SECTION A – CASE QUESTIONS (Total: 50 marks)

Answer 1(a)

To: Mr. Peter LIN, Director, FYL

From: Accounting Manager, FYL
c.c.: L.P. LEE, Ricky YUEN, S.Y. LEUNG (Directors)
Date: dd/mm/yyyy

I refer to your e-mail dated 18 June 2005 regarding your queries about the summary
consolidated financial statements for FYL for the year ended 31 March 2005.

The explanation of the differences between the accounting treatment of the investments in
BLL and SGL is as follows:

The objective of preparing consolidated financial statements is to give a true and fair view
of the state of affairs and results of the group as if it were a single economic entity.

In order to achieve this objective, the financial statements of member companies of our
Group are combined (or added up, in simple terms) and certain adjustments are made to
the combined statements.

FYL, as a parent company, shall present consolidated financial statements in which it

consolidates its investment in subsidiaries in accordance with the accounting standard
(HKAS 27).

A subsidiary is an entity that is controlled by another entity. In this case, control of SGL is
presumed to exist since FYL owns 100% of the issued shares of SGL.

However, FYL holds only 20% of the issued shares of BLL so that FYL has significant
influence, but not control over BLL.

Therefore, BLL should be accounted for as an associate under HKAS 28 since it is an

entity over which FYL has significant influence and it is neither a subsidiary nor an interest
in joint venture.

An investment in an associate shall be accounted for using the equity method. Under the
equity method, the investment in an associate is initially recognised at cost and the
carrying amount is increased or decreased to recognise FYL’s share of BLL’s profit or loss
after the date of acquisition. FYL’s share of BLL’s profit or loss is recognised in FYL’s
profit or loss.

The carrying amount of the investment in BLL is reduced under equity method reporting
when a dividend is received from BLL, and when an impairment occurs.

Besides, HKAS 28 requires us to make appropriate adjustments to FYL’s share of the

profits or losses after acquisition to account, for example, for depreciation of the
depreciable assets, based on their fair values at the date of acquisition.

Module A (May 2005 Session) 1

Please refer to the annex for detailed calculation of balance of investment in BLL as shown
in the consolidated balance sheet as at 31 March 2005.

The method of combining financial results in different currencies and the calculation of the
translation reserve are as follows:

FYL, BLL and SGL have to determine, as an accounting policy, their respective functional
currencies. This currency is that of the primary economic environment in which each of
the entities operates. All currencies other than the functional currency are foreign
currencies to the entity.

Once determined, the functional currency is not changed unless there is a change in
underlying transactions, events and conditions.

FYL, BLL and SGL shall each translate foreign currency items or transactions into its
functional currency. Any exchange difference arising from such translation is, in general,
recognised as a profit or loss.

However, FYL, BLL and SGL may present their respective financial statements in any
currency. If the presentation currency differs from the entity’s functional currency, it
translates its results and financial position into the presentation currency in accordance
with the procedures set out in HKAS 21.

Similarly, the results and financial position of a foreign operation are translated into a
presentation currency so that the foreign operation can be included in the financial
statements of the reporting entity by consolidation, proportionate consolidation or the equity
method.

Since we present the consolidated financial statements of FYL Group in HKD, the results of
BLL and SGL must be expressed in HKD so that consolidated financial statements may be
presented.

Assets and liabilities for each balance sheet presented (including comparatives) shall be
translated at the closing rate at the date of that balance sheet.

Income and expenses for each income statement (including comparatives) shall be
translated at exchange rates at the dates of the transactions.

For practical reasons, a rate that approximates the exchange rates at the dates of the
transactions, for example an average rate for the period, is often used to translate income
and expense items. However, if exchange rates fluctuate significantly, the use of the
average rate for a period is inappropriate.

Any goodwill arising from the acquisition of foreign operations (BLL and SGL) and fair value
adjustments to the carrying amounts of assets and liabilities on the acquisition shall be
treated as assets and liabilities of the foreign operation.

Thus they shall be expressed in the functional currency of the foreign operation and shall
be translated at the closing rate.

All resulting exchange differences shall be recognised as a separate component of equity.

In this case, the item translation reserve serves to keep all these resulting exchange
differences as a separate component of equity.

Module A (May 2005 Session) 2

The translation reserve essentially results from:

(a) translating income and expenses at the exchange rates at the dates of the
transactions and assets and liabilities at the closing rate. Such exchange
differences arise both on income and expense items recognised in profit or loss and
on those recognised directly in equity.

(b) translating the opening net assets at a closing rate that differs from the previous
closing rate.

These exchange differences (translation reserve) are not recognised in profit or loss
because the changes in exchange rates have little or no direct effect on present and future
cash flows from operations.

Please refer to the annex for detailed workings of the calculation of translation reserve.

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

Best regards

XXX

Answer 1(b)

Appendix A – Translation from AUD to HKD both the trial balances of BLL and SGL as at
31 March 2005

BLL SGL Exchange BLL SGL

AUD'000 AUD'000 rate HKD'000 HKD'000
Plant and equipment 24,000 5,000 6.00 144,000 30,000
Accumulated depreciation (6,000) (750) 6.00 (36,000) (4,500)
Inventory 8,600 500 6.00 51,600 3,000
Cash and receivables 11,610 2,425 6.00 69,660 14,550
Accounts payable (5,380) (300) 6.00 (32,280) (1,800)
Long term loans (11,950) (1,250) 6.00 (71,700) (7,500)
Share capital (9,000) (4,000) 5.80 (52,200) (23,200)
Retained profits
– at 1 April 2004 (4,000) (1,000) 5.80 (23,200) (5,800)
Sales (57,900) (5,000) 5.70 (330,030) (28,500)
Cost of goods sold 33,000 2,250 5.70 188,100 12,825
Depreciation expense 2,400 300 5.70 13,680 1,710
Operating expense 13,150 1,150 5.70 74,955 6,555
Interest expense 570 675 5.70 3,249 3,848
Dividend paid 900 - 5.60 5,040 -
- -
Translation reserve (4,874) (1,188)
- -

Module A (May 2005 Session) 3

Answer 1(c)

Appendix B – Calculation of the investment in BLL (investment in associate)

Exchange
AUD'000 rate HKD'000
Cost of investment at 1 April 2004 5,000 5.80 29,000
Share of profit for the year ended 31 March 2005
(AUD 8,780 x 20%) 1,756 5.70 10,009
Depreciation adjustment for the year
[AUD(5,000 - (9,000 + 4,000) x 20%)] / 10 (240) 5.70 (1,368)
Dividend received during the year (AUD900 x 20%) (180) 5.60 (1,008)
Share of net assets in AUD 6,336
Share of translation reserve of BLL (HK$4,874 x 20%) 975
Translation reserve of fair value adjustment:
- Fair value adjustment at 31 March 2005 2,160 6.00 12,960
- Depreciation adjustment for the year 240 5.70 1,368
- Fair value adjustment at 1 April 2004 (2,400) 5.80 (13,920)
408
Total translation reserve recognised for the year 1,383
Share of net assets in HKD at 31 March 2005** 38,016

** Share of net assets in HKD at 31 March 2005 may be reconciled to net asset of BLL as at
31 March 2005 as follows:

BLL
HKD'000
Share capital (52,200)
Retained profits – at 1 April 2004 (23,200)
Sales (330,030)
Cost of goods sold 188,100
Depreciation expense 13,680
Operating expense 74,955
Interest expense 3,249
Dividend paid 5,040
Translation reserve (4,874)
Net asset of BLL at 31 March 2005 125,280

Share of net asset of BLL at 31 March 2005 (125,280 x 20%) 25,056

Balance of fair value adjustment 12,960
Carrying of investment in BLL at 31 March 2005 38,016

Module A (May 2005 Session) 4

Answer 1(d)

Appendix C – Worksheet for preparation of the consolidated balance sheet of FYL Group as
at 31 March 2005

FYL SGL Dr Cr Group

HKD'000 HKD'000 HKD'000 HKD'000 HKD'000
Plant and equipment 150,000 30,000 - - 180,000
Accumulated depreciation (37,500) (4,500) - - (42,000)
Investment in subsidiaries 29,000 - - 29,000 -
Investment in associates 29,000 - 9,016 - 38,016
Inventory 100,000 3,000 - - 103,000
Cash and receivables 75,000 14,550 - - 89,550
Accounts payable (50,000) (1,800) - - (51,800)
Long term loans (100,000) (7,500) - - (107,500)
Share capital (129,000) (23,200) 23,200 - (129,000)
Retained profits at
1 April 2004 (50,000) (5,800) 5,800 - (50,000)
Profit for the year (16,500) (3,562) 1,008 8,641 (27,695)
Translation reserve - (1,188) - 1,383 (2,571)
- - 39,024 39,024 -

We have made a mistake in preparing FYL’s trial balances. The dividend received should
be deducted from the investment in associate rather than recognised as dividend income
since it is paid from pre-acquisition profit. We will correct FYL’s separate financial
statements when we submit the revised financial statements for your approval.

Module A (May 2005 Session) 5

Alternatively, candidates may present the journal entries as follows:

HK$’000 HK$’000
DR Share capital 23,200
DR Retained profits – pre-acquisition profit of subsidiaries 5,800
CR Investment in subsidiaries – cost of acquisition 29,000
Being elimination of FYL’s investment in SGL against SGL’s share capital, pre-acquisition
profits.

HK$’000 HK$’000
DR Profit or loss for the year - dividend income 1,008
CR Investment in associates 1,008
Being elimination of FYL’s dividend income against FYL’s investment in BLL.

We have made a mistake in preparing FYL’s trial balances. The dividend received should
be deducted from the investment in associate rather than recognised as dividend income
since it is paid from pre-acquisition profit. We will correct FYL’s separate financial
statements when we submit the revised financial statements for your approval.

HK$’000 HK$’000
DR Investment in associates 8,641
CR Profit or loss for the year – share of profits of 8,641
associates (HK$10,009 – HK$1,368)
Being recognition of FYL’s share of BLL’s profit for the year.

HK$’000 HK$’000
DR Investment in associates 1,383
CR Translation reserves – associates 1,383
Being recognition of translation reserve relating to BLL.

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

Module A (May 2005 Session) 6

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

Answer 2

It is definitely true that certified public accountants owe legal, contractual and ethical duties
to their employers. However, this does not necessarily mean that these are the only
duties that a certified public accountant has.

Additionally, as members of the Hong Kong Institute of Certified Public Accountants, they
have ethical duties towards the Institute.

In particular, they should observe the same fundamental principles set out in Statement 1.2
Professional Ethics - Explanatory Foreword and the same standards of behaviour and
competence as apply to other certified public accountants who are working in practising
offices. The fundamental principles are:

- certified public accountants should always have regard to any factors that might
reflect adversely upon their integrity and objectivity in relation to their professional
assignment or occupation.

- certified public accountants should carry out their professional work with a proper
regard for the technical and professional standards expected of a certified public
accountant and should not undertake professional work that they are not competent
to perform.

- certified public accountants should behave with courtesy and consideration towards
all with whom they come into contact in the course of their professional work.

- in circumstances not provided for by the ethical guidelines, certified public

accountants should behave in a manner consistent with the good reputation of the
profession and the Hong Kong Institute of CPAs.

These fundamental principles of professional ethics are drawn from the duties owed by
members of the profession, whether the members are in practice or not.

They set out the overriding requirement that a certified public accountant must at all times
perform his/her work objectively and impartially and free from influence by any
consideration which might appear to be in conflict with this requirement.

Statement 1.291 The Ethical Responsibilities of Members in Business sets out more
detailed guidelines for certified public accountants working in business.

At all times, certified public accountants should be conscious that integrity must be an
overriding principle. In conforming with this standard, they should not knowingly mislead
or misrepresent facts to others and should use due care to avoid doing so unintentionally.

Module A (May 2005 Session) 7

Candidates may have other arguments that certified public accountants owe ethical (not
statutory or contractual) duties to public. For example:

- financial statements prepared by certified public accountants are used by various

parties, e.g. government agencies, general public etc.

- certified public accountants have social responsibilities like all other citizens. They
shall act honestly and not affect other people’s interests in an unfair manner.

- other arguments that certified public accountants have ethical duties to the general
public.

Answer 3

Transaction (a)

Since it is likely that the estimated useful life of the investment property is much longer than
the lease term of five years, BCL is a lessor of an operating lease.

HKAS 17 requires that lease income from operating leases shall be recognised in income
on a straight-line basis over the lease term, unless another systematic basis is more
representative of the time pattern in which use benefit derived from the leased investment
property is diminished (which is not likely in this case).

The provision of the six-month rent-free period is a lease incentive, which shall be
recognised as an integral part of the net consideration agreed for the use of the leased
investment property.

BCL shall recognise the aggregate cost of incentives as a reduction of rental income over
the lease term.

Therefore, rental income recognised in the income statement for the year ending
31 December 2005 should be HK$9,720,000 ([HK$1,800,000 x (60-6) / 60] x 6).

Transaction (b)

Revenue from the sale of the house shall be recognised when all the following conditions
have been satisfied: (1) BCL has transferred to the buyer the significant risks and rewards
of ownership of the house; (2) BCL retains neither continuing managerial involvement to
the degree usually associated with ownership nor effective control over the house sold; (3)
the amount of revenue can be measured reliably; (4) it is probable that the economic
benefits associated with the transaction will flow to BCL; and (5) the costs incurred or to be
incurred in respect of the transaction can be measured reliably.

Provided that all these conditions are satisfied, the revenue from the sale of the house
should be recognised.

HKAS 18 requires that revenue shall be measured at the fair value of the consideration
received or receivable.

Module A (May 2005 Session) 8

When the inflow of cash consideration is deferred, the fair value of the consideration may
be less than the nominal value of cash received.

When the arrangement effectively constitutes a financing transaction, the fair value of the
consideration is determined by discounting all future receipts using an imputed rate of
interest.

The imputed rate of interest 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 the nominal value is recognised as an interest
revenue.

In this case, the amount of revenue recognised in the financial year ending 31 December
2005 = HK$1.2 million + discounted future cash flows of HK$10.8 million.

Transaction (c)

It is not likely that the pre-completion sale of the 50 self-developed residential properties
meets the definition of construction contracts set out in HKAS 11 since the contracts in
question are not likely to have been negotiated specifically for the construction of the
properties.

According to Interpretation No. 24, BCL shall apply HKAS 18 in recognising revenue arising
from pre-completion sale of the 50 residential properties. That is, revenue shall only be
recognised when all of the revenue recognition conditions set out in HKAS 18 are met.

The amount received of HK$38.5 million should be recognised as a liability in the balance
sheet before the revenue for the sale of properties is recognised.

Answer 4(a)

The amount of compensation expense in relation to the share options recognised in the
income statement for the year ended 31 December 2004:

As at 31 December 2004, the company expected that all the 300,000 outstanding share
options (400,000 – 100,000) would vest.

Based on the fair value of the share option at the date of grant, i.e. HK$5, total
equity-settled share-based payment to the managers should be HK$1,500,000 (300,000 x
HK$5).

This equity-settled share-based payment shall be expensed over the vesting period, i.e.
from 1 April 2004 to 31 March 2005.

The total compensation expense for the year ended 2004 should therefore be
HK$1,125,000.

Calculation: 300,000 x (9/12) x HK$5.

Module A (May 2005 Session) 9

The amount of compensation expense in relation to the share options recognised in the
income statement for the year ending 31 December 2005:

At the end of the vesting period, i.e. 31 March 2005, a total of 300,000 share options
ultimately vested.

Based on the fair value of the share option at the date of grant, i.e. HK$5, the total
compensation expense should therefore be HK$1,500,000 (300,000 x HK$5).

Since a total of HK$1,125,000 has been recognised in the year ended 31 December 2004,
compensation expense for the three months ended 31 March 2005, and hence for the year
ending 31 December 2005 should be HK$375,000 (HK$1,500,000 – HK$1,125,000).

Answer 4(b)

Share appreciation rights are examples of cash-settled share-based payments, as

compared with a share option which is an example of equity-settled share-based payment.

Cash-settled share-based payments are share-based payment transactions that will be

settled in cash or other assets (rather than with an entity’s own equity instruments).

The amount of services received (i.e. the compensation expense incurred) during the
period and liability recognised at each reporting date, shall be based on the fair value of
share appreciation rights at each reporting date.

Unlike the amount of service recognised for the share options which were measured at
their fair value at the grant date, the liability of the share appreciation rights will continue to
be remeasured at the fair value of the reporting date until the liability is settled.

Any changes in fair value of the share appreciation rights should be recognised in profit or
loss for the period as a compensation expense.

Module A (May 2005 Session) 10

Answer 5(a)

Calculation of the temporary differences of the equipment at 31 December 2004:

Taxable amount when APL recovers the carrying amount of the equipment through use in
future periods
= HK$20,000,000 – [(HK$20,000,000/8) x 1.25]
= HK$16,875,000

Deductible amount when APL recovers the carrying amount of the equipment through use
in future periods
= HK$20,000,000 – [(HK$20,000,000 x 0.9/10) x 1.25]
= HK$17,750,000

Deductible temporary difference

= HK$16,875,000 – HK$17,750,000
= HK$875,000

Tax base
= Carrying amount – (taxable amount – deductible amount)
= HK$20,000,000 – (HK$20,000,000 – HK$17,750,000)
= HK$17,750,000

Answer 5(b)

For the purpose of the consolidated financial statements of BHL, there are two temporary
differences:

­ Temporary difference relating to the production equipment of APL in 5(a); and

­ Temporary difference arising from the elimination of unrealised profits in BHL’s

inventory.

In the consolidated balance sheet of BHL as at 31 December 2004, unrealised profits of

HK$1,260,000 should have been eliminated [HK$5,600,000 x 9,000,000 / 40,000,000],
reducing the carrying amount of the inventory by HK$1,260,000 to HK$7,740,000.

On recovery of the inventory with a carrying amount of HK$7,740,000, the deductible

amount for BHL’s income tax purpose is HK$9,000,000.

As a result, a deductible temporary difference of HK$1,260,000 (HK$9,000,000 –

HK$7,740,000) as at 31 December 2004 arose in the consolidated financial statements of
BHL.

Deferred tax balances should be calculated using the tax rates that are expected to apply
to the reporting period or periods when the temporary difference reverses, based on tax
rates and tax law enacted or substantially enacted at the balance sheet date.

In the case of APL’s equipment, the deductible temporary difference of HK$875,000 will not
be reversed before 2006. Therefore, the applicable tax rate should be 15%.

Module A (May 2005 Session) 11

The deferred tax asset in relation to APL’s equipment should therefore be HK$131,250
(HK$875,000 x 15%).

For the purposes of calculating the amount of deferred tax assets in relation to BHL’s
inventory, the tax rate applicable should be 17.5%.

The deferred tax asset should be HK$220,500 = HK$1,260,000 x 17.5%

According to HKAS 12, a deferred tax asset should be recognised for all deductible
temporary differences to the extent that it is probable that taxable profit will be available
against which the deductible temporary difference can be utilised.

There are some exceptions to these general rules. However, these exceptions are not
likely to be applicable in this case.

In determining whether it is probable that taxable profit will be available against which the
deductible temporary difference can be utilised, BHL should consider:

- whether there are sufficient deferred tax liabilities, relating to the same taxation
authority and the same taxable enterprise, which are expected to reverse in the
same period as the deferred tax asset is expected to reverse.

- it is probable that BHL will have sufficient taxable profits (from sources other than
reversing deferred tax liabilities), relating to the same taxation authority and the
same taxable enterprise, in the same period as the deferred tax asset is expected to
reverse.

- tax planning opportunities, i.e. actions that BHL could take to create or increase
taxable profits in future periods so as to utilise the available tax deductions before
they expire.

It is not likely that BHL will have sufficient deferred tax liabilities since it did not have any
other temporary difference at 31 December 2004.

Assuming that either one or both of the remaining two conditions are satisfied, a deferred
tax asset should be recognised for the temporary differences. [Alternatively, candidates
may assume that the other two conditions are not satisfied and that no deferred tax asset
should be recognised.]

* * * END OF EXAMINATION PAPER * * *

(ANSWERS)

Module A (May 2005 Session) 12