12m (excluding the project).
Stauffer paid $18m for 100% of the company and the research and development project was
valued at $5m by Stauffer's valuation consultants at that date. Government approval has
now been received, making the project worth $8m at Stauffer's year end.
Required
Explain how the directors should treat the above items in the financial statements for the year
ended 30 September 20X6.
(The answer is at the end of the chapter)
3.1 Introduction
The fundamental principle of HKAS 36 is relatively simple. If an asset's carrying value is higher
than its ‘recoverable amount’, then the asset is said to have suffered an impairment loss. Its value
should therefore be reduced by the amount of the impairment loss.
HKAS 36 provides guidance on:
(a) When an asset should be tested for a possible impairment
(b) How the impairment test is carried out
(c) How any resulting impairment loss is accounted for and disclosed
Before we consider each of these in turn, the next two sections explain the scope of HKAS 36 and
provide a list of important definitions within it.
HKAS 36.2
3.2 Scope
HKAS 36 applies to all tangible, intangible and financial assets including those which have been
revalued, except for the following:
Inventories
Assets arising from construction contracts
Deferred tax assets
Assets arising under HKAS 19 Employee Benefits
Financial assets within the scope of HKFRS 9 Financial Instruments
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Key terms
Impairment loss. The amount by which the carrying amount of an asset exceeds its recoverable
amount.
Carrying amount. The amount at which an asset is recognised after deducting any accumulated
depreciation (amortisation) and accumulated impairment losses thereon.
Recoverable amount of an asset is the higher of its fair value less costs to sell and its value in
use.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Value in use is the present value of the future cash flows expected to be derived from an asset.
(HKAS 36)
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Financial Reporting
Where there are indications of impairment, or for those assets which require testing annually, an
impairment test must be performed. This involves comparing the carrying amount of the asset with
its recoverable amount.
We have already defined recoverable amount as the higher of fair value less costs to sell and value
in use.
HKAS 36.28 3.5.1 Fair value less costs to sell
Fair value is established in accordance with the requirements of HKFRS 13 Fair Value
Measurement. As we have already seen, it is defined as the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date. More detail on determining fair value is provided in Chapter 19.
While HKAS 36 provides no guidance on establishing fair value, it does clarify that costs of
disposal may include legal costs, stamp duty and similar transaction taxes, costs of removing the
asset, and direct incremental costs to bring an asset into condition for its sale. They do not,
however, include termination benefits (as defined in HKAS 19) and costs associated with reducing
or reorganising a business following the disposal of an asset are not direct incremental costs to
dispose of the asset.
HKAS 3.5.2 Value in use
36.30,33,39,
44,54-56 Value in use is the present value of the future cash flows expected to be derived from an asset.
The pre-tax cash flows and a pre-tax discount rate should be employed to calculate the present
value.
The calculation of value in use must reflect the following:
(a) An estimate of the future cash flows the entity expects to derive from the asset
(b) Expectations about possible variations in the amount and timing of future cash flows
(c) The time value of money
(d) The price for bearing the uncertainty inherent in the asset
(e) Other factors that would be reflected in pricing future cash flows from the asset
The standard provides further guidance in the assessment of cash flows and choice of discount rate.
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Cash flows
The HKAS states the following:
(a) Cash flow projections should be based on ‘reasonable and supportable’ assumptions.
(b) Projections of cash flows, normally up to a maximum period of five years, should be based
on the most recent budgets or financial forecasts.
(c) A steady or declining growth rate for each subsequent year (unless a rising growth rate
can be justified) can be used in extrapolating short-term projections of cash flows beyond
this period. Unless a higher growth rate can be justified, the long-term growth rate employed
should not be higher than the average long-term growth rate for the product, market, industry
or country.
HKAS 36 further states that future cash flows may include:
(a) Projections of cash inflows from continuing use of the asset.
(b) Projections of cash outflows necessarily incurred to generate the cash inflows from
continuing use of the asset.
(c) Net cash flows received/paid on disposal of the asset at the end of its useful life assuming
an arm's length transaction.
An asset's current condition is the basis for estimating future cash flows. It should be noted that
future cash flows associated with restructurings to which the entity is not yet committed, or to future
costs to add to, replace part of, or service the asset are excluded.
Estimates of future cash flows should exclude the following:
(a) Cash inflows/outflows from financing activities.
(b) Income tax receipts/payments.
Foreign currency future cash flows should initially be prepared in the currency in which they will
arise and will be discounted using an appropriate rate. Translation of the resulting figure into the
reporting currency should then be based on the spot rate at the year end.
Discount rate
The discount rate should be a current pre-tax rate (or rates) that reflects:
The current assessment of the time value of money
The risks specific to the asset
A rate that reflects current market assessments of the time value of money and the risks specific to
the asset is the return that investors would require if they were to choose an investment that
would generate cash flows of amounts, timing and risk profile equivalent to those that the
entity expects to derive from the asset.
This rate is estimated from:
The rate implicit in current market transactions for similar assets; or
The weighted average cost of capital of a listed entity that has a single asset which is similar
to that under review in terms of service potential and risks.
The discount should not include a risk weighting if the underlying cash flows have already been
adjusted for risk.
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budgets/forecasts for the next five years approved by management (excluding the effects of
general price inflation):
Year 1 2 3 4 5
$'000 $'000 $'000 $'000 $'000
Future cash flows 230 211 157 104 233
(including
disposal
proceeds)
If the plant was sold now it would realise $550,000, net of selling costs.
The entity estimates that the pre-tax discount rate specific to the plant is 15%, excluding the effects
of general price inflation.
Required
Calculate the recoverable amount of the plant.
Note: PV factors at 15% are as follows.
Year PV factor at 15%
1 0.86957
2 0.75614
3 0.65752
4 0.57175
5 0.49718
Solution
The fair value less costs to sell is given as $550,000
The value in use is calculated as $638,000
Future cash PV factor at Discounted
Year flows 15% future cash flows
$'000 $'000
1 230 0.86957 200
2 211 0.75614 160
3 157 0.65752 103
4 104 0.57175 59
5 233 0.49718 116
638
The recoverable amount is the higher of $550,000 and $638,000, thus $638,000.
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Solution
The recoverable amount is $45,000, being the higher of fair value less costs to sell and value
in use.
The carrying amount of the machine is $66,667 ($75,000 8/9).
Therefore an impairment loss of $21,667 must be recognised.
The revaluation surplus at the year end in relation to the machine is $8,867 ($10,400 –
($75,000/9 – $68,000/10) being the depreciation reserves transfer).
Therefore $8,867 is charged to other comprehensive income against the revaluation surplus
and the remaining $12,800 is charged to profit or loss by:
DEBIT Other comprehensive income $8,867
(revaluation surplus)
DEBIT Impairment loss expense (P/L) $12,800
CREDIT Property, plant and machinery $21,667
HKAS
36.63,110,114,
3.7 Subsequent accounting for an impaired asset
117,119 After reducing an asset to its recoverable amount, the depreciation charge on the asset should
then be based on its new carrying amount, its estimated residual value (if any) and its estimated
remaining useful life.
The annual review of assets to determine whether there may have been some impairment should
be applied to all assets, including assets that have already been impaired in the past.
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HKAS
36.6,66
3.8 Cash generating units
Topic highlights
When it is not possible to calculate the recoverable amount of a single asset, then that of its cash
generating unit (CGU) should be measured instead.
HKAS 36 explains the important concept of cash generating units. As a basic rule, the recoverable
amount of an asset should be calculated for the asset individually. However, there will be
occasions when it is not possible to estimate such a value for an individual asset, particularly in the
calculation of value in use. This is because cash inflows and outflows cannot be attributed to the
individual asset.
If it is not possible to calculate the recoverable amount for an individual asset, the recoverable
amount of the asset's cash generating unit should be measured instead.
Key term
A cash generating unit is the smallest identifiable group of assets for which independent cash
flows can be identified and measured.
HKAS 3.8.1 Identifying the cash generating unit to which an asset belongs
36.69,72
If the recoverable amount cannot be determined for an individual asset, an entity should identify
the smallest aggregation of assets that generate largely independent cash inflows.
As part of the identification process, an entity may take into account:
How management monitors the entity's operations (for example, by product line, business or
location)
How management makes decisions about continuing or disposing of the entity's operations
and assets
An asset or a group of assets is identified as a cash generating unit when an active market exists
for the output produced by the asset or the group. This is so even if some or all of the output is
used internally.
Unless a change is justified, it is necessary to identify consistently from period to period, the cash
generating units for the same type of asset.
The group of net assets (less liabilities) considered for impairment and those considered in the
computation of the recoverable amount should be alike. (For the treatment of goodwill and
corporate assets see below.)
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Self-test question 7
Shrub is a retail store belonging to Forest, a chain of such stores. Shrub makes all its retail
purchases through Forest's purchasing centre. Pricing, marketing, advertising and human
resources policies (except for hiring Shrub's cashiers and salesmen) are decided by Forest. Forest
also owns five other stores in the same city as Shrub (although in different neighbourhoods) and 20
other stores in other cities. All stores are managed in the same way as Shrub. Shrub and four other
stores were purchased five years ago and goodwill was recognised.
What is the cash generating unit for Shrub?
(The answer is at the end of the chapter)
Self-test question 8
Motorbike Publishing Co. owns 100 magazine titles of which 40 were purchased and 60 were self-
created. The price paid for a purchased magazine title is recognised as an intangible asset. The
costs of creating magazine titles and maintaining the existing titles are recognised as an expense
when incurred. Cash inflows from direct sales and advertising are identifiable for each magazine
title. Titles are managed by customer segments. The level of advertising income for a magazine
title depends on the range of titles in the customer segment to which the magazine title relates.
Management has a policy to abandon old titles before the end of their economic lives and replace
them immediately with new titles for the same customer segment.
What is the cash generating unit for the company?
(The answer is at the end of the chapter)
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The annual impairment test must be performed at the same time every year although it may be
performed at any time during an accounting period.
3.9.3 Impairment of goodwill where there is a non-controlling interest
If there is a non-controlling (minority) interest in a cash generating unit to which goodwill has
been allocated, and the non-controlling interest is measured as a proportion of the net assets of the
subsidiary, adjustment is required before comparing carrying amount and recoverable amount.
You may find it easier to come back to this section after studying the groups chapters where
alternative measurements of the non-controlling interest are discussed.
The issue here is that without adjustment, we are not comparing like with like:
The carrying amount of goodwill represents only that goodwill attributable to the parent
company; however,
The recoverable amount of the cash-generating unit includes the value of full goodwill
including that attributable to the non-controlling interest which is not recognised in the
financial statements.
Therefore, the carrying amount of the goodwill should be grossed up to include the goodwill
attributable to the non-controlling interest before the impairment test is conducted.
Solution
At 31 December 20X9 the cash generating unit consists of the subsidiary's identifiable net assets
(carrying amount $1,600,000) and goodwill of $1,050,000 (2,400,000 + (25% 1,800,000) –
1,800,000). Goodwill is grossed up to reflect the 25% non-controlling interest.
At 31 December 20X9:
Goodwill Net assets Total
$'000 $'000 $'000
Carrying amount 1,050 1,600 2,650
Unrecognised non-controlling interest 350 – 350
1,400 1,600 3,000
Recoverable amount (1,400)
Impairment loss 1,600
Allocation of impairment loss
unrecognised (goodwill) (350) –
recognised (goodwill /net assets) (1,050) (200)
Carrying value – 1,400
The impairment loss is recognised by:
DEBIT Impairment loss (P/L) $1,250,000
CREDIT Goodwill $1,050,000
CREDIT Net assets $200,000
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Financial Reporting
No journal entry is required in respect of the impairment loss allocated to the NCI goodwill as this is
unrecognised.
Solution
Recoverable Impairment
CV of assets HO allocation Total amount loss
$ $ $ $ $
CGU 1 640,000 312,958 952,958 980,000 -
CGU 2 2,150,000 1,051,345 3,201,345 3,145,000 56,345
CGU 3 1,300,000 635,697 1,935,697 1,800,000 135,697
4,090,000 2,000,000 6,090,000 192,042
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HKAS
36.104,105
3.11 Allocating an impairment loss to the assets of a cash
generating unit
An impairment loss should be recognised for a cash generating unit if the recoverable amount for
the cash generating unit is less than the carrying amount in the statement of financial position for
all the assets in the unit.
When an impairment loss is recognised for a cash generating unit, the loss should be allocated
between the assets in the unit in the following order:
(a) First, to the goodwill allocated to the cash generating unit (if any).
(b) Then, to all other assets in the cash generating unit within the scope of HKAS 36 (see
section 4.2), on a pro rata basis.
In allocating an impairment loss, the carrying amount of an asset should not be reduced below the
highest of:
(a) Its fair value less costs to sell;
(b) Its value in use (if determinable); or
(c) Zero.
Any remaining amount of an impairment loss should be recognised as a liability if required by other
HKAS.
An impairment review on 31 December 20X2 indicated that the recoverable amount of MH at that
date was $1.5 million. The capitalised development expenditure has no ascertainable external
market value and the current fair value less costs to sell of the property, plant and equipment is
$1,120,000. Value in use could not be determined separately for these two items.
Required
Calculate the impairment loss that would arise in the consolidated financial statements of Invest as
a result of the impairment review of MH at 31 December 20X2 and show how the impairment loss
would be allocated, stating the required journal entry.
Solution
Asset values Allocation of Carrying
at 31 Dec impairment value after
20X2 before loss impairment
impairment (W1)/(W2) loss
$'000 $'000 $'000
Goodwill (2,000 – 1,800) 200 (200) –
Property, plant and equipment 1,300 (180) 1,120
Development expenditure 200 (70) 130
Net current assets 250 – 250
1,950 (450) 1,500
201
Financial Reporting
WORKINGS
(1) Impairment loss
Carrying value 1,950
Recoverable amount 1,500
Impairment loss 450
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The recoverable amounts (including net current assets) at the year end were as follows:
$m
Division A 1,000
Division B 720
Group as a whole 1,825 (including Head office PPE at fair value less costs to sell of $80m)
The recoverable amounts of the two divisions were based on value in use. The fair value less costs
to sell of any individual item was substantially below this.
No impairment losses had previously been necessary.
Required
Discuss, with suitable computations showing the allocation of any impairment losses, the
accounting treatment of the impairment test.
Solution
Where there are multiple cash generating units, HKAS 36 Impairment of Assets requires two levels
of tests to be performed to ensure that all impairment losses are identified and fairly allocated.
First Divisions A and B are tested individually for impairment. In this instance, both are impaired
and the impairment losses are allocated first to any goodwill allocated to that unit and second to
other non-current assets (within the scope of HKAS 36) on a pro-rata basis. This results in an
impairment of the goodwill of both divisions and an impairment of the property, plant and
equipment in Division B only.
A second test is then performed over the whole business including unallocated goodwill and
unallocated corporate assets (the Head office) to identify if those items which are not a cash
generating unit in their own right (and therefore cannot be tested individually) have been impaired.
The additional impairment loss of (W2) $15m is allocated first against the unallocated goodwill of
$10m, eliminating it and then to the unallocated head office assets reducing them to $85m.
Divisions A and B have already been tested for impairment so no further impairment loss is
allocated to them or their goodwill as that would result in reporting them at below their recoverable
amount.
Carrying values after impairment test:
Division Division Head Unallocated
A B office goodwill Total
$m $m $m $m $m
PPE 780/(620 – 10)/(90 – 5) 780 610 85 - 1,475
Goodwill (60 – 20)/(30 – 30)/(10 – 10) 40 - - - 40
Net current assets 180 110 20 - 310
1,000 720 105 - 1,825
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Financial Reporting
WORKINGS
(1) Test of individual CGUs
Division A Division B Total
$m $m $m
Carrying value 1,020 760
Recoverable amount (1,000) (720)
Impairment loss 20 40 60
Allocated to:
Goodwill 20 30 50
Other assets in the scope of HKAS 36 - 10 10
20 40 60
Allocated to:
Unallocated goodwill 10
Other unallocated assets 5
15
HKAS
36.122,123, 3.12 Reversal of an impairment loss
124
Topic highlights
Impairment of goodwill may never be reversed.
Where a cash generating unit has been impaired in the past, this impairment can be reversed. The
reversal of the loss is allocated to the assets of the unit, except for goodwill pro rata with the
carrying amounts of those assets. The increases in carrying amounts are treated in the same way
as reversals of individual asset impairment, in other words, the carrying amount of an asset cannot
increase above the lower of:
(a) Its recoverable amount
(b) The carrying amount of the asset net of depreciation had no impairment been recognised
previously
Self-test question 9
Cannon Co. operates in a number of countries, with its operations in each being classified as
separate cash generating units. In one of the countries of operation, Adascus, legislation was
passed two years ago restricting exports, and as a result management of Cannon expected
production to decrease by 30% in their Adascan operation. Accordingly the Adascan CGU was
tested for impairment and an impairment of $1.473 million recognised in profit:
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Goodwill Assets
$'000 $'000
Cost at 1 January 20X1 1,000 2,000
Depreciation – (167)
1,000 1,833
The average remaining useful life of assets remained unchanged after the impairment, at 11 years.
Two years later at 31 December 20X3, it is thought that the effect of the legislation is less drastic
than expected, and production is expected to increase by 25%. The recoverable amount of the
Adascan CGU is now $1.91 million.
Required
Calculate the reversal of the impairment loss.
(The answer is at the end of the chapter)
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Financial Reporting
Illustration
Impairment loss and subsequent reversal
During 20X0, due to regulatory restrictions imposed on the manufacture of a new product in the
Components segment, the Group assessed the recoverable amount of the related product line. The
product line relates to a new product that was expected to be available for sale in 20X1. A
regulatory inspection in 20X0, however, revealed that the product did not meet certain
environmental standards, necessitating substantial changes to the manufacturing process. As a
result, production was deferred and the expected launch date delayed.
The recoverable amount of the CGU (the production line that will produce the product) was
estimated based on its value in use, assuming that the production line would go live in August
20X3. Based on the assessment in 20X0, the carrying amount of the product line was determined
to be $765,000 higher than its recoverable amount and an impairment loss was recognised. In
20X1, following certain changes to the recovery plan, the Group reassessed its estimates and
$210,000 of the initially recognised impairment has been reversed.
The estimate of value in use was determined using a pre-tax discount rate of 8% (20X0: 7.8%).
The impairment loss and its subsequent reversal was allocated pro-rata to the individual assets
constituting the production line as follows:
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8: Intangible assets and impairment of assets | Part C Accounting for business transactions
Original
carrying Reversal in
amount Loss in 20X0 20X1
$ $ $
Plant and equipment 1,340,000 512,550 140,700
Capitalised development costs 660,000 252,450 69,300
2,000,000 765,000 210,000
The impairment loss and subsequent reversal were recognised in cost of sales.
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Financial Reporting
Topic recap
Research Development
Investigation Application of
undertaken to gain research findings for
new knowledge the production of
new or improved
materials, processes
etc
Expense to profit or
loss
Subsequent measurement
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HKAS 36 Impairment
Impairment loss
arises where
Higher of
Disclosure requirements:
Impairment losses/reversals recognised in period on assets held at cost & assets at revalued amount
Additional disclosures for material impairment losses/reversals
209
Financial Reporting
Answer 1
The customer list is an internally generated item rather than a purchased item. It is likely to meet
the requirement to be identifiable as such a list may be sold to a competitor. The benefit of the list
is, however, unlikely to be controlled by Trainor Clothing. This is because an entity cannot control
the actions of its customers; those customers may choose to transfer their custom elsewhere.
$120,000 is not recognised as an intangible; instead it is recognised in profit or loss. This
conclusion is in line with HKAS 38 which specifically prohibits the recognition of a customer list as
an asset.
HKAS 38 prohibits the recognition of internally generated goodwill. Goodwill is not an identifiable
asset, nor is it controlled by an entity as a result of a past event. In addition, internally generated
goodwill is not capable of reliable measurement; Trainor Clothing is a different company to its
competitor and therefore the $500,000 recognised in that case is not appropriate here.
The brand is an acquired intangible asset. Where an intangible asset is acquired separately it is, by
definition, identifiable. Such an asset is also within the control of the acquiring entity as a result of a
past event. The acquisition of the asset is normally because there is an expectation of future
economic benefits. Cost can be measured reliably as the purchase price. Therefore the brand
Bonita Carina is recognised in Trainor Clothing’s statement of financial position initially at its cost of
$3 million.
Answer 2
At the end of 20X1, the production process is recognised as an intangible asset at a cost of
$190,000. This is the expenditure incurred since the date when the recognition criteria were met,
that is 1 December 20X1. The $310,000 expenditure incurred before 1 December 20X1 is
expensed, because the recognition criteria were not met. It will never form part of the cost of the
production process recognised in the statement of financial position.
This is recorded by:
DEBIT Intangible asset $190,000
DEBIT Development expense (P/L) $310,000
CREDIT Cash/payable $500,000
Answer 3
The beer pumping process project is in the development phase; based on the information provided,
the project is technically feasible, LDC can and does intend to complete the project and the project
will result in cost savings. Therefore provided that the related costs can be measured reliably they
should be capitalised. Capitalisation of costs is not allowed before all recognition criteria are met.
Testing and staff costs form part of the development costs and these should also be capitalised.
An allocation of the overheads of the R&D department do form part of the development costs to be
capitalised, as these are directly attributable costs. General overheads are not, however, directly
attributable costs and should be expensed.
Answer 4
The reversal of the impairment loss is recognised to the extent it increases the carrying amount of
the non-current asset to what it would have been had the impairment not taken place.
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This means that the reversal of the impairment loss can only be recognised at $10m. The asset is
recognised at $130m and a reversal of the impairment loss of $10m is recognised in the statement
of profit or loss.
This is recognised by:
DEBIT Property, plant and equipment $10,000,000
CREDIT Impairment loss expense (P/L) $10,000,000
Answer 5
Factors to consider would include the following:
(a) Legal protection of the brand name and the control of the entity over the (illegal) use by
others of the brand name (i.e. control over piracy).
(b) Age of the brand name.
(c) Status or position of the brand in its particular market.
(d) Ability of the management of the entity to manage the brand name and to measure activities
that support the brand name (e.g. advertising and PR activities).
(e) Stability and geographical spread of the market in which the branded products are sold.
(f) Pattern of benefits that the brand name is expected to generate over time.
(g) Intention of the entity to use and promote the brand name over time (as evidenced perhaps
by a business plan in which there will be substantial expenditure to promote the brand
name).
Answer 6
Stauffer brand
The Stauffer brand is an 'internally generated' intangible asset rather than a purchased one.
HKAS 38 specifically prohibits the recognition of internally generated brands, on the grounds that
they cannot be reliably measured in the absence of a commercial transaction. Stauffer will not
therefore be able to recognise the brand in its statement of financial position.
Licence
The licence is an intangible asset acquired by a government grant. It can be accounted for in one
of two ways:
The asset is recorded at the nominal price (cash paid) of $1m and depreciated at $200,000
per annum of its five year life, or
The asset is recorded at its fair value of $3m and a government grant is shown as deferred
income at $2m. The asset is depreciated over the five years at an annual rate of $600,000
per annum. The grant is amortised as income through profit or loss over the same period at
a rate of $400,000 per annum. This results in the same net cost of $200,000 in profit or loss
per annum as the first method.
Advertising campaign
The advertising campaign is treated as an expense. Advertising expenditure cannot be capitalised
under HKAS 38, as the economic benefits it generates cannot be clearly identified so no intangible
asset is created.
Patent
The patent is amortised to a nil residual value at $500,000 per annum based on its acquisition cost
of $8m and remaining useful life of 16 years.
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Financial Reporting
The patent cannot be revalued under the HKAS 38 rules as there is no active market as a patent is
unique. HKAS 38 does not permit revaluation without an active market as the value cannot be
reliably measured in the absence of a commercial transaction.
Acquisition
The difference between the price that Stauffer paid and the fair value of the net assets of the
acquired company will represent goodwill. The research and development project must also be
valued at fair value in a business combination to ensure the goodwill is stated accurately, while in
the acquiree's own financial statements it would not be revalued as there is no active market
because it is unique. Consequently, in a business combination HKAS 38/HKFRS 3 (revised) permit
intangible assets that do not have an active market to be valued on an ‘arm's length’ basis.
The values attributed in the group financial statements on the acquisition date are therefore:
$m
Net assets (excluding R&D project) 12
R&D project 5
Goodwill (remainder) 1
Purchase price 18
The fair value of the research and development project is measured at the acquisition date, not at
the year end and so it is not recorded at $8m. The project will be amortised over the expected
useful life of the product developed once the product is available for production.
Answer 7
In identifying Shrub's cash generating unit, an entity considers whether, for example:
(a) Internal management reporting is organised to measure performance on a store-by-store
basis.
(b) The business is run on a store-by-store profit basis or on a region/city basis.
All Forest's stores are in different neighbourhoods and probably have different customer bases.
So, although Shrub is managed at a corporate level, Shrub generates cash inflows that are largely
independent from those of Forest's other stores. Therefore, it is likely that Shrub is a cash
generating unit.
Answer 8
It is likely that the recoverable amount of an individual magazine title can be assessed. Even
though the level of advertising income for a title is influenced, to a certain extent, by the other titles
in the customer segment, cash inflows from direct sales and advertising are identifiable for each
title. In addition, although titles are managed by customer segments, decisions to abandon titles
are made on an individual title basis.
Therefore, it is likely that individual magazine titles generate cash inflows that are largely
independent one from another and that each magazine title is a separate cash generating unit.
Answer 9
At 31 December 20X3, the carrying amount of the assets are:
$'000
CV at 31 December 20X1 1,360
Depreciation X2 (1,360/11) (124)
Depreciation X3 (124)
1,112
Recoverable amount is $1.91 million and the excess over carrying amount is therefore
$798,000.
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8: Intangible assets and impairment of assets | Part C Accounting for business transactions
213
Financial Reporting
Exam practice
214
8: Intangible assets and impairment of assets | Part C Accounting for business transactions
The statement of financial position showed the following assets at 30 June 20X2:
Run Pro Jog Pro Total
$'000 $'000 $'000
Brand 25,000 5,000 30,000
Plant and equipment 40,000 25,000 65,000
Development cost capitalised 6,000 3,000 9,000
Inventories 12,000 8,000 20,000
83,000 41,000 124,000
Both brands are determined to be of indefinite life. No impairment has been recognised since
acquisition.
The above are the only assets that are directly attributable to the brands. Corporate assets are
negligible.
For the purpose of preparation of the annual financial statements, the management has carried out
the following estimation:
Run Pro Jog Pro Total
$'000 $'000 $'000
Value in use 64,000 60,000 124,000
Fair value less cost to sell
– Unit as a whole 60,000 58,000 118,000
– Plant and equipment 36,000 22,000 58,000
– Development cost capitalised nil nil nil
Inventories are excluded from the cash generating unit (CGU) carrying value and the impact has
been properly incorporated in determining the value in use. Impact of other working capital is
minimal.
The fair value less costs to sell of individual items under plant and equipment are indeterminable.
Inventories are with net realisable value/fair value less costs to sell higher than their carrying
amount
Required
(a) Briefly discuss and advise whether WSL is required to conduct asset impairment review at
30 June 20X2. (3 marks)
(b) 'The total of value in use of both brands is higher than their total net assets, there is no
impairment issue.' Comment on this statement with reasons. (5 marks)
(c) Determine the impairment of assets with detail calculation, if any, to be recognised by WSL
at 30 June 20X2. (9 marks)
(Total = 17 marks)
HKICPA June 2013
215
Financial Reporting
216
chapter 9
Leases
Topic list
Learning focus
Leasing transactions are extremely common in business and you will often come across
them in both your business and personal capacity. It is important for the accountant to be able
to advise from the perspective of both the lessor and the lessee. Off-balance sheet finance
and substance over form are both vital issues of which the accountant should be aware.
217
Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.14 Leases 3
3.14.01 Identify the types of lease within the scope of HKAS 17 and define
the terminology used in relation to leases
3.14.02 Classify leases as operating or finance leases by looking at the
substance of the transaction
3.14.03 Account for operating leases from the perspective of both the
lessee and the lessor
3.14.04 Disclose the relevant information relating to operating leases in the
accounts of both the lessee and the lessor
3.14.05 Account for finance leases from the perspective of both the lessee
and the lessor
3.14.06 Disclose the relevant information relating to finance leases in the
accounts of both the lessee and the lessor
3.14.07 Account for manufacturer/dealer leases
3.14.08 Account for sale and leaseback transactions
3.14.09 Explain the term off-balance sheet finance and the importance of
substance over form
3.14.10 Explain how to determine whether an arrangement contains a lease
218
9: Leases | Part C Accounting for business transactions
1 HKAS 17 Leases
Topic highlights
HKAS 17 covers the accounting for lease transactions by both lessees and lessors. A lease is a
contract for the hire of a specific asset.
A lease is a contract between a lessee and lessor for the hire of a specific asset. The lessor retains
ownership of the asset but conveys the right of the use of the asset to the lessee for an agreed
period of time in return for the payment of specified rentals.
219
Financial Reporting
Key terms
Lease. An agreement whereby the lessor conveys to the lessee in return for a payment or series of
payments the right to use an asset for an agreed period of time.
Finance lease. A lease that transfers substantially all the risks and rewards incidental to ownership
of an asset. Title may or may not eventually be transferred.
Operating lease. A lease other than a finance lease. (HKAS 17)
The classification of a lease as either finance or operating is therefore largely dependent upon the
transfer of risks and rewards. The next section explains what is meant by this term.
HKAS 17.7- 1.2.2 Risks and rewards
11
Risks are the risks of ownership, not other types of risk. These include:
Possibility of losses from idle capacity
Possibility of losses from technological obsolescence
Variations in return due to changing economic conditions
Rewards are represented by:
The expectation of profitable operation over the asset's economic life
Unrestricted access to the asset
Any gain from appreciation in value or realisation of a residual value.
HKAS 17 applies the same definitions and accounting principles to both lessees and lessors, but
the different circumstances of each may lead each to classify the same lease differently.
An assessment of risks and rewards may be inconclusive in deciding what type of lease a
particular arrangement is. In this instance, the standard provides examples of situations which
indicate an arrangement is a finance lease.
HKAS 17 provides the following examples of finance lease:
(a) The lease transfers ownership of the asset to the lessee by the end of the lease term.
(b) The lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable such that, at
the inception of the lease, it is reasonably certain that the option will be exercised.
(c) The lease term is for the major part of the economic life of the asset even if title is not
transferred.
(d) At the inception of the lease the present value of the minimum lease payments amounts to at
least substantially all of the fair value of the leased asset.
(e) The leased assets are of a specialised nature such that only the lessee can use them
without major modifications being made.
There are also some indicators of situations which individually or in combination could also lead to
a lease being classified as a finance lease.
(a) If the lessee can cancel the lease, the lessor's losses associated with the cancellation are
borne by the lessee.
(b) Gains or losses from the fluctuation in the fair value of the residual fall to the lessee (e.g. in
the form of a rent rebate equalling most of the sales proceeds at the end of the lease).
(c) The lessee has the ability to continue the lease for a secondary period at a rent which is
substantially lower than market rent.
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9: Leases | Part C Accounting for business transactions
Self-test question 1
Chin Garments Co has taken out a new lease on a factory building and surrounding land. The fair
value of the building is $70 million and the fair value of the land is $100 million. The lease is for 20
years with annual payments in arrears of $11 million. After 20 years, the business can extend the
lease for a further 20 years for an annual payment of $500,000.
Required
How is the lease classified in accordance with HKAS 17?
(The answer is at the end of the chapter)
Key terms
Minimum lease payments. The payments over the lease term that the lessee is or can be
required to make, excluding contingent rent, costs for services and taxes to be paid by and be
reimbursable to the lessor, together with:
(a) For a lessee, any amounts guaranteed by the lessee or by a party related to the lessee.
(b) For a lessor, any residual value guaranteed to the lessor by one of the following:
(i) The lessee
(ii) A party related to the lessee
(iii) An independent third party financially capable of meeting this guarantee.
However, if the lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than fair value at the date the option becomes exercisable for it to be reasonably
certain, at the inception of the lease, that the option will be exercised, the minimum lease payments
comprise the minimum payments payable over the lease term to the expected date of exercise of
this purchase option and the payment required to exercise it.
Interest rate implicit in the lease. The discount rate that, at the inception of the lease, causes the
aggregate present value of the:
(a) Minimum lease payments, and
(b) Unguaranteed residual value
to be equal to the sum of:
(a) The fair value of the leased asset
(b) Any initial direct costs
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Financial Reporting
Initial direct costs are incremental costs that are directly attributable to negotiating and
arranging a lease, except for such costs incurred by manufacturer or dealer lessors. Examples of
initial direct costs include amounts such as commissions, legal fees and relevant internal costs.
Lease term. The non-cancellable period for which the lessee has contracted to lease the asset
together with any further terms for which the lessee has the option to continue to lease the asset,
with or without further payment, when at the inception of the lease it is reasonably certain that the
lessee will exercise the option.
A non-cancellable lease is a lease that is cancellable only in one of the following situations:
(a) Upon the occurrence of some remote contingency.
(b) With the permission of the lessor.
(c) If the lessee enters into a new lease for the same or an equivalent asset with the same
lessor.
(d) Upon payment by the lessee of an additional amount such that, at inception, continuation of
the lease is reasonably certain.
The inception of the lease is the earlier of the date of the lease agreement and the date of
commitment by the parties to the principal provisions of the lease. As at this date:
(a) A lease is classified as either an operating lease or a finance lease
(b) In the case of a finance lease, the amounts to be recognised at the lease term are
determined
Economic life is either the:
(a) Period over which an asset is expected to be economically usable by one or more users
(b) Number of production or similar units expected to be obtained from the asset by one or more
users
Useful life is the estimated remaining period, from the beginning of the lease term, without
limitation by the lease term, over which the economic benefits embodied in the asset are expected
to be consumed by the entity.
Guaranteed residual value is:
(a) For a lessee, that part of the residual value which is guaranteed by the lessee or by a party
related to the lessee (the amount of the guarantee being the maximum amount that could, in
any event, become payable).
(b) For a lessor, that part of the residual value which is guaranteed by the lessee or by a third
party unrelated to the lessor who is financially capable of discharging the obligations under
the guarantee.
Unguaranteed residual value is that portion of the residual value of the leased asset, the
realisation of which by the lessor is not assured or is guaranteed solely by a party related to the
lessor.
Gross investment in the lease is the aggregate of:
(a) The minimum lease payments receivable by the lessor under a finance lease
(b) Any unguaranteed residual value accruing to the lessor
Net investment in the lease is the gross investment in the lease discounted at the interest rate
implicit in the lease.
Unearned finance income is the difference between the:
(a) Gross investment in the lease
(b) Net investment in the lease
The lessee's incremental borrowing rate of interest is the rate of interest the lessee would have
to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease,
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the lessee would incur to borrow over a similar term, and with a similar security, the funds
necessary to purchase the asset.
Contingent rent is that portion of the lease payments that is not fixed in amount but is based on a
factor other than just the passage of time (e.g. percentage of sales, amount of usage, price indices,
market rates of interest).
(HKAS 17)
Some of these definitions are only of relevance when we look at lessor accounting in section 3.
No
No
2 Lessee accounting
Topic highlights
Lessee accounting:
Operating leases: recognise rental expense on a straight line basis.
Finance leases: record an asset in the statement of financial position and a liability to pay
for it (at the lower of fair value of the asset or present value of minimum lease payments);
apportion the finance charge to give a constant periodic rate of return.
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Financial Reporting
Solution
Total amount payable $1,500 + (3 $2,500) = $9,000
Annual expense $9,000/3 years = $3,000
This expense is recognised in the years ended 31 December 20Y0 and 20Y1
Expense for y/e 31 Dec 20X9 $3,000 3/12 = $750
Expense for y/e 31 Dec 20Y2 $3,000 x 9/12 = $2,250
The 20X9 expense is recorded by:
DEBIT Operating lease expense $750
DEBIT Operating lease prepayment $750
CREDIT Cash $1,500
The 20Y0 expense is recorded by:
DEBIT Operating lease expense $3,000
CREDIT Cash $2,500
CREDIT Operating lease prepayment $500
The 20Y1 expense is recorded by:
DEBIT Operating lease expense $3,000
CREDIT Cash $2,500
CREDIT Operating lease prepayment $250
CREDIT Operating lease accrual $250
The 20Y2 expense is recorded by:
DEBIT Operating lease expense $2,250
DEBIT Operating lease accrual $250
CREDIT Cash $2,500
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The lessee should recognise the aggregate benefit of incentives as a reduction of rental expense
over the lease term, generally on a straight line basis.
Costs incurred by the lessee, including costs in connection with a pre-existing lease should be
accounted for in accordance with the relevant HKAS.
Solution
Total amount payable ($5,000 4) – $2,000 = $18,000
Annual expense $18,000/4 years = $4,500
Expense for y/e 31 Dec 20X8 $4,500 5/12 = $1,875
This is recorded by:
DEBIT Operating lease expense $1,875
DEBIT Operating lease prepayment $1,125
CREDIT Cash $3,000
Illustration
Accounting policy
Rentals payable under operating leases are charged to profit or loss on a straight line basis over
the term of the relevant lease except where another more systematic basis is more representative
of the time pattern in which economic benefits from the lease asset are consumed.
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Financial Reporting
At the reporting date the Group had outstanding commitments for future minimum lease payments
under non-cancellable operating leases, which fall due as follows:
20X3 20X2
$’000 $’000
Within one year 42,000 34,000
In the second to fifth years inclusive 66,000 68,000
After five years 24,000 -
132,000 102,000
Operating lease payments represent rentals payable by the Group for certain of its office
properties. Leases are negotiated for an average term of 6 years and rentals are fixed for an
average of 6 years with an option to extend for a further 4 years at the then prevailing market rate.
Self-test question 2
HKC entered into a non-cancellable agreement with a lessor company to acquire a major piece of
machinery for 3 years from 1 July 20X7. The lessor company incurred costs associated with
arranging the lease of $40,000. The machinery has an expected remaining useful life of 40 years at
1 July 20X7 and a carrying amount of $3.4 million. The terms of the lease agreement require an
initial non-refundable deposit of $12,000 and then monthly rentals of $3,000 paid in arrears.
HKC rents a number of items of machinery and equipment under similar terms; the average lease
term is 5 years.
Required
Prepare extracts from the financial statements of HKC Ltd for the year ended 31 December 20X7 in
respect of the lease.
(The answer is at the end of the chapter)
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The interest rate implicit in the lease is used to determine the present value of the minimum
lease payments. If it is not practical to determine this rate then the lessee's incremental
borrowing rate may be used.
Any initial direct costs of the lessee are added to the amount recognised as an asset. These may
be incurred in connection with securing or negotiating the lease, but should only include costs
which are directly attributable to activities performed by the lessee to obtain the finance lease.
2 The asset is depreciated
The asset held under the finance lease is depreciated over the shorter of the lease term and
the useful life of the asset.
If there is a reasonable certainty that the lessee will obtain ownership at the end of the lease,
the asset should be depreciated over the asset's useful life. The policy of depreciation
adopted should be consistent with similar non-leased assets and calculations should follow
the bases set out in HKAS 16 (see Chapter 5).
HKAS 17 (revised) introduced guidance on impairment of leased assets by referring to HKAS 36.
3 Lease payments are recorded
Minimum lease payments should be split into the finance charge under the finance lease and
a reduction of the outstanding obligation for future amounts payable.
The finance charge allocated to the accounting periods should produce a constant periodic
rate of interest on the outstanding balance of the lease obligation for each accounting
period, or a reasonable approximation thereto.
The normal method applied in order to achieve this is the actuarial method, discussed in the
next section. An alternative method is the sum of digits method, however this is not examinable.
Contingent rents should be charged in the periods in which they are incurred.
2.2.2 Actuarial method
The actuarial method, which is the best and most scientific method for interest allocation, is
derived from the assumption that interest charged by the lessor will be the same as the lessor's
desired rate of return, multiplied by its capital investment.
(a) The capital investment is identical to the fair value of the asset (less any initial deposit paid
by the lessee) at the commencement of the lease.
(b) The amount of capital invested reduces as each instalment is paid. The interest on the lease
decreases gradually as capital is repaid. It follows that the interest accruing is greatest in the
early part of the lease term. We will go through a simple example of the actuarial method in
this section.
Example: Finance lease with payments in arrears
On 1 January 20X0, Gordon Co. leased an asset with a fair value of $38 million and a useful life of
five years. The lease term was five years and the interest rate implicit in the lease was 9.9%. The
company is required to make five annual instalments of $10 million on 31 December, with the first
payment on 31 December 20X0. Gordon Co has no other leased assets.
Show the lease obligation working for each year of the lease and identify amounts to be recognised
in profit or loss in 20X0. You should state all relevant journal entries for 20X0.
Solution
Interest is calculated as 9.9% of the outstanding capital balance at the beginning of each year. The
outstanding capital balance reduces each year by the capital element comprised in each
instalment. The outstanding capital balance at 1 January 20X0 is the $38 million fair value at which
both the asset and liability are initially recorded. Depreciation on the plant is to be provided for at
the rate of 20% per annum on a straight line basis assuming a residual value of nil.
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Financial Reporting
Annual lease
Balance of lease at payment at Balance of lease
Year 1 Jan Interest 9.9% 31 Dec at 31 Dec
$'000 $'000 $'000 $'000
20X0 38,000 3,762 (10,000) 31,762
20X1 31,762 3,144 (10,000) 24,906
20X2 24,906 2,466 (10,000) 17,372
20X3 17,372 1,720 (10,000) 9,092
20X4 9,092 908 (10,000) -
Amounts to be included in profit or loss in 20X0 are: $m
Depreciation (38m/5 years) 7.600
Finance cost 3.762
Note that the $10m lease payment in 20X0 includes payment of the $3.762m interest for the year
plus a capital amount of $6.238m.
Journal entries
DEBIT Property, plant and equipment $38,000,000
CREDIT Finance lease obligation $38,000,000
To recognise the asset and finance lease obligation at the commencement of the lease.
DEBIT Finance cost (profit or loss) $3,762,000
CREDIT Finance lease obligation $3,762,000
To recognise the finance cost accruing on the lease obligation.
DEBIT Finance lease obligation $10,000,000
CREDIT Cash $10,000,000
To recognise the payment of the lease instalment.
DEBIT Depreciation expense $7,600,000
CREDIT Accumulated depreciation $7,600,000
To recognise depreciation on the leased asset.
Solution
Interest is calculated as 15% of the outstanding capital balance at the beginning of each year. The
outstanding capital balance reduces each year by the capital element comprised in each
instalment. The outstanding capital balance at 1 January 20X5 is $5,710 ($7,710 fair value less
$2,000 deposit).
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In the above examples, repayments are made at the end of each reporting period i.e. in arrears. It
may be that repayments are made at the start of a reporting period, i.e. in advance, and in this case
the lease obligation table takes a slightly different format. The following example illustrates this.
Example: Finance lease with payments in advance
Jesmond acquired an asset by way of a five-year term finance lease on 1 July 20X0. The asset had
a fair value of $102,500 and a useful life of five years and the lease contract required five equal
payments in advance of $25,000 each. The interest rate implicit in the lease is 11%. Jesmond’s
year end is 30 June.
Draw up the lease liability table for Jesmond for the whole five-year period, identifying amounts for
inclusion in the statement of profit or loss for the year ended 30 June 20X1 and preparing journal
entries for the first year of the lease term.
Solution
Interest at
B/ Repayment C/f 11% C/f
$ $ $ $ $
30.6.X1 102,500 (25,000) 77,500 8,525 86,025
30.6.X2 86,025 (25,000) 61,025 6,713 67,738
30.6.X3 67,738 (25,000) 42,738 4,701 47,439
30.6.X4 47,439 (25,000) 22,439 2,468 24,907
30.6.X5 24,907 (25,000)*
* There is a rounding difference of $93.
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 30 JUNE 20X1
$
Depreciation ($102,500/5 years) 20,500
Finance cost 8,525
Note that in this example, interest is calculated after the repayment i.e. it is based on the amount
owed throughout a period. Therefore, the table includes items in a different order to that seen
previously.
Journal entries
DEBIT Property, plant and equipment $102,500
CREDIT Finance lease obligation $102,500
To recognise the asset and finance lease obligation at the commencement of the lease.
DEBIT Finance lease obligation $25,000
CREDIT Cash $25,000
To recognise the payment of the lease instalment.
DEBIT Finance cost (profit or loss) $8,525
CREDIT Finance lease obligation $8,525
To recognise the finance cost accruing on the lease obligation.
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Financial Reporting
28,310
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9: Leases | Part C Accounting for business transactions
Solution
The company's accounts for the first year of the lease, the year ended 31 December 20X0, would
include the information given below.
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X0 (EXTRACTS)
$'000 $'000
Non-current assets
Assets held under finance leases
Plant and machinery at cost 38,000
Less accumulated depreciation ($38,000/5 years) 7,600
30,400
Non-current liabilities
Obligations under finance leases
(Balance at 31 December 20X1) 24,906
Current liabilities
Obligations under finance leases (31,762 – 24,906) 6,856
(Note that only the outstanding capital element is disclosed under liabilities, i.e. the total of the
minimum lease payments with future finance charges separately deducted.)
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 DECEMBER 20X0 (EXTRACT)
$'000
Interest payable and similar charges
Interest on finance leases 3,762
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Financial Reporting
It is the Company’s policy to lease certain equipment under finance leases. The average lease
term is 5 years. For the year ended 31 December 20X3, the average effective borrowing rate was
9.9%. Interest rates are fixed at the contract date. All leases are on a fixed repayment basis and no
arrangements have been entered into for contingent rental payments.
Self-test question 3
Potter leases an asset (as lessee) on 1 January 20X1, incurring $20,000 of costs in setting up the
agreement. Potter agrees to pay a non-refundable deposit of $58,000 on inception together with six
annual instalments of $160,000, payable in arrears.
Potter also guaranteed to the lessor that the lessor would receive at least $80,000 when the asset
is sold in the general market at the end of the lease term.
The fair value of the asset (equivalent to the present value of minimum lease payments) on
1 January 20X1 is $800,000. Its useful life to the company is five years.
The interest rate implicit in the lease has been calculated as 10%.
Required
(a) Prepare the relevant extracts from the statement of financial position and statement of profit
or loss of Potter in respect of the above lease for the year ended 31 December 20X1.
(b) Explain what would happen at the end of the lease if the asset could be sold by the lessor:
(i) For $80,000
(ii) For only $60,000
(The answer is at the end of the chapter)
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2.3 Recap
The following diagram gives a useful summary of the accounting treatment for a finance lease
by a lessee.
Accounting for a finance lease by a lessee
Start
233
Financial Reporting
3 Lessor accounting
Topic highlights
Lessor accounting:
Operating leases: record as long-term asset and depreciate over useful life, record income
on a straight line basis over the lease term.
Finance leases: record the amount due from the lessee in the statement of financial position
at the net investment in the lease, recognise finance income to give a constant periodic rate
of return.
To a certain extent at least, the accounting treatment of leases adopted by lessors will be a mirror
image of that used by lessees.
HKAS 17.49-
53
3.1 Operating leases
3.1.1 Accounting treatment
Statement of financial position
An asset held by a lessor under an operating lease is treated as a long-term asset and
depreciation is recorded over its useful life. The depreciation basis should be the same as the
lessor's policy on similar non-lease assets which shall follow the guidance in HKAS 16.
In determining whether there is an impairment of the leased asset, the lessor should refer to the
issues discussed in HKAS 36.
Statement of profit or loss and other comprehensive income
Income under an operating lease, excluding charges for services such as insurance and
maintenance, should be recognised over the period of the lease on a straight line basis. This is so
even if the receipts are not on such a basis, unless another systematic and rational basis is identified
as more representative of the time pattern in which the benefit from the leased asset is receivable.
In accordance with HK(SIC)Int-15 Operating Leases – Incentives (see section 2.1.1), the lessor
should recognise the aggregate cost of incentives as a reduction of rental income over the lease
term, generally on a straight line basis.
Initial direct costs incurred by lessors in negotiating and arranging an operating lease should be
capitalised and amortised over the lease term. These costs are included in the carrying amount of
the leased asset and recognised as an expense over the lease term on the same basis as lease
income.
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Illustration
Accounting policy
Rental income from operating leases is recognised on a straight line basis over the term of the
relevant lease. Initial direct costs incurred in negotiating and arranging an operating lease are
added to the carrying amount of the leased asset and recognised on a straight line basis over the
lease term.
Operating lease arrangements
Property rental income earned during the year was $12 million (20X2: $16.2 million). Direct
operating expenses arising on the investment property in the period amounted to $2 million (20X2:
$3.4 million). Certain of the Group’s properties held for rental purposes with a carrying amount of
$26 million have been disposed of since the reporting date. The remaining properties are expected
to generate rental yields of 6% on an ongoing basis. All of the properties have committed tenants
for the next 7 years. All operating lease contracts contain market review clauses in the event that
the lessee exercises its option to renew. Lessees do not have the option to purchase properties at
the expiry of the lease period.
At the reporting date the Group had contracted with tenants for the following future minimum lease
payments:
20X3 20X2
$’000 $’000
Within one year 12,000 12,000
In the second to fifth years inclusive 48,000 48,000
After five years 24,000 36,000
84,000 96,000
Self-test question 4
Moor Leasing Co leases a property to Rombald Hotel Co for 3 years from 1 July 20X4. Moor
Leasing Co incurs costs in arranging the lease of $136,000.
Details are as follows:
The carrying amount of leased property at commencement of lease is $51 million
The remaining useful life is 34 years
An initial non-refundable deposit of $1.8 million is required to be paid by Rombald Hotel Co
Monthly rentals of $75,000 are payable in arrears in accordance with the terms of the lease
Required
Prepare extracts from the financial statements of Moor Leasing Co for the year ended 31
December 20X4 in respect of the lease.
(The answer is at the end of the chapter)
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Financial Reporting
This net investment reduces over the period of the lease due to payments received; it will also
increase due to interest receivable. In other words, the movement is the direct opposite of the
movement seen in the finance lease obligation of a lessee:
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$
Balance 1 January 20X8 60,000
Instalment 1 January 20X8 (11,000)
Balance c/f 49,000
Interest at 12.8% 6,272
Balance at 31 December 20X8 55,272
Instalment 1 January 20X9 (11,000)
Balance c/f 44,272
Therefore, in the statement of financial position of Hire Co., a current and non-current asset is
recognised.
Non-current asset: Net investment in finance lease $44,272
Current asset: Net investment in finance lease (55,272 – 44,272) $11,000
Interest receivable of $6,272 is recognised in the statement of profit or loss and other
comprehensive income.
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Financial Reporting
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Solution
At the date of sale/inception of the lease
$ $
On the sale of the asset:
DEBIT Cash 1,320,000
CREDIT Asset 840,000
Deferred income 480,000
On the lease back of the asset:
DEBIT Asset 1,320,000
CREDIT Finance lease obligation 1,320,000
On the payment of the first instalment:
DEBIT Finance lease obligation 39,000
CREDIT Cash 39,000
Amounts charged to the statement of profit or loss and other comprehensive income for the year
ended 28 February 20X9 will include:
Depreciation of the asset ($1,320,000/40 years) $33,000
A release of the deferred income ($480,000/40 years) $12,000
Interest accrued on the lease at the implicit rate
Solution
Agreement 1 Sale is for fair value and therefore a profit of $10,000 is recognised immediately
in profit or loss.
Agreement 2 Sale is for less than fair value however the loss is not compensated for by low
future rentals. Therefore, the loss of $5,000 is recognised immediately.
Agreement 3 Sale is for less than fair value and the loss is compensated for by low future
rentals. Therefore, the loss of $30,000 is recognised in the statement of financial
position and released to profit or loss over the lease term.
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Financial Reporting
Agreement 4 Sale is for more than fair value. Therefore, a profit of $10,000 being the
difference between the fair value and carrying amount is recognised in profit or
loss immediately and the excess profit of $20,000 is recognised in the statement
of financial position and released to profit over the lease term.
Key term
Off-balance sheet finance is the funding or refinancing of a company's operations in such a way
that, under legal requirements and traditional accounting conventions, some or all of the finance
may not be shown in its statement of financial position.
‘Off-balance sheet transactions’ are transactions which meet the above objective. These
transactions may involve the removal of assets from the statement of financial position, as well as
liabilities, and they are also likely to have a significant impact on profit or loss.
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sheet. Unfortunately, the position of the company is then misstated and the user of the accounts is
misled.
You must understand that not all forms of 'off-balance sheet finance' are undertaken for cosmetic
or accounting reasons. Some transactions are carried out to limit or isolate risk, to reduce interest
costs and so on. In other words, these transactions are in the best interests of the company, not
merely a cosmetic repackaging of figures which would normally appear in the statement of financial
position.
241
Financial Reporting
HK(SIC) Int-27 includes a list of indicators that collectively demonstrate that, in substance,
a separate investment account and lease payment obligations do not meet the definitions
of an asset and a liability and should not be recognised by the entity.
Other obligations of an arrangement, including any guarantees provided and obligations
incurred upon early termination, should be accounted for under HKAS 37 or HKAS
39/HKFRS 9, depending on the terms. Further, it agreed that the criteria in HKAS 18.20
should be applied to the facts and circumstances of each arrangement in determining when
to recognise a fee as income that an entity might receive.
(c) A series of transactions that involve the legal form of a lease is linked, and therefore should
be accounted for as one transaction, when the overall economic effect cannot be
understood without reference to the series of transactions as a whole.
Example: Gas
A manufacturing company enters into an arrangement with a utilities company to supply a minimum
amount of gas for a specified period of time. The utilities company builds a facility next to the
manufacturing company to produce the gas as it is not practical to rely on one of its existing
facilities. The utilities company maintains ownership and control over the facility. The utilities
company charges the manufacturing company a fixed capacity charge plus a variable amount
based on the costs incurred in generating the gas supplied.
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7 Current developments
In August 2010, the IASB and American standards board, FASB, issued an Exposure Draft of a
new standard on leases with the intention of replacing IAS 17. A revised exposure draft was issued
in May 2013. It is highly likely that such a new standard will in turn be adopted by the HKICPA and
so replace HKAS 17. The 2013 exposure draft is currently being redeliberated and the IASB’s
current work plan suggests that a final standard will be issued in the second half of 2015.
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Financial Reporting
by the lessee (eg motor vehicles and equipment); Type B leases would be those where not more
than an insignificant amount of the underlying asset is consumed by the lessee (eg property).
Expenses and cash flows would be recognised as follows:
Statement of financial position The asset is derecognised and The asset continues to be
instead a lease receivable is recognised
recognised together with a
residual asset (a retained
interest in the underlying
asset)
Statement of profit or loss Profit on the lease at the start Rental income is recognised
of the lease is recognised
together with interest income
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Topic recap
HKAS 17 Leases
A lease that transfers substantially all of the A lease other than a finance lease
risks and rewards incidental to ownership of an
asset. Legal title may or may not pass at the
end of the lease term
Record asset and Record amount due Recognise rental Recognise non-
corresponding liability at from lessee at net expenditure on a current asset and
lower of fair value and investment in lease. straight line basis. depreciate.
PV of minimum lease
payments. Recognise finance Record income on
income to give constant a straight line basis
Depreciate asset over periodic rate of return. over the lease
shorter of lease term term.
and UL of asset. Manufacturers / dealers
recognise the difference
Allocate finance charge between cost of the
to give constant periodic asset and fair value as
rate of return (actuarial an outright sale.
method).
Profit or loss deferred and amortised over the lease Sale at FV Recognise profit/loss
term immediately
Sale > FV Defer excess profit
If substance is a secured loan record proceeds as a Sale < FV Recognise profit/loss
financial liability (HK(SIC)Int 27) immediately but defer any
loss where compensated
for by low future lease
payments
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Financial Reporting
Answer 1
Land and buildings leased together are considered separately for the purposes of lease
classification.
A lease of land is normally treated as an operating lease, unless title is expected to pass at
the end of the lease term.
A lease of buildings will be treated as a finance lease if it satisfies the requirements of
HKAS 17.
There is no indication that title will pass in respect of the land and therefore the lease in respect of
the land is classified as an operating lease. The ability to extend the lease for a secondary period
for below market rent suggests that the lease in respect of the building is a finance lease.
Therefore the lease payments will be split in line with the fair values of the land and the building.
$6,470,588 ($11,000,000 100/170) will be treated as payment on an operating lease for the land
and $4,529,412 ($11,000,000 70/170) will be treated as payment on a finance lease for the
building.
Answer 2
Statement of profit or loss for the year ended 31 December 20X7 (extract)
$
Operating lease expense 20,000
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Answer 3
(a) Financial statement extracts
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X1
$
Depreciation [(800,000 + 20,000 – 80,000)/5)] 148,000
Finance costs (Working) 74,200
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Financial Reporting
Answer 4
Statement of profit or loss for the year ended 31 December 20X4 (extract)
$
Depreciation (752,000)
Operating lease income 783,333
Statement of financial position at 31 December 20X4 (extract)
$
Property 50,384,000
Non-current liabilities
Deferred income 900,000
Current liabilities
Deferred income 600,000
Note – Operating lease arrangements
The company rents property out under arrangements classified as operating leases. Property rental
income earned in the year was $750,000. Direct operating expenses arising on the arrangement of
operating leases are added to the carrying amount of the underlying property and amortised over
the remaining useful life of the asset. The lessee does not have an option to purchase the property
at the expiry of the lease period.
At the reporting date the company had contracted with tenants for the following future minimum
lease payments:
$
Within one year (12m 75,000) 900,000
In the second to fifth years (18m 75,000) 1350,000
After five years
2,2500,000
WORKINGS
Income $
Total lease receipts (3 yrs 12 m $75,000) + $1,800,000 4,500,000
Annual credit to income therefore $4,500,000/3years 1,500,000
Income in the year $1,500,000 6/12m 750,000
Deferred income
Income in the year 750,000
Cash received (6m $75,000) + $1,800,000 2,250,000
Deferred income 1,500,000
Deferred income within one year ($1,500,000 – (12 $75,000)) 600,000
Deferred income in more than one year (balance) 900,000
Non-current asset
Property carrying amount at commencement of lease 51,000,000
Initial direct costs 136,000
51,136,000
Depreciation (51,136,000 / 34 years) 6/12m (752,000)
Carrying amount at 31 December 20X4 50,384,000
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Exam practice
249
Financial Reporting
250
chapter 10
Inventories
Topic list
Learning focus
Inventory and short-term work-in-progress valuation has a direct impact on a company's gross
profit and it is usually a material item in any company's accounts. This is therefore an
important subject area as far as the statement of profit or loss is concerned as there are
different accounting treatments for inventories.
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Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.06 Inventories 3
3.06.01 Scope and definition of HKAS 2 Inventories
3.06.02 Calculate the cost of inventories in accordance with HKAS 2
3.06.03 Use accepted methods of assigning costs including the allocation of
overheads to inventories
3.06.04 Explain the potential impact of net realisable value falling below
cost and make the required adjustments
3.06.05 Calculate and analyse variances in a standard costing system and
advise on the appropriate accounting treatment to be adopted in
respect of inventories
3.06.06 Prepare a relevant accounting policy note and other required
disclosures in respect of inventories
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The inventory balance is significant to many companies both as an asset and due to its impact on
profits. The measurement of inventory, however, remains a highly subjective area and a number of
different methods may be used in practice.
HKAS 2 provides guidance on the measurement of inventory and its recognition as an expense.
Key terms
Inventories are assets:
Held for sale in the ordinary course of business
In the process of production for such sale
In the form of materials or supplies to be consumed in the production process or in the
rendering of services
Net realisable value is the estimated selling price in the ordinary course of business less the
estimated costs of completion and the estimated costs necessary to make the sale.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date. (HKAS 2)
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Financial Reporting
Key terms
Fixed production overheads are defined by the standard as those indirect costs of production
that remain relatively constant regardless of the volume of production such as depreciation and
maintenance of factory buildings and equipment and the cost of factory management and
administration. Fixed production overheads must be allocated to items of inventory on the basis
of the normal capacity of the production facilities. Normal capacity is the expected achievable
production based on the average over several periods/seasons, under normal circumstances, and
taking into account the capacity lost through planned maintenance. The standard makes the
following additional points:
If it approximates to the normal level of activity then the standard states that the actual level
of production can be used.
Low production or idle plant will not result in a higher fixed overhead allocation to each
unit.
Unallocated overheads must be recognised as an expense in the period in which they were
incurred.
In periods of abnormally high production, the fixed production overhead allocated to each
unit will be decreased, so that inventories are not measured at more than cost.
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Variable production overheads are allocated to each unit on the basis of the actual use of
production facilities. Variable production overheads are defined as those indirect costs of
production that vary directly, or nearly directly, with the volume of production, such as
indirect materials and labour. When a production process results in the simultaneous
production of more than one product, and the costs of conversion are not separately
identifiable, they should be allocated between products on a rational and consistent basis.
An example of an appropriate basis given in the standard is the sales value of each product
when complete.
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Financial Reporting
HKAS
2.21,22
1.5 Techniques for the measurement of cost
HKAS 2 allows that techniques for the measurement of cost may be used for convenience where
these approximate to cost. The two methods mentioned within the standard are as follows:
(a) Standard costs, which take into account normal levels of raw materials used, labour time
and so on. They are reviewed and revised on a regular basis.
(b) The retail method, which is often used in the retail industry where there are large numbers
of items with a rapid turnover and similar margins. Here, the only practical method of
inventory valuation may be to take the total selling price of inventories and deduct an overall
average profit margin, thus reducing the value to an approximation of cost. The percentage
must take into consideration reduced price lines. Sometimes different percentages are
applied to different retail departments.
HKAS
2.23,25-27
1.6 Cost formulae
Topic highlights
Where inventory is not interchangeable, cost should be specifically identified. Where inventories
consist of interchangeable items, cost is assigned using the First in, First out (FIFO) or weighted
average formula.
Where items of inventory are not normally interchangeable or goods or services are produced and
segregated for specific projects, the cost of inventories should be specifically identified.
Where inventories consist of a number of interchangeable items, cost is assigned by using the
First In, First Out (FIFO) or weighted average cost formulae. Last In, First Out (LIFO) is not
permitted.
Under the weighted average cost method, a recalculation can be made after each purchase, or
alternatively only at the period end.
HKAS 2 requires that an entity should use the same cost formula for all inventories having
similar nature and use to the entity. For inventories with different nature or use (for example,
certain commodities used in one business segment and the same type of commodities used in
another business segment), different cost formulae may be justified. A difference in geographical
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location of inventories (and in the respective tax rules), by itself, is not sufficient to justify the use of
different cost formulae.
Solution
FIFO
Sales
Opening stock 100 $2.00 5 September 75 units
18 September 25 units
3.9 Purchase 100 $2.30 18 September 55 units
29 September 45 units
10.9 Purchase 50 $2.35 29 September 50 units
25.9 Purchase 80 $2.40 29 September 5 units
Closing stock 75 units
Sales are matched to the earliest purchases such that closing stock is made up of 75 units
purchased on 25 September. Closing stock is therefore measured at $180 (75 units $2.40).
Weighted average (period end)
The weighted average cost of stocks during September is:
100 units $2.00 200.00
100 units $2.30 230.00
50 units $2.35 117.50
80 units $2.40 192.00
330 units 739.50
therefore weighted average cost per unit $2.24
Closing stock is therefore measured at $168 (75 units $2.24)
Weighted average (continuous)
Date Purchases Sales Balance Weighted average price
1.9 100 $2 100 $2
3.9 100 $2.30 200 100 $2 100 $2.30
$2.15
100 100
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Financial Reporting
Topic highlights
NRV is the estimated selling price of an item of inventory less estimated costs to complete and sell
it.
Prudence requires that assets are not overstated. In the case of inventories, this means that they
should not be measured at an amount greater than the price that is expected to be realised from
their sale.
In some cases the cost of inventory may be greater than the amount for which it can be sold, for
example where:
Goods are damaged or obsolete
The costs to completion have increased
The selling price has fallen
The goods are to be sold at a loss as part of a marketing strategy
Production errors have led to increased costs
In these cases, inventory is carried at the NRV which is less than cost.
Inventory is normally written down on an item by item basis, but sometimes it may be appropriate
to group similar or related items together. This grouping together is acceptable for, say, items in
the same product line, but it is not acceptable to write down inventories based on a whole
classification (e.g. finished goods) or a whole business.
The assessment of NRV should be based on the most reliable evidence available and should take
place at the same time as estimates are made of selling price. Fluctuations of price or cost should
be taken into account if they relate directly to events after the reporting period, which confirm
conditions existing at the end of the period.
The reasons why inventory is held should also be taken into account. For example, where
inventory is held to satisfy a firm contract, its NRV will be the contract price. Any additional
inventory of the same type held at the period end will, in contrast, be assessed according to
general sales prices when NRV is estimated.
At each period end, NRV must be reassessed and compared with cost. Where circumstances have
changed since the end of the previous period and there is a clear increase in NRV, then the
previous write down must be reversed to the extent that the inventory is then valued at the lower of
cost and the new NRV. This situation may arise when selling prices have fallen in the past and then
risen again.
On occasion a write down to NRV may be of such size, incidence or nature that it must be
disclosed separately.
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Solution
Inventory must be measured line by line rather than as a whole, taking lower of cost and NRV in
each case:
Cost NRV Valuation
$m $m $m
Product A (Cost) 4.0 5.5 4.0
Product B (NRV) 10.0 9.5 9.5
Product C (Cost) 8.0 10.0 8.0
Product D (NRV) 14.0 13.0 13.0
34.5
Therefore it is measured at $34.5m (working) and should be written down by $500,000. This is
achieved by ($):
DEBIT Inventory written down 500,000
CREDIT Inventories 500,000
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Financial Reporting
Self-test question 1
Ramsbottom Co. is a manufacturer of components used in the motor industry. It makes two
products, XX1 and ZZ2.
Certain parts of the production process give rise to indirect costs specifically identifiable with only
one of these products, although other costs are not separately identifiable.
Budgeted cost information for March 20X1 is as follows:
XX1 ZZ2 Total
Budgeted output 1,000 units 1,200 units
$ $ $
Direct cost 365,000 380,000 745,000
Indirect production overheads
Identifiable 65,000 55,000 120,000
Other 80,000
During the month, costs were incurred in line with the budget, but due to a failure of calibration to a
vital part of the process, only 1,050 units of ZZ2 could be taken into inventory. The remainder
produced had to be scrapped, for zero proceeds.
Ramsbottom allocates indirect costs which are not specifically identifiable to an individual product
by reference to relative selling prices. This results in 55% being allocated to XX1 and 45% to ZZ2.
Required
Calculate the cost attributable to each product.
(The answer is at the end of the chapter)
HKAS 2.36-
39
1.9 Disclosure requirements
HKAS 2 requires the financial statements to disclose the following:
(a) The accounting policies adopted in measuring inventories, including the cost formula used
(b) The total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity
(c) The carrying amount of inventories carried at fair value less costs to sell
(d) The amount of inventories recognised as an expense during the period
(e) The amount of any write down of inventories to net realisable value recognised as expense
and in the period
(f) The amount of any reversal of any write down of inventories to net realisable value
recognised as reduction in ‘the amount of inventories recognised as an expense in the
period’
(g) The circumstance or events that led to the reversal of a write down of inventories
(h) The carrying amount of inventories pledged as security for liabilities
Information about the carrying amounts held in different classifications of inventories and the extent
of the changes in these assets is useful to financial statement users. Common classifications of
inventories are merchandise, production supplies, materials, work in progress and finished goods.
The inventories of a service provider may be described as work in progress.
Some entities adopt a format for profit or loss that results in amounts being disclosed other than the
cost of inventories recognised as an expense during the period. Under this format, an entity
presents an analysis of expenses using a classification based on the nature of expenses. In this
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case, the entity discloses the costs recognised as an expense for raw materials and consumables,
labour costs and other costs together with the amount of the net change in inventories for the
period.
Illustration
The following are illustrative disclosures in respect of inventories:
Significant accounting policies (extract)
Inventories
Inventories are stated at the lower of cost and net realisable value. Cost comprises direct materials,
and, where applicable, direct labour costs and those overheads that have been incurred in bringing
the inventories to their present location and condition. Cost is calculated using the weighted
average method. Net realisable value represents the estimated selling price less all estimated
costs of completion and costs to be incurred in marketing, selling and distribution.
Inventories
20X2 20X1
$’m $’m
Raw materials 12 14
Work-in-progress 35 28
Finished goods 17 18
64 60
Inventories classified as part of a disposal group held for
sale and measured at fair value less costs to sell 9 –
73 60
During the year, due to an increase in the estimated net realisable value of finished goods as a
result of changes in market preferences, a reversal of a previous write down of finished goods of
$Xm is recognised in cost of sales.
Inventories with a carrying amount of $Xm have been pledged as security for the Company’s
overdraft.
Self-test question 2
Hong Kong Floral Design Company (‘Floral’) manufactures silk flowers from its base in Hong
Kong. The annual inventory count was conducted on 31 May 20X4, being the year end, and the
following information has been determined from inventory sheets relating to work in progress:
$
Materials included in work in progress 320,000
Labour hours included in work in progress ($35 per hour) 460,250
In addition, the following overheads were incurred in the year:
$
Factory rent and rates 525,000
Floor supervisors’ salaries 320,000
Light, heat and power 345,000
Sales commission and distribution costs 210,000
Depreciation of production line machinery 187,000
Depreciation of delivery vehicles (used to deliver orders to customers) 165,000
Storage of finished goods 126,500
Light, heat and power, sales commission and distribution costs, depreciation and storage are all
considered to be variable costs.
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Financial Reporting
Overheads are absorbed on the basis of labour hours; the normal number of hours worked in a
year by production staff are 150,000, however due to an unusually high number of black rainstorm
signals in the year, resulting in the closure of the factory and suspension of production, only
125,000 hours were worked in the year ended 31 May 20X4.
Required
What is the value of work in progress at 31 May 20X4?
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Topic recap
HKAS 2 Inventories
Finished goods
Work in progress
Raw materials
Disclosures:
Accounting policies and cost formulae used
Carrying amount of inventories classified by type
Carrying amount of inventories measured at fair value less costs to sell
Inventories recognised as an expense in the period
Inventory write downs / reversal of write downs recognised in the period and circumstances that led to the
write down / reversal.
Carrying amount of inventories pledged as security
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Financial Reporting
Answer 1
The total cost attributable to XX1 is calculated as:
$365,000 + $65,000 + (55% $80,000) = $474,000
The cost per unit therefore being $474,000 / 1,000 = $474 each.
The total cost $474,000 attributable to XX1 can all be allocated to the inventories of XX1.
The total cost attributable to ZZ2 is:
$380,000 + $55,000 + (45% $80,000) = $471,000
The cost per unit therefore being $471,000 / 1,200 = $392.50 each.
The allocation of the cost for ZZ2 is therefore:
$392.50 1,050 = $412,125 as inventories
$392.50 150 = $58,875 as an expense
The indirect costs not specifically identifiable with either product which are allocated to the
scrapped ZZ2 cannot be recovered into the cost of XX1.
Answer 2
The direct costs to be included in the measurement of inventories are:
$
Direct materials 320,000
Direct labour 460,250
780,250
Overheads are included in the carrying amount of inventory only if they relate to bringing the
inventory to its current location and condition at the reporting date.
Costs that do not contribute to the current location and condition of inventories are recognised in
profit or loss in appropriate cost categories:
Distribution costs $
Sales commission and distribution costs 210,000
Depreciation of delivery vehicles 165,000
Storage of finished goods 126,500
501,500
The remaining overheads are included in the measurement of work-in-progress as they are
relevant to bringing the inventory to its current location and condition.
Certain overheads are fixed and these are absorbed based on the normal level of production:
$
Factory rent, and rates 525,000
Floor supervisors' salaries 320,000
845,000
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The labour hours spent on work in progress are $460,250/$35 = 13,150 hours. Fixed overheads to
be included in the valuation of work-in-progress are therefore 13,150 hours $5.63 = $74,035.
Actual hours worked by production staff in the year are 125,000. Therefore 125,000 $5.63 =
$703,750 of the fixed production overheads are absorbed into inventories. The remaining $845,000
– $703,750 = $141,250 are recognised in profit or loss in an appropriate cost category (likely to be
cost of sales or administrative expenses).
Variable overheads are absorbed based on the actual level of production:
$
Light, heat and power 345,000
Depreciation of production machinery 187,000
532,000
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Financial Reporting
Exam practice
266
chapter 11
Provisions, contingent
liabilities and contingent
assets
Topic list
Learning focus
Accounting for uncertainty and contingencies requires some judgment and supporting
evidence in applying the accounting standards. You must learn the recognition criteria for
provisions and be able to apply them. You should also be able to advise the directors on the
implications for the financial statements of the changes proposed.
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Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.16 Provisions, contingent liabilities and contingent assets 3
3.16.01 Define provisions, contingent liabilities and contingent assets within
the scope of HKAS 37
3.16.02 Distinguish provisions from other types of liabilities
3.16.03 Explain the criteria for recognition of provisions and apply them to
specific circumstances
3.16.04 Apply the appropriate accounting treatment for contingent assets
and liabilities
3.16.05 Disclose the relevant information relating to contingent liabilities in
the financial statements
3.16.06 Account for decommissioning, restoration and similar liabilities and
their changes
3.16.07 Disclose the relevant information relating to contingent assets in the
financial statements
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1.1 Objective
HKAS 37 Provisions, Contingent Liabilities and Contingent Assets aims to make sure that
provisions, contingent liabilities and contingent assets are being dealt with based on appropriate
recognition criteria and measurement bases. In addition, sufficient information should be
disclosed in the notes to the financial statements to enable users to understand their nature, timing
and amount.
Key terms
A provision is a liability of uncertain timing or amount.
A liability is a present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
A contingent liability is:
(a) 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
(b) A present obligation that arises from past events but is not recognised because:
(i) It is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; or
(ii) 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.
(HKAS 37.10)
We shall meet more definitions as we consider the accounting treatment of provisions and
contingencies.
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Financial Reporting
2 Provisions
Provisions are differentiated from other liabilities such as trade payables and accruals by the
HKICPA. The main difference is that there is uncertainty about the timing or amount of the future
expenditure for a provision. For certain accruals, uncertainty, though it exists, is generally much
less than for provisions.
HKAS 37 includes the criteria for recognising a provision as a liability in the statement of financial
position and also provides guidance for measuring such a provision. In addition, and due to the
subjective nature of the topic matter, it gives examples of common situations in which a provision
can be made.
HKAS 37 states that a provision should be recognised as a liability in the financial statements when:
An entity has a present obligation (legal or constructive) as a result of a past event
It is probable that an outflow of resources embodying economic benefits will be required
to settle the obligation
A reliable estimate can be made of the obligation
Some of these terms require further explanation, and this is given in the next two sections of the
chapter.
HKAS 2.1.1 Obligation
37.10,17-22
A legal obligation is a fairly easy idea to understand: it is a duty to act in a certain way deriving from
a contract, legislation, or some other operation of the law.
You should note that an event which does not currently give rise to a legal obligation may do so at
a later date due to changes in the law. In this case the obligation arises when new legislation is
virtually certain to be enacted as drafted; in many cases this is impossible to ascertain before
actual enactment.
You may not know what a constructive obligation is.
Key term
HKAS 37 defines a constructive obligation as:
‘An obligation that derives from an entity's actions where:
By an established pattern of past practice, published policies or a sufficiently specific current
statement, the entity has indicated to other parties that it will accept certain responsibilities
As a result, the entity has created a valid expectation on the part of those other parties that it
will discharge those responsibilities.’
The following question shows how this definition is applied and will help your understanding of a
constructive obligation.
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Self-test question 1
(a) Black Gold Oil Co. drills for oil in locations worldwide. Mindful of the public perception of
such oil companies after recent disasters involving oil spills, Black Gold Oil Co. has recently
used press and television advertisements to promote its green credentials, and in particular,
has pledged to clean up any contamination that it causes.
In the year ended 31 December 20X0, Black Gold Oil Co. causes extensive contamination in
a country in which there is no environmental legislation.
Does a present obligation exist at 31 December 20X0?
(b) A well-known retailer is under legal obligation to refund money to customers who return
unwanted goods within a 28-day period. The retailer has announced a policy of extending
this return period to 60 days, and accordingly has printed this promise on its carrier bags.
Does the retailer have a present obligation as a result of a past event?
(c) On 12 October 20X3 the Board of West Royd Co decided to close one of its operating
divisions, resulting in a large number of redundancies. The decision was publicly announced
at a press conference on 15 November 20X3, the day after a staff meeting was held to
inform employees of the decision.
Does West Royd Co have a present obligation at 31 October 20X3?
(The answer is at the end of the chapter)
In some instances, for example when a court case is underway, it is not clear whether there is a
present obligation. In these cases, all available evidence should be considered, and if it is more
likely than not that a present obligation exists at the reporting date, then a present obligation as a
result of a past event is deemed to exist.
HKAS 37.36-
38, 41
2.2 Measuring a provision
Topic highlights
The amount recognised as a provision should be the best estimate of the expenditure required to
settle the present obligation at the year end. This may be calculated using expected values when
the provision involves a large population of items.
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Financial Reporting
The third criterion which must be met in order to recognise a provision is that a reliable estimate
can be made of the obligation.
HKAS 37 provides detailed guidance on how this estimate should be made. The overriding
requirement is that the amount recognised as a provision shall be the best estimate of the
expenditure required to settle the present obligation at the end of the reporting period.
The standard goes on to say that this is the amount that an entity would pay to settle the obligation
or transfer it to a third party at the reporting date, even though a settlement or transfer at this time
will often be impossible or prohibitively expensive.
The estimates will be determined by the judgment of the entity's management supplemented by
the experience of similar transactions, and in some cases the reports from independent experts.
A provision should be measured before any related tax effect.
HKAS 37.40 2.2.1 Most likely outcome
Where a single obligation is being measured, the most likely outcome may be the best estimate of
the liability. HKAS 37 does, however, stipulate that all possible outcomes are considered and
where these are mostly higher (or mostly lower) than the expected outcome, the best estimate will
be higher (or lower).
Self-test question 2
Alice Co. sells goods with a warranty under which customers are covered for the cost of repairs of
any manufacturing defect that becomes apparent within the first six months of purchase. The
company's past experience and future expectations indicate the following pattern of likely repairs.
Cost of repairs if all goods
% of goods sold Defects suffered from the defect
$m
75 None –
20 Minor 1.0
5 Major 4.0
What is the expected cost of repairs and how is a provision recorded?
(The answer is at the end of the chapter)
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Future events
Future events which may affect the amount required to settle the entity's obligation should be taken
into account where there is sufficient evidence that they will occur.
These events may include future changes in technology or new legislation. The standard does,
however state that in the case of new legislation, in most cases sufficient objective evidence will
not exist until the legislation is actually enacted.
Expected disposal of assets
Gains from the expected disposal of assets should not be taken into account in measuring a
provision, even if the expected disposal is closely linked to the event giving rise to the provision.
HKAS 37.53-
57
2.3 Reimbursements
Some or all of the expenditure needed to settle a provision may be expected to be recovered from
a third party through insurance contracts, indemnity clauses or supplier’s warranties. These
amounts may be reimbursed to the entity or paid directly to the party to who the amount is due.
If so, the reimbursement shall be recognised when, and only when, it is virtually certain that
reimbursement will be received if the entity settles the obligation.
Generally, however, the entity will remain liable for the amount due, and would be required to pay
all of this if the third party failed to pay. This is reflected in the accounting treatment:
A provision is recognised for the full amount of the liability.
The reimbursement should be treated as a separate asset, and the amount recognised
should not be greater than the provision itself.
The provision and the amount recognised for reimbursement may be netted off in the
statement of profit or loss.
In some cases the entity will not be liable for the costs if the third party fails to pay. In this case
these costs are not included in the provision.
Self-test question 3
A corporate customer launched a legal case against Pioneer Machinery Co (‘PMC’) on 2 June
20X4 on the basis that a machine supplied by the company was faulty and as a result goods
produced by it were substandard, resulting in lost contracts and wasted materials.
PMC’s legal team has advised that the company has a 75% chance of losing the case and as a
result would have to pay $25,000,000 in damages.
PMC is covered by insurance for such an eventuality and if it loses the case against the customer it
is virtually certain that it can claim for the full amount of the loss net of a 10% excess.
Required
(a) Explain how the requirements of HKAS 37 are applied to this scenario and state the
necessary journal entries that should be made in the year ended 30 June 20X4.
(b) Identify amounts to be recognised in the financial statements of PMC in the year ended 30
June 20X4.
(The answer is at the end of the chapter)
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Financial Reporting
Where the effect of the time value of money is significant, so that a provision has been measured
at present value, the discount is unwound each year with a resulting increase to the provision. This
increase is recognised as a finance cost in profit or loss.
HKAS 37.61-
62
2.5 Use of provisions
A provision should be used only to set off expenditure for which the provision was originally recognised.
It is not permitted to set off expenditure against a provision formerly organised for another purpose
since this would conceal the impact of two different events.
HKAS 37.63-
65
2.6 Common scenarios
2.6.1 Future operating losses
No provisions should be recognised for future operating losses which do not meet the definition of
a liability and the general recognition criteria stated in the standard.
Expected future operating losses may, however, be indication of the impairment of assets related
to that operation.
Key term
An onerous contract is a contract in which the unavoidable costs of meeting the obligations under
the contract exceed the economic benefits expected to be received under it. The unavoidable costs
under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost
of fulfilling it and any compensation or penalties arising from failure to fulfil it. (HKAS 37.10)
If an entity has a contract that is onerous, the present obligation under the contract should be
recognised and measured as a provision.
A common example would be leasehold property which is vacated before the lease term ends. For
the remaining years of the lease, the cost of the property (future lease payments) exceeds the
benefits derived from the property (likely to amount to nil if it is to be left vacant). In this case,
provision should be made for the future unavoidable lease payments as at the date on which the
property is vacated. The provision is released as these payments are made in future years.
The provision is disclosed as current/non-current in accordance with HKAS 1. Practically this is
likely to mean that the total provision is split between the amount payable within one year and the
amount payable thereafter.
There is no obligation where cancellation of a contract does not result in the need to pay
compensation to another party.
HKAS 37.70- 2.6.3 Provisions for restructuring
83
One of the main purposes of HKAS 37 was to target abuses of provisions for restructuring.
Accordingly, HKAS 37 lays down strict criteria to determine when such a provision can be made.
Key term
HKAS 37 defines a restructuring as:
A programme that is planned and controlled by management and materially changes either:
The scope of a business undertaken by an entity; or
The manner in which that business is conducted.
(HKAS 37.10)
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The HKAS gives the following examples of events that may fall under the definition of
restructuring.
The sale or termination of a line of business
The closure of business locations in a country or region or the relocation of business
activities from one country or region to another
Changes in management structure, for example, the elimination of a layer of management
Fundamental reorganisations that have a material effect on the nature and focus of the
entity's operations
The question is whether or not an entity has an obligation at the year end. In respect of
restructuring, the standard states that there is a constructive obligation if:
The entity has a detailed formal plan for the restructuring
The entity has raised a valid expectation in those affected that it will carry out the
restructuring by starting to implement that plan or announcing its main features to those
affected by it
A mere management decision is not normally sufficient. Management decisions may
sometimes trigger off recognition, but only if earlier events such as negotiations with employee
representatives and other interested parties have been concluded subject only to management
approval.
When the sale of an operation is involved in the restructuring, HKAS 37 states that no obligation is
to be recognised until the entity has entered into a binding sale agreement. Until then, the entity
will be able to alter its decision and withdraw from the sale even if its intentions have been
announced publicly.
The HKAS states that a restructuring provision should include only the direct expenditures arising
from the restructuring that are both:
Necessarily entailed by the restructuring
Not associated with the ongoing activities of the entity
The following costs should specifically not be included within a restructuring provision:
Retraining or relocating continuing staff
Marketing
Investment in new systems and distribution networks
Future operating losses
Losses or gains on the expected disposal of assets
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Financial Reporting
(d) Environmental contamination. If the company has an environment policy such that other
parties would expect the company to clean up any contamination or if the company has broken
current environmental legislation then a provision for environmental damage must be made.
(e) Decommissioning or abandonment costs. When an oil company initially purchases an
oilfield it is put under a legal obligation to decommission the site at the end of its life. Prior to
HKAS 37 most oil companies built up the provision gradually over the life of the field so that
no one year would be unduly burdened with the cost.
HKAS 37, however, insists that a legal obligation exists on the initial expenditure on the field
and therefore a liability exists immediately. This would appear to result in a large charge to
profit or loss in the first year of operation of the field. However, the HKAS takes the view that
the cost of purchasing the field in the first place is not only the cost of the field itself but also
the costs of putting it right again. Therefore, all the costs of abandonment may be
capitalised.
*Entries to profit or loss should be made to an appropriate account, for example to a warranty costs
account in respect of a warranty provision or a legal costs account in respect of a provision for a
legal case.
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Illustration
Provisions
Restructuring Litigation Others
(Note 1) (Note 2) (Note 3) Total
$million $million $million $million
At 1 January 20X4 630 1,245 390 2,265
Provisions made in the year 92 210 60 362
Amounts used (180) (450) (30) (660)
Unused amounts reversed (25) (165) (85) (275)
Exchange difference 4 (5) – (1)
At 31 December 20X4 517 835 335 1,691
Notes
1 Restructuring
Restructuring provisions arose from a number of projects across the Group. These include
plans to close the manufacturing division in PRC. Restructuring provisions are expected to
result in future cash outflows when implementing the plans (usually over the following two to
three years).
2 Litigation
Litigation provisions have been set up to cover tax, legal and administrative proceedings that
arise in the ordinary course of business. These provisions cover several cases whose
detailed disclosure could be detrimental to the Group. The Group does not believe that any
of these litigation cases will have a material adverse impact on its financial position. The
timing of cash outflows depends on the outcome of proceedings.
3 Others
Other provisions are mainly in respect of onerous leases. These result from unfavourable
leases, breach of contracts or supply agreements above market prices in which the
unavoidable costs of meeting the obligations under the contracts exceed the economic
benefits expected to be received or for which no benefits are expected to be received.
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Now you understand provisions it will be easier to understand contingent assets and liabilities.
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Illustration
Contingent liabilities
During the reporting period, a customer of the Group instigated proceedings against it for alleged
defects in a product, which it claimed were the cause of a major fire in the customer’s premises on
18 August 20X3. Total losses to the customer have been estimated at $12 million and this amount
is being claimed from the Group.
The Group’s lawyers have advised that they do not consider that the lawsuit has merit and they
have recommended that it be contested. No provision has been made in these financial statements
as the group’s management do not consider that there is any probable loss.
3.3 Summary
The objective of HKAS 37 is to ensure that appropriate recognition criteria and measurement
bases are applied to provisions and contingencies and that sufficient information is disclosed.
The HKAS seeks to ensure that provisions are only recognised when a measurable
obligation exists. It includes detailed rules that can be used to ascertain when an obligation
exists and how to measure the obligation.
The standard attempts to eliminate the ‘profit smoothing’ which has gone on before it was
issued.
Self-test question 4
Explain the accounting treatment required in the following scenarios at 31 December 20X0:
(a) Rango Co., a healthcare provider, has been informed that due to upcoming legislation, it is
required to fit carbon monoxide detectors in all of its properties at a cost of $40,000. Any
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Financial Reporting
failure to do so by 30 September 20X1 will result in penalties of $5,000. Rango has not
undertaken the work by 31 December 20X0.
(b) Greenfingers Co. specialises in the sale of gardening equipment. As part of a strategy to
streamline operations, the company has decided to divest its plant division. A probable
purchaser has been identified, although no agreement has been reached by 31 December
20X0. Until an agreement has been formalised, the directors of Greenfingers will not advise
their employees of the divestment. Redundancy costs associated with the restructuring are
expected to be $120,000, and a further $50,000 will be spent on retraining certain staff
members to work in the furniture division of the company.
(The answer is at the end of the chapter)
You may wish to study the flow chart below, taken from HKAS 37, which is a good summary of its
requirements.
Self-test question 5
Cobo Co. manufactures goods which are sold with a one year warranty against defects.
(a) Should a provision be recognised for the cost of repairing faulty goods?
(b) Cobo Co.'s sales for the year are $40m. They anticipate that 60% of goods will not be faulty,
30% will need minor repairs that would cost $2m if all items were affected and 10% of goods
will need major repairs that would cost $4m if all items were affected. How much should be
provided for repairs?
(The answer is at the end of the chapter)
Self-test question 6
Asia Electric Co (‘AEC’) operates power plants and sells electricity wholesale to domestic power
providers. The following issues are relevant to the company in the year ended 31 December 20X1:
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1. The company constructed a hydro-electric power plant during the year that was ready for
use on 31 December 20X1. The construction cost of the plant amounted to $270 million .
Governmental planning permission was granted for the power plant on condition that AEC
dismantles the plant and restores the site on which it is located at the end of the plant’s
useful life (50 years). AEC estimates that the cost of this in 50 years will be $150 million and
the present value of this amount is $82 million. The accountant of AEC has created a
provision for $150 million and charged this as an exceptional expense in profit or loss.
2. In December 20X0 the former sales director of the company was dismissed. He brought an
unfair dismissal claim against AEC in February 20X1 and is seeking damages of $12 million.
The Company’s legal team has advised that the ex-employee has just a 55% chance of
winning her case the accountant has made no provision but has disclosed a contingent
liability in the statement of financial position at 31 December 20X1.
Required
(a) Comment on the accounting treatment applied by the Company accountant, suggesting the
correct treatment where necessary.
(b) Prepare the necessary numerical disclosures to be reported in the financial statements in the
year ended 31 December 20X1.
(The answer is at the end of the chapter)
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Financial Reporting
HK(IFRIC) Int-1 also deals with an increase in the liability that reflects the passage of time – also
referred to as the unwinding of the discount. This is recognised in profit or loss as a finance
cost as it occurs.
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Topic recap
HKAS 37 Provisions,
Contingent Liabilities and
Contingent Assets
Provisions Contingencies
Liability of uncertain timing and/or amount Liability of uncertain timing and/or amount Contingent asset
Recognise if: Possible obligation that arises from past Possible asset arising from past events
Present obligation (legal or events and whose existence will be whose existence will be confirmed by
constructive) as the result of a past confirmed by uncertain future events uncertain future events
event Or
Probable outflow of economic benefits Present obligation arising from past
Reliable estimate can be made of the events which is not recognised because:
obligation (i) outflow is not probable
(ii) amount can't be reliably
measured
Measure at:
Best estimate of expenditure Do not recognise unless virtually certain
Use expected values for a large (in which case not a contingent asset)
Do not recognise
population of items
Discount if the time value of money is
material
Disclose: Disclose the following unless the outflow Disclose where probable inflow:
Reconciliation of the carrying value of of resources is remote: Description of contingency
provisions at the start of the period to Description of contingency Estimate of financial effect
that at the end Estimate of financial effect
Background to the provision Details of uncertainties
Possibility of reimbursement
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Financial Reporting
Answer 1
(a) Black Gold Oil Co. has a constructive obligation, as the advertising campaign has created a
valid expectation on the part of those affected by it that the entity will clean up the
contamination that it has caused.
(b) The retailer has a legal obligation to refund money for unwanted goods within a 28-day
period after the sale, and a constructive obligation to provide refunds for 32 days beyond
this.
The past event is the sale, and therefore the retailer has a present obligation as a result of a
past event.
(c) The decision to close was made on 12 October 20X3 and this was first announced to
affected parties (staff members) on 14 November 20X3. At the year-end of 31 October 20X3
a past event has occurred (the decision to close). However there is no legal or constructive
obligation. A constructive obligation does not arise until 14 November 20X3.
Answer 2
The cost is found using 'expected values' (75% $NIL) + (20% $1.0m) + (5% $4.0m) =
$400,000.
The provision is recorded by:
DEBIT Warranty costs $400,000
CREDIT Warranty provision $400,000
Answer 3
(a) Provision
In respect of the case against PMC, a provision should be recognised. This is because the
recognition criteria are met as follows:
A legal case is underway and therefore a present legal obligation exists as a result of
a past event (the provision of the machine)
The legal team have advised that there is a 75% chance of PMC losing the case and
having to pay damages; 75% is deemed probable as it is more likely than not
The amount of damages can be estimated reliably (by the legal team) at $25 million
Therefore a provision is made by:
Insurance
The insurance is a reimbursement. HKAS 37 states that it can be recognised as an asset
only where a provision has been recognised and it is virtually certain that insurance monies
will be received if PMC settles the claim for damages.
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This is the case here and therefore PMC recognises an asset of 90% $25 million = $22.5
million by:
Answer 4
(a) At 31 December 20X0, there is no legal obligation to fit the carbon monoxide detectors, and
therefore Rango should not make a provision for either the cost of doing so or the fines
which would be incurred if it were in breach of the legislation.
If Rango has still not fitted the detectors at the 20X1 year end (i.e. when the legislation is in
force), then it should make a provision for the penalty of $5,000 for which it is liable (rather
than the $40,000 cost of fitting the detectors). This is because there is still no obligation for
the costs of fitting detectors because no obligating event has occurred (the fitting of the
detectors). However, an obligation might arise to pay fines or penalties under the legislation
because the obligating event has occurred (the non-compliant operation of Rango).
(b) Greenfingers is planning a restructuring of its business. A provision in respect of
restructuring can only be made when a year-end obligation is evidenced by a detailed formal
plan and an expectation on the part of those affected that the restructuring will happen. As at
31 December 20X0, the employees of Greenfingers are unaware of the plan and therefore
this criterion is not met. Therefore, no provision can be made.
If a provision could be made (i.e. if the sale had been announced to employees, so giving
rise to a valid expectation that the restructuring will occur and thus creating a constructive
obligation) then provision would be for the $120,000 redundancy costs but not the $50,000
retraining costs.
Answer 5
(a) Yes. Cobo Co. cannot avoid the expenditure on repairing faulty goods. A provision should be
made for the estimated cost of repairs.
(b) The cost of the provision is found using expected values: (60% $0m) + (30% $2m) +
(10% $4) = $1m.
Answer 6
(a) Hydro-electric power plant
The planning permission for the power plant requires that at the end of its useful life the plant
is removed and site restored.
The granting of the planning permission means that AEC has a legal obligation to
incur restoration costs in the future. The past event is the construction of the power
plant. Therefore AEC has a legal obligation as a result of a past event at the reporting
date.
The costs to be incurred in the future are a probable outflow of benefit.
AEC has estimated the restoration costs at $150 million.
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Financial Reporting
Therefore the HKAS 37 provision recognition criteria are met and the company accountant is
correct to make a provision.
The provision should be measured at the full cost of restoration as estimated at the time of
construction (i.e. it should not gradually accrue over the power plant’s life). HKAS 37
requires that provisions are measured at present value where the time value of money is
significant. This is the case here and so the provision is measured at $82 million rather than
$150 million.
Restoration costs form part of the cost of the power plant. Therefore the provision should not
be recognised in profit or loss but capitalised as part of PPE:
DEBIT PPE $82,000,000
CREDIT Restoration provision $82,000,000
This provision is gradually ‘wound up’ to $150 million over the 50 year life of the plant, with a
finance cost charged each year based on the rate used to discount $150 million to
$82 million.
Unfair dismissal case
The recognition criteria of HKAS 37 as applied as follows:
AEC has received a claim in the year for damages arising from an event that
happened in the previous year. Therefore a legal obligation exists as a result of a past
event.
The Company’s legal team consider there is a 55% chance of AEC losing the unfair
dismissal claim. This is more likely than not and therefore results in a probable outflow
of benefits.
The amount of damages claimed is $12 million; this is a reliable estimate of the
outflow to settle the obligation.
Therefore a provision should be made for $12 million by:
DEBIT Legal costs $12,000,000
CREDIT Legal provision $12,000,000
(b) AEC
Extract from statement of financial position at 31 December 20X1
$’000
Non-current assets
Property, plant and equipment (270 + 82) 352,000
Non-current liabilities
Provisions 82,000
Current liabilities
Provisions 12,000
Extract from statement of profit or loss for year ended 31 December 20X1
$’000
Operating expenses 12,000
Note: Provisions
Restoration Legal Total
$’000 $’000 $’000
At 1 January 20X1 - - -
Provided in year 82,000 12,000 94,000
At 31 December 20X1 82,000 12,000 94,000
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Exam practice
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Financial Reporting
XP was named as a defendant in a writ of summons, with a statement of claim by another printer
producer in relation to the alleged infringement of patent of design, claiming for a sum of HK$9.6
million. XP intended to settle with the plaintiff out of court. An offer letter of HK$3.8 million in
compensation was given to the plaintiff in January 20X3 and a counter-offer of HK$5 million
payable within one month was received in early March 20X3. The Board of XP approved to accept
the counter-offer of the plaintiff and made the payment on 20 April 20X3. The lawyer issued a fee
note of HK$650,000 to XP on 1 May 20X3 for the relevant legal service provided during the year.
Other than the existing HK$8 million provision relating to this case, XP had no other provision.
Required
(a) Explain and comment the appropriateness of the amount of the provisions recognised in the
management accounts at 31 March 20X3. (14 marks)
(b) The marketing director wrote the following email to the chief financial officer on 29 March
20X3: 'We just concluded the contract terms of a television advertisement for the new
products to be launched in the coming May with a cost of HK$1.8 million. As there was still
an un-utilised budget of HK$1.2 million for marketing expenses for this year, I suggest
making a partial provision for this expenditure first, please approve.' Do you agree the
recognition of the provision at 31 March 20X3? (3 marks)
(Total = 17 marks)
HKICPA December 2013
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chapter 12
Construction contracts
Topic list
Learning focus
Long-term contracts are an everyday part of business in many industry sectors, particularly
construction. You should be able to advise a client how this type of contract is accounted for
and why.
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Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.07 Construction contracts 3
3.07.01 Define a construction contract
3.07.02 Explain when contract revenue and costs should be recognised in
accordance with HKAS 11
3.07.03 Explain how contract revenue and costs should be measured and
apply these principles
3.07.04 Account for the expected loss and changes in estimates
3.07.05 Disclose information related to construction contracts in the
financial statements
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Solution
(a) If profits are deferred until the completion of the contract in 20X2, the revenue and profit
recognised on the contract in 20X1 would be nil, and the value of work in progress on
31 December 20X1 would be the costs incurred of $800,000.
$'000 $'000
DEBIT Work-in-progress 800
CREDIT Cash 800
HKAS 11 takes the view that this policy is unreasonable, because in 20X2, the total profit of
$400,000 would be recorded. Since the contract revenues are earned throughout 20X1 and
20X2, a profit of nil in 20X1 and $400,000 in 20X2 would be contrary to the accruals concept
of accounting.
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Financial Reporting
(b) It is fairer to recognise revenue and profit throughout the duration of the contract.
As at 31 December 20X1 revenue of $1,000,000 should be matched with cost of sales of
$800,000 in the statement of profit or loss, leaving an attributable profit for 20X1 of
$200,000.
$'000 $'000
DEBIT Account receivable 1,000
Cost of sales 800
CREDIT Sales 1,000
Cash 800
The only entry in the statement of financial position as at 31 December 20X1 is a receivable
of $1,000,000 recognising that the company is owed this amount for work done to date. No
balance remains for work in progress, the whole $800,000 having been recognised in cost of
sales.
Key terms
Construction contract. A contract specifically negotiated for the construction of an asset or a
combination of assets that are closely interrelated or interdependent in terms of their design,
technology and function or their ultimate purpose or use.
A fixed price contract is a construction contract in which the contractor agrees to a fixed contract
price, or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses.
A cost plus contract is a construction contract in which the contractor is reimbursed for allowable
or otherwise defined costs, plus a percentage of these costs or a fixed fee.
(HKAS 11)
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Solution
Year 1 $9 million
Year 2 $9.5 million
Year 3 $9.5 million
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Solution
$'000
Surveyors’ fees 12
Direct labour costs 134
Overheads (35% $134,000) 46.9
Materials (250,000 – 76,000) 174
Transport of heavy plant to site 10
Depreciation of heavy plant (5/12 10% $90,000) 3.75
380.65
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Financial Reporting
One of the criteria listed above which indicates that the outcome of a fixed price contract can be
estimated reliably is that the stage of contract completion can be reliably measured.
How should you decide on the stage of completion of any contract? The standard lists several
methods:
Proportion of contract costs incurred for work carried out to date
Surveys of work carried out
Physical proportion of the contract work completed
The proportion that contract costs incurred for work performed to date bear to the estimated total
contract costs:
Costs incurred to date WIP inventories
% on total costs = 100%
Total costs variation
Surveys of work performed, or physical proportion of the contract work completed:
Work certified
% on work performed = 100%
Total revenue variation
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Solution
$
Costs incurred to date (389 – 10) 379,000
Estimated future costs (150 + 10) 160,000
Total estimated costs 539,000
The contract is therefore 70.3% (379,000/539,000) complete
Revenue to be recognised: $890,000 70.3% = $625,670
The profit earned to date is therefore $246,670 ($625,670 – $379,000)
What amounts should be included in Discovery Construction’s financial statements for each of
these years?
Solution
1 Calculate expected profit
20X3 20X4 20X5
$'000 $'000 $'000
Contract price – estimated 800 700 700
total costs
2 Calculate percentage of completion
Costs incurred/total costs 37.5% 75% 100%
3 Calculate cumulative statement of profit or loss amounts
Revenue (% complete 1,500 3,000 4,000
revenue)
Cost of sales (costs incurred) (1,200) (2,475) (3,300)
Profit (% complete 300 525 700
expected profit)
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Financial Reporting
4 Calculate statement of profit or loss amounts for each year (cumulative amounts minus
amounts previously recognised)
$'000 $'000 $'000
Revenue 1,500 1,500 1,000
Cost of sales (1,200) (1,275) (825)
Profit 300 225 175
It is evident from the first example above that when the contract costs incurred to date is used to
determine the stage of completion, then only the contract costs reflecting the work to date should
be incorporated in costs incurred to date.
Costs relating to future activity, e.g. cost of materials delivered but not yet used, are to be
excluded.
Payments in advance made to subcontractors are to be excluded.
Topic highlights
When the outcome of a contract can be reliably estimated and the project is loss-making, the loss
must be recognised in the current year in full.
Any loss on a contract should be recognised as soon as it is foreseen. The loss will be the
amount by which total expected contract revenue is exceeded by total expected contract costs.
The amount of the loss is not affected by:
Whether work has started on the contract
The stage of completion of the work
Profits on other contracts (unless they are related contracts treated as a single contract).
Solution
The expected loss of $100,000 must be recognised in full, and forms part of cost of sales.
Therefore:
$'000
Revenue (balancing figure) 1,988
Cost of sales (28% $7.1m) + $100,000 (2,088)
Loss (100)
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HKAS 11.32-
34
2.3 Accounting treatment: outcome cannot be reliably estimated
Topic highlights
When the outcome of a contract cannot be reliably estimated no profit or loss is recognised;
revenue is recognised to the extent that recognised costs incurred are recoverable.
When the contract's outcome cannot be reliably estimated the following treatment should be
followed:
1 Contract costs are recognised as an expense as incurred
2 Revenue is recognised to the extent that contract costs are recoverable
This no profit/no loss approach reflects the situation near the beginning of a contract, i.e. the
outcome cannot be reliably estimated, but it is likely that costs will be recovered.
Contract costs which cannot be recovered should be recognised as an expense straight away.
HKAS 11 lists the following situations where this might occur:
The contract is not fully enforceable, i.e. its validity is seriously in question
The completion of the contract is subject to the outcome of pending litigation or legislation
The contract relates to properties which will probably be expropriated or condemned
The customer is unable to meet its obligations under the contract
The contractor cannot complete the contract or in any other way meet its obligations under
the contract
Where these uncertainties cease to exist, contract revenue and costs should be recognised as
normal, i.e. by reference to the stage of completion.
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Yes
Yes
Yes
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HKAS
11.43,44
2.5 Construction contracts in the statement of financial
position
The accounting treatment of construction contracts is profit or loss driven. Any amount included in
the statement of financial position is a balancing amount, calculated as:
Contract costs incurred X
Recognised profits less recognised losses X/(X)
Progress billings (X)
Amounts due from/to customers X/(X)
Where an amount due from customers is calculated, this is normally shown within inventories.
Where an amount due to customers is calculated, this is normally shown as ''payments on
account'' within payables.
Any amount invoiced but unpaid is shown as a receivable.
(W) $'000
Contract costs incurred 1,988
Recognised profits less recognised losses (100)
Progress billings (1,500)
Amounts due from customers 388
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Financial Reporting
The 20X6 contract costs incurred to date include $200,000 which relates to additional work
required for unforeseen extras. In 20X6 the contractor negotiated with the customer to recover the
cost of this additional work, but it was not until 20X7 that it became probable that the customer
would accept this contract variation.
Required
What amounts should be recognised in profit or loss in each of the three years?
Solution
$'000
20X5 25% expected profit of $148,000 37
$'000
20X7 Overall actual profit 80
Add: cumulative loss previously recognised 100
Profit recognised in 20X7 180
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Illustration
The following shows the format of the note to the accounts in respect of construction contracts.
Numbers are for illustrative purposes only:
Amounts due from (to) customers for contract work
31.12.X4 31.12.X3
$’000 $’000
Contracts in progress at the end of the reporting
period
Contract costs incurred plus recognised profits less 2,500 1,890
recognised losses
Less: progress billings (2,315) (1,670)
185 220
At 31 December 20X4, retentions held by customers for contract works amounted to $62,000 (31
December 20X3: $55,000). Advances received from customers for contract work amounted to
$10,000 (31 December 20X3: nil).
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Financial Reporting
Self-test question 1
At the start of 20X1 Globalle Company negotiated a fixed price contract of $14.0 million with
Oceanic for the construction of a container port. Globalle had estimated the costs of the contract to
be $13.3 million. Globalle estimates the stage of completion on its construction contracts by
reference to the physical proportion of the work completed.
During 20X1 the contract suffered protracted delays and difficulties, such that Globalle concluded
that there would be material cost overruns. It negotiated with Oceanic to try to get some
recompense for these unexpected difficulties in the form of contract variations, but without success.
At 31 December 20X1 when the contract was 30% physically complete, the costs incurred
amounted to $4.9 million and the costs to complete were estimated at $11.2 million.
Throughout 20X2 Globalle continued to try to win recompense from Oceanic, but without success. At 31
December 20X2 when the contract was 80% physically complete, the costs incurred amounted to $12.6
million and the costs to complete were estimated at $3.5 million. On that day and after these figures had
been drafted, Oceanic suddenly agreed in principle to a contract variation of $3.5 million, provided that
Globalle agreed to pay Oceanic a penalty for late completion of $280,000. Globalle agreed to these
terms and the relevant adjustments were made to the draft figures.
Required
Determine the following amounts in respect of the container port contract in Globalle’s financial
statements according to HKAS 11 Construction Contracts.
(a) The profit or loss to be recognised in the year ended 31 December 20X1.
(b) The revenue to be recognised in the year to 31 December 20X2.
(c) The profit or loss to be recognised in the year ended 31 December 20X2.
(The answer is at the end of the chapter)
Self-test question 2
Aero Company has the following information in respect of a construction contract:
Total contract price $100,000
Cost incurred to date $48,000
Estimated cost to completion $32,000
Progress billings
(of which $50,000 has been received) $58,000
Percentage complete (cost basis) 60%
Required
(a) Prepare relevant extracts from the statement of profit or loss and statement of financial
position.
(b) Show how the statement of financial position would differ if progress billings were $64,000
(of which $50,000 received).
(The answer is at the end of the chapter)
3 Current developments
The IASB issued IFRS 15 Revenue from Contracts with Customers in May 2014. The new
standard replaces IAS 11 and IAS 18; HKICPA will adopt the new standard as HKFRS 15 and it will
replace HKAS 11 and HKAS 18 in due course. The new standard was initially to be effective for
accounting periods starting on or after 1 January 2017, however it is now likely that the initial
application date will be deferred.
The new standard is considered in more detail in Chapter 14.
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Topic recap
Cost plus contract: contract in Contract specifically negotiated for the Fixed price contract: contract with
which the contractor is reimbursed construction of an asset or combination of a fixed price sometimes subject to
for costs plus a percentage of costs interrelated assets cost escalation clauses
or fixed fee
For a cost plus contract: Accounting treatment depends on whether For a fixed price contract:
Probable economic benefits will the outcome of the contract can be Contract revenue can be
flow to the entity reliably estimated reliably measured
Contract costs can be clearly Probable economic benefits
identified and measured will flow to entity
Stage of completion of contract
reliably measured
Costs to complete reliably
measured
Contract costs can be clearly
identified and measured
Disclose:
Revenue recognised in period
Methods to determine revenue recognised
Methods to determine stage of completion
Costs incurred plus recognised profits (less recognised losses) to date
Advances received
Retentions
Amounts due from/to customers:
Costs incurred x
Recognised profits/losses x/(x)
Progress billings (x)
x/(x)
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Financial Reporting
Answer 1
(a) $(2,100,000)
(b) $9,576,000
(c) $2,996,000
Profit / loss on contract 20X1 20X2
$'000 $'000
Contract price 14,000 14,000
Variation – 3,500
Penalty – (280)
14,000 17,220
Costs incurred to date (4,900) (12,600)
Estimated costs to completion (11,200) (3,500)
Profit / loss on contract (2,100) 1,120
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12: Construction contracts | Part C Accounting for business transactions
Answer 2
(a) STATEMENT OF PROFIT OR LOSS (EXTRACTS) $
Profit 12,000
WORKING
Current assets
Trade receivables
Progress billings to date 64,000
Less: cash received (50,000)
14,000
Current liabilities
Gross amounts due to customers
Contract costs incurred to date 48,000
Recognised profits 12,000
60,000
Less: progress billings to date (64,000)
(4,000)
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Financial Reporting
Exam practice
Contract A Contract B
$’000 $’000
Total agreed contract sum 42,000 65,000
Estimated total costs (original budget) 36,000 63,000
Costs incurred to date 25,600 30,000
Contract sum certified and billed to date 28,000 26,000
Total billing received to date 22,800 23,500
Revenue recognised up to 30 September 2011 18,200 N/A
Costs recognised up to 30 September 2011 15,600 N/A
Management has reassessed the cost budget and considered that the original budget of contract A
is reasonable while the budgeted total costs for contract B should be revised upward by 5%.
The stage of completion is determined based on the survey of work performed by external
architects at each month end.
Required
(a) Calculate the amounts to be recognised in profit or loss in the year ended
30 September 2012. (10 marks)
(b) Show the amounts to be disclosed and presented under HKAS 11 Construction Contracts for
Contacts In Progress as at 30 September 2012. (9 marks)
(Total = 19 marks)
HKICPA June 2013
308
chapter 13
Share-based payment
Topic list
Learning focus
309
Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.05 Share-based payment 2
3.05.01 Identify and recognise share-based payment transactions in
accordance with HKFRS 2
3.05.02 Account for equity-settled and cash-settled share-based payment
transactions
3.05.03 Account for share-based payment transactions with cash
alternatives
3.05.04 Account for unidentified goods or services in a share-based
payment transaction
3.05.05 Account for group and treasury share transactions
3.05.06 Disclosure requirement of share option
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1.1 Introduction
It is increasingly common for entities to issue shares or share options to other parties, such as
suppliers or employees, in return for goods or services received. In some instances neither shares
nor share options are issued, but cash consideration is promised at a later date, measured in
relation to share price. All of these transactions are examples of share-based payments.
Share option schemes are a common feature of directors’ remuneration packages and many
organisations also use such schemes to reward other employees. Share-based payments are also
a very common form of consideration for internet businesses which are notoriously loss making in
early years and therefore cash poor.
1.1.1 The accounting problem
Prior to the issue of HKFRS 2, no accounting guidance existed in relation to share-based
payments. This resulted in inconsistent treatment of expenses: those paid in cash were recognised
in profit or loss while those involving a share-based payment were not, because share options
initially had no value (since the exercise price is generally more than the market price of the share
on the date the option is granted).
As we shall see in this chapter, the issue of HKFRS 2 meant that companies were required to
recognise an expense in relation to share-based payments. As a result those companies which
made share-based payments saw a reduction in earnings, in some cases of a significant amount.
For this reason, HKFRS 2 remains controversial in practice.
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Financial Reporting
(b) The issue of equity instruments in exchange for control of another entity in a business
combination, or business under common control or the contribution of a business on the
formation of a joint venture.
HKFRS 2,
Appendix A
1.3 Definitions
The standard provides the following definitions.
Key terms
Share-based payment transaction is a transaction in which the entity:
(a) Receives goods or services from the supplier of those goods or services (including an
employee) in a share-based payment arrangement, or
(b) Incurs an obligation to settle the transaction with the supplier in a share-based payment
arrangement when another group entity receives those goods or services.
Share-based payment arrangement is an agreement between the entity (or another group entity)
and another party (including an employee) that entitles the other party to receive:
(a) Cash or other assets of the entity for amounts that are based on the price (or value) of equity
instruments (including shares or share options) of the entity or another group entity, or
(b) Equity instruments (including shares or share options) of the entity or another group entity
provided the specified vesting conditions are met.
Equity instrument is a contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities.
Equity instrument granted is the right (conditional or unconditional) to an equity instrument of the
entity conferred by the entity on another party, under a share-based payment arrangement.
Share option is a contract that gives the holder the right, but not the obligation, to subscribe to the
entity's shares at a fixed or determinable price for a specified period of time.
Fair value is the amount for which an asset could be exchanged, a liability settled, or an equity
instrument granted could be exchanged, between knowledgeable, willing parties in an arm's length
transaction.
Grant date is the date at which the entity and another party (including an employee) agree to a
share-based payment arrangement, being when the entity and the other party have a shared
understanding of the terms and conditions of the arrangement. At the grant date the entity confers
on the other party (the counterparty) the right to cash, other assets, or equity instruments of the
entity, provided the specified vesting conditions, if any, are met. If that agreement is subject to an
approval process (for example, by shareholders), the grant date is the date when that approval is
obtained.
Intrinsic value is the difference between the fair value of the shares to which the counterparty has
the (conditional or unconditional) right to subscribe or which it has the right to receive, and the price
(if any) the other party is (or will be) required to pay for those shares. For example, a share option
with an exercise price of $15 on a share with a fair value of $20, has an intrinsic value of $5.
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Financial Reporting
Note that the definition of fair value within HKFRS 2 differs from that within HKFRS 13 Fair Value
Measurement. When applying HKFRS 2, the definition contained within that standard should be
used rather than HKFRS 13.
Self-test question 1
Explain whether each of the following transactions are share-based transaction within the scope of
HKFRS 2:
1. Headingley makes a rights issue of shares to all shareholders, including employees who are
shareholders.
2. Horsforth issues shares to shareholders who are also employees at a discounted price.
3. Bramhope makes a cash payment to an employee that is based on a fixed multiple of the
company’s profit before tax.
4. Adel grants shares to a number of disadvantaged individuals in order to enhance its image
as a good corporate citizen.
5. Yeadon, an unlisted entity, allows its employees to use 50% of their bonus payment to
purchase share-appreciation rights. These rights entitle the employees to a cash payment
from Yeadon related to share price. As the company is unquoted, share price is determined
as five times EBITDA divided by the number of shares.
(The answer is at the end of the chapter)
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HKFRS 2 does not specify which account within equity the credit entry should be made to. Practice
varies depending on local regulatory requirements. In some cases it is made to retained earnings,
whilst in others the credit is put to a share-based payment reserve, share option reserve or shares-
to-be-issued reserve until such time as the award has been settled. At this time the credit balance
is transferred to share capital, other reserves or retained earnings.
Before considering when this accounting entry is made, we must consider how an equity settled
share-based payment is measured.
HKFRS 2.11- 2.1.1 Measurement of equity-settled share-based payment transactions
13
The general principle in HKFRS 2 is that an entity should measure a share-based payment
transaction at the fair value of the goods or services received.
In the case of equity-settled transactions, the application of this rule depends on who the
transaction is with:
(a) Where the transaction is with employees and forms part of their remuneration package, it is
not normally possible to measure directly the services received. Therefore the transaction is
measured by reference to the fair value of the equity instruments granted at the grant date
(the indirect method).
(b) Where the transaction is with parties other than employees, there is a rebuttable
presumption that the fair value of the goods or services received can be estimated reliably,
and therefore the transaction is measured at this amount (the direct method).
(c) Where this is not the case, the entity should measure the transaction’s value using the
indirect method.
Where the indirect method (by reference to the fair value of the equity instruments granted) is
adopted to measure a transaction, fair value is based on the market prices, if available, taking into
consideration the terms and conditions upon which those equity instruments were granted.
In the absence of market prices, the fair value of the equity instruments granted should be
approximated using a valuation technique. (These are not within the scope of this exam.)
Solution
Equity-settled transactions with employees are measured by reference to the fair value of the
equity instruments granted on the grant date.
Therefore 100 options 1,000 employees $8 = $800,000
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Financial Reporting
In some cases the equity instruments granted to employees vest immediately (ie the employee is
not required to complete a specified period of service before becoming unconditionally entitled to
the equity instruments). Here, it is presumed that the services have already been received (in the
absence of evidence to the contrary). The entity should therefore recognise the transaction in full
on the grant date, by recognising the fair value of the equity instruments granted as an expense
and a corresponding increase in equity.
Recognition over a period
Where the counterparty to the transaction has to meet specified vesting conditions before they
are entitled to the equity instruments, and these are to be met over a specified vesting period, the
expense is spread over this vesting period.
The expense recognised in each year of the vesting period should be based on the best available
estimate of the number of equity instruments expected to vest. That estimate should be revised if
subsequent information indicates that the number of equity instruments expected to vest differs
from previous estimates.
On the vesting date, the entity should revise the estimate to equal the number of equity instruments
that actually vest.
Once the goods and services received and the corresponding increase in equity have been
recognised, the entity should make no subsequent adjustment to total equity after the vesting date.
Vesting conditions are either service or performance conditions and these are discussed in the next
two sections.
HKFRS 2.19- 2.1.3 Service conditions
21
As we have seen, a service condition is a vesting condition that requires the counterparty to
complete a specified period of service. If the counterparty ceases to provide that service during the
vesting period, it has failed to satisfy the service condition and the equity instruments are forfeited.
This type of vesting condition is most usually associated with share-based transactions with
employees.
Where the equity instruments granted do not vest until the employee completes a specified period
of service, the entity should account for those services as they are rendered by the employee
during the vesting period. For example, if an employee is granted share options on condition that
he or she completes three years' service, then the services to be rendered by the employee as
consideration for the share options will be received in the future, over that three-year vesting
period. Therefore, the fair value of the equity instruments granted should be spread over the three
years, with an expense and corresponding increase in equity recognised in each year.
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Solution
As we saw earlier, the total fair value for the share options issued at grant date is:
$8 1,000 employees 100 options = $800,000
(a) In this situation the options vest immediately i.e. the employees are immediately entitled to
them. It is therefore assumed that Barbar has already benefited from the services provided
by the employees in exchange for the options. Barbar Co. should therefore charge $800,000
to profit or loss as employee remuneration on 1 July 20X1 and the same amount will be
recognised as part of equity on that date:
DEBIT Employee remuneration expense $800,000
CREDIT Equity – Share-based payment $800,000
reserve
(b) In the second situation, the options do not vest until two years have passed, and they only
vest for those employees who continue to work for Barbar at this date.
It is assumed that all employees will continue to work for Barbar.
Therefore in this case the $800,000 is spread over the two years ended 30 June 20X2 and
20X3 with $400,000 recognised as an expense and in equity in each year:
20X2
DEBIT Employee remuneration expense $400,000
CREDIT Equity – Share-based payment $400,000
reserve
20X3
DEBIT Employee remuneration expense $400,000
CREDIT Equity – Share-based payment $400,000
reserve
Therefore in the financial statements:
20X2 20X3
$ $
Remuneration expense in profit or loss 400,000 400,000
Equity – share-based payment reserve 400,000 800,000
This ensures that the expense associated with the share-based payment is matched to the
period in which Barbar benefits from the employees’ services.
We shall consider in later examples how this might differ if some employees left Barbar Co.
before the vesting date.
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Financial Reporting
Solution
The total expense to be recognised over the three-year vesting period is:
200 500 $8 = $800,000
Note that the changes in the value of the options after grant date do not affect the charge to profit
or loss for equity-settled transactions.
The remuneration expense should be recognised over the vesting period of three years. An amount
of $266,667 should be recognised for each of the three years 20X1, 20X2 and 20X3 in profit or loss
with a corresponding credit to equity.
It is important to remember that the expense recognised in each year of the vesting period should
be based on the best available estimate of the number of equity instruments expected to vest.
Therefore if any employees are expected to leave within the vesting period, this should be taken
into account when calculating the expense.
Solution
The expense to be recognised in each year in relation to the share options over the vesting period
is based on the estimated number of shares expected to vest. As options held by employees who
leave the company will not vest, these must be excluded from the amount recognised. Therefore:
Total expense
20X1 200 managers 90% 500 options $8 fair value $720,000
This is divided by the three-year vesting period to give an annual expense in 20X1 of $240,000
20X2 200 managers 86% 500 options $8 fair value $688,000
To date two years of expense should have been recognised i.e. $688,000 2/3 $458,667
As $240,000 was recognised in 20X1, the 20X2 expense is $458,667 – $240,000 $218,667
20X3 200 managers 80% 500 options $8 fair value $640,000
All expense should now have been recognised as the vesting period is complete.
Therefore in 20X3 the expense is $640,000 – $240,000 – $218,667 $181,333
Self-test question 2
Armley Co. issues 10,000 options to each of the 50 directors and senior managers on 1 July 20X1.
The exercise price of the options is $4.50 per share. The scheme participants have to stay with the
company for four more years before being able to exercise their options.
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At 31 December 20X1, it is estimated that 75% of the current directors and senior managers will
remain with the company for four years or more. The estimated figure is 70% by 31 December
20X2.
The fair value of an option is $3 at the grant date. Armley Co maintains a shares-to-be-issued
account within equity.
Required
Identify the journal entries required to record the share-based payment transaction in each of the
years ended 31 December 20X1 and 20X2.
(The answer is at the end of the chapter)
Self-test question 3
An entity grants 100 share options on its $1 shares to each of its 500 employees on 1 January
20X5. Each grant is conditional upon the employee working for the entity over the next three years.
The fair value of each share option as at 1 January 20X5 is $15.
On the basis of a weighted average probability, the entity estimates on 1 January that 20% of
employees will leave during the three-year period and therefore forfeit their rights to share options.
Required
Show the accounting entries which will be required over the three-year period in the event of the
following:
20 employees leave during 20X5 and the estimate of total employee departures over the
three-year period is revised to 15% (75 employees)
22 employees leave during 20X6 and the estimate of total employee departures over the
three-year period is revised to 12% (60 employees)
15 employees leave during 20X7, so a total of 57 employees left and forfeited their rights to
share options. A total of 44,300 share options (443 employees 100 options) are vested at
the end of 20X7.
You may assume that the entity maintains a share-based payment reserve in equity.
(The answer is at the end of the chapter)
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Financial Reporting
Self-test question 4
On 1 January 20X5 Collingham granted 100,000 share options to its Sales Director. The terms of
the share option scheme stated that in order for the options to vest:
1. The Sales Director would be required to work for Collingham for two years.
2. The share price of Collingham must increase at 15% per annum compound over the two
year vesting period.
At the date of grant the fair value of each share option was estimated at $55 taking into account the
estimated probability that the necessary share price growth would be achieved at 15%.
For the two years to 31 December 20X6 the increase in share price was 13% per annum
compound; the Sales Director remained employed throughout.
Required
How should the transaction be recognised?
(The answer is at the end of the chapter)
Self-test question 5
On 1 January 20X4 Pannal enters into a share-based payment transaction with 20 sales
employees that entitles each employee to 10,000 free shares at the end of a three-year period
provided that :
(a) The employee completes the three-year service period with the entity from the date of the
grant of the award, and
(b) The employee buys 1,000 shares at fair value on the date of the grant of the award and
holds them for the three year period.
(c) The employee achieves annual sales in each of the three years of $250,000 or above.
At 31 December 20X4, 1 of the 20 employees has left Pannal. All employees acquired the 1,000
shares as required at the grant date; the leaver has sold his 1,000 shares as has another
individual. This individual is expected to remain in the employment of Pannal until 31 December
20X6. At 31 December 20X4 17 of the 19 sales employees working for Pannal at the year end had
achieved the required sales target. As a result of their failure to achieve these targets, one of the
remaining two employees is expected to leave the company before 31 December 20X6.
Required
Explain how this share-based payment transaction should be accounted for by Pannal in the year
ended 31 December 20X4, making reference to each of the three conditions that must be met in
order for the employees to be awarded the shares.
(The answer is at the end of the chapter)
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Non-market conditions
(relate to operations and
activities)
Performance
conditions
Market conditions Relevant when determining
fair value of equity
(relate to share price)
instruments at grant date
Non-vesting
conditions
Solution
Although the 4,000 options are within the same scheme, they have different vesting dates: 2,000
vest in 20X1 and 2,000 vest in 20X2. In effect, these are two separate types of options and need to
be considered separately.
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Financial Reporting
HKFRS
2.31,32
2.2 Cash-settled share-based payment transactions
Topic highlights
Cash-settled share-based payment transactions are recognised as a liability and measured at the
fair value of that liability. They are remeasured at the end of each reporting period.
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As before, the account to which the debit entry is made will depend upon the counterparty and the
nature of the transaction.
The credit entry is made to an appropriate liability account eg a remuneration liability account or
trade payables account.
HKFRS 2.30 2.2.1 Measurement of cash-settled share-based payment transactions
The primary principle is that the fair value of the liability is used to measure the goods or services
acquired and the liability incurred by the entity.
The fair value of the liability should be reassessed at each reporting date till its settlement and
also at the date of settlement. Any changes in fair value are recorded as profit or loss for the
period.
HKFRS 2.32 2.2.2 Recognition of cash-settled share-based payment transactions
The services received from the employees, and a liability to pay for those services should be
recognised as services are rendered. For example, if a specified period of service has to be
completed by the employees before share appreciation rights are vested, the services received and
the related liability should then be recognised over that period.
Solution
(a) Journal entries for transactions: Chief Operating Officer
The transactions are settled in cash and hence liabilities are created.
31 December 20X1 $ $
DEBIT Remuneration expense 280
CREDIT Remuneration liability 280
It is assumed that the current share price is the best estimate of the final share price.
(calculation note: 20 10 $4.20 1/3 = $280)
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Financial Reporting
31 December 20X2
DEBIT Remuneration liability 280
CREDIT Remuneration expense 280
Reverses entries for 20X1 as share price is less than minimum
31 December 20X3
DEBIT Remuneration expense 880
CREDIT Remuneration liability 880
DEBIT Remuneration liability 880
CREDIT Cash 880
(calculation note: 20 10 $4.40 3/3 = $880)
(b) Journal entries for transactions: all individuals
31 December 20X1 $ $
DEBIT Remuneration expense 1,400
CREDIT Remuneration liability 1,400
(calculation note: 20 10 5 $4.20 1/3 = $1,400)
31 December 20X2:
DEBIT Remuneration liability 1,400
CREDIT Remuneration expense 1,400
31 December 20X3
DEBIT Remuneration expense 2,640
CREDIT Remuneration liability 2,640
DEBIT Remuneration liability 2,640
CREDIT Cash 2,640
(calculation note: 20 10 3 $4.40 3/3 = $2,640)
Accounting for share-based transactions with a choice of settlement depends on which party has
the choice.
Where the counterparty has a choice of settlement, the entity is deemed to have granted a
compound instrument, and a liability component and an equity component are identified.
Where the entity has a choice of settlement, the whole transaction is treated either, as cash-
settled or as equity-settled, depending on whether the entity has an obligation to settle in
cash.
HKFRS 2.3.1 Counterparty has choice of settlement
2.35,36,38
Where the counterparty to the transaction has a choice of settlement, a compound instrument has
been granted i.e. a debt and equity component must be identified.
Where the transaction is with parties other than employees and the fair value of the goods or
services received is measured directly, the entity shall measure the equity component of the
compound financial instrument as the difference between the fair value of the goods or
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services received and the fair value of the debt component, at the date when the goods or
services are received.
Where the transaction is with employees, the fair value of the compound instrument is estimated as
a whole. The debt and equity components must then be valued separately. Normally transactions
are structured in such a way that the fair value of each alternative settlement is the same.
The entity is required to account separately for the goods or services received or acquired in
respect of each component of the compound financial instrument. The debt component is
accounted for in the same way as a cash-settled share-based payment. The equity component is
recognised in the same way as an equity-settled share-based payment.
HKFRS 2.41- 2.3.2 Entity has choice of settlement
43
Where the entity chooses what form the settlement will take, a liability should be recognised to the
extent that there is a present obligation to deliver cash.
This is the case where, for example, the entity is prohibited from issuing shares or where it has a
stated policy, or past practice, of issuing cash rather than shares.
Where a present obligation exists, the entity should record the transaction as if it is a cash-settled
share-based payment transaction.
If no present obligation exists, the entity should treat the transaction as if it was purely an equity-
settled transaction. On settlement, if the transaction was treated as an equity-settled transaction
and cash was paid, the cash should be treated as if it was a repurchase of the equity instrument by
a deduction against equity.
Solution
This arrangement results in a compound financial instrument.
The fair value of the cash route is:
9,000 $310 = $2.79m
The fair value of the share route is:
10,000 $290 = $2.90m
The fair value of the equity component is therefore:
$110,000 ($2,900,000 less $2,790,000)
The share-based payment is recognised as follows:
Liability Equity Expense
$ $ $
20X7 1/3 9,000 $370 1,110,000 1,110,000
$110,000 1/3 36,667 36,667
20X8 2/3 9,000 $430 2,580,000 1,470,000
$110,000 1/3 36,667 36,667
20X9 9,000 $520 4,680,000 2,100,000
$110,000 1/3 36,666 36,666
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Financial Reporting
As the employee elects to receive shares rather than cash, $4,680,000 is transferred from liabilities
to equity at the end of 20X9. The balance on equity is $4,790,000.
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The amendments to HKFRS 2 clarify the classification of share-based payment transactions for
both the entity that receives the goods or services, and the entity that settles the share-based
payment transaction.
The entity receiving the goods or services will recognise the transaction as an equity-settled
share-based payment transaction only if:
the awards granted are its own equity instruments
it has no obligation to settle the transaction
In all other circumstances, the entity will measure the transaction as a cash-settled share-based payment.
Subsequent remeasurement of such equity-settled transactions will only be carried out for changes
in non-market vesting conditions.
The entity responsible for settling the transaction will recognise it as an equity-settled share-
based payment only if the transaction is settled in its own equity instruments. In all other
circumstances, the transaction will be recognised by the entity that settles the award as a cash-
settled share-based payment.
The guidance can be illustrated for the most commonly occurring scenarios as follows.
Classification
Obligation to
Entity settle share- Subsidiary's
receiving based individual Consolidated
goods and payment financial financial
services transaction How is it settled? statements statements
*The same classification will result if the settlement obligation lies with the shareholders or another
group entity (e.g. a fellow subsidiary).
As the classification may be different at the subsidiary and parent level, the amount recognised by
the entity receiving the goods or services may differ from the amount recognised by the entity
settling the transaction and in the consolidated financial statements.
Intragroup repayment arrangements will not affect the application of the principles described above
for the classification of group-settled share-based payment transactions.
Example: group cash-settled share-based transaction
On 1 January 20X1, Principal Co. implemented a share incentive scheme for the five members of
senior management at its subsidiary Sublime Co..
Principal will make a cash payment to the senior managers on 31 December 20X2 based on the
price of Sublime’s shares at that date, provided that the managers remain in service.
Ten share appreciation rights (SARs) are granted to each senior manager on 1 January 20X1,
each with a fair value of $80. The fair value of each SAR at 31 December 20X1 is $70 and at
31 December 20X2 is $90.
All five senior managers are expected to remain in employment until the settlement date.
Required
What entries are required to record this transaction in the financial statements of Principal, Sublime
and the Group?
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Financial Reporting
Solution
Principal
Principal is the entity responsible for settling the transaction. As the transaction will not be settled in
Principal’s own equity instruments it must be recognised as a cash-settled share-based payment
transaction.
On initial recognition of the liability based on the fair value of the SARs at the grant date, a debit is
made to the cost of investment in Sublime. Remeasurements of the liability due to subsequent
movements in the fair value of the SARs are recognised in profit or loss. The reason for this will
become apparent shortly.
$ $
20X1 DEBIT Cost of investment in Sublime 2,000
(5 10 SARs $80)/2 years
CREDIT Remuneration liability 2,000
To record the liability after one year’s service based on initial fair value of the SARs.
DEBIT Remuneration liability 250
$2,000 – (5 10 SARs $70)/2 years
CREDIT Remuneration expense 250
To remeasure the liability based on the period end fair value of the SARs.
$ $
20X2 DEBIT Cost of investment in Sublime
(5 10 SARs $80) – 2,000 2,000
CREDIT Remuneration liability 2,000
To record the liability after two years’ service based on initial fair value of the SARs.
$ $
DEBIT Remuneration expense 750
(5 10 SARs $90) – $3,750
CREDIT Remuneration liability 750
To remeasure the liability prior to settlement based on the period end fair value of the
SARs.
DEBIT Remuneration liability 4,500
CREDIT Cash 4,500
To record the settlement of the transaction.
Sublime
Sublime is the entity receiving the services of the five senior managers. It has no obligation to settle
the transaction itself and therefore it must be recognised as an equity-settled share-based payment
transaction:
$ $
20X1 DEBIT Remuneration expense 2,000
(5 10 SARs $80)/2 years
CREDIT Equity – share-based payment reserve 2,000
To record the first year’s service expense and corresponding increase in equity.
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It should now be apparent why the entries in Principal’s records are split between amounts related
to the initial fair value of the SARs (debited to Cost of Investment) and subsequent
remeasurements (debited/credited to profit or loss).
On consolidation the cost of investment in Principal must be cancelled against the equity and
reserves in Sublime. As HKFRS 2 requires that the movement in equity in Sublime’s accounts is
based on the $80 fair value at the grant date, and not remeasured, it follows that the movement in
the cost of investment in Principal’s accounts must be based on the same amount. Therefore, any
remeasurements must be dealt with separately through profit or loss.
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For example, it might reduce the exercise price of options granted to employees (i.e. reprice the
options), which increases the fair value of those options. The requirements to account for the
effects of modifications are expressed in the context of share-based payment transactions with
employees. However, the requirements shall also be applied to share-based payment transactions
with parties other than employees that are measured by reference to the fair value of the equity
instruments granted.
HKFRS 2.27-
29
4.1 Measurement in modification
The entity shall recognise, as a minimum, the services received measured at the grant date fair
value of the equity instruments granted, unless those equity instruments do not vest because of
failure to satisfy a vesting condition (other than a market condition) that was specified at grant date.
This applies irrespective of any modifications to the terms and conditions on which the equity
instruments were granted, or a cancellation or settlement of that grant of equity instruments. In
addition, the entity shall recognise the effects of modifications that increase the total fair value of
the share-based payment arrangement or are otherwise beneficial to the employee.
If a grant of equity instruments is cancelled or settled during the vesting period (other than a grant
cancelled by forfeiture when the vesting conditions are not satisfied):
(a) Cancellation
The entity shall account for the cancellation or settlement as an acceleration of vesting, and
shall therefore recognise immediately the amount that otherwise would have been
recognised for services received over the remainder of the vesting period.
(b) Payment made
Any payment made to the employee on the cancellation or settlement of the grant shall be
accounted for as the repurchase of an equity interest, i.e. as a deduction from equity,
except to the extent that the payment exceeds the fair value of the equity instruments
granted measured at the repurchase date. Any such excess shall be recognised as an
expense. However, if the share-based payment arrangement included liability components,
the entity shall remeasure the fair value of the liability at the date of cancellation or
settlement. Any payment made to settle the liability component shall be accounted for as an
extinguishment of the liability.
(c) New equity instruments are granted
If new equity instruments are granted to the employee and, on the date when those new
equity instruments are granted, the entity identifies the new equity instruments granted as
replacement equity instruments for the cancelled equity instruments, the entity shall account
for the granting of replacement equity instruments in the same way as a modification of the
original grant of equity instruments. The incremental fair value granted is the difference
between the fair value of the replacement equity instruments and the net fair value of the
cancelled equity instruments, at the date the replacement equity instruments are granted.
The net fair value of the cancelled equity instruments is their fair value, immediately before
the cancellation, less the amount of any payment made to the employee on cancellation of
the equity instruments that is accounted for as a deduction from equity.
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If the entity does not identify new equity instruments granted as replacement equity
instruments for the cancelled equity instruments, the entity shall account for those new
equity instruments as a new grant of equity instruments.
If an entity or counterparty can choose whether to meet a non-vesting condition, the entity
shall treat the entity’s or counterparty’s failure to meet that non-vesting condition during the
vesting period as a cancellation.
If an entity repurchases vested equity instruments, the payment made to the employee shall
be accounted for as a deduction from equity, except to the extent that the payment exceeds
the fair value of the equity instruments repurchased, measured at the repurchase date. Any
such excess shall be recognised as an expense.
Example: Cancellation
Flummery Co. granted 3,000 share options to each of its 50 managers on 1 January 20X1. The
options only vest if the managers are still employed by the entity on 31 December 20X3.
The fair value of the options was estimated at $12 on the grant date and the entity estimated that
the options would vest with 48 managers.
In 20X2 the entity decided to base all incentive schemes around the achievement of performance
targets and as a result the existing share option scheme was cancelled on 30 June 20X2 when the
fair value of the options was $28 and the market price of the entity’s shares was $45.
Compensation was paid to the 49 managers in employment at that date, at the rate of $36 per
option.
Required
How should the entity recognise the cancellation?
Solution
The original cost to the entity for the share option scheme was:
3,000 shares 48 managers $12 = $1,728,000
This was being recognised at the rate of $576,000 in each of the three years.
At 30 June 20X2 the entity should recognise a cost based on the amount of options it had vested
on that date. The total cost is:
3,000 49 managers $12 = $1,764,000
After deducting the amount recognised in 20X1, the 20X2 charge to profit or loss is $1,188,000.
The compensation paid is:
3,000 49 $36 = $5,292,000
Of this, the amount attributable to the fair value of the options cancelled is:
3,000 49 $28 (the fair value of the option, not of the underlying share) = $4,116,000
This is deducted from equity as a share buyback. The remaining $1,176,000 ($5,292,000 less
$4,116,000) is charged to profit or loss.
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HKFRS 2.47-
49
5.2 Determination of fair value
Information which enables an understanding of how fair value is determined includes the
disclosures below:
(a) If the entity has measured directly the fair value of goods or services received during the
period, the entity shall disclose how that fair value was determined.
(b) If the entity has rebutted the presumption that goods or services from parties other than
employees can be measured reliably, it shall disclose that fact, and give an explanation of
why the presumption was rebutted.
(c) If the entity has measured the fair value of goods or services received as consideration for
equity instruments of the entity indirectly, by reference to the fair value of the equity
instruments granted:
– For share options granted during the period, the weighted average fair value of those
options at the measurement date and information on how that fair value was
measured.
– For other equity instruments granted during the period (i.e. other than share options),
the number and weighted average fair value of those equity instruments at the
measurement date, and information on how that fair value was measured.
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HKFRS
5.3 Effect on profit or loss and financial position
2.50,51
Information which enables an understanding of the effect of share-based payment transactions on
profit or loss and financial position includes the following:
(a) The total expense recognised for the period arising from share-based payment
transactions in which the goods or services received did not qualify for recognition as
assets and hence were recognised immediately as an expense, including separate
disclosure of that portion of the total expense that arises from transactions accounted for as
equity-settled share-based payment transactions.
(b) The total carrying amount of liabilities arising from share-based payment transactions at the
end of the period and the total intrinsic value at the end of the period of liabilities for which
the counterparty’s right to cash or other assets had vested by the end of the period.
Illustration
The following illustrative disclosure is taken from the HKFRS 2 Implementation Guidance:
Share-based payments
During the year ended 31 December 20X5, the Company had four share-based payment
arrangements as described below:
Date of grant 1 January 20X4 1 January 20X5 1 January 2oX5 1 July 20X5
Number granted 50,000 75,000 50,000 25,000
Contractual life 10 years 10 years N/A 10 years
Vesting 1.5 years’ service Three years’ Three years’ Three years’
conditions and achievement service service and service and
of a share price achievement of a achievement of
target, which was target growth in atarget increase
achieved earnings per in market share.
share
The estimates fair value of each share option granted in the general employee share option plan is
$23.60. This was calculated by applying a binomial option pricing model. The model inputs were
the share price at grant date of $50, exercise price of $50, expected volatility of 30%, no expected
dividends, contractual life of ten years, and a risk-free interest rate of 5%. To allow for the effects of
early exercise, it was assumed that the employees would exercise the options after vesting date
when the share price was twice the exercise price. Historical volatility was 40%, which includes the
early years of the Company’s life; the Company expects the volatility of its share price to reduce as
it matures.
The estimated fair value of each share granted in the executive plan is $50.00, which is equal to
the share price at the date of grant.
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Financial Reporting
20X4 20X5
The weighted average share price at the date of exercise for share options exercised in the period
was $52. The options outstanding at 31 December 20X5 had an exercise price of $40 or $50, and
a weighted average remaining contractual life of 8.64 years.
20X4 20X5
$ $
Expense arising from share-based payment transactions 495,000 1,105,876
Expense arising from share and share option plans 495,000 1,007,000
Closing balance of liability for cash share appreciation plan - 98,867
Expense arising from increase in fair value of liability for cash - 9,200
share appreciation plan
HKAS As we have seen, an entity is required to recognise an expense in relation to share options over
12.68A-C the vesting period. The related tax deduction is not, however, received until the options are
exercised. In addition, the accounting expense is based on the fair value of the options at the grant
date, whereas the tax allowable expense is based on the share price at the exercise date.
There is therefore a deferred tax implication. This is also true of other forms of share-based
payments where the tax deduction differs from the cumulative remuneration expense.
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If the amount of the tax deduction (or estimated future tax deduction) exceeds the amount of the
related cumulative remuneration expense, this indicates that the tax deduction relates also to an
equity item.
The excess is therefore recognised directly in equity.
Example: Deferred tax implications of share-based payment
Lamar Co. has the following share option scheme at 31 December 20X1:
Fair value
of options
Director’s Options at grant Exercise Vesting
name Grant date granted date price date
$ $
N Yip 1 January 20X0 20,000 2.50 3.75 12/20X1
D Chan 1 January 20X1 90,000 2.50 5.00 12/20X3
The price of the company’s shares at 31 December 20X1 is $7 per share and at 31 December
20X0 was $7.50 per share.
The directors must be working for Lamar on the vesting date in order for the options to vest.
No directors have left the company since the issue of the share options and none are expected to
leave before December 20X3. The shares can be exercised on the first day of the month in which
they vest.
In accordance with HKFRS 2 an expense of $25,000 has been charged to profits in the year ended
31 December 20X0 in respect of the share option scheme. The cumulative expense for the two
years ended 31 December 20X1 is $110,000.
Tax allowances arise when the options are exercised and the tax allowance is based on the
option’s intrinsic value at the exercise date.
Assume a notional tax rate of 16%.
Required
What are the deferred tax implications of the share option scheme?
Solution
Year to 31 December 20X0
Deferred tax asset:
$
Fair value (20,000 $7.50 1/2) 75,000
Exercise price of option (20,000 $3.75 1/2) (37,500)
Intrinsic value (estimated tax deduction) 37,500
Tax at 16% 6,000
The cumulative remuneration expense is $25,000, which is less than the estimated tax deduction of
$37,500. Therefore:
a deferred tax asset of $6,000 is recognised in the statement of financial position
there is deferred tax income of $4,000 (25,000 16%)
the excess of $2,000 goes to equity
Year to 31 December 20X1
Deferred tax asset:
$
Fair value
(20,000 $7.50) 150,000
(90,000 $7 1/3) 210,000
360,000
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Financial Reporting
7 Current developments
Topic highlights
The IASB issued an exposure draft in 2014 that proposes narrow scope amendments to IFRS 2
(HKFRS 2).
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Financial Reporting
Topic recap
Where one group entity receives goods or services and another group
company settles the transaction the recipient company must still apply
the provisions of HKFRS 2
Transaction with Transaction with other Recognise as a liability Counterparty has Entity has choice
employees party measured at fair value choice
of the liability
Measure at fair value Measure at fair value of Identify debt and equity Recognise liability
of equity instrument goods/services Remeasure liability at component and to the extent there
on grant date received each reporting date account for each is an obligation to
until settlement and at separately deliver cash
settlement date
Recognise as Recognise as an
expense/in equity asset/expense and in
over the vesting equity, normally
period immediately
Vesting conditions
Service conditions and non-market based performance conditions are taken into account when determining the number of instruments
expected to vest.
Market-based performance conditions and non-vesting conditions are not. Instead they are inputs when determining fair value of an
instrument at the grant date.
Modifications
On cancellation or settlement the amount that would have been recognised over the remainder of the vesting period is measured
immediately
If payment is made to the other party on cancellation or settlement this is accounted for as the repurchase of an equity interest (and
expense where the payment exceeds fair value of the equity instruments)/extinguishment of liability.
Disclosures:
Information about the nature and extent of share-based payment arrangements
Information to enable users to understand how fair values were determined
Information to enable users to determine the effect on profit or loss and financial position
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Answer 1
1 This transaction is not within the scope of HKFRS 2 because it is an arrangement with
employees in their capacity as owners of equity instruments rather than their capacity as
employees.
2 This transaction is within the scope of HKFRS 2 because the favourable terms indicate that
Horsforth is dealing with the shareholders as employees rather than in their capacity as
equity holders.
3 In this transaction the cash payment is not based on Bramhope’s share price and therefore
the transaction is not within the scope of HKFRS 2.
4 The goods or services received by Adel in this transaction are unidentifiable. Despite this,
the transaction is within the scope of HKFRS 2. The goods and services received are likely
to include an expanded customer base, customer loyalty, employee loyalty and enhanced
reputation.
5 This is not a share-based payment transaction within the scope of HKFRS 2 because a fixed
multiple of EBITDA is unlikely to reflect the fair value of the entity’s share price.
Answer 2
The remuneration expense in respect of the options for the year ended 31 December 20X1 is
calculated as follows:
Fair value of options expected to vest at grant date:
(75% 50 employees) 10,000 options $3 =$1,125,000
Annual charge to profit or loss therefore $1,125,000 / 4 years = $281,250
Charge to profit or loss for y/e 31 December 20X1 = $281,250 6/12 months = $140,625
The accounting entry for the year ending 31 December 20X1 is:
$ $
DEBIT Remuneration expense 140,625
CREDIT Equity – shares-to-be-issued 140,625
In 20X2 the remuneration charge is for the whole year, and is calculated as:
(70% 50 employees) 10,000 options $3 = $1,050,000
Charge to date is $1,050,000 1.5/4 years = $393,750
Therefore charge for the year is $393,750 – $140,625 = $253,125
The accounting entry is:
Answer 3
20X5 $
Share-based payment reserve c/f and P/L expense ((500 – 75) 100 212,500
$15 1/3)
$ $
DEBIT Staff costs 212,500
CREDIT Equity – share-based payment reserve 212,500
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Financial Reporting
20X6 $
Share-based payment reserve b/f 212,500
Profit or loss expense 227,500
Share-based payment reserve c/f ((500 – 60) 100 $15 2/3) = 440,000
$ $
DEBIT Staff costs 227,500
CREDIT Equity – share-based payment reserve 227,500
20X7 $
Share-based payment reserve b/f 440,000
Profit or loss expense 224,500
Share-based payment reserve c/f (443 100 $15) = 664,500
$ $
DEBIT Staff costs 224,500
CREDIT Equity – share-based payment reserve 224,500
Answer 4
The Sales Director satisfied the service requirement but the share price growth condition was not
met.
The share price growth is a market performance condition and is taken into account in estimating
the fair value of the options at grant date. No adjustment is made on the basis of performance
against the market condition.
The expense recognised as a staff cost in profit or loss in each of the two years is ½ 100,000
$55 = $2.75m. This is recognised each year by:
DEBIT Staff costs $2,750,000
CREDIT Equity – shares to be $2,750,000
issued
At 31 December 20X6, the shares do not vest, because the performance condition is not met. The
recognised expenses are not, however written back; the equity balance may be transferred to
another reserve such as retained earnings.
Answer 5
The transaction is due to be settled in equity instruments and therefore this is an equity-settled
share-based payment transaction accounted for in accordance with HKFRS 2.
Such a transaction is recognised over the vesting period (here three years) as an expense (here a
staff costs expense) with a corresponding credit to an equity account, often a share-based payment
reserve.
This type of transaction is measured at the fair value of the equity instruments on the grant date ie
1 January 20X4. The amount recognised in profit or loss and equity is dependent upon the number
of instruments expected to vest at 31 December 20X6. This in turn is dependent upon the attached
conditions.
HKFRS 2 refers to three types of conditions: service vesting conditions, performance vesting
conditions and non-vesting conditions. Performance conditions are further classified into market or
non-market conditions.
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Exam practice
342
chapter 14
Revenue
Topic list
1 Revenue recognition
1.1 Accrual accounting
1.2 Recognition at point of sale
1.3 Recognition at other times
2 HKAS 18 Revenue
2.1 Scope
2.2 Definitions
2.3 Measurement of revenue
2.4 Identification of the transaction
2.5 Recognition: sale of goods
2.6 Recognition: rendering of services
2.7 Recognition: interest, royalties and dividends
2.8 Determining whether an entity is an agent or principal
2.9 Revenue recognition: examples
2.10 Disclosure
3 Interpretations relating to revenue recognition
3.1 HK(IFRIC) Int-12 Service Concession Arrangements
3.2 HK(IFRIC) Int-13 Customer Loyalty Programmes
3.3 HK(IFRIC) Int-15 Agreements for the Construction of Real Estate
4 Current developments
4.1 IFRS 15 Revenue from Contracts with Customers
4.2 Five step approach
4.3 Modification to contracts
4.4 Contract costs
4.5 Presentation of contracts with customers
4.6 Disclosure
4.7 Application
4.8 Effect of HKFRS 15
Learning focus
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Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.02 Revenue 3
3.02.01 Define revenue and identify revenue within the scope of HKAS 18
3.02.02 Measure revenue at the fair value of consideration received
3.02.03 Identify revenue transaction including multiple element
arrangements
3.02.04 Determine the recognition criteria for specified types of revenue
items including sales of goods, rendering of services and interest,
royalties and dividends
3.02.05 Disclose revenue as appropriate in the financial statements
3.02.06 Explain the recognition and measurement principles
3.02.07 Disclose revenue from contracts with customers as appropriate in
the financial statements
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1 Revenue recognition
Topic highlights
Revenue recognition is straightforward in most business transactions, but can be complicated in
some situations.
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Financial Reporting
completion of the contract activity at the year end, once the outcome on the contract can be
estimated reliably.
(a) Owing to the length of time taken to complete such contracts, to defer taking profit into
account until completion may result in the statement of profit or loss reflecting, not so much a
fair presentation of the activity of the company during the year, but rather the results relating
to contracts which have been completed by the year end.
(b) Revenue in this case is recognised when production on, say, a section of the total contract is
complete, even though no sale can be made until the whole is complete.
2 HKAS 18 Revenue
Topic highlights
HKAS 18 Revenue is concerned with the recognition of revenues arising from fairly common
transactions.
The sale of goods
The rendering of services
The use by others of entity assets yielding interest, royalties and dividends
Income, as defined by the HKICPA's Framework document, includes both revenues and gains.
Revenue is income arising in the ordinary course of an entity's activities and it may be called
different names, such as sales, fees, interest, dividends or royalties.
HKAS 18 governs the recognition of revenue in specific (common) types of transaction, being:
The sale of goods
The rendering of services
Interest income
Royalty income
Dividend income
The standard also includes an appendix which provides examples of the measurement and
recognition rules in particular circumstances.
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Key terms
Revenue is the gross inflow of economic benefits during the period arising in the course of the
ordinary activities of an entity when those inflows result in increases in equity, other than increases
relating to contributions from equity participants.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date. (HKAS 18)
Revenue does not include items which do not represent a flow of economic benefit into the entity,
e.g. sales taxes, value added taxes or goods and service taxes which are only collected for third
parties. The same should apply to revenues collected by an agent on behalf of a principal.
Revenue for the agent is only the commission earned from the principal for acting as an agent.
Topic highlights
Revenue is measured at the fair value of consideration received or receivable.
Revenue shall be measured at the fair value of the consideration received or receivable,
taking into account the amount of any trade discounts and volume rebates allowed by the
entity.
This is usually decided by agreement between the buyer and seller.
HKAS 18.11 2.3.1 Deferred consideration
When consideration is deferred beyond normal credit terms, the fair value of the amount receivable
may be less than the nominal amount of cash receivable.
In this case, the arrangement effectively constitutes a sales transaction with a financing
arrangement and results in both revenue (sales) income and interest income. The fair value of
sales consideration is determined by discounting all amounts receivable using an imputed rate of
interest. This is the more clearly determinable of either:
The prevailing rate for a similar instrument of an issuer with a similar credit rating; or
A rate of interest that discounts the nominal amount of the instrument to the current cash
sales price of the goods or services.
The difference between the fair value and nominal amount of consideration is recognised as
interest income.
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Financial Reporting
Solution
Sofa Co. must discount the $790,000 before recording revenue in respect of the sales:
2
$790,000 1/1.06 = $703,097
This discounted amount, which represents the fair value of consideration, is recognised as revenue
in the year ended 31 March 20X9 and as a receivable:
$ $
DEBIT Receivable 703,097
CREDIT Revenue 703,097
In the year ended 31 March 20Y0, the discount is unwound and the receivable increased by
$42,186 (6% $703,097) to $745,283. This amount is also recognised as interest income:
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Solution
The revenue must be broken down into that relating to the provision of the computer system and
that relating to the three years of support and maintenance.
Example 11 of the Illustrative Examples issued alongside HKAS 18 states that the amount of
revenue allocated to an after-sales service such as that provided by Mainframe Co is the amount
that will cover the expected costs of the services under the agreement together with a reasonable
profit on those services.
The revenue relating to the support and maintenance is calculated based on the profit mark-up of
50%:
3 years $50,000 150% = $225,000
Therefore, the revenue relating to the supply of the system is the balance of $800,000 – $225,000
= $575,000.
Revenue recognised in the year ended 31 December 20X4 is $637,500 ($575,000 + 10/36
$225,000).
Other than example 11 of the Illustrative Examples, which relates specifically to selling a product
with subsequent services (on which the above example is based) there is no further guidance in
HKAS 18 with regard to the ‘unbundling’ of sales contracts and how revenue should be allocated to
each element of a transaction. In practice revenue relating to a contract containing multiple
components could be allocated in a number of ways. This is considered to be a shortfall of HKAS
18 and is addressed in the upcoming HKFRS 15 Revenue from Contracts with Customers (see
Section 4).
2.4.1 Considering separate transactions together
Conversely, seemingly separate transactions must be considered together if their commercial
substance is not apparent when considered apart.. An example would be to sell an asset and at the
same time enter into an agreement to buy it back at a later date. The second transaction negates
the substance of the first and so both must be considered together. This sale and repurchase
situation is considered in more detail in section 2.9.3 of this chapter.
All of the following five conditions have to be fulfilled before revenue from the sale of goods can be
recognised:
(a) The entity has transferred to the buyer the significant risks and rewards of ownership of the goods
(b) The entity retains neither continuing managerial involvement to the degree usually
associated with ownership, nor effective control over the goods sold
(c) The amount of revenue can be measured reliably
(d) It is probable that the economic benefits associated with the transaction will flow to the entity
(e) The costs incurred or to be incurred in respect of the transaction can be measured reliably
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Self-test question 1
Property Solutions contracts to provide property repairs to customers over a given period, normally
24 months. During that time a fixed fee is paid by the customer and the company then attends
customer premises as required to attend to repairs. Sometimes it attends 4 times a year,
sometimes 10 and sometimes never, depending on variables outside the control of Property
Solutions, such as the weather. The company sets a fixed fee for existing customers based on the
level of callouts in the previous period. The accountant is currently recording an arbitrary amount of
the fixed fee on a given contract whenever there is a call out and then making adjustment for any
under or over provision at the end of the contract period.
Required
Advise how revenue in respect of repair contracts should be recognised by Property Solutions.
(The answer is at the end of the chapter)
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Financial Reporting
Once again, the points made above about probability and reliable measurement of
consideration on the sale of goods also apply here.
HKAS 2.7.1 Interest
18.30,32
Interest is recognised on a time proportion basis that takes into account the effective yield on the
asset.
The effective yield is the rate of interest required to discount the stream of future cash receipts
expected over the life of the asset to equate to the initial carrying amount of the asset.
When unpaid interest has accrued before an interest-bearing investment is acquired, the
subsequent interest received is allocated between pre and post acquisition periods. Only that
amount allocated to the post acquisition period is recognised as revenue.
HKAS 2.7.2 Royalties
18.30,33,
Illustrative Royalties are recognised on an accrual basis in accordance with the substance of the relevant
Guidance 20
agreement.
Royalties are usually recognised on the same basis that they accrue under the relevant
agreement. Practically this is often on a straight line basis over the life of the agreement.
Sometimes the true substance of the agreement may require some other systematic and rational
method of recognition.
Where rights are assigned for a fixed amount, the licensee is permitted to exploit those rights freely
and the licensor has no remaining obligations to perform, then the assignment is in effect a sale
and revenue should be recognised immediately. An example of this situation is a licensing
agreement to use software which is immediately downloaded by the purchaser.
In some cases the receipt of a royalty is contingent on a future event. Here revenue is recognised
only when it is probable that the royalty will be received. This is normally when the event has
occurred.
2.7.3 Dividends
Dividends are recognised when the shareholder's right to receive payment is established.
HKAS 18,
Illustrative
Guidance 21
2.8 Determining whether an entity is an agent or principal
An entity is acting as a principal when it has exposure to the significant risks and rewards
associated with the sale of goods or the rendering of services. Features that indicate that an entity
is acting as a principal include:
(a) The entity has the primary responsibility for providing the goods or services to the customer
or for fulfilling the order, for example by being responsible for the acceptability of the
products or services ordered or purchased by the customer;
(b) The entity has inventory risk before or after the customer order, during shipping or on return;
(c) The entity has latitude in establishing prices, either directly or indirectly, for example by
providing additional goods or services; and
(d) The entity bears the customer’s credit risk for the amount receivable from the customer.
An entity is acting as an agent when it does not have exposure to the significant risks and rewards
associated with the sale of goods or the rendering of services.
One feature indicating that an entity is acting as an agent is that the amount the entity earns is
predetermined, being either a fixed fee per transaction or a stated percentage of the amount billed
to the customer.
2.8.1 Measurement of revenue
The amount received by an agent from the customer is a gross amount ie it includes amounts
collected on behalf of the principal.
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14: Revenue | Part C Accounting for business transactions
The amounts collected on behalf of the principal do not result in increases in equity for the agent
and consequently they are not recognised as revenue. Instead, for an agent, revenue is the
amount of commission that it is paid by the principal.
For the principal in a transaction, revenue is measured at the gross amount received by the agent
from the customer; the commission paid to the agent is recognised as a cost of sales.
Solution
Nile Trading Co is an agent acting on behalf of the numerous suppliers that sell goods on its
website. This is evidenced by the fact that it does not have exposure to the risks and rewards of a
sale and it is paid a stated percentage of the selling price.
Therefore Nile Trading Co should recognise 6% of the selling price as its commission when it has
met its obligation to provide services as agent. This is likely to be when it has advised suppliers of
a sale and processed payment.
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Financial Reporting
Example
Hong Kong Drinks Co (HKDC) sells maturing stock to Asia Bank on 1 January 20X3 for $8 million
when the market value of the stock was $14 million. HKDC holds a call option to repurchase the
inventory on 1 January 20X8 for $12 million when the market value of the stock is expected to be
$16 million. The stock will remain at HKDC premises throughout the 5 year period. HKDC’s credit
rating means that it would pay 8.447% per annum on borrowings.
Required
Illustrate how the sale and repurchase transaction is accounted for
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Solution
HKDC retains the risks and rewards of ownership of the stock and retains managerial involvement
through the stock being retained at its premises. In addition the call option is structured so that the
market value of the stock significantly exceeds the repurchase price, so making the repurchase
economically compelling.
Therefore the sales proceeds are recognised as a loan with an annual finance cost of 8.447% by:
DEBIT Cash $8,000,000
CREDIT Secured loan $8,000,000
The loan is wound up by:
B/f Finance cost C/f
$ $ $
20X3 8,000,000 675,760 8,675,760
20X4 8,675,760 732,841 9,40,8601
20X5 9,408,601 794,745 10,203,346
20X6 10,203,346 861,877 11,065,223
20X7 11,065,223 934,777* 12,000,000
*rounding difference
The finance cost is recognised each year by (using 20X3 figures):
DEBIT Finance cost $675,760
CREDIT Secured loan $675,760
When the stock is repurchased, this is recorded by:
DEBIT Secured loan $12,000,000
CREDIT Cash $12,000,000
HKAS
18.35,36
2.10 Disclosure
The following items should be disclosed.
(a) The accounting policies adopted for the recognition of revenue, including the methods
used to determine the stage of completion of transactions involving the rendering of services.
(b) The amount of each significant category of revenue recognised during the period
including revenue arising from:
(i) the sale of goods
(ii) the rendering of services
(iii) interest
(iv) royalties
(v) dividends
(c) The amount of revenue arising from exchanges of goods or services included in each
significant category of revenue. (Exchanges of similar goods and services do not result in
revenue and therefore this relates only to exchanges of dissimilar goods and services – see
Section 2.3.2.)
Any contingent assets or liabilities, such as those relating to warranty costs, claims or penalties
should be treated according to HKAS 37 Provisions, Contingent Liabilities and Contingent Assets
(covered earlier).
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Financial Reporting
Self-test question 2
Consider the following scenarios and discuss how HKAS 18 should be applied to each
(a) Bradley Co. owns an office building which cost $5m and has a market value of $7m. On
1 April 20X2, Bradley Co. sold the building to Beck Co., a finance company, for $5.5m.
Bradley Co. has entered into an agreement to repurchase the building in three years' time for
$7m and Bradley Co. will continue to occupy the building after sale.
(b) Marianne Alltraders entered into a six-month contract to undertake accountancy training for a
customer over the period 1 September 20X2 to 28 February 20X3. The value of services
performed to the year end amounts to $45,000 out of a total contract value of $60,000.
All costs are expected to be recoverable.
(c) Maximum Velocity sold some bicycles to a customer for $15,000 on 1 October 20X2.
The customer has the right to return any unsold bikes before 30 April 20X3 for a full refund.
Maximum Velocity’s year end is 31 December.
(d) Admen performed advertising services for a customer costing $4,450 relating to a fixed price
$20,000 contract covering the period 1 December 20X2 to 31 March 20X3. Due to
fluctuating advertising costs, the expected total cost cannot be reliably measured at the year
end, but Admen is certain that the customer will pay the costs incurred to date.
The year end in all cases is 31 December 20X2.
(The answer is at the end of the chapter)
Key term
Service concession arrangements are arrangements whereby a government or other body
(grantor) grants contracts for the supply of public services – such as roads, energy distribution,
prisons or hospitals – to private operators. I.e. this is a public-to-private arrangement.
(HK(IFRIC) Int-12)
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(b) One in which the operator receives an intangible asset being the right to charge for access
to the public sector asset that it constructs or upgrades.
HK(IFRIC) Int-12 allows for the possibility that both types of arrangement may exist within a
single contract: to the extent that the government has given an unconditional guarantee of
payment for the construction of the public sector asset, the operator has a financial asset; to the
extent that the operator has to rely on the public using the service in order to obtain payment, the
operator has an intangible asset.
3.1.3 Accounting – Financial asset model
HK(IFRIC) For the first type of arrangement the operator recognises a financial asset measured at fair value
Int-12.15-16 to the extent that it has an unconditional contractual right to receive cash or another financial asset
from or at the direction of the grantor for the construction services.
The operator has an unconditional right to receive cash if the grantor contractually guarantees to
pay the operator:
(a) Specified or determinable amounts;
(b) The shortfall, if any, between amounts received from users of the public service and
specified or determinable amounts, even if payment is contingent on the operator ensuring
that the infrastructure meets specified quality or efficiency requirements.
3.1.4 Accounting – Intangible asset model
HK(IFRIC) The operator recognises an intangible asset measured at fair value to the extent that it receives a
Int-12.17 right (a licence) to charge users of the public service. A right to charge users of the public service is
not an unconditional right to receive cash because the amounts are contingent upon the extent to
which the public uses the service.
3.1.5 Operation revenue
HK(IFRIC) The operator of a service concession arrangement recognises and measures revenue in
Int-12.14,20 accordance with HKAS 11 and 18 for the services it performs.
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Financial Reporting
Solution
The transaction illustrates certain characteristics of a service concession arrangement that falls
within the scope of HK(IFRIC) 12:
The arrangement is between a public sector entity (the government) and an entity from the
private sector (Electricity Co.);
An infrastructure asset is constructed by Electricity Co. for the purpose of the arrangement,
and is used to supply electricity to public;
The government (the grantor) has control over the use of the power plant through the
following means:
– The government specifies the goods to be delivered (electricity) and to whom the
electricity should be provided (the public in the specified district); and
– The income that Electricity Co. needs to generate to cover both its operating costs and
the initial capital outlay from constructing the facility is wholly dependent on the user’s
demand for the electricity, the demand risk borne by Electricity Co.. However, the
arrangement still falls within the scope of HK(IFRIC) 12 as the government controls
the pricing through a capping mechanism (provided the cap is considered to be
substantive) and controls the residual interest in the facility, through the agreement
specifying that the facility must revert to government at the end of the concession
period.
Electricity Co. provides construction services to the grantor by constructing the facility. However,
instead of receiving an unconditional right to receive cash, it has obtained a right to charge the
public for electricity usage, i.e. it has obtained an intangible asset.
As stated in HK(IFRIC) 12, Electricity Co. does not recognise the facility as its own property, plant
and equipment, even though it is fully exposed to demand risk in respect of the electricity users.
During the construction phase:
DEBIT Intangible asset
CREDIT Construction revenue
Being the fair value of construction service provided under development
DEBIT Construction cost
CREDIT Cash
Being construction costs incurred
During the operating phase:
DEBIT Cash
CREDIT Operating revenue
Being electricity charges levied on the users
DEBIT Operating costs
CREDIT Cash
Being operating cost incurred (e.g. fuel, employee cost etc.)
DEBIT Operating costs / Impairment
CREDIT Intangible asset
Being amortisation and/or impairment of the intangible asset during the year
If the government had guaranteed that Electricity Co. would receive a minimum amount, i.e.
had agreed to top up a short-fall in receipts from the public, Electricity Co. would recognise a financial
asset to the extent that it had an unconditional contractual right to receive cash (or another financial
asset) and an intangible asset for the right to receive cash from users above the guaranteed minimum.
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Financial Reporting
What that essentially means is this: take Park-N-Shop for example, which awards one point for
every $100 that a customer spends: every point can be redeemed for goods with a retail price of
$1. The company estimates that 80% of points awarded will be redeemed based on past
experience. The accounting entries following a sale of goods for $200 would be:
$ $
DEBIT Cash/credit card receivables 200.00
CREDIT Deferred revenue – Loyalty points ($200/$100 1 pt x 1.60
80%)
CREDIT Revenue 198.40
A portion of the consideration paid by the customer will be allocated to deferred revenue as above,
measured as the fair value of the points awarded. Then when the customer utilises their points the
next time they spend:
$ $
DEBIT Cash/credit card receivables 98.40
DEBIT Deferred revenue 1.60
CREDIT Revenue 100.00
So in essence a proportion of revenue is deferred until later.
Case 2 refers to paragraph 8 of the Interpretation:
If a third party supplies the awards, the entity shall assess whether it is collecting the
consideration allocated to the award credits on its own account (i.e. as the principal in the
transaction) or on behalf of the third party (i.e. as an agent for the third party).
(a) If the entity is collecting the consideration on behalf of the third party, it shall:
(i) Measure its revenue as the net amount retained on its own account, i.e. the
discounts or incentives that otherwise would be offered to customers that have
not earned the award credits; and
(ii) Recognise this net amount as revenue when the third party becomes obliged to
supply the awards and entitled to receive consideration for doing so. These
events may occur as soon as the award credits are granted. Alternatively, if the
customer can choose to claim awards from either the entity or a third party,
these events may occur only when the customer chooses to claim awards from
the third party.
(b) If the entity is collecting the consideration on its own account, it shall measure its
revenue as the gross consideration allocated to the award credits and recognise the
revenue when it fulfils its obligations in respect of the awards.
In paragraph 8(a)(i) and (ii) of the Interpretation the entity supplying the award credits is acting as
an agent of the third party supplying the awards, which may be the case with airline loyalty
programmes where retailers or other service firms pay the airline a cost per mile for using their
loyalty programmes. However in case (b) the reference is to a similar programme but where the
retailer acts as a principal on their own account.
Look first at the accounting entries in the situation of Paragraph 8(a). Say that a retailer has a
loyalty programme arrangement with an airline such that, for every $10 that the customer spends
with the retailer, he is awarded one point which can be redeemed for one mile.
The face value of each point is $1. For each point issued, the retailer will pay $0.8 to the airline.
Based on past experience it is expected that 90% of points will be redeemed.
The retailer may be identified as acting as an agent of the airline in respect of the loyalty points
element of the transaction, or the retailer may be identified as the principal, depending on the
circumstances (see Section 2.8).
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Retailer as agent
If the retailer is considered to be the agent and makes a sale of $200 the accounting entries would
be:
$ $
DEBIT Cash/credit card receivables 200.00
CREDIT Commission income (20 $0.2 x 90%) 3.60
Liability to airline (20 $0.8 x 90%) 14.40
Revenue 182.00
Here the retailer recognises:
Revenue income in respect of the sale of its own goods / services of $182
Commission income in respect of the customer loyalty points at the net amount of $3.60
The benefits of such a scheme to the retailer are that they do not have to incur resources to
administer the scheme (the airline administers the redemptions) and they can exit the scheme at
any time with no obligation for the outstanding points.
Retailer as principal
If the retailer has collected the consideration allocated to the points on its own account, i.e. acting
as a principal rather than as an agent, then it is entitled to measure its income from the points at
the gross amount of $18 in the example above, but must separately recognise the $14.40 payable
to the airline as an expense.
$ $
DEBIT Cash/credit card receivables 200.00
CREDIT Income from loyalty programme (20 x $1 x 90%) 18
Revenue 182
And
DEBIT Loyalty programme expense (20 x $0.8 x 90%) 14.40
CREDIT Liability to airline 14.40
Regardless of whether the retailer is the agent of principal in the transaction, it recognises net
income of $3.60.
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The Interpretation focuses on the criteria that revenue can only be recognised when the entity has
transferred to the buyer control and the significant risks and rewards of ownership of the goods,
and distinguishes between circumstances in which these criteria are met "at a single point in time"
and "continuously as construction progresses".
If transfer of control and the significant risks and rewards of ownership of the real estate in its
entirety occurs at a single point of time (e.g. at completion, upon or after delivery), revenue is
recognised only when all the criteria in HKAS 18 are satisfied. Assuming that all of the other criteria
in HKAS 18 are met, this will be upon the occurrence of that single critical transfer of control and
the significant risks and rewards of ownership.
The Interpretation also envisages that the entity may transfer to the buyer control and the
significant risks and rewards of ownership of the work in progress in its current state as
construction progresses. In this case, if all of the criteria in HKAS 18 are met continuously as
construction progresses, revenue is recognised by reference to the stage of completion using the
percentage of completion method. The requirements of HKAS 11 are generally applicable to the
recognition of revenue and the associated expenses for such a transaction. Note that this form of
transaction is not applicable to property sales in Hong Kong.
3.3.5 Disclosures
When an entity recognises revenue using the percentage of completion method for agreements
that meet all the criteria in HKAS 18 continuously as construction progresses (see above), the
following disclosures are required:
How the entity determines which agreements meet all the criteria in HKAS 18 continuously
as construction progresses
The amount of revenue arising from such agreements in the period
The methods used to determine the stage of completion of agreements in progress
For any such agreements that are in progress at the reporting date, the following disclosures are
also required:
The aggregate amount of costs incurred and recognised profits (less recognised losses) to
date
The amount of advances received
Additional guidance
HK(IFRIC) Int-15 is accompanied by an information note which, although not part of the
Interpretation, summarises its requirements in the form of two flowcharts, which are reproduced at
the end of this section.
In addition, three illustrative examples designed to assist in the application of the Interpretation
accompany HK(IFRIC) Int-15.
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Financial Reporting
Solution
In this transaction, the terms of the agreement and all the surrounding facts and circumstances
indicate that the agreement is not a construction contract. The agreement is a forward contract that
gives the buyer an asset in the form of a right to acquire, use and sell the completed real estate at
a later date and an obligation to pay the purchase price in accordance with its terms.
Although the buyer might be able to transfer its interest in the forward contract to another party, the
entity retains control and the significant risks and rewards of ownership of the work in progress in
its current state until the completed real estate is transferred. Therefore, revenue should be
recognised only when all the criteria of HKAS 18 are met (at completion in this example).
Alternatively, assume that, in the jurisdiction, the law requires the entity to transfer immediately to
the buyer ownership of the real estate in its current state of completion and that any additional
construction becomes the property of the buyer as construction progresses.
The entity would need to consider all the terms of the agreement to determine whether this change
in the timing of the transfer of ownership means that the entity transfers to the buyer control and
the significant risks and rewards of ownership of the work in progress in its current state as
construction progresses. For example, the fact that if the agreement is terminated before
construction is complete, the buyer retains the work in progress and the entity has the right to be
paid for the work performed, might indicate that control is transferred along with ownership. If it
does, and if all the criteria in HKAS 18 are met continuously as construction progresses, the entity
recognises revenue by reference to the stage of completion using the percentage of completion
method taking into account the stage of completion of the whole building and the agreements
signed with individual buyers.
Self-test question 3
(a) Realbuild operates in the house building sector and currently does not report under HKFRS.
In the market in which Realbuild operates, the custom is to sign a contract which includes a
completion date when funds are transferred and the keys passed to the buyer. Realbuild's
accounting policy is to recognise revenue on signing the contract. Where there is still
building work to be completed after the keys are passed to the buyer, Realbuild delays
revenue recognition until the completion of the work.
(b) BCN Productions is a film production house. The company licenses one of its new films to a
distributor in a foreign country over which BCN Productions has no control. The film is
expected to appear before the public over a period of six months and BCN Productions
intends to recognise the revenue over this period.
(c) KSoft is a start-up company that will develop bespoke software systems for corporate clients.
The company's policy is to invoice fixed amounts which include the software development
and fees for ongoing post-delivery support while the new software system is implemented.
KSoft intends to recognise the revenue for both elements on installation of the software.
Required
Advise the directors as to the acceptability of the above accounting policies for revenue recognition
under HKAS 18 Revenue.
(The answer is at the end of the chapter)
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Yes
Separate components
Component(s) for the delivery of other Component for the construction of real estate
goods or services and directly related services (in accordance A
with HKAS 18)
Apply HKAS 18
Does the agreement or Yes The agreement or component is Revenue and costs are
A component meet the definition a construction contract within recognised by reference to the
of a construction contract? the scope of HKAS 11* stage of completion
No
Is the agreement or component The agreement or component is Revenue and costs are
Yes
only for the rendering of for the rendering of services recognised by reference to the
services? within the scope of HKAS 18 stage of completion
No
The agreement or component is Are the criteria for recognising Revenue and costs are
for the sale of goods within the revenue from the sale of goods Yes recognised by reference to the
scope of HKAS 18 ** met on a continuous basis? stage of completion
* The construction contract may need to be segmented in accordance with paragraph 8 of HKAS 11
** Directly related services may need to be separated in accordance with paragraph 13 of HKAS 18
4 Current developments
The IASB and US standard setter, FASB, issued IFRS 15 Revenue from Contracts with Customers
in May 2014; this standard replaces all existing IFRS and US GAAP revenue requirements,
including IAS 11, IAS 18, IFRIC 13, IFRIC 15, IFRIC 18 and SIC 31.
When adopted by HKICPA as HKFRS 15, the new standard will replace HKAS 11 and HKAS 18,
together with the relevant Hong Kong interpretations.
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Financial Reporting
The new standard was issued with an effective date of 1 January 2017, however the IASB has
issued an exposure draft proposing that this is delayed by a year to 1 January 2018.
Key terms
Revenue is income arising in the course of an entity’s ordinary activities
Income is increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in an increase in equity, other than
those relating to contributions from equity participants.
A contract is an agreement between two or more parties that creates enforceable rights and
obligations.
A customer is a party that has contracted with an entity to obtain goods or services that are an
output of the entity’s ordinary activities in exchange for consideration.
(HKFRS 15)
Revenue is therefore recognised when control over goods or services is transferred to the
customer.
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Solution
MBS provides Fashion Focus Co with goods and services that are capable of being distinct (eg
building design services could be sold separately, as could the other elements of the contract.)
In the context of this contract, however, MBS provides a significant service of integrating the inputs
in order to produce a single output being the retail outlet. Therefore the provision of each good or
service is not separately identifiable and there is a single performance obligation, being the
development of the property.
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Financial Reporting
Required
Identify the performance obligation(s) in the contract.
Solution
Each element of the contract could be used by the customer individually and is separately
identifiable ie the provision of the licence by TTC is not dependent on or highly interrelated with
other goods and services promised in the contract and would not be significantly affected if Koala
Design elected to use one of TTC’s competitor’s installation services and technical support
services.
Therefore there are three distinct performance obligations in the contract, being:
1. Provision of the licence
2. Installation of the software
3. Provision of technical support
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Solution
Licence provision $5,000/$9,500 $6,000 = $3,158
Installation service $1,500/$9,500 $6,000 = $947
Technical support service $3,000/$9,500 $6,000 = $1,895
HKFRS 15.31 4.2.5 Step 5: Recognise revenue when performance obligations are satisfied
– 32, 25
As each performance obligation is satisfied the related element of the transaction price is
recognised as revenue. Depending on the performance obligation it may be satisfied at a single
point in time or over a period of time. A performance obligation is satisfied over time if one of the
following criteria is met:
(a) The customer simultaneously receives and consumes the benefits provided by the entity’s
performance as the entity performs (eg a cleaning service).
(b) The entity’s performance creates or enhances an asset that the customer controls as the
asset is created or enhanced (eg customised software that is being written into a customer’s
existing IT infrastructure).
(c) The entity’s performance does not create an asset with an alternative use to the entity and
the entity has an enforceable right to payment for performance completed to date.
HKFRS 15.38 Performance obligation satisfied at a single point in time
Where a performance obligation is satisfied at a single point in time, the following should be
considered in determining that time:
1. Whether the entity has a present right to payment for the asset
2. Whether the entity has transferred legal title to the asset
3. Whether the entity has transferred physical possession of the asset
4. Whether the entity has transferred the risks and rewards of ownership to the customer
5. Whether the customer has accepted the asset
HKFRS Performance obligation satisfied over a period of time
15.39-45,
B14-B19 Revenue is only recognised when an entity can reasonably measure the outcome of a performance
obligation. In the early stages of a contract this is not always possible, and in this case revenue is
recognised to the extent of costs incurred.
Where an entity can reasonably measure the outcome of a performance obligation, revenue is
recognised based on progress towards satisfaction of the performance obligation. Progress is
measured by way of either an input or output method (which must be used consistently for similar
performance obligations).
Input methods may include the proportion of costs incurred, labour hours or machine hours worked
or time elapsed. Output methods may include the number of units produced, work certified or
contract milestones.
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Financial Reporting
Contract asset Entity’s right to consideration in exchange for goods or services that
it has transferred to a customer when that right is conditional on
something other than the passage of time (for example the entity’s
performance).
Receivable Entity’s right to consideration that is unconditional ie only the
passage of time is required before payment is due.
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4.5.1 Offsetting
HKFRS HKFRS 15 makes the following points about offsetting:
15.105
A single contract is presented either as a net contract asset or a net contract liability. Any
receivable is presented separately
Contract assets and liabilities in respect of different customers are not offset
HKFRS
15.110
4.6 Disclosure
HKFRS 15 requires that an entity provides both qualitative and quantitative information about:
(a) Its contracts with customers
(b) The significant judgments and changes in judgments made in applying HKFRS 15 to those
contracts and
(c) Any assets recognised from the costs to obtain or fulfil a contract with a customer.
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Financial Reporting
Topic recap
Examples:
Consignment sales recognised as revenue
when goods sold on to third party
Bill and hold sales revenue recognised when
buyer takes title provided that the goods are
available, payment terms are normal, delayed
delivery is acknowledged and delivery is
probable.
Sale and repurchase agreements may in
substance be secured loans.
Disclose:
Accounting policies
The amount of each significant category of revenue
The amount of revenue arising from exchanges of goods or services in each category.
HKAS
HK (IFRIC)
18 Revenue
Interpretations
Recognition
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Answer 1
The contract is for services that are performed by an indeterminate number of acts over (usually) a
two-year period.
In this case HKAS 18 requires that for practical purposes revenue is recognised on a straight-line
basis over the period, unless there is evidence for the use of another method that better reflects the
stage of completion.
As the number of call outs may vary significantly from year to year, it is unlikely that this is the
case. In particular it is impossible to identify what proportion of total call outs over the two year
period have occurred in any given accounting period before the two year period is complete.
Therefore it would appear that the accountant’s approach is incorrect.
Answer 2
(a) There are a number of factors that suggest the substance of this transaction is different to its
legal form. First, the building has a market value of $7m and is being sold for less than
market value, which immediately looks odd. Second, there is an agreement for Bradley Co.
to repurchase the assets in the future. If it were a genuine sale, this would be an unlikely
clause. Third, Bradley Co. retains occupancy of the building – again, if this were a genuine
sale it would be very unlikely that an asset would be sold and not occupied or used by the
purchaser.
Therefore, it seems obvious that the substance of this transaction is a secured loan. Bradley
Co. should continue to recognise the building in the statement of financial position as they
have the risks and rewards of ownership. The cash received from Beck Co. should be
recorded as a non-current liability and the finance on the loan should be charged in the
statement of profit or loss over the three-year period. The finance charge could be calculated
as the difference between the "sale" proceeds and the repurchase amount.
(b) Revenue should be accrued by Marianne Alltraders based on value of work performed rather
than accrued on a time apportioned basis in accordance with HKAS 18. Revenue recognised
is therefore $45,000.
(c) This is a consignment sale. Maximum Velocity should only recognise revenue in respect of
the bicycles when the significant risks and rewards of ownership have been transferred to
third party customers. The bikes remain in Maximum Velocity’s inventories until confirmation
has been received from the customer that they have been sold on.
(d) Since the outcome of the service transaction cannot be reliably measured at the year end,
only $4,450 is recognised as revenue by Admen rather than on a time apportioned basis.
This matches with the costs recognised ensuring that no profit is recorded until the outcome
can be reliably measured.
Answer 3
(a) The general rule under HKAS 18 Revenue is that revenue is recognised when the significant
risks and rewards of ownership have been transferred and there is no continuing managerial
involvement or effective control.
HK(IFRIC) 15 provides additional guidance regarding real estate sales and states that
revenue is recognised when the entity transfers control as well as the risks and rewards of
ownership, i.e. when the legal completion occurs and the keys are handed over in this case.
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Financial Reporting
Realbuild's current policy recognises the revenue before this is the case: revenue should be
recognised on the contract completion date rather than on signing the contract.
Where there is continuing building work to be undertaken, revenue can be recognised
provided the property has been delivered, so Realbuild's policy needs to be amended here
as well. However, a provision is also required to be recognised for the cost of work yet to be
performed and this is charged to profit or loss at the same time as the revenue is recognised,
i.e. on delivery of the property.
Note. A house-builder such as Realbuild selling to the general public is entering into
contracts to sell goods rather than a construction contract, as the buyer is not able to specify
the major structural elements of the design, which would be an indication of a construction
contract.
(b) Licence fees (and royalty income) are normally recognised straight line over the life of the
agreement. However, where the licensee has no remaining obligations to perform, or, as in
this case, no control over the use of the images once licensed, the substance of the
transaction is a sale, and revenue should be recognised at the time when the licence is
granted, so BCN Productions' policy is not appropriate.
(c) HKAS 18 provides guidance on the recognition of revenue from the development of
customised software: it should be recognised by reference to the stage of completion of the
development including completion of the services provided for post-delivery support.
Consequently, it is not appropriate to recognise the revenue on installation: it should be
recognised over the period of development and support (although not necessarily straight
line as can be matched to the level of work done in each period).
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Exam practice
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Financial Reporting
A customer choosing Plan II is required to enter into an insurance contract for two years at a pre-
paid premium of $6,000 per truck with Grant Insurance Inc. (GCC), an independent insurance
company, which takes full obligation of the insurance arrangement. The customer pays the full
insurance premium to YCL upon collection of the truck and YCL pays $5,500 to GCC on the same
date.
Sales orders of 12 trucks under Plan I and 20 trucks under Plan II were signed on
15 October 20X3. The trucks were delivered to customers on 30 November 20X3.
Required
(a) Prepare the journal entries to be entered in October, November and December 20X3 for
these two sales transactions. The effective interest rate is estimated to be 13%. (12 marks)
(b) YCL is planning to expand its business to Guangzhou in co-operation with Best Trade
Vehicle Limited (BT), a local car dealer. Discuss the factors for consideration in the
contractual arrangement with BT so that BT will only act as an agent of YCL in selling the
trucks. (8 marks)
(Total = 20 marks)
HKICPA June 2014
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chapter 15
Income taxes
Learning focus
Tax in one form or another is relevant to all organisations. You should therefore ensure that
you fully understand its operation in the financial statements. Hence this topic may appear with
other topics. You must study it and understand its relationship with other assets and liabilities.
Of course, in a business situation, the deferred tax consideration is always an important topic
as it may change the investment decision.
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Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.18 Income taxes 2
3.18.01 Account for current tax liabilities in accordance with HKAS 12
3.18.02 Record entries relating to income tax in the accounting records
3.18.03 Identify temporary differences (both inside and outside difference)
and calculate deferred tax amounts
3.18.04 Account for tax losses and tax credits
3.18.05 Identify initial recognition exemption for assets and liabilities
3.18.06 Account for deferred tax relating to investments in subsidiaries,
associates and joint ventures
3.18.07 Determine when tax assets and liabilities can be offset
3.18.08 Disclose relevant information with regard to income taxes
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1 Current tax
Topic highlights
Taxation consists of two components:
Current tax
Deferred tax
Key terms
Accounting profit. Profit or loss for a period before deducting tax expense.
Taxable profit/(tax loss). The profit (loss) for a period, determined in accordance with the rules
established by the taxation authorities, upon which income taxes are payable (recoverable).
Tax expense/(tax income). The aggregate amount included in the determination of profit or loss
for the period in respect of current tax and deferred tax.
Current tax. The amount of income taxes payable (recoverable) in respect of the taxable profit (tax
loss) for a period. (HKAS 12)
HKAS
12.12,13
1.2 Recognition of current tax liabilities and assets
Topic highlights
Current tax is the amount payable to the tax authorities in relation to the trading activities during
the period. It is generally straightforward.
The amount of tax payable (or receivable) must be calculated and then charged (or credited) to
profit or loss for the period and shown in the statement of profit or loss and other comprehensive
income.
Any unpaid tax in respect of the current or prior periods must be recognised as a liability.
Conversely, any excess tax paid in respect of current or prior periods over what is due should be
recognised as an asset.
1.2.1 Over and underprovisions
The year end tax liability (or asset) is generally an estimated amount, not settled until a later date.
It is often the case, therefore, that the liability (or asset) recognised is not equal to the amount
eventually paid (or recovered):
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Where the estimated tax liability exceeds the tax later paid to the authorities, tax has been
overprovided.
Where the estimated tax liability is less than the tax later paid to the authorities, tax has been
underprovided.
This under- or over-provision must be adjusted for in the following year’s tax charged to profit or loss:
$
Estimated current year tax charge X
Under/over provision in respect of prior year X/(X)
Income tax charge for the year X
Self-test question 1
Moorland operates in Hong Kong and is subject to a 16.5% tax rate. In the year ended
31 December 20X1, the company had tax-adjusted profits of $760,000. In the year ended
31 December 20X0, a current year tax liability of $130,000 was recognised; tax subsequently paid
in respect of the year was $126,700.
(a) What amounts are recognised in Moorland’s financial statements in respect of tax in the year
ended 31 December 20X1. You should provide journal entries?
(b) How does your answer change if the tax paid in respect of 20X0 was $131,000?
(The answer is at the end of the chapter)
Solution
Tax due on profits in 20X1 is $25,200 ($126,000 20%)
Tax repayment due on losses in 20X2 is $9,200 ($46,000 20%)
The taxable profits of 20X1 are sufficient to absorb the losses of 20X2 and therefore a repayment
for the full $9,200 can be claimed.
The double entry will be:
$ $
DEBIT Tax receivable (statement of financial position) 9,200
CREDIT Tax repayable (statement of profit or loss and
other comprehensive income) 9,200
The tax receivable will be shown as an asset until the repayment is received from the tax
authorities.
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HKAS
12.58,61A
1.4 Recognition of current tax
Current tax payable or repayable is recognised in profit or loss in the period to which it relates.
There are three exceptions to this rule:
(a) Tax arising from a business combination which is an acquisition (refer to sections 10 and
10.4 of this chapter).
(b) Tax arising from a transaction or event recognised in other comprehensive income
(c) Tax arising from a transaction or event recognised directly in equity
If a transaction or event is charged or credited to other comprehensive income or directly to equity,
it is logical to show its related tax in other comprehensive income or equity.
An example of this is where, under HKAS 8, a change in accounting policy that is applied
retrospectively, or a correction of a material prior period error is adjusted to the opening balance of
the retained earnings.
Deferred tax is an accounting measure which recognises the future tax impact of assets and
liabilities currently held in the statement of financial position. It is important to realise that
deferred tax is not an amount currently payable to the tax authorities, or relevant to tax
practitioners; it is quite simply an accounting adjustment.
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For example, if an entity holds an asset in its statement of financial position, it is reasonable to
assume that at some point in the future that asset will be realised (for example, an amount owed
will be received). At such a time as the asset is realised, tax will be payable on the related income
(assuming that tax arises on the cash receipt rather than when the asset is recognised for
accounting purposes). This tax payable at some point in the future is referred to as a deferred tax
liability.
Solution
To date Lightning Co. has claimed tax depreciation on the asset of $180, and so received tax relief
for this amount.
In the future, as Lightning Co. continues to use the asset, it will recover the $200 carrying amount
of the asset (i.e. it will earn that $200 in revenue – and probably more besides).
Also in the future Lightning Co. will be able to claim a further $120 of tax depreciation ($300 original
cost less the $180 tax relief already claimed). This value for tax purposes is known as the "tax
base".
The net effect in the future is $80 taxable income ($200 carrying amount – $120 tax base). This is
known as a "taxable temporary difference".
When applying a tax rate of 16.5%, tax payable in the future on the net taxable income amounts to
$13.20.
Lightning Co. therefore recognises a deferred tax liability of $13.20.
Equally, if an entity has a liability, and tax relief is provided when payment is actually made to settle
the liability (rather than when the liability is recognised for accounting purposes), then there is a
future tax benefit, known as a deferred tax asset.
Solution
In 20X1, Monarchy recognises a provision for a bad debt (a liability balance and
corresponding accounting expense) of $200,000.
When the balance is certified as a bad debt (e.g. because the client’s company is liquidated)
Monarchy will be able to reduce taxable profits by the $200,000. This is not expected to
happen until 20X3.
When the $200,000 is included as an allowable expense within taxable profits, it will result in
a reduction in tax payable of $33,000 ($200,000 16.5%).
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The $33,000 is not recognised as a current tax asset (i.e. a receivable) as the benefit is not
yet virtually certain.
Instead, a deferred tax asset of $33,000 may be recognised in respect of the doubtful debt.
This asset is only recognised if Monarchy Co. expects to have sufficient profits in two years'
time against which the bad debt expense may be relieved.
The remainder of this section of the chapter provides an overview of the process to recognise and
measure deferred tax. Later sections then consider each of the stages in the process in more
detail.
1 What is the carrying value of the item in the $200 asset ($200,000)
statement of financial position? provision
Note that for the purposes of this exercise, liabilities
should be regarded as negative amounts.
2 What is the "tax base" of the item? $120 asset Nil
Tax base is defined in the next section, but in (there is no liability
simple terms think of it as the carrying value of the / expense from the
item in a tax version of the statement of financial tax perspective
position. until the case is
certified as bad
debt)
3 What is the difference between carrying value and $80 ($200,000)
tax base – known as temporary difference?
4 What type of temporary difference?
A taxable temporary difference arises where Taxable Deductible
carrying value > tax base.
A deductible temporary difference arises where
tax base > carrying value
5 Apply tax rate to the temporary difference $13.20 $33,000
6 Deferred tax asset or liability?
A deferred tax liability arises from a taxable Liability Asset
temporary difference.
A deferred tax asset arises from a deductible
temporary difference.
The table above includes a number of new terms such as tax base and temporary difference. The
next section considers the HKAS 12 definitions of each of them.
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Key terms
Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of
taxable temporary differences.
Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:
Deductible temporary differences
The carry forward of unused tax losses
The carry forward of unused tax credits
Temporary differences are differences between the carrying amount of an asset or liability in the
statement of financial position and its tax base. Temporary differences may be either:
Taxable temporary differences, which are temporary differences that will result in taxable
amounts in determining taxable profit (tax loss) of future periods when the carrying amount
of the asset or liability is recovered or settled; or
Deductible temporary differences, which are temporary differences that will result in
amounts that are deductible in determining taxable profit (tax loss) of future periods when the
carrying amount of the asset or liability is recovered or settled.
The tax base of an asset or liability is the amount attributed to that asset or liability for tax
purposes. (HKAS 12)
HKAS 12 provides further guidance on some of the definitions seen above, and sections 2.2.1 to
2.2.3 below consider tax base, temporary differences and deferred tax asset/liability in turn.
HKAS 12.7 2.2.1 Tax base
The tax base of an asset is the amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to the entity when it recovers the carrying amount of the
asset.
Where those economic benefits are not taxable, the tax base of the asset is the same as its
carrying amount.
Make sure that you understand this idea by attempting the following self-test question.
Self-test question 2
State the tax base of each of the following assets:
(a) Interest receivable has a carrying amount of $1,000. The related interest revenue is not
taxable.
(b) Dividends receivable from a subsidiary have a carrying amount of $5,000. The dividends are
not taxable.
(c) A machine cost $10,000. For tax purposes, depreciation of $3,000 has already been
deducted in the current and prior periods and the remaining cost will be deductible in future
periods, either as depreciation or through a deduction on disposal. Revenue generated by
using the machine is taxable, any gain on disposal of the machine will be taxable and any
loss on disposal will be deductible for tax purposes.
(d) Trade receivables have a carrying amount of $10,000. The related revenue has already
been included in taxable profit (tax loss).
(e) A loan receivable has a carrying amount of $1 million. There are no tax consequences for
repayment of the loan.
(The answer is at the end of the chapter)
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HKAS 12.8 The tax base of a liability is its carrying amount, less any amount that will be deductible for tax
purposes in relation to the liability in future periods.
For revenue received in advance, the tax base of the resulting liability is its carrying amount, less
any amount of the revenue that will not be taxable in future periods.
Self-test question 3
State the tax base of each of the following liabilities:
(a) Current liabilities include accrued expenses with a carrying amount of $1,000. The related
expense will be deducted for tax purposes on an accrual basis.
(b) Current liabilities include revenue received in advance, with a carrying amount of $1,000.
The related revenue was taxed on an accrual basis.
(c) Current liabilities include accrued fines and penalties with a carrying amount of $100. Fines
and penalties are not deductible for tax purposes.
(d) A loan payable has a carrying amount of $1 million. There are no tax consequences for
repayment of the loan.
(The answer is at the end of the chapter)
HKAS 12, HKAS 12 gives the following examples of circumstances in which the carrying amount of an asset
Illustrative or liability will be equal to its tax base.
Examples
Accrued expenses have already been deducted in determining an entity's current tax
liability for the current or earlier periods.
A loan payable is measured at the amount originally received and this amount is the same
as the amount repayable on final maturity of the loan.
Accrued expenses will never be deductible for tax purposes.
Accrued income will never be taxable.
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In the long run, there is no difference between total taxable profits and total accounting profits
(except for permanent differences) so that temporary differences originate in one period and will be
reversed in one or more subsequent periods. Deferred tax is caused by temporary differences.
Sections 3 and 4 of this chapter consider taxable and deductible temporary differences in more detail.
2.2.3 Deferred tax assets and liabilities
Temporary differences give rise to deferred tax liabilities and assets:
A taxable temporary difference results in a deferred tax liability.
A deductible temporary difference results in a deferred tax asset.
Deferred tax assets also arise from unused tax losses that tax law allows to be carried forward.
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Solution
First, the deferred tax asset or liability must be considered for each of the items separately:
Non-current assets
Carrying amount (780,000 – 210,000) $570,000
Tax base (780,000 – 320,000) $460,000
Temporary difference $110,000
Taxable or deductible? Taxable since CA > TB
Deferred tax liability (110,000 16.5%) $18,150
Interest receivable
Carrying amount $160,000
Tax base $nil *
Temporary difference $160,000
Taxable or deductible? Taxable since CA > TB
Deferred tax liability (160,000 16.5%) $26,400
*The tax base of an asset is the amount that will be deductible for tax purposes in the future. Here
nothing will be deductible – instead an amount will be taxable.
Provision
Carrying amount ($98,000)
Tax base $nil **
Temporary difference $98,000
Taxable or deductible? Deductible since CA < TB
Deferred tax asset (98,000 16.5%) $16,170
** The tax base of a liability is its carrying amount ($98,000) less any amount deductible for tax
purposes in the future ($98,000).
In summary therefore:
$
Deferred tax liability 1 18,150
Deferred tax liability 2 26,400
Deferred tax asset (16,170)
Net deferred tax liability 28,380
The increase in deferred tax liability since 31 December 20X0 is $5,950 (28,380 – 22,430) and this
is accounted for by:
$ $
DEBIT Tax charge 5,950
CREDIT Deferred tax liability 5,950
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR CASARES
FOR THE YEAR ENDED 31 DECEMBER 20X1
$
Tax charge – deferred tax 5,950
STATEMENT OF FINANCIAL POSITION FOR CASARES AT 31 DECEMBER 20X1
$
Deferred tax liability 28,380
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Financial Reporting
Remember the basic rule that a taxable temporary difference arises where the carrying amount of
an item in the statement of financial position exceeds its tax base, and this taxable temporary
difference results in a deferred tax liability.
Try to understand the reasoning behind the recognition of deferred tax liabilities on taxable
temporary differences.
(a) When an asset is recognised, it is expected that its carrying amount will be recovered in
the form of economic benefits that flow to the entity in future periods.
(b) If the carrying amount of the asset is greater than its tax base, then taxable economic benefits
will also be greater than the amount that will be allowed as a deduction for tax purposes.
(c) The difference is therefore a taxable temporary difference and the obligation to pay the
resulting income taxes in future periods is a deferred tax liability.
(d) As the entity recovers the carrying amount of the asset, the taxable temporary difference will
reverse and the entity will have taxable profit.
(e) It is then probable that economic benefits will flow from the entity in the form of tax
payments, and so the recognition of all deferred tax liabilities (except those excluded below)
is required by HKAS 12.
The following are examples of circumstances that give rise to taxable temporary differences.
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*The tax base of an asset is the amount that will be deductible for tax purposes in the future. Here
nothing will be deductible in the future as tax relief has already been given.
HKAS 12, 3.1.2 Transactions that affect the statement of financial position
Illustrative
Examples (a) Depreciation of an asset is not deductible for tax purposes. No deduction will be available
for tax purposes when the asset is sold/scrapped.
(b) A borrower records a loan at proceeds received (amount due at maturity) less transaction
costs. The carrying amount of the loan is subsequently increased by amortisation of the
transaction costs against accounting profit. The transaction costs were, however, deducted
for tax purposes in the period when the loan was first recognised.
(c) A loan payable is measured on initial recognition at net proceeds (net of transaction costs).
The transaction costs are amortised to accounting profit over the life of the loan. Those
transaction costs are not deductible in determining the taxable profit of future, current or prior
periods.
(d) The liability component of a compound financial instrument (e.g. a convertible bond) is
measured at a discount to the amount repayable on maturity, after assigning a portion of the
cash proceeds to the equity component (see HKAS 32). The discount is not deductible in
determining taxable profit.
(e) Development costs may be capitalised and amortised over future periods in determining
accounting profit but deducted in determining taxable profit in the period in which they are
incurred. Such development costs have a tax base of nil as they have already been
deducted from taxable profit. The temporary difference is the difference between the carrying
amount of the development costs and their tax base of nil.
Solution
Carrying amount $120,000
Tax base (200,000 – 90,000) $110,000
Temporary difference $10,000
Taxable or deductible? Taxable since CA > TB
Therefore deferred tax liability (10,000 16.5%) $1,650
The logic behind this liability is as follows: In order to recover the carrying amount of $120,000, the
entity must earn taxable income of $120,000, but it will only be able to deduct $110,000 as a
taxable expense. The entity must therefore pay income tax of $10,000 16.5% = $1,650 when the
carrying amount of the asset is recovered.
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Example: Revaluation
During the year ended 31 December 20X1, Marshall revalues a non-current asset to $8,000,000.
The asset cost $6,000,000 three years ago and was being depreciated at 2% straight line. Capital
allowances were available at 4% straight line. Marshall’s rate of tax is 16.5%.
What deferred tax arises on the revaluation in 20X1, assuming that the revaluation gain is not
taxable in 20X1?
Solution
$'000
Carrying value of non-current asset prior to revaluation
($6,000,000 94%) 5,640
Revalued amount 8,000
Taxable temporary difference = revaluation gain 2,360
Therefore deferred tax liability (16.5% 2.36m) 389.4
HKAS
12.21,22
3.2 Taxable temporary differences which do not result in deferred
tax liabilities
There are two circumstances given in the standard where a taxable temporary difference does
not result in a deferred tax liability:
(a) The deferred tax liability arises from the initial recognition of goodwill.
(b) The deferred tax liability arises from the initial recognition of an asset or liability in a
transaction which:
(i) Is not a business combination (see Section 8)
(ii) At the time of the transaction affects neither accounting profit nor taxable profit (tax
loss)
HKAS 12.22 3.2.1 Initial recognition of an asset or liability
A temporary difference can arise on initial recognition of an asset or liability, e.g. if part or all of the
cost of an asset will not be deductible for tax purposes. The nature of the transaction which led to
the initial recognition of the asset is important in determining the method of accounting for such
temporary differences.
If the transaction affects either accounting profit or taxable profit, an entity will recognise any
deferred tax liability or asset. The resulting deferred tax expense or income will be recognised in
profit or loss.
Where a transaction affects neither accounting profit nor taxable profit it would be normal for an
entity to recognise a deferred tax liability or asset and adjust the carrying amount of the asset or
liability by the same amount. However, HKAS 12 does not permit this recognition of a deferred tax
asset or liability as it would make the financial statements less transparent. This will be the case
both on initial recognition and subsequently, nor should any subsequent changes in the
unrecognised deferred tax liability or asset as the asset is depreciated be made.
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An example of the initial recognition of an asset in a transaction which does not affect either
accounting or taxable profit at the time of the transaction is an intangible asset with a finite life
which attracts no tax allowances. In this case, taxable profit is never affected, and amortisation is
only charged to accounting profit after the transaction.
Solution
As at 20X7, as it recovers the carrying amount of the asset, Perris Co. will earn taxable income of
$10,000 and pay tax of $1,650. The resulting deferred tax liability of $1,650 would not be
recognised because it results from the initial recognition of the asset.
As at 20X8, the carrying value of the asset is now $8,000. In earning taxable income of $8,000, the
entity will pay tax of $1,320. Again, the resulting deferred tax liability of $1,320 is not recognised,
because it results from the initial recognition of the asset.
The following question on accelerated depreciation should clarify some of the issues and introduce
you to the calculations.
Self-test question 4
Jojo Co. buys equipment for $50,000 on 1 January 20X1 and depreciates it on a straight line basis
over its expected useful life of five years. For tax purposes, the equipment is depreciated at 25%
per annum on a straight line basis. The tax rate is 15%.
Required
Show the current and deferred tax impact in years 20X1 to 20X5 of the acquisition of the
equipment.
(The answer is at the end of the chapter)
Remember the basic rule that a deductible temporary difference arises where the carrying amount
of an asset or liability is less than its tax base, and this deductible temporary difference normally
results in a deferred tax asset.
Try to understand the reasoning behind the recognition of deferred tax assets on taxable
temporary differences:
(a) When a liability is recognised, it is assumed that its carrying amount will be settled in the
form of outflows of economic benefits from the entity in future periods.
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(b) When these resources flow from the entity, part or all may be deductible in determining
taxable profits of a period later than that in which the liability is recognised.
(c) A temporary tax difference then exists between the carrying amount of the liability and its
tax base.
(d) A deferred tax asset therefore arises, representing the income taxes that will be
recoverable in future periods when that part of the liability is allowed as a deduction from
taxable profit.
(e) Similarly, when the carrying amount of an asset is less than its tax base, the difference
gives rise to a deferred tax asset in respect of the income taxes that will be recoverable in
future periods.
The following are common examples of situations that result in a deductible temporary difference.
HKAS 12,
Illustrative
4.1 Examples of deductible temporary differences
Examples HKAS 12 provides a number of examples of deductible temporary differences.
4.1.1 Transactions affecting the statement of profit or loss and other
comprehensive income
(a) Retirement benefit costs (pension costs) are deducted from accounting profit as service is
provided by the employee. They are not deducted in determining taxable profit until the entity
pays either retirement benefits or contributions to a fund. (This may also apply to similar
expenses.)
(b) Accumulated depreciation of an asset in the financial statements is greater than the
accumulated depreciation allowed for tax purposes up to the end of the reporting period.
(c) The net realisable value of inventory, or the recoverable amount of an item of property,
plant and equipment falls and the carrying value is therefore reduced, but that reduction is
ignored for tax purposes until the asset is sold.
(d) Research costs (or organisation/other start-up costs) are recognised as an expense for
accounting purposes but are not deductible against taxable profits until a later period.
(e) Income is deferred in the statement of financial position, but has already been included in
taxable profit in current/prior periods.
A non-taxable government grant related to an asset is deducted in arriving at the carrying amount
of the asset but, for tax purpose, is not deducted from the asset’s depreciable amount (in other
words its tax base); the carrying amount of the asset is less than its tax base and this gives rise to
a deductible temporary difference. Government grants may also be set up as deferred income in
which case the difference between the deferred income and its tax base of nil is a deductible
temporary difference. (Note. Whichever method of presentation an entity adopts, a deferred tax
asset may not be recognised here according to the standard.)
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Solution
Carrying amount (recoverable amount) $2,600,000
Tax base (4,000,000 – 1,000,000) $3,000,000
Temporary difference $400,000
Taxable or deductible? Deductible since CA < TB
Therefore deferred tax asset (400,000 16.5%) $66,000
HKAS 12.27-
30
4.2 Recognition of deferred tax assets
Although the circumstances listed above will result in a deductible temporary difference, they will
not necessarily result in a deferred tax asset.
This is because the recognition criteria of HKAS 12 state that a deferred tax asset can only be
recognised to the extent that it is probable that taxable profit will be available against which it can
be utilised.
4.2.1 Sufficient taxable profit
When can we be sure that sufficient taxable profit will be available against which a deductible
temporary difference can be utilised? HKAS 12 states that this will be assumed when sufficient
taxable temporary differences exist which relate to the same taxation authority and the same
taxable entity. These should be expected to reverse as follows:
(a) In the same period as the expected reversal of the deductible temporary difference.
(b) In periods into which a tax loss arising from the deferred tax asset can be carried back
or forward.
Only in these circumstances is the deferred tax asset recognised, in the period in which the
deductible temporary differences arise.
4.2.2 Insufficient taxable profit
What happens when there are insufficient taxable temporary differences (relating to the same
taxation authority and the same taxable entity)? It may still be possible to recognise the deferred
tax asset, but only to the following extent.
(a) Taxable profits are sufficient in the same period as the reversal of the deductible temporary
difference (or in the periods into which a tax loss arising from the deferred tax asset can be
carried forward or backward), ignoring taxable amounts arising from deductible temporary
differences arising in future periods.
(b) Tax planning opportunities exist that will allow the entity to create taxable profit in the
appropriate periods.
With reference to (b), tax planning opportunities are actions that an entity would take in order to
create or increase taxable income in a particular period before the expiry of a tax loss or tax credit
carry forward. For example, in some countries it may be possible to increase or create taxable
profit by electing to have interest income taxed on either a received or receivable basis, or
deferring the claim for certain deductions from taxable profit.
In any case, where tax planning opportunities advance taxable profit from a later period to an
earlier period, the utilisation of a tax loss or a tax credit carry forward will still depend on the
existence of future taxable profit from sources other than future originating temporary differences.
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If an entity has a history of recent losses, then this is evidence that future taxable profit may not
be available.
Solution
Carrying amount ($75,000)
Tax base $nil *
Temporary difference $75,000
Taxable or deductible? Deductible since CA < TB
Therefore deferred tax asset (75,000 16.5%) $12,375
*The tax base of the liability is nil (carrying amount of $75,000 less the $75,000 that will be
deductible for tax purposes when the warranty costs are paid).
The logic behind this is as follows: when the liability is settled for its carrying amount, the entity's
future taxable profit will be reduced by $75,000 and so its future tax payments by $75,000 16.5%
= $12,375.
HKAS 12.34-
36
4.4 Tax losses and credits carried forward
HKAS 12 states that a deferred tax asset may be recognised by an entity which has unused tax
losses or credits (i.e. which it can offset against taxable profits) at the end of a period, to the extent
that it is probable future taxable profits will be available to set off the unused tax losses/credits.
The recognition criteria for deferred tax assets here is identical to the recognition criteria for
deferred tax assets arising from deductible differences. The fact that future taxable profits may not
be available is confirmed by the existence of unused tax losses. For an entity with a past record of
recent tax losses, a deferred tax asset arising from unused tax losses or credits should be
recognised only to the extent that it has adequate taxable temporary differences or where it is
certain that taxable profit will be available to set off the unused losses/credits.
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The following are important criteria for assessing the probability that taxable profit will be available
against which unused tax losses/credits can be utilised:
Availability of sufficient taxable temporary differences (same tax authority/taxable entity)
against which unused tax losses/credits can be utilised before they expire
The likelihood that the entity will have taxable profits before the expiry of the unused tax
losses/credits
The unlikely recurrence of unused tax losses resulting from identifiable causes
Availability of tax planning opportunities (see above)
Deferred tax asset is not recognised if it is probable that taxable profit will not be available.
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Solution
(a) A deferred tax liability is recognised of $(100,000 – 60,000) 18% = $7,200.
(b) A deferred tax liability is recognised of $(100,000 – 60,000) 25% = $10,000.
HKAS 12.51C In 2010, HKAS 12 was amended to include a rebuttable presumption that deferred tax on
investment properties carried at fair value under HKAS 40 should be measured based on recovery
through sale rather than use. The amendment was intended to avoid any subjective assessment in
trying to decide whether the carrying amount of an investment property will be recovered through
use or through sale.
As there is no capital gains tax in Hong Kong, this amendment will generally result in the deferred
tax liability on such investment properties being limited to the tax effect of any claw back on sale of
any depreciation allowances previously given. No deferred tax arises in respect of the excess of
fair value over cost.
Example
A company based in Hong Kong owns an investment property with a fair value carrying amount of
$10 million. The property cost $9 million. The tax base of the property is $8 million and the tax rate
on income is 16.5%.
Prior to the amendment to HKAS 12, if it were presumed that the carrying value of the property
would be recovered through use, the deferred tax liability would have been $330,000 (16.5%
($10 million – $8 million)).
The amendment, however, means that it is presumed that the carrying value will be recovered
through sale. Therefore, the deferred tax liability is restricted to the excess of allowances given
i.e. $165,000 (16.5% ($9million – $8million)).
The presumption is rebutted where the investment property is depreciable and is held with the
intention of consuming substantially all the economic benefits of the property through use rather
than sale, in other words, where the entity expects the asset’s income-generating ability to wear out
while the asset is still owned by the entity.
Self-test question 5
Crescent Co. owns a building with an original cost of $10m. In 20X1, the carrying value was $8m
and the asset was revalued to $15m. No equivalent adjustment was made for tax purposes. Total
depreciation allowance for tax purposes is $3m and the tax rate is 30%. If the asset is sold for more
than cost, the total tax depreciation allowance of $3m will be included in taxable income but sale
proceeds in excess of cost will not be taxable.
Required
State the deferred tax consequences if the entity:
(a) Expects to recover the carrying value through use,
(b) Expects to sell the building.
(The answer is at the end of the chapter)
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Financial Reporting
Self-test question 6
The facts are as in Self-test question 5 above, except that if the building is sold for more than cost,
the total tax depreciation allowance will be included in taxable income (taxed at 30%) and the sale
proceeds will be taxed at 40% after deducting an inflation-adjusted cost of $11m.
Required
State the deferred tax consequences if the entity:
(a) Expects to recover the carrying value through use,
(b) Expects to sell the building.
(The answer is at the end of the chapter)
If the tax base is not immediately apparent in Self-test question 6 above, it may be helpful to
consider the fundamental principle of HKAS 12: that an entity should recognise a deferred tax
liability (asset) whenever recovery or settlement of the carrying amount of an asset or liability would
make future tax payments larger (smaller) than they would be if such recovery or settlement would
have no consequences.
HKAS
12.53,54 5.3 Discounting
The standard does not allow deferred tax assets and liabilities to be discounted. This is because
the complexities and difficulties involved will affect reliability.
Discounting would require detailed scheduling of the timing of the reversal of each temporary
difference, but this is often impracticable. In addition, if discounting were permitted, it would affect
comparability.
It is, however the case that some temporary differences are based on discounted amounts e.g.
retirement benefit obligations.
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Self-test question 7
Antenna Exports Co acquired shares in another company for $75 million on 15 March 20X4. The
company intends to hold the shares for several years and has made an election to measure them
at fair value through other comprehensive income. The shares have a fair value of $82 million at 31
December 20X4.
Antenna Exports Co pays tax at 17% and unrealised gains are taxed when the underlying item is
sold.
Required
Discuss the tax implications of the investment in the year ended 31 December 20X4.
(The answer is at the end of the chapter)
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Financial Reporting
8 Summary flowchart
The following flowchart will help to summarise the approach to deferred tax that we have seen
throughout sections 2 to 7 of the chapter.
Is the item’s tax base different from its No No deferred tax implications
carrying value in the statement of
financial position?
Yes
Yes No
Apply the relevant tax rate to the A deferred tax asset is not
temporary difference. recognised in the financial
statements but the related
deductible temporary
difference should be disclosed.
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Self-test question 8
The new financial controller of Gerard Callagher Co (‘GCC’) has been asked to work on the
calculation of the deferred tax balance for one of the company’s oversea’s subsidiaries for inclusion
in the financial statements for the year ended 31 December 20X4. The subsidiary’s functional
currency is the Hong Kong Dollar. The balance on the deferred tax liability account of the
subsidiary at 31 December 20X3 was $2,300,800. The following information has been made
available to the financial controller.
1. The subsidiary has a small administrative office that was acquired in 20X1 at a cost of $60m.
Since its acquisition, the subsidiary has adopted a policy of revaluing property and the office
has a carrying amount of $70m at 31 December 20X4. A revaluation surplus of $14.2m was
recognised in the year.
2. The subsidiary’s manufacturing operations are run from a factory that cost $44m in 20W8,
with $26m of the cost attributable to the land on which the factory stands. The property has a
carrying amount of $15,840,500 at 31 December 20X4. The fair value of the property is
$15.85m. As this is substantially equal to the carrying amount, a revaluation surplus has not
been recognised.
3. On 31 March 2014, the company invested $9,500,000 in energy saving equipment for its
factory. This was determined to have a 10-year useful life.
4. The financial controller has increased the allowance for receivables from $1,800,000 to
$2,700,000. In addition, a specific allowance has been made for 75% of the $1,200,000
owed by a customer in financial difficulties. These allowances have been accounted for
correctly.
5. During the year, machinery at the subsidiary’s manufacturing premises malfunctioned,
resulting in excessive carbon emissions. As a result, the company was fined $250,000.
You have, from conversations with the tax department, gathered the following points about the
jurisdiction in which the subsidiary operates:
1. Industrial buildings built before 20X0 qualify for an industrial buildings allowance. This is 25%
of cost in the year of acquisition and 3% of cost on an annual basis thereafter. Neither
commercial property nor industrial buildings acquired after 20X0 qualify for tax allowances.
2. Energy saving equipment benefits from 100% tax relief in the year of acquisition.
3. Tax relief is provided on specific allowances for doubtful receivables when the allowance is
made; otherwise relief is provided only when an amount becomes irrecoverable.
4. Fines and penalties do not benefit from tax relief.
5. The corporate income tax rate is 28%.
6. Capital gains are not taxable.
7. Current tax assets and liabilities may be offset.
Required
Explain the deferred tax effect of each outstanding issue and calculate amounts to be recognised in
the financial statements for the year ended 31 December 20X4 in respect of deferred tax.
(The answer is at the end of the chapter)
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Financial Reporting
Illustration
The following are illustrative tax expense and deferred tax disclosure notes:
Income tax expense
Income tax recognised in profit or loss
Year ended 31 Year ended 31
December 20X3 December 20X2
$’000 $’000
Current tax 1,230 1,089
Under/(over) provision in prior year (12) 25
Deferred tax (70) (192)
Total income tax recognised in profit or loss 1,148 922
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15: Income taxes | Part C Accounting for business transactions
Hong Kong Profits Tax is calculated at 16.5% of the estimated assessable profit for both years.
Deferred tax
The following are the major deferred tax liabilities and assets recognised by the company and
movements thereon during the current and prior reporting periods:
Recognised Recognised Recognised
At in profit or in other At in profit or At 31
1 January loss comprehens Exchange 31 Decemb loss Exchange December
20X2 ive income differences er 20X2 differences 20X3
$'000 $'000 $'000 $'000 $'000 $'000 $'000 $'000
Deferred tax assets and liabilities are offset where the company has a legally enforceable right to
set off current tax assets and current tax liabilities and when the deferred taxes relate to the same
tax authority. The amounts determined after the appropriate offsetting are included in the statement
of financial position as follows:
20X3 20X2
$'000 $'000
Deferred tax assets 66 115
Deferred tax liabilities 645 785
At the reporting date, the company has unused tax losses of $1,650,000 available for offset against
future profits. A deferred tax asset has been recognised in respect of $1,080,000 of such losses.
No deferred tax asset has been recognised in respect of the remaining $570,000 as it is not
considered probable that there will be future taxable profits available in the relevant jurisdiction.
9.1 Reconciliation
Disclosure point number (4) listed above refers to a reconciliation between tax expense and
accounting profit. This should be presented as part of the income tax expense note (as illustrated
above). Two possible forms are suggested. The following example shows both possible forms:
Example: Reconciliation
Rugby Co. reports a profit before tax for the year ended 31 December 20X3 of $8.775m and a tax
expense of $3.977m. The tax rate applicable to the jurisdiction in which Rugby operates is 40%
(38% 20X2). Included in Rugby’s statement of profit or loss are the following items:
Charitable donations of $500,000
Fines for environmental pollution of $700,000
A gain on disposal of machinery of $125,000
Net taxable temporary differences at 1 January 20X3 were $1,850,000.
Required
Draft the tax reconciliation as required by HKAS 12 in the two forms allowed.
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Financial Reporting
Solution
The first form allowed reconciles between the product of accounting profit multiplied by the
applicable tax rate(s) and tax expense:
$'000 $'000
Profit before tax 8,775
Tax at applicable rate of 40% 3,510
Tax effect of expenses that are not deductible in determining
taxable profit:
Charitable donations (40% 500,000) 200
Fines for environmental pollution (40% 700,000) 280
480
Tax effect of income that is not taxable in determining taxable
profit:
Gain on disposal of property, plant and equipment (40% (50)
125,000)
Increase in opening deferred tax resulting from an increase in 37
tax rate (1,850,000 2%)
Tax expense 3,977
The alternative form of the required disclosure reconciles the applicable tax rate to the average
effective tax rate:
%
Applicable tax rate 40.0
Tax effect of expenses that are not deductible for tax purposes:
Charitable donations (200/8,775 100%) 2.3
Fines for environmental pollution (280/8,775 100%) 3.2
Tax effect of income that is not taxable in determining taxable profit:
Gain on disposal of property, plant and equipment (50/8,775 100%)) (0.6)
Effect on opening deferred taxes of reduction in tax rate (37/8,775 100%) 0.4
Average effective tax rate 45.3
There are a number of deferred tax implications of a business combination. Everything that
HKAS 12 states in relation to deferred tax and business combinations is brought together in this
section. Please note that accounting for business combinations is covered in the final section of
this book, Part D on group financial statements (chapters 27 to 31). You may find it easier to work
through this section of the chapter after those chapters.
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Self-test question 9
On 31 December 20X1, Basil Co. acquired a 60% stake in Lemongrass Co.. Among Lemongrass’s
identifiable assets at that date was inventory with a carrying amount of $8,000 and a fair value of
$12,000. The tax base of the inventory was the same as the carrying amount.
The consideration given by Basil Co. resulted in the recognition of goodwill acquired in the
business combination.
Income tax is payable by Basil Co. at 25% and by Lemongrass at 20%.
Required
What is the deferred tax impact of this transaction in the Basil group financial statements?
(The answer is at the end of the chapter)
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Financial Reporting
Self-test question 10
Silver acquired 80% of Gold on 1 January 20X1. During the year ended 31 December 20X5, Silver
sold goods to Gold for HK$12 million, charging a margin of 25%. At the year-end, a third of these
goods remained unsold by Gold.
The tax rate is 15%.
Required
Prepare consolidation journals and provide explanations showing how this transaction should be
accounted for in the consolidated financial statements of Silver.
(The answer is at the end of the chapter)
Self-test question 11
Red has owned 70% of the share capital of Yellow and 60% of the share capital of Green for many
years.
During the year, Yellow sold goods to Red at a total transfer price of HK$250 million, representing
a mark-up of 25%. At the reporting date inventory from Yellow which cost Red HK$25 million
remained in Red’s warehouse.
During the year, Green purchased goods from Yellow for HK$30 million. The transfer price is
established based on a margin of 20%. At the reporting date Green still has half of the goods in
inventory.
It is more likely than not that sufficient taxable profits will be available against which deductible
temporary differences can be utilised.
The tax rate is 16%.
Required
Explain and prepare the necessary consolidation journals to show the deferred tax effect of the
above transactions in the consolidated financial statements of the Red Group as at 31 March 20X6.
(The answer is at the end of the chapter)
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Financial Reporting
Self-test question 12
Oregano Co. owns 70% of Thyme Co.. During 20X1 Thyme sold goods to Oregano for $120,000 at
a mark-up of 20% above cost. Half of these goods are held in Oregano’s inventories at the year
end. The rate of income tax is 30%.
Required
What is the deferred tax impact of this transaction in the Oregano group financial statements?
(The answer is at the end of the chapter)
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Self-test question 13
On 1 September 20X1, Orchid acquired 90% of the ordinary share capital of Daffodil for
consideration totalling $1.75million. At the date of acquisition, Daffodil’s statement of financial
position showed net assets of $1.8million, although the fair value of inventory was assessed to be
$100,000 above its carrying amount.
Required
Explain the deferred tax implications, assuming a tax rate of 16.5%.
(The answer is at the end of the chapter)
Self-test question 14
Dandelion purchased 75% of the ordinary share capital of Bluebell for $1.1m when the net assets
of Bluebell were $1m, giving rise to goodwill of $350,000. At 31 December 20X1 the following is
relevant:
1 Goodwill has not been impaired
2 The net assets of Bluebell amount to $1.2m
Required
What temporary difference arises on this investment at 31 December 20X1?
(The answer is at the end of the chapter)
Self-test question 15
The Peninsula Group headed by Peninsula Co operates in a number of diverse industries
throughout South East Asia. It has recently appointed a new Managing Director from a country
where IFRS (HKFRS) are not applied. The Managing Director requires help in understanding how
the provision for deferred taxation would be calculated in the following situations under HKAS 12
Income taxes:
(i) A wholly owned overseas subsidiary, Linten Co a limited liability company, sold goods
costing $ 8.5 million to Peninsula Co on 1 September 20X5, and these goods had not been
sold by Peninsula Co before the year end. Peninsula Co had paid $ 11 million for these
goods. The Managing Director does not understand how this transaction should be dealt with
in the financial statements of the subsidiary and the group for taxation purposes. Linten Co
pays tax locally at 30%.
(ii) Fence, a limited liability company, is a wholly owned subsidiary of Peninsula Co, and is a
cash-generating unit in its own right. The value of the property, plant and equipment of
Fence at 31 October 20X5 was $ 6 million and purchased goodwill was $ 1 million before
any impairment loss. The company had no other assets or liabilities. An impairment loss of $
1•8 million had occurred at 31 October 20X5. The tax base of the property, plant and
equipment of Fence was $ 4 million as at 31 October 20X5. The directors wish to know how
the impairment loss will affect the deferred tax liability for the year. Impairment losses are not
an allowable expense for taxation purposes.
Assume a tax rate of 17%.
Required
Prepare notes for the Managing Director which detail, with suitable computations, how the
situations (i) and (ii) above will impact on the accounting for deferred tax under HKAS 12 Income
taxes in the group financial statements of the Peninsula Group.
(The answer is at the end of the chapter)
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Financial Reporting
Solution
Acquisitions
Any fair value adjustments made for consolidation purposes will affect the group deferred tax
charge for the year.
A taxable temporary difference will arise where the fair value of an asset exceeds its carrying
value, and the resulting deferred tax liability should be recorded against goodwill.
A deductible temporary difference will arise where the fair value of a liability exceeds its carrying
value, or an asset is revalued downwards. Again, the resulting deferred tax amount (an asset)
should be recognised in goodwill.
In addition, it may be possible to recognise deferred tax assets in a group which could not be
recognised by an individual company. This is the case where tax losses brought forward, but not
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considered to be an asset, due to lack of available taxable profits to set them against, can now be
used by another group company.
Goodwill
Goodwill arose on both acquisitions. According to HKAS 12, however, no provision should be made
for the temporary difference arising on this.
Blossom
1 A deductible temporary difference arises when the provision is first recognised. This results
in a deferred tax asset calculated as $540,000 (30% $1.8m). The asset may, however,
only be recognised where it is probable that there will be future taxable profits against which
the future tax allowable expense may be set. There is no indication that this is not the case
for Blossom.
2 A taxable temporary difference arises where investments are revalued upwards for
accounting purposes but the uplift is not taxable until disposal. In this case the carrying
value of the investments has increased by $2.5 million, and this has been recognised in
profit or loss. The tax base has not, however changed. Therefore, a deferred tax liability
should be recognised on the $2.5 million, and in line with the recognition of the underlying
revaluation, this should be recognised in profit or loss.
3 This intra-group transaction results in unrealised profits of $250,000 which will be eliminated
on consolidation. The tax on this $250,000 will, however, be included within the group tax
charge (which comprises the sum of the individual group companies' tax charges). From the
perspective of the group there is a temporary difference. Deferred tax should be provided on
this difference using the tax rate of Lily (the recipient company).
Snowdrop
1 Unrelieved tax losses give rise to a deferred tax asset only where the losses are regarded as
recoverable. They should be regarded as recoverable only where it is probable that there
will be future taxable profits against which they may be used. It is indicated that the future
profits of Snowdrop will not be sufficient to realise all of the brought forward loss, and
therefore the deferred tax asset is calculated only on that amount expected to be recovered.
2 Deferred tax is recognised on the unremitted earnings of investments, except where:
(a) The parent is able to control the payment of dividends
(b) It is unlikely that the earnings will be paid out in the foreseeable future
Lily controls Snowdrop and is therefore able to control its dividend payments, however it is
indicated that $2.4million will be paid as dividends in the next four years. Therefore, a
deferred tax liability related to this amount should be recognised.
3 The directors have assumed that the $300,000 relating to intangible assets will be tax
allowable, and the tax provision has been calculated based on this assumption. However,
this is not certain, and extra tax may have to be paid if this amount is not allowable.
Therefore, a liability for the additional tax amount should be recognised.
Self-test question 16
Oscar acquired 80% of the ordinary shares in Dorian Limited (Dorian) on 1 July 2005.
At acquisition, a property owned and occupied by Dorian had a fair value HK$30 million in excess
of its carrying value. This property had a remaining useful life at that time of 20 years.
Oscar is preparing its financial statements as at 30 June 2015. Goodwill on the acquisition of
Dorian has been calculated as $40 million, before taking account of the property revaluation. Non-
controlling interest at acquisition, using the proportion of net assets method, has been recorded as
$28 million before taking account of the property revaluation. There has been no impairment of
goodwill.
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Financial Reporting
Self-test question 17
Jenner Holdings (Jenner) operates in the recruitment industry. On 1 February 20X0, Jenner
acquired 60% of Rannon. It is now 31 March 20X4, and the consolidated financial statements of
Jenner are being prepared.
On the date of acquisition, HK$40,800,000 of the purchase consideration was allocated to the
domain name ‘www.alphabettajob.com’ which Rannon had registered some years earlier.
www.alphabettajob.com is well known in the recruitment industry and a popular job search website
and as a result Jenner was able to establish a fair value using an income-based valuation method.
The domain name is not recognised in Rannon’s individual financial statements and has a tax base
of nil.
The Jenner Group amortises acquired domain names over 10 years. The tax rate applicable to the
profits of both companies is 17%.
Required
Prepare journals and explanations to show how this domain name should be treated in the
consolidated financial statements of the Jenner Group as at 31 March 20X4.
(The answer is at the end of the chapter)
Self-test question 18
In 20X2 Hay Co acquired a subsidiary, Bee Co, which had deductible temporary differences of
$3m. The tax rate at the date of acquisition was 30%. The resulting deferred tax asset of $0.9m
was not recognised as an identifiable asset in determining the goodwill of $5m resulting from the
business combination. Two years after the acquisition, Hay Co decided that future taxable profit
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would probably be sufficient for the entity to recover the benefit of all the deductible temporary
differences.
Required
Explain the accounting treatment of the subsequent recognition of the deferred tax asset in 20X4.
(The answer is at the end of the chapter)
Self-test question 19
Lark, a limited company, has two wholly owned subsidiaries, Starling, another Hong Kong company
and Owl, which is located in Latviania. The following information is relevant to the year ended 31
August 20X8:
(a) Owl has made a tax adjusted loss equivalent to $6.5 million. This loss can only be relieved
through carry forward against future profits of Owl.
(b) During the year Starling has sold goods to Lark for $12 million, based on a 20% mark up.
Half of these goods are still in Lark's stock room at the year end.
Assume that the tax rate applicable to the group companies based in Hong Kong is 30%; the
Latvianian tax rate is 20%.
Required
What are the deferred tax implications of these issues for the consolidated financial statements of
the Lark group as at 31 August 20X8?
(The answer is at the end of the chapter)
Self-test question 20
Pandar, a public limited company, has three 100% owned subsidiaries, Candar, Landar, and Endar
SA, a foreign subsidiary.
(a) The following details relate to Candar:
(i) Pandar acquired its interest in Candar on 1 January 20X3. The fair values of the
assets and liabilities acquired were considered to be equal to their carrying amounts,
with the exception of freehold property which was considered to have a fair value $1m
in excess of its carrying amount. The directors have no intention of selling the
property.
(ii) Candar has sold goods at a price of $6 million to Pandar since acquisition and made a
profit of $2 million on the transaction. The inventories of these goods remaining in
Pandar's statement of financial position as at 30 September 20X3, were $3.6 million.
(b) Landar undertakes various projects from debt factoring to investing in property and
commodities. The following details relate to Landar for the year ended 30 September 20X3:
(i) Landar has a portfolio of readily marketable government securities which are held as
current assets for financial trading purposes. These investments are stated at market
value in the statement of financial position with any gain or loss taken to profit or loss.
These gains and losses are taxed when the investments are sold. Currently the
accumulated unrealised gains are $8 million.
(ii) Landar has calculated it requires an allowance for credit losses of $2 million against its
total loan portfolio. Tax relief is available when a specific loan is written off.
(c) Endar SA has unremitted earnings of $20 million which would give rise to additional tax
payable of $2 million if remitted to Pandar's tax regime. Pandar intends to leave the
earnings within Endar for reinvestment.
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Financial Reporting
(d) Pandar has unrelieved trading losses as at 30 September 20X3 of $10 million.
Current tax is calculated based on the individual company's financial statements (adjusted for tax
purposes) in the tax regime in which Pandar operates. Assume an income tax rate of 30% for
Pandar and 25% for its subsidiaries.
Required
Explain the deferred tax implications of the above information for the Pandar group of companies
for the year ended 30 September 20X3.
(The answer is at the end of the chapter)
Self-test question 21
The Dipyrone Company owns 100% of the Reidfurd Company. During the year ended 31
December 20X7:
(a) Dipyrone sold goods to Reidfurd for $600,000, earning a profit margin of 25%. Reidfurd held
30% of these goods in inventory at the year end.
(b) Reidfurd sold goods to Dipyrone for $800,000, earning a profit margin of 20%. Dipyrone held
25% of these goods in inventory at the year end.
The tax base of the inventory in each company is the same as its carrying amount. The tax rate
applicable to Dipyrone is 26% and that applicable to Reidfurd is 33%.
Required
What is the deferred tax asset at 31 December 20X7 in Dipyrone's consolidated statement of
financial position under HKAS 12 Income taxes, and HKFRS 10 Consolidated financial statements?
(The answer is at the end of the chapter)
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HK(SIC) Int-12 has been incorporated into HKAS 12 as part of the amendments to HKAS 12 issued
in December 2010. It is therefore withdrawn for accounting periods starting on or after 1 January
2012.
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Financial Reporting
Topic recap
Current
Currenttaxtax Current
Deferred
taxtax
CA > TB CA < TB
Taxable Deductible
temporary temporary
difference difference
Recognise only if
profits available
in future
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Application of HKAS 12
Individual
Current tax
company On
Current
consolidation
tax
Unrealised Unrealised
Accelerated
Taxable Deductible
Impaired Taxable
lossed on Deductible
profits on
temporary
tax temporary
asset temporary
intragroup temporary
intragroup
depreciation
difference difference difference
transactions difference
transactions
Capitalised
Taxable Deductible
Deferred Fair
Taxable
value Deductible
Fair value
development
temporary temporary
income adjustments
temporary adjustments
temporary
difference
costs difference difference difference
Taxable
Loan at Deductible
Tax losses Changes
Taxable in Changes
Deductible
in
temporary
amortised temporary
carried temporary
exchange temporary
exchange
difference
cost difference
forward difference
rates difference
rates
Revaluation
Taxable Undistributed
Taxable
temporary
of PPE temporary
retained
difference difference
earnings
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Financial Reporting
Answer 1
(a) The 20X0 tax charge was recognised by:
DEBIT Tax charge $130,000
CREDIT Current tax liability $130,000
On payment, the journal entry is:
DEBIT Current tax liability $126,700
CREDIT Cash $126,700
After payment, the current tax liability account has a credit balance of $3,300 remaining.
This is cleared to profit or loss by:
DEBIT Tax charge $3,300
CREDIT Current tax liability $3,300
The 20X1 tax charge is recognised by:
DEBIT Tax charge ($760,000 16.5%) $125,400
CREDIT Current tax liability $125,400
The tax charge in 20X1 is therefore:
$
Current year tax liability 125,400
Overprovision in 20X0 3,300
$125,400 is recognised as a current tax liability in the statement of financial position at
31 December 20X1
$122,100 ($125,400 – $3,300) is recognised as tax charge in the statement of profit or
loss and other comprehensive income for the year ended 31 December 20X1
(b) If the previous year’s tax was settled at $131,000, tax was underprovided. Therefore the
underprovision of $1,000 is added to the 20X1 tax charge to make it $126,400. The liability in
the statement of financial position remains unchanged at $125,400.
Answer 2
(a) The tax base of the interest receivable is $1,000.
(b) The tax base of the dividend is $5,000.
(c) The tax base of the machine is $7,000.
(d) The tax base of the trade receivables is $10,000.
(e) The tax base of the loan is $1 million.
In the case of (b), in substance the entire carrying amount of the asset is deductible against the
economic benefits. There is no taxable temporary difference. An alternative analysis is that the
accrued dividends receivable have a tax base of nil and a tax rate of nil is applied to the resulting
taxable temporary difference ($5,000). Under both analyses, there is no deferred tax liability.
Answer 3
(a) The tax base of the accrued expenses is $1,000.
(b) The tax base of the revenue received in advance is $1,000.
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(c) The tax base of the accrued fines and penalties is $100.
(d) The tax base of the loan is $1 million.
Answer 4
The temporary differences associated with the equipment are as follows:
Year
20X1 20X2 20X3 20X4 20X5
$ $ $ $ $
Carrying amount 40,000 30,000 20,000 10,000 –
Tax base 37,500 25,000 12,500 – –
Taxable temporary difference 2,500 5,000 7,500 10,000 –
Opening deferred tax liability – 375 750 1,125 1,500
Deferred tax expense (income): bal fig 375 375 375 375 (1,500)
Closing deferred tax liability @ 15% 375 750 1,125 1,500 –
Answer 5
The tax base of the building is $7m ($10m – $3m).
(a) If the entity expects to recover the carrying amount by using the building, it must generate
taxable income of $15m, but will only be able to deduct depreciation of $7m. On this basis
there is a deferred tax liability of $2.4m (($15m – $7m) 30%).
(b) If the entity expects to recover the carrying amount by selling the building immediately for
proceeds of $15m the deferred tax liability will be computed as follows:
Taxable temporary Deferred
difference Tax rate tax liability
$'000 $'000
Total tax depreciation allowance 3,000 30% 900
Proceeds in excess of cost 5,000 Nil –
Total 8,000 900
Note. The additional deferred tax that arises on the revaluation is charged directly to equity:
see Answer 6 below.
Answer 6
(a) If the entity expects to recover the carrying amount by using the building, the situation is as
in answer 5 (a) in the same circumstances.
(b) If the entity expects to recover the carrying amount by selling the building immediately for
proceeds of $15m, the entity will be able to deduct the indexed costs of $11m. The net profit
of $4m will be taxed at 40%. In addition, the total tax depreciation allowance of $3m will be
included in taxable income and taxed at 30%. On this basis, the tax base is $8m ($11m –
$3m), there is a taxable temporary difference of $7m and there is a deferred tax liability of
$2.5m ($4m 40% plus $3m 30%).
Answer 7
A temporary difference arises when the shares are revalued as the tax treatment is different from
the accounting treatment. The fair value gain of $7m is recognised in other comprehensive income
in accordance with the HKFRS 9 classification of the investment.
The gain is a taxable temporary difference and the company should recognise a deferred tax
liability of $1,190,000 ($7m 17%), representing the future tax to pay on the gain recognised,
payable when the investments are sold.
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Financial Reporting
Answer 8
Administrative office
The administrative office is commercial property and as such does not benefit from tax allowances.
Equally, no tax is charged on the capital gain that would be expected to arise on a disposal of the
office.
Therefore the difference between the carrying amount of the office and its tax base of $60m is a
permanent difference and there is no deferred tax impact.
Factory
The factory (excluding the land) is an industrial building and so benefits from an industrial buildings
allowance. Its tax base at 31 December 20X4 is calculated as:
$’000
Cost ($44m – $26m) 18,000
IBA 20W8 (25% $18m) (4,500)
IBA 20W9 – 2014 (3% $18m 6 years) (3,240)
Tax base at 31 December 20X4 10,260
The carrying amount of the property is $15,840,500, so resulting in a temporary difference of
$15,840,500 – $10,260,000 = $5,580,500
This is a taxable temporary difference because the carrying amount exceeds tax base. The
resulting deferred tax liability is 28% x $5,580,500 = $1,562,540
Energy-saving equipment
The energy saving equipment was acquired for $9,500,000 and had a 10-year useful life at
acquisition.
Depreciation for the year ended 31 December 20X4 is $9,500,000/10 years x 9/12months =
$712,500. The carrying amount of the equipment at the reporting date is therefore $9,500,000 -
$712,500 = $8,787,500.
The equipment benefits from 100% tax relief in 20X4. The tax base of an asset is defined as the
amount that will be deductible for tax purposes against taxable economic benefits that will flow to
an entity as the entity recovers the carrying amount of the asset.
As the subsidiary has already received a tax deduction for the full cost of the equipment, no further
amount will be deductible over the 10 years that the energy saving equipment is used. Therefore
tax base is nil.
A temporary difference of $8,787,500 – nil = $8,787,500 therefore arises. This is a taxable
temporary difference and results in a deferred tax liability of $8,787,500 28% = $2,460,500.
Allowance for receivables
Tax relief is provided for the expense associated with making a specific allowance for receivables
when the provision is made. The tax and accounting treatment are therefore aligned and there is
no deferred tax impact.
The expense associated with making any other allowance for receivables does not benefit from tax
relief until (and unless) the amount receivable is deemed irrecoverable.
Therefore the accounting and tax treatments are not aligned and there is a deferred tax impact.
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The carrying amount of the allowance is ($2,700,000). The tax base of a liability (including a
provision) is its carrying amount ($2,700,000) less any amount that will be deductible for tax
purposes in future periods ($2,700,000) ie nil.
Therefore there is a temporary difference of $2,700,000. This is a deductible temporary difference
because the tax base is greater than the carrying amount (being a negative amount).
The resulting deferred tax asset is $2,700,000 28% = $756,000.
Fines and penalties
The fine is an expense for accounting purposes. However, it will never benefit from tax relief.
Therefore this is a permanent different and has no deferred tax effect.
Financial statements
The net deferred tax liability reported in the statement of financial position is:
$’000
Factory 1,562,540
Energy saving equipment 2,460,500
General allowance for receivables (756,000)
Net deferred tax liability 3,267,040
This is an increase in the liability since last year; the increase of $3,267,040 - $2,300,800 =
$966,240 is recognised as part of the tax charge in profit or loss by:
DEBIT Tax charge $966,240
CREDIT Deferred tax liability $966,240
Answer 9
The excess of an asset’s fair value over its tax base at the time of a business combination results
in a deferred tax liability. As it arises in Lemongrass, the tax rate used is 20% and the liability is
$800 (($12,000 – $8,000) 20%).
The recognition of a deferred tax liability in relation to the initial recognition of goodwill is
specifically prohibited by HKAS 12.
Answer 10
Unrealised profit
There is an unrealised profit in inventory of HK$1,000,000 (25% HK$12m 1/3). This is
eliminated from inventory of Gold and profit in Silver, the selling company. This is a downstream
transaction and the adjustment to profit is allocated to the owners of the parent company only
(HK$'000):
DEBIT Cost of sales 1,000
CREDIT Inventory 1,000
The debit to cost of sales also adjusts retained earnings in the consolidated statement of financial
position.
Deferred tax
The adjustment for unrealised profit gives rise to a deductible temporary difference of
HK$1,000,000, and so a deferred tax asset of HK$150,000 (HK$1,000,000 15%). The tax credit
to profit is treated in the same way as the underlying temporary difference and is allocated to the
owners of the parent company only (HK$'000):
DEBIT Deferred tax liability 150
CREDIT Income tax (SPLOCI) 150
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Financial Reporting
The credit to income tax also adjusts retained earnings in the consolidated statement of financial
position.
Answer 11
On the sale of goods to Red and Green, as an individual company, Yellow has made and reported
a profit, and it will be taxed on this profit.
From a group perspective, the profit is not made until the goods are sold outside the group, and
equally tax is not relevant until this time.
Therefore, on consolidation, a provision is made against inventory for unrealised profit and a
deferred tax asset is recognised. The provision for unrealised profit creates a deductible temporary
difference as the provision for unrealised profit changes the carrying value of the asset, reducing it
in value, however the tax base remains unchanged.
The inventory sold by Yellow to Red has a carrying amount in the consolidated statement of
financial position at 31 March 20X6 of HK$25 million 100/125 = HK$20 million, but a tax base of
HK$25 million.
The inventory sold by Yellow to Green has a carrying amount in the consolidated statement of
financial position at 31 March 20X6 of HK$30 million (1 – 20%) 50% = HK$12 million but a tax
base of HK$15 million.
The deductible temporary difference arising is therefore HK$8 million (HK$5m + 3m).
Deferred tax of HK$1,280,000 (16% HK$8m) arises and should be recognised as a non-current
asset of the group (HK$000):
DEBIT Deferred tax asset 1,280
CREDIT Income taxes 1,280
DEBIT Attributable to NCI (30% 1,280) 384
CREDIT NCI (SOFP) (30% 1,280) 384
Answer 12
There is an unrealised profit relating to inventories still held within the group of ½ $20,000 =
$10,000, which must be eliminated on consolidation. But the tax base of the inventories is
unchanged, so it is higher than the carrying amount in the consolidated statement of financial
position and there is a deductible temporary difference of $10,000.
Answer 13
The carrying amount of the inventory in the group accounts is $100,000 more than its tax
base (being carrying amount in Daffodil’s own accounts).
Deferred tax on this temporary difference is 16.5% $100,000 = $16,500.
A deferred tax liability of $16,500 is recognised in the group statement of financial position.
Goodwill is increased by ($16,500 90%) = $14,850.
Answer 14
The tax base of the investment in Bluebell is the cost of $1.1m. The carrying value is the
share of net assets (75% $1.2m) + goodwill of $350,000 = $1.25m
The temporary difference is therefore $1.25m – $1.1m = $150,000.
This is equal to the group share of post acquisition profits: 75% $200,000 change in net
assets since acquisition.
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Answer 15
Intra-group sale
Linten Co has made a profit of $ 2.5 million on its sale to Peninsula Co. Tax is payable on the
profits of individual companies. Linten Co is liable for tax on this profit in the current year and will
have provided for the related tax in its individual financial statements. However, from the viewpoint
of the group the profit will not be realised until the following year, when the goods are sold to a third
party. The profit must therefore be eliminated from the consolidated financial statements. Because
the group pays tax before the profit is realised there is a temporary difference of $2.5 million and a
deferred tax asset of $750,000 (30% $2.5 million).
Impairment loss
The impairment loss in the financial statements of Fence reduces the carrying amount of property,
plant and equipment, but is not allowable for tax. Therefore the tax base of the property, plant and
equipment is different from its carrying amount and there is a temporary difference.
Under HKAS 36 Impairment of assets the impairment loss is allocated first to goodwill and then to
other assets:
Property,
plant and
Goodwill equipment Total
$m $m $m
Carrying amount at 31 October 20X5 1 6.0 7.0
Impairment loss (1) (0.8) (1.8)
– 5.2 5.2
HKAS 12 states that no deferred tax should be recognised on goodwill and therefore only the
impairment loss relating to the property, plant and equipment affects the deferred tax position.
The effect of the impairment loss is as follows:
Before After Difference
impairment impairment
$'000 $'000 $'000
Carrying amount 6,000 5,200
Tax base (4,000) (4,000)
Temporary difference 2,000 1,200 0.8
Tax liability (17%) 340 204 136
Therefore the impairment loss reduces the deferred tax liability by $136,000
Answer 16
(a) Goodwill was originally calculated as HK$40 million. The fair value adjustment to the
property reduces goodwill by HK$24 million (being 80% of the HK$30 million FV adjustment).
The non-controlling interest at acquisition was initially recorded at HK$28 million. As a result
of the fair value uplift this must be adjusted up by HK$6 million to HK$34 million (20% ×
HK$30 million).
The journal to record the adjustments to property, goodwill and the NCI at the date of
acquisition is:
DEBIT Property $30m
CREDIT Goodwill $24m
CREDIT NCI $6m
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Financial Reporting
The fair value uplift is subsequently depreciated such that by the reporting date its carrying
value is HK$15 million (10/20 yrs HK$30 million). The journal to record the consolidation
adjustment for extra depreciation is (HK$000):
DEBIT Group retained earnings (80% $15m) $12m
DEBIT NCI (20% 15,000) $3m
CREDIT Property – accumulated depreciation $15m
(b) At acquisition, property held within Dorian’s accounts is uplifted by HK$30 million as a
consolidation adjustment.
This results in a taxable temporary difference of HK$30 million, and so a deferred tax liability
of HK$4.8 million (16% × 30 million) at acquisition.
This is recognised by:
DEBIT Goodwill $3.84m
DEBIT Non-controlling interest (20% × $4.8m) $0.96m
CREDIT Deferred tax liability $4.8m
By the reporting date, HK$15 million of this temporary difference has reversed and therefore
a further journal is required to reduce the deferred tax liability by HK$2.4 million (16% × 15
million) (HK$000):
DEBIT Deferred tax liability $2.4m
CREDIT Retained earnings (80% $2.4m ) $1.92m
CREDIT NCI (20% $2.4m) $0.48m
Alternative answer 16
(a) The fair value adjustment to the property reduces goodwill by HK$24 million (being 80% of
the HK$30 million FV adjustment).
As a result of the fair value uplift, the non-controlling interest must be adjusted up by HK$6
million (20% × HK$30 million).
The journal to record the adjustments to property, goodwill and the NCI at the date of
acquisition is:
DEBIT Property $30m
CREDIT Goodwill $24m
CREDIT NCI $6m
The fair value uplift is subsequently depreciated such that by the reporting date its carrying
value is HK$15 million (10/20 yrs × HK$30 million). The journal to record the consolidation
adjustment for extra depreciation is:
DEBIT Group retained earnings (80% × $15m) $12m
DEBIT NCI (20% × 15,000) $3m
CREDIT Property – accumulated depreciation $15m
(b) At acquisition, property held within Dorian’s accounts is uplifted by HK$30 million as a
consolidation adjustment.
This results in a taxable temporary difference of HK$30 million, and so a deferred tax liability
of HK$4.8 million (16% × 30 million) at acquisition.
This is recognised by:
DEBIT Goodwill $3.84m
DEBIT Non-controlling interest (20% × $4.8m) $0.96m
CREDIT Deferred tax liability $4.8m
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By the reporting date, HK$15 million of this temporary difference has reversed and therefore
a further journal is required to reduce the deferred tax liability by HK$2.4 million (16% × 15
million):
DEBIT Deferred tax liability $2.4m
CREDIT Retained earnings (80% × $2.4m ) $1.92m
CREDIT NCI (20% × $2.4m) $0.48m
Answer 17
An intangible asset acquired in a business combination is recognised where it meets the definition
of an asset and is identifiable, ie it is either separable or arises from contractual or legal rights. This
is the case regardless of whether the acquiree recognises the asset on its individual statement of
financial position.
The Jenner Group amortises domain names over a 10-year (120 month) period. Rannon was
acquired 50 months prior to the reporting date, therefore the carrying amount of the domain name
as at 31 March 20X4 is 70/120 HK$40,800,000 = HK$23,800,000.
A deferred tax liability arises in respect of the fair value adjustment since this results in the carrying
amount of the domain name exceeding its tax base of nil. The deferred tax liability is 17%
HK$23,800,000 = HK$4,046,000.
Amortisation since acquisition of 50/120 x HK$40,800,000 = HK$17,000,000 on the domain name
and the HK$2,890,000 (HK$17,000,000 17%) movement in the associated deferred tax liability
must also be accounted for and allocated between group retained earnings and the non-controlling
interest:
(a)
DEBIT Intangible assets HK$40,800,000
CREDIT Goodwill HK$40,800,000
To recognise fair value adjustment on acquisition.
Answer 18
The entity recognises a deferred tax asset of $0.9m ($3m 30%) and, in profit or loss, deferred tax
income of $0.9m. Goodwill is not adjusted as the recognition does not arise within the
measurement period (ie within the 12 months following the acquisition).
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Financial Reporting
Answer 19
(a) An unrelieved tax loss gives rise to a deferred tax asset, however only where there are
expected to be sufficient future taxable profits to utilise the loss.
There is no indication of Owl's future profitability, although the extent of the current year
losses suggests that future profits may not be available. If this is the case then no deferred
tax asset should be recognised.
If, however, the current year loss is due to a one-off factor, or there are other reasons why a
return to profitability is expected, then the deferred tax asset may be recognised at 20% ×
$6.5 million = $1.3 million.
(b) The intra-group sale gives rise to an unrealised year end profit of $12 million × 20/120 × ½ =
$1 million. Consolidated profit and inventory are adjusted for this amount.
This profit has, however, already been taxed in the accounts of Starling. A deductible
temporary difference therefore arises which will reverse when the goods are sold outside the
group and the profit is realised. The resulting deferred tax asset is $1 million × 30% =
$300,000.
This may be recognised to the extent that it is recoverable.
Answer 20
(a) (i) Fair value adjustments are treated in a similar way to temporary differences on
revaluations in the entity's own accounts. A deferred tax liability is recognised under
HKAS 12 even though the directors have no intention of selling the property as it will
generate taxable income in excess of depreciation allowed for tax purposes. The
deferred tax of $1m 25% = $0.25m is debited to goodwill, reducing the fair value
adjustments (and net assets at acquisition) and increasing goodwill.
DEBIT Property $1m
CREDIT Goodwill $1m
To recognise fair value uplift
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(c) No deferred tax liability is required for the additional tax payable of $2m as Pandar controls
the dividend policy of Endar and does not intend to remit the earnings to its own tax regime
in the foreseeable future.
(d) Pandar's unrelieved trading losses can only be recognised as a deferred tax asset to the
extent they are considered to be recoverable. In assessing the recoverability there needs to
be evidence that there will be suitable taxable profits from which the losses can be deducted
in the future. To the extent Pandar itself has a deferred tax liability for future taxable trading
profits (e.g. accelerated tax depreciation) then an asset could be recognised.
Answer 21
$28,220
Under HKFRS 10, intra-group profits recognised in inventory are eliminated in full and HKAS 12
applied to any temporary differences that result. This profit elimination results in the tax base being
higher than the carrying amount, so deductible temporary differences arise. Deferred tax assets are
measured by reference to the tax rate applying to the entity who currently owns the inventory.
Dipyrone's eliminated profit
The profit on this intercompany sale is $600,000 25% = $150,000.
30% of these goods are in inventory at 31 December 20X7, so the unrealised profit is $150,000
30% = $450,000.
The tax rate used in calculating any deferred tax asset is that of the entity that owns the inventory,
which is Reidfurd. The deferred tax asset is therefore $450,000 33% = $14,850.
DEBIT Deferred tax asset $14,850
CREDIT Income tax (SPLOCI) $14,850
Reidfurd's eliminated profit
The profit on this intercompany sale is $800,000 20% = $160,000.
25% of these goods are in inventory at 31 December 20X7, so the unrealised profit is $160,000
25% = $40,000.
The tax rate used in calculating any deferred tax asset is that of the entity that owns the inventory,
which is Dipyrone. The deferred tax asset is therefore $40,000 26% = $10,400
DEBIT Deferred tax asset $10,400
CREDIT Income tax (SPLOCI) $10,400
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Financial Reporting
Exam practice
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15: Income taxes | Part C Accounting for business transactions
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430
chapter 16
Employee benefits
Topic list
5.3 Step 1 – Determine the deficit or surplus
1 HKAS 19 Employee Benefits
5.4 Step 2 – Determine the amount of the
1.1 Employee benefits
net defined benefit liability (asset)
1.2 The accounting problem
5.5 Step 3 – Determine amounts to be
1.3 Definitions
recognised in profit or loss
2 Short-term employee benefits 5.6 Step 4 – Determine amounts to be
2.1 Recognition and measurement recognised in other comprehensive
2.2 Short-term paid absences income
2.3 Profit-sharing schemes and bonus plans 5.7 Further issues – past service costs and
settlements
3 Post-employment benefits 5.8 Further issues – the asset ceiling
3.1 Types of post-employment benefits 5.9 Further issues – employee contributions
3.2 Multi-employer plans 5.10 Summary of accounting treatment
4 Defined contribution plans 5.11 Disclosure of defined benefit plans
4.1 Recognition and measurement 6 Termination benefits
4.2 Disclosure 6.1 Recognition
5 Defined benefit plans 6.2 Measurement
5.1 Introduction to accounting treatment
5.2 Accounting steps
Learning focus
An increasing number of companies and other entities now provide a pension and other
employee benefits as part of their employees' remuneration package. In view of this trend, it is
important that there is standard best practice for the way in which employee benefit costs are
recognised, measured, presented and disclosed in the sponsoring entities' accounts. You
must ensure that you understand and can apply the rules of HKAS 19 as amended in 2011.
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Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.04 Employee benefits 2
3.04.01 Identify short-term employee benefits in accordance with HKAS 19
and apply the recognition and measurement principles in respect of
short-term employee benefits
3.04.02 Distinguish between defined contribution plans and defined benefit
plans
3.04.03 Account for defined contribution plans
3.04.04 Identify termination benefits in accordance with HKAS 19 and apply
the recognition and measurement principles in respect of
termination benefits
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Before we look at HKAS 19, we should consider the nature of employee benefit costs and why
there is an accounting problem which must be addressed by a standard.
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Key terms
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16: Employee benefits | Part C Accounting for business transactions
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16: Employee benefits | Part C Accounting for business transactions
HKAS
19.13-18
2.2 Short-term paid absences
Short-term paid absences include paid holiday leave, sick leave, maternity or paternity leave and
jury service leave. These are classified by the standard as either:
Accumulating compensated absences, or
Non-accumulating compensated absences.
Accumulating absences are those that can be carried forward and used in future periods if the
current period’s entitlement is not used in full; non-accumulating absences are those which cannot
be carried forward and lapse if the current year entitlement is not used.
2.2.1 Accounting treatment
The cost of accumulating absences should be recognised as an expense when the employee
provides the service which results in entitlement to such absences. Where there is an unused
entitlement at the reporting date, a liability is recognised, based on an estimated amount.
The cost of non-accumulating absences should be recognised as an expense when the absences
occur.
Solution
A liability must be recognised in the statement of financial position to the extent that the entity
expects to have to pay sick leave next year as a result of the entitlement that has accumulated at
31 December 20X8:
2 employees 2 days $60 = $240
$ $
DEBIT Employee expense 240
CREDIT Liability 240
Being sick leave entitlement at 31 December 20X8 expected to be paid next year
HKAS
19.19-24
2.3 Profit-sharing schemes and bonus plans
HKAS 19 requires that an entity recognises the expected cost of profit-sharing and bonus
payments only when:
The entity has a present legal or constructive obligation to make such payments as a result
of past events, and
A reliable estimate of the obligation can be made.
In this case an expense and liability should be recognised.
Often conditions are attached to bonus payments, for example an employee must still be in the
entity's employment when the bonus becomes payable.
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Financial Reporting
Therefore, an estimate should be made based on the expectation of the level of bonuses that will
ultimately be paid. A reliable estimate can only be made when:
The formal terms of the plan include a formula to determine the amount of the benefit;
The entity determines the amount payable before the financial statements are authorised for
issue; or
Past practice provides clear evidence of the amount of a constructive obligation.
Solution
An expense should be recognised for the year in which the profits were made and therefore the
employees' services were provided, for:
$2m 5% = $100,000
Each of the 40 employees remaining with the entity at the year end is entitled to $2,500. A liability
of $100,000 should be recognised if the bonuses remain unpaid at the year end.
3 Post-employment benefits
Topic highlights
There are two types of retirement benefit plan:
Defined contribution plans
Defined benefit plans
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HKAS
19.32-39
3.2 Multi-employer plans
Multi-employer plans were defined above in Section 1.3. They are retirement benefit plans in which
various entities contribute assets to a pool. These pooled assets are then used to provide benefits
to employees of the various contributing entities.
HKAS 19 requires that an entity should classify such a plan as a defined contribution plan or a
defined benefit plan, under the terms of the plan (including any constructive obligation that exceeds
the formal terms of the plan).
If the multi-employer plan is a defined contribution plan, it is accounted for as normal, by
recognising the contributions made to the plan as an expense.
If, on the other hand, the multi-employer plan is a defined benefit plan, then HKAS 19 requires the
entity to account for it as a defined benefit plan. However, it should do so only on a proportional
basis. In other words it recognises its proportionate share of the obligation, assets and cost
associated with the plan. It should also make all of the normal disclosures for defined benefit plans.
However, determining the extent to which an entity participates in a defined benefit multi-employer
plan may be problematic. Therefore, it may be difficult to determine reliably the appropriate
proportionate share of the relevant data. In this case, where there is insufficient information to
determine the relevant amounts to use defined benefit accounting, then the entity should recognise
the plan as a defined contribution plan. However, it should also make as many additional
disclosures as possible to enable users to understand the nature of the plan. For example, an
entity should disclose that the plan is, in fact, a defined benefit plan and information about any
known surplus or deficit.
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Financial Reporting
HKAS
19.51-52
4.1 Recognition and measurement
Accounting for defined contribution plans is relatively straightforward:
1 Contributions to a defined contribution plan should be recognised as an expense in the
period they are payable (except to the extent that labour costs may be included within the
cost of assets).
2 Any liability for unpaid contributions that are due as at the end of the period should be
recognised as a liability (accrued expense).
3 Any excess contributions paid should be recognised as an asset (prepaid expense), but
only to the extent that the prepayment will lead to, for example, a reduction in future
payments or a cash refund.
Where contributions are not payable during the period (or within 12 months of the end of the
period) in which the employee provides the services to which they relate, the amount recognised
should be discounted, to reflect the time value of money.
Solution
$
Salaries 16,000,000
Bonus 4,000,000
20,000,000 4% = $800,000
$ $
DEBIT Staff costs expense 800,000
CREDIT Cash 760,000
Accrual 40,000
Illustration
Defined contribution plan
The Company operates a defined contribution retirement benefit scheme for all qualifying
employees. The assets of the scheme are held separately from those of the Company in funds
under the control of trustees. The total cost charged to profit or loss of $3.4 million represents
contributions payable to the scheme at a rate specified in the rules of the plan. At 31 December
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20X4, contributions of $250,000 due in respect of the current reporting period had not been paid
over to the schemes.
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Financial Reporting
HKAS 19.57
5.2 Accounting steps
HKAS 19 provides a four-step approach to accounting for defined benefit plans:
1 Determine the deficit or surplus (i) Use an actuarial technique in order to make a reliable
estimate of the cost to the entity of providing the post-
employment benefit that employees have earned in
current and past periods
(ii) Discount that benefit to determine the present value of
the defined benefit obligation
(iii) Deduct the fair value of plan assets from the present
value of the defined benefit obligation
2 Determine the amount of the The amount of deficit or surplus calculated in step 1 may
net defined benefit liability require adjustment for the effect of limiting a net defined
(asset) benefit asset to the asset ceiling.
3 Determine amounts to be These may include:
recognised in profit or loss (i) Current service cost
(ii) Past service cost and gain or loss on settlement
(iii) Net interest on the defined benefit liability (asset)
Each of these steps is considered in more detail in the following sections of the chapter.
HKAS
19.58-59
5.3 Step 1 – Determine the deficit or surplus
Measurement of the deficit or surplus is not required at every period end. However, it must be
made sufficiently regularly such that reported amounts are not materially different from the actual
value at the reporting date.
HKAS 19 encourages, but does not require, the use of a qualified actuary.
The cost of providing future benefits in respect of current and past services should be estimated
using an actuarial technique, the projected unit credit method.
HKAS 5.3.1 Estimation of future cost using the projected unit credit method
19.67-68,75-80
The projected unit credit method assumes that each period of an employee’s service gives rise to
an additional "unit" of future benefit. Each of these units is measured separately and they are
added together to calculate the total obligation.
In measuring the obligation, the actuary must make a number of actuarial assumptions, both
demographic and financial, for example:
What the defined benefits will be (this depends upon factors such as length of service and
final salary)
When benefits will be paid (this depends upon retirement age)
How many employees will draw a pension (this depends upon factors such as mortality rate)
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The standard requires actuarial assumptions to be unbiased and mutually compatible. They should
also be based on "market expectations" at the year end, over the period during which the
obligations will be settled.
HKAS 5.3.2 Discount the future benefit to present value
19.83-86
After the future cost of the defined benefit obligation has been measured, it must be discounted to
present value using an appropriate discount rate.
The standard requires that this is determined by reference to market yields at the end of the
reporting period on high quality corporate bonds. A 2014 amendment to IAS 19 clarified that
the bonds should be denominated in the same currency as the benefits to be paid.
In the absence of a "deep" market in such bonds, the yields on comparable government bonds
should be used as reference instead.
The corporate bonds that are used to determine a discount rate should have a term to maturity that
is consistent with the expected maturity of the post-employment benefit obligations, although a
single weighted average discount rate is sufficient.
HKAS 5.3.3 Fair value of plan assets
19.8,113-115
In order to determine the deficit or surplus, the fair value of plan assets must be deducted from the
present value of the defined benefit obligation.
Plan assets are:
(a) Assets such as stocks and shares, held by a fund that is legally separate from the reporting
entity, which exists solely to pay employee benefits.
(b) Insurance policies, issued by an insurer that is not a related party, the proceeds of which can
only be used to pay employee benefits.
Investments which may be used for purposes other than to pay employee benefits are not plan
assets.
The standard requires that the plan assets are measured at fair value, defined as the amount for
which an asset could be exchanged or a liability settled between knowledgeable, willing parties in
an arm’s length transaction. HKAS 19 includes the following specific requirements:
(a) The plan assets should exclude any contributions due from the employer but not yet paid.
(b) Plan assets are reduced by any liabilities of the fund that do not relate to employee benefits,
such as trade and other payables.
HKAS 5.4 Step 2 – Determine the amount of the net defined benefit
19.63-64
liability (asset)
In the statement of financial position, the amount recognised as a defined benefit liability (or
asset) should be the following.
(a) The present value of the defined obligation at the year end, minus
(b) The fair value of the assets of the plan as at the year end (if there are any) out of which
the future obligations to current and past employees will be directly settled.
Where there is a net defined benefit asset, the amount of this may be limited by the "asset ceiling".
We shall discuss this in more detail later in the chapter.
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Financial Reporting
(b) Net interest on the net defined benefit liability (asset), and
(c) Remeasurements.
The first two of these components are recognised in profit or loss. The third is recognised in other
comprehensive income and is dealt with in Section 5.6.
5.5.1 Service costs
Service costs include:
Current service cost, being the increase in the present value of the defined benefit obligation
resulting from employee services during the current period
Past service cost, being the change in the obligation relating to employee services in prior
periods arising from amendments or curtailments to the pension plan
Gains or losses on settlement of a defined benefit plan.
Current service costs normally arise in each financial year; past service costs and gains or losses
on settlement arise only where a pension plan is amended, curtailed or settled in a period. We shall
therefore concentrate on current service costs here and consider past service costs and gains or
losses on settlement in more detail in Section 5.7.
The current service cost is the increase in the present value of the defined benefit obligation
resulting from employee service in the current period. This increase arises from the fact that most
defined benefit pensions provide an incremental benefit for each year of service. The current
service cost is calculated using the projected unit credit method which we mentioned earlier.
Consider a situation where a defined benefit plan provides for a benefit of 2.5% of the employee's
salary in his/her final year, for each full year of service. The pension is payable from the age of 65.
If an employee is expected to earn $10,000 in his final year of employment, then each year of
service will result in an extra $250 for each year of retirement (assuming a 40-year working life). If
the employee is expected to live for 15 years after retirement, the benefit payable is the discounted
value at retirement date of $250 per annum for 15 years. The current service cost is the present
value of this discounted amount.
The current service cost increases the plan obligation and is charged to operating expenses in
profit or loss.
HKAS 5.5.2 Net interest on the net defined benefit liability (asset)
19.83, 123
Annual interest arises in respect of both the defined benefit obligation and the plan assets:
(i) An interest charge arises on the unwinding of the discount on the defined benefit obligation
as time passes, and
(ii) Interest income is recognised on the plan assets.
HKAS 19 requires that these two interest elements are calculated on a net basis as:
Net defined benefit liability (asset) discount rate
The net defined benefit liability (asset) should be determined as at the start of the
accounting period, taking account of changes during the period as a result of contributions
paid into the scheme and benefits paid out.
The discount rate is that determined by reference to market yields (at the year end) on
high quality fixed-rate corporate bonds.
The net interest cost is charged to finance costs in profit or loss.
HKAS
19.122, 127
5.6 Step 4 – Determine amounts to be recognised in other
comprehensive income
The third component of changes in a net defined benefit liability (asset) is remeasurements. These
are recognised in other comprehensive income and are never reclassified to profit or loss.
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445
Financial Reporting
Solution
Net defined
Obligation Assets benefit liability
$m $m $m
At 1 January 20X1 100 60 40
Current service cost 18
Contributions 12
Payments (15) (15)
Interest (5% 100m)/(5% 60m) 5 3
108 60
Remeasurements (β) 12 (5)
At 31 December 20X1 120 55 65
In the statement of profit or loss and other comprehensive income, the following amounts will
be recognised:
In profit or loss $m
Current service cost 18
Net interest on net defined benefit liability (5 – 3) 2
In other comprehensive income
Remeasurement losses on defined benefit liability (12 + 5) 17
[Note that the remeasurement in relation to both the asset and liability is a loss as it decreases the
asset and increases the liability.]
In the statement of financial position, the net defined benefit liability of $65m (120 – 55) will be
recognised.
Self-test question 1
JSX, a listed entity, has a defined benefits pension scheme. The following information relates to the
pension scheme for the year ended 31 October 20X8:
$
Current service cost 362,600
Contributions to scheme 550,700
Benefits paid 662,400
Fair value of scheme assets at 1 November 20X7 10,660,000
Fair value of scheme assets at 31 October 20X8 11,204,000
Present value of defined benefit obligation at 1 November 20X7 13,290,000
Present value of defined benefit obligation at 31 October 20X8 14,210,000
The yield on a high quality corporate bond was 4%.
Calculate the amount to be recognised in other comprehensive income in respect of the pension
scheme for the year ended 31 October 20X8.
(The answer is at the end of the chapter)
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Although we have now met the most common items which reconcile the plan surplus or deficit at
the start and end of a period, there are two further complications which you must be able to deal
with:
Past service cost
Settlements
HKAS 5.7.1 Past service cost
19.102-106
Past service costs arise as a result of the amendment or curtailment of a defined benefits plan.
A plan amendment arises when an entity introduces a new defined benefits plan, withdraws an
existing plan, or changes the benefits payable under an existing plan.
A curtailment occurs when an entity significantly reduces the number of employees covered by a
plan.
In either case, the past service cost is the resulting change in the present value of the defined
benefit plan. The past service cost may be positive where new benefits are introduced or negative
where existing benefits are withdrawn. The amount is advised by an actuary.
Past service costs are recognised as an expense in profit or loss at the earlier of the following
dates:
(a) When the plan amendment or curtailment occurs
(b) When the entity recognises related restructuring costs in accordance with HKAS 37 or
termination benefits in accordance with HKAS 19 (see Section 6).
HKAS 5.7.2 Settlements
19.109,111
A settlement occurs when an employer enters into a transaction to eliminate all or part of its post-
employment benefit obligations, for example, a one-off transfer of obligations under a plan to an
insurance company through the purchase of an insurance policy.
Self-test question 2
A defined benefit plan provides for retirement benefits at the rate of 1% of salary per annum for all
employees from the commencement of their employment. On 31 December 20X1, the defined
benefit obligation is measured at $18 million and the plan assets have a fair value of $15.5 million.
Corresponding amounts at 31 December 20X2 are $22.5 million and $16 million.
On 1 January 20X2, the rules of the plan are changed to provide for benefit at the rate of 2% of
salary for employees with 15 or more years' service and the defined benefit obligation on the new
basis is $20 million. Other relevant information is as follows:
Current service cost is $3 million for the year ended 31 December 20X2
Market yields on high quality corporate bonds were 4% at 1 January 20X2 and
4.5% at 31 December 20X2
An overall remeasurement loss of $1.2 million was identified
447
Financial Reporting
Required
What amount is recognised in profit or loss in respect of the defined benefit plan in the year ended
31 December 20X2?
(The answer is at the end of the chapter)
HKAS
19.64-65, 83
5.8 Further issues – the asset ceiling
In Section 5.4 we said that a net defined benefit asset is limited by the "asset ceiling". This term
relates to a threshold established by HKAS 19 to ensure that any pension surplus is carried at no
more than its recoverable amount. In other words, the net defined benefit asset is restricted to the
amount of cash savings available to the entity in the future.
HKAS 19 defines the asset ceiling as: "the present value of any economic benefits available in the
form of refunds from the plan or reductions in future contributions to the plan".
The standard further requires that the discount rate used to calculate the present value of future
economic benefits is the same as that used to calculate the net interest on the net defined benefit
liability (asset) i.e. a rate determined by reference to market yields at the end of the reporting
period on high quality corporate bonds.
Where the net defined benefit asset is reduced to the asset ceiling threshold, the related write
down is treated as a remeasurement and recognised in other comprehensive income.
Solution
Net defined
Obligation Assets benefit asset
$'000 $'000 $'000
At 1 January 20X1 5,000 5,700 700
Current service cost 1,500
Contributions 2,000
Payments (800) (800)
Interest (3% 5m)/(3% 5.7m) 150 171
5,850 7,071
Remeasurements (β) 90 29
At 31 December 20X1 5,940 7,100 1,160
Remeasurement due to asset ceiling (60)
Asset ceiling 1,100
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16: Employee benefits | Part C Accounting for business transactions
Therefore, the total remeasurement amount recognised in other comprehensive income is:
$'000
Remeasurement loss on obligation 90
Remeasurement gain on assets (29)
Remeasurement loss due to asset ceiling 60
Net remeasurement loss 121
449
Financial Reporting
The following diagram provided in Appendix A of HKAS 19 summarises the varying treatments:
Dependent on Independent of
number of years of number of years of
service service
Reduce service Reduce service Affect re- Reduce service cost
cost by being cost in the period measurements upon payment to
attributed to periods in which the related the plan
of service service is rendered
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Illustration
Defined benefit pension schemes
The Company operates defined benefit schemes for qualifying employees. Under the schemes, the
employees are entitled to retirement benefits varying between 2% and 5% of final salary on
attainment of a retirement age of 65. No other post-retirement benefits are provided. The schemes
are funded schemes.
451
Financial Reporting
Illustration
Employee benefits – actuarial assumptions and sensitivities
The following are the principal actuarial assumptions at the reporting date:
20X3 20X2
Discount rate at 31 December 5% 4.5%
Future salary increases 2% 2.5%
Inflation 3% 2%
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16: Employee benefits | Part C Accounting for business transactions
The sensitivities regarding the principal assumptions used to measure scheme liabilities are set out
below:
Assumption Change in assumption Impact on scheme liabilities
Discount rate Increase/decrease by 0.5% Decrease/increase by 1.2%
Salary growth Increase/decrease by 0.5% Decrease/increase by 2%
Rate of inflation Increase/decrease by 0.5% Decrease/increase by 1.7%
Assumptions regarding future mortality are based on published statistics and mortality tables. The
current longevities underlying the values of the liabilities in the defined benefit plan are as follows:
20X3 20X2
Longevity at age 65 for current pensioners
Males 18.5 18.2
Females 21.5 20.8
Longevity at age 65 for current members aged 45
Males 19.2 19
Females 22.7 22.3
The calculation of the defined benefit obligation is sensitive to the mortality assumptions set out
above. As the actuarial estimates of mortality continue to be refined, an increase of one year in the
lives shown above is considered remotely possible in the next financial year. The effect of this
change would be an increase in the employee benefit liability of $500,000.
Self-test question 3
Lewis, a public limited company, has a defined benefit plan for its employees. The present value of
the future benefit obligations at 1 January 20X7 was $890m and fair value of the plan assets was
$1,000 million. Further data concerning the year ended 31 December 20X7 is as follows:
$m
Current service cost 127
Benefits paid to former employees 150
Contributions paid to plan 104
453
Financial Reporting
6 Termination benefits
Topic highlights
Termination benefits are recognised as a liability and expense when an entity is demonstrably
committed to them.
Termination benefits are those employee benefits provided in exchange for the termination of an
employee's employment as a result of either:
An entity's decision to terminate an employee's employment before the normal retirement
date; or
An employee's decision to accept an offer of benefits in exchange for the termination of
employment.
These benefits are dealt with separately in HKAS 19 as unlike other benefits, the event which gives
rise to an obligation is the termination rather than the service of the employee.
Self-test question 4
Middleton Services Co (‘MSC’) announces a decision to close a factory located in PRC and
terminate all 150 employees on 1 June 20X4. The company agrees to pay $40,000 per employee
on termination and announces this to the workforce at the factory at the same time as it announces
the closure. Most employees will leave the company during June 20X4. However, to ensure that
remaining orders are completed, at least 30% of employees need to be retained until the factory is
closed at the end of January 20X5. As an incentive to encourage the required number of
employees to remain with MSC until closure, the company has offered those that stay a $75,000
payment on termination (rather than the $40,000 given to others), in addition to their usual wage
throughout the 8 months until the end of January 20X5. Based on this offer, MSC initially expects to
retain 50 employees until the closure of the factory. At 31 July 20X4 2 further employees leave the
factory, leaving 48 employees in service.
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16: Employee benefits | Part C Accounting for business transactions
Required
Explain how amounts to be paid on the termination of the factory’s 150 employees should be
accounted for in MSC’s financial statements for the year ended 31 July 20X4
(The answer is at the end of the chapter)
455
Financial Reporting
Topic recap
HKAS 19 Employee
Benefits
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16: Employee benefits | Part C Accounting for business transactions
Answer 1
Assets Obligation
$ $
At 1 November 20X7 10,660,000 13,290,000
Current service cost 362,600
Contributions 550,700
Benefits paid (662,400) (662,400)
Net interest (4% b/f assets/obligation) 426,400 531,600
Remeasurement loss on plan obligation (β) 688,200
Remeasurement gain on plan assets (β) 229,300
At 31 October 20X8 11,204,000 14,210,000
The remeasurement loss recognised in other comprehensive income is $458,900 (688,200 –
229,300)
Answer 2
The past service cost measured as the increase in the defined benefit obligation is $20m – $18m =
$2 million.
Net interest is calculated using the year-end market rate on a high quality corporate bond. This
rate is applied to the net defined benefit liability at the start of the year.
Therefore the total charge to profit or loss is:
$
Current service cost 3,000,000
Past service cost 2,000,000
Net interest 4.5% (18m – 15.5m) 112,500
5,112,500
Answer 3
STATEMENT OF FINANCIAL POSITION
$m
Net defined benefit asset 1 120
457
Financial Reporting
WORKINGS
Changes in the present value of the defined benefit obligation
$m
Opening defined benefit obligation 890
Current service cost 127
Past service cost 30
Interest cost 10% 890m 89
Benefits paid (150)
Remeasurement loss (β) 114
Closing defined benefit obligation 1,100
Changes in the fair value of plan assets
$m
Opening fair value of plan assets 1,000
Interest 10% 1,000 100
Contributions 104
Benefits paid (150)
Remeasurement gain (β) 176
Closing fair value of plan assets 1,230
Asset ceiling test
$m
Closing fair value of plan assets 1,230
Closing defined benefit obligation (1,100)
Closing net defined benefit asset 130
Asset ceiling (120)
Remeasurement loss 10
Answer 4
At 1 June 20X4, MSC expects to pay a total benefit in respect of closing the factory of:
$'000
50 employees $75,000 3,750
100 employees $40,000 4,000
7,750
Termination payment
Of this, $6,000,000 (150 $40,000) relates to termination of employment, as this would be the cost
to MSC of its decision to close the factory regardless of when employees are terminated.
A constructive obligation for this cost exists at 1 June 20X4 when the decision to close the factory
and make the termination payments is announced. Therefore a liability is recognised at this date
by:
DEBIT Termination expense (profit or loss) $6,000,000
CREDIT Liability for termination benefits $6,000,000
When the100 employees leave the factory in June and receive their termination benefit, the liability
is reduced by:
DEBIT Liability for termination benefits $4,000,000
(100 $40,000)
CREDIT Cash $4,000,000
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This is further reduced when an additional two employees leave at 31 July 20X4:
DEBIT Liability for termination benefits $80,000
(2 $40,000)
CREDIT Cash $80,000
The remaining $1,920,000 liability is reported as current at 31 July 20X4.
Additional payment
At 1 June 20X4, the additional expected payment of $1,750,000 (50 $35,000) is contingent on 50
employees providing a further eight months’ service and so it is payment for a service rather than
payment in respect of termination.
This amount is therefore recognised as a staff cost over the eight-month service period at $218,750
($1,750,000/8 months) per month. In June 20X4 this is recorded by:
DEBIT Staff costs $218,750
CREDIT Accrual for staff costs $218,750
At 31 July 20X4, a further month’s cost needs to be recorded and the accrual adjusted to reflect the
fact that two further employees have left service. The monthly cost is now $210,000 [(48
$35,000)/8], meaning that the total accrual should be $420,000. The following adjustment journal is
therefore recorded:
DEBIT Staff costs ($420,000 – $218,750) $201,250
CREDIT Accrual for staff costs $201,250
459
Financial Reporting
Exam practice
20X8 20X9
$'000 $'000
Current service cost 1,250 1,430
Benefits paid out 987 1,100
Contributions paid by entity 1,000 1,100
Present value of obligation at end of the year 23,000 20,400
Market value of plan assets at end of the year 21,500 17,840
Yield on corporate bonds at end of year 8% 9%
During 20X8, the benefits available under the plan were improved. The resulting increase in
the present value of the defined benefit obligation was $1 million.
On the final day of 20X9, Rhodes Co. divested of part of its business, and as part of the sale
agreement, transferred the relevant part of its pension fund to the buyer. The present value
of the defined benefit obligation transferred was $5.7 million and the fair value of plan assets
transferred was $5.4 million. Rhodes also made a cash payment of $200,000 to the buyer in
respect of the plan.
Assume that all transactions occur at the end of the year.
Required
(i) Calculate the net defined benefit liability as at the start and end of 20X8 and 20X9
showing clearly any remeasurement gain or loss on the plan each year. (6 marks)
(ii) Show amounts to be recognised in the financial statements in each of the years 20X8
and 20X9 in respect of the plan. (6 marks)
(Total = 12 marks)
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16: Employee benefits | Part C Accounting for business transactions
461
Financial Reporting
462
chapter 17
Borrowing costs
Topic list
Learning focus
Borrowing costs may be considered in the context of non-current assets or may be considered
in isolation. HKAS 23 concentrates particularly on the situation where the related borrowings
are applied to the construction of certain assets.
463
Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.12 Borrowing costs 3
3.12.01 Identify the expenses which constitute borrowing costs in
accordance with HKAS 23
3.12.02 Identify the assets which are qualifying assets
3.12.03 Determine when the capitalisation of borrowing costs shall
commence, be suspended and cease
3.12.04 Calculate the amount of borrowing costs to be capitalised from
specific borrowing and general borrowing
3.12.05 Prepare journal entries for borrowing costs, including expensed and
capitalised borrowing costs
3.12.06 Disclose relevant information with regard to borrowing costs
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17: Borrowing costs | Part C Accounting for business transactions
Key terms
Borrowing costs. Interest and other costs incurred by an entity in connection with the borrowing of
funds.
Qualifying asset. An asset that necessarily takes a substantial period of time to get ready for its
intended use or sale. (HKAS 23)
465
Financial Reporting
Self-test question 1
On 1 March 20X9 Vitality Co. borrowed $1.5 million to finance the production of a qualifying asset.
Work commenced immediately and the asset was expected to be complete within 6 months. Both
time and costs were, however underestimated and Vitality Co was forced to take an additional loan
of $450,000 on 1 August 20X9. The asset was completed on 31 December 20X9.
The interest rate attached to the initial loan was 8%; the interest rate on the second loan was 8.5%
Required
Ignoring compound interest, calculate the borrowing costs to be capitalised as part of the cost of
the asset at 31 December 20X9. Show the relevant journal entries with regard to borrowing costs.
(The answer is at the end of the chapter)
General borrowings
Where an entity uses a number of debt instruments to finance a variety of assets, difficulties
arise since there is no direct link between particular borrowings and a specific asset. For example,
central borrowings are lent to different parts of the group or entity. Judgment is therefore
necessary, particularly where more complex situations can arise (e.g. foreign currency loans).
In a situation where general borrowings are acquired and applied in part to finance a qualifying
asset, then the amount of borrowing costs eligible for capitalisation is arrived at by applying the
“capitalisation rate” to the capital expenditure on the asset.
The capitalisation rate is computed as the weighted average of the borrowing costs applicable to
the entity's outstanding borrowings during the period, excluding specific borrowings made to obtain
a qualifying asset. However, the amount of these borrowing costs must not exceed actual
borrowing costs incurred.
It may be more appropriate to compute a weighted average for borrowing costs for individual
parts of the group or entity, though an overall weighted average can be used for a group or entity
sometimes.
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17: Borrowing costs | Part C Accounting for business transactions
Solution
The weighted average cost of borrowing is:
5% 2m/(2m + 6m) + 8% 6m/(2m + 6m) = 7.25%
Therefore, interest to be capitalised is calculated as:
7.25% $500,000 12/12 = $36,250
Self-test question 2
Tumble Co. had the following loans in place at the beginning and end of 20X8.
1 January 31 December
20X8 20X8
$m $m
9% Bank loan repayable 20Y0 150 150
8% Bank loan repayable 20Y1 90 90
7.5% debenture repayable 20Y2 – 200
The $200 million 7.5% debenture was issued on 1 July 20X8 to fund the construction of a qualifying
asset (a piece of mining equipment). Construction on the asset began on 1 July 20X8 and was
ongoing at the year end.
On 1 January 20X8, Tumble Co. began construction of a qualifying asset, a piece of machinery for
a hydro-electric plant, using existing borrowings. Expenditure drawn down for the construction was:
$25 million on 1 January 20X8, $30 million on 1 October 20X8. At the year end construction of the
machine was not yet complete.
Required
Prepare the required journal entries in respect of borrowing costs for the year ended 31 December
20X8.
(The answer is at the end of the chapter)
467
Financial Reporting
asset's condition is taking place, e.g. where land is held without any associated development
activity, is to be excluded.
Solution
Total borrowing costs incurred in the year are $10 million 8% = $800,000.
Capitalisation of borrowing costs commences on 15 February when building work
commences and both expenditure and borrowing costs are being incurred.
Capitalisation ceases on 30 November when the physical construction of the property is
complete. Decoration and finishing qualify as minor modifications not construction.
Capitalisation does not cease during the temporary suspension of work for inclement
weather in May.
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17: Borrowing costs | Part C Accounting for business transactions
Self-test question 3
On 1 January 20X8 Allan Lee Co. borrowed $20 million to finance the production of two assets,
both of which were expected to take a year to build. Production started at the beginning of 20X8.
The loan facility was drawn down on 1 January 20X8, and was utilised as follows, with the
remaining funds invested temporarily:
Asset X Asset Y
$m $m
1 January 20X8 4.0 6.0
1 July 20X8 7.0 3.0
The loan rate was 10% and Allan Lee can invest surplus funds at 8%.
Required
Ignoring compound interest, calculate the borrowing costs which may be capitalised for each of the
assets and consequently the cost of each asset as at 31 December 20X8. You should also provide
the journal entries in respect of borrowing costs in the year.
(The answer is at the end of the chapter)
Self-test question 4
Autofact, a car manufacturer, prepares its accounts to 30 June each year. On 1 July 20X8, it
purchased for $20 million a leasehold interest in a site on which it began to construct a factory with
an estimated useful life of 30 years. The building cost $7million to construct and the plant and
equipment cost $5 million. The construction of the factory was complete on 31 March 20X9 and it
was brought into use on 1 July 20X9.
To finance this project, Autofact borrowed $32 million on 1 July 20X8. The rate of interest on the
loan was 5% per annum and it was repaid on 31 December 20X9.
Required
(a) Calculate the total amount to be included at cost in property, plant and equipment in respect
of this project at 30 June 20X9.
(b) Prepare relevant extracts from the notes to the accounts in respect of borrowing costs.
(The answer is at the end of the chapter)
469
Financial Reporting
Self-test question 5
On 1 July 20X5, Edson entered into a $20 million contract with another entity for the construction of
a new head office. Edson’s new head office was completed at the end of June 20X6. During this
period the payment schedule to the contractor was as follows:
$’000
1 July 20X5 1,000
30 September 20X5 7,000
31 March 20X6 10,000
30 June 20X6 2,000
20,000
Edson’s borrowings at 30 June 20X6 were:
A $7 million 10% 20Y0 loan note with simple interest payable annually. The loan notes were
issued on 1 July 20X5 specifically to raise funds for the head office project. The temporary
investment of funds until required resulted in interest income of $190,000.
A $10 million 12.5% loan notes with simple interest payable annually. The loan note balance
has remained unchanged throughout the year.
A $15 million 10% loan note with simple interest payable annually. The loan note balance
has remained unchanged throughout the year.
Required
(a) Calculate the total borrowing costs to be capitalised in the year ended 30 June 20X6.
(b) Prepare journal entries in respect of borrowing costs.
(The answer is at the end of the chapter)
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17: Borrowing costs | Part C Accounting for business transactions
Topic recap
Interest and other costs Directly attributable to the An asset that necessarily
incurred by an entity in acquisition, construction or takes a substantial period of
connection with the production of a qualifying time to get ready for its
borrowing of funds. asset. intended use or sale.
Cease capitalisation when the activities to prepare the asset for use or sale are substantially complete.
Disclose:
Amount of borrowing costs capitalised in period
Capitalisation rate used to determine the borrowing costs
eligible for capitalisation.
471
Financial Reporting
Answer 1
$
Borrowing costs
Initial loan: $1.5m 8% 6/12m 100,000
Second loan: $450,000 8.5% 10/12m 15,938
115,938
Journal entry
$ $
DEBIT Asset 115,938
CREDIT Accrued interest 115,938
To recognise interest costs capitalised as part of the cost of an asset.
Answer 2
Total borrowing costs incurred in the year are:
$’000
9% bank loan ($150m 9%) 13,500
8% bank loan ($90m 8%) 7,200
Debenture ($200m 7.5% 6/12m) 7,500
28,200
Borrowing costs to be capitalised are:
$’000
Mining equipment (debenture loan interest) 7,500
Hydro-electric plant machinery (Working) 2,803
10,303
Therefore the remaining $17,897,000 borrowing costs are recognised as an expense in the year.
Journal entry
$ $
DEBIT Mining equipment under construction 7,500,000
DEBIT Hydro-electric plant machinery under construction 2,803,000
DEBIT Finance costs (profit or loss) 17,897,000
CREDIT Accrued interest/bank 28,200,000
To recognise borrowing costs arising in the year
WORKING
150 90
Capitalisation rate = weighted average rate = 9% + 8% = 8.625%
150 90 150 90
3
Borrowing costs = ($25m 8.625%) + ($30m 8.625% /12)
= $2.803m
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17: Borrowing costs | Part C Accounting for business transactions
Answer 3
Asset X Asset Y
$'000 $'000
Borrowing costs incurred
Asset X $11.0m 10% 1,100 –
Asset Y $9.0m 10% – 900
1,100 900
Less: investment income
6
To 30 June 20X8 $7.0m/$3.0m 8% /12 (280) (120)
820 780
Cost of assets
Expenditure incurred 11,000 9,000
Borrowing costs 820 780
11,820 9,780
Journal entry
$ $
DEBIT Asset X 1,100,000
DEBIT Asset Y 900,000
CREDIT Accrued interest/bank 2,000,000
To recognise borrowing costs arising in the year
$ $
DEBIT Interest receivable/bank 400,000
CREDIT Asset X 280,000
CREDIT Asset Y 120,000
To recognise interest receivable on loan proceeds invested temporarily.
Answer 4
(a) The total amount to be included in property, plant and equipment at 30 June 20X9 is as
follows:
$'000
Lease 20,000
Building 7,000
Plant and equipment 5,000
Interest capitalised ($32,000 5% 9/12) 1,200
33,200
HKAS 23 states that capitalisation of borrowing costs must cease when substantially all the
activities necessary to prepare the asset for its intended use or sale are complete.
Accordingly, only nine months' interest (1 July 20X8 to 31 March 20X9) can be capitalised.
(b) Disclosure notes
Accounting policies
Borrowing costs
Borrowing costs directly attributable to the acquisition, construction or production of a
qualifying asset are capitalised as part of the cost of the asset. All other borrowing costs are
recognised as an expense in the period in which they are incurred.
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Financial Reporting
Answer 5
(a) The expenditure of $20m is allocated as:
$7 million to specific borrowings
$13 million to general borrowings
Borrowing costs to be capitalised are therefore:
$’000
Specific borrowings ($7m x 10%) 700.0
General borrowings (Working) 357.5
1,057.5
Less interest income (190.0)
867.5
WORKING: general borrowings
The weighted average borrowing cost is (12.5% 10/25) + (10% 15/25) = 11%
Expenditure is allocated to general borrowings, and interest to be capitalised and calculated
as follows:
General
borrowing
Specific General costs to be
Expenditure borrowings borrowings Rate Period capitalised
$’000 $’000 $’000 $’000
1 July 20X5 1,000 1,000
30 September 7,000 6,000 1,000 X 11% X 9/12m 82,500
20X5
31 March 20X6 10,000 – 10,000 X 11% X 3/12m 275,000
30 June 20X6 2,000 – 2,000 X 11% X 0/12m 0
20,000 7,000 13,000 357,500
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Financial Reporting
Exam practice
476
chapter 18 Financial instruments
Topic list 6 HKAS 39: Impairment of financial assets
6.1 Objective evidence of impairment
1 Financial instruments 6.2 Accounting for an impairment
1.1 Background
1.2 Definitions 7 HKAS 39/HKFRS 9: Embedded derivatives
7.1 Examples of embedded derivatives
2 HKAS 32: Presentation of financial 7.2 Accounting treatment of embedded
instruments derivatives
2.1 Objective 7.3 Reassessment of embedded derivatives
2.2 Scope
2.3 Classification of financial instruments as 8 HKAS 39: Hedging
financial assets, financial liabilities and 8.1 Introduction
equity 8.2 Definitions
2.4 Specific classification rules 8.3 Types of hedge
2.5 Offsetting a financial asset and a 8.4 Conditions for hedge accounting
financial liability 8.5 Accounting treatment
2.6 Interest, dividends, losses and gains 8.6 Exposures qualifying for hedge
2.7 Section summary accounting
8.7 Recap
3 HKFRS 9: Recognition of financial
instruments 9 HKFRS 7: Disclosure of financial
3.1 Scope instruments
3.2 Initial recognition 9.1 Objective
3.3 Reclassification of financial instruments 9.2 Classes of financial instruments and
3.4 Derecognition levels of disclosure
3.5 Section summary 9.3 Statement of financial position
disclosures
4 HKFRS 9: Measurement of financial 9.4 Statement of profit or loss and other
instruments comprehensive income disclosures
4.1 Initial measurement 9.5 Other disclosures
4.2 Subsequent measurement of financial 9.6 Nature and extent of risks arising from
assets financial instruments
4.3 Subsequent measurement of financial 9.7 Capital disclosures
liabilities
4.4 Trade date v settlement date accounting 10 Current developments
4.5 Section summary
10.1 HKFRS 9: Amended classification and
5 HKAS 39: Recognition and measurement measurement rules
rules 10.2 HKFRS 9: Hedge accounting
5.1 Scope 10.3 HKFRS 9: Credit losses (impairment)
5.2 Recognition and derecognition
5.3 Classification and measurement of
financial assets
5.4 Classification and measurement of
financial liabilities
5.5 Reclassification of financial instruments
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Financial Reporting
Learning focus
This is a highly controversial and very complex topic. You should concentrate on the essential
points. It is also the subject of ongoing change, as over a period of time HKAS 39 is being
replaced by HKFRS 9.
You need plenty of practice on the topics in this chapter in order to familiarise yourself with this
difficult area.
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.11 Financial assets, financial liabilities and equity instruments 2
3.11.01 Discuss and apply the criteria for the recognition and de-recognition
of a financial asset or financial liability
3.11.02 Discuss and apply the rules for the classification of a financial
asset, financial liability and equity, and their measurement
(including compound instrument)
3.11.03 Discuss and apply the treatment of gains and losses arising on
financial assets or financial liabilities
3.11.04 Discuss the circumstances that give rise to and apply the
appropriate treatment for the impairment of financial assets
3.11.05 Account for derivative financial instruments and simple embedded
derivatives, including the application of own-use exemption
3.11.06 Disclose relevant information with regard to financial assets,
financial liabilities and equity instruments
3.17 Hedge accounting 2
3.17.01 Identify fair value hedges, cash flow hedges and hedges for net
investment in accordance with HKAS 39
3.17.02 Account for fair value hedges, cash flow hedges and hedges for net
investment
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1 Financial instruments
Topic highlights
Accounting guidance on financial instruments is provided in four standards:
HKAS 32 Financial Instruments: Presentation
HKAS 39 Financial Instruments: Recognition and Measurement
HKFRS 7 Financial Instruments: Disclosures
HKFRS 9 Financial Instruments
1.1 Background
Financial instruments have, in recent years, become increasingly complex. They vary from
straightforward, traditional instruments, such as loan stock or shares through to complex "derivative
instruments".
The emergence of more complex instruments towards the end of the 20th century created a
problem in that existing accounting guidance was insufficient. Accounting standards boards
worldwide were forced to address this through the development of lengthy and detailed standards.
In Hong Kong the relevant standards were:
HKAS 32 Financial Instruments: Presentation, issued in 2004, which originally dealt with:
– the classification of financial instruments between liabilities and equity
– presentation of certain compound instruments
– disclosure of financial instruments
HKAS 39 Financial Instruments: Recognition and Measurement, issued in 2006, which dealt
with:
– recognition and derecognition of financial instruments
– the measurement of financial instruments
– hedge accounting
Both of these standards have, subsequent to their original issue, been amended numerous times
as the topic to which they relate continually evolves. In addition, two new standards have been
issued:
HKFRS 7 Financial Instruments: Disclosures, issued in 2005 replaced the part of HKAS 32
dealing with disclosure. In doing so, it revised, simplified and added to financial instrument
disclosure requirements.
HKFRS 9 Financial Instruments, originally issued in 2009 replaced certain parts of HKAS 39,
in particular with respect to the classification of financial assets. HKFRS 9 was expanded in
2010 to include guidance on the classification and measurement of financial liabilities and
the derecognition of financial assets and liabilities. This standard was subsequently
expanded again in 2013 and finally completed in 2014.
This chapter is based on the requirements of HKAS 32, HKAS 39, HKFRS 7 and the 2010 issue of
HKFRS 9. HKFRS 9 2010 addresses the issue of the recognition and measurement of financial
instruments, and HKAS 39, the part of hedging and impairment of financial assets are examinable.
The later issues of HKFRS 9 are covered in section 10 of the chapter and are examinable as
current developments.
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Financial Reporting
HKAS 32.11,
HKFRS 9, 1.2 Definitions
Appendix A
A number of definitions are common to all four standards.
Key terms
Financial instrument. Any contract that gives rise to both a financial asset of one entity and a
financial liability or equity instrument of another entity.
Financial asset. Any asset that is:
(a) cash;
(b) an equity instrument of another entity;
(c) a contractual right to receive cash or another financial asset from another entity; or to
exchange financial instruments with another entity under conditions that are potentially
favourable to the entity; or
(d) a contract that will or may be settled in the entity's own equity instruments and is a:
(i) non-derivative for which the entity is or may be obliged to receive a variable number of
the entity's own equity instruments
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18: Financial instruments | Part C Accounting for business transactions
(ii) derivative that will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity's own equity
instruments
Financial liability. Any liability that is a:
(a) contractual obligation to:
(i) deliver cash or another financial asset to another entity
(ii) exchange financial instruments with another entity under conditions that are potentially
unfavourable
(b) contract that will or may be settled in the entity's own equity instruments and is a:
(i) non-derivative for which the entity is or may be obliged to deliver a variable number of
the entity's own equity instruments
(ii) derivative that will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity's own equity
instruments
Equity instrument. Any contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Derivative. A financial instrument or other contract with all three of the following characteristics:
(a) Its value changes in response to the change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit
index, or other variable (sometimes called the "underlying")
(b) It requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to
changes in market factors
(c) It is settled at a future date (HKAS 32 and HKFRS 9)
HKAS 32.13- Some of the terms used within the definitions themselves need defining:
14
(a) A "contract" need not be in writing, but it must comprise an agreement that has "clear
economic consequences" and which the parties to it cannot avoid, usually because the
agreement is enforceable in law.
(b) An "entity" here could be an individual, partnership, incorporated body or government
agency.
HKAS 32 makes it clear that the following items are not financial assets or liabilities:
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Financial Reporting
Physical assets, e.g. inventories, property, plant and equipment, leased assets and
intangible assets (patents, trademarks etc.)
Prepaid expenses, deferred revenue and most warranty obligations
Liabilities or assets that are not contractual in nature e.g. income taxes that are the result of
statutory requirements imposed by governments.
Contractual rights/obligations that do not involve transfer of a financial asset, e.g.
commodity futures contracts, operating leases
Self-test question 1
Why do you think that physical assets and prepaid expenses do not qualify as financial
instruments?
(The answer is at the end of the chapter)
Contingent rights and obligations meet the definition of financial assets and financial liabilities
respectively, even though many do not qualify for recognition in financial statements. This is
because the contractual rights or obligations exist because of a past transaction or event (e.g.
assumption of a guarantee).
HKAS 1.2.2 Primary and derivative instruments
32.AG15
The examples of financial assets and liabilities given in the previous section may be referred to as
"primary instruments". You should also be aware of derivative financial instruments.
A derivative is a financial instrument that derives its value from the price or rate of an underlying
item. Common examples of derivatives include the following:
Forward contracts which are agreements to buy or sell an asset at a fixed price at a fixed
future date.
Futures contracts, which are similar to forward contracts except that contracts are
standardised and traded on an exchange.
Options, which are rights (but not obligations) for the option holder to exercise at a pre-
determined price; the option writer loses out if the option is exercised.
Swaps, which are agreements to swap one set of cash flows for another (normally interest
rate or currency swaps).
A simple example of a forward contract may help you to understand how it derives its value from an
underlying item. Say a forward contract exists to sell an asset for $8 on a given date. At today's
date the market price of the asset is $5 and therefore it would be fair to say that the contract is
worth $3. This value cannot, however, be established without reference to the price of the
underlying item, being the market price of the asset. If the underlying item is volatile, then the
settlement of the derivative can lead to a very different result from the one originally envisaged.
Derivatives usually have no, or very little, initial cost. Therefore, before the development of
HKAS 32 and HKAS 39, they may not have been recognised in the financial statements at all, or
recognised at a value bearing no relation to the current value. This is obviously misleading and
leaves users of the accounts unaware of the uncertainty and risk to which a company holding
derivatives is exposed.
Part of the reason why HKAS 32 and HKAS 39 were developed was in order to correct this
situation.
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To establish principles for presenting financial instruments as liabilities or equity and for
offsetting financial assets and financial liabilities. It applies to the classification of financial
instruments, from the perspective of the issuer, into financial assets, financial liabilities and
equity instruments; the classification of related interest, dividends, losses and gains; and
the circumstances in which financial assets and financial liabilities should be offset.
(HKAS 32)
HKAS 32.4 2.2 Scope
HKAS 32 should be applied in the presentation of all types of financial instruments, whether
recognised or unrecognised.
Certain items are excluded:
(a) Interests in subsidiaries, associates and joint ventures, unless these are accounted for using
HKFRS 9 as allowed by HKAS 27, HKAS 28 and HKAS 31
(b) Employers' rights and obligations under employee benefit plans (HKAS 19: Chapter 16)
(c) Insurance contracts
(d) Financial instruments, contracts and obligations under share-based payment transactions
(HKFRS 2: Chapter 13)
HKAS 32 requires that the issuer of a financial instrument classifies it, or its component parts, as a
financial asset, financial liability or equity based on:
the substance of the contractual arrangement on initial recognition
the definitions in the Key terms provided in section 1.2 above
The classification of the financial instrument is made when it is first recognised and this
classification will continue until the financial instrument is removed from the entity's statement of
financial position.
HKAS 32.16 2.3.1 Distinguishing financial liabilities and equity
Distinguishing a financial liability from equity may not be straightforward and therefore HKAS 32
provides additional guidance. The underlying principle is that of substance over form. Although
substance and legal form are often consistent with each other, this is not always the case.
An instrument is an equity instrument only if there is no contractual obligation to deliver cash or
another financial asset to another entity or to exchange another financial instrument with the
holder under potentially unfavourable conditions to the issuer.
Therefore, for example, a redeemable preference share is classified as a liability, rather than
equity, as there is an obligation to deliver cash at the redemption date. On the other hand, ordinary
shares are classified as equity as, although the holder of an equity instrument may be entitled to a
pro rata share of any distributions out of equity, the issuer does not have a contractual obligation to
make such a distribution.
A financial liability exists regardless of the way in which the contractual obligation to deliver
cash or a financial asset will be settled. The issuer's ability to satisfy an obligation may be
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Financial Reporting
restricted, e.g. by lack of access to foreign currency, but this is irrelevant as it does not remove the
issuer's obligation or the holder's right under the instrument.
Self-test question 2
During the financial year ended 31 December 20X5, Kim issued the financial instrument described
below. Identify whether it should be classified as liability or equity, explaining in not more than 40
words the reason for your choice. You should refer to the relevant Hong Kong Accounting
Standards.
Redeemable preference shares with a coupon rate 5%. The shares are redeemable on
31 December 20X9 at premium of 20%.
(The answer is at the end of the chapter)
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18: Financial instruments | Part C Accounting for business transactions
Classification Classification
under HKAS 32 under amended
Issued financial instrument before amendment HKAS 32
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Financial Reporting
Where a financial instrument contains both a liability and an equity element, HKAS 32 requires that
these component parts are classified separately according to the substance of the contractual
arrangement and the definitions of a financial liability and an equity instrument.
A common type of compound instrument is convertible debt. On the issue of such debt, the holder
is granted an option to convert it into an equity instrument (usually ordinary shares) of the issuer
rather than redeem it. This is the economic equivalent of the issue of conventional debt plus a
warrant to acquire shares in the future.
In this case the instrument is presented as part liability, part equity, and the usual way to calculate
the split is to:
(a) calculate the value for the liability component based on similar instruments with no
conversions rights, and
(b) deduct this from the instrument as a whole to leave a residual value for the equity component.
The reasoning behind this approach is that an entity's equity is its residual interest in its assets
amount after deducting all its liabilities.
The sum of the carrying amounts assigned to liability and equity will always be equal to the
carrying amount that would be ascribed to the instrument as a whole.
The following example should make this split clearer.
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18: Financial instruments | Part C Accounting for business transactions
Required
What is the value of the equity component in the bond issue?
Solution
The liability component is valued first, and the difference between the proceeds of the bond issue
and the fair value of the liability is assigned to the equity component. The present value of the
liability component is calculated using a discount rate of 8%, the market interest rate for similar
bonds having no conversion rights, as shown.
$
Present value of the principal: $2,500,000 payable at the end of three years
($2.5m 1/1.083)* 1,985,000
Present value of the interest: $125,000 payable annually in arrears for three
years ($125,000 (1/1.08 + 1/1.082 + 1/1.083) 322,137
Total liability component 2,307,137
Equity component (balancing figure) 192,863
Proceeds of the bond issue 2,500,000
* Note. Both the present value figures can be found using tables using an 8% discount factor for
the principal of 0.794 and for the interest of 2.577. In the case of the second (present value of the
interest), if tables are used, the present value is $322,125, giving an equity component balancing
figure of $192,875. The difference is due to rounding.
The split between the liability and equity components remains the same throughout the term of the
instrument, even if there are changes in the likelihood of the option being exercised. This is
because it is not always possible to predict how a holder will behave. The issuer continues to have
an obligation to make future payments until conversion, maturity of the instrument or some other
relevant transaction takes place.
Self-test question 3
On 1 January 20X1, an entity issued 100,000 6% convertible bonds at their par value of $20 each.
The bonds will be redeemed on 1 January 20X6. Each bond is convertible at the option of the
holder at any time during the five-year period. Interest on the bond will be paid annually in arrears.
The prevailing market interest rate for similar debt without conversion options at the date of issue
was 8%.
Required
At what value should the equity element of the hybrid financial instrument be recognised in the
financial statements of the entity at the date of issue?
(The answer is at the end of the chapter)
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Financial Reporting
(i) Non-derivative for which the entity is or may be obliged to deliver a variable number of the
entity's own equity instruments
(ii) Derivative that will or may be settled other than by the exchange of a fixed amount of cash or
other financial asset for a fixed number of the entity's own equity instruments.
Where the 'fixed for fixed test' described in (ii) is failed, i.e. a fixed amount of cash (or other
financial asset) is not exchanged for a fixed number of equity instruments, the convertible debt
instrument is classified as a liability in its entirety.
The 'fixed for fixed' test is always failed in the following circumstances, and may be failed in others:
Where the conversion ratio changes based on the issuing entity's share price, since the
number of equity instruments issued on conversion is not fixed
Where the convertible debt instrument is denominated in a foreign currency, since the
amount of cash exchanged for shares on conversion is not fixed in the functional currency of
the issuing entity
Where the conversion option is not classified as equity it is an embedded derivative. Although the
convertible instrument is classified in its entirety as a liability, it is therefore made up of two liability
elements:
(i) A financial liability host instrument
(ii) A financial liability embedded derivative
For such instruments the entity must assess whether the embedded derivative should be separated
from its host contract and accounted for as a derivative (at fair value through profit or loss).The
accounting treatment applied to embedded derivatives and their host instruments is considered in
more detail in section 7 of this chapter.
HKAS 32.16 2.4.5 Rights issues
A 2009 amendment to HKAS 32 (effective for periods starting on or after 1 February 2010) requires
that rights, options or warrants to acquire a fixed number of the entity's own equity
instruments for a fixed amount of any currency are equity instruments if the entity offers the
rights, options or warrants pro rata to all of its existing owners of the same class of its own
non-derivative equity instruments.
This is a very narrow amendment and does not extend to other instruments that grant the holder
the right to purchase the entity's own equity instruments such as the conversion feature in
convertible bonds.
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18: Financial instruments | Part C Accounting for business transactions
of the rights, the cash proceeds of Y30,000 ($15 3,000 ÷ 1.5) and the closing fair value of the
rights of Y6,000 would have been credited to equity.
Accounting treatment after the amendment
The rights offered in $ would be classified as equity. Hence, no liability or gain or loss would be
recognised in respect of the rights. On exercise of the rights, the cash proceeds of $30,000 would
be credited to equity.
Journal entries for accounting treatment prior to amendment
Y Y
1 December 20X2
DEBIT Equity (statement of changes in equity) 4,000
CREDIT Derivative liability 4,000
Being the issue of rights
31 December 20X2
DEBIT Profit or loss 2,000
CREDIT Derivative liability 2,000
Being the remeasurement of the liability to fair value
31 December 20X2
DEBIT Derivative liability 6,000
Cash 30,000
CREDIT Equity 36,000
Being the exercise of rights in full
Topic highlights
Interest, dividends, losses and gains are treated according to whether they relate to an equity
instrument or a financial liability.
The HKAS 32 guidance considered so far all relates to the classification of financial instruments for
presentation in the statement of financial position. The standard also considers how financial
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Financial Reporting
instruments are presented in the statement of profit or loss and other comprehensive income and
statement of changes in equity:
You should look at the requirements of HKAS 1 Presentation of Financial Statements for further
details of disclosure, and HKAS 12 Income Taxes for disclosure of tax effects.
3.1 Scope
Entities that early adopt HKFRS 9 are required to apply it to all types of financial instruments with
the exception of the following:
(a) Investments in subsidiaries, associates, and joint ventures that are accounted for under
HKASs 27, 28 and 31.
(b) Leases covered in HKAS 17.
(c) Employee benefit plans covered in HKAS 19.
(d) Equity instruments issued by the entity e.g. ordinary shares issued, or options and
warrants.
(e) Insurance contracts, including financial guarantee contracts to which HKFRS 4 is applied.
(f) Contracts for contingent consideration in a business combination, covered in HKFRS 3.
(g) Loan commitments that cannot be settled net in cash or another financial instrument.
(h) Financial instruments, contracts and obligations under share-based payment transactions,
covered in HKFRS 2.
(i) Rights to reimburse the entity for expenditure required to settle a provision recognised in
accordance with HKAS 27.
(j) Rights and obligations under HKFRS 15 Revenue from Contracts with Customers.
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18: Financial instruments | Part C Accounting for business transactions
HKFRS 9 requires that financial instruments are recognised in the statement of financial position
when the entity becomes a party to the contractual provisions of the instrument.
Notice that this is different from the recognition criteria in the Conceptual Framework and in most
other standards. Items are normally recognised when there is a probable inflow or outflow of
resources and the item has a cost or value that can be measured reliably.
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Financial Reporting
The following decision tree may help you to classify financial assets in accordance with HKFRS 9:
Is the financial asset held in No
order to collect future
contractual cash flows?
Yes
Do the contractual terms of the No
financial asset give rise to
cash flows on specified dates?
Yes
Are the cash flows solely No
payments of principal and
interest on the principal
outstanding?
Yes
Measure at amortised cost Measure at fair value
HKFRS 9,
4.2.1 3.2.3 Classification of financial liabilities
On initial recognition, HKFRS 9 require that financial liabilities are classified as either:
(a) at fair value through profit or loss, or
(b) financial liabilities at amortised cost
A financial liability is classified at fair value through profit or loss if:
(a) it is held for trading, or
(b) upon initial recognition it is designated at fair value through profit or loss.
Derivatives are always measured at fair value through profit or loss.
HKFRS 9 requires that when an entity changes its business model for managing financial assets, it
should reclassify all affected financial assets. This reclassification applies only to debt instruments,
as equity instruments must be classified as measured at fair value.
HKFRS 9 prohibits the reclassification of financial liabilities.
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HKFRS 9,
3.2.3-3.2.6
3.4 Derecognition
Topic highlights
Financial assets should be derecognised when the rights to the cash flows from the asset expire
or where substantially all the risks and rewards of ownership are transferred to another party.
Financial liabilities should be de-recognised when they are extinguished.
Derecognition refers to the removal of a previously recognised financial instrument from an entity's
statement of financial position.
3.4.1 Derecognition of financial assets
A financial asset should be derecognised by an entity when:
(a) the contractual rights to the cash flows from the financial asset expire, or
(b) the entity transfers substantially all the risks and rewards of ownership of the financial
asset to another party
The following are examples of the transfer of substantially all risks and rewards of ownership:
An unconditional sale of a financial asset
A sale of a financial asset together with an option to repurchase the financial asset at its fair
value at the time of repurchase
The standard also provides examples of situations where the risks and rewards of ownership have
not been transferred:
A sale and repurchase transaction where the repurchase price is a fixed price or the sale
price plus a lender's return
A sale of a financial asset together with a total return swap that transfers the market risk
exposure back to the entity
A sale of short-term receivables in which the entity guarantees to compensate the transferee
for credit losses that are likely to occur.
3.4.2 Derecognition of financial liabilities
A financial liability is derecognised when it is extinguished i.e. when the obligation specified in the
contract is discharged or cancelled or expires.
Where an existing borrower and lender of debt instruments exchange one financial instrument for
another with substantially different terms, this is accounted for as an extinguishment of the original
financial liability and the recognition of a new financial liability.
Similarly, a substantial modification of the terms of an existing financial liability or a part of it should
be accounted for as an extinguishment of the original financial liability and the recognition of a new
financial liability.
For this purpose, a modification is "substantial" where the discounted present value of cash flows
under the new terms, discounted using the original effective interest rate, is at least 10% different
from the discounted present value of the cash flows of the original financial liability.
The difference between the carrying amount of a financial liability (or part of a financial liability)
extinguished or transferred to another party and the consideration paid, including any non-cash
assets transferred or liabilities assumed, shall be recognised in profit or loss.
Example: Derecognition
A number of years ago Beijing Company issued loan stock with the following terms:
Interest to be paid annually in arrears at a rate of 5.5%
Loan to be repaid on 31 December 20X7
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Financial Reporting
Taking into account the transaction costs, the effective interest rate was 6%. Beijing had paid all
interest and capital due up to 31 December 20X1, and at that date the carrying amount of the loan
was $10 million.
During 20X1, the worldwide economic recession caused Beijing to suffer financial difficulties, and
an agreement to revise the terms of the loan stock from 20X2 onwards was reached with lenders.
The revised terms included an extension to the term of the loan and an increase to the coupon
rate.
The effective interest rate of the revised terms, excluding transaction costs was 8% per annum.
The present value of the cash flows, excluding transaction costs, under the revised terms was
$10.5 million at 6% and $9.5 million at 8%.
Transaction costs of $700,000 were payable on 1 January 20X2 in respect of the negotiations for
the revised terms.
How should the revision to the terms of the loan be treated in Beijing’s financial statements?
Solution
The revised terms negotiated by Beijing are such that the original loan should be derecognised and
a new financial liability recognised.
Derecognition of the old loan and recognition of the new liability is required if the present value of
the cash flows under the new terms is 10% or more different from the present value of the original
loan. The cash flows under the new terms must be discounted at the 6% effective interest rate of
the original loan and include the $700,000 transaction costs.
HKFRS 9. With transaction costs payable at the start of the period of the revised terms, they are added on in
B3.3.6 full to the $10.5m present value, giving a total of $11.2m. This is 12% different from the $10.0m
present value of the old loan, so the original loan should be derecognised and the new financial
liability recognised.
Self-test question 4
Discuss whether the following financial instruments would be derecognised.
(a) ABC sells an investment in shares, but retains a call option to repurchase those shares at
any time at a price equal to their current market value at the date of repurchase.
(b) DEF enters into a stocklending agreement where an investment is lent to a third party for a
fixed period of time for a fee.
(c) XYZ sells title to some of its receivables to a debt factor for an immediate cash payment of
90% of their value. The terms of the agreement are that XYZ has to compensate the factor
for any amounts not recovered by the factor after six months.
(The answer is at the end of the chapter)
A financial liability which is extinguished i.e., when the obligation specified in the contract is
discharged or cancelled or expires, should be derecognised by an entity.
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Where only part of a financial asset is derecognised, the carrying amount of the asset should be
allocated between the part retained and the part transferred based on their relative fair values on the
date of transfer. A gain or loss should be recognised based on the proceeds for the portion transferred.
On derecognition, the amount to be included in net profit or loss for the period is calculated as
follows:
$ $
Carrying amount of asset/liability (or the portion of asset/liability) transferred X
Less: proceeds received/paid X
any cumulative gain or loss reported as other comprehensive income X
(X)
Profit or loss X
The classification of financial assets and financial liabilities is of particular importance in terms of
how they are measured throughout their life.
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Financial Reporting
Financial liabilities
HKFRS 9 require that financial liabilities are initially measured at transaction price, i.e. the fair value
of consideration received except where part of the consideration received is for something other
than the financial liability. In this case the financial liability is initially measured at fair value
determined as for financial assets (see above). Transaction costs are deducted from this amount
for financial liabilities unless they are measured at fair value through profit or loss.
HKFRS 9,
5.2.1
4.2 Subsequent measurement of financial assets
Topic highlights
Financial assets are subsequently measured at:
fair value with changes in value recognised in other comprehensive income or profit or loss,
or
amortised cost with interest recognised in profit or loss.
As the classifications suggest, financial assets are measured, subsequent to initial recognition at:
fair value, or
amortised cost.
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Key terms
Amortised cost of a financial asset or financial liability is the amount at which the financial asset or
liability is measured at initial recognition minus principal repayments, plus or minus the cumulative
amortisation using the effective interest method of any difference between that initial amount and
the maturity amount, and minus any reduction (directly or through the use of an allowance account)
for impairment or uncollectability.
The effective interest method is a method of calculating the amortised cost of a financial
instrument and of allocating the interest income or interest expense over the relevant period. The
effective interest rate is the rate that exactly discounts estimated future cash payments or
receipts through the expected life of the financial instrument to the net carrying amount of the
financial asset or liability. (HKAS 39)
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Financial Reporting
How should ABC account for the debt instrument over its five-year term?
Solution
ABC will receive interest of $5,900 (125,000 4.72%) each year and $125,000 when the
instrument matures.
ABC must allocate the discount of $25,000 and the interest receivable over the five-year term at a
constant rate on the carrying amount of the debt. To do this, it must apply the effective interest rate
of 10%.
The following table shows the allocation over the years:
Profit or loss: Interest received during
Amortised cost at Interest income year Amortised cost
Year beginning of year for year (@10%) (cash inflow) at end of year
$ $ $ $
20X5 100,000 10,000 (5,900) 104,100
20X6 104,100 10,410 (5,900) 108,610
20X7 108,610 10,861 (5,900) 113,571
20X8 113,571 11,357 (5,900) 119,028
20X9 119,028 11,872 (125,000 + 5,900) –
Each year the carrying amount of the financial asset is increased by the interest income for the
year and reduced by the interest actually received during the year. In the year ended 31 December
20X5 this is recorded by:
DEBIT Financial asset - debt $100,000
CREDIT Cash/bank $100,000
To recognise the acquisition of the instrument on 1 January 20X5.
DEBIT Cash/bank $5,900
DEBIT Financial asset – debt $4,100
CREDIT Investment income $10,000
To recognise investment income in respect of the debt instrument.
Investments whose fair value cannot be reliably measured should be measured at cost.
Note that interest income is recognised in profit or loss each year, being the amount of interest
actually received plus the interest income related to the winding up of the financial asset to its
redemption value.
Self-test question 5
St Ives purchased a $20 million 6% debenture at par on 1 January 20X1 when the market rate of
interest was 6%. Interest is paid annually on 31 December. The debenture is redeemable at par on
31 December 20X2.
The market rate of interest on debentures of equivalent term and risk changed to 7% on
31 December 20X1.
Required
Show the charge or credit to profit or loss for each of the two years to 31 December 20X2 if the
debentures are classified as:
(a) financial assets at amortised cost.
(b) financial assets at fair value through profit or loss.
Fair value is to be calculated using discounted cash flow techniques.
(The answer is at the end of the chapter)
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HKFRS 9,
4.2.3 Reclassification
5.6.1-5.6.3
In section 3.3 we saw that in some circumstances an entity must reclassify financial assets from
one category to another.
Where financial assets are reclassified, that reclassification is applied prospectively from the
reclassification date. Previously recognised gains, losses or interest are not restated.
If an entity reclassifies a financial asset so that it is now measured at fair value, its fair value is
determined at the reclassification date. Any gain or loss arising from a difference between the
previous carrying amount and fair value is recognised in profit or loss.
If an entity reclassifies a financial asset so that it is now measured at amortised cost, its fair value
at the reclassification date becomes its new carrying amount.
Topic highlights
Financial liabilities are subsequently measured at fair value or amortised cost with gains and losses
recognised in profit or loss.
Except for financial liabilities at fair value through profit or loss (including most derivatives), all
financial liabilities should be recognised and measured at amortised cost. The exceptions should
be measured at fair value. However, if the fair value cannot be measured reliably, they should then
be measured at cost.
4.3.1 Financial liabilities measured at amortised cost
The definitions seen above in relation to financial assets at amortised cost remain relevant here.
Again, their application is best seen through examples.
Solution
(a) The premium on redemption of the loan notes represents a finance cost. The effective rate of
interest must be applied so that the debt is measured at amortised cost.
At the time of issue, the loan notes are recognised at their net proceeds of:
$199,680 (200,000 – 320).
The finance cost for the year ended 31 December 20X6 is calculated as follows:
B/f Interest @ 10% C/f
$ $ $
20X5 199,680 19,968 219,648
20X6 219,648 21,965 241,613
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Financial Reporting
Self-test question 6
On 1 January 20X2, an entity issued a debt instrument with a coupon rate of 5% at a par value of
$1,000,000. The directly attributable costs of issue were $30,000. The debt instrument is repayable
on 31 December 20X8 at a premium of $260,000.
Required
What is the total amount of the finance cost associated with the debt instrument?
A $294,000
B $318,000
C $514,000
D $640,000
(The answer is at the end of the chapter)
Self-test question 7
Grumble Co. issues a bond for $839,619 on 1 January 20X2. No interest is payable on the bond,
but it will be held to maturity and redeemed on 31 December 20X4 for $1m. The bond has not been
designated as at fair value through profit or loss.
Required
Calculate the charge to profit or loss of Grumble Co. for the year ended 31 December 20X2 and
the balance outstanding at 31 December 20X2.
(The answer is at the end of the chapter)
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2 using an alternative method which an entity believes to more faithfully represent changes in
value due to credit risk.
The gain or loss as a result of credit risk is recognised in other comprehensive income, unless it
creates or enlarges an accounting mismatch (in which case it is recognised in profit or loss). The
other gain or loss is recognised in profit or loss.
On derecognition any gains or losses recognised in other comprehensive income are not
reclassified to profit or loss.
Key terms
A regular way purchase or sale is a purchase or sale of a financial asset under a contract whose
terms require delivery of the asset within the time frame established generally by regulation or
convention in the marketplace concerned.
HKFRS 9 refers to two methods of accounting, being trade date and settlement date accounting.
An entity shall apply the same method consistently for all purchase and sales of financial assets
that are classified in the same way in accordance with HKFRS 9. For this purpose, assets that the
definition of held for trading form a separate classification from assets designated as measured at
fair value through profit or loss. In addition, investments in equity instruments accounted for using
the option provided in HKFRS 9 (irrevocable election to present in other comprehensive income
subsequent changes in the fair value of an investment in an equity instrument) form a separate
classification.
The trade date is the date on which an entity commits to purchase or sell an asset, and trade date
accounting results in:
the recognition of an asset to be received and liability to pay for it on the trade date, and
the derecognition of an asset to be sold and corresponding receivable on the trade date
(together with any gain or loss).
The settlement date is the date on which an asset is delivered to or by an entity, and settlement
date accounting results in:
the recognition of an asset on the settlement date and
the derecognition of an asset on the settlement date.
When trade date accounting is used interest does not start to accrue until the settlement date when
title passes.
When settlement date accounting is used:
(a) An asset subsequently measured at amortised cost is recognised initially at its fair value on
the trade date.
(b) Any change in the fair value of the asset to be received between the trade and settlement
date is not recognised for assets measured at amortised cost.
(c) Any change in the fair value of the asset to be received between the trade and settlement
date is recognised in profit or loss or other comprehensive income for assets measured at
fair value.
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Financial Reporting
The transaction was settled on 5 January 20X5 when the fair value was $1,007. The entity has
classified the asset as at fair value through profit or loss in accordance with HKFRS 9.
Required
How should the transactions be accounted for under trade date accounting and settlement date
accounting?
Solution
Trade date accounting
On 27 December 20X4, the entity should recognise the financial asset and the liability to the
counterparty at $1,000.
At 31 December 20X4, the financial asset should be remeasured to $1,005 and a gain of $5
recognised in profit or loss.
On 5 January 20X5, the liability to the counterparty of $1,000 will be paid in cash. The fair
value of the financial asset should be remeasured to $1,007 and a further gain of $2
recognised in profit or loss.
Settlement date accounting
No transaction should be recognised on 27 December 20X4.
On 31 December 20X4, a receivable of $5 should be recognised (equal to the fair value
movement since the trade date) and the gain recognised in profit or loss.
On 5 January 20X5, the financial asset should be recognised at its fair value of $1,007. The
receivable should be derecognised, the payment of cash to the counterparty recognised and
the further gain of $2 recognised in profit or loss.
5.1 Scope
HKAS 39.2
The scope of HKAS 39 is identical to that of HKFRS 9 (see section 3.1).
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503
Financial Reporting
FVTPL and AFS financial assets are remeasured to fair value at each reporting date. Fair value is
determined in accordance with HKFRS 13 Fair Value Measurement (see chapter 19). Note that on
the disposal of an AFS financial asset, cumulative amounts recognised in other comprehensive
income are reclassified to profit or loss.
HTM financial assets and loans and receivables are measured at amortised cost, calculated as
discussed in section 4 of this chapter.
Self-test question 8
Raincloud Trading Co (‘RTC’) acquires a listed equity investment on 6 May 20X1 with the intention
of holding it for the long term. The investment cost $13 million and RTC incurred transaction costs
of $500,000. At RTC’s year-end of 31 December 20X1 the market price of an identical investment
is $14.6 million.
Required
How is the asset initially and subsequently measured?
(The answer is at the end of the chapter)
Self-test question 9
On 1 January 20X1 Monsoon Machinery Co (‘MMC’) purchases a quoted debt instrument for its
fair value of $10 million. The debt instrument is due to mature on 31 December 20X5 and the entity
has the intention to hold the debt instrument till maturity. The instrument has a principal amount of
$12.5 million and the instrument carries fixed interest at 4.72% that is paid annually. (The effective
interest rate is 10%.)
Required
How should MMC account for the debt instrument over its five-year term?
(The answer is at the end of the chapter)
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Unlike HKFRS 9, HKAS 39 does not split the gain or loss arising on financial liabilities that are
designated as FVTPL and account for that part arising from credit risk separately.
HKAS 39.50-
54
5.5 Reclassification of financial instruments
In limited circumstances HKAS 39 requires or permits that non-derivative financial assets are
reclassified.
5.5.1 Reclassification out of the HTM category
If an entity no longer has the ability or intention to hold a held-to-maturity financial asset to maturity
it is reclassified to the available for sale category.
On reclassification:
It is remeasured to fair value
Any gain or loss is recognised in other comprehensive income.
Such a reclassification, or the sale of a held-to-maturity asset before the maturity date triggers a
penalty in accordance with the HKAS 39 ‘tainting rules’. The held-to-maturity category is now
deemed to be tainted and as a result:
1 All remaining held-to-maturity financial assets are reclassified as available for sale and
remeasured to fair value, and
2 The held-to-maturity category is unavailable to the entity for the remainder of the financial
year and the two subsequent financial years.
This penalty is avoided only where the financial asset sold or reclassified is insignificant compared
to the total amount of held-to-maturity assets or the reclassification was:
Within three months of maturity, or
After the entity has collected substantially all amounts of principal, or
Outside the entity’s control.
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Financial Reporting
Example
On 1 January 20X3, Ramsey Smith Co (‘RSC’) classifies a portfolio of eight newly issued ten-year
bonds as held-to-maturity investments. On 30 April 20X4, the entity sells half of the assets for their
fair value of $2,500 each. At that date the amortised cost of each financial asset using the effective
interest method was $2,100. On 1 January 20X7, the fair value of each bond was $2,750. The
entity has a 31 December reporting date.
Required
How should the above be accounted for?
Solution
On 30 April 20X4 the held-to-maturity category becomes tainted when RSC sells more than an
insignificant amount (50%) of the held-to-maturity financial assets.
At that date, the remaining financial assets must be reclassified as available-for-sale. They should
be measured at $10,000 (4 × $2,500) and the gain of $1,600 (4 × ($2,500 – $2,100)) recognised in
other comprehensive income.
The category of held-to-maturity investments is unavailable for classification for the remainder of
the 20X4 financial year and the two following financial years.
The financial assets may be reclassified as held-to-maturity on 1 January 20X7 when the
classification is cleansed.
On that date, the fair value of $11,000 (4 × $2,750) becomes the new amortised cost and the total
gain of $2,600 (4 × ($2,750 – $2,100)) recognised in other comprehensive income is amortised to
profit or loss over the remaining six-year term to maturity, using the effective interest rate method.
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Although HKFRS 9 guidance on the impairment of financial assets (credit losses) has now been
issued, the HKAS 39 rules remain examinable; HKFRS 9 credit loss guidance is considered as a
current development at the end of this chapter.
At each year-end, an entity should assess whether there is any objective evidence that a financial
asset or group of assets is impaired. Note that this is not necessary for financial assets measured
at fair value with changes recognised in profit or loss as any impairment is recognised for these
assets when they are remeasured at each period end.
Self-test question 10
Can you think of three examples of indications that a financial asset or group of assets may be
impaired?
(The answer is at the end of the chapter)
HKAS 39.59-
60
6.1 Objective evidence of impairment
Where there is objective evidence of impairment, an entity should determine the amount of any
impairment loss.
It may not be possible to identify a single, discrete event that caused the impairment. Rather the
combined effect of several events may have caused the impairment. Losses expected as a result
of future events, no matter how likely, are not recognised.
Objective evidence that a financial asset or group of assets is impaired includes observable data
that comes to the attention of the holder of the asset about the following events:
(a) Significant financial difficulty of the issuer or obligor.
(b) A breach of contract, such as a default or delinquency in interest or principal payments.
(c) The lender, for economic or legal reasons relating to the borrower's financial difficulty, granting
to the borrower a concession that the lender would not otherwise consider.
(d) It becoming probable that the borrower will enter bankruptcy or other financial reorganisation.
(e) The disappearance of an active market for that financial asset because of financial difficulties.
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Financial Reporting
(f) Observable data indicating that there is a measurable decrease in the estimated future cash
flows from a group of financial assets since the initial recognition of those assets, although the
decrease cannot yet be identified with the individual financial assets in the group, including:
(i) Adverse changes in the payment status of borrowers in the group (e.g. an increased
number of delayed payments or an increased number of credit card borrowers who
have reached their credit limit and are paying the minimum monthly amount).
(ii) National or local economic conditions that correlate with defaults on the assets in the
group (e.g. an increase in the unemployment rate in the geographical area of the
borrowers, a decrease in property prices for mortgages in the relevant area, a
decrease in oil prices for loan assets to oil producers, or adverse changes in industry
conditions that affect the borrowers in the group).
The disappearance of an active market because an entity's financial instruments are no longer
publicly traded is not evidence of impairment. A downgrade of an entity's credit rating is not, of
itself, evidence of impairment, although it may be evidence of impairment when considered with
other available information. A decline in the fair value of a financial asset below its cost or
amortised cost is not necessarily evidence of impairment (for example, a decline in the fair value of
an investment in a debt instrument that results from an increase in the risk-free interest rate).
HKAS 39.63-
65 6.2 Accounting for an impairment
6.2.1 Impairment of financial assets carried at amortised cost
The impairment loss is the difference between the asset's carrying amount and its recoverable
amount. The asset's recoverable amount is the present value of estimated future cash flows,
discounted at the financial instrument's original effective interest rate.
The amount of the loss should be recognised in profit or loss.
If the impairment loss decreases at a later date (and the decrease relates to an event occurring
after the impairment was recognised) the reversal is recognised in profit or loss. The carrying
amount of the asset must not exceed the original amortised cost.
Example: Impairment
Floribunda has a 7% loan receivable of $1m. Interest is payable annually in arrears and the
principal is repayable in three years' time. The amortised cost of the loan is $1m. The original
effective rate of interest was 7% and the current effective interest rate is 8%.
The borrower is in financial difficulty and Floribunda has granted a concession in that no annual
interest is payable and the principal will be repaid in three years' time at a premium of 10%.
Required
Explain how the carrying amount of the loan should be calculated.
Solution
The financial difficulty of, and the granting of a concession to, the issuer are both objective
evidence of impairment.
The recoverable amount should be calculated as $839,185 by discounting the $1.1m agreed
repayment at the original effective interest rate of 7% over a four-year period.
An impairment loss of $160,815 is therefore recognised in profit or loss.
In Year 1, interest income of $58,743 (7% $839,185) should be recognised and the
carrying amount of the loan increased to $897,928. This process should be repeated through
Years 2 to 4, at which point the loan will be carried at $1.1m immediately prior to repayment.
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Derivative contracts may be "embedded" in contracts that are not themselves derivatives (and may
not be financial instruments). These non-derivatives are known as host contracts, and may
comprise:
leases
sale or purchase contracts
insurance contracts
construction contracts
a debt or equity instrument
"Host"
Lease Accounted for as normal
contract
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Financial Reporting
(c) An embedded derivative caused by changes in the foreign exchange can be found in a
construction contract which is priced in a foreign currency.
HKFRS 9,
4.3.2-4.3.4
7.2 Accounting treatment of embedded derivatives
The accounting treatment for embedded derivatives differs depending on whether HKAS 39 or
HKFRS 9 is applied.
7.2.1 HKAS 39 rules
When an entity becomes party to a host contract with an embedded derivative, it must assess
whether the embedded derivative should be separated from its host contract and accounted for as
a derivative (at fair value through profit or loss). It must separate the embedded derivative if:
(a) The economic characteristics and risks of the embedded derivative are not closely related to
those of the host contract, and
(b) A separate instrument with the same terms as the embedded derivative would meet the
definition of a derivative, and
(c) The hybrid instrument is not measured at fair value with changes recognised in profit or loss
(in which case there is no benefit to separating the embedded derivative).
7.2.2 HKFRS 9 rules
HKFRS 9 simplifies accounting guidance in relation to embedded derivatives. Where HKFRS 9 is
applied, if the host contract is a financial asset within the scope of the standard, the classification
HKFRS 9,
4.3.2 and measurement rules of the standard are applied to the entire hybrid contract.
The same rules as HKAS 39 apply where this is not the case.
Earlier in the chapter we saw that where convertible debt is denominated in a foreign currency or
has a variable conversion ratio based on share price, then it is not split into equity and liability
components for accounting purposes. Instead the conversion option is treated as an embedded
derivative within a financial liability host contract.
Applying the HKFRS 9 guidance detailed above, the embedded derivative is separated from the
debt instrument host and accounted for separately since:
(a) The economic characteristics and risks of a debt contract are not closely related to those of a
share warrant
(b) A separate share warrant meets the definition of a derivative
(c) The debt instrument is not measured at fair value through profit or loss (unless specifically
designated as such to provide more relevant information)
Therefore two financial liabilities are recognised:
(i) A debt instrument measured at amortised cost, and
(ii) An embedded derivative (representing the conversion option) measured at fair value through
profit or loss.
HKFRS 9,
B4.3.1
7.3 Reassessment of embedded derivatives
Where HKAS 39 is applied, HK(IFRIC) Int-9 Reassessment of Embedded Derivatives is also
applicable.
This states that an entity is not permitted to reassess the treatment of an embedded derivative
throughout the life of a contract unless there is a significant change to the terms of the contract.
Where HKFRS 9 is applied, this guidance is now incorporated into the contents of the standard.
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HKFRS 9 guidance on hedge accounting was added to the standard in 2013. For the purposes of
the Module A syllabus, the 2013 edition of HKFRS 9 is examined as a current development and is
discussed in more detail in section 10 of this chapter. This section focuses on the HKAS 39
hedging guidance.
8.1 Introduction
It is normal business practice for a company to engage in hedging activities in order to reduce their
exposure to risk and uncertainty, such as changes in prices, interest rates or foreign exchange
rates. For example, an entity may have a fixed amount of foreign currency to pay on a particular
date, and hedge against unfavourable exchange rate movements by taking out a forward contract
to purchase the currency it needs to meet its obligation from a third party at a particular exchange
rate.
In this instance the forward contract is a derivative and so measured at fair value with changes in
value recognised in profit or loss. An accounting hedge involves recognising these changes in
value at the same time as any opposite gain or loss on a year end revaluation and then settlement
of the payable so as to minimise the impact on profit or loss of the transaction. This is an example
of a hedge that happens automatically.
HKAS 39 provides the guidance relating to hedging and allows hedge accounting where there is
a designated hedging relationship between a hedging instrument and a hedged item. It is
prohibited otherwise. Hedge accounting is therefore not mandatory.
Key terms
Hedging, for accounting purposes, means designating one or more hedging instruments so that
their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of
a hedged item.
A hedged item is an asset, liability, firm commitment, or forecasted future transaction that:
(a) exposes the entity to risk of changes in fair value or changes in future cash flows, and that
(b) is designated as being hedged.
A hedging instrument is a designated derivative or (in limited circumstances) another financial
asset or liability whose fair value or cash flows are expected to offset changes in the fair value or
cash flows of a designated hedged item. (A non-derivative financial asset or liability may be
designated as a hedging instrument for hedge accounting purposes only if it hedges the risk of
changes in foreign currency exchange rates.)
Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged
item attributable to a hedged risk are offset by changes in the fair value or cash flows of the
hedging instrument.
(HKAS 39)
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Financial Reporting
Generally only assets, liabilities etc. that involve external parties can be designated as hedged
items. The foreign currency risk of an intragroup monetary item (e.g. payable/receivable between
two subsidiaries) may qualify as a hedged item in the group financial statements if it results in an
exposure to foreign exchange rate gains or losses that are not fully eliminated on consolidation.
This can happen (per HKAS 21) when the transaction is between entities with different functional
currencies.
In addition, the foreign currency risk of a highly probable group transaction may qualify as a
hedged item if it is in a currency other than the functional currency of the entity and the foreign
currency risk will affect profit or loss.
Key terms
Fair value hedge. A hedge of the exposure to changes in the fair value of a recognised asset or
liability or an unrecognised firm commitment, or an identified portion of such an asset, liability or
firm commitment, that is attributable to a particular risk and could affect profit or loss.
Cash flow hedge. A hedge of the exposure to variability in cash flows that:
(a) is attributable to a particular risk associated with a recognised asset or liability (such as all or
some future interest payments on variable rate debt) or a highly probable forecast
transaction (such as an anticipated purchase or sale), and that
(b) could affect profit or loss.
Hedge of a net investment in a foreign operation. HKAS 21 defines a net investment in a
foreign operation as the amount of the reporting entity's interest in the net assets of that operation.
A forecast transaction is an uncommitted but anticipated future transaction.
A firm commitment is a binding agreement for the exchange of a specified quantity of resources
at a specified price on a specified future date or dates.
(HKAS 39)
We shall consider each type of hedge in detail in a moment, but first it is important to understand
the conditions for hedge accounting.
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Before a hedging relationship qualifies for hedge accounting, all of the following conditions must
be met:
(a) The hedging relationship must be formally documented (including the identification of the
hedged item, the hedging instrument, the nature of the hedged risk and the assessment of
the hedging instrument's effectiveness in offsetting the exposure to changes in the hedged
item's fair value or cash flows attributable to the hedged risk). The hedging relationship must
also be designated at its inception as a hedge based on the entity's risk management
objective and strategy.
(b) There is an expectation that the hedge is highly effective in offsetting changes in fair value or
cash flows ascribed to the hedged risk. (Note. The hedge does not have to be fully
effective.)
(c) For cash flow hedges, it must be highly probable that there is a forecast transaction since
such a transaction is the subject of the hedge. In addition, the transaction must present an
exposure to variations in cash flows that could eventually affect profit and loss.
(d) Reliable measurement of the effectiveness of the hedge.
(e) The assessment of the hedge is carried out on an ongoing basis (annually) and it has been
effective during the reporting period.
Effectiveness
Hedge effectiveness must be tested regularly and must fall within the range 80% to 125%. If it falls
outside e.g. 75% or 130%, then hedge accounting cannot be applied. Both the hedged item and
hedging instrument will be accounted for based on their respective accounting standard.
Change in hedging instrument
Hedge effectiveness =
Change in hedged item
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Financial Reporting
Required
Explain the impact of the transactions on the financial statements of the company:
(a) without hedge accounting
(b) with hedge accounting.
Solution
The futures contract was intended to protect the company from a fall in oil prices (which would
have reduced the profit when the oil was eventually sold). However, oil prices have actually risen,
so that the company has made a loss on the contract.
Without hedge accounting
The futures contract is a derivative and therefore must be remeasured to fair value at 31 December
20X8 under HKAS 39. The loss on the futures contract is recognised in profit or loss:
$ $
DEBIT Profit or loss (30,000 (30 – 25)) 150,000
CREDIT Financial liability 150,000
With hedge accounting
The loss on the futures contract is recognised in profit or loss as before, however with hedge
accounting, the inventories are also remeasured to fair value:
$
Fair value at 31 December 20X8 (30,000 27) 810,000
Cost (660,000)
Gain 150,000
The gain is also recognised in profit or loss:
$ $
DEBIT Inventory 150,000
CREDIT Profit or loss 150,000
With hedging the net effect on profit or loss is zero compared with a loss of $150,000 without
hedging.
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18: Financial instruments | Part C Accounting for business transactions
instrument exactly offset each other; the hedge is 100% effective and the net effect on profit or loss
is zero.
Required
Explain the impact of the transactions on the financial statements of the company with hedge
accounting.
Solution
STATEMENT OF FINANCIAL POSITION
1 January 31 December
20X3 20X3
$'000 $'000 $'000
Debt instrument (hedged item) 1,000 (40) 960
Derivative asset (hedging instrument) – 40 40
Cash (1,000)
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
$'000
Loss on debt instrument (40)
Gain on derivative 40
No ineffectiveness –
Gains and losses on hedged item and hedging instrument are both taken to the statement of profit
or loss.
Journal entries
On 1 January 20X3
$ $
DEBIT Financial asset 1,000,000
CREDIT Cash/bank/payable 1,000,000
To recognise the debt instrument at its fair value.
On 31 December 20X3
$ $
DEBIT Profit or loss $40,000
CREDIT Financial asset $40,000
To remeasure the debt instrument to fair value at the reporting date.
And
$ $
DEBIT Financial asset - derivative $40,000
CREDIT Cash/bank/payable $40,000
To measure the interest swap at fair value at the reporting date.
515
Financial Reporting
Solution
Change in hedging instrument
Hedge effectiveness =
Change in hedged item
$45,000
=
$40,000
= 112.5%
Hedge effectiveness of 112.5% is still within the window of 80% – 125%. Thus, hedge accounting
may be applied.
STATEMENT OF FINANCIAL POSITION
1 January 31 December
20X3 20X3
$'000 $'000 $'000
Debt instrument (hedged item) 1,000 (40) 960
Derivative asset (hedging instrument) – 45 45
Cash (1,000)
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
$'000
Loss on debt instrument (40)
Gain on derivative 45
Ineffective hedge 5
This results in an ineffective hedge of $5,000 gain recognised in profit or loss.
Journal entries
On 1 January 20X3
$ $
DEBIT Financial asset 1,000,000
CREDIT Cash/bank/payable 1,000,000
To recognise the debt instrument at its fair value.
On 31 December 20X3
$ $
DEBIT Profit or loss $40,000
CREDIT Financial asset $40,000
To remeasure the debt instrument to fair value at the reporting date.
And
$ $
DEBIT Financial asset - derivative $45,000
CREDIT Cash/bank/payable $45,000
To measure the interest swap at fair value at the reporting date.
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18: Financial instruments | Part C Accounting for business transactions
517
Financial Reporting
Required
Explain how the above transactions would be treated in Sparkle's financial statements for the year
ended 30 September 20X2.
Solution
Sparkle is hedging the volatility of the future cash inflow from selling the gold jewellery. The futures
contracts can be accounted for as a cash flow hedge in respect of those inflows, providing the
criteria for hedge accounting are met.
The gain on the forward contract should be calculated as:
$
Forward value of contract at 31.10.X1 (24,000 $388) 9,312,000
Forward value of contract at 30.9.X2 (24,000 $352) 8,448,000
Gain on contract 864,000
The change in the fair value of the expected future cash flows on the hedged item (which is not
recognised in the financial statements) should be calculated as:
$
At 31.10.X1 9,938,000
At 30.9.X2 9,186,000
752,000
As this change in fair value is less than the gain on the forward contract, the hedge is not fully
effective and only $752,000 of the gain on the forward should be recognised in other
comprehensive income. The remainder should be recognised in profit or loss:
$ $
DEBIT Financial asset (Forward a/c) 864,000
CREDIT Other comprehensive income 752,000
Profit or loss 112,000
Note that the hedge is still highly effective (and hence hedge accounting should continue to be
used):
$864,000/$752,000 = 115% which is within the 80% – 125% range.
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18: Financial instruments | Part C Accounting for business transactions
The fair value of the swap, determined by projecting future settlement amounts using the current
year's variable rate and discounting these to present value is:
31 December 20X1 $300,000
31 December 20X2 $125,000
31 December 20X3 nil
Solution
The purpose of the cash flow hedge is to fix the interest receivable at 9%. Interest receivable per
the terms of the loan agreement is:
31 December 20X1 $10m (7% + 2%) = $900,000
31 December 20X2 $10m (6% + 2%) = $800,000
31 December 20X3 $10m (5% + 2%) = $700,000
The net settlement in respect of the swap on each of these dates is:
Date Swap receipt at 7% Swap payment at Swap net
HIBOR
$ $ $
31 December 20X1 700,000 (700,000) Nil
31 December 20X2 700,000 (600,000) 100,000
31 December 20X3 700,000 (500,000) 200,000
Therefore, in each of the three years, the total amount of the interest income (i.e. loan interest
income + net position on the swap) is $900,000.
The journal entries are as follows:
1 January 20X1
$ $
DEBIT Loan receivable 10,000,000
CREDIT Cash 10,000,000
31 December 20X1
DEBIT Cash 900,000
CREDIT Interest income 900,000
519
Financial Reporting
31 December 20X2
DEBIT Cash 800,000
CREDIT Interest income 800,000
To record the cash received on net settlement of the interest rate swap.
To recycle into earnings amounts in OCI on account of the cash flow hedge, so that they are
matched with the relevant cash flow.
To reduce the carrying value of the interest rate swap from its initial fair value of $300,000 to
current fair value of $125,000.
31 December 20X3
DEBIT Cash 700,000
CREDIT Interest income 700,000
To record the cash received on net settlement of the interest rate swap.
To recycle into earnings amounts in OCI on account of the cash flow hedge, so that they are
matched with the relevant cash flow.
To adjust the carrying value of the interest rate swap to current fair value.
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18: Financial instruments | Part C Accounting for business transactions
521
Financial Reporting
8.7 Recap
Hedge accounting means designating one or more instruments so that their change in fair
value is offset by the change in fair value or cash flows of another item.
Hedge accounting is permitted in certain circumstances, provided the hedging relationship
is clearly defined, measurable and actually effective.
There are three types of hedge: fair value hedge; cash flow hedge; hedge of a net
investment in a foreign operation.
The accounting treatment of a hedge depends on its type.
HKFRS 7 was issued in 2005 to replace the disclosure requirements of HKAS 32. In doing so it has
revised and enhanced disclosure requirements in response to new techniques and approaches to
measuring risk management. The standard requires qualitative and quantitative disclosures
about exposure to risks arising from financial instruments, and specifies minimum disclosures
about credit risk, liquidity risk and market risk.
The HKICPA maintains that users of financial instruments need information about an entity's
exposures to risks and how those risks are managed, as this information can influence a user's
assessment of the financial position and financial performance of an entity or of the amount,
timing and uncertainty of its future cash flows.
In June 2011 HKFRS 13 Fair Value Measurement was issued. As a result, disclosures in relation to
financial instruments measured at fair value were relocated from HKFRS 7 to HKFRS 13.
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18: Financial instruments | Part C Accounting for business transactions
HKFRS 7.7-
19
9.3 Statement of financial position disclosures
The following must be disclosed in the notes to the financial statements:
(a) Carrying amount of financial assets and liabilities by HKAS 39 or HKFRS 9 category.
(b) Details of financial instruments designated as at fair value through profit or loss and financial
assets designated as at fair value through other comprehensive income.
(c) Reason for any reclassification between fair value and amortised cost (and vice versa).
(d) The carrying amount of financial assets the entity has pledged as collateral for liabilities
or contingent liabilities and the associated terms and conditions.
(e) When financial assets are impaired by credit losses and the entity records the impairment in
a separate account (e.g. an allowance account used to record individual impairments or a
similar account used to record a collective impairment of assets) rather than directly reducing
the carrying amount of the asset, it must disclose a reconciliation of changes in that
account during the period for each class of financial assets.
(f) The existence of multiple embedded derivatives, where compound instruments contain
these.
(g) Defaults and breaches.
HKFRS 7.13C The December 2011 amendment to HKFRS 7 in respect of offsetting financial assets and financial
liabilities requires an entity to disclose information about rights of offset and related arrangements.
As a minimum the following should be disclosed:
(a) The gross amounts of financial assets and financial liabilities under an enforceable master
netting agreement (i.e. an agreement whereby a single net settlement of all financial
instruments covered by the arrangement may be made) or similar;
(b) Amounts offset in accordance with the HKAS 32 criteria;
(c) Net amounts presented in the statement of financial position;
(d) Amounts subject to an enforceable master netting agreement not included in (b);
(e) The net amount after deducting (d) from (c).
HKFRS 7.20 9.4 Statement of profit or loss and other comprehensive income
disclosures
The entity must disclose the following items of income, expense, gains or losses, either on the
face of the financial statements or in the notes:
(a) Net gains/losses by HKAS 39 or HKFRS 9 category (broken down as appropriate: for
example, interest, fair value changes, dividend income)
(b) Interest income/expense
(c) Impairment losses by class of financial asset.
523
Financial Reporting
Credit risk The risk that one party to a financial instrument will cause a financial loss for
the other party by failing to discharge an obligation.
Currency risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in foreign exchange rates.
Interest rate risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market interest rates.
Liquidity risk The risk that an entity will encounter difficulty in meeting obligations
associated with financial liabilities.
Loans payable Loans payable are financial liabilities, other than short-term trade payables
on normal credit terms.
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18: Financial instruments | Part C Accounting for business transactions
Market risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices. Market risk comprises three
types of risk: currency risk, interest rate risk and other price risk.
Other price risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices (other than those arising from
interest rate risk or currency risk), whether those changes are caused by
factors specific to the individual financial instrument or its issuer, or factors
affecting all similar financial instruments traded in the market.
Past due A financial asset is past due when a counterparty has failed to make a
payment when contractually due.
525
Financial Reporting
However, HKFRS 7 requires entities to disclose an analysis of financial assets that are impaired.
This disclosure is relevant and should be given for impaired equity investments that are available
for sale.
Solution
No, the credit risk of financial guarantees should be included in the disclosures, as HKFRS 7
clarifies that the definition of credit risk includes that arising from financial guarantees.
Solution
All the financial instruments should be split across the maturity brackets in which the cash flows
occur. The requirement is to disclose each of the contractual payments in the period when they are
due (including principal and interest payments). The objective of this particular disclosure is to
show the liquidity risk of the entity.
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18: Financial instruments | Part C Accounting for business transactions
Solution
Yes, HKFRS 7 requires a maturity analysis based on the remaining contractual maturity only for
financial liabilities. Management can choose to disclose the maturity analysis showing remaining
contractual maturity for financial assets also as one of the disclosures to comply with the
requirement in HKFRS 7. However, it is not obligatory.
In practice, an entity should disclose a maturity analysis of financial assets and financial liabilities
showing expected maturity if this is the information provided to key management personnel to
manage the business. However, a maturity analysis based on the remaining contractual maturity
for financial liabilities should be disclosed.
Interest
rate risk Yield curve of market interest rates
Other price
risk
Prepayment risk
527
Financial Reporting
10 Current developments
The final issue of HKFRS 9 in 2014 was the culmination of a long-standing project carried out by
the IASB and FASB. HKFRS 9 has been issued gradually over a period of 5 years:
the 2009 standard introduced guidance on the classification and measurement of financial
assets.
the 2010 standard added guidance on the classification and measurement of financial
liabilities and embedded derivatives.
the 2013 standard introduced requirements on hedge accounting
the 2014 standard added a final chapter on credit losses (impairment) together with
amended classification and measurement guidance relating to financial assets.
For the purposes of Module A, the 2013 and 2014 issues of the standard are not fully examinable.
These are dealt with as current developments, and more detail is provided below.
Financial assets that do not meet these criteria are measured at fair value through profit or loss.
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18: Financial instruments | Part C Accounting for business transactions
Yes No
Yes Yes
529
Financial Reporting
Interest /dividend Profit or loss Profit or loss Profit or loss Profit or loss
revenue
Expected credit Profit or loss Profit or loss Profit or loss Profit or loss
losses (see below)
Foreign exchange Profit or loss Profit or loss Profit or loss Profit or loss
gains / losses
Other gains / losses - OCI OCI Profit or loss
on remeasurement
Gain/loss on Profit or loss Profit or loss Profit or loss but Profit or loss
derecognition with amounts OCI is not
previously reclassified.
recognised in
OCI reclassified
to profit or loss
Classifying financial assets in accordance with HKFRS 9 should result in the provision of more
useful information in the financial statements. For example:
where a debt instrument is held in the long term to collect contractual cash flows, the fair
value of that instrument is of limited relevance to users.
where the purpose of holding an instrument is to collect income but also to sell the asset, the
fair value gives an indication of selling price and so becomes more relevant.
Example:
On 1 July 20X1 Booker Williams (‘BW”) acquired $40 million 5% loan stock at a cost of $38 million.
Further information is as follows:
interest is payable annually in arrears
the loan stock will be redeemed at a 5% premium on 30 June 20X4
the effective interest rate attached to the loan stock is 8.49%
the fair value of the loan stock is $38.8 million at 30 June 20X2 and $40.8 million at 30 June
20X3.
The loan stock is held by BW within a business model whose objective is achieved both by
collecting contractual cash flows and selling financial assets.
Required
(a) Calculate amounts to be recognised in the financial statements of BW for the years ended 30
June 20X2 and X3
(b) State the relevant journal entries in the year ended 30 June 20X2
(c) State the relevant journal entries to recognise the disposal of the loan stock on 1 July 20X3
for $41 million
Solution
(a) The loan stock is classified as FVTOCI and initially measured at fair value of $38 million.
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18: Financial instruments | Part C Accounting for business transactions
531
Financial Reporting
The new model for hedge accounting differs from that in HKAS 39 in the following key areas:
Eligibility of hedging instruments
Eligibility of hedged items
Qualifying criteria for applying hedge accounting
Rebalancing
Discontinuation of hedging relationships
Accounting for the time value component of options and forward contracts
There are also limited changes in the accounting for hedge relationships.
10.2.1 Eligibility of hedging instruments
HKAS 39 permits entities to designate derivative instruments as hedging instruments; in addition
non-derivative financial instruments may be hedging instruments for hedges of foreign currency
risk.
Under HKFRS 9 eligibility of a financial instrument as a hedging instrument depends on whether
the instrument is measured at fair value through profit or loss (FVTPL) rather than whether it is a
derivative instrument. Therefore non-derivative instruments may be used as a hedging instrument
for all types of risks, not only foreign currency risks, provided they are measured at FVTPL.
10.2.2 Eligibility of hedged items
HKAS 39 permits entities to designate recognised assets or liabilities, firm commitments, highly
probable forecast transactions, and net investments in foreign operations as hedged items. In
addition, for financial assets and financial liabilities, entities may designate certain risk components
of the asset or liability (e.g. interest-rate risk, foreign currency risk) as the hedged item, provided
that the risk is separately identifiable and reliably measurable.
HKFRS 9 also allows entities to designate risk components of non-financial assets and liabilities as
hedged items provided that the risk component is separately identifiable and can be reliably
measured.
In addition the new standard allows certain group exposures to be designated as a hedged item.
10.2.3 Qualifying criteria for applying hedge accounting
The HKAS 39 80%-125% hedge effectiveness test of whether a hedging relationship qualifies for
hedge accounting has been removed by HKFRS 9 and replaced with a principles-based approach.
To qualify for hedge accounting under HKFRS 9, the following criteria must all apply:
(a) An economic relationship must exist between the hedged item and the hedging instrument,
i.e. the hedging instrument and the hedged item must be expected to have offsetting
changes in fair value;
(b) The effect of credit risk must not dominate the fair value changes, i.e. the fair value changes
due to credit risk are not a significant driver of the fair value changes of either the hedging
instrument or the hedged item; and
(c) The hedge ratio of the hedging relationship (quantity of hedging instrument vs quantity of
hedged item) must be the same as that resulting from the quantity of the hedged item that
the entity actually hedges and the quantity of the hedging instrument that the entity actually
uses to hedge that quantity of hedged item.
This allows genuine hedging relationships to be accounted for as such whereas the HKAS 39 rules
sometimes prevented management from accounting for an actual hedging transaction as a hedge.
10.2.4 Rebalancing
Rebalancing is a new concept introduced in HKFRS 9. It refers to adjustments (where there is
already a hedging relationship) to the designated quantities of the hedged item or the hedging
instrument for the purpose of maintaining a hedge ratio that complies with the hedge.
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18: Financial instruments | Part C Accounting for business transactions
The standard requires rebalancing to be undertaken if the risk management objective remains the
same, but the hedge effectiveness requirements are no longer met. Where the risk management
objective for a hedging relationship has changed, rebalancing does not apply and the hedging
relationship must be discontinued.
10.2.5 Discontinuation of hedging relationships
Unlike under HKAS 39, under the new standard, an entity is not allowed to discontinue hedge
accounting where the hedging relationship still meets the risk management objective and
continues to meet all other qualifying criteria.
10.2.6 Accounting for the time value component of options and forward
contracts
Under HKAS 39 the part of an option that reflects time value and the forward element of a forward
contract are treated as derivatives held for trading purposes so creating volatility in profit or loss.
Under HKFRS 9, the time value component of an option is treated as a cost of hedging, and
presented in other comprehensive income. This is intended to decrease inappropriate volatility in
profit or loss and it should be more consistent with risk management practices.
The new standard also allows an entity to elect for the forward element of a forward contract either
in the same way as HKAS 39 (in profit or loss) or in a similar way to the part of an option that
reflects time value
10.2.7 Accounting for hedge relationships
IFRS 9/HKFRS 9 retains the three types of hedge recognised in HKAS 39: fair value hedges, cash
flow hedges and hedges of a net investment.
The accounting for these has generally not changed, with the following exceptions:
In a fair value hedge, if the hedged item is an investment in an equity instrument held at fair
value through other comprehensive income, the gains and losses on both the hedged
investment and the hedging instrument are recognised in other comprehensive income. This
ensures that hedges of investments of equity instruments held at fair value through other
comprehensive income can be accounted for as hedges.
In a cash flow hedge of a forecast transaction, if a non-financial asset or liability is
recognised, an entity must remove the effective portion of the hedge recognised in other
comprehensive income and include it in the initial cost or carrying amount of the non-
financial item. The option which existed under HKAS 39 to reclassify the effective portion to
profit or loss when the hedged item affects earnings is removed.
533
Financial Reporting
Credit losses X
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18: Financial instruments | Part C Accounting for business transactions
Example
On 1 January 20X4 Lord Robinson (‘LR’) acquired an investment in $600,000 8% loan stock. The
investment is measured at amortised cost.
At 1 January 20X4 there is a 6% probability that the borrower will default on the loan during 20X4
resulting in a 100% loss.
At 31 December 20X4 there is 1% probability that the borrower will default on the loan before 31
December 20X5 resulting in a 100% loss.
At 31 December 20X5 the borrower is expected to breach its covenants as a result of cash flow
problems. There is a 40% probability of the loan defaulting over the remainder of its term.
At 31 December 20X6 the borrower breached its covenants and there is a 70% probability of
default over the remainder of the loan term.
Required
What impairment loss and interest revenue are recognised at initial recognition and in each of the
years ended 31 December 20X4, 20X5 and 20X6?
Solution
Impairment allowance Interest revenue
1 January 20X4 6% $600,000 = $36,000 -
31 December 20X4 1% $600,000 = $6,000 $600,000 8% = $48,000
(stage 1)
31 December 20X5 40% $600,000 = $240,000 $600,000 8% = $48,000
(stage 2)
31 December 20X6 70% $600,000 = $420,000 ($600,000 – $420,000) 8% =
$14,400
(stage 3)
535
Financial Reporting
Example:
Expected default Gross carrying Credit loss
rate amount allowance
Current 0.5% $560,000 $2,800
1 – 30 days past due 1.2% $490,000 $5,880
31 – 60 days past due 3.4% $250,000 $8,500
61 – 90 days past due 4% $90,000 $3,600
Over 90 days past due 10.8% $55,000 $5,940
$26,720
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18: Financial instruments | Part C Accounting for business transactions
537
Financial Reporting
Topic recap
Financial
Text instruments with settlement options are either financial assets
or financial liabilities
Rights
issues/options/warrants are
equity where the entity offers
them pro rata to all existing
owners.
538
18: Financial instruments | Part C Accounting for business transactions
Initially measured at transaction price/fair value. Initially measured at transaction price/fair value.
Transaction costs are added for assets measured at Transaction costs are deducted for liabilities
amortised cost. measured at amortised cost.
Embedded derivatives
Derivatives embedded within host contracts
such as leases or a debt instrument.
If host contract is a financial asset, HKFRS 9 rules If host contract is not a financial asset, split derivative
are applied to the whole hybrid contract. and host contract and account separately.
539
Financial Reporting
HKAS 39 Hedging
Hedged item (an asset or liability) is Hedged item is a future cash flow. Hedged item is the investment in a
remeasured to fair value at the period foreign subsidiary within consolidated
end and the gain or loss recognised in Hedging instrument (derivative) is accounts.
profit or loss. remeasured to fair value and the
effective gain or loss is recognised in Hedging instrument is the loan taken to
Hedging instrument (derivative) is also OCI. fund the acquisition of the subsidiary.
remeasured to fair value and the gain
or loss recognised in profit or loss. This is reclassified to profit or loss Gains and losses on both are matched
when the effect of the future cash flow in other comprehensive income.
is recognised in profit or loss.
Significance of financial instruments on Nature and extent of risks arising from financial
financial position and performance instruments and their management
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18: Financial instruments | Part C Accounting for business transactions
Answer 1
Refer to the definitions of financial assets and liabilities given in section 1.2:
(a) Physical assets: control of these creates an opportunity to generate an inflow of cash or
other assets, but it does not give rise to a present right to receive cash or other financial
assets.
(b) Prepaid expenses, etc.: the future economic benefit is the receipt of goods/services rather
than the right to receive cash or other financial assets.
Answer 2
Liability. The preference shares require regular distributions to the holders but more importantly
have the debt characteristic of being redeemable. Therefore, according to HKAS 32 Financial
Instruments: Presentation they must be classified as liability.
Answer 3
Note. The method to use here is to find the present value of the principal value of the bond, $2m
(100,000 $20) and the interest payments of $120,000 annually (6% $2m) at the market rate for
non-convertible bonds of 8%, using the discount factor tables. The difference between this total
and the principal amount of $2m is the equity element.
$
Present value of principal $2m 0.681 1,362,000
Present value of interest $120,000 3.993 479,160
Liability value 1,841,160
Principal amount 2,000,000
Equity element 158,840
Answer 4
(a) ABC should derecognise the asset as its option to repurchase is at the prevailing market
value.
(b) DEF should not derecognise the asset as it has retained substantially all the risks and
rewards of ownership. The stock should be retained in its books even though legal title is
temporarily transferred.
(c) XYZ has received 90% of its transferred receivables in cash, but whether it can retain this
amount permanently is dependent on the performance of the factor in recovering all of the
receivables. XYZ may have to repay some of it and therefore retains the risks and rewards of
100% of the receivables amount. The receivables should not be derecognised. The cash
received should be treated as a loan.
The 10% of the receivables that XYZ will never receive in cash should be treated as interest
over the six-month period; it should be recognised as an expense in profit or loss and
increase the carrying amount of the loan.
At the end of the six months, the receivables should be derecognised by netting them
against the amount of the loan that does not need to be repaid to the factor. The amount
remaining is bad debts which should be recognised as an expense in profit or loss.
541
Financial Reporting
Answer 5
(a) Amortised cost (b) FV through P/L
20X1 20X2 20X1 20X2
$'000 $'000 $'000 $'000
Profit or loss
Interest income (W1)/(W2) 1,200 1,200 1,200 1,387
Gain/(loss) due to change in
FV (W2) – – (187) –
1,200 1,200 1,013 1,387
Statement of financial
position
Financial asset (W1)/(W2) 20,000 – 19,813 –
WORKINGS
1 Amortised cost
$'000
Cash – 1.1.20X1 20,000
Effective interest at 6% (same as nominal as no discount on 1,200
issue/premium on redemption)
Coupon received (nominal interest 6% 20m) (1,200)
At 31.12.20X1 20,000
Effective interest at 6% 1,200
Coupon and capital received ((6% 20m) + 20m) (21,200)
At 31.12.20X2 –
2 Fair value
$'000
Cash 20,000
Effective interest (as above) 1,200
Coupon received (as above) (1,200)
Fair value loss (balancing figure) (187)
At 31.12.20X1 (W3) 19,813
Interest at 7% (7% 19,813) 1,387
Coupon and capital received ((6% 20m) + 20m) (21,200)
At 31.12.20X2 –
3 Fair value at 31.12.20X1
$'000
Interest and capital due on 31.12.20X2 at new market rate 19,813
(21.2m/1.07)
Answer 6
D $
Issue costs 30,000
Interest $1,000,000 5% 7 350,000
Premium on redemption 260,000
Total finance cost 640,000
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18: Financial instruments | Part C Accounting for business transactions
Answer 7
The bond is a "deep discount" bond and is a financial liability of Grumble Co.. It is measured at
amortised cost. Although there is no interest as such, the difference between the initial cost of the
bond and the price at which it will be redeemed is a finance cost. This must be allocated over the
term of the bond at a constant rate on the carrying amount.
To calculate amortised cost we need to calculate the effective interest rate of the bond:
1,000,000
= 1.191 over three years
839,619
1/3
To calculate an annual rate, we take the cube root, (1.191) = 1.06, so the annual interest rate is
6%
The charge to the statement of profit or loss and other comprehensive income is $50,377
($839,619 6%)
The balance outstanding at 31 December 20X2 is $889,996 ($839,619 + $50,377)
Answer 8
The equity investment is classified as available-for-sale. It does not meet the criteria to be
classified as any other type of financial asset:
RTC intends to hold it in the long term and so it is not held for trading and therefore is not
classified as at fair value through profit or loss.
Payments are not fixed or determinable (a dividend may be received but this is not
guaranteed) and so the investment is neither held-to-maturity nor loans and receivables.
The investment is initially measured at fair value (cost) plus transaction costs:
DEBIT Available-for-sale financial asset $13,500,000
CREDIT Cash $13,500,000
To record the acquisition of the equity investment and related transaction costs
Subsequently at the year-end, the investment is re-measured to fair value:
DEBIT Available-for-sale financial asset $1,100,000
CREDIT Other comprehensive income $1,100,000
To re-measure the equity investment to fair value.
Answer 9
The financial asset is classified as held-to-maturity since it has fixed payments and fixed maturity
and MMC has the positive intention and ability to hold it to maturity. (Note that it cannot be
classified as loans and receivables as it is quoted.)
MMC will receive interest of $590,000 (12.5m 4.72%) each year and $12.5 million when the
instrument matures.
MMC must allocate the discount of $2.5 million and the interest receivable over the five year term at a
constant rate on the carrying amount of the debt. To do this, it must apply the effective interest rate of
10%.
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Financial Reporting
Answer 10
A financial asset or group of assets is impaired when its recoverable amount is less than its
carrying amount. Possible indications would be:
(a) a trade receivable balance where it is now learnt that the credit customer is in financial
difficulties
(b) a borrower not paying an interest payment on time
(c) an investment in shares where the underlying company has filed for bankruptcy protection
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18: Financial instruments | Part C Accounting for business transactions
Exam practice
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Financial Reporting
was HK$70 million and the fair value of the liability component was HK$430 million. On 31
December 20X3, the fair value of the conversion option was HK$100 million and the fair value of
the liability component was HK$420 million.
For a compound instrument issued by GPL, GPL adopts an accounting policy to account for the
debt component at amortised cost and the conversion option, being an equity component is not
remeasured. For a hybrid instrument issued by GPL, GPL adopts an accounting policy to account
for the debt component at amortised cost and the conversion / early redemptions option, being a
derivative component, at fair value through profit or loss.
Required
(a) Discuss the accounting implications and prepare the journal entries with detailed calculations
for the issue of CB on 1 July 20X3. (5 marks)
(b) Prepare the journal entries with detailed calculations for the partial conversion of CB on 1
October 20X3. (5 marks)
(c) Assume there had not been any conversion in part (b), prepare the journal entries with
detailed calculations for the CB as at 31 December 20X3 and discuss the classification of
current / non-current of the CB in the statement of financial position. (6 marks)
(Note: Ignore any tax effect)
(Total = 16 marks)
HKICPA December 2014
546
chapter 19
Topic list
Learning focus
HKFRS 13 Fair Value Measurement provides guidance on how fair value should be
determined when another standard requires an item to be measured at fair value.
547
Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
LO3.17 Hedge accounting 2
3.17.02 Account for fair value hedges, cash flow hedges and hedges for net
investment
Prepare the financial statements for an individual entity in accordance
with Hong Kong Financial Reporting Standards and statutory reporting
requirements
LO4.01 Primary financial statement preparation 3
4.01.01 Prepare the statement of financial position, the statement of profit or
loss and other comprehensive income, the statement of changes in
equity and the statement of cash flows of an entity in accordance
with Hong Kong accounting standards
Prepare the financial statements for a group in accordance with Hong
Kong Financial Reporting Standards and statutory reporting
requirements
LO4.06 Business combinations 3
4.06.05 Explain the recognition principle and measurement basis of
identifiable assets and liabilities and the exception
4.06.12 Explain and account for measurement period adjustments
LO4.07 Investments in associates 3
4.07.03 Explain the reasons for and impact of equity accounting, including
notional purchase price allocation on initial acquisition, fair value
adjustments, upstream and downstream transactions, and uniform
accounting policies
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19: Fair value measurement | Part C Accounting for business transactions
The IASB and American standard-setter, FASB, added a project on fair value measurement to their
agenda in 2005 with the aim of developing a single source of guidance for all fair measurements
required or permitted by IFRS. Previously individual standards had included requirements on
determining and disclosing fair value. However as new standards were developed these
requirements became dispersed and inconsistent. Furthermore, whilst some standards provided
extensive fair value guidance, others contained very limited guidance. The effect of this was
diversity in practice, so resulting in reduced comparability among different entities’ financial
statements.
The fair value project was completed in 2011 when IFRS 13 Fair Value Measurement was issued;
this was subsequently adopted by HKICPA as HKFRS 13. The standard defines fair value and
provides a single framework for its measurement. It also provides requirements for the disclosure
of items measured at fair value in the financial statements and those items not measured at fair
value but for which fair value must be disclosed. On the issue of HKFRS 13, fair value
measurement and disclosure guidance was deleted from a number of existing standards.
1.1 Scope
HKFRS 13.5-
7 HKFRS 13 applies where another standard either requires or permits fair value measurement and /
or disclosures about fair value measurement. It also applies where a standard requires
measurement at modified fair value, eg fair value less costs to sell. The standard applies to both
initial and subsequent measurement.
HKFRS 13 does not apply to the following:
(a) the measurement and disclosure requirements do not apply to:
share-based payment transactions (HKFRS 2)
leasing transactions (HKAS 17)
measurements that have similarities to fair value but are not fair value eg net
realisable value (HKAS 2) and value in use (HKAS 36).
(b) the disclosure requirements do not apply to:
defined benefit plan assets measured at fair value (HKAS 19)
retirement benefit plan investments measured at fair value (HKAS 26)
assets for which recoverable amount is fair value (HKAS 36)
Key terms
Fair value is defined as the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date.
Orderly transaction is a transaction that assumes exposure to the market for a period before the
HKFRS 13 measurement date to allow for marketing activities that are usual and customary for transactions
Appendix A
involving such assets or liabilities; it is not a forced transaction (eg a forced liquidation or distress
sale).
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Financial Reporting
Market participants are buyers and sellers in the principal (or most advantageous) market for the
asset or liability that have all of the following characteristics:
(a) they are independent of each other ie they are not related parties as defined in HKAS 24,
although the price in a related party transaction may be used as an input to a fair value
measurement if the entity has evidence that the transaction was entered into at market
terms.
(b) they are knowledgeable, having a reasonable understanding about the asset or liability and
the transaction using all available information, including information that might be obtained
through due diligence efforts that are usual and customary.
(c) they are able to enter into a transaction for the asset or liability.
(d) they are willing to enter into a transaction for the asset or liability, ie they are motivated but
not forced or otherwise compelled to do so.
(HKFRS 13)
This definition of fair value is referred to as an ‘exit price’, in other words the determination of fair
value assumes that a party owns an asset (or has incurred a liability) and wishes to transfer it
rather than assuming that a party wants to acquire the asset or liability.
HKFRS Entities do not necessarily sell assets at the prices paid to acquire them or transfer liabilities at the
13.57-60 prices received to assume them. Where an HKFRS requires that an item is initially measured at fair
value, the difference between the two values may therefore lead to the recognition of a day one
gain or loss. Such gains or losses may commonly be recognised for assets or liabilities within the
scope of:
HKFRS 3 Business Combinations (the gain on a bargain purchase)
HKAS 39 Financial Instruments: Recognition and Measurement or HKFRS 9 Financial
Instruments
1.2.1 Orderly transaction
HKFRS
Fair value is determined by reference to an orderly transaction. Note that the following are not
13.B43 considered orderly transactions:
(a) a transaction in which there is only one potential buyer for an item.
(b) a transaction that was entered into and performed in a time that is not long enough to carry
on marketing and due diligence efforts that are usual and customary for transactions
involving such items.
(c) a transaction which the seller is compelled to enter into and complete (eg for financial
reasons or regulatory instruction)
(d) a transaction in which the seller is near bankruptcy/receivership
2 Measurement approach
Fair value is a market-based, rather than an entity-specific, measurement. It is therefore measured
using the assumptions that market participants would use when pricing the asset under current
market conditions, taking into account any relevant characteristics of the asset. Whether an entity
actually intends to hold an asset or settle a liability is irrelevant when measuring fair value.
HKFRS 13 states that in order to determine the fair value of an item, all of the following should be
HKFRS 13. considered:
B2
1. The asset or liability that is being measured
2. The highest and best use (for a non-financial asset)
3. The principal or most advantageous market
4. Appropriate valuation technique(s)
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19: Fair value measurement | Part C Accounting for business transactions
Key terms
Unit of account is the level at which an asset or liability is aggregated or disaggregated in an IFRS
for recognition purposes.
Fair value measurements are based on an asset or a liability's unit of account, which is specified
by each FRS where a fair value measurement is required. For most assets and liabilities, the unit of
account is the individual asset or liability, but in some instances may be a group of assets or
liabilities.
Example: Unit of account
When determining the fair value of an entity’s 75% investment in the 100,000 equity shares of
another company, the unit of account may either be:
each individual share, such that total fair value of the investment is 75,000 fair value per
share, or
the 75% shareholding, such that the total fair value may be determined to include a control
premium.
The issue of the unit of account for shareholdings is currently under review by the IASB, and an
exposure draft was issued in 2014 which proposes that quoted investments in subsidiaries,
associates and joint ventures are measured as the quoted price multiplied by the quantity of
shares, without adjustment.
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Financial Reporting
Self-test question 1
Hornblower Pacific (‘HP’) acquires a research and development project as part of a business
combination. HP does not intend to complete the project, as if it were completed, it would compete
with one of HP’s own technologies under development. Instead HP intends to ‘lock up’ the project
to prevent its competitors from accessing the technology. Therefore the project principally provides
defensive value to HP by improving the prospects for the output of its own project and preventing
competitor access to the developed technology.
Required
How might the highest and best use of the project be determined for the purpose of measuring fair
value in order to apply HKFRS 3?
(The answer is at the end of the chapter)
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19: Fair value measurement | Part C Accounting for business transactions
Key terms
Principal market is the market with the greatest volume and level of activity for the asset or
liability.
Most advantageous market is the market that maximises the amount that would be received to
sell the asset or minimises the amount that would be paid to transfer the liability after taking into
account transaction costs and transport costs.
(HKFRS 13)
Self-test question 2
The following information relates to the inventory held by Pacific Components on its acquisition by
Global Parts Co.
Product line 1 (100,000 units)
Market Asia Europe Africa
Sales volume in previous 12 months 240,300 180,300 90,200
$ $ $
Selling price per unit 350 390 325
Transaction costs 10 20 15
Transport to market costs 5 30 20
Net price received 335 340 290
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Financial Reporting
Required
Determine the fair value of the inventory for the purposes of applying HKFRS 3 Business
Combinations.
(The answer is at the end of the chapter)
Self-test question 3
Tower Investments acquired a property by way of a finance lease in the year ended 31 December
20X3. It sublets the property to small businesses. The lease stipulates that the property must be
used for commercial rather than residential purposes. This restriction is not imposed by the
planning authorities and therefore at a future date the property could be used for residential
purposes. The owner has established that were the property to be sold at 31 December 20X3, it
would raise $29million if sold as a residential apartment block or $25million if sold as offices. In
either case, legal fees of 1% of the sale price would be incurred.
Required
Explain how the fair value of the property is determined.
Approach Techniques
Market approach A valuation technique that uses prices and other relevant information
generated by market transactions involving identical or comparable
assets and liabilities.
Cost approach A valuation technique that reflects the amount that would be required
currently to replace the service capacity of an asset.
Income approach A valuation technique that converts future amounts (eg cash flows or
income) to a single discounted amount. The fair value measurement is
determined on the basis of the value indicated by current market
expectations about those future amounts.
Entities must use a valuation technique (or techniques) consistent with one of these three
approaches to measure fair value in a given situation.
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19: Fair value measurement | Part C Accounting for business transactions
Certain techniques are better suited to particular circumstances. For example, an income approach
is better suited to a service industry whereas a cost or asset based approach may be better suited
to a property company.
Whichever valuation technique is selected should be applied consistently from period to period. A
change of valuation technique is only appropriate if the change results in a measurement that is
equally or more representative of fair value in the circumstances. This may be the case if:
new markets develop
available information changes
valuation techniques improve
market conditions change
A change in technique may also be required where there are quoted prices for an item but market
activity declines. In this case the emphasis must be on whether a transaction price is based on an
orderly transaction, rather than a forced sale.
A change in valuation technique is considered to be a change of accounting estimate in
accordance with HKAS 8, and must be disclosed in the financial statements.
2.4.2 Fair value hierarchy
In order to use a valuation technique, additional information, or ‘inputs’ are required. For example in
the case of an equity investment in a listed company:
INPUT VALUATION
TECHNIQUE
HKFRS
HKFRS 13 introduces a fair value hierarchy that categorises inputs to valuation techniques into
13.72, 73, 76, three levels: level 1, level 2 and level 3. Level 1 inputs are observable and the most reliable; level
81, 82, 86 3 inputs are unobservable and the least reliable type of input.
The objective of this hierarchy is to increase consistency and comparability in fair value
measurements and related disclosures,
The fair value hierarchy gives the highest priority to level 1 inputs and the lowest priority to level 3
inputs:
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or
liabilities that the entity can access at the measurement date.
Level 2 inputs are inputs other than quoted prices included within Level 1 that are
observable for the asset or liability, either directly or indirectly, for example:
Quoted prices for similar assets in active markets
Quoted prices for identical or similar assets in non-active markets
Inputs other than quoted prices that are observable for the asset such as interest rates
Further examples are provided in HKFRS 13 Appendix B paragraph B35.
Level 3 inputs are unobservable inputs for the asset or liability, using the entity's own
assumptions about market exit value. Further examples are provided in HKFRS 13 Appendix
B paragraph B36.
Level 3 inputs are used to measure fair value to the extent that relevant observable inputs are not
available, so allowing for situations where there is little, if any, market activity for an asset at the
measurement date.
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Financial Reporting
An items fair value is categorised according to the lowest level input. Therefore a fair value
measurement of quoted shares based on the unadjusted share price is a level 1 measurement,
whereas a fair value measurement of an unquoted investment using a valuation technique based
on discounted cash flows is a level 3 measurement.
Example: Fair value hierarchy
The fair value of an equity investment in an unquoted healthclub company, Fit Fast Co is
determined based upon the company’s earnings before interest, tax, depreciation and amortisation
(EBITDA), multiplied by a published price earnings ratio applicable to quoted companies in the
healthcare and fitness sector adjusted for lack of marketability.
Required
What level are the inputs used in determining fair value and what is the category of the fair value
measurement?
Solution
The inputs are:
The price earnings ratio applicable to quoted companies in the same sector is a level 1 input,
however the adjustment to it for lack of marketability is a level 3 input. The EBITDA of Fit Fast Co
Is a level 2 input.
Therefore overall the measurement is a Level 3 measurement.
The following table details examples of inputs that may be used to measure fair value:
Level 1 Equity shares in a listed company Unadjusted quoted prices in an active market
Level 2 Licensing arrangement arising Royalty rate in the contract with the unrelated
from a business combination party at inception of the arrangement
Cash-generating unit Valuation multiple (eg a multiple of earnings or
revenue or a similar performance measure)
derived from observable market data, eg from
prices in observed transactions involving
comparable businesses
Finished goods inventory at a Price to customers adjusted for differences
retail outlet between the condition and location of the
inventory item and the comparable (ie similar)
inventory items
Building held and used Price per square metre derived from observable
market data, eg prices in observed transactions
involving comparable buildings in similar locations
Level 3 Cash-generating unit Financial forecast (eg of cash flows or profit or
loss) developed using the entity’s own data
Three-year option on exchange- Historical volatility, ie the volatility for the shares
traded shares derived from the shares’ historical prices
Interest rate swap Adjustment to a mid-market consensus (non-
binding) price for the swap developed using data
not directly observable or otherwise corroborated
by observable market data
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19: Fair value measurement | Part C Accounting for business transactions
557
Financial Reporting
to the bank is just $800,000. The bank will not agree to discount the amount paid by Manford Co to
extinguish the loan.
Taper Co is seeking similar financing to the bank loan and has a similar credit profile to Manford
Co. Taper Co is indifferent to obtaining a new bank loan or assuming Manford Co’s bank loan.
Required
What is the fair value (transfer value) of Manford Co’s bank loan?
Solution
As Taper Co has the same credit profile as Manford Co, if it were to take out a bank loan, the bank
would lend only $800,000 (the market value of Manford Co’s loan) in return for the same cash flows
as are outstanding in respect of Manford Co’s loan. This is because the bank would require a
higher rate of interest to compensate for the increased credit risk.
Therefore the transfer value (fair value ) of Manford Co’s loan is $800,000.
Self-test question 4
Colne Co and Padiham Co individually enter into legal obligations to each pay $200,000 to Lanco
Co in seven years in exchange for some goods.
Colne Co has a very good credit rating and can borrow at 4%. Padiham Co’s credit rating is lower
and it can borrow at 8%.
Required
What is the fair value of the legal obligation that Colne Co and that Padiham Co must record in
their financial statements?
No
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19: Fair value measurement | Part C Accounting for business transactions
4 Disclosure
HKFRS
13.91-99 HKFRS 13 requires disclosures to help users assess:
(a) for assets and liabilities measured at fair value on a recurring or non-recurring basis after
initial recognition, the valuation techniques and inputs used to develop those measurements.
(b) for recurring fair value measurements (i.e. those measured at each period end) using
significant unobservable (level 3) inputs, the effect of the measurements on profit or loss or
other comprehensive income for the period.
In order to achieve this, the following should be disclosed as a minimum for each class of financial
assets and liabilities measured at fair value (asterisked disclosures are also required for financial
assets and liabilities measured at amortised cost but for which fair value is disclosed):
(a) The fair value measurement at the end of the period, and for non-recurring measurements
the reason for the measurement.
(b) The level of the fair value hierarchy within which the fair value measurements are
categorised in their entirety.*
(c) For assets and liabilities measured at fair value at each reporting date (recurring fair value
measurements), the amounts of any transfers between level 1 and level 2 of the fair value
hierarchy and reasons for the transfers
(d) For fair value measurements categorised within level 2 and 3 of the hierarchy, a description
of the valuation techniques and inputs used in the fair value measurement, plus details of
any changes in valuation techniques.*
(e) For fair value measurements categorised within level 3 of the fair value hierarchy,
quantitative information about the significant unobservable inputs used in the fair value
measurement.
(f) For recurring fair value measurements categorised within level 3 of the fair value hierarchy:
A reconciliation from the opening to closing balances
The amount of unrealised gains or losses recognised in profit or loss in the period and
the line item in which they are recognised
A narrative description of the sensitivity of the fair value measurement to changes in
unobservable inputs
(g) For recurring and non-recurring fair value measurements categorised within level 3 of the fair
value hierarchy, a description of the valuation processes used by the entity.
(h) For recurring and non-recurring fair value measurements, if the highest and best use of a
non-financial asset differs from its current use, a disclosure of that fact and why the asset is
being used in a different way from its highest and best use.*
An entity should also disclose its policy for determining when transfers between levels of the fair
value hierarchy are deemed to have occurred.
For each class of assets and liabilities that are not measured at fair value but for which fair value is
disclosed, the asterisked (*) information listed above is required.
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Financial Reporting
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19: Fair value measurement | Part C Accounting for business transactions
Topic recap
Measurement approach
561
Financial Reporting
Answer 1
The highest and best use of the project is determined on the basis of use of the project by market
participants, which may be:
(a) Continuing with the development
If market participants would continue to develop the project and that use would maximise the
value of the group of assets or of assets and liabilities in which the project would be used (ie
the asset would be used in combination with other assets or with other assets and liabilities).
The fair value of the project would be measured on the basis of the price that would be
received in a current transaction to sell the project, assuming that the R&D would be used
with its complementary assets and the associated liabilities and that those assets and
liabilities would be available to market participants.
(b) Ceasing development for competitive reasons
If market participants would lock up the project and that use would maximise the value of the
group of assets or of assets and liabilities in which the project would be used.
The fair value of the project would be measured on the basis of the price that would be
received in a current transaction to sell the project, assuming that the R&D would be used (ie
locked up) with its complementary assets and the associated liabilities and that those assets
and liabilities would be available to market participants.
(c) Ceasing development
If market participants would discontinue development because the project is not expected to
provide the required rate of return and would not provide defensive value through being
locked up.
The fair value of the project would be measured on the basis of the price that would be
received in a current transaction to sell the project on its own (which might be zero).
Answer 2
Product line 1
Product line 1 is sold in three markets – Asia, Europe and Africa.
Asia is the principal market as it has the greatest sales volume.
If a principal market exists then the price in that market must be used to establish fair value.
Fair value takes into account transport costs but not transaction costs.
The selling price of product line 1 in Asia is $350 and transport costs are $5. Therefore the
fair value of one unit is $345.
The fair value of inventory held is therefore 100,000 $345 = $34,500,000.
Product line 2
Product line 2 is sold in equal volumes in Asia and Africa. Therefore there is no principal
market.
The most advantageous market is Africa as each sale in this market results in greater net
proceeds ($2,180) than each sale in Asia.
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19: Fair value measurement | Part C Accounting for business transactions
Although transaction costs are taken into account when determining the most advantageous
market, fair value once determined is not adjusted for these costs.
Fair value is based on the African market despite the fact that the fair value of $2,230 (selling
price $2,450 less transport costs of $220) is less than the equivalent amount in the Asian
market ($2,300 - $60 = $2,240).
The fair value of inventory held is therefore 500 $2,230 = $1,115,000.
The total fair value of inventory is $34,500,000 + $1,115,000 = $35,615,000
Answer 3
The fair value is determined in accordance with HKFRS 13 by reference to exit (selling) prices. It is
assumed that the property will be sold to a market participant that will use the property in its highest
and best use. In this case the higher value is $29m for residential purposes.
Where there is a restriction in use of an asset, as is the case here, HKFRS 13 considers whether
that restriction would be passed on to a purchaser in a future sale. That is not the case here – the
property could be used on a residential basis in the future. Therefore the current restriction in use is
not relevant when determining fair value.
Transaction costs are not taken into account when determining fair value and therefore the 1%
legal fees are not relevant.
Fair value is therefore $29 million.
Answer 4
The fair value of Colne Co’s promise is approximately $152,000. This is the present value of
7
$200,000 in seven years at 4% ($200,000 x 1/1.04 ).
The fair value of Padiham Co’s promise is approximately $116,600. This is the present value of
7
$200,000 in seven years at 8% ($200,000 x 1/1.08 ).
These two values are different, even though the amount and period are the same, due to the
different risk profiles of the two companies.
563
Financial Reporting
Exam practice
$ million
3,000,000 ordinary shares of Long Pont Limited (LP), a company listed on London 9.0
Stock Exchange, which represent less than 1% of the total number of issued shares
of LP.
400 ordinary shares of Printon Medical Inc. (PMI), a privately owned entity, which 8.0
accounted for 10% equity interest in PMI.
6 million shares of Micro Vision Company (MVC), a privately owned entity, with total 12.0
number of issued shares of 14 million. ZIL can appoint three out of eight directors to
the board of MVC.
A loan lent to Goldstan Enterprise (GE) on 1 January 2013, carried interest at HIBOR 15.0
plus 4% payable in arrears at the anniversary date of the lending, repayable on 31
December 20X6. The rate of HIBOR is determined at 1 January of each annual
period.
Required
(a) Explain the appropriate accounting treatment (including classification between current and
non-current presentation) for the above investments in the consolidated statement of
financial position of ZIL as at 30 June 20X3 in accordance with HKFRS 9 Financial
Instruments and other applicable standards. (14 marks)
(b) For those investments which will be subsequently measured at fair value after acquisition,
identify the appropriate level of fair value hierarchy under HKFRS 13 Fair Value
Measurement. (4 marks)
(Total = 18 marks)
564
chapter 20
Topic list
Learning focus
Statements of cash flows are very relevant in practice. They are a required element of a set of
financial statements and often provide more useful information than that within the other
financial statements with regard to liquidity.
565
Financial Reporting
Learning outcomes
Competency
level
Prepare the financial statements for an individual entity in accordance
with Hong Kong Financial Reporting Standards and statutory reporting
requirements
4.01 Primary financial statement preparation 3
4.01.01 Prepare the statement of financial position, the statement of profit or
loss and other comprehensive income, the statement of changes in
equity and the statement of cash flows of an entity in accordance
with Hong Kong accounting standards
4.09 Consolidated financial statement preparation 3
4.09.03 Prepare a consolidated statement of cash flows
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20: Statements of cash flows | Part C Accounting for business transactions
Cash is a key element of any business. It must be monitored and managed in order to maintain a
liquid position. While the statement of financial position provides a period end cash balance, this in
itself does not provide any indication of how an entity generates, uses and manages its cash.
Similarly, profit, while providing a good indication of the performance of an entity does not provide
any indication of the liquidity of a business, since it is calculated using the accrual basis.
The statement of cash flows is therefore required to form part of a set of financial statements by
HKAS 1. HKAS 1 does not, however, prescribe the format and content of a statement of cash
flows. This guidance is provided within HKAS 7 Statement of Cash Flows.
Before considering the standard, it is important to appreciate the advantages of cash flow
information.
567
Financial Reporting
(k) Variance statements, which compare actual cash flows against the forecast, can be used to
monitor forecasts.
Looking at the same question from a different angle, readers of accounts can be misled by the
profit figure.
(a) Shareholders might believe that if a company makes a profit after tax of, say $1 million then
this is the amount which it could afford to pay as a dividend. Unless the company has
sufficient cash available to stay in business and also to pay a dividend, the shareholders'
expectations would be wrong.
(b) Employees might believe that if a company makes profits, it can afford to pay higher wages
next year. This opinion may not be correct: the ability to pay wages depends on the
availability of cash.
(c) Creditors might consider that a profitable company is a going concern.
(i) If a company builds up large amounts of unsold inventories of goods, their cost
would not be chargeable against profits, but cash would have been used up in making
them, thus weakening the company's liquid resources.
(ii) A company might capitalise large development costs, having spent considerable
amounts of money on research and development, but only charge small amounts
against current profits. As a result, the company might show reasonable profits, but
get into severe difficulties with its liquidity position.
(d) Management might suppose that if their company makes a historical cost profit, and
reinvests some of those profits, then the company must be expanding. This is not the case:
in a period of inflation, a company might have a historical cost profit but a current cost
accounting loss, which means that the operating capability of the firm will be declining.
(e) Survival of a business entity depends not so much on profits as on its ability to pay its debts
when they fall due. Such payments might include "profit and loss" items such as material
purchases, wages, interest and taxation etc., but also capital payments for new non-current
assets and the repayment of loan capital when this falls due (e.g. on the redemption of
debentures).
1.2.1 Objective
The objective of this standard is to require the provision of information about the historical changes
in cash and cash equivalents of an entity by means of a statement of cash flows which classifies
cash flows during the period from operating, investing and financing activities.
1.2.2 Scope
Users of an entity's financial statements are interested in how the entity generates and uses cash
and cash equivalents. This is the case regardless of the nature of the entity's activities. Therefore,
all entities must provide a statement of cash flows as an integral part of an entity's financial
statements.
HKAS 7.6-9 1.2.3 Definitions
The standard gives the following definitions, the most important of which are cash and cash
equivalents.
568
20: Statements of cash flows | Part C Accounting for business transactions
Key terms
Cash comprises cash on hand and demand deposits.
Cash equivalents are short-term, highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of changes in value.
Cash flows are inflows and outflows of cash and cash equivalents.
Operating activities are the principal revenue-producing activities of the entity and other activities
that are not investing or financing activities.
Investing activities are the acquisition and disposal of long-term assets and other investments not
included in cash equivalents.
Financing activities are activities that result in changes in the size and composition of the
contributed equity and borrowings of the entity. (HKAS 7)
The standard expands on the definition of cash equivalents: they are held to meet short-term cash
commitments rather than for investment or other long-term purposes. They are required to:
1 be readily convertible to a known amount of cash and therefore their maturity date should
normally be three months from its acquisition date
2 be subject to an insignificant risk of changes in value.
Based on the definition, therefore:
Deposits available on demand are cash equivalents;
Deposits with a fixed maturity of more than three months are not cash equivalents;
Pledged deposits (amounts held by banks as security) are not cash equivalents;
Money market holdings, short-term government bonds and treasury bills are cash
equivalents;
Equity investments (i.e. holdings of ordinary shares in other companies) are not cash
equivalents;
Preference share investments are cash equivalents where acquired within a short period
of their maturity and with a specified redemption date;
Where bank overdrafts are repayable on demand and are treated as part of an entity's total
cash management system, an overdrawn balance is included in cash and cash equivalents;
Loans and other borrowings are not cash equivalents, but instead are classified as cash
flows from financing activities.
Movements between different types of cash and cash equivalents are not included in cash flows.
The investment of surplus cash in cash equivalents is part of cash management, not part of
operating, investing or financing activities.
569
Financial Reporting
HKAS
7.10,11
2.1 Presentation of a statement of cash flows
According to HKAS 7, reported cash flows during a period should be classified into operating,
investing and financing activities in a statement of cash flows.
The way of presenting cash flows under operating, investing and financing activities is dependent
on the nature of the reporting entity. The classification enables users to understand the impact of
each activity on cash and cash equivalents and their interrelationship.
570
20: Statements of cash flows | Part C Accounting for business transactions
571
Financial Reporting
The most obvious way to obtain information about gross cash receipts and payments is simply to
extract the information from the accounting records. An alternative method involves adjusting sales,
cost of sales and other items in the statement of profit or loss for:
changes in inventories, receivables and payables during the period
other non-cash items
other items for which the cash effects are investing or financing cash flow.
Practically, this involves reconstructing nominal ledger accounts in order to extract cash flows. This
may be a laborious task, however, and the indirect method described below may be easier.
572
20: Statements of cash flows | Part C Accounting for business transactions
It is important to understand why certain items are added and others subtracted. Note the
following points:
(a) Depreciation is not a cash expense, but is deducted in arriving at the profit figure in the
statement of profit or loss. It makes sense, therefore, to eliminate it by adding it back.
(b) By the same logic, a loss on a disposal of a non-current asset (arising through
underprovision of depreciation) needs to be added back and a profit deducted.
(c) An increase in inventories means less cash – you have spent cash on buying inventory.
(d) An increase in receivables means the company's debtors have not paid as much, and
therefore there is less cash.
(e) A decrease in payables means the company has paid more to suppliers and so has less
cash.
The illustration below shows a full statement of cash flows using the indirect method.
573
Financial Reporting
Example: Interest
Odile Co. reports the following amounts in its financial statements relating to interest:
$
Finance costs in the statement of profit or loss 8.7
Interest accrued at start of year 1.2
Interest accrued at end of year 3.1
What is Odile Co.’s interest paid?
Solution
Interest paid is calculated as 1.2m + 8.7m – 3.1m = $6.8 million.
574
20: Statements of cash flows | Part C Accounting for business transactions
575
Financial Reporting
Where non-current assets are disposed of, the cash proceeds is calculated by adding any profit on
disposal (or deducting any loss) to (from) the carrying value of the disposals (identified from the
non-current asset note).
Example: Cash flows associated with non-current assets
The following extracts are taken from the financial statements of Rooibus for the year ended
30 September 20X0:
STATEMENT OF FINANCIAL POSITION
20X0 20W9
$m $m
Cost of PPE 520 420
Accumulated depreciation 165 189
Solution
Cost $m Depreciation $m
b/f 420 b/f 189
Additions (balancing) 165 Charge 55
Revaluation 20 Disposals (balancing) (79)
Disposal (85) c/f 165
c/f 520
Cash paid to acquire non-current assets $165m
Proceeds of sale of non-current assets (85m – 79m – 5.5m) $0.5m
2.4 Disclosure
HKAS 7.43 2.4.1 Non cash transactions
Investing and financing transactions that do not require the use of cash or cash equivalents shall
be excluded from a statement of cash flows. Such transactions shall be disclosed elsewhere in the
financial statements in a way that provides all the relevant information about these investing and
financing activities.
HKAS 2.4.2 Components of cash and cash equivalents
7.45,46
The components of cash and cash equivalents should be disclosed and a reconciliation should be
presented, showing the amounts in the statement of cash flows reconciled with the equivalent
items reported in the statement of financial position.
576
20: Statements of cash flows | Part C Accounting for business transactions
It is also necessary to disclose the accounting policy used in deciding the items included in cash
and cash equivalents, in accordance with HKAS 1, but also because of the wide range of cash
management practices worldwide.
Illustration
Accounting policies
For the purpose of the consolidated statement of cash flows, cash and cash equivalents comprise
cash on hand and demand deposits, and short-term highly liquid investments that are readily
convertible into known amounts of cash, are subject to an insignificant risk of changes in value, and
have a short maturity of generally within three months when acquired, less bank overdrafts which
are repayable on demand and form an integral part of the Group’s cash management.
For the purpose of the statement of financial position, cash and cash equivalents comprise cash on
hand and at banks, including term deposits and assets similar in nature to cash, which are not
restricted as to use.
Cash and cash equivalents
20X4 20X3
$’000 $’000
Cash and bank balances other than time deposits 290,000 276,000
Time deposits with original maturity of less than three - 37,000
months when acquired
Cash and cash equivalents 290,000 313,000
Bank balances other than time deposits earn interest at floating rates based on daily bank deposit
rates. Short-term time deposits are made for varying periods of between one day and three months
depending on the immediate cash requirements of the Group, and earn interest at the respective
short term time deposit rates. The bank deposits are deposited with creditworthy banks with no
recent history of default.
577
Financial Reporting
578
20: Statements of cash flows | Part C Accounting for business transactions
579
Financial Reporting
HKAS Consolidated statements of cash flows are prepared in the same way as a single company
7.37,39 statement of cash flows, however they include extra line items:
Acquisitions and disposals of subsidiaries are reported as cash flows from investing activities
Dividends paid to the non-controlling interests are reported as cash flows from financing
activities
Dividends received from associates and joint ventures accounted for using the equity
method are reported as cash flows from operating activities
Cash flows that are internal to the group should be eliminated in the preparation of a consolidated
statement of cash flows.
Example: Elimination of intra-group cash flows
Cann Co. disposed of property, plant and equipment with a carrying value of $215,000 in the year
ended 31 October. The company reported a profit on the combined disposals of $39,500. Included
within the disposal figures was a machine sold to Cann's subsidiary Wood Co. for $12,400.
During the year, Wood disposed of property, plant and equipment with a carrying value of $43,000,
recording a loss on disposal of $5,600. All disposals were made to companies outside the group.
580
20: Statements of cash flows | Part C Accounting for business transactions
What amount will be reported as proceeds on disposal of property, plant and equipment in the
consolidated statement of cash flows?
Solution
Cann $'000 $'000
Carrying amount on disposal 215.0
Profit on disposal 39.5
254.5
Less: intercompany proceeds (12.4)
242.1
Wood
Carrying amount on disposal 43.0
Loss on disposal (5.6)
37.4
Consolidated proceeds on disposal 279.5
You should also remember that adjustments made to consolidated profit for non-cash items in the
reconciliation to cash flows from operating activities should reflect the amounts included within the
consolidated statement of profit or loss and other comprehensive income. Therefore, for example,
the amount of depreciation or profit on disposal should take into account any consolidation
adjustment.
Example: Consolidation adjustments
Landon Co. acquired 80% of Crowther Co. a number of years ago. In the year ended 31 December
20X1, Landon reported a depreciation charge of $560,000 and Crowther reported a depreciation
charge of $320,000. At the start of that year, Landon transferred a machine to Crowther with a
resulting increase in depreciation of $10,000 per annum.
The adjustment required to consolidated profit for the purposes of calculating cash flows from
operating activities is therefore:
$'000
Landon depreciation 560
Crowther depreciation 320
Consolidation adjustment (10)
Added back to profit in respect of depreciation 870
HKAS
7.39,42 3.1 Acquisitions and disposals of subsidiaries
Where a subsidiary undertaking joins or leaves a group during a financial year the cash flows of
the group should include the cash flows of the subsidiary undertaking concerned for the same
period as that for which the group's statement of profit or loss and other comprehensive income
includes the results of the subsidiary undertaking.
If a subsidiary is acquired or disposed of during the accounting period the net cash effect of the
purchase or sale transaction should be shown separately under "Cash flows from investing
activities".
581
Financial Reporting
The net cash effect is the cash purchase price/cash disposal proceeds net of any cash or cash
equivalents acquired or disposed of:
As the cash effect of the acquisition/disposal of the subsidiary is dealt with in a single line item,
care must be taken not to double count the effects of the acquisition/disposal when looking at the
movements in individual asset balances.
Each of the individual assets and liabilities of a subsidiary acquired/disposed of during the period
must be excluded when comparing group statements of financial position for cash flow calculations
as follows:
Where a subsidiary is acquired in the period: property, plant and equipment, inventories,
payables, receivables etc. at the date of acquisition should be subtracted from the movement
on these items.
Where a subsidiary is disposed of in the period: property, plant and equipment,
inventories, payables, receivables etc. at the date of disposal should be added to the
movement on these items.
Example: Disposal of subsidiary
Extracts from the statements of financial position of the Burke Group at 31 December are as
follows:
20X2 20X1
$'000 $'000
Current assets
Inventory 664 791
Trade receivables 515 532
Cash 214 431
Current liabilities
Trade payables 590 645
During the year ended 31 December 20X2, the Burke Group sold its controlling interest in Bryan
Co. for $6.5 million in cash. On the disposal date, balances included in Bryan’s statement of
financial position were as follows:
$'000
Current assets
Inventory 103
Trade receivables 45
Cash 79
Current liabilities
Trade payables 67
(a) What adjustments are required to consolidated profit in respect of working capital in order to
calculate cash flows from operating activities?
(b) What is the cash flow reported in investing activities in respect of the disposal of Bryan Co.?
582
20: Statements of cash flows | Part C Accounting for business transactions
Solution
(a) Working capital adjustments must take account of the disposal of Bryan Co.
$'000
Inventory
b/f 791
c/f 664
Decrease 127
Less: amount attributable to disposal (103)
Decrease in inventory (added back to profit) 24
Trade receivables
b/f 532
c/f 515
Decrease 17
Less: amount attributable to disposal (45)
Increase in receivables (deducted from profit) (28)
Trade payables
b/f 645
c/f 590
Decrease 55
Less: amount attributable to disposal (67)
Increase in payables (added back to profit) 12
Illustration
The following illustrates the disclosure requires where a subsidiary is acquired:
Business combinations
Consideration transferred
583
Financial Reporting
The Company acquired 100% of the equity shares in Subsidiary Co during the year. Consideration
transferred was as follows:
Subsidiary Co
$000
Cash 5,600
Contingent consideration arrangement 350
5,950
The contingent consideration requires the Company to pay the vendors an additional $500,000 if
Subsidiary Co’s profit before interest and tax in the two years post-acquisition exceeds $1million.
$350,000 represents the estimated fair value of this obligation.
Assets acquired and liabilities recognise at the date of acquisition
Subsidiary Co
$000
Current assets
Cash and cash equivalents 90
Trade and other receivables 350
Inventories 180
Non-current assets
Plant and equipment 5,250
Current liabilities
Trade and other payables (210)
Non-current liabilities
Deferred tax liabilities (340)
5,320
HKAS 7.42A
3.1.2 Changes in ownership interest with no loss of control
Changes in ownership interests in a subsidiary that do not result in a loss of control, such as the
subsequent purchase or sale by a parent of a subsidiary's equity instruments, are accounted for as
equity transactions (see HKFRS 10 Consolidated Financial Statements) unless the subsidiary is
held by an investment entity and measured at fair value through profit or loss.
Accordingly, the resulting cash flows are classified in the same way as other transactions with
owners, as cash flows from financing activities.
584
20: Statements of cash flows | Part C Accounting for business transactions
Solution
The non-controlling interests share of profit after tax represents retained profit plus dividends paid.
NON-CONTROLLING INTEREST
$'000
Balance as at 31 December 20X8 345
Profit for the period 42
Example: Associate
The following are extracts of the consolidated results of Connie Company for the year ended
31 December 20X9.
585
Financial Reporting
Solution
The associate profit after tax represents retained profit plus dividend.
ASSOCIATE
$'000
Balance as at 31 December 20X8 306
Share of profit for the period 36
586
20: Statements of cash flows | Part C Accounting for business transactions
As this amount is already included within profit for the year, no further adjustment is required:
$'000
Revenue 40
Exchange loss (3)
Net amount reported in profit 37
587
Financial Reporting
Self-test question 1
The draft consolidated accounts for Bestway Co. are shown below:
DRAFT CONSOLIDATED STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31
DECEMBER 20X8
$'000
Operating profit 13,365
Share of profits after tax of associates 4,950
Finance cost (1,350)
Profit before taxation 16,965
Income tax (4,860)
Profit for the year 12,105
Attributable to: owners of the parent 11,205
non-controlling interest 900
12,105
DRAFT CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER
20X8 20X7
$'000 $'000 $'000 $'000
Assets
Non-current assets
Buildings 18,675 19,800
Machinery 16,200 2,700
34,875 22,500
Goodwill 900 -
Investments in associates 13,590 12,690
49,365 35,190
Current assets
Inventories 17,775 9,000
Trade receivables 16,650 11,475
Cash 40,635 16,380
75,060 36,855
124,425 72,045
588
20: Statements of cash flows | Part C Accounting for business transactions
20X8 20X7
$'000 $'000 $'000 $'000
Equity and liabilities
Equity
Share capital 61,407 36,855
Retained earnings 31,005 22,500
92,412 59,355
Non-controlling interest 1,035 –
93,447 59,355
Non-current liabilities
Loans 19,530 6,030
Deferred tax 270 117
19,800 6,147
Current liabilities
Trade payables 6,660 4,320
Income tax 4,158 1,953
Accrued finance charges 360 270
11,178 6,543
124,425 72,045
Notes
1 There had been no acquisitions or disposals of buildings during the year. The depreciation
charge for the year was $1,125,000 for buildings and $1,800,000 for machinery. Machinery
costing $3m was sold for $3m resulting in a profit of $900,000.
2 On 1 January 20X8 Bestway Co. acquired a 75% interest in Oneway Co.. The net assets at
acquisition were as follows:
$'000
Machinery 1,485
Inventories 288
Trade receivables 252
Cash 1,008
Trade payables (612)
Income tax (153)
2,268
Non-controlling interest (567)
1,701
Goodwill 900
2,601
7,920,000 shares issued as part consideration 2,475
Balance of consideration paid in cash 126
2,601
3 A dividend of $2,700,000 was paid during the year.
Required
Prepare a consolidated statement of cash flows for the Bestway Group for the year ended
31 December 20X8 as required by HKAS 7.
(The answer is at the end of the chapter)
Self-test question 2
Consolidated statement of financial position of the Jade Group as at 31 December
589
Financial Reporting
20X5 20X4
Non-current assets $m $m
Property, plant and equipment 590 440
Goodwill 9 13
Investment in associate 17 14
616 467
Current assets
Inventories 99 93
Trade receivables 137 114
Short-term deposits 3.5 2
Cash 18 12
257.5 221
873.5 688
Equity attributable to owners of the parent
Share capital 230 150
Revaluation surplus 5 -
Retained earnings 340 332
575 482
Non-controlling interest 8 17.5
583 499.5
Non-current liabilities
Borrowings 140 100
Finance lease obligations 15 4.5
Deferred tax 30 27.5
185 132
Current liabilities
Trade payables 90.5 49.5
Accrued interest 0.7 0.9
Finance lease obligations 7.5 1
Income tax payable 6.8 5.1
105.5 56.5
873.5 688
Consolidated statement of profit or loss of the Jade Group for the year ended 31 December 20X5
20X5
$m
Revenue 98.5
Cost of sales (55)
Gross profit 43.5
Other operating expenses (21)
Profit from operations 22.5
Finance cost (10)
Gain on sale of subsidiary 3
Share of profit of associate 5
Profit before tax 20.5
Tax (4.8)
Profit after tax 15.7
Profit attributable to:
Owners of the parent 12.6
Non-controlling interest 3.1
590
20: Statements of cash flows | Part C Accounting for business transactions
Notes:
1 There was no other comprehensive income
2 Land was revalued upwards during the year and depreciation of $8 m was charged to profit
or loss in respect of other property, plant and equipment. Additions of plant include $30
million acquired under finance leases. A factory was disposed of in the year for $25 million in
cash; its carrying amount was $29.5 million at the date of disposal and the loss of disposal is
included within cost of sales.
3 During the year, Jade disposed of a subsidiary for $39 million cash consideration. At the date
of disposal the net assets of the subsidiary were:
$m
Property, plant and equipment 63.5
Inventory 2
Trade receivables 4.5
Cash 3.5
Trade payables (13)
Income tax (0.5)
Borrowings (20)
40
An 80% shareholding in the subsidiary had been acquired seven years previously for a cash
payment of $22 million, when its net assets were $22.5million, giving rise to $4 million goodwill.
Required
Prepare the consolidated statement of cash flows of the Jade Group for the year ended 31
December 20X5. No notes are required.
4 Current developments
Topic highlights
As a result of the IASB’s Disclosure Initiative, amendments have been proposed to IAS 7
(HKAS 7) in order to improve the quality of cash flow information provided in financial
statements.
The Disclosure Initiative is a portfolio of projects designed to improve the information provided in
financial reports. The first output of the Initiative related to IAS 1 (HKAS 1); the second phase
relates to cash flows and IAS 7 (HKAS 7).
ED/2014/6 proposes that IAS 7 is amended to:
1 Require a reconciliation of the opening and closing amounts in the statement of financial
position of all amounts from which cash flows are classified as financing activities, with the
exception of equity items. Movements to be disclosed would include:
Changes from financing cash flows
Changes from obtaining or losing control of subsidiaries/other businesses
Other non-cash changes (eg exchange differences and changes in fair value)
2 Improve disclosures about restrictions on cash and cash equivalent balances. such as tax
liabilities that would arise if foreign cash were transferred to an entity’s main country of
operations.
The first of the proposed changes would result in improved disclosure of debt movements in
a period; the second would enable users to better understand the liquidity position of an
entity.
591
Financial Reporting
Topic recap
Non-controlling interest
Cash flows from investing activities
Include dividends paid to the non-controlling
may include:
interest as a cash flow from financing
receipts from the sale of non-
activities.
current assets and investments
payments to acquire non-current
assets and investments
Associates/joint ventures
interest received
Eliminate share of profit or loss in
dividends received
calculation of cash generated from
operations
Include dividend received from
associate/JV as cash flow from operating
activities
592
20: Statements of cash flows | Part C Accounting for business transactions
Answer 1
BESTWAY CO
CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER
20X8
$'000 $'000
Cash flows from operating activities
Net profit before tax 16,965
Adjustments for:
Depreciation (1,125 + 1,800) 2,925
Profit on sale of plant (900)
Share of associate's profits (4,950)
Interest payable 1,350
Operating profit before working capital changes 15,390
Increase in trade and other receivables (16,650 – 11,475 – 252) (4,923)
Increase in inventories (17,775 – 9,000 – 288) (8,487)
Increase in trade payables (6,660 – 4,320 – 612) 1,728
Cash generated from operations 3,708
Interest paid (270 + 1,350 – 360) (1,260)
Income taxes paid (W1) (2,655)
Net cash used in operating activities (207)
Cash flows from investing activities
Purchase of subsidiary undertaking (W2) 882
Purchase of property, plant and equipment (W3) (15,915)
Proceeds from sale of plant 3,000
Dividends from associate (W4) 4,050
Dividends paid to non-controlling interest (W5) (432)
Net cash used in investing activities (8,415)
Cash flows from financing activities
Issue of ordinary share capital (W6) 22,077
Issue of loan notes (19,530 – 6,030) 13,500
Dividends paid (2,700)
Net cash from financing activities 32,877
Net increase in cash and cash equivalents 24,255
Cash at 1.1.X8 16,380
Cash at 31.12.X8 40,635
593
Financial Reporting
WORKINGS
1 Taxation
$'000 $'000
Opening balance
Income tax 1,953
Deferred tax 117
2,070
Statement of profit or loss expense 4,860
On acquisition of subsidiary 153
Closing balances
Income tax 4,158
Deferred tax 270
(4,428)
Cash outflow 2,655
2 Purchase of subsidiary
$'000
Cash received on acquisition 1,008
Less cash consideration (126)
Cash inflow 882
3 Purchase of tangible non-current assets: machinery
$'000
Carrying value at 1 Jan X8 2,700
Depreciation (1,800)
Disposal (3,000 – 900) (2,100)
On acquisition of subsidiary 1,485
285
Cash outflow on additions 15,915
Carrying value at 31 Dec 20X8 16,200
4 Dividends from associate
$'000
Opening balance 12,690
Share of profit after tax 4,950
17,640
Closing balance (13,590)
Cash inflow 4,050
5 Non-controlling interest
$'000
Opening balance –
Profit for year 900
On acquisition 567
1,467
Closing balance (1,035)
Cash outflow 432
6 Issue of ordinary share capital
$'000
Closing balance 61,407
Non-cash consideration (2,475)
Opening balance (36,855)
Cash inflow 22,077
594
20: Statements of cash flows | Part C Accounting for business transactions
Answer 2
STATEMENT OF CASH FLOWS FOR JADE GROUP FOR THE YEAR ENDED 31 DECEMBER
20X5
$m $m
Cash flows from operating activities
Profit before tax 20.5
Adjustments for:
Depreciation 8
Loss on disposal of property (25 – 29.5) 4.5
Gain on sale of subsidiary (3)
Share of profit of associate (5)
Finance costs 10
Increase in trade receivables (137 – (114-4.5)) (27.5)
Increase in inventories (99-(93-2) (8)
Increase in trade payables (90.5 – (49.5-13)) 54
Cash generated from operations 53.5
Finance costs paid (W1) (10.2)
Income taxes paid (W2) (0.1)
Net cash from operating activities 43.2
Cash flows from investing activities
Sale of property 25
Purchases of property, plant and equipment (W3) (216)
Dividends received from associate (W4) 2
Proceeds from sale of subsidiary net of cash balance (39-3.5) 35.5
Net cash used in investing activities (153.5)
Cash flows from financing activities
Proceeds from issue of share capital (230 – 150) 80
Repayment of finance lease obligations (W5) (13)
Cash proceeds of borrowings (W6) 60
Dividends paid to equity shareholders of parent (W7) (4.6)
Dividends paid to non-controlling interest (W8) (4.6)
Net cash from financing activities 117.8
Net increase in cash and cash equivalents 7.5
Cash and cash equivalents at the beginning of the period (12 + 2) 14
Cash and cash equivalents at the end of the period (18 + 3.5) 21.5
Workings
1 Finance costs
$m
Opening balance 0.9
Statement of profit or loss 10
10.9
Closing balance (0.7)
Cash inflow 10.2
595
Financial Reporting
2 Taxation
$m $m
Opening balance
Income tax 5.1
Deferred tax 27.5
32.6
Statement of profit or loss expense 4.8
On disposal of subsidiary (0.5)
Closing balances
Income tax 6.8
Deferred tax 30
(36.8)
Cash outflow 0.1
3 Purchase of PPE
$m
Carrying amount b/f 440
Revaluation 5
Finance lease additions 30
Depreciation (8)
Disposal (29.5)
On disposal of subsidiary (63.5)
374
Cash outflow on additions 216
Carrying amount c/f 590
4 Dividend from associate
$m
Opening balance 14
Share of profits 5
19
Closing balance (17)
Cash inflow 2
5 Finance lease
$m
Opening balance (1 + 4.5) 5.5
New leases 30
35.5
Closing balance (7.5 + 15) (22.5)
Cash inflow 13
6 Borrowings
$m
Opening balance 100
Disposal of subsidiary (20)
80
Closing balance (140)
Cash inflow 60
596
20: Statements of cash flows | Part C Accounting for business transactions
597
Financial Reporting
Exam practice
1,408 1,104
598
20: Statements of cash flows | Part C Accounting for business transactions
599
Financial Reporting
600
chapter 21
Topic list
Learning focus
Related party transactions are a controversial area of accounting. They are, however,
relatively common in practice. You must be able to identify related parties and make the
necessary disclosures.
601
Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.20 Related party disclosures 3
3.20.01 Identify the parties that may be related to a business entity in
accordance with HKAS 24
3.20.02 Identify the related party disclosures
3.20.03 Explain the importance of being able to identify and disclose related
party transactions
602
21: Related party disclosures | Part C Accounting for business transactions
Users of financial statements would normally and reasonably assume that the transactions
reported in those financial statements took place on normal commercial terms, i.e. on what is called
an arm's length basis.
If the two parties to the transaction were in some way closely related, e.g. family members or fellow
companies in a group, normal commercial terms may not apply. One party may influence or be
influenced by the other.
Therefore, HKAS 24 requires full disclosure of transactions with certain parties who are defined as
being related to the reporting entity which is producing the financial statements.
It is important to remember that disclosure of a related party transaction does not necessarily mean
there is anything wrong with the transaction. The transaction may in fact be on normal commercial
terms, or, if it is not, there may be very good reasons which are in the best interests of the entity. It
is simply about providing users with information which may be of interest to them and to allow them
to draw their own conclusions about the nature of the transaction, its effect on the financial
statements, its appropriateness and the stewardship of management.
603
Financial Reporting
Key terms
Related party is a person or entity that is related to the entity that is preparing its financial
statements.
(a) A person or a close member of that person's family is related to a reporting entity if that
person:
(i) has control or joint control over the reporting entity;
(ii) has significant influence over the reporting entity; or
(iii) is a member of the key management personnel of the reporting entity or of a parent of
the reporting entity.
(b) An entity is related to a reporting entity if any of the following conditions applies:
(i) the entity and the reporting entity are members of the same group
(ii) one entity is an associate or joint venture of the other entity (or an associate or joint
venture of a group of which the other entity is a member)
(iii) both entities are joint ventures of the same third party
(iv) one entity is a joint venture of a third entity and the other entity is an associate of the
third entity
(v) the entity is a post-employment benefit plan for the benefit of employees of either the
reporting entity or an entity related to the reporting entity. If the reporting entity is itself
such a plan, the sponsoring employers are also related to the reporting entity
(vi) the entity is controlled or jointly controlled by a person identified in (a)
(vii) the person identified in (a)(i) has significant influence over the entity or is a member of
the key management personnel of the entity (or a parent of the entity)
(viii) the entity, or any member of a group of which it is a part, provides key management
personnel services to the reporting entity or to the parent of the reporting entity.
Related party transaction is a transfer of resources, services or obligations between a reporting
entity and a related party, regardless of whether a price is charged.
Control is the power to govern the financial and operating policies of an entity so as to obtain
benefits from its activities.
Significant influence is the power to participate in the financial and operating policy decisions of
an entity, but is not control over those policies. Significant influence may be gained by share
ownership, statute or agreement.
Joint control is the contractually agreed sharing of control over an economic activity.
Key management personnel are those persons having authority and responsibility for planning,
directing and controlling the activities of the entity, directly or indirectly, including any director
(whether executive or otherwise) of that entity.
Close members of the family of a person are those family members who may be expected to
influence, or be influenced by, that person in their dealings with the entity and include:
(a) that person's children and spouse or domestic partner
(b) children of that person's spouse or domestic partner; and
(c) dependants of that person or that person's spouse or domestic partner (HKAS 24)
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21: Related party disclosures | Part C Accounting for business transactions
Solution
For Parent’s separate financial statements, both subsidiaries and all three associates are classified
as related parties.
For Subsidiary A's financial statements, Parent, Subsidiaries B and C, and all three associates are
classified as related parties.
For Subsidiary B's separate financial statements, Parent, Subsidiaries A and C, and all three
associates are related parties.
For Subsidiary C's financial statements, Parent, Subsidiaries A and B and all three associates are
related parties.
For the financial statements of Associates 1, 2 and 3, Parent and Subsidiaries A, B and C are their
related parties. Associates 1, 2 and 3 are not classified as related to each other.
For Parent's consolidated financial statements, Associates 1, 2 and 3 are related to the Group.
605
Financial Reporting
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21: Related party disclosures | Part C Accounting for business transactions
(d) The expense recognised during the period in respect of bad and doubtful debts due from
related parties.
Amounts incurred by the entity for the provision of key management personnel services that are
provided by a separate management entity should be disclosed.
These disclosures should be made separately for the following categories of related party:
The parent
Entities with joint control or significant influence over the entity
Subsidiaries
Associates
Joint ventures in which the entity is a venture
Key management personnel of the entity or its parent
Other related parties
Substantiation is a must if an entity decides to disclose that related party transactions were made
on terms equivalent to those that prevail in arm's length transactions.
Items of a similar nature may be disclosed in aggregate except when separate disclosure is
necessary for an understanding of the effects of related party transactions on the financial
statements of the entity.
Illustration
The following is an example of a related party disclosure
Related party transactions
Balances and transactions between the Company and its subsidiaries, which are related parties of
the Company, have been eliminated on consolidation and are not disclosed in this note. Details of
transactions between the Group and other related parties are disclosed below:
Trade sales Trade purchases Amounts due Amounts due to
from related related parties
parties
20X4 20X3 20X4 20X3 20X4 20X3 20X4 20X3
$’000 $’000 $’000 $’000 $’000 $’000 $’000 $’000
Fellow 456 342 210 198 34 45 17 19
subsidiaries
Holding company 634 567 – – 78 65 – –
Sales of goods to related parties were made at the Group’s usual list price less average discounts
of 6%. Purchases were made at market price discounted to reflect the quantity of goods purchased
and the relationship between the parties.
The amounts outstanding are unsecured and will be settled in cash. No guarantees have been
given or received. No expense is recognised in the period for bad or doubtful debts in respect of
amounts due from related parties. The above amounts due from / to related parties are included in
trade and other receivables and trade and other payales respectively.
Loans to / from related parties
20X4 20X3
$’000 $’000
Loans from fellow subsidiaries 4,000 3,200
The Group also received consultancy services from a company controlled by D Light, a director of
the Company, for which a management fee of $28,000 was charged.
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Financial Reporting
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21: Related party disclosures | Part C Accounting for business transactions
Of course not all related party transactions are on preferential terms for one party or the other,
however they may be. The disclosures required by the standard are therefore designed to allow
users of the accounts to assess this.
Self-test question 1
Anthony Co. (A) is an 80% owned subsidiary of Basso Co. (B). The directors of A are W, X, Y and
Z. Which of the following are related parties of A?
C, which is not part of the B group, but of which W is a director.
D, who owns 20% of the shares in A.
E, the financial controller of A (who is not a director of A).
F, the wife of the chairman of P, a company in the B group.
(The answer is at the end of the chapter)
Self-test question 2
Heathcliff Co has the following relationships with a number of other companies:
Control over Rochester
Significant influence over two companies, Lockwood and Fairfax
Joint control with another party, Wildfell, over a joint venture, Markham
Joint control with another party, Eyre, over a joint venture, Haworth
Required
Apply the HKAS 24 definition of a related party to identify which companies are related to each
other.
(The answer is at the end of the chapter)
Self-test question 3
Tennant Lilley Co, which runs a chain of garages, has two directors: Louis Richardson, who holds a
55% share in the company (which gives him control) and Flora McDonald, who holds a 25% share
in the company. The remaining 20% of shares are held equally by two external investment firms.
Flora McDonald also has a 40% shareholding (which gives her significant influence) in a McDonald
family company, eparts.com, and this company is a major supplier to Tennant Lilley Co. Flora has
no involvement in the day to day running of the company. Louis Richardson holds no shares other
than those in Tennant Lilley, but is a non-executive director of a toy manufacturing company,
Playwell.
Louis’ wife, Emma, owns 100% of the shares and is the sole director of a private company, Emma
Designs Co, which designs, sells and makes evening gowns.
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Financial Reporting
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21: Related party disclosures | Part C Accounting for business transactions
Topic recap
Not included:
Two entities with key management personnel
in common
Two venturers which share control over a joint
venture
Bodies engaged in normal business dealings
such as providers of finance
Any single customer, supplier etc as a result
of economic dependence.
Disclose:
Relationships between parents and subsidiaries (regardless of whether they have transacted)
Name of parent/ultimate controlling party
Key management personnel compensation (categorised)
Where related party transactions have occurred, disclose by category of related party:
- Nature of the related party relationship
- Amount of transactions
- Outstanding balances and provisions against them
- Bad debt expense recognised in respect of related parties
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Financial Reporting
Answer 1
Basso Group
F
Wife of chairman of P
R/P
B P
80%
20% Directors
D A W, X, Y and Z
Financial controller of A
Director
E C
1 C and A are subject to common influence from W, but C is not a related party unless one or
both companies have subordinated their own separate interests in entering into a
transaction. (This assumes that W is the only director to serve on both boards; if there were
a common nucleus of directors, a related party relationship would almost certainly exist.)
2 D is almost certainly not a related party. According to the definition, D might be presumed to
be a related party, but the existence of a parent company means that D is unlikely to be able
to exert significant influence over A in practice (depends on your argument).
3 E may be a related party, despite the fact that he or she is not a director. A financial
controller would probably come within the definition of key management personnel. The
issue would be decided by the extent to which E is able to control or influence the policies of
the company in practice.
4 F may be a related party. Companies P and A are under common control and F presumably
falls within the definition of close family of a related party of B. F is not a related party if it can
be demonstrated that she has not influenced the policies of A in such a way as to inhibit the
pursuit of separate interest.
Answer 2
Heathcliff Heathcliff is related to Rochester by virtue of part (b)(i) of the definition of a
related party.
Heathcliff is related to both associates Lockwood and Fairfax and both joint
ventures, Markham and Haworth by virtue of part (b) (ii).
It is not necessarily related to Eyre and Wildfell, although the substance of the
relationship with these companies may show them to be related.
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21: Related party disclosures | Part C Accounting for business transactions
Rochester Rochester is related to Heathcliff as stated above (part (b)(i) of the definition).
It is also a member of the group that has significant influence over Lockwood
and Fairfax and joint control over Markham and Haworth and therefore it is
related to these 4 companies (part (b)(ii) of the definition).
Rochester is not related to Eyre and Wildfell (unless the substance of its
relationship with them reveals this to be the case).
Lockwood As stated previously, Lockwood is related to both Heathcliff and Rochester
(part (b)(ii)).
It is also related to Haworth and Markham (part (b)(iv) of the definition)
It is not related to Fairfax, Eyre and Wildfell (unless the substance of its
relationship with them reveals this to be the case).
Fairfax Again, as for Lockwood, Fairfax is related to Heathcliff and Rochester (part
(b)(ii)) as well as Haworth and Markham (part (b)(iv)).
It is not related to Lockwood, Eyre and Wildfell (unless the substance of its
relationship with them reveals this to be the case).
Markham As described above, Markham is related to Heathcliff and Rochester (part (b)(ii)
and Lockwood and Fairfax (part (b)(iv)).
It is also related to its other joint venturer, Wildfell (part (b) (ii))
It is related to the other joint venture of Heathcliff, Haworth (part (b)(iii))
It is not related to Eyre (unless the substance of the relationship suggests this
is the case)
Haworth As described above, Haworth is related to Heathcliff and Rochester (part (b)(ii),
Lockwood and Fairfax (part (b)(iv)) and Markham (part (b)(iii))
It is also related to its other joint venturer, Eyre (part (b) (ii))
It is not related to Wildfell (unless the substance of the relationship suggests
this is the case)
Wildfell As identified, Wildfell is related to Markham (part (b)(ii) but is only related to
other companies in the scenario if the substance of its relationship with them
reveals this to be the case.
Eyre As identified, Eyre is related to Haworth (part (b)(ii) but is only related to other
companies in the scenario if the substance of its relationship with them reveals
this to be the case.
Answer 3
(a) Louis Richardson is related by virtue of the fact he controls Tennant Lilley and is a member
of the company’s key management personnel.
Emma Richardson is also related because she is a close family member of Louis
Richardson.
Flora McDonald is related to Tennant Lilley because she is a member of the company’s key
management personnel.
Playwell may be related to Tennant Lilley, depending on whether Louis Richardson’s non-
executive director role makes him key management personnel of the company. Key
management personnel is defined by HKAS 24 as persons with authority and responsibility
for planning, directing and controlling the activities of an entity, including any director
(whether executive or otherwise) of that entity. This definition would suggest that a non-
613
Financial Reporting
executive director is key management personnel and therefore Playwell is related to Tennant
Lilley.
Emma Designs Co is related to Tennant Lilley as it is controlled by Emma Richardson.
Eparts.com is not related to Tennant Lilley. Flora McDonald has significant influence over
eparts.com but that company would only be related to Tennant Lilley if Flora McDonald had
control over Tennant Lilley, which she does not.
(b) A related party transaction is a transfer of resources, services or obligations between a
reporting entity and a related party, regardless of whether a price is charged. Therefore
almost all transactions between a reporting entity and its related parties must be disclosed.
The following are related party transactions of Tennant Lilley:
The rent agreement between Emma Designs Co and Tennant Lilley Co.
The service and repair contract between Playwell and Tennant Lilley Co
The employment services provided to Tennant Lilley by its directors.
(c) Related party transactions
The Company is related to:
Emma Designs Co, a company owned by the wife of Louis Richardson, who controls
Tennant Lilley.
Playwell, a company of which Louis Richardson is a non-executive director. [Note: this
assumes that Louis Richardson’s non-executive director role makes him key
management personnel of the company, as argued above.]
During the year the Company provided services to Playwell and rented a property to Emma
Designs Co. The total amount of these transactions in the year was as follows:
Provision of services Rental of property
$ $
Other related parties 120,000 400,000
The amounts outstanding at the year end in respect of these transactions was:
Provision of services Rental of property
$ $
Other related parties - 26,000
No amount has been provided for this amount and no amount was recognised in profit or
loss in respect of bad or doubtful debts with a related party in the year.
Remuneration of key management personnel
The remuneration of the directors, who are key management personnel of the group, is set
out below in aggregate for each of the categories specified in HKAS 24 Related Party
Disclosures. Further information is provided in the Directors’ Remuneration report.
$
Short-term employee benefits 425,000
Post-employment benefits 37,000
Share-based payments 8,200
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21: Related party disclosures | Part C Accounting for business transactions
Exam practice
Company A 25 minutes
The following table sets out the details of shareholders and members of the board of directors of
five entities:
Required
Determine and explain whether the following entities and persons are related parties of Company A
under HKAS 24 Related Party Disclosures.
(a) Company B
(b) Company C
(c) Company D
(d) Company E
(e) GIL
(f) Mr. Ma
(g) Ms. Chan
(h) Mr. Wang
(14 marks)
HKICPA June 2011
615
Financial Reporting
616
chapter 22
Accounting policies,
changes in accounting
estimates and errors; events
after the reporting period
Topic list
1 HKAS 8 Accounting Policies, Changes in 5 HKAS 10 Events after the Reporting Period
Accounting Estimates and Errors 5.1 Objective
1.1 Objective 5.2 Definitions
1.2 Definitions 5.3 Events after the reporting period
5.4 Accounting treatment
2 Accounting policies 5.5 Further disclosure
2.1 Selection of accounting policy 5.6 Summary decision tree
2.2 Changes in accounting policy
2.3 Disclosing changes in accounting policy
3 Accounting estimates
3.1 Accounting for a change in accounting
estimate
3.2 Disclosure of a change in accounting
estimate
4 Errors
4.1 Accounting treatment to correct an error
4.2 Disclosure of an error
Learning focus
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Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.01 Accounting policies, changes in accounting estimates and 3
errors
3.01.01 Distinguish between accounting policies and accounting estimates
in accordance with HKAS 8
3.01.02 Account for a change in accounting policy
3.01.03 Account for a change in accounting estimate
3.01.04 Correct a prior period error
3.15 Events after the reporting period 3
3.15.01 Explain the period during which there is responsibility for reporting
events in accordance with HKAS 10
3.15.02 Define adjusting and non-adjusting events
3.15.03 Explain when the financial statements should be prepared on a
basis other than going concern
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22: Accounting policies, changes in accounting estimates and errors; events after the reporting period
| Part C Accounting for business transactions
Key terms
Accounting policies are the specific principles, bases, conventions, rules and practices adopted
by an entity in preparing and presenting financial statements.
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. Changes in accounting estimates result from new information or new developments and,
accordingly, are not corrections of errors.
Material. Omissions or misstatements of items are material if they could, individually or collectively,
influence the economic decisions that users make on the basis of the financial statements.
Materiality depends on the size and nature of the omission or misstatement judged in the
surrounding circumstances. The size or nature of the item, or a combination of both, could be the
determining factor.
Prior period errors are omissions from, and misstatements in, the entity's financial statements for
one or more prior periods arising from a failure to use, or misuse of, reliable information that:
was available when financial statements for those periods were authorised for issue
could reasonably be expected to have been obtained and taken into account in the
preparation and presentation of those financial statements
Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies,
oversights or misinterpretations of facts, and fraud.
619
Financial Reporting
2 Accounting policies
Topic highlights
Changes in accounting policy are applied retrospectively.
HKAS 8.7,10-
13
2.1 Selection of accounting policy
Where an HKFRS specifically applies to a transaction, then the relevant accounting policy should
be determined by applying that standard or interpretation.
Where there is no applicable HKFRS, management should use its judgment in developing and
applying an accounting policy that results in information that is relevant and reliable. Management
should refer to:
(a) the requirements in HKFRS dealing with similar and related issues.
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities and
expenses in the Conceptual Framework.
Management may also consider the most recent pronouncements of other standard-setting
bodies that use a similar conceptual framework to develop standards, other accounting literature,
including Accounting Guidelines and Accounting Bulletins, and accepted industry practices if these
do not conflict with the sources above.
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22: Accounting policies, changes in accounting estimates and errors; events after the reporting period
| Part C Accounting for business transactions
An entity must select and apply its accounting policies for a period consistently for similar
transactions, other events and conditions, unless a HKFRS specifically requires or permits
categorisation of items for which different policies may be appropriate. If an HKFRS requires or
permits categorisation of items, an appropriate accounting policy must be selected and applied
consistently to each category.
621
Financial Reporting
company made a profit of $20,000 for the year ended 31 December 20X6 and $30,000 for the year
ended 31 December 20X5 (excluding any adjustment for depreciation). In the year ended
31 December 20X6, the company elects to adopt HKAS 16 in full.
1 January 1 January 31 December
20X5 Depreciation 20X6 Depreciation 20X6
$ $ $
Equipment A 6,000 ÷ 10
Cost 6,000 6,000 6,000
Accumulated depreciation – (600) (600) (600) (1,200)
Carrying amount 6,000 5,400 4,800
1 January Impairment 1 January 31 December
20X5 loss 20X6 Depreciation 20X6
$ $ $
Equipment B 8,000 ÷ 10
Cost 10,000 (2,000) 8,000 8,000
Accumulated depreciation – – (800) (800)
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22: Accounting policies, changes in accounting estimates and errors; events after the reporting period
| Part C Accounting for business transactions
Based on the above extract, the 20X6 profit would be adjusted for depreciation of $1,400 and the
opening retained earnings also adjusted for 20X5's depreciation/impairment charge of $2,600. One
year's comparative must be presented which means the profits for last year and the opening
retained earnings for last year are recalculated.
The adjustment must be made from the original date it affects the financial statements, this is
known as retrospective application.
HKAS
8.29,30
2.3 Disclosing changes in accounting policy
As a result of a change in accounting policy, retrospective adjustments should be reported as an
adjustment to the opening balance of each affected component of equity.
Comparative information should also be restated unless it is impracticable to do so. This means
that all comparative information must be restated as if the new policy had always been in force,
with amounts relating to earlier periods reflected in an adjustment to opening reserves of the
earliest period presented.
Certain disclosures are required when a change in accounting policy has a material effect on the
current period or any prior period presented, or when it may have a material effect in subsequent
periods.
These include:
(a) reasons for the change
(b) amount of the adjustment for the current period and for each period presented
(c) amount of the adjustment relating to periods prior to those included in the comparative
information
(d) the fact that comparative information has been restated or that it is impracticable to do so
623
Financial Reporting
An entity should also disclose information relevant to assessing the impact of new HKFRS on the
financial statements where these have not yet come into force.
Illustration
Due to the limited number of areas of choice available within HKFRS, most changes in accounting
policy are the result of new or amended standards. Illustrative disclosure notes detailing newly
implemented amendments and upcoming amendments are as follows:
Changes in Accounting Policies
The HKICPA has issued a number of amendments to HKFRSs and one new Interpretation that are
first effective for the current accounting period of the Company. Of these, the following
developments are relevant to the Company’s financial statements:
(a) Amendments to HKAS 32, Financial instruments: Presentation – Offsetting financial
assets and financial liabilities
The amendments to HKAS 32 clarify the offsetting criteria in HKAS 32. The amendments do
not have a significant impact on the Company’s financial statements.
(b) Amendments to HKAS 36, Recoverable amounts disclosure for non-financial assets
The amendments to HKAS 36 modify the disclosure requirements for impaired non-financial assets.
Among them the amendments expand the disclosures required for an impaired asset or cash
generating unit whose recoverable amount is based on fair value less costs of disposal. The
amendments do not have a significant impact on the Company’s financial statements.
Future changes in accounting policies
The Company has not early applied the following amendments and new standards that have been
issued by the HKICPA but are not yet effective for the year ended 31 December 2014. The
adoption of the following amendments or standards will not result in substantial changes to the
Company’s accounting policies.
Effective for
accounting periods
beginning on or after
3 Accounting estimates
HKAS
8.32,33
Topic highlights
Changes in accounting estimate are not applied retrospectively.
Estimates arise in relation to business activities because of the uncertainties inherent within
them. Judgments are made based on the most up-to-date information and the use of such
estimates is a necessary part of the preparation of financial statements. It does not undermine their
reliability.
Examples of accounting estimates include:
a necessary irrecoverable debt allowance
useful lives of depreciable assets
provision for obsolescence of inventory
warranty obligations
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22: Accounting policies, changes in accounting estimates and errors; events after the reporting period
| Part C Accounting for business transactions
HKAS 8.36
3.1 Accounting for a change in accounting estimate
The effect of a change in an accounting estimate should be included in the determination of net
profit or loss in one of:
(a) the period of the change, if the change affects that period only.
(b) the period of the change and future periods, if the change affects both.
In other words the change is applied prospectively.
Changes may occur in the circumstances which were in force at the time the estimate was
calculated, or perhaps additional information or subsequent developments have come to light.
An example of a change in accounting estimate which affects only the current period is the
irrecoverable debt estimate. However, a revision in the life over which an asset is depreciated
would affect both the current and future periods, in the amount of the depreciation expense.
Reasonably enough, the effect of a change in an accounting estimate should be included in the
same expense classification as was used previously for the estimate. This rule helps to ensure
consistency between the financial statements of different periods.
The materiality of the change is also relevant. The nature and amount of a change in an
accounting estimate that has a material effect in the current period (or which is expected to have a
material effect in subsequent periods) should be disclosed. If it is not possible to quantify the
amount, this impracticability should be disclosed.
625
Financial Reporting
4 Errors
Topic highlights
Prior period errors must be corrected retrospectively.
Errors discovered during a current period which relate to a prior period may arise through:
mathematical mistakes
mistakes in the application of accounting policies
misinterpretation of facts
oversights
fraud
Most of the time these errors can be corrected through net profit or loss for the current period.
Where they are material prior period errors, however, this is not appropriate. The standard
considers two possible treatments.
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22: Accounting policies, changes in accounting estimates and errors; events after the reporting period
| Part C Accounting for business transactions
Self-test question 1
During 20X7 Gordon Co. discovered that certain items had been included in inventory at
31 December 20X6, valued at $4.2 million, which had in fact been sold before the end of the
reporting period and included correctly in revenue.
The following figures for 20X6 (as reported) and 20X7 (draft) are available:
20X6 20X7 (draft)
$'000 $'000
Sales 47,400 67,200
Cost of goods sold (34,570) (55,800)
Profit before taxation 12,830 11,400
Income taxes (2,245) (1,880)
Profit for the period 10,585 9,520
Retained earnings at 1 January 20X6 were $13 million. The cost of goods sold for 20X7 includes
the $4.2 million error in opening inventory. The income tax rate was 16% for 20X6 and 20X7. No
dividends have been declared or paid.
Required
(a) Show the statement of profit or loss and other comprehensive income for 20X7, with the
20X6 comparative, and retained earnings.
(b) Prepare a disclosure note in respect of the error as required by HKAS 8.
(The answer is at the end of the chapter)
Self-test question 2
Sherry Campbell Co (‘SCC’) runs a number of restaurants and hotels in Hong Kong. The Company
accountant has prepared draft financial statements for the year ended 31 December 20X4. Extracts
are as follows:
Retained profit for the year $255 million (20X3: $130 million)
Opening retained earnings $985 million (20X3: $890 million)
Profit is stated before depreciation has been charged.
The following issues have not yet been dealt with by the Company accountant:
1 An industrial dishwashing machine was acquired from an Indian supplier on 1 January 20X3
at a cost of Rs 2 million. The cost was incorrectly treated as a cost of sales. The exchange
rate on the purchase date was 1 Rs: $0.12. At 31 December 20X3 it was 1 Rs: $0.11 and at
31 December 20X4 it was 1 Rs: $0.115.
2 An oven range originally costing $920,000 had a carrying amount of $368,000 at 1 January
20X4.
3 SCC had been charging depreciation at a rate of 15% on cost. However, it is now thought
that a rate of 20% is more appropriate.
4 SCC acquired an investment property on 1 January 20X2 at a cost of $250 million and
immediately let it to small business tenants. This is the company’s only investment property
and it elected to apply the cost model, adopting a 50 year useful life. At 31 December 20X4,
the SCC Board decided that the HKAS 40 fair value model should be adopted in order that
more relevant and reliable information were included in the financial statements. The
property had a fair value of $263 million at 31 December 20X2, $275 million at 31 December
20X3 and $279 million at 31 December 20X4.
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Financial Reporting
Required
Draft extracts from the statement of financial position, statement of profit or loss and other
comprehensive income and statement of changes in equity for the year ended 31 December 20X4,
including 20X3 comparative amounts.
(The answer is at the end of the chapter)
Key term
The standard defines events after the reporting period as:
Those events, favourable and unfavourable, that occur between the end of the reporting period and
the date when the financial statements are authorised for issue.
It goes on to classify such events as one of two types:
(a) those that provide evidence of conditions that existed at the end of the reporting period
(adjusting events after the reporting period); and
(b) those that are indicative of conditions that arose after the reporting period (non-adjusting
events after the reporting period).
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22: Accounting policies, changes in accounting estimates and errors; events after the reporting period
| Part C Accounting for business transactions
(b) Where the management of an entity must issue the financial statements to a supervisory
board for approval, the date of authorisation is the date on which the management
authorises the financial statements for issue to the supervisory board.
Events after the reporting period include all events up to the date when the financial statements are
authorised for issue, even if those events occur after the public announcement of profit or of other
selected financial information.
HKAS 10.9 5.3.1 Adjusting events
Adjusting events add information on conditions that existed at the reporting date. They may include
the following:
(a) The settlement after the reporting period of a court case which confirms an entity had a
present obligation at the end of the reporting period.
(b) The bankruptcy of a customer after the reporting period which confirms that the receivables
balance was overstated at the end of the reporting period.
(c) The sale of inventories after the year end at an amount lower than cost which confirms that
inventories were overstated at the end of the reporting period.
(d) The determination after the reporting period of the cost of assets purchased or proceeds of
the sale of assets before the end of the reporting period.
(e) The determination after the reporting period of the amount of profit-sharing or bonus
payments which confirms the existence of obligation at the end of the reporting period.
(f) The discovery of fraud or errors showing the financial statements are incorrect.
Any event after the reporting period which indicates that an entity is no longer a going concern is
classified as an adjusting event.
HKAS 5.3.2 Non-adjusting events
10.12,22
Non-adjusting events provide information about conditions arising after the reporting date.
Examples may include the following:
(a) The destruction of a non-current asset in the period after the reporting date due to fire or
flood.
(b) A decline in the fair value of investments after the reporting date due to circumstances
arising after the reporting date.
(c) A major business combination after the reporting period.
(d) An announcement of a plan to discontinue an operation.
(e) Purchases of assets, classification of assets as held for sale (HKFRS 5), disposals of assets
or expropriation of assets by government.
(f) An announcement of or commencement of a major restructuring.
(g) Share transactions after a reporting period.
(h) Abnormally large changes after the reporting period in foreign exchange rates.
(i) Changes in tax rates or tax laws enacted or announced after the reporting period.
(j) Entering into significant commitments.
(k) Commencing litigation due to events arising after the reporting period.
HKAS 10 is also clear that an equity dividend declared after the end of the reporting period is a
non-adjusting event and should not be recognised as a liability. This is because there is no
obligation at the reporting date; the obligation does not arise until the dividend is declared.
629
Financial Reporting
Illustration
Events after the reporting period
On 1 February 20X5, the premises of a Subsidiary Co were seriously damaged by fire. Insurance
claims have been put in hand but the cost of refurbishment is currently expected to exceed these
by $2 million.
630
22: Accounting policies, changes in accounting estimates and errors; events after the reporting period
| Part C Accounting for business transactions
Required
Discuss the implication of the above events and indicate whether they are adjusting or non-
adjusting events.
Solution
The impairment of inventory is a non-adjusting event because legislation is not passed until after
the reporting date. Therefore, at the reporting date the value of inventory is unaffected.
The dividend declared after the reporting date is non-adjusting also because as at the reporting
date there is no obligation to pay a dividend.
The discovery of an irrecoverable debt in the post-reporting date period provides evidence that the
debt could not be paid at the reporting date. Therefore, it is an adjusting event.
Does an event fall in the period after No The event is not an event after the
the reporting date and before the reporting date and is outside the
financial statements are authorised for scope of HKAS 10
issue?
Yes
Yes Yes No
631
Financial Reporting
Topic recap
Unless impracticable,
correct retrospectively.
A change in accounting
policy only arises where:
required by an HKFRS
it results in more reliable Disclose: Disclose:
and relevant reporting The nature and amount of the Nature of the error
change unless impracticable to Amount of correction for
A voluntary change is estimate each prior period
applied retrospectively so Amount of correction at
that financial statements are the beginning of the
presented as if the policy had earliest prior period
always been applied. presented
Disclose:
Reasons for change
Amount of adjustment for
the current and prior
periods
The fact that comparative
information is restated (or
that it is impracticable)
632
22: Accounting policies, changes in accounting estimates and errors; events after the reporting period
| Part C Accounting for business transactions
Adjust the financial statements Event impacts going Event does not
and disclosures to reflect the concern. impact going
event. concern.
If material, disclose:
nature of the
event
estimated
financial effect
633
Financial Reporting
Answer 1
(a) STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
20X6 20X7
$'000 $'000
Sales 47,400 67,200
Cost of goods sold (W1) (38,770) (51,600)
Profit before tax 8,630 15,600
Income tax (W2) (1,573) (2,552)
Profit for the year 7,057 13,048
RETAINED EARNINGS
20X6 20X7
Opening retained earnings $'000 $'000
As previously reported 13,000 23,585
Correction of prior period error (4,200 – 672) – (3,528)
As restated 13,000 20,057
Profit for the year 7,057 13,048
Closing retained earnings 20,057 33,105
WORKINGS
1 Cost of goods sold 20X6 20X7
$'000 $'000
As stated in question 34,570 55,800
Inventory adjustment 4,200 (4,200)
38,770 51,600
2 Income tax 20X6 20X7
$'000 $'000
As stated in question 2,245 1,880
Inventory adjustment (4,200 16%) (672) 672
1,573 2,552
634
22: Accounting policies, changes in accounting estimates and errors; events after the reporting period
| Part C Accounting for business transactions
Answer 2
Dishwashing machine
The machine was incorrectly accounted for at the date of purchase; this is a prior period error and
must be corrected retrospectively ie as if the error had not occurred.
The machine should have been recognised as a non-current asset at 1 January 20X3 measured at
$240,000 (Rs 2 million 0.12).
This is a non-monetary asset and is not therefore subsequently re-measured in line with changing
exchange rates.
The machine should have been depreciated in the year ended 31 December 20X3 by 15%
$240,000 = $36,000. The carrying amount at 31 December 20X3 should therefore be $240,000 –
$36,000 = $204,000.
The machine should have been depreciated in the year ended 31 December 20X4 by 20%
$240,000 = $48,000. The carrying amount at 31 December 20X4 should therefore be $204,000 –
$48,000 = $156,000
Oven range
Rate of depreciation is an accounting estimate and any change to the rate is accounted for
prospectively, with no adjustment made to comparative balances or opening retained earnings.
Depreciation was previously charged at $138,000 ($920,000 15%) per annum.
The carrying amount of the oven range at 1 January 20X4 is $368,000.
Depreciation in the year ended 31 December 20X4 is $184,000 ($920,000 20%).
The carrying amount of the oven rangey at 31 December 20X4 is therefore $184,000 ($368,000 –
$184,000)
Investment property
HKAS 40 allows investment property to be measured using either the cost or the fair value model.
Where the fair value model is adopted, changes in fair value are recognised in profit or loss.
A change from one model to another is a change in accounting policy and must be accounted for
retrospectively.
The necessary adjustments are calculated as follows:
Cost model Fair value model Adjustment
$000 $000 $000
1 January 20X2 250,000 250,000
Profit or loss y/e (5,000) 13,000 18,000
31 December 20X2
31 December 20X2 245,000 263,000
Profit or loss y/e (5,000) 12,000 17,000
31 December 20X3
31 December 20X3 240,000 275,000
Profit or loss y/e Depreciation not yet 4,000 4,000
31 December 20X4 accounted for
31 December 20X4 279,000
Therefore the carrying amount of the property in the statement of financial position is $279 million
at 31 December 20X4 and $275 million at 31 December 20X3.
The gain on re-measurement recognised in the statement of profit or loss is $4 million in the year
ended 31 December 20X4 and $17 million in the previous year.
In the statement of changes in equity, retained earnings brought forward at 1 January 20X2 are
subject to a prior period adjustment of $18million.
635
Financial Reporting
636
22: Accounting policies, changes in accounting estimates and errors; events after the reporting period
| Part C Accounting for business transactions
Exam practice
637
Financial Reporting
and the buyer on 30 November 20X3 which has been approved by the board of directors but
subject to the approval of the shareholders of SAC. (You should comment on the
classification of these production lines as at 31 December 20X3). (5 marks)
(d) The new Companies Ordinance has come into effect from 3 March 20X4. The financial
controller of SAC is considering the impact on financial reporting and the directors’ report.
(You should advise not less than four changes in respect of these two areas). (4 marks)
Required
Discuss the implications for each of the above events.
(Total = 16 marks)
638
chapter 23
Topic list
Learning focus
HKAS 33 is applicable to listed entities. You should be aware of the calculation of EPS and,
since this is a measurement of performance, how it can be manipulated.
639
Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.22 Earnings per share 3
3.22.01 Explain the meaning and significance of a company’s earnings per
share
3.22.02 Calculate the earnings per share, including the impact of a bonus
issue, a rights issue and an issue of shares at full market value in
accordance with HKAS 33
3.22.03 Explain the relevance of a company’s diluted earnings per share
3.22.04 Discuss the limitations of using earnings per share as a
performance measure
640
23: Earnings per share | Part C Accounting for business transactions
Key terms
Ordinary share. An equity instrument that is subordinate to all other classes of equity instruments.
Potential ordinary share. A financial instrument or other contract that may entitle its holder to
ordinary shares.
Options, warrants and their equivalents. Financial instruments that give the holder the right to
purchase ordinary shares.
Contingently issuable ordinary shares are ordinary shares issuable for little or no cash or other
consideration upon the satisfaction of specified conditions in a contingent share agreement.
Contingent share agreement. An agreement to issue shares that is dependent on the satisfaction
of specified conditions.
Dilution is a reduction in earnings per share or an increase in loss per share resulting from the
assumption that convertible instruments are converted, that options or warrants are exercised, or
that ordinary shares are issued upon the satisfaction of specified conditions.
Antidilution is an increase in earnings per share or a reduction in loss per share resulting from the
assumption that convertible instruments are converted, that options or warrants are exercised, or
that ordinary shares are issued upon the satisfaction of certain conditions.
(HKAS 33.5)
641
Financial Reporting
one class of ordinary shares and ordinary shares of the same class have the same right to receive
dividends.
1.3.2 Potential ordinary shares
HKAS 33 identifies the following examples of potential ordinary shares:
(a) Financial liabilities or equity instruments, including preference shares, that are
convertible into ordinary shares
(b) Share warrants and options
(c) Shares that would be issued upon the satisfaction of certain conditions resulting from
contractual arrangements, such as the purchase of a business or other assets
642
23: Earnings per share | Part C Accounting for business transactions
On 30 June 20X0, 5 million irredeemable cumulative preference shares of the same class as the
10 million remaining were cancelled and shareholders paid 67c per share. At this date the shares
had a carrying amount of 50c each.
Fixed dividends on preference shares are as follows:
Irredeemable cumulative preference shares: 3c every six months
Redeemable preference shares: 5c per annum
Profit after tax reported for the year ended 31 December 20X0 was $36,900,000.
Required
What are profits attributable to ordinary shareholders for the purposes of calculating basic EPS?
Solution
$
Profit after tax 36,900,000
Redeemable preference share dividend does not need
adjustment as it will already have been accounted for as a
finance cost within the calculation of profit
Irredeemable preference dividend:
1.1.X0 – 30.6.X0 15m shares 3c (450,000)
1.7.X0 – 31.12.X0 10m shares 3c (300,000)
Excess paid to cancel shares (67c – 50c) 5m (850,000)
Profits attributable to ordinary shareholders 35,300,000
643
Financial Reporting
Where a uniting of interests takes place the number of ordinary shares used for the calculation is
the aggregate of the weighted average number of shares of the combined entities, adjusted to
equivalent shares of the entity whose shares are outstanding after the combination.
Ordinary shares that will be issued on the conversion of a mandatorily convertible instrument are
included in the calculation from the date the contract is entered into.
If ordinary shares are partly paid, they are treated as a fraction of an ordinary share to the extent
they are entitled to dividends relative to fully paid ordinary shares.
Contingently issuable shares (including those subject to recall) are included in the computation
when all necessary conditions for issue have been satisfied.
1.4.3 Required basic EPS
Basic EPS should be calculated for profit or loss attributable to ordinary equity holders of the
parent entity and profit or loss from continuing operations attributable to those equity holders
(if this is presented).
644
23: Earnings per share | Part C Accounting for business transactions
Solution
Weighted average number of ordinary shares outstanding for year 20X5:
6 months
1,000,000 + 400,000 = 1,200,000
12 months
$3,000,000
Therefore, EPS for year 20X5 = = $2.50
1,200,000
HKAS 1.5.2 Bonus issues, share splits and reverse share splits
33.28,29
Events such as bonus issues change the number of shares outstanding, without a corresponding
change in resources.
Here it is necessary to make adjustments so that the current and prior period EPS figures are
comparable.
Bonus issues and share splits can be considered together as they have a similar effect.
In both cases, ordinary shares are issued to existing shareholders for no additional
consideration. The number of ordinary shares has increased without an increase in resources.
Therefore, the number of ordinary shares outstanding before the event must be adjusted for
the proportionate change in the number of shares outstanding as if the event had occurred at the
beginning of the earliest period reported.
Reverse share splits are a consolidation of ordinary shares which generally reduces the number of
ordinary shares outstanding without a corresponding reduction in resources. However, when the
overall effect is a share repurchase at fair value, the reduction in the number of ordinary shares
outstanding is the result of a corresponding reduction in resources. The weighted average number
of ordinary shares outstanding for the period in which the combined transaction takes place is
adjusted for the reduction in the number of ordinary shares from the date the special dividend is
recognised.
Solution
Weighted average number of ordinary shares outstanding for year 20X7:
2
1,000,000 + 1,000,000 /5 = 1,400,000
An alternative calculation of this amount is as follows:
1 Jan 20X7 – 30 June 1,000,000 7/5 6/12 months 700,000
20X7
Bonus issue 400,000
1 July 20X7 – 31 Dec 1,400,000 6/12 months 700,000
20X7
1,400,000
Calculation using the tabular approach may prove easier to use in examples where there is more
than one issue in the year.
645
Financial Reporting
Note that the bonus fraction of 7/5 is calculated as the number of shares post bonus issue/number
of shares pre bonus issue, and is applied to all periods in the table before the bonus issue.
$7,000,000
EPS (20X7) = = $5.00
1,400,000
$5,600,000
Original EPS (20X6) = = $5.60
1,000,000
$5,600,000
Restated EPS (20X6) = = $4.00
1,400,000
The restated EPS for 20X6 may alternatively be calculated using the reciprocal of the bonus
fraction ($5.60 5/7 = $4.00).
Note. Number of shares for all earlier accounting periods should be adjusted by the new issue as
the reserves used for the bonus issue are carried down from prior periods.
The TERP is the theoretical price at which the shares would trade after the rights issue and takes
into account the diluting effect of the bonus element in the rights issue. It is calculated as:
Total market value of original shares pre rights issue + Proceeds of rights issue
TERP =
Number of shares post rights issue
The adjustment factor is used to increase the number of shares in issue prior to the rights issue for
the bonus element.
The comparative EPS for the previous period is adjusted by the reciprocal of the rights adjustment
factor.
Example: Theoretical ex-rights value
The following information is provided for an entity which is making a rights issue.
20X2 20X3
Profit attributable to ordinary equity holders of the parent entity $600,000 $720,000
Shares outstanding before rights issue: 100,000 shares
Rights issue: One new share for each five outstanding shares (20,000 new shares total)
Exercise price: $5.00
Date of rights issue: 1 March 20X3
Market price of one ordinary share immediately before exercise on 1 March 20X3: $8.00
Reporting date 31 December
Required
Calculate the theoretical ex-rights value per share and the basic EPS for each of the years 20X2
and 20X3.
646
23: Earnings per share | Part C Accounting for business transactions
Solution
1 Theoretical ex-rights price is calculated as:
Self-test question 1
Gardner Edson Co has reported the following after tax profit figures in recent years:
$’m
20X6 110
20X7 150
20X8 180
On 1 January 20X6 and 20X7, the number of shares outstanding was 5,000,000. During 20X7, the
company announced a rights issue with the following details:
Rights: 1 new share for every 5 outstanding
Exercise price: $5
Las date to exercise rights 1 March 20X7
The market value of one share in Gardner Edson Co immediately prior to exercise on 1 March
20X7 was $11.
Required
Calculate earnings per share for each of the years 20X6, 20X7 and 20X8.
Self-test question 2
Random Co., a listed company, had 5 million ordinary shares in issue at 1 January 20X1. Between
this date and 31 December 20X2, the following share issues took place:
1 May 20X1 1 for 5 bonus issue
1 October 20X1 Cash issue: 1 million shares were issued at $3.50. $2.10 has been paid in
respect of each share and accordingly holders of these 1m shares are entitled
647
Financial Reporting
Like basic EPS, diluted EPS provides a measure of the interest of each ordinary share in the profits
of an entity. Unlike basic earnings per share, diluted EPS takes into account dilutive potential
ordinary shares outstanding during the period.
Diluted EPS is therefore the calculation of what the EPS would have been if all the dilutive potential
ordinary shares had been actual shares in issue during the period.
HKAS 33.41- 1.6.1 Dilutive potential ordinary shares
44
Dilutive potential ordinary shares are securities which do not (at present) have any "claim" to a
share of equity earnings, but may be converted to ordinary shares and so give rise to such a
claim in the future. They include:
options or warrants
convertible loan stock or convertible preference shares
equity shares which at present are not entitled to any dividend, but will be entitled after
some future date.
If these instruments are converted into ordinary shares, the number of shares ranking for dividend
will increase, however the profits figure will generally not increase proportionately. Therefore, such
a conversion will reduce the profits attributable to each share. In other words they will have a
dilutive effect on EPS.
Diluted EPS is therefore calculated to indicate to investors the possible effects of a future dilution.
Note that only dilutive potential ordinary shares form part of the diluted EPS calculation.
Potential ordinary shares may also be anti-dilutive. In this case a conversion would increase the
number of ordinary shares but increase earnings to a greater extent, meaning that EPS increases
overall.
In determining whether potential ordinary shares are dilutive or antidilutive, each issue or series of
potential ordinary shares is considered separately rather than in aggregate.
648
23: Earnings per share | Part C Accounting for business transactions
This calculation is achieved in steps, with each group of potentially dilutive ordinary shares added
in turn from the most dilutive to the least dilutive. Options and warrants are generally included first
as they do not affect the profits part of the calculation.
After each addition, diluted EPS is calculated and the diluted earnings per share is the lowest figure
calculated at any stage in the sequence.
649
Financial Reporting
an issue of "free" shares. It is these "free" shares which are dilutive. The denominator of the DEPS
calculation is increased by the number of "free" shares issuable to reflect this.
Note that where the exercise price of share options exceeds average market value in a period, the
options are not dilutive.
Solution
Discussion: A company should assume the exercise of options in calculating diluted EPS. The
assumed proceeds from these issues should be considered to have been received from the issues
of shares at fair value. The difference between the number of shares issued and the number of
shares that would have been issued at fair value should be treated as an issue of ordinary shares
for no consideration.
The exercise of options has no impact on profits.
$3,000,000
Basic EPS (20X3) = = $1.50
2,000,000
For calculation of Diluted EPS (20X3)
Shares
Number of ordinary shares in issue during 20X3 2,000,000
Number of shares under share options 50,000
Number of shares that would have been issued at fair value = (50,000 $2/$4)
Therefore, number of shares issued for no consideration 25,000
2,025,000
$3,000,000
Therefore, diluted EPS (20X3) = = $1.48
2,025,000
Where expenses related to employee share options have not yet been recognised in profit or loss
in accordance with HKFRS 2, a further adjustment is required to the calculation of diluted earnings
per share.
Here, the expense which has not yet been recognised is calculated as a per share option amount.
This is then added to the exercise price, before the number of "free" shares is calculated.
Therefore:
Exercise price per share = $2 + ($15,000/50,000) = $2.30
Proceeds raised on exercise of options = $2.30 50,000 = $115,000
$115,000 / $4 = 28,750 shares would be issued at fair value, therefore 50,000 − 28,750 = 21,250
"free" shares would be issued
650
23: Earnings per share | Part C Accounting for business transactions
If the amount calculated is less than basic earnings per share, the loan stock is dilutive and should
be included in diluted earnings per share.
Solution
The increase in profits on conversion is: $4 million 5% 74% = $148,000
The number of potential ordinary shares is $4 million / $100 20 = 800,000
Earnings per share is therefore $148,000/800,000 = 18.5c. As this is lower than the basic earnings
per share of 45c, the convertible loan stock is dilutive and should be considered in the calculation
of diluted earnings per share:
Diluted earnings per share
Profits for the year attributable to ordinary shareholders: 45c 30million = $13.5 million.
$13,500,000 $148,000
DEPS 44.31c
30,000,000 800,000
Convertible preference shares are antidilutive whenever the amount of the dividend on such shares
declared in or accumulated for the current period per ordinary share obtainable on conversion
exceeds basic earnings per share.
In this case the instrument should be ignored for the purposes of calculating diluted EPS.
Self-test question 3
Lytton Co. has calculated amounts for basic earnings per share for the year ended 28 February
20X5 in accordance with HKAS 33 as:
Profit attributable to ordinary shareholders $29,295,000
Weighted average number of ordinary shares 46,500,000
The following is also relevant at 28 February 20X5:
1 There are 100,000 vested employee share options outstanding with an exercise price of $3.20
651
Financial Reporting
2 Lytton is also financed via $10 million 6% loan stock convertible into ordinary shares at a
rate of:
18 per $100 in 20X6
20 per $100 in 20X7
22 per $100 in 20X8
3 The average market value of a Lytton ordinary share in the year ended 28 February 20X5
was $4.20
4 Lytton pays tax at a rate of 25%
What is diluted earnings per share for the year ended 28 February 20X5?
(The answer is at the end of the chapter)
31 December Do not include the CIOS Include, from 1 July 20X7 to 31 December 20X7,
20X7 since the conditions were the CIOS shares that would be issuable if
not satisfied as at that date. 31 December 20X7 was the end of the contingency
period.
31 December Do not include the CIOS Include, from 1 January 20X8 to 31 December
20X8 since the conditions were 20X8, the CIOS that would be issuable if
not satisfied as at that date. 31 December 20X8 was the end of the contingency
period.
31 December Include the CIOS from Include, from 1 January 20X9 to 30 June 20X9, the
20X9 1 July 20X9. CIOS that would be issuable at 30 June 20X9.
652
23: Earnings per share | Part C Accounting for business transactions
In this case, if the effect is dilutive, the calculation of diluted EPS is based on the number of
ordinary shares that would be issued if the amount of earnings at the end of the reporting period
were the amount of earnings at the end of the contingency period.
Because earnings may change in future periods, the calculation of basic EPS does not include
such CIOS until the end of the contingency period because not all necessary conditions have been
satisfied.
HKAS 33.54 1.7.2 Contingent on future market price of the ordinary shares
The number of ordinary shares contingently issuable may depend on the future market price of the
ordinary shares.
In that case, if the effect is dilutive, the calculation of diluted EPS is based on the number of
ordinary shares that would be issued if the market price at the end of the reporting period were the
market price at the end of the contingency period.
If the condition is based on an average of market prices over a period of time that extends beyond
the end of the reporting period, the average for the period of time that has lapsed is used.
Because the market price may change in a future period, the calculation of basic EPS does not
include such CIOS until the end of the contingency period because not all necessary conditions
have been satisfied.
HKAS 33.55 1.7.3 Contingent on both future earnings and future market price of the
ordinary shares
The number of ordinary shares contingently issuable may depend on future earnings and future
prices of the ordinary shares. In such cases, the number of ordinary shares included in the diluted
EPS calculation is based on both conditions (i.e. earnings to date and the current market price at
the end of the reporting period).
CIOS are not included in the diluted EPS calculation unless both conditions are met.
Solution
Year ended 31 December 20X6
As the conditions for the issue of the additional ordinary shares to YY Co. have not been satisfied
as at 31 December 20X6, no contingently issuable shares were considered outstanding for
inclusion in the computation of basic EPS for the year ended 31 December 20X6. The denominator
of basic EPS was calculated as follows:
6
20,000,000 + (1,000,000 /12) = 20,500,000 shares
653
Financial Reporting
The original contingency period is the three-year period ending 31 December 20X8. Assuming the
contingency period ended at 31 December 20X6, the average annual profit was $12,000,000 and
according to the agreement 200,000 ordinary shares should be issued to YY Co.:
$12,000,000 – $8,000,000
= 200,000 shares
20
The denominator of the diluted EPS was calculated as follows:
6
20,500,000 + (200,000 /12) = 20,600,000 shares
Year ended 31 December 20X7
As the conditions for the issue of the additional ordinary shares to YY Co. have not been satisfied
as at 31 December 20X7, no contingently issuable shares were considered outstanding for
inclusion in the computation of basic EPS for the year ended 31 December 20X7. The denominator
of basic EPS was 21,000,000 shares.
Assuming the contingency period ended at 31 December 20X7, the average annual profit was:
$12,000,000 $5,000,000
= $8,500,000
2
and according to the agreement 25,000 ordinary shares should be issued to YY Co.:
$8,500,000 – $8,000,000
= 25,000 shares
20
The denominator of the diluted EPS was calculated as follows:
21,000,000 + 25,000 = 21,025,000 shares
Restatement of diluted EPS for the year ended 31 December 20X6 previously reported is not
permitted.
Year ended 31 December 20X8
As the conditions for the issue of the additional ordinary shares to YY Co. have not been satisfied
as at 31 December 20X8, no contingently issuable shares were considered outstanding for
inclusion in the computation of basic EPS for the year ended 31 December 20X8. The denominator
of basic EPS was 21,000,000 shares.
Assuming the contingency period ended at 31 December 20X8, the average annual profit was:
$12,000,00 0 $5,000,000 $4,000,000
= $7,000,000
3
and according to the agreement no ordinary shares should be issued to YY Co.
654
23: Earnings per share | Part C Accounting for business transactions
Standalone EPS =
Profit saved on issue of potential ordinary shares
Number of potential ordinary shares
If standalone EPS > BEPS, potential If standalone EPS < BEPS, potential
ordinary shares are anti-dilutive and ordinary shares are dilutive and
are ignored included in DEPS
655
Financial Reporting
Disclosure must still be made where the EPS figures (basic and/or diluted) are negative (i.e. a loss
per share).
Comparative EPS figures should also be presented. If, in the current period, the number of ordinary
or potential ordinary shares outstanding changes as a result of a capitalisation, bonus issue, share
split or reverse share split, comparative basic and diluted earnings per share should be adjusted
retrospectively.
1.10 Disclosure
In addition to EPS figures, an entity must disclose:
HKAS 33. 70 (a) The profit attributable to ordinary shareholders used in the EPS and diluted EPS calculations
and a reconciliation of this to profit for the period.
(b) The weighted average number of ordinary shares used in the EPS and diluted EPS
calculations and a reconciliation of these amounts to each other.
(c) Instruments that could potentially dilute basic EPS but which are not included in the
calculation of diluted EPS because they are anti-dilutive.
(d) Any transactions after the reporting date which would have changed significantly the number
of ordinary shares or potential ordinary shares at the period end had the transactions
occurred before that date.
Case study
Earnings per share
(a) Basic earnings per share
The calculation of the basic earnings per share is based on the consolidated profit
attributable to owners of the Company of approximately HK$296,780,000 (20X3:
HK$278,360,000) and the weighted average of 3,915,245,000 ordinary shares (20X3:
3,850,671,000 ordinary shares) in issue during the year, calculated as follows:
Weighted average number of ordinary shares
20X4 20X3
‘000 ‘000
Issued ordinary shares at the beginning of the year 3,850,671 3,847,245
Effect of new shares issued 64,574 –
3,915,245 3,850,671
(b) Diluted earnings per share
Diluted earnings per share for the years ended 30 June 20X4 and 20X3 was the same as the
basic earnings oer share because the exercise prices of the Company’s outstanding share
options were higher than the average market price of the Company’s shares during both
periods.
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is not very rational, as EPS can depend on many, often subjective, assumptions used in preparing
the statement of profit or loss and other comprehensive income. It does not necessarily bear any
relation to the value of a company, and of its shares. Nevertheless, in practice the market is
sensitive to EPS.
EPS is commonly used as a means of assessing the stewardship and management role
performed by company directors and managers. Remuneration packages are often linked to EPS
growth, thereby increasing the pressure on management to improve EPS. The danger of this,
however, is that management effort may go into distorting results to produce a favourable EPS.
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Financial Reporting
Topic recap
Disclose basic and diluted EPS from continuing and discontinued (where relevant) operations on the
face of the statement of profit or loss and other comprehensive income.
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23: Earnings per share | Part C Accounting for business transactions
Answer 1
20X6 20X7 20X8
$ $ $
20X6 EPS as originally reported
$110,000,000/5,000,000 22
20X6 EPS restated for rights issue =
10 20
($110,000,000/5,000,000)
11
20X7 EPS including effects of rights issue 25.4
150,000,000
5m× 2 / 12×11/ 10 + 6m×10 / 12
20X8 EPS 30
$180,000,000/6,000,000
Working – theoretical ex-rights price
Fair value of all outstanding shares + total received from exercise of rights
No shares outstanding prior to exercise + no shares issued in exercise
Answer 2
(a) 20X1
1 Jan 20X1 – 5,000,000 6/5 4/12 months 2,000,000
30 April 20X1
Bonus issue 5m/5 1,000,000
1 May 20X1 – 6,000,000 5/12 months 2,500,000
30 Sept 20X1
Part paid cash issue
1m 60% 600,000
1 Oct 20X1 – 6,600,000 3/12 months 1,650,000
31 Dec 20X1
6,150,000
4,981,500
Therefore, earnings per share is = 81.00c
6,150,000
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Financial Reporting
20X2
NB the part paid shares are now fully paid and therefore the opening balance of shares is
7m rather than 6.6m
1 Jan 20X2 – 7,000,000 3.65/3.64 7/12 months 4,094,551
31 July 20X2
Rights issue 7m/7 1,000,000
1 August 20X2 – 8,000,000 5/12 months 3,333,333
31 Dec 20X2
7,427,884
Computation of theoretical ex-rights price
Fair value of all outstanding shares
total received from exercise of rights ($3.65 7) + ($3.55 1)
= = $3.64
Number of shares outstanding prior to 8
exercise number of shares issued in exercise
6,165,200
Therefore earnings per share is = 83.00c
7,427,884
Answer 3
$29,295,000
Basic EPS = = 63 cents
46.5 million
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23: Earnings per share | Part C Accounting for business transactions
Exam practice
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Financial Reporting
662
chapter 24
Operating segments
Topic list
Learning focus
Listed companies are required to apply HKFRS 8 Operating Segments and you must be able
to identify reportable operating segments and the required disclosures.
663
Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.23 Operating segments 3
3.23.01 Identify and discuss the nature of segmental information to be
disclosed in accordance with HKFRS 8
3.23.02 Explain when operating segments should be aggregated and
disaggregated
3.23.03 Disclose the relevant information for operating segments and
appropriate entity-wide information
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Many entities now operate on a multinational basis in a number of different geographical and
product markets. These distinct markets may operate very differently from one another and be
subject to different levels of risks and returns, and differing future prospects.
The reason for segment reporting is to provide users of accounts with information on such
segments so that they can make a better assessment of an entity's past performance and position,
and identify which segments of an entity are successful and which are less so.
Key term
An operating segment is a component of an entity:
(a) that engages in business activities from which it may earn revenues and incur expenses
(including revenues and expenses relating to transactions with other components of the
same entity),
(b) whose operating results are regularly reviewed by the entity's chief operating decision maker
to make decisions about resources to be allocated to the segment and assess its
performance, and
(c) for which discrete financial information is available. (HKFRS 8)
The term "chief operating decision maker" identifies a function, not necessarily a manager with a
specific title. That function is to allocate resources and to assess the performance of the entity's
operating segments.
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Financial Reporting
HKFRS 8 requires entities within its scope to report financial and descriptive information about its
reportable segments, so the first task is to understand which segments are reportable. Reportable
segments are either individual operating segments or aggregations of operating segments (see
below) that meet the specified criteria (the "10% test" explained below).
Self-test question 1
Styledesign, a listed clothing manufacturer, trades in five business areas which are reported
separately in its internal accounts provided to the chief operating decision maker. The results of
these segments for the year ended 31 December 20X1 are as follows.
OPERATING SEGMENT INFORMATION AS AT 31 DECEMBER 20X1
Revenue Segment Segment Segment
External Internal Total profit/(loss) assets liabilities
$m $m $m $m $m $m
Ladies' fashion: Asia 14 7 21 1 31 14
Rest of world 56 3 59 13 778788 34
Mens' fashion 59 8 67 9 104 35
Childrens' fashion 22 0 22 (2) 30 12
Sportswear 12 3 15 2 18 10
Uniforms 18 24 42 (1) 54 19
181 45 226 22 315 124
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24: Operating segments | Part C Accounting for business transactions
Required
Which of the operating segments of Styledesign constitute a "reportable" operating segment under
HKFRS 8 Operating Segments for the year ending 31 December 20X1?
(The answer is at the end of the chapter)
Management to identify
operating segments reporting
Yes Aggregate
Any operating segments meet segments if
all aggregation criteria? desired
No
No
Do identified reportable Yes
segments account for 75% of
the total external revenue?
No
HKFRS
8.29,30
1.4.4 Restatement of previously reported information
If an entity changes the structure of its internal organisation in a manner that causes the
composition of its reportable segments to change, the corresponding information for earlier periods,
including interim periods, shall be restated unless the information is not available and the cost to
develop it would be excessive. The determination of whether the cost is excessive shall be made
for each individual item of disclosure. Following a change in the composition of its reportable
segments, an entity shall disclose whether it has restated the corresponding items of segment
information for earlier periods.
If an entity has changed the structure of its internal organisation in a manner that causes the
composition of its reportable segments to change and if segment information for earlier periods,
including interim periods, is not restated to reflect the change, the entity shall disclose in the year
in which the change occurs segment information for the current period on both the old basis and
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Financial Reporting
the new basis of segmentation, unless the necessary information is not available and the cost to
develop it would be excessive.
HKFRS 8.20-
24,28, 1.5 Disclosures
32,33,34
Topic highlights
HKFRS 8 disclosures are of:
general information about segments
financial information about segments
– segment profit or loss
– segment assets
– segment liabilities
– basis of measurement
Disclosures are also required about the revenues derived from products or services and about the
countries in which revenues are earned or assets held, even if that information is not used by
management in making decisions.
Disclosures required by the HKFRS are extensive, and best learned by looking at the example and
proforma, which follow the list.
(a) General information
(i) Factors used to identify the entity's reportable segments
(ii) Judgments made by management in applying the aggregation criteria
(iii) Types of products and services from which each reportable segment derives its
revenues
(b) Information about profit or loss, assets and liabilities
For each reportable segment the entity must disclose a measure of profit or loss.
The following further items must also be disclosed if they are included in the measure of
segment profit or loss reported to the chief operating decision maker, or are otherwise
regularly reported to the chief operating decision maker:
External
Revenue
Interest revenue Inter-co segment
Interest expense
Depreciation and amortisation
Other material non-cash items
Material items of income/expense (HKAS 1)
Profit Share of profit of associates/joint ventures equity
accounted
Profit or loss (as reported to chief operating
decision maker)
Income tax expense
A measure of total assets and liabilities is also reported for each reportable segment if such
amounts are regularly provided to the chief operating decision maker.
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24: Operating segments | Part C Accounting for business transactions
The following further items must also be disclosed if they are included in the measure of
segment assets reported to the chief operating decision maker, or are otherwise regularly
reported to the chief operating decision maker:
External revenue
(2) By:
Entity's country of domicile, and
Geographical areas
All foreign countries (subdivided if
(1)
Non-current assets material)
Notes
1 Non-current assets excludes financial instruments, deferred tax assets, post-
employment benefit assets, and rights under insurance contracts.
2 External revenue is allocated based on the customer's location.
(g) Information about reliance on major customers (i.e. those who represent more than 10%
of external revenue).
1.5.1 Disclosure example from HKFRS 8
The following example is adapted from the HKFRS 8 Implementation Guidance, which emphasises
that this is for illustrative purposes only and that the information must be presented in the most
understandable manner in the specific circumstances.
The hypothetical company does not allocate tax expense (tax income) or non-recurring gains and
losses to reportable segments. In addition, not all reportable segments have material non-cash
items other than depreciation and amortisation in profit or loss. The amounts in this illustration,
denominated in thousands of dollars, are assumed to be the amounts in reports used by the chief
operating decision maker.
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24: Operating segments | Part C Accounting for business transactions
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Financial Reporting
The post-implementation review of IFRS 8 (HKFRS 8) published by the IASB in 2013 concluded
that the use of this management perspective has made communication with investors easier. It also
noted that the benefits are increased where all aspects of an entity’s reporting align, so that
operating segment disclosures and management commentary are based on the same segments.
There do, however, remain a number of criticisms of HKFRS 8, as detailed in the next section.
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24: Operating segments | Part C Accounting for business transactions
Self-test question 2
Alwoodley Foods, a listed company based in Hong Kong, is engaged in business activities as
follows:
Results reviewed by Quantitative
Managing Director thresholds met
Retail sales (bakery) Yes Yes
Online sales (bakery) Yes No
Catering services (business market) Yes No
Catering services (domestic market) Yes No
Manufacturing (bakery products) Yes Yes
Publishing – cook books and magazines Yes Yes
Publishing - website No No
Leasing – offices Yes No
Leasing – manufacturing sites Yes No
It has been determined that the Managing Director of Alwoodley Foods is the chief operating
decision maker. A measure of profit or loss is reported to her but no measure of assets or liabilities
is reported.
When aggregated the business and domestic catering services operations meet the quantitative
threshold. The online sales and office leasing operations also meet the quantitative thresholds
when aggregated.
Discrete financial information is available for the business activities for the year ended 31
December 20X1:
SEGMENT INFORMATION FOR THE YEAR ENDED 31 DECEMBER 20X1
Revenue Revenue by location of customer
External Internal Total Hong Kong PRC Other
$m $m $m $m $m $m
Retail sales (bakery) 129 - 129 78 34 17
Online sales (bakery) 7 7 7 - -
Catering services (business) 48 7 55 52 3 -
Catering services (domestic) 11 - 11 11 - -
Manufacturing (bakery) 3 37 40 38 2 -
Publishing – books and 32 - 32 15 12 5
magazines
Publishing - website 3 - 3 3 - -
Leasing - offices 13 - 13 13 - -
Leasing – manuf’g sites 10 5 15 12 3 -
Adjustments - (49) (49) (49)
Total reported 256 - 256 180 54 22
Alwoodley Foods has no investments in other companies,
Required
(a) Prepare an operating segments disclosure note for Alwoodley Foods in accordance with
HKFRS 8 insofar as the information provided allows.
(b) Identify the additional information that is required in order to provide a complete HKFRS 8
disclosure note for Alwoodley Foods.
(The answer is at the end of the chapter)
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Financial Reporting
Topic recap
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24: Operating segments | Part C Accounting for business transactions
Answer 1
Revenue as % of Profit or loss as % of
total revenue profit of all segments Assets as % of total
($226m) in profit ($25m) assets ($315m)
Ladies' fashion * 35.4% 56% 34.6%
Mens' fashion 29.6% 36% 33.0%
Childrens' fashion 9.7% 8% 9.5%
Sportswear 6.6% 8% 5.7%
Uniforms 18.6% 4% 17.1%
* The ladies' fashion segments are aggregated due to their similar economic characteristics
At 31 December 20X1 three of the five operating segments are reportable operating segments:
Ladies' fashion
All size criteria are met
Mens' fashion
All size criteria are met
Children's fashion
The children's fashion segment is not separately reportable as it does not meet the quantitative
thresholds. It can, however, still be reported as a separate operating segment if management
believes that information about the segment would be useful to users of the financial statements.
Alternatively, the group could consider amalgamating it with another segment, providing the two
operating segments have similar economic characteristics and share a majority of the
"aggregation" criteria, which may be the case, particularly if "uniforms" refers to school uniforms.
Otherwise it would be disclosed in an "All other segments" column.
Sportswear
The sportswear segment does not meet the quantitative thresholds and therefore is not separately
reportable. It can also be reported separately if management believes the information would be
useful to users. Alternatively, the group may be able to amalgamate it with another segment,
providing the operating segments have similar economic characteristics and share a majority of the
"aggregation" criteria. Otherwise, it would also be disclosed in an "All other segments" column.
Uniforms
The uniforms segment meets the quantitative threshold in respect of revenue and assets and so is
reported separately.
Note. HKFRS 8.15 states that at least 75% of total external revenue must be reported by operating
segments. This condition has been met as the reportable segments (excluding children's wear and
sportswear) account for 81% of total external revenue (147/181).
Answer 2
Alwoodley Foods
(a) Operating segments disclosure note
Reportable segments are those segments of the business that meet the HKFRS 8 definition
of an operating segment and meet quantitative thresholds as set by HKFRS 8.
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Financial Reporting
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24: Operating segments | Part C Accounting for business transactions
(b) An entity must disclose a measure of profit or loss for each reportable segment as reviewed
by the chief operating decision maker. Therefore this information is required and must be
disclosed for the four reportable segments.
In addition the following information is required for each of the four reportable segments and
should be disclosed if included in the measure of profit or loss or otherwise reviewed by the
chief operating decision maker:
interest revenue and expense
depreciation and amortisation and other material non-cash items
material items of income/expense
income tax expense
In order to reconcile the amounts above to entity wide equivalent amounts, the same
information is required for the non-reportable segments.
The geographical information should be extended to include information on the location of
non-current assets and therefore the carrying amount of non-current assets is required
according to whether it is based in Hong Kong, PRC or another country.
Information on reliance on major customers is required and should be disclosed.
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Financial Reporting
Exam practice
HKFRS 8 18 minutes
Ms. Li, the finance manager of a company listed on The Stock Exchange of Hong Kong Limited, is
assessing the segment reporting requirements under HKFRS 8 Operating Segments included in
the financial statements of the company and has tentatively concluded that:
(a) the company has a free choice in determining a business activity or business activities as an
operating segment;
(b) the company can have 12 reportable segments;
(c) segment information should be prepared in conformity with the accounting policies adopted
for preparing and presenting the financial statements of the company; and
(d) during the financial year, the company disposed of the businesses of one of its reportable
segments. The company is required to restate the comparatives segment information in the
financial statements for the current year.
Required
Please comment on the above conclusions with reference to HKFRS 8 Operating Segments.
(10 marks)
HKICPA May 2007
678
chapter 25
Topic list
Learning focus
The preparation of interim financial statements is relevant for evaluating the performance of a
listed entity. Therefore, the application of accounting standards is very important to measure
the performance in a consistent manner.
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Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.24 Interim financial reporting 3
3.24.01 Identify the circumstances in which interim financial reporting is
required in accordance with HKAS 34
3.24.02 Explain the purpose and advantages of interim financial reporting
3.24.03 Explain the recognition and measurement principles of interim
financial statements and apply them
3.24.04 Disclose the relevant information for interim financial statements
including seasonality
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1.1 Objective
The objective of HKAS 34 is to prescribe the minimum content of an interim financial report
and to prescribe the principles for recognition and measurement in complete or condensed
financial statements for an interim period.
Relevant and reliable interim financial reporting enhances users' understanding of the performance
and position of an entity. In addition, it may be a requirement for some companies.
The advantages of interim reporting are:
(a) Financial information is more useful if provided more frequently and in a timely manner.
(b) It provides up to date information, since investors do not only make investment and
divestment decisions at period ends.
(c) Investors can see the impact of events soon after they occur.
(d) Interim information may help to project financial amounts for the full year.
(e) Interim results can provide evidence of trends and seasonality which is not evident from
annual results.
Key terms
Interim period is a financial reporting period shorter than a full financial year.
Interim financial report means a financial report containing either a complete set of financial
statements (as described in HKAS 1) or a set of condensed financial statements (as described in
this standard) for an interim period. (HKAS 34)
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Financial Reporting
HKAS 34.6,8
1.4 Minimum components
The standard specifies the minimum component elements of an interim financial report:
Condensed statement of financial position
Condensed statement of profit or loss and other comprehensive income
Condensed statement of changes in equity
Condensed statement of cash flows
Selected explanatory notes
The rationale for requiring only condensed statements and selected note disclosures is that entities
need not duplicate information in their interim report that is contained in their report for the previous
financial year. Interim statements should focus more on new events, activities and
circumstances.
HKAS 34.
9-11
1.5 Form and content
HKAS 1 should be followed when full financial statements are given as interim financial statements,
otherwise HKAS 34 states the minimum contents that should be disclosed.
Where condensed financial statements are given instead, they should include, at least, those
headings and subtotals that appeared in its most recent annual financial statements and selected
explanatory notes. Additional items or notes should be presented if their omission results in
misleading condensed interim financial statements.
Where an entity is within the scope of HKAS 33 Earnings Per Share it should present basic and
diluted EPS for the interim period.
HKAS 1.5.1 Selected explanatory notes
34.15,15A,
According to HKAS 34, an entity should include in its interim report an explanation of events and
transactions that are significant to an understanding of changes in financial position and
performance since the end of the last reporting period. Information disclosed in relation to those
events and transactions should update the relevant information presented in the most recent
annual financial report.
It is not necessary for the notes to the interim accounts to provide relatively insignificant updates to
the information provided in the most recent annual financial report.
Self-test question 1
Give some examples of the events and transactions for which disclosures would be required if they
were significant.
(The answer is at the end of the chapter)
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25: Interim financial reporting | Part C Accounting for business transactions
(d) Nature and amount of changes in estimates of amounts reported in earlier interim reports
of the same financial year, or prior financial years.
(e) The issue, repayment and repurchase of equity or debt securities.
(f) Dividends paid on ordinary shares and dividends paid on other shares.
(g) Where segment information is provided in the annual financial statements, the following
should be disclosed in the interim financial statements:
(i) Revenues from external customers (if included in the measure of profit reviewed by
the chief operating decision maker);
(ii) Intersegment revenues (if included in the measure of profit reviewed by the chief
operating decision maker);
(iii) A measure of segment profit or loss;
(iv) A measure of total assets and liabilities for a particular reportable segment if such
amounts are regularly provided to the chief operating decision maker and if there has
been a material change from the amount disclosed in the last financial statements for
that reportable segment;
(v) A description of differences in the basis of segmentation or measurement of profit or
loss from the last annual financial statements;
(vi) A reconciliation of total profit or loss of reportable segments to the entity's profit or loss
before tax and discontinued operations.
(h) Events after the interim period that have not been reflected in the financial statements for the
interim period;
(i) The effect of the acquisition or disposal of subsidiaries during the interim period.
(j) For financial instruments, the disclosures about fair value required by HKFRS 13 Fair Value
Measurement and HKFRS 7 Financial Instruments: Disclosures.
(k) For entities becoming or ceasing to be investment entities, the relevant HKFRS 12
disclosures.
An amendment to HKAS 34 made in 2014 clarifies that these disclosures must be given either in
the interim financial statements or incorporated by cross-reference from the interim financial
statements to some other statement (eg management commentary). The other statement must be
available to users of the financial statements on the same terms as the interim statements and at
the same time. This amendment is effective retrospectively for annual periods starting on or after 1
January 2016.
Except as required above, the disclosures required by other HKFRS are not required if an entity's
interim financial report includes only condensed financial statements and selected explanatory
notes rather than a complete set of financial statements.
The entity should also disclose the fact that the interim report has been produced in compliance
with HKAS 34 on interim financial reporting.
Illustration
The following are examples of select disclosure notes required in interim reports:
1 General information
The condensed interim consolidated financial statements are for the six months ended 30
June 20X3 and have been prepared in accordance with HKAS 34. They do not include all of
the information required in annual financial statements in accordance with HKFRS and
should be read in conjunction with the consolidated financial statements for the year ended
31 December 20X2.
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25: Interim financial reporting | Part C Accounting for business transactions
HKAS 34.23
1.7 Materiality
In deciding how to account for an item in an interim financial report, materiality should be assessed
in relation to the interim period financial data. It should be recognised that interim measurements
may rely to a greater extent on estimates than annual financial data.
HKAS 34
Illustrative 1.9 Applications of the recognition and measurement principles
examples
Section B Specific applications of the recognition and measurement principles are provided in an appendix
to the standard. Some of these examples are explained below, by way of explanation and
illustration.
1.9.1 Payroll taxes and insurance contributions paid by employers
The assessment of these costs is done annually in some countries, though they are paid at an
uneven rate during the year. A large portion of the taxes is paid in the earlier phase of the year
while a much smaller portion is paid in the later part of the year. This situation thus entails the use
of an estimated average annual tax rate in an interim statement, not the actual tax paid since the
taxes are assessed on an annual basis, even though the payments pattern is uneven.
Self-test question 2
As an employer, Hung Line Co is required to pay 3% of annual salaries into an insurance fund.
Contributions are capped at $500,000, which means that no contributions for salaries in excess of
this amount are required.
One of Hung Line Co’s directors earns a monthly salary of $50,000.
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Financial Reporting
Required
What amount should be recognised as an expense in Hung Line’s interim financial statements for
the first 6 months of the year in respect of insurance contributions relating to the director?
(The answer is at the end of the chapter)
Example: Bonus
BlueBear's year end is 31 December and it is currently preparing interim financial statements for
the six months to 30 June 20X1. It has a contractual agreement with its staff that it will pay them
an annual bonus equal to 8% of their annual salary if the full year's output exceeds 5,000,000 units.
Budgeted output is 5,500,000 units and the entity has achieved budgeted output during the first six
months of the year. Annual salaries are estimated to be $80 million, with the salary cost in the first
half year to 30 June being $35 million.
Required
How should the bonus be reflected in the interim financial statements?
Solution
It is probable that the bonus will be paid, given that the actual output already achieved in the year is
in line with budgeted figures, which exceed the required level of output. So a bonus of $2.8 million
(8% $35m) should be recognised in the interim financial statements at 30 June 20X1.
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be part of a non-monetary intangible asset that has not yet been recognised, it would not be
appropriate to have it 'deferred'; it should be expensed in the interim report.
1.9.7 Depreciation
Depreciation and amortisation should be calculated and charged in an interim statement only on
non-current assets already acquired. No such calculation is required for those non-current assets
to be acquired later in the financial year.
1.9.8 Foreign currency translation gains and losses
HKAS 21 should be applied and the amounts should be computed based on the same principles as
at the financial year end.
1.9.9 Tax on income
An income tax expense (tax on profits), calculated based on an estimated average annual tax rate
for the year, should be included in the interim statements of an entity. To illustrate, suppose a tax
rate of 20% is to be applied on the first $500,000 of a company's profit and 22% on profits above
$500,000. A company which makes a profit of $500,000 in its first half year, and expects to make
$500,000 in the second half year should apply an expected annual average tax rate of 21% in the
interim financial report, not 20%. Since income tax on company profits is charged on an annual
basis, an effective annual rate is therefore considered as appropriate for each interim period.
Suppose a company earns pre-tax income of $300,000 in the first quarter of the year, but expects a
loss of $100,000 in each of the following three quarters, so that net income before tax for the whole
year is zero. Assume also that the tax rate for the current year is 20%. The loss will not be
anticipated in this case and thus a tax charge of $60,000 should be recorded for the first quarter of
the year (20% of $300,000) and a negative tax charge of $20,000 for each of the next three
quarters, if actual losses are the same as anticipated.
Where the tax year and the financial year of a company do not coincide, a separate estimated
weighted average annual tax rate should be used in the interim periods that fall within the tax year.
Tax credits are given, based on amounts of capital expenditure or research and development and
so on, to set off against the tax payable in some countries. If these credits are calculated and
granted annually, it is appropriate to include anticipated tax credits within the calculation of the
estimated average tax rate for the year. This average tax rate is then applied to calculate the
income tax for interim periods. However, in the case of a tax benefit relating to a specific one-time
event, it should be recognised within the tax expense for the interim period in which the event
occurs.
Self-test question 3
Flyman is currently preparing interim financial statements for the six months to 30 June 20X1. Its
profit before tax for the six-month period to 30 June 20X1 is $5 million. The business is seasonal
and the profit before tax for the six months to 31 December 20X1 is almost certain to be $9 million.
Income tax is calculated as 14% of reported annual profit before tax if it does not exceed $10
million. If annual profit before tax exceeds $10 million the tax rate on the whole amount is 16%.
Required
Under HKAS 34 what should the taxation charge be in the interim financial statements?
(The answer is at the end of the chapter)
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Topic recap
Minimum components:
Condensed statement of financial position
Condensed statement of profit or loss and other
comprehensive income
Condensed statement of changes in equity
Condensed statement of cash flows
Selected notes
Basic and diluted EPS if within scope of HKAS 33
The same headings and sub-totals as those in the most
recent annual financial statements should be used.
Notes should include an explanation of significant events and
transactions in the interim period and comments on
seasonality.
690
25: Interim financial reporting | Part C Accounting for business transactions
Answer 1
HKAS 34 provides the following list of events and transactions for which disclosures would be
required if they were significant:
(a) The write down of inventories to net realisable value and the reversal of such a write-down
(b) Recognition of a loss from the impairment of financial assets, property, plant and equipment,
intangible assets, or other assets, and the reversal of such a loss
(c) Reversal of any provisions for the costs of restructuring
(d) Acquisitions and disposals of items of property, plant and equipment
(e) Litigation settlements
(f) Corrections of prior period errors
(g) Changes in the business or economic circumstances that affect the fair value of the entity's
financial assets and financial liabilities, whether those assets and liabilities are recognised at
fair value or amortised cost
(h) Any loan default or breach of a loan agreement that has not been remedied on or before the
end of the reporting period
(i) Related party transactions
(j) Transfers between levels of the fair value hierarchy used in measuring the fair value of
financial instruments
(k) Changes in the classification of financial assets as a result of a change in the purpose or use
of those assets, and
(l) Changes in contingent liabilities or contingent assets.
This list is not exhaustive.
Individual HKFRS provide guidance regarding disclosure requirements for many of the items listed
above. When the events or transactions listed are significant, the interim report should provide an
explanation of and update to the relevant information included in the financial statements of the last
annual reporting period.
Answer 2
The director’s annual salary is 12 $50,000 = $600,000. This is in excess of the $500,000
contribution cap.
The annual contribution for the director is therefore $500,000 3% = $15,000.
Although the salary in the first six months of the year is $300,000 and below the contributions cap,
to recognise a contributions expense of 3% $300,000 = $9,000 would mean that an unequal
expense of $6,000 is recognised in the second half of the year.
Therefore the expense to be recognised in the interim financial statements is $15,000 6/12 =
$7,500.
691
Financial Reporting
Answer 3
The taxation charge in the interim financial statements is based upon the weighted average rate for
the year. In this case the entity’s tax rate for the year is expected to be 16%. The taxation charge in
the interim financial statements will be $5m 16% = $800,000.
692
25: Interim financial reporting | Part C Accounting for business transactions
Exam practice
Hintrim 18 minutes
Hintrim's accounting year ends on 31 December each year and it is currently preparing interim
financial statements for the half year to 30 June 20X4.
The financial controller is unsure about how to deal with three issues relating to HKAS 34 Interim
Financial Reporting, and has asked for your help.
(a) Hintrim has a contractual agreement with its staff that it will pay them an annual bonus equal
to 10% of their annual salary if the full year's output exceeds one million units. Budgeted
output is 1.4 million units and the entity has achieved budgeted output during the first six
months of the year. Annual salaries are estimated to be $100 million, with the cost in the first
half year to 30 June being $45 million.
How should the bonus be reflected in the interim financial statements?
(b) The price of Hintrim's products tends to vary. At 30 June 20X4, it has inventories of 100,000
units, at a cost per unit of $1.40. The net realisable value of the inventories is $1.20 per unit
at 30 June 20X4. The expected net realisable value of the inventories at 31 December 20X4
is $1.55 per unit.
How should the value of the inventories be reflected in the interim financial statements?
(c) Hintrim's profit before tax for the six-month period to 30 June 20X4 is $6 million. The
business is seasonal and the profit before tax for the six months to 31 December 20X4 is
almost certain to be $10 million. Income tax is calculated as 25% of reported annual profit
before tax if it does not exceed $10 million. If annual profit before tax exceeds $10 million the
tax rate on the whole amount is 30%.
Advise the financial controller. (10 marks)
693
Financial Reporting
694
chapter 26
Presentation of financial
statements
Topic list
Learning focus
HKAS 1 affects all entities and you must be familiar with the requirements of the standard.
695
Financial Reporting
Learning outcomes
Competency
level
Prepare the financial statements for an individual entity in accordance
with Hong Kong Financial Reporting Standards and statutory reporting
requirements
4.01 Primary financial statement preparation 3
4.01.01 Prepare the statement of financial position, the statement of profit or
loss and other comprehensive income, the statement of changes in
equity and the statement of cash flows of an entity in accordance
with Hong Kong accounting standards
4.01.02 Explain the minimum line items that should be presented in the
financial statements and criteria for additional line items
4.02 Financial statement disclosure requirements 3
4.02.01 Disclose accounting policy and items required by the HKFRS,
Companies Ordinance and other rules and regulations
4.02.02 Explain the importance to disclose significant judgment and
estimates
696
26: Presentation of financial statements | Part C Accounting for business transactions
Old New
Balance sheet Statement of financial position
Income statement Statement of profit or loss and other comprehensive income
Cash flow statement Statement of cash flows
697
Financial Reporting
(b) Changes in equity arising from all other transactions are reported in the statement of profit
or loss and other comprehensive income.
The statement of profit or loss and other comprehensive income therefore includes both:
the profit or loss for the period and
other comprehensive income.
HKAS 1.7 Other comprehensive income is defined by HKAS 1 (Revised) as income and expense (including
reclassification adjustments) that are not recognised in profit or loss as required or
permitted by other HKFRS. The standard goes on to list the components of other comprehensive
income as:
(a) changes in the revaluation surplus
(b) those actuarial gains and losses on defined benefit plans not recognised in profit or loss
(c) gains and losses arising from translating the financial statements of a foreign operation
(d) gains and losses from investments in equity instruments measured at fair value through
other comprehensive income
(e) the effective portion of gains and losses on hedging instruments in a cash flow hedge.
698
26: Presentation of financial statements | Part C Accounting for business transactions
Current liabilities
Trade and other payables 115,100 187,620
Short-term borrowings 150,000 200,000
Current portion of long-term borrowings 10,000 20,000
Current tax payable 35,000 42,000
Short-term provisions 5,000 4,800
Total current liabilities 315,100 454,420
Total liabilities 492,750 692,700
Total equity and liabilities 1,466,500 1,524,200
699
Financial Reporting
700
26: Presentation of financial statements | Part C Accounting for business transactions
(a) The entity expects to realise, sell or (a) The entity expects to settle the liability in
consume the asset in its normal its normal operating cycle
operating cycle
(b) The asset is held primarily for trading (b) The liability is held primarily for trading
(c) The entity expects to realise the asset (c) The liability is due to be settled within
within 12 months after the reporting 12 months after the reporting period
period
(d) The asset is cash or a cash equivalent (d) The entity does not have an
unless the asset is restricted from being unconditional right to defer settlement of
exchanged or used to settle a liability for the liability for at least 12 months after
at least the 12 months after the reporting the reporting period. Terms of a liability
period that could, at the option of the
counterparty, result in its settlement by
the issue of equity instruments do not
affect the classification
A long-term financial liability due to be settled within 12 months of the end of reporting period
should be classified as a current liability, even if an agreement to refinance, or to reschedule
payments, on a long-term basis is completed after the reporting period and before the financial
statements are authorised for issue.
A long-term financial liability that is payable on demand because the entity breached a
condition of its loan agreement should be classified as current at the end of reporting period even
if the lender has agreed after the reporting period, and before the financial statements are
authorised for issue, not to demand payment as a consequence of the breach.
701
Financial Reporting
HK Interpretation 5 was issued in November 2010. It sets out the conclusions of the HKICPA in
relation to whether a term loan subject to a repayment on demand clause should be classified as
current or non-current.
HKICPA concludes that the classification depends on the rights and obligations of the lender and
borrower as contractually agreed and in force at the reporting date. Where a lender has an
unconditional right to call the loan at any time, it must be classified by the borrower as current,
regardless of the probability of the lender exercising their right within 12 months.
HKAS 1.79 1.2.4 Disclosure of share capital and reserves
HKAS 1 requires that the following information is disclosed either in the statement of financial
position or statement of changes in equity or notes to the accounts:
(a) For each class of share capital:
(i) the number of shares authorised
(ii) the number of shares issued and fully paid, and issued but not fully paid
(iii) par value per share, or that the shares have no par value
(iv) a reconciliation of the number of shares outstanding at the beginning and end of the
period
(v) the rights of each class of shares
(vi) shares held by the entity itself or a subsidiary or an associate, and
(vii) shares reserved for issue under options and contracts for the sale of shares, including
terms and amounts, and
(b) A description of the nature and purpose of each reserve within equity.
Note that the new Companies Ordinance in Hong Kong abolishes the concepts of authorised share
capital and par value per share from 2014.
Self-test question 1
The following are assets and liabilities of a boat and ship building company at 31 December 20X4:
(a) Specialist steel that is used in the construction of warships. The steel is left over from a
recently completed order; it is unlikely to be used within 12 months as the company has no
current orders for warships.
(b) Two completed small fishing boats that are available for sale to the general public.
(c) An amount of $6million due from a customer that has contracted the company to build a
tugboat. $3.7million of the $6million has been billed to the customer.
(d) A part complete tourist boat that the company intends to offer for sale to local river cruise
companies when complete. The boat is likely to take 14 months to complete.
(e) The company has an outstanding bank loan of $60million. The maturity date attached to the
loan was 20Y0, however the company has breached a covenant during 20X4 making it
repayable on demand. The bank has stated that it will not demand repayment.
Required
Explain how these assets should be presented in the statement of financial position of the boat and
shipbuilding company at 31 December 20X4.
(The answer is at the end of the chapter)
702
26: Presentation of financial statements | Part C Accounting for business transactions
Other comprehensive income for the year, net of tax 14,000) 28,000
Total comprehensive income for the year 107,250 93,500
703
Financial Reporting
20X9 20X8
$'000 $'000
Profit attributable to
Owners of the parent 97,000 52,400
Non-controlling interests 24,250 13,100
121,250 65,500
Total comprehensive income attributable to
Owners of the parent 85,800 74,800
Non-controlling interests 21,450 18,700
107,250 93,500
Earnings per share (in currency units)
Basic and diluted 0.46 0.30
704
26: Presentation of financial statements | Part C Accounting for business transactions
Other comprehensive income for the year, net of tax (14,000) 28,000
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 107,250 93,500
Total comprehensive income attributable to
Owners of the parent 85,800 74,800
Non-controlling interests 21,450 18,700
107,250 93,500
705
Financial Reporting
(g) If a financial asset is reclassified out of fair value through other comprehensive income to fair
value through profit or loss, any cumulative gain or loss previously recognised in other
comprehensive income that is reclassified to profit or loss
(h) Tax expense
(i) A single amount for the total of discontinued operations.
Additional line items, headings and subtotals should be presented when such presentation is
relevant to an understanding of the entity's financial performance.
An analysis of expenses by either nature or function, whichever provides information that is reliable
and more relevant, should also be disclosed either in the statement of profit or loss and other
comprehensive income or in the notes to the accounts.
When items of income or expense are material, their nature and amount must be disclosed
separately, either in the statement of profit or loss and other comprehensive income or in the notes
to the accounts.
HKAS 1 does not permit the following in the statement of profit or loss and other comprehensive
income:
The offsetting of income and expenses (unless required or permitted by an HKFRS)
The presentation of any items of income or expense as extraordinary items.
Other comprehensive income section
As a result of the Disclosure Initiative HKAS 1 requires that other comprehensive income arising
from associates and joint ventures is presented separately from the rest of other comprehensive
income.
Consequently, the other comprehensive income section presents line items for the amounts for the
period of:
(a) Items of other comprehensive income classified by nature and grouped into those that:
will not be reclassified subsequently to profit or loss
will be reclassified subsequently to profit or loss when specific conditions are met.
(b) The share of the other comprehensive income of associates and joint ventures accounted for
using the equity method, separated into the share of items that:
will not be reclassified subsequently to profit or loss
will be reclassified subsequently to profit or loss when specific conditions are met.
Items of other comprehensive income should be presented either:
net of related tax effects, or
before related tax effects, with one amount shown for the aggregate amount of income tax
relating to those items.
Where the second approach is adopted, the amount of tax should be allocated between those
items which may be reclassified subsequently to profit or loss and those which will not.
Reclassification adjustments relating to components of other comprehensive income should be
disclosed either in the statement of profit or loss and other comprehensive income or in the notes
to the accounts. These are amounts reclassified to profit or loss in the current period that were
recognised in other comprehensive income in previous periods. Users can use this information to
assess the impact of reclassifications on profit or loss.
Additional line items, headings and subtotals should be presented when such presentation is
relevant to an understanding of the entity's financial performance.
706
26: Presentation of financial statements | Part C Accounting for business transactions
1.3.4 Subtotals
HKAS 1.85A
The guidance on subtotals applicable to the statement of financial position (see section 1.2.2) is
also applicable to the statement of profit or loss and other comprehensive income.
For any subtotals presented in the statement of profit or loss and other comprehensive income, the
line items should be disclosed that reconcile those subtotals back to the line items required by
HKFRS.
1.3.5 Allocation of profit and total comprehensive income
HKAs 1.81B
The following items must also be disclosed in the statement of profit or loss and other
comprehensive income as allocations for the period:
(a) Profit or loss for the period attributable to:
(i) non-controlling interests
(ii) owners of the parent.
(b) Total comprehensive income for the period attributable to:
(i) non-controlling interests
(ii) owners of the parent.
Self-test question 2
(a) Explain what is other comprehensive income and why these items are not recognised in
profit or loss.
(b) Explain what is reclassification and why disclosure of reclassification adjustments is
important.
(The answer is at the end of the chapter)
707
Financial Reporting
The analysis should identify, for each balance within shareholders' funds, individual items of other
comprehensive income aggregated within it. This enables users of the accounts to see in which
reserve each type of other comprehensive income is accumulated.
1.4.1 Proforma
ABC GROUP – STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED
31 DECEMBER 20X9
Financial
Translation assets Cash Non-
Share Retained of foreign at FV flow Revaluation controlling Total
capital earnings operations through OCI hedges surplus Total interests equity
Balance at $'000 $'000 $'000 $'000 $'000 $'000 $'000 $'000 $'000
1 January 600,000 118,100 (4,000) 1,600 2,000 – 717,700 29,800 747,500
20X8
Changes in
accounting
policy – 400 – – – – 400 100 500
Restated
balance 600,000 118,500 (4,000) 1,600 2,000 – 718,100 29,900 748,000
Changes
in equity
for 20X8
Balance at
31 December
20X8 600,000 161,700 2,400 17,600 (400) 1,600 782,900 48,600 831,500
Changes in
equity for
20X9
Issue of share
capital 50,000 – – – – – 50,000 – 50,000
Total
comprehensive
income for the
year – 96,600 3,200 (14,400) (400) 800 85,800 21,450 107,250
Transfer to
retained
earnings – 200 – – – (200) – – –
Balance at
31 December
20X9 650,000 243,500 5,600 3,200 (800) 2,200 903,700 70,050 973,750
Self-test question 3
The accountant of Chinatea Co. has returned to work after a sabbatical break of some years. She
is unaware of the issue of HKAS 1 (revised) or the new Companies Ordinance and has prepared
draft financial statements as follows in accordance with what she remembers of HKAS 1 prior to
the revision:
708
26: Presentation of financial statements | Part C Accounting for business transactions
709
Financial Reporting
end of the reporting period was $180,000. This has not been reflected in the financial
statements. Deferred tax relating to the revaluation amounts to $95,000.
(c) Current liabilities include a short-term provision of $20,000 and tax liability of $33,700.
(d) There was a 1 for 3 bonus issue of shares in the year which was funded by the proceeds of
previous share issues.
(e) The long-term receivable balance relates to a customer who has been given an extended
two-year credit period.
Required
Re-draft the financial statements of Chinatea Co., including a statement of changes in equity in
accordance with HKAS 1 (revised). Comparatives are not required.
(The answer is at the end of the chapter)
710
26: Presentation of financial statements | Part C Accounting for business transactions
Where an entity is not a going concern, the financial statements should not be prepared on a going
concern basis and this fact should be disclosed together with:
the basis on which the financial statements have been prepared
the reason why the entity is not regarded as a going concern.
Key term
Material. Omissions or misstatements of items are material if they could, individually or collectively,
influence the economic decisions that users make on the basis of the financial statements.
Materiality depends on the size and nature of the omission or misstatement judged in the
surrounding circumstances. The size or nature of the item, or a combination of both, could be the
determining factor.
(HKAS 1 (revised))
711
Financial Reporting
helps users to better understand the reported position and performance. Significant judgments
may include:
Whether the risks and rewards of ownership of assets have been transferred to/from another
party.
Whether sales of goods are financing arrangements rather than revenue generating
activities.
HKAS 1.125 1.5.5 Estimation uncertainty
An entity must disclose in the notes information regarding key assumptions about the future, and
other sources of measurement uncertainty, that have a significant risk of causing a material
adjustment to the carrying amounts of assets and liabilities within the next financial year.
HKAS 1.5.6 Dividends
1.107,137
Entities may not present dividends on equity instruments in the statement of profit or loss. Equity
dividends must be presented on the face of the statement of changes in equity or in the
notes.
This reflects the fact that an equity dividend distribution is an owner change in equity, which must
be presented separately from non-owner changes in equity.
Equity dividends declared after the reporting date but before the financial statements are
authorised for issue should be considered as a non-adjusting event after the reporting period.
HKAS 1 permits an entity to make this disclosure either:
1 on the face of the statement of financial position as a separate component of equity
2 in the notes to the financial statements
712
26: Presentation of financial statements | Part C Accounting for business transactions
Self-test question 4
The accountant of Worldwide Components Co (‘WCC') is currently preparing the statutory accounts
for the year ended 20X4 for some of the Group subsidiaries. She had identified that one of the
subsidiaries, that produces a single high tech component, is being sued for copyright violation by a
much larger competitor. There is a possibility that the subsidiary will lose the case and as a result
may not be able to continue to trade.
Required
(a) Advise the accountant with regard to the preparation of the statutory accounts for the
subsidiary.
(b) Identify factors that may indicate that a company is not a going concern.
(The answer is at the end of the chapter)
On declaring a distribution of non-cash assets, this Interpretation addresses the following issues:
(a) When should the entity recognise the dividend payable?
(b) How should an entity measure the dividend payable?
(c) When an entity settles the dividend payable, how should it account for any difference
between the carrying amount of the assets distributed and the carrying amount of the
dividend payable?
The interpretation applies only where:
all owners of the same class of equity instruments are treated equally in a distribution
the asset is not controlled by the same party before and after the transfer.
713
Financial Reporting
Self-test question 5
James Wheelwright owns 80% of Kowloon Trucks Co., established by his shareholding of 100% of
the Class A voting shares in that company. The remaining 20% of the company is owned by Asia
Motors Co. (which is not related to Mr Wheelwright). Asia Motors Co. holds 100% of the Class B
voting shares in Kowloon Trucks Co..
During the year Kowloon Trucks Ltd paid a dividend to its Class A and B shareholders. Kowloon
Trucks Co. and Asia Motors Co. agreed that an unwanted property would be transferred from
714
26: Presentation of financial statements | Part C Accounting for business transactions
Kowloon Trucks Co. to Asia Motors Co. in lieu of a Class B share cash dividend. The property had
a carrying amount of $4.5milion at the date of the transfer and a fair value of $5.2 million.
Required
Explain the appropriate accounting treatment for this transaction
(The answer is at the end of the chapter)
3 Current developments
At the start of 2015, the IASB proposed amendments to IAS 1 in order to clarify the criteria for the
classification of a liability as either current or non-current. The amendments are likely to be adopted
by the HKICPA.
The proposed amendments address an apparent inconsistency within IAS 1 (HKAS 1):
Paragraph 69(d) of IAS 1 states that a liability is current when an entity does not have an
unconditional right to defer settlement of that liability for at least 12 months after the reporting
period.
Paragraph 73 states that an obligation is non-current if an entity expects, and has the
discretion, to refinance or roll over an obligation for at least 12 months after the reporting
period under an existing loan facility.
These paragraphs provide two inconsistent bases for the classification of a liability as non-current:
An unconditional right to defer settlement for at least 12 months (in paragraph 69(d)), and
An expectation, and the discretion, to roll over an obligation for at least 12 months (in
paragraph 73).
In order to address this inconsistency, the IASB propose to delete the word ‘unconditional’ from
paragraph 69(d) and change the word ‘discretion’ in paragraph 73 to ‘right’. As a result it will be
explicit that only rights in place at the end of a reporting period affect the classification of a liability.
In addition, two further amendments are proposed:
1 The inclusion of an explanation of the link between a settlement of a liability and outflow of
resources by stating within paragraph 69 that settlement refers to ‘the transfer to the
counterparty of cash, equity instruments, other assets or services.’
2 Reorganisation of guidance in the standard to group similar examples together in order to
distinguish between circumstances that do affect rights in existence at the reporting date
and those that do not.
715
Financial Reporting
Topic recap
716
26: Presentation of financial statements | Part C Accounting for business transactions
Answer 1
(a) The specialist steel is raw material inventory. It will be used within the normal operating cycle
of the company and therefore it is classified as a current asset. As there are currently no
orders for warships the company should assess whether the inventory might be impaired.
(b) The completed fishing boats are finished goods inventory. They are held for the purpose of
being traded and are expected to be sold in the normal operating cycle of the company.
Therefore they are classified as current assets even if a sale is not expected within 12
months.
(c) The amount due from a customer forms part of trade and other receivables. It is expected to
be realised in the normal operating cycle of the company and is therefore classified as
current. It is irrelevant to classification and recognition that part of the $6m has been billed
and part has not.
(d) The part complete boat is work-in-progress inventory. Even though it will take 14 months to
complete, and possibly even longer to sell, it is classified as a current asset. This is because
the inventory is subject to a sale in the ordinary course of business.
(e) The loan is repayable on demand and is therefore classified as current; this is regardless of
the bank’s statement that it will not demand repayment.
Answer 2
(a) Other comprehensive income (‘OCI’) includes items identified by HKAS 1 that are not
recognised in profit or loss and are not recognised directly in equity but are accumulated in
equity.
HKAS 1 specifies the following types of OCI:
Exchange differences on translating foreign operations
Gains/losses on the hedging instrument in a cash flow hedge
Gains on property revaluation
Gains/losses on certain financial assets
Remeasurements of defined benefit pension schemes
There is no obvious principle that results in the recognition of these gains and losses in OCI
rather than profit or loss. They all reflect re-measurements as a result of movements in a
price or valuation, but so do some items that are included in profit or loss (eg gains or losses
on investment properties measured at fair value).
(b) In some cases other comprehensive income may be reclassified to profit or loss at a later
date; in other cases it is not. HKAS 1 requires that other comprehensive income is presented
on the basis of whether it may or may not be reclassified (or ‘recycled’) to profit or loss.
For example exchange gains or losses in relation to a foreign operation that are recognised
as OCI are reclassified and reported as part of the gain or loss on the eventual disposal of
the operation.If cumulative exchange differences in this situation amount to a loss, the
reclassification adjustment is made by:
DEBIT Gain / loss on disposal of foreign X
operation (profit or loss)
CREDIT Other comprehensive income X
Reclassification adjustments must be disclosed in order to inform users of amounts that were
included as income or expenses in other comprehensive income in a previous period and
717
Financial Reporting
are included in profit or loss in the current period. Without this information, users are unable
to identify the profit or loss attributable to the current year’s activities or to fully understand
the impact of the underlying events that affect OCI/profit or loss.
Answer 3
STATEMENT OF FINANCIAL POSITION OF CHINATEA CO. AT 31 $
DECEMBER 20X9
ASSETS
Non-current assets
Property, plant and equipment (905,000 – 25,000 (W1)) 880,000
Other intangible assets (W1) 25,000
905,000
Current assets
Inventories 31,200
Trade receivables (56,450 + 10,000) 66,450
Cash and cash equivalents 10,900
108,550
Total assets 1,013,550
EQUITY AND LIABILITIES
Share capital 40,000
Retained earnings 379,540
Revaluation surplus 285,000
704,540
Non-current liabilities
Loan notes 100,000
Deferred tax (on revaluation) 95,000
195,000
Current liabilities
Trade and other payables (114,010 – 33,700 – 20,000) 60,310
Current tax payable 33,700
Short term provisions 20,000
Total current liabilities 114,010
Total liabilities 309,010
Total equity and liabilities 1,013,550
718
26: Presentation of financial statements | Part C Accounting for business transactions
STATEMENT OF CHANGES IN EQUITY FOR CHINATEA CO. FOR THE YEAR ENDED 31
DECEMBER 20X9
Retained Revaluation
Share capital earnings surplus Total
$ $ $ $
At 1 January 20X9 40,000 332,890 - 372,890
Dividends - (25,000) - (25,000)
Total comprehensive income - 71,650 285,000 356,650
At 31 December 20X9 40,000 379,540 285,000 704,540
WORKINGS
1 Non-current assets
Land and Fixtures and
buildings fittings Patent Total
$ $ $ $
Cost b/f 700,000 200,000 30,000 930,000
Additions – 15,000 – 15,000
Revaluation 200,000 – – 200,000
Cost c/f 900,000 215,000 30,000 1,145,000
719
Financial Reporting
Answer 4
(a) The subsidiary makes a single component and is being sued by a larger competitor for
copyright violation.
If the subsidiary loses the case it is probable that it will go out of business as it will no longer
have a product. The management must therefore assess the situation in order to assess the
likelihood of losing the case.
If the subsidiary is expected to lose the case then the financial statements should not be
prepared on the going concern basis. Instead a break-up basis should be used. This is not
described by HKAS 1 but will result in a different presentation and measurement of items in
the financial statements. HKAS 1 does require that disclosure is made of the fact that the
financial statements are not prepared on a going concern basis and the basis on which they
are prepared. The reason why the entity is not a going concern should also be disclosed.
If the subsidiary is expected to win the case then the financial statements should be
prepared on the going concern basis, however disclosure should be made of the material
uncertainties that cast doubt on the company’s ability to continue as a going concern.
(b) In assessing going concern, management should take into account all available information
including that about the future (at least 12 months beyond the reporting date). The following
factors may indicate that a company is not a going concern:
Low levels of current and expected profitability
Negative operating cash flows (historic or budgeted)
Adverse key financial ratios
Inability to pay dividends
Expected inability to meet debt repayment schedules
A growth in levels of competition
A decline for demand for products/failure to reinvest in new products.
An inability to agree suitable financing with the bank/withdrawal of financial support
from bank
Financing long term assets through short-term finance such as an overdraft.
Withdrawal of supplier credit
Pending legal or regulatory proceedings against the entity.
Answer 5
This payment is covered by HK(IFRIC) Int- 17 Distribution of non-cash assets to owners.
This interpretation applies only where all shareholders of the same class of equity instruments are
treated equally. Asia Motors Co. is the sole Class B shareholder in Kowloon Trucks Co. and
therefore it applies in this case.
HK (IFRIC) Int-17 does not apply where the asset being transferred is controlled by the same
parties before and after the transfer.
The interpretation states that the dividend payment should be recorded at the fair value of the asset
transferred, being $5,2 million.
The difference of $700,000 between the fair value and the carrying amount of the asset is
recognised as a gain in profit and loss and disclosed.
720
26: Presentation of financial statements | Part C Accounting for business transactions
Exam practice
AZ 27 minutes
AZ is a listed manufacturing company. Its finished products are stored in a nearby warehouse until
ordered by customers. AZ has performed very well in the past, but has been in financial difficulties
in recent months and has been re-organising the business to improve performance.
The trial balance for AZ at 31 March 20X3 was as follows:
$'000 $'000
Sales 124,900
Cost of goods manufactured in the year to
31 March 20X3 (excluding depreciation) 94,000
Distribution costs 9,060
Administrative expenses 16,020
Restructuring costs 121
Interest received 1,200
Loan interest paid 639
Land and buildings (including land $20,000,000) 50,300
Plant and equipment 3,720
Accumulated depreciation at 31 March 20X2:
Buildings 6,060
Plant and equipment 1,670
Investment properties (at fair value) 24,000
Inventories at 31 March 20X2 4,852
Trade receivables 9,330
Bank and cash 1,190
Ordinary shares, fully paid 20,430
6% redeemable preference shares 1,000
Revaluation surplus 3,125
Retained earnings at 31 March 20X2 27,137
Ordinary dividends paid 1,000
Preference dividends paid 60
7% loan stock 20X7 18,250
Trade payables 8,120
Proceeds of share issue 2,400
214,292 214,292
721
Financial Reporting
(iv) The closing inventories at 31 March 20X3 were $5,180,000. An inspection of finished goods
found that a production machine had been set up incorrectly and that several production
batches, which had cost $50,000 to manufacture, had the wrong packaging. The goods
cannot be sold in this condition but could be repacked at an additional cost of $20,000.
They could then be sold for $55,000. The wrongly packaged goods were included in closing
inventories at their cost of $50,000.
(v) The preference shares will be redeemed for $1,000,000 in 20X9. Preference dividends are
paid on 31 March each year.
(vi) The 7% loan is a 10-year loan due for repayment by 31 March 20X7. Interest on this loan
needs to be accrued for the six months to 31 March 20X3.
(vii) The restructuring costs in the trial balance represent the cost of a major restructuring of the
company to improve competitiveness and future profitability.
(viii) No fair value adjustments were necessary to the investment properties during the period.
(ix) During the year the company issued two million new ordinary shares for cash at $1.20 per
share. The proceeds have been recorded as 'Proceeds of share issue'.
Required
Prepare the statement of profit or loss and other comprehensive income and statement of changes
in equity for AZ for the year to 31 March 20X3 and a statement of financial position at that date.
Notes to the financial statements are not required, but all workings must be clearly shown.
(15 marks)
722
Part D
The emphasis in this section is on the legal environment in Hong Kong. The purpose of this
section is to develop your understanding of the Hong Kong legal environment, including the
legal framework and the related implications for business activities. This is considered as the
basic knowledge and foundation for a future certified public accountant.
723
Financial Reporting
724
chapter 27
Principles of consolidation
Topic list
Learning focus
You are very likely to come across groups of companies in practice and in your exam. It is
important that you can identify different types of group companies and know how to account
for them.
The goodwill calculation (including gain on bargain purchase) and the related treatment are
also vital for the preparation of group financial statements.
725
Financial Reporting
Learning outcomes
726
27: Principles of consolidation | Part D Group financial statements
A group of companies is the result of one company (the parent company) buying a controlling
share in one or more other companies (subsidiaries). This situation is very common where a parent
company:
buys a customer in order to secure custom
buys a supplier in order to secure supplies
buys a competitor in order to increase market share
buys an overseas company in order to gain entry to a new geographical market, or
buys another company in order to diversify.
727
Financial Reporting
HKAS 28.3,
HKFRS 10,
1.3 Definitions
Appendix A,
HKFRS 11, A number of definitions are given in the relevant standards, including the following relating to group
Appendix A entities:
Key terms
Group. A parent and its subsidiaries. (HKFRS 10)
Parent. An entity that controls one or more entities. (HKFRS 10)
Subsidiary. An entity that is controlled by another entity. (HKFRS 10)
Control. An investor controls an investee when the investor is exposed, or has rights, to variable
returns from its involvement with the investee and has the ability to affect those returns through
power over the investee. (HKFRS 10)
Consolidated financial statements are the financial statements of a group in which the assets,
liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented
as those of a single economic entity. (HKFRS 10)
Power. Existing rights that give the current ability to direct the relevant activities.
(HKFRS 10)
Relevant activities. Activities of the investee that significantly affect the investee's returns.
(HKFRS 10)
Associate. An entity over which the investor has significant influence. (HKAS 28)
Significant influence is the power to participate in the financial and operating policy decisions of
the investee but is not control or joint control of those policies. (HKAS 28)
Joint arrangement. An arrangement of which two or more parties have joint control.
(HKFRS 11)
Joint operation. A joint arrangement whereby the parties that have joint control of the
arrangement have rights to the assets, and obligations for the liabilities, relating to the
arrangement. (HKFRS 11)
Joint venture. A joint arrangement whereby the parties that have joint control of the arrangement
have rights to the net assets of the arrangement. (HKFRS 11)
Some of these definitions are considered in more detail later in this and subsequent chapters.
728
27: Principles of consolidation | Part D Group financial statements
We will be looking at six accounting standards in this and the next three chapters. HKFRS 10 to 12
and the revised versions of HKAS 27 and 28 (known as HKAS 27 (2011) and HKAS 28 (2011))
were issued in June 2011 as a "package of five" standards. They are applicable together and must
be applied to periods beginning on or after 1 January 2013:
HKFRS 3 (revised) Business Combinations
HKFRS 10 Consolidated Financial Statements
HKFRS 11 Joint Arrangements
HKFRS 12 Disclosure of Interests in Other Entities
HKAS 27 (2011) Separate Financial Statements
HKAS 28 (2011) Investments in Associates and Joint Ventures
HKFRS 9 was covered in Chapter 18.
Note that this chapter includes mention of HKAS 27 (revised). Before 2011, HKAS 27 was entitled
Consolidated and Separate Financial Statements, and HKAS 27 (revised) refers to this standard
rather than HKAS 27 (2011) Separate Financial Statements. The 'old' HKAS 27 is included in order
to provide some detail of the original definition of control, now superseded by that provided in
HKFRS 10.
2 Principles of consolidation
Topic highlights
Consolidated financial statements are prepared where a parent controls another entity. The
definition of control includes three elements.
2.1 Control
As we have already seen, a parent-subsidiary relationship is established when one entity controls
another. The definition of control provided in HKAS 27 (revised) has now been superseded by that
provided in HKFRS 10.
729
Financial Reporting
730
27: Principles of consolidation | Part D Group financial statements
Protective rights are not substantive rights. Protective rights are rights designed to protect the
interest of the party holding those rights without giving that party power over the entity to which the
rights relate eg rights held by a lender that can be used to prevent a borrower from undertaking
activities that could significantly change the credit risk of the borrower.
Solution
Yes CNC has power over SMC because it holds voting rights together with substantive potential
voting rights that give it the current ability to direct the relevant activities of SMC.
De facto control
As we have seen, power exists where an investor has the practical ability to direct an investee’s
relevant activities. The standard is clear that this can sometimes be achieved when an investing
company holds only a minority of voting rights and no potential voting rights or other rights. In
order to assess whether this is the case, the following should be considered:
The size of the investor’s shareholding relative to others
Potential voting rights held by the investor and other parties
Other contractual rights
Any other facts such as the investor’s voting patterns at previous shareholders’ meetings.
The following situations taken from HKFRS 10 illustrate de facto control:
1. Investor 1 holds 45% of the ordinary shares in Company A, a company whose relevant
activities are directed by votes attached to ordinary shares. The remaining 55% of shares
are held by hundreds of unrelated investors who each own less than 1% of Company A.
There are no arrangements for these shareholders to act collectively and past experience
indicates that few exercise their voting rights at all.
Investor 1 has power over Company A.
2. Investor 2 holds 45% of the voting rights of Company B. Two other investors each hold 26%
of the voting rights. The remaining 3% voting rights are held by three other shareholders in
equal part. There are no other arrangements that affect decision making.
Investor 2 does not have power over Company B because the two investors holding 26%
could readily co-operate to outvote Investor 2.
3. Investor 3 holds 45% of the voting rights of Company C. Eleven other shareholders each
hold 5% of the voting rights of the company. None of the shareholders has contractual
arrangements to consult others or make collective decisions.
The distribution of voting rights is inconclusive in this case; other facts and circumstances
should be considered.
HKFRS 10 contains no specific thresholds to indicate when the distribution of voting rights is
sufficient to reach a conclusion regarding power. Therefore a high level of judgment is required in
this area.
731
Financial Reporting
Example: Control
Abacus and Bandero each hold 50% of the voting rights in Candice, a company that they
established. The shareholder’s agreement between Abacus and Bandero states that:
1. The purpose of Candice is to acquire, manage and sell commercial property with the
objective of generating capital gains.
2. All decisions regarding major capital activities and associated financing require the
agreement of both Abacus and Bandero.
3. Abacus is responsible for the day to day management activities of Candice, such as
identifying tenants, negotiating rental agreements and rent collection. Abacus is paid for
these services at cost plus a fixed margin.
Required
Analyse the situation to identify which party/parties may control Candice.
Solution
In order to establish which party/parties control Candice, it is necessary to identify which has power
over Candice, a right to returns from the company and can use its power to affect returns.
It is likely that both capital activities and day to day management activities will affect Candice’s
returns significantly. It must therefore be established which set of activities has the greatest effect
on returns.
The fact that the stated objective of Candice is to generate capital gains may indicate that capital
activities have the most significant impact. If so, it is likely that Abacus and Bandero have joint
control as these activities are directed by joint decision making.
If day to day management activities are considered to be more significant, it should be concluded
that Abacus has control of Candice as it directs these activities unilaterally.
732
27: Principles of consolidation | Part D Group financial statements
733
Financial Reporting
In January 2015, amendments to HKFRS 10 further clarified the application of the investment entity
exemption. These are effective from 1 January 2016:
1 The exemption from preparing consolidated financial statements (section 2.2.1) is still
available to a parent even where the ultimate (or intermediate) parent is an investment entity
and measures all of its subsidiaries at fair value rather than produce consolidated financial
statements.
2 The requirement to consolidate as normal a subsidiary that provides services to an
investment entity only applies where:
(a) the subsidiary itself is not an investment entity and
(b) the subsidiary’s main purpose is to provide services and activities that are related to
the investment activities of the investment entity parent.
HKFRS 10 does not deal with methods of accounting for business combinations and the calculation
of goodwill (this is covered by HKFRS 3 (revised)), but it does provide guidance on consolidation
procedures.
734
27: Principles of consolidation | Part D Group financial statements
In such cases the subsidiary may prepare additional statements to the reporting date of the rest of
the group, for consolidation purposes. If this is not possible, the subsidiary's accounts may still be
used for the consolidation, provided that the gap between the reporting dates is three months or
less.
Where a subsidiary's accounts are drawn up to a different accounting date, adjustments should
be made for the effects of significant transactions or other events that occur between that date and
the parent's reporting date.
HKFRS 2.3.4 Uniform accounting policies
10.B87
Consolidated financial statements should be prepared using uniform accounting policies for like
transactions and other events in similar circumstances.
Adjustments must be made where members of a group use different accounting policies, so that
their financial statements are suitable for consolidation.
HKFRS 2.3.5 Date of inclusion/exclusion
10.20, B88,
HKFRS 3, The results of subsidiary undertakings are included in the consolidated financial statements from
Appendix A
the acquisition date, defined as the date on which the investor obtains control of the investee.
Income and expenses of the subsidiary should be based on the asset and liability values
recognised in the consolidated financial statements at this date. For example, future depreciation
should be calculated based upon the fair value of the related asset at the acquisition date.
The results of subsidiary undertakings should cease to be included within the consolidated financial
statements on the date on which the parent ceases to control the subsidiary. From this date the
investment is accounted for as an associate in accordance with HKAS 28 or a financial asset in
accordance with HKFRS 9.
HKAS 2.3.6 Accounting for subsidiaries, joint ventures and associates in the
27(2011).10
parent's separate financial statements
A parent company will usually produce its own, single company financial statements. HKAS 27
(2011) Separate Financial Statements provides accounting guidance to be applied in the
preparation of these single company statements. In these statements, investments in subsidiaries,
joint ventures and associates included in the consolidated financial statements should be either:
(a) accounted for at cost, or
(b) in accordance with HKFRS 9 or
(c) using the equity method in accordance with HKAS 28.
The option to measure an investment using the equity method was introduced as a 2014
amendment to HKAS 28. The amendment is effective from 1 January 2016.
Where subsidiaries are classified as held for sale in accordance with HKFRS 5 they should be
accounted for in accordance with HKFRS 5 in the parent’s separate financial statements.
735
Financial Reporting
Disclosures requirements in respect of associates and joint arrangements are given in Chapter 29.
HKFRS
12.10-19
3.1 Disclosure of consolidated subsidiaries
An entity should disclose information which enables users of the consolidated financial statements:
(a) to understand:
(i) the composition of the group
(ii) the interest that non-controlling interests have in the group's activities and cash flows.
(b) to evaluate:
(i) the nature and extent of significant restrictions on its ability to access or use assets
and settle liabilities of the group
(ii) the nature of, and changes in, the risks associated with interests in subsidiaries
(iii) the consequences of changes in its ownership interest in a subsidiary where control is
not lost
(iv) the consequences of losing control in a subsidiary in the reporting period.
3.1.1 Non-coterminous year ends
Where the financial statements of a subsidiary used to prepare consolidated financial statements
are prepared to a date different from that of the consolidated financial statements, the following
must be disclosed:
(a) The date of the end of the reporting period of the financial statements of the subsidiary.
(b) The reason for using a different date.
3.1.2 Non-controlling interests
The following should be disclosed for each of a group's subsidiaries that have non-controlling
interests that are material to the reporting entity:
(a) The name of the subsidiary
(b) The principal place of business/country of incorporation of the subsidiary
(c) The proportion of ownership interests held by non-controlling interests
(d) The proportion of voting rights held by non-controlling interests if different from the proportion
of ownership interests held
(e) The profit or loss allocated to non-controlling interests of the subsidiary during the reporting
period
(f) Accumulated non-controlling interests of the subsidiary at the end of the reporting period
(g) Summarised financial information about the subsidiary.
3.1.3 The nature and extent of significant restrictions
The following must be disclosed:
(a) Significant restrictions on the group's ability to access or use the assets and settle the
liabilities of the group, such as:
(i) those that restrict the ability of a parent or subsidiaries to transfer cash or other assets
to or from other entities in the group.
(ii) guarantees or other requirements that may restrict dividends and other capital
distributions being paid or loans and advances being made or repaid to or from other
entities in the group.
(b) The nature and extent to which protective rights of non-controlling interests can significantly
restrict the entity's ability to access or use the assets and settle the liabilities of the group.
736
27: Principles of consolidation | Part D Group financial statements
(c) The carrying amounts in the consolidated financial statements of the assets and liabilities to
which those restrictions apply.
3.1.4 Nature of the risks associated with an entity's interests in subsidiaries
The terms of any contractual arrangements that could require the parent or its subsidiaries to
provide financial support to a subsidiary should be disclosed, including events or circumstances
that could expose the reporting entity to a loss.
If during the reporting period a parent or any of its subsidiaries has, without being contractually
required to do so, provided financial support to a subsidiary, it should disclose:
(a) the type and amount of support provided
(b) the reasons for providing the support.
If during the reporting period a parent or any of its subsidiaries has, without being contractually
required to do so, provided financial support to a previously unconsolidated entity and that
provision of support resulted in a controlling relationship, an explanation of the relevant factors in
reaching that decision must be disclosed.
Any current intentions to provide support to a subsidiary including providing assistance in obtaining
financial support should be disclosed.
3.1.5 Changes in ownership which do not result in the loss of control
A schedule must be presented that shows the effects on equity attributable to owners of the parent
of any changes in its ownership interest in a subsidiary that do not result in the loss of control.
3.1.6 Loss of control
If control of a subsidiary has been lost during a reporting period, the following should be disclosed:
(a) The gain or loss on disposal
(b) The portion of the gain or loss attributable to measuring any retained investment at fair value
on the date on which control is lost
(c) The line items in profit or loss in which the gain or loss is recognised.
737
Financial Reporting
Illustration
The following illustration relates to a group with consolidated subsidiaries:
Group composition
The Company has three subsidiaries that are material to the Group in 20X3 and 20X2.
the Group holds a majority of voting rights in 2 subsidiaries, Arran and Diabeg
the Group holds less than a majority of voting rights in Sutherland (see below).
Non-controlling interests have a material interest in two subsidiaries.
All Group companies prepare financial statements to a 31 December reporting date.
Sutherland
Although the Group has less than half the voting rights in Sutherland, management has determined
that the Group controls Sutherland, This is on the basis that the remaining voting rights in
Sutherland are widely dispersed, historical attendance at shareholder meetings shows that the
Group has been able to control the outcome of voting, and there is no indication that other
shareholders exercise their votes collectively.
Non-controlling interests
The following subsidiaries have material NCI:
The following is summarised financial information for Diabeg and Sutherland, prepared in
accordance with HKFRS, modified for fair value adjustments on acquisition and differences in the
Group’s accounting policies. The information is before inter-company eliminations with other
companies in the Group
Diabeg Sutherland
In $’000 20X3 20X2 20X3 20X2
Revenue 32,000 30,500 21,800 20,900
Profit 8,000 8,200 4,200 3,800
Profit attributable to NCI 1,600 1,640 2,310 2,090
Other comprehensive income - - - 100
Total comprehensive income 8,000 8,200 4,200 3,900
Total comprehensive income 1,600 1,640 2,310 2,145
attributable to NCI
738
27: Principles of consolidation | Part D Group financial statements
There are no significant restrictions on the Group’s ability to access or use the assets and settle the
liabilities of the Group.
We have seen that HKFRS 10 defines control and prescribes procedures for the preparation of
consolidated financial statements. HKFRS 3 Business Combinations, revised in 2008, is the
second relevant standard on group accounting, and provides guidance on the following:
(a) The recognition and measurement of the assets and liabilities acquired when a parent
company achieves control over a subsidiary or other business
(b) The recognition and measurement of any non-controlling interest in the subsidiary or business
(c) The recognition and measurement of goodwill arising on the acquisition of a subsidiary or
business
(d) Necessary disclosures to provide information to evaluate a business combination.
Key terms
Acquirer is the entity that obtains control of the acquiree.
Acquiree is the business or businesses that the acquirer obtains control of in a business
combination.
Non-controlling interest is the equity in a subsidiary not attributable, directly or indirectly, to a
parent.
739
Financial Reporting
HKFRS 3.4-5
and B7-B12
4.3 Accounting for a business combination
An entity shall determine whether a transaction or other event is a business combination which
requires that the assets acquired and liabilities assumed constitute a business. If the assets
acquired are not a business, the reporting entity shall account for the transaction or other event as
an asset acquisition.
Definition of a business
A business consists of inputs and processes applied to those inputs that have the ability to create
outputs. Although businesses usually have outputs, outputs are not required for an integrated set to
qualify as a business. The three elements of a business are defined as follows:
(a) Input: Any economic resource that creates, or has the ability to create, outputs when one or
more processes are applied to it. Examples include non-current assets (including intangible
assets or rights to use non-current assets), intellectual property, the ability to obtain access
to necessary materials or rights and employees.
(b) Process: Any system, standard, protocol, convention or rule that when applied to an input or
inputs, creates or has the ability to create outputs. Examples include strategic management
processes, operational processes and resource management processes. These processes
typically are documented, but an organised workforce having the necessary skills and
experience following rules and conventions may provide the necessary processes that are
capable of being applied to inputs to create outputs. (Accounting, billing, payroll and other
administrative systems typically are not processes used to create outputs.)
(c) Output: The result of inputs and processes applied to those inputs that provide or have the
ability to provide a return in the form of dividends, lower costs or other economic benefits
directly to investors or other owners, members or participants.
To be capable of being conducted and managed for the purposes defined, an integrated set of
activities and assets requires two essential elements – inputs and processes applied to those
inputs, which together are or will be used to create outputs. However, a business need not include
all of the inputs or processes that the seller used in operating that business if market participants
are capable of acquiring the business and continuing to produce outputs, for example, by
integrating the business with their own inputs and processes.
The nature of the elements of a business varies by industry and by the structure of an entity's
operations (activities), including the entity's stage of development. Established businesses often
have many different types of inputs, processes and outputs, whereas new businesses often have
few inputs and processes and sometimes only a single output (product). Nearly all businesses also
have assets, but a business need not have liabilities.
740
27: Principles of consolidation | Part D Group financial statements
An integrated set of activities and assets in the development stage might not have outputs. If not,
the acquirer should consider other factors to determine whether the set is a business. Those
factors include, but are not limited to, whether the set:
(a) has begun planned principal activities;
(b) has employees, intellectual property and other inputs and processes that could be applied to
those inputs;
(c) is pursuing a plan to produce outputs; and
(d) will be able to obtain access to customers that will purchase the outputs.
HKFRS 3 (revised) requires that business combinations are accounted for by applying the
acquisition method. This involves:
(a) identifying the acquirer
(b) determining the acquisition date
(c) recognising and measuring the identifiable assets acquired, liabilities assumed and non-
controlling interests in the acquiree
(d) recognising and measuring goodwill.
HKFRS3.6-7 4.3.1 Identifying the acquirer
For each business combination, one of the combining entities must be identified as the acquirer, in
other words a business combination is not considered to be a merger.
HKFRS 3.8-9 4.3.2 Determining the acquisition date
The acquisition date is the date on which the acquirer gains control of the acquiree. This is
normally the date on which consideration is transferred and assets and liabilities are acquired.
The date may, however, be earlier or later, for example where written agreement provides for this.
741
Financial Reporting
5 Goodwill
Topic highlights
Goodwill is calculated as the excess of consideration plus the non-controlling interests over the fair
value of identifiable net assets acquired.
The non-controlling interests can be measured as a proportion of the net assets of the acquiree or
at fair value.
742
27: Principles of consolidation | Part D Group financial statements
743
Financial Reporting
(c) Anderson Co. records the investment in Potter Co. by: $'000 $'000
DEBIT Investment 100,250
CREDIT Cash 100,000
Liability for contingent consideration 250
Contingent consideration may be payable in the form of equity, a debt instrument or (as in the
above example) cash. In the case of equity or debt, it is classified in the acquirer's financial
statements in accordance with HKAS 32.
The subsequent accounting for contingent consideration will depend on the type of contingent
HKFRS 3.58 consideration, how it is classified and why a change in the fair value of the consideration arose:
(a) If the change in fair value is due to additional information obtained within the measurement
period (see section 5.4) that affects the position at the acquisition date, goodwill should be
remeasured.
(b) If the change is due to events which took place after the acquisition date, for example,
meeting earnings targets:
(i) Contingent consideration classified as equity is not remeasured and its subsequent
settlement is accounted for within equity.
(ii) Contingent consideration classified as an asset or a liability that:
744
27: Principles of consolidation | Part D Group financial statements
Is within the scope of HKFRS 9 is measured at fair value at each reporting date
with any gain or loss recognised in profit or loss in accordance with that
standard
Is not within the scope of HKFRS 9 is measured at fair value at each reporting
date with changes in fair value recognised in profit or loss.
745
Financial Reporting
746
27: Principles of consolidation | Part D Group financial statements
the shares of entity B at the date of gaining control, a fair value of $400,000 is assigned to the 40%
non-controlling interests, indicating that entity A has paid a control premium of $30,000. The fair
value of entity B's identifiable net assets is $700,000.
Calculate goodwill measuring the non-controlling interests
(a) as a proportion of the net assets of the acquiree
(b) at fair value
Solution
(a) Non-controlling interests measured as a proportion of the net assets of the acquiree
Goodwill:
$'000
Consideration 630
Non-controlling interests ($700 40%) 280
910
Fair value of identifiable net assets (100%) (700)
Goodwill 210
(b) Non-controlling interests measured at fair value
Goodwill:
$'000
Consideration 630
Non-controlling interests 400
1,030
Fair value of identifiable net assets (100%) (700)
Goodwill 330
The first method calculates only the amount of goodwill associated with the controlling interests.
The second method calculates goodwill to be $120,000 higher. This $120,000 is the goodwill
associated with the non-controlling interests. The second calculation could be stripped out into the
two elements as:
Controlling Non-controlling
interests interests
$'000 $'000
Consideration/fair value 630 400
Share of identifiable net assets (60%/40%) (420) (280)
Goodwill 210 120
Note that goodwill is not proportionate. If the total goodwill were split proportionately in the ratio
60:40, then the controlling interests would be allocated $198,000 and the non-controlling interests
$132,000. This is not the case due to the control premium associated with a controlling interest.
The premium to acquire control may reflect the value of synergies between the parent and
subsidiary.
747
Financial Reporting
This method will increase reported net assets in the statement of financial position.
Testing goodwill for impairment will be easier as there is no need to gross up part-owned
subsidiaries.
It should, however be noted that since goodwill as initially measured will be greater in the
statement of financial position, there is a greater likelihood of an impairment arising and any
impairment losses will be greater than those arising if the non-controlling interest had been
measured as a proportion of net assets.
Another consideration when deciding how to measure the non-controlling interest is whether an
entity intends to acquire more shares in the subsidiary at a future date.
As you will see in Chapter 30, where an existing interest in a subsidiary is increased, goodwill is not
recalculated and instead the parent's equity is adjusted (normally reduced) by the difference
between consideration paid for the additional interest and the change in the non-controlling
interest's net assets (including any goodwill).
This adjustment to the parent's equity is less where non-controlling interest goodwill is recognised
than where the non-controlling interest is simply measured as a proportion of net assets.
The following table summarises the impact at various stages of the two methods of measuring the
non-controlling interest:
NCI in statement of financial Higher as the NCI balance Lower as the NCI balance is
position at acquisition date includes NCI goodwill. the proportion of net assets of
the subsidiary owned by the
NCI.
Goodwill in statement of Higher as goodwill includes Lower as the balance includes
financial position at both group and NCI goodwill. only the group goodwill.
acquisition date
NCI in statement of financial There is a lower risk of the NCI Higher risk of the NCI balance
position at subsequent balance being negative if the becoming negative as losses
dates subsidiary is loss-making since are allocated.
the starting position was
higher.
Impairment testing Less complex as the carrying More complex: the carrying
value of goodwill is compared amount of goodwill must be
with recoverable amount. grossed up prior to comparing
with recoverable amount.
Impairment of goodwill Goodwill impairment related to Goodwill impairment related to
100% of the acquiree is the parent's interest is
recognised. recognised.
Allocation of impairment Any impairment losses to date The impairment losses are
losses at the reporting date are allocated between the allocated to the parent.
parent and NCI based on
ownership interests.
Subsequent acquisition Lower impact on parent's Higher impact on parent's
equity because the NCI has a equity as a result of the lower
higher carrying value prior to carrying value of the NCI prior
the acquisition. to the acquisition.
748
27: Principles of consolidation | Part D Group financial statements
Solution
Goodwill
$ $
Consideration transferred 51,000
Non-controlling interests (64,000 (below) 25%) 16,000
67,000
Share of net assets acquired as represented by
Ordinary share capital 20,000
Retained earnings 21,000
Fair value adjustment 23,000
(64,000)
Goodwill 3,000
Self-test question 1
Large Co. acquired 90% of the ordinary shares in Small Co. on 31 May 20X8, transferring
$300,000 cash immediately, $100,000 in one year's time and 20,000 Large Co. shares to the
shareholders of Small Co.. Large Co. also agreed to issue a further 10,000 shares in one year’s
time if Small Co. achieved an increase in profits of 5% over that year. At the acquisition date the
equity and reserves section of Small Co.'s statement of financial position included the following
balances:
749
Financial Reporting
$
Share capital (100,000 shares) 100,000
Retained earnings 249,000
Revaluation reserve 50,000
The following information is also relevant:
1 The fair value of Small Co.'s land was $60,000 in excess of its book value, however Small
Co. had not yet completed a revaluation exercise for the year.
2 Small Co. had not included a provision for legal costs of $40,000 in the accounts, despite the
recognition criteria of HKAS 37 being met.
3 The share price of Large Co. shares on the acquisition date was $1.60
4 The share price of Small Co. shares on the acquisition date was $1.25
5 An appropriate discount rate is 6%
6 The fair value of the contingent consideration is estimated to be 90% of the value of the
share price on the acquisition date.
7 In the year following the acquisition, Small Co. increased profits by 8%.
Required
(a) What goodwill arises on the acquisition of the controlling interests in Small Co., assuming
that the non-controlling interests is measured at fair value?
(b) How is the investment recognised in the separate financial statements of Large Co. on the
acquisition date?
(c) What journals must Large Co. make subsequent to the acquisition in respect of the deferred
and contingent consideration (assuming that it is paid)?
(The answer is at the end of the chapter)
The following sections consider specific guidance on establishing the fair value of specific assets
and liabilities in the case of a business combination.
HKFRS 3.11 5.3.1 Restructuring and future losses
An acquirer should not recognise liabilities for future losses or other costs expected to be
incurred as a result of the business combination.
HKFRS 3 (revised) explains that a plan to restructure a subsidiary following an acquisition is not a
present obligation of the acquiree at the acquisition date. Neither does it meet the definition of a
contingent liability. Therefore an acquirer should not recognise a liability for such a
restructuring plan as part of allocating the cost of the combination unless the subsidiary was
already committed to the plan before the acquisition.
This prevents creative accounting. An acquirer cannot set up a provision for restructuring or
future losses of a subsidiary and then release this to profit or loss in subsequent periods in order to
reduce losses or smooth profits.
HKFRS 3.B31 5.3.2 Intangible assets
The acquiree may have intangible assets, such as development expenditure. These can be
recognised separately from goodwill only if they are identifiable. An intangible asset is identifiable
only if it:
(a) is separable, i.e. capable of being separated or divided from the entity and sold, transferred,
or exchanged, either individually or together with a related contract, asset or liability
(b) arises from contractual or other legal rights.
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27: Principles of consolidation | Part D Group financial statements
HKFRS 3.45-
50
5.4 Measurement period adjustments
Sometimes elements of the goodwill calculation such as the fair value of a particular asset or
contingent consideration can only be determined provisionally by the end of the reporting period in
which an acquisition takes place.
Where this is the case, goodwill is initially calculated based on those provisional values, and
management will then continue to work to identify actual values after the reporting date for as long
as the measurement period lasts.
The measurement period is that period of time immediately after the acquisition date when the
acquirer may still be obtaining the information needed to identify and measure each element of the
goodwill calculation:
Consideration transferred
The non-controlling interest
The fair value of the net assets of the acquiree.
During this period the acquirer may adjust any provisional amounts to reflect new information
obtained about facts and circumstances that existed as of the acquisition date. Amounts are
adjusted retrospectively i.e. as if the actual amount had always been known. This means that the
amount of goodwill initially calculated and the fair value of net assets or consideration initially
recognised may change.
The measurement period ends on the earlier of:
the date by which the acquirer has received all the information it was seeking or learns that
the information cannot be obtained, or
12 months after the acquisition date.
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Financial Reporting
Any further adjustments after the measurement period should be recognised only to correct an
error in accordance with HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
Any subsequent changes in estimates are dealt with in accordance with HKAS 8 (i.e. the effect is
recognised in the current and future periods). HKAS 8 requires an entity to account for an error
correction retrospectively, and to present financial statements as if the error had never occurred by
restating the comparative information for the prior period(s) in which the error occurred.
Solution
30 June 20X1
$m
Consideration transferred 78
Provisional fair value of net assets acquired (71)
Goodwill 7
30 June 20X2
$m
Consideration transferred 78
Actual fair value of net assets acquired (71m + 2m) (73)
Goodwill 5
Therefore goodwill is initially recognised at $7m in the consolidated financial statements at 30 June
20X1, however at 30 June 20X2 the amount is reduced to $5m with a corresponding increase of
$2m to group intangible assets:
$m $m
DEBIT Intangible assets 2
CREDIT Goodwill 2
As the adjustment is made retrospectively the 20X1 comparative financial statements provided in
20X2 are adjusted to reflect the lower value of goodwill.
Self-test question 2
Ariadne Co. acquired all of the share capital of Rebecca Co. on 30 September 20X7. At the
Ariadne Group's year end of 31 December 20X7, management have still not ascertained the fair
value of an item of property, plant and equipment held by Rebecca Co. at the acquisition date. A
provisional value of $300,000 is allocated to the asset, which had a remaining useful life of five
years at the acquisition date.
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27: Principles of consolidation | Part D Group financial statements
On 1 March 20X8, Ariadne received an independent valuer's report which allocated the asset a fair
value of $400,000 on the acquisition date.
Required
What amounts are reported in the group accounts in the year ended 31 December 20X7 and
31 December 20X8 in respect of the asset? You should provide comparative information as at
31 December 20X8.
(The answer is at the end of the chapter)
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Financial Reporting
Subsequent to acquisition the non-controlling interests at a given reporting date can be calculated
either by:
(a) calculating the NCI share of the net assets of the acquiree at the reporting date (as adjusted
for consolidation purposes). Where the fair value method is used the NCI goodwill must be
added to this, or
(b) calculating the NCI share of post-acquisition reserves movement (as adjusted for
consolidation purposes) and adding this to NCI as measured at the acquisition date.
Example: Goodwill
On 1 January 20X9, Flatley Co. acquired 70% of the ordinary shares of Gringo Co. at a cost of
$700,000. The net assets of Gringo Co. at this date were $740,000. The non-controlling interests
had a fair value of $250,000.
In the year to 31 December 20X9, Gringo retained profits of $100,000.
What goodwill arises on the acquisition of Gringo, and what is the value of the non-controlling
interests at 31 December 20X9 assuming that the non-controlling interests is measured:
(a) as a proportion of the net assets of the acquiree
(b) at fair value?
Solution
Goodwill
Proportion of net assets Fair value
method method
$ $
Consideration 700,000 700,000
NCI (30% $740,000)/fair value 222,000 250,000
922,000 950,000
Net assets of acquiree (740,000) (740,000)
Goodwill 182,000 210,000
In rare cases a subsidiary may have a negative equity balance. In this case the non-controlling
interests is reported as a deficit balance in the consolidated statement of financial position in
accordance with HKFRS 10. In other words, a group does not cease to allocate the non-controlling
interests' share of losses to them simply because this would result in a negative balance.
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27: Principles of consolidation | Part D Group financial statements
Self-test question 3
Graham Collins Co (‘GCC’) acquired control of a supplier Loweth Lane (‘LL’), through the
acquisition of an 84% equity shareholding in that company on 1 August 20X3. GCC elected to
measure the NCI at fair value. The agreed consideration was:
$29 million cash payable on the acquisition date
$10 million loan notes payable on the first anniversary of the acquisition and contingent upon
LL achieving stated profits targets.
1 share in GCC issued on the acquisition date for every 15 acquired in LL.
At the acquisition date, LL’s share capital amounted to 5 million shares with a carrying amount of
$18 million and the company’s reported reserves were $30.4 million.
Additional information
1 The quoted share price of GCC at 1 August 20X3 was $21.50 and the fair value of a share in
LL, determined using an income based valuation technique was $10.15
2 At 1 August 20X3, the fair value of the contingent consideration was determined to be $9.8
million; at 31 December 20X3, as a result of the poor performance of LL, the fair value of this
consideration was considered to be $4.3 million.
3 The financial statements of LL prepared as at the acquisition date included:
$750,000 relating to licensing fees paid to GCC for the right to use technology
developed by that company. The remaining licence term is 5 years. GCC has recently
charged other suppliers $1m for licences for a 10 year period.
A balance of $200,000 due from GCC in respect of goods delivered. The balance was
settled at acquisition and formed part of the cash paid by GCC on 1 August 20X3.
A $500,000 provision in respect of a legal case brought against GCC by a customer.
The $500,000 carrying amount of the provision was estimated at 31 December 20X2;
at the acquisition date, legal advisers suggested that a more accurate measurement of
the expected settlement was $550,000. The case was subsequently settled at
$475,000 in October 20X3.
A property with a carrying amount of $6 million. The property is currently used for
industrial purposes and based on that use has an estimated market value of
$6.3million. Surveyors have advised GCC that the property would achieve $6.6
million if sold on the basis of conversion to ‘warehouse apartments’.
Required
(a) State the journal entry required in GCC’s accounts on 1 August 20X3 to recognise the
acquisition
(b) Calculate goodwill arising on the acquisition of LL by GCC at 1 August 20X3 (the acquisition
date). You should explain the calculation of LL’s identifiable net assets at the acquisition
date.
(c) Explain how the contingent consideration is accounted for at 31 December 20X3
(d) Calculate goodwill as recognised at 31 December 20X3 and subsequent period ends.
(The answer is at the end of the chapter)
HKFRS 3.59-
63, B64
5.6 Disclosures
HKFRS 3 (revised) requires that an acquirer discloses information to enable the users of its
financial statements to evaluate the nature and financial effect of a business combination that
755
Financial Reporting
occurs during the current period or after the end of the period but before the financial statements
are authorised for issue. This information should include:
the name and a description of the acquiree
the acquisition date
the percentage of voting equity interests acquired
the reasons for the business combination
a qualitative description of the factors that make up the goodwill recognised
the acquisition date fair value of the total consideration transferred and each major class of
consideration
for contingent consideration:
– the amount recognised at acquisition
– a description of the arrangement
– an estimate of the range of outcomes
details of acquired receivables
amounts recognised for each class of assets and liabilities acquired
disclosure in accordance with HKAS 37 for contingent liabilities recognised
the amount of goodwill expected to be deductible for tax purposes
details of transactions that are recognised separately from the acquisition of assets and
assumption of liabilities in the business combination
the amount of acquisition related costs and how they are recognised (including the line item)
the amount of a gain in a bargain purchase and a description of reasons why the transaction
resulted in a gain
the amount of any non-controlling interests and the measurement basis applied
valuation techniques used to determine the fair value of the non-controlling interests where
relevant.
The fair value of the retained interest where a business combination is achieved in stages
and details of any gain recognised in remeasuring this interest to fair value
The amounts of revenue and profit or loss of the acquiree included in the consolidated
statement of profit or loss since acquisition
The revenue and profit or loss of the Group for the current reporting period as though the
acquisition date for all business combinations that occurred in the period was as at the
beginning of the period.
Illustration
On 1 September 20X3 the Fanfare Group acquired 85% of the issued share capital of Devonald
Distribution Co. for cash consideration of $87 million. Devonald Distribution Co. is a logistics
company with a worldwide distribution network. The Fanfare Group has used the services of
Devonald Distribution Co. for a number of years and the acquisition has been made in order to
secure the company’s ongoing service and achieve synergies. The transaction has been
accounted for using the acquisition method of accounting.
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27: Principles of consolidation | Part D Group financial statements
6 Current developments
The IASB issued ED/2014/4 Measuring Quoted Investments in Subsidiaries, Joint Ventures and
Associates at Fair Value in September 2014. This proposes amendments to IFRS 10 (HKFRS 10),
IFRS 12 (HKFRS 12), IAS 27 (HKAS 27) and IAS 28 (HKAS 28) as well as IAS 36 (HKAS 36) and
IFRS 13 (HKFRS 13).
As a result of the proposed amendments, standards would clarify that the fair value of an
investment that is quoted in an active market is determined on the basis of an individual quoted
market price without adjustment in the following cases.
IFRS 10 (HKFRS 10) Consolidated Financial Statements – where an investment entity
measures its subsidiaries at fair value.
IFRS 12 (HKFRS 12) Disclosure of Interests in Other Entities – where the fair value of each
material joint venture and associate measured using the equity method is disclosed
IAS 27 (HKAS 27) Separate Financial Statements- where an entity measures investments in
subsidiaries, associates and joint ventures at fair value in its separate financial statements.
IAS 28 (HKAS 28) Investments in Associates and Joint Ventures – where certain entities, such as
mutual funds, can elect to measure their investments in associates and joint ventures at fair value.
757
Financial Reporting
Topic recap
Principles of consolidation
Levels of investment
Consideration:
Contingent consideration included at
fair value
Payment in respect of pre-existing
relationships is not part of
Consolidated financial statements must consideration
be prepared for all subsidiaries under the Most acquisition-related costs are
control of a parent other than those held recognised as an expense, with the
for sale. exception of share and debt issue
costs
In certain circumstances a parent
company which is itself a subsidiary is
exempt from preparing consolidated Non-controlling interest is measured at
financial statements. either fair value or as a proportion of the
net assets of the acquiree.
Investment entities must measure
subsidiaries at fair value through profit or
loss rather than consolidate them unless Net assets of the acquiree are measured
they provide services relating to at fair value:
investment activities. Fair value adjustments are either
recognised by the acquiree or made as
a consolidation adjustment.
Provisions for future losses/
Consolidation procedures:
restructuring are not recognised
The parent's and subsidiaries'
Intangible assets are recognised if
financial statements are combined
identifiable
on a line by line basis.
Contingent liabilities are recognised at
Intra-group balances and
fair value if reliable
transactions are eliminated.
Adjustments must be made where a
subsidiary has a different year-end
from a parent. Positive goodwill is recognised as an
Uniform accounting policies are
asset and tested for impairment
applied. annually
A subsidiary is included from the
Negative goodwill is reviewed and is
date on which control is obtained. then recognised as a gain on bargain
purchase.
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27: Principles of consolidation | Part D Group financial statements
Answer 1
(a) $ $
Cash consideration 300,000
Deferred cash consideration ($100,000 1/1.06) 94,340
Equity consideration (20,000 $1.60) 32,000
Contingent equity consideration (10,000 $1.60
90%) 14,400
440,740
Non-controlling interests (10,000 $1.25) 12,500
453,240
Fair value of net assets
Share capital 100,000
Retained earnings 249,000
Revaluation reserve 50,000
Land – fair value adjustment 60,000
Provision – fair value adjustment (40,000)
(419,000)
Goodwill 34,240
Note that Small's actual 8% increase to profits in the year following acquisition does not
affect the measurement of the contingent equity consideration (and so the calculation
of goodwill). This contingent consideration is measured at its estimated fair value at the
acquisition date. Subsequent changes to this fair value are only made where
information becomes available during the measurement period which affects the fair
value at the acquisition date.
(b)
DEBIT Investment $440,740
CREDIT Cash/Bank $300,000
CREDIT Liability $94,340
CREDIT Share capital $32,000
CREDIT Shares to be issued $14,400
To recognise the investment in Small Co. in Large Co.’s individual financial statements.
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Financial Reporting
31 May 20X9
DEBIT Shares to be issued $14,400
CREDIT Share capital $14,400
To recognise the issue of the contingent deferred shares.
Answer 2
STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER
20X7 – EXTRACT $
WORKING
Provisional value of asset 300,000
Depreciation (300,000 / 5 years) 3/12 (15,000)
285,000
WORKING
Fair value of asset 400,000
Depreciation to 31 Dec 20X7 (400,000 / 5 years) 3/12 (20,000)
380,000
Depreciation for y/e 31 Dec 20X8 (400,000 / 5 years) (80,000)
300,000
The property, plant and equipment balance in the 20X7 comparative financial statements as
reported in 20X8 is increased by $95,000. This increase is balanced by the following adjustments
also made to the 20X7 figures:
The carrying value of goodwill is decreased by $100,000 being the difference between the
acquisition date provisional value and fair value. The depreciation expense is increased by $5,000
being the difference between the depreciation charge as recognised in the 20X7 financial
statements, based on the provisional value and the depreciation charge for 20X7 based on the fair
value ($'000):
$'000 $'000
DEBIT Property, plant and equipment 95
DEBIT Depreciation expense 5
CREDIT Goodwill 100
Answer 3
(a) In GCC’s financial statements the investment is recognised by:
DEBIT Investment in LL (financial asset) $44,620,000
DEBIT Trade payable $200,000
CREDIT Cash $29,000,000
CREDIT Loan notes to be issued $9,800,000
CREDIT Share capital $6,020,000
To record the acquisition of the subsidiary and settlement of the trade account with LL.
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27: Principles of consolidation | Part D Group financial statements
Working 1
The investment in LL is a financial asset investment in GCC’s separate financial statements
and as such is measured initially at its fair value:
$000
Cash (working 2) 28,800
Loan notes (at fair value) 9,800
Shares issued (working 3) 6,020
44,620
Working 2
$200,000 of the cash payment is in respect of a pre-existing relationship, being the balance
due from GCC for goods supplied. This does not form part of the consideration for the
acquisition.
Working 3
The share consideration is recognised at fair value, equating to the number of shares issued
in GCC multiplied by the quoted share price:
(84% 5m)/15 = 280,000 shares
at fair value of $21.50 per share = $6,020,000
(b) Goodwill arising on acquisition
$000 $000
Consideration transferred (cost of investment) – part (a) 44,620
Fair value of the NCI (16% 5m shares $10.15) 8,120
52,740
Identifiable net assets at acquisition date:
Share capital 18,000
Reserves as reported 30,400
Trade receivable settled replaced by cash 0
Adjustment to carrying amount of provision ($550,000 – (50)
$500,000)
Fair value adjustment to property ($6.6million – $6 million) 600
(48,950)
Goodwill 3,790
Notes
The licence is a reaquired right in accordance with HKFRS 3. No adjustment is
made to LL’s financial statements in respect of this; HKFRS 3 requires that this
is measured based on the remaining contractual term of the contract regardless
of the possibility of contract renewals.
LL’s trade receivable account of $200,000 with GCC has been settled, however
there is no change to net assets as LL receives cash instead.
The fair value of the provision is the acquisition date estimate of the outflow of
resources required to settle the obligation, being $550,000
The property is measured at fair value in accordance with HKFRS 13. Therefore
the highest and best use of the property is considered and the fair value is
$6.6 million.
761
Financial Reporting
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27: Principles of consolidation | Part D Group financial statements
Exam practice
XYZ 18 minutes
XYZ is a listed entity engaged in the provision of recruitment services, preparing financial
statements to 30 June each year. Part of the directors' long term strategy is to identify opportunities
for the takeover of other related businesses. In 20X1, the directors decided to expand their
operations into the second major city of the country in which XYZ operates by taking over an
existing recruitment agency. On 1 July 20X1, XYZ paid $14,700,000 for 800,000 of the 1,000,000
shares in the successful AB Agency. At that date, AB had share capital of $1,000,000 and retained
earnings of $2,850,000. At the date of acquisition, AB's brand name was valued by specialists at
$2,900,000 and following the acquisition it has been recognised in the consolidated financial
statements of XYZ. Apart from retained earnings, AB has no other reserves.
AB has continued to be very successful and, therefore, XYZ's directors have been seeking further
acquisitions. On 1 April 20X7, XYZ gained control of a small online recruitment business, paying
$39.60 per share to acquire 60,000 out of 100,000 issued shares in the CD Agency. CD's share
capital is $100,000 and retained earnings at 1 July 20X6 were $700,000; at 30 June 20X7, they
were $780,000. CD paid no dividends during the year ended 30 June 20X7. CD's profits can be
assumed to accrue evenly over time. Since acquisition CD has continued to produce growth in both
profit and market share.
The directors follow the accounting treatment required for goodwill arising on consolidation by
HKFRS 3 Business Combinations (revised). It is group policy to measure NCI at acquisition at full
fair value. The fair value of the NCI shares at acquisition was $17 per share for AB and $35 per
share for CD. XYZ has no investments other than those in AB and CD.
Required
Calculate the balance of goodwill on acquisition to be included in the consolidated financial
statements of XYZ for the year ended 30 June 20X8. (10 marks)
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Financial Reporting
764
chapter 28
Consolidated accounts:
accounting for subsidiaries
Topic list
Learning focus
Group accounting is relevant to many entities. You should be able to perform a simple
consolidation.
765
Financial Reporting
Learning outcomes
Competency
level
Prepare the financial statements for a group in accordance with Hong
Kong Reporting Standards and statutory reporting requirements
4.04 Acquisition of subsidiaries 3
4.04.01 Prepare a consolidated statement of financial position for a
simple/complex group structure including pre and post acquisition
profits, non-controlling interests and goodwill
4.04.02 Prepare a consolidated statement of profit or loss and other
comprehensive income for a simple/complex group structure,
dealing with an acquisition and the non-controlling interest
4.09 Consolidated financial statement preparation 3
4.09.01 Prepare a consolidated statement of financial position in
compliance with HKFRS 10
4.09.02 Prepare a consolidated statement of profit or loss and other
comprehensive income
766
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
As we saw in the last chapter, HKFRS 10 requires a parent to present consolidated financial
statements, in which the accounts of the parent and subsidiary (or subsidiaries) are combined and
presented as a single entity.
The basic principles of the consolidated statement of financial position require that the assets and
liabilities of a parent and subsidiary company are added together, and the parent's investment in
the subsidiary is eliminated against the equity of that subsidiary. Therefore, only the parent
company's share capital is shown in the consolidated accounts. In the simplest case the journal
required to achieve this is:
DEBIT Share capital of subsidiary
DEBIT Pre-acquisition reserves of subsidiary
CREDIT Parent’s investment in subsidiary
The following example illustrates this.
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Financial Reporting
The adjustments column shows the effect of the consolidation adjustment journal:
$ $
DEBIT Share capital of subsidiary 30,000
DEBIT Pre-acquisition reserves of subsidiary 70,000
CREDIT Parent’s investment in subsidiary 100,000
To recognise the acquisition of subsidiary.
In this instance the $70,000 retained earnings of the subsidiary must have been made pre-
acquisition and they are therefore eliminated and not available to the group.
2.1 Goodwill
Topic highlights
Goodwill is recognised as an asset in the consolidated statement of financial position and tested for
impairment annually.
In the example above, the 100% investment in the subsidiary was purchased for $100,000 on a
date when the net assets of the subsidiary were $100,000. Therefore no goodwill arose. As we saw
in the last chapter, however, this is an unusual situation.
We shall now introduce goodwill into the consolidation process.
Example: Goodwill
The following statement of financial position relates to A Co. and B Co. as at 31 December 20X7.
A Co. B Co.
$ $
Non-current assets 4,000 3,200
Investment in B Co. 3,800 –
Current assets 2,400 500
10,200 3,700
Represented by:
Share capital 8,000 3,000
Reserves 1,900 500
9,900 3,500
Current liabilities 300 200
10,200 3,700
A Co. acquired all of the share capital of B Co. on 31 December 20X7.
The consolidation process now involves:
1 adding together the assets and liabilities of A and B
2 eliminating the investment in B shown in A's books against B's equity
3 calculating and including goodwill in the consolidated statement of financial position
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28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
In both of the examples seen so far, the consolidation is performed on the date of the acquisition
and therefore group reserves are equal to the parent company's reserves.
In the following example, we shall see how the post-acquisition profits of a subsidiary are taken into
account in calculating group reserves.
769
Financial Reporting
The acquisition journal in this case is the same as that in the example before. The difference is
that in removing $500 of B’s reserves, $200 post acquisition reserves remain to be carried
across to form part of group reserves.
This example shows how group retained earnings comprise all of the parent company's retained
earnings plus the group share (100% in this case) of the subsidiary's post acquisition retained
earnings.
So far we have only dealt with situations where the parent company owns all of the share capital in
the subsidiary. As we saw in the last chapter, however, there may be a non-controlling interest in
the subsidiary. This may be measured at fair value or as a proportion of the net assets in the
subsidiary, and the next two examples consider each of these situations.
770
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
771
Financial Reporting
Consolidation adjustment
$ $
DEBIT Share capital 3,000
Pre-acquisition reserves (B Co.) 500
Goodwill on consolidation 1,000
CREDIT Cost of investment 3,800
Non-controlling interests 700
To recognise the acquisition of B Co and resulting goodwill and non-controlling interests
The non-controlling interests in net assets are shown within the equity and liabilities section of the
statement of financial position. This amount represents the net assets of the subsidiary which
legally belong to its non-controlling shareholders.
The goodwill calculated in this example of $1,000 is attributable to the parent company, A Co, only.
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28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
Consolidated
A Co. B Co. Adjustments A Co.
$ $ $ $
Represented by:
Share capital 8,000 3,000 (3,000) 8,000
Reserves 1,900 500 (500) 1,900
9,900 3,500 9,900
Non-controlling interests – – 950 950
Current liabilities 300 200 500
10,200 3,700 11,350
Consolidation adjustment
$ $
DEBIT Share capital 3,000
Pre-acquisition reserves (B Co.) 500
Goodwill on consolidation 1,250
CREDIT Cost of investment 3,800
Non-controlling interests 950
To recognise the acquisition of B Co and resulting goodwill and non-controlling interests
Again, the non-controlling interests is represented in the bottom half of the consolidated statement
of financial position, however this time at fair value.
The goodwill calculated in this example of $1,250 is 'full goodwill' being the goodwill attributable to
both A Co. and the non-controlling interests.
773
Financial Reporting
Consolidation adjustments
(i) $ $
DEBIT Share capital 3,000
Pre-acquisition reserves (B Co.) 500
Goodwill on consolidation 1,000
CREDIT Cost of investment 3,800
Non-controlling interests 700
To recognise the acquisition of B Co. and the resulting goodwill and non-controlling interest
(ii)
DEBIT Reserves 40
CREDIT Non-controlling interests 40
To allocate the NCI share of B Co.’s post-acquisition profits
The following example again includes post-acquisition profits in the subsidiary, but this time the
non-controlling interest is measured at fair value at the acquisition date.
774
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
775
Financial Reporting
Consolidation adjustments
(i) $ $
DEBIT Share capital 3,000
Pre-acquisition reserves (B Co.) 500
Goodwill on consolidation 1,250
CREDIT Cost of investment 3,800
Non-controlling interests 950
As we saw in the last chapter, HKFRS 3 (revised) requires that for the purposes of consolidation
and the calculation of goodwill the assets and liabilities of the subsidiary are measured at fair value.
This may mean that adjustments are required as part of the consolidation process.
776
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
The non-current assets of B Co. were valued at $1,400 on 1 January 20X7, and were estimated to
have a remaining useful life of seven years. The revaluation was not recorded in the books of B
Co..
B Co. provides depreciation at 10% per annum on cost of non-current assets. There have been no
additions or disposal of non-current assets since 1 January 20X7.
The non-controlling interests are measured as a proportion of the net assets of the subsidiary.
Consolidation journal $ $
DEBIT Goodwill 140
DEBIT Share capital 1,000
DEBIT Reserves (300 + 150) 450
CREDIT Investment 1,300
CREDIT Non-controlling interest 290
To recognise the acquisition of B Co. and resulting goodwill and non-controlling
interest.
4 Calculate additional depreciation required in respect of the fair value adjustment
$
Depreciation provided in the books of B Co. ($1,500 10%) 150
Depreciation based on fair value $1,400 (200)
7 years
Depreciation adjustment on consolidation (50)
777
Financial Reporting
Consolidation journal $ $
DEBIT Reserves 50
CREDIT Non-current assets 50
To record additional depreciation on fair value adjustment.
5 Allocate non-controlling interest share of post acquisition profit in B Co.
$
Post acquisition profits in B Co.
Per B Co.’s statement of financial position 400
Fair value adjustment at acquisition (W2) 150
Pre-acquisition reserves (W3) (450)
Post-acquisition additional depreciation (W4) (50)
50
Consolidation journal $ $
DEBIT Reserves 10
CREDIT Non-controlling interest 10
To allocate the non-controlling interest share of B Co.’s post-acquisition profits
778
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
One of the basic principles underlying consolidation is that of viewing a group as a single economic
entity. Therefore any intra-group (intercompany) transactions must be eliminated on consolidation
so that the consolidated financial statements show only transactions with third parties outside the
group.
Common intra-group transactions include:
one company lending money to another group company
trading between group companies
one company selling a non-current asset to another company.
We shall consider each of these in turn.
2.5.1 Intra-group lending
As a result of intra-group lending one group company will show a loan in their statement of financial
position and another group company will show an investment (or receivable).
On consolidation these should be eliminated against each other and are therefore not added
across to form part of group borrowings or group investments.
2.5.2 Intra-group trading
Intra-group trading may result in one group entity recognising a receivable at the period end and
another recognising a payable. These may be referred to as "current accounts". Again they should
be cancelled against each other prior to the consolidation.
Where the amounts outstanding are not equal due to cash in transit, the recipient company should
account for the cash in transit as if it had been received prior to the period end. The receivable and
payable amounts will then be equal and may be cancelled.
A further result of intra-group trading is that of unrealised profits in stock. These are profits made by
one group company selling to another. Until such time as the inventory in question is sold outside
the group, the profit is not realised. Therefore, on consolidation, the unrealised profit in closing
stock should be eliminated from the selling company's profits as part of the consolidation, and the
closing inventory of the group should be recorded at cost to the group.
779
Financial Reporting
The profit recorded by A Co. on sale of the goods to B Co. is $40m 25% = $10m. From the
viewpoint of the group, $5m (1/2 x $10m) is unrealised and should be eliminated from A Co's
profits prior to consolidation.
Consolidation adjustment
$ $
DEBIT A Co.'s cost of sales 5m
CREDIT Inventory 5m
To eliminate the unrealised profit in inventory.
Consolidated inventory = $54m + $42m – $5m = $91m
Consolidated reserves = ($100m – $5m) + ($50m – $40m) 100% = $105m
(b) Now suppose that B Co sold the goods to A Co rather than vice versa. This time the
consolidation adjustment is made to B Co’s books as follows:
Consolidation adjustment
$ $
DEBIT B Co.'s cost of sales 5m
CREDIT Inventory 5m
To eliminate the unrealised profit in inventory.
Consolidated inventory = $54m + $42m – $5m = $91m
Consolidated reserves = $100m + ($50m – $40m – $5m) 100% = $105m
(c) Now suppose that A Co holds 80% of the shares in B Co rather than 100% of the shares and
the NCI was measured at acquisition at $12m.
This makes no difference to calculated amounts if A Co is the selling company, however it
does result in changes if B Co is the selling company.
Consolidation adjustment
$ $
DEBIT B Co.'s cost of sales 5m
CREDIT Inventory 5m
To eliminate the unrealised profit in inventory.
Consolidated inventory = $54m + $42m – $5m = $91m
Consolidated reserves = $100m + ($50m – $40m – $5m) 80% = $104m
Non-controlling interest = $12m + ($50m – $40m – $5m) 20% = $13m
Group reserves are $1 less than seen previously because only 80% of the subsidiary’s
retained profit (after adjustment for the unrealised profit) is included. The remaining 20% is
allocated to the non-controlling interest.
Therefore where there is a non-controlling interest and the subsidiary is the selling company,
the NCI is allocated its share of the unrealised profit.
780
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
A consolidated statement of profit or loss and other comprehensive income is prepared by adding
all the individual items in the subsidiary's statement of profit or loss and other comprehensive
income to those in the parent company's accounts.
Similar complications as those seen in relation to the statement of financial position are relevant.
781
Financial Reporting
The effects of intra-group lending, trading and transfers of assets will all need to be eliminated from
the consolidated statement of profit or loss and other comprehensive income.
In the case of intra-group lending, interest receivable in the lender's books is cancelled against
interest payable in the borrower's books prior to consolidation.
In the case of intra-group trading, sales in one group company's books are cancelled against cost
of sales in another group company's books prior to consolidation. Where there is an unrealised
profit in inventory this must also be eliminated. We saw the elimination of an unrealised profit from
a statement of financial position perspective in section 2.5. A debit entry was made to the selling
company’s reserves and a credit entry to consolidated inventories. When dealing with the
consolidated statement of profit or loss, the debit element of this entry results in an adjustment to
cost of sales. The following example illustrates this.
782
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
In the case of intra-group transfers of non-current assets, any profit or loss arising in the year must
be eliminated from the consolidated profit or loss. In addition, in the year of transfer and
subsequent years, adjustment must be made so that the depreciation charge recorded in the
consolidated statement of profit or loss and other comprehensive income is based on the cost of
the asset to the group. As before, adjustment is made to the selling company’s books. Where the
selling company is the subsidiary and there is a non-controlling interest, the relevant percentage of
the adjustment is allocated to the NCI.
Example: Intra-group transfer of assets
The following information relates to A Co. and its 70% owned subsidiary, B Co., for the year ended
31 December 20X7.
A Co. B Co.
$ $
Revenue 500 400
Cost of sales (220) (140)
Gross profit 280 260
Other income 90 30
Expenses (270) (180)
Retained profit for the year 100 110
During the year, A Co. transferred an asset used for administrative purposes to B Co. making a
profit of $80. As a result of the transfer depreciation has increased by $8 per annum.
Consolidation adjustments:
(i) $ $
DEBIT Other income 80
CREDIT Non-current assets (SOFP) 80
To eliminate the unrealised profit in non-current assets.
(ii) $ $
DEBIT Non-current assets (SOFP) 8
CREDIT Operating expenses 8
To eliminate the additional depreciation charged as a result of the intra-group transfer of a non-
current asset.
783
Financial Reporting
Where a subsidiary is acquired mid-year, care must be taken to ensure that the subsidiary's results
are included in the consolidation only from the date of acquisition. Practically, this will involve pro-
rating the subsidiary's results prior to adding across.
A Co. acquired 70% of the ordinary share capital of B Co. on 1 April 20X7.
784
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
The consolidated statement of profit or loss for the year ended 31 December 20X7 is:
Allocated to:
Owners of the parent (70%) 65 29.4 $65 +($29.4 x 9/12) 87.05
Non-controlling interests (30%) 12.6 ($12.6 x 9/12) 9.45
96.5
785
Financial Reporting
Now try the following questions to practise the topics listed above.
786
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
Self-test question 1
Bootie Co. has owned 80% of Goose Co.'s equity since its incorporation. On 31 December 20X8 it
despatched goods which cost $80,000 to Goose, at an invoiced cost of $100,000. Goose received
the goods on 2 January 20X9 and recorded the transaction then. The two companies' draft
accounts as at 31 December 20X8 are shown below:
STATEMENTS OF PROFIT OR LOSS
Bootie Goose
$'000 $'000
Revenue 5,000 1,000
Cost of sales 2,900 600
Gross profit 2,100 400
Other expenses 1,700 320
Net profit 400 80
Income tax 130 25
Profit for the year 270 55
STATEMENT OF CHANGES IN EQUITY
$'000 $'000
Opening balance 2,260 285
Total comprehensive income (profit) for the year 270 55
Dividends (130) (40)
Closing balance 2,400 300
STATEMENTS OF FINANCIAL POSITION
Bootie Goose
$'000 $'000 $'000 $'000
ASSETS
Non-current assets
Property, plant and 1,920 200
equipment
Investment in Goose 80 –
2,000 200
Current assets
Inventory 500 120
Trade receivables 650 40
Bank and cash 390 35
1,540 195
3,540 395
EQUITY AND LIABILITIES
Equity
Share capital 2,000 100
Retained earnings 400 200
2,400 300
Current liabilities
Trade payables 910 30
Dividend payable 100 40
Tax 130 25
1,140 95
3,540 395
Required
Prepare draft consolidated financial statements (ignoring tax).
(The answer is at the end of the chapter)
787
Financial Reporting
Self-test question 2
The draft statements of financial position of Okay and its subsidiary Chestnut at 30 September
20X8 are as follows:
Okay Chestnut
$ $ $ $
Non-current assets
Tangible assets, carrying amount
Land and buildings 225,000 270,000
Plant 202,500 157,500
427,500 427,500
Investment
Shares in Chestnut at cost 562,500
Current assets
Inventory 255,000 180,000
Receivables 375,000 90,000
Bank 112,500 22,500
742,500 292,500
1,732,500 720,000
Okay Chestnut
$ $
Equity
Share capital 1,125,000 450,000
Retained earnings 450,000 202,500
1,575,000 652,500
Current liabilities 157,500 67,500
1,732,500 720,000
788
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
Self-test question 3
You are provided with the following statements of financial position for Shakier and Minoa.
STATEMENTS OF FINANCIAL POSITION AS AT 31 OCTOBER 20X0
Shakier Minoa
$'000 $'000 $'000 $'000
Non-current assets, at carrying amount
Plant 325 70
Fixtures 200 50
525 120
Investment
Shares in Minoa at cost 200
Current assets
Inventory at cost 220 70
Receivables 145 105
Bank 100 –
465 175
1,190 295
Equity
Ordinary shares 700 170
Retained earnings 215 50
915 220
Current liabilities
Payables 275 55
Bank overdraft – 20
275 75
1,190 295
The following information is also available:
(a) Shakier purchased 70% of the issued ordinary share capital of Minoa four years ago, when
the retained earnings of Minoa were $20,000. There has been no impairment of goodwill.
(b) For the purposes of the acquisition, plant in Minoa with a book value of $50,000 was
revalued to its fair value of $60,000. The revaluation was not recorded in the accounts of
Minoa. Depreciation is charged at 20% using the straight line method.
(c) Shakier sells goods to Minoa at a mark up of 25%. At 31 October 20X0, the inventories of
Minoa included $45,000 of goods purchased from Shakier.
(d) Minoa owes Shakier $35,000 for goods purchased and Shakier owes Minoa $15,000.
(e) It is the group's policy to value the non-controlling interests at fair value.
(f) The market price of the shares of the non-controlling shareholders just before the acquisition
was $1.50.
Required
Prepare the consolidated statement of financial position of Shakier as at 31 October 20X0 (ignoring
tax).
(The answer is at the end of the chapter)
789
Financial Reporting
5 Complex groups
A parent company must prepare consolidated financial statements for all subsidiaries within its
control, whether that control is direct or indirect.
So far, we have considered only direct control, for example a situation where P owns 80% of S.
This section of the chapter considers two types of complex groups in which indirect control is also
evident:
Vertical groups
D-shaped groups
S1
75%
S2
Here:
P owns 90% of S1, and therefore S1 is a subsidiary of P
S1 owns 75% of S2 and therefore S2 is a subsidiary of S1
As P controls S1 which in turn controls S2, S2 is within the control of P (referred to as a sub-
subsidiary)
In this case the consolidated financial statements of P should include the assets, liabilities and
results of both S1 and S2.
The consolidation is performed in the same way as the simple consolidations seen earlier in the
chapter, however the calculation of goodwill becomes more complex, and is based on:
an effective group interest of P in S2 of 67.5% (90% 75%)
an effective non-controlling interest in S2 of 32.5%, being
25% owned directly by other shareholders in S2
7.5% (10% 75%) owned indirectly by other shareholders in S1
790
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
Solution
The group effective shareholding is 56% (80% 70%)
Therefore the effective non-controlling interest is 44%
$'000
Cost of investment (80% $9m) 7,200
NCI (44% $8m) 3,520
Net assets of acquiree (8,000)
Goodwill 2,720
Note that the goodwill arising on the acquisition of Fabulous would be calculated in the normal way,
separately from the goodwill arising on the acquisition of Excellent.
Solution
$'000
Cost of investment (80% $9m) 7,200
NCI (44% 3m $3.50) 4,620
Net assets of acquiree (8,000)
Goodwill 3,820
In both of these examples the sub-subsidiary is acquired after the subsidiary. It may be the case
that a vertical group develops where a parent company buys a subsidiary which itself already holds
a sub-subsidiary. In this case separate calculations are still required for the goodwill arising in both
the subsidiary and sub-subsidiary, but the acquisition date for both is the same, being the date on
which the parent company acquired the subsidiary (and so the sub-subsidiary). The date on which
the subsidiary acquired the sub-subsidiary is irrelevant.
5.1.2 Non-controlling interest and group reserves
Both non-controlling interests and group reserves are based on the respective effective
shareholdings of the non-controlling interest and group.
791
Financial Reporting
Solution
(a) Statement of financial position $'000
Non-controlling interest at acquisition 3,520
Share of post acquisition profits 44% (6.2m – 5m) 528
Non-controlling interest 4,048
Self-test question 4
Below are the statements of financial position of three companies, Alpha, Beta and Gamma as at
31 December 20X5:
Alpha Beta Gamma
$'000 $'000 $'000
Investments
300,000 shares in Beta 450
240,000 shares in Gamma 320
Current assets 890 610 670
1 Alpha acquired its interest in Beta on 1 January 20X2. Beta acquired its interest in Gamma
on 1 January 20X3.
2 The retained earnings of Beta and Gamma were:
1 January 20X3 1 January 20X2
$'000 $'000
Beta 100 80
Gamma 60 50
Beta has 400,000 shares in issue and Gamma has 300,000 shares in issue.
3 Alpha Group's policy is to value non-controlling interests at the date of acquisition at the
proportionate share of the fair value of the acquiree's identifiable assets acquired and
liabilities assumed. The fair values of the identifiable net assets of Beta and Gamma were
equivalent to their book values at the respective date of acquisition.
4 Beta and Gamma form separate cash generating units. An impairment review carried out at
31 December 20X5 revealed that Beta had a recoverable amount of $780,000 (including its
investment in Gamma) and that no impairment losses were required in respect of the group's
investment in Gamma.
792
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
Required
(a) Prepare the consolidated statement of financial position of Alpha and its subsidiary
companies as at 31 December 20X5.
(b) Calculate the goodwill and consolidated reserves at 31 December 20X5 on the assumption
that Alpha acquired Beta on 1 January 20X3 and that Beta had acquired Gamma on
1 January 20X2 (ignoring impairment losses).
(The answer is at the end of the chapter)
40% S1
40%
S2
Here:
P owns 80% of S1 and therefore S1 is a subsidiary of P.
P owns 40% of S2 directly and another 40% indirectly through S1. S2 is therefore a sub-
subsidiary of P.
As with vertical groups, an effective interest is calculated in S2 and the consolidation is based on
this percentage. In this case the relevant percentage is 72% (being a 40% direct holding and a
32% indirect holding calculated as 80% 40%). The non-controlling interest effective percentage is
therefore 28%.
5.2.1 Goodwill, non-controlling interest and retained earnings
The calculations for goodwill, the non-controlling interest and retained earnings are the same as
those seen in the case of vertical groups, with one exception. Goodwill arising in the sub-subsidiary
must include two elements to cost, being:
the cost of the parent's direct holding
the parent's share of the subsidiary's holding in the sub-subsidiary (i.e. the indirect holding).
Example: Goodwill
Goose acquired 90% of Duck a number of years ago. On 1 January 20X1, Duck and Goose both
acquired 30% of Gander, each paying $4 million for their 30% share. On this date the net assets of
Gander amounted to $10 million.
Required
What goodwill arises on the acquisition assuming that the non-controlling interest is measured as a
proportion of net assets?
793
Financial Reporting
Solution
Group effective holding is 57% (30% + (90% 30%))
Therefore the NCI share is 43%
$'000
Cost of direct holding 4,000
Cost of indirect holding ($4m 90%) 3,600
NCI (43% $10m) 4,300
Net assets of acquiree (10,000)
Goodwill 1,900
Self-test question 5
On 1 January 20X5 Goldman, a public limited company acquired 60% of Shapwell, a public limited
company.
On 30 July 20X3 Goldman acquired 10% of Benton, a public limited company, and on the same
day Shapwell acquired 80% of Benton.
The statements of financial position of the three companies as at 31 December 20X9 are as
follows:
Goldman Shapwell Benton
$m $m $m
Non-current assets
Property, plant and equipment 2,978 1,650 810
Investment in Shapwell 900 – –
Investment in Benton 27 240 –
3,905 1,890 810
Current assets
Inventories 400 180 270
Trade receivables 510 325 189
Cash 140 105 116
1,050 610 575
4,955 2,500 1,385
Equity
Ordinary share capital 750 320 150
Retained earnings 2,805 1,572 850
3,555 1,892 1,000
Current liabilities
Trade payables 1,400 608 385
4,955 2,500 1,385
During the year, Shapwell sold goods to Benton for $ 220m including a mark-up of 25%. Half of
these goods remain in inventories at the year-end.
The retained earnings of the three companies at the acquisition dates were:
30.7.X3 1.1.X5
$m $m
Goldman 1,610 1,860
Shapwell 700 950
Benton 40 100
The book values of the identifiable net assets at the acquisition date are equivalent to their fair
values. The fair value of Goldman's 10% holding in Benton on 1 January 20X5 was $ 50m.
794
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
Goldman and Shapwell hold their investments in subsidiaries at cost in their separate financial
statements. It is group policy to measure the non-controlling interests at fair value at acquisition.
The directors valued the non-controlling interests in Shapwell at $ 536m and Benton at $ 210m on
1 January 20X5.
No impairment losses have been necessary in the consolidated financial statements to date.
Required
(a) Prepare the consolidated statement of financial position of Goldman group as at 31
December 20X9.
(b) Another company, Sword has an 80% holding in Dagger, which in turn has a 55% holding in
Pistol. Explain why it is important to establish the dates of acquisition of the two companies
when preparing the consolidated financial statements.
795
Financial Reporting
Topic recap
Mechanics: Mechanics:
1 add assets and liabilities on a line by 1 add income and expenditure on a
line basis line by line basis (pro rate for mid-
2 eliminate P's investment in S against year acquisition)
the equity of S 2 eliminate dividend income from S in
3 recognise the non-controlling P's SOCI
interest 3 recognise the non-controlling
4 include P's share capital only interest in profits
Calculate goodwill:
FV of consideration paid X Goodwill impairment charge
NCI at acquisition X
FV of net assets of acquiree (X)
X
Recognise as an asset and test
for impairment annually.
Unrealised profits are eliminated against Unrealised profits are eliminated against
the selling company's reserves the selling company’s profits
796
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
Complex groups
Vertical D-shaped
P P
80%
80%
40% S1
S1
40%
70%
S2
S2
797
Financial Reporting
Note: Although we have used a consolidation schedule in the chapter, these answers are prepared
in a variety of ways in order to display that there is flexibility in how you prepare a consolidation.
Answer 1
Consolidated statement of profit or loss for the Bootie Group for the year ended 31 December 20X8
Bootie Goose Total (W2)(ii) (W3)(ii) (W3)(iv) Group
$’000 $’000 $’000 $’000 $’000 $’000 $’000
Revenue 5,000 1,000 6,000 (100) 5,900
Cost of (2,900) (600) (3,500) 100 (20) (3,420)
sales
Gross 2,100 400 4,600 2,480
profit
Other (1,700) (320) (2,020) (2,020)
expenses
Net profit 400 80 480 (20) 460
Income tax (130) (25) (155) (155)
Profit for 270 55 325 (20) 305
the year
Attributable
to:
Owners of 270 55 325 (11) (20) 294
the parent
NCI 11 11
305
Consolidated statement of financial position for the Bootie Group as at 31 December 20X8
Bootie Goose Total (W1) (W2)(i) (W3)(i) (W3)(iii) (W3)(iv) (W4) Group
$’000 $’000 $’000 $’000 $’000 $’000 $’000 $’000
Non-current
assets
PPE 1,920 200 2,120 2,120
Investment 80 - 80 (80) -
in Goose
2,000 200 2,200 2,120
Current
assets
Inventory 500 120 620 100 (20) 700
Trade 650 40 690 (100) 590
receivables
Bank and 390 35 425 425
Cash
1,540 195 1,735 1,715
3,540 395 3,935 3,835
798
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
Bootie Goose Total (W1) (W2)(i) (W3)(i) (W3)(iii) (W3)(iv) (W4) Group
$’000 $’000 $’000 $’000 $’000 $’000 $’000 $’000
Equity &
liabilities
Equity
Share 2,000 100 2,100 (100) 2,000
capital
Retained 400 200 600 (40) (20) 32 572
earnings
2,400 300 2,700
Non- 20 40 60
controlling
interest
2,632
Current
liabilities
Trade 910 30 940 100 (100) 940
payables
Dividend 100 40 140 (32) 108
payable
Tax 130 25 155 155
1,140 95 1,235 1,203
3,540 395 3,935 3,835
Consolidated statement of changes in equity for the Bootie Group for the year ended 31 December
20X8
Share Retained
capital earnings NCI Group
$’000 $’000 $’000 $'000
Opening balance (W5) 2,000 416 57 2,408
Group profit for the year 294 11 294
Dividends (130) (8) (130)
Closing balance 2,000 572 60 2,572
WORKINGS
1 Elimination of investment
The cost of Bootie’s investment in Goose is eliminated against Goose’s share capital and the
NCI recognised by:
DEBIT Share capital $100,000
CREDIT NCI $20,000
CREDIT Investment in Goose $80,000
Note that since the shares in Goose were acquired on that company’s incorporation, no
goodwill arises. The NCI must be measured at the carrying amount of its shares in Goose of
$20,000 (20% $100,000).
2 Allocation of profits of Goose
(i) Since incorporation Goose has made retained profits of $200,000. 20% of these are
allocated to the NCI by:
DEBIT Retained earnings (20% $200,000) $40,000
CREDIT NCI $40,000
(ii) Of these retained earnings, $55,000 are made in the year. 20% of these are allocated
to the NCI by:
DEBIT Profit attributable to owners of the parent $11,000
CREDIT NCI $11,000
799
Financial Reporting
3 Intercompany sale
(i) Bootie despatched goods before the year end at an invoiced amount of $100,000; at
the year end, Goose’s books must be adjusted as though it had received and
accounted for the goods by:
DEBIT Inventory $100,000
CREDIT Trade payables $100,000
(note that purchases are usually recorded as a debit to cost of sales, however at the
period end any remaining inventory is credited out of cost of sales and debited to
inventory. The journal above achieves this outcome in a single step.)
(ii) The intercompany sales are eliminated by:
DEBIT Revenue $100,000
CREDIT Cost of sales $100,000
(iii) The intercompany balances are eliminated by:
DEBIT Trade payables $100,000
CREDIT Trade receivables $100,000
(iv) The unrealised profit of $20,000 ($100,000 – $80,000) is eliminated by:
DEBIT Cost of sales $20,000
CREDIT Inventory $20,000
As Bootie is the seller, the adjustment to profit is allocated to the owners of the parent only.
The adjustment is recognised in retained earnings in the statement of financial position.
4 Dividend
Bootie’s dividend does not require adjustment as it is payable outside the group.
Part of Goose’s dividend ($32,000 being 80% x $40,000) is payable within the group and
requires elimination. This is achieved by:
DEBIT Dividend payable $32,000
CREDIT Consolidated retained earnings $32,000
Dividends payable outside the group are therefore $138,000 ($130,000 + (20% $40,000)).
5 Proof of brought forward amounts
Group retained earnings $’000
Retained earnings of Bootie b/f 260
80% of retained earnings of Goose b/f (80% 185) 148
408
800
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
Answer 2
OKAY
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER 20X8
Okay Chestnut W2 W3 W4 W5 W6 Consol’d
$'000 $'000 $'000 $'000 $'000 $'000 $'000 $'000
Land and 225 270 120 615
buildings
Plant 202.5 157.5 360
Goodwill 22.5 (22.5) -
Inventory 255 180 (10.5) 424.5
Receivables 375 90 (15) 450
Bank 112.5 22.5 135
1,984.5
Share 1,125 450 (450) 1,125
capital
Retained 450 202.5 (105) (22.5) (15) (10.5) (19.5) 495
earnings
NCI 135 19.5 154.5
Current 157.5 67.5 (15) 210
liabilities
1,984.5
WORKINGS
360,000
1 Group structure: = 80%
450,000
2 Goodwill
$ $
Consideration transferred 562,500
Non-controlling interests (675,000 20%) 135,000
697,500
Less: net assets acquired
Share capital 450,000
Retained earnings 105,000
Revaluation reserve 120,000
(675,000)
Goodwill 22,500
Consolidation adjustment
$ $
DEBIT Goodwill 22,500
DEBIT Share capital 450,000
DEBIT Reserves 105,000
DEBIT Revaluation reserve 120,000
CREDIT Investment 562,500
CREDIT NCI 135,000
To recognise the acquisition of Chestnut and resulting goodwill and NCI.
3 Goodwill impairment
Goodwill is fully impaired, therefore:
$ $
DEBIT Retained earnings 22,500
CREDIT Goodwill 22,500
To record the goodwill impairment.
801
Financial Reporting
4 Intra-group balances
Intra-group balances are eliminated by:
DEBIT Payables 15,000
CREDIT Receivables 15,000
To cancel intra-group balances.
5 Unrealised profit
DEBIT Retained earnings 10,500
CREDIT Inventory 10,500
To eliminate the unrealised profit in inventory.
6 Post-acquisition profits
$'000
Post acquisition profits (202.5 – 105) 97.5
Attributable to NCI (20%) 19.5
DEBIT Retained earnings 19,500
CREDIT NCI 19,500
To allocate the NCI share of post-acquisition profits.
Answer 3
SHAKIER
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 OCTOBER 20X0
$'000 $'000
Non-current assets
Plant (W4) 397
Fixtures (200 + 50) 250
647
Intangible asset: goodwill (W1) 77
724
Current assets
Inventory (W5) 281
Receivables (W6) 200
Bank 100
581
1,305
Equity and liabilities
Share capital 700
Retained earnings (W2) 221
921
Non-controlling interests (W3) 84
1,005
Current liabilities
Payables (W7) 280
Bank overdraft 20
300
1,305
802
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
WORKINGS
1 Goodwill
$'000 $'000
Consideration transferred 200.0
Fair value of the non-controlling 76.5
interest (30% 170,000 $1.50)
276.5
Net assets acquired
Share capital 170
Retained earnings 20
Revaluation surplus (60 – 50) 10
(200.0)
Goodwill in parent 76.5
2 Retained earnings
$'000 $'000
Shakier 215.0
PUP (W5) 9.0
Additional depreciation on plant (8 (W4) 70%) 5.6
(14.6)
200.4
Minoa: 70% (50 – 20) 21.0
221.4
3 Non-controlling interests
$'000 $'000
Share capital 170
Revaluation 10
Less: excess depreciation (8)
2
Retained earnings 50
222
Non-controlling interest in subsidiary's identifiable net 67
assets: 30% $222,000
Goodwill attributable to NCI (76.5 – (200 30%)) 17
Non-controlling interests 84
4 Plant
$'000 $'000
Shakier 325
Minoa
Per question 70
Revalued (60 – 50) 10
Depreciation on revalued plant (10 20% 4) (8)
72
397
5 Inventory
$'000 $'000
Shakier 220
Minoa 70
Less: PUP (45 25/125) (9)
61
281
803
Financial Reporting
6 Receivables
$'000 $'000
Shakier 145
Less: intragroup 35
110
Minoa 105
Less: intragroup 15
90
200
7 Payables
$'000 $'000
Shakier 275
Less: intragroup 15
260
Minoa 55
Less: intragroup 35
20
280
Answer 4
(a) ALPHA GROUP CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT
31 DECEMBER 20X5
$'000
Goodwill (W2) 84
Current assets (890 + 610 + 670) 2,170
2,254
WORKINGS
1 Group structure
Alpha
= 75%
= 80%
804
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
2 Goodwill
Beta Gamma
$'000 $'000 $'000 $'000
84
805
Financial Reporting
4 Non-controlling interests
Beta Gamma
$'000 $'000
NCI at acquisition (W2) 120 144
NCI share of post acquisition reserves:
Beta ((W3) 220 25%) 55
Gamma ((W3) 40 40%) 16
Less: NCI share of investment in Gamma (320 25%) (80)
95 160
255
(b) Alpha acquired Beta on 1 January 20X3 and Beta acquired Gamma on 1 January
20X2
Revised workings:
2 Goodwill
Beta Gamma
$'000 $'000 $'000 $'000
99
3 Consolidated reserves
Alpha Beta Gamma
$'000 $'000 $'000
Per question 400 300 100
Reserves at acquisition (W2) (100) (60)
200 40
Group share of post acq'n
reserves:
Beta (200 75%) 150
Gamma (40 60%) 24
574
Note. All other figures in the consolidated statement of financial position would be the
same as in part (a). The consolidated statement of financial position would appear as
follows:
806
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
255
Answer 5
(a) GOLDMAN GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X9
$m
Non-current assets
Property, plant and equipment (2,978 + 1,650 + 810) 5,438
Goodwill (W2) 320
5,758
Current assets
Inventories (400 + 180 + 270 – (W5) 22) 828
Trade receivables (510 + 325 + 189) 1,024
Cash (140 + 105 + 116) 361
2,213
7,971
Equity attributable to owners of the parent
Ordinary share capital 750
Retained earnings (W3) 3,623
4,373
Non-controlling interests (W4) 1,205
5,578
Current liabilities
Trade payables (1,400 + 608 + 385) 2,393
7,971
807
Financial Reporting
Workings
1 Group structure
Goldman
1.1.X5 60%
30.7.X3
Shapwell 10%
30.7.X3 80%
Benton Effective interest (60% × 80%) + 10% 58%
Non-controlling interests 42%
100%
320
3 Retained earnings
Goldman Shapwell Benton
$m $m $m
Per question 2,805 1,572 850
P/L gain on investment in Benton (50 – 27) 23
Less unrealised profit (W5) (22)
Retained earnings at acq'n (W2) (950) (100)
600 750
Group share of post acq'n ret'd earnings:
Shapwell (600 60%) 360
Benton (750 58%) 435
3,623
4 Non-controlling interests
Shapwell Benton
$m $m
NCI at acquisition (W2) 536 210
NCI share of post acq'n ret'd earnings:
Shapwell 600 40%) 240
Benton (750 42%) 315
Less NCI share of investment in Benton (240 40%) (96)
680 525
1,205
808
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
809
Financial Reporting
Exam practice
Bailey 45 Minutes
Bailey, a public limited company, has acquired shares in two companies. The details of the
acquisitions are as follows:
Fair value Ordinary
Ordinary Reserves of net share
Date of share at assets at Cost of capital
Company acquisition capital acquisition acquisition investment acquired
$m $m $m $m $m
Hill 1 January 20X6 500 440 1,040 720 300
Campbell 1 May 20X9 240 270 510 225 72
810
28: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements
The draft financial statements for the year ended 31 December 20X9 are as follows:
STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER 20X9
Bailey Hill Campbell
Non-current assets $m $m $m
Property, plant and equipment 2,300 1,900 700
Investment in Hill 72720 – –
Investment in Campbell 225 – –
3,245 1,900 700
Current assets 3,115 1,790 1,050
6,360 3,690 1,750
Equity
Share capital 1,000 500 240
Reserves 3,430 1,800 330
4,430 2,300 570
Non-current liabilities 350 290 220
Current liabilities 1,580 1,100 960
6,360 3,690 1,750
STATEMENTS OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE
YEAR ENDED 31 DECEMBER 20X9
Bailey Hill Campbell
$m $m $m
Revenue 5,000 4,200 2,000
Cost of sales (4,100) (3,500) (1,800)
Gross profit 900 700 200
Distribution and administrative expenses (320) (175) (40)
Dividend income from Hill and Campbell 36 - -
Profit before tax 616 525 160
Income tax expense (240) (170) (50)
PROFIT FOR THE YEAR 376 355 110
811
Financial Reporting
Required
Prepare the consolidated statement of financial position for the Bailey group as at 31 December
20X9 and the consolidated statement of profit or loss and other comprehensive income for the year
then ended.
(25 marks)
812
chapter 29
Consolidated accounts:
accounting for associates
and joint arrangements
Topic list
1 Associates
1.1 Definitions
1.2 Excluded associates
1.3 The equity method
1.4 Application of the equity method
1.5 Consolidation adjustments
1.6 Losses in an associate
1.7 Impairment losses
1.8 Indirect investment in an associate
2 Joint arrangements
2.1 Definitions
2.2 HKFRS 11 Joint Arrangements
3 Disclosure requirements
3.1 Nature, extent and financial effects of an entity’s interests in joint arrangements and associates
Learning focus
This chapter
Type here builds on the basic principles of consolidated accounts seen in the previous
chapters. Associates and joint arrangements are common and you should know how to
account for them.
813
Financial Reporting
Learning outcomes
Competency
level
Prepare the financial statements for a group in accordance with Hong
Kong Reporting Standards and statutory reporting requirements
4.07 Investments in associates 3
4.07.01 Define an associate in accordance with HKAS 28 (2011)
4.07.02 Explain what significant influence is and apply the principle
4.07.03 Explain the reasons for and impact of equity accounting, including
notional purchase price allocation on initial acquisition, fair value
adjustments, upstream and downstream transactions, and uniform
accounting policies
4.07.04 Account for investors' share of losses of an associate in excess of
its investments in associates
4.07.05 Explain the impairment test and related treatments for investments
in associates
4.07.07 Prepare the disclosure in respect of associates
4.08 Interest in joint arrangements 3
4.08.01 Define joint arrangements in accordance with HKFRS 11
4.08.02 Explain the difference among jointly controlled operations and joint
ventures
4.08.03 Explain how an entity should account for a joint venture
4.08.04 Account for the transactions between a venturer and a joint venture
4.08.05 Disclose the relevant information in the venturer's financial
statements
814
29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
1 Associates
Topic highlights
An associate is an entity over which an investor has significant influence. This is assumed where at
least 20% of the voting power is held by an investor but may be achieved in other ways.
As we saw in Chapter 27, an associate is something less than a subsidiary, but more than a simple
investment. HKAS 28 (2011) provides guidance on which entities meet the definition of an
associate and how they should be accounted for within the consolidated financial statements.
HKAS 28 (2011) does not apply to investments in associates or joint ventures held by venture
capital organisations, mutual funds, unit trusts, and similar entities that are measured at fair value
in accordance with HKFRS 9.
Note that in the separate financial statements of the investor, an interest in an associate is
accounted for either:
at cost, or
in accordance with HKFRS 9.
Key terms
Associate. An entity, including an unincorporated entity such as a partnership, over which an
investor has significant influence and which is neither a subsidiary nor an interest in a joint venture.
Significant influence is the power to participate in the financial and operating policy decisions of
the investee but is not control or joint control over those policies.
Equity method. A method of accounting whereby the investment is initially recorded at cost and
adjusted thereafter for the post acquisition change in the investor's share of the investee’s net
assets. The investor’s profit or loss includes its share of the profit or loss of the investee’s profit or
loss and the investor’s other comprehensive income includes its share of the investee’s other
comprehensive income.
(HKAS 28 (2011))
815
Financial Reporting
HKAS 28
(2011).17
1.2 Excluded associates
HKAS 28 (2011) applies to all investments in associates unless the investment is classified as
'held for sale' in accordance with HKFRS 5 in which case it should be accounted for under HKFRS
5.
An investor is exempt from applying HKAS 28 (2011) accounting procedures under the following
circumstances:
(a) If it is a parent exempt from preparing consolidated financial statements under HKFRS 10.
(b) All of the following apply:
(i) The investor is a wholly-owned subsidiary or it is a partially owned subsidiary of
another entity and its other owners, including those not otherwise entitled to vote,
have been informed about, and do not object to, the investor not applying the equity
method.
(ii) Its securities are not publicly traded.
(iii) It is not in the process of issuing securities in public securities markets.
(iv) The ultimate or intermediate parent publishes consolidated financial statements that
comply with HKFRS.
HKAS 28 was amended in 2015 to clarify that the second exemption (exemption (b)) applies even
where the investor’s ultimate or intermediate parent is an investment entity as defined by HKFRS
10 and it measured its investments at fair value in its consolidated financial statement. Investment
entities are defined in chapter 27.
Even where an investee operates under severe long-term restrictions that significantly impair its
ability to transfer funds to the investor, the accounting requirements of HKAS 28 (2011) must be
applied. Significant influence must be lost before the equity method ceases to be applicable.
HKAS 28
(2011).10-11,
1.3 The equity method
22, 27,33 HKAS 28 (2011) requires that associates are accounted for using the equity method in
consolidated financial statements. Note that consolidated financial statements will only be
prepared where there is also at least one subsidiary.
Under the equity method:
(a) the investment in an associate is initially recognised at cost and the carrying amount is
increased or decreased to recognise the investor's share of the profit or loss of the investee
after the date of acquisition. It is decreased by any distributions received from an investee.
(b) the investor's share of the profit or loss of the investee is recognised in the investor's profit or
loss and their share of the other comprehensive income of the investee is recognised in
other comprehensive income.
Therefore, the investment in associate is shown in the consolidated financial statements in just one
line in the statement of financial position and a maximum of two in the statement of profit or loss
and other comprehensive income. This treatment reflects the fact that the associate and its income
streams are not controlled.
The use of the equity method should be discontinued from the date that the investor ceases to
have significant influence.
When preparing the consolidated financial statements, the most recent available financial statements
of the associate should be used. Where practicable, these should be prepared to the same reporting
date as the financial statements of the investor. Where this is not practicable, the difference
between the end of the reporting period of the associate and that of the investor shall be no
more than three months, and adjustment should be made for transactions during this time.
816
29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
Uniform accounting policies should be applied in the investor's and associate's accounts and where
this is not the case, the associate's accounts should be adjusted. This requirement does not apply
where an associate is an investment entity that measures its interests in subsidiaries at fair value.
The application of the equity method results in the following line items being included in the
consolidated financial statements:
Statement of financial position
Investment in associate shown as a non-current asset
Statement of profit or loss and other comprehensive income
Share of profit (loss) of associate
Share of associate's other comprehensive income
Example: Associate
Panda Co. acquires 30,000 of the 120,000 ordinary shares in Aardvark for $100,000 cash on
1 January 20X1. In the year to 31 December 20X1, Aardvark earns profits after tax of $80,000,
from which it declares a dividend of $20,000. Aardvark reports no other comprehensive income.
How will Aardvark's results be accounted for in the individual and consolidated accounts of Panda
Co. for the year ended 31 December 20X1?
Solution
Individual accounts
1 record at cost on 1 January 20X1
$ $
DEBIT Investment in associate 100,000
CREDIT Cash 100,000
817
Financial Reporting
On acquisition of the associate shareholding, although the investment is always initially carried at
cost, the consideration paid is notionally allocated to the fair value of the net assets acquired.
(a) Where the cost of the investment exceeds the fair value of net assets acquired, notional
goodwill exists within the carrying value of the investment in the statement of financial
position. This is not recognised separately as goodwill and is not amortised.
(b) Where the cost of the investment is less than the fair value of net assets acquired, the
difference is included as income in the determination of the investor's share of the
associate's profit or loss in the period in which the investment is acquired.
1.4.2 Consolidated statement of profit or loss and other comprehensive
income
Under equity accounting, the associate's revenue, cost of sales and so on are not aggregated with
those of the group. Instead, the consolidated statement of profit or loss and other comprehensive
income will only include the group share of the associate's profit after tax and other comprehensive
income for the year.
In effect, this is the corresponding treatment to the associate's parent company's treatment: the
investing company is the non-controlling interests here.
818
29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
Self-test question 1
Set out below are the draft accounts of Parent Co. and its subsidiaries and of Associate Co..
Parent Co. acquired 20% of the equity capital of Associate Co. five years ago when the latter's
retained earnings stood at $60,000.
SUMMARISED STATEMENT OF FINANCIAL POSITION
Parent Co. and
subsidiaries Associate Co.
$'000 $'000
Property, plant and equipment 400 180
Investment in Associate at cost 80 –
Loan to Associate Co. 30 –
Current assets 190 70
Loan from Parent Co. – (30)
700 220
Share capital 200 100
Retained earnings 500 120
700 220
SUMMARISED STATEMENTS OF PROFIT OR LOSS
Parent Co. and
subsidiaries Associate Co.
$'000 $'000
Profit before tax 120 100
Taxation 30 20
90 80
Required
Prepare the summarised consolidated accounts of Parent Co.
Note. Assume that there are no non-controlling interests in the subsidiary companies.
(The answer is at the end of the chapter)
819
Financial Reporting
Self-test question 2
Peter Co. bought 30,000 ordinary shares representing 30% of the share capital on 31 December
20X6 in Agnes Co. at a cost of $60,000 when the statement of financial position of Agnes was as
follows:
AGNES CO.
DRAFT STATEMENT OF FINANCIAL POSITION AT DATE OF SHARE PURCHASE
ASSETS $
Non-current assets
Goodwill 50,000
Tangible assets 200,000
250,000
Current assets 80,000
Total assets 330,000
EQUITY AND LIABILITIES
Equity
Share capital 100,000
Retained earnings 110,000
Non-current liabilities: 7% loan notes 120,000
Total equity and liabilities 330,000
During the year to 31 December 20X7 Agnes Co. made a profit before tax of $90,000 and the
taxation charge on the year's profits was $20,000. A dividend of $30,000 was paid on 31 December
out of these profits.
The statement of financial position of Agnes Co. on 31 December 20X7 was as follows:
ASSETS $
Non-current assets
Goodwill 50,000
Tangible assets 210,000
260,000
Current assets 110,000
Total assets 370,000
EQUITY AND LIABILITIES
Equity
Share capital 100,000
Retained earnings 150,000
Non-current liabilities: 7% loan notes 120,000
Total equity and liabilities 370,000
Calculate the amounts for the associate which would appear in the consolidated accounts of the
Peter group, in accordance with the requirements of HKAS 28 (2011).
(The answer is at the end of the chapter)
820
29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
An associate is not deemed to be part of the single economic entity that is the group. That is
because its assets and liabilities and therefore resulting income and expenditure are not controlled
within the group.
Since an associate is not considered to be part of the group, there is no need to eliminate intra-
group transactions.
Certain consolidation adjustments do, however, remain relevant, in particular unrealised profits,
referred to by HKAS 28 (2011) as the effect of upstream and downstream transactions, and fair
value adjustments.
HKAS 28 1.5.1 'Upstream' and 'downstream' trading transactions
(2011).28
"Upstream" transactions are sales made by an associate to the parent company or a group
subsidiary. "Downstream" transactions are sales made by the parent company or a group
subsidiary to an associate.
The group share of unrealised profits and losses resulting from 'upstream' and 'downstream'
transactions are eliminated.
Although HKAS 28 is clear as to the amount of elimination for an upstream or downstream
transaction, it does not specify how the adjustment should be made. Common entries are as
follows:
Upstream transaction (associate is the seller), where A% is the parent's holding in the associate,
and PUP is the provision for unrealised profit:
DEBIT Cost of sales of parent PUP A%
CREDIT Group inventories PUP A%
OR
DEBIT Share of profit of associate PUP A%
CREDIT Group inventories PUP A%
Downstream transaction (parent or subsidiary is the seller):
DEBIT Cost of sales of parent/subsidiary PUP A%
CREDIT Investment in associate PUP A%
821
Financial Reporting
Because the sale was made to the associate, the group's share of the unsold inventories forms part
of the investment in associate at the year end. If the sale had been from the associate A to P, i.e.
an upstream transaction, the double entry would have been:
$ $
DEBIT P: Cost of sales 6,000
CREDIT P: Inventories 6,000
If preparing the consolidated statement of profit or loss, you would deduct the $6,000 from the
group share of the associate's profit.
Note. In the examples above, the debit could be to items other than cost of sales, depending on
the subject of the intra-group transaction.
Example
The Cook Group has held a 40% interest in Redding Co, which gives it significant influence over
that company, for many years. On 12 October 20X4, a Cook Group company transfers a machine
used for packaging to Redding Co for its fair value of $450,000. At that date the asset had a
carrying amount of $490,000 and a remaining useful life of 10 years.
Required
What journal entries are required on consolidation in respect of this transfer?
Solution
The transfer is from a Cook Group company to Redding Co, therefore it is a downstream
transaction.
The asset has a fair value of $450,000 and the sale at this amount provides evidence of an
impairment loss of $40,000.
This loss is recognised in full by the Cook Group.
On the sale, in its individual company accounts the selling company (a member of the Cook Group)
makes the following entries:
$ $
DEBIT Sales and distribution expenses 40,000
DEBIT Cash 450,000
CREDIT Property plant and equipment 490,000
To derecognise the machine and recognise the resulting loss.
Therefore the $40,000 loss is already recognised in full in the financial statements of the Cook
Group Company. This ensures that no further adjustment is required on consolidation. (Note that
Redding Co recognises the machine at $450,000, being cost and therefore no adjustment is
required to the carrying amount of the investment in Redding).
822
29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
Self-test question 3
On 1 July 20X4 Peninsula Traders Co acquires a 40% interest in Island Imports Co for $30 million.
Peninsula Traders determines that the investment meets the definition of an associate in
accordance with HKAS 28. At the acquisition date the book value of the net assets of Island
Imports Co total $54 million. The following information is relevant:
1 Property with a book value of $10 million has a fair value of $15 million. The property has a
remaining useful life of 25 years.
2 Included in the net assets of Island Imports Co is goodwill relating to an acquisition that took
place in 20X0. The goodwill has a carrying amount of $4 million.
3 Island Imports Co has not recognised brand names with a total fair value of $5 million
because these were developed internally. They are determined to have a remaining useful
life of 5 years at the date of acquisition.
4 A supplier of Island Imports Co has brought an action against the company and is claiming
damages of $1 million. Island Imports Co has not recognised a liability on account of its legal
team advising that the probability of having to pay this amount is just 30%. The fair value of
the contingent liability is $700,000. This is unchanged at 31 December 20X4.
5 Island Imports Co reports profits of $8 million and no other comprehensive income in the
year ended 31 December 20X4. This accrues evenly throughout the year.
6 Island Imports pays no dividends in the year ended 31 December 20X4.
Required
(a) State the journal entries required in respect of the acquisition of Island Imports Co in
Peninsula Trader’s individual accounts in the year ended 31 December 20X4
(b) Show the notional allocation of the purchase consideration to the net assets of Island
Imports at 1 July 20X4.
(c) State the journal entries required on consolidation in the year ended 31 December 20X4 in
respect of Island Imports Co.
(d) Prepare extracts from the consolidated statement of financial position and statement of profit
or loss in respect of the investment in Island Imports Co.
(The answer is at the end of the chapter)
823
Financial Reporting
HKAS 28
1.6 Losses in an associate
(2011).38-39
Where an investor is loss making and the parent company's share of losses equals or exceeds its
interest in the associate, the parent must discontinue recognising its share of further losses.
For this purpose the investment in the associate includes:
initial cost
the group share of the associate's post-acquisition retained total comprehensive income
other long term interests such as long-term loans or preference shares.
After the interest in the associate is reduced to zero, additional losses are provided for and a
liability recognised to the extent that the investor has incurred legal or constructive obligations or
made payments on behalf of the associate.
Should the associate return to profit, the parent may resume recognising its share of profits only
after they equal the share of losses not recognised.
824
29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
incurred a loss of $10million for the year ended 31 December 20X8 and did not declare a dividend.
At 31 December 20X8 the fair value of CLG’s investment in Riordan Co is $27.5 million and
estimated costs to sell the investment are $1.0 million.
Required
Determine amounts to be recognised in the consolidated financial statements of CLG in the year
ended 31 December 20X8 in respect of the investment in Riordan.
Solution
On 1 January 20X8 the investment in Riordan is initially measured in the separate financial
statements of the investor at cost of $30 million by:
DEBIT Investment in Riordan $30m
CREDIT Cash/bank $30m
To recognise the investment in Riordan.
On consolidation at 31 December 20X8, the investment is transferred to be an investment in an
associate by:
DEBIT Investment in associate $30m
CREDIT Investment in Riordan $30m
To transfer the investment to investments in associates.
CLG recognises its $3m (30% x $10m) share of Riordan’s losses for the year by:
DEBIT Share of loss of associate (CSPL) $3m
CREDIT Investment in associate $3m
To recognise the group share of Riordan’s loss.
The carrying amount of the investment in associate is $27m and the recoverable amount is $26.5m
($27.5m - $1.0m). Therefore an impairment loss of $500,000 is recognised by:
DEBIT Impairment loss (CSPL) $500,000
CREDIT Investment in associate $500,000
To recognise the impairment loss in respect of the associate.
In the consolidated financial statements of CLG for the year ended 31 December 20X8, the
following amounts are recognised:
CONSOLIDATED STATEMENT OF FINANCIAL POSITION $ ‘000
Investment in associate 26,500
825
Financial Reporting
2 Joint arrangements
Topic highlights
A joint venture is a contractual arrangement where two or more parties jointly control an economic
activity.
When two or more entities wish to enter into a business arrangement together, however do not
want to create a formal long-term partnership, it is common to form a joint venture. This type of
business vehicle generally exists to fulfil short term projects, such as the construction of a building
or structure. When the project is complete, the joint venture ceases to exist.
There are different forms of joint venture, as we shall see, but essentially, entities which form the
joint venture (venturers) contribute assets, expertise and in some cases equity to the venture. In
return they are entitled to a share of the profits of the joint venture.
HKFRS 11 Joint Arrangements was issued in June 2011 and replaced HKAS 31 Interests in Joint
Ventures. HKFRS 11 considers the different forms of joint venture which may be undertaken and
how each form should be accounted for.
This section of the chapter considers definitions in relation to joint arrangements and then explains
the requirements of HKFRS 11.
HKFRS 11,
Appendix A
2.1 Definitions
Before thinking about the different types of joint venture and how they are accounted for, we must
consider the definitions provided by HKFRS 11.
Key terms
Joint arrangement. An arrangement of which two or more parties have joint control.
Joint control. The contractually agreed sharing of control of an arrangement, which exists only
when decisions about the relevant activities require the unanimous consent of the parties sharing
control.
Joint operation. A joint arrangement whereby the parties that have joint control of the
arrangement have rights to the assets and obligations for the liabilities relating to the arrangement.
Joint venture. A joint arrangement whereby the parties that have joint control of the arrangement
have rights to the net assets of the arrangement.
(HKFRS 11)
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29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
Contractual arrangement
HKFRS 11, HKFRS 11 states that the contractual arrangement may be evidenced in a number of ways
B2, B4 including:
a written contract between the controlling parties
minutes of discussions between controlling parties
incorporation of the arrangement in the articles or by-laws of the joint arrangement.
The contractual arrangement will deal with issues such as:
(a) the purpose, activity and duration of the joint venture
(b) the appointment of the board of directors and voting rights of the controlling parties
(c) capital contributions by the controlling parties
(d) the sharing by the controlling parties of the output, income, expenses or results of the joint
venture.
One party may be identified in the contractual arrangement as the operator or manager of the joint
venture. This does not indicate that that party controls the joint arrangement, simply that they are
acting within the financial and operating policies agreed by the controlling parties in accordance
with the contractual arrangement.
If it is evident that the operator does have control of the activity then the arrangement is a
subsidiary of the operator rather than a joint operation or venture.
Unanimous consent
HKFRS 11. Joint control exists only when decisions about the relevant activities of a joint arrangement require
B5-B9 the unanimous consent of the parties that collectively control the arrangement.
827
Financial Reporting
In some cases unanimous consent is implicit. In the example above, a 75% majority is required to
make decisions. Therefore Abacus and Bacchus have implicit joint control because a 75% majority
cannot be achieved without their unanimous consent.
In other situations, the required threshold to make decisions about relevant activities can be met by
more than one combination of parties agreeing together. In this case unanimous consent only
exists if the contractual arrangement specifies which parties must agree unanimously to decisions
about the relevant activities of the arrangement.
Example – unanimous consent
Three parties establish an arrangement: Austen has 50% of the voting rights, Bronte and Christie
both have 25%. The contractual agreement between the parties specifies that at least 75% of
voting rights are required to make decisions about the relevant activities of the arrangement.
In this situation, either Austen and Bronte or Austen and Christie can agree to reach 75% of voting
rights. Therefore, unanimous consent only exists if the contractual agreement between the parties
stipulates which two parties must agree unanimously to decisions about the relevant activities of
the management. If the contractual agreement does not stipulate which parties must agree, there is
no unanimous consent and this is not a joint arrangement within the scope of HKFRS 11.
A joint operation is a joint arrangement whereby the parties that have joint control (the joint
operators) have rights to the assets, and obligations for the liabilities, of that joint arrangement. A
joint arrangement that is not structured through a separate entity is always a joint operation.
A joint venture is a joint arrangement whereby the parties that have joint control (the joint
venturers) of the arrangement have rights to the net assets of the arrangement.
A joint arrangement that is structured through a separate entity may be either a joint operation or a
joint venture. In order to ascertain the classification, the parties to the arrangement should assess
the terms of the contractual arrangement together with any other facts or circumstances to assess
whether they have:
rights to the assets, and obligations for the liabilities, in relation to the arrangement
(indicating a joint operation)
rights to the net assets of the arrangement (indicating a joint venture).
Detailed guidance is provided in the appendices to HKFRS 11 in order to help this assessment,
giving consideration to, for example, the wording contained within contractual arrangements.
Self-test question 4
Can you think of any examples of situations where the following may occur?
(a) Joint operation not structured through a separate entity.
(b) Joint venture structured through a separate entity.
(The answer is at the end of the chapter)
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29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
829
Financial Reporting
The use of the equity method should be discontinued from the date on which the joint venturer
ceases to have joint control over, or have significant influence on, a joint venture.
3 Disclosure requirements
An entity should disclose information about significant judgments and assumptions made in
determining:
that it has joint control of an arrangement or significant influence over another entity, and
the type of joint arrangement (joint operation or joint venture) when the arrangement is
structured through a separate vehicle.
It should also disclose information to allow users of the financial statements to evaluate:
the nature, extent and financial effects of its interests in joint arrangements and associates,
including the nature and effects of its contractual relationship with other investors.
the nature of, and changes in, risks associated with interests in joint ventures and
associates.
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29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
Illustration
The following illustration relates to associates; disclosure in respect of joint arrangements would
take the same form.
Associates
The Group has two associates that are material to the Group, both of which are equity accounted.
Copper Steel
Nature of relationship with Strategic retailer providing Supplier of raw materials to the
the Group access to new customers in Group
Asia
Principal place of business / Hong Kong PRC
country of incorporation
Ownership interest / voting 40% 35%
rights held
Fair value of ownership $40,650,000 N/A
interest (if listed)
Self-test question 6
It is 1 December 20X9.
Aardvark Co., a company with subsidiaries, entered into an agreement with Bilton Co., a public
limited company, on 1 December 20X8. For an investment of $50 million, each of the companies
holds one half of the equity in an entity, Dante Co., a public limited company, which operates
offshore oil rigs. The contractual arrangement between Aardvark Co. and Bilton Co. establishes
joint control of the activities that are conducted in Dante Co.. The main feature of Dante Co.’s legal
831
Financial Reporting
form is that Dante Co., not Aardvark Co. or Bilton Co., has rights to the assets, and obligations for
the liabilities, relating to the arrangement.
The terms of the contractual arrangement are such that:
(a) Dante Co. owns the oil rigs. The contractual arrangement does not specify that Aardvark Co.
or Bilton Co. have rights to the oil rigs.
(b) Aardvark Co. and Bilton Co. are not liable in respect of the debts, liabilities or obligations of
Dante Co.. If Dante Co. is unable to pay any of its debts or other liabilities or to discharge its
obligations to third parties, the liability of each party to any third party will be limited to the
unpaid amount of that party’s capital contribution.
(c) Aardvark Co. and Bilton Co. have the right to sell or pledge their interests in Dante Co..
(d) Each party receives a share of the income from operating the oil rig in accordance with its
interest in Dante Co..
Dante Co. made an after-tax profit of $5,600,000 in the period ended 30 November 20X9. There
are no impairments during the year.
During the same year, Aardvark Co. joined with Fennel Co. to set up Karling Co., a foreign
incorporated entity, to mine for petroleum in Northern Asia. Aardvark Co and Fennel Co. each
have a 50% stake and joint control in Karling Co. Aardvark Co. and Fennel Co each transferred a
number of their own assets to Karling Co. on incorporation. A contractual arrangement is signed
by both Aardvark Co. and Fennel Co. such that their own assets would revert to them on the
liquidation of Karling Co.. The agreement also clarifies that each party would be individually liable
for the liabilities of Karling Co. in proportion to their respective shareholdings on the liquidation of
the company.
Aardvark Co. also owns a 10% interest in a pipeline, which is used to transport the oil from the
offshore oil rigs to a refinery on the land. Aardvark Co. has joint control over the pipeline and has to
pay its share of the maintenance costs. Aardvark Co. has the right to use 10% of the capacity of
the pipeline.
Required
(i) Discuss how the above arrangements would be accounted for in Aardvark Co.’s financial
statements for the year ended 30 November 20X9. (8 marks)
(ii) Based on the information above, state the amounts which should be shown in Aardvark
Co.’s consolidated statement of financial position and consolidated statement of profit or loss
for the year ended 30 November 20X9 in respect of Dante Co..
(The answer is at the end of the chapter)
832
29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
Topic recap
Significant influence:
Power to participate but not control
Presumed where investor holds ≥ 20%
voting shares Joint Venture Joint Operation
Evidenced by: A joint arrangement A joint arrangement
- Board representation where the parties that where parties that
- Participation in the policy making have joint control of have joint control
process the arrangement have rights to the
- Material transactions between have rights to the net assets and
investor and investee assets of the obligations for the
- Interchange of management arrangement. liabilities relating to
personnel the arrangement.
- Provision of essential technical
information Includes all joint
arrangements not
structured through a
separate entity.
Disclosures:
How joint control or significant influence over another entity has been determined
How the type of joint arrangement is determined when the arrangement is structured through a
separate vehicle
The nature, extent and financial effects of interests in joint arrangements and associates
The nature of, and changes in, risks associated with interests in joint ventures and associates.
833
Financial Reporting
Answer 1
PARENT CO.
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME
$'000
Net profit 120
Share of profits of associate (20% 80) 16
Profit before tax 136
Income tax expense 30
Profit attributable to the owners of Parent Co. 106
PARENT CO.
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
834
29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
Answer 2
CONSOLIDATED STATEMENT OF PROFIT OR LOSS
$
Group share of associate's profit after tax 30% (90,000 – 20,000) 21,000
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
$
Interest in associate 72,000
The asset 'interest in associate' comprises:
Cost 60,000
Share of post-acquisition retained earnings 30% (150,000 – 110,000) 12,000
72,000
Answer 3
(a) Peninsula Trader Co’s individual accounts:
1 July 20X4
$ $
DEBIT Financial asset investment 30,000,000
CREDIT Cash 30,000,000
To recognise the acquisition of an investment in Island Imports Co.
(b)
Book value at 1 July 20X4 Fair value at 1 July 20X4
($) ($)
Property, plant and 10,000,000 15,000,000
equipment
Goodwill 4,000,000 -
Intangible assets - 5,000,000
Contingent liability - (700,000)
Other net assets 40,000,000 40,000,000
Total 54,000,000 59,300,000
40% interest 23,720,000
Cost of investment 30,000,000
Notional goodwill 6,280,000
Note: goodwill is not an identifiable asset and so is excluded from the fair value statement of
financial position.
(c) Journal entries on consolidation at 31 December 20X4
1. $ $
DEBIT Investment in associate 30,000,000
CREDIT Financial asset investment 30,000,000
To transfer the investment in Island Imports Co to be recognised as an associate.
2. $ $
DEBIT Investment in associate (W) 1,600,000
CREDIT Share of profits of associate (CSPLOCI) 1,600,000
To recognise the group share of the associate’s profits since acquisition.
(W) $8,000,000 6/12m 40% = $1,600,000
835
Financial Reporting
3. $ $
DEBIT Share of profits of associate (W) 40,000
CREDIT Investment in associate 40,000
To recognise additional depreciation on the fair value adjustment
(W) $5 million /25 years = $200,000 additional depreciation per annum
For the post acquisition period: $200,000 6/12m = $100,000
Group share: $100,000 40% = $40,000
4. $ $
DEBIT Share of profits of associate (W) 200,000
CREDIT Investment in associate 200,000
To recognise additional depreciation on the fair value adjustment
(W) $5 million /5 years = $1,000,000 amortisation per annum
For the post acquisition period: $1,000,000 6/12m = $500,000
Group share: $500,000 40% = $200,000
(d) Consolidated statement of financial position at 31 December 20X4
$ ‘000
Investment in associate (30,000 + 1,600 – 40 – 200) 31,360
Consolidated statement of profit or loss for the year ended 31 December 20X4
$ ‘000
Share of profits of associate (1,600 – 40 – 200) 1,360
Answer 4
(a) An example of a joint operation may involve building an aircraft. Say that Boeing is to build
the body of the aircraft and the engines are to be built by Rolls Royce as specified by the
airline customer for the aircraft. You can see that different parts of the manufacturing
process are carried out by each of the joint operators. In the Rolls Royce factory, workers
will work on the engines for the Boeing plane alongside others working on engines for
different aircraft.
Each operator, Boeing and Rolls Royce, bears its own costs and takes a share of revenue
from the aircraft sale. That share is decided in the contractual arrangement between the
venturers.
Other examples may arise in the oil, gas and mineral extraction industries. In such
industries companies may, say, jointly control and operate an oil or gas pipeline. Each
company transports its own products down the pipeline and pays an agreed proportion of
the expenses of operating the pipeline (perhaps based on volume).
A further example is a property which is jointly controlled, each operator taking a share of
the rental income and bearing a portion of the expense.
In each case, the key issue is that the joint controller is entitled to a share of assets and
liabilities of the joint arrangement, rather than a share of net assets.
(b) A common situation is where two or more entities transfer the relevant assets and liabilities
to a joint venture in order to combine their activities in a particular line of business.
In other situations, an entity wishing to start operations in a foreign country will set up a joint
venture with the government of the foreign country (or an agency of it).
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29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
Answer 5
(a) AB Co. has made a profit of $0.2 million, but only 50% of this can be considered as realised,
ie that part attributable to the other venturer. AB Co. should therefore recognise a gain of
$0.1 million.
(b) A loss of $0.2 million has been made on the inventories, the entire amount of which should
be recognised by AB Co.. It is known that the loss will be made, even though the inventories
have not yet been sold, and the standard requires that the full loss should be recognised
immediately when they represent a reduction in the net realisable value.
Answer 6
Dante Co
Dante Co. is a joint arrangement between Aardvark Co. and Bass Co.. To determine how Dante
Co. should be accounted for in Aardvark Co.’s financial statements, it is necessary to consider
whether Dante Co. is a joint venture or a joint operation, according to HKFRS 11 Joint
Arrangements.
A joint arrangement is an arrangement, as here, of which two or more parties have joint control. A
joint venture is a joint arrangement whereby the parties that have control of the arrangement have
rights to the net assets of the arrangement. A joint operation is a joint arrangement whereby the
parties that have control of the arrangement have rights to the assets, and obligations for the
liabilities, relating to the arrangement. Where a joint arrangement is not structured through a
separate entity, it is always a joint operation.
Dante Co. is a separate entity. As such, it could be either a joint operation or joint venture, so other
facts must be considered.
There are no facts that suggest that Aardvark Co. or Bass Co. have rights to substantially all the
benefits of the assets of Dante Co. nor an obligation for its liabilities.
Each party’s liability is limited to any unpaid capital contribution.
As a result, each party has an interest in the net assets of Dante Co. and should account for it as a
joint venture using the equity method as required by HKAS 28 Investments in Associates and Joint
Ventures.
This requires the investment in the joint venture to be recognised in the statement of financial
position at cost plus or minus the investor’s share of the total comprehensive income of the joint
venture after acquisition minus any distributions received by the investor and minus any impairment
losses.
In the statement of profit or loss and other comprehensive income, the investor’s share of the joint
venture’s profit after tax and other comprehensive income is recognised.
Karling Co
As this joint arrangement is structured as a separate entity, Karling Co. could be either a joint
operation or joint venture. The terms of the contractual arrangement must be considered to
determine which form of joint arrangement it is. As the contractual arrangement gives Aardvark
Co. and Fennel Co. rights to the assets and obligations for the liabilities of Karling Co., this is a joint
operation.
Pipeline
Although Aardvark Co.’s interest in the pipeline is only 10%, it has joint control over the pipeline.
Therefore it is appropriate to account for the pipeline as a joint arrangement under HKFRS 11.
The pipeline is a jointly controlled asset, and it is not structured through a separate vehicle.
Accordingly, the arrangement is a joint operation.
837
Financial Reporting
Both Karling Co. and the Pipeline are accounted for as a joint operation. HKFRS 11 Joint
Arrangements requires that a joint operator recognises line-by-line the following in relation to its
interest in a joint operation:
(i) Its assets, including its share of any jointly held assets
(ii) Its liabilities, including its share of any jointly incurred liabilities
(iii) Its revenue from the sale of its share of the output arising from the joint operation
(iv) Its share of the revenue from the sale of the output by the joint operation, and
(v) Its expenses, including its share of any expenses incurred jointly.
This treatment is applicable in both the separate and consolidated financial statements of the joint
operator.
In the consolidated financial statements of Aardvark Co., equity accounting principles will be used
to account for the investment in Dante Co..
In the consolidated statement of profit or loss and other comprehensive income, the profit for the
year will include the $ 2,800,000 group share of Dante Co’s profit after tax (50% $5,600,000).
The investment in Dante Co. is shown as ‘investment in joint ventures’ in the consolidated
statement of financial position. The initial investment will be recorded at cost as follows (assuming,
for simplicity, that the consideration is paid in cash):
DEBIT Investment in joint ventures $50,000,000
CREDIT Cash $50,000,000
At the end of the year, the carrying amount of the investment is adjusted for the amount of the
group's share of the joint venture's total comprehensive income retained for the year.
DEBIT Investment in joint ventures $2,800,000
CREDIT Income from shares in joint ventures $2,800,000
The investment in joint ventures is then stated at $52,800,000, being cost plus the group share of
post-acquisition retained total comprehensive income.
838
29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
Exam practice
839
Financial Reporting
An extract of the financial statements of the three companies for the year ended
31 March 20X2 is shown below.
840
29: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements
Assume that you are Charmaine Yuen, the accounting manager, and you are required to draft a
memorandum to Ms. Pindy Lee, a Director of APE. In your memorandum, you should:
(a) For the investment in DPE in the consolidated financial statements of APE, identify and
justify the applicable financial reporting standard, and advise the appropriate classification
and accounting treatment.
(You are not required to describe the detailed accounting method.) (13 marks)
(b) Discuss and advise as to the accounting treatments for the bankrupt customer in the
consolidated financial statements of APE for the year ended 31 March 20X2. (7 marks)
(c) Prepare an annex to your memorandum, showing the worksheets for:
(i) the consolidated statement of profit or loss and other comprehensive income of APE
for the year ended 31 March 20X2, (10 marks)
(ii) the consolidated statement of financial position of APE as at 31 March 20X2, and
(10 marks)
(iii) the consolidated statement of changes in equity of APE for the year ended 31 March
20X2. (10 marks)
(Ignore the deferred tax implications. Consolidation adjustments are to be shown in the form
of a worksheet. For part 1(c)(i) and (ii), you may use the template in green colour paper
provided and/or the script booklet for Case Questions to prepare your answers. You are
required to show the detailed calculations for each figure, journal entries are not required.)
(Total = 50 marks)
841
Financial Reporting
842
chapter 30
Changes in group
structures
Topic list
2 Step acquisitions
2.1 Application of acquisition accounting
1 Disposals
2.2 Calculation of goodwill when control is
1.1 Types of disposal
acquired
1.2 Full disposal of a subsidiary
2.3 Preparation of the consolidated financial
1.3 Partial disposal of subsidiary: subsidiary
statements
to subsidiary
2.4 Increased shareholding in subsidiary
1.4 Partial disposal of subsidiary: subsidiary
to associate 3 Merger accounting for common control
1.5 Partial disposal of subsidiary: subsidiary combinations
to financial asset 3.1 Introduction
1.6 Reclassification adjustments 3.2 The principles
1.7 Full disposal of associate 3.3 The procedures
1.8 Partial disposal of associate: associate 3.4 Accounting period covered by a newly
to financial asset formed parent
1.9 Disclosure requirements on the disposal 3.5 Disclosures in addition to those required
of an investment by applicable HKFRS
3.6 Earnings per share
Learning focus
843
Financial Reporting
Learning outcomes
Competency
level
Prepare the financial statements for a group in accordance with Hong
Kong Financial Reporting Standards and statutory reporting
requirements
4.03 Principles of consolidation 3
4.03.09 Explain how to account for changes in parent's ownership interest in
a subsidiary without losing control
4.05 Disposal of subsidiaries 3
4.05.01 Account for the disposal of a subsidiary by a group
4.05.02 Account for the change of ownership in subsidiaries without loss of
control
4.06 Business combinations 3
4.06.10 Explain the accounting for step acquisition
4.07 Investments in associates 3
4.07.06 Account for the disposal of an associate
4.11 Merger accounting for common control combinations 2
4.11.01 Describe the principles and practices of merger accounting
4.11.02 Apply merger accounting to a common control combination
844
30: Changes in group structures | Part D Group financial statements
1 Disposals
Topic highlights
A subsidiary or associate may be disposed of in its entirety or in part, so that the status of the
investment changes.
A parent company may choose to dispose of all or part of its investment in a subsidiary or
associate. A gain or loss on disposal is normally calculated and included in the consolidated
financial statements as well as the parent company's individual accounts.
The treatment of the disposal and calculation of any gain or loss depends upon the type of
disposal.
845
Financial Reporting
40%
Loss of control but retaining an
associate or a jointly controlled entity
As you will see from the diagram, where an interest in a subsidiary is reduced from say 80% to
60%, this does not involve crossing that all-important 50% threshold.
HKAS 1.1.2 Subsidiary held for sale
27(2011).10
HKAS 27 (2011) requires that in the separate financial statements of the investor, a subsidiary,
jointly controlled entity or associate is held at cost, using the equity method or in accordance with
HKFRS 9.
HKAS 27 (2011) is aligned with HKFRS 5 by clarifying that a parent entity that accounts for an
investment in a subsidiary in accordance with HKFRS 9 (in its separate financial statements) and
subsequently classifies the investment as held for sale (or held in a disposal group classified as
held for sale) would continue to account for the investment in accordance with HKFRS 9.
HKFRS 5 measurement requirements only apply to investments that are held at cost.
Where a subsidiary is disposed of, a profit or loss on disposal will be recognised in both the
parent's individual and the consolidated financial statements. The calculation of each of these
amounts will be different.
846
30: Changes in group structures | Part D Group financial statements
The profit on disposal may be taxable and where it is, the tax is based on the parent's gain rather
than the group's.
1.2.2 Gain or loss in consolidated accounts
The calculation of the gain or loss in the consolidated accounts is a little more complex:
$ $
Fair value of consideration received X
Less: net assets of subsidiary at disposal date X
goodwill at disposal date X
non-controlling interests at disposal date (X)
(X)
Group profit/(loss) X/(X)
This gain or loss may need to be disclosed separately if it is material.
The difference between the gain or loss in the parent company’s account and the gain or loss in the
consolidated accounts is always calculated as the increase (or decrease) in the subsidiary’s net
assets between the acquisition and disposal date that are relevant to the investment that has been
disposed of.
Solution
(a)
AB Co’s gain $’000
Fair value of consideration received 20,000
Less: carrying value of investment disposed of (12,000)
Gain on disposal 8,000
847
Financial Reporting
(b)
Reconciliation $’000
Group gain on disposal 1,250
Share of increase in reserves between acquisition and disposal 6,750
75% ($24m – $15m)
AB Co gain 8,000
Self-test question 1
Land Co. has owned 80% of the ordinary share capital in Rover Co. for a number of years. The
investment cost $980,000 when the net assets of Rover Co. were $1.175 million and goodwill of
$45,000 arose on acquisition, $5,000 relating to the non-controlling interests which was measured
at fair value. Goodwill has not been impaired. On 30 June 20X9 Land Co. disposed of the whole
shareholding in Rover Co. for $1.2 million. At the date of disposal Rover Co. had net assets of $1
million and non-controlling interests of $205,000.
(a) What gain is reported in Land Co.'s individual accounts?
(b) What gain is reported in the Land Group consolidated accounts?
(c) Reconcile the individual company and consolidated gain.
(The answer is at the end of the chapter)
As we have already said, where a controlling shareholding is retained, the 'accounting boundary' is
not crossed and HKFRS 3 (revised) and HKFRS 10 do not consider the transaction to be a
disposal.
In the parent company's individual accounts a profit or loss is recognised on the disposal of the
investment calculated in the same way as we saw earlier, being proceeds less carrying amount of
the investment.
In the consolidated financial statements, however:
no gain or loss on disposal is calculated
goodwill is not re-calculated
the transaction is accounted for through shareholders' equity.
848
30: Changes in group structures | Part D Group financial statements
Solution
1 Adjustment required to the non-controlling interests:
At disposal date: $
NCI based on old shareholding (10% $560,000) 56,000
NCI based on new shareholding (30% $560,000) 168,000
Adjustment required 112,000
The non-controlling interests must be increased by $112,000.
2 Journal adjustment is therefore:
$ $
DEBIT Bank/cash 120,000
CREDIT NCI 112,000
Shareholders' equity ($120,000 – $112,000) 8,000
849
Financial Reporting
Self-test question 2
In 20X8, A acquired a 100% equity interest in B for cash consideration of $125,000.
B's identifiable net assets at fair value were $100,000. Goodwill of $25,000 was identified and
recognised. In the subsequent years, B increased net assets by $20,000 to $120,000. This is
reflected in equity attributable to the parent. A then disposed of 30% of its equity interest to non-
controlling interests for $40,000. In A’s separate financial statements the investment was measured
at cost and the disposal has been correctly accounted for.
What adjustment is required in respect of the disposal in the preparation of the consolidated
financial statements?
(The answer is at the end of the chapter)
In this instance control is lost and therefore a gain or loss on disposal must be calculated in both
the parent company's and the consolidated financial statements.
The gain or loss in the parent company's accounts is again calculated as proceeds less carrying
amount of investment, and any tax due will be based on this figure.
850
30: Changes in group structures | Part D Group financial statements
851
Financial Reporting
The gain that relates to the shares that have been disposed of can be reconciled to the parent
company as illustrated previously.
852
30: Changes in group structures | Part D Group financial statements
Point to note
The adjustment to parent's equity is calculated as follows:
$'000
Fair value of consideration received 280
Increase in non-controlling interests in net assets at the date of disposal (40% 400*) (160)
Adjustment to parent's equity 120
*Share capital 160
Reserve 240
400
This increases group reserve and does not go through group profit or loss for the year. (Note that
there is no goodwill in this example, as the subsidiary was acquired on incorporation.)
Solution: Subsidiary status
The statements of financial position immediately after the sale will appear as follows:
Linda Co. Vivi Co. Consolidated
$'000 $'000 $'000
Investment in Vivi (160 – 64) 96 – –
Other assets 1,280 500 1,780
1,376 500 1,780
Share capital 400 160 400
Retained earnings (Note) 776 240 920
Current liabilities 200 100 300
1,376 500 1,620
Non-controlling interests 160
1,780
Note. Linda's reserves are $560,000 + $216,000 profit on disposal. Group reserves are increased
by the adjustment above: $800,000 + $120,000 = $920,000.
853
Financial Reporting
854
30: Changes in group structures | Part D Group financial statements
If the subsidiary holds revalued assets, the revaluation surplus previously recognised in
consolidated other comprehensive income should be transferred to group retained earnings.
Self-test question 3
Noel Co. bought 80% of the share capital of Fanny Co. for $324,000 on 1 October 20X5.
At that date Fanny Co.'s retained earnings balance stood at $180,000. The statements of financial
position at 30 September 20X8 and the summarised statements of profit or loss to that date are
given below:
Noel Co. Fanny Co.
$'000 $'000
Non-current assets 360 270
Investment in Fanny Co. 324 –
Current assets 370 370
1,054 640
Equity
Ordinary shares 540 180
Reserves 414 360
Current liabilities 100 100
1,054 640
Profit before tax 153 126
Tax (45) (36)
Profit for the year 108 90
No entries have been made in the accounts for any of the following transactions.
Assume that profits accrue evenly throughout the year.
It is the group's policy to value the non-controlling interests at its proportionate share of the fair
value of the subsidiary's identifiable net assets.
Ignore tax on the disposal.
Required
Prepare the consolidated statement of financial position and statement of profit or loss at 30
September 20X8 in each of the following circumstances. (Assume no impairment of goodwill.)
(a) Noel Co. sells its entire holding in Fanny Co. for $650,000 on 30 September 20X8.
855
Financial Reporting
(b) Noel Co. sells one quarter of its holding in Fanny Co. for $160,000 on 30 September 20X8.
In the following circumstances you are required to calculate the gain on disposal, group retained
earnings and carrying value of the retained investment at 30 September 20X8.
(c) Noel Co. sells one half of its holding in Fanny Co. for $340,000 on 30 June 20X8, and the
remaining holding (fair value $250,000) is to be dealt with as an associate.
(d) Noel Co. sells one half of its holding in Fanny Co. for $340,000 on 30 June 20X8, and the
remaining holding (fair value $250,000) is to be dealt with as a financial asset at fair value
through other comprehensive income.
(The answer is at the end of the chapter)
Where an associate is disposed of in full, a gain arises in both the parent and group financial
statements.
The gain in the parent's financial statements is calculated in the same way as we have seen
previously: proceeds less carrying amount of investment.
In the consolidated financial statements, the gain or loss is calculated as:
$ $
Proceeds X
Less: Cost of investment X
Share of post-acquisition profits retained by associate at disposal X
Impairment of investment to date (X)
(X)
Profit/(loss) X/(X)
In the consolidated financial statements in the year of disposal:
no investment is recognised in the statement of financial position
the group share of the associate's results is included in the statement of profit or loss and
other comprehensive income to the date of disposal.
856
30: Changes in group structures | Part D Group financial statements
Note that like the gain calculation in respect of part disposals of subsidiaries, this calculation
includes the fair value of the financial asset retained. Therefore, once again, the gain is made up of
two elements:
A gain on disposal, and
A gain on the revaluation of the financial asset.
Self-test question 4
Trinidad Co. bought 70% of the stated capital of Tobago Co. for $ 120 million on 1 January 20X6.
At that date Tobago Co.'s retained earnings stood at $10 million.
The statements of financial position at 31 December 20X8, summarised statements of profit or loss
and other comprehensive income to that date and movement on retained earnings are given below.
Trinidad Tobago Co.
Group
$’m $’m
STATEMENTS OF FINANCIAL POSITION
Non-current assets
Property, plant and equipment 200 80
Investment in Tobago Co. 120 –
320 80
Current assets 890 140
1,210 220
Equity
Share capital 500 100
Retained reserves 400 90
900 190
Current liabilities 310 30
1,210 220
857
Financial Reporting
Trinidad Co. sold one half of its holding in Tobago Co. for $120 million on 30 June 20X8. At that
date, the fair value of the 35% holding in Tobago Co. was slightly more at $130 million due to a
share price rise. The remaining holding meets the definition of an associate. This does not
represent a discontinued operation.
No entries have been made in the accounts for the above transaction.
Assume that profits and other comprehensive income accrue evenly throughout the year.
It is the group's policy to measure the non-controlling interest at acquisition at fair value. The fair
value of the non-controlling interest on 1 January 20X6 was $51.4million
Required
Prepare the consolidated statement of financial position, statement of profit or loss and other
comprehensive income and a reconciliation of movement in retained reserves for the year ended
31 December 20X8. (Ignore income taxes on the disposal. No impairment losses have been
necessary to date.)
(The answer is at the end of the chapter)
2 Step acquisitions
Topic highlights
The acquisition method is only applied when control is achieved. Therefore, goodwill only arises on
the acquisition of a subsidiary, either in one or a number of transactions.
When a parent company gradually builds up an investment in another company to a stage where it
controls that company, this is referred to as a step acquisition.
For example a company may:
initially purchase a 10% share in a company, so achieving a financial asset accounted for in
accordance with HKFRS 9
then increase the shareholding to 40%, so achieving an associate investment accounted for
in accordance with HKAS 28 (2011)
finally increase the shareholding to 75%, so achieving a subsidiary investment accounted for
in accordance with HKFRS 10 and HKFRS 3 (revised).
858
30: Changes in group structures | Part D Group financial statements
10%
40%
Goodwill is identified and net assets remeasured to fair value only in respect of the transaction that
achieved control, and not in respect of any earlier or subsequent acquisitions of equity interests.
When more shares are acquired in an existing subsidiary, goodwill is not recalculated; we shall
consider this situation later in the chapter.
HKFRS
3.32,41,42
2.2 Calculation of goodwill when control is acquired
Topic highlights
Where control is achieved any previously held interest is revalued to fair value; the gain or loss is
recognised in profit or loss.
On the date on which control is achieved, previously held interests (measured in accordance with
HKFRS 9 or HKAS 28 (2011)) are remeasured to fair value and this value is included in
calculating goodwill.
Any gain or loss arising from the remeasurement will be recognised in profit or loss.
The calculation of goodwill now becomes:
$
Consideration transferred X
Non-controlling interests X
Fair value of previously held interest X
X
Fair value of net assets of acquiree (X)
Goodwill X
859
Financial Reporting
860
30: Changes in group structures | Part D Group financial statements
Between 20X3 and 20X8 in the C Group financial statements a total of $8,000 is therefore
recognised to increase the carrying amount of the Investment. This is recorded by:
DEBIT Investment $8,000
CREDIT Retained earnings $5,000
CREDIT Revaluation reserve $3,000
The carrying amount of the investment immediately prior to the acquisition of more shares is
therefore $48,000.
At this stage the existing shareholding must be treated as if disposed of and reacquired at its fair
value of $50,000. The net effect of this is the recognition of a gain of $2,000 by:
DEBIT Investment $2,000
CREDIT Profit or loss (gain on disposal of $2,000
investment in associate)
(The revaluation gain of $3,000 previously recognised in OCI is not reclassified to profit or loss
because it would not be reclassified if the interest in D were disposed of.).
The further acquisition of shares is recognised at cost (as in C’s separate financial statements), so
giving a total carrying amount of the investment at this stage of the consolidation of $105,000
($50,000 existing shareholding after equity accounting and remeasurement to fair value + $55,000
new shareholding at cost).
On the 20X8 acquisition C will measure goodwill as follows:
$
Fair value of consideration given for controlling interests 55,000
Non-controlling interests (fair value) 30,000
Fair value of previously-held interest 50,000
Sub-total 135,000
Less: fair value of net assets of acquiree (110,000)
Goodwill 25,000
861
Financial Reporting
HKFRS
10.B96 2.4 Increased shareholding in subsidiary
Topic highlights
An increase in shareholding in an existing subsidiary is treated as a transaction between owners
with an adjustment made to reserves; goodwill is not recalculated.
Where an investment goes from, for example, a 60% subsidiary to an 80% subsidiary, the 50%
threshold has not been crossed, so there is no re-measurement to fair value and no gain or loss to
profit or loss for the year. The increase is treated as a transaction between owners. As with
disposals, ownership has been reallocated between parent and non-controlling shareholders.
Accordingly the parent's equity is adjusted. HKFRS 10 does not give detailed guidance as to how
to measure the amount to be allocated to the parent and non-controlling interests to reflect a
change in their relative interests in the subsidiary. In most cases, however, the best approach is to
recognise the change as the difference between the fair value of consideration paid and the
decrease in non-controlling interests. (As the parent's share has increased, the NCI share has
decreased.)
$
Fair value of consideration paid (X)
Decrease in NCI in net assets at date of transaction X
Decrease in NCI in goodwill at date of transaction (Note) X
Adjustment to parent's equity (X)
Note. This line is only required where non-controlling interests are measured at fair value at the
date of acquisition.
862
30: Changes in group structures | Part D Group financial statements
863
Financial Reporting
* It is assumed that non-controlling interests are reduced proportionately. Under the fair value
10 th
option, the closing balance represents /25 of the acquisition date fair value (11,200) plus 10%
of the change in net assets since acquisition (2,000).
Self-test question 5
Good, whose year end is 30 June 20X9 has a subsidiary, Will, which it acquired in stages. The
details of the acquisition are as follows:
Holding Retained earnings Purchase
Date of acquisition acquired at acquisition consideration
% $m $m
1 July 20X7 20 270 120
1 July 20X8 60 450 480
The share capital of Will has remained unchanged since its incorporation at $300 million. The fair
values of the net assets of Will were the same as their carrying amounts at the date of the
acquisition. Good did not have significant influence over Will at any time before gaining control of
Will. The group policy is to measure non-controlling interests at its proportionate share of the fair
value of the subsidiary's identifiable net assets. The fair value of a 20% interest on 1 July 20X8 was
$130m.
Required
(a) Calculate the goodwill on the acquisition of Will that will appear in the consolidated statement
of financial position at 30 June 20X9.
(b) Calculate the profit on the derecognition of any previously held investment in Will to be
reported in group profit or loss for the year ended 30 June 20X9.
(The answer is at the end of the chapter)
864
30: Changes in group structures | Part D Group financial statements
A further 35% stake in Frankie was acquired on 30 September 20X9 for $4,025,000 (equivalent to
the fair value of $14.375 per share on that date) giving Happy control over Frankie. The fair value
of Frankie's identifiable assets and liabilities at that date was $9,400,000, and Frankie 's reserves
stood at $7,800,000.
For consistency with the measurement of other shares, Happy holds all investments in subsidiaries
and associates as financial assets at fair value through other comprehensive income in its separate
financial statements in accordance with HKFRS 9 and as permitted by HKAS 27 (2011).
At 31 December 20X9, the fair value of Happy's 60% holding in Frankie was $7,020,000 (and total
cumulative gains recognised in other comprehensive income in Happy's separate financial
statements amounted to $975,000).
Summarised statements of financial position of the two companies at that date show:
Happy Frankie
$'000 $'000
Non-current assets
Property, plant and equipment 38,650 7,600
Investment in Frankie 7,020 –
45,670 7,600
Current assets 12,700 2,200
58,370 9,800
Equity
Share capital 10,200 800
Reserves 40,720 7,900
50,920 8,700
Liabilities 7,450 1,100
58,370 9,800
The difference between the fair value of the identifiable assets and liabilities of Frankie and their
book value relates to the value of a plot of land. The land had not been sold by 31 December 20X9.
Income and expenses are assumed to accrue evenly over the year. Neither company paid
dividends during the year.
Group policy is to measure non-controlling interests at the date of acquisition at their proportionate
share of the net fair value of the identifiable assets acquired and liabilities assumed.
No impairment losses on recognised goodwill have been necessary to date.
Required
(a) Prepare the consolidated statement of financial position of Happy Group as at 31 December
20X9 in the following circumstances:
(i) The 25% interest in Frankie allowed Happy significant influence over the financial and
operating policy decisions of Frankie.
(ii) The other 75% of shares were held by a single shareholder and Happy was allowed
no influence in the running of Frankie until acquiring control.
(b) Show the consolidated current assets, non-controlling interests and reserves figures if Happy
acquired an additional 10% interest in Frankie on 1 January 20Y0 for $1,200,000.
865
Financial Reporting
Solution
Parts (a)(i) and (a)(ii) to the example would generate the same overall answer.
(a) HAPPY GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X9
$'000
Non-current assets
Property, plant and equipment (38,650 + 7,600 + (W6) 800) 47,050
Goodwill (W2) 1,260
48,310
Current assets (12,700 + 2,200) 14,900
63,210
Equity attributable to owners of the parent
Share capital 10,200
Reserves (W3)/(W4) 40,660
50,860
Non-controlling interests (W5) 3,800
54,660
Liabilities (7,450 + 1,100) 8,550
63,210
WORKINGS
1 Group structure
Part (i) 30 31
September December
1 January 20X9 20X9
20X9
SOCI
9
Associate – Equity account /12 Consolidate
3
/12
SOCI
Consolidate
3
/12
866
30: Changes in group structures | Part D Group financial statements
2 Goodwill
$'000 $'000
Consideration transferred 4,025
Non-controlling interests (9,400 40%) 3,760
FV of P's previously held equity interest
(800,000 25% $14.375) 2,875
10,660
Less: Fair value of identifiable assets acq'd
and liabilities assumed:
Share capital 800
Reserves 7,800
Fair value adjustments (W6) 800
(9,400)
1,260
3 Consolidated reserves (if previously held as an associate) (i)
Happy Frankie Frankie
$'000 $'000 $'000
25% 60%
Per question 40,720 7,800 7,900
Profit on derecognition of
investment (note) 355
Fair value movement (W6) - -
Reserves at acquisition (5,800) (7,800)
2,000 100
Share of post acqn reserves
Frankie – 25% (2,000 25%) 500
Frankie – 60% (100 60%) 60
Less: Fair value gain recognised
in Happy's separate FS (975)
40,660
Note. Profit on derecognition of 25% associate
$'000
Fair value at date control obtained (200,000 shares $14.375) 2,875
P's share of carrying value [2,020 + ((7,800 – 5,800) 25%)] (2,520)
355
4 Consolidated reserves (if previously held as a financial asset) (ii)
Happy Frankie
$'000 $'000
Per question 40,720 7,900
Profit on derecognition of investment* 855
Fair value movement (W6) - -
Reserves at acquisition (7,800)
100
Frankie – share of post acquisition reserves
(100 60%) 60
Less: Fair value gain recognised in Happy's
separate FS (975)
40,660
* Profit on derecognition of 25% investment
867
Financial Reporting
$'000
Fair value at date control obtained (200,000 shares $14.375) 2,875
Cost (2,020)
855
5 Non-controlling interests
$'000
Net assets at year end per question 8,700
Fair value adjustment (W6) 800
9,500
NCI share 40% = $3,800,000
6 Fair value adjustments
At acquisition At year end
Measured at date control achieved 30 September 31 December
(only) 20X9 Movement 20X9
$'000 $'000 $'000
868
30: Changes in group structures | Part D Group financial statements
Solution
Parts (a)(i) and (a)(ii) to the example would generate the same overall answer.
(a) HAPPY GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X9
$'000
Non-current assets
Property, plant and equipment (38,650 + 7,600 + (W2) 800) 47,050
Goodwill (W2) 2,100
49,150
Current assets (12,700 + 2,200) 14,900
64,050
Equity attributable to owners of the parent
Share capital 10,200
Reserves (W3)/(W4) 40,660
50,860
Non-controlling interests (W5) 4,640
55,500
Liabilities (7,450 + 1,100) 8,550
64,050
WORKINGS
1 Group structure
Part (i)
SOCI
9
Associate – Equity account /12 Consolidate
3
/12
Part (ii)
SOCI
Consolidate
3
/12
869
Financial Reporting
2 Goodwill
Group NCI
$'000 $'000 $'000
Consideration transferred 4,025
FV NCI 4,600
FV P's previously held equity
interest 2,875
Fair value of identifiable assets
acq'd and liabilities assumed:
Share capital 800
Reserves 7,800
Fair value adjustments (W6) 800
9,400
60%/40% (5,640) (3,760)
1,260 840
2,100
870
30: Changes in group structures | Part D Group financial statements
Note. The profit would be the same whether the financial asset had been revalued or
not, as any revaluation above original cost previously recognised in other
comprehensive income is transferred to profit or loss.
5 Non-controlling interests
$'000 $'000
Net assets at year end per question 8,700
Fair value adjustment (W6) 800
9,500
40% 3,800
NCI in goodwill (W2) 840
4,640
6 Fair value adjustments
At acquisition At year end
Measured at date control achieved 30 September 31 December
(only) 20X9 Movement 20X9
$'000 $'000 $'000
Land (9,400 – (800 + 7,800)) 800 – 800
HKFRS 3 (revised) Business Combinations applies to all business combinations except where a
combination is specifically excluded from its scope. For those business combinations outside the
scope of HKFRS 3 (revised), for example, business combinations involving entities or businesses
871
Financial Reporting
under common control, there is no specific accounting standard addressing the appropriate
accounting treatment.
HKFRS 3 (revised) defines a business combination involving entities or businesses under common
control as 'a business combination in which all of the combining entities or businesses are
ultimately controlled by the same party or parties both before and after the business combination,
and that control is not transitory. HKICPA has issued Accounting Guideline 5 (AG5) to give
guidance on how such combinations should be accounted for, given that they fall outside the scope
of HKFRS 3 (revised). AG5 refers to these combinations as 'common control combinations' to
distinguish them from other business combinations which fall within or outside the scope of HKFRS
3 (revised).
HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, contains requirements
for the selection of accounting policies in the absence of a HKFRS that specifically applies to an
issue. Common control combinations fall outside the scope of HKFRS 3 (revised). Accordingly, an
entity selects an appropriate accounting policy in accordance with the requirements set out in
HKAS 8 and many entities consider that merger accounting is an appropriate accounting policy for
common control combinations.
AG5 sets out the basic principles and procedures of merger accounting when recognising a
common control combination.
It should be noted that interspersing a shell entity between a parent entity and a single subsidiary
does not represent the combination of two businesses and accordingly is not addressed in AG5.
In practice, these transactions may be accounted for by applying a principle similar to that for a
reverse acquisition.
An essential difference exists between a business combination effected by the purchase of a
company's shares for cash and that executed by an exchange of shares.
A business combination involving a share exchange which is characterised by a continuity of
ownership is regarded as a pooling of interests of both parties rather than an acquisition, and
should be accounted for differently.
872
30: Changes in group structures | Part D Group financial statements
the acquirer's interest in the net fair value of the acquiree's identifiable assets, liabilities and
contingent liabilities over cost at the time of the common control combination to the extent of the
continuation of the controlling party or parties' interests. Similarly, in accordance with HKFRS 10,
the effects of all transactions between the combining entities or businesses, whether occurring
before or after the combination, are eliminated in preparing the consolidated financial statements
of the combined entity.
873
Financial Reporting
Companies Ordinance requires the consolidated financial statements to cover the accounting
period of the parent. It could be argued that this requirement prevents the disclosure of
comparative information. In substance, however, where the combining entities or businesses are
continuing to trade as before, but with a new legal parent, it is appropriate to prepare consolidated
financial statements as if the parent had been in existence throughout the reported periods
presented with a prominent footnote explaining the basis on which consolidated financial
statements are prepared.
874
30: Changes in group structures | Part D Group financial statements
On 31 December 20X1, Apex acquired 100% shareholdings in Xero and Yoho from Pear and
Shareholder S. In return, Apex issued 14,000 and 6,000 ordinary shares to Pear and Shareholder
S, respectively. Apex, Xero and Yoho have financial year ends of 31 December. The fair values of
assets and liabilities of Yoho as at 31 December 20X1 are equal to their carrying values.
Ignore any tax effect arising from the business combination.
Pear Pear
New parent 85%
entity
Apex
The statements of profit or loss of Apex, Xero and Yoho for the year ended 31 December 20X1 are:
Apex Xero Yoho
$ $ $
The statements of financial position of Apex, Xero and Yoho as at 31 December 20X1 are:
Apex Apex Xero Yoho
(before issue (after issue
of shares) of shares*)
$ $ $ $
Investment in subsidiaries – 233,000 – –
* The 20,000 new shares issued by Apex as consideration are recorded at a value equal to
the deemed cost of acquiring Xero and Yoho ($233,000). The deemed cost of acquiring Xero
is $113,000, being the existing book values of net assets of Xero as at 31 December 20X1
($100,000) plus remaining goodwill arising on the acquisition of Xero by Pear ($13,000). The
deemed cost of acquiring Yoho is $120,000, being the existing book values of net assets of
Yoho as at 31 December 20X1. The deemed cost used in this example is for illustrative
purposes only and does not necessarily represent the value to be reported in the individual
financial statements of Apex as the cost of acquiring the subsidiaries.
875
Financial Reporting
The statements of profit or loss of Apex, Xero and Yoho for the year ended 31 December 20X0 are:
Apex Xero Yoho
$ $ $
Revenue 2,000 38,000 45,000
Profit or loss (3,000) 15,000 12,000
The statements of financial position of Apex, Xero and Yoho as at 31 December 20X0 are:
Apex Xero Yoho
$ $ $
Net assets 18,000 80,000 100,000
Required
Prepare the consolidated financial statements of Apex for the year ending 31 December 20X1
(including the comparative figures, which would be presented for 20X0).
Solution
As Apex, Xero and Yoho are under the common control of Pear before and after the business
combination, the business combination is specifically excluded from the scope of HKFRS 3
(revised).
The directors of Apex choose to account for the acquisition of the shareholdings in Xero and Yoho
using the principles of merger accounting.
Under the principles of merger accounting, the assets and liabilities of Xero and Yoho are
consolidated in the financial statements of Apex using the existing book values as stated in the
consolidated financial statements of Pear immediately prior to the combination. This procedure
requires recording of goodwill arising on the original acquisition of Xero by Pear and non-controlling
interests in Yoho as stated in the consolidated financial statements of Pear immediately prior to the
combination. There is no recognition of any additional goodwill or excess of the acquirer's interest
in the net fair value of the acquiree's identifiable assets, liabilities and contingent liabilities over cost
at the time of this combination.
The consolidated statement of profit or loss of Apex for the year ended 31 December 20X1 is:
Apex Xero Yoho Adjustments Consolidated
$ $ $ $ Adj $
Adjustment
Y1 Being an adjustment to reflect the profit attributable to the non-controlling interests in Yoho
prior to the combination. ($20,000 25%)
876
30: Changes in group structures | Part D Group financial statements
Adjustments
Relating to Xero:
X1 Being an adjustment to record goodwill arising on the original acquisition of Xero by Pear as
stated in the consolidated financial statements of Pear immediately prior to the combination
($13,000).
X2 Being an adjustment to eliminate the accumulated profits of Xero generated prior to the
original acquisition of Xero by Pear ($5,000).
X3 Being an adjustment to eliminate the share capital of Xero against the related investment
cost of Apex. An adjustment of $85,000 has been made to a separate reserve in the
consolidated financial statements of Apex ($113,000 – $28,000).
Relating to Yoho:
Y4 Being an adjustment to reflect the profits attributable to the non-controlling interests in Yoho
prior to the combination ($100,000 25%).
Y5 Being an adjustment to eliminate the share capital of Yoho against the related investment
cost of Apex. An adjustment of $75,000 has been made to a separate reserve in the
consolidated financial statements of Apex ($120,000 75% – $15,000).
The consolidated statement of profit or loss of Apex for the year ended 31 December 20X0 is:
Apex Xero Yoho Adjustments Consolidated
$ $ $ $ Adj $
Revenue 2,000 38,000 45,000 85,000
Adjustment
Y1 Being an adjustment to reflect the profit attributable to the non-controlling interests in Yoho
prior to the combination ($12,000 25%).
877
Financial Reporting
878
30: Changes in group structures | Part D Group financial statements
Topic recap
Disposals
Subsidiary Associate
879
Financial Reporting
Step acquisitions
CSOFP: consolidate based on CSOFP: consolidate based on Adjust shareholders' equity by:
year-end holding. year-end holding. FV consideration paid (X)
Decrease in NCI at
CSPLOCI: include dividend CSPLOCI: equity account to date date of transaction X
income to date control attained, control attained, then consolidate Decrease in NCI
then consolidate results. results. goodwill at date of
transaction X
X
Merger accounting
Single uniform set of accounting CSPLOCI includes the combined Consolidation performed in
policies adopted; otherwise no results of the combining entities accordance with HKFRS 10.
adjustment is made to the carrying from the earliest date presented /
values of assets and liabilities in date of combination if earlier.
the acquired company.
880
30: Changes in group structures | Part D Group financial statements
Answer 1
(a) Land Co.'s accounts $'000
Fair value of consideration received 1,200
Less: carrying value of investment disposed of (980)
Profit on disposal 220
Answer 2
In A’s individual financial statements the disposal has been recognised correctly by:
$ $
DEBIT Cash 40,000
CREDIT Investment (30% x $125,000) 37,500
CREDIT Gain on disposal (parent’s equity) 2,500
In the consolidated financial statements the disposal would be recognised (on a standalone basis) by:
$ $
DEBIT Cash 40,000
CREDIT Non-controlling interest (W) 36,000
CREDIT Parent’s equity 4,000
(W) The adjustment to equity will be:
$
Fair value of consideration received 40,000
Amount recognised as non-controlling interests (30% 120,000) 36,000
Positive movement in parent equity 4,000
881
Financial Reporting
Answer 3
(a) Complete disposal at year end (80% to 0%)
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER 20X8
Noel Fanny Adjustment 1 Adjustment 2 Disposal Consolidated
$'000 $'000 $'000 $'000 $'000 $'000
Non-current 360 270 (270) 360
assets
Investment 324 (324)
Goodwill 36 (36)
Current 370 370 (370) 1,020
assets 650
1,380
Share capital 540 180 (180) 540
Reserves 414 360 (180) (36) 182 740
NCI 72 36 (108) -
Current 100 100 (100) 100
liabilities
1,380
WORKINGS
1 Goodwill
$'000
Consideration transferred 324
NCI: 20% (180 + 180) 72
396
Net assets (180 + 180) (360)
36
882
30: Changes in group structures | Part D Group financial statements
883
Financial Reporting
CONSOLIDATED STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 30 SEPTEMBER 20X8
Noel Fanny Adjustment 1 Adjustment 2 Disposal Consolidated
$'000 $'000 $'000 $'000 $'000 $'000
Profit before 153 126 279
tax
Profit on
disposal –
Tax (45) (36) (81)
108 90 198
Owners of 108 90 (18) 180
parent
NCI 18 18
198
WORKING: Disposal
Adjustment is made to equity as control is not lost. $'000
NCI before disposal 80% (360 + 180) 432
NCI after disposal 60% (360 + 180) (324)
Required adjustment 108
884
30: Changes in group structures | Part D Group financial statements
3 Investment in associate
$'000
Fair value at date control lost (new 'cost') 4250
Share of post acquisition reserves (90 3/12 40%) 9
259
(d) Partial disposal: subsidiary to financial asset (80% to 40%)
1 Profit on disposal – as in part (c)
2 Group reserves
$'000
Noel Co.'s reserves 414
Group profit on disposal (W1) 140
Fanny: share of post acquisition reserves (157.5 (see below) 80%) 126
680
Fanny
$'000
At date of disposal (360 – (90 3/12)) 337.5
Reserves at acquisition (180.0)
157.5
Answer 4
TRINIDAD GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31.12.X8
$’m
Non-current assets
Property, plant and equipment 200.00
Investment in Tobago 133.15
333.15
Current assets 1,010.00
1,343.15
Equity attributable to owners of the parent
Share capital 500.00
Retained reserves 533.15
1,033.15
Current liabilities 310.00
1,343.15
TRINIDAD GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR THE YEAR ENDED 31.12.X8
$’m
Profit before interest and tax 110.00
Profit on disposal of shares in subsidiary 80.30
Share of profit of associate 2.10
Profit before tax 192.40
Income tax expense (44.00)
Profit for the year 148.40
Other comprehensive income (not reclassified to P/L) net of tax 13.00
Share of other comprehensive income of associate 1.05
Other comprehensive income for the year 14.05
Total comprehensive income for the year 162.45
885
Financial Reporting
$’m
Profit attributable to:
Owners of the parent 146.60
Non-controlling interests 1.80
148.40
Total comprehensive income attributable to:
Owners of the parents 159.75
Non-controlling interests 2.70
162.45
TRINIDAD GROUP
CONSOLIDATED RECONCILIATION OF MOVEMENT IN RETAINED RESERVES
$’m
Balance at 31 December 20X7 (W7) 373.40
Total comprehensive income for the year 159.75
Balance at 31 December 20X8 533.15
Workings
Consolidation schedule for Trinidad – statement of financial position at 31 December 20X8
Trinidad (W2) (W3(i)) (W6) Consolidated
$’m $’m $’m $’m $’m
PPE 200 200
Investment in Tobago/Ass 120 (60) 70 3.15 133.15
320 333.15
Current assets 890 120 1,010
1,210 1,343.15
886
30: Changes in group structures | Part D Group financial statements
Consolidation schedule for Trinidad – statement of profit or loss and other comprehensive income
for the year ended 31 December 20X8
Trinidad Tobago Total (W2) (W3 (ii)) (W6) Consolidated
(6/12)
$’m $’m $’m $’m $’m $’m $’m
PBIT 100 10 110 110
Profit on disposal 60 20.3 80.3
Share of profit of 2.1 2.1
Tobago
Tax (40) (4) (44) (44)
Profit for year 60 6 66
148.4
Profit attributable
to:
Owners of 60 4.2 64.2 60 20.3 2.1 146.6
Trinidad
NCI 1.8 1.8 1.8
TCI attributable
to:
Owners of 70 6.3 76.3 60 20.3 3.15 159.75
Trinidad
NCI 2.7 2.7 2.7
1 Timeline
SOCI
Subsidiary – 6/12 Associate – 6/12
887
Financial Reporting
888
30: Changes in group structures | Part D Group financial statements
4 Goodwill – Tobago
$’m $’m
Consideration transferred 120.0
Non-controlling interests (FV) 51.4
Less:
Share capital 100
Retained reserves 10
(110.0)
61.4
889
Financial Reporting
Answer 5
(a) Goodwill (at date control obtained)
$m $m
Consideration transferred 480
Non-controlling interests (750 20%) 150
Fair value of previously held equity interest 130
760
Less: Fair value of identifiable assets acquired and
liabilities assumed
Share capital 300
Retained earnings 450
7 (750)
10
(b) Profit on derecognition of investment
$m
Fair value at date control obtained 130
Cost (120)
10
890
30: Changes in group structures | Part D Group financial statements
Exam practice
891
Financial Reporting
The following table summarises information from the three companies' statements of profit or loss
for the year ended 31 March 20X8:
MCL FSL SWL
$'000 $'000 $'000
Revenue 300,000 140,000 72,500
Cost of sales (243,000) (112,000) (58,000)
Gross profit 57,000 28,000 14,500
Distribution costs (15,000) (7,500) (4,000)
Administrative expenses (10,000) (5,000) (2,500)
Depreciation and amortisation (3,000) (1,500) (1,000)
Profit from operations 29,000 14,000 7,000
Finance costs 4,000 (2,000) (1,000)
Profit before tax 25,000 12,000 6,000
Tax (7,000) (5,000) (2,000)
Profit of the year 18,000 7,000 4,000
On 30 September 20X7, MCL sold 2.4 million shares in SWL for $8 million. The gain on this
disposal has not been included in the above statements of profit or loss. The fair value of the
remaining holding was $5 million at the date of disposal.
On 31 March 20X8, MCL sold all its plant and equipment, with an original purchase cost of
$20 million and a carrying amount of $12 million, to a bank for its fair value of $16 million cash.
MCL then leased the plant and equipment back from the bank under a finance lease over four
years. The lease arrangement called for annual year-end payments of $1.6 million. At the end of
the lease term, the bank is obligated to return the plant and equipment to MCL at an amount that
has the overall effect, taking into account the lease payments, of providing the bank with a yield of
the best lending rate minus 1% per annum. The remaining useful lives of the plant and equipment
at 31 March 20X8 ranged from 8 to 10 years. No entries relating to the disposal have been
recorded by MCL and the group.
During the year ended 31 March 20X8, FSL sold goods to MCL at an invoiced value of
$1 million. FSL usually sold goods at cost plus 25%. Half of the goods were still held in MCL's
inventory at 31 March 20X8.
MCL has adopted an accounting policy which depreciates plant and equipment using the straight
line method over a 10-year life with no residual value. It is also the group's policy that interests in
subsidiaries and associates are carried at cost in the separate financial statements and non-
controlling interests are valued using the proportion of net assets method. SWL's results for the six
months ended 30 September 20X7 were exactly half of its annual results in the year ended
31 March 20X8.
You have then added the gain on disposal of investment in SWL into MCL's financial statements
and prepared draft consolidated financial statements of MCL for the year ended 31 March 20X8.
After you sent these draft consolidated financial statements to MCL's directors for review, one of
the directors, who is not a certified public accountant, sent you an email as follows:
892
30: Changes in group structures | Part D Group financial statements
Required
Prepare a memorandum in response to the issues raised by Ms. Faria Lee. In your memorandum,
you should:
(a) discuss the reasons for the amount of $12 million of plant and equipment as shown in the
consolidated statement of financial position; (5 marks)
(b) discuss how MCL should account for its interest in SWL before and after the disposal of the
2.4 million shares in SWL (no computation is expected in this part); (10 marks)
(c) discuss why the amount of the gain on disposal of the investment in SWL as shown in the
separate statement of profit or loss and in the consolidated statement of profit or loss is
different; and (5 marks)
(d) discuss with appropriate calculation, the impact of the rights issue on the earnings per share
of MCL for the year ended 31 March 20X8. (10 marks)
(Total = 30 marks)
HKICPA February 2008 (amended)
893
Financial Reporting
894
chapter 31
Consolidation of foreign
operations
Topic list
Learning focus
895
Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.19 The effects of changes in foreign exchange rates 2
3.19.01 Determine the functional currency of an entity in accordance with
HKAS 21
3.19.02 Translate foreign operation financial statements to the presentation
currency
3.19.03 Account for foreign currency transactions within an individual
company and in the consolidated financial statements
3.19.04 Account for disposal or partial disposal of a foreign operation
896
31: Consolidation of foreign operations | Part D Group financial statements
Key terms
Foreign currency is a currency other than the functional currency of the entity.
Functional currency is the currency of the primary economic environment in which the entity
operates.
Presentation currency is the currency in which the financial statements are presented.
Exchange rate is the ratio of exchange for two currencies.
Exchange difference is the difference resulting from translating a given number of units of one
currency into another currency at different exchange rates.
Spot exchange rate is the exchange rate for immediate delivery.
897
Financial Reporting
898
31: Consolidation of foreign operations | Part D Group financial statements
(c) Whether cash flows from the activities of the foreign operation directly affect the cash
flows of the parent and are readily available for remittance to it.
(d) Whether the activities of the foreign operation are financed from its own cash flows or by
borrowing from the parent.
Where these indicators are mixed, management must use judgment, giving priority to primary
factors in section 1.2.2 above.
Solution
(a) Lomas operates as an extension of Real, therefore it can be concluded that its functional
currency is the same as that of Real.
(b) Ariadne obviously has a significant degree of automony:
– 70% of purchases are from third party suppliers.
– Cash reserves (when available) are maintained in local currency.
– It is able to secure (and presumably service) borrowings in its own right rather than
rely on the parent company.
We can therefore conclude that the functional currency of Ariadne is the Rand.
HKAS 21.13,
35 1.2.4 Change in functional currency
The functional currency of an entity can be changed only if there is a change to the underlying
transactions, events and conditions that are relevant to the entity. For example, an entity's functional
currency may change if there is a change in the currency that mainly influences the sales price of
goods and services.
Where there is a change in an entity's functional currency, the entity translates all items into the
new functional currency prospectively (i.e., from the date of the change) using the exchange rate
at the date of the change.
Self-test question 1
Hong Kong Foods (‘HKF’) acquired 52% of the ordinary shares of another company, T42Co., on 1
May 20X7. T42 Co. is located in India and operates several tea plantations.
The income of T42 Co. is denominated and settled in rupees. The output of the tea plantations is
routinely traded in rupees and its price is determined initially by local supply and demand. T42 Co.
pays 40% of its costs and expenses in Hong Kong Dollars with the remainder being incurred locally
and settled in rupees. T42’s management has a considerable degree of authority and autonomy in
carrying out the operations of T42 and is not dependent upon HKF or other group companies for
finance.
899
Financial Reporting
Required
Recommend which currency is the functional currency of T42 Co., applying the principles set out in
HKAS 21.
(The answer is at the end of the chapter)
HKAS
21.21,22
2.1 Foreign currency transactions: initial recognition
HKAS 21 states that a foreign currency transaction should initially be translated to the functional
currency, by applying the spot exchange rate between the reporting currency and the foreign
currency at the date of the transaction.
An average rate for a period may be used if exchange rates do not fluctuate significantly.
For example, suppose a local company buys a large consignment of goods from a supplier in
Singapore. The order is placed on 1 March and the agreed price is SG$124,000. At the time of
delivery the rate of foreign exchange was SG$4 to $1. The local company would record the amount
owed in its books as follows.
$ $
DEBIT Purchases (124,000 ÷ 4) 31,000
CREDIT Payables account 31,000
900
31: Consolidation of foreign operations | Part D Group financial statements
Example: Exchange
Silk Co. sells goods to a Japanese company on 1 May 20X9, and agrees that payment should be
made in Japanese Yen at a price of ¥116,000 at the end of July 20X9. Silk Co. prepares its
accounts to 30 June. Relevant exchange rates are:
1 May 20X9 ¥10.75 to $1
30 June 20X9 ¥11 to $1
31 July 20X9 ¥11.6 to $1
Silk Co. would record the sale as follows:
$ $
DEBIT Receivables account (¥116,000 ÷ 10.75) 10,791
CREDIT Sales 10,791
At the period end, Silk Co must re-translate the receivable amount based on the spot rate on
30 June 20X9. The re-translated receivables balance will be $10,545 (¥116,000 ÷ 11). Therefore:
$ $
DEBIT Exchange loss 246
CREDIT Receivables account ($10,791 – $10,545) 246
An exchange loss arises as the receivables amount has lost value in $.
When the ¥116,000 are paid at the end of July, Silk Co. will convert them into $, to obtain
(¥116,000 ÷ 11.6) $10,000. Therefore, a further loss arises:
$ $
DEBIT Cash 10,000
Exchange loss 545
CREDIT Receivables account 10,545
901
Financial Reporting
When a gain or loss on a non-monetary item is recognised in other comprehensive income (for
example, where property is revalued), any related exchange differences should also be
recognised in other comprehensive income.
3.1 Introduction
Now that you have covered the main aspects of foreign currency translation in a single company
context, you are ready to tackle consolidation of foreign operations (usually a subsidiary). Apart
from the foreign currency aspects, the usual consolidation rules apply (intra-group transactions,
non-controlling interest etc). Look back to Chapters 27 to 30 if unsure of any of these rules.
HKAS 21.38-
40
3.2 Translation of financial statements to presentation currency
An individual entity may choose to present its financial statements in any currency, including one
which is different from its functional currency.
Where a group contains individual entities with different functional currencies, each of their financial
statements must be translated into a common presentation currency prior to consolidation.
902
31: Consolidation of foreign operations | Part D Group financial statements
Where financial statements are required to be translated into a presentation currency, and the
functional currency of the reporting entity is not hyperinflationary, the following procedures are
applied:
(a) Assets and liabilities in the statement of financial position are translated at the closing rate at
the year end.
(b) Income and expenses in the statement of profit or loss and other comprehensive income are
translated at the spot rates applicable on the dates of the transactions, although an average
rate is usually used for practical purposes where the exchange rate does not fluctuate
significantly.
(c) Resulting exchange differences are recognised in other comprehensive income.
Share capital is translated at the historical rate on the date of acquisition and reserves form a
balancing figure to include the exchange difference.
The gain or loss is accumulated in reserves in the consolidated statement of financial position.
Where a subsidiary in which an exchange difference arises is not wholly-owned, a proportion of
accumulated exchange differences is allocated to the non-controlling interest and therefore form
part of the non-controlling interest in the consolidated statement of financial position.
HKAS 12 Income Taxes should be applied when there are tax effects arising on the translation of
the financial statements of foreign operations.
903
Financial Reporting
Required
(a) How would the exchange gain or loss on the investment in Crockpot be recognised in the
consolidated financial statements of Stockpot for the year ending 31 December 20X1
assuming that Stockpot maintains a foreign exchange reserve?
(b) How would your answer differ if Stockpot held 80% of the shares in Crockpot rather than
100%?
Solution
(a) Calculation of exchange difference $m $m
Net assets at 1 January 20X1 at rate on 31.12.X0 N$800 @ 2.0 400
Net assets at 1 January 20X1 at rate on 31.12.X1 N$800 @ 3.0 267 133 loss
(b) If Stockpot owned 80% rather than 100% of Crockpot, the exchange difference is allocated
between the group and non-controlling interest in proportion to their respective ownership
interests.
904
31: Consolidation of foreign operations | Part D Group financial statements
At the start of December, Mariol issued an invoice for goods provided to a new customer, Blarney
Co., based in Liffeland. The invoice was denominated in Punt, as agreed with the customer, and
was for Pt 1.2 million. This invoice is not reflected in the financial statements above and at the
period end remains unpaid.
100% of the share capital of Mariol was purchased by Rhonda Co. on 1 January 20X1 and Rhonda
requires Mariol to translate its financial statements into $ before reporting its financial results.
Relevant exchange rates are:
Gilder:$ Punt: Gilder
1 January 20X1 1:8.5 not known
1 December 20X1 1:9 5:1
31 December 20X1 1:10 5.5:1
Average for 20X1 1:8 not known
Required
Prepare the translated financial statements of Mariol ready for submission to its parent company.
Solution
First the transaction with Blarney must be reflected in the financial statements:
1 December 20X1 Gilder 000 Gilder 000
DEBIT Receivables (1,200/5) 240
CREDIT Sales 240
To record the transaction at the point of sale.
31 December 20X1
DEBIT Exchange loss (240 – (1,200/5.5)) 22
CREDIT Receivables 22
To measure the receivables at the year end.
905
Financial Reporting
WORKING
Exchange gain
Opening net assets G1,760 At OR 8.5 14,960
At CR 10 17,600
2,640 gain
Retained profits G408 At AR 8 3,264
At CR 10 4,080
816 gain
Overall gain 3,456
906
31: Consolidation of foreign operations | Part D Group financial statements
The exchange differences arising are recorded as other comprehensive income in the consolidated
accounts and accumulated in group equity.
Example: Goodwill
Surf Co. acquired 100% of Wave Co. for consideration of ¥78.6 million (foreign currency) on 1 April
20X8 when the net assets of Wave Co. were ¥66 million. Surf Co.'s presentation currency is the $
and relevant exchange rates are:
1 April 20X8 ¥12:$1
31 March 20X9 ¥11:$1
At what amount is goodwill recognised in the consolidated statement of financial position on
31 March 20X9 and what amount is recognised as an exchange difference on goodwill for the
period?
Solution
Goodwill
¥'000 Rate $'000
Consideration transferred 78,600
Net assets of Wave at 1 April 20X8 (66,000)
At 1 April 20X8 12,600 12 * 1,050
Foreign exchange gain – Balance 95
At 31 March 20X9 12,600 11 ** 1,145
* Historical rate
** Closing rate
Goodwill is therefore reported in the statement of financial position at $1,145,000 and an exchange
gain of $95,000 is recognised in other comprehensive income.
907
Financial Reporting
as at the parent's own reporting date as long as the foreign operation’s reporting date is within
three months of the parent’s. However, adjustments are made for any significant changes in
exchange rates which took place in the intervening period between the two dates.
HKAS 21.48- 3.4.4 Disposal of foreign entity
49
A parent may dispose or part dispose of its foreign subsidiary. For this purpose, a full disposal
includes:
a disposal of all interests held in a subsidiary
any disposal where control over the subsidiary is lost.
A part disposal is any other reduction in ownership in a foreign subsidiary i.e. where control is
retained.
Full disposal
On disposal, a profit or loss on disposal is calculated as normal. In addition, historical cumulative
exchange differences arising on consolidation and included in group reserves up to the date of
disposal are reclassified to profit or loss.
Therefore the gain or loss on disposal is made up of two elements:
1 The actual gain or loss on disposal
2 The reclassified cumulative exchange differences
This means that these exchange differences are effectively recognised twice. The first time they
are recognised in other comprehensive income as they arise each period on consolidation. They
are then recognised for a second time, albeit in a different place, when they are transferred to the
profit or loss on disposal. This double recognition is sometimes called recycling of profits or losses.
Note that the cumulative exchange differences that have been attributed to the non-controlling
interests are derecognised as part of the non-controlling interest balance. They therefore have an
impact on the gain or loss calculated on disposal, as discussed in Chapter 30.
Partial disposal
If the parent part disposes of a foreign subsidiary such that it still retains control after the disposal,
the cumulative exchange differences previously recognised in other comprehensive income are re-
allocated between the group and non-controlling interest in proportion to the new ownership
interests.
Self-test question 3
Trinity acquired 90% of its foreign subsidiary Merrion on 1 January 20X2. Merrion is based in
Uberland where the local currency is the Uber (U). Trinity's investment in Merrion cost U68 million
and on the acquisition date, the retained earnings of Merrion amounted to U66 million.
The statements of financial position of the two companies at 31 December 20X4 are as follows:
Trinity Merrion
$'000 U'000
Non-current assets
Property plant and equipment 128,000 112,500
Investments 34,000 –
162,000 112,500
Current assets
Inventories 12,000 15,000
Receivables 17,500 22,500
Cash 3,500 2,500
195,000 152,500
908
31: Consolidation of foreign operations | Part D Group financial statements
Trinity Merrion
$'000 U'000
Equity
Share capital 10,000 4,000
Retained earnings 116,000 80,000
126,000 84,000
Long-term liabilities
Long-term borrowings 20,000 12,000
Deferred tax 15,500 20,000
35,500 32,000
Current liabilities
Trade payables 19,500 18,500
Tax 12,000 10,000
Bank overdraft 2,000 8,000
33,500 36,500
195,000 152,500
The following information is relevant:
(1) As a result of the movement in exchange rates, Trinity have decided to impair the goodwill
arising on the acquisition of Merrion in full at 31 December 20X3.
(2) Trinity measures the non-controlling interest as a proportion of the fair value of the net
assets of the acquiree.
(3) During 20X3 Merrion began selling goods to Trinity, achieving a margin of 25%. At the
reporting date, Trinity held goods in stock which it had purchased from Merrion on the last
day of the year for U2.5 million. Trinity had recorded these goods using the closing exchange
rate of U2.5:$1.
(4) Merrion reported profits of U6 million and U8 million in the years ended 31 December 20X2
and 20X3 respectively. It has paid no dividends in either year.
Exchange rates are as follows:
1 January 20X2 U2.0:$1
Average for 20X2 U2.1:$1
31 December 20X2 U2.2:$1
1 August 20X3 U2.3:$1
31 December 20X3 U2.5:$1
Average for 20X3 U2.4:$1
Required
Translate the statement of financial position of Merrion at 31 December 20X3 into $ and prepare
the consolidated statement of financial position of the Trinity group at 31 December 20X3.
You should work to the nearest $'000.
(The answer is at the end of the chapter)
909
Financial Reporting
Topic recap
Apply spot rate to transactions Translate foreign subsidiary accounts to presentation currency
before recording in the accounts
Record settlement at spot rate on Statement of profit or loss and other comprehensive income:
settlement date → exchange all income and expenditure at average rate
difference
910
31: Consolidation of foreign operations | Part D Group financial statements
Answer 1
Factors to consider in determining functional currency of T42Co
HKAS 21 The effects of changes in foreign exchange rates defines functional currency as 'the
currency of the primary economic environment in which the entity operates'. Each entity, whether
an individual company, a parent of a group, or an operation within a group, should determine its
functional currency and measure its results and financial position in that currency.
An entity should consider the following factors:
(1) What is the currency 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)?
(2) What is the currency of the country whose competitive forces and regulations mainly
determine the sales prices of its goods and services?
(3) What is 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.)
Applying the first of these, it appears that T42's functional currency is the rupee. The price it
charges is denominated and settled in rupees and is determined by local supply and demand.
However, when it comes to costs and expenses, T42 pays in a mixture of Hong Kong Dollars and
rupees so that aspect is less clear-cut.
Other factors may also provide evidence of an entity's functional currency:
(1) It is the currency in which funds from financing activities are generated.
(2) It is the currency in which receipts from operating activities are usually retained.
T42 Co. does not depend on group companies for finance. Furthermore, T42 Co. operates with a
considerable degree of autonomy, and is not under the control of the parent as regards finance or
management. It also generates sufficient cash flows to meet its cash needs. These aspects point
away from the Hong Kong Dollar as the functional currency.
The position is not clear-cut, and there are arguments on both sides. However, on balance it is the
rupee that should be considered as the functional currency, since this most faithfully represents the
economic reality of the transactions, both operating and financing, and the autonomy of T42 Co. in
relation to the parent company.
Answer 2
28 October 20X1
The paintings are purchases and the purchase is translated into $ using the spot rate (i.e. the
exchange rate on the date of the transaction):
$ $
DEBIT Purchases (9.2m/1.8) 5,111,111
CREDIT Payable 5,111,111
31 December 20X1
At the year end, the payable balance is re-translated using the closing rate (the exchange rate at
the period end). The resulting gain is recognised in profit or loss for the year:
Retranslate payable to 9.2m/2 = $4.6m
911
Financial Reporting
Answer 3
Consolidated statement of financial position for the Trinity Group at 31 December 20X3
Trinity Merrion W3 W4(i) W4(ii) W4(iii) W5 W6 Consolidated
$000 $000 $000 $000 $000 $000 $000 $000 $000
Property plant and equipment 128,000 45,000 173,000
Investments 34,000 – (34,000) –
Goodwill 2,500 (500) (2,000) –
162,000 45,000 173,000
Inventories 12,000 6,000 (250) 17,750
Receivables 17,500 9,000 26,500
Cash 3,500 1,000 4,500
195,000 61,000 221,750
Share capital 10,000 2,000 (2,000) 10,000
Retained earnings 116,000 39,190 (33,000) (2,000) (619) (225) 119,346
FX reserve (7,590) 759 (500) (7,331)
NCI (759) 3,500 619 (25) 3,335
126,000 33,600 125,350
Long-term borrowings 20,000 4,800 24,800
Deferred tax 15,500 8,000 23,500
35,500 12,800 48,300
Trade payables 19,500 7,400 26,900
Tax 12,000 4,000 16,000
Bank overdraft 2,000 3,200 5,200
33,500 14,600 48,100
195,000 61,000 221,750
Workings
1 Translation of Merrion's statement of financial position
Merrion Rate Merrion
U'000 $'000
Non-current assets
Property plant and equipment 112,500 2.5 45,000
Current assets
Inventories 15,000 2.5 6,000
Receivables 22,500 2.5 9,000
Cash 2,500 2.5 1,000
152,500 61,000
Equity
Share capital 4,000 2 2,000
Pre-acquisition retained earnings 66,000 2 33,000
Post-acquisition retained earnings 14,000 W2 6,190
Exchange difference W3 (7,590)
84,000 33,600
912
31: Consolidation of foreign operations | Part D Group financial statements
$
Exchange loss in 20X2 3,311,688
Exchange loss in 20X3 4,278,787
Cumulative exchange loss in the exchange rate reserve 7,590,475
To the nearest ‘000 7,590
On consolidation, the NCI share of the exchange loss is allocated to the NCI by ($’000):
DEBIT NCI 759
CREDIT Foreign exchange reserve (10% 7,590) 759
913
Financial Reporting
4 Goodwill
U'000 $’000
Consideration 68,000
NCI (10% 70m) 7,000
Net assets (66 + 4) (70,000)
Goodwill 5,000
Retranslation of goodwill
At 1.1.X3 5,000 2 2,500
At 31.12.X3 5,000 2.5 2,000
Foreign exchange reserve 500
(i) The consolidation journal to originally recognise the acquisition is ($'000):
DEBIT Share capital (U4,000/2) 2,000
DEBIT Retained earnings 33,000
DEBIT Goodwill 2,500
CREDIT NCI (U7,000/2) 3,500
CREDIT Investment (U68,000/2) 34,000
(ii) The retranslation of goodwill is effected by ($'000):
DEBIT Foreign exchange reserve 500
CREDIT Goodwill 500
(iii) The goodwill impairment is effected by ($'000):
DEBIT Retained earnings 2,000
CREDIT Goodwill 2,000
5 Post acquisition retained earnings
The NCI is allocated its share of post acquisition retained earnings being $6,190,000 10%
= $619,000 ($'000):
DEBIT Retained earnings 619
CREDIT NCI 619
6 Unrealised profit
Merrion has charged a margin of 25% and therefore 25% of the cost to Trinity is profit. The
unrealised profit on the $1m (U2.5m/2.5) is therefore $250,000.
The seller is Merrion and therefore 10% of the profit is attributable to the NCI ($'000):
DEBIT Retained earnings (90%) 225
DEBIT NCI (10%) 25
CREDIT Inventory 250
914
31: Consolidation of foreign operations | Part D Group financial statements
Exam practice
Home 27 minutes
The statements of profit or loss for Home and its wholly owned subsidiary Foreign for the year
ended 31 July 20X6 are shown below.
Home Foreign
$'000 Crowns '000
Revenue 3,000 650
Cost of sales (2,400) (550)
Gross profit 600 100
Distribution costs (32) (41)
Administrative expenses (168) (87)
Finance costs (15) (10)
Profit (loss) before tax 385 (38)
Income tax (102) 10
Profit (loss) for the year 283 (28)
Notes
1 The presentation currency of the group is the HK $ and Foreign's functional currency is the
Crown.
2 Home acquired 100% of the ordinary share capital of Foreign on 1 August 20X4 for 204,000
Crowns. Foreign's share capital at that date comprised 1,000 ordinary shares of 1 Crown
each, and its reserves were 180,000 Crowns. In view of its subsidiary's losses, Home's
directors conducted an impairment review of the goodwill at 31 July 20X6. They concluded
that the goodwill had lost 20% of its value during the year (before taking exchange
differences into account). The impairment should be reflected in the consolidated financial
statements for the year ended 31 July 20X6.
3 On 1 June 20X6, Home purchased an item of plant for 32,000 Florins. At the year end, the
payable amount had not yet been settled. No exchange gain or loss in respect of this item is
reflected in Home's statement of profit or loss above.
4 Exchange rates are as follows:
On 1 August 20X4: 1.7 Crowns = $1
On 31 July 20X6: 2.2 Crowns = $1
Average rate for year ended 31 July 20X6: 2.4 Crowns = $1
On 1 June 20X6: 1.5 Florins = $1
On 31 July 20X6: 1.6 Florins = $1
5 During the year, Foreign made sales of 50,000 Crowns to Home. None of the items
remained in inventory at the year end.
Required
Prepare the consolidated statement of profit or loss for the Home group for the year ended 31 July
20X6. (Work to the nearest HK $100.) (15 marks)
915
Financial Reporting
916
Answers to exam practice
questions
917
Financial Reporting
918
Answers to exam practice questions
919
Financial Reporting
(b) The general knowledge, skill and experience that the director has (subjective test).
Directors are responsible for the preparation of financial statements in accordance with the
financial reporting framework required by the law or jurisdiction, and for such internal control as the
directors determine is necessary to enable the preparation of financial statements that are free
from material misstatement, whether due to fraud or error.
It is improper to state all the cost of acquisition of the patent as a software licence in the financial
statements in order to mislead the tax authority for the calculation of the tax deductible expenditure.
The creation of fictitious agreements or invoices for recording assets is improper/a fraud.
To make any false statement in connection with a claim for any deduction for tax purposes, or to
prepare or maintain or authorise the preparation or maintenance of any false books of account or
other records, or/and make use of any fraud for tax purposes may constitute an offence under the
relevant tax law.
920
Answers to exam practice questions
For an entity which does not prepare financial statements on a going concern basis, assets and
liabilities which are originally measured at historical cost may need to be measured on realisable
(settlement) value.
When an entity does not prepare financial statements on a going concern basis, it shall disclose
that fact, together with the basis on which it prepared the financial statements and the reason why
the entity is not regarded as a going concern.
Question 2
Mr. Kong’s behaviour is unethical.
As a professional accountant he must comply with the fundamental principles of integrity,
objectivity, professional competence and due care, confidentiality and professional behaviour as
set out in section 100.5 of the Code of Ethics for Professional Accountants (the ‘Code’).
A professional accountant in business is expected to encourage an ethics-based culture in an
employing organisation that emphasises the importance that senior management places on ethical
behaviour (300.5 of the Code).
A professional accountant in business should not knowingly engage in any business, occupation,
or activity that impairs or might impair integrity, objectivity or the good reputation of the profession
and as a result would be incompatible with the fundamental principles (300.6 of the Code).
A professional accountant in business who has responsibility for the preparation or approval of the
general purpose financial statements of an employing organisation shall be satisfied that those
financial statements are presented in accordance with the applicable financial reporting standards.
Ms. Yuen has been threatened with dismissal if she does not comply with Mr. Kong's wishes.
However, in complying with Mr. Kong's wishes, Ms. Yuen would become associated with fraudulent
transactions and misleading information and be in direct breach of the fundamental principles laid
out in the Code.
Safeguards should be applied to eliminate threats, such as consultation with superiors within the
employing organisation, the audit committee or those charged with governance of the organisation
or with a relevant professional body.
If Ms. Yuen believes that unethical behaviour or actions by Mr. Kong will continue to occur within
the company, she may consider obtaining legal advice.
In the extreme situation where all available safeguards have been exhausted and it is not possible
to reduce the threat to an acceptable level, Ms. Yuen should refuse to be associated with
information she determines is misleading and may conclude that it is appropriate to resign from the
company (300.15 of the Code).
Question 3
Mr Lee’s behaviour is unethical.
As a professional accountant, he has to comply with the fundamental principles of integrity,
objectivity, professional competence and due care, confidentiality and professional behaviour as
set out in s.100.5 of the Code of Ethics for Professional Accountants (the ‘Code’).
When a professional accountant holds a senior position within an organisation, a professional
accountant in business is expected to encourage an ethics-based culture in the employing
organization that emphasizes the importance that senior management places on ethical behaviour
(300.5 of the Code).
A professional accountant in business shall not knowingly engage in any business, occupation, or
activity that impairs or might impair integrity, objectivity or the good reputation of the profession and
as a result would be incompatible with the fundamental principles (300.6 of the Code).
921
Financial Reporting
Self-interest threat may be created as Ms. Wong participates in the incentive compensation
arrangements offered by the entity so that she can get a high bonus if she co-operates with Mr.
Lee.
Safeguards shall be applied to eliminate threats, such as ethics and conduct programmes, policies
and procedures to empower and encourage employees to communicate with senior management
within the entity, the audit committee or those charged with governance of the organisation or
consultation with another appropriate professional accountant (300.14 of the Code).
Ms. Wong should note that creating a forged document is a criminal offence and should refuse to
co-operate.
In circumstances where Ms. Wong believes that unethical behaviour or actions by Mr. Lee will
continue to occur within the company, she may consider obtaining legal advice.
In those extreme situations where all available safeguards have been exhausted and it is not
possible to reduce the threat to an acceptable level, Ms. Wong shall refuse to be or remain
associated with information she determines is misleading and may conclude that it is appropriate to
resign from the company (300.15 of the Code).
922
Answers to exam practice questions
Accordingly, for the purpose of incorporation of the historical financial information of STL in
its prospectus, STL is not qualified for reporting under either the SME-FRF or HKFRS for
Private Entities.
923
Financial Reporting
Goodwill and property, plant and equipment are considered fully impaired as both the fair value
less costs to sell and value in use are nil.
Inventories are stated at net realisable value of 60% of the cost in accordance with HKAS 2.9.
924
Answers to exam practice questions
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 20X5.
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).
925
Financial Reporting
As in the case of Building B, this building should be classified as a non-current asset held for sale
under HKFRS 5.
According to HKFRS 5.5, the measurement provisions of HKFRS 5 do not apply to the non-current
assets that are accounted for in accordance with the fair value model in HKAS 40.
Since CLL accounts for investment property at fair value model, Building C will continue to be
measured in accordance with HKAS 40.
The fair value of Building C at 31 December 20X7 is $22 million.
Question 2
(a) Tower A is reclassified from an investment property under HKAS 40 to an owner-occupied
property under HKAS16 upon commencement of occupation for own use at end of March
20X3 (or since April 20X3).
Tower B is treated as an investment property continuously, but transferred from under
construction to completed property upon completion of the construction by end of May
20X3(or since June 20X3).
Tower C is reclassified from owner-occupied property to investment property upon the end of
the owner-occupation from 1 April 20X3.
Tower D is derecognised as an asset from 1 May 20X3 under the sales and operating lease
back arrangement.
(b) Carrying amount at 30 June 20X3:
Tower A – Owner-occupied property stated at cost model
Deemed cost at 31 March 20X3: fair value of HK$26.4 million
Depreciation for 3 months ended 30 June 20X3:
HK$ 26.4 million (0.25 year / 47.25 years) = HK$ 0.14 million
Cost less accumulated depreciation:
HK$26.4 million – 0.14 million = HK$26.26 million
Tower B – investment property stated at fair value of HKD19.2 million
Tower C – investment property stated at fair value of HKD40.0 million
(c) Amounts recognised in the income statement for the six months ended 30 June 20X3:
Fair value gain on investment properties = HK$2 million
Tower A: HK$26.4 million – 25.8 million = HK$0.6 million
Tower B: HK$19.2 million – (14.2 million + 3.8 million) = HK$1.2 million
Tower C: HK$40.0 million – (38.0 million + 1.8 million) = HK$0.2 million
Depreciation of owner-occupied properties = HK$0.41 million
Tower A: HK$0.14 million
Tower C: HK$30 million (0.25/50) or (3mths/ 600mths)= HK$0.15 million
Tower D: HK$18 million / 50 4/12 or HK$18 million / 600 mths 4mths = HK$0.12 million
Gain on disposal of owner-occupied property = HK$13.02 million
Tower D: HK$30 million – (17.1 million - 0.12 million) = HK$13.02 million
Operating lease expense of Tower D = HK$0.16 million (HK$0.08 million x 2)
926
Answers to exam practice questions
Amount recognised in the other comprehensive income for the six months ended
30 June 20X3:
Revaluation gain on reclassification of owner-occupied property to investment property
Tower C: HK$38.0 million – (28.5 million - 0.15 million) = HK$9.65 million
927
Financial Reporting
928
Answers to exam practice questions
No provision for relocation and installation cost is recognised as there is no present obligation at
31 May 20Y1.
Electricity generator:
This is presented as property, plant and equipment, as YM intend to continue manufacturing until
the end of August 20Y1 and it is expected that the electricity generator would not be available for
immediate sale as at 31 May 20Y1.
It is measured at the lower of carrying amount and recoverable amount.
The recoverable amount is the higher of:
fair value less costs to sell = $4 million
value in use = the present value of the future cash flows expected to be derived from the
operation from June to end of August 20Y1.
Assuming the value in use is less than the fair value less costs to sell of $4 million, the impairment
loss recognised is $1.2 million ($5.2 million – $4 million).
Land under operating lease:
This is presented as a prepaid lease payment as YM intends to continue manufacturing and so use
the land until the end of August 20Y1 and therefore the land would not be available for immediate
sale as at 31 May 20Y1. It is measured at the lower of carrying amount and recoverable amount.
The recoverable amount is the higher of:
fair value less costs to sell = not less than $35 million (assuming the costs to sell is minimal)
value in use = the present value of the future cash flows expected to be derived from the
operation from June to end of August 20Y1.
No impairment is recognised as the recoverable amount is expected to be greater than the carrying
amount of $13 million.
Inventories – raw material:
These are measured at the lower of cost and net realisable value.
The cost is $8.4 million.
As it is expected that all the raw materials will be consumed for the production of tiles and sales at
a profit, the net realisable value is higher than the cost.
Therefore the inventories are measured at $8.4million.
Inventories – finished products:
Again these are measured at the lower of cost and net realisable value.
The cost is $6.4million.
Net realisable value is
$3.2 million 100/80 = $4 million for that half of the goods made to order
$3.2 million 40% = $1.28 million for the remaining half of the goods
The goods are therefore measured at $4.48 million, being:
$3.2 million (cost) for that half of the goods made to order
$1.28 million (NRV) for the remaining half of the goods.
929
Financial Reporting
Question 2
(a) Based on the information provided in the question, the significant deterioration of Run Pro’s
sales performance is an impairment indicator. When such an indication exists, the entity
shall estimate the recoverable amount of the asset of Run Pro.
The brand, being an intangible asset with indefinite useful life, and therefore no amortisation
is recognised, is required to be tested for impairment at least annually, irrespective of
whether there is any indication of impairment.
Accordingly, WSL is required to perform an asset impairment review in both Run Pro and
Jog Pro at 30 June 20X2.
(b) An asset or cash generating unit (CGU) is considered to be impaired when its recoverable
amount declines below its carrying amount.
The recoverable amount of an asset or a CGU is the higher of its fair value less costs to sell
and its value in use.
The recoverable amount is determined for an individual asset, unless the asset does not
generate cash inflows that are largely independent of those from other assets or groups of
assets.
If that is the case, the recoverable amount is determined for the CGU to which the asset
belongs, unless either:
The asset’s fair value less costs to sell is higher than its carrying amount; or
The asset’s value in use can be estimated to be close to its fair value less costs to sell and
fair value less costs to sell can be determined.
A CGU is the smallest group of assets that generates largely independent cash inflows. This
may be a single asset or group of assets.
Based on the information provided, each brand is considered as a cash generating unit.
The value in use of the group of assets (i.e. the intangible asset, plant and equipment,
developed cost capitalised and inventories) under individual brands and fair value less costs
to sell of each of the two brands and individual categories of assets are determinable.
HKAS 36 has a bottom-up approach to impairment testing.
It is incorrect to compare the aggregate value in use with the total net assets of both brands
to determine whether an individual brand or other asset is impaired.
(c)
Run Pro Jog Pro
$'000 $'000
Net assets of the CGU, other than inventories (a) 71,000 33,000
Value in use of the CGU (b) 64,000 60,000
Fair value less cost to sell of the CGU (c) 60,000 58,000
The recoverable amount (d) (The higher of (b) and (c)) 64,000 60,000
Recoverable amount > Carrying amount of assets under the CGU NO YES
Impairment issue YES NO
Excess of net assets over the recoverable amount (d) – (a) = (e) (7,000)
According to the result above, the brand "Run Pro" is considered impaired and the
impairment loss, HK$7 million, should be first allocated pro-rata on the basis of the carrying
amount of each individual assets.
930
Answers to exam practice questions
Chapter 9 Leases
(a) Purchase option regarding classification of the lease by SRC
According to HKAS 17.10, if the lessee (SRC) has the option to purchase the asset at a price
that is expected to be sufficiently lower than the fair value at the date the option becomes
exercisable for it to be reasonably certain, at the inception of the lease, that the option will be
exercised, it would normally lead to a lease being classified as a finance lease.
The option price is $10,000. In view of the fact that SRC estimated the economic useful life
of the leased equipment to be eight years while the lease term is just five years, plus the fair
value of the leased equipment at 1 January 20X7 is $227,500, it is reasonable to expect that
the option price is sufficiently lower than the then fair value after five years. Therefore, SRC
should classify the lease as a finance lease.
(b) 12.93% is the implicit rate that, at the inception of the lease, causes the aggregate present
value of the minimum lease payment and the unguaranteed residual value to be equal to the
fair value of the leased asset:
931
Financial Reporting
Present
Annual Unguaranteed value
lease residual at implicit rate
Date payment value 12.93%
$ $ $
01/01/20X7 53,069 53,069
01/01/20X8 53,069 46,993 = 53,069 / (1.1293)1
01/01/20X9 53,069 41,612 = 53,069 / (1.1293)2
01/01/20Y0 53,069 36,848 = 53,069 / (1.1293)3
01/01/20Y1 53,069 32,629 = 53,069 / (1.1293)4
31/12/20Y1 30,000 16,333 = 30,000 / (1.1293)5
227,484
932
Answers to exam practice questions
Chapter 10 Inventories
(a) Net realisable value of inventories is the estimated selling price in the ordinary course of
business less the estimated costs of completion and the estimated costs necessary to make
the sale.
Assessment of impairment of property, plant and equipment involves comparing the carrying
amount of the asset with its recoverable amount, which is the higher of its fair value less
costs of disposal and its value in use.
Fair value less costs of disposal is the amount obtainable from the sale of an asset or cash
generating unit in an arm’s length transaction between knowledgeable, willing parties, less
the costs of disposal.
Value in use is the present value of the future cash flows expected to be derived from an
asset or cash-generating unit.
(b) The Final Order provides indicator that only 500,000 units would be sold at a price above the
unit cost.
If there is no possible way to sell them to other customers, the net realisable value of the
remaining 300,000 units will be nil, a write down of inventories up to $3,600,000 (300,000 x
$12) would be recognised.
The inventories of the finished goods, after write down the inventories, will be carried at
$6,000,000 as at 31 October 20X3.
For raw material purchased for the production of this model and work in progress under
production, net realisable value is assessed with consideration of alternative use and their
estimated selling price.
For the moulds used to produce the item concerned, a total of 10 months depreciation of
$250,000 has been recognised and the carrying amount as at 31 October 20X3 is $200,000.
The Final Order provides indicators that there would be no more new sales of the items and
therefore the mould should be subject to impairment testing.
Value in use is considered nil and the recoverable amount should be determined based on
fair value less costs to sell. Given the estimated selling price of scrap metal is $10,000, an
impairment of $190,000 will be recognised.
933
Financial Reporting
(b) As at 30 June 20X8, DCL has no obligation to perform the safety inspection of the production
line, accordingly no provision should be recognised.
The cost for the inspection should be recognised as expense when incurred.
OR
The information provided in the question has not stated whether DCL, by an established
pattern of past practice, published policies or a sufficiently specific current statement, has
indicated to other parties that it must carry out the safety inspection on an annual basis and
therefore, it has created a valid expectation on the other parties in respect of this activity.
If there is evidence to prove the above, this can be considered as a constructive obligation
and therefore a provision should be provided.
(c) Any future loss on sales of aged finished goods should be considered in the measurement of
the net realisable value of the inventory under HKAS 2 instead of HKAS 37.
The net realisable value is the estimated selling price in the ordinary course of business less
the estimated costs of completion and the estimated costs necessary to make the sale.
Sales of finished goods at a price below the cost immediately after the date of the statement
of financial position (July 20X8) is a strong indicator of the amount of net realisable value at
30 June 20X8.
Accordingly, this should be recorded as a write down of inventories and no separate
provision should be recognised in the current liabilities.
(d) DCL has an obligation to pay the bonus to two executive directors in accordance with the
directors' service contract.
It should be possible to make a reliable estimate of the provision amount based on the
amount of profit before tax and the accrued bonus.
Accordingly, a provision should be recognised as at 30 June 20X8.
Question 2
A provision should be recognised when and only when:
An entity has a present obligation (legal or constructive) as a result of a past event;
It is probable that an outflow of resources embodying economic benefits will be required to
settle the obligation; and
A reliable estimate can be made of the amount of the obligation.
Provision for discount coupon
XP had the obligation to give the discount upon issue of the letter and before the expiry date.
As XP is still able to make a profit, after the deduction of HK$500, for the sales of the new printer,
there are no outflow of resources nor transfer of economic benefits.
It may be possible for XP to make an estimate of number of new sales with the usage of the
discount coupon should there have been a similar scheme in the past.
Conclusion:
A provision should only be recognised when all the conditions under HKAS 37.14 are met.
No provision should be recognised at 31 March 20X3. Accordingly, the provision for the discount
coupon of HK$750,000 should be reversed.
934
Answers to exam practice questions
Warranty provision
XP has a contractual obligation to provide the free of charge repair service.
XP needs to incur and has incurred the cost for labour and parts replacement for the repair service,
there will be a transfer of economic benefits.
It is presumed that XP can make an estimate of the amount to be incurred for the provision of the
repair service in respect of the product sales made in the year based on the historical performance.
Conclusion:
A provision should be recognised at 31 March 20X3.
The amount recognised should be the best estimate of the expenditure recognised to settle the
present obligation at the end of the reporting period.
With the presumption that the ratio of expenditure incurred to the sales of the past five years is a
reliable estimate of the amount to be incurred for repair services, XP should adjust downward the
provision to an amount ranging from HK$2.80 million (HK$437 million x 0.64%) to HK$4.37 million
(HK$437 million x 1%).
OR
Assuming 0.8% of the sales is considered to be the best estimate of the amount to be incurred for
the repair service, XP can adjust downward to approximately HK$3.5 million (437 million 0.8%).
Litigation provision
XP is considered to have an obligation to compensate the plaintiff that arises from a past sales
transaction.
The compensation of cash payment represents a transfer of economic benefits for XP.
It is presumed that XP could make an estimate of the compensation amount taking into
consideration the offer given by XP and counter-offer from the plaintiff approved by the Board.
The payment made in April is an adjusting event after the reporting period.
Conclusion:
The provision should be adjusted downward to HK$5,650,000, i.e. HK$5 million compensation to
plaintiff and HK$650,000 legal fee for provided services.
(b) Disagree with the comment:
No provision should be recognised at 31 March 20X3 for the cost of television advertising to
be launched after the end of the reporting period because:
The agreement is executory and XP had no present obligation (or XP had future
obligation only) for the future services to be received from the counter-party.
HKAS 37 does not allow artificial ‘smoothing” of results by early recognition in the
profit or loss before the costs are actually incurred.
935
Financial Reporting
Working:
1 Revenue:
Contract A Contract B
$'000 $'000
Contract sum certified and billed to date 28,000 26,000
Less: Revenue previously recognised up to (18,200) ---
30 September 2011
9,800 26,000
936
Answers to exam practice questions
(b)
The amounts to be disclosed and presented under HKAS 11 at 30 September 2012:
Contract A Contract B Total
$'000 $'000 $'000
Costs incurred 25,600 30,000 55,600
Recognised profits (loss) W1 4,000 (1,150) 2,850
Progress billings (28,000) (26,000) (54,000)
Amount due from customers for contract works 1,600 2,850 4,450
937
Financial Reporting
(b) Managerial staff who leave during the two-year period will forfeit their rights to the share
options. Accordingly, those staff who left during the vesting period will not be entitled to any
share-based benefit.
Under HKFRS 2, the share-based payment expense recognised in each year of the vesting
period should be based on the best available estimate of the number of equity instruments
expected to vest.
The estimate should be revised if subsequent information indicates that the number of equity
instruments expected to vest differs from previous estimates.
On the vesting date, the entity should revise the estimate to equal the number of equity
instruments that actually vest.
Chapter 14 Revenue
(a) (i) Counter sales at department stores:
NFL has the primary responsibility for providing the goods to the customers of
department stores with its sales team.
NFL retains inventory risk as the ownership of the goods has not been transferred to
department stores.
NFL has latitude in establishing prices while the department stores will only share 20%
of the invoice amounts for the service provided.
Customers' credit risk is borne by the department stores but it is considered as a weak
indicator for department store operation.
Taking into consideration the features listed above, it is considered that NFL acts as a
principal because it has exposure to the significant risks and rewards associated with
the sale of goods while the department stores act as an agent and service provider
rather than customers of NFL.
Significant risks and rewards of ownership are transferred to the department store
customers when they acquire possession of the goods and invoices are issued by the
department store.
The return or exchange offered to the customers represents only an insignificant risk
of ownership as past history demonstrates that the return rate is insignificant.
Revenue is therefore recognised at the time of sale to the department store
customers.
The amount recognised as revenue of NFL is the gross selling price charged to the
customers.
The 20 per cent of the retail prices retained by the department stores is a selling and
distribution expense of NFL and is not offset against the revenue.
(ii) Distributors:
NFL has no primary responsibility for providing the goods to their retail store
customers.
NFL does not bear inventory risk after the delivery of goods to distributors as the
goods are non-returnable unless there are quality problems.
Although NFL has latitude in establishing price charges for the goods to be sold by the
distributors at their own retail store, it is the distributors to bear their customers’ credit
risk.
938
Answers to exam practice questions
Taking into consideration the features listed above, we can conclude that the
distributors are acting as principal rather than agent of NFL as they have exposure to
the significant risks and rewards associated with the sales of goods at their own retail
stores. The distributors are therefore considered to be the customers of NFL.
Revenue is recognised by NFL when the goods are delivered and accepted by the
distributors either after their quality inspection or after the 7 days return period has
elapsed.
The amount recognised as the revenue of NFL is the invoice price, i.e. 50% of the pre-
determined retail price of the items delivered and accepted by the distributors.
(b) HKAS 18.10 states that the amount of revenue arising on a transaction is usually determined
by agreement between the entity and the buyer. It is measured at the fair value of the
consideration received or receivable taking into account the amount of any trade discounts
and volume rebates allowed by the entity.
NFL should estimate the distributors to whom the company is likely to give the volume
discount, i.e. annual quantity delivery will be above 100,000 pieces, at the time of sale on a
monthly basis, and recognise revenue net of the amount of volume discount.
The final discount will be true up to the end of the year for the actual amount of discount
given. The discount should be presented as a reduction in revenue.
939
Financial Reporting
Question 2
Temporary differences at 30 September 20X3 = Carrying amount less tax base
Where tax base of asset = Carrying amount – taxable amount + deductible amount
Patent:
Carrying amount = HK$4.5 million x 1/5 = HK$0.9 million
Tax base = HK$(0.9 – 0.9 + 0) = 0
Temporary difference is HK$0.9 million.
Deferred tax at 30 September 20X3:
Patent being a non-tax deductible expenditure and the initial recognition is not part of a business
combination and does not affect either accounting profit or taxable profit, therefore no deferred tax
liability should be recognised.
Software licence:
Carrying amount = HK$2.4 million x 1/5 = HK$0.48 million
Tax base = HK$(0.48 – 0.48 + 0) = 0
Temporary difference is HK$0.48 million.
Deferred tax at 30 September 20X3:
Deferred tax liability: HK$0.48 million x 30% = HK$144,000
940
Answers to exam practice questions
22,863 21,613
Remeasurement losses 137 (113) 250
19,700 18,035
Remeasurement losses 700 (195) 895
During 20X8, there is an improvement in the future benefits available under the plan
and as a result there is a past service cost of $1million, being the increase in the
present value of the obligation as a result of the change.
During 20X9, Rhodes sells part of its operations and transfers the relevant part of the
pension scheme to the purchaser. This is a settlement. The overall gain on settlement
is calculated as:
$'000
Present value of obligation settled 5,700
Fair value of plan assets transferred on settlement (5,400)
Cash transferred on settlement (200)
Gain 100
(ii) STATEMENT OF FINANCIAL POSITION
20X8 20X9
$'000 $'000
Net defined benefit liability 1,500 2,560
941
Financial Reporting
942
Answers to exam practice questions
943
Financial Reporting
The time when the asset is available for use, i.e. when it is in the location and
condition necessary for it to be capable of operating in the manner intended by
management, and therefore deprecation of an asset begins. For the hotel property of
RHE, it should start for depreciation at the date of the pre-opening activities start, i.e. 1
July 20X4.
The most appropriate depreciation method, which reflects the pattern in which the
assets' future economic benefits are expected to be consumed by the entity, for each
separately depreciable component.
(c) The equipment and furniture in the hotel rooms at a cost of HK$40 million and the
corresponding borrowing cost capitalised are considered as separately depreciable
components with a useful life of 5 years.
The remaining cost of the hotel construction of HK$160 million and the corresponding
borrowing cost capitalised are depreciated over 30 years.
Total borrowing costs capitalised : HK$8,666,667 (HK$3,900,000 + HK$4,766,667)
Allocated to equipment and furniture: HK$1,733,333 (40/200 x HK$8,666,667)
Allocated to hotel building structure: HK$6,933,334 (160/200 x HK$8,666,667)
Depreciation for 6 months from 1 July to 31 December 20X4:
[(HK$40,000,000 + HK$1,733,333) / 5 6/12] + [(HK$160,000,000 + HK$6,933,334) /
30 6/12]
= HK$4,173,333 + HK$2,782,222
= HK$6,955,555
944
Answers to exam practice questions
If a cash flow hedge meets the conditions for hedge accounting during the period, it
shall be accounted for as follows:
(a) The portion of the gain or loss on the hedging instrument that is determined to
be an effective hedge shall be recognised in other comprehensive income and
(b) The ineffective portion of the gain or loss on the hedging instrument shall be
recognised in profit or loss
If a hedge of a forecast transaction subsequently results in the recognition of a non-
financial asset or a non-financial liability, the amount that had been recognised in
other comprehensive income shall be:
(a) reclassified from equity to profit or loss as a reclassification adjustment in the
same period or periods during which the hedged forecast cash flows affect profit
or loss or
(b) included in the initial cost or other carrying amount of the asset or liability.
(iii) The variable rate bond of SC has a cash flow exposure to changes in the market rate
of interest.
An increase in the market interest rate, assuming other variables affecting the
valuation of the bond are unchanged, theoretically means that the fair value of a
variable rate bond will not change while a fixed rate bond will decrease.
Since SC measures the bond at amortised cost, the increase in the market interest
rate of 0.5% will not result in any adjustment to the carrying amount of the bond.
The interest rate swap, as a derivative, is measured at fair value through profit or loss,
if hedge accounting is not adopted.
An increase in the market interest rate of 0.5 per cent will result in SC receiving more
under the variable rate interest amount in exchange for paying 2 per cent fixed interest
amount.
Theoretically, the fair value of the interest rate swap should be increased and a gain
will be recognised in profit or loss.
(b) If SC designates the hedge as a fair value hedge, the non-cancellable purchase order in Yen
is considered as a firm commitment to be hedged (hedged item) in connection with the spot
foreign currency risk.
The Yen forward contract is considered to be as the hedging instrument.
As a financial derivative, the Yen forward contract will have been reported at fair value on
each reporting date, with gains or losses reported in profit or loss.
Under a fair value hedge, the change in fair value of the firm commitment related to the
hedged risk will also be recognised in profit or loss and adjusts the carrying amount of the
hedged item. This applies if the hedged item is otherwise measured at cost. For SC's
hedged item which is an unrecognised firm commitment, its cumulative change in the fair
value attributable to the hedged risk is recognised as an asset or liability.
Question 2
(a) As the functional currency of GPL is RMB while the settlement of the CB is HK$, it does not
fulfil the definition of equity instrument, that is, to be settled by exchanging a fixed amount of
cash for a fixed number of its own equity instruments. Accordingly, under GPL's accounting
policies, the debt component of the CB is carried at amortised cost and the conversion
option is accounted for as a derivative at fair value through profit or loss.
In accordance with HKFRS9 B4.3.3, when the CB is a hybrid instrument, that is, the
embedded conversion option classified as a derivative and the host instrument, the initial
945
Financial Reporting
carrying amount of the host instrument is the residual amount after separating the embedded
derivative.
Journal entries for the issue of CB on 1 July 20X3:
Dr Cash / Bank HK$500 million
Cr Convertible Bond – liability HK$420 million
Cr Derivative – conversion option HK$80 million
(b) Carrying amount of the debt component of the CB to be converted at 1 October 20X3:
HK$(420 million) [1 + (6.3% 3/12)] HK$ (50/500) million = HK$42.66 million
Carrying amount of derivative component of the CB to be converted at 1 October 20X3:
HK$70(500-430) million HK$ (50/500) million = HK$7 million
Journal entries for the conversion of CB into shares on 1 October 20X3:
Dr Convertible Bond – liability HK$42.66 million
Dr Derivative – conversion option HK$7 million
Cr Equity HK$49.66 million
(c) Effective interest expense of the debt component of the CB for the year ended
31 December 20X3:
HK$420 million (6.3%*6/12) = HK$13.23 million
Fair value change of derivative component of the CB for the year ended 31 December 20X3:
Initial fair value (HK$80 million) – year-end fair value (HK$100 million)= fair value loss of
HK$20 million
Journal entries for the year ended 31 December 20X3:
Finance cost – effective interest HK$13.23 million
Fair value change – profit or loss HK$20 million
Cr Convertible Bond – liability HK$13.23 million
Cr Derivative – conversion option HK$20 million
The CB should be classified as non-current at the statement of financial position. With the
maturity on 30 June 20X9, the issuer has an unconditional right to defer settlement of the
liability for at least twelve months after the reporting period. Under HKAS 1.69(d), it
mentions the terms of a liability that could, at the option of the counterparty, result in its
settlement by the issue of equity instruments that do not affect its classification.
946
Answers to exam practice questions
Being an unquoted equity investment, cost may be an appropriate estimate of fair value of
investment in PMI, this may be the case if sufficient more recent information is not available
to determine fair value, or if there is a wide range of possible fair value measurement and
cost represents the best estimate of fair value within that range.
Investment in the equity instrument of MVC is considered as an investment in an associate
as ZIL holds more than 20 per cent of the voting power of MVC and has representation on
the board of directors of MVC and therefore is able to participate in policy-making processes.
Investment in MVC will be accounted for under equity method, i.e. initially recognised at cost
and the carrying amount is increased or decreased to recognise ZIL’s share of the profit or
loss of MVC after the date of acquisition. ZIL’s share of the profit or loss of MVC is
recognised in ZIL’s profit or loss. Distributions received from MVC reduce the carrying
amount of the investment. Adjustments to the carrying amount may also be necessary for
changes in ZIL’s proportionate interest in MVC arising from changes in MVC’s other
comprehensive income.
The loan to GE is on contractual terms that give rise on specified dates to cash flow is solely
payment of principal and the interest on the principal amount outstanding.
Providing that the loan to GE held by ZIL within a business model whose objective is to hold
the investment in order to collect contractual cash flows, the loan to GE shall be measured at
amortised cost. Otherwise they are measured at fair value.
The equity investments in LP and PMI will be presented as a non-current asset unless it is
expected to be realized within twelve months of the reporting period and it should be
presented as a current asset.
The investments in associate, MVC, will be presented as a non-current asset.
The loan to GE with a repayment date after twelve months of the reporting period will be
presented as a non-current asset.
(b) For the equity investment in LP, it is expected that the fair value is measured with level 1
input, i.e. quoted prices (unadjusted) in active markets for identical assets that ZIL can
access at the measurement date.
For the equity investment in PMI, as it is unquoted, it is expected that the fair value is
measured with unobservable input,
i.e. level 3, or even with observable input, it requires adjustment using an unobservable input
and if that adjustment results in a significantly higher or lower fair value measurement, the
resulting measurement would still be categorised within level 3 of the fair value.
947
Financial Reporting
(b) To examine whether the net cash flow from operating activities is sufficient to support the
proposed relocation and expansion we must first consider the other uses to which the cash
flow has been put:
$'000
Net capital expenditure (W5) 260
Bond repayment (W6) 171
431
Extent to which financed by new issue of shares (740-460) 280
Net cash requirement to finance capital expenditure and bond 151
Dividend 40
Overall net cash requirement 191
Net cash flow from operating activities 310
Increase in cash at bank 119
The above shows that the company's overall net cash requirement during the year was
easily met by available cash flow from operations. However, the company would have to
forecast future cash flow and consider relocation costs and any likely future capital
commitments before deciding whether future cash flows would be sufficient to fund the
relocation.
Also, the above shows that net capital expenditure was financed by a new issue of shares
and that much of the net cash flow from operating activities was used to repay part of the
bond. The company would have to balance the likelihood of these events recurring* with the
need to fund the above relocation costs.
* The company would also need to consider the likely impact of this on the equity/debt ratio
(up from 1.95:1 to 8:1).
948
Answers to exam practice questions
Tax paid 52
949
Financial Reporting
950
Answers to exam practice questions
(b) This is a non-adjusting event under HKAS 10. SW should recognise the HK$3 million (20%
of HK$15 million) compensation for the breach of contract in the period subsequent to 31
March 20X2.
The sales orders were received and the sales contracts were signed before the end of the
reporting period. At the reporting date there was no indication that SW would fail to fulfil the
sales orders.
The failure in the production and delivery of orders was due to the suspension of production
from 15 April 20X2, and therefore not a condition that existed at 31 March 20X2.
If this event is considered to be material, SW should disclose the nature of the event and its
financial effect in the notes to the financial statements.
(c) This is a non-adjusting event under HKAS 10. SW should not recognise the HK$5 million
subsidy as government grant in the year ended 31 March 20X2. It should however recognise
the subsidy as government grant in the period subsequent to 31 March 20X2.
It is possible to argue that there is reasonable assurance that SW would comply with the
conditions attached (HKAS 20.7 (a)). The relevant employment period of local workers was
the six months ended 31 December 20X1 and the application for the subsidy was on 8
March 20X2, which is during the year ended 31 March 20X2.
However, there was no reasonable assurance that the subsidy would be received
(HKAS 20.7 (b)) at 31 March 20X2, as the subsidy is discretionary and subject to approval
by the local government which was not obtained until 8 April 20X2.
If this event is considered to be material, SW should disclose the nature of the event and its
financial effect in the notes to the financial statements.
Question 2
(a) This is an non-adjusting event under HKAS 10.
Given SAC declares dividends to holders of equity instruments (as defined in HKAS 32
Financial Instruments: Disclosure and Presentation) on 29 April 20X4, it shall not recognise
those dividends as a liability at the end of the reporting period (i.e. 31 December 20X3)
because no obligation exists at that time.
The amount of dividends proposed or declared before the financial statements are
authorised for issue but not recognised as a distribution to owners during the period, and the
related amount per share are disclosed in the notes in accordance with HKAS 1.137.
(b) This is an adjusting event under HKAS 10.
The unauthorised building works were carried out during the year ended 31 December 20X3
which provides evidence of the non-compliance that existed at the end of the reporting
period.
Therefore, the cost of removal of HK$500,000 should be provided in the financial statements
for the year ended 31 December 20X3 while the maximum penalty of HK$400,000 is not
required to be provided when the entity has rectified the illegal building works before the
financial statements are authorised to be issued.
(c) The production lines for sale may be classified as assets held for sale under HKFRS 5. For
assets to be classified as held for sale, there are two conditions: (i) the relevant assets must
be available for immediate sale in its present condition and (ii) its sale must be highly
probable.
It depends on whether the production lines are abandoned at year-end which are available
for immediate sale in their present condition.
For the sale to be highly probable, HKFRS 5.8 sets out the following criteria:
951
Financial Reporting
(i) the appropriate level of management must be committed to a plan to sell the asset
and an active programme to locate a buyer and complete the plan must have been
initiated;
(ii) the asset (or disposal group) must be actively marketed for sale at a price that is
reasonable in relation to its current fair value;
(iii) the sale should be expected to qualify for recognition as a completed sale within one
year from the date of classification; and
(iv) actions required to complete the plan should indicate that it is unlikely that significant
changes to the plan will be made or that the plan will be withdrawn.
The probability of shareholders’ approval should be considered as part of the assessment of
whether the sale is highly probable. If the management of SAC is the same as the
shareholders of SAC or if there are any discussions with a majority of shareholders, the sale
may be considered as highly probable.
(d) Financial Reporting
1. The new Companies Ordinance (new CO), the 10th Schedule has been replaced by
Schedule 4. Instead of a long list of specific items to disclose, Schedule 4 contains
only 5 items.
Items to be disclosed under Schedule 4:
(i) the aggregate amount of outstanding loans made under the authority of ss.280
and 281 (these are loans made to eligible employees to enable them to buy
shares in the company);
(ii) the financial statements have been prepared in accordance with the applicable
accounting standards (as mentioned above);
(iii) if a group produces consolidated financial statements, the following must be
included in the notes to the consolidated financial statements:
• the parent’s company level statement of financial position; and
• a note disclosing the movement in the parent company’s reserves.
(iv) the name of the parent undertaking and the parent undertaking’s country of
incorporation or its principal place of business; and
(v) auditors’ remuneration.
2. New provisions are introduced in the new CO to allow a greater number of private
companies to prepare simplified directors' report and financial statements under SME-
FRS.
3. The new CO adopts the concept of no-par value for all shares in Hong Kong
companies. The concepts of ’nominal value”’, ‘share premium’, ’capital redemption
reserve’ and ‘authorised share capital’ are abolished.
4. The entity has flexibility to choose whether to pay for redemptions or share buy-backs
out of capital or distributable profits.
Directors' report
5. A new ’business review’ section must be included in the directors’ report unless the
company is exempt.
6. Disclosure of significant transactions, arrangements or contracts entered into by the
company, where a director has a material interest, has been moved to the financial
statements and will therefore be subject to audit.
952
Answers to exam practice questions
953
Financial Reporting
954
Answers to exam practice questions
(d) The conclusion is incorrect. The company is not required to remove from the prior year
amounts the portion of the operating segment that was disposed of prior to the end of the
current year.
The disposal of a portion of an operating segment is not considered a change of the
structure of an entity's internal organisation in a manner that causes the composition of its
reportable segments to change, which would require restatement of prior periods in
accordance with HKFRS 8.29.
Furthermore, if management judges that an operating segment identified as a reportable
segment in the immediately preceding period is of continuing significance, information about
that segment shall continue to be reported separately in the current period even if it no
longer meets the criteria for reportability in HKFRS 8.13.
955
Financial Reporting
AZ CO.
STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X3
$'000
Non-current assets
Property, plant and equipment (W2) 48,262
Investment properties 24,000
72,262
Current assets
Inventories (5,180 – (W3) 15) 5,165
Trade receivables 9,330
Cash and cash equivalents 1,190
15,685
87,947
Equity
Share capital (20,430 + (W4) 2,400) 22,830
Retained earnings (27,137 – 1,000 + 3,685) 29,822
Revaluation surplus (3,125 + 4,000) 7,125
59,777
Non-current liabilities
Redeemable preference shares 1,000
7% debentures 20X7 18,250
19,250
Current liabilities
Trade payables 8,120
Income tax payable 161
Interest payable (1,278 – 639) 639
8,920
87,947
AZ CO.
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 MARCH 20X3
Share Retained Revaluation Total
capital earnings surplus
$'000 $'000 $'000 $'000
Balance at 1 April 20X2 20,430 27,137 3,125 50,692
Issue of share capital 2,400 2,400
Dividends (1,000) (1,000)
Total comprehensive income for the year 3,685 4,000 7,685
Balance at 31 March 20X3 22,830 29,822 7,125 59,777
WORKINGS
1 Expenses
Cost of sales Distribution Admin Other
$'000 $'000 $'000 $'000
Per TB 94,000 9,060 16,020 121
Opening inventories 4,852
Depreciation on buildings (W2) 1,515
Depreciation on P&E (W2) 513
Closing inventories (5,180 – (W3) 15) (5,165)
94,200 9,060 17,535 121
956
Answers to exam practice questions
3 Inventories
$'000
Defective batch:
Selling price 55
Cost to complete: repackaging required (20)
NRV 35
Cost (50)
Write off required (15)
4 Share issue
The proceeds have been recorded separately in the trial balance. This requires a transfer to
the appropriate accounts:
$'000 $'000
DEBIT Proceeds of share issue 2,400
CREDIT Share capital (2,000 $1.20) 2,400
To transfer the proceeds of the share issue to the share capital account.
957
Financial Reporting
2 Goodwill on acquisition of CD
$'000
Purchase consideration (39.6 60,000) 2,376
NCI share (W4) 1,400
Net assets acquired at 1 April 20X3
(100 + (700 + (80 9/12))) (860)
Goodwill on acquisition 2,916
3 NCI at acquisition of AB
Number of shares = 200,000
Net of the acquisition date amounts of the identified assets acquired and the liabilities
assumed = HK$[42 + 16 + 8] million = HK$66 million
Net of the acquisition date amounts of the identified assets acquired and the liabilities
assumed (as above) = HK$66 million
Post acquisition profit reported by BDC before adjustment of depreciation and amortisation
attributable to fair value up to 1 April 20Y0 = HK$8 million
958
Answers to exam practice questions
Additional depreciation for the period from 1 October 20X9 to 31 March 20Y0:
= HK$16 million / 10 0.5
= HK$0.8 million
Additional amortisation for the period from 1 October 20X9 to 31 March 20Y0:
= HK$8 million / 10 0.5
= HK$0.4 million
Adjusted post acquisition profit of BDC incorporated into the consolidated financial
statements of SCL up to 1 April 20Y0 = HK$[8 – 0.8 – 0.4] million = HK$6.8 million
959
Financial Reporting
$m
Profit attributable to:
Owners of the parent 548
Non-controlling interests ((40% x 355) – (W2) 6 – (W4) 8 – (W6) 4) 124
672
Total comprehensive income attributable to:
Owners of the parent 612
Non-controlling interests ((40% x 375) – (W2) 6 – (W4) 8 – (W6) 4) 132
744
WORKINGS
1 Group structure
Bailey
1.1.X6 (4 years ago) 1.5.X9 (current year)
300 72
= 60% = 30%
500 240
Hill Campbell
Pre-acqn reserves $440m $270m
2 (i) Goodwill (Hill)
$m $m
Consideration transferred 720
Non-controlling interests (at "full" fair value) 450
Fair value of net assets at acquisition
Share capital 500
Reserves 440
Fair value adjustment (W6) 100
(1,040)
130
Consolidation adjustment journal ($m)
DEBIT Goodwill 130
DEBIT Share capital 500
DEBIT Reserves 440
DEBIT Property, plant and equipment 100
CREDIT Investment in H 720
CREDIT NCI 450
To recognise the acquisition of Hill and associated goodwill and NCI.
(ii) Impairment losses to date
Consolidation adjustment journal ($m):
DEBIT Reserves (60%) 12
DEBIT NCI (40%) 8
CREDIT Goodwill 20
To recognise the cumulative goodwill impairment
$15m of the debit entry relates to the impairment loss arising in the year and therefore
this is reported in the SPLOCI as part of administrative expenses. 40% of this is
attributable to the NCI ($6m).
3 Post acquisition reserves of associate (Campbell)
$m
Share of post acquisition retained reserves ((330-270) 30%) 18
960
Answers to exam practice questions
961
Financial Reporting
962
Answers to exam practice questions
963
Financial Reporting
(c) (i) APE – Worksheet for the Consolidated Statement of Profit or Loss and Other
Comprehensive Income for the year ended 31 March 20X2
Profit attributable
to:
Owners of the
parent 12,010
Non-controlling
interests 620 7 620
12,630
964
Answers to exam practice questions
(c) (ii) APE – Worksheet for the Consolidated Statement of Financial Position as at
31 March 20X2
965
Financial Reporting
(c) (iii) APE – Worksheet for the Consolidated Statement of Changes in Equity for the
year ended 31 March 20X2
Non-
Share Retained controlling
capital earnings Total interest Total equity
HK'000 HK'000 HK'000 HK'000 HK'000
Balance at
1 April 20X1 30,000 50,680* 80,680 7,670** 88,350
Changes in equity
Dividends (3,500) (3,500) (3,500)
Dividend paid to
NCI (250) (250)
Total
comprehensive
income for the
year 12,010 12,010 620 12,630
Balance at
31 March 20X2 30,000 59,190 89,190 8,040 97,230
Workings:
W1
Retained earnings,
1 April 20X1 44,000 22,500 12,250 1 50,680*
800 2
2,050 4
720 5
W2
Non-controlling
interests,
1 April 20X1 200 2,1 6,000 7,670**
- 4 2,050
180 5
966
Answers to exam practice questions
HK$'000 20%
Profit for the year before adjustment 3,750 750
Less: depreciation on undervalued plant and equipment CJE 2 (500) (100)
Add: previous year’s unrealised profit now realised CJE 5 (2,500k – 1,600k) 900 180
Less: current year's unrealised profit CJE 6 [35% (9,000k-6,000k)] (1,050) (210)
Adjusted profit 3,100
NCI's share 20% 620 620
967
Financial Reporting
*Alternatively, share of profits of associates may be debited instead of gain on disposal, i.e. EA2
Elimination of intercompany sales of PPE (10,000k–8,000k) 4 years / 5 years unrealised 30%
Associate
968
Answers to exam practice questions
969
Financial Reporting
During the period from 1 October 20X7 to 31 March 20X8 (after the disposal of the
2,400,000 shares), the investment in 30% equity interest in SWL 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 MCL's share of SWL's profit or
loss after the date SWL became an associate. MCL's share of SWL's profit or loss will
be recognised in MCL's consolidated profit or loss.
HKFRS 10 states that the income and expenses of a subsidiary are included in the
consolidated financial statements from the acquisition date, i.e. the date on which the
acquirer effectively obtains control of the acquiree, until the date on which the parent
ceases to control the subsidiary. Thus, SWL's income and expenses from 1 April 20X7
to 30 September 20X7 should be included in the consolidated financial statements for
the year ended 31 March 20X8.
The difference between the proceeds from the disposal of the subsidiary plus the fair
value of the interest retained and the carrying amount of the net assets as of the date
of disposal is recognised in the consolidated statement of profit or loss as the gain or
loss on the disposal of the subsidiary.
In MCL's separate financial statements for the year ended 31 March 20X8, the
investment in SWL would continue to be accounted for at cost.
(c) Difference in gains on disposal at entity and consolidated level
During the period from 1 April 20X7 to 30 September 20X7 (before the disposal of the
2,400,000 shares), the investment in 60% equity interest in SWL shall be accounted for as a
subsidiary.
The difference between the proceeds from the disposal of a 30% equity interest in SWL plus
the fair value of the 30% equity interest retained and the carrying amount of the net assets in
the consolidated financial statements as of the date of disposal is recognised in the
consolidated statement of profit or loss as the gain or loss on the disposal of the subsidiary.
The relevant carrying amount as of the date of disposal to be recognised in the consolidated
statement of financial position should have already been increased or decreased to
recognise MCL's share of SWL's profit or loss after the date of acquisition since MCL's share
of SWL's profit or loss will be recognised in MCL's consolidated profit or loss.
However, when separate financial statements are prepared, investments in subsidiaries shall
be accounted for either at cost, or in accordance with HKFRS 9.
In this case, MCL stated the investment at cost. Thus the calculation of gain or loss on
disposal will be based simply on the difference between proceeds from the disposal and the
cost of the investment.
(d) Impact of rights issue on EPS of MCL for 20X8
In this rights issue, the exercise price ($9) of the rights issue is less than the fair value of the
shares ($12). Therefore such a rights issue includes a bonus element.
In calculating the basic EPS for the current year, the number of ordinary shares from 1 April
20X7 to 31 December 20X7 to be used in calculating basic earnings per share would be
adjusted by the following bonus factor:
Fair value per share immediately prior to the exercise of rights
Theoretical ex-rights fair value per share
970
Answers to exam practice questions
of the rights, and dividing by the number of shares outstanding after the exercise of the
rights.
2 shares at fair value of $12 prior to rights issue = $24
1 share at discounted rights issue price of $9 = $9
Ex-rights price (3 shares at fair value of $33 after issue) = $33/3 = $11
The bonus factor = $12 / $11 = 1.09
Since the rights issue is made part way through the year (1 January 20X8), a time-
apportionment is required.
Thus, weighted average number of ordinary shares outstanding:
10,000,000 shares 12/11 9/12 = 8,181,818
plus (10,000,000 + 5,000,000) shares 3/12 = 3,750,000 = 11,931,818
The comparative basic EPS i.e. basic EPS for the year ended 31 March 20X7, should be
adjusted accordingly by dividing by the factor of 1.09.
I hope the above explanation has answered your questions. Please feel free to contact me if
you have further queries.
Best regards
Pindy Lee
971
Financial Reporting
Workings
1 Group structure
Home
1.8.X4 100%
972
Question bank – questions
973
Financial Reporting
974
Question bank – questions
975
Financial Reporting
Required
Assume that you are the accounting manager, and you are required to draft a memorandum to Ms.
Chen, a Director of PCF. In your memorandum, you should:
(a) discuss and calculate the effect of the business combination, at 31 March 20Y0, on the
25 per cent equity interests in SNT held by PCF in the separate financial statements of PCF
and at consolidated level (ignore taxation); (14 marks)
(b) discuss the rationale for the recognition of the intangibles in the consolidated financial
statements that are not recognised in the financial statements of SNT; (10 marks)
(c) calculate the amount of goodwill as at 31 March 20Y0 if deferred tax implications are
ignored; (5 marks)
(d) discuss the rationale and calculate the effect on goodwill if deferred tax implications follow
from recognising the difference between the fair values and book values of the identifiable
net assets is taken into consideration (assuming a tax rate of 16 per cent); and (10 marks)
(e) discuss and calculate the amount of revenue in relation to 200,000 loyalty points, granted
before 1 April 20X8, to be recognised for the year ended 31 March 20X9 and 31 March
20Y0. (11 marks)
(Total = 50 marks)
HKICPA February 2010 (amended)
976
Question bank – questions
Question 2 90 minutes
Assume that you are Mr. Vincent Lee, the accounting manager of Peter Wong Equipment Group
Limited (PWE). PWE is a company incorporated in Bermuda with limited liability. Its shares are
listed on The Stock Exchange of Hong Kong Limited (the “Hong Kong Stock Exchange”).
The consolidated financial statements are presented in Hong Kong dollars, which is the same as
the functional currency of PWE. PWE has a number of subsidiary companies in various countries.
On 1 April 20X1, PWE acquired an equity interest in Sandy Jolly Limited (SJL), a company
incorporated in Hong Kong. The following are the extracts of the draft consolidated financial
statements of PWE for the year ended 31 March 20X2 and the statement of financial position of SJL
as at 1 April 20X1, the date of acquisition.
Consolidated statement of profit or loss and other comprehensive income of PWE (the Group)
for the year ended 31 March 20X2 (extract)
HK$’000
Revenue 853,000
Cost of sales (800,350)
Gross profit 52,650
Administrative expenses (35,100)
Finance costs (2,300)
Share of profits of associates 1,650
Profit before tax 16,900
Tax expense (1,050)
Profit for the year (Note 1) 15,850
977
Financial Reporting
Additional information
1 Profit for the year has been arrived at after charging (crediting):
HK$’000
Auditor’s remuneration 1,000
Depreciation of property, plant and equipment 32,600
Exchange loss arising on translating the foreign currency bank deposits 500
Exchange loss arising on translating the foreign currency bank loans 1,260
Impairment loss recognised in respect of trade receivables 711
Loss on disposal of property, plant and equipment (Note 3) 2,500
Operating lease rentals 200
Release of prepaid land lease payments 600
2 PWE issued 3,000,000 new ordinary shares (in addition to 10,000,000 existing shares) at
HK$10 each, which have a total fair value of HK$30,000,000 at the acquisition date, and
paid cash of HK$4,000,000, in consideration for 80% of SJL’s shares. At the date of
acquisition, all of SJL’s assets and liabilities were recorded at their fair values. The fair value
of non-controlling interests of SJL was recorded as HK$8,000,000 on the acquisition date.
During the year, PWE did not make any further issue of ordinary shares.
3 An analysis of the movement on the Group’s property, plant and equipment during the year
showed that the property, plant and equipment with a carrying amount of HK$29,000,000
was sold for HK$26,500,000.
4 During the year, no goodwill has suffered from any impairment and the Group has not repaid
any bank loans.
5 The increase in the other reserves is solely attributed to the controlling shareholders' share
of the translation reserve arising on the translation of foreign subsidiaries.
6 The exchange difference arising on the translation of foreign subsidiaries is summarised as
below:
HK$'000
Trade and other receivables 4,500
Trade and other payables (1,500)
Cash and cash equivalents 2,000
5,000
7 The certificate of deposit is a 5-year certificate of deposit that pays 4% compounded semi-
annually with a maturity date of 31 December 20X6.
978
Question bank – questions
8 Included in cash and cash equivalents are foreign currency demand deposits. An exchange
loss of HK$500,000 arises on the translation of these foreign currency demand deposits.
You have prepared the draft consolidated financial statements of PWE for the year ended
31 March 20X2. After you sent these draft consolidated financial statements to PWE’s directors for
review, one of the directors, who is not a certified public accountant, sent you an e-mail as follows:
Assume that you are the accounting manager, a certified public accountant, and you are required
to draft a memorandum to Fatima Choi, a Director of PWE. In your memorandum, you should:
(a) discuss the appropriate treatment of the certificate of deposit with reference to:
(i) the accounting standards; and (5 marks)
(ii) the ethical issues (6 marks)
(b) discuss the disclosure requirements relating to the fact that various new HKFRSs have been
issued but are not yet effective and are not early adopted; (6 marks)
(c) briefly describe the presentation requirement of the cash flow effects of the acquisition of
SJL. Show the calculation of goodwill and the net cash flow arising on the acquisition of
SJL; and (10 marks)
(d) prepare an annex to your memorandum showing the Consolidated Statement of Cash Flows,
using the indirect method, for PWE for the year ended 31 March 20X2, beginning with profit
before tax. All figures should be rounded to the nearest HK$’000. (23 marks)
(Total = 50 marks)
HKICPA June 2012 (amended)
979
Financial Reporting
Question 3 81 minutes
Assume that you are Mr. Tommy Lau, the accounting manager of Papaya Limited (PPY). PPY is a
company incorporated in Hong Kong and is principally engaged in the manufacturing of consumer
products. PPY acquired 80 per cent of the ordinary shares of Sheffield Limited (SFL) for
HK$25,600,000 on 1 April 20X7.
At the acquisition date, SFL reported retained earnings of HK$12,000,000 and no revaluation
reserve. The carrying amount of all assets and liabilities approximated the fair value except for
intangible assets. The fair and book values of the intangible assets of SFL (with a remaining life of
ten years), excluding deferred tax liability on fair value adjustments, is HK$18,500,000 and
HK$16,000,000 respectively at the date of acquisition.
Non-controlling interests are measured as the non-controlling interest's proportionate share of the
acquiree's net identifiable assets as at acquisition date. Investment in SFL was carried at cost. Both
companies did not have any reserves other than retained earnings and revaluation reserves.
On 1 April 20X7, PPY commenced construction of a plant which was expected to take three years
to complete. In the year ended 31 March 20Y0, HK$600,000 interest which qualified for
capitalisation had not been capitalised in the draft accounts.
On 1 April 20X9, PPY held inventory purchased from SFL during the year ended 31 March 20X9
for HK$1,200,000 which had been manufactured by SFL at a cost of HK$800,000. During the year
ended 31 March 20Y0, SFL sold goods costing HK$3,200,000 to PPY for HK$4,800,000. PPY sold
the inventory on hand at the beginning of the year, but continued to hold 40 per cent of its 20X9
purchases from SFL on 31 March 20Y0. It is the group's accounting policy to allocate to non-
controlling interests the adjustments to unrealised profits from upstream transactions. The tax rate
for the years of assessment from 20X7/X8 to 20X9/Y0 was 16.5 per cent.
PPY holds an investment property which was let out, charging arm’s length rentals, to a senior
manager of SFL. PPY acquired this property on 1 April 20X9 at a price of HK$6,000,000. The
estimated useful life of the property was 50 years from 1 April 20X9. The fair value of the property
at 31 March 20Y0 remains at HK$6,000,000 and the rental income to PPY for the year ended
31 March 20Y0 amounts to HK$300,000. This property is included in PPY's statement of financial
position at its fair value as an investment property. PPY adopts the revaluation model for property,
plant and equipment, except for construction in progress, which is stated at cost. Intangible assets
are carried at cost. Depreciation is provided using the straight line method.
The draft financial data of the two companies for the year ended 31 March 20Y0 are shown below:
PPY SFL
HK$ HK$
Sales 80,000,000 38,400,000
Cost of sales* (51,200,000) (25,600,000)
Gross profit 28,800,000 12,800,000
Other income (Dividend income) 1,280,000 –
Distribution costs (3,000,000) (2,300,000)
Administrative expenses (5,000,000) (2,500,000)
Finance costs (5,760,000) (1,120,000)
Profit before tax 16,320,000 6,880,000
Income tax expense (3,520,000) (2,080,000)
Profit for the year 12,800,000 4,800,000
Other comprehensive income that will not be reclassified to
profit or loss: revaluation surplus 6,000,000 1,200,000
Total comprehensive income for the year 18,800,000 6,000,000
* Cost of sales includes the depreciation of the plant and amortisation of intangible assets
980
Question bank – questions
Retained Revaluation
Share capital earnings surplus Total equity
HK$ HK$ HK$ HK$
PPY
Balance, 1 April 20X9 32,000,000 36,400,000 4,000,000 72,400,000
Total comprehensive income – 12,800,000 6,000,000 18,800,000
Dividends – (3,200,000) – (3,200,000)
Balance, 31 March 20Y0 32,000,000 46,000,000 10,000,000 88,000,000
Retained Revaluation
Share capital earnings surplus Total equity
HK$ HK$ HK$ HK$
SFL
Balance, 1 April 20X9 16,000,000 21,800,000 1,000,000 38,800,000
Total comprehensive income – 4,800,000 1,200,000 6,000,000
Dividends – (1,600,000) – (1,600,000)
Balance, 31 March 20Y0 16,000,000 25,000,000 2,200,000 43,200,000
PPY SFL
HK$ HK$
Property, plant and equipment, net 40,000,000 7,600,000
Investment property 20,800,000 12,000,000
Investment in SFL, at cost 25,600,000 –
Intangible assets, net – 11,200,000
Inventories 51,200,000 21,600,000
Trade and other receivables 25,000,000 14,000,000
Cash and cash equivalents 23,000,000 10,400,000
185,600,000 76,800,000
981
Financial Reporting
Required
Assume that you are Tommy Lau, the accounting manager, and you are required to draft a
memorandum to Gabriel Wong, a Director of PPY. In your memorandum, you should:
(a) discuss the reason for the different figures for the investment property in the consolidated
financial statements and in the financial statements of PPY; and (7 marks)
(b) prepare an annex to your memorandum showing worksheets for:
(i) the consolidated statement of profit or loss and other comprehensive income, and
(12 marks)
(ii) the consolidated statement of financial position. (26 marks)
(Total = 45 marks)
(Consolidation adjustments are to be shown in the form of a worksheet. You have to show
the detailed calculations of each figure though journal entries are not required.)
HKICPA December 2010 (amended)
982
Question bank – questions
Question 4 54 minutes
Assume that you are Mr. Ricky Lam, the accounting manager of Sun Tech Limited ("STL"). STL is
a company incorporated and listed in Hong Kong and is principally engaged in the manufacturing of
electronic products.
In June 20X8, STL made an offer to the shareholders of Moon-night Limited ("MNL") to acquire a
controlling interest in the 400 million shares of MNL. STL was prepared to pay $1.50 cash per
share, provided that 70% of the shares could be acquired. The directors of MNL recommended that
the offer be accepted. By 1 July 20X8, when the offer expired, 75% of the shares had changed
hands and were now in the possession of STL.
STL also acquired 25% of the 400 million shares of Earth-ray Limited ("ERL") on 1 July 20X8 for a
cash consideration of $145 million. A summary of the acquisition of the shares of MNL and ERL by
STL is as follows:
Share capital Retained
Date of % Cost of at acquisition earnings at Net assets at
acquisition acquired investment date acquisition date acquisition date
$'000 $'000 $'000 $'000
MNL 1 July 20X8 75 450,000 400,000 160,000 560,000
ERL 1 July 20X8 25 145,000 400,000 180,000 580,000
The following table summarises information from the three companies' statements of profit or loss
for the year ended 30 June 20X9:
STL MNL ERL
$'000 $'000 $'000
Revenue 878,900 388,900 300,000
Cost of sales (374,400) (112,400) (120,000)
Gross profit 504,500 276,500 180,000
Other income 14,000 16,000 15,000
Distribution and administrative costs (216,200) (115,800) (120,000)
Depreciation and amortisation (30,000) (10,000) (10,000)
Profit before tax 272,300 166,700 65,000
Tax (112,400) (50,000) (24,000)
Profit for the year 159,900 116,700 41,000
The fair value of the identifiable net assets of MNL and ERL at the date of acquisition was the
same as the carrying amount of those assets. Neither company had any reserves other than
retained earnings.
During the year ended 30 June 20X9, STL sold goods to MNL and ERL at an invoiced value of
$100 million and $15 million respectively. STL invoiced goods to its subsidiary and associated
company at cost plus 20%. One-third (1/3) of the goods and half (1/2) of the goods were still held in
MNL's inventory and in ERL's inventory respectively at 30 June 20X9.
On 1 July 20X8, MNL sold equipment to STL for $60 million. At that date, the carrying amount of
the equipment was $52 million and the equipment was estimated to have a remaining useful life of
10 years. The resulting gain was recorded as other income by MNL. STL has adopted an
accounting policy which depreciates plant and equipment using the straight line method with no
residual value. It is also the group policy that non-controlling interest shall be measured at the non-
controlling interest's proportionate share of the subsidiary's identifiable net assets.
Joint venture
STL is considering a joint venture with Johnson Limited ("JSL"). STL and JSL will have equal
interests in the joint venture, which will be set up as a separate legal entity. JSL will contribute
$10 million in cash while STL will contribute machinery which is stated in its statement of financial
position at a cost of $12 million and a carrying amount of $8 million. The machinery has a fair value
983
Financial Reporting
assessed as $10 million on the basis of its depreciated replacement cost. It is noted that the
significant risks and rewards of ownership of the contributed machinery can be transferred to the
joint venture and the resulting gain can be reliably measured.
You have prepared draft consolidated financial statements of STL for the year ended
30 June 20X9. After you sent these draft consolidated financial statements to STL's directors for
review, one of the directors, who is not a certified public accountant, sent you an email as follows:
Required
Prepare a memorandum in response to the issues raised by Mr. Sunny Sun. In your
memorandum, you should:
(a) briefly discuss the reason for the goodwill and calculate the amount of goodwill as shown in
the consolidated statement of financial position; (5 marks)
(b) discuss how STL should account for its contribution to the joint venture and prepare the
relevant journal entries in STL's separate financial statements and in the consolidated
financial statements; (10 marks)
(c) discuss why tax effects of adjustments for intragroup transactions are needed. Illustrate, with
appropriate calculation, by using the intragroup sales of goods from STL to MNL as an
example (assume a tax rate of 16%); (7 marks)
(d) explain why the amount of sales from STL to ERL has not been eliminated in the
consolidated statement of profit or loss. Discuss and calculate the amount of ERL's profit that
STL should share (assume a tax rate of 16%). (8 marks)
(Total = 30 marks)
HKICPA May 2009 (amended)
984
Question bank – questions
Question 5 90 minutes
Assume that you are Mr. John Chan, the accounting manager of Global Resources Limited
("GRL"), which is a company incorporated in Hong Kong and listed in the Growth Enterprise Market
of The Stock Exchange of Hong Kong Limited. GRL and its subsidiaries (GRL Group) are
principally engaged in the natural resources business in the People's Republic of Bangladesh; and
the provision of medical equipment services and related accessories, and the provision of medical
research and development services in mainland China. Now, GRL intends to disinvest its
investment in the medical research and development business.
Asia Medical Research Limited ("AMR")
On 1 April 20X8, GRL acquired 600,000 of the 1,000,000 ordinary shares issued by Asia Medical
Research Limited ("AMR") for $7.5 million in cash. On that date, the fair value of the net identifiable
assets of AMR was the same as their carrying amount, and the share capital and retained earnings
of AMR were $1 million and $9 million respectively with no other components of equity. GRL is
entitled to appoint three out of the five directors on the board. All board decisions are made by
simple majority resolution. On 1 April 20Y1, AMR issued 500,000 shares to a new investor, Simon
Firth Limited ("SFL"), for $8 million. As a result, GRL's shareholdings in AMR decreased to 40%.
In addition, SFL has the right to appoint two new directors to the board making a total of seven
directors on the board. The fair value of GRL's investment in AMR was valued at $9.6 million on
1 April 20Y1.
China Development Services Limited ("CDS")
On 1 April 20Y0, GRL acquired 2,640,000 ordinary shares in China Development Services Limited
("CDS") for $12 million in cash. Thus GRL owns 2,640,000 out of the 4,000,000 shares of CDS,
giving it a 66% interest. On 1 April 20Y1, CDS issued 400,000 shares to a new investor, Michael
Sun Limited ("MSL"), for $5.5 million. As a result, GRL's shareholdings in CDS decreased to 60 per
cent. The carrying amount of CDS's net identifiable assets in the consolidated financial statements
of GRL, as at 31 March 20Y1, was $12.9 million.
Other relevant information:
(i) At the date of acquisition, the fair values of CDS's assets were equal to their carrying
amounts with the exception that the fair value of CDS's inventory was $500,000 below its
carrying amount; and it was written down by this amount shortly after acquisition as an
impairment loss and it has not changed in its fair value since then.
(ii) On 2 April 20Y0, GRL sold an item of plant to CDS at $2.5 million. Its carrying amount prior
to the sale was $2 million. The estimated remaining useful life of the plant at the date of sale
was five years. GRL, AMR and CDS depreciate their property, plant and equipment using
the straight line method.
(iii) There were no intra-group payables or receivables at 31 March 20Y1. No dividends were
paid during the year by any of the said companies.
(iv) It is the group's policy to measure non-controlling interests at its proportionate share of the
subsidiary's net identifiable assets at the acquisition date. Goodwill arising from the
acquisition of AMR and CDS has not subsequently been impaired. For the assets of both
AMR and CDS, no gain or loss has been previously recognised in other comprehensive
income.
Ms. Linda Ho, a director of GRL is concerned about the implications of the above transactions and
information. She wondered if it may result in any gain or loss to be recognised and if it may make
any difference in the consolidation process.
985
Financial Reporting
The draft statements of financial position of the companies at 31 March 20Y1 are:
GRL AMR CDS Total
$’000 $’000 $’000 $’000
ASSETS
Non-current assets
Property, plant and equipment 18,400 9,000 10,400 37,800
Investment in AMR 7,500 - - 7,500
Investment in CDS 12,000 - - 12,000
Current assets
Inventory 5,900 3,000 4,200 13,100
Accounts receivable 2,200 2,000 1,500 5,700
Cash 1,000 1,000 2,000 4,000
47,000 15,000 18,100 80,100
Required
Assume that you are John Chan, the accounting manager, and you are required to draft a
memorandum to Ms. Linda Ho, a Director of GRL. In your memorandum, you should:
(a) discuss and advise, with calculations, the accounting treatments for the investment in AMR
in the consolidated financial statements of GRL on 1 April 20Y1;
(14 marks)
(b) discuss and advise, with calculations, the accounting treatments for the investment in CDS in
the consolidated financial statements of GRL on 1 April 20Y1; and
(10 marks)
(c) prepare an annex to your memorandum showing worksheets for the consolidated statement
of financial position of GRL as at 1 April 20Y1 after considering the transactions and other
information. Ignore the deferred tax implications.
(26 marks)
(Total = 50 marks)
(Consolidation adjustments are to be shown in the form of a worksheet. You have to show
the detailed calculations of each figure, but journal entries are not required.)
HKICPA December 2011
986
Question bank – questions
Question 6 90 minutes
Assume that you are Miss Melody Li, the accounting manager of Magic Holding Limited (MHL),
which is a company incorporated in Hong Kong. MHL’s functional and presentation currency is the
Hong Kong dollar (HKD).
On 31 December 2011, MHL acquired 80% of the ordinary share capital of Stone Dove Limited
(SDL), which is located in Australia. At the date of acquisition, SDL’s share capital was 24 million
Australian dollars (AUD24 million) and the retained earnings were AUD30 million. SDL had not
issued any share capital since its acquisition by MHL. The following financial statements relate to
MHL and SDL for the year ended 31 December 20X2.
Statement of retained earnings of MHL and SDL for the year ended 31 December 20X2
MHL SDL
HKD’000 AUD’000
Retained earnings, 1 January 694,500 30,000
Profit after tax 90,000 10,000
Retained earnings, 31 December 784,500 40,000
Statement of financial position for MHL and SDL as at 31 December 20X2
MHL SDL
HKD’000 AUD’000
ASSETS
Non-current assets 1,170,000 76,000
Investment in SDL 427,500 –
Current assets
Inventory 225,000 6,000
Accounts receivable 120,000 12,000
Cash 27,000 6,600
Total assets 1,969,500 100,600
987
Financial Reporting
988
Question bank – questions
(c) Calculate the total translation reserves to be presented in the consolidated statement
of financial position of MHL as at 31 December 20X2.
(You may consider analyse into translation reserves on net assets, fair value adjustment and
goodwill, or use other presentation method to calculate the translation reserves).
(14 marks)
(d) Prepare an annex to your memorandum showing the worksheets for the consolidated
statement of financial position of MHL as at 31 December 20X2. (21 marks)
(Recognise the deferred tax implications at the relevant tax rate. Assume that appropriate
accounting treatments have been made in the statements of retained earnings and
statements of financial position as presented.
Consolidation adjustments are to be shown in the form of a worksheet. For Question 1(d),
you may use the template in green colour paper provide and/or the script booklet for Case
Questions to prepare your answers. You have to show the detailed calculations of each
figure, but journal entries are not required).
HKICPA December 2013 (amended)
Question 7 90 minutes
Assume that you are Mr. Raymond Wong, the accounting manager of Debussy Limited (DBL),
which is principally engaged in the manufacture and sale of musical instruments. DBL is a
company incorporated in Hong Kong and is listed on the Main Board of the Stock Exchange of
Hong Kong. The financial year end date of DBL is 30 September. DBL acquired 70% of the
ordinary shares of Stanford Limited (STF) for $768 million on 1 October 20W8.
At the acquisition date, STF reported retained earnings of $350 million and a revaluation reserve of
$10 million. The carrying amount of all assets and liabilities approximated the fair value except for
intangible assets. The book and fair values of the intangible assets of STF (with a remaining useful
life of eight years), excluding deferred tax liability on fair value adjustments, were $40 million and
$120 million respectively at the date of acquisition.
Non-controlling interests are measured as the non-controlling interest’s proportionate share in the
recognised amounts of the acquiree’s net identifiable assets as at the acquisition date. Investment
in STF was carried at cost. Both companies had no reserves other than retained earnings and
revaluation reserves.
On 1 October 20X1, DBL held inventory purchased from STF at an invoiced price of
$36 million which had been manufactured by STF at a cost of $24 million. During the six months
ended 31 March 20X2, STF sold musical instruments costing $96 million to DBL for $144 million.
As at 31 March 20X2, DBL had sold the entire beginning inventory, but continued to hold 35% of its
current period purchases from STF.
DBL adopted the revaluation model for property, plant and equipment while intangible assets were
carried at cost. Depreciation and amortisation is provided using the straight-line method. The tax
rate for the years of assessment from 20W8/W9 to 20X1/X2 was 16.5%.
On 1 May 20X2, DBL entered into a contract with Forever Young Limited (FYL). The contract
requires DBL to make a ten-year variable rate $30 million loan to FYL while FYL at the same time
makes a ten-year fixed rate loan for the same amount to DBL. There are no transfers of principal
at inception of the two loans, since DBL and FYL have a netting agreement. During the ten years,
DBL will pay a fixed rate of 3% per six months and receive a variable amount based on six-month
HIBOR, reset on a semi-annual basis. The fixed and variable amounts are determined on the
basis of a principal amount of $30 million.
989
Financial Reporting
The draft financial data of the two companies for the six months ended 31 March 20X2 are shown
below:
DBL STF
$'000 $'000
Sales 2,400,000 1,152,000
Cost of sales (1,536,000) (769,000)
Gross profit 864,000 383,000
Other income (including dividend income) 38,000
Distribution costs (90,000) (69,000)
Administrative expenses* (150,000) (75,000)
Finance costs (172,000) (34,000)
Profit before tax 490,000 205,000
Income tax expense (106,000) (61,000)
Profit for the period 384,000 144,000
Other comprehensive income that will not be reclassified to
profit or loss: revaluation surplus 180,000 36,000
Total comprehensive income for the period 564,000 180,000
STF
Balance, 1 October 20X1 480,000 654,000 30,000 1,164,000
Total comprehensive income – 144,000 36,000 180,000
Dividends – (48,000) – (48,000)
Balance, 31 March 20X2 480,000 750,000 66,000 1,296,000
DBL STF
$'000 $'000
Property, plant and equipment, net 1,824,000 788,000
Investment in STF, at cost 768,000 –
Intangible assets, net – 136,000
Inventory 1,536,000 648,000
Trade and other receivables 750,000 420,000
Cash and cash equivalents 690,000 312,000
5,568,000 2,304,000
990
Question bank – questions
DBL STF
$'000 $'000
Share capital 960,000 480,000
Retained earnings 1,380,000 750,000
Revaluation surplus 300,000 66,000
2,640,000 1,296,000
Trade and other payables 1,428,000 408,000
Long term loan 1,500,000 600,000
5,568,000 2,304,000
You have prepared the draft condensed consolidated financial statements of DBL for the six
months ended 31 March 20X2. After you sent these draft condensed consolidated financial
statements to DBL’s directors for review, one of the directors, Ms. Janice Lam, sent you an e-mail
as follows:
Condensed consolidated financial statements of DBL for the six months ended 31 March 20X2
Could you please clarify the following points relating to DBL’s draft condensed consolidated
financial statements which I have just reviewed.
(a) I know that our interim financial report has complied with the requirements of HKAS 34, and
thus we have complied with this HKFRS. Why don’t you say that we have complied with
HKFRSs in the notes to the financial statements? By the way, I understand that we have to
disclose segment information in our annual financial statements. However, this is only the
interim financial report; I don’t think we need to disclose segment information!
(b) I am puzzled about the disclosure in relation to related parties. Who actually are the related
parties of DBL? I understand that I am related to DBL because I am a director of DBL, but I
don’t think my private business, Beethoven Limited (BTV), is related. Although I have a
100% investment in BTV, which purchases musical instruments regularly from STF, it is not
related to DBL in any sense!
(c) I know that we have just entered into a contract with FYL. How shall we account for this
contract?
(d) I find that it is difficult to obtain the figures in the condensed consolidated financial
statements. Can you tell me more about how you arrived at each figure?
I would appreciate your clarification for the upcoming board meeting.
Best regards,
Janice
991
Financial Reporting
(c) discuss and identify the related party relationship among DBL, BTV and STF in their
respective financial statements; (7 marks)
(d) briefly discuss and advise the appropriate accounting treatment of the contract with
FYL. Detail calculation is not required; and (5 marks)
(e) prepare an annex to your memorandum showing worksheets for:
(i) the condensed consolidated statement of profit or loss and other
comprehensive income for the six months ended 31 March 20X2, and
(11 marks)
(ii) the condensed consolidated statement of financial position as at
31 March 20X2. (19 marks)
(Consolidation adjustments are to be shown in the form of a worksheet. For Question
1(e), you may use the template in green colour paper provided and/or the script
booklet for Case Questions to prepare your answers. You are required to show the
detailed calculations for each figure, journal entries are not required.)
HKICPA June 2013 (amended)
Question 8 90 minutes
Assume that you are Miss Karen Lam, the accounting manager of Proper Holdings Limited (PHL),
which is a company incorporated in Hong Kong. PHL had a partially-owned subsidiary, Sunderland
Limited (SDL), and an 25% associate, Assorted Limited (ASL), for many years.
On 1 January 20X2, PHL acquired an 85% interest in Supercar Limited (“SPC”) by issuing
10,560,000 ordinary shares (with a fair value of $13,200,000) and paying $2,272,000 in cash. The
fair value of non-controlling interests at the date of acquisition was $2,880,000. There is no
impairment of goodwill since the date of acquisition of SPC. PHL classifies cash received from
investment income under the category of investing activities.
Fair value of the net identifiable assets of SPC as at the acquisition date is as follows:-
$’000
Non-current asset
Machinery 7,920
Current assets
Inventory 1,536
Accounts receivable 1,344
Cash and cash equivalent 5,376
Current liabilities
Accounts payable 3,264
Tax payable 816
992
Question bank – questions
Profit for the year and total comprehensive income attributable to:
Owners of PHL 74,700
Non-controlling interests 6,000
80,700
20X2 20X1
$’000 $’000
ASSETS
Non-current assets
Goodwill 6,256
Investments in associates 66,000 60,000
Buildings at net book value 122,680 132,000
Machinery at cost 180,000 84,000
Less: Accumulated depreciation (72,000) 108,000 (66,000) 18,000
Financial assets measured at fair value 24,600 24,600
through other comprehensive income
Current assets
Inventory 118,500 60,000
Accounts receivable 111,000 76,500
Cash and cash equivalents 272,464 109,200
829,500 480,300
993
Financial Reporting
20X2 20X1
Non-current liabilities
Obligation under finance lease 882 1,280
Bank borrowings 129,318 38,920
Current liabilities
Accounts payable 44,002 28,428
Obligation under finance lease 398 372
Tax payable 29,520 13,800
Accrued interest 2,400 1,800
829,500 480,300
Non-current assets
There have been no acquisitions or disposals of buildings during the year ended
31 December 20X2. During the year, machinery with an original cost of $28 million was sold for
$30 million resulting in a gain of $6 million. The gain on the disposal was included in the operating
profit and there was a new machinery acquired in 20X2.
Leased machinery
On 1 January, 20X1, PHL leased a machinery under a five-year non-cancellable lease agreement.
Equal annual payments of $487,805 that are due on 31 December each year provide the lessor
with a 7% return on net investment. Titles to the machinery will pass to PHL at the end of the
lease. The fair value of the machinery is $2,000,000 and the expected useful life is 8 years. The
present value factor for an annuity for 5 periods discounted at 7% is 4.100.
Share - based payment
On 1 November 20X1, PHL approved a plan that granted the top executive of its subsidiary, SDL,
options to purchase a total of 1,000,000 shares of PHL’s ordinary shares at $1.25 per share. The
options were granted on 1 January 20X2, vest on 31 December 20X5, and may be exercised from
1 January 20X6 to 31 December 20X7. Using the Black-Scholes model, the fair value of each
option was estimated at $0.50.
Question 1 (50 marks – approximately 90 minutes)
Assume that you are Karen Lam, the accounting manager, and you are required to draft a
memorandum to Ms. Tess Chow, a Director of PHL. In your memorandum, you should:
(a) Briefly describe the disclosure requirement under HKAS 7 relating to the acquisition
of a subsidiary and prepare a disclosure note to the consolidated financial statements
on the net cash flows in the acquisition of SPC as a subsidiary. (6 marks)
(b) Advise the appropriate accounting treatment, with journal entries, for the
share-based payment made by PHL in the individual financial statements of SDL and
PHL, and in the consolidated financial statements of PHL for the year ended 31
December 20X2. (The correct entries have already been made in the draft consolidated
financial statements as presented). (10 marks)
(c) In relation to the leased machinery of PHL, for the first two years (up to
31 December 20X2) (Round to nearest dollar):
(i) advise PHL (lessee) as to the appropriate accounting treatment for the lease and
calculate the outstanding lease liabilities; and
(ii) prepare the relevant journal entries for PHL (lessee) of the lease.
(13 marks)
(d) Prepare an annex to your memorandum showing the consolidated statement of cash
flows of PHL for the year ended 31 December 20X2, using the indirect method starting
with profit before taxation. (21 marks)
HKICPA June 2014 (amended)
994
Question bank – questions
Question 10 27 minutes
Howard Development Limited ("HDL") has financial difficulties and successfully renegotiated the
contractual terms of a bank loan of principal HK$200 million on 30 June 20X9, the date of the
statement of financial position:
Original Modified
Term of interest 8 per cent payable yearly in 6 per cent payable yearly in
arrears arrears since 1 July 20X9
Date of repayment 30 June 20Y0 30 June 20Y3
The original effective interest rate is 8 per cent. No fees for renegotiating the finance are payable.
The holders of 100 units of HK$1 million, 4 per cent convertible bonds (the "Bonds") of HDL have
agreed to convert the Bonds into 250 million ordinary shares on 30 June 20X9 and waive the
payment of interest. Each unit of the Bonds was originally convertible into two million ordinary
shares and with a maturity date of 30 June 20Y0. Interest is payable yearly in arrears.
The carrying amount of the Bonds as at 30 June 20X9 is as follows:
HK$
Current liabilities:
The Bonds (effective interest rate: 8 per cent) 96,296,296
Bonds interest payable 4,000,000
Equity:
Convertible bonds equity reserve 7,133,058
The market price of the ordinary shares of HDL on 30 June 20X9 was HK$0.45.
995
Financial Reporting
Required
(a) Discuss the accounting treatment for HDL in relation to the modification of the terms of the
bank loan. (8 marks)
(b) Prepare the journal entries that HDL should make on 30 June 20X9 in relation to the
conversion of the Bonds. (7 marks)
(Total = 15 marks)
HKICPA February 2010
Question 11 25 minutes
Modern Department Store ("MDS") adopted a share option scheme which allows the board of
directors of the company to award share options to employees at nil consideration. On 1 April
20X8, 2,000,000 share options were granted to the Chief Operating Officer ("the COO"). Subject to
the continued employment of the COO with the company, one-fourth of the awarded share options
shall become vested at the end of each anniversary from the date of grant. MDS expects that all
the awarded share options will vest.
On 1 April 20Y0, MDS entered into an agreement with the COO to cancel the unvested awarded
share options at a consideration of HK$5,500,000.
Fair value of the share options of MDS (assuming same for different vesting dates):
1 April 20X8 HK$8
31 March 20X9 HK$3
31 March 20Y0 HK$5
1 April 20Y0 HK$5
Required
(a) Calculate the amount of compensation expense in relation to the share options awarded by
MDS for the years ended 31 March 20X9 and 31 March 20Y0 respectively. (4 marks)
(b) Explain the accounting implication of and calculate the compensation expense upon the
cancellation of the unvested awarded share options on 1 April 20Y0 to the financial
statements of MDS for the year ending 31 March 20Y1. (7 marks)
(c) Assuming that the share options were awarded to the director of Bargain Store (BS), a
subsidiary of MDS, instead of the COO of the company, without any intra-group charge for
such share-based payment arrangement, explain the accounting implication for the financial
statements of BS for the year ended 31 March 20Y0. (3 marks)
(Total = 14 marks)
HKICPA December 2010
Question 12 25 minutes
Anna Manufacturing Limited ("AML"), a company listed on the Hong Kong Stock Exchange, had a
convertible bond (CB) with a principal amount of HK$800 million issued on 1 December 20X8.
Fixed interest at 6 per cent per annum is payable annually in arrears. The holders are entitled to
convert the CB into 50 million ordinary shares of AML at any time before the redemption by AML at
30 November 20Y2 at principal amount.
On 1 April 20Y0, the holders of CB exercised their options to convert into shares in AML. On the
same date, AML borrowed an interest-free loan of HK$500 million from its major shareholder for a
term of two years.
996
Question bank – questions
Effective interest rate of AML's other external borrowings was 8 per cent and 6 per cent per annum
on 1 December 20X8 and 1 April 20Y0 respectively.
The functional currency of AML is the Hong Kong dollar.
Required
(a) Prepare journal entries for the issue of CB on 1 December 20X8. (5 marks)
(b) Prepare journal entries for the conversion of CB into shares on 1 April 20Y0. (5 marks)
(c) Prepare journal entries for the recognition of the interest-free loan on 1 April 20Y0. (4 marks)
(Total = 14 marks)
(Note. Tax effect is ignored.)
HKICPA December 2010
Question 13 11 minutes
Cleantech Motor Limited ("CML") is an overseas company incorporated in the British Virgin Islands
and registered under the Hong Kong Companies Ordinance in October 20X8 with a share capital of
HK$60 million contributed by two shareholders in cash. It is not a member of a corporate group.
During 20X9, CML incurred approximately HK$28 million for the development activities for an
electrical vehicle project, out of which approximately HK$5 million is not yet paid at the end of
financial period. A letter of intent has been signed with an automobile manufacturing company for
licensing the technology from CML at a consideration of not less than HK$50 million if it is
successfully developed. It was so far unable to complete the technical feasibility study on the
computerised energy saving monitoring system and no module is available for testing. The other
asset of the entity is cash kept at a bank. CML has 100 employees. The management does not
have intention to raise funds publicly at this moment.
Required
You are the auditors of CML. Advise the directors of CML whether they can prepare the financial
statements as at 31 December 20X9 in accordance with the Small and Medium-sized Entity
Financial Reporting Standard.
(6 marks)
HKICPA December 2010
Question 14 31 minutes
(a) Paper Box Limited ("PBL") is a manufacturer of paper-based packaging products. Due to
insufficient production capacity to meet the market demand for its products, PBL leased two
new printing machines from United Machinery Corporation ("UMC") for a fixed term of four
years. Monthly rental for the two machines is $200,000 for the first year and then increased
by $10,000 annually. The lease is non-cancellable and there are no rights to extend the
lease term or purchase the machines at the end of the term. The machines are required to
be returned to UMC upon expiry of the lease term. UMC sells similar machines at a price of
$12,000,000 per unit and the estimated useful life of each machine is 10 years.
Required
Discuss PBL's accounting treatment of the lease arrangement with UMC. (5 marks)
(b) PBL has three other printing machines which have been used for four years and their
estimated useful life is ten years. The carrying amount and the estimated fair value of the
machines are $15,000,000 and $18,000,000 respectively on 1 October 20Y1. On the same
date, PBL entered into an agreement with Easy Finance Limited (EFL) to sell the three
machines at $17,000,000 and lease them back for five years with an annual future lease
997
Financial Reporting
payment of $4,500,000. At the end of the lease term, PBL has an option to buy the
machines from EFL at $50,000.
Required
"As PBL has sold the machines to EFL, no amount should be reflected in the balance of
plant and equipment on the statement of financial position of PBL" according to PBL’s Chief
Operating Officer.
(i) Do you agree with the Chief Operating Officer? Explain PBL's accounting treatment
for the lease arrangement with EFL. (Discount rate of 8 per cent is used, if applicable)
(8 marks)
(ii) Discuss the impact on the accounting treatment of PBL of shortening the lease term to
three years with an annual future lease payment of $4,000,000 and cancellation of
PBL's options to buy the machines from EFL. (4 marks)
(Total = 17 marks)
HKICPA December 2011
Question 15 27 minutes
Marsh Global Limited ("MG") is a company listed on The Stock Exchange of Hong Kong Limited
with an issued capital of 1,000 million ordinary shares. The board of directors is considering the
funding needs to finance the expansion of its businesses in mainland China, and two options are
under discussion:
Option 1: A rights issue of 200 million ordinary shares at $5 per rights share.
Option 2: A four-year convertible bond of $1,000 million with semi-annual interest of 2 per cent
payable on 1 April and 1 October. Every $8 bond can be converted into 1 ordinary
share of MG from 1 July 20Y2 until 31 December 20Y5, the redemption date of the
convertible bond.
The relevant fund raising exercise is planned to be completed by the end of December 20Y1.
Required
You are the Chief Financial Officer of MG and you are requested by the board of directors to
prepare an analysis of the impact of these two options on:
(a) the financial position of MG as at 31 December 20Y1. (5 marks)
(b) the earnings per share of MG for the year ending 31 December 20Y2, assuming
(i) the estimated profit before finance expenses is $800 million, and
(ii) the funds raised and the expansion of business in mainland China will only affect the
earnings of MG from 20Y3; and
(6 marks)
(c) the disclosure of financial risks under HKFRS 7. (4 marks)
(Total = 15 marks)
(Assume MG's bank borrowings are carried at an interest rate of 2.5 per cent semi-annually and
ignore the tax effect.)
HKICPA December 2011
998
Question bank – questions
Question 16 27 minutes
On 1 July 20X8, Gibb Investment Inc. ("GII") entered into contracts for the following financial
instruments:
(a) An investment in 300,000 units of mandatorily convertible bonds ("Bonds") issued by a listed
company with a principal amount of in aggregate $15 million, carrying an interest rate of 6%
per annum payable semi-annually in arrears on 30 June and 31 December up to and
including 31 December 20Y0. On 31 December 20Y0, each unit of the Bonds will be
mandatorily converted into one share in the listed company at the conversion price of $50
per share.
(b) A deposit of a principal amount of $10 million with a commercial bank carries an interest rate
of 2.5% per annum and has a maturity date of 30 June 20Y0. Interest will be receivable at
maturity together with the principal. In addition, an additional 3% interest per annum will be
payable by the bank if the exchange rate of HKD against RMB exceeds or is equal to $1.15
to RMB 1.
Gll's functional currency is Hong Kong dollars.
Required
Explain how GII shall account for the above financial instruments in the financial statements for the
year ended 31 December 20X8. (15 marks)
HKICPA May 2009 (amended)
Question 17 22 minutes
Bestpoint Printing Limited ("BP"), established in the People’s Republic of China (PRC), is a wholly-
owned subsidiary of Glory Publishing Group ("GP"). BP is entitled to a two-year exemption from
foreign enterprise income tax (FEIT) from its first profit-making year, as computed under PRC
accounting standards (PRC GAAP) and tax regulations. For the following three years, it enjoyed a
50% reduction in the rate of FEIT. 20X3 was BP's first profit-making year. The standard tax rate for
BP was 24% for the periods up to 31 December 20X7. With the enactment of the new tax law
during 20X7, BP will be subject to FEIT at 25% for the year beginning 1 January 20X8. GP is
subject to Hong Kong profits tax at 17.5%.
BP acquired a printing machine on 1 July 20X3 at a cost of $20 million. For the purpose of FEIT
calculations, the machine is depreciated over 10 years with a residual value of 10% of the cost
from the corresponding date of acquisition, which is the same for the preparation of BP's PRC
GAAP financial statements. In the preparation of GP's consolidated financial statements, the
machine is depreciated over 16 years with nil residual value.
Required
(a) Calculate the deferred tax asset or liability position in relation to the machine at
31 December 20X7 accounted for in GP's consolidated financial statements. (5 marks)
(b) Prepare the journal entry(ies) to record the deferred income taxes at 31 December 20X8 for
GP's consolidated financial statements with calculations supporting the balances recorded.
(5 marks)
(c) Assuming GP has a deferred tax asset of $500,000 in respect of its own plant and
equipment at 31 December 20X8, explain how the deferred taxes will appear on the
consolidated statement of financial position at that date. (2 marks)
(Total = 12 marks)
HKICPA February 2008 (amended)
999
Financial Reporting
1000
Question bank – answers
1001
Financial Reporting
1002
Question bank – answers
Gain on step acquisition on previously held interest at consolidated level would be equal to:
The remeasured acquisition-date fair value of the 25% equity interest $
(25% $40,000,000) 10,000,000
Less: carrying amount of the 25% equity interest at consolidated level (7,750,000)
Thus, gain on step acquisition at consolidated level would be 2,250,000
1003
Financial Reporting
1004
Question bank - answers
1005
Financial Reporting
Thus the goodwill, after considering the deferred tax implication of the fair value differences
will be:
$
Original goodwill amount 8,000,000
+ deferred tax liability for inventory 128,000
+ deferred tax liability for intangibles 512,000
8,640,000
Or:
In this case, the carrying amount of net identifiable assets ($28,000,000) is increased
to its fair value ($32,000,000) but the tax base will remain at cost,
a taxable temporary difference of $4,000,000 arises,
which results in a deferred tax liability of 16% $4,000,000
= $640,000 and this affects the amount of goodwill.
$
Original goodwill amount 8,000,000
+ deferred tax liability for inventory and intangibles 640,000
8,640,000
Or:
$
Total fair value 40,000,000
– Fair value of SNT's recognised net identifiable assets, after tax
($32,000,000 – $128,000 – $512,000) 31,360,000
8,640,000
(e) Customer loyalty programme
According to the HK(IFRIC)-Int 13, SNT should apply paragraph 13 of HKAS 18 and account
for points of the loyalty programme as a separately identifiable component of the sales
transactions in which they are granted (the "initial sales").
The fair value of the consideration received or receivable in respect of the initial sales shall
be allocated between the award credits (the loyalty points) and the other component of the
sale.
Since SNT supplies the awards itself, SNT shall recognise the consideration allocated to
loyalty points as revenue only when loyalty points are redeemed and it fulfils its obligations to
supply awards. In other words, a portion of the consideration shall be allocated to loyalty
points and recognition of revenue thereof shall be deferred.
In this case, since SNT's management has measured the fair value of each loyalty point to
be $1, SNT shall recognise $200,000 ($1 200,000) as revenue only when the loyalty points
are redeemed and thus the recognition of revenue of this portion of consideration amounting
to $200,000 has been deferred to a period after 1 April 20X8.
The amount of revenue recognised shall be based on the number of award credits that have
been redeemed in exchange for awards, relative to the total number expected to be
redeemed.
Year ended 31 March 20X9
As at 31 March 20X9, 81,000 of the points have been redeemed in exchange for foodstuffs.
Thus the amount of revenue to be recognised for the year ended 31 March 20X9
= (number of points redeemed / total number of points expected to be redeemed)
$200,000
= (81,000 points / 180,000 points) $200,000
= $90,000
1006
Question bank - answers
1007
Financial Reporting
Answer 2
To : Ms. Choi, Director of PWE
From : Vincent Lee, Accounting Manager, PWE
c.c. : Jason Lam, Andy Cheng, Nick Chan (Directors)
Date : dd/mm/yyyy
Subject : Consolidated financial statements of PWE as at 31 March 20X2
I refer to your e-mail dated 16 May 20X2 regarding your queries about the draft consolidated
financial statements of PWE as at 31 March 20X2.
(a) (i) Certificate of deposit
Paragraph 54 of HKAS 1 (Revised) Presentation of Financial Statements requires
cash and cash equivalents to be presented as a line item in the statement of financial
position.
Cash is defined by HKAS 7 Statement of Cash Flows as cash on hand and demand
deposits while cash equivalents are defined as short-term, highly liquid investments
that are readily convertible to known amounts of cash and which are subject to an
insignificant risk of changes in value.
Since the certificate of deposit (HK$7,500,000) has a maturity more than three months
from the date of acquisition, it cannot meet the definition of cash and cash equivalents.
Therefore, we cannot include the certificate of deposit amounting to HK$7,500,000
(20X1: nil) in the cash and cash equivalents.
Classified as non-current
HKAS 1 (Revised) Presentation of Financial Statements specifies the classification of an asset as
current when:
(a) it expects to realise the asset, or intends to sell or consume it, in its normal operating cycle;
(b) it holds the asset primarily for the purpose of trading;
(c) it expects to realise the asset within twelve months after the reporting period; or
(d) the asset is cash or a cash equivalent (as defined in HKAS 7) unless the asset is restricted
from being exchanged or used to settle a liability for at least twelve months after the
reporting period.
All other assets should be classified as non-current. Since the certificate of deposit of
HK$7,500,000 (20X1: nil) is not expected to be realised within twelve months after the reporting
period, it cannot be classified as current and therefore it should be classified as a non-current
asset.
(a) (ii) Ethical issues
A distinguishing feature of the accountancy profession is its acceptance of the
responsibility to act in the public interest. In acting in the public interest, a professional
accountant shall observe and comply with the Code of Ethics for Professional
Accountants.
With all the relevant facts discussed above, clearly we are not allowed to include the
certificate of deposit into the cash and cash equivalents and it would violate
fundamental principles such as integrity, objectivity, professional competence and due
care as well as professional behaviour:
Integrity - A professional accountant should be straightforward and honest in all
professional and business relationships. It would not be honest if I
misrepresent the certificate of deposit as cash and cash equivalents when in
fact it is not.
1008
Question bank - answers
1009
Financial Reporting
1010
Question bank - answers
HK$'000 HK$'000
1011
Financial Reporting
Answer 3
To: Gabriel Wong (Director), PPY
From: Tommy Lau, Accounting Manager, PPY
c.c.: Renee Ho, Chris Wong, Adrian Cheung (Directors)
Date: dd/mm/yyyy
I refer to your email of 8 May 20Y0 concerning the draft consolidated financial statements of PPY
as at 31 March 20Y0.
(a) Investment property
HKAS 40 defines an investment property as a property held to earn rentals or for capital
appreciation or both, rather than for use in the production or supply of goods or services or
for administrative purposes; or sale in the ordinary course of business.
From the perspective of PPY, the property is an investment property because it meets the
definition stated above by leasing it to another party (a senior manager of SFL). Therefore,
PPY correctly treats the property as an investment property in its separate financial
statements.
However, PPY’s property is leased to, and occupied by, an employee of its subsidiary (SFL).
Paragraph 9(c) of HKAS 40 specifies that owner-occupied property includes property
occupied by employees (whether or not the employees pay rent at market rates) and it is one
of the examples of items that are not investment property and are therefore outside the
scope of HKAS 40.
From the perspective of the group, an employee of SFL is an employee of the group. Thus
the property does not qualify as an investment property in the consolidated financial
statements, because the property is owner-occupied from the perspective of the group.
Therefore, the relevant investment property, with a fair value of HK$6 million, has to be
reclassified as property, plant and equipment in the consolidated financial statements.
Nonetheless, the rent paid by the senior manager of SFL to PPY is not an intragroup income
and expense and thus the relevant rental income is not eliminated in preparing the
consolidated financial statements.
I hope the above explanation has answered your questions. For the details, please refer to
the annex. Please feel free to contact me if you have further queries.
Best regards,
Tommy Lau
1012
Question bank - answers
(b) Annex
(i) Worksheet for the consolidated statement of profit or loss and other
comprehensive income
Other
comprehensive
income:
revaluation
surplus 6,000,000 1,200,000 7,200,000
Total
comprehensive
income 18,800,000 6,000,000 23,710,850
1013
Financial Reporting
1014
Question bank - answers
WORKING:
Reconciling consolidated retained earnings and consolidated revaluation surplus
1015
Financial Reporting
Note. The journal entries are for illustrative purpose only. They are not required by the question.
HK$ HK$
W1 - Elimination of investment in subsidiary
DEBIT Share capital 16,000,000
DEBIT Retained earnings 12,000,000
DEBIT Goodwill 1,530,000
DEBIT Intangible assets 2,500,000
CREDIT Deferred tax liability 412,500
CREDIT Investment in SFL 25,600,000
CREDIT Non-controlling interests (30,087,500 20%) 6,017,500
1016
Question bank - answers
HK$
Reconciliation of Non-controlling interests in SOFP:
Shareholders’ equity of SFL at 31 March 20Y0 43,200,000
Fair value adjustment of intangible assets 2,500,000
Tax on fair value adjustment of intangible assets (2.5m 16.5%) (412,500)
Accumulated amortisation on fair value adjustment of intangible assets
(2.5m/10 3) (750,000)
Tax on acc. amortisation on fair value adjustment of intangible assets 123,750
Unrealised profit on upstream sale (640,000)
Tax on unrealised profit on upstream sale 105,600
Adjusted shareholders' equity of SFL at 31 March 20Y0 44,126,850
1017
Financial Reporting
or
20% NCI
Shareholders' equity of SFL at 31 March 20Y0 43,200,000 8,640,000
Fair value adjustment of intangible assets 2,500,000 500,000
Tax on fair value adjustment of intangible assets
(2.5m 16.5%) (412,500) (82,500)
Accumulated amortisation on fair value adjustment of
intangible assets (2.5m/10 3) (750,000) (150,000)
Tax on acc. amortisation on fair value adjustment of
intangible assets 123,750 24,750
Unrealised profit on upstream sale (640,000) (128,000)
Tax on unrealised profit on upstream sale 105,600 21,120
Adjusted shareholders' equity of SFL at 31 March 20Y0 44,126,850 8,825,370
Answer 4
To: Sunny Sun (Director), STL
From: Ricky Lam, Accounting Manager, STL
c.c.: Susan Chow, Emily Tsim, Rachael Lau (Directors)
Date: dd/mm/yyyy
I refer to your email dated 18 September 20X9 regarding your queries about the draft consolidated
financial statements for STL as at 30 June 20X9.
Goodwill
Goodwill is an asset representing the future economic benefits arising from other assets acquired
in a business combination that are not individually identified and separately recognised.
HKFRS 3 (revised) requires the acquirer, having recognised the identifiable assets, the liabilities
and any non-controlling interests, to identify any difference between:
the aggregate of the consideration transferred, any non-controlling interest in the acquiree
and, in a business combination achieved in stages, the acquisition-date fair value of the
acquirer's previously held equity interest in the acquiree; and
the net identifiable assets acquired.
The difference is generally recognised as goodwill.
The amount of goodwill is calculated as follows:
Consideration transferred ($1.50 75% 400 million shares) = $450 million
Amount of non-controlling interest in MNL ($560 million 25%) = $140 million
Total = $450 million + $140 million = $590 million
Identifiable net assets of MNL acquired = $560 million
1018
Question bank - answers
If the above mentioned exception applies, the gain or loss is regarded as unrealised and therefore
is not recognised in profit and loss.
In this case, it is reasonable to assume that the exception does not apply and therefore the gain
should be recognised in profit or loss.
Therefore STL shall recognise that portion of the gain that is attributable to the interests of the
other venturer, i.e. 50%.
The journal entries for STL, in its separate financial statements, to record its contribution to the joint
venture, are:
$m $m
DEBIT Interests in JV – capital contribution 10
Accumulated depreciation – machinery 4
CREDIT Interests in JV – unrealised gain on contribution of machinery 1
Other income – gain on contribution of machinery to JCE 1
Machinery 12
According to HKAS 28 (2011), in the consolidated financial statements of the venturer, unrealised
gains or losses on non-monetary assets contributed to joint ventures shall be eliminated against
the investment under the equity method. Such unrealised gains or losses shall not be presented as
deferred gains or losses in the venturer's consolidated statement of financial position.
It is not appropriate to present unrealised gains or losses on non-monetary assets contributed to
joint ventures as deferred items since such items do not meet the recognition criteria for assets or
liabilities as defined in the Conceptual Framework.
Therefore, STL shall make the following adjustment under the equity method, in addition to the
above adjustment, in its consolidated financial statements:
$m $m
DEBIT Interests in JV – unrealised gain on contribution of machinery 1
CREDIT Machinery held in JV 1
Tax effect of consolidation adjustments for intragroup transactions
Since taxes are being charged on the individual entities, the consolidation adjustments will not
affect the current tax liability, i.e. the amount that is expected to be paid in tax.
However, tax-effect adjustments are necessary when, during the consolidation, adjustments are
made to the carrying amounts of assets.
The consolidation adjustments relating to the carrying amount of assets will affect the differences
between the tax base and the carrying amount of an asset. This then affects future tax (deferred
tax amounts) rather than current tax payable.
HKAS 12 provides examples of circumstances that give rise to deductible temporary differences
e.g.: "unrealised profits resulting from intragroup transactions are eliminated from the carrying
amount of assets, such as inventory or property, plant or equipment, but no equivalent adjustment
is made for tax purposes".
In this case, to eliminate intragroup sales and unrealised profit on inventory on downstream sales,
inventory is to be reduced by ($100,000,000 20/120 1/3) = $5,555,555 as the cost to the
consolidated group differs from that to the subsidiary (MNL).
In MNL's accounts, the inventory is carried at $100,000,000 and has a tax base of $100,000,000,
giving rise to no temporary differences.
From the group's point of view, the inventory has a carrying amount of $94,444,445, giving a
temporary difference of $5,555,555.
As the expected future deduction is greater than the assessable amount, a deferred tax asset
exists for the group, though there is no effect on the amount of tax payable in the current period.
Deferred tax asset thereof = $5,555,555 16% = $888,888
1019
Financial Reporting
1020
Question bank - answers
Answer 5
To : Ms. Linda HO, Director of GRL
From : John Chan, Accounting Manager
Date : dd/mm/yyyy
Subject : Investment in subsidiaries and consolidated financial statements of GRL as at 1 April
20Y1 after the transactions
I refer to your message regarding your queries about the investment in subsidiaries and the draft
consolidated financial statements of GRL as at 1 April 20Y1 after the transactions.
(a) Investment in AMR
The issue of shares by AMR to SFL has reduced GRL's interest in AMR to 40 per cent, i.e.
less than 50 per cent. Also, GRL is entitled to appoint only three out of the total seven seats
in the board of directors. Therefore, GRL has lost control of AMR.
Since GRL holds 20 per cent or more of the voting power of AMR, there is a presumption
that GRL has significant influence over AMR and hence AMR should be accounted for as an
associate.
In this case, GRL should stop consolidating AMR from the date that control was lost, i.e.
1 April 20Y1.
Paragraph 25 of HKFRS 10 Consolidated Financial Statements states that if a parent loses
control of a subsidiary, the parent should derecognise the assets and liabilities of the former
subsidiary from the consolidated statement of financial position and recognise any
investment retained in the former subsidiary at its fair value when control is lost.
A partial disposal of the investment in AMR, as a subsidiary, but retaining an interest as an
associate creates the recognition of a gain or loss on the entire interest.
Since the loss of control of a subsidiary is a significant economic event, the retained interest,
ie the new investor-investee relationship, is recognised and measured at fair value at the
date when control is lost.
A gain or loss should be recognised on the part that has been disposed of and a further
holding gain or loss is recognised on the investment retained, being the difference between
the fair value of the investment and the carrying amount of the investment.
On 1 April 20Y1, the carrying amounts of AMR that should be derecognised =
100% of the net identifiable assets of AMR = $12 million
+ goodwill ($7.5 million + 40% ($1 million + $9 million) – $10 million = $1.5 million)
= $13.5 million
GRL should derecognise the carrying amount of any non-controlling interests (NCI) in AMR
(the former subsidiary) at the date when control is lost (including any components of other
comprehensive income attributable to them).
On 1 April 20Y1, non-controlling interest, measured at its proportionate share of the AMR’s
net identifiable assets, should be 40% $12 million = $4.8 million.
GRL should also recognise the fair value of the consideration received from the transaction.
However, in this case, GRL has not received any consideration from the transaction.
Any investment retained in AMR (the former subsidiary) should be recognised at its fair value
at the date when control is lost. Thus, GRL should recognise its investment in AMR at its fair
value on 1 April 20Y1, i.e. $9.6 million.
1021
Financial Reporting
GRL should also reclassify to profit or loss, or transfer directly to retained earnings any gain
or loss previously recognised in other comprehensive income. However, for the assets of
AMR, no gain or loss has been previously recognised in other comprehensive income.
The resulting difference, i.e.
Investment in AMR = $9.6 million
+ Non-controlling interest = $4.8 million
- Net identifiable assets of AMR = $12 million
- Goodwill = $1.5 million
= $0.9 million
Alternatively, candidates may exclude AMR from the consolidation and prepare a terminal
entry:
DEBIT Investment in AMR 9.6
CREDIT Investment in AMR 7.5
CREDIT Retained earnings (11m – 9m) 60% 1.2
CREDIT Gain on disposal 0.9
1022
Question bank - answers
Any difference between the amount by which the non-controlling interests are adjusted and
the fair value of the consideration paid or received shall be recognised directly in equity and
attributed to the owners of the parent.
Thus the difference between the consideration received ($5,500,000) and the amount that
NCI is adjusted ($2,974,000), amounting to $2,526,000, should be recognised directly in
equity attributable to the owners of the parent.
The corresponding consolidation journal entry is summarised as below:
$ $
DEBIT Cash 5,500,000
CREDIT Non-controlling interest 2,974,000
CREDIT Equity attributable to owners of the parent 2,526,000
Alternatively:
DEBIT Cash 5,500,000
DEBIT Non-controlling interest 4,386,000
CREDIT Non-controlling interest 7,360,000
CREDIT Equity attributable to owners of the parent 2,526,000
I hope the above explanation has answered your questions. For the details, please refer to
the annex. Please feel free to contact me if you have further queries.
Best regards,
John Chan
(c)
GRL – CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 1 APRIL 20Y1
Adjustment
GRL AMR CDS DEBIT CREDIT Group
$'000 $'000 $'000 ref $'000 $'000 ref $'000
ASSETS
Non-current assets
Property, plant and 18,400 9,000 10,400 W3 100 500 W3 28,400
equipment 9,000 (a)
Goodwill W1 5,400 1,500 (a) 5,400
W5 1,500
Investments in CDS 12,000 - - 12,000 W1 -
Investment in AMR 7,500 - - 7,500 W5 -
Investment in (a) 9,600 9,600
associate
Current assets
Inventory 5,900 3,000 4,200 W2 500 500 W1 10,100
3,000 (a)
Accounts receivable 2,200 2,000 1,500 2,000 (a) 3,700
Cash 1,000 1,000 2,000 (b) 5,500 1,000 (a) 8,500
47,000 15,000 18,100 65,700
1023
Financial Reporting
W5 1,000
Retained earnings 24,000 11,000 8,900 W1 6,500 500 W2 27,614
W3 500 100 W3
W4 986 900 (a)
W5 9,000
W6 800
Other components
of equity - - - 2,526 (b) 2,526
43,000 12,000 12,900 49,140
Alternative
GRL – CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 1 APRIL 20Y1
Adjustment
GRL CDS DEBIT CREDIT Group
$'000 $'000 ref $'000 $'000 ref $'000
ASSETS
Non-current assets
Property, plant and 18,400 10,400 W3 100 500 W3 28,400
equipment
1024
Question bank - answers
Adjustment
GRL CDS DEBIT CREDIT Group
$'000 $'000 $'000 $'000 $'000
Share capital 19,000 4,000 W1 4,000 19,000
Other components of
equity - - 2,526 (b) 2,526
43,000 12,900 49,140
Non-controlling - - 3,400 W1 7,360
interests
986 W4
2,974 (b)
Non-current liability
Debenture - 1,000 1,000
Current liability
Accounts payable 4,000 4,200 8,200
47,000 18,100 65,700
Goodwill calculations (not required by the question)
Investment in Investment in
AMR CDS
$'000 $'000
1025
Financial Reporting
Question 6
To: Ms. Tess Chow, Director of MHL
From: Melody Li, Accounting Manager
Date: dd/mm/yyyy
Subject: Brand name, patent, earnings per share and the consolidated financial statements of
MHL
I refer to your queries regarding the brand name, patent, earnings per share and the consolidated
financial statements of MHL.
Answer 1(a)
Brand name
The brand name, Magica, is an internally generated intangible asset.
HKAS 38 establishes a much higher hurdle for the recognition of internally generated
assets than purchased ones. In particular, it specifically prohibits the recognition of
internally generated brands.
HKAS 38.64 states that expenditure on internally generated brands cannot be
distinguished from the cost of developing the business as a whole.
Therefore, MHL should not recognise the brand name in its consolidated statement of
financial position.
1026
Question bank - answers
Patent
Since the patent is expected to expire in 20 years, it should be amortised to a nil residual value at
HKD2 million / 20 years, i.e. HKD100,000 per annum.
A patent cannot be revalued under HKAS 38 because there is no active market as a patent is
unique (HKAS 38.78).
HKAS 38 does not permit revaluation without an active market as the value cannot be reliably
measured in the absence of a commercial transaction.
Therefore, MHL should not revalue the patent in its consolidated statement of financial position.
Answer 1(b)
Earnings per share
The basic and diluted earnings per share of MHL for the year ended 31 December 20X2
are calculated as follows:
Shares fraction weighted
outstanding average
1 Jan to 30 Sep 23,250,000 9/12 17,437,500
Issued on 1 Oct 5,000,000
1 Oct to 31 Dec 28,250,000 3/12 7,062,500
Weighted average number of shares 24,500,000
Basic EPS = HKD147,189,600 / 24,500,000 = HKD6.01
Considering the dilutive effects of the warrants:
The proceed raised on the exercise of the warrants is 3,000,000 x exercise price of HKD60 =
HKD180,000,000
To raise the same amount, the number of shares to be issued at market value of HKD100 would be
HKD180,000,000 / HKD100 = 1,800,000 shares
Thus “free shares” = 3,000,000 shares – 1,800,000 shares = 1,200,000 shares*
(*alternatively, it can be calculated as [(100 – 60) / 100] × 3,000,000 = 1,200,000 shares)
Considering the dilutive effects of convertible bonds:
Interest saving after tax = HKD10 million × 4% × (1–16.5%) = HKD334,000
Additional shares = HKD10 million / HKD1,000 × 20 = 200,000 shares.
The EPS of this convertible bond is therefore HKD334,000 / 200,000 shares = HKD1.67
As this is smaller than the basic EPS (HKD6.01), the convertible bond is dilutive and should be
taken into account in the calculation of the diluted EPS.
Diluted EPS with warrants and convertible bonds is HKD(147,189,600 + 334,000) / (24,500,000 +
1,200,000 + 200,000) shares = HKD147,523,600 / 25,900,000 shares = HKD5.70.
1027
Financial Reporting
Answer 1(c)
Translation reserve for SDL
Translation reserve on goodwill
Goodwill
AUD’000
Net assets at book value* 54,000
Add: fair value adjustment after deferred tax** 7,000
Adjusted fair value of net assets 61,000
Goodwill *7,450
1028
Question bank - answers
or Group share after tax = 3,760 – 1,128 = 2,632 (i.e. 3,760 × (1 – 30%))
NCI share after tax = 940 – 282 = 658 (i.e. 940 × (1 – 30%))
Translation reserve on net assets:
AUD’000 Rate HKD’000
Net assets (at book value) b/f (24,000 + 30,000) 54,000 7.60 410,400
Net profit for 20X2 10,000 7.80 78,000
488,400
Net assets (at book value) c/f 64,000 8.10 518,400
Translation reserve *30,000
Group share 80% 24,000
1029
Financial Reporting
I hope that the above explanation has answered your questions. For further details please refer to
the annex. Please feel free to contact me if you have further queries
Best regards,
Melody Li
Answer 1(d)
MHL – Worksheet for the Consolidated Statement of Financial Position as at 31 December 20X2
MHL SDL Consolidated
HKD'000 HKD'000 HKD'000 Ref. HKD'000 HKD'000
Non-current 1,170,000 615,600 76,000 1, 2 7,800 1,858,500
assets 4,700 4
Investment in
SDL 427,500 – 1 427,500 –
Goodwill 56,620 1
3,725 3 60,345
Current assets
Inventory 225,000 48,600 273,600
Receivables 120,000 97,200 217,200
Cash 27,000 53,460 80,460
1,969,500 814,860 2,490,105
1030
Question bank - answers
Non-current
liabilities 120,000 259,200 379,200
1,969,500 814,860 2,490,105
Journal entries and reconciliations are not required
CJE 1 HKD'000 HKD'000
Dr Share capital 182,400
Dr Retained earnings 228,000
Dr Non-current assets 76,000
Dr Goodwill 56,620
Cr Deferred tax liability 22,800
Cr Investment in SDL 427,500
Cr NCI 92,720
CJE 2
Dr Amortisation 7,800
Cr Accumulated amortisation 7,800
[10 million ÷ 10 years × 7.80] (Amortisation on undervalued assets)
CJE 3
Dr Goodwill 3,725
Cr Translation reserve (Goodwill) 3,725
(Translation gain on goodwill)
CJE 4
Dr Non-current assets 4,700
Cr Translation reserve (FV adjustment) 3,760
Cr NCI 940
Dr Translation reserve (FV adjustment) 1,128
Dr NCI 282
Cr DTL 1,410
(Allocation of translation gain on fair value adjustment)
Or net Translation reserve 2,632, NCI 658
CJE 5
Dr Income to NCI 14,508
Cr NCI 14,508
1031
Financial Reporting
CJE 6
Dr Translation reserve 6,000
Cr NCI 6,000
(NCI's share of Translation reserve on net assets: 20% of HKD30 million)
Reconciliation of NCI:
20% NCI
HKD'000 HKD'000
Net assets 518,400 103,680
FV adjustment
72,900 – 21,870 51,030 10,206
569,430 113,886
Note 2
Goodwill (1c) 7,450
closing rate 8.1 60,345 60,345
Note 3
Retained earnings
current year profit 10,000
additionalamortisation (1,000)
tax impact (30%) 300
9,300
average rate 7.8 72,540
controlling interest 80%
58,032 784,500 842,532
Note 4
Non-controlling interests
Total adjusted net assets (1c) 77,750
less: goodwill (only controlling
interest) (7,450)
70,300
NCI portion (20%) 14,060
closing rate 8.1 113,886 113,886
Note 5
Deferred tax liabilities (DTL)
on FV adjustment (10,000 × 30%) 3,000
on amortisation (1,000 × 30%) (300)
2,700
closing rate 8.1
21,870 21,870
1032
Question bank - answers
Question 7
To: Ms. Janice Lam, Director of DBL
From: Raymond Wong, Accounting Manager, DBL
c.c.: Lucas Chong, Josiah Wong, Andrea Cheung (Directors)
Date: dd/mm/yyyy
Subject: Condensed consolidated financial statements of DBL for the six months ended 31
March 20X2
I refer to your e-mail dated 7 May 20X2 regarding your queries about the draft condensed
consolidated financial statements of DBL for the six months ended 31 March 20X2.
Answer 1(a)
Compliance with HKFRS
HKAS 34.19 specifies that if an entity’s interim financial report is in compliance with HKAS 34, that
fact shall be disclosed.
However, an interim financial report shall not be described as complying with HKFRSs unless it
complies with all the requirements of HKFRSs.
Condensed financial statements do not comply with all the requirements of HKFRSs.
Therefore DBL’s interim financial report cannot be described as complying with HKFRSs.
Answer 1(b)
Segment information
In accordance with HKAS 34.16A(g), disclosure of segment information is required in an entity's
interim financial report only if HKFRS 8 Operating Segments requires that entity to disclose
segment information in its annual financial statements.
HKFRS 8 applies to the separate financial statements of an entity (HKFRS 8.2(a)(i)) and the
consolidated financial statements of a group with a parent (HKFRS 8.2(b)(i)) whose equity
instruments are traded in a public market. As DBL is listed on the Main Board of the Stock
Exchange of Hong Kong, segment information is required to be disclosed.
Therefore, DBL should disclose the relevant segment information under the
HKAS 34.16A(g) in its interim financial report since HKFRS 8 Operating Segments does require
DBL to disclose segment information in its annual financial statements.
Answer 1(c)
Related party relationship
HKAS 24 (Revised) defines a related party as a person or entity that is related to the entity that is
preparing its financial statements.
A person is related to a reporting entity if that person is a member of the key management
personnel of the reporting entity or of a parent of the reporting entity (HKAS 24.9(a)(iii)).
Key management personnel are those persons having authority and responsibility for planning,
directing and controlling the activities of the entity, directly or indirectly, including any director
(whether executive or otherwise) of that entity.
As you (Janice) are the director of DBL, you are a related party of DBL (key management
personnel) and STF (key personnel of the parent of STF) pursuant to HKAS 24.9(a)).
1033
Financial Reporting
DBL and STF are related parties to each other according to HKAS 24.9(b)(i) since they are
members of the same group. In addition, for financial statements of both DBL and STF, BTV is a
related party as BTV is controlled by you (Janice), who is a related party falling into the scope of
HKAS 24.9(a) (HKAS 24.9(b)(vi)).
For BTV’s financial statements, DBL and STF are related parties to BTV because BTV is controlled
by you and you are a key management personnel of DBL which is the parent of STF (HKAS
24.9(b)(vii) and (a)(i)).
Answer 1(d)
Contract with FYL
The contract with FYL meets the definition of a derivative (HKFRS 9) because its value changes in
response to changes in an underlying variable (HIBOR), there is no initial net investment, and
settlements occur at future dates.
The contractual effect of the loans is the equivalent of an interest rate swap arrangement with no
initial net investment. Therefore, it should be accounted for as a derivative under HKFRS 9.
Guidance on implementing HKFRS 9 Financial Instruments specifies that non-derivative
transactions should be aggregated and treated as a derivative when the transactions result, in
substance, in a derivative.
Indicators of this would include:
they are entered into at the same time and in contemplation of one another.
they have the same counterparty.
they relate to the same risk.
there is no apparent economic need or substantive business purpose for structuring the
transactions separately that could not also have been accomplished in a single transaction.
Under HKFRS 9, DBL should recognise the derivative as a financial asset or a financial liability in
its statement of financial position when, and only when, DBL becomes party to the contractual
provisions of the instrument.
The default assumption with regard to derivatives under HKFRS 9 is that they are to be measured
at fair value with changes in fair value taken to profit and loss.
I hope the above explanation has answered your questions. For the details, please refer to the
annex. Please feel free to contact me if you have further queries.
Best regards,
Raymond Wong
1034
Question bank - answers
Answer 1(e)
Annex
(i) Worksheet for the condensed consolidated statement of profit or loss and other
comprehensive income for the six months ended 31 March 20X2
Profit attributable
to:
Owners of the
parent 445,472
Non-controlling
interests 40,745 W4 40,745
486,217
Total comprehensive income attributable to:
Owners of the
parent 650,672
Non-controlling
interests 51,545 W4&4a 51,545
702,217
1035
Financial Reporting
WORKING:
Reconciling consolidated retained earnings and consolidated revaluation surplus
DBL STF Eliminations Consolidated
$'000 $'000 Dr($'000) working Cr($'000) $'000
Retained earnings,
1 October 20X1 1,092,000 654,000 21,000 W2 3,465 1,280,251
8,400 W6 1,386
350,000 W1
91,200 W5
Profit for the period
attributable to the
owners of the
parent 384,000 144,000 445,472
Dividends declared (96,000) (48,000) W3 48,000 (96,000)
Retained earnings,
31 March 20X2 1,380,000 750,000 1,629,723
1036
Question bank - answers
Note. The journal entries are for illustrative purpose only. They are not required by the question.
W1 - Elimination of investment in subsidiary
$'000 $'000
Dr Share capital 480,000
Dr Retained earnings 350,000
Dr Revaluation reserve 10,000
Dr Goodwill 133,240
Dr Intangible assets 80,000
Cr Deferred tax liability($80m × 16.5%) 13,200
Cr Investment in STF 768,000
Cr Non-controlling interests (BS) (906.8m × 30%) 272,040
W2 - Past and current amortisation on revalued intangible assets
$'000 $'000
Dr Opening retained earnings ($80m/8*3*70%) 21,000
Dr Non-controlling interests (SOFP) ($80m/8*3*30%) 9,000
Dr Amortisation ($80m/8*0.5) 5,000
Cr Accumulated amortisation 35,000
1037
Financial Reporting
$'000 $'000
Profit of STF before adjustment 144,000
Add: previous period's unrealised
($36m-24m) 12,000
profit now realised
Tax effects on previous period's
($12m × 16.5%) (1,980) 10,020
unrealised profit
Less: current period's unrealised profit (35%*(144m - 96m)) (16,800)
Tax effects on current period
($16.8m × 16.5%) 2,772 (14,028)
unrealised profit
Less: amortisation on revalued intangible assets (5,000)
Tax effects on amortisation on
($5m × 16.5%) 825 (4,175)
revalued intangible assets
Adjusted profit 135,817
Non-controlling interests' share (30%) 40,745
1038
Question bank - answers
or
30% NCI
Shareholders' equity of STF at 31 March 20X2 1,296,000 388,800
Fair value adjustment of intangible assets 80,000 24,000
Tax on fair value adjustment of intangible (80m × 16.5%) (13,200) (3,960)
assets
Accumulated amortisation on fair value (80m/8 × 3.5) (35,000) (10,500)
adjustment of intangible assets
Tax on acc. amortisation on fair value adjustment of intangible assets 5,775 1,733
Question 8
To Ms. Tess Chow, Director of PHL
From Karen Lam, Accounting Manager
Date dd/mm/yyyy
Subject Goodwill and net cash flows on acquisition of SPC, share based payment, leased
machinery and consolidated statement of cash flows of PHL.
I refer to your queries regarding the note showing the calculation of goodwill and net cash flows on
acquisition of SPC, the share based payment, the leased machinery and the consolidated
statement of cash flows of PHL.
Answer 1(a)
HKAS 7.39 requires that the aggregate cash flows arising from obtaining or losing control of
subsidiaries or other businesses units shall be presented separately and classified as investing
activities.
Therefore PHL should disclose, in aggregate, in respect of obtaining control of SPC as a subsidiary
during the year each of the following:
(a) the total consideration paid;
(b) the portion of the consideration consisting of cash and cash equivalents;
(c) the amount of cash and cash equivalents in the subsidiaries over which control is obtained;
and
1039
Financial Reporting
the amount of the assets and liabilities other than cash or cash equivalents in the subsidiaries over
which control is obtained, summarised by each major category (HKAS 7.40).
Obtaining control of subsidiary
During the year, the Group obtained control of subsidiary SPC. The fair values of assets acquired
and liabilities assumed were as follows:
$'000 $'000
Fair value of identifiable net assets acquired
Machinery 7,920
Inventory 1,536
Accounts receivable 1,344
Cash and cash equivalent 5,376
Accounts payable (3,264)
Taxation payable (816) 12,096
Add: Goodwill on acquisition 6,256
Less: Fair value of NCI (2,880)
Total consideration 15,472
Non-cash consideration (13,200)
Cash consideration 2,272
Cash and cash equivalent acquired (5,376)
Net cash (inflow) on acquisition of a subsidiary (3,104)
Answer 1(b)
Accounting for share based payment (SBP) transaction is governed by HKFRS 2.
SDL, being the entity receiving the services of its top executives, shall measure the services
received as either an equity-settled or a cash settled SBP transaction by assessing:
(i) the nature of the awards granted, and
(ii) its own rights and obligations (para. 43A)
Since the awards are granted by its parent and there is no indication that SDL has an obligation to
settle, SDL shall measure the services received as an equity-settled SBP transaction (para. 43B).
SDL shall subsequently re-measure such SBP transaction only for changes in non-market
performance conditions.
PHL, being the entity settling a SBP transaction when another entity (SDL) in the group receives
the services, shall recognise the transaction as an equity-settled SBP transaction as it is settled in
its own equity instruments (para. 43C).
From the consolidated group’s perspective, the group receives services as consideration for its
own equity instrument; therefore, it should be accounted for as an equity-settled SBP transaction.
$ $
Staff cost ($0.5 x 1,000,000 × 1/4) 125,000
Cr Equity / contribution from PHL 125,000
In PHL's books
$ $
Dr Investment in SDL ($0.5 × 1,000,000 × 1/4) 125,000
Cr Other reserves (equity) – ESOP 125,000
1040
Question bank - answers
Answer 1(c)(i)
Since the title to the machinery will pass to PHL (the lessee) and the present value of the minimum
lease payments ($487,805 × 4.100 approximates to $2,000,000) amounts to substantially all of the
fair value of the leased machinery, it is a finance lease to PHL (the lessee).
PHL should record both the asset and an obligation under finance lease at the present value of the
leased machinery (i.e. $2,000,000).
Lease Amortisation Schedule (Lessee)
(7%) Interest on Annual Lease Lease Liability
Date Lease Liability Payment Recovery Lease Liability
1 January 20X1 $2,000,000
31 December 20X1 $140,000 $487,805 $347,805 $1,652,195
31 December 20X2 $115,654 $487,805 $372,151 $1,280,044
Answer 1(c)(ii)
The relevant journal entries for PHL (lessee) for the lease for the first two years (up to 31
December 20X2) are as follows:
1 January 20X1 $ $
Leased Machinery 2,000,000
Cr Obligation under finance lease 2,000,000
31 December 20X1
Interest expense 140,000
Obligation under finance lease 347,805
Cr Cash 487,805
Depreciation 250,000
Cr Accumulated depreciation 250,000
31 December 20X2
Interest expense 115,654
Obligation under finance lease 372,151
Cr Cash 487,805
Depreciation 250,000
Cr Accumulated depreciation 250,000
I hope the above explanation has answered your questions. For further details, please refer to the
annex. Please feel free to contact me if you have further queries.
Best regards,
Karen Lam
1041
Financial Reporting
Answer 1(d)
Consolidated statement of cash flows for PHL for the year ended 31 December 20X2
Cash flows from operating activities $'000 $'000
Profit before taxation 110,400
Adjustment for:
Depreciation (W1) 19,320
Gain on disposal of PPE (6,000)
Share of profit from associates (21,000)
Dividends from long-term investments (9,300)
Interest expense 9,000
1042
Question bank - answers
c/f 349,380
1043
Financial Reporting
1044
Question bank - answers
Answer 10
(a) HDL must determine whether the modification is considered to be an extinguishment of the
original bank loan in accordance with HKFRS 9.
HKFRS 9, 3.3.2 requires an exchange between an existing borrower and lender of debt
instruments with substantially different terms to be accounted for as extinguishment of the
original financial liability and the recognition of a new financial liability. Similarly, a substantial
modification of the terms of an existing financial liability is accounted for as an
extinguishment of the original financial liability and the recognition of a new financial liability.
B3.3.6 of HKFRS 9 states that the terms are substantially different if the discounted present
value of the cash flows under the new terms, including any fees paid net of any fees received
and discounted using the original effective interest rate, is at least 10 per cent different from
the discounted present value of the remaining cash flows of the original financial liability.
The modified cash flow of the bank loan is as follows:
1045
Financial Reporting
HK$ HK$
Answer 11
(a) Share-based compensation expense for the year ended 31 March 20X9:
1046
Question bank - answers
OR
The journal entries to be recorded by BS for the year ended 31 March 20Y0 were:
HK$ HK$
DEBIT Share compensation expense 4,333,333
CREDIT Contribution from MDS 4,333,333
Answer 12
(a) The value of the financial liability component of the CB at initial recognition:
2 3
[(6% HK$800 / 1.08) + (6% HK$800 / 1.08 ) + (6% HK$800 / 1.08 ) + (6% HK$800 /
4 4
1.08 ) + (HK$800 / 1.08 )] million
Journal entries for the issue of the convertible bond (CB) on 1 December 20X8:
HK$m HK$m
DEBIT Cash 800
CREDIT Convertible Bond – liability 747
CREDIT Equity – conversion option 53
(b) Carrying amount of the financial liability component of the CB at 1 April 20Y0:
1047
Financial Reporting
(c) HKFRS 9 requires an entity to measure the financial liability at fair value, plus transaction
costs that are directly attributable to the issue of the financial liabilities, at initial recognition.
Measurement of the fair value of the interest-free loan of HK$500 million based on the
effective interest rate of other borrowings of AML, i.e. 6 per cent:
HK$500 million / 1.062 = HK$445 million
The journal entries for the recognition of the interest-free loan on 1 April 20Y0:
HK$m HK$m
DEBIT Bank or Cash 500
CREDIT Loan from a shareholder 445
Equity – contribution from a shareholder 55
Answer 13
Overseas companies are subject to the same qualifying criteria to use the SME-FRF as Hong Kong
companies.
CML does not carry out a banking business, an insurance business or a regulated business
licenced under Part V of the Securities and Futures Ordinance. Nor does it, insofar as can be
concluded from the information provided, accept loans of money at interest by way of trade or
business. Therefore the company is eligible to use the SME-FRF if the stipulated criteria are met.
CMLis a private company that is not a member of a group. Therefore, regardless of its size, it can
apply the SME-FRF if both of its shareholders give written approval every year that it is applied.
Under SME-FRS s.4 Intangible assets, an intangible asset arising from development phase of an
internal project should be recognised if, and only if, an entity can demonstrate all the conditions set
out in 4.7 are fulfilled.
One of these conditions is the technical feasibility of completing the intangible asset so that it will
be available for use or sale. Based on the information stated, CML did not demonstrate that this
condition has been met. Accordingly, the HK$28 million expenditure cannot be recognised as an
intangible asset, but charged to profit or loss.
As a result, the total assets of CML at 31 December 20X9 were estimated to be approximately
HK$37 million [= 60 – (28 – 5) million].
Provided that both shareholders of CML agree to prepare the financial statements in accordance
with the SME-FRS, CML qualifies for reporting under the SME-FRS for the year ended
31 December 20X9.
1048
Question bank - answers
Answer 14
(a) Classification of lease
PBL should account for the lease with UMC as an operating lease, since:
there is no transfer of ownership of those two printing machines nor option to
purchase the machines by PBL.
the lease term of four years is not the majority of the ten-year economic life of the
machines.
the total gross rental over the lease term is [($200,000 12) + ($210,000 12) +
($220,000 12) + ($230,000 12)] = $10,320,000. The present value of the minimum
lease payments is not substantially all of the fair value of the leased assets, i.e.
$24,000,000 [$12,000,000 2].
Alternative:
The total gross rental over the lease term is [($200,000 12) + ($210,000 12) + ($220,000
12) + ($230,000 12)] = $10,320,000. Assuming a discount rate of 8 per cent is used, the
present value of the above minimum lease payment amounts (calculated based on yearly
basis at accrual) is approximately $8,507,000 which is not substantially all of the fair value of
the leased assets, i.e. $24,000,000 [$12,000,000 2].
Accordingly, risks and rewards incidental to ownership of the machines are not transferred.
Accounting treatment
The lease payments shall be recognised as an expense on a straight line basis over the
lease term.
Monthly expense recognised = $10,320,000 / 48 = $215,000.
1049
Financial Reporting
Answer 15
(a) The financial position of MG as at 31 December 20Y1 is affected as follows:
Option 1
The rights issue is an equity transaction and will increase MG's net assets by $1,000 million.
Option 2
The convertible bond is a compound financial instrument which contains both a liability and
an equity component.
1050
Question bank - answers
1051
Financial Reporting
Answer 16
Classification of financial assets
GII's investments are both financial assets. According to HKFRS 9, financial assets are classified
as measured at either amortised cost or fair value depending on:
1 the entity's business model for managing the financial assets and
2 the contractual cash flow characteristics of the financial assets.
In particular, a financial asset is measured at amortised cost where:
1 the asset is held within a business model where the objective is to hold assets in order to
collect contractual cash flows
2 the contractual terms of the financial asset give rise on specified dates to cash flows that are
solely payments of principal and interest on the principal outstanding.
For this purpose, interest is consideration for the time value of money and for the credit risk
associated with the principal amount.
Embedded derivatives
Derivatives embedded within a host which is a financial asset within the scope of HKFRS 9 are not
separated out for accounting purposes; instead the entire hybrid contract is accounted for as one
and classified as measured at amortised cost or fair value through profit or loss in accordance with
the guidelines above.
Application: convertible bonds
For the holder, convertible bonds are a financial asset within the scope of HKFRS 9. The standard
requires that the holder analyses the instrument in its entirety (rather than split it into the host
contract and conversion option, as was required under HKAS 39).
GII will be entitled to receive a contracted interest payment of $450,000 ($15 million 6% / 2) on
31 December 20X8, 30 June 20X9, 31 December 20X9, 30 June 20Y0 and 31 December 20Y0
from the listed company. These contractual interest payments are not only consideration for the
time value of money and credit risk; they are also linked to the value of the equity of the issuer of
the bonds.
Therefore, the bonds should be classified as at fair value through profit or loss.
At initial recognition at 1 July 20X8, the financial asset will be measured at fair value.
After initial recognition, the asset will be measured at fair value with gains or losses recognised in
profit or loss.
Application: deposit with commercial bank
The deposit is considered a financial asset classified as held at amortised cost.
The additional 3% interest is an example of an embedded derivative, however, as the host contract
is a financial asset, the derivative is not separated out for the purposes of accounting and the entire
hybrid contract is accounted for together.
Answer 17
(a) Deferred tax position at 31 December 20X7 accounted for in GP's consolidated financial
statements:
Carrying amount of the printing machine at 31 December 20X7:
$20,000,000 [1 – (4.5 years/16 years)] = $14,375,000
Tax base at 31 December 20X7:
$20,000,000 [1 – (1 – 0.1) (4.5 years/10 years)] = $11,900,000
1052
Question bank - answers
1053
Financial Reporting
1054
Glossary of terms
1055
Financial Reporting
1056
Glossary of terms
A service condition is a vesting condition that requires the counterparty to complete a specified
period of service during which services are provided to the entity. If the counterparty, regardless of
the reason, ceases to provide service during the vesting period, it has failed to satisfy the condition.
A service condition does not require a performance target to be met.
A performance condition is a vesting condition that requires:
(a) The counterparty to complete a specified period of service (i.e. a service condition); the
service requirement can be explicit or implicit; and
(b) Specified performance targets to be met while the counterparty is rendering the service
required in (a).
The period of achieving the performance target(s):
(a) Shall not extend beyond the end of the service period; and
(b) May start before the service period on the condition that the commencement date of the
performance target is not substantially before the commencement of the service period.
A performance target is defined by reference to:
(a) The entity's own operations (or activities) or the operations or activities of another entity in
the same group (i.e. a non-market condition); or
(b) The price (or value) of the entity's equity instruments or the equity instruments of another
entity in the same group (including shares and share options) (i.e. a market condition).
A performance target might relate either to the performance of the entity as a whole or to some part
of the entity (or part of the group), such as a division or an individual employee.
A market condition is a performance condition upon which the exercise price, vesting or
exercisability of an equity instrument depends that is related to the market price (or value) of the
entity's equity instruments (or the equity instruments of another entity in the same group) such as:
(a) Attaining a specified share price or a specified amount of intrinsic value of a share option; or
(b) Achieving a specified target that is based on the market price (or value) of the entity's equity
instruments (or the equity instruments of another entity in the same group) relative to an
index of market prices of equity instruments in other entities.
A market condition requires the counterparty to complete a specified period of service (i.e. a
service condition); the service condition can be explicit or implicit.
Accounting estimates. Judgements, based on up to date information that must be made in order
to apply an accounting policy, e.g. useful life and residual value of an asset.
Accounting policies. The specific principles, bases, conventions, rules and practices adopted by
an entity in preparing and presenting financial statements.
Accounting profit. Profit or loss for a period before deducting tax expense.
Accrual basis. The effects of transactions and other events are recognised when they occur (and
not as cash or its equivalent is received or paid) and they are recorded in the accounting records
and reported in the financial statements of the periods to which they relate.
Acquiree. The business or businesses that the acquirer obtains control of in a business
combination. Referred to in HKFRS 10 as the investee.
Acquirer. The entity that obtains control of the acquiree. Referred to in HKFRS 10 as the investor.
Active market. A market in which all the following conditions exist:
(a) The items traded in the market are homogenous
(b) Willing buyers and sellers can normally be found at any time; and
(c) Prices are available to the public.
1057
Financial Reporting
1058
Glossary of terms
Cash equivalents. Short-term, highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of changes in value.
Cash flow hedge. Hedge of the exposure to variability in cash flows that:
(a) is attributable to a particular risk associated with a recognised asset or liability (such as all or
some future interest payments on variable rate debt) or a highly probable forecast
transaction (such as an anticipated purchase or sale), and that
(b) could affect profit or loss.
Cash flows. Inflows and outflows of cash and cash equivalents.
Cash generating unit. The smallest identifiable group of assets for which independent cash flows
can be identified and measured.
Cash-settled share-based payment transaction. A share-based payment transaction that is
settled in an amount of cash determined by reference to share price.
Change in accounting estimate. 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. Changes in accounting estimates result from new information or new developments and,
accordingly, are not corrections of errors.
Chief operating decision maker. Identifies the function (not necessarily an individual) that
allocates resources and assesses the performance of an entity’s operating segments.
Close members of the family of a person. Those family members who may be expected to
influence, or be influenced by, that person in their dealings with the entity and include:
(a) that person's children and spouse or domestic partner
(b) children of that person's spouse or domestic partner; and
(c) dependants of that person or that person’s spouse or domestic partner.
Closing rate. The spot exchange rate at the end of the reporting period.
Comparability. An enhancing qualitative characteristic. Information is more useful if it can be
compared with similar information about other entities or the same entity for another period.
Compound instrument A financial instrument that is split into equity and liability parts and
presented accordingly in the statement of financial position.
Conceptual framework A statement of generally accepted theoretical principles which form the
frame of reference for financial reporting.
Consolidated financial statements. The financial statements of a group in which the assets,
liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented
as those of a single economic entity.
Construction contract. A contract specifically negotiated for the construction of an asset or a
combination of assets that are closely interrelated or interdependent in terms of their design,
technology and function or their ultimate purpose or use.
Constructive obligation. An obligation that derives from an entity's actions where:
By an established pattern of past practice, published policies or a sufficiently specific current
statement, the entity has indicated to other parties that it will accept certain responsibilities, and
As a result, the entity has created a valid expectation on the part of those other parties that it
will discharge those responsibilities.
Contingent asset. 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.
1059
Financial Reporting
Control. An investor controls an investee when the investor is exposed, or has rights, to variable
returns from its involvement with the investee and has the ability to affect those returns through
power over the investee.
Corporate governance. The system by which companies are directed and controlled.
Cost. The amount of cash or cash equivalents paid or the fair value of other consideration given to
acquire an asset at the time of its acquisition or construction.
Cost model. A measurement model allowed by HKAS 40 Investment Property. Where it is applied,
investment property is measured in accordance with the historical cost model of HKAS 16 at cost
less accumulated depreciation less accumulated impairment losses.
Cost plus contract. A construction contract in which the contractor is reimbursed for allowable
or otherwise defined costs, plus a percentage of these costs or a fixed fee.
Credit losses Impairment losses on financial assets. They may be:
12 month credit losses, i.e. the lifetime credit losses expected to arise from a default that
occurs within 12 months, or
Lifetime credit losses, i.e. the expected credit losses if a default occurred at any time in the
term of a financial asset.
Costs to sell. The incremental costs directly attributable to the disposal of an asset (or disposal
group), excluding finance costs and income tax expense.
Current asset An asset that:
(a) An entity expects to realise, sell or consume the asset in its normal operating cycle
(b) Is held primarily for trading
(c) An entity expects to realise the asset within 12 months after the reporting period
(d) Is cash or a cash equivalent unless the asset is restricted from being exchanged or used to
settle a liability for at least the 12 months after the reporting period
Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be
paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the
1060
Glossary of terms
undiscounted amount of cash or cash equivalents that would be required to settle the obligation
currently.
Current liability A liability that:
(a) An entity expects to settle the liability in its normal operating cycle
(b) Is held primarily for trading
(c) Is due to be settled within 12 months after the reporting period
(d) An entity does not have an unconditional right to defer settlement of for at least 12 months
after the reporting period. Terms of a liability that could, at the option of the counterparty,
result in its settlement by the issue of equity instruments, do not affect the classification
Current service cost. The increase in the present value of the defined benefit obligation resulting
from employee service in the current period.
Current tax. The amount of income taxes payable (recoverable) in respect of the taxable profit (tax
loss) for a period.
D-shaped group A group in which the parent company controls a subsidiary and the parent
company and subsidiary together control a further subsidiary.
Deferred tax assets. The amounts of income taxes recoverable in future periods in respect of:
Deductible temporary differences
The carry forward of unused tax losses
The carry forward of unused tax credits
Deferred tax liabilities. The amounts of income taxes payable in future periods in respect of
taxable temporary differences.
Defined benefit plans. Post-employment benefit plans other than defined contribution plans.
Defined contribution plans. Post-employment benefit plans under which an entity pays fixed
contributions into a separate entity (a fund) and will have no legal or constructive obligation to pay
further contributions if the fund does not hold sufficient assets to pay all employee benefits relating
to employee service in the current and prior periods.
Depreciable amount. The cost of an asset, or other amount substituted for cost, less its residual
value.
Depreciable assets. Assets which:
Are expected to be used during more than one accounting period.
Have a limited useful life.
Are held by an entity for use in the production or supply of goods and services, for rental to
others, or for administrative purposes.
Depreciation. The systematic allocation of the depreciable amount of an asset over its useful life.
Derivative. A financial instrument or other contract with all three of the following characteristics:
(a) Its value changes in response to the change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit
index, or other variable (sometimes called the "underlying")
(b) It requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to
changes in market factors
(c) It is settled at a future date.
Development. The application of research findings or other knowledge to a plan or design for the
production of new or substantially improved materials, devices, products, processes, systems or
services before the start of commercial production or use.
1061
Financial Reporting
Diluted earnings per share Earnings per share calculated after adjusting the net profit attributable
to ordinary shareholders and the weighted average number of shares outstanding for the effects of
all dilutive potential ordinary shares.
Dilution. A reduction in earnings per share or an increase in loss per share resulting from the
assumption that convertible instruments are converted, that options or warrants are exercised, or
that ordinary shares are issued upon the satisfaction of specified conditions.
Discontinued operation. A component of an entity that either has been disposed of or is classified
as held for sale and:
(a) Represents a separate major line of business or geographical area of operations
(b) Is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations or
(c) Is a subsidiary acquired exclusively with a view to resale.
Disposal group. Group of assets to be disposed of, by sale or otherwise, together as a group in a
single transaction, and liabilities directly associated with those assets that will be transferred in the
transaction. (In practice, a disposal group could be a subsidiary, a cash-generating unit or a single
operation within an entity.)
Dividends. Distributions of profit to holders of equity investments, in proportion with their holdings,
of each relevant class of capital.
Earnings per share. A measure of the amount of profits earned by a company for each ordinary
share.
Economic life. Either the:
(a) Period over which an asset is expected to be economically usable by one or more users, or
(b) Number of production or similar units expected to be obtained from the asset by one or more
users.
Effective interest method. A method of calculating the amortised cost of a financial instrument
and of allocating the interest income or interest expense over the relevant period. The effective
interest rate is the rate that exactly discounts estimated future cash payments or receipts through
the expected life of the financial instrument to the net carrying amount of the financial asset or
liability.
Embedded derivative A derivative that is embedded within a host contract that may or may not be
a financial instrument.
Employee benefits. All forms of consideration given by an entity in exchange for service rendered
by employees.
Entity specific value. The present value of the cash flows an entity expects to arise from the
continuing use of an asset and from its disposal at the end of its useful life, or expects to incur
when settling a liability.
Equity. The residual interest in the assets of the entity after deducting all its liabilities.
Equity instrument granted. The right (conditional or unconditional) to an equity instrument of the
entity conferred by the entity on another party, under a share-based payment arrangement.
Equity instrument. A contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities.
Equity method. A method of accounting whereby an interest in a jointly controlled entity is initially
recorded at cost and adjusted thereafter for the post acquisition change in the venturer's share of
net assets of the jointly controlled entity. The profit or loss of the venturer reflects the venturer's
share of the profit or loss of the jointly controlled entity.
Equity-settled share-based payment transaction. A share-based payment transaction that is
settled in equity instruments.
1062
Glossary of terms
Event after the reporting period. Those events, favourable and unfavourable, that occur between
the end of the reporting period and the date when the financial statements are authorised for issue.
Exchange difference. The difference resulting from translating a given number of units of one
currency into another currency at different exchange rates.
Exchange rate. The ratio of exchange for two currencies.
Expenses. Decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity, other than those
relating to distributions to equity participants.
Fair value. The price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Fair value hedge. A hedge of the exposure to changes in the fair value of a recognised asset or
liability, or an identified portion of such an asset or liability, that is attributable to a particular risk
and could affect profit or loss.
Fair value hierarchy A hierarchy of inputs to a valuation technique as established by HKFRS 13.
Fair value model. A measurement model allowed by HKAS 40 Investment Property. Where it is
applied, investment property is measured at fair value at each reporting date with changes
recognised in profit or loss.
Fair value less costs to sell. The amount obtainable from the sale of an asset or cash generating
unit in an arm's length transaction between knowledgeable, willing parties, less the costs of
disposal.
Faithful representation. A fundamental qualitative characteristic. Financial information should
faithfully represent the phenomena it purports to represent. To be a perfectly faithful representation,
a depiction should be complete, neutral and free from error.
FIFO (First In First Out). A cost formula uses in the measurement of cost of inventory that
assumes that the first inventories to be purchased will be the first to be sold.
Finance lease. A lease that transfers substantially all the risks and rewards incidental to ownership
of an asset. Title may or may not eventually be transferred.
Financial asset. Any asset that is:
(a) cash;
(b) an equity instrument of another entity;
(c) a contractual right to receive cash or another financial asset from another entity; or to
exchange financial instruments with another entity under conditions that are potentially
favourable to the entity; or
(d) a contract that will or may be settled in the entity's own equity instruments and is a:
(i) non-derivative for which the entity is or may be obliged to receive a variable number of
the entity's own equity instruments; or
(ii) derivative that will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity's own equity
instruments.
Financial instrument. Any contract that gives rise to both a financial asset of one entity and a
financial liability or equity instrument of another entity.
Financial liability. Any liability that is a:
(a) Contractual obligation to:
(i) deliver cash or another financial asset to another entity
1063
Financial Reporting
(ii) exchange financial instruments with another entity under conditions that are potentially
unfavourable
(b) Contract that will or may be settled in the entity's own equity instruments and is a:
(i) non-derivative for which the entity is or may be obliged to deliver a variable number of
the entity's own equity instruments; or
(ii) derivative that will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity's own equity
instruments.
Financing activities. Activities that result in changes in the size and composition of the contributed
equity and borrowings of the entity.
Firm commitment is a binding agreement for the exchange of a specified quantity of resources at
a specified price on a specified future date or dates.
Fixed price contract. A construction contract in which the contractor agrees to a fixed contract
price, or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses.
Fixed production overheads. Defined by the standard as those indirect costs of production that
remain relatively constant regardless of the volume of production such as depreciation and
maintenance of factory buildings and equipment and the cost of factory management and
administration. Fixed production overheads must be allocated to items of inventory on the basis
of the normal capacity of the production facilities. Normal capacity is the expected achievable
production based on the average over several periods/seasons, under normal circumstances, and
taking into account the capacity lost through planned maintenance. The standard makes the
following additional points:
If it approximates to the normal level of activity then the standard states that the actual level
of production can be used.
Low production or idle plant will not result in a higher fixed overhead allocation to each unit.
Unallocated overheads must be recognised as an expense in the period in which they were
incurred.
In periods of abnormally high production, the fixed production overhead allocated to each
unit will be decreased, so that inventories are not measured at more than cost.
Variable production overheads are allocated to each unit on the basis of the actual use of
production facilities.
Foreign currency. A currency other than the functional currency of the entity.
Foreign operation. An entity that is a subsidiary, associate, joint venture or branch of a reporting
entity, the activities of which are based or conducted in a country or currency other than those of
the reporting entity.
Forecast transaction is an uncommitted but anticipated future transaction.
Forgivable loans. Loans which the lender undertakes to waive repayment of under certain
prescribed conditions.
Functional currency. The currency of the primary economic environment in which the entity
operates.
Future economic benefit. The potential to contribute, directly or indirectly, to the flow of cash and
cash equivalents to the entity. The potential may be a productive one that is part of the operating
activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a
capability to reduce cash outflows, such as when an alternative manufacturing process lowers the
cost of production.
GAAP (generally accepted accounting principles) All the rules, from whatever source, that
govern accounting.
1064
Glossary of terms
Gains. Increases in economic benefits. As such they are no different in nature from revenue.
Going concern. The entity is normally viewed as a going concern, that is, as continuing in
operation for the foreseeable future. It is assumed that the entity has neither the intention nor the
necessity of liquidation or of curtailing materially the scale of its operations.
Goodwill. An asset representing the future economic benefits arising from other assets acquired in
a business combination that are not individually indentified and separately recognised.
Government. Government, government agencies and similar bodies whether local, national or
international.
Government assistance. Action by government designed to provide an economic benefit specific
to an entity or range of entities qualifying under certain criteria.
Government grants. Assistance by government in the form of transfers of resources to an entity in
return for past or future compliance with certain conditions relating to the operating activities of the
entity. They exclude those forms of government assistance which cannot reasonably have a value
placed upon them and transactions with government which cannot be distinguished from the
normal trading transactions of the entity.
Grant date. The date at which the entity and another party (including an employee) agree to a
share-based payment arrangement, being when the entity and the other party have a shared
understanding of the terms and conditions of the arrangement. At grant date the entity confers on
the other party (the counterparty) the right to cash, other assets, or equity instruments of the entity,
provided the specified vesting conditions, if any, are met. If that agreement is subject to an
approval process (for example, by shareholders), grant date is the date when that approval is
obtained.
Grants related to assets. Government grants whose primary condition is that an entity qualifying
for them should purchase, construct or otherwise acquire non-current assets. Subsidiary conditions
may also be attached restricting the type or location of the assets or the periods during which they
are to be acquired or held.
Grants related to income. Government grants other than those related to assets.
Gross investment in the lease. The aggregate of:
(a) The minimum lease payments receivable by the lessor under a finance lease
(b) Any unguaranteed residual value accruing to the lessor
Group. A parent and all its subsidiaries.
Guaranteed residual value.
(a) For a lessee, that part of the residual value which is guaranteed by the lessee or by a party
related to the lessee (the amount of the guarantee being the maximum amount that could, in
any event, become payable).
(b) For a lessor, that part of the residual value which is guaranteed by the lessee or by a third
party unrelated to the lessor who is financially capable of discharging the obligations under
the guarantee.
Hedge effectiveness. The degree to which changes in the fair value or cash flows of the hedged
item attributable to a hedged risk are offset by changes in the fair value or cash flows of the
hedging instrument.
Hedge of a net investment in a foreign operation. HKAS 21 defines a net investment in a
foreign operation as the amount of the reporting entity's interest in the net assets of that operation.
Hedged item. An asset, liability, firm commitment, or forecasted future transaction that:
(a) exposes the entity to risk of changes in fair value or changes in future cash flows, and that
(b) is designated as being hedged.
1065
Financial Reporting
Hedging. For accounting purposes, means designating one or more hedging instruments so that
their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of
a hedged item.
Hedging instrument. A designated derivative or (in limited circumstances) another financial asset
or liability whose fair value or cash flows are expected to offset changes in the fair value or cash
flows of a designated hedged item. (A non-derivative financial asset or liability may be designated
as a hedging instrument for hedge accounting purposes only if it hedges the risk of changes in
foreign currency exchange rates.)
Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair
value of the consideration given to acquire them at the time of their acquisition. Liabilities are
recorded at the amount of proceeds received in exchange for the obligation, or in some
circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected
to be paid to satisfy the liability in the normal course of business.
HKFRS due process The process followed by HKICPA in setting a new HKFRS.
Identifiable. An asset is identifiable if it either:
(a) is separable, i.e. capable of being separated or divided from the entity and sold, transferred,
licensed, rented or exchanged, either individually or together with a related contract,
identifiable asset or liability, regardless of whether the entity intends to do so.
(b) arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations.
Impairment loss. The amount by which the carrying amount of an asset exceeds its recoverable amount.
Impracticable. Applying a requirement is impracticable when the entity cannot apply it after
making every reasonable effort to do so.
Inception of the lease. The earlier of the date of the lease agreement and the date of commitment
by the parties to the principal provisions of the lease. As at this date:
(a) A lease is classified as either an operating lease or a finance lease
(b) In the case of a finance lease, the amounts to be recognised at the lease term are
determined.
Income. Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants.
Incremental costs. Initial direct costs are incremental costs that are directly attributable to
negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer
lessors. Examples of initial direct costs include amounts such as commissions, legal fees and
relevant internal costs.
Initial direct costs. Incremental costs that are directly attributable to negotiating and arranging a
lease, except for such costs incurred by manufacturer or dealer lessors. Examples of initial direct
costs include amounts such as commissions, legal fees and relevant internal costs.
Intangible asset. An identifiable non-monetary asset without physical substance.
Integrated report A concise communication about how an organisation’s strategy, governance,
performance and prospects, in the context of its external environment, lead to the creation of value
in the short, medium and long tem.
Interest. The charge for the use of cash or cash equivalents or amounts due to the entity.
Interest cost. The increase during a period in the present value of a defined benefit obligation
which arises because the benefits are one period closer to settlement.
1066
Glossary of terms
Interest rate implicit in the lease. The discount rate that, at the inception of the lease, causes the
aggregate present value of the:
(a) Minimum lease payments
(b) Unguaranteed residual value
to be equal to the sum of:
(a) The fair value of the leased asset
(b) Any initial direct costs.
Interim financial report. A financial report containing either a complete set of financial statements
(as described in HKAS 1) or a set of condensed financial statements (as described in HKAS 34)
for an interim period.
Interim period. A financial reporting period shorter than a full financial year.
Intrinsic value. The difference between the fair value of the shares to which the counterparty has
the (conditional or unconditional) right to subscribe or which it has the right to receive, and the price
(if any) the other party is (or will be) required to pay for those shares. For example, a share option
with an exercise price of $15 on a share with a fair value of $20, has an intrinsic value of $5.
Inventories. Assets:
Held for sale in the ordinary course of business
In the process of production for such sale
In the form of materials or supplies to be consumed in the production process or in the
rendering of services.
Investing activities. The acquisition and disposal of long-term assets and other investments not
included in cash equivalents.
Investment entity. An entity which:
obtains funds from one or more investors for the purpose of providing those investors with
investment management services
commits to its investors that its business purpose is to invest funds solely for returns from
capital appreciation, investment income or both, and
measures and evaluates the performance of substantially all of its investments on a fair
value basis.
Investment property. Property (land or a building – or part of a building – or both) held (by the
owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both,
rather than for:
(a) Use in the production or supply of goods or services or for administrative purposes
(b) Sale in the ordinary course of business.
Joint arrangement. An arrangement of which two or more parties have joint control.
Joint control. The contractually agreed sharing of control of an arrangement, which exists only when
decisions about the relevant activities require the unanimous consent of the parties sharing control.
Joint operation. A joint arrangement whereby the parties that have joint control of the
arrangement have rights to the assets and obligations for the liabilities relating to the arrangement.
Joint operator. A party to a joint operation that has joint control of that joint operation.
Joint venture. A joint arrangement whereby the parties that have joint control of the arrangement
have rights to the net assets of the arrangement.
Joint venturer. A party to a joint venture that has joint control of that joint venture.
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Financial Reporting
Key management personnel. Those persons having authority and responsibility for planning,
directing and controlling the activities of the entity, directly or indirectly, including any director
(whether executive or otherwise) of that entity.
Lease. An agreement whereby the lessor conveys to the lessee in return for a payment or series of
payments the right to use an asset for an agreed period of time.
Lease term. The non-cancellable period for which the lessee has contracted to lease the asset
together with any further terms for which the lessee has the option to continue to lease the asset,
with or without further payment, when at the inception of the lease it is reasonably certain that the
lessee will exercise the option.
Lessee's incremental borrowing rate of interest. The rate of interest the lessee would have to
pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the
lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to
purchase the asset.
Legal obligation A duty to act in a certain way deriving from a contract, legislation or some other
operation of the law.
Level 1 inputs Quoted prices (unadjusted) in active markets for identical assets or liabilities that an
entity can access at the fair value measurement date.
Level 2 inputs Inputs other than quoted prices (Level 1 inputs) that are observable for an asset.
Level 3 inputs Unobservable inputs for an asset or liability using an entity’s own assumptions
about market exit value.
Liability. A present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
Liquidation. The "end of the road" for the company. It occurs when it is certain that the life of the
company will come to an end. The process by which this occurs is called winding up. You can use
the terms "liquidation" and "winding up" to mean broadly the same thing. However, the company
does not have to be in financial difficulties to be wound up. The members of the company may
decide at any time to take such action, and in some cases are obliged to do so (for example, if the
company were set up to achieve a specific purpose and this has been fully achieved, there is no
reason for the company to go on trading).
Liquidity. The availability of sufficient funds to meet deposit withdrawals and other short-term
financial commitments as they fall due.
Losses. Decreases in economic benefits. As such they are no different in nature from other
expenses.
Management commentary A narrative report that accompanies financial statements. Known as
management discussion and analysis in Hong Kong.
Market participants are buyers and sellers in the principal (or most advantageous) market for the
asset or liability that have all of the following characteristics:
(a) they are independent of each other ie they are not related parties as defined in HKAS 24,
although the price in a related party transaction may be used as an input to a fair value
measurement if the entity has evidence that the transaction was entered into at market
terms.
(b) they are knowledgeable, having a reasonable understanding about the asset or liability and
the transaction using all available information, including information that might be obtained
through due diligence efforts that are usual and customary.
(c) they are able to enter into a transaction for the asset or liability.
(d) they are willing to enter into a transaction for the asset or liability, ie they are motivated but
not forced or otherwise compelled to do so.
1068
Glossary of terms
Material. Omissions or misstatements of items are material if they could, individually or collectively,
influence the economic decisions that users make on the basis of the financial statements.
Materiality depends on the size and nature of the omission or misstatement judged in the
surrounding circumstances. The size or nature of the item, or a combination of both, could be the
determining factor.
Measurement. The process of determining the monetary amounts at which the elements of the
financial statements are to be recognised and carried in the statement of financial position and
statement of comprehensive income.
Measurement date. The date at which the fair value of the equity instruments granted is
measured. For transactions with employees and others providing similar services, the
measurement date is grant date. For transactions with parties other than employees (and those
providing similar services), the measurement date is the date the entity obtains the goods or the
counterparty renders service.
Measurement period. The measurement period is that period of time immediately after the
acquisition date when the acquirer may still be obtaining the information needed to identify and
measure each element of the goodwill calculation. It ends on the earlier of the date when all
information sought by the acquirer is either obtained or found to be unavailable and 12 months
from the acquisition date.
Minimum lease payments. The payments over the lease term that the lessee is or can be
required to make, excluding contingent rent, costs for services and taxes to be paid by and be
reimbursable to the lessor, together with:
(a) For a lessee, any amounts guaranteed by the lessee or by a party related to the lessee.
(b) For a lessor, any residual value guaranteed to the lessor by one of the following:
(i) The lessee
(ii) A party related to the lessee
(iii) An independent third party financially capable of meeting this guarantee.
However, if the lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than fair value at the date the option becomes exercisable for it to be reasonably
certain, at the inception of the lease, that the option will be exercised, the minimum lease payments
comprise the minimum payments payable over the lease term to the expected date of exercise of
this purchase option and the payment required to exercise it.
Monetary items. Units of currency held and assets and liabilities to be received or paid in a fixed
or determinable number of units of currency.
Most advantageous market The market that maximises the amount that would be received to sell
an asset or minimises the amount that would be paid to transfer a liability after taking into account
transaction and transport costs.
Multi-employer plans. Defined contribution plans (other than state plans) or defined benefit plans
(other than state plans) that:
(a) pool the assets contributed by various entities that are not under common control
(b) use those assets to provide benefits to employees of more than one entity, on the basis that
contribution and benefit levels are determined without regard to the identity of the entity that
employs the employees concerned.
Net defined benefit liability (asset). The deficit or surplus when the fair value of pension plan
assets is deducted from the present value of the defined benefit obligation, adjusted for any effect
of limiting a net defined benefit asset to the asset ceiling.
Net interest on the defined benefit liability (asset) is the change during the period in the net
defined benefit liability (asset) that arises from the passage of time.
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Financial Reporting
Net investment in a foreign operation. The amount of the reporting entity's interest in the net
assets of that operation.
Net investment in the lease. The gross investment in the lease discounted at the interest rate
implicit in the lease.
Net realisable value. The estimated selling price in the ordinary course of business less the
estimated costs of completion and the estimated costs necessary to make the sale.
Non-adjusting event. An event that provides information about conditions arising after the
reporting date.
Non-cancellable lease. A lease that is cancellable only in one of the following situations:
(a) Upon the occurrence of some remote contingency.
(b) With the permission of the lessor.
(c) If the lessee enters into a new lease for the same or an equivalent asset with the same
lessor.
(d) Upon payment by the lessee of an additional amount such that, at inception, continuation of
the lease is reasonably certain.
Non-controlling interest. The equity in a subsidiary not attributable, directly or indirectly, to a
parent.
Non-current asset. An asset intended for use on a continuing basis in the entity's activities, i.e. it
is not intended for resale.
Obligation. A duty or responsibility to act or perform in a certain way. Obligations may be legally
enforceable as a consequence of a binding contract or statutory requirement. Obligations also
arise, however, from normal business practice, custom and a desire to maintain good business
relations or act in an equitable manner.
Off-balance sheet finance. The funding or refinancing of a company's operations in such a way
that, under legal requirements and traditional accounting conventions, some or all of the finance
may not be shown in its statement of financial position.
Onerous contract. A contract in which the unavoidable costs of meeting the obligations under the
contract exceed the economic benefits expected to be received under it. The unavoidable costs
under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost
of fulfilling it and any compensation or penalties arising from failure to fulfil it.
Operating activities. The principal revenue-producing activities of the entity and other activities
that are not investing or financing activities.
Operating lease. A lease other than a finance lease.
Operating segment. A component of an entity:
(a) that engages in business activities from which it may earn revenues and incur expenses
(including revenues and expenses relating to transactions with other components of the
same entity),
(b) whose operating results are regularly reviewed by the entity's chief operating decision maker
to make decisions about resources to be allocated to the segment and assess its
performance, and
(c) for which discrete financial information is available.
Options, warrants and their equivalents. Financial instruments that give the holder the right to
purchase ordinary shares.
Ordinary share. An equity instrument that is subordinate to all other classes of equity instruments.
Orderly transaction is a transaction that assumes exposure to the market for a period before the
measurement date to allow for marketing activities that are usual and customary for transactions
1070
Glossary of terms
involving such assets or liabilities; it is not a forced transaction (eg a forced liquidation or distress
sale).
Other comprehensive income Defined items of income and expense that are not initially
recognised in profit or loss.
Other long-term employee benefits. Employee benefits (other than post-employment benefits
and termination benefits) that are not due to be settled within 12 months after the end of the period
in which the employees render the related service.
Owner-occupied property. Property held by the owner (or by the lessee under a finance lease) for
use in the production or supply of goods or services or for administrative purposes.
Parent. An entity that controls one or more entities.
Past service cost. The change in the present value of the defined benefit obligation for employee
service in prior periods, resulting from a plan amendment (the introduction or withdrawal of, or
changes to, a defined benefit plan) or a curtailment (a significant reduction by the entity in the
number of employees covered by a plan).
Plan assets comprise:
(a) assets held by a long-term employee benefit fund
(b) qualifying insurance policies
Post-employment benefit plans. Formal or informal arrangements under which an entity provides
post-employment benefits for one or more employees.
Post-employment benefits. Employee benefits (other than termination benefits) which are
payable after the completion of employment.
Potential ordinary share. A financial instrument or other contract that may entitle its holder to
ordinary shares.
Power. Existing rights that give the current ability to direct the relevant activities.
Present value of a defined benefit obligation. The present value, without deducting any plan
assets, of expected future payments required to settle the obligation resulting from employee
service in the current and prior periods.
Present value. The present discounted value of the future net cash flows in the normal course of
business.
Presentation currency. The currency in which the financial statements are presented.
Principal market The market with the greatest volume and level of activity for an asset or liability.
Prior period errors. Omissions from, and misstatements in, the entity's financial statements for
one or more prior periods arising from a failure to use, or misuse of, reliable information that:
was available when financial statements for those periods were authorised for issue
could reasonably be expected to have been obtained and taken into account in the
preparation and presentation of those financial statements.
Property, plant and equipment. Tangible items that are:
Held for use in the production or supply of goods or services, for rental to others, or for
administrative purposes
Expected to be used during more than one period
Prospective application of a change in accounting policy and of recognising the effect of a
change in an accounting estimate, respectively, are:
applying the new accounting policy to transactions, other events and conditions occurring
after the date as at which the policy is changed
1071
Financial Reporting
recognising the effect of the change in the accounting estimate in the current and future
periods affected by the change.
Provision. A liability of uncertain timing or amount.
Puttable financial instrument An instrument where the holder can ’put’ the instrument i.e. require
the issuer to redeem it in cash.
Qualifying asset. An asset that necessarily takes a substantial period of time to get ready for its
intended use or sale.
Qualitative characteristics The attributes, as identified in the Conceptual Framework, that make
the information provided in financial statements useful to investors, lenders and creditors.
Qualitative characteristics are split into fundamental characteristics (relevance and faithful
representation) and enhancing characteristics (comparability, verifiability, timeliness and
understandability).
Realisable value. The amount of cash or cash equivalents that could currently be obtained by
selling an asset in an orderly disposal.
Receiver A person or firm appointed by a company’s creditors to act if a company has broken the
terms of a debenture.
Reclassification adjustments The reclassification of an amount previously recognised as other
comprehensive income to profit or loss. Only limited items as defined in HKFRS may be
reclassified.
Recognition. The process of incorporating in the statement of financial position or statement of
comprehensive income an item that meets the definition of an element and satisfies the following
criteria for recognition:
(a) It is probable that any future economic benefit associated with the item will flow to or from
the entity.
(b) The item has a cost or value that can be measured with reliability.
Recoverable amount (of an asset). The higher of an asset's fair value less costs to sell and its
value in use.
Related party. A person or entity that is related to the entity that is preparing its financial
statements.
Related party transaction. A transfer of resources, services or obligations between a reporting
entity and a related party, regardless of whether a price is charged.
Relevance. Information has the quality of relevance when it influences the economic decisions of
users by helping them evaluate past, present or future events or confirming, or correcting, their
past evaluations.
Relevant activities. Activities of the investee that significantly affect the investee's returns.
Remeasurements of the net defined benefit liability (asset) comprise:
1072
Glossary of terms
Residual value. The estimated amount that an entity would currently obtain from disposal of the
asset, after deducting the estimated costs of disposal, if the asset were already of the age and in
the condition expected at the end of its useful life.
Restructuring. A programme that is planned and controlled by management and materially
changes either:
The scope of a business undertaken by an entity; or
The manner in which that business is conducted.
Retrospective application. Applying a new accounting policy to transactions, other events and
conditions as if that policy had always been applied.
Retrospective restatement. Correcting the recognition, measurement and disclosure of amounts
of elements of financial statements as if a prior period error had never occurred.
Return on plan assets. Interest, dividends and other revenue derived from the plan assets,
together with realised and unrealised gains or losses on the plan assets, less any cost of
administering the plan (other than those included in the actuarial assumptions used to measure the
defined benefit obligation) and less any tax payable by the plan itself.
Revaluation. Restatement of assets and liabilities.
Revenue. The gross inflow of economic benefits during the period arising in the course of the
ordinary activities of an entity when those inflows result in increases in equity, other than increases
relating to contributions from equity participants.
Royalties. Charges for the use of non-current assets of the entity, e.g. patents, computer software
and trademarks.
Service concession arrangements. Arrangements whereby a government or other body grants
contracts for the supply of public services – such as roads, energy distribution, prisons or hospitals
– to private operators.
Service cost comprises:
(a) Current service cost which is the increase in the present value of the defined benefit
obligation resulting from employee service in the current period.
(b) Past service cost, which is the change in the present value of the defined benefit obligation
for employee service in prior periods, resulting from a plan amendment (the introduction or
withdrawal of, or changes to, a defined benefit plan) or a curtailment (a significant reduction
by the entity in the number of employees covered by a plan); and
(c) Any gain or loss on settlement.
Settlement A transaction that eliminates all further legal or constructive obligations for part or all of
the benefits provided under a defined benefit plan, other than a payment of benefits to, or on behalf
of employees that is set out in the terms of the plan and included in the actuarial assumptions.
Settlement date The date on which an asset is delivered to or by an entity (relevant to financial
instruments)
Settlement value. The undiscounted amounts of cash or cash equivalents expected to be paid to
satisfy the liabilities in the normal course of business.
Share option. A contract that gives the holder the right, but not the obligation, to subscribe to the
entity's shares at a fixed or determinable price for a specified period of time.
Share-based payment arrangement. An agreement between the entity (or another group entity)
and another party (including an employee) that entitles the other party to receive:
(a) cash or other assets of the entity for amounts that are based on the price (or value) of equity
instruments (including shares or share options) of the entity or another group entity, or
(b) equity instruments (including shares or share options) of the entity or another group entity
provided the specified vesting conditions are met.
1073
Financial Reporting
1074
Glossary of terms
Theoretical ex-rights price (TERP) The theoretical price at which the shares would trade after a
rights issue, taking into account the diluting effect of the bonus element in the rights issue.
Timeliness. An enhancing characteristic which means having information available in time to be
capable of influencing decisions.
Trade date The date on which an entity commits to purchase or sell an asset (relevant to financial
instruments)
True and fair Financial statements are true and fair when they depict a faithful representation of
transactions and events in accordance with the Conceptual Framework.
Understandability. An enhancing qualitative characteristic. Classifying, characterising and
presenting information clearly and concisely makes it understandable.
Unearned finance income. The difference between the:
(a) Gross investment in the lease
(b) Net investment in the lease
Unguaranteed residual value. That portion of the residual value of the leased asset, the
realisation of which by the lessor is not assured or is guaranteed solely by a party related to the
lessor.
Unit of account is the level at which an asset or liability is aggregated or disaggregated in an IFRS
for recognition purposes.
Useful life. The estimated remaining period, from the beginning of the lease term, without limitation
by the lease term, over which the economic benefits embodied in the asset are expected to be
consumed by the entity.
Value in use. The present value of the future cash flows expected to be derived from an asset.
Variable production overheads. Those indirect costs of production that vary directly, or nearly
directly, with the volume of production, such as indirect materials and labour.
Verifiability. An enhancing qualitative characteristic. Different knowledgeable and independent
observers could reach consensus that a depiction is a faithful representation.
Vertical group A group in which the parent controls a subsidiary and that subsidiary in turn
controls one or more further subsidiaries.
Vest. To become an entitlement. Under a share-based payment arrangement, a counterparty's
right to receive cash, other assets, or equity instruments of the entity vests when the counterparty’s
entitlement is no longer conditional on the satisfaction of any vesting conditions.
Vested employee benefits. Employee benefits that are not conditional on future employment.
Vesting conditions are the conditions that determine whether the entity receives the services that
entitle the counterparty to receive cash, other assets or equity instruments of the entity, under a
share-based payment arrangement. Vesting conditions are either service conditions or
performance conditions. Service conditions require the counterparty to complete a specified period
of service. Performance conditions require the counterparty to complete a specified period of
service and specified performance targets to be met (such as a specified increase in the entity's
profit over a specified period of time). A performance condition might include a market condition. A
market condition is a condition that is related to the market price or value of an entity’s equity
instruments.
Vesting period. The period during which all the specified vesting conditions of a share-based
payment arrangement are to be satisfied.
Weighted Average Cost Method. A cost formula uses in the measurement inventory that uses
weighted averages to determine the cost of items of inventory.
1075
Financial Reporting
1076
Index
1077
Financial Reporting
1078
Index
Note: Key Terms and their page references are given in bold
1079
Financial Reporting
1080
Index
GAAP for Small and Medium-sized Entities, HK(SIC) Int-27 Evaluating the Substance of
46 Transactions in the Legal Form of a Lease,
Gains, 57 241
Generally Accepted Accounting Principles HK(SIC) Int-32 Intangible Assets – Website
(GAAP), 45 Costs, 188
Going concern, 53, 710 HK(SIC) Interpretations, 38
Goodwill, 198, 740, 742, 768, 790, 793, 859, HKAS 1 Presentation of Financial
906 Statements, 490, 697
Government, 161 HKAS 2 Inventories, 253
Government assistance, 161, 166 HKAS 7 Statement of Cash Flows, 568
Government grants, 161, 162 HKAS 8 Accounting Policies, Changes in
Government related entities, 608 Accounting Estimates and Errors, 381,
Grant date, 312 622, 752
Grants related to assets, 161, 163 HKAS 8 Accounting Policies, Changes in
Grants related to income, 161, 164 Accounting Estimates and Errors, 619
Gross investment in the lease, 222 HKAS 10 Events after the Reporting Period,
Group, 728 628
Group reserves, 769, 791 HKAS 11 Construction Contracts, 291
Growth Enterprise Market, 41 HKAS 11 Construction Contracts, 362
Guaranteed residual value, 222 HKAS 12 Income Taxes, 379, 490, 903
HKAS 16 Property, Plant and Equipment,
117
H HKAS 17 Leases, 219, 241
Hedge accounting, 531 HKAS 18 Revenue, 346, 362
Hedge effectiveness, 511 HKAS 19 Employee Benefits, 433
Hedge of a net investment in a foreign HKAS 20 Government Grants, 161
operation, 512 HKAS 21 The Effects of Changes in Foreign
Hedged item, 511 Exchange Rates, 897
Hedges of a net investment, 521 HKAS 23 Borrowing Costs, 465
Hedging, 511 HKAS 24 Related Party Disclosures, 603
Hedging instrument, 511 HKAS 32 Financial Instruments:
Held for sale, 98 Presentation, 479
Held to maturity (HTM), 503 HKAS 32: Presentation of financial
Highly probable sale, 99 instruments, 482
Historical cost, 59 HKAS 33 Earnings Per Share, 641, 682
HK(IFRIC) Int-1 Changes in Existing HKAS 34 Interim Financial Reporting, 681
Decommissioning, Restoration and Similar HKAS 36 Impairment of Assets, 190, 753
Liabilities, 281 HKAS 37 Provisions, Contingent Liabilities
HK(IFRIC) Int-10 Interim Financial Reporting and Contingent Assets, 269
and Impairment, 689 HKAS 38 Intangible Assets, 175
HK(IFRIC) Int-13 Customer Loyalty HKAS 39 Embedded Derivatives, 509
Programmes, 359 HKAS 39 Financial Instruments: Recognition
HK(IFRIC) Int-15 Agreements for the and Measurement, 479
Construction of Real Estate, 361 HKAS 39 Hedging, 511
HK(IFRIC) Int-4 Determining whether an HKAS 39 Recognition and measurement
Arrangement contains a Lease, 242 rules, 502
HK(IFRIC) Int-5 Rights to Interests from HKAS 40 Investment Property, 143
Decommissioning Restoration and HKFRS 2 Share-based Payment, 311
Environmental Rehabilitation Funds, 282 HKFRS 3 Business Combinations, 408, 739,
HK(IFRIC) Interpretations, 38 871
HK(SIC) Int-10 Government Assistance – no HKFRS 5 Non-current Assets Held for Sale
specific relation to operating activities, 166 and Discontinued Operations, 97
HK(SIC) Int-15 Operating Leases – HKFRS 7 Financial instruments Disclosures,
Incentives, 224 479, 522
HK(SIC) Int-21 Income Taxes – Recovery of HKFRS 8 Operating segments, 665
Revalued Non-depreciable Assets, 414 HKFRS 9, 490, 495
HK(SIC) Int-25 Income taxes – Changes in HKFRS 9 Financial Instruments, 479
the Tax Status of an Entity or its HKFRS 10, 584, 603, 729, 732, 734, 754,
Shareholders, 415 766, 767, 845, 848, 858, 862, 873, 907
1081
Financial Reporting
1082
Index
1083
Financial Reporting
1084
Notes
1085
Financial Reporting
1086
Notes
1087
Financial Reporting
1088
Notes
1089
Financial Reporting
1090
Notes
1091
Financial Reporting
1092
Notes
1093
Financial Reporting
1094
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