SECTION A – CASE QUESTIONS

To: Mr. WONG, Director, FPL

From: Raymond CHAN, Accounting Manager, FPL
c.c.: Carmen HE, Ricky LEE, Christopher YUNG (Directors)
Date: dd/mm/yyyy

I refer to your e-mail dated 18 May 2006 regarding your queries about the draft
consolidated financial statements for FPL for the year ended 31 March 2006. My
responses to your queries are as follows:

Answer 1(a)(i)

General accounting treatments for ESL and UAL in FPL’s consolidated financial
statements

Before I explain the accounting treatments for the dividends received from UAL and
ESL, I may need to explain to you the general principles used in accounting for UAL
and ESL in FPL’s consolidated financial statements.

FPL, 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

ESL is presumed to exist since FPL owns 80% of the issued shares of ESL.

Therefore, ESL’s financial statements should be included in FPL’s consolidated

financial statements from the acquisition date, i.e. 1 April 2005.

FPL should adopt FRS 3 to account for the business combination with ESL.

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, FPL’s financial statements and those of its
subsidiaries are combined and a number of consolidation adjustments are made to the
combined financial statements.

These consolidated adjustments include eliminating the investment cost in ESL

against its equity at the acquisition date, any income and expenses arising from
intragroup transactions between FPL and ESL during the year, and any intragroup
balances between FPL and ESL at the balance sheet date (or other examples of
common consolidation adjustments).

In respect of UAL, FPL holds only 20% of UAL’s issued shares. FPL does not have
control or joint control over UAL.

Module A (February 2006 Session) 1

Therefore, UAL should be accounted for as an associate under HKAS 28 since it is an
entity over which FPL has significant influence and it is neither a subsidiary nor an
interest in a joint venture.

The investment in UAL, an associate, shall be accounted for using the equity method.

Under the equity method, the investment in UAL is initially recognised at cost and
adjusted thereafter for the post-acquisition change in FPL’s share of net assets of UAL.
FPL’s profit or loss includes its share of UAL’s profit or loss.

Answer 1(a)(ii)

Dividends received from ESL and UAL

It is true that a dividend is a kind of revenue and should be accounted for in

accordance with the relevant accounting standard for revenue accounting (HKAS 18).

Therefore, in FPL’s books and its financial statements at the entity level, dividends
shall be recognised as revenue when FPL's right to receive payment is established,
i.e. when ESL or UAL declared the dividend.

However, in the consolidated financial statements of FPL, the dividend revenue from
subsidiaries such as ESL should be eliminated since they are intragroup transactions.

Similarly, FPL’s consolidated cash flow statement should reflect the cash flows of the
group, i.e. it should only deal with flows of cash and cash equivalents external to the
group.

Accordingly, cash flows that are internal to the group, e.g. dividends received from
ESL, should be eliminated in the preparation of the consolidated cash flow statement.

Under the equity method accounting for the investment in UAL, dividends received
from the associate UAL should be eliminated against FPL’s investment in it to reflect
the post-acquisition change in FPL’s share of UAL’s net assets.

In accordance with HKAS 7 Cash Flow Statements, FPL should restrict its reporting in
the cash flow statement to the cash flows between FPL itself and the investee, UAL,
for example, to dividends and advances.

Since the cash flows like dividends and advances between FPL and UAL are not
eliminated, they are reported in the consolidated cash flow statement accordingly.

Answer 1(a)(iii)

Accounting for the foreign currency non-current loan

It is correct that the non-current borrowing from the vendor of the 20% interest in UAL
is subject to HKAS 39 Financial Instruments – Recognition and Measurement since
the non-current borrowing is a financial liability.

A financial liability is a contractual obligation to deliver cash or another financial asset

to another entity.

Module A (February 2006 Session) 2

In accordance with HKAS 39, the non-current borrowing should initially be measured
at its fair value plus directly attributable transaction costs (not material in our case)
which are HKD5,000,000 (FC2,500,000).

Since the borrowing is non-current and it is raised to finance the purchase of the 20%
interest in UAL, it does not satisfy the definition of being held for trading.

Accordingly, the borrowing is measured at amortised cost using the effective interest
method in accordance with HKAS 39, since the company has not designated the
borrowing as a financial liability at fair value through profit and loss.

Under the amortised cost method, the carrying amount of the non-current loan in
foreign currency at 31 March 2006 was the initial carrying amount of FC2,500,000,
minus principal repayments, plus or minus the cumulative amortisation using the
effective interest method of the difference between the initially recognised amount and
the maturity amount (no amortisation was required in our case).

In our case, there was no principal repayment during the year ended 31 March 2006
and no amortisation was required since the borrowing was repayable at its initial
carrying amount in 2008.

The carrying amount of the borrowing in foreign currency was still FC2,500,000.
Therefore, changes in fair value of the borrowing have no effect on the carrying
amount of the borrowing in foreign currency (although the fair value of the borrowing is
required to be disclosed in the notes to the financial statements).

The increase in the carrying amount was caused by the changes in exchange rates
during the year when the borrowing was accounted for in accordance with HKAS 21
The Effects of Changes in Foreign Exchange Rates.

The non-current borrowing is a foreign currency monetary item since it is a liability to

be settled by a fixed or determinable number of units of currency.

The non-current borrowing at a carrying amount of FC2,500,000, as a foreign currency

monetary item, should be translated using the closing rate (i.e. at the balance sheet
date).

The carrying amount of the non-current borrowing of HKD5,300,000 was arrived at by

translating the carrying amount of the FC2,500,000 at the exchange rate at the
balance sheet date.

Since there was a change in the exchange rate between the date when the borrowing
was initially recognised (i.e. 1 April 2005) and the balance sheet date, an exchange
difference of HKD300,000 resulted.

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

Best regards

Raymond Chan

Module A (February 2006 Session) 3

Answer 1(b)

Consolidated Cash Flow Statement for the year ended 31 March 2006

HKD’000 HKD’000
Cash flows from operating activities **
Profit before tax 9,700
Adjustments for:
Share of profit of an associate (1,000)
Translation loss 300
Interest expense 400
Depreciation 4,000
Operating profits before working capital changes 13,400
Increase in inventories 5,300-3,900-1,000 (400)
Decrease in accounts receivable 2,700-2,600-1,400 1,300
Decrease in accounts payable 1,200-380-1,000 (180)
Cash generated from operations 14,120
Interests paid 400-200 (200)
Income taxes paid 1,000+1,400-2,100 (300)
Net cash from operating activities 13,620

Cash flows from investing activities

Purchase of property, plant and equipment (14,000)
48,000-5,000-33,000+4,000
Acquisition of investment in associate (1,000)
Acquisition of subsidiary 6,000-200 (5,800)
Dividend received from associate 600
Net cash used in investing activities (20,200)

Cash flows from financing activities

Proceeds from issuance of share capital 4,000
Dividend paid to parent shareholders (3,000)
Dividend paid to minority interests (520)
1,200+(6,600x20%)+600-2,600
Net cash from financing activities 480
Net decrease in cash and cash equivalents (6,100)
Cash and cash equivalents at the beginning of the period 6,300
Cash and cash equivalents at the end of the period 200

Module A (February 2006 Session) 4

** The direct method may be used alternatively:

HKD’000 HKD’000
Cash flows from operating activities
Cash received from customers
(Sales 35,700 35,700
+ Changes in accounts receivable) 2,700-2,600-1,400 1,300 37,000
Cash paid to suppliers
(Cost of sales less employee cost 19,200-5,000 (14,200)
+ Other expenses less employee cost 3,400-2,000-300 (1,100)
+ Changes in accounts payable 1,200-380-1,000 (180)
+ Changes in inventories) 5,300-1,000-3,900 (400) (15,880)
Cash paid to employees 5,000+2,000 (7,000)
Cash generated from operations 14,120
Interests paid 400-200 (200)
Income taxes paid 1,000+1,400-2,100 (300)
Net cash from operating activities 13,620

Notes to the Consolidated Cash Flow Statement

1. Combination with a subsidiary

During the period the group combined with a subsidiary, ESL. The fair value of
assets acquired and liabilities assumed at the acquisition date were as follows:

HKD’000
Property, plant and equipment 5,000
Inventories 1,000
Accounts receivable 1,400
Cash and cash equivalent 200
Accounts payable (1,000)
6,600
Minority interest in assets and liabilities (1,320)
5,280
Goodwill acquired on business combination 720
6,000
Satisfied by:
Cash 6,000

HKD’000
Cash consideration 6,000
Bank balances and cash acquired (200)
Cash flow on business combination, net of cash acquired 5,800

Module A (February 2006 Session) 5

2. Major non-cash transaction

During the year, the group acquired a 20% equity interest in an associate by
paying cash of HK$1,000,000 and raising a non-current borrowing of FC2,500,000
(HK$5,000,000 at the acquisition date) from the vendor repayable at 31 March
2008.

3. Cash and cash equivalents

Cash and cash equivalents consist of cash on hand and balances with banks.

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

Module A (February 2006 Session) 6

SECTION B – ESSAY / SHORT QUESTIONS

Answer 2

The statement is only valid under certain circumstances when additional conditions
are satisfied.

In normal cases, companies should prepare financial statements that present a true
and fair view by complying with the applicable accounting standards.

However, in some cases, small and medium sized companies may report under The
Small and Medium-sized Entity Financial Reporting Framework (“SME-FRF”), which
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”) which gives a true and correct view.

A private company incorporated under the Companies Ordinance that applies

exemptions available under Section 141D of the Ordinance qualifies for reporting
under SME-FRF.

An entity, other than a company incorporated under the Companies Ordinance,

subject to any specific requirements imposed by the law of the entity’s place of
incorporation and subject to its constitution, qualifies for reporting under the
SME-FRF when:

(1) the entity does not have public accountability;

(2) the entity is considered to be an SME in terms of its size; and
(3) all of its owners agree to prepare the financial statements in accordance with
the SME-FRS.

An entity has public accountability for the purposes of the SME-FRF if:

(1) at any time during the current or preceding reporting period, the entity is an
issuer of securities;
(2) the entity is an institution authorised under the Banking Ordinance;
(3) the entity is an insurer authorised under the Insurance Companies Ordinance;
or
(4) the entity is a corporation which is granted a licence under the Securities and
Futures Ordinance to carry on business in a regulated activity in Hong Kong.

An entity is considered to be an SME if it does not exceed any two of the following:

(1) total annual revenue of HK$50 million.

(2) total assets of HK$50 million at the balance sheet date.
(3) 50 employees.

Therefore, the mere fact an overseas incorporated company has an annual revenue
of less than HK$50 million would not make the company eligible to adopt SME
reporting. The overseas incorporated company has to satisfy all the conditions
mentioned above.

Module A (February 2006 Session) 7

Answer 3

Investment in SHL

Because the investment in SHL is held for trading, it is considered as a financial asset
at fair value through profit or loss under HKAS 39.

After initial recognition, the investment in SHL shall be measured at fair value, without
any deduction for transaction costs APES may incur on sale or other disposal.

The investment is measured at its fair value as at 31 December 2005, i.e. the current
bid price of HK$22 per share.

Carrying amount as at 31 December 2005 = 300,000 x HK$22

= HK$6,600,000.

Investment in TTL

The investment is classified as an available-for-sale financial asset under HKAS 39.

After initial recognition, an available-for-sale financial asset shall be measured at its

fair value, without any deduction for transaction costs it may incur on sale or other
disposal, except for investments in equity instruments that do not have a quoted
market price in an active market and whose fair value cannot be reliably measured.

As the ordinary shares of TTL have similar features, the investment shall be
measured at cost less impairment loss.

The amount of impairment loss is measured as the difference between the carrying
amount of the investment and the present value of estimated future cash flow
discounted at the current market rate of return for a similar financial asset.

Assuming that the present value of the estimated future dividend discounted at the
current market rate of return for a similar investment is greater than cost, the
investment would be stated at HK$4,500,000 in APES’s consolidated balance sheet
as at 31 December 2005.

Investment in certificate of deposit

The investment is classified as loans and receivables under HKAS 39 as it is a

non-derivative financial asset with fixed and determinable payment that is not quoted
in an active market.

If the investment is quoted in an active market, it is classified as held-to-maturity

investment.

It shall be measured at amortised cost using the effective interest method.

Calculation of the amortised cost:

HK$[2,264,000 x (1 + 6%)] - (2,500,000 x 4.25%)

= HK$2,293,590.

Module A (February 2006 Session) 8

Answer 4(a)

Leasehold property

Under HKFRS 5, a non-current asset shall be classified as held for sale, subject to
certain conditions, if its carrying amount will be recovered principally through a sale
transaction rather than through continuing use.

Since the leasehold property is not available for immediate sale in its present
condition as at 31 December 2005, it should not be classified as non-current assets
as held for sale under HKFRS 5.

Even though HTT Group has taken a decision to sell the leasehold property, it cannot
be committed to the sale until a purchaser has been identified and there is a binding
sale agreement. The leasehold property should continue to be accounted for as
property, plant and equipment and measured at its cost less accumulated
depreciation and any accumulated impairment losses.

Because the sale of the leasehold property is envisaged as part of a restructuring, the
leasehold property is reviewed for impairment, under HKAS 36.

As the market price of the leasehold property is higher than the original cost, which
should be higher than the carrying amount as of 31 December 2005, no impairment is
required to be recognised.

Answer 4(b)

Machinery, equipment and furniture and fixtures

Since the machinery acquired after 2002 will be shipped to the Shenzhen plant, they
should be continuously accounted for as property, plant and equipment and
measured at their cost less accumulated depreciation and any accumulated
impairment losses.

Under HKFRS 5, it is inappropriate to classify as held for sales for the other
machinery, equipment, and furniture and fixtures which are to be abandoned, as their
carrying amount will be recovered principally through continuing use.

However, an impairment loss will be recognised to write down the carrying amount to
nil for the other machinery, equipment, and furniture and fixtures to be abandoned.

Answer 4(c)

Transportation contract

The cost of HK$800,000 incurred for the shipping of the machinery from Hong Kong
to Shenzhen does not constitute direct expenditure arising from the restructuring as
the activity is associated with the future conduct of the business and not liabilities for
restructuring. Accordingly, no provision should be recognised for the transportation
contract as at 31 December 2005.

The deposit of HK$100,000 will be recognised as an asset.

Module A (February 2006 Session) 9

Answer 4(d)

Unpaid annual leave

The unpaid annual leave is a vesting accumulating compensated absence. An

obligation arises as employees render service that increases their entitlement to
future compensated absences.

HTT Group should recognise the expected cost of this short-term employee benefit
when the employees render service that increases their entitlement to future
compensated absences.

A liability should be recognised for the unused entitlement to the paid leave as at
31 December 2005.

The liability should be measured based on the amount that HTT Group expects to
pay to the workers as a result of the unused entitlement that has accumulated as at
31 December 2005.

Answer 4(e)

Severance payment

Severance payment under the Employment Ordinance is a termination benefit under

HKAS 19.

HTT Group should recognise a liability for the severance payment in the balance
sheet as at 31 December 2005 as it has been demonstrably committed to the
redundancy prior to that day.

The liability should be measured based on the amount that HTT Group is required to
pay the workers in accordance with the Employment Ordinance as a result of the
redundancy that has accumulated as at 31 December 2005.

Severance payment does not provide HTT Group with a future economic benefit and
is recognised as an expense immediately.

Answer 5(a)

Goodwill is defined as future economic benefits arising from assets that are not
capable of being individually identified and separately recognised.

In a business combination, the acquirer shall, at the acquisition date, recognise

goodwill acquired as an asset and initially measure that goodwill at its cost, being the
excess of the cost of the business combination over the acquirer's interest in the net
fair value of the identifiable assets, liabilities and contingent liabilities recognised.

After initial recognition, the acquirer shall measure goodwill acquired in a business
combination at cost less any accumulated impairment losses.

Module A (February 2006 Session) 10

In accordance with HKFRS 3.55 and HKAS 36.10(b), irrespective of whether there is
any indication of impairment, an entity shall also test goodwill acquired in a business
combination for impairment annually or more frequently if events or changes in
circumstances indicate that it might be impaired.

For the purpose of impairment testing, goodwill is allocated to each of the Group’s
cash-generating units expected to benefit from the synergies of the combination.

Answer 5(b)

In assessment of impairment of goodwill, HKAS 36 requires that when goodwill

relates to a cash-generating unit (“CGU”) but has not been allocated to that CGU, the
CGU shall be tested for impairment whenever there is an indication that the unit may
be impaired.

For this purpose, the CGU's carrying amount (excluding any goodwill related but not
allocated to the CGU) is compared with the CGU's recoverable amount. If the
carrying amount of the CGU (excluding any goodwill related but not allocated to it)
exceeds the recoverable amount of the CGU, the entity shall recognise an
impairment loss.

The recoverable amount of W of HK$1,100,000 > Carrying amount (excluding any

goodwill) at 31 December 2005 of HK$900,000, so EHL should not recognise an
impairment loss for W.

The recoverable amount of X of HK$2,300,000 > Carrying amount (excluding any

goodwill) at 31 December 2005 of HK$1,900,000, so EHL should not recognise an
impairment loss for X.

The recoverable amount of Y of HK$2,400,000 < Carrying amount (excluding any

goodwill) at 31 December 2005 of HK$2,500,000, so EHL should recognise an
impairment loss of HK$100,000 for other assets.

The recoverable amount of Z of HK$5,000,000 > Carrying amount (excluding any

goodwill) at 31 December 2005 of HK$4,400,000, so EHL should not recognise an
impairment loss for Z.

If the aggregate carrying amount (including the goodwill allocated) of the group of W,
X, Y and Z exceeds the aggregate recoverable amount of the group, EHL should
recognise an impairment loss.

Aggregate carrying amount (including the goodwill allocated)

= HK$900,000 + HK$1,900,000 + HK$2,500,000 - HK$100,000 + HK$4,400,000 +
HK$1,400,000
= HK$11,000,000.

Aggregate recoverable amount

= HK$1,100,000 + HK$2,300,000 + HK$2,400,000 + HK$5,000,000
= HK$10,800,000.

Module A (February 2006 Session) 11

Goodwill impairment to be recognised
= HK$10,800,000 - HK$11,000,000
= HK$200,000.

Total impairment loss to be recognised in EHL's consolidated financial statements for

the year ended 31 December 2005 is therefore HK$300,000.

* * * END OF EXAMINATION PAPER * * *

(ANSWERS)

Module A (February 2006 Session) 12