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HKMAST13 (3" front binder)_Layout 1 02/08/2013 11:15 Page 1

Qualification Programme

Qualification Programme

Module A: Financial Reporting


Module A: Financial Reporting

4th EDITION F O U RT H E D I T I O N
LEARNING PACK

Qualification Programme

Module A
Financial Reporting
First edition 2010
Fourth edition 2013

ISBN 9781 4453 6965 5


Previous ISBN 9781 4453 6125 3

British Library Cataloguing-in-Publication Data


A catalogue record for this book is available from the
British Library

Published by

BPP Learning Media Ltd


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reproduced, stored in a retrieval system or transmitted in
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written permission of the copyright holders.

The contents of this book are intended as a guide and not


professional advice. Although every effort has been made
to ensure that the contents of this book are correct at the
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the Author make no warranty that the information in this
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We are grateful to HKICPA for permission to reproduce the


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copyright of which is owned by HKICPA.

©
HKICPA and BPP Learning Media Ltd
2013

ii
Contents

Page
Director's message v
Introduction vi
Module structure vii
Chapter features viii
Learning outcomes ix

Module A Financial Reporting

Part A Legal environment


1 Legal environment 3

Part B Financial reporting framework


2 Financial reporting framework 25
3 Small company reporting 65

Part C Accounting for business transactions


I Statements of financial position and comprehensive income
4 Non-current assets held for sale and discontinued operations 85
5 Property, plant and equipment 103
6 Investment property 123
7 Government grants 137
8 Intangible assets and impairment of assets 147
9 Leases 187
10 Inventories 213
11 Provisions, contingent liabilities and contingent assets 227
12 Construction contracts 245
13 Share-based payment 265
14 Revenue 291
15 Income taxes 317
16 Employee benefits 355
17 Borrowing costs 381
18 Financial instruments 393
II Statement of cash flows
19 Statements of cash flows 445

Introduction iii
Page
III Disclosure and reporting
20 Related party disclosures 475
21 Accounting policies, changes in accounting estimates and errors; events
after the reporting period 487
22 Earnings per share 505
23 Operating segments 527
24 Interim financial reporting 539
25 Presentation of financial statements 553

Part D Group financial statements


26 Principles of consolidation 579
27 Consolidated accounts: accounting for subsidiaries 613
28 Consolidated accounts: accounting for associates and joint arrangements 659
29 Changes in group structures 683
30 Consolidation of foreign operations 729

Answers to exam practice questions 753


Question bank – questions 799
Question bank – answers 823
Glossary of terms 869
Index 887

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
authorized 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!

Jonathan Ng
Executive Director
Hong Kong Institute of Certified Public Accountants

Introduction v
Introduction

This is the fourth 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 Structure
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 six-month rule and examinable
standards.
Overall Structure of Module A (Financial Reporting)

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 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.

Examples Illustrations of particular techniques or concepts with a worked solution or


explanation provided immediately afterwards.

Case study An example or illustration not requiring a solution, designed to enrich your
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.

Topic recap Reviews and recaps on the key areas covered in the chapter.

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.

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.

viii Financial Reporting


Learning outcomes

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

LO1. Legal environment


Describe the Hong Kong legal framework and related
implications for business activities
LO1.01 Types and relative advantage of alternative forms of 2
organisation:
1.01.01 Identify the types and relative advantages of 1
alternative forms of organisation
LO1.02 Legal procedures for establishment and governance of 2
companies:
1.02.01 Describe the legal procedures for the 1
establishment and governance of companies
Describe the obligations of directors and officers of companies
LO1.03 Powers, duties and obligations of directors and company 2
secretaries:
1.03.01 Describe the powers, duties and obligations of 1
company directors
1.03.02 Describe the powers, duties and obligations of the 1
company secretary
Describe the legal requirements associated with company
structure, share offerings, debt obligations and restructuring
LO1.04 Share issues and prospectus requirements: 2

Introduction ix
Chapter
where
Competency covered

1.04.01 Describe the procedure for issuing shares and the 1


requirement for a prospectus
LO1.05 Debt instruments and registration of charges: 2
1.05.01 Describe the procedure for the issue of debt 1
instruments
1.05.02 Describe the procedure for the registration of 1
charges over company debt
LO1.06 Statutory reporting and documentation requirements: 3
1.06.01 Explain the statutory registers that must be kept 1
by a company
1.06.02 Identify the financial statements that a company 1
must prepare
LO1.07 Appointment and removal of auditors: 3
1.07.01 Describe the procedures for the appointment, 1
removal and resignation of company auditors
LO1.08 Restructuring, including appointment of receivers and 1
liquidators:
1.08.01 Identify the reasons for which a company may 1
restructure, including the appointment of
receivers and liquidators
LO2. Financial reporting framework
Describe the financial reporting framework in Hong Kong and
the related implications for business activities
LO2.01 The role and setting of accounting standards: 2
2.01.01 Understand the role of accounting standards 2
2.01.02 Understand the role of the HKICPA, Securities 2
and Futures Commission (SFC), Financial
Reporting Council (FRC), the Hong Kong
Insurance Authority (HKIA), the Hong Kong
Monetary Authority (HKMA) and the Hong Kong
Stock Exchange (HKEx)
LO2.02 Hong Kong Financial Reporting Standards: 2
2.02.01 Describe how Hong Kong Financial Reporting 2
Standards are set
LO2.03 Small and Medium-sized Entity Financial Reporting 2
Framework and Financial Reporting Standard:
2.03.01 Identify the conditions under which an entity may 3
adopt the SME Financial Reporting Framework
and Financial Reporting Standard
2.03.02 Describe the requirements of the SME Financial 3
Reporting Framework and Financial Reporting
Standard

x Financial Reporting
Chapter
where
Competency covered

LO2.04 Hong Kong Financial Reporting Standard for Private 2


Entities
2.04.01 Identify the conditions under which an entity may 3
adopt the HKFRS for Private Entities
2.04.02 Describe the requirements of the HKFRS for 3
Private Entities
LO2.05 Code of Ethics for Professional Accountants: 3
2.05.01 Explain the requirements of the Code of Ethics for 2
Professional Accountants
LO2.06 Hong Kong (IFRIC) Interpretations, Hong Kong 2
Interpretations and Hong Kong (SIC) Interpretations:
2.06.01 Describe the status of Hong Kong (IFRIC) 2
Interpretations, Hong Kong Interpretations and
Hong Kong (SIC) Interpretations
LO2.07 Other professional pronouncements and exposure drafts: 2
2.07.01 Identify other professional pronouncements and 2
exposure drafts relevant to the financial reporting
Conceptual Framework
LO2.08 Regulatory bodies and their impact on accounting: 2
2.08.01 Identify relevant regulatory bodies and their 2
impact on accounting
LO2.09 Accounting principles and conceptual frameworks: 2
2.09.01 Explain what is meant by a conceptual framework 2
and GAAP
2.09.02 Identify the advantages and disadvantages of a 2
conceptual framework
2.09.03 Identify the components and requirements of the 2
HKICPA's Conceptual Framework
2.09.04 Explain those requirements of HKAS 1 2
Presentation of Financial Statements which
overlap with the HKICPA's Conceptual
Framework
LO2.10 Current developments 2
2.10.01 Identify areas of accounting in which current 2
developments are occurring
LO3. Accounting for business transactions
Account for transactions in accordance with Hong Kong
Financial Reporting Standards
LO3.01 Accounting policies, changes in accounting estimates and 3
errors:
3.01.01 Distinguish between accounting policies and 21
accounting estimates in accordance with HKAS 8

Introduction xi
Chapter
where
Competency covered
3.01.02 Account for a change in accounting policy 21
3.01.03 Account for a change in accounting estimate 21
3.01.04 Correct a prior period error 21
LO3.02 Revenue: 3
3.02.01 Define revenue and identify revenue within the 14
scope of HKAS 18
3.02.02 Measure revenue at the fair value of 14
consideration received
3.02.03 Identify revenue transaction including multiple 14
element arrangements

3.02.04 Determine the recognition criteria for specified 14


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 14
statements
3.02.06 Explain the recognition and measurement 14
principles
LO3.03 Government grants and assistance: 3
3.03.01 Accounting and presentation of government grants 7
3.03.02 Disclosure of government grants and assistance
in accordance with HKAS 20 7
LO3.04 Employee benefits: 2
3.04.01 Identify short-term employee benefits in 16
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 16
and defined benefit plans
3.04.03 Account for defined contribution plans 16
3.04.04 Identify termination benefits in accordance with 16
HKAS 19 and apply the recognition and
measurement principles in respect of termination
benefits

xii Financial Reporting


Chapter
where
Competency covered

LO3.05 Share-based payment: 2


3.05.01 Identify and recognise share-based payment 13
transactions in accordance with HKFRS 2
3.05.02 Account for equity-settled and cash-settled share- 13
based payment transactions
3.05.03 Account for share-based payment transactions 13
with cash alternatives
3.05.04 Account for unidentified goods or services in a 13
share-based payment transaction
3.05.05 Account for group and treasury share 13
transactions
3.05.06 Disclosure requirement of share option 13
LO3.06 Inventories: 3
3.06.01 Scope and definition of HKAS 2 Inventories 10
3.06.02 Calculate the cost of inventories in accordance 10
with HKAS 2
3.06.03 Use accepted methods of assigning costs 10
including the allocation of overheads to
inventories
3.06.04 Explain the potential impact of net realisable 10
value falling below cost and make the required
adjustments
3.06.05 Calculate and analyse variances in a standard 10
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 10
other required disclosures in respect of
inventories
LO3.07 Construction contracts: 3
3.07.01 Define a construction contract 12
3.07.02 Explain when contract revenue and costs should 12
be recognised in accordance with HKAS 11
3.07.03 Explain how contract revenue and costs should 12
be measured and apply these principles
3.07.04 Account for the expected loss and changes in 12
estimates
3.07.05 Disclose information related to construction 12
contracts in the financial statements

Introduction xiii
Chapter
where
Competency covered

LO3.08 Property, plant and equipment: 3


3.08.01 Identify the non-current assets which fall within or 5
outside the scope of HKAS 16
3.08.02 State and apply the recognition rules in respect of 5
property, plant and equipment
3.08.03 Determine the initial measurement of property, 5
plant and equipment, including assets acquired
by exchange or transfer
3.08.04 Determine the accounting treatment of 5
subsequent expenditure on property, plant and
equipment
3.08.05 Determine the available methods to measure 5
property, plant and equipment subsequent to
initial recognition
3.08.06 Account for the revaluation of property, plant and 5
equipment
3.08.07 Define “useful life” and allocate an appropriate 5
useful life for an asset in a straightforward
scenario
3.08.08 Explain the different methods of depreciation: 5
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 5
equipment
3.08.10 Disclose relevant information relating to property, 5
plant and equipment in the financial statements
LO3.09 Intangible assets: 3
3.09.01 Define an intangible asset and scope of HKAS 38 8
3.09.02 Apply the definition of an intangible asset to both 8
internally-generated and purchased intangibles
3.09.03 Account for the recognition and measurement of 8
intangible assets in accordance with HKAS 38
3.09.04 Describe the subsequent accounting treatment of 8
intangible assets including amortisation
3.09.05 Distinguish between research and development 8
and describe the accounting treatment of each
3.09.06 Explain how goodwill arises 8
3.09.07 Account for goodwill 8
3.09.08 Disclose relevant information in respect of 8
intangible assets under HKAS 38

xiv Financial Reporting


Chapter
where
Competency covered

LO3.10 Investment property: 3


3.10.01 Identify an investment property within the scope 6
of HKAS 40 and situation when a property can be
transferred in and out of the investment property
category
3.10.02 Distinguish investment property from other 6
categories of property holdings and describe the
difference in accounting treatment
3.10.03 Apply the recognition and measurement rules 6
relating to investment property
3.10.04 Account for investment property 6
3.10.05 Disclose relevant information, including an 6
accounting policy note, for investment property

LO3.11 Financial assets, financial liabilities and equity 2


instruments:
3.11.01 Discuss and apply the criteria for the recognition 18
and de-recognition of a financial asset or financial
liability
3.11.02 Discuss and apply the rules for the classification 18
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 18
losses arising on financial assets or financial
liabilities
3.11.04 Discuss the circumstances that give rise to and 18
apply the appropriate treatment for the
impairment of financial assets
3.11.05 Account for derivative financial instruments and 18
simple embedded derivatives, including the
application of own-use exemption
18
3.11.06 Disclose relevant information with regard to
financial assets, financial liabilities and equity
instruments

Introduction xv
Chapter
where
Competency covered

LO3.12 Borrowing costs: 3


3.12.01 Identify the expenses which constitute borrowing 17
costs in accordance with HKAS 23
3.12.02 Identify the assets which are qualifying assets 17
3.12.03 Determine when the capitalisation of borrowing 17
costs shall commence, be suspended and cease
3.12.04 Calculate the amount of borrowing costs to be 17
capitalised from specific borrowing and general
borrowing
3.12.05 Prepare journal entries for borrowing costs, 17
including expensed and capitalised borrowing
costs
3.12.06 Disclose relevant information with regard to 17
borrowing costs
LO3.13 Impairment of assets: 3
3.13.01 Identify assets that are within the scope of 8
HKAS 36
3.13.02 Identify an asset that may be impaired by 8
reference to common external and internal
indicators
3.13.03 Identify the cash generating unit an asset belongs 8
to
3.13.04 Calculate the recoverable amount with reference 8
to value-in-use and fair value less cost to sell
3.13.05 Calculate the impairment loss, including the loss 8
relating to cash-generating units
3.13.06 Allocate impairment loss and account for 8
subsequent reversal
3.13.07 Disclose relevant information with regard to 8
impairment loss, including critical judgement and
estimate

xvi Financial Reporting


Chapter
where
Competency covered

LO3.14 Leases: 3
3.14.01 Identify the types of lease within the scope of 9
HKAS 17 and define the terminology used in
relation to leases
3.14.02 Classify leases as operating or finance leases by 9
looking at the substance of the transaction
3.14.03 Account for operating leases from the perspective 9
of both the lessee and the lessor
3.14.04 Disclose the relevant information relating to 9
operating leases in the accounts of both the
lessee and the lessor
3.14.05 Account for finance leases from the perspective
9
of both the lessee and the lessor
3.14.06 Disclose the relevant information relating to
9
finance leases in the accounts of both the lessee
and the lessor
3.14.07 Account for manufacturer/dealer leases
9
3.14.08 Account for sale and leaseback transactions
9
3.14.09 Explain the term off-balance sheet finance and
9
the importance of substance over form
3.14.10 Explain how to determine whether an
9
arrangement contains a lease
LO3.15 Events after the reporting period: 3
3.15.01 Explain the period during which there is 21
responsibility for reporting events in accordance
with HKAS 10
3.15.02 Define adjusting and non-adjusting events 21
3.15.03 Explain when the financial statements should be 21
prepared on a basis other than going concern
LO3.16 Provisions, contingent liabilities and contingent assets: 3
3.16.01 Define provisions, contingent liabilities and 11
contingent assets within the scope of HKAS 37
3.16.02 Distinguish provisions from other types of 11
liabilities
3.16.03 Explain the criteria for recognition of provisions 11
and apply them to specific circumstances
3.16.04 Apply the appropriate accounting treatment for 11
contingent assets and liabilities
3.16.05 Disclose the relevant information relating to 11
contingent liabilities in the financial statements
3.16.06 Account for decommissioning, restoration and 11
similar liabilities and their changes
3.16.07 Disclose the relevant information relating to 11
contingent assets in the financial statements

Introduction xvii
Chapter
where
Competency covered

LO3.17 Hedge accounting: 2


3.17.01 Identify fair value hedges, cash flow hedges and 18
hedges for net investment in accordance with
HKAS 39
3.17.02 Account for fair value hedges, cash flow hedges 18
and hedges for net investment
LO3.18 Income taxes: 2
3.18.01 Account for current tax liabilities in accordance 15
with HKAS 12
3.18.02 Record entries relating to income tax in the 15
accounting records
3.18.03 Identify temporary differences (both inside and 15
outside difference) and calculate deferred tax
amounts
3.18.04 Account for tax losses and tax credits 15
3.18.05 Identify initial recognition exemption for assets 15
and liabilities
3.18.06 Account for deferred tax relating to investments in 15
subsidiaries, associates and joint ventures
3.18.07 Determine when tax assets and liabilities can be 15
offset
3.18.08 Disclose relevant information with regard to 15
income taxes
LO3.19 The effects of changes in foreign exchange rates: 2
3.19.01 Determine the functional currency of an entity in 30
accordance with HKAS 21
3.19.02 Translate foreign operation financial statements 30
to the presentation currency
3.19.03 Account for foreign currency transactions within 30
an individual company and in the consolidated
financial statements
3.19.04 Account for disposal or partial disposal of a 30
foreign operation
LO3.20 Related party disclosures: 3
3.20.01 Identify the parties that may be related to a 20
business entity in accordance with HKAS 24
3.20.02 Identify the related party disclosures 20
3.20.03 Explain the importance of being able to identify 20
and disclose related party transactions

xviii Financial Reporting


Chapter
where
Competency covered

LO3.21 Non-current assets held for sale and discontinued 3


operations:
3.21.01 Define non-current assets (or disposal groups) 4
held for sale or held for distribution to owners and
discontinued operations within the scope of
HKFRS 5 4
3.21.02 Explain what assets are within the measurement
provision of HKFRS 5
4
3.21.03 Determine when a sale is highly probable
3.21.04 Measure non-current assets held for sale and 4
discontinued operations including initial
measurement, subsequent measurement and
change of plan
3.21.05 How to account for impairment loss and
4
subsequent reversals
3.21.06 Present the non-current asset held for sale and
4
discontinued operation in the financial statements
(including the prior year restatement)
LO3.22 Earnings per share: 3
3.22.01 Explain the meaning and significance of a 22
company's earnings per share
3.22.02 Calculate the earnings per share, including the 22
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 22
earnings per share
3.22.04 Discuss the limitations of using earnings per 22
share as a performance measure
LO3.23 Operating segments: 3
3.23.01 Identify and discuss the nature of segmental 23
information to be disclosed in accordance with
HKFRS 8
3.23.02 Explain when operating segments should be 23
aggregated and disaggregated
3.23.03 Disclose the relevant information for operating 23
segments and appropriate entity-wide information

Introduction xix
Chapter
where
Competency covered

LO3.24 Interim financial reporting: 3


3.24.01 Identify the circumstances in which interim 24
financial reporting is required in accordance with
HKAS 34
3.24.02 Explain the purpose and advantages of interim 24
financial reporting
3.24.03 Explain the recognition and measurement 24
principle of interim financial statements and apply
them
3.24.04 Disclose the relevant information for interim 24
financial statements including seasonality
LO4. Preparation and presentation of financial statements
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 19, 25
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 25
4.01.02 Explain the minimum line items that should be
presented in the financial statements and criteria
for additional line items
LO4.02 Financial statement disclosure requirements: 3
4.02.01 Disclose accounting policy and items required by 25
the HKFRS, Companies Ordinance and other
rules and regulations
4.02.02 Explain the importance to disclose significant 25
judgement and estimates

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 26
single economic entity
4.03.02 Define a subsidiary and when a group should 26
start and stop consolidating a subsidiary
4.03.03 Explain what constitutes control and the impact of 26
potential voting rights
4.03.04 Describe the reasons why the directors of a 26
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 26
statements
4.03.06 Explain the importance of eliminating intra-group 26
transactions
4.03.07 Explain the importance of uniform accounting 26
policies and coterminous year ends in the
preparation of consolidated accounts
4.03.08 Apply the appropriate accounting treatment of 26
consolidated goodwill
4.03.09 Explain how to account for changes in parent's 29
ownership interest in a subsidiary without losing
control
LO4.04 Acquisition of subsidiaries: 3
4.04.01 Prepare a consolidated statement of financial 27
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 27
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 29
group
4.05.02 Account for the change of ownership in 29
subsidiaries without loss of control

Introduction xxi
Chapter
where
Competency covered

LO4.06 Business combinations: 3


4.06.01 Explain the scope of business combinations in 26
accordance with HKFRS 3
4.06.02 Identify business combination and the difference 26
between acquisition of asset and business
4.06.03 Determine the acquisition date of an acquisition 26
4.06.04 Identify the identifiable assets (including 26
intangibles) and liabilities acquired in a business
combination
4.06.05 Explain the recognition principle and 26
measurement basis of identifiable assets and
liabilities and the exception
4.06.06 Explain what contingent consideration is and how 26
to account for it initially and subsequently
4.06.07 Explain how to account for acquisition-related 26
costs, including those related to issue debt or
equity securities
4.06.08 Determine what is part of the business 26
combination transaction and the consideration
4.06.09 Calculate goodwill (including bargain purchase) 26
and account for it
4.06.10 Explain the accounting for step acquisition 29
4.06.11 Account for non-controlling interest when the 26
subsidiary has negative equity balance
4.06.12 Explain and account for measurement period 26
adjustments
LO4.07 Investments in associates: 3
4.07.01 Define an associate in accordance with HKAS 28 28
(2011)
4.07.02 Explain what significant influence is and apply the 28
principle
4.07.03 Explain the reasons for and impact of equity 28
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 28
associate in excess of its investments in associates
4.07.05 Explain the impairment test and related
treatments for investments in associates 28
4.07.06 Account for the disposal of an associate 29
4.07.07 Prepare the disclosure in respect of associates
28

xxii Financial Reporting


Chapter
where
Competency covered

LO4.08 Interests in joint arrangements: 3


4.08.01 Define joint arrangements in accordance with 28
HKFRS 11
4.08.02 Explain the difference among jointly controlled 28
operations and joint ventures
4.08.03 Explain how an entity should account for a joint
venture 28
4.08.04 Account for the transactions between a venturer
and a joint venture 28
4.08.05 Disclose the relevant information in the venturer's
financial statements 28
LO4.09 Consolidated financial statement preparation 3
4.09.01 Prepare a consolidated statement of financial 27
position in compliance with HKFRS 10
4.09.02 Prepare a consolidated statement of profit or loss 27
and other comprehensive income
4.09.03 Prepare a consolidated statement of cash flows 19
LO4.10 Financial statement disclosure requirement 3
4.10.01 Disclose the relevant information for business 26
combinations occurred during and subsequent to
the reporting period
LO4.11 Merger accounting for common control combinations 2
4.11.01 Describe the principles and practices of merger 29
accounting
4.11.02 Apply merger accounting to a common control 29
combination

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

1 Hong Kong legal framework


1.1 Types and relative advantages of alternative forms of organisation
1.2 Legal procedures for establishment of companies
1.3 Corporate governance
2 Obligations of directors and officers of companies
2.1 Directors’ responsibilities
2.2 Officers of companies
3 Legal requirements associated with company structure, share offerings, financial statements,
debt obligations and restructuring
3.1 Share issues and prospectus requirements
3.2 Debt instruments and registration of charges
3.3 Statutory reporting and documentation requirements
3.4 Appointment and removal of auditors
3.5 Restructuring, including appointment of receivers and liquidators
3.6 Financial statements requirements

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

In this chapter you will cover the following 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
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
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

1 Hong Kong legal framework


Topic highlights
Certified public accountants need to understand the different forms of business entities that operate
in Hong Kong. You can apply the knowledge you obtain from this section of the Learning Pack to
demonstrate this competence.

The liability of the members of companies can be unlimited or limited. We are mainly concerned
with limited companies in this section.

1.1 Types and relative advantages of alternative forms of


organisation
Topic highlights
Commercial organisations may take a number of forms, including sole trader businesses,
partnerships, companies and joint ventures.
These are considered in turn in this section.

1.1.1 Sole trader business


A sole proprietorship also known as a sole trader, or simply proprietorship, is a type of
business entity which is owned and run by one individual and where there is no legal distinction
between the owner and the business. All profits and all losses accrue to the owner (subject to
taxation). All assets of the business are owned by the proprietor and all debts of the business are
their debts and they must pay them from their personal resources. This means that the owner has
unlimited liability. It is a "sole" proprietorship in the sense that the owner has no partners
(partnership). A sole proprietor may do business with a trade name other than his or her legal
name. This also allows the proprietor to open a business account with banking institutions.
This form of business has a major advantage in that it is easy and quick to set up. Furthermore
details of the business and its operation remain private as there is no requirement to file documents
such as accounts.
There are, however, drawbacks to operating as a sole trader, the main one being that the sole
trader is not legally separated from his business and therefore remains individually and personally
liable for any losses that the business makes.
In Hong Kong, all the investor needs to do is to apply for a business licence from the Business
Registration Office of the Inland Revenue Department. Every person carrying on a business shall
make such an application within one month of the commencement of the business.
1.1.2 Partnerships
A partnership is a business entity formed by the Hong Kong Partnerships Ordinance, which
defines a partnership as "the relation between persons carrying on a business in common with a
view of profit" and is not a joint stock company or an incorporated company.
There must be at least two partners, but not more than 20 partners, otherwise it would be treated
as a company (single entity) unless the partnership is a partnership of professional solicitors,
accountants and stockbrokers. The partners share any profits and losses and inject funding by way
of partners' capital.
There are two different kinds of partnership. If the business entity registers with the Registrar of
Companies it takes the form of a limited partnership defined in the Limited Partnerships Ordinance.

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.

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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.

1.2 Legal procedures for establishment of companies


Companies are established under the provisions of the Companies Ordinance (Chapter 32 of the
Law of Hong Kong). A company operates under a memorandum or agreement between
subscribers or shareholders. It is common to also have articles of association for a company, which
are more detailed rules and regulations regarding meetings, resolutions and activities of the
company.
The new Companies Ordinance (the “new CO”) for Hong Kong was passed on 12 July 2012 with
21 Parts comprising 921 sections and 11 schedules, and will come into operation in 2014 after the
enactment of subsidiary legislation. The new CO was drafted with four major objectives:
1 enhancing corporate governance
2 ensuring better regulation
3 facilitating business
4 modernising the law
On disclosure, the new CO allows companies meeting specified size criteria (e.g. small and
medium enterprises or SME) to prepare simplified financial statements and directors’ reports. As
before, the new CO does not give a definition of what is a "true and fair view" for preparation of
financial statements.
The new CO abolishes the requirement to have a Memorandum of Association (“MA”) as a constitutional
document of a local company. A company incorporated in Hong Kong under the new CO is only required
to have Articles of Association (“AA”). Under the new CO, the information which was required to be
contained in the MA under the Companies Ordinance (Cap. 32) (“Cap. 32”) will be set out in the AA.
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)

7
Financial Reporting

 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).
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, 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.
For the purposes of this section, two or more persons holding one share jointly are treated as one
member.
If a company's articles fail to satisfy the requirements of s.11, it is a public company, although the
term "public company" is not actually used in or defined by the new CO.
The main advantage of private companies is that they need not file accounts with their annual
return and, subject to a number of exceptions, they may waive compliance with certain
requirements as to the content of their accounts (s.359). When a private company sends its annual
return to the Registrar of Companies they are signed by a director or the secretary, stating that the
company has complied with s.11.
If a company alters its articles so that it no longer satisfies s.11, from the date of alteration the
company will cease to be a private company and within 14 days it must deliver to the Registrar a

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1: Legal environment | Part A Legal environment

prospectus or a statement in lieu of a prospectus in the form and containing the particulars
specified in the Companies (Winding up and Miscellaneous Provisions) Ordinance, which is the
revised name for the remaining provisions of the old Companies Ordinance. These documents are
also required before a company which is formed as a public company may allot any of its shares or
debentures.
Under the new CO s.94, the company must, within 15 days after the date on which the alteration takes
effect, deliver to the Registrar for registration:

(a) a notice of the change of the company’s status in the specified form; and
(b) a copy (certified by an officer of the company to be true) of the company’s annual financial
statements that are:
(i) prepared in accordance with section 379; and
(ii) prepared for the financial year immediately before the financial year in which the alteration
takes effect.
Under the new CO, the annual return of a public company or a guarantee company will no longer be
filed with reference to the date of Annual General Meeting ("AGM") as an AGM may be dispensed with
under s.612 of the new CO. The requirement is to deliver the annual return in respect of every financial
year of the company instead of in each calendar year.
Pursuant to sections 662(3) and (4) of the new CO, the annual return of a public company or a
guarantee company should be filed (together with certified true copies of the relevant financial
statements, directors' report and auditor's report) within 42 days after the company's return date.
The return date for a public company is 6 months after the end of the company's accounting reference
period while the return date for a guarantee company is 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
December every year, the accounting reference period is from the 1 January of a year to 31 December
of the same year.
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.

1.3 Corporate governance


Topic highlights
Corporate governance has become increasingly important in recent years due to a number of
high profile corporate collapses. The new CO seeks to emphasise the importance of corporate
governance.

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.

9
Financial Reporting

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 director 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
(e) To increase transparency regarding auditors' independence, disclosure of non-audit fees
paid to auditors should be made.
The new CO in Hong Kong has introduced some measures for enhancing corporate governance, in
particular in the following areas:
(a) Strengthening the accountability of directors by requiring every private company to have
at least one natural person acting as director (rather than a corporate director, ie a company
acting as director) in order to enhance transparency and accountability.
(b) Enhancing shareholder engagement in the decision making process by:
 introducing detailed and comprehensive rules for the passing of written resolutions,
thus making it easier for shareholders to vote and companies to pass resolutions;
 by requiring companies to bear the expenses of circulating members’ statements
relating to AGMs, thus avoiding members being deterred from doing this by the cost;
 educing the threshold requirement for members to demand a poll from 10% to 5% of
the total voting rights
(c) Improving the disclosure of company information by requiring public companies and
large private companies (i.e. those that do not qualify for simplified reporting to prepare a
more comprehensive directors’ report, including a ‘business review’. This will include

10
1: Legal environment | Part A Legal environment

information relating to environmental and employee matters, thus promoting corporate social
responsibility
(d) Fostering shareholder protection by:
 introducing rules to deal with directors’ conflicts of interests;
 requiring the approval of disinterested shareholders where shareholder approval is
required for transactions of public companies and their subsidiaries;
 introducing stricter rules for the ratification of the conduct of directors to prevent
conflicts of interest and abuse of power;
 extending the scope of the ‘unfair prejudice’ remedy
(e) Strengthening auditors’ rights by empowering auditors to require information or
explanations from a wider range of persons than was previously the case.

2 Obligations of directors and officers of companies


Topic highlights
The directors have statutory duties laid down in the Companies Ordinance, common law duties of
reasonable care and skill and fiduciary duties in equity.

2.1 Directors' responsibilities


Directors are first and foremost responsible for the operation of a company, ensuring that it
operates as the shareholders intended within the corporate legal environment.
The new CO broadens the definition of director to "include any person occupying the position of
director by whatever name called". Directors' responsibilities are therefore imposed on the senior
management of a company, whether they are the directors, chief executives, senior managers or
other officers; it depends on the role they actually fulfil.
Section 456 of the new CO maintains the restriction on corporate directorship in public companies,
companies limited by guarantee and private companies which are members of a group of
companies of which a listed company is a member. This restriction, however, does not apply to
other private companies which are required to have at least one director who is a natural person.
The new CO requires every private company to have at least one director who is a natural person,
to enhance transparency and accountability.
The liability of directors is not specifically set out in the Companies Ordinance, and is generally
established by case law. In some situations, directors may be held personally liable for losses
caused to the company as a result of their actions. The new CO states that any provision in a
company’s articles or a contract which seeks to enable a director to avoid liability for any
negligence, default, breach of duty or breach of trust as a result of their actions will be void (Part
10 Division 3 section 468).
2.1.1 Duties and responsibilities
The Companies Registry issued “A Guide on Directors’ Duties” in July 2009. The general principles
of directors’ duties were explained as follows:
1 duty to act in good faith for the benefit of the company as a whole
2 duty to use powers for a proper purpose for the benefit of members as a whole
3 duty not to delegate powers except with proper authorisation and duty to exercise
independent judgment
4 duty to exercise care, skill and diligence

11
Financial Reporting

5 duty to avoid conflicts between personal interests and interests of the company
6 duty not to enter into transactions in which the directors have an interest except in
compliance with the requirements of the law
7 duty not to gain advantage from use of position as a director
8 duty not to make unauthorised use of the company’s property or information
9 duty not to accept personal benefit from third parties conferred because of position as a
director
10 duty to observe the company's memorandum and articles of association and resolutions
11 duty to keep proper books of account
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 not agree to fetter their discretion. As the powers delegated to directors
by the memorandum and articles 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.

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1: Legal environment | Part A Legal environment

(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
 the financial statements are accurate and presented in accordance with law
(especially for example the Companies Ordinance) and regulations
 roper books and accounts are kept

2.1.2 Powers and obligations


(a) Powers of directors
The general power of managing a company is usually vested in the directors. Formally the
powers of directors are defined by articles. The directors may meet together to despatch
business, adjourn, and otherwise regulate their meetings as they think fit under Table A,
art 100.
At common law, directors can only exercise their powers collectively by passing resolutions
at a properly convened meeting of the board of directors; they have no power to act
individually as agents for the company. However, a company's articles will usually empower
the board of directors to delegate its power to individual directors or to committees of
directors (Table A, art 104), and to the managing director (art 111), so that a meeting is not
required for each and every decision taken by the board of directors.
(b) Directors' obligations
If a person does not comply with his duties as a director he may be liable to civil or criminal
proceedings and may be disqualified from acting as a director.
Various important legal issues have been raised locally and overseas with regard to the fulfillment
of directors’ duties or the execution of their powers. Agency creation is an important topic. An
agency relationship is created when one person acquires the authority to act for another, the
principal. An agency relationship could be created by:
1. express appointment;
2. conduct of the parties;
3. necessity of the situation;
4. ratification; and
5. estoppel.
Some practical legal views related to the agency theory are as follows.
(a) Indoor Management Rule
The Indoor Management Rule, also known as the Turquand Rule (Royal British Bank v
Turquand (1856) 6 E&B 327), entitles an outsider to assume that the internal procedures of a
company have been complied with. This is a practical approach to solving problems facing
outsiders because an outsider would have difficulty in discovering what is going on in a
company, e.g. whether a company director has exceeded his authority as given to him by the
Articles of Association, or whether there has been some non-compliance with an internal
procedure.

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Financial Reporting

(b) The doctrine of estoppel


English law defines estoppel as: "a principle of justice and of equity. It comes to this: when a
man, by his words or conduct, has led another to believe in a particular state of affairs, he
will not be allowed to go back on it when it would be unjust or inequitable for him to so."
(Moorgate Mercantile v Twitchings [1976] 1 QB 225, CA at 241 per Lord Denning MR).
Estoppel could be by record with issue or cause of action. Estoppel could also be by deed of
rules, regarded as technical or formal estoppel. Under English law, estoppel by
representation of fact, promissory estoppel and proprietary estoppel are regarded as
reliance-based estoppels. All three estoppels are estoppels by representation.
Estoppel allows a party to a contract, acting in good faith, to prevent the counterparty from
breaking a contract by relying upon certain rights, or upon a set of facts (e.g. words said or
actions performed) which is different from an earlier set of facts, in certain situations. For
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.

2.2 Officers of companies


Topic highlights
The secretary of a company is the chief administrative officer. The position involves
communications with the Companies Registry and with members in relation to all legal and
administrative issues. The secretary usually has actual power to bind the company in respect of
actions normally expected of a company secretary.

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 (section 154, Companies Ordinance). 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

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1: Legal environment | Part A Legal environment

 deals with matters relating to liaison with members


 deals with formal communications between the company and the Companies Registry

3 Legal requirements associated with company


structure, share offerings, debt obligations and
restructuring
Topic highlights
There are legal requirements associated with the company structure, share offerings, debt
obligations and restructuring.

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.

3.1 Share issues and prospectus requirements


When a company is first established, shares are issued as follows:
(a) In a private company they are issued by allotment, with the directors passing a resolution at
a board meeting stating that shares are to be issued to named persons.
(b) In a public company they are issued by a renounceable allotment letter, which allows issued
shares to be transferred by the initial holder within a specified period of time.
The power to allot shares is normally delegated to the directors by the Articles or by an ordinary
resolution passed by the members at a general meeting.
When a public company seeks to raise capital from the general public it must issue a prospectus.
Detailed requirements of such a prospectus may be found on the website of the Hong Kong Stock
Exchange, although knowledge is not required for the Module A exam.

3.2 Debt instruments and registration of charges


Debt instruments are a type of financial instrument. The accounting treatment of these is found in a
later chapter. Issuers of debt finance, such as banks, will often require security for their loan in
case a company is unable to meet repayments. This security is normally a charge over individual
assets (a fixed charge) or over a group of changing assets (a floating charge). Where the borrower
defaults on repayment, a floating charge crystallises and the lender takes control of the asset(s)
held as security and may sell it or them to realise funds.
3.2.1 Registration of charges
Part 8 of the new CO deals with registrtaion of charges. It specifies that two registers of charges
must be maintained:
(a) The Companies Registry must keep a record for each company (section 27)
(b) The company must keep its own register, either at its own office or at a location of which the
Registry is aware (Part 8 Division 7 section 352).
Fixed and floating charges must be registered at the Companies Registry within one month of their
execution.
Any charge not registered within this time period will be void against the liquidator and any creditor
of the company. This does not mean that the company no longer owes the money, but it does

15
Financial Reporting

relegate the obligation to the level of an unsecured creditor. Therefore, the charge remains valid
against the company. Irrespective of the terms of the debenture, failure to register makes the whole
debt immediately repayable. This will normally result in insolvency within a short period of time.
Any fixed charge on land and buildings must be registered in the Land Office within one month of
being executed. This also applies if any floating charge that includes land or buildings crystallises.
The requirement to register is set out in Part 8 Divisions 2 and 3 of the Companies Ordinance. Not
all charges have to be registered, but the exclusions generally fall outside the Module A syllabus.
Charges must be registered by the debtor company, though the creditor can perform this function
(Division 2 section 335). Registration secures the position of the creditor and also serves as an
indication of the obligation to prospective future lenders if they choose to search the register.
Once registration has occurred, a non-current asset that secures a fixed charge can only be sold
with the consent of the secured lender. Some debentures are issued under a trust deed so that
only one registration is necessary. Also, if the directors seek release from the charge they need
only approach the trustees instead of potentially many lenders.
As we have seen, the creation of a floating charge does not prevent dealing in the asset.
On liquidation, charges are prioritised using the following principles:
 Fixed charges rank ahead of floating charges
 Charges of the same kind are ranked in order of their date of creation
The security to the lender is the value of the asset at disposal and not the debt. Therefore, if a
company is liquidated and an asset is sold for $50,000 with a loan outstanding of $70,000, the
difference will rank as unsecured.
Some lenders reinforce their position by including a negative pledge clause in their floating charge
documents. This is a condition that states that the company will not create any later legal or
equitable charges over specific assets ranking in priority to a floating charge.

3.3 Statutory reporting and documentation requirements


A company must keep statutory registers of:
 members
 directors
 directors' interests, including loans to directors
 charges over the company's assets
 meetings
 resolutions
 substantial interests in shares
The records must be kept at the registered office or another location if permission is granted by the
Companies Registry.
The company must prepare a
 statement of financial position
 statement of profit or loss and other comprehensive income
Both of these documents must be approved and signed.
These financial statements have to be filed with the Registrar and sent to all members and
debenture holders.
A listed public company is permitted to produce summary financial statements for the members in
place of the full accounts.
Companies must keep proper accounting records to enable the accounts to be prepared with
reasonable accuracy. An annual return must be sent to the Registry.

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1: Legal environment | Part A Legal environment

3.4 Appointment and removal of auditors


The first auditors of a new company are appointed by the first directors of the company.
For existing companies, the appointment or reappointment of auditors is confirmed by the members
in the Annual General Meeting. If the AGM does not appoint an auditor, the court can make an
appointment.
If the auditors resign from their position, the directors or the shareholders at a general meeting may
appoint new auditors.
3.4.1 New auditors
Where new auditors are appointed at a general meeting it is necessary to serve special notice
(28 days) to the members. In some cases this may be impossible, but the notice period may not be
less than 21 days.
Notification to the members may be by any mode of communication permitted by the Articles of
Association.
The remuneration of auditors is determined by whoever appoints the auditors.
3.4.2 Removal and resignation of auditors
The company must pass an ordinary resolution if it wishes to remove the auditors. If this occurs
before the expiry of the period of office, special notice of 28 days to the company by the person
seeking to remove the auditor is mandatory.
Any representations by the auditors relating to (or relevant to) the removal or resignation must be
sent to the members. The removed or resigning auditor is entitled to attend the next AGM.
The auditor can resign in writing at any time. Unless the auditor wishes to make a statement to the
members, the notice to the company must state that there are no relevant circumstances
connected with the resignation that need to be brought to the attention of the members. The notice
of resignation must be deposited with the Companies Registry. If there is a statement made by the
auditor relating to the circumstances of resignation this must be sent to all of the members.
3.4.3 Auditor’s rights
The new CO enhances the rights of auditors. Pursuant to s. 412 of the new CO, auditors may
require information and explanation for the performance of their duties from a wider range of
persons, including persons holding or accountable for any accounting records of the company or a
Hong Kong incorporated subsidiary of the company.
It also empowers auditors to require the company to obtain information and explanation for the
performance of their duties from persons holding or accountable for the accounting records of
a non-Hong Kong incorporated subsidiary.

3.5 Restructuring, including appointment of receivers and


liquidators
Companies may alter their capital structure or make other arrangements to improve profitability or
liquidity, increase efficiency or ultimately rescue the business. The law sets out to protect the
members and outside parties in the event of these actions.
3.5.1 Restructuring
Restructuring is a common response to a change in business conditions. A company may
restructure its financing arrangements, its assets or its operations in order to save money and
achieve efficiencies.
Debt restructuring is the process where a company with cash flow problems restructures or
renegotiates debts in order to improve or restore liquidity so that trading may continue.

17
Financial Reporting

Capital restructuring involves reallocating assets to improve liquidity. Certain assets are sold and
replaced with alternative assets which can be better utilised to earn revenue and profits.
The overall motives of restructuring are reduced risk, reduced cost of capital and increased
liquidity.
3.5.2 Liquidation

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.

3.6 Financial statements requirements


Under the new CO, Hong Kong companies have a statutory duty to prepare financial statements
and file these financial statements with the Companies Registry unless exempted. Some of the
relevant Ordinance provisions are as follows:

 s.379 - a company's directors must prepare for each financial year financial statements that
comply with the ordinance requirements, and directors must instead prepare for the financial
year consolidated statements if the company is a holding company and not a wholly owned
subsidiary of another corporate

 s.380(1) - the annual financial statements must give a true and fair view of the financial
position of the company as at the end of the financial year and the financial performance of
the company for the financial year

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1: Legal environment | Part A Legal environment

 s.380(2) - the annual consolidated statements must give a true and fair view of the financial
position of the company and all the subsidiary undertakings as a whole as at the end of the
financial year, and the financial performance of the company and all the subsidiary
undertakings as a whole for the financial year

 s.380(3) – the financial statements for a financial year must comply with Part 1 and 2 of
Schedule 4, depending on reporting exemption

 s.380(4) – the financial statements for a financial year must comply with any other
requirements of the Ordinance in relation to the financial statements and the accounting
standards applicable to the financial statements

 s.380(5) - the financial statements must contain all additional information necessary to give a
true and fair view

 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 2 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.

19
Financial Reporting

Topic recap

Legal environment

HongHong
KongKong
LegalLegal Hong
Directors
Kong and
Legal
officers of a company Hong Legal
Kong requirements
Legal
Framework Framework Framework

Types of organisation: Directors’ duties and responsibilities Share issues:


Ÿ Sole proprietor Ÿ Fiduciary duties Ÿ Prospectus required where
Ÿ Partnerships Ÿ Duty to exercise skill and care a public company seeks to
Ÿ Companies Ÿ Responsibilities in respect of raise capital from general
financial reporting public.

A business licence to Directors’ powers and obligations: Debt & charges:


operate as a sole proprietor Ÿ Power of directors – managing the Ÿ Fixed charge: charge over
is applied for from the company single asset
Inland Revenue Ÿ Directors’ obligations – compliance Ÿ Floating charge: charge over
Department. with duties group of assets.
Two registers of charges must
Partnerships are formed by be maintained.
the Hong Kong
Partnerships Ordinance.

A company is established
under the provisions of the
Companies Ordinance.

Joint ventures may be any


type of legal structure.

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 Ÿ arrange board meetings Ÿ maintain statutory registers
the conditions to remain Ÿ arrange general meetings Ÿ prepare statements of
private must register as Ÿ record meeting minutes financial position and
public. Ÿ maintain company records comprehensive income.
Ÿ liaise with members
Ÿ deal with formal
communications with the
Companies Registry
Corporate governance is Auditors
the system by which Ÿ New auditors appointed at
companies are directed and AGM
controlled. Ÿ Removal of auditors by
ordinary resolution
Ÿ Resignation at any time in
writing

Restructuring
Ÿ Debt restructuring
(renegotiate debts to
improve liquidity)
Ÿ Capital restructuring
(reallocate assets to
improve liquidity)
Ÿ Liquidation (winding
up the company)
Ÿ Receivership
(recovery of money for
creditors)

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1: Legal environment | Part A Legal environment

Exam practice

Preparing financial statements 15 minutes


During an audit of the financial statements of a Hong Kong incorporated company listed on the
Main Board of The Stock Exchange of Hong Kong Limited, the auditor reported to the Audit
Committee of the company that no impairment assessment had been done by the management in
respect of the goodwill arising on an acquisition of a subsidiary in the prior year under HKAS 36
Impairment of Assets. In a meeting with the directors of the company, one of the executive
directors told the auditor that "We are not responsible for the preparation of financial statements.
We have delegated this task to our financial controller. Please talk to him directly." The financial
controller, being a professional accountant, responded that, "the financial statements will be
approved by the Board of Directors instead of me; it is not my problem if the financial statements
are not prepared in accordance with Hong Kong Financial Reporting Standards."
Required
Comment on the validity of the statements given by the executive director and the financial
controller of the company in respect of their responsibilities in the preparation of the financial
statements. (8 marks)
HKICPA May 2009

21
Financial Reporting

22
Part B

Financial reporting
framework

The emphasis in this section is on an in-depth understanding of the financial reporting


framework in Hong Kong. The purpose of this section is to develop your understanding about
the financial reporting framework in Hong Kong, the role of accounting standards and the
financial reporting requirements under Hong Kong Financial Reporting Standards.

23
Financial Reporting

24
chapter 2

Financial reporting
framework
Topic list 7.2 Advantages and disadvantages of a conceptual
framework
7.3 Generally Accepted Accounting Principles
1 Regulatory bodies and their impact on
(GAAP)
accounting
1.1 The role of the Hong Kong Institute of 8 The HKICPA’s Conceptual Framework
CPAs (HKICPA) 8.1 Preface
1.2 The role of the Stock Exchange of Hong 8.2 Introduction
Kong (SEHK) Ltd 8.3 Purpose and status
1.3 Securities and Futures Commission (SFC) 8.4 Scope
1.4 Financial Reporting Council (FRC) 8.5 Users and their information needs
1.5 Hong Kong Insurance Authority (HKIA) 8.6 The objective of financial statements
1.6 Hong Kong Monetary Authority (HKMA) 8.7 Information about economic resources, claims
and changes in resources and claims
2 Financial reporting requirements under
8.8 The reporting entity
HKFRS
9 Qualitative characteristics of financial information
3 Hong Kong Financial Reporting Standards
9.1 Fundamental qualitative characteristics
3.1 The setting of HKFRS and due process
9.2 Enhancing qualitative characteristics
3.2 Current Hong Kong FRS
9.3 The cost constraint on useful financial reporting
3.3 Scope of HKFRS
9.4 Underlying assumption
3.4 Accounting standards and choice
10 The elements of financial statements
4 Other sources of financial reporting guidance
10.1 Financial position
4.1 HK(IFRIC) Interpretations, Hong Kong
10.2 Performance
Interpretations and HK(SIC) Interpretations
10.3 Capital maintenance
4.2 Conceptual Framework for Financial
10.4 Section summary
Reporting (the Conceptual Framework)
4.3 Accounting Guidelines and implementation 11 Recognition of the elements of financial
guidance statements
4.4 Accounting Bulletins 11.1 Probability of future economic benefits
11.2 Reliability of measurement
5 Additional requirements for listed companies
11.3 Recognition of items
5.1 Companies listed on the Main Board
5.2 Companies listed on GEM 12 Measurement of the elements of financial
5.3 Acceptance of Mainland Accounting and statements
Auditing Standards
13 Fair presentation and compliance with HKFRS
6 Code of Ethics for Professional Accountants 13.1 Extreme case disclosures
6.1 Fundamental principles 13.2 Break-up basis accounts
6.2 Obligation to comply with the Code of
Ethics 14 Management commentary
6.3 Revision to Code of Ethics 14.1 Purpose
14.2 Contents
7 Conceptual Framework and GAAP
7.1 A conceptual framework 15 Current developments
15.1 Conceptual Framework
15.2 Other IASB Projects

25
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

In this chapter you will cover the following learning outcomes:


Competency
level
Describe the financial reporting framework in Hong Kong and the related
implications for business activities
2.01 The role and setting of accounting standards 2
2.01.01 Understand the role of accounting standards
2.01.02 Understand the role of the HKICPA, Securities and Futures
Commission (SFC), Financial Reporting Council (FRC), the Hong
Kong Insurance Authority (HKIA), the Hong Kong Monetary
Authority (HKMA) and the Hong Kong Stock Exchange (HKEx)
2.02 Hong Kong Financial Reporting Standards 2
2.02.01 Describe how Hong Kong Financial Reporting Standards are set
2.05 Code of Ethics for Professional Accountants 3
2.05.01 Explain the requirements of the Code of Ethics for Professional
Accountants
2.06 Hong Kong (IFRIC) Interpretations, Hong Kong Interpretations 2
and Hong Kong (SIC) Interpretations
2.06.01 Describe the status of Hong Kong (IFRIC) Interpretations, Hong
Kong Interpretations and Hong Kong (SIC) Interpretations
2.07 Other professional pronouncements and exposure drafts 2
2.07.01 Identify other professional pronouncements and exposure drafts
relevant to the financial reporting Conceptual Framework
2.08 Regulatory bodies and their impact on accounting 2
2.08.01 Identify relevant regulatory bodies and their impact on accounting
2.09 Accounting principles and conceptual frameworks 2
2.09.01 Explain what is meant by a conceptual framework and GAAP
2.09.02 Identify the advantages and disadvantages of a conceptual
framework
2.09.03 Identify the components and requirements of the HKICPA's
Conceptual Framework
2.09.04 Explain those requirements of HKAS 1 Presentation of Financial
Statements which overlap with the HKICPA's Conceptual
Framework
2.10 Current developments 2
2.10.01 Identify areas of accounting in which current developments are
occurring

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2: Financial reporting framework | Part B Financial reporting framework

1 Regulatory bodies and their impact on accounting


Topic highlights
The main regulatory bodies influencing accounting within Hong Kong are the Hong Kong Institute
of Certified Public Accountants (HKICPA), and for listed companies, the Hong Kong Stock
Exchange (HKEx). Other bodies include the Securities and Future Commissions (SFC), Financial
Reporting Council (FRC), the Hong Kong Insurance Authority (HKIA) and the Hong Kong Monetary
Authority (HKMA). Throughout this chapter we shall meet the regulations and requirements put in
place by these bodies, but first, a brief introduction to each.

1.1 The role of the Hong Kong Institute of CPAs (HKICPA)


The HKICPA issues HKFRS and non-mandatory guidance documents including Accounting
Guidelines and Accounting Bulletins.
The HKICPA is the only statutory accounting body in existence in Hong Kong responsible for the
establishment of accounting and auditing standards and guidelines, as well as for the
administration and regulation of the accounting profession in Hong Kong.
Pursuant to the Professional Accountants Ordinance (Chapter 50), the Council of the HKICPA (the
Council) may, in relation to the practice of accountancy, issue or specify any standards of
accounting practices required to be observed, maintained or otherwise applied by members of the
Hong Kong Institute of CPAs. In this respect, the objectives of the Council are to:
(a) develop, in the public interest, a single set of high quality, understandable and enforceable
accounting standards that require high quality, transparent and comparable information in
financial statements and other financial reporting to help participants in the capital markets
and other users of the information to make economic decisions
(b) promote the use and rigorous application of those standards
(c) promote, support and enforce compliance with those standards by members of the HKICPA
whether as preparers or auditors of financial information
(d) bring about convergence of accounting standards with International Financial Reporting
Standards (IFRS).

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.

27
Financial Reporting

1.3 Securities and Futures Commission (SFC)


Topic highlights
The Securities and Futures Commission (SFC) is an independent non-governmental statutory body,
and is established by the Securities and Futures Commission Ordinance (SFCO). It is outside the
civil service, responsible for regulating the securities and futures markets in Hong Kong.

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
trading  Monitor licensees' financial soundness and compliance
 Advising on securities with the Ordinance, codes, guidelines, rules and
regulations
 Advising on futures contracts
 Handle misconduct complaints against licensees
 Advising on corporate
finance  Investigate and take action against misconduct

 Providing automated trading


services
 Securities margin financing
 Asset management

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2: Financial reporting framework | Part B Financial reporting framework

Areas of regulation Methods

Investment products offered  Set standards for the authorisation and regulation of
to the public investment products
 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
 Administer the Codes on Takeovers and Mergers and
Share Repurchases
 Consider requests for exemptions from prospectus
requirements under the Companies Ordinance
 Enquire into listed companies' suspected prejudicial or
fraudulent transactions or provision of false or misleading
information to the public
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
 Oversee its systems and technology
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

1.4 Financial Reporting Council (FRC)


The FRC is an independent statutory body set up under the Financial Reporting Council Ordinance,
which was enacted on 13 July 2006. The FRC was established on 1 December 2006. It became
fully operational on 16 July 2007.

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Financial Reporting

The role of the FRC is to:


 conduct independent investigations into possible auditing and reporting irregularities in
relation to listed entities
 enquire into possible non-compliance with financial reporting requirements on the part of
listed entities
 require listed entities to remove any non-compliance identified
The FRC may initiate investigations into a possible relevant irregularity or enquiries upon receipt of
complaints or on its own initiative an enquiry into possible relevant non-compliance with financial
reporting requirements on the part of listed entities.
Relevant irregularity means an auditing or reporting irregularity. It is defined in section 4 of the
Financial Reporting Council Ordinance (the "FRC Ordinance").
Any auditing or reporting irregularity exists if an auditor in respect of the audit of the financial
statements of a listed entity or a reporting accountant in respect of the preparation of an
accountants' report required for a listing document:
(a) falsified or caused to be falsified a document;
(b) made a statement, in respect of a document, that was material and that he knew to be false
or did not believe to be true;
(c) has been negligent in the conduct of his profession;
(d) has been guilty of professional misconduct;
(e) did or omitted to do something that would reasonably be regarded as bringing or likely to
bring discredit upon the auditor or reporting accountant himself, the Hong Kong Institute of
Certified Public Accountants (HKICPA) or the accountancy profession;
(f) failed to comply with a professional standard, i.e. any (a) statement of professional ethics; or
(b) standard of accounting, auditing and assurance practices, as issued or specified by the
council of the HKICPA from time to time;
(g) failed to comply with the provisions of any bylaw or rule made or any direction lawfully given
by the council of the HKICPA.
A relevant non-compliance exists if a relevant financial report of a listed entity does not comply with
a relevant requirement. A relevant non-compliance is defined in section 5 of the Financial
Reporting Council Ordinance (the "FRC Ordinance").
A relevant requirement refers to accounting requirements as provided in:
 the Companies Ordinance;
 the standards of accounting practice issued or specified by the Council of the Hong Kong
Institute of Certified Public Accountants (i.e. the Hong Kong Financial Reporting Standards);
 the International Financial Reporting Standards issued by the International Accounting
Standards Board;
 the Listing Rules;
 any generally acceptable accounting principles allowed for usage under the Listing Rules; or
 the relevant SFC Codes or guidelines.
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

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2: Financial reporting framework | Part B Financial reporting framework

and Futures Commission or The Stock Exchange of Hong Kong Limited for follow-up action. The
FRC is not empowered to discipline or prosecute.

1.5 Hong Kong Insurance Authority (HKIA)


The Office of the Commissioner of Insurance (OCI) is the regulatory body set up for the
administration of the Insurance Companies Ordinance (Cap. 41) (ICO). The OCI was established
in June 1990. The Office is headed by the Commissioner of Insurance who has been appointed as
the Insurance Authority (IA) for administering the ICO.
The principal functions of the IA are to ensure that the interests of policy holders or potential policy
holders are protected and to promote the general stability of the insurance industry. The IA has the
following major duties and powers:
(a) Authorisation: Authorisation of insurers to carry on insurance business in or from Hong
Kong. The IA has set out the criteria for authorisation which include, among other things,
strong financial position, proper management, viable business plan and physical presence in
Hong Kong in order to ensure that an adequate level of security is provided to the insuring
public.
(b) Regulation of insurers: The regulatory objective of the IA is to ensure the financial
soundness and integrity of the insurance market. The primary duty is to ensure that insurers
conduct their activities in a prudent manner so that their obligations and policy holders'
expectations will be met. Other operational aspects, such as setting of premium rates and
policy terms and conditions, are largely left to self-regulation by the industry. Regulatory
work is done primarily through the examination of the annual audited financial statements
and business returns submitted by the insurers. Where causes for concern are identified in
respect of an insurer, the IA is empowered under the ICO to take interventionary actions for
protection of the interests of policy holders and potential policy holders.
(c) Regulation of insurance intermediaries: An insurance agent is required to be properly
appointed by an insurer and registered with the Insurance Agents Registration Board (IARB), in
accordance with the Code of Practice for the Administration of Insurance Agents issued by the
Hong Kong Federation of Insurers. Under this central registration system, the IARB provides
enquiry services to and handles complaints from the public relating to insurance agents.
An insurance broker may seek authorisation directly from the IA, or may apply to become a
member of an approved body of insurance brokers, in order to carry on insurance broking
business in or from Hong Kong. An approved body of insurance brokers is charged with the
responsibilities of ensuring that its members comply with the statutory requirements and that
the interests of policy holders and potential policy holders are properly protected. It also
provides enquiry services to and handles complaints from the public relating to its members.
An insurance broker who is directly authorised by the IA is subject to the same statutory
requirements as applicable to a member of an approved body of insurance brokers.
(d) Liaison with the insurance industry: The IA believes in consultation and has worked
closely with the representative bodies of the insurance industry in promoting self-regulation
by the industry with the aim of enhancing the protection of policy holders. As one of the self-
regulatory measures, the Insurance Claims Complaints Bureau (ICCB) was established in
1990. Any claimant who feels aggrieved that his claim under a personal policy is not fairly
treated may lodge a complaint with the ICCB. The ICCB is empowered to make an award of
up to $800,000 per case. The IA also reviews the guidelines and regulations developed
within the system regularly to ensure that they are keeping up with market developments and
provide adequate protection to the insuring public.

1.6 Hong Kong Monetary Authority (HKMA)


The Hong Kong Monetary Authority (HKMA) was established on 1 April 1993 by merging the Office
of the Exchange Fund with the Office of the Commissioner of Banking. Its main functions and
responsibilities are governed by the Exchange Fund Ordinance and the Banking Ordinance and it
reports to the Financial Secretary.

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Financial Reporting

The HKMA is the government authority in Hong Kong responsible for maintaining monetary and
banking stability. Its main functions are:
 maintaining currency stability within the framework of the Linked Exchange Rate system
 promoting the stability and integrity of the financial system, including the banking system
 helping to maintain Hong Kong's status as an international financial centre, including the
maintenance and development of Hong Kong's financial infrastructure
 managing the Exchange Fund.

2 Financial reporting requirements under HKFRS


Topic highlights
The Companies Ordinance provides the legal requirements for companies.

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.

3 Hong Kong Financial Reporting Standards


HKFRS set out recognition, measurement, presentation and disclosure requirements dealing with
transactions and events that are important in general purpose financial statements.
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.

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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.

3.1 The setting of HKFRS and due process


Topic highlights
The Financial Reporting Standards Committee (FRSC) of HKICPA has a mandate to develop
financial reporting standards to achieve convergence with the International Financial Reporting
Standards (IFRS) issued by the International Accounting Standards Board (IASB).

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.
(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

33
Financial Reporting

the Council agrees with the IASB Basis for Conclusions so as to enable users to understand
any changes made to the IFRS.

3.2 Current Hong Kong FRS


HKFRS set out recognition, measurement, presentation and disclosure requirements dealing with
transactions and events that are important in general purpose financial statements.
The following table shows the list of Hong Kong Accounting Standards in issue as at 31 May 2013:

Hong Kong Accounting Standards

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
(Revised)
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
HKAS 36 Impairment of Assets
HKAS 37 Provisions, Contingent Liabilities and Contingent Assets
HKAS 38 Intangible Assets
HKAS 39 Financial Instruments: Recognition and Measurement

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Hong Kong Accounting Standards

HKAS 40 Investment Property


HKAS 41 Agriculture
HKFRS 1
First-time Adoption of Hong Kong Financial Reporting Standards
(Revised)
HKFRS 2 Share-based Payment
HKFRS 3
Business Combinations
(Revised)
HKFRS 4 Insurance Contracts
HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations
HKFRS 6 Exploration for and Evaluation of Mineral Resources
HKFRS 7 Financial Instruments: Disclosures
HKFRS 8 Operating Segments
HKFRS 9 Financial Instruments
HKFRS 10 Consolidated Financial Statements
HKFRS 11 Joint Arrangements
HKFRS 12 Disclosure of Interests in Other Entities
HKFRS 13 Fair Value Measurement
HKFRS for
HKFRS for Private Entities
PEs

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.

3.3 Scope of HKFRS


Any limitation of the applicability of a specific HKFRS is made clear within that standard. HKFRS
are not intended to be applied to immaterial items, nor are they retrospective. Each individual
HKFRS lays out its scope at the beginning of the standard.

3.4 Accounting standards and choice


It is sometimes argued that companies should be given a choice in matters of financial reporting on
the grounds that accounting standards are detrimental to the quality of such reporting. There are
arguments on both sides.
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.

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Financial Reporting

(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.

4 Other sources of financial reporting guidance


4.1 HK(IFRIC) Interpretations, Hong Kong Interpretations and
HK(SIC) Interpretations
As well as HKFRS, you will also see reference to HK(IFRIC) Interpretations. IFRICs are the
publications of the IFRS Interpretations Committee.
The IFRS Interpretations Committee is the interpretative body of the IASB. The mandate of the
Interpretations Committee is to review on a timely basis widespread accounting issues that have
arisen within the context of current IFRS and to provide authoritative guidance (IFRICs) on those
issues.
IFRICs and their predecessors SICs are adopted in Hong Kong as HK(IFRIC) Interpretations and
HK(SIC) Interpretations. A number of these interpretations are considered throughout this Learning
Pack.

4.2 Conceptual Framework for Financial Reporting (the


Conceptual Framework)
The Conceptual Framework sets out the concepts underlying the preparation and presentation of
financial statements for external users. Its objectives are to:
(a) assist the Council in the development of future accounting standards and guidelines and in
its review of existing accounting standards and guidelines;

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2: Financial reporting framework | Part B Financial reporting framework

(b) assist preparers of financial statements in applying accounting standards and guidelines and
in dealing with topics that have yet to form the subject of an accounting standard or
guideline;
(c) assist auditors in forming an opinion as to whether financial statements conform with
accounting standards;
(d) assist users of financial statements in interpreting the information contained in financial
statements prepared in conformity with accounting standards and guidelines; and
(e) provide those who are interested in the work of the Council with information about its
approach to the formulation of accounting standards and guidelines.
The Conceptual Framework is discussed in more detail in sections 8 to 12 of this chapter.

4.3 Accounting Guidelines and implementation guidance


Accounting Guidelines (AGs) have effect as guidance statements and indicators of best practice.
They are persuasive in intent. Unlike HKFRS, AGs are not mandatory, but are consistent with the
purpose of HKFRS in that they help define accounting practice in the particular area or sector to
which they refer. Therefore, they should normally be followed, and members of the Hong Kong
Institute of CPAs should be prepared to explain departures if called upon to do so. Many AGs
issued previously have already been superseded with the publication of a new HKFRS which
addresses and sets out mandatory practice in relation to accounting issues which were previously
the subject of an AG. The AGs in issue at the time of publication are:
AG 1 Preparation and Presentation of Accounts from Incomplete Records
AG 5 Merger Accounting for Common Control Combinations
AG 7 Preparation of Pro Forma Financial Information for Inclusion in Investment Circulars
In a number of HKFRS, e.g. HKAS 39, guidance on implementing the standard is included, either
with the standard or in a separate document. The Preface to Hong Kong Financial Reporting
Standards has not clarified the status of this guidance. For the purpose of this Learning Pack, this
implementation guidance is considered as having the same status as the accounting guidelines.
(Implementation guidance is not the same as application guidance, which is often an integral part
of the HKFRS.)

4.4 Accounting Bulletins


Accounting Bulletins (ABs) are informative publications on subjects of topical interest and are
intended to assist members or to stimulate debate on important accounting issues. They do not
require the approval of the Council of the Hong Kong Institute of CPAs and they do not have the
same authority as either HKFRS or AGs.
There are currently three ABs in issue:
AB 1 Disclosure of Loans to Officers
AB 3 Guidance on Disclosure of Directors' Remuneration
AB 4 Guidance on the Determination of Realised Profits and Losses in the Context of Distribution
under the Hong Kong Companies Ordinance

5 Additional requirements for listed companies


Topic highlights
The SEHK requires listed companies to comply with its Listing Rules.

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Financial Reporting

5.1 Companies listed on the Main Board


The disclosure requirements for companies listed on the Main Board, both in respect of annual
financial reporting and interim financial reporting, are set out in the Appendix 16 of the Listing
Rules.
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, and not less than 21 days before the date of the annual general
meeting. Note that the three-month limit for the release of the annual report relates to annual
accounting periods ending on or after 31 December 2010. Prior to that the limit was four months.
The Listing Rules require certain financial information disclosures, other than those required by
HKFRS or the Companies Ordinance, which are normally presented in the notes to financial
statements. These disclosures include:
 analysis of the maturity profile of borrowings
 analysis of directors' remuneration by emolument bands; analysis of employees' emoluments
by emolument bands; pension schemes
 credit policy and aged analysis of accounts receivable; and aged analysis of accounts
payable
An entity which either meets the definition of a Financial Conglomerate or a Banking Company is
subject to some additional disclosure requirements under the Listing Rules.
The Main Board requirement for paid announcements was abolished on 25 June 2007. Main Board
issuers are required to publish their announcements on their own website as well as the HKEx
website.
Any Main Board issuer that does not have its own website will be in breach of the Listing Rules.
5.1.1 Interim reports
A company listed on the Main Board is required to issue an interim report for the first six months of
a financial year. This report must be published not later than two months after the end of that
interim period.
Interim reports should contain the following financial information:
 Statement of profit or loss or statement of profit or loss and other comprehensive income.
 Balance sheet (statement of financial position).
 Cash flow statement (statement of cash flows).
 A statement of movements in equity other than those arising from capital transactions with
shareholders and distributions to shareholders.
 Comparative figures, accounting policies and other notes to the financial statements.
Interim reports should comply with the requirements of HKAS 34 Interim Financial Reporting, or for
companies reporting under international financial reporting standards, IAS 34.
The Listing Rules require that the interim reports should be reviewed by the entity's audit
committee or, where such a committee has not been formed, by the external auditors.

5.2 Companies listed on the Growth Enterprise Market (GEM)


The disclosure requirements for companies listed on the GEM, both in respect of annual financial
reporting and interim financial reporting, are principally set out in Chapter 18 Financial Information
of the GEM Rules.

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Companies listed on the GEM are subject to tighter reporting requirements. For example, they are
required to publish annual reports within three months; and half-yearly reports and quarterly reports
within 45 days after the end of each relevant financial period.
The disclosure requirements for annual reporting under the GEM Rules are in many ways similar to
the Listing Rules though there are some specific disclosures which are only applicable under the
GEM Rules. For instance, companies listed on GEM are subject to the following additional
disclosure requirements:
(a) A comparison of actual business progress with business objectives stated in listing
documents (for a few reporting periods after the year of listing only).
(b) Extension of the disclosure of directors' emoluments by showing the amount of emoluments
by director on an anonymous basis.
(c) The interests (if any) of the sponsor, and its directors, employees and associates, and of the
interests of the management shareholders of the issuer.
(d) As regards the compliance with corporate governance disclosure, specification of work
undertaken by the audit committee and number of meetings held, and so on.
For companies listed on GEM, the principal means of information dissemination on GEM is
publication on the Internet website operated by the SEHK. Companies listed on GEM are not
generally required to issue paid announcements in the press.
A GEM issuer that does not have its own website will be in breach of the Listing Rules.

5.3 Acceptance of Mainland Accounting and Auditing Standards


In December 2010, the Hong Kong Stock Exchange issued its Consultation Conclusions on the
Acceptance of Mainland Accounting and Auditing Standards and Mainland Audit Firms for
Mainland Incorporated Companies Listed in Hong Kong. The amendments to the Listing Rules:
 allow Mainland incorporated issuers to prepare their financial statements using Mainland
accounting standards; and
 allow Mainland audit firms vetted, nominated and endorsed by the Ministry of Finance of
China and the China Securities Regulatory Commission to service these issuers using
Mainland auditing standards.
Both Hong Kong Auditing Standards and Mainland Auditing Standards are allowed for Mainland
incorporated companies listed in Hong Kong.
As a result of this change, it is expected that compliance costs will be reduced for Mainland
companies listed in Hong Kong and market efficiency increased.

6 Code of Ethics for Professional Accountants


Topic highlights
Members of the HKICPA are bound by its Code of Ethics.

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
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.

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Financial Reporting

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.

6.1 Fundamental principles


All certified public accountants, whether in business or in public practice, are required to comply
with the following fundamental principles:
(a) Integrity: a certified public accountant should be straightforward and honest in all
professional and business relationships. Integrity also implies fair dealing and truthfulness.
In particular, section 110 of the Code of Ethics requires that a certified accountant should not
be associated with reports, returns, communications or other information where they believe
that the information: (1) contains a materially false or misleading statement; (2) contains
statements or information furnished recklessly; or (3) omits or obscures information required
to be included where such omission or obscurity would be misleading. A certified public
accountant should not be associated with such reports, returns, communications or other
information unless the certified public accountant provides a modified report in respect of the
above mentioned matters.
(b) Objectivity: a certified public accountant should not allow bias, conflict of interest or undue
influence of others to override professional or business judgments.
In particular, section 120 of the Code of Ethics requires that all certified public accountants
should not compromise their professional or business judgment because of bias, conflict of
interest or the undue influence of others. Relationships that bias or unduly influence the
professional judgment of the certified public accountant should be avoided.
A certified public accountant may be exposed to situations that may impair objectivity. It is,
however, impracticable to define and prescribe all such situations.
(c) Professional competence and due care: a certified public accountant has a continuing
duty to maintain professional knowledge and skill at the level required to ensure that a client
or employer receives competent professional service based on current developments in
practice, legislation and techniques. A certified public accountant should act diligently and in
accordance with applicable technical and professional standards when providing
professional services.
(d) Confidentiality: a certified public accountant should respect the confidentiality of information
acquired as a result of professional and business relationships and should not disclose any
such information to third parties without proper and specific authority unless there is a legal
or professional right or duty to disclose. Confidential information acquired as a result of
professional and business relationships should not be used for the personal advantage of
the certified public accountant or third parties.
(e) Professional behaviour: a certified public accountant should comply with relevant laws and
regulations and should avoid any action that discredits the profession.
Ethics in accounting is of utmost importance to accounting professionals and those who rely on
their services. Accounting professionals know that people who use their services, especially
decision makers using financial statements, expect them to be highly competent, reliable, and
objective. Those who work in the field of accounting must not only be well qualified but must also
possess a high degree of professional integrity. A professional's good reputation is one of his or her
most important assets.
There is a very fine line between acceptable accounting practice and management's deliberate
misrepresentation in the financial statements.

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The financial statements must meet the following criteria:


(a) Technical compliance: a transaction must be recorded in accordance with generally
accepted accounting principles (GAAP).
(b) Economic substance: the resulting financial statements must represent the economic
substance of the event that has occurred.
(c) Full disclosure and transparency: sufficient disclosure must be made so that the effects of
transactions are transparent to the reader of the financial statements.
Accounting plays a critical function in society. It affects human behaviour especially when pay or
compensation is impacted, and to deliberately mask the nature of accounting transactions could be
deemed as unethical behaviour.

Example: Shepherd Co.


The finance director of Shepherd Co., a CPA, has carried out the following actions in June 20X9:
(a) Employed his brother's cleaning company to clean Shepherd Co.'s offices every week
(b) Used information that he acquired while at work to recommend to his sister that she buys
shares in Shepherd Co.'s parent company
(c) Approved the monthly management accounts of the company by signing his name, even
though he had not looked at them.
Has the finance director contravened any of the fundamental principles of the Code of Ethics for
Professional Accountants?
Solution
(a) contravenes the principle of objectivity
(b) contravenes the principle of confidentiality
(c) contravenes the principle of integrity

6.2 Obligation to comply with the Code of Ethics


Professional accountants have obligations to comply with the Code of Ethics. Compliance is
monitored by employers and the HKICPA.
Disciplinary actions may be taken by HKICPA for non-compliance with the Code of Ethics,
including removal from the Institute's membership register.

6.3 Revision to Code of Ethics


The Code of Ethics for Professional Accountants (the Code) was revised in 2010 so as to maintain
convergence with the revised Code of Ethics for Professional Accountants issued by the IESBA in
July 2009. The revisions clarify requirements for all professional accountants and significantly
strengthen the independence requirements of auditors. The revised Code came into effect from
1 January 2011.
In addition to the IESBA Code, the Hong Kong Code contains additional local requirements in
Part D, such as the Prevention of Bribery Ordinance. These form an integral part of the Code, and
members should ensure that they are aware of the additional requirements and comply with them.

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Financial Reporting

7 Conceptual Framework and GAAP


Topic highlights
A conceptual framework is a statement of generally accepted theoretical principles which form
the frame of reference for financial reporting. There are advantages and disadvantages to having a
conceptual framework.

7.1 A conceptual framework


A conceptual framework is a statement of generally accepted theoretical principles which form
the frame of reference for financial reporting. In other words, a conceptual framework will form the
basis for determining which events should be accounted for, how they should be measured and
how they should be communicated to the user. It is used to aid the development of new accounting
standards and the evaluation of those already in existence, and although theoretical in nature, a
conceptual framework for financial reporting has highly practical final aims.
Where a conceptual framework does not exist, standards tend to be produced in a haphazard
fashion, generally in response to an accounting issue that has arisen. Inconsistencies and
contradictions may therefore appear and, in turn, ambiguity which affects the true and fair concept
of reporting. This ad hoc approach is avoided where a framework exists, and the specific rules
within standards are based on sound basic principles, so ensuring a consistency of approach.
Another problem with the lack of a conceptual framework has become apparent in the USA. The
large number of highly detailed standards produced by the Financial Accounting Standards
Board (FASB) has created a financial reporting environment governed by specific rules rather than
general principles. However, accounting scandals such as Enron in the US have exposed the
weaknesses of this approach.

7.2 Advantages and disadvantages of a conceptual framework


Advantages
(a) Standards do not have to be developed on a haphazard, reactive basis, concentrating
resources on combating a problem that has been identified in practice, rather than
developing a consistent suite of standards that cover all problems.
(b) The standard-setting process in many countries in the past has been subject to political
interference, where interested parties have tried to influence the setting of standards in their
favour. For example, pharmaceutical companies may argue for the costs of research and
development to be capitalised in all situations, regardless of the likely recoverability of the
cost. A standard-setter should be better able to stand firm against pressure, if standards can
be seen to be deriving from a published conceptual framework.
(c) In the past, some standards seem to have concentrated on the income statement (the
calculation of profit or loss), while others have concentrated on the statement of financial
position (the valuation of net assets).
Disadvantages
(a) Financial statements are drawn up to serve the interests of a variety of user groups, and it
is not clear that a single conceptual framework can be devised that will satisfy the
information needs of all users.
(b) It can be argued that different accounting statements should be drawn up to achieve different
purposes. For example inventory might be of most use when measured at marginal cost in a
decision-making statement, and at full absorption cost in a financial reporting statement.
(c) The experience in countries that have issued conceptual frameworks is that little notice is
taken of them by standard-setting bodies when deciding on new standards.

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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.

7.3 Generally Accepted Accounting Principles (GAAP)


GAAP signifies all the rules, from whatever source, which govern accounting.
In individual countries this is seen as a combination of:
 national company law
 national accounting standards
 local stock exchange requirements
Although the above sources form the basis for the GAAP of individual countries, the effects of other
non-mandatory sources in a particular country are also included in the concept, such as:
 International Accounting Standards
 statutory requirements in other countries
 long-standing accounting practices in areas not subject to a standard
Unlike countries such as the USA, GAAP does not have any statutory dominance or meaning in
many countries, such as the UK. The term, if mentioned in legislation, is only to a limited extent.
There are different views of GAAP in different countries. One view, held in most of Europe, is that
GAAP is a dynamic concept with accounting practices constantly changing in response to
circumstances. The term applies to those practices which the accounting profession regards as
permissible and legitimate in the circumstances in which it has been applied.
However, not all the countries share the same view. In the USA, the equivalent of a "true and fair
view" is "fair presentation in accordance with GAAP". Generally Accepted Accounting Principles
are viewed as having "substantial authoritative support". The adoption of accounting principles that
do not have substantial authoritative support in the preparation of accounts is presumed to be
misleading or inaccurate.
The above leads to the effect that "new" or "different" accounting principles are not acceptable
unless they have been adopted by the mainstream accounting profession, usually the standard-
setting bodies and/or professional accountancy bodies.
A conceptual framework for financial reporting can be defined as an attempt to codify existing
GAAP in order to reappraise current accounting standards and to produce new standards.
7.3.1 Mandatory and advisory sources
In Hong Kong, there are both mandatory and advisory sources of generally accepted accounting
principles (GAAP).

Mandatory sources are the following:

(a) Companies Ordinance. Legal requirements include maintenance of accounting records,


content of financial statements, and audits of companies incorporated in Hong Kong. The
new Hong Kong Companies Ordinance was issued in 2012, is being enacted by subsidiary
legislation and will become effective during 2014. Further detail on some of the sections
relevant to Module A was provided in Chapter 1.
(b) Hong Kong Financial Reporting Standards (HKFRS). The term HKFRS includes both
Standards (HKFRS and HKAS) and Interpretations (HK(IFRIC)-Ints, HK(SIC)-Ints, and
HK-Ints).
(i) Standards and Interpretations are developed by the Financial Accounting Standards
Committee of the Hong Kong Institute of Certified Public Accountants (HKICPA).
(ii) Standards and Interpretations are virtually identical to their international equivalents
(International Financial Reporting Standards) except for three Hong Kong
Interpretations (HK-Ints) which have been developed locally by the HKICPA.

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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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8 The HKICPA's Conceptual Framework


Topic highlights
The Conceptual Framework provides the basis for the development of HKFRS / HKAS.

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

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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.

8.3 Purpose and status


The introduction gives a list of the purposes of the Conceptual Framework.
(a) To give guidance to the Council of HKICPA in developing new financial reporting standards
and reviewing existing standards. Accounting standards will be more consistent and logical if
they are developed from an orderly set of concepts.
(b) To assist preparers of financial statements in applying HKFRS. The concepts guide
preparers in their broader fulfilment of GAAP.
(c) To assist auditors in forming an opinion as to whether financial statements conform with
HKFRS. An independent review by the auditor of the recognition and measurement
decisions by preparers relating to revenues, expenses, assets and liabilities in the financial
statements can be undertaken by reference to the details about primary elements.
(d) To assist users of financial statements in interpreting the information. The quality of
disclosures can be judged by users against the list of qualitative characteristics.
(e) To provide those who are interested in the work of the Council with information about its
approach to the formulation of HKFRS. The process of communication between the Council
of HKICPA and its constituents can be enhanced because the conceptual underpinnings of
proposed accounting standards will be more apparent.
The Conceptual Framework is not an HKFRS and so does not overrule any individual HKFRS. In a
limited number of cases there may be a conflict between an HKFRS and the Conceptual
Framework; here, the HKFRS will prevail. The number of such cases will diminish over time as
the Conceptual Framework is used as a guide in the production of new HKFRS. The Conceptual
Framework itself will be revised occasionally depending on the experience of the HKICPA in using
it.

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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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)

CF.OB5 8.5 Users and their information needs


Users of financial statements include investors, employees, lenders, suppliers and other trade
creditors, customers, government and their agencies and the public.
The Conceptual Framework places particular emphasis on existing and potential investors, lenders
and other creditors. It states that other users of financial statements may find general purpose
financial statements useful, however those reports are not primarily directed towards those other
groups.

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)

CF.OB2-12 8.6 The objective of financial statements


Topic highlights
The Conceptual Framework states that:
"The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to existing and potential investors, lenders and other creditors in
making decisions about providing resources to the entity."

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

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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.

8.7 Information about economic resources, claims and changes


in resources and claims
General purpose financial reports provide information about the financial position of a reporting
entity, which is information about:
 the entity’s economic resources, and
 claims against the reporting entity.
Financial reports also provide information about the effects of transactions and other events that
change a reporting entity’s economic resources and claims. Both types of information provide
useful input for decisions about providing resources to an entity.
CF.OB13-14 8.7.1 Economic resources and claims
Information about the nature and amounts of a reporting entity’s economic resources and claims
can help users to identify the reporting entity’s financial strengths and weaknesses. That
information can help users to assess:
 the reporting entity’s liquidity and solvency,
 its needs for additional financing, and
 how successful it is likely to be in obtaining that financing.
Information about priorities and payment requirements of existing claims helps users to predict how
future cash flows will be distributed among those with a claim against the reporting entity.
CF.OB15-21 8.7.2 Changes in economic resources and claims
Changes in a reporting entity’s economic resources and claims result from:
(a) an entity’s financial performance, and
(b) other events or transactions such as issuing debt or equity instruments.
To properly assess the prospects for future cash flows from the reporting entity, users need to be
able to distinguish between both of these changes.

8.8 The reporting entity


This section of the Conceptual Framework has not yet been issued. An Exposure Draft was issued
in 2010 in which a reporting entity is defined as follows:
"A reporting entity is a circumscribed area of economic activities whose financial information has
the potential to be useful to existing and potential equity investors, lenders, and other creditors
who cannot directly obtain the information they need in making decisions about providing
resources to the entity and in assessing whether the management and the governing board of
that entity have made efficient and effective use of the resources provided."

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A reporting entity has three features:


(a) Economic activities of an entity are being conducted, have been conducted, or will be
conducted
(b) Those economic activities can be objectively distinguished from those of other entities and
from the economic environment in which the entity exists
(c) Financial information about the economic activities of that entity has the potential to be
useful in making decisions about providing resources to the entity and in assessing whether
the management and the governing board have made efficient and effective use of the
resources provided.
These features are necessary but not always sufficient to identify a reporting entity.
During the course of 2013 a discussion paper relating to all remaining phases of the Conceptual
Framework project, including ‘the reporting entity’ will be issued and the IASB aims to complete the
project by 2015.

9 Qualitative characteristics of financial information


Topic highlights
The Conceptual Framework states that qualitative characteristics are the attributes that make the
information provided in financial statements useful to existing and potential investors, lenders and
creditors. The two fundamental qualitative characteristics are relevance and faithful representation.
These are supported by four enhancing qualitative characteristics of comparability, verifiability,
timeliness and understandability.

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.

CF.QC5-16 9.1 Fundamental qualitative characteristics


The fundamental qualitative characteristics are relevance and faithful representation.
9.1.1 Relevance
Relevant financial information is capable of making a difference in the decisions made by users.
Information may be capable of making a difference in a decision even if some users choose not to
take advantage of it or are already aware of it from other sources. Financial information is capable
of making a difference in decisions if it has predictive value, confirmatory value or both. Financial
information has a confirmatory value if it confirms or changes previous evaluations.
Materiality
Materiality is related to relevance. Information is material if omitting it or misstating it could
influence decisions that users make on the basis of financial information about a specific reporting
entity. Materiality is an entity-specific aspect of relevance based on the nature or magnitude, or
both, of the items to which the information relates in the context of an individual entity’s financial

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Financial Reporting

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.

CF.QC19-32 9.2 Enhancing qualitative characteristics


Comparability, verifiability, timeliness and understandability are qualitative characteristics that
enhance the usefulness of information that is relevant and faithfully represented.
9.2.1 Comparability
Users' decisions involve choosing between alternatives, for example, selling or holding an
investment, or investing in one reporting entity or another. Consequently, information about a
reporting entity is more useful if it can be compared with similar information about other entities and
with similar information about the same entity for another period or another date.
Comparability is the qualitative characteristic that enables users to identify and understand
similarities in, and differences among, items. Unlike the other qualitative characteristics,
comparability does not relate to a single item. A comparison requires at least two items.
Consistency, although related to comparability, is not the same. Consistency refers to the use of
the same methods for the same items, either from period to period within a reporting entity or in a
single period across entities. Comparability is the goal; consistency helps to achieve that goal.
9.2.2 Verifiability
Verifiability helps assure users that information faithfully represents the economic phenomena it
purports to represent. Verifiability means that different knowledgeable and independent observers
could reach consensus, although not necessarily complete agreement, that a particular depiction is
a faithful representation.
Verification can be direct or indirect. Direct verification means verifying an amount through direct
observation, for example, by counting cash. Indirect verification means checking the inputs to a
model, formula or other technique and recalculating the outputs using the same methodology.

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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.

CF.QC35-39 9.3 The cost constraint on useful financial reporting


Cost is a constraint on the information that can be provided by financial reporting. Reporting
financial information imposes costs, and it is important that those costs are justified by the benefits
of reporting that information. There are several types of costs and benefits to consider.
Providers of financial information expend most of the effort involved in collecting, processing,
verifying and disseminating financial information, but users ultimately bear those costs in the form
of reduced returns. Users of financial information also incur costs of analysing and interpreting the
information provided. If needed information is not provided, users incur additional costs to obtain
that information elsewhere or to estimate it.
Reporting financial information that is relevant and faithfully represents what it purports to represent
helps users to make decisions with more confidence.

CF.4.1 9.4 Underlying assumption


The Conceptual Framework identifies going concern as an underlying assumption in preparing
financial statements.
The financial statements are normally prepared on the assumption that an entity is a going concern
and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has
neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such
an intention or need exists, the financial statements may have to be prepared on a different basis
and, if so, the basis used is disclosed.

10 The elements of financial statements


Topic highlights
Transactions and other events are grouped together in broad classes according to their economic
characteristics. These broad classes are the elements of financial statements: assets, liabilities,
equity, income and expenses.

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Financial Reporting

This chapter of the Conceptual Framework is taken from the 1997 Framework. It lays out these
elements as follows:
Elements of
financial statements

Measurement of financial Measurement of performance


position in the statement in the statement of profit or
of financial position loss and other comprehensive
income

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.

CF.4.4 – 4.7 10.1 Financial position


The elements related to the measurement of financial position are assets, liabilities and equity.

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
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

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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)

It is important to distinguish between a present obligation and a future commitment. A


management decision to purchase assets in the future does not, in itself, give rise to a present
obligation.
Settlement of a present obligation will involve the entity giving up resources embodying economic
benefits in order to satisfy the claim of the other party. This may be done in various ways, not just
by payment of cash.
Liabilities must arise from past transactions or events. In the case of, say, recognition of future
rebates to customers based on annual purchases, the sale of goods in the past is the transaction
that gives rise to the liability.
CF.4.19 10.1.3 Provisions
Some liabilities can be measured only with a degree of estimation for example payments to be
made under existing warranties. These liabilities are known as provisions.

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 2
Consider the following situations. In each case, do we have an asset or liability within the
definitions given by the Conceptual Framework? Give reasons for your answer.
(a) Manu Co. has purchased a patent for $20,000. The patent gives the company sole use of a
particular manufacturing process which will save $3,000 a year for the next five years.
(b) Hirecar Co. paid Michael Wood $10,000 to set up a car repair shop, on condition that priority
treatment is given to cars from the company's fleet.
(c) Sellcar Co. provides a warranty with every car sold.
(The answer is at the end of the chapter)

CF.4.20-4.23
10.1.4 Equity
Equity is defined above as a residual, but it may be sub-classified in the statement of financial
position. This is relevant to the decision-making needs of the users as it will indicate legal or other
restrictions on the ability of the entity to distribute or otherwise apply its equity. Some reserves are
required by statute or other law, e.g. for the future protection of creditors. The amount shown for

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Financial Reporting

equity depends on the measurement of assets and liabilities. It has nothing to do with the
market value of the entity's shares.

CF.4.24-4.28 10.2 Performance


Profit is used as a measure of performance, or as a basis for other measures (eg earnings per
share).
It depends directly on the measurement of income and expenses, which in turn depend (in part) on
the concepts of capital and capital maintenance adopted.
The elements of income and expense are therefore defined.

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.
CF.4.29-4.32 10.2.1 Income
Both revenue and gains are included in the definition of income. Revenue arises in the course of
ordinary activities of an entity and may be referred to by names including sales, fees, interest,
dividends rent or royalties.

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.

10.3 Capital maintenance


Capital maintenance refers to the concept that profits can only be made when the capital of an
organisation is restored to, or maintained at the level that it was at the start of an accounting

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2: Financial reporting framework | Part B Financial reporting framework

period. The concept is commonly separated into two types: physical and financial capital
maintenance.
Under the physical capital maintenance concept, a profit is earned only when the operating
capability of an organisation at the end of a period exceeds the operating capability at the start of
the period.
Under the financial capital maintenance concept, a profit is earned when the money value of net
assets at the end of a period exceeds their money value at the start of the period.
CF.4.36 10.3.1 Capital maintenance adjustments
A revaluation gives rise to an increase or decrease in equity.

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.

10.4 Section summary


Make sure you learn the important definitions.
 Financial position:
– Assets
– Liabilities
– Equity
 Financial performance:
– Income
– Expenses

11 Recognition of the elements of financial


CF.4.37-4.39
statements
Topic highlights
Items which meet the definition of assets or liabilities may still not be recognised in financial
statements because they must also meet certain recognition criteria.

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)

Regard must be given to materiality (see above).

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Financial Reporting

CF.4.40
11.1 Probability of future economic benefits
Probability here means the degree of uncertainty that the future economic benefits associated
with an item will flow to or from the entity. This must be judged on the basis of the characteristics
of the entity's environment and the evidence available when the financial statements are
prepared.

CF.4.41-4.43 11.2 Reliability of measurement


The cost or value of an item, in many cases, must be estimated. The Conceptual Framework
states, however, that the use of reasonable estimates is an essential part of the preparation of
financial statements and does not undermine their reliability. Where no reasonable estimate can be
made, the item should not be recognised, although its existence should be disclosed in the notes,
or other explanatory material.
Items may still qualify for recognition at a later date due to changes in circumstances or
subsequent events.

CF.4.44-4.53 11.3 Recognition of items


We can summarise the recognition criteria for assets, liabilities, income and expenses, based on
the definition of recognition given above.
Statement of financial position
 An asset is recognised when it is probable that the future economic benefits will flow to the
entity and the asset has a cost or value that can be measured reliably.
 A liability is recognised when it is probable that an outflow of resources embodying
economic benefits will result from the settlement of a present obligation and the amount at
which the settlement will take place can be measured reliably.
Statement of profit or loss and other comprehensive income
 Income is recognised when an increase in future economic benefits related to an increase in
an asset or a decrease of a liability has arisen that can be measured reliably.
 An expense is recognised when a decrease in future economic benefits related to a
decrease in an asset or an increase of a liability has arisen that can be measured reliably.

12 Measurement of the elements of financial


CF.4.54-4.56 statements
Topic highlights
A number of different measurement bases are used in financial statements. They include:
 historical cost
 current cost
 realisable (settlement) value
 present value of future cash flows

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)

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2: Financial reporting framework | Part B Financial reporting 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.

13 Fair presentation and compliance with HKFRS


Topic highlights
Compliance with HKFRS is presumed to result in financial statements that achieve a fair
HKAS presentation.
1.15,16,18-20

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.

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Financial Reporting

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".

HKAS 13.1 Extreme case disclosures


1.17,23
In very rare circumstances, management may conclude that compliance with a requirement in a
standard or interpretation may be so misleading that it would conflict with the objective of
financial statements set out in the Conceptual Framework, but the relevant regulatory framework
prohibits departure from the requirements.
In such cases the entity needs to reduce the perceived misleading aspects of compliance by
disclosing:
(a) the title of the standard, the nature of the requirement and the reason why management has
reached its conclusion.
(b) for each period, the adjustment to each item in the financial statements that would be
necessary to achieve fair presentation.
HKAS 1 states what is required for a fair presentation:
(a) Selection and application of accounting policies.
(b) Presentation of information in a manner which provides relevant, reliable, comparable and
understandable information.
(c) Additional disclosures where required.

HKAS 13.2 Break-up basis accounts


1.25,26
HKAS 1 requires that, when preparing financial statements, management should assess the ability
of an entity to continue as a going concern.
Financial statements should be prepared on a going concern basis unless management either
intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so.
In assessing whether an entity is a going concern, management must take into account all
available information about the future, being at least 12 months from the end of the reporting
period. They may consider current and expected profitability, debt repayment schedules and
potential sources of replacement financing.
Where an entity is not a going concern, the financial statements are prepared on a basis other than
that of a going concern, most commonly the break-up basis.
13.2.1 Content of break-up basis accounts
The term break-up basis is not defined in accounting standards and may be interpreted differently
by different people.
If the accounts are prepared on a basis other than that of a going concern, it does not automatically
mean that all assets are written down to their scrap value, nor that provision is made for all the
costs of winding up the business. All of the normal rules of accounting still apply, other than that of
going concern. The recognition, measurement and presentation of assets and liabilities will be
affected as follows.

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2: Financial reporting framework | Part B Financial reporting framework

Assets
(a) Non-current assets should be assessed for impairment, and written down to their
recoverable amount if this is less than their carrying amount.
As we shall see later in the Learning Pack, recoverable amount is the higher of net realisable
value and value in use.
 Realisable value was defined in section 12 as the amount of cash or cash equivalents
that could currently be obtained by selling the asset.
 Value in use is the present value of the future cash flows associated with the asset.
It should be remembered that the value in use is likely to be lower than previously expected
since the time frame for use will be shorter than if the company were a going concern.
Therefore, realisable value will often be taken as the recoverable amount.
(b) In addition, inventories will continue to be measured at the lower of cost and net realisable
value, however when an entity is not a going concern, it becomes more likely that cost will
exceed net realisable value.
(c) Amounts receivable are stated at their realisable value i.e. the cash expected to be
recovered. Practically this will be equal to gross receivables net of irrecoverable debts and
an allowance for receivables as usual, however in the context of a company which is not a
going concern the identification of irrecoverable debts and calculation of an allowance may
require additional consideration.
(d) Monetary items, such as cash are stated at their face value.
(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.

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Financial Reporting

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.
 possess the fundamental characteristics of relevance and faithful representation and
maximise the enhancing characteristics of comparability, verifiability, timeliness and
understandability.

15 Current developments
15.1 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. The IASB is currently
working towards a discussion paper covering all remaining phases of the project and this is
expected to be issued during the course of 2013. The IASB aims to complete the project by 2015.

15.2 Other IASB projects


The IASB is engaged in a number of ongoing projects. These are discussed in more detail in the
relevant chapters of this Learning Pack.

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2: Financial reporting framework | Part B Financial reporting framework

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.

HK(IFRIC) Interpretations Fundamental principles:


provide guidance where Ÿ Integrity
issues have arisen over the Ÿ Objectivity
interpretation of HKFRS. Ÿ Professional competence
& due care
Ÿ Confidentiality
Ÿ Professional behaviour
The Conceptual Framework
sets out the concepts
underlying the preparation
and presentation of financial
statements.

Accounting Guidelines (non


mandatory) are indicators of
best practice.

Accounting Bulletins (non


mandatory) are publications
on subjects of topical
interest.

SEHK regulates the financial


reporting compliance of listed Additionally for listed
companies in terms of the companies:
Listing and GEM Rules. Listing Rules contain
additional disclosure
requirements and require
interim reports.
SFC regulates the securities
and futures markets in Hong GEM Rules contain
Kong. additional disclosure
requirements.

FRC investigates auditing and


reporting irregularities in listed
companies.

HKIA is the regulatory body


related to the insurance
industry.

HKMA is responsible for


maintaining monetary and
banking stability.

61
Financial Reporting

Conceptual Framework

A statement of generally accepted theoretical principles which


form the frame of reference for financial reporting.

The HKICPA’s Conceptual Framework

Purpose of the Conceptual Framework:


Ÿ Aid development of new standards/review of existing
standards
Ÿ Assist application of HKFRS
Ÿ Assist auditors in forming opinion
Ÿ Assist users to interpret financial information

Conceptual framework Qualitative characteristics Elements of FS

To provide financial Fundamental:


information that is useful Ÿ Relevance Financial position:
to investors and creditors Ÿ Faithful representation Ÿ Assets
in making decisions. This Ÿ Liabilities
includes information Ÿ Equity
about:
Ÿ economic resources Enhancing:
Ÿ Comparability
Financial performance:
Ÿ economic claims Ÿ Income
Ÿ changes in economic Ÿ Verifiability
Ÿ Expenses
resources and claims Ÿ Timeliness
Ÿ Understandability

Underlying assumption: Recognise when:


going concern otherwise Ÿ it is probable future economic benefit will flow to/from the entity
break-up basis accounts. Ÿ cost or value can be measured reliably

Measure at:
Ÿ historical cost Ÿ realisable (settlement)
Ÿ current cost value
Ÿ PV of future cash flows

Fair presentation
Ÿ Presumed to be achieved by compliance with HKFRS
Ÿ Departure from HKFRS is allowed if necessary to achieve fair presentation
Ÿ “True and fair override” disclosures are necessary in the case of a departure

Management commentary (Management discussion and analysis)


Ÿ Narrative report to accompany financial statements
Ÿ IFRS Practice Statement issued 2010

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2: Financial reporting framework | Part B Financial reporting framework

Answers to self-test questions

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
(a) This is an asset, albeit an intangible one. There is a past event, control and future economic
benefit (through cost savings).
(b) This cannot be classified as an asset. Hirecar Co. has no control over the car repair shop
and it is difficult to argue that there are "future economic benefits".
(c) The warranty claims in total constitute a liability; the business has taken on an obligation.
It would be recognised when the warranty is issued rather than when a claim is made.

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Financial Reporting

Exam practice

Fair presentation 11 minutes


"Financial statements should be prepared on a going concern basis and measured with historical
cost in order to present fairly the financial position of an entity." Comment on this statement.
(6 marks)
HKICPA June 2012

Mr. Kong 9 minutes


Mr. Kong, a member of Hong Kong Institute of Certified Public Accountants (the "Institute"), is the
Chief Financial Controller of a company. At the end of the financial period, the company has
certain old and obsolete inventories kept in the warehouse. In order to avoid recognising an
impairment loss in the financial statements, Mr. Kong has asked the accounting manager Ms.
Yuen, who is also a member of the Institute, to create a forged purchase order from an existing
customer for the inventories at a selling price above the cost, with a delivery date six months later.
He has asked her to provide a copy to the auditor as evidence that the inventory does not require
writing down to net realisable value. Mr. Kong has also threatened Ms. Yuen with dismissal if she
is not willing to comply with his wishes.
Required
Discuss the behaviour of Mr. Kong and what Ms. Yuen should do in accordance with the Code of
Ethics for Professional Accountants.
(5 marks)
HKICPA June 2011

64
chapter 3

Small company reporting

Topic list

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
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.

65
Financial Reporting

Learning outcomes

In this chapter you will cover the following 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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3: Small company reporting | Part B Financial reporting framework

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 new 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.

2 Financial Reporting in Hong Kong


Topic highlights
Until recently, two financial reporting options existed in Hong Kong: the SME-FRS was applicable
to most small and medium-sized entities and full HKFRS to all others. The introduction of the
HKFRS for Private Entities adds a third, middle tier, which can be adopted by unlisted entities.

2.1 Three financial reporting options


As a result of the introduction of the HKFRS for Private Entities, Hong Kong now has three financial
reporting options:
1 The SME-FRF & FRS which can only be applied by certain unlisted entities (see section 3)
2 The new HKFRS for Private Entities which can be applied by any private entity (see section 4.2)
3 Full HKFRS which must be applied by publicly listed entities and may be applied by any
private entity.

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Financial Reporting

The options available to each type of entity are summarised in the following table:

Can apply:

Non-listed companies which meet the criteria to – SME-FRF & FRS


use the SME-FRF & FRS – HKFRS for Private Entities (meet the
criteria to use HKFRS for Private
Entities)
– Full HKFRS
Non-listed companies which do not meet the – HKFRS for Private Entities (meet the
criteria to use the SME-FRF & FRS criteria to use HKFRS for Private
Entities)
– Full HKFRS
Publicly listed companies – Full HKFRS

3 SME-FRF and SME-FRS


Topic highlights
The SME-FRF and SME-FRS can only be applied by certain unlisted entities. The SME-FRF
provides a conceptual framework for small company reporting and the SME-FRS sets out recognition,
measurement, presentation and disclosure requirements for companies reporting under it.

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
Those companies which satisfy the criteria set out in Part 9 Division 2 section 359 of the new CO
qualify for reporting under the SME-FRF and so can apply the SME-FRS in preparing their financial
statements. Reporting under this regime is not, however, a requirement for such companies, but a
choice.
A company applying s.359 above should obtain agreement from all of the shareholders of the
company in writing that the financial statements are properly prepared. Thus the interests of the
minority shareholders are protected.
Section 359 does not apply to:
 a private company which is itself a holding company of subsidiaries
 a private company which is a subsidiary of another company formed and registered under
the Companies Ordinance.
A Hong Kong company which has a controlled investment in the PRC which does not meet the
legal definition of a subsidiary does, however, satisfy the criteria for reporting under s.359 and
therefore can apply the SME-FRS.

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Part 9 (“Accounts and Audit”) of the new CO, contains the accounting and auditing provisions in
relation to the keeping of accounting records, the preparation and circulation of annual financial
statements, directors’ and auditor’s reports and the appointment and rights of auditors.
New provisions are introduced to make it easier and more efficient for SMEs to be able to use
simplified accounting and reporting requirements, to require public and large companies to include
an analytical business review in directors’ reports, and to enhance auditors’ right to information.
This Part also introduces new sanctions relating to the contents of auditor’s reports.
3.1.2 Facilitating Simplified Reporting
It becomes easier for SMEs to prepare simplified financial and directors’ reports in the following
ways:
 a private company (with the exception of a bank/deposit-taking company, an insurance
company or a stockbroker) will automatically qualify for simplified reporting if it qualifies as a
“small private company”.
 Small private company (defined in new CO Schedule 3 section 1)
If it meets any two of the following size criteria for two consecutive periods:
annual revenue ≤ HK$100 million
total assets ≤ HK$100 million
employees ≤ 100 employees
For example, a company with a property valued at more than HK$100 million can still apply to use
the SME-FRS if its annual revenue is less than HK$100 million and it has less than 100 employees.
 the holding company of a group of companies that qualifies as a “group of small private
companies” will also qualify for simplified reporting (Part 9 Division 2 section 365).
 a private company that is not a member of a corporate group may adopt simplified reporting
with the agreement of all the members.
Allowing small guarantee companies and groups of small guarantee companies, which have a total
annual revenue of not more than $25 million, to qualify for simplified reporting (Part 9 Division 2
sections 363 and 366).
A private company or a group of private companies which is not qualified as a “small private
company” or a “group of small private companies” respectively may prepare simplified reports if it
meets a higher size criteria and if the members holding 75% of the voting rights so resolve and no
member objects.
Making the summary financial reporting provisions more user-friendly and extending their
application to companies in general (rather than confining them to listed companies, as in the
current Companies Ordinance).
SME-FRS 17, 3.1.3 Overseas companies
22-24
A company incorporated outside Hong Kong is not bound by the new CO and should prepare its
separate financial statements in accordance with the requirements imposed by the law in its place
of incorporation. Provided that the specific requirements of the place of incorporation are met,
these companies may report under the SME-FRF and apply the SME-FRS if:
1 They have no public accountability. An entity has public accountability for the purposes of
the SME-FRF if:
(a) at any time during the current or preceding reporting period, the entity (whether in the
public or private sector) is an issuer of securities, that is, its equity or debt securities
are publicly traded or it is in the process of issuing publicly traded equity or debt
securities;
(b) the entity is an institution authorised under the Banking Ordinance;
(c) the entity is an insurer authorised under the Insurance Companies Ordinance; or

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(d) 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.
2 They meet any two of the following size criteria for two consecutive periods:
annual revenue ≤ HK$50 million
total assets ≤ HK$50 million
employees ≤ 50 employees
For example, a company with a property valued at more than HK$50 million can still apply to
use the SME-FRS if its annual revenue is less than HK$50 million and it has less than 50
employees. (Note that the size criteria for overseas companies are different from the
requirement applicable to Hong Kong companies as stated in Section 3.1.1 of this Learning
Pack.)
3 All owners agree to apply the SME-FRS. (A shareholder agreement should be signed every year.)
These qualifying conditions are applicable to all overseas companies, including a subsidiary or an
intermediate holding company of a listed entity.
SME-FRS 20 When a company has not been considered to be an SME in terms of its size under section 3.1.2
point 2 above and subsequently becomes an SME, the company will not qualify for reporting under
the SME-FRF until the company has been determined to be an SME for two consecutive reporting
periods.
Now the Companies Ordinance, Part 16 (“Non-Hong Kong Companies”) deals with companies
incorporated outside Hong Kong which have established a place of business in Hong Kong.
There is no fundamental change to the current rules.
Example
An overseas company meets the size criteria for reporting under the SME-FRF as follows:

Year ended Company A

31 December 20X5 Criteria not met


31 December 20X6 Criteria met
31 December 20X7 Criteria met
31 December 20X8 Criteria met
In what period(s), if any, may the company report under the SME-FRF?
Solution
 In 20X5 the company does not satisfy the criteria and so cannot report under the SME-FRF.
 In 20X6 and 20X7, the company does meet the criteria, however will not have been
determined to be an SME for two consecutive reporting periods and so cannot report under
the SME-FRF.
 In 20X8 the company satisfies the criteria for two consecutive reporting periods and so
qualifies for reporting under the SME-FRF.

SME-FRS 21 Where a company has previously qualified for reporting under the SME-FRF in terms of section
3.1.2, the company will no longer qualify for reporting under the SME-FRF in terms of size criteria
set in section 3.1.2 point 2 above until the company is no longer an SME for two consecutive
reporting periods.

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Example
An overseas company, Company B, previously qualified as an SME and reported under the SME-
FRF with the following changes:

Year ended Company B

31 December 20X5 Criteria continue to be met


31 December 20X6 Criteria not met
31 December 20X7 Criteria not met
31 December 20X8 Criteria not met
May Company B qualify to report under the SME-FRF for the year ending 31 December 20X6 and
onwards?
Solution
 In 20X6 and 20X7 Company B continues to qualify for reporting under the SME-FRF until
Company B is no longer an SME for two consecutive reporting periods.
 In 20X8 Company B is no longer an SME for three consecutive reporting periods and should
transfer to HKFRS for its financial statements starting from the year ending 31 December 20X8.

For an entity that qualifies for reporting under the SME-FRF, the appropriate application of the
SME-FRS, with additional disclosure when necessary, would result in financial statements that
achieve a proper presentation appropriate for SMEs.
For a company applying s.141D of the Hong Kong Companies Ordinance, compliance with the
SME-FRF and SME-FRS is necessary in order for financial statements to give a true and correct
view.

3.2 The requirements of the SME-FRF and SME-FRS


Sections 1 to 17 of SME-FRS set out detailed financial reporting requirements for entities reporting
under SME-FRF and SME-FRS. You should refer to the original text of SME-FRF and SME-FRS
when it is necessary.
The SME FRS is in the most part a simplified version of the full HKFRS regime, However, the
SME-FRS differs from the full HKFRS regime in certain key areas, which include the following:
(a) There is no requirement to include a cash flow statement in a set of SME-FRS financial
statements (FRS 1.1).
(b) Changes in equity may be disclosed in a note rather than in a separate primary statement
(FRS 1.29).
(c) Leasehold interests in land from the Government of the HKSAR, or elsewhere with similar
features, are accounted for as property, plant and equipment (FRS 3.13).
(d) There is no separate category of "investment property". Instead, the definition of property,
plant and equipment includes properties held for rental purposes or investment potential
(FRS section on definitions & FRS 3.1)
(e) The recognition of deferred tax is prohibited (FRS 14.4). Instead the only tax expense
recognised is that calculated based on profits assessed for tax purposes for the period i.e. as
is payable to the taxation authorities in respect of that period.
(f) Investments cannot be carried at fair value. Instead, all held-to-maturity securities are stated
at amortised cost, other current investments are stated at the lower of cost and net realisable
value and other long-term investments are stated at cost less accumulated impairment
losses (FRS 6.7 & 6.8).

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(g) Entities can decide whether or not to use a discounting technique in the impairment test and
in estimating any provisions (FRS 9.8 and 10.3).
(h) The SME-FRS does not have specific section dealing with employee benefits, and therefore
does not have specific requirements covering the matters within the scope of HKAS 19,
Employee benefits, and HKFRS 2, Share based payment . Instead, example 5 of Appendix
1 to the SME-FRS indicates that provisions for long service pay and for other post
employment retirement schemes would fall under section 10 "Provisions, contingent liabilities
and contingent assets" of the SME-FRS.
(i) The rules on accounting for speculative and non-speculative forward foreign exchange
contracts (FRS 15.6-15.8) appear to have been drafted based on SSAP 11, Foreign
currency translation , and therefore still refer to calculating "discounts and premiums" on the
contracts, as well as "gains and losses"

4 Introduction to the HKFRS for Private Entities


Topic highlights
On 30 April 2010, the HKICPA issued the HKFRS for Private Entities. This new standard became
applicable immediately, and provided a new reporting option for those private companies which did
not meet the criteria to use the SME-FRS & FRF and were therefore previously forced to apply full
HKFRS.

4.1 Development of the HKFRS for Private Entities


The HKFRS for Private Entities is based on the International Financial Reporting Standard for
Small and Medium-sized Entities (IFRS for SMEs), which was issued in July 2009. Despite its
name, this IFRS for SMEs was developed by the IASB to apply to entities which are not publicly
accountable and publish general purpose financial statements for external users, (rather
than those which meet certain size definitions).
The Council considered that a variation of the IFRS for SMEs should be adopted in Hong Kong as
a reporting option for eligible non-listed companies, and as a result issued the HKFRS for Private
Entities.
4.1.1 Amendments made to the IFRS for SMEs in developing the HKFRS for
Private Entities
The HKFRS for Private Entities is based on the IASB’s IFRS for SMEs, however the following
amendments are made to make the standard more relevant to Hong Kong:
(a) The term "SMEs" is replaced by "Private Entities"
The term SMEs is widely used in Hong Kong and associated with the locally developed
SME-FRF & FRS. For clarity and differentiation, this HKFRS which is based on the "IFRS for
SMEs" is called "Hong Kong Financial Reporting Standard for Private Entities" (HKFRS for
Private Entities).
(b) The recognition and measurement principles in section 29 Income Tax of the IFRS for SMEs
is replaced by the extant version of HKAS 12 Income Taxes
The Council considers that it is more appropriate to include the recognition and
measurement principles contained in the extant version of HKAS 12 Income Taxes in the
new HKFRS. The relevant disclosures contained in the IFRS for SMEs are, however,
retained.

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(c) The measurement of deferred tax liabilities associated with an investment property
measured at fair value is capped at the amount of tax that would be payable on its sale to an
unrelated market participant at fair value at the end of the reporting period
This amendment will restrict the amount of deferred taxation recognised in relation to
revaluation gains of investment properties as such tax is in practice never paid in Hong
Kong. This provision removes an anomaly currently in HKAS 12 Income Taxes.

4.2 Eligibility to use the HKFRS for Private Entities


Council has approved the adoption of the HKFRS for Private Entities as a financial reporting
option for companies that:
(a) do not have public accountability; and
(b) publish general purpose financial statements for external users.

4.2.1 Public accountability


An entity is defined as having public accountability (and so may not use the new standard) if:
 its debt or equity instruments are traded in a public market (or it is in the process of issuing
its debt or equity instruments for trading in a public market), or
 it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary
businesses.
A public market means any domestic or foreign stock exchange market, or an over-the-counter
market.
In general, an entity that holds assets in a fiduciary capacity as one of its primary businesses may
be a bank, insurance company, securities broker/dealer, mutual fund or investment bank.
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.

4.2.2 General purpose financial statements


HKFRS are designed to apply to the general purpose financial statements of profit-oriented entities.
General purpose financial statements are directed towards the common information needs of a
wide range of users, for example, shareholders, creditors, employees and the public at large. The
objective of financial statements is to provide information about the financial position,
performance and cash flows of an entity that is useful to those users in making economic
decisions.

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.

5 Contents of the HKFRS for Private Entities


5.1 Overview
Topic highlights
The HKFRS for Private Entities is a self-contained standard incorporating accounting principles that
are based on full HKFRS, but which have been simplified to suit the private entities within its scope.

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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.

5.2 Simplified accounting


The HKFRS for Private Entities simplifies certain recognition and measurement principles in full
HKFRS. The more useful simplifications are highlighted below.
(a) Research and development costs and borrowing costs must be expensed immediately.
(b) Financial instruments
Financial instruments meeting specified criteria are measured at cost or amortised cost. All
others are measured at fair value through profit or loss.
In addition, a simplified principle is established for derecognition and hedge accounting
requirements are simplified and tailored to private entities.
(c) Property, plant and equipment and intangibles
Only the cost model is allowed. There is no need to review residual value, useful life and
depreciation method unless there is an indication that they have changed since the most
recent reporting date.
(d) Goodwill and other indefinite-life intangibles
An impairment test is performed only if there are indications of impairment (rather than
annually). Goodwill is measured at cost less accumulated amortisation and impairment
losses. All intangible assets are considered to have a finite useful life. If a reliable estimate of
goodwill or intangible assets cannot be made, it is presumed to be ten years.
(e) Investments in associates and jointly-controlled entities
The cost model, equity model and fair value model are permitted as an accounting policy
choice that should be applied to the whole class of associates or jointly-controlled entities.
An entity using the cost model must measure an investment for which there is a published
price using the fair value model.

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(f) Exchange differences


An exchange difference that is recognised initially in other comprehensive income is not
reclassified in profit or loss on disposal of the investment in a foreign subsidiary. This
treatment is less burdensome than that required under full HKFRS because it eliminates the
need for tracking exchange differences after initial recognition.
(g) Non-current assets held for sale
There is no separate held-for-sale classification; instead holding an asset or group of assets
for sale is an indicator of impairment.
(h) Equity-settled share-based payment
If observable market prices are not available to measure the fair value of an equity-settled
share-based payment, the directors' best estimate is used.
(i) Defined benefit plans
All actuarial gains and losses are recognised immediately (in profit or loss or other
comprehensive income). All past service costs are to be recognised immediately in profit or
loss. To measure the defined benefit obligation, the projected unit credit method should be
used only if it can be applied without undue cost or effort. (Note. HKAS 19 has been revised
and has incorporated these simplifications.)
(j) Biological assets
The cost-depreciation-impairment model is used unless the fair value is readily determinable
without undue cost or effort. In this case, the fair value through profit or loss model should be
applied.
(k) Borrowing costs
All borrowing costs are expensed immediately.
(l) Government grants
Government grants are recognised in income (at fair value) when the performance
conditions are met.
(m) Investment property
If an entity can measure the fair value of an item of investment property reliably, without
undue cost or effort, it must use fair value. Otherwise the cost model is applied.

5.3 Simplified presentation


In order to reduce costs for preparers, while still meeting the needs of users, the HKFRS for Private
Entities has simplified financial statement presentation requirements as follows:
(a) An entity is not required to present a statement of financial position at the beginning of the
earliest comparative period when the entity applies an accounting policy retrospectively or
makes a retrospective restatement of items in its financial statements, or when it reclassifies
items in its financial statements as required under HKAS 1.
(b) An entity is permitted to present a single statement of income and retained earnings in place
of separate statements of comprehensive income and changes in equity if the only changes
to its equity during the periods for which financial statements are presented, arise from profit
or loss, payment of dividends, corrections of prior period errors, and changes in accounting
policy.
(c) All deferred tax assets and liabilities are classified as non-current assets or liabilities.

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5.4 Omitted topics


The HKFRS for Private Entities does not address the following topics that are covered in full
HKFRS, because these topics are not generally considered to be relevant to private entities:
 Earnings per share
 Interim financial reporting
 Segment reporting
 Classification for non-current assets (or disposal groups) as held for sale

5.5 Examples of options in full HKFRS not included in the HKFRS


for Private Entities
The HKFRS for Private Entities does not allow the following accounting treatments available under
full HKFRS. This is generally because a simplified treatment is available instead (see section 5.2
above):

Treatment disallowed in HKFRS for Private


Entities:
Property, plant and equipment and Revaluation model
intangible assets
Borrowing costs Capitalisation of borrowing costs
Defined pension plans Deferral of actuarial gains and losses
Financial instruments* Available-for-sale and held-to-maturity
classifications are not available
Government grants Various accounting options excluded
Investment property Accounting policy choice
Consolidation Measurement of the non-controlling interest at
fair value

* 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).

5.6 Simplified disclosure


A number of disclosure requirements contained in full HKFRS have been omitted from the HKFRS
for Private Entities for the following reasons:
 They relate to topics covered in full HKFRS but omitted from the HKFRS for Private Entities.
 They relate to recognition and measurement principles contained in full HKFRS that have
been replaced by simplifications.
 They relate to options in full HKFRS that are not included in the HKFRS for Private Entities.
 Some disclosures are not included on the basis of users' needs or cost-benefit
considerations.
Examples of simplified and reduced disclosure requirements include the following:
 There is no requirement to disclose the fair value of the carrying amount for property, plant
and equipment and investment property.
 The vast majority of the disclosure requirements of HKFRS 7 Financial Instruments:
Disclosures are not required.

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 There is no requirement to disclose estimates used to measure the recoverable amount of


cash generating units containing goodwill.
 In relation to income taxes, entities are only required to provide an explanation of the
significant differences in amounts reported in the statement of profit or loss and other
comprehensive income and amounts reported to tax authorities.
 In relation to investments in associates, the following disclosures are omitted:
– Summarised financial information relating to assets, liabilities, revenues and profit or
loss.
– Share of contingent liabilities and the nature and extent of any significant restrictions
on the ability of associates to transfer funds to the investor, if any.

5.7 Updates and amendments to the HKFRS for Private Entities


The HKICPA expects to undertake a review of HKFRS for Private Entities in accordance with the
IASB timetable to review its IFRS for SMEs. The IASB is currently in the middle of a
comprehensive post-implementation review of user entities' experience in applying the IFRS for
SMEs. A Request for Information was issued in 2012 and the Board is currently discussing
responses. It will consider whether to amend the IFRS for SMEs for:
1 issues identified in the review
2 new and amended full IFRS adopted since the IFRS for SMEs was issued.
Beyond this, the IASB anticipate that the standard 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.

6 Impact of the HKFRS for Private Entities


Topic highlights
The HKFRS for Private Entities affects many companies, whether at an individual entity level, or
subsidiaries in larger groups. Similar to full HKFRS, the HKFRS for Private Entities enables a true
and fair view to be given on the financial statements.

6.1 Key concerns


A key area of concern for all businesses, especially individual companies in Hong Kong, is to
ensure that the benefits of application of the HKFRS for Private Entities outweigh the costs
associated with doing so.
The principal issue is therefore to ensure that the financial costs of preparation do not increase and
the needs of stakeholders are still met.
The HKFRS addresses this concern, ensuring that
 financial statements are based on the same conceptual framework as full HKFRS,
condensed and specifically tailored for private entities; and
 the burden of preparing financial statements in accordance with full HKFRS is reduced.

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6.2 Comparison with full HKFRS


6.2.1 The omitted topics
The following topics have been omitted completely from the HKFRS for Private Entities (compare
to full HKFRS), because they are not expected to be relevant for majority of entities which meet the
criteria of choosing HKFRS for Private Entities (PEs):
 Earnings per share
 Interim financial reporting
 Segment reporting
 Special accounting for assets held for sale
6.2.2 Not an option
The HKFRS for Private Entities does not include the following options, because it is considered that
PEs will choose to follow the simpler options as they will generally be less costly, require less
expertise and achieve greater comparability with their peers.
If a PE feels strongly about using one or more of the complex options, it could elect to follow the full
HKFRS rather than the HKFRS for Private Entities.
Property, plant and equipment
 The revaluation model is not an option.
 Property, plant and equipment carried at cost less accumulated depreciation and
impairment.
Intangible assets
 The revaluation model is not an option.
 Intangible assets carried at cost less accumulated amortisation and impairment.
Borrowing costs
 The capitalisation model is not allowed.
 All borrowing costs should be expensed.
Government grants
 Various options excluded.
 Only single simplified method retained, that is, recognition in income (at fair value) when the
performance conditions are met.
Investment property
 Measurement is driven by circumstances rather than allowing an accounting policy choice
between the cost and fair value models.
Financial instruments
 Available-for-sale and held-to-maturity categories are not available.
Note. The above are just some of the differences between full HKFRS and the HKFRS for Private Entities.

6.2.3 Considerations prior to adopting the HKFRS for Private Entities


The HKFRS for Private Entities aims to simplify and reduce the potentially ever-increasing
reporting requirements of the full HKFRS. However, in determining whether to adopt the HKFRS for
Private Entities, management is advised to consider the facts and circumstances of the PE,
including but not limited to the following matters.

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Must all PEs apply the HKFRS for Private Entities?


No. The adoption of the HKFRS for Private Entities is an option for PEs. If compliance with the full
HKFRS is required, desired or preferred by a PE, the PE may continue using or adopt the full
HKFRS and need not adopt the HKFRS for Private Entities.
Will the financial statements of a PE meet the needs of users?
PEs will have to consider whether financial statements prepared under the HKFRS for Private
Entities meet the needs of their own specific users. The financial statements of PEs generally are
not widely circulated, and the needs of individual users of those financial statements tend to be
specific, but not necessarily the same.
The HKFRS for Private Entities is based on the same framework as the full HKFRS. In developing
the IFRS for SMEs, the IASB attempted to consider the needs of users of the financial statements
of an SME. However, due to the specific needs of individual users, careful assessment will be
needed by each SME to determine whether the IFRS for SMEs will meet their needs. The IFRS for
SMEs concentrates on items such as short-term cash flows, liquidity, and balance sheet strength.
The IASB concluded that the full IFRS at times provided too much information for the needs of an
SME user, while in other situations other needs were not being met by the full IFRSs.
The HKICPA has held meetings with the Inland Revenue Department of the HKSAR Government
and representatives of Hong Kong Association of Banks since the issuance of the IFRS for SMEs.
Both parties acknowledged the standard setting role of the HKICPA and have no objection in principle
to relieving PEs from complying with the full HKFRS in the preparation of financial statements.
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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Topic recap

Small company reporting

Financial reporting options in Hong Kong

Full HKFRS HKFRS for Private SME-FRF & FRS


Entities

Must be applied by May be applied May be applied by private entities


publicly listed by entities which: meeting set criteria:
entities; may be 1. have no public Ÿ HK entities applying s.141D of
applied by private accountability Companies Ordinance
entities 2. prepare Ÿ Overseas entities with no
general public accountability
purpose which meet the size test and
financial where all owners agree to
statements apply the SME-FRS

Based on the Conceptual basis and qualifying


IASB's IFRS for criteria set out in SME-FRF
SMEs this is a
self-contained
standard

Compared to full HKFRS, provides: Recognition, measurement,


Ÿ simplified accounting eg all R&D costs presentation and disclosure
expensed as incurred. requirements provided in
Ÿ simplified presentation eg all SME-FRS
deferred tax balances classified as non-
current
Ÿ omitted topics eg EPS
Ÿ simplified disclosure eg most HKFRS 7
disclosures not required

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3: Small company reporting | Part B Financial reporting framework

Exam practice

HKFRS for Private Entities 16 minutes


Sigma Technology Limited (STL) was established in the Macau Special Administration Region
(MSAR) in 2008 by Mr. Ong and is engaged in trading computer hardware. More than 50 staff are
employed by the company. STL has prepared its financial statements in accordance with the Small
and Medium-sized Entity Financial Reporting Framework (SME-FRF) since it was established for
both internal and external users. For the three years ended 31 December 20X1, STL reported the
following data in its management accounts:
20W9 20X0 20X1
HK$'000 HK$'000 HK$'000
Revenue 43,528 53,456 48,621
Profit for the year 8,602 11,731 8,980
Total assets 20,984 32,327 28,489
Total liabilities 13,729 16,341 14,201
Required
(a) Explain whether STL can report under the SME-FRF for the years ended
31 December 20X0 and 31 December 20X1. (3 marks)
(b) Explain whether STL can report under the Hong Kong Financial Reporting Standard for
Private Entities (HKFRS for Private Entities) for the year ended 31 December 20X1.
(2 marks)
(c) "Revaluation and impairment of property, plant and equipment are prohibited under HKFRS
for Private Entities". Explain whether this statement is correct. (2 marks)
(d) Assuming that Mr. Ong plans to list STL on the Growth Enterprise Market of The Stock
Exchange of Hong Kong Limited and is considering incorporating the financial information of
the entity for each of the two years ended 31 December 20X1 and 6 months ended 30 June
20X2 in the prospectus, explain whether STL can report the historical financial information in
its prospectus under the SME-FRF or the HKFRS for Private Entities. (2 marks)
(Total = 9 marks)
HKICPA December 2012 (amended)

81
Financial Reporting

82
Part C

Accounting for business


transactions

The emphasis in this section is on an in-depth understanding of each accounting standard


relating to transactions. The purpose of this section is to develop your knowledge about
different accounting standards categorised into three areas: Statements of Financial Position
and Comprehensive Income, Statements of Cash Flows, and Disclosure and Reporting. You
should be able to identify and apply relevant accounting standards in resolving the accounting
issues to be faced in the examination and the business world.

83
Financial Reporting

84
chapter 4

Non-current assets held for


sale and discontinued
operations
Topic list

1 HKFRS 5 Non-current assets Held for Sale and Discontinued Operations


1.1 Introduction and definitions
1.2 Scope
2 Classification of assets held for sale or for distribution to owners
2.1 Highly probable sale
2.2 Assets held for distribution to owners
2.3 Assets to be abandoned
2.4 Summary decision tree
3 Measurement of assets held for sale
3.1 Initial measurement
3.2 Subsequent measurement
3.3 Impairment losses
3.4 Reversal of impairment losses
3.5 Measurement where assets are no longer classified as held for sale
4 Presentation of assets held for sale
4.1 Presentation of a non-current asset or disposal group classified as held for sale
4.2 Additional disclosures
5 Discontinued operations
5.1 Definition of discontinued operations
5.2 Presentation of discontinued operations

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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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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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1 HKFRS 5 Non-current Assets Held for Sale and


Discontinued Operations
Topic highlights
HKFRS 5 requires assets and disposal groups "held for sale" to be presented separately in the
statement of financial position.
The results of discontinued operations should be presented separately in the statement of profit or
loss and other comprehensive income.

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
(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)

HKFRS 1.2 Scope


5.2,5,5A
The classification and presentation requirements of HKFRS 5 (sections 2 and 4) apply to all
recognised non-current assets and to all disposal groups.
The measurement requirements of the HKFRS (section 3) apply to all recognised non-current
assets other than those listed below, which continue to be measured in accordance with the
relevant HKFRS noted:
(a) Deferred tax assets (HKAS 12)
(b) Assets arising from employee benefits (HKAS 19)
(c) Financial assets (HKAS 39/HKFRS 9)
(d) Investment properties accounted for in accordance with the fair value model (HKAS 40)
(e) Agricultural and biological assets that are measured at fair value less costs to sell (HKAS 41)
(f) Insurance contracts (HKFRS 4)
The measurement requirements of the standard also apply to all disposal groups and such a group
may include any assets and liabilities including current assets, current liabilities and those assets
listed above which are excluded from the scope of the standard on an individual basis.

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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).

2 Classification of assets held for sale or for


HKFRS 5.6,7 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, and
(b) its sale must be highly probable (i.e., significantly more likely than not).

HKFRS 2.1 Highly probable sale


5.8,8A,9,11
For an asset to qualify as being held for sale, the sale must be "highly probable". The following
must apply:
(a) Management must be committed to a plan to sell the asset.
(b) There must be an active programme to locate a buyer.
(c) The asset must be actively marketed for sale at a price that is reasonable in relation to its
current fair value.
(d) The sale should be expected to take place within one year from the date of classification.
(e) It is unlikely that significant changes to the plan will be made or that the plan will be
withdrawn.
The probability of shareholders' approval (if required in the jurisdiction) should be considered as
part of the assessment of whether the sale is highly probable.
An entity that is committed to a sale plan involving loss of control of a subsidiary shall classify all
the assets and liabilities of that subsidiary as held for sale when the criteria are met, regardless of
whether the entity will retain a non-controlling interest in its former subsidiary after the sale.
If an asset (or disposal group) is not sold within one year, it can still be classified as held for sale
only when the delay has been caused by events or circumstances beyond the entity's control.
The entity is required to produce sufficient evidence to show its commitment to sell the asset or
disposal group, otherwise it must cease to classify the asset as held for resale.
When a disposal group (e.g., a subsidiary) is acquired solely with a view to its subsequent disposal,
an entity is allowed to classify it as an asset held for sale only if the sale is expected to occur within
a year and it is highly probable that all the criteria mentioned above will be satisfied within a short
period (normally three months) after the acquisition of the disposal group.

HKFRS 5.12A 2.2 Assets held for distribution to owners


A non-current asset (or disposal group) is classified as held for distribution to owners when the
entity is committed to distribute the asset (or disposal group) to the owners.

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For this to be the case:


 the assets must be available for immediate distribution in their present condition, and
 the distribution must be highly probable.
In order for the distribution to be considered highly probable:
1 actions to complete the distribution should have been initiated
2 these actions should be expected to be completed within 12 months of the date of
classification.
Actions required to complete the distribution should indicate that it is unlikely that significant
changes to the distribution will be made or that the distribution will be withdrawn. The probability of
shareholders' approval (if required in the jurisdiction) should be considered as part of the
assessment of whether the distribution is highly probable.

HKFRS 5.13 2.3 Assets to be abandoned


An asset that is to be abandoned should not be classified as held for sale. Since its carrying
amount is to be recovered principally through continuing use rather than sale, it should not be
classified as held for sale. However separate disclosure may be required (see section 5 below)
when a disposal group to be abandoned meets the definition of a discontinued operation.

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Financial Reporting

2.4 Summary decision tree


The following decision tree will help you to make a decision as to whether an asset or disposal
group should be classified as held for sale:

Asset or disposal group to be Abandoned


sold or abandoned?

Sold

No
Available for sale in present
condition?

Yes

Sale highly probable? Consider


sub criteria:
Ÿ Management committed
to plan No
No
Ÿ Active programme to Acquired with a view to
locate buyer resale?

Ÿ Marketed at fair value


Yes
Ÿ Significant changes to
plan unlikely
No
Yes Highly probable that sub-
criteria met within three
Yes months of purchase?

No
Sale expected within one year?

Yes

Criterial met before the end of No


the year?

Yes

Classify as held for sale and Disclose as non-adjusting


event after the reporting Do not classify as held
re-measure and disclose in
period (see Chapter 22) for sale
accordance with HKFRS 5

Self-test question 1
Should the following be classified as held for sale at a 31 December 20X1 year end?
1 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.

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4: Non-current assets held for sale and discontinued operations | Part C Accounting for business transactions

2 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 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.
(The answer is at the end of the chapter)

3 Measurement of assets held for sale

Key terms
Fair value. The price that would be received to sell an asset or paid to transfer a liability in an
HKFRS 5
Appendix A
orderly transaction between market participants at the measurement date.
Costs to sell. The incremental costs directly attributable to the disposal of an asset (or disposal
group), excluding finance costs and income tax expense.
Recoverable amount. The higher of an asset's fair value less costs to sell and its value in use.
Value in use. The present value of estimated future cash flows expected to arise from the
continuing use of an asset and from its disposal at the end of its useful life. (HKFRS 5)

HKFRS
5.15,15A
3.1 Initial measurement
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
Fair value less costs to sell is equivalent to net realisable value. 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.
On subsequent measurement of 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.

HKFRS 5.20 3.3 Impairment losses


Assets held for sale are outside the scope of HKAS 36 and the guidance on impairments provided
within HKFRS 5 applies instead.

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Financial Reporting

Where fair value less costs to sell is lower than carrying amount, the asset or disposal group held
for sale is impaired, and the difference between carrying amount and fair value less costs to sell
must be recognised as an impairment loss.

Example: Tang Co.


Tang Co. has owned a printing machine for several years. The machine cost $400,000 and is being
depreciated over a period of 10 years. At 1 October 20X8, the machine is carried in the statement
of financial position at $280,000. On 31 March 20X9 the management of Tang Co. decided to sell
the machine and immediately instructed a specialist selling agency to market the machine. The
current market value of such a machine is $270,000 and Tang Co. has agreed to pay a 5%
commission to the specialist selling agency.
At what value should the machine be included in the statement of financial position at
30 September 20X9, assuming that it has not yet been sold and that fair values remain unchanged
since classification as held for sale?
Solution
At the date of transfer to held for sale the carrying amount was:
$280,000 – ($400,000/10 years  6/12) = $260,000
The fair value less costs to sell was:
$270,000  95% = $256,500
On transfer to the held for sale category an impairment of $3,500 is recognised. Thereafter no
depreciation is charged, meaning that the asset held for sale is included in the statement of
financial position at 30 September 20X9 as a current asset carried at $256,500.

HKFRS 5.23 3.3.1 Impairment losses and disposal groups


An impairment loss recognised for a disposal group reduces the carrying amount of the non-current
assets of the disposal group that are within the scope of HKFRS 5 in the following order:
1 Any goodwill within the disposal group
2 Other assets on a pro rata basis.

Example: Random Co.


Random Co. makes the decision to dispose of a division of its business on 15 February 20X9 and
immediately begins an active programme to find a buyer. The assets of this division make up a
disposal group, and are measured as follows:
Carrying amount at
15 February
20X9
$'000
Goodwill 450
Intangible asset 1,000
Property, plant and equipment 2,000
Inventory 1,300
Other current assets 900
Total 5,650

The fair value of the disposal group is $5.4 million and costs to sell are $290,000.
An impairment loss is therefore recognised on transfer of the disposal group to held for sale of
$540,000, and this is allocated to the non-current assets which fall within the scope of the

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measurement provisions of HKFRS 5. Therefore, no impairment loss is allocated to inventory or the


other current assets.
The loss is allocated in the first place to goodwill and thereafter to other non-current assets on a
pro-rata basis:
Carrying
Carrying amount after
amount at allocation of
15 February Impairment impairment
20X9 loss loss
$'000 $'000 $'000
Goodwill 450 (450) –
Intangible asset 1,000 (30) 970
Property, plant and equipment 2,000 (60) 1,940
Inventory 1,300 – 1,300
Other current assets 900 900
Total 5,650 540 5,110

HKFRS 5.21 3.4 Reversal of impairment losses


Where an asset or disposal group held for sale is measured at fair value less costs to sell, any
subsequent increase in fair value less costs to sell is recognised, however not in excess of
cumulative impairment losses recognised in accordance with HKFRS 5 or HKAS 36.

HKFRS 5.27 3.5 Measurement where assets are no longer classified as held
for sale
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.

4 Presentation of assets held for sale


HKFRS 5.38-
40
4.1 Presentation of a non-current asset or disposal group
classified as held for sale
Separate classifications are to be presented in the statement of financial position for non-current
assets and disposal groups. Likewise separate disclosure is also required for the liabilities of a
disposal group in the statement of financial position.
(a) Assets and liabilities held for sale should not be offset.
(b) The major classes of assets and liabilities held for sale should be separately disclosed
either in the statement of financial position or in the notes.
If the disposal group is a newly acquired subsidiary that meets the criteria to be classified as held
for sale on acquisition, disclosure of the major classes of assets and liabilities is not required.
Re-presentation of prior year comparatives is not required to reflect those assets classified as held
for sale only in the current year.

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Financial Reporting

Example: Colway Co.


At the end of 20X9, Colway Co. decides to dispose of a machine and Division D of its business.
Division D is a disposal group. Both of these intended disposals meet the criteria to be classified as
held for sale, and their carrying amount after this classification is:
$'000
Machine 15
Non-current assets of Division D 340
Current assets of Division D 120
Liabilities of Division D 260
Presentation in the statement of financial position of Colway Co. is therefore as follows:
$'000 $'000
Non-current assets X X
Current assets X X
Non-current assets classified as held for sale 475 X
Total assets X X

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.

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.

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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.

Self-test question 2
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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Financial Reporting

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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Self-test question 3
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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Financial Reporting

Topic recap

HKFRS 5 Non-Current Assets Held for Sale and Discontinued Operations

Non-current assets/disposal groups held Discontinued operations


for sale

Non-current asset/disposal group is Operation which is disposed of or held for


classified as held for sale if: sale and:
Ÿ available for immediate sale in present Ÿ represents a separate major
condition, and business/geographical area
Ÿ the sale is highly probable: Ÿ is part of a plan to dispose of a separate
– Management committed to sale plan; major business/geographical area
– Active programme to locate buyer; Ÿ is a subsidiary acquired with a view to
– Marketed at reasonable price; resale
– Sale expected to take place < 12
months
– Unlikely that sale plan will be
changed.

Measurement Disclosure

Lower of carrying amount and fair value Disclose single amount in statement of profit
less costs to sell. or
comprehensive
loss and otherincome
comprehensive
comprising:income
Ÿ Post tax profit or loss of the
comprising:
Ÿ postdiscontinued
tax profit or loss
operations
of the discontinued
and
Ÿoperations
Post taxandgain or loss on
If FV less costs to sell < carrying amount Ÿ postdisposal/measurement
tax gain or loss on to fair
recognise impairment loss. In disposal disposal/measurement
value less costs to sell.
to fair value less
group set against: costs to sell.
1. goodwill
2. other assets on pro rata basis

No further depreciation/amortisation Disclose further analysis of the single amount


in the SPLOCI or notes.

Disclosure

Disclose net cash operating, investing and


financing cash flows of the discontinued
Ÿ Disclose separately as current assets / operation.
current liabilities held for sale without
offsetting
Ÿ Disclose separate classes of assets /
liabilities held for sale

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Answers to self-test questions

Answer 1
1 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.
2 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.

Answer 2
(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 3
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

Note. Discontinued operations


During the year the company ran down a material business operation with all activities ceasing on
26 December 20X1. The results of the operation 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) (190) (90)
Loss before tax (140) (10)
Income tax expense (15 + (90  30%)) 42 3
Loss after tax (98) (7)
Post-tax gain on remeasurement and subsequent
disposal of assets classified as held for sale (90  70%) 63 –
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)

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Exam practice

Disposal Groups 22 minutes


Super Shoes Limited ("SS") is the holding company of Rocket Running Limited ("RR") and Soft
Walking Limited ("SW"). At the board meeting of SS on 30 June 20X9, the management decided
to dispose of all the assets of RR to an independent third party and close down the retailing
operation of SW by the end of October 20X9. The assets of RR and SW as at 30 June 20X9 are
measured in the consolidated financial statements before classification as held for sale and / or
adjustment for impairment as a result of sales / closure of operation, if applicable, as follows:
RR SW
HK$'000 HK$'000
Goodwill 2,400 2,700
Intangible assets 12,500 -
Property, plant and equipment 48,300 18,800
Inventories 16,600 6,400
Trade receivables 4,500 1,300
Financial assets held for trading 8,000 -
TOTAL 92,300 29,200

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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Financial Reporting

102
chapter 5

Property, plant and


equipment
Topic list

1 HKAS 16 Property, Plant and Equipment


1.1 Scope
1.2 Definitions
1.3 Recognition of non-current assets
1.4 Measurement
1.5 Depreciation
1.6 Revaluations
1.7 Impairment
1.8 Retirements and disposals
1.9 Disclosure
1.10 Current developments

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

In this chapter you will cover the following 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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1 HKAS 16 Property, Plant and Equipment


Topic highlights
HKAS 16 covers all aspects of accounting for property, plant and equipment. This represents the
bulk of items which are "tangible" non-current assets.

HKAS 16.2,3 1.1 Scope


HKAS 16 should be followed when accounting for property, plant and equipment unless another
accounting standard requires a different treatment.
HKAS 16 does not apply to the following:
(a) Property, plant and equipment classified as held for sale in accordance with HKFRS 5
(b) Biological assets related to agricultural activity
(c) The recognition and measurement of exploration and evaluation assets
(d) Mineral rights and mineral reserves, such as oil, gas and other non-regenerative resources.
However, the standard applies to property, plant and equipment used to develop the assets
described in (b) and (d).

HKAS 16.6 1.2 Definitions


The standard gives a large number of definitions.

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
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 16.7 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
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).
Inspections and overhauls
Certain assets require periodic overhauls or inspections in order to operate. The cost of these
overhauls/inspections should be included in the carrying amount of the relevant asset and
depreciated as a separate element of the asset to the date of the next overhaul/inspection.
HKAS 16.12 1.3.4 Subsequent expenditure
Subsequent expenditure on a non-current asset may be capitalised where the expenditure
enhances the economic benefits of the asset beyond its current standard or performance. This may
be achieved through extension of the asset's life, improved quality of output or an increased
operating capacity. Day to day servicing costs, repairs and maintenance do not meet this criteria
and therefore must be expensed to profit or loss.

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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
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.

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Financial Reporting

HKAS 16.24 1.4.2 Exchanges of assets


HKAS 16 specifies that exchange of items of property, plant and equipment, regardless of whether
the assets are similar, are measured at fair value, unless the exchange transaction lacks
commercial substance or the fair value of neither of the assets exchanged can be measured
reliably. If the acquired item is not measured at fair value, its cost is measured at the carrying
amount of the asset given up.

Example: Exchange of assets


A ship owner has properties with a carrying value of $10m. He is going to exchange his properties
for a ship which has a market value of $20m by paying an additional sum of cash of $5m.

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

HKAS 1.4.3 Measurement subsequent to initial recognition


16.30,31
HKAS 16 offers two possible treatments here, requiring you to choose between keeping an asset
recorded at cost or revaluing it to fair value.
(a) Cost model. Carry the asset at its cost less any accumulated depreciation and any
accumulated impairment losses.
(b) Revaluation model. Carry the asset at a revalued amount, being its fair value at the date of
the revaluation less any subsequent accumulated depreciation and subsequent accumulated
impairment losses. HKAS 16 makes clear that the revaluation model is available only if
the fair value of the item can be measured reliably.
Depreciation, revaluation and impairment are discussed in more detail in the next three sections of
the chapter.

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.

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(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.

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.

HKAS 1.5.1 The mechanics of depreciation


16.48,50,55,
58,60 The standard states the following:
(a) The depreciable amount of an item of property, plant and equipment should be allocated on
a systematic basis over its useful life.
(b) The depreciation method used should reflect the pattern in which the asset's economic
benefits are consumed by the entity.
(c) The depreciation charge for each period should be recognised as an expense unless it is
included in the carrying amount of another asset.
Land and buildings are dealt with separately even when they are acquired together because land
use right normally is considered as a lease and accounted for in accordance with the requirements
under HKAS 17. Buildings do have a limited life and must be depreciated. Any increase in the
value of land on which a building is standing will have no impact on the determination of the
building's useful life.
Depreciation is usually treated as an expense, but not where it is absorbed by the entity in the
process of producing other assets. For example, depreciation of plant and machinery can be
incurred in the production of goods for sale (inventory items). In such circumstances, the
depreciation is included in the cost of the new assets produced.
Depreciation should commence when an asset is available for use. In other words it is in the
location and condition necessary for ordinary use.
HKAS 1.5.2 Useful life
16.56,57
The useful life of a depreciable asset is estimated based on the following factors:
 Expected physical wear and tear
 Obsolescence
 Legal or other limits on the use of the assets

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The judgment on useful life is based on the entity's past experience with similar assets or classes
of assets. The task of estimating the useful life will be much more onerous when an entirely new
type of asset is acquired (i.e. through technological advancement or through use in producing a
brand new product or service).
It is indicated in the standard that the useful life of an asset might be shorter than its physical life.
The physical wear and tear the asset is likely to endure is one of the key factors that we need to
look at. It is affected by circumstances such as the entity's repair and maintenance programme and
number of shifts for which the asset will be used, and so on. Other factors such as obsolescence
(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.
HKAS 16.53 1.5.3 Residual value
The residual value of an asset is likely to be immaterial in most instances. However, if the
residual value is expected to be significant, it must then be estimated at the date of acquisition or at
any subsequent revaluation. The residual value should be estimated based on the current situation
with other similar assets, used in the same way, which are now at the end of their useful lives. Any
future cost relating to the disposal should be netted off against the gross residual value.
HKAS 1.5.4 Depreciation methods
16.60,62
HKAS 16 requires the depreciation method used to reflect the pattern in which the asset's future
economic benefits are expected to be consumed by the entity. A variety of methods are available
and these include the straight line method, the diminishing balance method and the units of
production method.
Straight line depreciation results in a constant annual depreciation charge. This method simply
spreads the depreciable amount evenly over the useful life.
Diminishing balance depreciation results in a higher depreciation charge in the earlier years of
an asset's useful life and a lower charge in later years. It is calculated as a constant percentage of
an asset's carrying amount.
The units of production method results in a charge based on expected output. The charge is
therefore higher in periods of higher output and lower when there is a lower output.
Consistency is important. The depreciation method selected should be applied consistently from
period to period unless altered circumstances justify a change. When the method is changed, the
effect should be quantified and disclosed and the reason for the change should be stated. Change
of policy is not allowed simply because of the profitability situation of the entity.
Self-test question 1
A computer system cost $20,000 and is being depreciated at 10% using the diminishing balance
method. How does this asset appear in the statement of financial position in the first and second
year of ownership?
Why is the diminishing balance method more appropriate for such an asset?
(The answer is at the end of the chapter)

Self-test question 2
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

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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)

HKAS 16.51 1.5.5 Review of useful life and residual value


A review of the useful life and residual value of property, plant and equipment should be carried
out at least at each financial year end and the depreciation charge for the current and future
periods should be adjusted if expectations have changed significantly from previous estimates.
Changes to the useful life or residual value are treated as changes in accounting estimates and are
accounted for prospectively as adjustments to future depreciation.

Example: Review of useful life


A machine costs $100,000 and has a useful life of 10 years since its acquisition in 20X7. At the end
of the second year of use, the asset is assessed to have a remaining useful life of five years. The
company adopts the straight line depreciation method.
What will be the depreciation charge for 20X9?

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

HKAS 16.61 1.5.6 Review of depreciation method


The depreciation method should also be reviewed at least at each financial year end and, if
there has been a significant change in the expected pattern of economic benefits from those
assets, the method should be changed to suit this changed pattern. When such a change in
depreciation method takes place the change should be accounted for as a change in accounting
estimate and the depreciation charge for the current and future periods should be adjusted.

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Example: Review of depreciation method


Using the same data as above, assume that at the end of the second year the company changes
from the straight line method to the diminishing balance method of depreciation, at a rate of 25%
per annum.
The carrying amount of $80,000 is therefore written off from 20X9 onwards using the diminishing
balance method over its remaining useful life.
The depreciation charge for 20X9 is therefore $20,000 (25%  $80,000).

HKAS 16.31 1.6 Revaluations


Where an entity chooses to apply the revaluation model to property, plant and equipment, the
revalued assets are carried at a revalued amount less subsequent depreciation and impairment
losses. Revalued amount is the fair value of the asset at the date of revaluation.
HKFRS 13.9- 1.6.1 Fair value
33,76,81,86

HKFRS 13, issued in May 2011, amended the definition of fair value contained within HKAS 16 to
"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".

HKFRS 13 also deleted the HKAS 16 guidance on establishing fair value and replaced this with a
requirement to instead refer to the requirements of HKFRS 13 Fair Value Measurement.
This standard requires that the following are considered in determining fair value:
1 The asset being measured.
2 The principal market (i.e. that where the most activity takes place) or where there is no
principal market, the most advantageous market (i.e. that in which the best price could be
achieved) in which an orderly transaction would take place for the asset.
3 The highest and best use of the asset and whether it is used on a standalone basis or in
conjunction with other assets.
4 Assumptions that market participants would use when pricing the asset.
Having considered these factors, HKFRS 13 provides a hierarchy of inputs for arriving at fair value.
It requires that level 1 inputs are used where possible:
Level 1 Quoted prices in active markets for identical assets that the entity can access at the
measurement date.
Level 2 Inputs other than quoted prices that are directly or indirectly observable for the asset.
Level 3 Unobservable inputs for the asset.
HKAS 16.34 1.6.2 Frequency of revaluations
Valuations must be kept up to date so that the carrying amount of a revalued asset does not differ
materially from its fair value. In some cases annual revaluation is necessary, whereas in others it
may be necessary to revalue the item only every three or five years.
HKAS 1.6.3 Consistency of revaluation
16.36,38
When an item of property, plant and equipment is revalued, the whole class of assets to which it
belongs should be revalued.
All items within a class should be revalued simultaneously. In this way, selective revaluation of
certain assets and disclosure of a mixture of costs and values from different dates in the financial
statements can be avoided. Entities are permitted to have revaluation on a rolling basis if the

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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

(b) The double entry is:


$ $
DEBIT Buildings 150,000
CREDIT Administrative expenses (profit or loss) 80,000
Other comprehensive income (revaluation surplus) 70,000
Note. The line item for the credit to profit or loss is not specified in the standard, but it is generally
made to the same account as any depreciation and other costs relating to the buildings.

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.

Example: Revaluation decrease


Rupert Co. acquired a building for an original cost of $3.5 million at the start of 20X1. It was
revalued upwards to $3.8 million in January 20X3. The value has now fallen to $3 million at
31 December 20X3.
How should the decrease in value be recorded at 31 December 20X3?

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Financial Reporting

Solution
The double entry is:
$ $
DEBIT Other comprehensive income (revaluation surplus) 300,000
Administrative expenses (profit or loss) 500,000
CREDIT Building 800,000

1.6.5 Depreciation of revalued assets


Where a depreciated asset is revalued, future depreciation is calculated based on the revalued
amount. One effect of an upwards revaluation is therefore an increase to the depreciation charge.
Normally, a revaluation surplus is only realised when the asset is sold, but when it is being
depreciated, part of that surplus is being realised as the asset is used. The amount of the surplus
realised is the difference between depreciation charged on the revalued amount and the (lower)
depreciation which would have been charged on the asset's original cost. This amount can be
transferred to retained (i.e. realised) earnings. This transfer is effected in the statement of
changes in equity; it is not reflected in the statement of profit or loss and other comprehensive
income.

Example: Revaluation and depreciation


Roosevelt Co. purchased a property on 1 January 20X1. Details are as follows:
 Cost $9million
 Useful life 50 years
On 1 January 20X6 the property was revalued to $8.5million, with the useful life unchanged.
(a) Account for the revaluation.
(b) Calculate depreciation for the year ended 31 December 20X6 and the amount that may be
transferred to retained earnings from the revaluation surplus in that year.

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.

HKAS 16.68 1.8 Retirements and disposals


When an asset is permanently withdrawn from use, or sold or scrapped, and no future
economic benefits are expected from its disposal, it should be withdrawn from the statement of
financial position.
Gains or losses are the difference between the estimated net disposal proceeds and the carrying
amount of the asset. They should be recognised as income or expense in profit or loss.
HKAS 1.8.1 Derecognition
16.67,68,68A
An entity is required to derecognise the carrying amount of an item of property, plant or
equipment that it disposes of on the date the criteria for the sale of goods in HKAS 18 Revenue
would be met. This also applies to parts of an asset.
An entity cannot classify as revenue a gain it realises on the disposal of an item of property, plant
and equipment.
However, an entity that, in the course of its ordinary activities, routinely sells items of property,
plant and equipment that it has held for rental to others shall transfer such assets to inventories at
their carrying amount when they cease to be rented and become held for sale. The proceeds from
the sale of such assets shall be recognised as revenue in accordance with HKAS 18 Revenue.
HKFRS 5 does not apply when assets that are held for sale in the ordinary course of business are
transferred to inventories.
Example: Derecognition
A property was purchased at a cost of $10m and has a useful life of 50 years. At the end of
Year 20, the property was revalued to $30m and its useful life remains unchanged. The property
was sold at the beginning of Year 22 for $33m.
Solution
Accounting entries:
At the end of Year 20, the following accounting entries reflect the revaluation:
$m $m
30
DEBIT Property ($30m – ( /50  $10m)) 24
CREDIT Revaluation surplus 24

In Year 21, the following adjustments are to be made:


$m
Depreciation based on revalued amount ($30m  1/30) 1.0
Depreciation based on original cost ($10m  1/50) 0.2
Depreciation increase related to revaluation surplus is regarded as realised 0.8

DEBIT Revaluation surplus 0.8


CREDIT Retained profits 0.8
Being realisation of part of revaluation reserve due to additional depreciation provided on
revaluation surplus.

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Financial Reporting

In Year 22, the following adjustments are to be made:


$m $m
DEBIT Bank (disposal proceeds) 33
Accumulated depreciation 1
CREDIT Property 30
Gain on disposal (in profit or loss) 4
Being revalued property disposed of at a profit
DEBIT Revaluation reserve ($24m – $0.8m) 23.2
CREDIT Retained profit 23.2

Being realisation of revaluation reserve upon disposal of asset.


The following analysis shows that the distributable profits remain the same, whether the property is
revalued or not:
$m
Without revaluation of the asset
Cost 10.0
Less: Accumulated depreciation ($0.2  21 years) (4.2)
Carrying amount 5.8
Disposal proceeds (33.0)
Profit realised on disposal 27.2

$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 3
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)

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.

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(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 27)
(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:
(a) Basis used to revalue the assets
(b) Effective date of the revaluation
(c) Whether an independent valuer was involved
(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

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Financial Reporting

The following format (with notional figures) is commonly used to disclose non-current assets
movements:
Land and Plant and
buildings equipment Total
$ $ $
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
Depreciation
At 1 January 20X8 10,000 6,000 16,000
Charge for year 1,000 3,000 4,000
Eliminated on disposals – (500) (500)
At 31 December 20X8 11,000 8,500 19,500
Carrying amount
At 31 December 20X8 41,000 4,500 45,500
At 1 January 20X8 30,000 4,000 34,000

1.10 Current developments


The IASB proposed amendments to IAS 16 in December 2012. As HKAS 16 is converged with IAS
16, these will also affect HKAS 16. The amendments would clarify that depreciation methods must
reflect a pattern of consumption of economic benefits from an asset rather than a pattern of
generation of economic benefits by an asset. Therefore a revenue-based method of depreciation
is not allowed.
A revenue-based method of depreciation is a method whereby the depreciation charge in a given
year is calculated based on the revenue earned in that year as a proportion of total revenues
expected to be generated by the asset over its useful life.
Comments on the Exposure Draft are due by 2 April 2013. Finalised amendments are expected in
the fourth quarter of 2013.

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Topic recap

HEADING
HKAS 16 Property, Plant and Equipment

Recognise an asset when:


1. it is probable that future economic benefits
associated with the asset will flow to the
entity and
2. the cost of the asset can be measured reliably.

Subsequent expenditure is recognised as an asset only


where it enhances the benefits of the asset.

Initial Subsequent measurement Depreciation


measurement

Cost model Revaluation model

Measured at cost Carrying amount = Carrying amount = Allocate depreciable


including: cost – accumulated revalued amount – amount (revalued
Ÿ purchase price depreciation – accumulated amount) less residual
Ÿ duties and accumulated depreciation – value over useful life.
taxes impairment losses. accumulated
Ÿ directly impairment losses. Land usually not
attributable depreciated.
costs
Ÿ dismantling Review useful life,
costs (HKAS 37) Rules: residual value and
Ÿ borrowing Valuations must be kept up to date. depreciation method
costs (HKAS 23) at least each financial
Model must be applied to the whole class of year.
asset.
Changes accounted for
prospectively.

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:
Ÿ Measurement bases Ÿ Recoverable amounts
Ÿ Depreciation methods and Ÿ Restrictions on title
estimations Ÿ Estimated costs of restoring site
Ÿ Reconciliation of cost/revalued Ÿ Expenditure on assets under
amount and accumulated construction
depreciation b/f to the same Ÿ Capital commitments
amounts c/f Ÿ Additional disclosure for revalued
assets

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Financial Reporting

Answers to self-test questions

Answer 1
First year Second year
$ $
Cost 20,000 20,000
Accumulated depreciation
Yr 1 ($20,000  10%) (2,000) (2,000)
Yr 2 ($18,000  10%) – (1,800)
Carrying amount 18,000 16,200

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 2
(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)

(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

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Answer 3
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 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
$3,000
2 Monthly depreciation is = $250 per machine per month
12
3 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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Financial Reporting

Exam practice

Phoenix Real Estate 16 minutes


Phoenix Real Estate Limited ("Phoenix") is a property developer in China. In 20X3, Phoenix
acquired the land use rights of two pieces of land in Beijing for hotel development:
Property One – Since the date of the acquisition of the land, the board of Phoenix has decided to
run the hotel on its own and commenced the pre-operating activities of the hotel on 1 January 20X5
when the development is completed and the hotel is available for its intended use. The hotel's
grand opening took place on 1 July 20X5.
Property Two – Since the date of the acquisition of the land, the board of Phoenix decided to lease
the whole property to earn rental income. A lease agreement was entered into to lease the whole
property to its holding company (the "Tenant") for a period of eighteen years for the operation of a
hotel.
The monthly revenue amount of the hotel operation is provided by the Tenant at the close of
business of each month-end date.
Other information on these two properties:

Property One Property Two

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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chapter 6

Investment property

Topic list

1 HKAS 40 Investment Property


1.1 Definitions
1.2 Recognition
1.3 Initial measurement
1.4 Measurement subsequent to initial recognition
1.5 Transfers
1.6 Disposals
1.7 Summary of accounting treatment of property
1.8 Disclosure requirements

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

In this chapter you will cover the following 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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1 HKAS 40 Investment Property


Topic highlights
Land and building may be acquired for investment purpose rather than for use in the business.
The cash flows generated by this investment are largely independent of other assets held by the
entity. The accounting treatment of investment property is covered by HKAS 40.

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. 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.

Self-test question 1
Propex had the following properties but is unsure how to account for them:
1 Tennant House which cost $150,000 five years ago. The property is freehold and is let out to
private individuals for six-monthly periods. The current market value of the property is
$175,000.
2 Stowe Place which cost $75,000. This is used by Propex as its headquarters. The building
was acquired 10 years ago.
3 Crocket Square is a recently started development which 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
Describe the most appropriate accounting treatment for each of these properties.
(The answer is at the end of the chapter)

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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

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)

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Financial Reporting

HKAS 40.16 1.2 Recognition


Investment property should be recognised as an asset when two conditions are met:
(a) It is probable that the future economic benefits that are associated with the investment
property will flow to the entity, and
(b) The cost of the investment property can be measured reliably.

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

HKAS 40 requires an entity to choose between two models:


 The fair value model
 The cost model
Whatever policy it chooses should be applied to all of its investment property.
Where an entity chooses to classify a property held under an operating lease as an investment
property, there is no choice. The fair value model must be used for all the entity's investment
property, regardless of whether it is owned or leased.
HKAS 1.4.1 Fair value model
40.33,35, 53,
HKFRS 13.9- Where the fair value model is chosen, the following rules apply:
33,76, 81, 86
1 An entity that chooses the fair value model should measure all of its investment property at
fair value, except in the extremely rare cases where this cannot be measured reliably. In
such cases it should apply the HKAS 16 cost model.
2 A gain or loss arising from a change in the fair value of an investment property should be
recognised in net profit or loss for the period in which it arises.
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.

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This standard requires that the following are considered in determining fair value:
1 The asset being measured
2 The principal market (i.e. that where the most activity takes place) or where there is no
principal market, the most advantageous market (i.e. that in which the best price could be
achieved) in which an orderly transaction would take place for the asset
3 The highest and best use of the asset and whether it is used on a standalone basis or in
conjunction with other assets
4 Assumptions that market participants would use when pricing the asset.
Having considered these factors, HKFRS 13 provides a hierarchy of inputs for arriving at fair value.
It requires that level 1 inputs are used where possible:
Level 1 Quoted prices in active markets for identical assets that the entity can access at the
measurement date.
Level 2 Inputs other than quoted prices that are directly or indirectly observable for the asset.
Level 3 Unobservable inputs for the asset.
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.

HKAS 40.56 1.4.3 Cost model


The model here is the same as the cost model in HKAS 16. Investment property should be
measured at depreciated cost, less any accumulated impairment losses. If an entity chooses
the cost model, it should disclose the fair value of its investment property.
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.

HKAS 40.57-
65
1.5 Transfers
Transfers to or from investment property are justified only when there is a change in the use of
the property.

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Financial Reporting

1.5.1 Transfers from investment property


HKAS 40 cites two instances when property is transferred from investment property to another
category:
(a) Commencement of owner occupation
(b) Commencement of development with a view to sale.
In the first instance on transfer the property falls within the scope of HKAS 16, and the accounting
guidance of that standard must be applied. In the second instance on transfer the property falls
within the scope of HKAS 2. In both cases where the investment property was previously carried at
fair value, the property's cost for subsequent accounting under HKAS 16 or HKAS 2 should be its
fair value at the date of change of use.
1.5.2 Transfers to investment property
HKAS 40 also provides two instances when property is transferred to investment property from
another category:
(a) End of owner occupation
(b) Commencement of an operating lease to another party.
In the first instance, the transfer removes the property from the scope of HKAS 16 and in the
second from the scope of HKAS 2.
HKAS 16 is to be applied up to the date of change of use when an owner-occupied property
becomes an investment property and the property has to be carried at fair value. The difference at
the date of change between the carrying amount of the property under HKAS 16 and its fair value
should be treated as a revaluation under HKAS 16.
The following table summarises the requirements of HKAS 40 on recognition and measurement
issues that arise when an entity uses the fair value model for investment property.

Transfer from To Measurement rules

Investment Owner-occupied The property's deemed cost for subsequent accounting


property carried property in accordance with HKAS 16 shall be its fair value at
at fair value the date of change in use.
Inventories The property's deemed cost for subsequent accounting
in accordance with HKAS 2 shall be its fair value at the
date of change in use.
Inventories Investment Any difference between the fair value of the property at
property that will the date of change in use and its previous carrying
be carried at fair amount shall be recognised in profit or loss.
value

Owner-occupied An entity shall apply HKAS 16 to the owner-occupied


property property up to the date of change in use. The entity
shall treat any difference at that date between the
carrying amount of the property in accordance with
HKAS 16 and its fair value in the same way as a
revaluation in accordance with HKAS 16. (See Note
below)

Note. Any resulting decrease in the carrying amount of the property is recognised in profit or loss.
However, to the extent that an amount is included in revaluation surplus for that property, the
decrease is recognised in other comprehensive income and reduces the revaluation surplus within
equity.

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6: Investment property | Part C Accounting for business transactions

Any resulting increase in the carrying amount is treated as follows:


(a) To the extent that the increase reverses a previous impairment loss for that property, the
increase is recognised in profit or loss. 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.

HKAS 1.6 Disposals


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.
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.

1.7 Summary of accounting treatment of property


Depending on which standard's scope a property falls within, it may be subject to significantly
different accounting treatment:

HKAS 16 HKAS 16 HKAS 2 HKAS 40 HKAS 40


cost model revaluation cost model fair value
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)

Gains and Depreciation Revaluations No Depreciation Changes in


losses and recognised in depreciation and impairment fair value
impairment other recognised in recognised
recognised in comprehensive profit or loss in profit or
profit or loss income loss. No
depreciation

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Financial Reporting

HKAS 40.75 1.8 Disclosure requirements


Disclosures in respect of investment properties are particularly important due to the choice of
accounting treatment provided by the standard. Users must be aware of whether the carrying
amount represented in the statement of financial position relates to cost or fair value.
Where the fair value model is used, users have an indication of the achievable proceeds on a sale
of an investment property; where the cost model is used, the requirement to disclose fair value
achieves the same end.
In addition, detail of amounts recognised in profit or loss, such as rental income and changes in fair
value, help users to determine the quality of an investment property in generating returns.
The following must be disclosed:
 Whether an entity applies the cost model or fair value model
 Whether property interests held as operating leases are included in investment property
 Criteria for classification as investment property
 Use of independent professional valuer (encouraged but not required)
 Amounts recognised in profit or loss for:
– rental income
– direct operating expenses from property that did generate rental income
– direct operating expenses from property that did not generate rental income
– cumulative change in fair value recognised in profit or loss on sale of an investment
property from a pool of assets in which the cost model is used to a pool in which the
fair value model is used
 Any restrictions or obligations associated with the investment property
HKAS 40.76 - 1.8.1 Fair value model – additional disclosures
78
An entity that adopts the fair value model must also disclose the following:
(a) A reconciliation of the carrying amount of the investment property at the beginning and end
of the period, including separate details for those properties for which reliable fair value
cannot be determined.
(b) Disclosure of adjustments to valuations obtained (for example to avoid double counting).
(c) Where fair value cannot be established reliably:
(i) A description of the property
(ii) Explanation of why fair value cannot be established reliably
(iii) A range of estimates within which fair value is likely to lie (where possible)
(iv) The carrying amount of any property disposed of and gain or loss recognised.

HKAS 40.79 1.8.2 Cost model – additional disclosures


An entity that adopts the cost model must also disclose:
 depreciation methods used
 useful lives or depreciation rates used
 the gross carrying amount and accumulated depreciation at the start and end of the period
 a reconciliation of the carrying amount of the investment property at the beginning and end
of the period
 the fair value of investment property

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6: Investment property | Part C Accounting for business transactions

Topic recap

HKAS 40 Investment Property

HEADING Definition HEADINGMeasurement HEADING Disclosure

Disclose
Land, building
singleoramount
part ofinbuilding
statement
heldofby Ÿ Whichsingle
Disclose measurement
amount inmodel
statement
is applied
of
comprehensive
the owner (or lessee
incomeunder
comprising:
finance lease) Ÿ Criteria for classification
comprehensive income comprising:
as investment property
Ÿ Post
to earn rentals/for
tax profit
capital
or loss
appreciation
of the rather Ÿ ŸUsePost
of independent
tax profit or valuer
loss of the
than fordiscontinued
use/sale in the
operations
ordinaryand course of Ÿ Amounts
discontinued
recognised
operations
in profitand
or loss
Ÿ Post
business. Includes:
tax gain or loss on Ÿ ŸRestrictions
Post tax gain
or obligations
or loss onassociated with the
Ÿ Land disposal/measurement
held for undeterminedtofuturefair use property.
disposal/measurement to fair
Ÿ Property
value being
less costs
constructed
to sell. for use as an value less costs to sell.
investment property

A building held by one group company and Fair value


Fair valuemodel
model Cost model
Cost model
leased to another group company is Ÿ Ÿ Reconciliation
Reconciliation of Ÿ ŸDepreciation
Depreciation
investment property in the individual of carrying
carrying amount methods
methods
company accounts and owner-occupied in amount
b/f and c/f b/f Ÿ ŸReconciliation
Reconciliation
of
the consolidated accounts. Ÿ Adjustments
and c/f to of carrying
carrying amount
Ÿvaluations
Adjustments amount
b/f and c/f b/f
Ÿ Furtherto valuations
details Ÿ FV and c/f
of property
Ÿwhere
Further
FV can’t Ÿ FV of
details where
be established property
Transferssingle
Disclose to/fromamount
investment
in statement
propertyofallowed
FV cant be
reliably
comprehensive
when there is a income
change comprising:
in use:
established
Ÿ Commencement
Ÿ Post tax profitof orowner
loss ofoccupation
the
reliably
Ÿ Commencement
discontinued operations
of development
and with view
Ÿto sale
Post tax gain or loss on
Ÿ Enddisposal/measurement
of owner occupation to fair
Ÿ Commencement
value less costs
of operating
to sell. lease to
another party

Initial measurement: cost including transaction


costs

Subsequently choose and apply to all investment


property:

Cost model Fair value model


Ÿ Measured at depreciated cost Ÿ Measured to fair value at
less impairment losses (as reporting date
HKAS 16) Ÿ Changes in fair value
recognised in profit or loss

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Financial Reporting

Answer to self-test question

Answer 1
1 Tennant House
 Held for its investment potential and not for use by Propex
 Treat as investment property in accordance with HKAS 40
 Rental income to profit or loss
 If following fair value model – revalue to market value of $175,000. The difference of
$25,000 credited to profit or loss
 If following cost model – depreciate based on cost and do not revalue. Depreciation for
current period is $3,000 and net book value is $135,000 (150,000 – (5  3,000))
 Need to be consistent and use either fair value or cost model for all investment
properties.
2 Stowe Place
 Held for use by Propex
 Considered as owner-occupied property and accounted for in accordance with
HKAS 16
 Depreciate over useful life 75,000  2% = 1,500 per annum to profit or loss
 Carrying value of $75,000 – ($1,500  10) = 60,000 to be shown in statement of
financial position.
3 Crocket Square
 Not yet complete so accounting treatment relates to the cost incurred to date
 Propex is constructing the property to let out to another company, Speedex. During
construction, and after completion, the property is therefore within the scope of
HKAS 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 insignificant to the arrangement as a whole. Therefore, Propex should treat
Smith Tower as an investment property and apply the provisions of HKAS 40.

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Exam practice

Cliff Land Limited 27 minutes


Cliff Land Limited (CLL) owns the following three buildings in Hong Kong:

Building A Building B Building C

Usage Warehouse Director's quarter Earning rental


income
Date of acquisition 1 January 20X0 1 January 20W8 1 January 20X5
Cost of the building $20 million $36 million $18 million
Fair value of the $28 million $22 million $22 million
building at 31 December
20X7

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)

135
Financial Reporting

136
chapter 7

Government grants

Topic list

1 HKAS 20 Government Grants


1.1 Scope
1.2 Definitions
1.3 Government grants
1.4 Excluded government assistance
1.5 Disclosure
1.6 HK(SIC) Int-10 Government Assistance – no specific relation to operating activities

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

In this chapter you will cover the following 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

1 HKAS 20 Government Grants


Topic highlights
In many countries entities may receive government grants for various purposes (grants may be
called subsidies, premiums, or given other titles). They may also receive other types of assistance
which may be in many forms. The treatment of government grants is covered by HKAS 20
Accounting for Government Grants and Disclosure of Government Assistance.

HKAS 20.2 1.1 Scope


HKAS 20 does not cover the following situations:
(a) Accounting for government grants in financial statements reflecting the effects of changing
prices
(b) Government assistance given in the form of "tax breaks"
(c) The government acting as part-owner of the entity
(d) Government grants covered by HKAS 41 Agriculture

HKAS 20.3-5 1.2 Definitions


These definitions are provided in the standard.

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.

HKAS 20.12- 1.3.1 Accounting treatment of government grants


22
There are two methods which could be used to account for government grants, and the arguments
for each are given in HKAS 20.
(a) Capital approach: the grant is recognised outside profit or loss.
(b) Income approach: the grant is recognised in profit or loss over one or more periods.

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.

HKAS 20.23 1.3.2 Non-monetary government grants


When a non-monetary asset, such as a piece of land or other resources, is given by the
government to an entity as a grant, the fair value of the asset is assessed and used to account for
both the asset and the grant. On the other hand, both may be recorded at a nominal value.

HKAS 20.24- 1.3.3 Presentation of grants related to assets


28
Two choices are available for disclosing government grants related to assets (including non-
monetary grants at fair value) in the statement of financial position:
(a) Deduct the grant in arriving at the carrying amount of the asset.
(b) Set up the grant as deferred income.
The two alternatives are considered as equally acceptable and an example for both is shown
below.

Example: Accounting for grants related to assets


In the year ended 31 December 20X8, Tiger-Lily Co. receives a grant of $100,000 towards the cost
of a new freehold property in a development zone. The cost of the property is $700,000, and the
purchase was completed on 30 June 20X8. The property is to be depreciated at an annual rate of
2% on cost.
Illustrate how the grant will affect the financial statements of Tiger-Lily for the years ended
31 December 20X8, 20X9 and 20Y0 assuming profits before depreciation in those years of
$250,000, $280,000 and $315,000.

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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

STATEMENT OF FINANCIAL POSITION AT YEAR END (EXTRACT)


$ $ $
Non-current asset at cost 700,000 700,000 700,000
Depreciation (14,000) (28,000) (42,000)
Carrying amount 686,000 672,000 658,000
Deferred income
Government grant
deferred income 98,000 96,000 94,000

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.
HKAS 20.32- 1.3.5 Repayment of government grants
33
If a grant must be repaid it should be accounted for as a change in an accounting estimate.
In other words, the revision is accounted for prospectively. HKAS 8 requires that the nature and
amount of such a change in an accounting estimate is disclosed.
(a) Repayment of a grant related to income: apply first against any unamortised deferred income
set up in respect of the grant; any excess should be recognised immediately as an expense.
(b) Repayment of a grant related to an asset: increase the carrying amount of the asset or
reduce the deferred income balance by the amount repayable. The cumulative additional
depreciation that would have been recognised to date in the absence of the grant should be
immediately recognised as an expense.
The circumstances relating to repayment may entail a reassessment of the asset value and an
impairment of the new carrying amount of the asset.
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.

HKAS 20.39 1.5 Disclosure


Disclosure is required of the following:
(a) Accounting policy adopted, including method of presentation.
(b) Nature and extent of government grants recognised and other forms of assistance received.
(c) Unfulfilled conditions and other contingencies attached to recognised government
assistance.

1.6 HK(SIC) Int-10 Government Assistance – no specific relation


to operating activities
The aim of government assistance to entities in some countries is to encourage entities or to
provide long-term support of business activities either in certain regions or industry sectors.
Conditions to receive assistance may have no particular relationship with the operating activities of
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

HKAS 20 Government Grants

Government Grants Government Assistance

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
incomefor comprising:
compliance comprehensive
1. Government income
assistance
comprising:
without
withŸ certain
Post conditions.
tax profit or loss of the Ÿ Post
valuetax
e.g.
profit or loss of the
discontinued operations and Ÿdiscontinued operations
Free technical adviceand
Ÿ Post tax gain or loss on
Includes: Ÿ Post
Ÿ tax gain or
Provision of loss on
guarantees
Ÿ forgivable
disposal/measurement
loans to fair disposal/measurement to fair
Ÿ below value less interest
market costs to loans
sell. 2. Transactions
value less costs
withtogovernment
sell.
Ÿ non-monetary assets (grant = fair value of that cannot be distinguished
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:
Ÿ the
1. Postentity
tax profit or loss with
will comply of the
conditions
discontinued
attached to theoperations
grant and
Ÿ Post tax gain or loss on
disposal/measurement
2. the entity will receive the to fair
value less costs to sell.
grant.

Grants related to assets


1. Deduct from carrying amount of
asset, or
2. Set up deferred income account.

Presentation

Grants related to income


1. Deduct from related expense, or
2. Present as separate credit.

Grants related to assets


1. Increase carrying amount of asset or
reduce deferred income
balance
2. Recognise cumulative
additional depreciation as expense.
Repayment is accounted for as a change
in accounting estimate

Grants related to income


1. Reduce any unamortised
deferred income balance
2. Recognise excess as expense.
Disclose
Disclosuresingle amount in statement of
Ÿcomprehensive income comprising:
Accounting policy
Ÿ Postand
Ÿ Nature taxextent
profit or
of loss of the
grants recognised
anddiscontinued operations
other assistance receivedand
Ÿ Post tax
Ÿ Unfulfilled gain or loss
conditions andon
other
disposal/measurement to fair
contingencies.
value less costs to sell.

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7: Government grants | Part C Accounting for business transactions

Answers to self-test questions

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 Cash 100,000
To record the asset at its cost
DEBIT Cash 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

DEBIT Deferred income ($20,000 / 5 years) 4,000


CREDIT Operating expenses 4,000
The release of the deferred income is matched to the depreciation expense, so the net effect is an
expense of $16,000 relating to the asset.

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Financial Reporting

Exam practice

PMT and WY 9 minutes


Peak Medical Technology Corporation ("PMT") conducts research and product development for an
anaesthetic injection under contract with WY Corporation ("WY"), a pharmaceutical company. The
research and development contract requires that WY pays PMT an up-front amount of $1.5 million
when the contract is signed, $2 million upon the successful completion of clinical trials, and
$1.5 million upon the delivery of the first pilot unit of the injection. All payments are non-refundable.
The total cost of completion of the project is estimated to be $3 million.
PMT has invested $25 million in equipment for its research and development centre, which has an
anticipated useful life of eight years. Depreciation is charged on a straight-line basis. In the period
of acquisition, PMT received a government grant of $10 million towards purchase of the equipment,
which is conditional on certain employment targets being achieved within the next four years.
Required
Determine how PMT should recognise and measure the government grant by reference to the
relevant accounting standards. (5 marks)
HKICPA May 2007 (amended)

146
chapter 8

Intangible assets and


impairment of assets
Topic list

1 HKAS 38 Intangible Assets 4 HKAS 36 Impairment of Assets


1.1 The objectives of the standard 4.1 Introduction
1.2 The scope of the standard 4.2 Scope
1.3 Definition of an intangible asset 4.3 Definitions
1.4 Recognition of an intangible asset 4.4 Identification of a possible impairment
1.5 Initial measurement of an intangible asset 4.5 Impairment test
1.6 Subsequent measurement of an intangible 4.6 Recognition and measurement of an
asset impairment loss
4.7 Subsequent accounting for an impaired
2 Research and development costs
asset
2.1 Definitions
4.8 Cash generating units
2.2 Recognition
4.9 Goodwill and impairment
2.3 Initial measurement
4.10 Corporate assets
2.4 Recognition of an expense
4.11 Allocating an impairment loss to the assets
2.5 Measurement of intangible assets
of a cash generating unit
subsequent to initial recognition
4.12 Reversal of an impairment loss
2.6 Amortisation of intangible assets
4.13 Disclosure
2.7 Disposals/retirements of intangible assets
4.14 Current developments
2.8 Disclosure requirements
4.15 Section summary
2.9 HK(SIC) Int-32 Intangible Assets –
Website Costs
2.10 Current developments
2.11 Section summary
3 Goodwill (HKFRS 3 (revised))
3.1 What is goodwill?
3.2 Purchased goodwill
3.3 HKFRS 3 (revised) Business Combinations

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.

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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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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1 HKAS 38 Intangible Assets


Topic highlights
Intangible assets are defined by HKAS 38 as non-monetary assets without physical substance.
They must be:
 identifiable.
 controlled as a result of a past event.
 able to provide future economic benefits.

HKAS 38 Intangible Assets was issued in August 2004 and revised in May 2009 to reflect changes
introduced by HKFRS 3 (revised) Business Combinations.

1.1 The objectives of the standard


(a) To establish the criteria for when an intangible asset may or should be recognised.
(b) To specify how intangible assets should be measured.
(c) To specify the disclosure requirements for intangible assets.

HKAS 38.2,3 1.2 The scope of the standard


HKAS 38 applies to all intangible assets with the following exceptions:
 Financial assets (HKAS 32)
 The recognition and measurement of exploration and evaluation assets (HKFRS 6)
 The development and extraction of minerals, oils, gas and other non-regenerative resources
(HKFRS 6)
 Intangible assets held for sale in the ordinary course of business (HKAS 2 and HKAS 11)
 Deferred tax assets (HKAS 12)
 Leases within the scope of HKAS 17
 Assets arising from employee benefits (HKAS 19)
 Goodwill acquired in a business combination (HKFRS 3 (revised))
 The recognition and measurement of insurance contracts (HKFRS 4)
 Intangible assets within the scope of HKFRS 5 Non-current Assets Held for Sale and
Discontinued Operations

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, and
(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.

HKAS 38.17 1.3.3 Expected future economic benefits


An item can only be recognised as an intangible asset if economic benefits are expected to flow in
the future from ownership of the asset.

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Future economic benefits may include:


 revenue from the sale of products or services
 cost savings
 other benefits resulting from the use of an asset by an entity
Again, this element of the definition is easily applied to purchase intangible assets, such as patents
or copyrights allowing production of items to sell. It may be more difficult to apply to expenditure on
internally generated items such as research and development projects, as the success of such a
project may be hard to gauge. For this reason, HKAS 38 considers research and development in
more detail and this is covered in section 2 of this chapter.

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.

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.

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Financial Reporting

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.

HKAS
38.72,74,75
1.6 Subsequent measurement of an intangible asset
After recognition, an entity may choose to apply either the cost model or revaluation model.
Intangible assets are therefore carried at either:
 cost less accumulated amortisation less accumulated impairment losses, or
 fair value at date of revaluation less subsequent accumulated amortisation and subsequent
accumulated impairment losses.
The detailed rules with regard to revaluation and amortisation are considered in more detail later in
this chapter after the recognition rules and initial measurement rules for research and development
costs are discussed.

2 Research and development costs


HKAS
38.8,52
Topic highlights
Research costs are always recognised as an expense. Development costs must be recognised as
an asset if they meet certain criteria.

HKAS 38 requires that internally generated assets are classified into research and development
phases.

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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.

HKAS 38 provides examples of both research and development as follows.

HKAS 38.56 2.1.1 Examples of research costs


(a) Activities aimed at obtaining new knowledge
(b) The search for, evaluation and final selection of, applications of research findings or other
knowledge
(c) The search for alternatives for materials, devices, products, processes, systems or services
(d) The formulation, design, evaluation and final selection of possible alternatives for new or
improved materials, devices, products, systems or services
HKAS 38.59 2.1.2 Examples of development activities
(a) The design, construction and testing of pre-production or pre-use prototypes
(b) The design of tools, jigs, moulds and dies involving new technology
(c) The design, construction and operation of a pilot plant on a scale which is not feasible for
commercial production
(d) The design, construction and testing of a chosen alternative for new or improved materials,
devices, products, processes, systems or services

HKAS 38.53 2.2 Recognition


Although it defines the terms research and development, HKAS 38 provides the accounting
treatment for the "research phase" and "development phase" of a project. If an entity cannot
distinguish between these phases, the standard requires that costs are treated as if incurred in the
research phase only.
HKAS 38.55 2.2.1 Research phase
Research activities, which are carried out at the research stage of a project, do not meet the
recognition criteria under HKAS 38. It is uncertain that future economic benefits will flow to the
entity from the project at the research stage of a project and there is too much doubt about the
likely success or otherwise of the project.
Research costs should therefore be written off as an expense as they are incurred.
HKAS 38.57 2.2.2 Development phase
Development costs must be recognised as intangible assets when the following strict criteria can
be demonstrated:
(a) The technical feasibility of completing the intangible asset so that it will be available for use
or sale.
(b) Its intention to complete the intangible asset and use or sell it.
(c) Its ability to use or sell the intangible asset.

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Financial Reporting

(d) How the intangible asset will generate probable future economic benefits. Among other
things, the entity should demonstrate the existence of a market for the output of the
intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of
the intangible asset.
(e) Its ability to measure the expenditure attributable to the intangible asset during its
development reliably.
When these criteria are not met, development costs should be written off as an expense as incurred.

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 1
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)

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

Intangible acquired Internally generated


Separately as part of business intangible –
purchased intangible combination development

Recognise as an  Meets definition of  Meets definition of  Technically feasible


asset if: intangible asset intangible asset  Intention to complete
 Probable economic  Probable economic  Commercially viable
benefits benefits
 Probable economic
 Cost reliably  Fair value reliably benefits
measured measured
 Resources available
to complete
 Expenditure reliably
measured

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Intangible acquired Internally generated


Separately as part of business intangible –
purchased intangible combination development

Initially Cost + directly Fair value at date of Directly attributable costs


measured at: attributable costs in acquisition from date when criteria
preparing asset for use first met

HKAS 38.68– 2.4 Recognition of an expense


70
Expenditure on an intangible should be expensed as incurred when it does not meet the criteria
for recognition either as an identifiable intangible asset or as goodwill arising on an acquisition.
Examples of such expenditure are stated in the HKAS:
 Start up costs, i.e. costs of establishing a new business
 Training costs
 Advertising and promotional costs
 Business relocation or reorganisation costs
Prepaid costs for services, for example advertising or marketing costs for campaigns that have
been prepared but not yet launched, can still be recognised as a prepayment.
HKAS 38 2.4.1 Advertising and promotional activities
BC46A-46H
There is often confusion as to whether the costs of advertising and promotional activities qualify as
an intangible asset. HKAS 38 has been amended to clarify that for advertising and promotional
activities:
(a) In the case of goods, an expense is recognised when the entity has the right to access those
goods.
(b) In the case of services, an expense is recognised when the entity receives those services.
(c) A right to access goods is received by the entity when the supplier has made them available
to the entity.
(d) The contract terms for the supply of goods or services determine when an expense should
be recognised.
(e) A prepayment can be recognised as an asset when payment has been made in advance of
the entity obtaining the right to access the goods or receiving the services.
The amendment clarifies that catalogues are considered to be a form of advertising and
promotional activity. Expenses incurred in printing mail order catalogues are recognised once the
catalogues are printed and not when they are distributed to customers.

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.

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Financial Reporting

(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.
(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; and
(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 2
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,

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instead it should be transferred from revaluation surplus directly to retained earnings and disclosed
in the statement of changes in equity.

2.6 Amortisation of intangible assets


Topic highlights
Capitalised intangible assets are amortised over their expected useful life. Where this is indefinite,
an annual impairment test replaces amortisation.

HKAS 2.6.1 Useful life


38.88,90,94
An intangible asset may have a finite or indefinite useful life. An indefinite useful life, in this
sense, means that there is no foreseeable limit to the period over which the asset is expected to
generate net cash inflows for the entity.
The useful life of an intangible asset is affected by many factors, including: technical, technological,
commercial or other types of obsolescence; expected usage; life cycles of typical product; the level
of maintenance expenditure required; the stability of the industry; expected actions by competitors;
and legal or similar restrictions on the use of the asset, such as the expiry dates of related leases.
Intangible assets which are susceptible to technological obsolescence, such as computer software,
normally have short lives. However, uncertainty does not justify the choice of a life that is
unrealistically short.
The useful life of an intangible asset may originate from contractual or other legal rights. It
should not exceed the period of the rights, though it may be shorter depending on the duration in
which the asset is to be used by the entity.
HKAS 38.100 2.6.2 Residual value
The residual value of an intangible asset with a finite useful life is assumed to be zero. This is not
the case when a third party has a commitment to buying the intangible asset at the end of its useful
life or when an active market exists for that type of asset (so that its expected residual value can be
measured) and it is likely that there will be a market for the asset at the end of its useful life.

HKAS 38.97, 2.6.3 Amortisation period


104
An intangible asset with a finite useful life is amortised over its expected useful life, starting when
the asset is available for use.
Amortisation should cease at the earlier of the date that the asset is classified as held for sale in
accordance with HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations and the
date that the asset is derecognised.
Annual review of the amortisation period of an intangible asset with finite useful life should be
carried out at the end of each financial year.

HKAS 2.6.4 Amortisation method


38.98,104
The amortisation method used should reflect the pattern in which the asset's future economic
benefits are consumed. If such a pattern cannot be predicted reliably, the straight line method
should be used.
HKAS 38 has been amended to remove wording perceived as prohibiting the use of the unit of
production method if it results in a lower amount of accumulated amortisation than under the
straight line method. Entities may use the unit of production method when the resulting
amortisation charge reflects the expected pattern of consumption of the expected future economic
benefits embodied in an intangible asset.
The amortisation method used for an intangible asset with a finite useful life should be reviewed at
each financial year end.

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Financial Reporting

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.
HKAS 2.6.6 Intangible assets with indefinite useful lives
38.107-109
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 3
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)

Example: Computer software and hardware


The treatments can be illustrated by reference to computer software and hardware. The treatment
depends on the nature of the asset and its origin.

Asset Origin Treatment

Computer software Purchased Capitalise


Operating system for Purchased Include in hardware cost
hardware
Computer software Charge to expense until "Development criteria"
Operating system for Internally are met. Amortise over useful life, based on
hardware developed pattern of benefits (straight line is default)
(For use or sale)

HKAS 2.7 Disposals/retirements of intangible assets


38.112-113
An intangible asset should be derecognised from the statement of financial position when it is
disposed of or when there is no further expected economic benefit from its future use. On disposal
the gain or loss arising from the difference between the net disposal proceeds and the
carrying amount of the asset should be taken to profit or loss as a gain or loss on disposal
(i.e. treated as income or expense).
For example, if a fishing licence with a carrying amount of $2m is sold for $3m, then the licence is
derecognised from the statement of financial position and $1m profit on disposal is taken to profit.

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.

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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.
(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.

2.9 HK(SIC) Int-32 Intangible Assets – Website Costs


Websites are being used for business purposes to a large extent, including taking orders for
products or services; promotion and advertising of products and services; and trading access to
information contained on the website.
Many companies incur significant costs in developing such websites, and these may include the
following:
(a) Planning costs – including, for example, the costs of undertaking feasibility studies,
determining the objectives and functionalities of the website, exploring ways of achieving the
desired functionalities, identifying appropriate hardware and web applications and selecting
suppliers and consultants.
(b) Application and infrastructure development costs – including the costs of obtaining and
registering a domain name and of buying or developing hardware and operating software
that relate to the functionality of the site (for example, updateable content management

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systems and e-commerce systems, including encryption software, and interfaces with other
IT systems used by the entity).
(c) Content costs – expenditure incurred on preparing, accumulating and posting the website
content.
(d) Operating costs.
The issue arises as to how these costs should be treated within the financial statements.
2.9.1 HK(SIC) Int-32 treatment
HK(SIC) Int-32 resolves that a website developed by an entity and funded by internal expenditure
is viewed as an internally generated intangible asset that is subject to the requirements of HKAS 38
Intangible Assets. This is the case whether the website is for internal or external access.
Specifically, the treatment is as follows:
(a) Website planning costs are an expense charged to profit or loss.
(b) Application and infrastructure development costs. Expenditure which can be directly
attributed, or allocated on a reasonable and consistent basis, to preparing the website for its
intended use is to be included in the cost of the website and recognised as an intangible
asset. Examples include expenditure on purchasing or creating content (other than content
for marketing an entity's own products and services) solely for a website, and expenditure to
enable use of the content (such as acquisition fee of a licence to reproduce) on the website.
These expenditures should be included in the cost of development when the condition is
met. However, HKAS 38 does not allow the recognition of an expenditure as part of the cost
of an intangible asset at a later date if the expenditure was initially recognised as an expense
in previous financial statements (for instance, when the content of a fully amortised copyright
is subsequently provided on a website).
(c) Content development. According to HKAS 38, expenditure incurred in the content
development stage to advertise and promote an entity's own products and services (such as
digital photographs of products) should be recognised as an expense when incurred. For
example, expenditure on professional services for taking digital photographs of an entity's
products and for enhancing their display should be recorded as an expense when the
professional services are received, not when the digital photographs are displayed on the
website.
(d) Operating. The operating stage commences when the development of a website is
complete. Unless expenditure meets the criteria in HKAS 38, it should be recognised as an
expense when it is incurred.
A website which is recognised as an intangible asset under HK(SIC) Int-32 should be measured
after initial recognition by applying the requirements as stated in HKAS 38. The useful life of a
website is best estimated to be short.

2.10 Current developments


The IASB proposed amendments to IAS 38 in December 2012. As HKAS 38 is converged with IAS
38, these will also affect HKAS 38. The amendments would clarify that amortisation methods must
reflect a pattern of consumption of economic benefits from an asset rather than a pattern of
generation of economic benefits by an asset. Therefore a revenue-based method of amortisation
is not allowed.
A revenue-based method of amortisation is a method whereby the amortisation charge in a given
year is calculated based on the revenue earned in that year as a proportion of total revenues
expected to be generated by the asset over its useful life.
Comments on the Exposure Draft are due by 2 April 2013. Finalised amendments are expected in
the fourth quarter of 2013.

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2.11 Section summary


 An intangible asset should be recognised only on the condition that it is probable that future
economic benefits will flow to the entity and the cost of the asset can be measured reliably.
 An asset is initially recorded at cost but carried either at cost or revalued amount in
subsequent periods.
 Expense the costs as incurred if the recognition criteria are not met.
 Amortisation of an intangible asset with finite useful life should be spread over the useful life
of the asset. No amortisation should be recorded for an intangible asset with an indefinite
useful life.

Self-test question 4
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
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)

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3 Goodwill (HKFRS 3 (revised))


Topic highlights
Purchased goodwill arising on consolidation is retained in the statement of financial position as an
intangible asset under HKFRS 3 (revised). It must then be reviewed annually for impairment under
HKAS 36.

Goodwill is a type of intangible asset, however as we have seen in the earlier sections of this
chapter, it does not fall within the scope of HKAS 38. Instead, HKFRS 3 applies, providing
guidance on the calculation and accounting treatment of goodwill.
The detailed calculation of goodwill, and accounting treatment is considered in more detail in the
chapters of the Learning Pack which cover group accounting. Here we introduce the concept of
goodwill and its treatment in the accounts.

3.1 What is goodwill?


Goodwill is created by good relationships between a business and its customers:
 through reputation for high quality products or standard or service
 through good customer service
 through the personality of staff members
The value of goodwill to a business might be considerable, however as we have already seen,
internally generated goodwill is not recognised in the statement of financial position.
This may seem odd, given its value to a business in generating future revenues, which may be far
more than many tangible assets, particularly in a service organisation, however there is good
reason for not recognising internally generated goodwill:
(a) Goodwill is inherent in the business but has not been paid for and it does not possess an
"objective" value. How much such goodwill is worth can be guessed, but the guesswork is a
matter of subjective opinion and is not based on concrete facts.
(b) Goodwill keeps changing from day to day. It might be damaged by one bad act of customer
relations and improved by a good one. Staff with a good personality might retire or leave the
entity and new staff need time to familiarise themselves with the job, and so on. Since the
value of goodwill is continually changing, it cannot practically be recorded in the accounts of
the business.

3.2 Purchased goodwill


Topic highlights
Purchased goodwill is shown in the statement of financial position because it has been paid for.
It has no tangible substance, and so it is an intangible non-current asset.

Whereas a business which builds up internally generated goodwill over time cannot objectively
value this goodwill, at such time as that business is sold, its goodwill becomes measurable. This is
because the price paid to purchase an existing business will generally exceed the sum of the
values of the individual assets within the business. The excess represents payment for the goodwill
of the business.
3.2.1 Measurement of purchased goodwill
When a business is sold, the selling price is likely to include a premium for goodwill.

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The calculation of this premium is not really a problem for accountants, who must simply record the
goodwill in the accounts of the new business. The value of the goodwill is a matter for the
purchaser and seller to agree upon in fixing the purchase/sale price. Two approaches may be
taken to this issue:
1 The selling price of the business is agreed by the seller and the buyer without specifically
considering the value of goodwill. The purchased goodwill will then be the excess of the
purchase consideration over the value of the identifiable net assets of the new business.
2 Negotiation is a major element in the computation of goodwill. There are various ways of
valuing goodwill and a majority of them are related to the profit record of the acquired
business.
It does not matter how goodwill is calculated, the amount recorded by the buyer will be the
difference between the purchase consideration and his own valuation of the net assets acquired.
If A values his net assets at $40,000, goodwill is agreed at $21,000 and B agrees to pay $61,000
for the business when the net assets are valued at only $38,000, then the goodwill recorded by B
will be $23,000 ($61,000 – $38,000).

3.3 HKFRS 3 (revised) Business Combinations


Topic highlights
Purchased goodwill is retained in the statement of financial position as an intangible asset under
the requirements of HKFRS 3 (revised). It must then be reviewed for impairment annually.

HKFRS 3 (revised) deals with the accounting treatment of goodwill obtained through a business
combination, in other words goodwill arising when one company (the parent) acquires a controlling
interest in another company (the subsidiary).
Various definitions for goodwill are possible. HKFRS 3 (revised) defines goodwill differently from
the traditional definition and places much emphasis on benefits, rather than the method of
computation.

Key term
Goodwill. Future economic benefits arising from assets that are not capable of being individually
identified and separately recognised. (HKFRS 3 (revised))

HKFRS 3.32 3.3.1 Accounting for goodwill arising in a business combination


Acquired goodwill is initially measured at cost and recognised as an asset in the accounts. Cost is
the excess of the purchase consideration over the fair value of the acquiree's identifiable assets,
liabilities and contingent liabilities.
After initial recognition, acquired goodwill is not amortised, but is then measured at cost less any
accumulated impairment losses. According to HKAS 36 Impairment of Assets, goodwill is to be
tested for impairment at least once a year.
3.3.2 Goodwill and non-controlling interests
Where the parent company acquires less than 100% of the equity shares in the subsidiary
company, another party will own some of the subsidiary. This party is referred to as the non-
controlling interest.
The revised HKFRS 3 considers the group as an economic entity. All providers of equity including
non-controlling interests are treated as shareholders in the group, even if they are not shareholders
in the parent.
Therefore, it may be necessary to recognise goodwill attributed to the non-controlling interest.

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We will have a discussion on this in a later chapter.


HKFRS 3.34- 3.3.3 Bargain purchase
36
A bargain purchase is sometimes referred to as negative goodwill. It arises when the value of the
combination is less than the net of the acquisition-date amounts of the identifiable assets acquired
and the liabilities assumed. This may occur where there is a forced sale, or the purchased
company is loss-making. Alternatively, it may be the result of the application of recognition and
measurement rules within HKFRS 3 (revised).
Prior to the recognition of a gain on a bargain purchase, the acquirer must carry out a
reassessment to see whether it has correctly identified all of the assets acquired and all of the
liabilities assumed. The acquirer must recognise any additional assets or liabilities that are
identified in that review and must review the procedures used to measure the amounts this HKFRS
requires to be recognised at the date of acquisition for all of the following:
(a) The identifiable assets acquired and liabilities assumed.
(b) The non-controlling (formerly minority) interest in the accquiree, if any.
(c) For a business combination achieved in stages, the acquirer's previously held interest in the
acquiree.
(d) The consideration transferred.
The purpose of this review is to ensure that the measurements appropriately reflect all the available
information as at the acquisition date.

Self-test question 5
What are the characteristics of goodwill which separate it from other types of intangible assets?
Should these differing characteristics affect the accounting treatment of goodwill?
State your reasons.
(The answer is at the end of the chapter)

4 HKAS 36 Impairment of Assets


Topic highlights
HKAS 36 Impairment of Assets covers the write down of assets where their carrying value exceeds
the recoverable amount.

4.1 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.

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HKAS 36.2 4.2 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
 Investment property measured at fair value
 Biological assets related to agricultural activity that are measured at fair value less costs to
sell
 Deferred acquisition costs and intangible assets arising from an insurer's contractual rights
under insurance contracts within the scope of HKFRS 4 Insurance Contracts
 Non-current assets held for sale, which are dealt with under HKFRS 5 Non-current Assets
Held for Sale and Discontinued Operations
Instead, the relevant standard's requirements for recognition and measurement of assets should be
applied.

HKAS 36.6 4.3 Definitions


HKAS 36 provides a number of definitions, including the following:

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)

HKAS 36.10 4.4 Identification of a possible impairment


An impairment test is required for all assets when there is an indication of impairment at the
reporting date. In addition, certain assets should be tested for impairment annually. They are:
 goodwill acquired in a business combination
 intangible assets with an indefinite useful life
 intangible assets which are not yet available for use.
Note that the concept of materiality applies, and only material impairment needs to be identified.
HKAS 36.12 4.4.1 Indications of impairment
The various ways in which the indications of a possible impairment of assets might be recognised
are suggested in HKAS 36. These suggestions are mostly based on common sense.

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(a) External sources of information


(i) A fall in the asset's market value that is more significant than would normally be
expected from passage of time over normal use.
(ii) A significant change in the technological, market, legal or economic environment of
the business in which the assets are employed.
(iii) An increase in market interest rates or market rates of return on investments likely to
affect the discount rate used in calculating value in use.
(iv) The carrying amount of the entity's net assets being more than its market
capitalisation.
(b) Internal sources of information
(i) Evidence is available of obsolescence or physical damage to an asset.
(ii) Significant changes with an adverse effect on the entity have taken place in the period
or are expected to in the near future with the result that the asset's expected use or
useful life will change.
(iii) Evidence is available that an asset is performing or will perform worse than expected.
(iv) Cash outflows to operate and maintain an asset are significantly higher than those
budgeted.
(v) Cash inflows from an asset are significantly lower than budgeted.

4.5 Impairment test


Topic highlights
Impairment is determined by comparing the carrying amount of the asset with its recoverable
amount.
The recoverable amount of an asset is the higher of the asset's fair value less costs to sell and
its value in use.

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 4.5.1 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.
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 4.5.2 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.

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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.
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, and
 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

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 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.

Example: Recoverable amount


An entity has a single manufacturing plant which has a carrying value of $749,000. A new
government elected in the country passes legislation significantly restricting exports of the product
produced by the plant. As a result, and for the foreseeable future, the entity's production will be cut
by 40%. Cash flow forecasts have been prepared derived from the most recent financial
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:
Year Future cash PV factor at Discounted
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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4.6 Recognition and measurement of an impairment loss


Topic highlights
Where the carrying amount exceeds the recoverable amount of an asset the difference should be
recognised as an impairment loss.
An impairment loss is recognised in profit or loss unless it reverses a previous upwards revaluation.

4.6.1 Measurement of an impairment loss


An impairment loss is measured as the excess of carrying amount over recoverable amount. When
impairment is identified, the impaired asset must be written down to its recoverable amount.
HKAS 36.59- 4.6.2 Recognition of an impairment loss
61
If the recoverable amount of an asset is less than its carrying amount in the statement of financial
position, an impairment loss has occurred. This loss should be recognised immediately.
(a) The asset's carrying amount should be reduced to its recoverable amount in the statement
of financial position.
(b) The impairment loss should be recognised immediately.
The recognition of an impairment loss depends on whether the asset in question is held at historic
cost or a revalued amount.
Where an asset is held at historic cost any impairment loss is recognised in profit or loss.
Where an asset is held at a revalued amount any impairment loss is recognised as follows:
(a) To the extent that there is a revaluation surplus held in respect of the asset, the impairment
loss should be charged to revaluation surplus.
(b) Any excess should be charged to profit or loss.

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4.6.3 Summary decision tree


The following decision tree will help to summarise the accounting steps seen so far:
Is there an indicator of An impairment test is not
potential impairment? required under HKAS 36
unless the asset is goodwill or
No an intangible asset with an
indefinite useful life or not yet
available for use.
Yes
An impairment test must be
performed by calculating the
fair value less costs to sell and
the value in use of the asset.
The higher of the two is
recoverable amount

Is the recoverable amount less No The asset is not impaired and


than the carrying amount of the should remain at carrying
asset? amount in the financial
statements
Yes
The asset is impaired and the
difference between the
carrying amount and
recoverable amount is the
impairment loss

Is the asset’s carrying amount No Debit the impairment loss to


based on cost? the revaluation reserve
Yes
Debit the impairment loss to
profit or loss

Example: Impairment loss


The accountant of Louella Co. has identified a machine which she believes to be impaired. The
machine cost $68,000 on 1 January 20X7 and was revalued to $75,000 on 31 December of that
year, resulting in a revaluation surplus of $10,400. The machine continued to be depreciated over
the remaining nine years of its ten-year life.
By 31 December 20X8, the development of new technology meant that the machine had fallen in
value such that its fair value less costs to sell was just $42,000. The accountant calculated a value
in use of $45,000.
What impairment loss should the accountant recognise and where should it be recorded?

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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.

HKAS
36.63,110,114,
4.7 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.
4.7.1 Reversal of impairment losses
In some cases, the recoverable amount of an asset that has previously been impaired might turn
out to be higher than the asset's current carrying value. An impairment loss recognised previously
for an asset should be reversed if, and only if, there has been a change in the estimates used to
determine the asset's recoverable amount since the last impairment loss was recognised.
(a) The reversal of the impairment loss should be recognised immediately as income in profit
or loss for the year.
(b) The carrying amount of the asset should be increased to its new recoverable amount.
The asset cannot be revalued to a carrying amount that is higher than its value would have been if
the asset had not been impaired originally, i.e. its depreciated carrying value had the impairment
not taken place. Depreciation of the asset should now be based on its new revalued amount, its
estimated residual value (if any) and its estimated remaining useful life.

HKAS
36.6,66
4.8 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.

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Financial Reporting

Key term
A cash generating unit is the smallest identifiable group of assets for which independent cash
flows can be identified and measured.

HKAS 4.8.1 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.)

Self-test question 6
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 7
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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4.9 Goodwill and impairment


HKAS 4.9.1 Allocating goodwill to cash generating units
36.80,84
Acquired goodwill does not generate independent cash flows and has to be allocated to the cash
generating units (or groups of cash generating units) of the buyer. These units are expected to
benefit from the synergies of the combination and should:
(a) represent the lowest level within the entity at which the goodwill is monitored for internal
management purposes.
(b) not be larger than an operating segment as defined by HKFRS 8 Operating Segments
before aggregation.
Pragmatically, the allocation of goodwill may not be completed before the first reporting date after a
business combination, especially if the buyer uses provisional values to account for the
combination for the first time. The initial allocation of goodwill must be done before the end of the
first reporting period after the date of acquisition.
HKAS 36.88, 4.9.2 Testing cash generating units with goodwill for impairment
90
We have to consider the following two situations:
(a) where goodwill has been allocated to a cash generating unit.
(b) where goodwill has been allocated to a group of units because allocation to a specific cash
generating unit is impossible.
In the first instance, the annual impairment test is to be carried out on the cash generating unit to
which goodwill has been allocated. The carrying amount of the unit, including goodwill, is
compared with the recoverable amount. An impairment loss must be recognised when the
carrying amount of the unit is bigger than the recoverable amount.
In the second instance, where goodwill is not allocated to a CGU, the impairment test of that CGU
is carried out by comparing its carrying amount (excluding goodwill) with its recoverable
amount. An impairment loss must be recognised if the carrying amount is bigger than the
recoverable amount.
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.
4.9.3 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.

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Example: Non-controlling interest


On 1 January 20X9 a parent acquires a 75% interest in a subsidiary for $2,400,000, when the
identifiable net assets of the subsidiary are $1,800,000. The non-controlling interest is measured as
a proportion of the net assets of the subsidiary. The subsidiary is a cash generating unit.
At 31 December 20X9, the recoverable amount of the subsidiary is $1,400,000. The carrying
amount of the subsidiary's identifiable assets is $1,600,000.
Calculate the impairment loss at 31 December 20X9.

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

HKAS 4.10 Corporate assets


36.100,102
Corporate assets include group and divisional assets that do not generate cash inflows
independently from other assets and hence their carrying amount cannot be fully attributed to a
cash generating unit under review. Head office building, equipment or a research centre are
examples of corporate assets.
An entity should identify all the corporate assets that relate to a cash generating unit in an
impairment test of that unit.
(a) An entity compares the carrying amount of the unit (including the portion of the asset) with its
recoverable amount when a portion of the carrying amount of a corporate asset can be
allocated to the unit on a reasonable and consistent basis.
(b) If a portion of the carrying amount of a corporate asset cannot be reasonably and
consistently allocated to the unit, the entity:
(i) recognises the impairment loss by comparing the carrying amount of the unit
(excluding the asset) with its recoverable amount.
(ii) allocates a portion of the carrying amount of the asset on a reasonable and consistent
basis by identifying the smallest group of cash generating units that includes the cash
generating unit to which the asset belongs.
(iii) recognises the impairment loss by comparing the carrying amount of that group of
cash generating units (including the portion of the asset allocated to the group of units)
with the recoverable amount of the group of units.

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Example: Corporate assets


Rainbow has identified three CGUs within its business, and allocated assets to each as follows:
Carrying value of allocated assets
CGU 1 $640,000
CGU 2 $2,150,000
CGU 3 $1,300,000
Rainbow operates from a corporate campus with a carrying value of $2 million. This has not yet
been allocated to the CGUs, however it is considered that it can be allocated in full based on
carrying value.
The recoverable values of CGUs 1 to 3 are $980,000, $3,145,000 and $1,800,000 respectively.
What impairment losses (if any) have the CGUs suffered?

Solution
CV of assets HO allocation Total Recoverable Impairment
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

Head office allocation:


CGU 1 640/4,090  $2 million = $312,958
CGU 2 2,150/4,090  $2 million = $1,051,345
CGU 3 1,300/4,090  $2 million = $635,697

HKAS
36.104,105
4.11 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.

Example: Impairment loss (1)


On 31 December 20X1 Invest purchased all the shares of MH for $2 million. The net fair value of
the identifiable assets acquired and liabilities assumed of MH at that date was $1.8 million.

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Financial Reporting

MH made a loss in year ended 31 December 20X2 and at 31 December 20X2 the net assets of MH
– based on fair values at 1 January 20X2 – were as follows:
$'000
Property, plant and equipment 1,300
Capitalised development expenditure 200
Net current assets 250
1,750

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.

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

WORKINGS
1 Impairment loss
Carrying value 1,950
Recoverable amount 1,500
Impairment loss 450

Amount to allocate against goodwill 200


Amount to allocate pro-rata against other assets 250
2 Allocation of the impairment losses on pro-rata basis
Initial Impairment NBV if Reallocation Actual Impaired
value pro-rated fully loss value
allocated allocated

$'000 $'000 $'000 $'000 $'000 $'000


PPE (250  1,300 217 1,083 (37) 180 1,120
1,300/1,500)
Dev exp (250  200 33 167 37 70 130
200/1,500)
The amount not allocated to the PPE because they cannot be taken below their recoverable
amount is allocated to other remaining assets pro-rata, in this case all against the development
expenditure.

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Hence the development expenditure is reduced by a further 37 (217 – 180), making the total
impairment 70 (33 + 37).
The net current assets are not included when pro-rating the impairment loss as they are outside the
scope of HKAS 36.

Example: Impairment loss (2)


The Burgos Group is made up of two cash generating units (as a result of a combination of various
past 100% acquisitions), plus a head office, which was not allocated to any given cash generating
unit as it supports both divisions.
Due to falling sales as a result of an economic crisis, an impairment test was conducted at the year
end. The consolidated statement of financial position showed the following net assets at that date.
Division A Division B
Head Unallocated Total
office goodwill
$m $m $m $m $m
Property, plant & equipment (PPE) 780 620 90 - 1,490
Goodwill 60 30 - 10 100
Net current assets 180 110 20 - 310
1,020 760 110 10 1,900
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.

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Financial Reporting

Carrying values after impairment test:


Division Division Head Unallocated Total
A B office goodwill
$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

WORKINGS
1 Test of individual CGUs:
Division A Division B
$m $m
Carrying value 1,020 760
Recoverable amount (1,000) (720)
Impairment loss 20 40

Allocated to:
Goodwill 20 30
Other assets in the scope of HKAS 36 - 10
20 40

2 Test of group of CGUs:


$m
Revised carrying value (1,000 + 720 + 110 + 10) 1,840
Recoverable amount (1,825)
Impairment loss 15

Allocated to:
Unallocated goodwill 10
Other unallocated assets 5
15

HKAS
36.122,123, 4.12 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.

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Self-test question 8
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:
Goodwill Assets
$'000 $'000
Cost at 1 January 20X1 1,000 2,000

Depreciation – (167)

1,000 1,833

Impairment (1,000) (473)

CV at 31 December 20X1 – 1,360

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)

HKAS 4.13 Disclosure


36.126,130,
131 HKAS 36 calls for substantial disclosure about impairment of assets. The information to be
disclosed includes the following:
For each class of asset:
(a) The amount of impairment losses recognised in profit or loss in the period and the line item
in the statement of profit or loss and other comprehensive income where they are included.
(b) The amount of reversals of impairment losses recognised in the period and the line item in
the statement of profit or loss and other comprehensive income where they are included.
(c) The amount of impairment losses on revalued assets recognised in other comprehensive
income in the period.
(d) The amount of reversals of impairment losses on revalued assets recognised in other
comprehensive income in the period.
For each material impairment loss recognised or reversed during the period for an individual
asset, including goodwill, or a cash generating unit:
(a) The events and circumstances that led to the recognition or reversal of the impairment loss.
(b) The amount of the impairment loss recognised or reversed.
(c) For an individual asset:
– the nature of the asset
– if the entity reports segment information in accordance with HKFRS 8, the reportable
segment to which the asset belongs

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(d) For a cash generating unit:


– a description of the cash generating unit
– the amount of the impairment loss recognised or reversed by class of assets and
reportable segment (if HKFRS 8 applies)
– if the aggregation of assets for identifying the cash generating unit has changed, a
description of the old and new ways of aggregating assets and reasons for the change
(e) Whether the recoverable amount of the asset or cash generating unit is fair value less costs
to sell or value in use.
(f) If recoverable amount is fair value less costs to sell, the basis used to determine this
amount.
(g) If recoverable amount is value in use, the discount rates used in the current and previous
estimates.
For the aggregate impairment losses and the aggregate reversals of impairment losses
recognised during the period which are not material:
(a) The main classes of assets affected by impairment losses and reversals.
(b) The main events and circumstances that led to the recognition of these impairment losses
and reversals.

4.14 Current developments


The IASB issued an exposure draft in January 2013 which proposes to amend IAS 36 (and so
HKAS 36) to reduce disclosure requirements in relation to the recoverable amount of impaired
assets. The standard currently requires that the recoverable amount of CGUs which include
goodwill or intangibles with indefinite useful lives is disclosed when the carrying amount of the
goodwill or intangible assets with indefinite lives is significant in relation to the entity’s total goodwill
or intangibles with indefinite lives. The amendments will remove this requirement and instead
require that recoverable amount of an asset or CGU is disclosed only where there has been an
impairment loss or reversal in the period.

4.15 Section summary


The main aspects of HKAS 36 to consider are:
 indications of impairment of assets
 measuring recoverable amount, as net selling price or value in use
 measuring value in use
 cash generating units
 accounting treatment of an impairment loss, for individual assets and cash generating units
 reversal of an impairment loss

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Topic recap

HKAS 38 Intangible Assets

Ÿ Identifiable non-monetary asset without physical substance


Ÿ controlled by the entity as a result of a past event
Ÿ from which the entity expected future benefits to flow

Separately acquired Acquired in business Internally generated


combination

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

Recognise if: Recognise if: Recognise if:


1 probable future 1 probable future 1 technically feasible
economic economic 2 intend to complete
benefits will flow benefits will flow 3 commercially viable
2 cost can be 2 fair value can be 4 probable economic benefits
measured reliably measured reliably 5 resources available to
complete
6 expenditure reliably measured

Measure at cost + Measure at fair Measure at directly attributable costs


directly value at date of since date when recognition criteria
attributable costs. acquisition. met.

Subsequent measurement

Cost model or Revaluation model Amortisation

Cost less Revalued amount Ÿ Amortise over useful life


accumulated less subsequent Ÿ Residual value assumed to be nil
amortisation less amortisation less Ÿ Where useful life is indefinite an annual
accumulated subsequent impairment test replaces amortisation
impairment losses impairment losses

Only allowed where there is an active market i.e.


Ÿ items are homogenous
Ÿ willing buyers and sellers exist
Ÿ prices are public

Goodwill

Ÿ Internally generated goodwill is not recognised (HKAS 38)


Ÿ Purchased positive goodwill is recognised in the statement of financial position at cost less impairment losses
(HKFRS 3)
Ÿ A bargain purchase (negative goodwill) is reviewed and then recognised as a gain in profit or loss (HKFRS 3)

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HKAS 36 Impairment

Indicators of impairment Testing Accounting

External sources: Asset held at historic cost:


Ÿ Fall in market value Impairment test is Impairment loss recognised in
Ÿ Change in area of business required where there are profit or loss.
asset employed in indicators of impairment or
Ÿ Increase in interest rates annually for:
Ÿ Entity's net assets exceed Ÿ goodwill Asset held at revalued amount:
market capitalisation. Ÿ intangibles with an Impairment loss charged against
indefinite life revaluation reserve in respect of
Ÿ intangibles not yet the asset and then to profit or loss.
available for use
Internal sources
Ÿ Obsolescence/damage
CGU:
Ÿ Changes within entity
Impairment loss allocated to:
Ÿ Evidence of under-
1 goodwill in the CGU
performance of asset 2 all other assets in the
Ÿ Costs of maintaining asset
CGU within the scope of
higher than expected HKAS 36 on pro rata
Ÿ Cash generated by an asset
basis.
lower than expected. NB loss allocated to goodwill may
never be reversed.

Test cash generating unit where it is not possible to calculate


the recoverable amount of a single asset:
Ÿ allocate goodwill to CGUs benefiting from synergies of
combination
Ÿ allocate corporate assets to CGUs if possible
Ÿ adjustment may be required to carrying amount of goodwill
where there is a non-controlling interest.

Impairment loss
arises where

Carrying amount > Recoverable


amount

Higher of

Fair value less costs to Value in use


sell

Future cash flows expected


to be derived from asset
discounted to present value
using pre-tax rate.

Disclosure requirements:
Ÿ Impairment losses/reversals recognised in period on assets held at cost & assets at revalued amount
Ÿ Additional disclosures for material impairment losses/reversals

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Answers to self-test questions

Answer 1
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.

Answer 2
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.
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.

Answer 3
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 4
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.

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Financial Reporting

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.
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 5
Goodwill may be distinguished from other intangible non-current assets by reference to the
following characteristics.
(a) It is incapable of realisation separately from the business as a whole.
(b) Its value has no reliable or predictable relationship to any costs which may have been
incurred.
(c) Its value arises from various intangible factors such as skilled employees, effective
advertising or a strategic location. These indirect factors cannot be valued.

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(d) The value of goodwill may fluctuate widely according to internal and external circumstances
over relatively short periods of time.
(e) The assessment of the value of goodwill is highly subjective.
It could be argued that, because goodwill is so different from other intangible non-current assets it
does not make sense to account for it in the same way. Thus the capitalisation and amortisation
treatment would not be acceptable. Furthermore, because goodwill is so difficult to value, any
valuation may be misleading, and it is best eliminated from the statement of financial position
altogether. However, there are strong arguments for treating it like any other intangible non-current
asset. This issue remains controversial.

Answer 6
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 7
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 8
 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.
 The impairment of goodwill cannot be reversed.
 The impairment of assets can be reversed provided that the new carrying amount is not in
excess of the carrying amount had no impairment arisen ie $1.5 million ($1.833m  9/11
years).
 Therefore, a reversal of $388,000 ($1.5m – $1.112m) is recognised in profit or loss.

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Financial Reporting

Exam practice

York Marble Limited 32 minutes


York Marble Limited ("YM") has operated a tile manufacturing plant in the city centre for more than
15 years. Due to a recent change in government policy on environmental protection and city
development, YM was ordered to close the production plant by the end of September 20Y1 and
return the leasehold land to the government early at a consideration based on the market price of
land with a similar remaining lease term and location.
As at 31 May 20Y1, YM had the following assets related to the production plant:
$m
Buildings and infrastructure 23.8
Production equipment 48.0
Electricity generator 5.2
Land under operating lease up to 20Z4 13.0
Inventories – Raw materials 8.4
Inventories – Finished products 6.4
According to the original lease, YM is required to dismantle the buildings and infrastructure before
returning the bare land to the government. Previously, the company has recognised a provision for
the dismantling to be carried out by the end of the lease term of the land in the cost of these
assets. The carrying amount of the provision at 31 May 20Y1 is $1.5 million. Based on a quotation
from a contractor, it costs $3 million for this exercise to be carried out by September 20Y1.
All production equipment will be relocated to another manufacturing plant of YM 60 km away for
continuing usage. The relocation and installation costs are estimated to be $4 million. YM agreed
to sell the electricity generator to another company at $4 million. The relocation cost will be borne
by the buyer.
Although the final consideration of the leasehold land to be paid by the government has yet to be
determined, the government has indicated to YM that the amount would be not less than
$35 million.
YM will continue manufacturing until the end of August and it is expected that all the raw materials
will be consumed for the production of tiles and sold at a profit. Half of the finished products were
made to order with a gross profit of 20% and delivered to customers in early June 20Y1. The
remaining half is obsolete and old model items which could only be sold at 40% of the cost.
Required
Discuss the accounting treatment under Hong Kong Financial Reporting Standards that should be
adopted by YM for each individual asset as at 31 May 20Y1.
(18 marks)
HKICPA December 2011

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chapter 9

Leases

Topic list

1 HKAS 17 Leases 6 Interpretations relating to lease accounting


1.1 Scope of HKAS 17 6.1 HK(SIC) Int-27 Evaluating the Substance
1.2 Types of lease of Transactions in the Legal Form of a
1.3 Other definitions Lease
1.4 Section summary 6.2 HK(IFRIC) Int-4 Determining whether an
Arrangement contains a Lease
2 Lessee accounting 6.3 HK-Int 4 Lease – Definition of the Length
2.1 Operating leases of Lease Term in respect of Hong Kong
2.2 Finance leases Land Leases
2.3 Recap
7 Current developments
3 Lessor accounting
3.1 Operating leases
3.2 Finance leases
3.3 Manufacturer or dealer lessors
3.4 Lessors' disclosures for finance leases
4 Sale and leaseback transactions
5 Off-balance sheet finance explained
5.1 Reasons for off-balance sheet finance
5.2 The problem with off-balance sheet finance

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.

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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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

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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.

HKAS 17.2 1.1 Scope of HKAS 17


HKAS 17 is applied in accounting for all leases other than:
 leases to explore for or use minerals, oil, natural gas and similar resources
 licensing agreements for items such as films, video recordings, plays, manuscripts, patents
and copyrights.
The standard is not applied as the basis of measurement for:
 property held by lessee that is accounted for as an investment property
 investment property provided by lessors under operating leases
 biological assets held by lessees under finance leases
 biological assets provided by lessors under operating leases.

1.2 Types of lease


Topic highlights
There are two forms of lease: finance lease and operating lease.

In some cases, leasing can be considered to be a medium-term or long-term source of finance.


From the point of view of the lessee, therefore, leasing such an asset is very similar to
purchasing it using a loan. The lessee has all of the benefits and responsibilities of ownership
except for the capital allowances. These types of longer-term lease are known as finance leases.
Other leases are of a very different nature. For example, a businessman may decide to hire (lease)
a car for a week while his own is being repaired. A lease of this nature is for a short period of time
compared with the asset's useful life and the lessor will expect to lease it to many different lessees
during that life. Furthermore, the lessor rather than the lessee will be responsible for maintenance.
These types of lease are known as operating leases.
HKAS 17.4 1.2.1 Definitions
HKAS 17 Leases classifies leases as either finance leases or operating leases and requires that
different accounting treatment is applied for each.
In distinguishing between them, the standard gives the following definitions.

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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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HKAS 1.2.3 Classification of a lease


17.13,15A
Classification is made at the inception of the lease. Any revised agreement should be treated as
a new agreement over its term. In contrast, changes in estimates (e.g. of economic life or residual
value of the property) or changes in circumstances (e.g. default by the lessee) do not lead to a new
classification of a lease for accounting purposes.
Land and buildings
When a lease includes both land and building elements, an entity must consider each of these
elements in turn and classify them as finance or operating lease separately. With regard to the
land, the standard states that an important consideration is that land normally has an indefinite
economic life. This is likely to result in the land element being classified as an operating lease in
view of the low level of risks and rewards associated with the land which would have been
transferred to the lessee during the lease period.

HKAS 17.4 1.3 Other definitions


HKAS 17 gives a substantial number of definitions.

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
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.

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Financial Reporting

Key terms (cont'd)


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,
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)

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Some of these definitions are only of relevance when we look at lessor accounting in section 3.

1.4 Section summary


The following diagram should help you remember how to determine whether a lease is a finance
lease or an operating lease.

Is ownership transferred Yes


by the end of the lease term?

No

Does the lease contain a Yes


bargain purchase option?

No

Is the lease term for a Yes


major part of the asset's
useful life?
No

Is the present value of minimum


lease payments greater than Yes
or substantially equal to the
asset's fair value?
No

Operating lease Finance lease

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.

HKAS 17.33 2.1 Operating leases


As stated in HKAS 17, rentals under an operating lease should be charged as an expense over
the period of the lease on a straight line basis. This is so even if unequal lease payments are
made, unless another systematic and rational basis is justified by the circumstances.

Example: Operating lease


Flora Co. entered an operating lease agreement in order to obtain use of a photocopier for a period
of three years starting on 1 October 20X9. The terms of the lease stated that payment of $2,500

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Financial Reporting

should be made annually in arrears for each of the three years of the lease in addition to an initial
non-refundable deposit of $1,500.
What expense is recognised in Flora Co.'s financial statements for the year ended 31 December
20X9?

Solution
Total amount payable $1,500 + (3  $2,500) = $9,000
Annual expense $9,000/3 years = $3,000
Expense for y/e 31 Dec 20X9 $3,000  3/12 = $750

2.1.1 HK(SIC) Int-15 Operating Leases – Incentives


In negotiating a new or renewed operating lease, the lessor may provide incentives for the lessee
to enter into the agreement. Examples include an up-front cash payment to the lessee. The
question arises as to how incentives in an operating lease should be recognised in the financial
statements of both the lessee and the lessor.
HK(SIC) Int-15 provides that all incentives for the agreement of a new or renewed operating lease
should be recognised as an integral part of the net consideration agreed for the use of the leased
asset, irrespective of the incentive's nature or the form or the timing of payments.
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.

Example: Operating lease incentives


Fauna Co. enters into an operating lease agreement on 1 August 20X8 in order to obtain use of a
machine. The lease term is four years and $5,000 is payable annually in advance. As an incentive,
the lessor has agreed a reduction of 40% off the first year's rental payment.
What expense is recorded by Fauna Co. in the year ended 31 December 20X8 in respect of this
agreement?

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

HKAS 17.35 2.1.2 Lessees' disclosures for operating leases


Disclosures of the following, which are in addition to the requirements under HKFRS 7 (see
Chapter 18), are required:
 The total of future minimum lease payments under non-cancellable operating leases for
each of the following periods:
– Not later than one year
– Later than one year and not later than five years
– Later than five years.
 The total of future minimum sublease payments expected to be received under
non-cancellable subleases at the end of the reporting period.
 Lease and sublease payments recognised as an expense for the period, with separate
amounts for minimum lease payments, contingent rents, and sublease payments.

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 A general description of the lessee's significant leasing arrangements including, but not
limited to, the following:
– Basis on which contingent rent payments are determined
– Existence and terms of renewal or purchase options and escalation clauses
Restrictions imposed by lease arrangements, such as those concerning dividends, additional debt,
and further leasing.

2.2 Finance leases


From the lessee's point of view there are two main accounting problems:
(a) Whether the asset should be capitalised as if it had been purchased.
(b) How the lease charges should be allocated between different accounting periods.
HKAS 2.2.1 Accounting treatment
17.20,25,27,
28 HKAS 17 requires that a finance lease is accounted for as follows:
1 An asset and corresponding liability are recorded
At the inception of the lease an asset and corresponding liability are recorded at the lower of
the fair value of the leased asset and the present value of the minimum lease payments.
Note that HKAS 17 uses the term "fair value" in a way that differs from the definition of fair
value in HKFRS 13 Fair Value Measurement. Therefore, in respect of leases fair value
should be measured in accordance with HKAS 17 rather than HKFRS 13.
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.

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Financial Reporting

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.
Show the lease obligation working for each year of the lease and identify amounts to be recognised
in profit or loss in 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.
Annual lease
Balance of lease Interest payment at Balance of lease
Year at 1 Jan 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.

Example: Finance lease with deposit and payments in arrears


On 1 January 20X5 Jennifer Co. acquired a machine from Alice Co. under a finance lease. The
cash price of the machine was $7,710 while the minimum payments in the lease agreement totalled
$10,000. The agreement required the immediate payment of a $2,000 deposit with the balance
being settled in four equal annual instalments commencing on 31 December 20X5. The finance
charge of $2,290 represents interest of 15% per annum, calculated on the remaining balance of the
liability during each accounting period.
Required
Show the breakdown of each instalment between interest and capital, using the actuarial method.

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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).
Capital at Interest Capital at
Year 1 Jan 15% Instalment 31 Dec
$ $ $ $
20X5 5,710 856 2,000 4,566
20X6 4,566 685 2,000 3,251
20X7 3,251 488 2,000 1,739
20X8 1,739 261 2,000 –
2,290 8,000

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.
Solution
B/f Repayment C/f Interest at C/f
11%
$ $ $ $ $
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 ie it is based on the amount
owed throughout a period. Therefore, the table includes items in a different order to that seen
previously.

2.2.3 Finance leases with different payment schedules


In the examples above, all finance leases agreements have involved one annual payment. In some
cases, payments are required monthly or quarterly. Where this is the case, the working should be
drawn up as we have seen, with one row representing each payment period. Therefore, where
there are quarterly repayments, the table will include four rows for each accounting year:

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Financial Reporting

B/f Interest 7% Repayment C/f


31.3.X1 119,400 8,358 (20,000) 107,758
30.6.X1 107,758 7,543 (20,000) 95,301
30.9.X1 95,301 6,671 (20,000) 81,972
31.12.X1 81,972 5,738 (20,000) 67,710
28,310

Finance charge Year end liability

HKAS 17.31 2.2.4 Lessees' disclosure for finance leases


HKAS 17 states that it is not appropriate to show liabilities for leased assets as deductions from the
leased assets and therefore these amounts should not be netted off.
In addition, a distinction should be made between current and non-current lease liabilities, if the
entity makes this distinction for other liabilities.
HKAS 17 also requires substantial disclosures to be provided in the notes to the accounts (in
addition to those required by HKFRS 7: see Chapter 18), including the following:
(a) The net carrying amount at the end of the reporting period for each class of asset.
(b) A reconciliation between the total of minimum lease payments at the end of the reporting
period, and their present value. In addition, an entity should disclose the total of minimum
lease payments at the end of the reporting period, and their present value, for each of the
following periods:
(i) Not later than one year
(ii) Later than one year and not later than five years
(iii) Later than five years.
(c) Contingent rents recognised as an expense for the period.
(d) Total of future minimum sublease payments expected to be received under non-
cancellable subleases at the end of the reporting period.
(e) A general description of the lessee's significant leasing arrangements including, but not
limited to, the following:
(i) The basis on which contingent rent payments are determined
(ii) The existence and terms of renewal or purchase options and escalation clauses
(iii) Restrictions imposed by lease arrangements, such as those concerning dividends,
additional debt, and further leasing.

Example: Lessee disclosures


These disclosure requirements will be illustrated for Gordon Co. (the first example in section 2.2.2).
We will assume that Gordon Co. makes up its accounts to 31 December and uses the actuarial
method, as shown in the example above, to apportion finance charges.

Solution
The company's accounts for the first year of the lease, the year ended 31 December 20X0, would
include the information given below.

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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

Self-test question 1
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 financial statements 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)

2.2.5 Arguments against capitalisation


The main argument in favour of capitalisation of assets acquired under a finance lease is
substance over form. The substance of the arrangement is that the lessee owns the asset, since
the risks and rewards of ownership have transferred to them and they in effect pay for the asset by
way of a financing arrangement.
The main arguments against capitalisation are as follows:
(a) Legal position. The benefit of a lease to a lessee is an intangible asset, not the ownership
of the equipment. It may be misleading to users of accounts to capitalise the equipment
when a lease is legally quite different from a loan used to purchase the equipment.

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Capitalising leases also raises the question of whether other executory contracts should be
treated similarly, for example contracts of employment.
(b) Complexity. Many small businesses will find that they do not have the expertise necessary
for carrying out the calculations required for capitalisation.
(c) Subjectivity. To some extent, capitalisation is a somewhat arbitrary process and this may
lead to a lack of consistency between companies.
(d) Presentation. The impact of leasing can be more usefully described in the notes to financial
statements. These can be made readily comprehensible to users who may not understand
the underlying calculations.

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

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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.

HKAS 17.56 3.1.2 Lessors' disclosures for operating leases


The following should be disclosed (on top of HKFRS 7 requirements).
 For each class of asset, the gross carrying amount, the accumulated depreciation and
accumulated impairment losses at the end of the reporting period:
– Depreciation recognised in income for the period
– Impairment losses recognised in income for the period
– Impairment losses reversed in income for the period.
 The future minimum lease payments under non-cancellable operating leases in the
aggregate and for each of the following periods:
– Not later than one year
– Later than one year and not later than five years

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– Later than five years.


 Total contingent rents recognised in income.
 A general description of the lessor's leasing arrangements.

3.2 Finance leases


Some of the definitions listed in the Key terms in section 1 of this chapter are relevant to lessor
accounting and you should review them again.
 Unguaranteed residual value
 Gross investment in the lease
 Unearned finance income
 Net investment in the lease

HKAS 3.2.1 Accounting treatment


17.36,38-41
According to HKAS 17, the amount due from the lessee under a finance lease is to be shown as
a receivable, at an amount of the net investment in the lease, in the statement of financial
position of the lessor.
The finance income under a finance lease should be recognised so as to generate a constant
periodic rate of return on the lessor's outstanding net investment in each period. A reasonable
approximation may be made to arrive at the constant periodic rate of return.
The lease payments (excluding costs for services) for the accounting period should be applied
against the gross investment in the lease. This will result in reducing both the principal and the
unearned finance income.
Regular review should be carried out on the estimated unguaranteed residual values used to
calculate the lessor's gross investment in a lease. If there has been a reduction in the value, the
income allocation over the lease term must be revised. Immediate recognition is required for any
reduction in respect of amounts already accrued.
The initial amount of the finance lease receivable should include the initial direct costs incurred
by lessors (e.g. commissions, legal fees and other costs that are directly attributable to negotiating
and arranging a lease).

Example: Finance leases: lessor accounting


Hire Co. leased an asset to another company with effect from 1 January 20X8. The terms of the
lease were as follows:
 Lease term of eight years
 Rentals of $11,000 are payable in advance
 The interest rate implicit in the lease is 12.8%
The fair value of the asset on 1 January 20X8 was $59,500 and legal fees associated with the
lease amounting to $500 were payable by Hire Co. on this date.
What amounts are recognised in Hire Co.'s financial statements for the year ended 31 December
20X8 in respect of the lease?
Solution
The net investment in the lease is calculated as:
$
Amount due from lessee (fair value of the asset) 59,500
Direct costs 500
60,000

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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:
$
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.

HKAS 17.42- 3.3 Manufacturer or dealer lessors


46
In some instances, manufacturers lease out assets which they have made, rather than sell them.
Similarly, dealers acquire assets for resale but in some circumstances may instead lease these out
to third parties.
Unlike normal lessor companies which buy assets at their fair value and in leasing them out make a
profit only on the financing arrangements, these companies acquire the asset in the first place for
less than fair value:
 Manufacturers acquire the asset for cost
 Dealers generally acquire the asset at a discount
Therefore, the manufacturer or dealer makes two types of income:
1 A profit or loss (being the difference between the cost /reduced price and fair value), and
2 Interest from financing arrangements.
HKAS 17 therefore requires the following accounting treatment:
(a) The selling profit/loss is recognised in income for the period as if it was an outright sale.
For this purpose:
– revenue is the lower of the fair value of the asset or the present value of the minimum
lease payments calculated using a market rate of interest
– cost of sales is the cost (or carrying amount if different) of the asset less the present
value of any unguaranteed residual value.
(b) If interest rates are artificially low, the selling profit is restricted to that which would apply
had a commercial rate been applied.
(c) Costs incurred in connection with negotiating and arranging a lease are recognised as an
expense when the selling profit is recognised (at the start of the lease term).
HKAS 17.55 3.3.1 Manufacturers or dealers and operating leases
A lessor who is a manufacturer or dealer should not recognise any selling profit on entering into
an operating lease because it is not the equivalent of a sale. The manufacturer or dealer has
retained the assets with a view to using them to generate rental income.

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Financial Reporting

HKAS 17.47 3.4 Lessors' disclosures for finance leases


The following should be disclosed (in addition to the requirements of HKFRS 7):
(a) A reconciliation between the total gross investment in the lease at the end of the reporting
period, and the present value of minimum lease payments receivable at the end of the
reporting period. In addition, an entity should disclose the total gross investment in the lease
and the present value of minimum lease payments receivable at the end of the reporting
period, for each of the following periods:
(i) Not later than one year
(ii) Later than one year and not later than five years
(iii) Later than five years.
(b) Unearned finance income.
(c) The unguaranteed residual values accruing to the benefit of the lessor.
(d) The accumulated allowance for uncollectible minimum lease payments receivable.
(e) Contingent rents recognised in income in the period.
(f) A general description of the lessor's material leasing arrangements.

4 Sale and leaseback transactions


HKAS 17.58- In a sale and leaseback transaction, an asset is sold and then leased back by the same seller. The
65 lease payment and sale price are normally linked because they are part of the same package in the
negotiation. The type of lease involved determines the accounting treatment for the lessee and the
seller.
(a) In a sale and leaseback transaction which results in a finance lease, any apparent profit or
loss (that is, the difference between the sale price and the previous carrying amount) should
be deferred and amortised in the financial statements of the seller/lessee over the lease
term. It should not be recognised as income immediately since, in substance, there has
been no genuine sale.
(b) If the leaseback is an operating lease:
(i) Any profit or loss should be recognised immediately, provided it is clear that the
transaction is established at a fair value.
(ii) Where the sale price is below fair value, any profit or loss should be recognised
immediately except that if the apparent loss is compensated by future lease payments
at below market price it should to that extent be deferred and amortised over the
period for which the asset is expected to be used.
(iii) If the sale price is above fair value, the excess over fair value should be deferred
and amortised over the period over which the asset is expected to be used.
Immediate recognition of the loss (carrying value less fair value) is required where the fair value of
the asset at the time of the sale is less than the carrying amount in an operating lease.
A sale and leaseback should be accounted in the same way as other leases by the buyer or
lessor.
If the disclosure requirements of both the lessees and lessors are followed, it should result in
satisfactory disclosure of sale and leaseback transactions.

Example: Sale and finance leaseback


Osborne Co. owned an asset with a carrying amount of $840,000 on 1 March 20X8. On this date
Osborne Co. sold the asset to a bank for $1,320,000, being the present value of the minimum
lease payments, and then undertook to lease it back under a 40-year finance lease.

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The annual rental is $39,000 payable in advance.


End of reporting period for Osborne Co. is 28 February.
Required
How should the transaction be accounted for by Osborne Co.?

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

Example: Sale and operating leaseback


On 1 January 20X2 Cable Co. owned an asset with a carrying amount of $80,000. The fair value of
the asset on that date was $90,000.
In order to improve its liquidity position, Cable Co. has negotiated possible agreements to sell the
asset and lease it back under an operating lease for seven years. The financial controller is
currently assessing the four agreements.
The agreements are as follows:
Agreement 1 Sale for $90,000 with annual future lease payments at a market rate of $15,000
Agreement 2 Sale for $75,000 with annual future lease payments of $15,000
Agreement 3 Sale for $50,000 with annual future lease payments of $10,000
Agreement 4 Sale for $110,000 with annual future lease payments of $17,500
How would each of these agreements be accounted for in Cable Co.'s financial statements?

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.

5 Off-balance sheet finance explained


Topic highlights
HKAS 17 (revised) has closed many loopholes, but some still argue that it is open to
manipulation.

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.

5.1 Reasons for off-balance sheet finance


Off-balance sheet transactions may be entered into for a number of reasons, including the
following:
(a) In some countries, companies traditionally have a lower level of gearing than companies in
other countries. Off-balance sheet finance is used to keep gearing low, probably because of
the views of analysts and brokers.
(b) A company may need to keep its gearing down in order to stay within the terms of loan
covenants imposed by lenders.
(c) A listed company with high borrowings is often expected (by analysts and others) to declare
a rights issue in order to reduce gearing. This has an adverse effect on a company's share
price and so off-balance sheet financing is used to reduce gearing and the expectation of a
rights issue.
(d) Analysts' short-term views are a problem for companies developing assets which are not
producing income during the development stage. Such companies will match the borrowings
associated with such developing assets, along with the assets themselves, off-balance
sheet. They are brought back into the statement of financial position once income is being
generated by the assets. This process keeps return on capital employed higher than it would
have been during the development stage.
(e) In the past, groups of companies have excluded subsidiaries from consolidation in an off-
balance sheet transaction because they carry out completely different types of business and
have different characteristics. The usual example is a leasing company (in say a retail group)
which has a high level of gearing. This exclusion is now disallowed.
You can see from this brief list of reasons that the overriding motivation is to avoid
misinterpretation.
In other words, the company does not trust the analysts or other users to understand the reasons
for a transaction and so avoids any effect such transactions might have by taking them off-balance

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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.

5.2 The problem with off-balance sheet finance


Due to increasingly sophisticated off-balance sheet finance transactions, the users of financial
statements do not always have a proper or clear view of the state of the company's affairs. The
disclosures required by national company law and accounting standards did not in the past provide
sufficient rules for disclosure of off-balance sheet finance transactions and so very little of the true
nature of the transaction was exposed.
Whatever the purpose of such transactions, insufficient disclosure creates a problem. This
problem has been debated over the years by the accountancy profession and other interested
parties and some progress has been made (see the later sections of this chapter). However,
company collapses during recessions have often revealed much higher borrowings than originally
thought, because part of the borrowing was off-balance sheet.
The main argument used for banning off-balance sheet finance is that the true substance of the
transactions should be shown, not merely the legal form, particularly when it is exacerbated by
poor disclosure.

6 Interpretations relating to lease accounting


6.1 HK(SIC) Int-27 Evaluating the Substance of Transactions in
the Legal Form of a Lease
HK(SIC) Int-27 addresses issues that may arise when an arrangement between an entity and an
investor involves the legal form of a lease. It contains the following provisions:
(a) Accounting for arrangements between an entity and an investor should reflect the substance
of the arrangement. All aspects of the arrangement should be evaluated to determine its
substance, with weight given to those aspects and implications that have an economic effect.
In this respect, HK(SIC) Int-27 includes a list of indicators that individually demonstrate that an
arrangement may not, in substance, involve a lease under HKAS 17 Leases:
(i) An entity retains all of the risks and rewards of ownership of an underlying asset and
enjoys substantially the same rights to its use as before the arrangement.
(ii) The primary reason for the arrangement is to achieve a particular tax result.
(iii) An option is included on terms that make its exercise almost certain.
These indicators are particularly relevant in the case of sale and leaseback transactions,
where the substance of the transaction may be a secured loan.
(b) If an arrangement does not meet the definition of a lease, and is therefore outside the
scope of HKAS 17, HK(SIC) Int-27 considers:
(i) whether a separate investment account and lease payment obligation that might exist
represent assets and liabilities of the entity.
(ii) how the entity should account for other obligations resulting from the arrangement.
(iii) how the entity should account for a fee it might receive from an investor.

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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.

6.2 HK(IFRIC) Int-4 Determining whether an Arrangement contains


a Lease
6.2.1 The issue
In recent years arrangements have developed that do not take the legal form of a lease but which
convey rights to use assets in return for a payment or series of payments. Examples of such
arrangements include the following:
(a) Outsourcing arrangements.
(b) Telecommunication contracts that provide rights to capacity.
(c) Take-or-pay and similar contracts, in which purchasers must make specified payments
regardless of whether they take delivery of the contracted products or services.
6.2.2 HK(IFRIC) Int-4 treatment
The Interpretation specifies that an arrangement that meets the following criteria is, or contains, a
lease that should be accounted for in accordance with HKAS 17 Leases:
(a) Fulfilment of the arrangement depends upon a specific asset. The asset need not be
explicitly identified by the contractual provisions of the arrangement. Rather, it may be
implicitly specified because it is not economically feasible or practical for the supplier to fulfil
the arrangement by providing use of alternative assets.
(b) The arrangement conveys a right to control the use of the underlying asset. This is the
case if any of the following conditions are met:
(i) The purchaser in the arrangement has the ability or right to operate the asset or
direct others to operate the asset (while obtaining more than an insignificant amount of
the output of the asset).
(ii) The purchaser has the ability or right to control physical access to the asset
(while obtaining more than an insignificant amount of the output of the asset).
(iii) There is only a remote possibility that parties other than the purchaser will take more
than an insignificant amount of the output of the asset and the price that the purchaser
will pay is neither fixed per unit of output nor equal to the current market price at the
time of delivery.

6.3 HK-Int 4 Lease – Determination of the Length of Lease Term in


respect of Hong Kong Land Leases
6.3.1 The issue
This Interpretation addresses the issue of how the length of the lease term of a Hong Kong land
lease should be determined for the purpose of applying the amortisation (depreciation)
requirements under HKAS 16 and HKAS 17, as appropriate.

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6.3.2 HK-Int 4 treatment


The lease term of a Hong Kong land lease for the purpose of applying the amortisation
(depreciation) requirements under HKAS 16 and HKAS 17, as appropriate, shall be determined by
reference to the legal form and status of the lease. Renewal of a lease is assumed only when the
lessee has a renewal option and it is reasonably certain at the inception of the lease that the lessee
will exercise the option. Options for extending the lease term that are not at the discretion of the
lessee shall not be taken into account by the lessee in determining the lease term.
Consequently, lessees shall not assume that the lease term of a Hong Kong land lease will be
extended for a further 50 years, or any other period, while the HKSAR Government retains the sole
discretion as to whether to renew. Any general intention to renew certain types of property leases
expressed by the HKSAR Government is not sufficient grounds for a lessee to include such
extensions in the determination of the lease term for amortisation (depreciation).
Similarly, for the leases in the New Territories expiring shortly before 30 June 2047, the legal limit
in these leases shall be assumed to be the maximum lease term.
For those leases which extend beyond 30 June 2047 (e.g. those with an original lease term of 999
years), lessees shall assume that any legal rights under the leases that extend the lease term to
beyond 30 June 2047 will be protected for the full duration of the lease in the absence of any
indication to the contrary.

7 Current developments
In August 2010, the IASB and American standards board, FASB, issued an Exposure Draft of a
new standard which is intended to replace IAS 17. It is highly likely that such a new standard will in
turn be adopted by the HKICPA and so replace HKAS 17.
The Exposure Draft proposes that there is no distinction between operating and finance leases,
and instead all leases are accounted for in the same way. A "right of use" approach is suggested
for both lessees and lessors; this would result in the recognition of a liability for payments and an
asset, being the right to use the underlying asset.
The IASB intends to re-expose the topic of leases during the course of 2013 and as yet there is no
target date for the issue of a new IFRS, and hence HKFRS.

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Financial Reporting

Topic recap

HKAS 17 Leases

Lease – contract for the hire of a specific


asset

Finance lease Operating lease

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

Lessee accounting Lessor accounting Lessee accounting Lessor accounting

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).

Sale and finance leaseback Sale and operating leaseback

Ÿ Profit or loss deferred and amortised over the lease Sale at FV Recognise profit/loss
term immediately
Sale > FV Defer excess profit
Ÿ 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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Answer to self-test question

Answer 1
(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

STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X1 (EXTRACT)


$
Non-current assets
Leased asset [(800,000 + 20,000) – 148,000] 672,000
Non-current liabilities
Finance lease liability – over one year (Working) 561,820
Current liabilities
Finance lease liability – within one year (Working) (656,200 – 561,820) 94,380
WORKING
Bal b/f Interest accrued at Payment Bal c/f
10% 31 Dec 31 Dec
$ $ $ $
800,000
(58,000)
20X1 742,000 74,200 (160,000) 656,200
20X2 656,200 65,620 (160,000) 561,820

(b) Treatment of guaranteed residual value


At the end of the lease, the lessee will have an asset at residual value of $80,000 in its
statement of financial position and a finance lease liability of $80,000 representing the
residual value guaranteed to the lessor.
(i) If the lessor is able to sell the asset for the value guaranteed by the lessee, the lessee
has no further liability and derecognises the asset and lease liability:
$ $
DEBIT Finance lease liability 80,000
CREDIT Leased asset 80,000

(ii) If the lessor is unable to sell the asset for the value guaranteed by the lessee, the
lessee has a liability to make up the difference of $80,000 – $60,000 = $20,000:
Recognise impairment loss on asset (as soon as known during the lease term):
$ $
DEBIT Profit or loss 20,000
CREDIT Leased asset 20,000
Make guaranteed payment to lessor and derecognise the asset and lease liability:
$ $
DEBIT Finance lease liability 80,000
CREDIT Cash 20,000
CREDIT Leased asset 60,000

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Financial Reporting

Exam practice

Thompson Manufacturing Inc. 27 minutes


On 1 January 20X7, Thompson Manufacturing Inc. (TMI), the lessor, entered into a non-cancellable
lease agreement for equipment with Silver Rod Company (SRC), the lessee. The following
information pertains to the lease:
Annual lease payment due at the beginning of each year, beginning on
$53,069
1 January 20X7
Option to purchase at the end of lease term $10,000
Lease term 5 years
Economic useful life of leased equipment 8 years
Lessor's manufacturing cost $200,000
Fair value of leased equipment at 1 January 20X7 $227,500
Estimated unguaranteed residual value of leased equipment at the end of
$30,000
lease term
Lessor's implicit rate 12.93%
Lessee's incremental borrowing rate 10%
Required
(a) Discuss how the purchase option at the end of the lease term offered by TMI to SRC will
affect the classification of this lease by SRC. (3 marks)
(b) Prepare an amortisation schedule that would be suitable for TMI for the lease term.
(5 marks)
(c) Prepare all the journal entries that TMI should make for each of the years ended
31 December 20X7 and 20X8. (7 marks)
(Total = 15 marks)
HKICPA September 2008 (amended)

212
chapter 10

Inventories

Topic list

1 Accounting for inventories


1.1 Scope
1.2 Definitions
1.3 Measurement of inventories
1.4 Cost of inventories
1.5 Techniques for the measurement of cost
1.6 Cost formulae
1.7 Net realisable value (NRV)
1.8 Recognition as an expense
1.9 Disclosure requirements

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

In this chapter you will cover the following 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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1 Accounting for inventories


Topic highlights
Inventory is measured at the lower of cost and net realisable value.

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.

HKAS 2.2,3 1.1 Scope


HKAS 2 applies to all inventories other than:
 work in progress under construction contracts (covered by HKAS 11 Construction
Contracts)
 financial instruments (covered by HKFRS 9 Financial Instruments)
 biological assets (covered by HKAS 41)
The standard does not apply to the measurement of inventories held by:
 producers of agricultural and forest products
 commodity-broker traders

HKAS 2.6,8 1.2 Definitions


The standard provides the following definitions:

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)

The definition of inventories in effect refers to:


 finished goods, being those held for sale
 work in progress (WIP), being those in the process of production, and
 raw materials, being those supplies to be consumed in the production process.

HKAS 2.9 1.3 Measurement of inventories


The standard states that "Inventories shall be measured at the lower of cost and net realisable
value."
These terms are explained in more detail in sections 1.4 and 1.7 of the chapter.

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Financial Reporting

HKAS 2.10 1.4 Cost of inventories


Topic highlights
Cost includes all costs of purchase, costs of conversion and other costs incurred in bringing
inventories to their present condition and location.

The cost of inventories includes all:


 costs of purchase
 costs of conversion
 other costs incurred
Each of these types of cost is covered in turn below.
HKAS 2.11 1.4.1 Costs of purchase
HKAS 2 states that the costs of purchase may include all of:
 purchase price
 import duties and other irrecoverable taxes
 transport, handling and any other cost directly attributable to the acquisition of finished
goods, services and materials
Costs of purchase should be net of trade discounts, rebates and other similar amounts when
measuring inventory.
HKAS 2.12- 1.4.2 Costs of conversion
14
Costs of conversion of inventories includes:
(a) costs directly related to the units of production, e.g. direct materials, direct labour.
(b) a systematic allocation of fixed and variable production overheads that are incurred in
converting materials into finished goods.

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.
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.

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Key terms (cont'd)


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.

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.
HKAS 2.15- 1.4.3 Other costs
17
Other costs are included in the cost of inventories if they are incurred in bringing the inventories to
their present location and condition. Examples of such costs are non-production overheads and
the costs of designing products for specific customers. In limited circumstances, as identified by
HKAS 23, borrowing costs are also included in the cost of inventories.
The standard lists types of cost which would not be included in cost of inventories but should be
recognised as an expense in the period they are incurred:
(a) Abnormal amounts of wasted materials, labour or other production costs.
(b) Storage costs (except costs which are necessary in the production process before a further
production stage).
(c) Administrative overheads not incurred to bring inventories to their present location and
conditions.
(d) Selling costs.

Example: Cost of inventory


Highdef Co. manufactures component parts used in the production of televisions. The following
details are relevant to a production run in August 20X4:
Cost of raw materials per unit $85 after 15% trade discount
Import duty (raw materials) 5%
Labour costs per unit $25
Production overheads $400,000
Expected (normal) output 50,000 units
Actual output 40,000 units

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Financial Reporting

The cost of each unit is therefore calculated as:


$
Direct materials 85.00
Import duty (5%  $85) 4.25
Direct labour 25.00
Overheads allocation ($400,000/50,000) 8.00
Cost 122.25

HKAS 2.19 1.4.4 Cost of inventory of a service provider


Service providers sometimes have inventory, for example the work in progress of a lawyer. This
work in progress should be measured at cost i.e. the costs of labour and attributable overheads,
excluding any profit margin.
Labour and costs relating to sales and general administrative personnel and non-attributable
overheads are not included in the cost of work in progress. They are expensed as incurred.
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.

Example: Measurement of cost


Assume that a manufacturing company has a budgeted standard total production cost of $1 per
unit for the year, based on a forecasted production of 1,000,000 units. There is no opening
inventory and the year end accounts show actual production of 1,000,000 units, closing inventory
of 200,000 units and an unfavourable cost variance of $100,000. The analysis shows that $80,000
of the variance comes from a charge in a purchase cost of goods resulting from a foreign currency
alignment early in the year and the remaining $20,000 is from a labour strike mid-year.
The $20,000 unfavourable variance from the labour strike is a period cost wholly recognised as an
expense since it was not incurred under normal operating conditions.
Unless the exchange movement happened under unusual circumstances, the price variance
resulting from exchange difference is regarded as arising under normal operating conditions. To
better reflect the cost of goods sold and the cost of closing inventory, the price variance will be
allocated between inventories and cost of goods sold based on the closing inventories of $200,000
as a percentage of the total number of units produced. The closing inventories at standard cost of
$200,000 are 20% of the actual production, so inventories will be allocated 20% of the $80,000
price variance i.e. $16,000. Cost of goods sold will be charged with the balance of $64,000. Closing
inventories will therefore amount to $216,000.

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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
location of inventories (and in the respective tax rules), by itself, is not sufficient to justify the use of
different cost formulae.

Example: Inventory valuation (1)


Arneson Co. trades in widgets and has bought and sold the following inventory during the month of
September 20X1:
Date Volume Cost
1 September opening stock 100 units $2.00 each
3 September purchase 100 units $2.30 each
5 September sale 75 units
10 September purchase 50 units $2.35 each
18 September sale 80 units
25 September purchase 80 units $2.40 each
29 September sale 100 units
What is the value of inventory at 30 September using
(a) FIFO
(b) Weighted average cost (period end)
(c) Weighted average cost (continuous)?

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Financial Reporting

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
5.9 75 125 $2.15
10.9 50  $2.35 175  50  $2.35   125  $2.15 
 $2.21
50  125
18.9 80 95 $2.21
25.9 80  $2.40 175  80  $2.40    95  $2.21
 $2.30
80  95
29.9 100 75 $2.30
Therefore, closing stock is measured at $172.50 (75 units × $2.30)

HKAS 2.28- 1.7 Net realisable value (NRV)


33

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.

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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.

HKAS 2.34 1.8 Recognition as an expense


An expense related to inventory is recognised in profit or loss in the following circumstances:
(a) When inventories are sold, the carrying amount of those inventories is recognised as an
expense.
(b) Any write down of inventories to NRV and all losses of inventories are recognised as an
expense in the period the write down or loss occurs.
(c) Any reversal of a previous write down of inventories, arising from an increase in NRV, is
recognised as a reduction in the amount of inventories recognised as an expense in the
period in which the reversal occurs.

Example: Inventory valuation (2)


Given Co. has the following categories of inventory:
Cost Selling price Costs to sell
$m $m $m
Product A 4 6 0.5
Product B 10 11 1.5
Product C 8 12 2
Product D 14 16 3
Required
Determine the amount at which inventory should be valued.

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Financial Reporting

Inventory must be valued line by line rather than as a whole, taking lower of cost and NRV in each
case:
$m
Product A (Cost) 4.0
Product B (NRV) 9.5
Product C (Cost) 8.0
Product D (NRV) 13.0
34.5

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.

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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
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.

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Financial Reporting

Topic recap

HKAS 2 Inventories

Ÿ Finished goods
Ÿ Work in progress
Ÿ Raw materials

Measure at the lower of:

Cost Net realisable value

Includes: Estimated selling price in the ordinary course


Ÿ Cost of purchase of business less estimated costs of
Ÿ Direct costs of conversion completion and estimated costs to make
Ÿ Allocated overheads during the sale.
conversion
Ÿ Costs of bringing the inventory to its
present location and condition

Where inventory items are not interchangeable


identify specific cost.

Where inventory items are interchangeable use


cost formulae to assign cost to an item:

FIFO Weighted average


Inventory is assumed to move A weighted average cost to be
"first in, first out" therefore cost allocated to each item of inventory
allocated to inventory items is is calculated either on a periodic or
the most recent purchase continuous basis.
prices.

Disclosures:
Ÿ Accounting policies and cost formulae used
Ÿ Carrying amount of inventories classified by type
Ÿ Carrying amount of inventories measured at fair value less costs to sell
Ÿ Inventories recognised as an expense in the period
Ÿ Inventory write downs / reversal of write downs recognised in the period and circumstances that led to the
write down / reversal.
Ÿ Carrying amount of inventories pledged as security

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Answer to self-test question

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.

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Financial Reporting

Exam practice

Lotto 9 minutes
After its end of year physical inventory count and valuation, the accounts staff of Lotto have
reached a valuation of $153,699 at cost for total inventories held at the year end.
However, on checking the figures, the chief bookkeeper has come across the following additional
facts.
(a) The count includes damaged goods which originally cost $2,885. These could be repaired at
a cost of $921 and sold for $3,600.
(b) The count excludes 300 units of item 730052 which were sold to a customer SC on a sale or
return basis, at a price of $8 each. The original cost of the units was $5 each. SC has not yet
indicated to Lotto whether these goods have been accepted, or whether they will eventually
be returned.
(c) The count includes 648 units of item 702422. These cost $7.30 each originally but because
of dumping on the market by overseas suppliers, a price war has flared up and the unit cost
price of the item has fallen to $6.50. The price reduction is expected to be temporary, lasting
less than a year or so, although some observers of the market predict that the change might
be permanent. Lotto has already decided that if the price reduction lasts longer than six
months, it will reduce its resale price of the item from $10.90 to about $10.
Required
Calculate the closing inventory figure for inclusion in the annual accounts of Lotto, making
whatever adjustments you consider necessary in view of items (a) to (c). Explain your treatment of
each item. (5 marks)

226
chapter 11

Provisions, contingent
liabilities and contingent
assets
Topic list

1 HKAS 37 Provisions, Contingent Liabilities and Contingent Assets


1.1 Objective
1.2 Definitions
2 Provisions
2.1 Recognising a provision
2.2 Measuring a provision
2.3 Reimbursements
2.4 Changes in provisions
2.5 Use of provisions
2.6 Common scenarios
2.7 Disclosure of provisions
3 Contingent liabilities and contingent assets
3.1 Contingent liabilities
3.2 Contingent assets
3.3 Summary
4 Interpretations relating to provision accounting
4.1 HK(IFRIC) Int-1 Changes in Existing Decommissioning, Restoration and Similar Liabilities
4.2 HK(IFRIC) Int-5 Rights to Interests from Decommissioning, Restoration and Environmental
Rehabilitation Funds
5 Current developments

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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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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 HKAS 37 Provisions, Contingent Liabilities and


Contingent Assets
Published financial statements must include all the information necessary for a proper
understanding of the company's financial position.
In some cases this means that uncertain events must be reported. HKAS 37 provides guidance on
accounting for uncertainty with the result that provisions, or uncertain liabilities, may be included in
the statement of financial position and contingent assets and liabilities may be disclosed.
The provisions for liabilities covered by HKAS 37 are somewhat different from those "provisions"
for depreciation and doubtful debts in your earlier studies.
There was no accounting standard dealing with provisions before the issue of HKAS 37. Provisions
often known as "big bath" provisions are made by companies wanting to show their results in the
most favourable way. They made large "one off" provisions in years where a high level of
underlying profits was generated. These provisions were then available to conceal expenditure in
future years when perhaps the underlying profits were not favourable.
That is to say, provisions were used to achieve profit smoothing. Since reported profits do not
represent the level of actual profits achieved in the year, profit smoothing is viewed as misleading.

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.

HKAS 37.10 1.2 Definitions


The following definitions are provided within the standard:

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 37.14 2.1 Recognising a provision


Topic highlights
Under HKAS 37, a provision should be recognised:
 When an entity has a present obligation, legal or constructive
 It is probable that a transfer of economic benefits will be required to settle it
 A reliable estimate can be made of its amount

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; and
 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 37.17- 2.1.1 Obligation
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,
and
 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 2010, Black Gold Oil Co. causes extensive contamination in
a country in which there is no environmental legislation.
Does a constructive obligation exist at 31 December 2010?
(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?
(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 37.23- 2.1.2 Probable transfer of economic benefits


24
A transfer of economic benefits is regarded as "probable" if the event is more likely than not to
occur for the purpose of HKAS 37 so the probability that the event will occur is greater than the
probability that it will not. The standard clarifies that the probability should be based on considering
the population as a whole, rather than one single item, in situations where there are a number of
similar obligations.

Illustration: Transfer of economic benefits


In the case of a warranty obligation of a company, though the probability of an outflow of economic
resources (transfer of economic benefits) may be extremely small in respect of one specific item,
the probability of some transfer of economic benefits is quite likely to be much higher when the
population is considered as a whole. A provision should be made for the expected amount when
there is a greater than 50% probability of some transfer of economic benefits.

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.

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.

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Financial Reporting

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).

HKAS 37.39 2.2.2 Expected values


Where the provision being measured involves a large population of items, the obligation is
estimated by weighting all possible outcomes by their associated probabilities, i.e. expected value.

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.
% of goods sold Defects Cost of repairs if all goods
suffered from the defect
$m
75 None –
20 Minor 1.0
5 Major 4.0
What is the expected cost of repairs?
(The answer is at the end of the chapter)

HKAS 37.42- 2.2.3 Other considerations when measuring a provision


52
HKAS 37 requires that the following are considered when measuring a provision:
Risks and uncertainties
Risks and uncertainties surrounding an event should be taken into consideration when making the
best estimate of a provision required. Uncertainty does not, however, justify the creation of
excessive provisions or an overstatement of liabilities.
Discounting
Where the effect of the time value of money is material, the amount of a provision should be the
present value of the expenditure required to settle the obligation.
An appropriate discount rate should be used, and the standard requires this to be a pre-tax rate
that reflects current market assessments of the time value of money. The discount rate(s) should
not reflect risks for which future cash flow estimates have been adjusted.
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.

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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.

HKAS 37.59-
60
2.4 Changes in provisions
Provisions should be reviewed at each reporting date and adjusted to reflect the current
best estimate. If it is no longer probable that a transfer of economic benefits will be required to
settle the obligation, the provision should be reversed.
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.

HKAS 37.66- 2.6.2 Onerous contracts


68

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)

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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)

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, and
 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.

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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, and
 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

HKAS 37 2.6.4 Other scenarios


Appendix C
(a) Warranties. A provision is appropriate where on past experience it is probable, i.e. more
likely than not, that some claims will emerge. The provision must be estimated, however, on
the basis of the class as a whole and not on individual claims. There is a clear legal
obligation in this case.
(b) Major repairs. In the past it has been quite popular for companies to provide for expenditure
on a major overhaul to be accrued gradually over the intervening years between overhauls.
Under HKAS 37 this is not permissible as HKAS 37 would argue that this is a mere intention
to carry out repairs, not an obligation. The entity can always sell the asset in the meantime.
The only solution is to treat major assets such as aircraft, ships, furnaces etc. as a series of
smaller assets where each part is depreciated over shorter lives. Therefore, any major
overhaul may be argued to be replacement and therefore classified as capital rather than
revenue expenditure.
(c) Self insurance. A number of companies have created a provision for self insurance based
on the expected cost of making good fire damage and so on instead of paying premiums to
an insurance company. Under HKAS 37 this provision is not justifiable as the entity has no
obligation until a fire or accident occurs. No obligation exists until that time.
(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.

HKAS
37.84,85,92
2.7 Disclosure of provisions
Disclosures for provisions fall into two parts.
 Disclosure of details of the change in carrying value of a provision from the beginning to
the end of the year, including:
– carrying amount at the beginning and end of the period
– additional provisions made in the period
– amounts incurred and charged against the provision in the period
– unused amounts reversed in the period

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– the increase in the period in the discounted amount arising from the passage of time
and effect of any change in the discount rate
Note that comparative information is not required.
 Disclosure of the background to the making of the provision and the uncertainties affecting
its outcome, including for each class of provision:
– a brief description of the nature of the obligation and expected timing of any resulting
outflows of economic benefits
– an indication of the uncertainties about the amount or timing of outflows
– the amount of any expected reimbursement stating the amount of any asset that has
been recognised for the expected reimbursement.
In very rare circumstances, such disclosure may prejudice seriously the position of the entity in a
dispute with other parties on the subject matter of the provision. In this case disclosure of the
above information is not required, however the following should be disclosed:
 the general nature of the dispute
 the fact that, and reason why, the information has not been disclosed.

3 Contingent liabilities and contingent assets


Topic highlights
An entity should not recognise a contingent liability, but they should be disclosed where there is a
possible outflow of economic resources.
An entity should not recognise a contingent asset, but they should be disclosed where there is a
probable inflow of economic resources.

Now you understand provisions it will be easier to understand contingent assets and liabilities.

HKAS 37.10 3.1 Contingent liabilities


We saw the definition of a contingent liability earlier in the chapter. To recap, 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 entity's control
(b) A present obligation that arises from past events but is not recognised because:
– it is not probable that a transfer of economic benefits will be required to settle the
obligation
– the amount of the obligation cannot be measured with sufficient reliability
In other words, a contingent liability is an obligation that does not meet the HKAS 37 recognition
criteria for a provision because there is no present obligation, or the transfer of resources is only
possible or the amount cannot be measured reliably.
HKAS 37.27- 3.1.1 Accounting treatment
28
Contingent liabilities should not be recognised in financial statements but they should be
disclosed, unless the probability of an outflow of economic resources is remote.
HKAS 37.86- 3.1.2 Disclosure: contingent liabilities
88,92
A brief description must be provided of all material contingent liabilities unless they are likely to
be remote.

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In addition, the following should be provided for each class of contingent liability, where practicable:
 An estimate of their financial effect
 Details of any uncertainties relating to the amount or timing of the outflow
 The possibility of any reimbursement
When determining classes of contingent liability, an entity should consider whether the nature of
items is sufficiently similar for aggregated amounts to fulfil the disclosure requirements.
Where a provision and contingent liability result from the same circumstances, an entity should
indicate the link between the provision and contingent liability.
In very rare circumstances, such disclosure may prejudice seriously the position of the entity in a
dispute with other parties on the subject matter of the contingent liability. In this case disclosure of
the above information is not required, however the following should be disclosed:
 The general nature of the dispute
 The fact that, and reason why, the information has not been disclosed.

3.2 Contingent assets


Earlier in the chapter we defined a contingent asset as a possible asset that arises from past
events and whose existence will be confirmed by the occurrence of one or more uncertain future
events not wholly within the entity's control.
HKAS 3.2.1 Accounting treatment
37.31,33,34
A contingent asset must not be recognised. Only when the realisation of the related economic
benefits is virtually certain should recognition take place. At that point, the asset is no longer a
contingent asset.
Where a contingent asset offers a probable inflow of resources, it should be disclosed.
HKAS 3.2.2 Disclosure: contingent assets
37.89,92
Contingent assets must only be disclosed in the notes if they are probable.
In that case the following should be provided:
 a brief description of the nature of the contingent asset
 an estimate of its likely financial effect, where practicable, or a statement to the effect that it
is not practicable.
In very rare circumstances, such disclosure may prejudice seriously the position of the entity in a
dispute with other parties on the subject matter of the contingent asset. In this case disclosure of
the above information is not required, however the following should be disclosed:
 the general nature of the dispute
 the fact that, and reason why, the information has not been disclosed.

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.

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Financial Reporting

Self-test question 3
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 HK$40,000. Any
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 4
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)

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4 Interpretations relating to provision accounting


4.1 HK(IFRIC) Int-1 Changes in Existing Decommissioning,
Restoration and Similar Liabilities
4.1.1 The issue
HK(IFRIC) Int-1 applies where an entity has included decommissioning, restoration and similar
costs within the cost of an item of property, plant and equipment under HKAS 16 and as a provision
(liability) under HKAS 37.
An example would be a liability that was recognised by the operator of an oil rig for costs that it
expects to incur in the future when the rig is shut down (decommissioned). Such a provision should
be discounted to present value.
HK(IFRIC) Int-1 addresses changes in the value of the provision that may arise from:
(a) changes in the discount rate
(b) revised estimates of the timing and amount of costs
4.1.2 Required treatment
Where an entity applies the cost model to property, plant and equipment, these changes in value of
the provision are required to be capitalised as part of the cost of the asset and depreciated over the
remaining life of the item to which they relate.
Where an entity applies the revaluation model to property, plant and equipment, the changes in
value of the provision must be recognised as follows:
(a) A decrease in the liability is recognised in other comprehensive income and accumulated
within the revaluation surplus (other than where it reverses a revaluation deficit on the asset
that was previously recognised in profit or loss)
(b) An increase in the liability is recognised in profit or loss (other than where a credit balance
exists in the revaluation surplus in respect of that asset, in which case it is recognised in
other comprehensive income and reduces the revaluation surplus).
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.

4.2 HK(IFRIC) Int-5 Rights to Interests from Decommissioning,


Restoration and Environmental Rehabilitation Funds
4.2.1 The issue
Some entities have an obligation to decommission assets or to perform environmental restoration.
Such entities may make contributions to a fund which is established to reimburse those costs of
decommissioning, restoration or rehabilitation when they are incurred. This fund may be set up to
meet the decommissioning costs of one contributor or for a number of contributors.
Matters for discussion with reference to HK(IFRIC) Int-5 are:
(a) How should the interest in a fund be dealt with by a contributor?
(b) How should an obligation be accounted for when a contributor has an obligation to make
additional contributions?
4.2.2 HK(IFRIC) Int-5 treatment
The following treatments are specified in HK(IFRIC) Int-5:
(a) If an entity recognises a decommissioning obligation under HKFRS and contributes to a fund
to segregate assets to pay for the obligation, it should apply HKFRS 10 Consolidated
Financial Statements, HKFRS 11 Joint Arrangements and HKAS 28 Investments in

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Financial Reporting

Associates and Joint Ventures, to determine whether decommissioning funds should be


consolidated or accounted for under the equity method.
(b) When a fund is not consolidated or accounted for under the equity method, and that
fund does not relieve the contributor of its obligation to pay decommissioning costs, the
contributor should recognise:
(i) its obligation to pay decommissioning costs as a liability
(ii) its rights to receive reimbursement from the fund as a reimbursement under
HKAS 37
(c) A right to reimbursement should be measured at the lower of the:
(i) amount of the decommissioning obligation recognised
(ii) contributor's share of the fair value of the net assets of the fund attributable to
contributors
Changes in the carrying amount of this right (other than contributions to and payments from
the funds) should be recognised in profit or loss.
(d) When a contributor has an obligation to make potential additional contributions to the fund,
that obligation is a contingent liability within the scope of HKAS 37. When it becomes
probable that the additional contributions will be made, a provision should be recognised.

5 Current developments
The IASB and FASB added a project on Liabilities to their active agenda in 2002 and issued an
Exposure Draft in 2005; the topic was re-exposed in 2010.
The ED proposed the following:
 The "probable" recognition criterion is removed, and instead uncertainty is reflected in the
measurement of a liability i.e. through use of a probability-weighted average of the outflows
for the range of possible outcomes.
 A liability is measured at the amount an entity would pay at the end of a reporting period to
be relieved of the present obligation. This should be determined as:
– the present value of the resources required to fulfil the obligation, or
– the amount an entity would have to pay to cancel the obligation, or
– the amount an entity would have to pay to transfer the obligation to a third party.
 If the liability is to pay cash to a counterparty, the outflows would be any expected cash
payments plus associated costs.
 If the liability is to undertake a service at a future date, the outflows would be the amounts
that the entity estimates it would pay a contractor at the future date to undertake the service
on its behalf.
The effects of these proposals would include the recognition of far more provisions than at present,
and where these are measured by reference to third party payment, a profit margin would be
included so increasing the amount of the provision.
The project was deferred in 2010 and added to the IASB’s research programme in 2012. The
issues will now be considered in conjunction with the Conceptual Framework work on elements
and measurement and a discussion paper is expected on this during the course of 2013.

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Topic recap

HKAS 37 Provisions,
Contingent Liabilities and
Contingent Assets

= accounting for uncertainty

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
Ÿ 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
Ÿ probable outflow of economic benefits Present obligation arising from past
Ÿ 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:
Ÿ best estimate of expenditure Do not recognise unless virtually certain
Ÿ use expected values for a large (in which case not a contingent asset)
Do not recognise
population of items
Ÿ discount if the time value of money is
material

Disclose: Disclose the following unless the outflow Disclose where probable inflow:
Ÿ Reconciliation of the carrying value of of resources is remote: Ÿ description of contingency
provisions at the start of the period to Ÿ Description of contingency Ÿ estimate of financial effect
that at the end Ÿ Estimate of financial effect
Ÿ Background to the provision Ÿ Details of uncertainties
Ÿ Possibility of reimbursement

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Financial Reporting

Answers to self-test questions

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 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.

Answer 2
The cost is found using "expected values" (75%  $NIL) + (20%  $1.0m) + (5%  $4.0m) =
$400,000

Answer 3
(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 4
(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.

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Exam practice

Darren Company Limited 23 minutes


Darren Company Limited ("DCL") is engaged in the manufacture of batteries. On the unaudited
statement of financial position as at 30 June 20X8, it has recognised the following provisions as
current liabilities:
(a) A provision for late delivery penalty
In May 20X8, DCL received a sales order for 7,000,000 units of rechargeable batteries for
which the agreed delivery date is 31 August 20X8. It is expected that DCL would earn a
gross profit of $1 per unit. Due to a shortage in the supply of raw materials, at the reporting
date, the management realised that they could only supply the goods at the earliest on
10 September 20X8. According to the sales contract, DCL would compensate the customer
for late delivery at $0.01 per unit per day.
(b) A provision for annual safety inspection of the production line
The last inspection was carried out in June 20X7. Due to a large backlog of sales orders, the
management decided to postpone the annual inspection until mid-September 20X8.
(c) A provision for the loss on sales of aged finished goods
The products were manufactured in late 20X6 with an expected normal usage period of two
years from the date of production. Due to the short expiry period, they were sold at a price
below cost in July 20X8.
(d) A provision for bonus payments to two executive directors
In accordance with the directors' service contract, two executive directors are entitled to
receive, in addition to monthly salaries, a bonus of equivalent to 5% of the profit before
taxation and the accrued bonus.
Required
Discuss the appropriateness of the provisions recognised by DCL. (13 marks)
HKICPA February 2008 (amended)

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chapter 12

Construction contracts

Topic list

1 HKAS 11 Construction contracts


1.1 The accounting problem
1.2 Scope of the standard
1.3 Definitions
1.4 Contract revenue and contract costs
1.5 Combining and separating construction contracts
2 Accounting for construction contracts
2.1 Reliable estimate of outcome
2.2 Accounting treatment: outcome can be reliably estimated
2.3 Accounting treatment: outcome cannot be reliably estimated
2.4 Summary of the treatment of construction contracts in the statement of profit or loss
2.5 Construction contracts in the statement of financial position
2.6 Changes in estimates
2.7 Section summary
2.8 Disclosures
3 Current developments

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

In this chapter you will cover the following 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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1 HKAS 11 Construction Contracts


Topic highlights
A construction contract is a contract specifically negotiated for the construction of an asset or a
combination of interrelated assets.

1.1 The accounting problem


Imagine that you are the accountant at a company which is building a hospital under contract with
the government. The hospital will take four years to build and over that time your company will
have to pay for costs such as workers' wages and building materials. The government will make
periodic payments at pre-determined stages of construction.
How do you decide what amounts to include in the statement of profit or loss in each of the four
years?
This is the problem addressed by HKAS 11 Construction Contracts.

Example: Construction contract


Suppose that a contract is started on 1 January 20X1, with an estimated completion date of
31 December 20X2. The final contract price is $2,000,000. In the first year, to 31 December 20X1:
(a) Costs incurred amounted to $800,000.
(b) Half the work on the contract was completed.
(c) Certificates of work completed have been issued, to the value of $1,000,000. (Note. It is
usual, in a construction contract, for a qualified person such as an architect or engineer to
inspect the work completed, and if it is satisfactory, to issue certificates. This will then be the
notification to the customer that progress payments are due to the contractor. Progress
payments are commonly the amount of valuation on the work certificates issued, minus a
precautionary retention of 10%.)
(d) It is estimated with reasonable certainty that further costs to completion in 20X2 will be
$800,000.
What is the contract profit in 20X1, and what entries would be made for the contract at
31 December 20X1 if:
(a) profits are deferred until the completion of the contract?
(b) a proportion of the estimated revenue and profit is credited to profit or loss in 20X1?

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.

1.2 Scope of the standard


Topic highlights
HKAS 11 applies to construction contracts which span a period end.

HKAS 11 is applied in accounting for construction contracts in the financial statements of


contractors.
A construction contract within the scope of HKAS 11 does not have to last for a period of more than
one year. The main point is that the contract activity starts in one financial period and ends in
another, thus creating the problem: to which of two or more periods should contract income and
costs be allocated?
Where the rendering of services is directly related to a construction contract, for example services
provided by a project manager or architect, these services are also accounted for in accordance
with HKAS 11. In all other cases, the rendering of services, even where a service contract spans a
period end, is within the scope of HKAS 18.

HKAS 11.3-6 1.3 Definitions


HKAS 11 provides the following definitions.

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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The definition of a construction contract includes:


(a) contracts for the construction of single assets such as bridges or roads
(b) contracts for the construction of inter-related assets such as refineries or complex pieces of
equipment
(c) contracts for services related to the construction of an asset such as project manager
services
(d) contracts for the destruction or restoration of assets
Contracts are further broken down into fixed price and cost plus contracts. The distinction between
these two types is relevant when accounting for construction contracts and is considered in
section 2.1.

1.4 Contract revenue and contract costs


As well as the more formal definitions above, the standard includes detailed guidance on what
amounts should be included in contract revenue and contract costs.
HKAS 11.11- 1.4.1 Contract revenue
15
Contract revenue includes:
(a) the initial amount of revenue specified in the contract; and
(b) variations in contract work, claims and incentive payments:
Examples of variations:
1 A variation, or instruction by the customer for a change in the scope of work to be performed,
may increase or decrease contract revenue.
2 A claim, being an amount that an entity seeks to collect from the customer as reimbursement
for extra costs, may increase contract revenue.
3 Cost escalation clauses in a fixed price contract will increase contract revenue.
4 Incentive payments, being additional amounts paid to a contractor if specified standards are
met or exceeded will increase contract revenue.
5 Penalties imposed on contractors due to delays will decrease contract revenue.
Variations are only included as part of contract revenue to the extent that:
(i) it is probable that they will result in revenue; and
(ii) they are capable of being reliably measured.
The result is that contract revenue is measured at the fair value of received or receivable revenue.

Example: Contract revenue


Loriload has a fixed price contract for $9 million to build a bridge. By the end of year 1 it is apparent
that the associated costs have increased by around 5% and accordingly in year 2 the customer
approves a variation of $500,000. The contract is completed in year 3.
What amount should be used as contract revenue in calculations in relation to the construction
contract at the end of the three years?

Solution
Year 1 $9 million
Year 2 $9.5 million
Year 3 $9.5 million

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Financial Reporting

HKAS 11.16- 1.4.2 Contract costs


20
Contract costs consist of:
(a) costs that relate directly to the specified contract.
(b) costs that are attributable to contract activity in general and can be allocated to the contract
(c) such other costs as are specifically chargeable to the customer under the terms of the
contract.
Costs that relate directly to a specific contract include the following:
 Site labour costs, including site supervision
 Costs of materials used in construction
 Depreciation of plant and equipment used on the contract
 Costs of moving plant, equipment and materials to and from the contract site
 Costs of hiring plant and equipment
 Costs of design and technical assistance that are directly related to the contract
 Estimated costs of rectification and guarantee work, including expected warranty costs
 Claims from third parties
Costs that are attributable to general contract activity and can be allocated to specific contracts
include:
 insurance
 general costs of design and technical assistance
 construction overheads
These costs should be allocated systematically and rationally, and all costs with similar
characteristics should be treated consistently. The allocation should be based on the normal level
of construction activity. Borrowing costs may be attributed in this way (see HKAS 23: Chapter 17).
Some costs cannot be attributed to contract activity and so the following should be excluded
from construction contract costs:
 General administration costs (unless reimbursement is specified in the contract)
 Selling costs
 R&D (unless reimbursement is specified in the contract)
 Depreciation of idle plant and equipment not used on any particular contract

Example: Contract costs


Alphabeta has commenced a contract on 1 August 20X1 for the construction of a motorway.
Information on contract costs incurred in the year ended 31 December 20X1 is as follows:
$'000
Surveyors' fees 12
Direct labour costs 134
Materials delivered to the site 250
Transport of heavy plant to site 10
The following information is also relevant:
 Overheads are to be apportioned at 35% of direct labour costs
 Inventory of materials on site at the 20X1 year end is $76,000
 The heavy plant was acquired at a cost of $90,000 two years ago and is being depreciated
over 10 years on a straight line basis.
What are contract costs incurred as at 31 December 20X1?

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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

HKAS 11.7-9 1.5 Combining and separating construction contracts


HKAS 11 accounting rules are normally applied to each of an entity's construction contracts in turn.
Sometimes, however, one contract is split into component parts and each is accounted for
separately, or a group of contracts are grouped and accounted for together.
The construction of a series of assets under one contract should be treated as several contracts where:
 separate proposals are submitted for each asset.
 separate negotiations are undertaken for each asset; the customer can accept/reject each
individually.
 identifiable costs and revenues can be separated for each asset.
A group of contracts should be treated as one single construction contract where:
 the group of contracts are negotiated as a single package.
 contracts are closely interrelated, with an overall profit margin.
 the contracts are performed concurrently or in a single sequence.

2 Accounting for construction contracts


Topic highlights
Revenue and costs associated with a contract should be recognised according to the stage of
completion of the contract when the outcome of the activity can be estimated reliably. If a loss
is predicted on a contract, then it should be recognised immediately.

HKAS 2.1 Reliable estimate of outcome


11.23,24
The accounting treatment applied to a construction contract depends on whether the outcome of
the contract can be measured reliably. HKAS 11 provides guidance on when this is the case for
both fixed price and cost plus contracts:
(a) Fixed price contracts
In the case of a fixed price contract, the outcome of a construction contract can be estimated
reliably when all of the following conditions are satisfied:
(i) Total contract revenue can be reliably measured.
(ii) It is probable that economic benefits of the contract will flow to the entity.
(iii) Stage of contract completion at the period end and costs to complete the contract can
be reliably measured.
(iv) Costs attributable to the contract can be identified clearly and be reliably measured so
that actual costs can be compared to previous estimates.

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Financial Reporting

(b) Cost plus contracts


In the case of a cost plus contract, the outcome of a construction contract can be estimated
reliably when both of the following conditions are satisfied:
(i) it is probable that economic benefits of the contract will flow to the entity,
(ii) the costs attributable to the contract (whether or not reimbursable) can be identified
clearly and be reliably measured.
HKAS 11.30 2.1.1 Determining the stage of completion
Topic highlights
The stage of completion of a contract is normally measured using the costs basis, sales basis or
physical completion basis.

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

2.2 Accounting treatment: outcome can be reliably estimated


HKAS 2.2.1 Profitable contract
11.22,26
Where the outcome of a contract can be reliably estimated and the contract is expected to be
profitable based on contract revenue, costs to date and expected costs to complete, the
percentage completion method is applied.
The percentage of completion method is an application of the accruals assumption. Contract
revenue is matched to the contract costs incurred in reaching the stage of completion, so revenue,
costs and profit are attributed to the proportion of work completed:
(a) Contract revenue is recognised as revenue in the accounting periods in which the work is
performed.
(b) Contract costs are recognised as an expense in the accounting period in which the work to
which they relate is performed.
(c) Where amounts have been recognised as contract revenue, but their collectability from the
customer becomes doubtful, such amounts should be recognised as an expense, not a
deduction from revenue.

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Example: Profitable contract with reliably estimated outcome


Gosforth Construction assesses the stage of completion of its contracts by reference to costs
incurred as a percentage of total costs. The company commenced Contract A in 20X1. The
contract has a fixed price of $890,000, recorded costs during 20X1 are $389,000, of which $10,000
relates to unused inventory. Expected future costs are $150,000.
Required
How much profit should be reported in 20X1 in accordance with HKAS 11?

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)

Example: Inclusion in financial statements


Discovery Construction commenced a $4 million contract to build a velodrome in the year ended
31 December 20X3. Details of the contract costs are as follows:
31 Dec 20X3 31 Dec 20X4 31 Dec 20X5
Estimated total costs $3.2 million $3.3 million $3.3 million
Costs incurred to date $1.2 million $2.475 million $3.3 million

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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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.

HKAS 2.2.2 Loss-making contract


11.36,37

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).

Example: Loss-making contract (1)


Randall has a contract to construct a new head office for a multinational company. The contract
price has been agreed as $7 million. When Randall first signed the contract, the estimated total
costs to completion were assessed as $6.2 million. By the end of the first year of the contract,
however, price rises have meant that estimated total costs are now $7.1 million. The contract is
assessed as 28% complete by the end of the first year, based on costs incurred.
What amounts should be recognised in profit or loss in the first year of the 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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Financial Reporting

2.4 Summary of the treatment of construction contracts in the


statement of profit or loss
The following flow chart will help to summarise the accounting treatment seen in sections 2.1 – 2.3
of the chapter.
Does the construction period No Recognise contract revenue
span a period end? and expenses in the period in
which the contract is
undertaken.

Yes

Can the outcome of the No Recognise contract costs as


project be estimated reliably? incurred.
Recognise revenue to the
extent that contract costs are
recoverable.

Yes

Is the project expected to No Recognise the expected loss


make a profit? immediately.

Yes

Apply the percentage


completion method: revenue,
costs and profits are
recognised according to the
stage of completion of the
contract.

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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.

Example: Loss-making contract (2)


Assume that in the previous example the customer had been billed a total of $1.5million, and had
paid $1,280,000 of this.
The amounts reported in the statement of financial position would therefore be:
$'000
Amounts due from customers (W) 388
Receivables 220

(W) $'000
Contract costs incurred 1,988
Recognised profits less recognised losses (100)
Progress billings (1,500)
Amounts due from customers 388

HKAS 11.38 2.6 Changes in estimates


According to HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, the effect
of any change in the estimate of contract revenue, costs or the outcome of a contract should be
treated as a change in accounting estimate. In other words, the change is accounted for
prospectively and does not affect amounts recognised in respect of previous years of a contract.

Example: Changes in estimates


Revenues and costs relating to a three-year contract commencing 1 January 20X5 are as follows:
20X5 20X6 20X7
$'000 $'000 $'000
Revenue per contract 1,200 1,200 1,200
Agreed variation - - 200
Total contract revenue 1,200 1,200 1,400
Contract costs incurred to date 263 700 1,320
Contract costs to completion 789 600 –
Total contract costs 1,052 1,300 1,320
Overall profit 148 (100) 80
% complete, using costs basis 25% 54% 100%

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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

20X6 Loss is expected and is recognised in full (100)


Less: profit previously recognised (37)
Loss recognised in 20X6 (137)

$'000
20X7 Overall actual profit 80
Add: cumulative loss previously recognised 100
Profit recognised in 20X7 180

2.7 Section summary


A methodical approach is crucial for the valuation of long-term construction contracts and the other
disclosure requirements under HKAS 11. The following method suggests a breakdown of the
process into five logical steps, and is to be applied where the outcome of a contract can be
estimated reliably.
1 The contract value is compared to the estimated total costs (costs to date plus estimated
costs to completion) to be incurred on the contract. If a foreseeable loss on the contract is
expected (that is, if the estimated total costs exceed the contract value), then this loss must
be charged against profits. If a loss has already been charged previously, then only the
difference between this loss and the loss currently estimated needs to be charged.
2 Apply the percentage of completion to date (or other formula given in the question) to the
calculation of the sales revenue attributable to the contract for the period (for example,
percentage of completion  total contract value, less revenue already recognised in previous
periods).
3 Calculate the cost of sales on the contract for the period.
$
Total contract costs  percentage complete (or follow instructions in question) X
Less any costs charged in previous periods (X)
X
Add foreseeable losses in full (not previously charged) X
Cost of sales on contract for the period X
4 Deduct the cost of sales for the period as calculated above (including any foreseeable loss)
from the sales revenue calculated at step 2 to give profit (loss) recognised for the period.

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5 Calculate amounts due to/from customers for inclusion in the statement


of financial position
$
Contract costs incurred to date X
Recognised profits/(losses) to date X
X
Progress billings to date (X)
Amounts due from/(to) customers X
Note. The progress billings figure above represents the total billed revenue. Unpaid billed revenue
will be shown under trade receivables.
HKAS
11.39,40,42
2.8 Disclosures
The following should be disclosed in respect of construction contracts:
 The amount of contract revenue recognised as revenue in the period
 The methods used to determine the contract revenue recognised in the period
 The methods used to determine the stage of completion of contracts in progress
In addition, the following should be disclosed for contracts in progress at the reporting date:
 The aggregate amount of costs incurred and recognised profits (less recognised losses) to date
 The amount of advances received (amounts received before the related work is performed)
 The amount of retentions (amounts billed but unpaid until defects are rectified or conditions
specified in the contract are met)
An entity should also present:
 The gross amount due from customers for contract work as an asset
 The gross amount due to customers for contract work as a liability.

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)

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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 and FASB issued an Exposure Draft in relation to revenue recognition in June 2010. It is
proposed that the resulting standard will replace both IAS 18 Revenue and IAS 11 Construction
Contracts (and so their HKAS equivalents).
A revised exposure draft on the topic of revenue from contracts with customers was issued in
November 2011, which simplifies a number of the original proposals. A final standard is expected during
the course of 2013.
This project is considered in more detail in Chapter 14.

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Topic recap

HKAS 11 Construction Contracts

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

HKAS 11 applies where a contract spans


the period end

For a cost plus contract: Accounting treatment depends on whether For a fixed price contract:
Ÿ Probable economic benefits will the outcome of the contract can be Ÿ Contract revenue can be
flow to the entity reliably estimated reliably measured
Ÿ Contract costs can be clearly Ÿ Probable economic benefits
identified and measured will flow to entity
Ÿ Stage of completion of contract
reliably measured
Ÿ Costs to complete reliably
measured
Ÿ Contract costs can be clearly
identified and measured

Can be reliably measured Can't be reliably measured

Profitable contract Loss-making contract No profit or loss is recognised.


Revenue is recognised to the extent
that recognised costs incurred are
recoverable

Revenue, costs and profit are Loss is recognised in full as soon as it is


recognised based on stage of foreseen
completion

Disclose:
Ÿ Revenue recognised in period
Ÿ Methods to determine revenue recognised
Ÿ Methods to determine stage of completion
Ÿ Costs incurred plus recognised profits (less recognised losses) to date
Ÿ Advances received
Ÿ Retentions
Ÿ Amounts due from/to customers:

Costs incurred x
Recognised profits/losses x/(x)
Progress billings (x)
x/(x)

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Financial Reporting

Answers to self-test questions

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

Amounts to be recognised 20X2 20X2


20X1 cumulative (cum – 20X1)
$'000 $'000 $'000
Revenue (30%  $14m / 80%  $17.22m) 4,200 13,776 9,576
Costs (β) (6,300) 6,580

Loss (in full) (2,100)


Profit (80%  $1.12m) 896 2,996

At 31 December 20X1 the expected loss must be recognised immediately.


Under the agreement made on 31 December 20X2, the contract revenue is increased by the
variation and reduced by the penalty.
The profit for the year ended 31 December 20X2 is the profit to date, PLUS the loss recognised in
20X1.

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Answer 2
(a) STATEMENT OF PROFIT OR LOSS (EXTRACTS) $

Revenue (60%  100,000) 60,000

Expenses (60%  80,000) (48,000)

Profit 12,000

STATEMENT OF FINANCIAL POSITION (EXTRACTS)


Current assets
Gross amounts due from customers
Contract costs incurred to date 48,000
Recognised profits 12,000
60,000
Less: progress billings to date (58,000)
2,000
Trade receivables

Progress billings to date 58,000


Less: cash received (50,000)
8,000

WORKING

Overall expected profitability $


Total revenue 100,000
Total expected costs (48,000 + 32,000) (80,000)
Overall expected profit 20,000

(b) STATEMENT OF FINANCIAL POSITION (EXTRACTS) $

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

Construction contracts 22 minutes


(a) "It is not prudent to recognise profit on outstanding work in progress in construction
contracts. Revenue and cost should only be recognised upon the completion of the
construction work." Discuss. (5 marks)
(b) At 30 June 20X9, Vertical Construction Company ("VC") had a fixed price construction
contract in progress, named Waterfall Golf Villa, a project to construct 80 condominium units.
60 units have been completed and the remaining 20 units are expected to be completed in
the last quarter of 20X9. A survey of completed construction work will be carried out upon
completion of all units. Construction was begun in April 20X8 and the outcome of the
contract could not be estimated reliably at 30 June 20X8. According to the original bid
estimate, VC would have a profit margin of 20%. Based on the actual costs incurred and the
latest information, there will be an increase in the estimated total costs because of a 15%
increase in the price of construction material. However, a loss is not anticipated. An
instalment contract sum for the construction has been received by VC in accordance with the
contracted payment schedule.
Required
Explain how VC should account for this construction contract in the financial statements for
the year ended 30 June 20X9. (7 marks)
(Total = 12 marks)
HKICPA May 2009

264
chapter 13

Share-based payment

Topic list

1 HKFRS 2 Share-Based Payment


1.1 Introduction
1.2 Objective and scope
1.3 Definitions
2 Recognition and measurement of share-based payments
2.1 Equity settled share-based payment transactions
2.2 Cash settled share-based payment transactions
2.3 Share-based payments with a choice of settlement
2.4 Section summary
3 Share-based payment transactions – further issues
3.1 Group cash-settled share-based payment transactions
3.2 Treasury share transactions
4 Disclosure of share-based payment transactions
4.1 Nature and extent of share-based payment arrangements
4.2 Determination of fair value
4.3 Effect on profit or loss and financial position
5 Share-based payment transactions and deferred tax
5.1 Measurement of temporary difference
6 Modifications to the terms and conditions on which equity instruments were granted, including
cancellations and settlements
6.1 Measurement in modification

Learning focus

Share-based payment is a controversial area. It is, however relevant, as share option


schemes are common.

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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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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13: Share-based payment | Part C Accounting for business transactions

1 HKFRS 2 Share-Based Payment


Topic highlights
Share-based payment transactions are those transactions where an entity receives goods or
services in return for its own equity instruments or an amount of cash related to the value of its
equity instruments.

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.

HKFRS 2.1-6 1.2 Objective and scope


HKFRS 2 requires an entity to reflect in its profit or loss and financial position the effects of
share-based payment transactions, including expenses associated with transactions in which
share options are granted to employees.
The standard must be applied to all share-based payment transactions whether or not the goods or
services received under the share-based payment transaction can be individually identified,
including:
(a) Equity-settled share-based payment transactions
(b) Cash-settled share-based payment transactions
(c) Transactions in which the entity receives or acquires goods or services and the terms of the
arrangement provide either the entity or the supplier of those goods or services with a choice
of whether the entity settles the transaction in cash (or other assets) or by issuing equity
instruments.
The standard also applies to group-settled share-based transactions. That is where one group
entity receives goods or services and another entity within the group settles the share-based
payment transaction. In this case HKFRS 2 applies to both entities.
Certain transactions are outside the scope of the HKFRS:
(a) Transactions with employees and others in their capacity as a holder of equity instruments of
the entity (for example, where an employee receives additional shares in a rights issue to all
shareholders)

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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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13: Share-based payment | Part C Accounting for business transactions

Key terms (cont'd)


Measurement date is 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.
Vest means 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.
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.
Vesting period is the period during which all the specified vesting conditions of a share-based
payment arrangement are to be satisfied.

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.

2 Recognition and measurement of share-based


HKFRS 2.7-8
payments
The basic principle presented in HKFRS 2 with regard to recognition is that an entity should
recognise goods or services received or acquired in a share-based payment transaction when it
obtains the goods or as the services are received.
The goods or services received should be recognised as an expense, or asset where appropriate.
The corresponding accounting entry depends on whether the share-based payment will be equity
or cash-settled.

HKFRS 2.10 2.1 Equity settled share-based payment transactions


Topic highlights
Equity-settled share-based payment transactions with parties other than employees are measured
at the fair value of the goods or services received and recognised in equity, normally immediately.
Equity settled share-based payment transactions with employees are measured at the fair value of
the equity instruments on the grant date and recognised in equity over the vesting period.

Goods or services received or acquired in an equity-settled share-based payment transaction


should be recognised in equity:
DEBIT Expense / asset
CREDIT Equity
Before considering when this accounting entry is made, we must consider how an equity settled
share-based payment is measured.

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Financial Reporting

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.)

Example: Measurement of equity-settled share-based transactions


Barbar Co. issues 100 share options to each of its 1,000 employees on 1 July 20X1.
The fair value of the share options is $8 on grant date.
Required
How is the share-based transaction measured?

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

HKFRS 2.1.2 Recognition of equity-settled share-based payment transactions


2.14,15
Where the equity instruments granted vest immediately i.e. the recipient party becomes entitled to
them immediately, then the transaction is accounted for in full on the grant date. This is normally
the case with transactions with parties other than employees, which are:
 measured at the fair value of the goods or services received, and
 recognised when the goods or services are provided.
Where the counterparty to the transaction has to meet specified 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. This is normally the case with transactions with employees,
discussed in more detail in the next section.

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13: Share-based payment | Part C Accounting for business transactions

HKFRS 2.1.3 Transactions with employees


2.14,15
Where the equity instruments granted to employees vest immediately (i.e. the employee is not
required to complete a specified period of service before becoming unconditionally entitled to the
equity instruments), 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.
Where the equity instruments granted do not vest until the counterparty 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.
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.

Example: Equity-settled share-based payment transaction – vesting period (1)


Continuing with the example above:
(a) Assume that the share options issued by Barbar Co. to its employees vest immediately and
there is a three-year period over which the employees may exercise the share options.
Employees are entitled to exercise the options regardless of whether or not they remain in
the entity’s employment during the period of exercise.
(b) Assume that the share options issued by Barbar Co. on 1 July 20X1 do not vest until 1 July
20X3, and this is conditional upon the individual employees remaining in employment with
the company. It is not anticipated that any employees will leave before this date. This
assumption is confirmed at 1 July 20X3 when all 1,000 employees remain in employment.
Required
When is the transaction recognised in each instance assuming a year end of 30 June?

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.
(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.

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Financial Reporting

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 20X3
$ $
Remuneration expense in profit or loss 400,000 400,000
Equity 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.

Example: Equity-settled share-based payment transaction – vesting period (2)


Whiston Co. provides each of 200 managers with 500 share options on 1 January 20X1. Each
option has a fair value of $8 at the grant date, $10 on 1 January 20X2, $13 on 1 January 20X3 and
$12 on 31 December 20X3.
The options do not vest until 31 December 20X3 and are dependent on continued employment.
All 200 managers are expected to remain with the company.
Required
Explain the accounting treatment of the share options in each of the years 20X1, 20X2 and 20X3.

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.

Example: Equity-settled share-based payment transaction – vesting period (3)


The circumstances are as in the example above, however managers are expected to leave the
company as follows:
 At 31 December 20X1, it is estimated that 10% of managers will have left by the end of 20X3.
 At 31 December 20X2, it is estimated that 14% of managers will have left by the end of 20X3.
 By the end of 20X3, 20% of the original managers awarded share options have actually left.
Required
Explain the accounting treatment in each of the years 20X1, 20X2 and 20X3.

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13: Share-based payment | Part C Accounting for business transactions

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 1
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.
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.
Required
Show how the option scheme would be reflected in the financial statements for the years ended
31 December 20X1 and 31 December 20X2.
(The answer is at the end of the chapter)

Self-test question 2
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)

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Financial Reporting

 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.
(The answer is at the end of the chapter)

2.1.4 Multiple vesting dates


In the share-based payment schemes seen in the above examples, there is one date on which the
share options vest. It may, however, be the case that there are a number of vesting dates within one
scheme. In this case, the options relating to each vesting date should be accounted for separately.

Example: Equity-settled share-based payment transaction – multiple vesting dates


On 1 January 20X0, Newsome Co. granted 4,000 options to each of the four directors of the
company. Half of these vest on 31 December 20X1 and half on 31 December 20X2 on the
condition that the directors continue to be employed by Newsome Co. on the relevant vesting date.
It was expected that all of the directors would continue to be employed to 31 December 20X2.
However on 31 March 20X1, one of the directors left the company. This departure did not alter
expectations with regards to the remaining directors continuing in employment. All directors in
receipt of vested options exercised these options at the first opportunity.
On 1 January 20X0, the fair value of each option was estimated to be HK$50.
Required
Show the accounting treatment in each of the years ended 31 December 20X0, 20X1 and 20X2.
Solution
Although the 4,000 options are within the same scheme, they have different vesting dates: 2,000
vest in 20X1 and 2,000 vest in 20X2. In effect, these are two separate types of options and need to
be considered separately.
Options vesting in 20X1
Y/e 31 Options expected to vest FV of Charge to
Dec option profit or loss
HK$ HK$
20X0 2,000  4 = 8,000  50 = 400,000 1yr/2yrs 200,000
20X1 2,000  3 = 6,000  50 = 300,000 300,000
(200,000)
100,000
Options vesting in 20X2
Y/e 31 Options expected to vest FV of Charge to
Dec option profit or loss
HK$ HK$
20X0 2,000  4 = 8,000  50 = 400,000  1yr/3yrs 133,333

20X1 2,000  3 = 6,000  50 = 300,000  2yrs/3yrs 200,000


(133,333)
66,667

20X2 2,000  3 = 6,000  50 = 300,000 300,000


(200,000)
100,000

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The expense in relation to the share-based payment scheme is recognised by (HK$):


$ $
20X0 DEBIT Directors’ remuneration (200,000 + 133,333) 333,333
CREDIT Share-based payment reserve 333,333
20X1 DEBIT Directors’ remuneration (100,000 + 66,667) 166,667
CREDIT Share-based payment reserve 166,667
20X2 DEBIT Directors’ remuneration 100,000
CREDIT Share-based payment reserve 100,000

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.

The following may be included as cash-settled share-based payment transactions:


 The grant of share appreciation rights to employees: instead of the entitlement to an equity
instrument, the employees are entitled to a future cash payment which is based on the
increase in the entity's share price from a specified level over a specified period of time, or
 The grant to its employees of a right to receive a future cash payment by giving them a right
to shares that are redeemable
A liability should be recognised where goods or services are received or acquired in a cash-settled
share-based payment transaction. It is recorded by a debit to an expense or asset account and a
credit to a liability account.
DEBIT Expense/asset
CREDIT Liability
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.

Example: Cash-settled share-based payment transaction


Arthing Co. has provided a share incentive scheme to a number of its employees on 1 January
20X1. This allows for a cash payment to be made to the individuals concerned equal to the share
price at the end of a three-year period subject to the following conditions.
1 Vesting will be after three years
2 The share price must exceed $4
3 The employee must be with the company on 31 December 20X3

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Financial Reporting

Each scheme issued will result in payment, subject to the conditions outlined, equal to the value of
10 shares at the end of the three-year period if the conditions are satisfied. The payments, once
earned, are irrevocable.
The Chief Operating Officer has been issued 20 such schemes.
The share prices over the next three years were as follows:
31 December 20X1 $4.20
31 December 20X2 $3.80
31 December 20X3 $4.40
Required
(a) Prepare the journal entries for the transactions of the share incentives issued to the Chief
Operating Officer.
(b) Assuming that on 1 January 20X1 four other individuals were also granted equivalent rights
to the Chief Operating Officer and that on 1 January 20X2, two of those individuals left the
company, prepare the journal entries for the transactions relating to the incentive schemes.

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)
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)

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2.3 Share-based payments with a choice of settlement


Topic highlights
Where there is a choice of settlement and the counterparty has that choice, both a debt and equity
component of the share-based transaction is identified and accounted for separately.
Where there is a choice of settlement and the entity has that choice, a liability must be recognised
to the extent there is an obligation to deliver cash.

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
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.

Example: Choice of settlement


On 1 January 20X7 an entity grants an employee a right under which he can, if he is still employed
on 31 December 20X9, elect to receive either 10,000 shares or cash to the value, on that date, of
9,000 shares.

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Financial Reporting

The market price of the entity's shares is $310 at the date of grant, $370 at the end of 20X7, $430
at the end of 20X8 and $520 at the end of 20X9, at which time the employee elects to receive the
shares. The entity estimates the fair value of the share route to be $290. Show the accounting
treatment.

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
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.

2.4 Section summary


Equity-settled share-based payment transactions
 Total expenses on equity settlement is expensed to statement of profit or loss:
Number of shares granted  Fair value of options on grant date
Vesting period (years)

 Corresponding entry to equity


 Expensed annually over the vesting period
 No adjustment even though fair value of option changes
Cash-settled share-based payment transactions
 Total expenses on liability settlement expensed to statement of profit or loss:
Number of shares granted  Fair value of options at each reporting date
Vesting period (years)

 Corresponding entry to liability


 Only the residual amount is expensed to statement of profit or loss
 Expensed annually over the vesting period
Choice of settlement – counterparty’s choice
 Compound instrument is split into debt and equity components
 Debt component is accounted for as a cash-settled transaction
 Equity component is accounted for as an equity-settled transaction

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13: Share-based payment | Part C Accounting for business transactions

Choice of settlement – entity’s choice


 Account for as cash-settled if there is an obligation to deliver cash
 Account for as equity-settled otherwise

3 Share-based payment transactions – further issues


Topic highlights
An entity that receives goods or services in a share-based payment transaction must account for
those goods or services no matter which entity in the group settles the transaction, and no matter
whether the transaction is settled in shares or cash.

3.1 Group cash-settled share-based payment transactions


Amendments to HKFRS 2 Share-based Payment: Group Cash-Settled Share-Based Payment
Transactions, which are effective for periods beginning on or after 1 January 2010 clarify how an
individual subsidiary in a group should account for some share-based payment arrangements in its
own financial statements.
HKFRS 3.1.1 Share-based payment transactions among group entities
2.43A-D
HKFRS 2 applies when an entity enters into a share-based payment transaction regardless of
whether the transaction is to be settled by the entity itself, or by another group member on behalf of
the entity.
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

Subsidiary Subsidiary Equity of the subsidiary Equity Equity


Subsidiary Subsidiary Cash Cash Cash
Subsidiary Subsidiary Equity of the parent Cash Equity

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Financial Reporting

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

Subsidiary Parent* Equity of the parent Equity Equity


Subsidiary Parent* Cash Equity Cash

*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?

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 Profit or loss 250
To remeasure the liability based on the period end fair value of the SARs.

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$ $
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 Profit or loss 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 2,000
To record the first year’s service expense and corresponding increase in equity.
20X2 DEBIT Remuneration expense 2,000
(5  10 SARs  $80) – $2,000
CREDIT Equity 2,000
To record the second year's service expense and corresponding increase in equity.

As the transaction is treated as equity-settled in Sublime’s financial statements, no re-


measurement takes place.
Group
The Principal Group as the receiving entity has the obligation to settle in cash and therefore in the
consolidated accounts the transaction is accounted for as cash-settled:
$ $
20X1 DEBIT Expense 1,750
(5  10 SARs  $70)/2 years
CREDIT Remuneration liability 1,750
To recognise the liability at the end of the first year of service based on the fair value of
the SARs at this date.
20X2 DEBIT Expense 2,750
(5  10 SARs  $90) – $1,750
CREDIT Remuneration liability 2,750
To remeasure the liability at the settlement date based on the fair value of the SARs at
this date.

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Financial Reporting

$ $
DEBIT Remuneration liability 4,500
CREDIT Cash 4,500
To record the settlement of the transaction.

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.

3.2 Treasury share transactions


Where a company holds a number of its own shares, those shares are known as "Treasury
shares".
Guidance on treasury share transactions previously contained within HK(Int)IFRIC 11 is
incorporated into HKFRS 2 with effect from 1 January 2010.
Where an entity grants rights to its own equity instruments to employees, and then either chooses
or is required to buy those equity instruments from another party, in order to satisfy its obligations
to its employees under the share-based payment arrangement, the transaction is accounted for as
an equity-settled transaction.

4 Disclosure of share-based payment transactions


HKFRS 2.44 HKFRS 2 has extensive disclosure requirements including:
(a) Information that enables users of the financial statements to understand the nature and
extent of share-based payment arrangements that existed during the period.
(b) Information that enables users of the financial statements to understand how the fair value
of the goods or services received, or the fair value of the equity instruments granted,
during the period was determined.
(c) Information that enables users of the financial statements to understand the effect of share-
based payment transactions on the entity’s profit or loss for the period and on its financial
position.

HKFRS 2.45 4.1 Nature and extent of share-based payment arrangements


Information which aids an understanding of the nature and extent of share-based payment
arrangements includes the following:
(a) A description of each type of share-based payment arrangement that existed at any time
during the period.
(b) The number and weighted average exercise priced of share options outstanding at the
beginning of the period, granted during the period, forfeited during the period, exercised
during the period, expired during the period, outstanding at the end of the period and
exercisable at the end of the period.
(c) For share options exercised during the period, the weighted average share price at the date
of exercise.

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(d) For share options outstanding at the end of the period, the range of exercise prices and
weighted average remaining contractual life.

HKFRS 2.47-
49
4.2 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.

HKFRS
2.50,51
4.3 Effect on profit or loss and financial position
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.

5 Share-based payment transactions and deferred


tax
Topic highlights
A share-based payment will result in a deductible temporary difference and so deferred tax asset.

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.

283
Financial Reporting

5.1 Measurement of temporary difference


The deductible temporary difference is measured as:
Carrying amount of share-based payment expense X
Less: tax base of share-based payment expense
(estimated amount tax authorities will permit as a deduction
in future periods, based on year end information) (X)
Temporary difference (X)
Deferred tax asset at X% X
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

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13: Share-based payment | Part C Accounting for business transactions

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
Exercise price of options
(20,000  $3.75) (75,000)
(90,000  $4.50  1/3) (135,000)
Intrinsic value (estimated tax deduction) 150,000
Tax at 16% 24,000
Less: previously recognised (6,000)
18,000
The cumulative remuneration expense is $110,000, which is less than the estimated tax deduction
of $150,000. Therefore:
 a deferred tax asset of $24,000 is recognised in the statement of financial position at
31 December 20X1
 there is potential deferred tax income of $18,000 for the year ended 31 December 20X1
 of this, $13,600 (16% ($110,000 – $25,000)) is recognised in the statement of profit or loss
 the remainder ($4,400) is recognised in equity.

6 Modifications to the terms and conditions on


which equity instruments were granted, including
cancellations and settlements
Topic highlights
An entity might modify the terms and conditions on which the equity instruments were granted.

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
6.1 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.

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Financial Reporting

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.
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.

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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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Financial Reporting

Topic recap

HKFRS 2 Share-Based Payment

Share-based payments are transactions where an entity receives goods


or services in return for its own equity instruments or an amount of cash
related to the value of its own equity instruments.

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

Equity-settled SBP Cash-settled SBP Choice of settlement

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

Modifications
Ÿ On cancellation or settlement the amount that would have been recognised over the remainder of the vesting period is measured
immediately
Ÿ 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:
Ÿ Information about the nature and extent of share-based payment arrangements
Ÿ Information to enable users to understand how fair values were determined
Ÿ Information to enable users to determine the effect on profit or loss and financial position

Share-based payments and deferred tax


A share-based payment results in a deductible temporary difference and so a deferred tax asset

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Answers to self-test questions

Answer 1
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 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:

DEBIT Remuneration expense 253,125


CREDIT Equity 253,125

Answer 2
20X5 $
Equity c/d and P/L expense ((500 – 75)  100  $15  1/3) 212,500

$ $
DEBIT Expenses 212,500
CREDIT Equity 212,500

20X6 $
Equity b/d 212,500
Profit or loss expense 227,500
Equity c/d ((500 – 60)  100  $15  2/3) = 440,000

$ $
DEBIT Expenses 227,500
CREDIT Equity 227,500

20X7 $
Equity b/d 440,000
Profit or loss expense 224,500
Equity c/d (443  100  $15) = 664,500

$ $
DEBIT Expenses 224,500
CREDIT Equity 224,500

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Financial Reporting

Exam practice

Nextap Company Limited 18 minutes


Nextap Company Limited (NCL) granted each of its 240 managerial staff 20,000 share options on 1
July 20X1. Each option entitles the holder to subscribe to one share of NCL at HK$7.5. 8,000
share options (Type A) were immediately vested. The remaining 12,000 share options (Type B) do
not vest until 30 June 20X3 and are conditional upon the continued employment of the staff on that
day. The market price of NCL's shares at 1 July 20X1 was HK$8. NCL estimated that the fair
value of the Type B share option is HK$1.5 and 15% of the managerial staff will leave during the
two-year period and therefore forfeit their rights to the share options. During the financial year
ended 30 June 20X2, 22 managerial staff had left the company and 10 exercised the Type A option
to subscribe to the shares on 30 April 20X2. NCL has not revised its estimate of the total
managerial staff departures over the two-year period.
Required
(a) Prepare the journal entries for the share options issued by NCL during the year ended 30
June 20X2. (7 marks)
(b) Explain how the estimate of the total number of managerial staff departures will affect the
accounting for the share-based payment. (3 marks)
(Total = 10 marks)
HKICPA December 2012

290
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

Learning focus

Revenue is an important part of any commercial organisation’s financial statements. You


should therefore be able to explain the recognition and measurement criteria of HKAS 18 and
apply them in practice.

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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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

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1 Revenue recognition
Topic highlights
Revenue recognition is straightforward in most business transactions, but can be complicated in
some situations.

1.1 Accrual accounting


Accrual accounting is the fundamental concept which underpins the financial statements. This
requires that costs are matched with the revenue they generate.
Therefore the point at which revenue is recognised must be identified so that the correct treatment
can be applied to the related costs. A simple example involves buying goods for resale: the cost of
the purchases should be carried as an asset in the statement of financial position until such time as
they are sold; they should then be written off as a charge to the trading account.
The decision has a direct impact on profit since under the prudence concept it would be
unacceptable to recognise the profit on sale until a sale had taken place in accordance with the
criteria of revenue recognition.

1.2 Recognition at point of sale


In most circumstances revenue should be recognised as earned at the point of sale, because at
that point four criteria will generally have been met.
1 The product or service has been provided to the buyer.
2 The buyer has recognised his liability to pay for the goods or services provided. The
converse of this is that the seller has recognised that ownership of goods has passed from
himself to the buyer.
3 The buyer has indicated his willingness to hand over cash or other assets in settlement of
his liability.
4 The monetary value of the goods or services has been established.
Therefore, as you will be aware, the normal moment at which revenue should be recognised in the
statement of profit or loss is when the goods are sold.
Before the point of sale, there is not normally firm evidence that the above criteria will be met, in
particular:
 Until the production process is complete, there is a risk that a flaw or error in the process will
result in goods being written off.
 Even when the product is complete there is no guarantee that a buyer will be found.
If revenue is recognised after the point of sale, for example when cash is received, costs may
already have been charged and so will not necessarily be matched to revenue in the same period.
Furthermore, revenue recognition would then depend on fortuitous circumstances, such as the
cash flow of a company's customers, and might fluctuate misleadingly from one period to another.

1.3 Recognition at other times


There are times when revenue is recognised at other times than at the completion of a sale,
for example in the recognition of profit on long-term construction contracts. Under HKAS 11
Construction Contracts contract revenue and contract costs associated with the construction
contract should be recognised as revenue and expenses respectively by reference to the stage of
completion of the contract activity at the year end, once the outcome on the contract can be
estimated reliably.

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Financial Reporting

(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.

HKAS 18.1-6 2.1 Scope


HKAS 18 covers the revenue from specific types of transaction or events:
 Sale of goods (manufactured products and items purchased for resale)
 Rendering of services
 Use by others of entity assets yielding interest, royalties and dividends
Interest, royalties and dividends are included as income because they arise from the use of an
entity's assets by other parties.
Various types of revenue arising from leases, changes in value of financial instruments or other
current assets, insurance contracts, natural increases in agricultural assets and mineral ore
extraction, are covered by other standards and are therefore specifically excluded from this
standard. Reference can be made to the other specific standards for the accounting treatment of
these types of revenue.

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HKAS 18.7,8 2.2 Definitions


The following definitions are given in the standard.

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.

HKAS 2.3 Measurement of revenue


18.9,10

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, 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 financing transaction resulting 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 revenue.

Example: Sofa Co.


Sofa Co. manufactures and sells furniture. It provides all customers with two years' "interest free
credit". On 31 March 20X9, the last day of the accounting year, Sofa Co. made sales of $790,000,
with all customers taking advantage of the interest free credit option.
Sofa Co. has an imputed rate of interest of 6%.
What amounts are recorded in the financial statements of Sofa Co. in respect of the above sale in
the years ended 31 March 20X9, 20Y0 and 20Y1?

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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 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:

DEBIT Receivable 42,186


CREDIT Equity 42,186
In the year ended 31 March 20Y1, the discount is again unwound by $44,717 (6%  $745,283):

DEBIT Receivable 44,717


CREDIT Interest income 44,717
The receivable is now recorded at $790,000, and therefore when cash payment is received, it is
recorded by:

DEBIT Cash 790,000


CREDIT Receivable 790,000

HKAS 18.12 2.3.2 Exchanges of goods and services


Where goods and services are exchanged for other goods and services of a similar nature and
value, the transaction is not considered to generate revenue.
Where goods and services are exchanged for dissimilar goods or services, the transaction is
regarded as generating revenue, and the revenue is measured at the fair value of the goods or
services received (less any cash or cash equivalents paid).
Where the fair value of the goods or services received cannot be reliably measured, revenue is
measured at the fair value of goods or services given up (less any cash transfer).

HKAS 18.13 2.4 Identification of the transaction


Each transaction will usually be recognised in the financial statements as a whole. However, it may
be necessary to break a complicated transaction into its component parts. For example, a sale may
include both a transfer of goods and the provision of future services. The revenue from the latter
should be deferred and recognised as income over the period in which the service is performed.

Example: Component parts of transaction


On 1 March 20X4 Mainframe Co. contracted to deliver a customer a computer system on that date
and provide support and maintenance services for the following three years. The price of the
contract to provide both the computer system and support and maintenance services is $800,000.
The cost of providing support and maintenance services is $50,000 per annum and Mainframe
charges a standard 50% profit mark-up
What revenue is recognised in the financial statements of Mainframe in the year ended
31 December 20X4?

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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.
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).

Conversely, seemingly separate transactions must be considered together if apart they lose
their commercial meaning. 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 of this chapter.

HKAS 18.14 2.5 Recognition: sale of goods


Topic highlights
Generally revenue is recognised on the sale of goods when the entity has transferred to the buyer
the significant risks and rewards of ownership and when the revenue can be measured
reliably.

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
HKAS 18.15- 2.5.1 Transfer of risks and rewards
17
The transfer of risks and rewards can only be decided by examining each transaction. Usually, the
transfer occurs at the same time as either the transfer of legal title, or the passing of
possession to the buyer. This is what happens when you buy something in a shop – both title and
possession pass from the seller to the purchaser when the purchaser buys the goods and leaves
the shop with them.
If significant risks and rewards remain with the seller, then the transaction is not a sale and
revenue cannot be recognised yet, for example if the receipt of the revenue from a particular sale
depends on the buyer receiving revenue from his own sale of the goods.
It is possible for the seller to retain only an "insignificant" risk of ownership and for the sale and
revenue to be recognised. The main example here is where the seller retains title only to ensure
collection of what is owed on the goods. This is a common commercial situation, and when it arises
the revenue should be recognised on the date of sale.

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Financial Reporting

HKAS 2.5.2 Probable economic benefits


18.18,19
Revenue can only be recognised once the inflow of economic benefits to the seller is probable,
thus the probability of the entity receiving the revenue arising from a transaction must be assessed.
It may only become probable that the economic benefits will be received when an uncertainty is
removed, for example government permission for funds to be received from another country. Only
when the uncertainty is removed should the revenue be recognised.
This is in contrast with the situation where revenue has already been recognised but where the
collectability of the cash is now brought into doubt. Where recovery has ceased to be probable,
the amount should be recognised as an expense, not an adjustment of the revenue previously
recognised. These points also refer to services and interest, royalties and dividends in section 2.7
below.
Revenue and expenses relating to the same transaction should be recognised at the same time (an
application of the matching concept). It is usually possible to estimate such expenses reliably at
the date of sale (e.g. warranty costs, shipment costs, etc.). Where they cannot be estimated
reliably, then revenue cannot be recognised; any consideration which has already been received is
treated as a liability.

2.6 Recognition: rendering of services


When the outcome of a transaction involving the rendering of services can be estimated reliably,
the associated revenue should be recognised by reference to the stage of completion of the
transaction at the reporting date.
HKAS 2.6.1 Estimated reliably
18.20,23
The outcome of a transaction can be estimated reliably when all of the following conditions are
satisfied:
(a) The amount of revenue can be measured reliably.
(b) It is probable that the economic benefits associated with the transaction will flow to the entity.
(c) The stage of completion of the transaction at the reporting date can be measured reliably.
(d) The costs incurred for the transaction and the costs to complete the transaction can be
measured reliably.
The parties to the transaction will normally have to agree the following before an entity can make
reliable estimates.
(a) Each party's enforceable rights regarding the service to be provided and received by the
parties
(b) The consideration to be exchanged
(c) The manner and terms of settlement
HKAS 2.6.2 Stage of completion
18.24,25
There are various possible methods of determining the stage of completion of a transaction,
including:
 surveys of work performed
 services performed to date as a percentage of total services to be performed
 costs incurred to date as a percentage of total estimated costs
For practical purposes, when services are performed by an indeterminate number of acts over a
period of time, revenue should be recognised on a straight line basis over the period, unless
there is evidence for the use of a more appropriate method. If one act is of more significance than
the others, then the significant act should be carried out before revenue is recognised.

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HKAS 18.26- 2.6.3 Outcome cannot be estimated reliably


28
In uncertain situations, when the outcome of the transaction involving the rendering of services
cannot be estimated reliably, the standard requires that revenue is recognised only to the extent
of the expenses recognised that are recoverable.
This is particularly likely during the early stages of a transaction, but it is still probable that the
entity will recover the costs incurred. So the revenue recognised in such a period will be equal to
the expenses incurred, with no profit.
If the costs are not likely to be reimbursed, then they must be recognised as an expense
immediately. When the uncertainties cease to exist, revenue should be recognised as laid out in
the first paragraph of section 2.6.

HKAS 18.29 2.7 Recognition: interest, royalties and dividends


Revenue arising from the use by others of the entity's assets yielding interest, royalties and
dividends is recognised when:
(a) it is probable that the economic benefits associated with the transaction will flow to the entity,
and
(b) the amount of the revenue can be measured reliably
Once again, the points made above about probability and collectability on 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 accruals 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.

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Financial Reporting

HKAS 18,
Illustrative
2.8 Determining whether an entity is an agent or principal
Guidance 21
Rules for determining whether an entity is acting as an agent were amended in 2009. In an agency
relationship, the gross inflows of economic benefits include amounts collected on behalf of the
principal and which do not result in increases in equity for the entity. The amounts collected on
behalf of the principal are not revenue. Instead, revenue is the amount of commission.
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.

HKAS
18,Illustrative
2.9 Revenue recognition: examples
examples
The appendix to HKAS 18 provides a number of examples of the application of the recognition
criteria. These examples assume that the amount of revenue can be measured reliably, it is
probable that economic benefits will flow to the entity and costs can be measured reliably.
The following transactions are common in practice.
2.9.1 Consignment sales
Consignment sales are transactions whereby one entity (the seller) sells goods to another (the
buyer) and that entity undertakes to sell the goods to a third party on behalf of the seller. The
goods which are transferred are often referred to as consignment inventory. The seller normally
retains legal title to the goods until such time as they are sold on to a third party.
This form of arrangement is common in the motor trade whereby a manufacturer sells cars to a
dealer who sells them on to the ultimate customer. Often where an onward sale is not achieved,
the dealer can return the cars to the manufacturer.
In this situation, the risks and rewards are not deemed to have passed from the seller (the
manufacturer) to the buyer (the dealer) until such time as an onward sale is made. Therefore, the
manufacturer does not record a sale until a car is sold to a third party. In the meantime, although
the cars are in the dealer’s showroom, they remain the inventory of the manufacturer.
2.9.2 Bill and hold sales
Bill and hold sales refer to those sales where the buyer requests that delivery of goods purchased
is delayed, however in the meantime accepts legal title and billing.
In these circumstances, revenue is recognised when the buyer takes title, provided that:
(a) it is probable that delivery will be made
(b) the goods are available for delivery
(c) the buyer acknowledges the delayed delivery
(d) normal payment terms apply

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2.9.3 Sale and repurchase agreements


A sale and repurchase agreement refers to a transaction where one party sells an asset to another,
but the terms of the sale provide for the asset to be repurchased by the seller at a later date under
certain conditions.
This form of arrangement is common amongst whisky distillers, who sell their stocks to banks while
they mature. When the whisky has matured, it is re-purchased by the distillery. The whisky is not, in
the meantime physically transferred to bank premises, but remains on site at the distillery. In this
case, the substance of the transaction is obviously a secured loan: the bank is effectively lending
money to the distillery secured on the whisky.
These arrangements should be accounted for in accordance with their commercial substance. Not all
situations will be as straightforward as the whisky example, and the appendix to HKAS 18 states that
consideration should be given as to whether the risks and rewards of ownership have been
transferred to the buyer (regardless of legal title). Where this is the case, a sale should be recorded.
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.
Any contingent gains or losses, 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).

Self-test question 1
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.
(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)

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3 Interpretations related to revenue recognition


Topic highlights
Three Interpretations are relevant to revenue recognition:
 HK(IFRIC) Int-12 Service Concession Arrangements
 HK(IFRIC) Int-13 Customer Loyalty Programmes
 HK(IFRIC) Int-15 Agreements for the Construction of Real Estate

3.1 HK(IFRIC) Int-12 Service Concession Arrangements


3.1.1 What is a service concession arrangement?

Key term
Service concession arrangements are 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. The objective of this project of the HK(IFRIC) is to clarify how
certain aspects of existing HKICPA literature are to be applied to service concession
arrangements. (HK(IFRIC) Int-12)

3.1.2 Two types of service concession arrangements


HK(IFRIC) Int-12 identifies two types of service concession arrangement:
(a) One in which the operator has a contractual right to receive cash or another financial asset
from the government
(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
For the first type of arrangement the operator recognises a financial asset measured at fair value
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
The operator recognises an intangible asset measured at fair value to the extent that it receives a
right (a licence) to charge users of the public service.

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3.1.5 Operating revenue


The operator of a service concession arrangement recognises and measures revenue in
accordance with HKAS 11 and 18 for the services it performs.

Example: Electricity Co.


Electricity Co. is a private sector entity, which has entered into an arrangement with government to
supply a minimum quantity of electricity for 30 years to the public within a specific district.
Electricity Co. designs and builds a power plant on government land to produce the needed
electricity and maintains control over all significant aspects of operating the power plant within the
terms of the agreement. The agreement provides for the following:
 The legal title to the power plant will be transferred to the government body at the end of the
arrangement.
 Electricity Co. is responsible for repairs, maintenance, and capital expenditure related to the
power plant.
 Electricity Co. must stand ready to deliver a minimum quantity of electricity each month.
 Electricity Co. is paid by the public directly, charge is based primarily on their own usage.
 The government regulates the prices that Electricity Co. may charge to the public such that
Electricity Co.'s return is capped by reference to operating costs and capital investment. The
government does not guarantee any minimum level of income for Electricity Co.
How should the above transaction be accounted for?

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.

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Financial Reporting

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
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.

3.2 HK(IFRIC) Int-13 Customer Loyalty Programmes


3.2.1 The issue
Customer loyalty programmes are programmes whereby customers who buy goods or services are
awarded credits by an entity. These may include reward points or travel miles and can be
redeemed in the future for free or discounted goods.
HK(IFRIC) Int-13 Customer Loyalty Programmes addresses accounting for such arrangements by
the entities which grant the credits.
The deferred amount is recognised as revenue only when the entity has fulfilled its obligations by
supplying the awards itself or paying a third party to do so.
3.2.2 Key provisions
The Interpretation requires that the proceeds of the initial sale are split between:
 revenue, and
 deferred revenue associated with the credits awarded
The proceeds recognised as deferred revenue are measured by reference to the fair value of the
credits awarded. The fair value of award credits should take into account:
 the amount of discounts or incentives that would otherwise be offered to customers who
have not earned award credits from an initial sale; and
 the proportion of award credits that are not expected to be redeemed by customers (any
expected forfeitures), If customers can choose from a range of different awards, the fair
value of the award credits will reflect the fair values of the range of available awards,
weighted in proportion to the frequency with which each award is expected to be selected.

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The deferred amount is recognised as revenue only when the entity has fulfilled its obligations by
supplying the awards itself or paying a third party to do so.
HK(IFRIC) Int-13 gives a choice as to whether the amount allocated to the award credits should be:
(a) Equal to their fair value (irrespective of the fair values of the other components); or
(b) A proportion of the total consideration based on the fair value of the award credits relative to
the fair values of the other components of the sale.
In developing the HK(IFRIC) Int-13, it was decided that it should not be more prescriptive than
HKAS 18 Revenue, which does not specify which of the above should be used.
If at any time the expected costs of meeting the obligation exceed the consideration received, the
entity has an onerous contract for which HKAS 37 would require recognition of a liability.
If HK(IFRIC) Int-13 causes an entity to change its accounting policy for customer loyalty awards,
HKAS 8 applies.

Example: Loyalty points


Loyalty points can arise in one of two ways – either by the entity implementing its own loyalty
programmes (e.g. Park-N-Shop) or by a third party applying such loyalty programmes (e.g. HSBC
credit card providing the programme for the retailers who participate in its programme). The entity
can also recognise this deferred revenue by either allocating the deferred revenue systematically
(amortisation) or on a sale-by-sale basis. The following examples are shown on a sale-by-sale
basis for convenience.
Case 1 is easy, according to paragraph 7 of the Interpretation:
If the entity supplies the awards itself, it shall recognise the consideration allocated to
award credits as revenue when award credits are redeemed and it fulfils its obligations to
supply awards. 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.
What that essentially means is this: take Park-N-Shop for example, who award one point for every
$100 that a customer spends: every 100 points can be redeemed for goods with a retail price of
$100. The accounting entries following a sale of goods for $200 would be:
$ $
DEBIT Cash/credit card receivables 200
CREDIT Deferred revenue – Loyalty points ($200/$100  1 point) 2
CREDIT Revenue 198
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
DEBIT Deferred revenue 2
CREDIT Revenue 100
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

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Financial Reporting

(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.
If the retailer makes a sale of $200 the accounting entries would be:
$ $
DEBIT Cash/credit card receivables 200
CREDIT Commission income (20  $0.2) 4
Liability to airline (20  $0.8) 16
Revenue 180
The retailer acts as an agent of the airline and earns commission of $0.2 per point issued. A sale of
$200 leads to the issue of 20 points and commission income of 20  $0.2 = $4.
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.
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 as
the gross $20 in the example above, but must separately recognise the $16 payable to the airline
as an expense. In either case the net income of $4 is ultimately recognised from the transaction.
$ $
DEBIT Cash/credit card receivables 200
CREDIT Income from loyalty programme (20 x $1) 20
Revenue 180
And
DEBIT Loyalty programme expense (20 x $0.8) 16
CREDIT Liability to airline 16

3.3 HK(IFRIC) Int-15 Agreements for the Construction of Real


Estate
HK(IFRIC) Int-15 Agreements for the Construction of Real Estate is effective for annual periods
beginning on or after 1 January 2009.
3.3.1 Reasons for issuing HK(IFRIC) Int-15
The issues addressed in the Interpretation were first published in a draft Interpretation D21 Real
Estate Sales in July 2007. In response to concerns expressed in relation to improving the
articulation between HKAS 11 Construction Contracts and HKAS 18 Revenue and providing

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additional guidance on how to account for revenue in HKAS 18, the Hong Kong Financial Reporting
Interpretations Committee (HK(IFRIC)) provides guidance on the following two issues in HK(IFRIC)
Int-15:
 Determining whether an agreement for the construction of real estate is within the scope of
HKAS 11 or HKAS 18
 When revenue from the construction of real estate should be recognised
The Interpretation standardises accounting practice across jurisdictions for the recognition of
revenue among real estate developers for sales of units, such as apartments or houses, "off plan",
that is, before construction is complete.
3.3.2 Main features of HK(IFRIC) Int-15
The detailed guidance in HK(IFRIC) Int-15 assumes that the entity has previously analysed the
agreement for the construction of real estate and any related agreements and concluded that it will
retain neither continuing managerial involvement to the degree usually associated with ownership
nor effective control over the constructed real estate to an extent that would preclude recognition of
some or all of the consideration as revenue. If recognition of some of the consideration as revenue
is precluded, the following discussion applies only to the part of the agreement for which revenue
will be recognised.
In some circumstances, agreements may need to be split into separately identifiable components,
with each such component being accounted for separately and the fair value of the total
consideration received or receivable for the agreement allocated to each component. The seller
then applies the requirements of HK(IFRIC) Int-15 to any components for the construction of real
estate in order to determine whether each component is within the scope of HKAS 11 or HKAS 18.
3.3.3 Determining whether the agreement is within the scope of HKAS 11 or
HKAS 18
HKAS 11 applies when the agreement meets the definition of a construction contract set out in
paragraph 3 of HKAS 11. An agreement for the construction of real estate meets the definition of a
construction contract when the buyer is able to specify:
(a) the major structural elements of the design of the real estate before construction begins,
and/or
(b) major structural changes once construction is in progress (whether or not it exercises that
ability).
In contrast, if construction could take place independently of the agreement and buyers have only
limited ability to influence the design of the real estate, the agreement will be for the sale of goods
or the rendering of services and within the scope of HKAS 18.
3.3.4 Accounting for revenue from construction of real estate
Construction contracts (within the scope of HKAS 11)
Where the agreement is a construction contract under HKAS 11, and the outcome of the contract
can be estimated reliably, revenue is recognised by reference to the stage of completion of the
contract activity in accordance with HKAS 11. HK (IFRIC) Int-15 has not introduced any new
requirements or guidance that will affect such contracts.
Agreements for the rendering of services (HKAS 18)
Where the agreement falls within the scope of HKAS 18, and the entity is not required to acquire
and supply construction materials, it may be only an agreement for the rendering of services. This
may arise, for example, in arrangements where the customer acts in essence as its own general
contractor and enters into agreements with individual suppliers for specific goods and services.
Where the entity is responsible only for assembling materials supplied by others (i.e. it has no
inventory risk for the construction materials), the agreement is an agreement for the rendering of
services.

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Financial Reporting

In such circumstances, if the criteria in HKAS 18 are met, revenue is recognised by reference to
the stage of completion of the transaction 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.
Agreements for the sale of goods (HKAS 18)
An agreement for the construction of real estate will be an agreement for the sale of goods under
HKAS 18 if it involves the provision of services together with construction materials. For such
contracts, the applicable recognition criteria are those set out in HKAS 18.
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.
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
Consequential amendments to the Appendix in HKAS 18
HK(IFRIC) Int-15 superseded the real estate guidance (Example 9) in HKAS 18.
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 in
the Appendix.
In addition, three illustrative examples designed to assist in the application of the Interpretation
accompany HK(IFRIC) Int-15.

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Effective date and transition


HK(IFRIC) Int-15 is effective for annual periods beginning on or after 1 January 2009. Earlier
application is permitted. If an entity applies the Interpretation for a period beginning before
1 January 2009, that fact should be disclosed.
Changes in accounting policy resulting from the adoption of the Interpretation are required to be
accounted for retrospectively in accordance with HKAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors. Therefore, entities will be required to re-examine and, where
applicable, retrospectively restate the revenue recognition for agreements that are in progress as at
the opening date of the earliest period presented for comparative purposes.

Example: Apartment purchase


An entity is developing residential real estate and starts marketing individual units (apartments)
while construction is still in progress. Buyers enter into a binding sale agreement that gives them
the right to acquire a specified unit when it is ready for occupation. They pay a deposit that is
refundable only if the entity fails to deliver the completed unit in accordance with the contracted
terms. Buyers are also required to make progress payments between the time of the initial
agreement and contractual completion.
The balance of the purchase price is paid only on contractual completion, when buyers obtain
possession of their unit. Buyers are able to specify only minor variations to the basic design but
they cannot specify or alter major structural elements of the design of their unit. In the jurisdiction,
no rights to the underlying real estate asset transfer to the buyer other than through the agreement.
Consequently, the construction takes place regardless of whether sale agreements exist.
How should the above transaction be accounted for?

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.

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Self-test question 2
(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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Analysis of a single agreement for the construction of real estate

Can components other than for the construction of real No


estate be identified within the agreement (e.g. a sale of land A
or provision of property management service)?

Yes

Split the agreement into separately identifiable components

Allocate the fair value of the consideration received or


receivable to each component

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 Yes The agreement or component is Revenue and costs are
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

No Revenue is recognised when all


the conditions in paragraph 14
of HKAS 18 have been satisfied

* 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

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4 Current developments
The IASB and FASB issued an Exposure Draft (ED) in relation to revenue recognition in June
2010. A revised exposure draft on the topic of revenue from contracts with customers was issued in
November 2011, which simplifies a number of the original proposals. A new standard is expected
during the course of 2013 and this will replace both IAS 18 Revenue and IAS 11 Construction
Contracts (and so their HKAS equivalents).
The proposals would require an entity to:
1 Identify a contract with a customer.
2 Identify separate performance obligations in the contract (such that if more than one good or
service is promised, each is accounted for separately only if it could be sold separately or the
customer could benefit from the good or service either alone or together with resources
which are readily available).
3 Determine the transaction price as the amount of consideration to which an entity expects to
be entitled in exchange for transferring promised goods or services to a customer, excluding
amounts collected on behalf of third parties.
4 Allocate the transaction price to the separate performance obligations in proportion to the
standalone selling price of the goods or services underlying each performance obligation.
5 Recognise revenue when each performance obligation is satisfied by the transfer of the
promised good or service to the customer.
The ED also proposes that the costs of obtaining a contract are recognised as an asset if the entity
expects to recover those costs.
Costs of fulfilling a contract which are not eligible for capitalisation in accordance with another
standard would be capitalised only if they:
 relate directly to a contract
 generate or enhance resources which will be used to satisfy future performance obligations,
and
 are expected to be recovered.
For many companies this new approach will not result in a significant change to the amount or
timing of revenue recognised. In other cases there will be a change, for example, when a mobile
phone contract is sold and a handset is provided free of charge, the standard would now require
separate up front recognition of revenue relating to the handset.

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Topic recap

HKAS 18 Revenue Recognition

Measure at the fair value of consideration received or


receivable.
Discount deferred consideration; difference between cash
receivable and discounted amount is interest receivable.

Sale of goods Provision of services Interest, royalties and


dividends

Recognise when: Recognise when: Recognise when:


Ÿ significant risks and rewards Ÿ revenue can be measured Ÿ probable economic
transferred to buyer reliably benefits will flow to the
Ÿ no retention of managerial Ÿ probable economic benefits entity
involvement / effective control will flow Ÿ revenue can be
Ÿ revenue can be measured Ÿ stage of completion can be measured reliably
reliably measured reliably
Ÿ probable economic benefits Ÿ costs can be measured
will flow reliably
Ÿ costs can be measured reliably

Examples:
Ÿ Consignment sales recognised as revenue
when goods sold on to third party
Ÿ 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.
Ÿ Sale and repurchase agreements may in
substance be secured loans.

Disclose:
Ÿ Accounting policies
Ÿ The amount of each significant category of revenue
Ÿ The amount of revenue arising from exchanges of goods or services in each category.

HKAS
HK (IFRIC)
18 Revenue
Interpretations
Recognition

HK(IFRIC) Int-12 Service HK(IFRIC) Int-13 Customer HK(IFRIC) Int-15 Agreements


Concession Arrangements Loyalty Programmes for Construction of Real Estate

Recognise when: Where a customer is HKAS 11 applies where the


Ÿ financial asset model applies awarded “credits” when buyer can specify major
where unconditional making a purchase, sales structural elements of design
contractual right to receive proceeds are split between before construction begins /
cash Ÿ immediate revenue major structural changes once
Ÿ intangible asset model applies Ÿ deferred revenue associated construction is in progress.
to extent there is right to with the credits
charge users of service Otherwise HKAS 18 applies.
Ÿ HKAS 11/18 may be applied.

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Answers to self-test questions

Answer 1
(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) Maximum Velocity should not recognise any revenue in respect of the bicycles as the
significant risks and rewards of ownership have not been transferred at the year end. The
bikes remain in Maximum Velocity’s inventories until confirmation has been received from
the customer that they have been sold on and any money received from him is treated as a
payment in advance.
(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 2
(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.
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.

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(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 of sale, 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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Financial Reporting

Exam practice

Nero Fashion 29 minutes


Nero Fashion Limited (NFL) is a clothing manufacturer in mainland China and distributes its
products through the following channels:
 Counter sales at department stores – walk-in customers purchase and collect the goods
upon the issue of an invoice by and make cash or credit card payments to the department
stores. In accordance with the consignment contract signed between the department store
and NFL, the selling price is determined and inventory is managed by NFL, the sales teams
are employed by NFL while the cashier service is provided by the department stores. The
department stores pay 80% of the retail price of the goods sold to NFL on a monthly basis.
The department stores accept returns or exchanges of goods within 7 days of the invoice
date and all these items are returned to NFL and the amounts deducted from the total
remitted to NFL.
 Distributors – NFL ships the goods to the designated location in accordance with the
instructions of the distributors, including the items and quantity requested. Distributors can
open their own retail store to sell the goods, but NFL will determine the retail prices for the
goods, which are normally the same as the prices offered in counter sales at department
stores. Goods are not returnable except for items with quality problems which can be
returned within 7 days of delivery. The distributors have to sign and return an acceptable
confirmation at the completion of quality inspection or 7 days of delivery, whichever is earlier.
NFL will issue an invoice to the distributors at 50% of the pre-determined retailing price of
items delivered on a monthly basis.
Based on the past three years historical data, less than 0.1% of sales were returned from
customers of department stores within the 7-day period and around 5% of sales were returned from
distributors before signing the confirmation under the above return policies.
Required
(a) Discuss how NFL should account for the sales revenue through these channels, with
reference to HKAS 18 Revenue.
(i) Counter sales at department stores (7 marks)
(ii) Distributors (6 marks)
(b) Discuss how NFL should account for monthly revenue if it will give a 10% discount of the
invoiced amount to the distributors when the respective annual quantity delivered is above
100,000 pieces. (3 marks)
(Total = 16 marks)
HKICPA June 2012 (amended)

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Income taxes

Topic list 5 Measurement of deferred tax


5.1 Full provision method
1 Current tax 5.2 Applicable tax rate
1.1 Definitions 5.3 Discounting
1.2 Recognition of current tax liabilities and
6 Recognition of deferred tax
assets
1.3 Measurement of current tax 7 Presentation of deferred tax
1.4 Recognition of current tax
1.5 Presentation of current tax 8 Summary flowchart

2 Introduction to deferred tax 9 Disclosure of income taxes


2.1 Calculation of deferred tax 9.1 Reconciliation
2.2 Definitions 10 Deferred taxation and business
2.3 Measurement of deferred tax combinations
2.4 Recognition of deferred tax 10.1 Temporary differences arising as a result
3 Taxable temporary differences of business combinations
3.1 Examples of taxable temporary differences 10.2 Recognition criteria
3.2 Taxable temporary differences which do 10.3 Application of the recognition criteria
not result in deferred tax liabilities 10.4 Recognition of deferred tax assets
arising from business combinations
4 Deductible temporary differences 10.5 Section summary
4.1 Examples of deductible temporary
differences 11 Interpretations relating to deferred tax
4.2 Recognition of deferred tax assets 11.1 HK(SIC) Int-21 Income Taxes –
4.3 Deductible temporary differences which do Recovery of Revalued Non-depreciable
not result in deferred tax assets Assets
4.4 Tax losses and credits carried forward 11.2 HK(SIC) Int-25 Income Taxes – Changes
4.5 Reassessment of unrecognised deferred in the Tax Status of an Entity or its
tax assets Shareholders

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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Learning outcomes

In this chapter you will cover the following 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

HKAS 12 Income Taxes covers both current and deferred tax.


 Current tax is the amount actually payable to the tax authorities in relation to the trading
activities of the entity during the period.
 Deferred tax is an accounting measure, used to match the tax effects of transactions with
their accounting impact and thereby produce less distorted results.
The parts of the standard relating to current tax are fairly brief, because this is the simple and
uncontroversial area. This section of the chapter deals with current tax and we come on to deferred
tax in section 2.

HKAS 12.5 1.1 Definitions


These are some of the definitions given in HKAS 12. We will look at the rest later.

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?
(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)

HKAS 12.14 1.2.2 Tax losses carried back


HKAS 12 also requires recognition as an asset of the benefit relating to any tax loss that can be
carried back to recover current tax of a previous period. This is acceptable because it is probable
that the benefit will flow to the entity and it can be reliably measured. In Hong Kong, tax losses
carried back are not allowed from the tax perspective.

Example: Tax losses carried back


Dredger operates in a jurisdiction where trading losses may be carried back one year to offset
against trading profits for the purposes of tax. In the year ended 31 December 20X1, Dredger had
tax-adjusted profits of $126,000; in the following year, the company reported a tax-adjusted loss of
$46,000. Dredger pays tax at 20%.
Required
Calculate the tax effect and prepare the corresponding journal entry for 20X2.

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 12.46 1.3 Measurement of current tax


The measurement of current tax liabilities (assets) for the current and prior periods is
straightforward. Their measurement is the amount expected to be paid (or recovered from) the tax
authorities. The enacted (or substantively enacted) tax rates (and tax laws) at the end of reporting
period should be used.

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.

HKAS 12.77 1.5 Presentation of current tax


Tax assets and liabilities should be disclosed distinctly from other assets and liabilities in the
statement of financial position of an entity.
The tax expense (income) relating to the current period should be presented on the face of the
statement of profit or loss and other comprehensive income.
HKAS 12.71 1.5.1 Offsetting current tax assets and liabilities
Current tax assets and liabilities can be offset, but this should happen only when certain conditions
apply.
(a) The entity has a legally enforceable right to set off the recognised amounts.
(b) The entity intends to settle the amounts on a net basis, or to realise the asset and settle the
liability at the same time.
An entity may have a right to set off a current tax asset against a current tax liability when they
relate to income taxes levied by the same taxation authority and the taxation authority permits the
entity to make or receive a single net payment. The tax expense (income) related to the profit or
loss from ordinary activities should be shown in the statement of profit or loss and other
comprehensive income.

2 Introduction to deferred tax


Topic highlights
Deferred tax is an accounting measure, used to match the tax effects of transactions with their
accounting impact. It is quite complex.

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

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tax is not an amount currently payable to the tax authorities, or relevant to tax practitioners; it is
quite simply an accounting adjustment.
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.

Example: Deferred tax liability


Lightning Co. owns a non-current asset that cost $300 and has a carrying amount of $200.
Cumulative depreciation for tax purposes (sometimes known as capital allowances) is $180 and
the tax rate is 16.5%.
What is the deferred tax impact?

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.

Example: Deferred tax asset


Monarchy Co. operates in a jurisdiction where general provisions for bad debts recognised in the
statement of financial position do not benefit from tax relief until such time as they are certified as a
bad debt. Monarchy Co. recognises such a provision in 20X1 for $200,000. It expects to be
certified as a bad debt in two years' time. The company has always paid tax on all income at 16.5%
and does not believe that this will change in the near future.
What is the deferred tax impact?

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.

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 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%).
 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.

2.1 Calculation of deferred tax


The HKAS 12 method of calculating deferred tax assets and liabilities is as follows. It is referenced
to the examples in the above section in order to aid understanding:

Asset General provision


for bad debt

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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HKAS 12.5 2.2 Definitions

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.

2.2.2 Temporary differences


As we have already seen, a temporary difference (which may be taxable or deductible) arises
where there is a difference between the carrying amount of item and its tax base:
 Where carrying amount > tax base there is a taxable temporary difference
 Where carrying amount < tax base there is a deductible temporary difference
The approach to calculating temporary differences provided within HKAS 12 is known as a
"balance sheet approach". This is because the carrying amount of an item is found in the statement
of financial position and the tax base of an item is in effect its carrying amount for tax purposes.
It may be easier to think about the reason for deferred tax from a profit or loss point of view instead
(remembering that assets and liabilities are of course related to income and expenses!).
Accounting profits and taxable profits are different, as you will know from your tax studies. There
are two reasons for the differences:
(a) Permanent differences occur when revenue or expenses included in accounting profits are
excluded from the computation of taxable profits (for example, client entertainment expenses
may not be allowable for tax purposes).
(b) Temporary differences occur when revenue or expenses are included in both accounting
profits and taxable profits, but in different accounting periods. We have already seen two
examples of this – where depreciation on an asset is charged faster for tax purposes than for
accounting purposes, and where a provision is recognised as an expense when payable but
does not benefit from tax relief until paid.

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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.

HKAS 12.47 2.3 Measurement of deferred tax


A deferred tax asset or liability is measured by applying the tax rate to the temporary difference
calculated.
The tax rate applied to the temporary difference should be that which is expected to apply to the
period when the asset is realised or the liability is settled, based on tax laws in place by the
reporting date.
More detailed measurement rules are provided in section 5 of this chapter.

HKAS 12.58 2.4 Recognition of deferred tax


Deferred tax assets and liabilities relating to all temporary differences should be aggregated and
the overall deferred tax liability or asset recorded in the financial statements.
From year to year, only the movement in this amount is recorded. The opposite entry is to the
deferred tax charge, which forms part of the overall tax charge in the statement of profit or loss and
other comprehensive income.
More detailed recognition rules are provided in section 6 of this chapter.

Example: Deferred tax


The following is relevant to Casares Co. in the year ended 31 December 20X1:
 Non-current assets originally cost $780,000. Accumulated depreciation to date is $210,000
and tax allowances given amount to $320,000 on a cumulative basis
 Interest receivable in Casares' statement of financial position is $160,000. This will not be
taxed until it is received in the year ended 31 December 20X2.
 A provision for $98,000 for legal expenses payable is included in the statement of financial
position. This will not be allowable for tax purposes until it is paid in the year ended
31 December 20X2.
The tax rate applicable to Casares is 16.5%, and since all tax arises within the same taxation
authority deferred tax assets and liabilities may be offset.
At 31 December 20X0 the deferred tax liability reported in Casares' financial statements was
$22,430.
Required
Calculate amounts to be recognised in Casares’ financial statements in respect of deferred tax in
the year ended 31 December 20X1.

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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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3 Taxable temporary differences


Topic highlights
Deferred tax liabilities arise from taxable temporary differences.

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.

HKAS 12, 3.1 Examples of taxable temporary differences


Illustrative
Examples HKAS 12 provides a number of examples of situations where taxable temporary differences may arise.
3.1.1 Transactions affecting the statement of profit or loss and other
comprehensive income
(a) Depreciation of an asset is accelerated for tax purposes. When new assets are purchased,
allowances may be available against taxable profits which exceed the amount of
depreciation chargeable on the assets in the financial accounts.
(b) Development costs which have been capitalised will be amortised in profit or loss, but they
were deducted in full from taxable profit in the period in which they were incurred.
Example: Taxable temporary differences (1)
Leeming Bar Co. is engaged in research and development activities. In the year ended 31 August
20X2, the company spent $740,000 on such activities. $310,000 of this meets the requirements of
HKAS 38 and has been capitalised. To date no amortisation has been charged. For tax purposes
the full $740,000 qualifies for 100% relief in the year of expenditure. The applicable tax rate is
16.5%.
Required
What is the deferred tax impact of this expenditure?
Solution
Carrying amount $310,000
Tax base $nil *
Temporary difference $310,000
Taxable or deductible? Taxable since CA > TB
Therefore deferred tax liability (310,000  $51,150
16.5%)

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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.

Example: Taxable temporary differences (2)


A company purchased a machine for production costing $200,000. At the end of 20X9 the carrying
amount is $120,000. The total depreciation allowance for tax purposes is $90,000 and the current
tax rate is 16.5%.
Required
Calculate the deferred tax liability for the machinery.

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.

HKAS 12.20 3.1.3 Fair value adjustments and revaluations


In the following examples, an asset in the statement of financial position is adjusted to be carried at
fair value, however such an adjustment is not made for tax purposes and original cost remains the
tax base.

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(a) Current investments or financial instruments carried at fair value.


(b) Investment properties carried at fair value.
In the case of revalued property, plant and equipment, there is a taxable temporary difference
only where the revaluation does not affect current taxable profits.
If the revaluation affects the taxable profit for the current period, the tax base of the asset changes
to become equal to fair value (and so carrying value) and no temporary difference arises.

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.

Example: Initial recognition


As an example of the last paragraph, suppose Perris Co. intends to use an asset which cost
$10,000 in 20X7 through its useful life of five years. Its residual value will then be nil. The tax rate is
16.5%. Any capital gain on disposal would not be taxable (and any capital loss not deductible).
Depreciation of the asset is not deductible for tax purposes.
Required
State the deferred tax consequences in each of years 20X7 and 20X8.

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)

4 Deductible temporary differences


Topic highlights
Deferred tax assets arise from deductible temporary differences.
The standard states that deferred tax assets can only be recognised when sufficient future
taxable profits exist against which they can be utilised.

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.)

Example: Deductible temporary differences (1)


Teide Co. owns a specialised machine which originally cost $4,000,000. In the year ended
31 October 20X2 as the result of economic recession, Teide undertook an impairment review and
found that the recoverable amount of the machine was $2,600,000, this being $800,000 lower than
carrying amount. At 31 October 20X2, tax allowances given in respect of the machine amounted to
$1,000,000.
Required
What amount of deferred tax is recognised in respect of the machine at 31 October 20X2?

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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

4.1.2 Fair value adjustments and revaluations


A fair value which is lower than cost may be shown for current investments or financial instruments.
However, no equivalent adjustment for tax is to be made.

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.

Example: Deductible temporary differences (2)


Rombauld Co. recognises a liability of $75,000 for accrued product warranty costs on 31 December
20X1. These product warranty costs will not be deductible for tax purposes until the entity pays
claims. The tax rate is 16.5%.
Required
State the deferred tax implications of this situation.

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.

4.3 Deductible temporary differences which do not result in


deferred tax assets
HKAS 12.33 4.3.1 Initial recognition of an asset or liability
There are circumstances where the overall rule for recognition of deferred tax asset is not allowed.
This applies where the deferred tax asset arises from initial recognition of an asset or liability in a
transaction which is not a business combination, and at the time of the transaction, affects neither
accounting nor taxable profit/tax loss.
The example given by the standard is of a non-taxable government grant related to an asset,
deducted in arriving at the carrying amount of the asset. For tax purposes, however, it is not
deducted from the asset's depreciable amount (i.e. its tax base). The carrying amount of the asset
is less than its tax base and this gives rise to a deductible temporary difference, however this is not
recognised as a deferred tax asset.

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.

Example: Taxable profit not available


Jerome Co. has made trading profits for a number of years, however due to an economic downturn
in the first half of the year, reported a taxable loss of $270,000 in the year ended 31 December
20X1. In accordance with local tax law, Jerome intends to carry $130,000 of this back to 20X0 to
set against the taxable profits of that year, and carrying the remaining $140,000 forward
indefinitely. By the end of 20X1, management had identified an upturn in orders and felt that
Jerome would return to profit in 20X2.
What is the deferred tax impact, if any, of Jerome’s losses?
Jerome pays tax at 16.5%.
Solution
 The $130,000 carried back to 20X0 is relevant to current tax rather than deferred tax, and a
receivable of $21,450 should be recognised.
 It appears that the $140,000 carried forward will be able to be utilised by Jerome and
therefore a deferred tax asset of $23,100 can be recognised (16.5%  $140,000).

HKAS 12.37 4.5 Reassessment of unrecognised deferred tax assets


An entity should carry out a reassessment for all unrecognised deferred tax assets at the end of
each reporting period. The availability of future taxable profits and whether part or all of any
unrecognised deferred tax assets should now be recognised are the issues to be considered. This
may be due to an expected continuation in improvement of trading conditions. Conversely, a
previously recognised deferred tax asset may require decreasing or derecognising where future
taxable profits are no longer available.

5 Measurement of deferred tax


Topic highlights
A deferred tax asset or liability is measured by applying the tax rate which is expected to apply to
the period when the asset is realised or the liability is settled to the temporary difference. The
resulting amount is not discounted.

5.1 Full provision method


HKAS 12 adopts the full provision method of providing for deferred tax, in other words deferred tax
is provided for on all temporary differences, irrespective of the future plans of an entity.
This method has the advantage that it recognises that each temporary difference at the year end
has an effect on future tax payments. The disadvantage of full provision is that, under certain
types of tax system, it gives rise to large liabilities that may fall due only far in the future.

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HKAS 12.47 5.2 Applicable tax rate


Where the tax rate fluctuates year to year, consideration must be given to which tax rate to apply
to temporary differences in calculating a deferred tax asset or liability.
HKAS 12 requires deferred tax assets and liabilities to be measured at the tax rates expected to
apply in the period when the asset is realised or liability settled, based on tax rates and laws
enacted (or substantively enacted) at the end of the reporting period.
This is referred to as the liability method.
HKAS 12.49 5.2.1 Different rates of tax
Some countries apply different tax rates to different levels of taxable income. Average tax rates
should then be used to measure the deferred tax assets and liabilities since these rates are
expected to be applied to the taxable profit (loss) of the periods in which the temporary differences
are expected to reverse.
HKAS 5.2.2 Manner of recovery or settlement
12.51,51A
In some jurisdictions either the tax rate or the tax base will differ depending on the way in which an
entity recovers or settles the carrying amount of an asset or liability.
For example, the tax rate applicable to income from the ongoing use of an asset may differ from
the tax rate applicable to a chargeable gain on its sale.
In this instance the entity must consider the expected manner of recovery or settlement. Deferred
tax liabilities and assets must be measured accordingly, using an appropriate tax rate and tax
base.

Example: Manner of recovery/settlement


Clio Co. has an asset with a carrying amount of $100,000 and a tax base of $60,000. If the asset
were sold, a tax rate of 18% would apply. A tax rate of 25% would apply to other income.
Required
State the deferred tax consequences if the entity:
(a) sells the asset without further use.
(b) expects to keep the asset and recover its carrying amount through use.

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.

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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)

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.

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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.

6 Recognition of deferred tax


HKAS As with current tax, deferred tax is normally recognised as income or an expense and included in
12.58,61A the profit or loss for the period. The amount recognised comprises:
(a) deferred tax relating to temporary differences
(b) adjustments arising as a result of changes in the carrying amount of deferred tax assets and
liabilities due to changes in the tax rates, reassessment of the recoverability of deferred tax
assets or a change in the expected recovery of an asset.
The exceptions to recognition of deferred tax in profit or loss are where the tax arises from the
events below.
(a) A transaction or event which is recognised in other comprehensive income e.g. a
revaluation.
(b) A transaction or event which is recognised (in the same or a different period) directly in
equity e.g. the correction of an error.
(c) A business combination (other than the acquisition by an investment entity of a subsidiary
that is required to be measured at fair value through profit or loss) (see section 10.4 of the
chapter).
Where transactions or events are recognised in other comprehensive income or directly in equity,
the related tax is also recognised in other comprehensive income or directly in equity.
Where it is not possible to determine the amount of tax that relates to items recognised in other
comprehensive income or directly in equity, such tax amounts should be based on a reasonable
pro rata allocation of the entity's tax.

7 Presentation of deferred tax


HKAS 12.74 Deferred tax assets and liabilities can be offset only if:
(a) the entity has a legally enforceable right to set off current tax assets against current tax
liabilities, and
(b) the deferred tax assets and liabilities relate to income taxes levied by the same taxation
authority on either:
(i) the same taxable entity, or
(ii) different taxable entities which intend either to settle current tax liabilities and assets
on a net basis, or to realise the assets and settle the liabilities simultaneously, in each
future period in which significant amounts of deferred tax liabilities or assets are
expected to be settled or recovered.

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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

Calculate the temporary difference


between the tax base and carrying
value of the item.

Does a taxable temporary difference No Is it probable that taxable


result (this is the case where tax base profits will be available in the
< carrying value) future against which the
deductible temporary
difference can be used?

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.

Recognise the movement in the .


deferred tax asset/liability in:
 profit or loss
 other comprehensive income
 equity (directly)
depending on where the underlying
transaction/event is recognised.

Offset the individual deferred tax


assets and liabilities only where there
is a legally enforceable right and they
relate to the same taxation authority.

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9 Disclosure of income taxes


The following disclosures are required in relation to income taxes:
1 The major components of tax expense in profit or loss, including the following:
(a) Current tax expense
(b) Adjustments recognised in the period for the current tax of previous periods;
(c) The amount of deferred tax expense (income) relating to the origination and reversal
of temporary differences;
(d) The amount of deferred tax expense (income) relating to changes in tax rates or the
imposition of new taxes;
2 The aggregate deferred tax relating to items that are charged or credited directly to equity.
3 The amount of income tax (including deferred tax) relating to each component of other
comprehensive income.
4 An explanation of the relationship between tax expense and accounting profit in either or
both of the following forms:
(a) A numerical reconciliation between tax expense and the product of accounting profit
multiplied by the applicable tax rate(s), or
(b) A numerical reconciliation between the average effective tax rate and the applicable
tax rate.
5 An explanation of changes in the applicable tax rate(s) compared to the previous accounting
period.
6 The amount (and expiry date, if any) of deductible temporary differences, unused tax losses
and unused tax credits for which no deferred tax asset is recognised in the statement of
financial position.
7 In respect of each type of temporary difference:
(a) The amount of deferred tax assets and liabilities recognised in the statement of
financial position.
(b) The amount of deferred tax income or expense recognised in profit or loss.
8 The amount of a deferred tax asset and the nature of evidence supporting its recognition
when:
(a) the utilisation of the deferred tax asset is dependent on future taxable profits in excess
of the profits arising from the reversal of existing taxable temporary differences, and
(b) the entity has suffered a loss in either the current or preceding period in the tax
jurisdiction to which the deferred tax asset relates.

9.1 Reconciliation
Disclosure point number (4) listed above refers to a reconciliation between tax expense and
accounting profit. Two possible forms are suggested. The following example shows both possible
forms:

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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.

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

10 Deferred taxation and business combinations


Topic highlights
Temporary differences may arise as a result of business combinations.

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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 26 to 30).

10.1 Temporary differences arising as a result of business


combinations
Earlier in the chapter we considered a number of common situations which result in either a taxable
or deductible temporary difference.
When interests are held in subsidiaries, branches, associates or joint ventures, temporary
differences arise because the carrying amount of the investment (i.e. the parent's share of the net
assets including goodwill) becomes different from the tax base (often the cost) of the investment.
Reasons for these differences include the following:
 The existence of undistributed profits of subsidiaries, branches, associates and joint
ventures
 Changes in foreign exchange rates when a parent and its subsidiary are based in different
countries
 A reduction in the carrying amount of an investment in an associate to its recoverable
amount
The temporary difference in the consolidated financial statements may be different from the
temporary difference associated with that investment in the parent's separate financial statements
when the parent carries the investment in its separate financial statements at cost or revalued
amount.
HKAS 12 provides examples of both taxable and deductible temporary differences.
HKAS 12, 10.1.1 Taxable temporary differences
Illustrative
Examples In a business combination, such as when one company buys all the shares of another company,
the cost of the acquisition must be allocated to the fair values of the identifiable assets and
liabilities acquired as at the date of the transaction. Temporary differences can arise when the tax
bases of the identifiable assets and liabilities acquired are not affected by the business
combination. For example, where the carrying amount of an asset is increased to fair value but the
tax base of the asset remains at cost to the previous owner, a taxable temporary difference arises
which results in a deferred tax liability and this will also affect goodwill.
The following are also provided by the standard as examples of situations which will result in a
taxable temporary difference:
(a) Unrealised losses resulting from intragroup transactions are eliminated by inclusion in
the carrying amount of inventory or property, plant and equipment.
(b) Retained earnings of subsidiaries, branches, associates and joint ventures are included in
consolidated retained earnings, but income taxes will be payable if the profits are distributed
to the reporting parent.
(c) Investments in foreign subsidiaries, branches or associates or interests in foreign joint
ventures are affected by changes in foreign exchange rates.
(d) An entity accounts in its own currency for the cost of the non-monetary assets of a foreign
operation that is integral to the reporting entity's operations but the taxable profit or tax
loss of the foreign operation is determined in the foreign currency.

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Self-test question 7
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)

HKAS 12, 10.1.2 Deductible temporary differences


Illustrative
Examples In a business combination, when a liability is recognised on acquisition but the related costs are
not deducted in determining taxable profits until a later period, a deductible temporary difference
arises resulting in a deferred tax asset. A deferred tax asset will also arise when the fair value of an
identifiable asset acquired is less than its tax base. In both these cases goodwill is affected (see
below).
The standard also provides the following examples of situations will result in a deductible
temporary difference:
(a) 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.
(b) Investments in foreign subsidiaries, branches or associates or interests in foreign joint
ventures are affected by changes in foreign exchange rates.
(c) A foreign operation accounts for its non-monetary assets in its own (functional) currency.
If its taxable profit or loss is determined in a different currency (under the presentation
currency method) changes in the exchange rate result in temporary differences. The
resulting deferred tax is charged or credited to profit or loss.

Self-test question 8
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)

10.2 Recognition criteria


HKAS 12 provides recognition criteria for both deferred tax liabilities and assets in a business
combination situation.
HKAS 12.39 10.2.1 Deferred tax liability
Entities should recognise a deferred tax liability for all taxable temporary differences associated
with investments in subsidiaries, branches and associates, and interests in joint ventures, except to
the extent that both of these conditions are satisfied:

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(a) The parent/investor/venturer is able to control the timing of the reversal of the temporary
difference.
(b) It is probable that the temporary difference will not reverse in the foreseeable future.
HKAS 12.44 10.2.2 Recognition of deferred tax asset
HKAS 12 requires that a deferred tax asset should be recognised for all deductible temporary
differences arising from investments in subsidiaries, branches and associates, and interests in joint
ventures, to the extent that (and only to the extent that) both these are probable that:
(a) the temporary difference will reverse in the foreseeable future
(b) taxable profit will be available against which the temporary difference can be utilised
The prudence principle discussed above for the recognition of deferred tax assets should be
considered.

10.3 Application of the recognition criteria


HKAS 12.40 10.3.1 Undistributed profits
Where a parent company controls the dividend policy of its subsidiary, it can control the timing of
the reversal of temporary differences. In addition, it would often be impracticable to determine the
amount of income taxes payable when the temporary differences reverses.
Therefore, when the parent has determined that those profits will not be distributed in the
foreseeable future, the parent does not recognise a deferred tax liability. The same applies to
investments in branches.
HKAS 12.41 10.3.2 Foreign exchange
Where a foreign operation's taxable profit or tax loss (and therefore the tax base of its non-
monetary assets and liabilities) is determined in a foreign currency, changes in the exchange rate
give rise to temporary differences. These relate to the foreign entity's own assets and liabilities,
rather than to the reporting entity's investment in that foreign operation, and so the reporting entity
should recognise the resulting deferred tax liability or asset. The resulting deferred tax is charged
or credited to profit or loss.

HKAS 12.42 10.3.3 Associates


An investor in an associate does not control that entity and so cannot determine its dividend
policy. Therefore, unless there is an agreement requiring that the profits of the associate should not
be distributed in the foreseeable future, the investor should recognise a deferred tax liability arising
from taxable temporary differences associated with its investment in the associate. Where an
investor cannot determine the exact amount of tax, but only a minimum amount, then the deferred
tax liability should be that amount.
HKAS 12.43 10.3.4 Joint arrangements
In a joint arrangement, the agreement between the parties usually deals with profit sharing. When
a joint venturer or joint operator can control the sharing of profits and it is probable that the profits
will not be distributed in the foreseeable future, a deferred liability is not recognised.

HKFRS 3.24,
HKAS
10.4 Recognition of deferred tax arising from business
12.15,66-68 combinations
HKFRS 3 Business Combinations requires an entity to recognise any deferred tax assets (to the
extent that they meet the relevant recognition criteria) or deferred tax liabilities resulting from
temporary differences on a business combination as identifiable assets and liabilities at the date of
acquisition.
These deferred tax assets and deferred tax liabilities, consequently, will affect the amount of
goodwill or the bargain purchase gain the entity recognises.

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An entity will not, however, recognise deferred tax liabilities arising from the initial recognition of
goodwill.
A business combination may result in a change in the probability of realising a pre-acquisition
deferred tax asset of the acquirer. There is a chance that the acquirer will recover its own deferred
tax asset that was not recognised before the combination of the businesses, e.g. by setting off
unused tax losses against the future taxable profit of the acquiree.
Alternatively, as a result of the business combination it might no longer be probable that future
taxable profit will allow the deferred tax asset to be recovered. The acquirer should recognise a
change in the deferred tax asset in the period of the business combination, but does not take it into
account in calculating the goodwill or bargain purchase gain it recognises in the business
combination.
The potential benefit of the acquiree's income tax loss carry forwards or other deferred tax assets
might not satisfy the criteria for separate recognition when a business combination is initially
accounted for but might be realised subsequently. An entity shall recognise acquired deferred tax
benefits that it realises after the business combination as follows:
(a) Acquired deferred tax benefits recognised within the measurement period that result from
new information about facts and circumstances that existed at the acquisition date shall be
applied to reduce the carrying amount of any goodwill related to that acquisition. If the
carrying amount of that goodwill is zero, any remaining deferred tax benefits shall be
recognised in profit or loss.
(b) All other acquired deferred tax benefits realised shall be recognised in profit or loss (or, if this
standard so requires, outside profit or loss).

Self-test question 9
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 10
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)

Example: Deferred tax arising from business combinations


In recent years, Lily Co. has made the following acquisitions of other companies:
 On 1 January 20X6, it acquired 90% of the share capital of Blossom, resulting in goodwill of
$1.4 million.

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 On 1 July 20X6 it acquired the whole of the share capital of Snowdrop for $6 million. At this
date the fair value of the net assets of Snowdrop was $4.5 million and their tax base was
$4 million.
The following information is relevant to Lily Group’s year ended 31 December 20X6:
Blossom
1 Blossom has made a provision amounting to $1.8 million in its accounts in respect of
litigation. This is tax allowable only when the cost is actually incurred. The case is expected
to be settled within 12 months.
2 Blossom has a number of investments classified as at fair value through profit or loss in
accordance with HKFRS 9. The remeasurement gains and losses recognised in profit or loss
for accounting purposes are not taxable/tax allowable until such date as the investments are
sold. To date the cumulative unrealised gain is $2.5 million.
3 Blossom has sold goods to Lily in the year making a profit of $1 million. A quarter of these
goods remain in Lily’s inventory at the year end.
Snowdrop
1 At its acquisition date, Snowdrop had unrelieved brought forward tax losses of $0.4 million.
It was initially believed that Snowdrop would have sufficient taxable profits to utilise these
losses and a deferred tax asset was recognised in Snowdrop’s financial statements at
acquisition. Subsequent events have proven that the future taxable profits will not be
sufficient to utilise the full brought forward loss.
2 At acquisition Snowdrop’s retained earnings amounted to $3.5 million. The directors of Lily
Group have decided that in each of the next four years to the intended listing date of the
group, they will realise earnings through dividend payments from the subsidiary amounting to
$600,000 per annum. Snowdrop has not declared a dividend for the current year. Tax is
payable on remittance of dividends.
3 $300,000 of the purchase price of Snowdrop has been allocated to intangible assets. The
recognition and measurement criteria of HKFRS 3 and HKAS 38 do not appear to have been
met, however the directors believe that the amount is allowable for tax and have calculated
the tax charge accordingly. It is believed that this may be challenged by the tax authorities.
Required
What are the deferred tax implications of the above issues for the Lily Group?

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
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.

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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.

10.5 Section summary


In relation to deferred tax and business combinations you should be familiar with:
 circumstances that give rise to taxable temporary differences
 circumstances that give rise to deductible temporary differences
 their treatment once an acquisition takes place
 reasons why deferred tax arises when investments are held
 recognition of deferred tax on business combinations

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11 Interpretations relating to deferred tax


11.1 HK(SIC) Int-21 Income Taxes – Recovery of Revalued Non-
depreciable Assets
HK(SIC) Int-21 deals with cases where a non-depreciable asset (freehold land) is carried at
revaluation under HKAS 16.
The Interpretation deems that no part of such an asset’s carrying amount will be recovered through
use. Therefore the deferred tax asset or liability that arises from revaluation must be measured
based on recovery through sale of the asset.
In some jurisdictions, this will result in the use of a capital gains tax rate rather than the rate
applicable to corporate earnings.
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.

11.2 HK(SIC) Int-25 Income Taxes – Changes in the Tax Status of


an Entity or its Shareholders
A change in the tax status of an entity or its shareholders may have consequences for an entity by
increasing or decreasing its tax liabilities or assets.
This may, for example, occur upon:
 the public listing of an entity's equity instruments
 the restructuring of an entity's equity
 a controlling shareholder's move to a foreign country.
As a result of such an event, an entity may be taxed differently; it may for example gain or lose tax
incentives or become subject to a different rate of tax in the future.
A change in the tax status of an entity or its shareholders may have an immediate effect on the
entity's current tax liabilities or assets. The change may also increase or decrease the deferred tax
liabilities and assets recognised by the entity, depending on the effect the change in tax status has
on the tax consequences that will arise from recovering or settling the carrying amount of the
entity's assets and liabilities.
A change in the tax status of an entity or its shareholders does not give rise to increases or
decreases in amounts recognised directly in equity. The current and deferred tax consequences of
a change in tax status shall be included in net profit or loss for the period, unless those
consequences relate to transactions and events that result, in the same or a different period, in a
direct credit or charge to the recognised amount of equity. Those tax consequences that relate to
changes in the recognised amount of equity, in the same or a different period (not included in net
profit or loss), shall be charged or credited directly to equity.

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Topic recap

HKAS 12 Income Taxes

Current
Currenttaxtax Current
Deferred
taxtax

Tax charge is adjusted for under/over Accounting measure to match tax


provision of previous period. effects of transactions with their
accounting impact

Tax charge is adjusted for under/over Compares carrying amount (CA) of


provision of previous period. asset/liability with its tax base (TB) to
find a temporary difference.

Tax base = amount attributed to an


Recognise in profit or loss for the asset or liability for tax purposes.
period other than:
Ÿ tax on business combination
Ÿ tax on item of OCI
Ÿ tax on item in equity

CA > TB CA < TB

Taxable Deductible
temporary temporary
difference difference

Apply tax rate expected to apply when asset is


realised or liability settled, based on manner of
recovery/settlement

Deferred tax Deferred tax


liability asset

Do not discount to present value

Recognise only if
profits available
in future

Recognise in profit or loss unless deferred tax


arises from:
Ÿ an item recognised in OCI
Ÿ an item recognised in equity
Ÿ a business combination (acquisition)

Offset deferred tax assets and liabilities only if:


Ÿ legally enforceable right of set off
Ÿ relate to taxes levied by the same authority

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Answers to self-test questions

Answer 1
(a) $
Current year tax liability ($760,000  16.5%) 125,400
Overprovision in 20X0 ($130,000 – $126,700) 3,300
Therefore
 $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.
(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 –

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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
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 8
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 9
 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.

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Answer 10
 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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Exam practice

Healthy Supplement Inc 29 minutes


Healthy Supplement Inc. (HSI) was incorporated on 1 October 20X1 and is engaged in the design
and manufacture of nutrition products. Below is the computation of income tax for the first financial
year ended 30 September 20X2:
HK$'000
Profit before tax 54,018
Adjusted for:
Non-taxable interest income (1,039)
Release of government grant to P/L (1,200)
Depreciation charged to P/L 15,933
Non-deductible legal and professional fees 1,358
Provision for product warranty charged to P/L 4,200
Depreciation allowance (38,500)
Government grant received 9,600
Warranty expenses paid (1,248)
Assessable profit 43,122
Income tax prepaid on 30 June 20X2 4,600
During the year, HSI acquired plant and equipment of HK$94,334,000 which are depreciated on a
straight line basis over useful lives of 3 to 10 years, all of them were still in use by the entity.
Included in this amount is HK$4,388,000 related to certain expenditure which is not tax deductible
under tax law. The non-tax deductible items were acquired on 1 April 20X2 and depreciated for half
a year out of an estimated useful life of 5 years up to the end of the reporting period.
An asset-related government grant is taxable upon receipt while HSI adopted HKAS 20 to
recognise the grant to profit or loss over the expected useful lives of the related assets.
Warranty expenses are tax deductible when payment is made.
The standard income tax rate for HSI is 20%. A 2% tax rate deduction is provided for an entity's
first year of operation.
Required
(a) Calculate the current tax expense for the year ended and the current tax payable as at 30
September 20X2. (2 marks)
(b) Calculate the deferred tax assets/liabilities as at 30 September 20X2 and the deferred tax
credit/charge for the year then ended. (8 marks)
(c) Prepare the tax reconciliation for disclosure in the financial statements of HSI for the year
ended 30 September 20X2. (6 marks)
(Total = 16 marks)
HKICPA December 2012 (amended)

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354
chapter 16

Employee benefits

Topic list

1 HKAS 19 Employee Benefits


1.1 Employee benefits 5.3 Step 1 – Determine the deficit or surplus
1.2 The accounting problem 5.4 Step 2 – Determine the amount of the
1.3 Definitions net defined benefit liability (asset)
5.5 Step 3 – Determine amounts to be
2 Short-term employee benefits recognised in profit or loss
2.1 Recognition and measurement 5.6 Step 4 – Determine amounts to be
2.2 Short-term paid absences recognised in other comprehensive
2.3 Profit-sharing schemes and bonus plans income
3 Post-employment benefits 5.7 Further issues – past service costs and
3.1 Types of post-employment benefits settlements
3.2 Multi-employer plans 5.8 Further issues – the asset ceiling
5.9 Summary of accounting treatment
4 Defined contribution plans 5.10 Disclosure of defined benefit plans
4.1 Recognition and measurement
4.2 Disclosure 6 Termination benefits
6.1 Recognition
5 Defined benefit plans 6.2 Measurement
5.1 Introduction to accounting treatment
5.2 Accounting steps 7 Current developments

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

In this chapter you will cover the following 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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1 HKAS 19 Employee Benefits


Topic highlights
HKAS 19 Employee Benefits provides guidance on the accounting treatment to be applied to short-
term employment benefits, post-employment benefits (pensions), other long-term employment
benefits and termination benefits. Amendments to the standard in 2011 reduced the complexity of
accounting for employee benefits.

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.

HKAS 19.5 1.1 Employee benefits


Companies generally provide their employees with a package of pay and benefits, which may
include some or all of the following:
 Short-term benefits including:
– wages and salaries
– contributions to Mandatory Provident Fund
– paid annual leave
– paid sick leave
– paid maternity/paternity leave
– profit shares and bonuses paid within 12 months of the year end
– paid jury service
– paid military service
– non-monetary benefits, e.g. medical care, cars, free goods
 Post-employment benefits, e.g. pensions and post-employment medical care
 Other long-term benefits, e.g. profit shares, bonuses or deferred compensation payable later
than 12 months after the year end, sabbatical leave, long-service benefits
 Termination benefits, e.g. early retirement payments and redundancy payments
Benefits may be paid to the employees themselves, to their dependants (spouses, children, etc.) or
to third parties.

1.2 The accounting problem


In the case of the short-term benefits listed above, the employee will receive the benefit at about
the same time as he or she earns it. The accounting is therefore relatively straightforward with the
costs of providing the benefit recognised as an expense in the employer's financial statements.
Accounting for the cost of deferred employee benefits is less clear cut. This is because of the
long time scale, complicated estimates and uncertainties involved in these types of benefit. In
addition, the costs could be viewed in a number of ways, for example as deferred salary to the
employee or as a deduction from the employee’s true gross salary.
In the past, entities accounted for these benefits simply by making a charge to the profit or loss of
the employing entity on the basis of actual payments made. This led to substantial variations in
reported profits of these entities and disclosure of information on these costs was usually sparse.

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Financial Reporting

1.2.1 The accounting solution


HKAS 19 addresses the problem described above by prescribing how employee benefits should be
recognised and measured.
The standard requires an entity to recognise:
(a) a liability when an employee has provided a service in exchange for benefits to be received
by the employee at some time in the future.
(b) an expense when the entity receives the economic benefits from a service provided by an
employee regardless of when the employee received or will receive the benefits for providing
the service.
The application of these basic rules to each of the categories of employee benefits described in
section 1.1 is provided in HKAS 19 and described throughout the remainder of this chapter. First,
however, we must consider a number of important definitions within the standard.

HKAS 19.8 1.3 Definitions


You should refer back to the following definitions as necessary as you work through the rest of this
chapter.

Key terms

Definitions of employee benefits


Employee benefits are all forms of consideration given by an entity in exchange for service
rendered by employees.
Short-term employee benefits are employee benefits (other than termination benefits) that are
expected to be settled wholly before 12 months after the end of the annual reporting period in
which the employees render the related service.
Post-employment benefits are employee benefits (other than termination benefits and short-term
employee benefits) which are payable after the completion of employment.
Termination benefits are employee benefits provided in exchange for the termination of an
employee’s employment as a result of either:
(a) an entity's decision to terminate an employee's employment before the normal retirement
date, or
(b) an employee's decision to accept an offer of benefits in exchange for the termination of
employment.
Other long-term employee benefits are all employee benefits other than short-term employee
benefits, post-employment benefits and termination benefits.
Definitions relating to classification of plans
Post-employment benefit plans are formal or informal arrangements under which an entity
provides post-employment benefits for one or more employees.
Defined contribution plans are 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.
Defined benefit plans are post-employment benefit plans other than defined contribution plans.

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Key terms (cont'd)


Multi-employer plans are 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; and
(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.
Definitions relating to the net defined benefit liability (asset)
The net defined benefit liability (asset) is the deficit or surplus, adjusted for any effect of limiting
a net defined benefit asset to the asset ceiling.
The deficit or surplus is:
(a) the present value of the defined benefit obligation less
(b) the fair value of plan assets (if any).
The asset ceiling is 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 present value of a defined benefit obligation is 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.
Plan assets comprise:
(a) Assets held by a long-term employee benefit fund
(b) Qualifying insurance policies
Fair value is the amount for which an asset could be exchanged or a liability settled between
knowledgeable, willing parties in an arm’s length transaction.
Definitions relating to defined benefit cost
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.
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.
Remeasurements of the net defined benefit liability (asset) comprise:
(a) actuarial gains and losses
(b) the return on plan assets, excluding amounts included in net interest on the defined benefit
liability (asset); and
(c) any change in the effect of the asset ceiling, excluding amounts included in net interest on
the net defined benefit liability (asset).

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Financial Reporting

Key terms (cont'd)


Actuarial gains and losses are changes in the present value of the defined benefit obligation
resulting from:
(a) experience adjustments (the effects of differences between the previous actuarial
assumptions and what has actually occurred), and
(b) the effects of changes in actuarial assumptions.
The return on plan assets is interest, dividends and other income derived from the plan assets,
together with realised and unrealised gains or losses on the plan assets, less:
(a) any cost of managing plan assets; and
(b) any tax payable by the plan itself, other than tax included in the actuarial assumptions used
to measure the present value of the defined benefit obligation.
A settlement is 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.
(HKAS 19)

2 Short-term employee benefits


Topic highlights
Short-term employee benefits are those benefits that are expected to be settled wholly before
12 months after the end of the period in which the employees provide the related services. The
cost of the benefits to be paid in exchange for the employee's services should be recognised in the
period on an accruals basis.

As mentioned in section 1.1, short-term employee benefits include:


 monetary benefits such as wages and salaries, annual leave, sick leave, maternity leave,
and profit shares and bonuses paid within 12 months.
 non-monetary benefits such as medical care, housing and company cars.

HKAS 19.11 2.1 Recognition and measurement


HKAS 19 requires that short-term employee benefits are recognised in the period in which the
related service is provided by the employee as:
(a) a liability (after deducting any amount already paid), and
(b) an expense unless another standard (such as HKAS 2 or HKAS 16) requires or permits
inclusion in the cost of an asset.
The amount recognised should not be discounted.
Where the amount already paid exceeds the undiscounted amount of the benefits, the resulting
asset should be recognised as a prepayment to the extent that it will lead to a reduction in future
payments or refund.
The standard explains how these rules are applied in the case of short-term compensated
absences and profit-sharing and bonus plans.

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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.

Example: Sick pay


An entity has 10 employees, each of whom is entitled to seven days of paid sick leave per annum.
Unused sick leave may be carried forward for one year. Current year leave must be used before carried
forward leave. At 31 December 20X8, each employee had, on average, two days of leave unused.
Based on past experience the entity expects eight employees to take no more than seven days of sick
leave in the coming year. The remaining two employees are expected to take nine days each.
Assuming that each sick day costs the entity $60, what liability for sick leave must be accrued in
the statement of financial position as at 31 December 20X8?

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.

Example: Bonus plan


Lowdown Co. has a contractual agreement to pay a total of 5% of its net profit each year as a
bonus. The bonus is divided between the employees who are with the entity at its year end. The
following data is relevant:
Net profit $2,000,000
Average employees 50
Employees at start of year 60
Employees at end of year 40
Required
How should the expense be recognised?

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

HKAS 3.1 Types of post-employment benefits


19.26-30
Post-employment benefits are those benefits provided to employees after they have stopped
working. They may include:
 retirement benefits (pensions), and
 other benefits such as post-employment life insurance or medical care.
Post-employment benefit schemes are often referred to as "plans". Employers (and sometimes
employees) make regular contributions to the plan and this money is invested in long-term assets
such as stocks and shares.
The return on the plan assets, and sometimes the proceeds of the sale of plan assets, is used to
pay for the post-employment benefits.
There are two types of post-employment benefit plans:
 defined contribution, and
 defined benefit.

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3.1.1 Defined contribution plans


These plans involve fixed amounts (normally a percentage of an employee's salary) being paid into
the plan each year. These amounts, or contributions, may be made by the employer and current
employees.
The level of benefits paid out to former employees is resultant on how the plan's investments have
performed. In other words there is no guarantee of a fixed amount of benefit.
3.1.2 Defined benefit plans
These plans involve fixed amounts being paid out of the plan to former employees as benefits. The
fixed amount is normally calculated as a percentage (based on the number of years' service) of
final salary.
As before, contributions are made by the employer (and possibly current employees) and these are
invested. The level of contributions is not, however, fixed. Instead it is set at an amount that is
expected to result in sufficient investment returns to meet the obligation to pay the defined post-
retirement benefits.
Where it appears that there are insufficient assets in the fund, the employer will be required to
make increased contributions; where it appears that there are surplus assets in the fund, the
employer may stop paying contributions for a period (known as a contributions holiday).

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.

4 Defined contribution plans


Topic highlights
Contributions to a defined contribution plan are recognised as an expense in the period in which
they are payable.

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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.

Example: Defined contribution plan


Highlife Co. agrees to contribute 4% of employees' total remuneration into a post-employment plan
each period.
In the year ended 31 December 20X1, the company paid total salaries of $16 million. A bonus of
$4 million based on the income for the period was paid to the employees in March 20X2.
The company had paid $760,000 into the plan by 31 December 20X1.
Required
Calculate the total expense for post-employment benefits for the year and the accrual which will
appear in the statement of financial position at 31 December 20X1.

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

HKAS 19.53 4.2 Disclosure


HKAS 19 requires that the following is disclosed in respect of defined contribution schemes:
(a) A description of the plan
(b) The amount recognised as an expense in the period

5 Defined benefit plans


Topic highlights
Defined benefit plans are recognised in the statement of financial position. Changes in the plan are
broken down into their constituent parts and recognised in profit or loss or other comprehensive
income immediately.

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5.1 Introduction to accounting treatment


As we have already discussed, contributions made to defined benefit plans may vary considerably
from year to year. The accounting treatment applied to defined contribution plans is therefore not
appropriate here, as expensing contributions would result in volatile profits.
Instead, HKAS 19 requires a net defined benefit liability (asset) to be shown in the statement of financial
position. This is defined as the deficit or surplus in a defined benefit plan and is calculated as:
(a) the present value of the defined benefit obligation (i.e. the obligation to pay future benefits to
employees) less
(b) the fair value of any plan assets
Where the present value of the defined benefit obligation exceeds the fair value of plan assets, a
plan is in deficit and an overall net defined benefit liability is recognised; where the fair value of plan
assets exceeds the present value of the defined benefit obligation, a plan is in surplus and an
overall net defined benefit asset is recognised.
Both the present value of the obligation and the fair value of the plan assets are normally
calculated and advised by an actuary. HKAS 19 provides guidance on this. The role of the
accountant is therefore to recognise the changes in these amounts from year to year in accordance
with HKAS 19.

HKAS 19.61 5.1.1 Constructive obligation


In determining the extent of the obligation to provide retirement benefits, an entity must assess not
only its legal obligation under the formal terms of a defined benefit plan, but also any constructive
obligation that arises from the entity’s informal practices.
Informal practices give rise to a constructive obligation where the entity has no realistic alternative
but to pay employee benefits, for example, where a change in an entity’s informal practices would
cause unacceptable damage to its relationship with employees.

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)

4 Determine remeasurements to These may include:


be recognised in other (i) actuarial gains and losses
comprehensive income
(ii) return on plan assets excluding amounts included in net
interest on the defined benefit liability (asset)

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Financial Reporting

(iii) any change in the effect of the asset ceiling excluding


amounts included in 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)
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.
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.

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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.

HKAS 19.120 5.5 Step 3 – Determine amounts to be recognised in profit or loss


The change in the net defined benefit liability (asset) as measured by an actuary at the start and
the end of a financial period can be attributed to contributions made into the plan, payments made
out of the plan and three further components:
(a) service costs
(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.

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Financial Reporting

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.
Remeasurements may include:
(a) actuarial gains and losses;
(b) the return on plan assets (excluding amounts included in net interest on the net defined
benefit liability (asset)); and
(c) any change in the effect of the asset ceiling (excluding amounts included in net interest on
the net defined benefit liability (asset)).
The asset ceiling is a complication that is not relevant in every case, so it is dealt with separately,
later in the chapter.
HKAS 19.128 5.6.1 Actuarial gains and losses
We have already seen, in section 5.3.1, that in measuring the defined benefit obligation, the
actuary must make a number of actuarial assumptions regarding issues such as mortality and
salary increases.
Actuarial gains and losses arise from changes to the defined benefit obligation because of changes
in actuarial assumptions and experience adjustments:
(a) Actual events: The calculation of the plan obligation and the current service cost is based
on estimates of numbers of employees remaining in the plan during the current year as well
as estimates about salary changes during the current year. Where staff leave or salaries are
increased by amounts different from those expected, the year end obligation will be different
from that previously expected.
(b) Actuarial assumptions are revised: The valuation of the plan obligation depends upon a
number of what are called actuarial assumptions. These include the discount rate, estimates
of staff remaining in the plan until retirement, projected salaries on retirement, mortality rates
and the length of time over which benefits need to be paid. These estimates can be changed
as the entity, or its actuaries, reassess the future.

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(c) Actual returns on plan assets: The valuation of the plan assets includes an estimated rate
of return for the current year. At the year end the plan assets may have grown by an amount
different from that expected.
Such actuarial gains and losses are recognised in other comprehensive income.
5.6.2 Return on plan assets
A new valuation of the plan assets is carried out at each period end, using current fair values. Any
difference between the new value, and what has been recognised up to that date (normally the
opening balance, interest, and any cash payments into or out of the plan) is treated as a
"remeasurement" and recognised in other comprehensive income.

Example: Defined benefit plan


The following information relates to a defined benefit pension plan operated by Snow Co.:
$m
Present value of defined benefit obligation at 1 January 20X1 100
Present value of defined benefit obligation at 31 December 20X1 120
Fair value of plan assets at 1 January 20X1 60
Fair value of plan assets at 31 December 20X1 55
Current service cost 18
Contributions made into the scheme 12
Payments made to members of the scheme 15
The yield on a high quality corporate bond is 5%.
Calculate amounts to be recognised in profit or loss and other comprehensive income in the year
ended 31 December 20X1 and the value of the net defined benefit liability in the statement of
financial position at that date.

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.

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Financial Reporting

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)

5.7 Further issues – past service costs and settlements


Topic highlights
Past service costs arise when a pension plan is amended or curtailed; they are recognised
immediately in profit or loss.
Settlements occur when plan benefits are reduced. Gains or losses on settlement are recognised in
profit or loss immediately.

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).

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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.

The gain or loss on a settlement is the difference between:


(a) the present value of the defined benefit obligation being settled, as valued on the date of
the settlement; and
(b) the settlement price, including any plan assets transferred and any payments made by the
entity directly in connection with the settlement.
Any gains or losses on settlement are recognised immediately in profit or loss when the settlement
occurs.

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.
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.

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Financial Reporting

Example: The asset ceiling


Rowan Co. operates a defined benefit pension scheme for its employees. At 1 January 20X1 the
present value of the defined benefit obligation was $5 million and the fair value of the plan assets
was $5.7 million. Equivalent values at 31 December 20X1 were $5.94 million and $7.1 million.
For the year ended 31 December 20X1:
 Current service cost was $1.5 million
 The interest rate applicable to the net defined benefit asset was 3%
 Contributions of $2 million were made to the plan
 $800,000 was paid out to former employees of Rowan
The present value of future economic benefits in relation to the plan is $1.1 million.
What amount of remeasurement is recognised in other comprehensive income in the year ended
31 December 20X1?

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

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

5.9 Summary of accounting treatment


This section summarises the accounting treatment that we have met so far.

Opening figures Net defined benefit liability (asset):


 Present value of obligation, less
 Fair value of plan assets
As advised by actuary
Contributions As advised by the actuary DEBIT Plan assets
CREDIT Cash / other assets
Benefits paid Pension payments made to retired DEBIT Plan obligation
former employees CREDIT Plan assets

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Current service Increase in plan obligation as a result DEBIT Operating expense (profit or loss)
cost of one extra year’s service. CREDIT Plan obligation
As advised by actuary
Past service cost Change in plan obligation as a result Improvement of benefits:
of improvement or withdrawal of DEBIT Operating expense (profit or loss)
benefits. CREDIT Plan obligation
Withdrawal of benefits:
DEBIT Plan obligation
CREDIT Operating expense (profit or
loss)
Gains or losses Difference between the present value Loss on settlement:
on settlement of the obligation on settlement date DEBIT Operating expense (profit or loss)
and the settlement amount. CREDIT Plan obligation
Gain on settlement:
DEBIT Plan obligation
CREDIT Operating expense (profit or
loss)
Net interest on Based on high quality corporate bond DEBIT Finance cost (profit or loss)
net defined yield at end of period and net defined CREDIT Plan obligation
benefit liability benefit liability (asset) at start of And
(asset) period.
DEBIT Plan assets
Discount rate %  net defined benefit
CREDIT Finance cost (profit or loss)
liability (asset) b/f
Remeasurements Due to actuarial differences, the actual DEBIT Other comprehensive income
return on plan assets differing from the CREDIT Plan obligation / assets
return calculated within net interest Or
and change in the effect of the asset
DEBIT Plan obligation / assets
ceiling. Calculated as a balancing
figure CREDIT Other comprehensive income

Closing figures Net defined benefit liability (asset):


 Present value of obligation, less
 Fair value of plan assets
As advised by actuary

HKAS
19.63-64
5.10 Disclosure of defined benefit plans
5.10.1 The statement of financial position
In the statement of financial position, the amount recognised as a net defined benefit liability
should be calculated as:
$
Present value of defined benefit obligation at year end X
Fair value of plan assets at year end (X)
Net defined benefit liability X/(X)
If this total is a negative amount, there is a net defined benefit asset and this should be shown in
the statement of financial position as the lower of (a) and (b) below.
(a) The net defined benefit asset as calculated above
(b) The asset ceiling (see section 5.8)

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Financial Reporting

HKAS 19.120 5.10.2 The statement of profit or loss and other comprehensive income
The following amounts should be recognised in profit or loss:
 Current service cost
 Past service cost
 Gain or loss on settlement
 Net interest on the net defined benefit liability (asset)
Remeasurements should be recognised in other comprehensive income.

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

Present value of benefit obligations at 31 December 1,100 As valued by


Fair value of plan assets at 31 December 1,230 professional actuaries

Interest cost (gross yield on "blue chip" corporate bonds) 10%


On 1 January 20X7 the plan was amended to provide additional benefits with effect from that date
subject to a minimum employment period of eight years. The present value of the additional
benefits was calculated by actuaries at $30 million.
The present value of future economic benefits available to Lewis in respect of the plan was
$120 million at 31 December 20X7.
Required
Prepare the required notes to the statement of profit or loss and other comprehensive income and
statement of financial position for the year ended 31 December 20X7.
Assume the contributions and benefits were paid on 31 December 20X7.
(The answer is at the end of the chapter)

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.

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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.

HKAS 19.165 6.1 Recognition


HKAS 19 states that termination benefits should be recognised in full as a liability and an expense
at the earlier of:
(i) when the entity can no longer withdraw the offer of termination benefits; and
(ii) when the entity recognises costs for a restructuring that is within the scope of HKAS 37 and
involves the payment of termination benefits.

HKAS 19.169 6.2 Measurement


Termination benefits are measured in accordance with the nature of the employee benefit:
 If the termination benefits are an enhancement of post-employment benefits, they are
accounted for as such.
 Otherwise:
– if the termination benefits are expected to be settled wholly before 12 months after the
end of the annual reporting period in which the termination benefit is recognised, then
they are accounted for as short-term employee benefits.
– if the termination benefits are not expected to be settled wholly before 12 months after
the end of the annual reporting period, then they are accounted for as other long-term
employee benefits.

7 Current developments
The IASB issued an exposure draft in March 2013 which proposes to amend IAS 19 (and so HKAS
19 which is aligned with IAS 19). The proposed amendments specify that contributions from
employees or third parties set out in the terms of a defined benefit plan are recognised as a
reduction in the service cost in the same period in which they are paid, provided that the
contributions are linked solely to the employees' service rendered in that period. This is the case
where, for example, the contributions are a fixed percentage of salary and the percentage does not
change from year to year.

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Financial Reporting

Topic recap

HKAS 19 Employee
Benefits

Short-term employee Post-employment benefits Termination benefits


benefits

e.g. e.g. Benefits provided in


Ÿ Annual leave Ÿ Pensions exchange for termination of
Ÿ Sick pay Ÿ Post-employment an employee's employment
Ÿ Medical care medical care

Recognise in the period Recognise as a liability and


the related service is expense at the earlier of:
provided by the employee Ÿ when the entity can no
as a: longer withdraw the
Ÿ liability offer of termination
Ÿ expense benefits.
Ÿ when the entity
recognises a cost for
restructuring involving
the payment of
termination benefits.

Defined contribution Defined benefit

Recognise contributions as an Recognise the net defined benefit liability/asset in the


expense in the period in which statement of financial position:
they are payable.
Accruals/prepayments may arise. Present value of obligation X
Less Fair value of plan assets (X)
Net defined benefit liability/(asset) X/(X)

An asset is limited by the asset ceiling to the present


value of future economic benefits in relation to the plan.

Each element of the change in the present value of the


obligation and fair value of plan assets is recognised
individually:

Obligation Assets Recognised in:


b/f X X
Contributions X
Benefits paid out (X) (X)
Current service cost X Profit or loss
Past service cost X/(X) Profit or loss
Loss on settlement X Profit or loss
Gain on settlement (X) Profit or loss
Net interest on defined X X Profit or loss
benefit liability / asset
Remeasurements X/(X) X/(X) Other
comprehensive
income
c/f X X

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Answers to self-test questions

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

NOTE TO THE STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME


Defined benefit expense recognised in profit or loss
$m
Current service cost 127
Past service cost 30
Interest cost 10%  (1,000 – 890) (11)
Defined benefit costs recognised in other
comprehensive income
Remeasurement gain on defined benefit pension plan 52
(176 – 114 – 10) (W)

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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

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Exam practice

Employee benefits 29 minutes


(a) HKAS 19 as amended in July 2011 requires that all actuarial gains and losses (or
remeasurements) are recognised immediately in other comprehensive income. Prior to these
amendments, entities were permitted to defer actuarial gains and losses in excess of 10% of
the value of the plan assets or obligation and recognise them over an extended period, either
in profit or loss or in other comprehensive income.
Required
What will be the effect of the new requirements on the financial statements of entities which
previously chose to defer actuarial gains and losses? (4 marks)
(b) The following information relates to the defined benefit employee compensation scheme of
Rhodes Co.:
Present value of obligation at start of 20X8 ($'000) 20,000
Market value of plan assets at start of 20X8 ($'000) 20,000

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 = 16 marks)

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Financial Reporting

380
chapter 17

Borrowing costs

Topic list

1 HKAS 23 Borrowing Costs


1.1 Definitions
1.2 Recognition

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.

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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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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1 HKAS 23 Borrowing Costs


Topic highlights
HKAS 23 looks at the treatment of borrowing costs, particularly where the related borrowings are
applied to the construction of certain assets. These are what are usually called "self-constructed
assets", where an entity builds its own inventory or non-current assets over a substantial period of
time.

HKAS 23.5 1.1 Definitions


Only two definitions are given by the standard.

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)

HKAS 23.6 1.1.1 Borrowing costs


The standard lists what may be included in borrowing costs:
(a) Interest expense calculated using the effective interest method as described in HKFRS 9
Financial Instruments
(b) Finance charges in respect of finance leases recognised in accordance with HKAS 17
Leases (See Chapter 9)
(c) Exchange differences arising from foreign currency borrowings to the extent they are
regarded as an adjustment to interest costs
HKAS 23.7 1.1.2 Qualifying assets
The standard says that any of the following may be qualifying assets:
 Inventories
 Manufacturing plants
 Power generation facilities
 Intangible assets
 Investment properties
Financial assets and inventories manufactured or produced over short periods are not qualifying
assets, nor are assets ready for sale or their intended use when purchased.

HKAS 23.8,9 1.2 Recognition


All eligible borrowing costs must be capitalised.
Only borrowing costs that are directly attributable to the acquisition, construction or production of
a qualifying asset can be capitalised as part of the cost of that asset. The standard lays out the
criteria for determining which borrowing costs are eligible for capitalisation.
All other borrowing costs are expensed to profit or loss.
The journal entry to record borrowing costs is therefore:
DEBIT Qualifying asset cost Eligible borrowing costs
Finance cost Ineligible borrowing costs
CREDIT Cash/Accrual Total borrowing costs

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Financial Reporting

HKAS 23.10- 1.2.1 Borrowing costs eligible for capitalisation


15
It is necessary to identify those borrowing costs that are directly attributable to the acquisition,
construction or production of a qualifying asset. These borrowing costs would have been avoided
had the expenditure on the qualifying asset not been made. This is straightforward where funds
have been borrowed for the financing of one particular asset.
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).
Once the relevant borrowings are identified with a specific asset, the amount of borrowing costs
to be capitalised during a period will be the actual borrowing costs incurred on those borrowings,
less any investment income on the temporary investment of those borrowings. It is not unusual to
invest some or all of the funds before they are actually used to finance the qualifying asset.

Self-test question 1
On 1 January 20X9 Vitality Co. borrowed $1.5 million to finance the production of two assets, both
of which were expected to take a year to build. Work started at the beginning of 20X9. Expenditure
was as follows, with the remaining funds invested temporarily.
Asset A Asset B
$'000 $'000
1 January 20X9 250 500
1 July 20X9 250 500
The loan rate was 8% and Vitality Co. can invest surplus funds at 5%.
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 20X9. Show the relevant
journal entries with regard to borrowing costs.
(The answer is at the end of the chapter)

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.

Example: Capitalising interest


On 1 March 20X5 Dunedin Co. drew down $500,000 from existing general borrowings in order to
finance the construction of a new asset. Existing borrowings were as follows:
Bank loan $2,000,000 5% annual interest
Loan notes $6,000,000 8% annual interest
Construction of the asset commenced on 1 April 20X8 and was completed on 31 March 20X9.
What amount of interest must be capitalised in accordance with HKAS 23?

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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 7.5% debenture was issued to fund the construction of a qualifying asset (a piece of mining
equipment), construction of which began on 1 July 20X8.
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.
Required
Calculate the borrowing costs that can be capitalised for the hydro-electric plant machine.
(The answer is at the end of the chapter)

HKAS 23.16 1.2.2 Carrying amount exceeds recoverable amount


As required by other HKFRS, the carrying amount of a qualifying asset must be written down or
written off in situations where the carrying amount (or expected ultimate cost) of the asset
exceeds its recoverable amount or net realisable value. These written down amounts may be
written back in future periods under certain circumstances (again as allowed by other HKFRS).

HKAS 23.17- 1.2.3 Commencement of capitalisation


19
Three events or transactions must be taking place for capitalisation of borrowing costs to be
started:
(a) Expenditure on the asset is being incurred
(b) Borrowing costs are being incurred
(c) Activities are in progress that are necessary to prepare the asset for its intended use or sale
Expenditure must result in cash payments, transfer of other assets or assumption of interest-
bearing liabilities. Any progress payments or grants received in connection with the asset will be
treated as deductions from expenditure. It is allowed by HKAS 23 to use the average carrying
amount of the asset during a period (including capitalised borrowing costs) as a reasonable
approximation of the expenditure to which the capitalisation rate is applied in the period.
Presumably more exact calculations can be used.
Activities necessary to prepare the asset for its intended sale or use encompass not only
physical construction work, but also technical and administrative work prior to construction, e.g.
obtaining permits. However, holding an asset when no production or development that changes the
asset's condition is taking place, e.g. where land is held without any associated development
activity, is to be excluded.

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Financial Reporting

HKAS 23.20- 1.2.4 Suspension of capitalisation


21
Capitalisation of borrowing costs should be suspended for any extended periods where active
development is interrupted.
Any borrowing costs incurred during such periods should be expensed through profit or loss.
Capitalisation of borrowing costs is not normally suspended during:
 a period when substantial technical and administrative work is being carried out
 a temporary delay occurs which is a necessary part of getting an asset ready for intended
use, e.g. while inventories are maturing

HKAS 23.22- 1.2.5 Cessation of capitalisation


25
Once all the activities necessary to prepare the qualifying asset for its intended use or sale are
substantially complete, the capitalisation of borrowing costs should come to an end. This will
normally be the case when the physical construction of the asset is completed, though routine
administrative work and minor modifications may still be outstanding.
An asset may be completed in parts or stages and each part can be used while construction is still
in progress on the other parts. Capitalisation of borrowing costs should be terminated for each part
as it is completed. The example quoted in the standard is a business park consisting of several
buildings.

Example: Commencement, suspension and cessation of capitalisation


Lam Co. borrowed $10 million on 1 January 20X8 in anticipation of commencing work to build a
new head office later in the year. The interest rate provided by Lam Co.’s bank was 8% per annum,
and the loan had a term of five years. Construction began on 15 February and the property was
occupied for use on 20 December 20X8.
The following information is relevant:
1 February Expenditure on building materials began to be incurred
15 February Building work began
6 May Building work was suspended due to tropical storms, common to the
region through May and June
16 May Building work recommenced
30 November Building work is completed and approved by the regulatory authorities
1 December Decoration and finishing of the property to Lam Co.’s specification
commences
15 December Decoration and finishing work is completed.
What journal entries are required to record the borrowing costs in the year ended 31 December
20X8?

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

 Therefore, capitalised costs are:


$10 million  8%  288/365 days = $631,233
$ $
DEBIT Property under construction 631,233
Finance costs (800,000 – 631,233) 168,767
CREDIT Cash / interest accrual 800,000

HKAS 23.26 1.2.6 Disclosure


The following should be disclosed in the financial statements in relation to borrowing costs:
(a) Amount of borrowing costs capitalised during the period.
(b) Capitalisation rate used to determine the amount of borrowing costs eligible for
capitalisation.

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.
(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 $20million 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 $5million. 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 $32million on 1 July 20X8. The rate of interest on the
loan was 5% per annum and it was repaid on 31 December 20X9.
Required
Calculate the total amount to be included at cost in property, plant and equipment in respect of this
project at 30 June 20X9.

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Financial Reporting

Topic recap

HKAS 23 Borrowing Costs

Eligible borrowing costs on qualifying assets MUST be


capitalised.

Eligible borrowing costs Qualifying assets

Borrowing costs Eligible

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.

Includes: Where general borrowings Includes:


Ÿ Interest expense are acquired calculate the Ÿ Inventories
calculated using the eligible borrowing cost as: Ÿ Manufacturing plants
effective interest method weighted average interest Ÿ Power generation facilities
Ÿ Finance charges in rate of general borrowings Ÿ Intangible assets
respect of finance leases ("capitalisation rate") × Ÿ Investment properties
Ÿ Exchange differences on capital expenditure on the Excludes:
foreign currency qualifying asset Ÿ Financial assets
borrowings to the extent Ÿ Inventories manufactured
they are regarded as an over short periods
adjustment to interest Ÿ Assets ready for
costs. sale/intended use when
purchased

Commence capitalisation when: 1 expenditure on the asset is being incurred


2 borrowing costs are being incurred
3 activities are in progress to prepare the asset for use or sale

Suspend capitalisation when active development is interrupted for extended periods.

Cease capitalisation when the activities to prepare the asset for use or sale are substantially complete.

Disclose:
Ÿ Amount of borrowing costs capitalised in period
Ÿ Capitalisation rate used to determine the borrowing costs
eligible for capitalisation.

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Answers to self-test questions

Answer 1
Asset A Asset B
$ $
Borrowing costs
To 31 December 20X9 ($0.5m, $1m)  8% 40,000 80,000
Less: investment income
To 30 June 20X9 ($0.25m, $0.5m)  5%  6/12 (6,250) (12,500)
33,750 67,500
Cost of assets
Expenditure incurred 500,000 1,000,000
Borrowing costs 33,750 67,500
533,750 1,067,500

Capitalisation of borrowing costs


$ $
DEBIT Asset A 40,000
DEBIT Asset B 80,000
CREDIT Accrued interest 120,000

Receipt of investment income by investing surplus funds


$ $
DEBIT Cash 18,750
CREDIT Asset A 6,250
CREDIT Asset B 12,500

Answer 2
 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

Answer 3
Asset X Asset Y
$'000 $'000
Borrowing costs
6
To 30 June 20X8 $4.0m/$6.0m  10%  /12 200 300
6
To 31 December 20X8 $11.0m/$9.0m  10%  /12 550 450
750 750
Less: investment income
6
To 30 June 20X8 $7.0m/$3.0m  8%  /12 (280) (120)
470 630
Cost of assets
Expenditure incurred 11,000 9,000
Borrowing costs 470 630
11,470 9,630

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Financial Reporting

Answer 4
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.

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Exam practice

Rondo Hospitality Enterprise 27 minutes


Rondo Hospitality Enterprise (RHE) is a hotel operator. The management is considering investing
in a new hotel project with 150 rooms. The construction of the hotel building and installation of
equipment, furniture and fixtures is scheduled to commence on 1 March 20X3 and be completed by
the end of June 20X4. The hotel would be available for use at the same time. The total cost of
HK$200 million will be payable in five equal instalments beginning 1 March 20X3 and then payable
every 4 months.
Without any delay in the completion of the construction and other unforeseen events, RHE plans to
have the pre-opening activities for three months and then commence the operation of the new hotel
by 1 October 20X4.
RHE co-ordinates its financing activities through a centralised treasury function, with borrowings
being raised from various sources such as bond issues and bank loans, to finance general
requirements, including the acquisition and development of qualifying assets. It is expected that
the borrowing requirements of RHE will be much greater than the amounts to be incurred for the
hotel project.
The expected useful life of the hotel property is 30 years. It is expected that RHE needs to replace
certain equipment and furniture in the hotel rooms every five years in addition to carrying out
regular repair and maintenance works. Around HK$40 million of the budgeted expenditure is
attributable to these capitalised items. The structure of the building can be used until the end of the
hotel's useful life.
Required
(a) Calculate the borrowing costs to be capitalised for qualifying assets for the year ending 31
December 20X3 and 20X4. Assume the capitalisation rate to be applied to the expenditure
on the qualifying asset is 6.5%. (3 marks)
(b) Discuss the factors the management of RHE should consider in relation to the depreciation
of the hotel property. (6 marks)
(c) Calculate the depreciation to be charged for the year ending 31 December 20X4 with the
explanation, assuming a straight line basis is adopted by RHE for depreciation.
(6 marks)
(Total = 15 marks)
HKICPA December 2012

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chapter 18

Financial instruments
Topic list 4.4 Trade date v settlement date accounting
4.5 Reclassification
1 Financial instruments 4.6 Section summary
1.1 Background
5 HKFRS 9: Embedded derivatives
1.2 Definitions
5.1 Examples of embedded derivatives
2 HKAS 32: Presentation of financial 5.2 Accounting treatment of embedded
instruments derivatives
2.1 Objective 5.3 Reassessment of embedded derivatives
2.2 Scope
6 HKAS 39: Hedging
2.3 Classification of financial instruments as
6.1 Introduction
financial assets, financial liabilities and
6.2 Definitions
equity
6.3 Types of hedge
2.4 Specific classification rules
6.4 Conditions for hedge accounting
2.5 Offsetting a financial asset and a
6.5 Accounting treatment
financial liability
6.6 Exposures qualifying for hedge
2.6 Interest, dividends, losses and gains
accounting
2.7 Section summary
6.7 Recap
3 HKFRS 9: Recognition of financial
7 HKFRS 7: Disclosure of financial
instruments
instruments
3.1 Scope
7.1 Objective
3.2 Initial recognition
7.2 Classes of financial instruments and
3.3 Reclassification of financial assets
levels of disclosure
3.4 Derecognition
7.3 Statement of financial position
3.5 Section summary
disclosures
4 HKFRS 9: Measurement of financial 7.4 Statement of profit or loss and other
instruments comprehensive income disclosures
4.1 Initial measurement 7.5 Other disclosures
4.2 Subsequent measurement of financial 7.6 Nature and extent of risks arising from
assets financial instruments
4.3 Subsequent measurement of financial 7.7 Capital disclosures
liabilities
8 Current developments

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.

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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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 continues to be a work in
progress and in due course will be developed further to replace HKAS 39 in its entirety.
This chapter is based on those parts of all four standards in issue at 31 May 2013. The HKICPA
operates a six-month rule, meaning that new or revised standards which have been issued by the
cut-off date (31 May 2013 for December 2013 exams and 30 November 2013 for June 2014
exams) are only examined where they have been effective or will become effective within 13
months from the first day of the month in which the examination takes place. In the case of HKFRS
9, the effective date is January 2015 so it is examinable. Any subsequent amendments made to
HKFRS 9 will be examined according to the six-month rule as stated above.

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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
(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)

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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 1.2.1 Financial assets and liabilities


32.AG4, AG8,
AG11-12, The definitions of financial assets and financial liabilities may seem complicated, but the
AG20-21
essential point is that while there may be a chain of contractual rights and obligations, it will lead
ultimately to the receipt or payment of cash or the acquisition or issue of an equity instrument.
Examples of financial assets and liabilities may include:

Financial assets Financial liabilities


Trade receivables Trade payables
An investment in shares Loans payable
A loan made to another party Redeemable preference shares

HKAS 32 makes it clear that the following items are not financial assets or liabilities:
 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
 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).

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Financial Reporting

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.

2 HKAS 32: Presentation of financial instruments


HKAS 32.2 2.1 Objective
The objective of HKAS 32 is:
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)

2.3 Classification of financial instruments as financial assets,


financial liabilities and equity
Topic highlights
Financial instruments are classified as financial assets, financial liabilities or equity. Financial
instruments issued to raise capital must be classified as liabilities or equity.
The critical feature of a financial liability is the contractual obligation to deliver cash or another
financial instrument.

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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
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)

2.4 Specific classification rules


As well as providing the general classification rules explained in the section above, HKAS 32 also
provides guidance on the classification of specific instruments and instruments with specific
characteristics. They are:
 puttable financial instruments and obligations arising on liquidation
 financial instruments with contingent settlement provisions
 financial instruments with settlement options
 compound instruments
 rights issues
The remainder of this section deals with each in turn.
HKAS 2.4.1 Puttable financial instruments and obligations arising on liquidation
32.16A-B,E
HKAS 32 was amended in 2008 to introduce criteria for certain puttable instruments and
obligations arising on liquidation to be classified as equity. Prior to these amendments, these
instruments would have been classified as financial liabilities.

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Financial Reporting

Puttable financial instruments


A puttable financial instrument is an instrument where the holder can "put" the instrument i.e.
require the issuer to redeem it in cash. For example, some ordinary shares are puttable, and prior
to the revision to HKAS 32, these were classified as liabilities. They are now classified as equity,
but only if:
(a) the holder is entitled to a pro-rata share of the entity's net assets on liquidation.
(b) the instrument is in the class of instruments that is the most subordinate and all instruments
in that class have identical features.
(c) the instrument has no other characteristics that would meet the definition of a financial liability.
(d) the total expected cash flows attributable to the instrument over its life are based
substantially on the profit or loss, the change in the recognised net assets or the change in
the fair value of the recognised and unrecognised net assets of the entity (excluding any
effects of the instrument itself). Profit or loss or change in recognised net assets for this
purpose is as measured in accordance with relevant HKFRS.
In addition to the criteria set out above, the entity must have no other instrument that has terms
equivalent to (d) above and that has the effect of substantially restricting or fixing the residual
return to the holders of the puttable financial instruments.
Where the specified criteria are no longer met, or when they are subsequently met, the instrument
should be reclassified. If the instrument presented as equity is reclassified as a financial liability, it
will be measured at fair value at the date of reclassification with any difference between the fair
value and the carrying amount to be recognised in equity. When the inverse applies, the financial
liability will be reclassified to equity at its carrying amount at the date of reclassification.
HKAS 32.16C Obligations arising on liquidation
As a result of the amendment mentioned above, instruments imposing an obligation on an entity to
deliver to another party a pro-rata share of the net assets on liquidation should be classified as
equity.
The following examples illustrate the types of instruments impacted by the new requirements:

Classification Classification
under HKAS 32 under amended
Issued financial instrument before amendment HKAS 32

Share puttable throughout its life at fair value, Liability Equity


that is also the most subordinate, does not
contain any other obligation, with discretionary
dividends based on profits of the issuer
Share puttable at fair value, that is not the most Liability Liability
subordinate
Share puttable at fair value only on liquidation, Liability Compound (part
that is also the most subordinate, but contains equity, part liability)
a fixed non-discretionary dividend
Share puttable at fair value only on liquidation, Liability Equity
that is also the most subordinate, but contains
a fixed discretionary dividend and does not
contain any other obligation
Any of the instruments described above issued Liability Liability
by a subsidiary held by non-controlling parties,
in the consolidated financial statements

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Even though the amendments permit certain instruments that were previously presented as
financial liabilities to now be presented as equity, derivatives over such equity instruments may not
be presented as equity.
Puttable instruments and instruments puttable only on liquidation that are classified as equity in the
separate or individual financial statements of the issuing entity and represent non-controlling
interests should be classified as financial liabilities in the consolidated financial statements of the
group.
HKAS 32.25 2.4.2 Financial instruments with contingent settlement provisions
The settlement of some financial instruments depends on events which are beyond the control of
both the holder and issuer of the instrument:
(a) The occurrence or non-occurrence of uncertain future events
(b) The outcome of uncertain circumstances
For example, an entity might have to deliver cash instead of issuing equity shares. In this situation
it is not immediately clear whether the entity has an equity instrument or a financial liability.
Such financial instruments should be classified as financial liabilities unless the possibility of
settlement is remote.
HKAS 32.26 2.4.3 Financial instruments with settlement options
When a derivative financial instrument gives one party a choice over how it is settled (e.g., the
issuer can choose whether to settle in cash or by issuing shares) the instrument is a financial
asset or a financial liability unless all the alternative choices would result in it being an equity
instrument.
HKAS 2.4.4 Compound financial instruments
32.28,29,32

Topic highlights
Compound instruments are split into equity and liability parts and presented accordingly in the
statement of financial position.

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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Financial Reporting

Example: Valuation of compound instruments


Strauss Co. issues 1,000 convertible bonds at the start of 20X0. The bonds have a three-year term,
and are issued at par with a face value of $2,500 per bond, giving total proceeds of $2,500,000.
Interest is payable annually in arrears at a nominal annual interest rate of 5%. Each bond is
convertible at any time up to maturity into 300 common shares.
When the bonds are issued, the prevailing market interest rate for similar debt without conversion
options is 8%. At the issue date, the market price of one common share is $2. The dividends
expected over the three-year term of the bonds amount to 11 cents per share at the end of each
year. The risk-free annual interest rate for a three-year term is 4%.
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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Convertible debt instruments where conversion is at the option of the issuing entity are not
compound instruments and do not require the split-accounting approach described above. Instead,
such instruments are accounted for as a liability in their entirety.

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.

Example: Rights issue


Background
On 1 December 20X2, ABC offered all of its existing shareholders rights to acquire one new
common share for every three common shares held at a price of $15 per share. ABC's functional
currency is Y, and ABC has only one class of shares outstanding. There were a total of 3,000 rights
offered and they initially traded at $2 each.
The rights were subject to expiry on 31 December 20X2 and were fully subscribed on that date.
On 31 December 20X2, the common share price was $18 per share and the closing fair value of
the rights was $3 per share (i.e. $18 – $15).
Exchange rate: $/Y = 1.5/1
Accounting treatment prior to amendment
The rights offered in $ would have been accounted for as derivative liabilities. On 1 December
20X2, a liability of Y4,000 ($2  3,000 ÷ 1.5) would have been recognised with a corresponding
debit to equity, representing the distribution of the rights to common shareholders. Subsequently,
the liability would have been re-measured at fair value, increasing to Y6,000 (3,000  $3 ÷ 1.5),
and a loss of Y2,000 (Y6,000 – Y4,000) would have been recognised in profit or loss. On exercise
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

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Journal entries for accounting treatment after the amendment


Y Y
31 December 20X2
DEBIT Cash 30,000
CREDIT Equity 30,000
Being the exercise of rights in full

HKAS 32.42 2.5 Offsetting a financial asset and a financial liability


Financial assets and liabilities are normally presented separately in the statement of financial
position. A financial asset and financial liability should only be offset, with the net amount reported
in the statement of financial position, when an entity:
(a) has a legally enforceable right of set off
(b) intends to settle on a net basis, or to realise the asset and settle the liability simultaneously,
i.e. at the same moment
This will reflect the expected future cash flows of the entity in these specific circumstances. In all
other cases, financial assets and financial liabilities are presented separately.
HKAS An amendment was made to HKAS 32 in December 2011 in order to clarify the existing offsetting
32.AG38A-F rules as detailed above.
 In order to result in the offset of a financial asset and financial liability, a right of set-off must
be available immediately rather than being contingent on a future event.
 The right of set-off must be exercisable by either counterparty.
The amendment also clarified situations which may be classified as simultaneous realisation of an
asset and settlement of a liability.

HKAS 32.35 2.6 Interest, dividends, losses and gains


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
instruments are presented in the statement of profit or loss and other comprehensive income and
statement of changes in equity:

Financial liabilities Equity instruments


Interest, dividends, gains and losses are Dividends are recognised directly in equity
recognised in profit or loss. (and so disclosed in the statement of changes
in equity).
Transaction costs are a deduction from 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.

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2.7 Section summary


 Financial instruments issued to raise capital must be classified as liabilities or equity.
 The substance of the financial instrument is more important than its legal form.
 The critical feature of a financial liability is the contractual obligation to deliver cash or
another financial instrument.
 Compound instruments are split into equity and liability parts and presented accordingly.
 Interest, dividends, losses and gains are treated according to whether they relate to an
equity instrument or a financial liability.

3 HKFRS 9: Recognition of financial instruments


Topic highlights
HKFRS 9 applies to the recognition of financial assets and liabilities.

The guidance on recognition of financial instruments now comes from HKFRS 9.

3.1 Scope
All entities are required to apply HKFRS 9 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) Insurance contracts.
(e) Equity instruments issued by the entity e.g. ordinary shares issued, or options and
warrants.
(f) Financial guarantee contracts.
(g) Contracts for contingent consideration in a business combination, covered in HKFRS 3.
(h) Contracts requiring payment based on climatic, geological or other physical variables.
(i) Loan commitments that cannot be settled net in cash or another financial instrument.
(j) Financial instruments, contracts and obligations under share-based payment transactions,
covered in HKFRS 2.

HKFRS 9,
3.1.1
3.2 Initial recognition
Topic highlights
Financial instruments are recognised when the entity becomes a party to the contractual provisions
of the instrument.
Financial assets are classified as measured at amortised cost or fair value. Financial liabilities are
classified at fair value through profit or loss or amortised cost.

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.

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Financial Reporting

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.

HKFRS 9, 3.2.1 Classification of financial assets


4.1.1-4.1.2
On recognition, HKFRS 9 requires that financial assets are classified as measured at either:
 amortised cost, or
 fair value
This classification is made on the basis of both:
(a) the entity's business model for managing the financial assets, and
(b) the contractual cash flow characteristics of the financial asset.
A financial asset is classified as measured at amortised cost where:
(a) the objective of the business model within which the asset is held is to hold assets in order to
collect contractual cash flows, and
(b) 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.
An application of these rules means that equity investments may not be classified as measured at
amortised cost and must be measured at fair value. This is because contractual cash flows on
specified dates are not a characteristic of equity instruments. In addition, all derivatives are
measured at fair value.
A debt instrument may be classified as measured at either amortised cost or fair value depending
on whether it meets the criteria above. Even where the criteria are met at initial recognition, a debt
instrument may be classified as measured at fair value through profit or loss if doing so eliminates
or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an
"accounting mismatch") that would otherwise arise from measuring assets or liabilities or
recognising the gains and losses on them on different bases.
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

Note that the HKFRS 9 requirement to classify financial assets on recognition as one of two types
is a significant simplification of the previous HKAS 39 rules. These required financial assets to be
classified as one of four types, being:
 at fair value through profit or loss
 held to maturity
 available for sale, and
 loans and receivables

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HKFRS 9, 3.2.2 Classification of financial liabilities


4.2.1
On initial recognition, HKFRS 9 requires 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.
These classification rules are unchanged from those previously contained within HKAS 39.

HKFRS 9,
4.4.1-4.4.2
3.3 Reclassification of financial assets
Topic highlights
Financial assets may be reclassified from one category to another in certain circumstances.

Although on initial recognition financial assets must be classified in accordance with the
requirements of HKFRS 9, in some cases they may be subsequently reclassified.
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.

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.

HKFRS 9 now provides the rules with regard to derecognition. 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
HKFRS 9 includes the following 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

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 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
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

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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.

HKFRS 9, 3.4.3 Partial derecognition


3.2.2
Partial derecognition of a financial asset or liability is possible on condition that the derecognised
part comprises only:
(a) identifiable cash flows
(b) a share of the total cash flows on a fully proportionate (pro rata) basis
For example, a holder of bonds has the right to two separate sets of cash inflows: those relating to
the principal and those relating to the interest. It could retain the right to receive the principal and
sell the right to receive interest to another party.
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

3.5 Section summary


 HKFRS 9 applies to the recognition of financial assets and liabilities. Financial instruments
are recognised when the entity becomes a party to the contractual provisions of the
instrument.
 Financial assets are classified as measured at amortised cost or fair value; financial liabilities
are classified at fair value through profit or loss or amortised cost.
 Financial assets may be reclassified from one category to another in certain circumstances.
Financial liabilities may not be reclassified.

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 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 derecognised when they are extinguished.

4 HKFRS 9: Measurement of financial instruments


Topic highlights
Financial instruments are initially measured at fair value. Transaction costs increase this amount
for financial assets classified as measured at amortised cost and decrease this amount for financial
liabilities classified as measured at amortised cost.

The classification of financial assets and financial liabilities is of particular importance in terms of
how they are measured throughout their life.

HKFRS 9, 4.1 Initial measurement


5.1.1, 5.1.2A
Financial assets
HKFRS 9 requires that financial assets are initially measured at the transaction price, i.e. the fair
value of consideration given, except where part of the consideration given is for something other
than the financial asset. In this case the financial asset is initially measured at fair value evidenced
by a quoted price in an active market for an identical asset (i.e. an HKFRS 13 level 1 input) or
based on a valuation technique that uses only data from observable markets. The difference
between the fair value at initial recognition and the transaction price is recognised as a gain or loss.
In the case of financial assets classified as measured at amortised cost, transaction costs directly
attributable to the acquisition of the financial asset increase this amount.
Financial liabilities
HKFRS 9 requires 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 classified as measured at amortised cost.

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 normally recognised in 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.

HKFRS 4.2.1 Financial assets measured at fair value


13.76,81,86
Where a financial asset is classified as measured at fair value, fair value is established at each period
end in accordance with HKFRS 13 Fair Value Measurement. That standard requires that a fair value
hierarchy is applied with three levels of input:

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Level 1 inputs Unadjusted quoted prices in active markets for identical assets or liabilities that
the entity can access at the measurement date.
Level 2 inputs Inputs other than quoted prices included within Level 1 that are observable for
the asset or liability, either directly or indirectly. These may include quoted
prices for similar assets or liabilities in active markets or quoted prices for
identical or similar assets and liabilities in markets that are not active.
Level 3 inputs Unobservable inputs for the asset or liability.
Any changes in fair value are normally recognised in profit or loss. There is an exception to this rule
where the financial asset is an investment in an equity instrument not held for trading. In this case
the entity can make an irrevocable election to recognise changes in the fair value in other
comprehensive income.

Example: Asset measurement


On 6 November 20X3 Stripe Co. acquires a listed equity investment with the intention of holding it
in the long term. The investment cost $500,000. At Stripe Co.'s year end of 31 December 20X3, the
market price of an identical investment is $520,000. How is the asset initially and subsequently
measured?
Stripe Co. has elected to present the equity investment in other comprehensive income.
Solution
 The asset is initially recognised at the fair value of the consideration, being $500,000
 At the period end it is remeasured to $520,000
 This results in the recognition of $20,000 in other comprehensive income.

HKAS 39.9 4.2.2 Financial assets measured at amortised cost


HKFRS 9 does not itself define amortised cost, however it does refer to the definition of this and
other relevant terms within HKAS 32 and HKAS 39. The example which follows the definitions will
help you to understand their application.

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)

Example: Financial asset measured at amortised cost


On 1 January 20X5 Abacus Bee Co. (ABC) purchases a debt instrument for its fair value of
$100,000. The debt instrument is due to mature on 31 December 20X9. The instrument has a
principal amount of $125,000 and the instrument carries fixed interest at 4.72% that is paid
annually. (The effective interest rate is 10%.)
How should ABC account for the debt instrument over its five-year term?

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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.
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.
4.2.3 "Old" rules for subsequent measurement of financial assets
As we have already said, HKFRS 9 has superseded HKAS 39 in respect of providing guidance for
the accounting for financial assets. An understanding of the "old" rules with regard to subsequent
accounting for financial assets will help you to understand the reduction in complexity afforded by
the introduction of HKFRS 9.

Old HKAS 39 Category Measured at Gains and losses


Financial asset at fair value through profit or Fair value Profit or loss
loss
Available for sale financial asset Fair value Other comprehensive income
Financial asset held to maturity Amortised cost Profit or loss
Loans and receivables Amortised cost Profit or loss

While the treatment under HKAS 39 seems very similar to that under HKFRS 9, the initial
classification of each financial instrument was more complex as certain instruments could fall into
more than one category or indeed fall foul of strict classification rules after initial classification and
have to be reclassified.
The transition to HKFRS 9 must be applied retrospectively, although the business model
assessment need only be made on the date of initial application of the new standard.
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.

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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)

HKFRS 9, 4.3 Subsequent measurement of financial liabilities


5.3.1

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.

Example: Finance cost


On 1 January 20X5 a company issued $200,000 loan notes. Issue costs were $320. The loan
notes do not carry interest, but are redeemable at a premium of $41,613 on 31 December 20X6.
The effective finance cost of the loan notes is 10%.
What is the finance cost in respect of the loan notes for the year ended 31 December 20X6, and
what is the carrying amount of the loan notes at that date?

Solution
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

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.

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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)

HKFRS 9, 4.3.2 Financial liabilities at fair value through profit or loss


5.7.1
Financial liabilities which are held for trading and classified as fair value through profit or loss are
remeasured to fair value each year in accordance with HKFRS 13 (see section 4.2.1) with any gain
or loss recognised in profit or loss.
HKFRS 9 HKFRS 9 requires that financial liabilities which are designated as measured at fair value through
B5.7.16 profit or loss are treated differently. In this case the gain or loss in a period must be classified into:
 gain or loss resulting from credit risk; and
 other gain or loss.
The gain or loss resulting from credit risk is established either:
1 as the amount of change in the fair value that is not attributable to changes in market
conditions giving rise to market risk, or
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 recycled
to profit or loss.

HKFRS 9,
3.1.2-3.1.6,
4.4 Trade date v settlement date accounting
Appendix A A regular way purchase or sale of financial assets shall be recognised and derecognised using
trade date accounting or settlement date accounting.

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.

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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.

Example: Trade date and settlement date accounting


Gaylord entered into a contractual commitment on 27 December 20X4 to purchase a financial
asset for $1,000. On 31 December 20X4, the entity’s reporting date, the fair value was $1,005.
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.
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.

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Financial Reporting

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.

HKAS 39.58 4.4.1 Impairment and uncollectability of financial assets

Topic highlights
Financial assets measured at amortised cost must be tested for impairment when there is objective
evidence of impairment. Any loss is recognised in profit or loss.

At each year end, an entity should assess whether there is any objective evidence that a financial
asset or group of assets is impaired. Although HKFRS 9 now applies to the recognition and
measurement of financial assets, HKAS 39 continues to provide the guidance on impairments.
Due to the reduced number of classifications of financial assets under HKFRS 9, this area is less
complex than it was prior to the issue of the new standard, and only those financial assets
classified as measured at amortised cost need be tested for impairment.

Self-test question 8
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- 4.4.2 Objective evidence of impairment


60
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.
(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:

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(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- 4.4.3 Impairment of financial assets carried at amortised cost
65
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.

HKFRS 9,
5.6.1-5.6.3 4.5 Reclassification
Earlier we saw that an entity may 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.

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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.

4.6 Section summary


 Financial instruments are initially measured at fair value. Transaction costs increase this
amount for financial assets classified as measured at amortised cost and decrease this
amount for financial liabilities classified as measured at amortised cost.
 Financial assets are subsequently measured at:
– fair value with changes in value normally recognised in profit or loss, or
– amortised cost with interest recognised in profit or loss.
 Financial liabilities are subsequently measured at fair value or amortised cost with gains and
losses recognised in profit or loss.
 Financial assets measured at amortised cost must be tested for impairment when there is
objective evidence of impairment. Any loss is recognised in profit or loss.

5 HKFRS 9: Embedded derivatives


Topic highlights
Embedded derivatives are derivative instruments that are embedded within a host contract that
may or may not be a financial instrument.

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

5.1 Examples of embedded derivatives


Possible examples include:
(a) Contingent rentals based on sales included as a term in a lease of retail premises:

"Host"
Lease Accounted for as normal
contract

Embedded Contingent Treat as derivative, i.e. re-


derivative rentals measured to fair value with
changes recognised in profit or
loss
(b) A bond which is redeemable in five years' time with part of the redemption price based on
the increase in the Hong Kong Index.

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(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
5.2 Accounting treatment of embedded derivatives
Topic highlights
Where the host contract is within the scope of HKFRS 9 the hybrid contract is accounted for as one
instrument. Otherwise, HKFRS 9 requires that the embedded derivative is separated from the host
contract where certain conditions are met and accounted for separately.

HKFRS 9 now provides the accounting guidance in relation to embedded derivatives.


Unless the host contract is a financial asset within the scope of the standard, HKFRS 9 requires
that an embedded derivative is separated from its host contract and accounted for as a
derivative when the following conditions are met:
(a) The economic characteristics and risks of the embedded derivative are not closely related to
the economic characteristics and risks of the host contract.
(b) A separate instrument with the same terms as the embedded derivative would meet the
definition of a derivative.
(c) The hybrid (combined) instrument is not measured at fair value with changes in fair value
recognised in profit or loss (a derivative embedded in a financial liability need not be
separated out if the entity holds the combined instrument at fair value through profit or loss).
The host contract is accounted for in accordance with relevant accounting standards.
HKFRS 9, 5.2.1 Financial asset host contract
4.3.2
Where the host contract is a financial asset within the scope of the standard, the classification and
measurement rules of the standard are applied to the entire hybrid contract.
This is a simplification of the rules which applied to financial assets as well as other host contracts
prior to the issue of HKFRS 9.

HKFRS 9,
B4.3.1
5.3 Reassessment of embedded derivatives
As a result of the expansion of HKFRS 9, the contents of HK(IFRIC) Int-9 Reassessment of
Embedded Derivatives have been incorporated into the standard and the Interpretation itself has
been withdrawn.
The standard 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.

6 HKAS 39: Hedging


Topic highlights
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.

6.1 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

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Financial Reporting

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 requires hedge accounting where there
is a designated hedging relationship between a hedging instrument and a hedged item. It is
prohibited otherwise.

HKAS 39.9 6.2 Definitions


The definitions in HKAS 39 relevant to hedging are given below.

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)

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.

HKAS 39.86 6.3 Types of hedge


There are three types of hedge covered by HKAS 39:
(a) Fair value hedges, which involve hedging against a change in the value of a recognised
asset or liability (the above example involving a foreign currency payable is an example of a
fair value hedge)

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(b) Cash flow hedges, which involve hedging against a change in the value of future certain
cash flows (for example, where an entity is due to receive a payment in foreign currency),
and
(c) Net investment hedges, which involves hedging an investment in a foreign group company.
The formal definitions of each type of hedge are as follows:

Key terms
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.
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.
(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.

HKAS 39.88 6.4 Conditions for hedge accounting


Topic highlights
Hedge accounting is permitted in certain circumstances, provided the hedging relationship is
clearly defined, measurable and actually effective.

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.

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Financial Reporting

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

6.5 Accounting treatment


Topic highlights
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.

HKAS 39.89 6.5.1 Fair value hedges


In a fair value hedge, the hedged item is a recognised asset or liability. When hedge accounting is
applied, this is remeasured to fair value at the period end in accordance with HKFRS 13 Fair Value
Measurement and any gain or loss on the hedged item attributable to the hedged risk is
recognised in profit or loss.
The hedging instrument is a derivative and in accordance with HKAS 39 / HKFRS 9 any gain or
loss resulting from re-measuring the hedging instrument at fair value is also recognised in profit
or loss.

Example: Fair value hedge (1)


A company owns inventories of 30,000 gallons of oil which cost $660,000 on 1 December 20X8.
In order to hedge the fluctuation in the market value of the oil the company signs a futures contract
to deliver 30,000 gallons of oil on 31 March 20X9 at the futures price of $25 per gallon.
The market price of oil on 31 December 20X8 is $27 per gallon and the futures price for delivery on
31 March 20X9 is $30 per gallon.
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

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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.

Example: Fair value hedge (2)


As at 1 January 20X3, a company purchases a debt instrument that has a principal amount of
$1 million at a fixed interest rate of 6% per year. The instrument is classified as a financial asset
measured at fair value. The fair value of the instrument is $1 million.
The company is exposed to a risk of the decline in the fair value of the instrument if the market
interest rate increases because of the fixed interest rate.
The company enters into an interest rate swap. It exchanges the fixed interest rate payments it
receives on the bond for floating interest rate payments, in order to offset the risk of a decline in fair
value. If the derivative hedging instrument is effective, any decline in the fair value of the bond
should be offset by opposite increases in the fair value of the derivative instrument. The company
designates and documents the swap as a hedging instrument. On entering into the swap, the swap
has a fair value of zero.
Assuming market interest rates have increased to 7%, the fair value of the bond will have
decreased to $960,000.
At the same time, the company determines that the fair value of the swap has increased by
$40,000. Since the swap is a derivative, it is measured at fair value with changes in fair value
recognised in profit or loss. The changes in fair value of the hedged item and the hedging
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.

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Financial Reporting

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.

Example: Fair value hedge (3)


Assuming the information is the same as above. However, the company determines that the fair
value of the swap has increased by $45,000 instead of $40,000.
Required
Explain the impact of the transactions on the financial statements of the company.

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.

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HKAS 39.95 6.5.2 Cash flow hedges


A cash flow hedge involves hedging future cash flows. Initially therefore, only the hedging
instrument (the derivative) is recognised.
The part of the gain or loss arising from an effective hedge of a hedging instrument is recognised
in other comprehensive income while the ineffective portion of the gain or loss on the hedging
instrument should be recognised in profit and loss.
In the case where a hedging transaction results in the recognition of a non-financial asset or
liability, changes in the value of the hedging instrument recognised in other comprehensive income:
(a) are adjusted against the carrying value of the asset or liability
(b) are 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 (such as in
the periods that depreciation expense is recognised).

Example: Basic cash flow hedge


Randall Co. expected to purchase an item of plant for 20 million South African Rand in one year's
time on 31 August 20X2. In order to offset the risk of movement in the exchange rate, Randall
enters into a forward contract to purchase Rand 20 million in one year for a fixed amount
($20,500,000). The forward contract is designated as a cash flow hedge and has an initial fair value
of zero.
At the year end (31 December 20X1), the Rand has appreciated and the value of Rand 20 million is
$20,650,000. The machine will still cost Rand 20 million so the company concludes that the hedge
is 100% effective. Thus the entire change in the fair value of the hedging instrument is recognised
directly in other comprehensive income:
$ $
DEBIT Forward contract 150,000
CREDIT Other comprehensive income 150,000

The effect of the cash flow hedge is to lock in the price of Rand 20 million for the item of plant. The
other comprehensive income of $150,000 will either:
(i) be reclassified to profit or loss as the machine is depreciated, or
(ii) be deducted from the initial carrying amount of the machine.

Example: Cash flow hedge


Sparkle is a manufacturer and retailer of gold jewellery.
On 31 October 20X1, the cost of Sparkle's inventories of finished jewellery was $8.280 million with
a gold content of 24,000 troy ounces. At that date their sales value was $9.938 million.
The selling price of gold jewellery is heavily dependent on the current market price of gold (plus a
standard percentage for design and production costs).
Sparkle's management wished to reduce their business risk of fluctuations in future cash inflow
from sale of the jewellery by hedging the value of the gold content of the jewellery. In the past this
has proved to be an effective strategy.
Therefore, it sold futures contracts for 24,000 troy ounces of gold at $388 per troy ounce at
31 October 20X1. The contracts mature on 30 October 20X2.
On 30 September 20X2 the fair value of the jewellery was $9.186m and the forward price of gold
per troy ounce for delivery on 30 October 20X2 was $352.

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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.

Example: Cash flow hedge – interest rate swap


On 1 January 20X1, Arlington Co. lends $10 million to another entity, with a maturity date of three
years later on 31 December 20X3. The interest rate attached to the loan is variable at HIBOR +
2%, and interest is due annually on 31 December.
Arlington expects interest rates to decline and so simultaneously enters an interest rate swap on
1 January 20X1 in order to hedge its position.
The terms of the swap are as follows:
 There is no initial cost
 The notional principal is $10 million
 Arlington will receive fixed interest at 7%
 Arlington will pay variable interest at HIBOR
 Net settlement is made annually on 31 December, and the swap is also repriced on this
date.

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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

HIBOR at each of these dates is:


31 December 20X1 7%
31 December 20X2 6%
31 December 20X3 5%
All criteria for cash flow hedge accounting have been met and the hedging relationship is expected
to be 100% effective at inception and on an ongoing basis.
What journal entries are required in respect of the loan and cash flow hedge throughout the three-
year term?

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

To record the inception of the loan.


(Note. No entry is required in respect of the swap as it was acquired at no cost)

31 December 20X1
DEBIT Cash 900,000
CREDIT Interest income 900,000

To record the receipt of interest in respect of the loan.

DEBIT Interest rate swap 300,000


CREDIT Other comprehensive income 300,000

To record the fair value of the interest rate swap.

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Financial Reporting

31 December 20X2
DEBIT Cash 800,000
CREDIT Interest income 800,000

To record the receipt of interest in respect of the loan.

DEBIT Cash 100,000


CREDIT Other comprehensive income 100,000

To record the cash received on net settlement of the interest rate swap.

DEBIT Other comprehensive income 100,000


CREDIT Interest income 100,000

To recycle into earnings amounts in OCI on account of the cash flow hedge, so that they are
matched with the relevant cash flow.

DEBIT Other comprehensive income 175,000


CREDIT Interest rate swap 175,000

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 receipt of interest in respect of the loan.

DEBIT Cash 200,000


CREDIT Other comprehensive income 200,000

To record the cash received on net settlement of the interest rate swap.

DEBIT Other comprehensive income 200,000


CREDIT Interest income 200,000

To recycle into earnings amounts in OCI on account of the cash flow hedge, so that they are
matched with the relevant cash flow.

DEBIT Other comprehensive income 125,000


CREDIT Interest rate swap 125,000

To adjust the carrying value of the interest rate swap to current fair value.

DEBIT Cash 10,000,000


CREDIT Loan receivable 10,000,000

To record repayment of the loan at the maturity date.

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HKAS 39.102 6.5.3 Hedges of a net investment


Hedges of a net investment arise in the consolidated accounts where a parent company takes a
foreign currency loan in order to buy shares in a foreign subsidiary. The loan and the investment
need not be denominated in the same currency, however assuming that the currencies perform
similarly against the parent company's own currency, it should be the case that fluctuations in the
exchange rate affect the asset (the net assets of the subsidiary) and the liability (the loan) in
opposite ways, hence gains and losses are hedged.
In this type of accounting hedge, the hedging instrument is the foreign currency loan rather than a
derivative.
You may understand this type of hedge better after studying Chapter 30, Foreign Currency
Transactions, but in a simple sense, without applying hedging rules:
(a) The loan would be retranslated to the parent's own currency at the year end using the spot
exchange rate; any resultant gain or loss would be recognised in profit or loss.
(b) Prior to consolidation, the subsidiary's accounts would be translated into the parent's own
currency with any gain or loss recognised in other comprehensive income.
(c) On consolidation, the gain or loss on the loan would affect consolidated profit or loss and the
loss or gain on the translation of the subsidiary's net assets would affect consolidated
reserves.
The net investment hedge ensures that the gains and losses are both recognised in other
comprehensive income and accumulated in reserves by:
 recognising the portion of the gain or loss on the hedging instrument that is determined to be
effective in other comprehensive income
 recognising the ineffective portion in profit or loss
Any gain or loss recognised in other comprehensive income is reclassified to profit or loss on the
disposal or partial disposal of the foreign operation.

6.6 Exposures qualifying for hedge accounting


HKAS 39 was amended in 2008 to clarify what can be designated as a hedged risk and when an
entity may designate a portion of the cash flows of a financial instrument as a hedged item.
The risks specified are:
 interest rate risk
 foreign currency rate risk
 credit risk
 prepayment risk
The portions of the cash flows of a financial instrument that may be designated as a hedged item
are one or more of the following:
(a) The cash flows of a financial instrument for part of its time period to maturity.
(b) A percentage of the cash flows of a financial instrument.
(c) The cash flows of a financial instrument associated with a one-sided risk of that instrument.
(d) Any contractually specified cash flows of a financial instrument that are independent from the
other cash flows of that instrument.
(e) The portion of the cash flows of an interest bearing financial instrument that is equivalent to a
financial instrument with a risk-free rate.
(f) The portion of the cash flows of an interest bearing financial instrument that is equivalent to a
financial instrument with a quoted or variable inter-bank rate.

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Financial Reporting

6.7 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.

7 HKFRS 7: Disclosure of financial instruments


Topic highlights
HKFRS 7 specifies the disclosures required for financial instruments. In addition, HKFRS 13
disclosures are applied where financial instruments are measured at fair value. HKFRS 7 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.

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.

HKFRS 7.1 7.1 Objective


The objective of HKFRS 7 is to require entities to provide disclosures in their financial statements
that enable users to evaluate:
(a) the significance of financial instruments for the entity's financial position and performance.
(b) the nature and extent of risks arising from financial instruments to which the entity is
exposed during the period and at the reporting date, and how the entity manages those
risks.
The principles in HKFRS 7 complement the principles for recognising, measuring and presenting
financial assets and financial liabilities in HKAS 32 Financial Instruments: Presentation, HKAS 39
Financial Instruments: Recognition and Measurement and HKFRS 9 Financial Instruments.

HKFRS 7.6 7.2 Classes of financial instruments and levels of disclosure


When HKFRS 7 requires disclosures by class of financial instrument, an entity must group financial
instruments into classes that are appropriate to the nature of the information disclosed and that
take into account the characteristics of those financial instruments. Sufficient information should be
provided to permit reconciliation to the line items presented in the statement of financial position.

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HKFRS 7.7-
19
7.3 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 7.4 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.

HKFRS 7.21 7.5 Other disclosures


Entities must disclose in the summary of significant accounting policies the measurement basis
used in preparing the financial statements and the other accounting policies that are relevant to an
understanding of the financial statements.

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Financial Reporting

HKFRS 7.22- 7.5.1 Hedge accounting


24
Disclosures must be made relating to hedge accounting, as follows:
(a) Description of hedge.
(b) Description of financial instruments designated as hedging instruments and their fair value
at the reporting date.
(c) The nature of the risks being hedged.
(d) For cash flow hedges, periods when the cash flows will occur and when they will affect
profit or loss.
(e) For fair value hedges, gains or losses on the hedging instrument and the hedged item.
(f) The ineffectiveness recognised in profit or loss arising from cash flow hedges and net
investments in foreign operations.
HKFRS 7.25, 7.5.2 Fair value
26,29
HKFRS 7 retains the following general requirements in relation to the disclosure of fair value for
those financial instruments measured at amortised cost:
(a) For each class of financial assets and financial liabilities an entity shall disclose the fair
value of that class of assets and liabilities in a way that permits it to be compared with its
carrying amount.
(b) In disclosing fair values, an entity shall group financial assets and financial liabilities into
classes, but shall offset them only to the extent that their carrying amounts are offset in the
statement of financial position.
It also states that disclosure of fair value is not required where:
 carrying amount is a reasonable approximation of fair value
 for investments in equity instruments that do not have a quoted market price in an active
market for an identical instrument, or derivatives linked to such equity instruments
HKFRS HKFRS 13 provides disclosure requirements in respect of the fair value of financial instruments
13.91,93, 95, measured at fair value. It requires that information is disclosed to help users assess:
97
(a) for assets and liabilities measured at fair value 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):
1 The fair value measurement at the end of the period
2 The level of the fair value hierarchy within which the fair value measurements are
categorised in their entirety
3 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
4 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
5 For recurring fair value measurements categorised within level 3 of the fair value hierarchy

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6 A reconciliation from the opening to closing balances


7 The amount of unrealised gains or losses recognised in profit or loss in the period and the
line item in which they are recognised
8 A narrative description of the sensitivity of the fair value measurement to changes in
unobservable inputs
9 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.
An entity should also disclose its policy for determining when transfers between levels of the fair
value hierarchy are deemed to have occurred.

Example: Fair value disclosures


For assets and liabilities measured at fair value at the end of the reporting period, the HKFRS
requires quantitative disclosures about the fair value measurements for each class of assets and
liabilities. An entity might disclose the following for assets to comply with points 1 and 2 above:

HK$'000 Fair value measurements at the end of the


reporting period using
Description 31.12.X9 Level 1 Level 2 Level 3
inputs inputs inputs
Trading equity securities 45 45 – –
Non-trading equity securities 32 – – 32
Corporate securities 90 9 81 –
Derivatives – interest rate 78 – 78 –
contracts

Total recurring fair value 245 54 159 32


measurements

7.6 Nature and extent of risks arising from financial instruments


In undertaking transactions in financial instruments, an entity may assume or transfer to another
party one or more of different types of financial risk as defined below. The disclosures required
by the standard show the extent to which an entity is exposed to these different types of risk,
relating to both recognised and unrecognised financial instruments.

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.
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.

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Financial Reporting

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.

HKFRS 7.33 7.6.1 Qualitative disclosures


For each type of risk arising from financial instruments, an entity must disclose:
(a) the exposures to risk and how they arise.
(b) its objectives, policies and processes for managing the risk and the methods used to
measure the risk.
(c) any changes in (a) or (b) from the previous period.
HKFRS 7.34- 7.6.2 Quantitative disclosures
38
For each financial instrument risk, summary quantitative data about risk exposure must be
disclosed. This should be based on the information provided internally to key management
personnel. More information should be provided if this is unrepresentative of an entity's exposure to
risk.
Information about credit risk must be disclosed by class of financial instrument:
(a) Maximum exposure at the year end without taking account of collateral held or other credit
enhancements. (This disclosure is not required where the carrying amount of financial
instruments best represents the maximum exposure to credit risk.)
(b) A description of collateral held as security and of other credit enhancements, and their
financial effect, in respect of the maximum exposure to credit risk (whether as disclosed in
(a) or represented by carrying amount).
(c) Information about the credit quality of financial assets that are neither past due nor impaired.
(d) Information about the credit quality of financial assets whose terms have been renegotiated.
(e) An analysis of the age of financial assets that are past due as at the end of the reporting
period but not impaired.
(f) An analysis of financial assets that are individually determined to be impaired as at the end
of the reporting period, including the factors the entity considered in determining that they
are impaired.
(g) Collateral and other credit enhancements obtained during the reporting period and held at
the reporting date, including the nature and carrying amount of the assets and policy for
disposing of assets not readily convertible into cash.
Example: Credit risk disclosure (1)
An entity holds equity investments in other entities. Its management asserts that the HKFRS 7
credit risk disclosures are not relevant.
Do the credit risk disclosures required by HKFRS 7 apply to an entity's holdings of equity
investments?
Solution
The definition of equity in HKAS 32 requires the issuer to have no obligation to pay cash or transfer
other assets. It follows that such equity investments are subject to price risk, not credit risk. Most of
the HKFRS 7 credit risk disclosures are not therefore relevant to investments in equity instruments.
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.

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Example: Credit risk disclosure (2)


HKFRS 7 defines credit risk as "the risk that one party to a financial instrument will cause a
financial loss for the other party by failing to discharge an obligation". If an entity issues a financial
guarantee, the financial loss will not result from a default by the other party of the contract (the
holder), but from a default by the third party (the debtor). Does this mean that the credit risk of
financial guarantees can be excluded from the disclosure of the maximum exposure to credit risk?

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.

HKFRS 7.39 7.6.3 Liquidity risk


For liquidity risk entities must disclose:
 a maturity analysis of both derivative and non-derivative financial liabilities
 a description of the way risk is managed
Within the maturity analysis, any amounts repayable under a loan agreement that includes a clause
giving the lender the unconditional right to demand repayment at any time must be classified in the
earliest time bracket.

Example: Liquidity risk (1)


HKFRS 7 requires the disclosure of a maturity analysis for financial liabilities that shows the
remaining contractual maturities.
Should the following financial instruments be shown in one maturity bracket, or split across the
maturity brackets in which the cash flows occur?
(a) A derivative which has multiple cash flows
(b) A loan which has annual contractual interest payments
(c) A loan which has annual contractual interest and principal repayments

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.

Example: Liquidity risk (2)


HKFRS 7 requires entities to disclose (a) a maturity analysis for financial liabilities that shows the
remaining contractual maturities; and (b) a description of how it manages the liquidity risk inherent
in (a).
Does this mean that a maturity analysis for financial assets based on remaining contractual
maturities, is no longer required?

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.

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Financial Reporting

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.

HKFRS 7.40- 7.6.4 Market risk: sensitivity analysis


41
An entity shall disclose a sensitivity analysis for each type of market risk to which the entity is
exposed at the reporting date, showing how profit or loss and equity would have been affected by
changes in the relevant risk variable that were reasonably possible at that date; the methods and
assumptions used in preparing the sensitivity analysis; and changes from the previous period in the
methods and assumptions used, and the reasons for such changes.
Assuming that a reasonably possible change in the relevant risk variable had occurred at the
reporting date and had been applied to the risk exposures in existence at that date:
Disclosures required in connection with market risk are:
(a) sensitivity analysis, showing the effects on profit or loss of changes in each market risk.
(b) if the sensitivity analysis reflects interdependencies between risk variables, such as interest
rates and exchange rates the method, assumptions and limitations must be disclosed.
7.6.5 Risk variables that are relevant to disclosing market risk
Market risk

Interest
rate risk Yield curve of market interest rates

Currency risk Foreign exchange rates

Other price
risk

Equity price risk Prices of equity instruments

Commodity price risk Market prices of commodities

Prepayment risk

Residual value risk

7.7 Capital disclosures


Certain disclosures about capital are required. An entity's capital does not relate solely to financial
instruments, but has more general relevance. Accordingly, those disclosures are included in
HKAS 1, rather than in HKFRS 7.

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8 Current developments
8.1 IFRS 9 development
The issue of IFRS 9 (HKFRS 9) and its subsequent expansion in 2010 represent the first stages of
the culmination of a long-standing project carried out by the IASB and FASB concerned with
reducing the complexity surrounding financial instruments.
HKICPA are following the lead of the IASB and it is intended that HKFRS 9 will ultimately replace
HKAS 39 in its entirety. The IASB continue to work on the replacement project and in response to
requests from interested parties that the accounting for financial instruments should be improved
quickly, the project to replace IAS 39 (and in turn HKAS 39) has been divided into phases.
As each phase is completed, the relevant portions of IAS 39 will be deleted and chapters in IFRS 9
will be created to replace the requirements in IAS 39. As the IASB issues new sections of IFRS 9,
HKICPA will adopt these to form HKFRS 9.
Phases 1 and 2 of the project relating to the classification and measurement of financial assets and
financial liabilities are now obviously complete.
Phase 3 of the project relates to impairment methodology. The Request for Information on the
feasibility of an expected loss model for the impairment of financial assets was published on
25 June 2009. This formed the basis of an Exposure Draft, Financial Instruments: Amortised Cost
and Impairment, published in November 2009. A supplement to the ED was issued in January
2011 and the topic was re-exposed in March 2013. The latest exposure draft builds upon previous
EDs to develop a more forward-looking provisioning model which recognises credit losses on a
more timely basis. IAS 39 currently applies an incurred loss model, requiring that credit losses
(impairments) are recognised only when a credit loss event has occurred; the ED proposes that
credit losses are recognised before a credit loss event occurs.
Phase 4 of the project relates to hedge accounting. Proposals in respect of general hedge
accounting have been exposed and final amendments to IFRS 9 are expected during the course of
2013. As a result of the proposed new hedge accounting requirements, companies will be able to
reflect their risk management activities better in the financial statements, and there will be
enhanced presentation and disclosure requirements.

8.2 Other proposals


In addition to the on-going development of IFRS 9, limited amendments to the classification and
measurement requirements of IFRS 9 which are already in issue have also been proposed. These
address application questions raised by entities which have adopted the standard early on a
voluntary basis. They also reduce the differences between IFRS and US GAAP in accounting for
financial instruments. The proposed amendments would:
 Improve the contractual cash flow test and
 Introduce a fair value through OCI category for simple debt instruments.

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Financial Reporting

Topic recap

HKAS 32 Presentation of Financial


Instruments

Financial assets Financial liabilities Equity

Ÿ Cash Ÿ Contractual obligation to


Any contract that evidences
Ÿ Equity instrument of another deliver cash/another financial
a residual interest in the
entity asset
assets of an entity after
Ÿ Contractual right to receive Ÿ Contractual obligation to
deducting all of its liabilities
cash/a financial asset exchange financial
Ÿ Contractual right to exchange instruments under
financial instruments under unfavourable conditions
favourable conditions Ÿ Certain contracts settled by
Ÿ Certain contracts settled by delivery of entity's own equity
receipt of entity's own equity instruments
instruments.

Puttable financial instruments may be classified as either liability


or equity depending on the conditions.

Financial instruments with


contingent settlement
provisions are financial
liabilities unless possibility of
settlement is remote.

Financial instruments with settlement options are either financial assets


Text
or financial liabilities

Compound financial instruments are split into a debt and equity


component.

Rights
issues/options/warrants are
equity where the entity offers
them pro rata to all existing
owners.

Financial assets and liabilities are only offset where an entity:


Ÿ has a legally enforceable right of set off and
Ÿ intends to settle on a net basis or realise the asset and liability
simultaneously.

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HKFRS 9 Financial Instruments

Financial assets Financial liabilities


Classified as measured at either: Classified as measured at either:

Amortised cost Fair value Amortised cost FV through profit or


If: loss
Ÿ aim is to hold assets If:
to collect contractual Ÿ held for trading or
cash flows and Ÿ designated as FV
Ÿ cash flows of through profit or
principal and interest loss on initial
arise on specified recognition.
dates.

Equity instruments Derivatives


Derivatives

May be reclassified if an entity changes its business Reclassification is not allowed.


model for managing financial assets.

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.

Interest on amortisation Remeasured annually Interest on amortisation Remeasured annually


recognised in profit or with changes in fair recognised in profit or with changes in fair
loss. value recognised in loss. value recognised in
Tested for impairment profit or loss unless profit or loss. If
when indications exist, asset is equity not held designated as
with any loss for trading (OCI). measured at FV then
recognised in profit or gains or losses due to
loss. credit risk are
recognised in OCI.

Derecognise when: Derecognise when the obligation specified in the


Ÿ contractual rights to cash flows of asset contract is discharged or cancelled or expires.
expire, or Substantial modification of the terms of a financial
Ÿ risks and rewards of ownership transferred liability is an extinguishment.

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.

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Financial Reporting

HKAS 39 Hedging

Conditions for hedge accounting:


1 Hedge is formally documented
2 Hedge is expected to be highly effective (80% – 125%)
3 Forecast transaction is highly probable (cash flow
hedges)
4 Effectiveness of hedge can be measured reliably
assessment of hedge carried out on ongoing basis
and effective during period.

Fair value hedge Cash flow hedge Net investment hedge

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.

HKFRS 7 Disclosure of Financial Instruments

Significance of financial instruments on Nature and extent of risks arising from financial
financial position and performance instruments and their management

Ÿ Statement of financial position disclosures Qualitative and quantitative disclosure for:


Ÿ Statement of comprehensive income Ÿ credit risk
disclosures Ÿ currency risk
Ÿ Hedge accounting Ÿ interest rate risk
Ÿ Fair value of financial instruments at Ÿ liquidity risk
amortised cost Ÿ loans payable
Ÿ market risk
Ÿ other price risk
Ÿ past due (overdue asset)

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Answers to self-test questions

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.

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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
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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Financial Reporting

Exam practice

Sonna Inc. 30 minutes


(a) On 1 January 20X1, Sonna Inc. (SC) issued HK$2,000 million of three-year Hong Kong
Interbank Borrowing Rate (HIBOR) plus 180 basis points variable rate bond at par value.
Interest is payable annually. On the same date, SC entered into an interest rate swap with a
bank by paying 2 per cent fixed interest amount and receiving HIBOR plus 180 basis points
for three-year and exchange at the dates of interest payment dates. SC measures the bond
at amortised cost.
Required:
(i) Explain the difference between the fair value interest rate risk and the cash flow
interest rate risk in the context of a bank loan. (2 marks)
(ii) Explain what a hedged item and hedging instrument are and discuss how hedge
accounting affects the accounting treatment of a hedging instrument in the financial
statements under cash flow hedges. (6 marks)
(iii) Assuming hedge accounting is not adopted, explain the accounting treatment for the
bond and interest rate swap if the market interest rate is increased by 0.5% on 30
September 20X1, the current year end date (no quantification of the effect is required).
(5 marks)
(b) On 1 August 20X1, SC entered into a non-cancellable purchase order to acquire equipment
from Monta Corporation, a Japanese entity, at Yen 300 million. Payment is made upon
delivery of the equipment to Hong Kong on 31 December 20X1. On 30 September 20X1,
SC entered into a forward contract to exchange Yen 300 million at a pre-determined
exchange rate between the Yen and Hong Kong dollar on 31 December 20X1. The
functional currency of SC is the Hong Kong dollar.
Required
Discuss the accounting implications for the purchase contract and forward contract if fair
value hedge accounting is adopted. (4 marks)
(Total = 17 marks)
HKICPA June 2012 (amended)

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chapter 19

Statements of cash flows

Topic list

1 Cash flows and HKAS 7


1.1 Cash flows: advantages
1.2 HKAS 7 Statement of Cash Flows
2 Single company statements of cash flows
2.1 Presentation of a statement of cash flows
2.2 Cash generated from operations
2.3 Specific cash flows
2.4 Disclosure
2.5 Producing a statement of cash flows
3 Consolidated statements of cash flows
3.1 Acquisitions and disposals of subsidiaries
3.2 The non-controlling interest
3.3 Associates and joint ventures
3.4 Foreign currency cash flows

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.

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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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 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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19: Statements of cash flows | Part C Accounting for business transactions

1 Cash flows and HKAS 7


Topic highlights
Statements of cash flows are a useful addition to the financial statements of companies because
it is recognised that accounting profit is not the only indicator of a company's performance.
A statement of cash flows focuses on the sources and uses of cash and is a useful indicator of
company’s liquidity and solvency.

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.

1.1 Cash flows: advantages


The main advantages of using cash flow accounting (including both historical and forecast cash
flows) are as follows.
(a) A company's ability to generate cash affects its survival. Cash flow accounting addresses
this critical issue.
(b) Since "profit" is dependent on accounting conventions and concepts, cash flow is viewed as
more comprehensive.
(c) Cash flow is factual, objective and is not subject to as much manipulation as profits.
(d) Both long-and short-term creditors have more interest in an entity's ability to repay them than
in its profitability. Cash flow accounting is more direct than "profits" in pointing out the
availability of cash.
(e) Cash flow reporting is better than traditional profit reporting in the comparison of the results
of different companies.
(f) The needs of all users are better satisfied by cash flow reporting.
(i) It provides management with information that is useful in decision making ("relevant
costs" to a decision are future cash flows in management accounting). Traditional
profit accounting does not provide exclusive help in decision making.
(ii) A satisfactory basis for stewardship accounting is provided by cash flow accounting for
shareholders and auditors.
(iii) Cash flow accounting better serves the information needs of creditors and employees.
(g) When compared with profit forecasts, cash flow forecasts are more useful and easier to
prepare.
(h) It is easier to audit cash flow accounts than accounts prepared based on the accruals
concept.
(i) The accrual concept can be confusing whereas cash flows are easily understood.
(j) Cash flow accounting can be retrospective and also prospective in providing a forecast for
the future. This information can be of great value to all users of accounting information.

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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 HKAS 7 Statement of Cash Flows


Topic highlights
HKAS 7 provides the format of a statement of cash flows and guidance on the required content.

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.

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19: 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.

2 Single company statements of cash flows


Topic highlights
Cash flows are classified as cash flows from operating, investing and financing activities in a
statement of cash flows. Cash flows from operating activities may be calculated using the direct or
indirect method.

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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.

HKAS 7.13- 2.1.1 Operating activities


15
This section of the statement of cash flows shows whether, and to what extent, companies can
generate cash from their operations. It is this cash from day-to-day trading which must, in the
end pay for all cash outflows relating to other activities, such as paying loan interest, tax and
dividends.
The standard gives the following as examples of cash flows from operating activities.
 Cash receipts from the sale of goods and the rendering of services
 Cash receipts from royalties, fees, commissions and other revenue
 Cash payments to suppliers for goods and services
 Cash payments to and on behalf of employees
 Cash payments/refunds of income taxes unless they can be specifically identified with
financing or investing activities
 Cash receipts and payments from contracts held for dealing or trading purposes
The effects of these transactions are all included in the calculation of profit or loss, however certain
items may be included in the net profit or loss for the period which do not relate to operational cash
flows. For example, the profit or loss on the disposal of property, plant and equipment will be
included in net profit or loss, but the cash flows will be classed as investing. However, cash
payments to manufacture or acquire assets held for rental to others and subsequently held for sale
as described in paragraph 68A of HKAS 16 Property, Plant and Equipment are cash flows from
operating activities. The cash receipts from rents and subsequent sales of such assets are also
cash flows from operating activities.
HKAS 7.16 2.1.2 Investing activities
Cash flows from investing activities show the extent of new investment in assets that will generate
future income and cash flows. Only expenditures that result in a recognised asset in the statement
of financial position are eligible for classification as investing activities.
The standard gives the following examples of cash flows arising from investing activities.
 Cash payments to acquire property, plant and equipment, intangibles and other long-term
assets, including those relating to capitalised development costs and self-constructed
property, plant and equipment
 Cash receipts from sales of property, plant and equipment, intangibles and other long-term
assets
 Cash payments to acquire shares or debentures of other entities
 Cash receipts from sales of shares or debentures of other entities
 Cash advances and loans made to other parties
 Cash receipts from the repayment of advances and loans made to other parties
 Cash payments for or receipts from futures/forward/option/swap contracts except when the
contracts are held for dealing purposes, or the payments/receipts are classified as financing
activities

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19: Statements of cash flows | Part C Accounting for business transactions

HKAS 7.17 2.1.3 Financing activities


Cash flows from financing activities show the share of cash claimed by capital providers during the
period. This serves as an indicator of likely future interest and dividend payments.
The standard gives the following examples of cash flows which might arise under these headings:
 Cash proceeds from issuing shares
 Cash payments to owners to acquire or redeem the entity's shares
 Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short- or
long-term borrowings
 Cash repayments of amounts borrowed
 Cash payments by a lessee for the reduction of the outstanding liability relating to a finance
lease
2.1.4 Example of statement of cash flows
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X9
$'000 $'000
Cash flows from operating activities
Cash receipts from customers 34,630
Cash paid to suppliers and employees (32,400)
Cash generated from operations 2,230
Interest paid (320)
Income taxes paid (820)
Net cash from operating activities 1,090
Cash flows from investing activities
Purchase of property, plant and equipment (840)
Proceeds from sale of equipment 30
Interest received 250
Dividends received 250
Net cash used in investing activities (310)
Cash flows from financing activities
Proceeds from issuance of share capital 330
Proceeds from long-term borrowings 330
Payment of finance lease liabilities (100)
Dividends paid* (1,250)
Net cash used in financing activities (690)
Net increase in cash and cash equivalents 90
Cash and cash equivalents at beginning of period 230
Cash and cash equivalents at end of period 320
* This could also be shown as an operating cash flow
Cash and cash equivalents:
20X9 20X8
$'000 $'000
Cash on hand and balances with banks 50 35
Short-term investments 270 195
Cash and cash equivalents 320 230

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Financial Reporting

HKAS 7.18 2.2 Cash generated from operations


The standard offers a choice of method for the calculation of cash generated from operations:
(a) The direct method involves disclosing major classes of gross cash receipts and gross cash
payments
(b) The indirect method involves adjusting the profit or loss for the effects of:
1 transactions of a non-cash nature
2 any deferrals or accrual of past or future operating cash receipts or payments and
3 items of income or expense associated with investing or financing cash flows
The example shown above in section 2.1.4 uses the direct method.
HKAS 7.19 2.2.1 The direct method
The direct method involves listing cash receipts and cash payments in respect of day-to-day
transactions. A simple example may be as follows:
$
Cash in respect of cash sales X
Cash received from credit customers X
Cash purchases (X)
Cash paid to credit suppliers (X)
Cash expenses paid (including wages) (X)
Cash generated from operations X
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.

HKAS 7.20 2.2.2 The indirect method


This method is undoubtedly easier from the point of view of the preparer of the statement of cash
flows. The profit or loss for the period is adjusted for the following:
 Changes during the period in inventories, operating receivables and payables
 Non-cash items, e.g. depreciation, provisions, profits/losses on the sales of assets
 Other items, the cash flows from which should be classified under investing or financing
activities.
A proforma of such a calculation is as follows:
$
Profit before taxation (statement of profit or loss) X
Depreciation X
Loss (profit) on sale of non-current assets (working capital) X
(Increase)/decrease in inventories (X)/X
(Increase)/decrease in receivables (X)/X
Increase/(decrease) in payables X/(X)
Cash generated from operations X
Interest (paid)/received (X)
Income taxes paid (X) )
Net cash flows from operating activities X

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19: 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.

Illustration: Indirect method


STATEMENT OF CASH FLOWS (INDIRECT METHOD) FOR THE YEAR ENDED 31 DECEMBER
20X9
$'000 $'000
Cash flows from operating activities
Profit before taxation 2,630
Adjustments for:
Depreciation 540
Investment income (450)
Interest expense 390
3,110
Increase in trade and other receivables (600)
Decrease in inventories 1,000
Decrease in trade payables (1,280)
Cash generated from operations 2,230
Interest paid (320)
Income taxes paid (820)
Net cash from operating activities 1,090
Cash flows from investing activities
Purchase of property, plant and equipment (840)
Proceeds from sale of equipment 30
Interest received 250
Dividends received 250

Net cash used in investing activities (310)

Cash flows from financing activities


Proceeds from issue of share capital 330
Proceeds from long-term borrowings 330
Payment of finance lease liabilities (100)
Dividends paid* (1,250)

Net cash used in financing activities (690)


Net increase in cash and cash equivalents 90
Cash and cash equivalents at beginning of period 230
Cash and cash equivalents at end of period 320

* This could also be shown as an operating cash flow

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Financial Reporting

Cash and cash equivalents:


20X9 20X8
$'000 $'000
Cash on hand and balances with banks 50 35
Short-term investments 270 195
Cash and cash equivalents 320 230

2.2.3 Indirect versus direct


Use of the direct method is encouraged, but not required, by HKAS 7, as this method provides
information which may be useful in estimating future cash flows, which is not available under the
indirect method.

2.3 Specific cash flows


HKAS 2.3.1 Interest and dividends
7.31,34
Sources (cash inflows) and uses (outflows) of cash relating to interest and dividends should be
separately disclosed. Each cash flow should be classified consistently from period to period either
as operating, investing or financing.
Dividends paid by the entity can be classified in one of two ways:
(a) As a financing cash flow, showing the cost of obtaining financial resources.
(b) As a component of cash flows from operating activities so that users can assess the
entity's ability to pay dividends out of operating cash flows.
Interest paid or received is calculated by reference to the statement of profit or loss amount for the
year adjusted for any accrual or other statement of financial position amount.
Dividends paid or received are identified in the notes to a set of financial statements.

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.

HKAS 2.3.2 Taxes on income


7.35,36
Cash flows relating to taxes should also be separately disclosed. They should be classified as
items under operating activities unless they can be specifically identified with financing and
investing activities.
It is often difficult to match cash flows arising from taxes with the originating underlying transaction,
therefore tax cash flows are usually classified as arising from operating activities.
Tax paid (or refunded) is calculated by reference to the tax charge (or credit) for the year, adjusted
for any statement of financial position amounts.

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19: Statements of cash flows | Part C Accounting for business transactions

Example: Taxes on income


Allister's estimated tax payable for the year ended 31 March 20X1 is $89,100. The equivalent figure
for the year ended 31 March 20X0 was $97,200. The tax charge reported in the statement of profit
or loss for the year ended 31 March 20X1 was $101,000, which included a $12,000 increase in
deferred tax.
What tax was paid in the year?
Solution
$
Tax liability b/f 97,200
Tax charge ($101,000 – $12,000) 89,000
186,200
Tax liability c/f (89,100)
Tax paid 97,100

2.3.3 Finance lease payments


Rentals under a finance lease include capital and interest elements. These are split out for the
purpose of inclusion in the statement of cash flows and reported as "financing" and "operating"
cash flows respectively.

Example: Lotus Co.


The notes to the financial statements of Lotus Co. show the following in respect of finance leases:
Year ended 31 December 20X9 20X8
$'000 $'000
Amounts payable within one year 12 8
Within 2-5 years 110 66
122 74
Less finance charges allocated (14) (8)
108 66
Additions to non-current assets acquired under finance leases were shown in the non-current asset
note at $56,000.
What is the capital repayment to be shown in the statement of cash flows for Lotus Co. in the year
ended 31 December 20X9?
Solution
Finance leases
$'000
Balance at 31 December 20X8 66
Additions for the year 56
Balance at 31 December 20X9 (108)
Capital repayment (balancing fig) 14

2.3.4 Cash flows associated with non-current assets


Where non-current assets are acquired through purchase, rather than lease, the additions figure in
the non-current asset note (adjusted for any outstanding amount owed) equates to the cash
outflow.

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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

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME


Depreciation charge 55
Loss on disposal of PPE 5.5
Other comprehensive income
Revaluation surplus (land) 20
Assets costing $85m were disposed of in the year.
Required
What cash has Rooibus paid to acquire new non-current assets in the period, and what are the
proceeds of sale of old non-current assets?

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

2.3.5 Borrowings and share capital


When calculating the proceeds of a share or loan issue or loan repaid, the balance outstanding at
the start of the period should be compared with the balance at the end of the period.

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.

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19: 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.

HKAS 2.4.3 Other disclosures


7.48,50
All entities should disclose, together with a commentary by management, any other information
likely to be of importance.
(a) Restrictions on the use of or access to any part of cash equivalents.
(b) The amount of undrawn borrowing facilities which are available.
(c) Cash flows which increased operating capacity compared to cash flows which merely
maintained operating capacity.

2.5 Producing a statement of cash flows


Remember the steps involved in preparation of a statement of cash flows using the indirect
method:
Step 1
Set out the proforma leaving plenty of space.
Step 2
Complete the reconciliation of profit before tax to net cash from operating activities, as far as
possible.
Step 3
Calculate the following where appropriate.
 Tax paid
 Dividends paid
 Interest paid/received
 Purchase and sale of non-current assets
 Issues of shares
 Repayment of loans
Step 4
Work out the profit if not already given using: opening and closing balances, tax charge and
dividends.
Step 5
Slot the figures into the statement and any notes required.

Example: Kowloon Co.


Set out below are the financial statements of Kowloon Co.. You are the financial controller, faced
with the task of implementing HKAS 7 Statement of Cash Flows.

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Financial Reporting

KOWLOON CO.
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR
ENDED 31 DECEMBER 20X9
$'000
Revenue 2,553
Cost of sales (1,814)
Gross profit 739
Other income: interest received 25
Distribution costs (125)
Administrative expenses (264)
Finance costs (75)
Profit before tax 300
Income tax expense (140)
Profit for the year 160
KOWLOON CO.
STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER
20X9 20X8
Assets $'000 $'000
Non-current assets
Property, plant and equipment 380 305
Intangible assets 250 200
Investments – 25
Current assets
Inventories 150 102
Receivables 390 315
Short-term investments 50 –
Cash at bank 2 1
Total assets 1,222 948
Equity and liabilities
Equity
Share capital 360 300
Revaluation surplus 100 91
Retained earnings 260 180
Non-current liabilities
Long-term loan 170 50
Current liabilities
Trade payables 127 119
Bank overdraft 85 98
Taxation 120 110
Total equity and liabilities 1,222 948
The following information is available:
(a) The proceeds of the sale of non-current asset investments amounted to $30,000.
(b) Fixtures and fittings, with an original cost of $85,000 and a net book value of $45,000, were
sold for $32,000 during the year.
(c) The following information relates to property, plant and equipment.
31.12.20X9 31.12.20X8
$'000 $'000
Cost 720 595
Accumulated depreciation (340) (290)
Net book value 380 305
(d) 50,000 $1 ordinary shares were issued during the year at a premium of 20 cents per share.
(e) The short-term investments are highly liquid and are close to maturity.
(f) Dividends of $80,000 were paid during the year.

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19: Statements of cash flows | Part C Accounting for business transactions

Required
Prepare a statement of cash flows for the year to 31 December 20X9 using the format laid out in
HKAS 7.
Solution
KOWLOON CO.
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X9
$'000 $'000
Cash flows from operating activities
Profit before tax 300
Depreciation charge (W1) 90
Loss on sale of property, plant and equipment (45 – 32) 13
Profit on sale of non-current asset investments (30 – 25) (5)
Interest expense (net) (75 – 25) 50
(Increase)/decrease in inventories (102 – 150) (48)
(Increase)/decrease in receivables (315 – 390) (75)
Increase/(decrease) in payables (127 – 119) 8
333
Interest paid (75)
Dividends paid (80)
Tax paid (110 + 140 – 120) (130)
Net cash from operating activities 48
Cash flows from investing activities
Payments to acquire property, plant and equipment (W2) (201)
Payments to acquire intangible non-current assets (250 – 200) (50)
Receipts from sales of property, plant and equipment 32
Receipts from sale of non-current asset investments 30
Interest received 25
Net cash used in investing activities (164)
Cash flows from financing activities
Issue of share capital (360 – 300) 60
Long-term loan (170 – 50) 120
Net cash from financing activities 180
Increase in cash and cash equivalents 64
Cash and cash equivalents at 1.1.X9 (97)
Cash and cash equivalents at 31.12.X9 (33)
ANALYSIS OF CASH AND CASH EQUIVALENTS
31.12.X9 31.12.X8
$'000 $'000
Cash at bank 2 1
Short-term investments 50 -
Overdraft (85) (98)
(33) (97)

459
Financial Reporting

WORKINGS
1 Depreciation charge
$'000
Accumulated depreciation at 31 December 20X8 290
Accumulated depreciation on assets sold (85 – 45) (40)
Accumulated depreciation 31 December 20X9 (340)
Charge for the year (90)
2 Purchase of property, plant and equipment
$'000
Cost at 31 December 20X8 595
Revaluation (100 – 91) 9
Cost on assets sold (85)
Cost 31 December 20X9 (720)
Purchase for the year (balancing fig) (201)

3 Consolidated statements of cash flows


Topic highlights
A consolidated statement of cash flows includes extra line items for cash flows associated with:
 acquisitions and disposals of subsidiaries
 non-controlling interests
 associates and joint ventures
Note that accounting for group financial statements is covered in Section D of this Learning Pack.

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.
What amount will be reported as proceeds on disposal of property, plant and equipment in the
consolidated statement of cash flows?

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19: Statements of cash flows | Part C Accounting for business transactions

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".
The net cash effect is the cash purchase price/cash disposal proceeds net of any cash or cash
equivalents acquired or disposed of:

Subsidiary acquired Subsidiary disposed of


Cash price (X) Cash proceeds X
Subsidiary's cash and cash equivalents Subsidiary's cash and cash equivalents
at acquisition date X at disposal date (X)
Cash to acquire subsidiary (X) Proceeds of sale of subsidiary X

461
Financial Reporting

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.?

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

462
19: Statements of cash flows | Part C Accounting for business transactions

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

(b) Proceeds from disposal of Bryan Co.


$'000
Cash proceeds 6,500
Cash in Bryan Co. at disposal (79)
Proceeds from disposal of Bryan Co. 6,421

HKAS 7.40 3.1.1 Disclosure


An entity shall disclose, in aggregate, in respect of both obtaining and losing control of subsidiaries
or other businesses during the period each of the following:
(a) The total consideration paid or received.
(b) The portion of the consideration consisting of cash and cash equivalents.
(c) The amount of cash and cash equivalents in the subsidiaries or other businesses over which
control is obtained or lost.
(d) The amount of the assets and liabilities other than cash or cash equivalents in the
subsidiaries or other businesses over which control is obtained or lost, summarised by each
major category.
Disclosures (c) and (d) are not required in respect of subsidiaries controlled by investment entities
and measured at fair value through profit or loss.

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.

3.2 The non-controlling interest


The group statement of cash flows should only deal with flows of cash and cash equivalents which
are external to the group, so all intra-group cash flows should be eliminated.
Dividends paid to non-controlling interests should be included under the heading "Cash from
financing activities" and disclosed separately.

463
Financial Reporting

Example: Non-controlling interest


The following are extracts of the consolidated results for Marcus Company for the year ended
31 December 20X9.
CONSOLIDATED STATEMENT OF PROFIT OR LOSS (EXTRACT)
$'000
Group profit before tax 200
Income tax expense (32)
Profit for the year 168
Profit attributable to:
Owners of the parent 126
Non-controlling interests 42
168
CONSOLIDATED STATEMENT OF FINANCIAL POSITION (EXTRACT)
20X9 20X8
$'000 $'000
Non-controlling interests 362 345
Calculate the dividends paid to the non-controlling interest during the year.

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

Balance as at 31 December 20X9 (362)


Dividend paid (balancing fig) 25

3.3 Associates and joint ventures


The following cash flows should be included in a consolidated statement of cash flows in respect of
an associate or joint venture:
 Cash inflows from sales to the associate or joint venture
 Cash outflows from purchases from the associate or joint venture
 Dividends from the associate or joint venture
 Investments in an associate or joint venture
As transactions and balances between group companies and associates/joint ventures are not
cancelled for the purpose of producing consolidated financial statements, the normal approach to
adjusting consolidated operating profit for movements in working capital will ensure that cash
inflows from sales to associates/joint ventures and cash outflows on purchases from
associates/joint ventures are included within consolidated cash flow from operating activities.
Within the reconciliation of profit to cash flows from operating activities, however, the share of profit
from a joint venture or associate must be eliminated. This is treated as a non-cash item of income
and deducted from consolidated profit in calculating consolidated cash flows from operating
activities.
Instead, the dividend actually received from the associate/joint venture is included in the operating
cash flows section of the statement of cash flows. This is calculated by reconciling the opening
investment in associate/joint venture balance to the closing balance.

464
19: Statements of cash flows | Part C Accounting for business transactions

Where a group invests in or divests of an associate or joint venture in the year, the associated cash
flow is disclosed within the investing activities section of the statement of cash flows.

Example: Associate
The following are extracts of the consolidated results of Connie Company for the year ended
31 December 20X9.
CONSOLIDATED STATEMENT OF PROFIT OR LOSS (EXTRACT)
$'000
Group profit before tax 224
Share of associate's profit after tax 36
260
Tax (group) 42
Profit after tax 218

CONSOLIDATED STATEMENT OF FINANCIAL POSITION (EXTRACTS)


20X9 20X8
$'000 $'000
Investment in associate 312 306

Calculate the dividend received from the associate.

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

Balance as at 31 December 20X9 (312)


Dividend received from associate (balancing fig) 30

3.4 Foreign currency cash flows


Foreign exchange issues are relevant to the consolidated statement of cash flows in two situations:
(i) Where an entity has transacted during the period in a currency other than its own
functional/reporting currency
(ii) Where a subsidiary has a different functional currency from that of the rest of the group.
3.4.1 Transactions in foreign currency – settled
In accordance with HKAS 21, where transactions denominated in a foreign currency have taken
place during a period, and been subsequently settled, any foreign exchange gain or loss is
recognised in profit or loss.
For the purposes of preparing the statement of consolidated cash flows, no adjustment is required
in respect of these exchange gains or losses, as they represent amounts realised in cash flows.
The following example will help you to understand this.

465
Financial Reporting

Example: Settled transactions


Flora Co. sold goods denominated in pounds sterling in the year ended 31 October 20X1. At the
date of the transaction, a trade receivable and revenue of $40,000 were recorded after applying the
spot exchange rate on the date of the transaction. Before the period end, the customer paid the
amount due, which on the date of payment could be exchanged by Flora for $37,000. Accordingly,
Flora recognised an exchange loss of $3,000.
HKAS 7 requires that the applicable exchange rate in the case of foreign currency cash flows is
that applied on the date of the cash flow. Therefore, $37,000 must be reported as a cash inflow
within cash flows from operating activities in Flora's statement of cash flows.
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

3.4.2 Transactions in foreign currency – unsettled


Where a foreign currency transaction has taken place during the period, however is not settled at
the period end, any monetary items are re-translated in accordance with HKAS 21 giving rise to an
exchange difference recognised in profit or loss. In addition a "foreign currency" balance is included
in the year-end statement of financial position.
On preparation of the statement of cash flows, therefore:
(i) the exchange gain or loss forms an adjustment within the reconciliation of profit to cash flows
from operating activities;
(ii) the exchange gain or loss is taken into account when calculating the movement in the
relevant monetary balance.
The following example will help you to understand why this is the case.

Example: Unsettled transactions


Webb Co. purchased goods denominated in Zloty during the year ended 31 December 20X2 for
ZTY 150,000. This was Webb’s first transaction with a new supplier. At the date of the purchase
the ZTY:$ exchange rate was 1.25:1 and accordingly a purchase and payable were recorded at
$120,000. At the period end, Webb had not paid the amount due to the supplier and the trade
payable balance was retranslated using the closing rate to $100,000, resulting in an exchange gain
of $20,000.
In respect of this transaction, a $100,000 expense is therefore reported in profit ($120,000
purchases net of $20,000 exchange gain).
In preparing the statement of cash flows, HKAS 7 requires that the gain on retranslation is
deducted from profits (which include the $100,000 net expense) as a non-cash item, so meaning
that the transaction in Zloty has a net effect on cash of:
$'000
Expense within profit figure (100)
Deduct non-cash gain (20)
(120)
It is clear from the scenario that no cash flow has occurred in respect of this transaction and the
adjustment for movement in payables must therefore serve to eliminate the $120,000. In order to
make the increase in trade payables equal to the $120,000 and so eliminate it in full, the exchange
gain must once again be taken into account:

466
19: Statements of cash flows | Part C Accounting for business transactions

$'000
ZTY payables b/f –
ZTY payables c/f 100
Increase 100
Remove effect of exchange gain 20
Increase in trade payables (add back to profit in reconciliation) 120
Therefore, the net effect on cash flows from operating activities is nil ($100,000 expense – $20,000
gain + $120,000 increase in payables).

3.4.3 Foreign subsidiary


The cash flows of a foreign subsidiary must be translated into the functional currency of the group
for inclusion in the consolidated statement of cash flows.
The applicable exchange rate is the spot rate on the dates of the cash flows, however the average
rate for a period may be used if this approximates to the actual rate. HKAS 21 does not allow the
use of the closing rate.

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

467
Financial Reporting

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)

468
19: Statements of cash flows | Part C Accounting for business transactions

Topic recap

HKAS 7 Statement of Cash Flows

A statement of cash flows is a useful indicator of a


company's liquidity and solvency.

Presentation Consolidated statement of cash flows

Cash flows from operating activities Direct method: Acquisition/Disposal of subsidiary


may include: include gross Ÿ Cash paid on acquisition/received on
Ÿ cash receipts from sales operating cash flows disposal is stated net of cash in the
Ÿ cash payments for operating subsidiary on disposal date
expenses Ÿ Acquisition/disposal is taken into account
Ÿ cash flows associated with income Indirect method: when calculating movements in working
tax adjust profit for non- capital and cash flows.
Ÿ interest paid cash items, accrued
Ÿ dividends paid /deferred amounts
and non-operating
cash flows.

Non-controlling interest
Cash flows from investing activities
Include dividends paid to the non-controlling
may include:
interest as a cash flow from financing
Ÿ receipts from the sale of non-
activities.
current assets and investments
Ÿ payments to acquire non-current
assets and investments
Associates/joint ventures
Ÿ interest received
Ÿ Eliminate share of profit or loss in
Ÿ dividends received
calculation of cash generated from
operations
Ÿ Include dividend received from
associate/JV as cash flow from operating
activities

Cash flows from financing activities Foreign currency cash flows


may include: Ÿ Do not adjust for exchange
Ÿ proceeds of share / debt issue differences on settled amounts
Ÿ payments on redemption of shares Ÿ Adjust for exchange differences on
Ÿ repayments of debt unsettled amounts
Ÿ dividends paid Ÿ Translate cash flows of a foreign
subsidiary at spot rate on the date of the
cash flows (or average rate) for inclusion
in consolidated statement of cash flows
Change in cash and cash
equivalents (including deposits
available on demand, money market
holdings, government bonds, treasury
bills, overdrafts repayable on demand)

Disclose: Ÿ Non-cash transactions Ÿ Components of cash & cash


equivalents

469
Financial Reporting

Answer to self-test question

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

470
19: Statements of cash flows | Part C Accounting for business transactions

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

471
Financial Reporting

Exam practice

Chong Co. 36 minutes


Chong Co. provides bookkeeping services for over 1,000 clients. The company now plans to
expand into banking and finance services but feels to do so it may have to expand the office. This
has prompted worries about the company's current cash flow position, especially the cash flow
from its present operations, and whether the cash flow is sufficient to support such a relocation and
expansion.
The directors of Chong Co. require cash flow information quickly and have asked you to provide a
calculation of the company’s net cash flow from operating activities for the year ended 31 October
20X7. Unfortunately, the urgency of the request has meant that the company's statement of profit
or loss and other comprehensive income is not yet available. However, they have provided you
with the following information:
SUMMARISED DRAFT STATEMENTS OF FINANCIAL POSITION AS AT 31 OCTOBER
20X7 20X6
$'000 $'000
Assets
Non-current assets
Property, plant and equipment at cost 1,240 1,016
Less depreciation 276 232
964 784
Current assets
Receivables 380 319
Cash at bank 64 1
444 320
Total assets 1,408 1,104

Equity and liabilities


Capital and reserves
Equity share capital 740 460
Retained profits 224 86
964 546
Non-current liabilities
Long-term bond 120 280
Deferred taxation 72 44
192 324
Current liabilities
Trade payables 212 146
Bank overdraft - 56
Taxation payable 40 32
252 234

1,408 1,104

472
19: Statements of cash flows | Part C Accounting for business transactions

Additional cash flow information:


(i) Property, plant and equipment costing $52,000, and in respect of which $32,000
depreciation had been provided, was disposed of during the year. The items were sold for
$16,000. Operating profit includes any profits or losses on disposal.
(ii) The company paid a dividend of $40,000 during the year.
(iii) A finance charge of $15,000 has been recognised as an expense for the year. The actual
cash payment was $12,000.
(iv) The tax charge of $88,000 includes deferred tax of $28,000.
(v) Part of the bond was repaid during the year. This incurred a redemption penalty of $8,000
which has been written off against income.
Required
(a) Prepare a statement of cash flows in accordance with HKAS 7 to calculate the company's
net cash flow from operating activities. (Note: a full statement of cash flows showing "cash
flow from investing activities" and "cash flow from financing activities" is NOT required in
answer to this part of the question.) (12 marks)
(b) Comment on whether the "net cash flow from operating activities" calculated in (a) above is
sufficient to support the proposed expansion of the office. (8 marks)
(Total = 20 marks)

473
Financial Reporting

474
chapter 20

Related party disclosures

Topic list

1 HKAS 24 Related Party Disclosures


1.1 Objective
1.2 Scope
1.3 Definitions
1.4 Disclosure
1.5 The importance of disclosure
1.6 Section summary

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.

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Learning outcomes

In this chapter you will cover the following 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

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1 HKAS 24 Related Party Disclosures


Topic highlights
HKAS 24 is a disclosure standard. It does not prescribe any debits or credits. Its aim is to help
users understand whether the financial statements may have been affected by transactions which
were not on normal commercial terms. These sorts of transactions can arise when an entity has
transactions with entities or individuals who influence or are influenced by the entity. These entities
and individuals are called related parties. Disclosures of these transactions increase the
accountability of management to users of the financial statements.

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.

HKAS 24.1 1.1 Objective


HKAS 24 aims to ensure that financial statements contain the disclosures necessary to draw
attention to the possibility that the reported financial position and results may have been affected
by the existence of related parties and by material transactions with them. In other words, this is a
standard which is primarily concerned with disclosure.

HKAS 24.3 1.2 Scope


According to the standard, related party transactions and outstanding balances are to be presented
in separate financial statements of a parent, venturer or investor as well as in consolidated financial
statements. Disclosures should be in accordance with HKAS 27 and HKFRS 10.
This is an amendment to the previous version of HKAS 24 which did not require disclosure in the
separate financial statements of a parent or wholly-owned subsidiary that are made available or
published with the group's financial statements.
Related party transactions and outstanding balances with other entities in the group are to be
disclosed in an entity's financial statements. However, no intragroup transactions and balances
except for those between an investment entity and its subsidiaries are to be shown as they are
eliminated in the preparation of consolidated financial statements.
An investment entity is a particular type of parent company defined in Chapter 26.

HKAS 24.9 1.3 Definitions


The following important definitions are given by the standard. The definitions of control and
significant influence are the same as those given in HKAS 27, 28 and 31.

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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)
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)

HKAS 1.3.1 Related party relationships


24.10,12
When considering each possible related party relationship, attention must be paid to the
substance of the relationship, not merely the legal form.
The standard also clarifies that in the definition of a related party:
 an associate includes subsidiaries of the associate
 a joint venture includes subsidiaries of the joint venture

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For example, an associate's subsidiary and the investor that has significant influence over the
associate are related to each other.

Example: Parent and subsidiaries


Parent entity has a controlling interest in Subsidiaries A, B and C, and has significant influence
over Associates 1 and 2. Subsidiary C has significant influence over Associate 3.
Are they related parties of each other?

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.

HKAS 24.11 1.3.2 Relationships which are not related parties


HKAS 24 lists the following which are not necessarily related parties.
(a) Two entities simply because they have a director or other key management personnel in
common or because a member of key management personnel of one entity has significant
influence over the other entity.
(b) Two venturers, simply because they share joint control over a joint venture.
(c) Certain other bodies, simply as a result of their role in normal business dealings with the
entity:
(i) providers of finance
(ii) trade unions
(iii) public utilities
(iv) government departments and agencies of a government that does not control, jointly
control or significantly influence the reporting entity
simply by virtue of their normal dealings with an entity (even though they may affect the
freedom of action of an entity or participate in its decision-making process).
(d) Any single customer, supplier, franchisor, distributor, or general agent with whom the entity
transacts a significant amount of business, simply by virtue of the resulting economic
dependence.
HKAS 24.21 1.3.3 Related party transactions
HKAS 24 provides examples of transactions which may take place between related parties. They
include:
 purchases or sales of goods (finished or unfinished)
 purchases or sales of property and other assets

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 rendering or receiving of services


 leases
 transfer of research and development
 transfers under licence agreements
 provision of finance
 provisions of guarantees and collateral security
 settlement of liabilities on behalf of the entity or by the entity on behalf of another party.

HKAS 1.4 Disclosure


24.13,17-
19,23,24 A notable feature of HKAS 24 is that it is almost wholly concerned with disclosures. Its provisions
supplement those disclosure requirements required by national company legislation and other
HKAS (especially HKAS 1 and HKFRS 12).
Relationships between parents and subsidiaries must be disclosed irrespective of whether any
transactions have taken place between the related parties. An entity must disclose the name of
its parent and, if different, the ultimate controlling party. This will enable a reader of the financial
statements to be able to form a view about the effects of a related party relationship on the
reporting entity.
If neither the parent nor the ultimate controlling party produces financial statements available for
public use, the name of the next most senior parent that does so shall also be disclosed.
An entity should disclose key management personnel compensation in total for each of the
following categories:
 Short-term employee benefits
 Post-employment benefits
 Other long-term benefits
 Termination benefits
 Share-based payment
Where related party transactions have occurred during the period, the nature of the related party
relationship should be disclosed together with (as a minimum):
(a) The amount of the transactions
(b) The amount of outstanding balances, including commitments, and
(i) their terms and conditions including whether they are secured and the nature of the
consideration to be provided in settlement; and
(ii) details of any guarantees given or received
(c) Provisions for doubtful debts related to the amount of outstanding balances, and
(d) The expense recognised during the period in respect of bad and doubtful debts due from
related parties.
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 venturer
 Key management personnel of the entity or its parent, and
 Other related parties
Substantiation is a must if an entity decides to put up disclosures that related party transactions
were made on terms equivalent to those that prevail in arm's length transactions.

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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.
HKAS 1.4.1 Government related entities
24.25,26
The disclosures listed above need not be made in respect of transactions with:
(a) a government that has control, joint control or significant influence over the reporting entity,
and
(b) another entity that is a related party because the same government has control, joint control
or significant influence over both the reporting entity and the other entity.
Instead, the reporting entity should disclose:
(a) the name of the government and the nature of its relationship with the reporting entity
(b) information in sufficient detail to enable users of the financial statements to understand the
effect of related party transactions on those financial statements, including:
(i) the nature and amount of each individually significant transaction, and
(ii) for other transactions that are collectively significant, a qualitative or quantitative
indication of their extent.

1.5 The importance of disclosure


As we have already said, in the absence of information to the contrary, users of the financial
statements are likely to assume that an entity has entered into all of its transactions on an arm's
length basis, and acted in its own interests throughout an accounting period. Therefore they would
assume that the entity's results and position are a true reflection of the performance of the entity
and the stewardship of the management.
Where related party transactions have occurred this is not always the case. For example, the
following may affect the financial statements:
 The provision of a longer credit period to related parties
 A lower selling price to related parties
 Transactions which would not occur without the related party relationship
 Transactions with third parties which are affected by a related party relationship
Such transactions may have an adverse effect on the financial statements. Take, for example, the
situation where a director of Company A is the majority shareholder in Company B, and uses the
position of influence in Company A to ensure that Company A buys goods from Company B at
inflated prices. The profits of Company A are therefore lower than they might otherwise be and the
profits of Company B are higher. The shareholders of Company A are entitled to know about this
related party transaction so that they may assess its effect on the profits of Company A, and the
stewardship of the director.
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.

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Financial Reporting

1.6 Section summary


HKAS 24 is primarily concerned with disclosure. You should learn the following:
 Definitions: these are very important
 Relationships covered
 Relationships that may not necessarily be between related parties
 Disclosures: again, very important, representing the whole purpose of the standard

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)

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Topic recap

HKAS 24 Related Party Disclosures

Objective: to ensure that financial statements contain the disclosures


necessary to draw attention to the possibility that financial position and
performance may have been affected by material transactions with related
parties.

Related party Related party transaction

A person (or close family member of that A transfer of resources, services or


person) is related to an entity if they obligations between a reporting entity
Ÿ control/jointly control the entity and a related party regardless of
Ÿ are key management personnel whether a price is charged

An entity is related to another entity if:


Ÿ they are members of the same group
Ÿ one is an associate or joint venture of the
Include:
Ÿ purchases/sales of goods/services
other
Ÿ purchases/sales of assets
Ÿ both are joint ventures of another party
Ÿ leases
Ÿ one is a joint venture and the other an
Ÿ transfers of research and
associate of another party
Ÿ one is a post-employment benefits plan of the
development
Ÿ transfers under licence
other or of an entity related to the other
Ÿ provision of finance
Ÿ the entity is controlled/jointly controlled by a
Ÿ provision of guarantees
person listed above
Ÿ settlements of liabilities
Ÿ a person listed above is key management
personnel or has significant influence of the
other entity

Not included:
Ÿ Two entities with key management personnel
in common
Ÿ Two venturers which share control over a joint
venture
Ÿ Bodies engaged in normal business dealings
such as providers of finance

Disclose:
Ÿ relationships between parents and subsidiaries (regardless of whether they have transacted)
Ÿ name of parent/ultimate controlling party
Ÿ key management personnel compensation (categorised)
Ÿ 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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Answer to self-test question

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.

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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:

Shareholders Member of board of Director(s)

Company A Mr. Kwok (75%) Mr. Kwok


Growth Investment Limited (GIL) Mrs. Kwok (wife of Mr. Kwok)
(25%) Mr. Ma on behalf of GIL
Company B Mrs. Kwok (50%) Mrs. Kwok
Ms. Chan (50%) Ms. Chan
Company C GIL (100%) Mr. Wang
Company D Mr. Ma (100%) Mr. Ma
Company E Mr. Scott (50%) Mr. Scott
Mr. Smith (50%) Mr. Smith
Mrs. Kwok

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

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486
chapter 21

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

HKAS 8 is relevant to all organisations preparing financial statements in accordance with


HKFRS; it is important that you know how accounting policies should be selected, and when
they, and accounting estimates can be changed.
HKAS 10 is also very relevant in practice as all entities have a period between the reporting
date and authorising of the accounts during which time significant events may occur.

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Learning outcomes

In this chapter you will cover the following 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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1 HKAS 8 Accounting Policies, Changes in


Accounting Estimates and Errors
Topic highlights
HKAS 8 deals with the treatment of changes in accounting estimates, changes in accounting
policies and errors.

HKAS 8.1 1.1 Objective


The objective of HKAS 8 is to prescribe:
 The criteria for selecting and changing accounting policies
 The accounting treatment and disclosure of:
– changes in accounting policies,
– changes in accounting estimates, and
– corrections of errors.
The standard is intended to enhance the relevance and reliability of an entity's financial statements,
and the comparability of those financial statements over time and with the financial statements of
other entities.
The standard was extensively revised in October 2008. The new title reflects the fact that the
material on determining profit or loss for the period has been transferred to HKAS 1.

HKAS 8.5 1.2 Definitions


The following definitions are given in the standard.

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.

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Financial Reporting

Key terms (cont'd)


Retrospective application is applying a new accounting policy to transactions, other events and
conditions as if that policy had always been applied.
Retrospective restatement is correcting the recognition, measurement and disclosure of amounts
of elements of financial statements as if a prior period error had never occurred.
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
 recognising the effect of the change in the accounting estimate in the current and future
periods affected by the change
Impracticable. Applying a requirement is impracticable when the entity cannot apply it after
making every reasonable effort to do so. It is impracticable to apply a change in an accounting
policy retrospectively or to make a retrospective restatement to correct an error if one of the
following applies.
 The effects of the retrospective application or retrospective restatement are not
determinable.
 The retrospective application or retrospective restatement requires assumptions about what
management's intent would have been in that period.
 The retrospective application or retrospective restatement requires significant estimates of
amounts and it is impossible to distinguish objectively information about those estimates
that:
(i) provides evidence of circumstances that existed on the date(s) at which those
amounts are to be recognised, measured or disclosed; and
(ii) would have been available when the financial statements for that prior period
were authorised for issue, from other information. (HKAS 8.5)

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,

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including Accounting Guidelines and Accounting Bulletins, and accepted industry practices if these
do not conflict with the sources above.
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.

HKAS 2.2 Changes in accounting policy


8.14,16,17
The same accounting policies are usually adopted from period to period, to allow users to analyse
trends over time in profit, cash flows and financial position. Changes in accounting policy will
therefore be rare and should be made only if the change:
(a) is required by an HKFRS, or
(b) results in the financial statements providing reliable and more relevant information about the
effects of transactions, other events or conditions on the entity's financial position, financial
performance or cash flows.
The standard highlights two types of event which do not constitute changes in accounting policy.
(a) Adopting an accounting policy for a new type of transaction or event not dealt with
previously by the entity.
(b) Adopting a new accounting policy for a transaction or event which has not occurred in the
past or which was not material.
In the case of tangible non-current assets, if a policy of revaluation is adopted for the first time then
this is treated, not as a change of accounting policy under HKAS 8, but as a revaluation under
HKAS 16 Property, Plant and Equipment (see Chapter 5). The following paragraphs do not
therefore apply to a change in policy to adopt revaluations.
HKAS 2.2.1 Accounting for a change in accounting policy
8.19,22-25
Where a change in accounting policy is the result of the initial application of an HKFRS, that
change should be accounted for in accordance with the specific transitional provisions, if any, in
that HKFRS. For example, HKFRS 13 Fair Value Measurement, issued in June 2011 should be
applied prospectively from the first date on which it is applied.
Otherwise, a change in accounting policy should be applied retrospectively.
Retrospective application means that the new accounting policy is applied to transactions and
events as if it had always been in use. In other words, the policy is applied from the earliest date
such transactions or events occurred.
Where it is impracticable (see Key terms) to apply a change in accounting policy retrospectively
because the cumulative amount of change cannot be determined, it should be applied
prospectively.

HKAS 2.3 Disclosing changes in accounting policy


8.29,30
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.

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Financial Reporting

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
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.
Example: Retrospective application
A training company capitalises all equipment based on cost but has not depreciated it over its
useful life due to the amounts involved being immaterial. In advance of extensive capital
expenditure, the company now wishes to change its accounting policy and apply in full the
provisions of HKAS 16 Property, Plant and Equipment.
Details of the equipment are as follows:
Fair value Useful life/
Acquisition as at remaining useful
date Cost 1 January 20X6 life (years)
$ $
Equipment A 1 January 20X5 6,000 unknown 10
Equipment B Unknown 10,000 8,000 10
The value-in-use is the same as fair value at 1 January 20X6. The financial period of the company
ends on 31 December. Opening retained earnings are $700,000 on 1 January 20X5 and the
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)

Carrying amount 10,000 8,000 7,200

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Alternative
1 December 31 December 1 January
20X5 Depreciation 20X5 Revaluation 20X6
$ $ $
Equipment B
Cost 10,000 10,000 ÷ 10 10,000 8,000
Accumulated depreciation – (1,000) (1,000) (2,000) –
1,000
Carrying amount 10,000 9,000 Impairment loss 8,000
As the company did not depreciate the equipment the carrying amount of the equipment would
have been the original cost of $6,000 and $10,000 as at 31 December 20X6. As there has been a
change in accounting policy in 20X6, the financial statements must be adjusted to present non-
current assets as though HKAS 16 has always been applied. The table above depicts the changes
in carrying amount if HKAS 16 had been applied on the initial recognition of the equipment.
Under these circumstances, the company must apply HKAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors to adopt HKAS 16 and present one year's comparative
information. The financial statement extracts will be as follows:
STATEMENT OF FINANCIAL POSITION RESTATED – EXTRACTS
1 January 31 December 31 December
20X5 Comparative 20X5 20X6
$ $ $
Equipment A 6,000 ÷ 10
Cost 6,000 6,000 6,000
Accumulated depreciation – (600) (600) (600) (1,200)
6,000 5,400 4,800

1 January 31 December 31 December


20X5 Comparative 20X5 20X6
$ $ $
Equipment B 8,000 ÷ 10
Cost 10,000 (2,000) 8,000 8,000
Accumulated depreciation – – (800) (800)
10,000 8,000 7,200
Retained earnings 700,000 +27,400 727,400 +18,600 746,000

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME RESTATED –


EXTRACTS
31 December 31 December
Year ended 20X5 20X6
$ $
Profit before depreciation 30,000 20,000
Depreciation Equipment A (600) (600)
Equipment B 0 (800)
Impairment Equipment B – –
27,400 18,600
Alternative presentation
Profit before depreciation 30,000 20,000
Depreciation Equipment A (600) (600)
Equipment B (1,000) (800)
Impairment Equipment B (1,000) –
27,400 18,600

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Financial Reporting

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.

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

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.

HKAS 3.2 Disclosure of a change in accounting estimate


8.39,40
Where there is a change in accounting estimate, an entity must disclose the nature and amount of
the change that has an effect in the current period or is expected to have an effect in future
periods, unless it is impracticable to estimate that effect.
If the amount of the effect in future periods is not disclosed because estimating it is impracticable,
that fact must be disclosed.

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Illustration: Prospective application


All equipment is capitalised based on cost and depreciated over its useful life. As at 1 January
20X6, the equipment's productivity is lower than expected and machines frequently break down.
A re-assessment of the remaining useful life has been done. Details of the equipment are as
follows:
Original useful life Remaining useful
Acquisition from life from 1 Jan
date Cost 1 January 20X5 20X6
Equipment 1 January 20X5 $10,000 10 years 5 years

1 January 1 January 31 December


20X5 20X6 20X6
$ $ $
Equipment 10,000 ÷ 10 10,000 9,000 ÷ 5 9,000
Cost 10,000 (1,000) (1,800) (1,800)
Acc depreciation – (1,000) 9,000 7,200
10,000
When the useful life changes, the depreciation charge will also change resulting in $1,800 being
charged in the 20X6 financial statements. No adjustment to the comparative figures is required.

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.

HKAS 8.42- 4.1 Accounting treatment to correct an error


45
Prior period errors must be corrected retrospectively. This involves:
(a) either restating the comparative amounts for the prior period(s) in which the error occurred
(b) or, when the error occurred before the earliest prior period presented, restating the opening
balances of assets, liabilities and equity for that period
so that the financial statements are presented as if the error had never occurred.
Only where it is impracticable to determine the cumulative effect of an error on prior periods can
an entity correct an error prospectively.

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Financial Reporting

HKAS 8.49 4.2 Disclosure of an error


The following must be disclosed in relation to an error:
(a) Nature of the prior period error.
(b) For each prior period, to the extent practicable, the amount of the correction.
(i) For each financial statement line item affected
(ii) If HKAS 33 applies, for basic and diluted earnings per share
(c) The amount of the correction at the beginning of the earliest prior period presented.
(d) If retrospective restatement is impracticable for a particular prior period, the
circumstances that led to the existence of that condition and a description of how and from
when the error has been corrected.
Subsequent periods need not repeat these disclosures.

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
Show the statement of profit or loss and other comprehensive income for 20X7, with the 20X6
comparative, and retained earnings.
(The answer is at the end of the chapter)

5 HKAS 10 Events after the Reporting Period


Topic highlights
HKAS 10 identifies events arising between the reporting date and date on which the financial
statements are authorised for issue as either adjusting or non-adjusting. HKAS 10 should be
familiar from your earlier studies, but it still could come up in part of a question.

HKAS 10.1 5.1 Objective


HKAS 10 prescribes:
 when an entity should adjust its financial statements for events after the reporting period; and
 the disclosures that an entity should give about the date when the financial statements were
authorised for issue and about events after the reporting period.

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21: Accounting policies, changes in accounting estimates and errors; events after the reporting period
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HKAS 10.3 5.2 Definitions

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).

HKAS 10.4-7 5.3 Events after the reporting period


The definition above defines an event after the reporting period as an event that occurs between
the reporting date and the date that the financial statements are authorised for issue:

End of reporting period Date of authorisation


↓ ↓
Accounting period Events after the reporting period

The authorisation process varies from entity to entity:


(a) Where an entity must submit its financial statements to shareholders for approval after the
financial statements have been issued, the date of authorisation is the same as the date of issue;
(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.

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Financial Reporting

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.

5.4 Accounting treatment


The accounting treatment of an event after the reporting period depends on how it is classified.
HKAS 5.4.1 Adjusting events
10.8,14,19
As the name suggests, the financial statements are adjusted to reflect an adjusting event. For
example, the bankruptcy of a customer after the reporting period should be written off in the year-
end financial statements as irrecoverable.
Disclosures within the financial statements should also be updated in the light of the adjusting
event.
Where an event after the reporting date results in going concern issues, for example, management
decides that it intends to liquidate the business or cease trading or that it has no other choice but to
either cease trading or liquidate the business or there is a deterioration in operating results or
financial position, the financial statements should be presented to reflect this decision. Therefore,
the going concern assumption is no longer appropriate and the financial statements should be
prepared on the break-up basis. Break-up basis accounts are discussed in more detail in section
13.2, Chapter 2.
HKAS 5.4.2 Non-adjusting events
10.10,21
Non-adjusting events do not result in adjustment to the financial statements, however where non-
adjusting events are material, they should be disclosed.
The following should be disclosed for each material category of non-adjusting event after the
reporting period:
(a) The nature of the event, and
(b) An estimate of its financial effect, or a statement that such an estimate cannot be made.

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21: Accounting policies, changes in accounting estimates and errors; events after the reporting period
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HKAS 10.17 5.5 Further disclosure


In addition to the disclosures in respect of both adjusting and non-adjusting events, an entity must
disclose the date when the financial statements were authorised for issue and who gave that
authorisation.
If the entity's owners or others have the power to amend the financial statements after issue, the
entity must also disclose that fact.

Example: Adjusting or non-adjusting events


A company has a financial year end of 31 December 20X0 and the financial statements are
authorised for issue on 31 March 20X1. The following events have arisen during the three months
after the end of the reporting period:
1 The inventory of motor vehicles has deteriorated in value due to legislation passed on
31 January 20X1 which increases road tax and the new policy to introduce a one car per
family limit.
2 An ordinary dividend of $0.1 million is declared after the reporting date.
3 The credit department discovered that a major customer owing $2 million has gone into
liquidation.
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.

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Financial Reporting

5.6 Summary decision tree


A decision tree for application of HKAS 10 is a useful summary of the key learning points:
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

Does the event provide additional No Is the event material, disclosure of


evidence about a condition that which could influence the economic
existed at the reporting date, or does it decisions made by users?
relate to going concern matters?

Yes Yes No

The event should be adjusted for in Disclose the No adjustment or


the financial statements and nature and disclosure is
disclosures updated if necessary financial effect of necessary in the
the non- financial
adjusting event statements
in a note to the
financial
statements

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21: Accounting policies, changes in accounting estimates and errors; events after the reporting period
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Topic recap

HKAS 8 Accounting Policies, Changes in Accounting


Estimates and Errors

Accounting policies Accounting estimates Errors

Specific principles, bases, Arise because of uncertainties Omissions from and


conventions, rules and and require judgment to be misstatements in prior
practices adopted by an applied e.g. useful lives of period financial statements
entity in preparing and depreciable assets, warranty arising from a failure to use
presenting financial obligations, allowance for reliable information
statements. receivables. available for use or
obtainable when the
financial statements were
prepared.
Accounting policies are A change in accounting
selected by applying relevant estimates is applied
HKFRS. prospectively so that it affects
only current/future accounting
If no HKFRS is available, periods.
management should apply
judgment and the policy
should result in relevant and
reliable information.

Unless impracticable,
correct retrospectively.
A change in accounting
policy only arises where:
Ÿ required by an HKFRS
Ÿ it results in more reliable Disclose: Disclose:
and relevant reporting The nature and amount of the Ÿ Nature of the error
change unless impracticable to Ÿ Amount of correction for
A voluntary change is estimate each prior period
applied retrospectively so Ÿ 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

Changes resulting from the


introduction of a new HKFRS
are applied in accordance
with the transitional
provisions of that HKFRS.

Disclose:
Ÿ Reasons for change
Ÿ Amount of adjustment for
the current and prior
periods
Ÿ The fact that comparative
information is restated (or
that it is impracticable)

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Financial Reporting

HKAS 10 Events after the


Reporting Period

Events which occur between


the end of the reporting period
and when the financial
statements are authorised for
issue.

Adjusting events Non-adjusting events

Events which provide evidence Events which are indicative of


of conditions that existed at the conditions that arose after the
end of the reporting period. reporting period.

Adjust the financial statements Event impacts going Event does not
and disclosures to reflect the concern. impact going
event. concern.

Adjust the financial Do not adjust the


statements so that financial statements.
they are prepared on
the break-up basis
rather than going
concern basis.

If material, disclose:
Ÿ nature of the
event
Ÿ estimated
financial effect

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21: Accounting policies, changes in accounting estimates and errors; events after the reporting period
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Answer to self-test question

Answer 1
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

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Financial Reporting

Exam practice

Star Workshop Inc 20 minutes


In the preparation of the financial statements for the year ended 31 March 20X2 of Star Workshop
Inc. (SW), the financial controller identified the following transactions / events which happened after
the end of the reporting period but before the date when the financial statements are authorised for
issue:
(a) A customer informed SW on 3 April 20X2 that all the goods delivered to the customer's
warehouse on 25 March 20X2 were not produced in accordance with the agreed
specification. SW reproduced the order and shipped the replacement goods to the customer
on 10 April 20X2. The invoice of HK$8 million issued on 25 March 20X2 has not been
cancelled and the customer had settled when it confirmed the acceptance of the
replacement goods. (4 marks)
(b) The production of a plant has been suspended since 15 April 20X2 due to the sudden
shortage of electricity supply. Sales orders of HK$15 million received in February 20X2 with
a planned production and delivery in May 20X2 could not be fulfilled. According to the terms
of the sale contracts, SW agreed to compensate the counterparty by 20% of the contract
price for breach of contract. (4 marks)
(c) An official letter issued on 8 April 20X2 by the local government regarding the approval of a
subsidy of HK$5 million has been received. The subsidy was given to SW because of the
employment of more than 1,000 local workers during the six months ended 31 December
20X1. According to the published government notice, enterprises are encouraged to employ
local workers and, subject to approval, a discretionary subsidy will be granted. SW applied
for the subsidy on 8 March 20X2. (3 marks)
Required
Discuss how the above transactions/events should be dealt with in the financial statements of SW
for the year ended 31 March 20X2.
(Total = 11 marks)
HKICPA June 2012 (amended)

504
chapter 22

Earnings per share

Topic list

1 HKAS 33 Earnings Per Share


1.1 Objective of HKAS 33
1.2 Scope of HKAS 33
1.3 Definitions
1.4 Basic EPS
1.5 Weighted average number of ordinary shares: the effect of changes in capital
1.6 Diluted EPS
1.7 Diluted EPS: contingently issuable ordinary shares
1.8 Presentation
1.9 Significance of earnings per share
1.10 Limitations of EPS

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.

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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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

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22: Earnings per share | Part C Accounting for business transactions

1 HKAS 33 Earnings Per Share


Topic highlights
Earnings per share is a measure of the amount of profits earned by a company for each ordinary
share. Earnings are profits after tax and preference dividends.

HKAS 33.1 1.1 Objective of HKAS 33


HKAS 33 provides guidance on calculating and disclosing earnings per share (EPS). The purpose
of disclosing EPS is to enable comparison of the performance of an entity, both over time and with
other entities.

HKAS 33.2-4 1.2 Scope of HKAS 33


HKAS 33 has the following scope restrictions:
(a) Only companies with (potential) ordinary shares which are publicly traded need to present
EPS (including companies in the process of being listed).
(b) EPS need only be presented on the basis of consolidated results where the parent's
results are shown as well.
(c) Where companies choose to present EPS, even when they have no (potential) ordinary
shares which are traded, they must do so according to HKAS 33.

HKAS 33.5-7 1.3 Definitions


The following definitions are given in HKAS 33.

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)

1.3.1 Ordinary shares


Ordinary shares are defined above as those shares which are subordinate to other classes of
share capital. This means that ordinary shares participate in profit for the period only after other
types of shares, e.g. preference shares. The standard also notes that there may be more than

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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

HKAS 33.10 1.4 Basic EPS


Topic highlights
Basic EPS is calculated by dividing the profit or loss for the period attributable to ordinary
shareholders by the weighted average number of ordinary shares outstanding during the period.

Basic EPS is calculated as:


Profit / (loss) attributable to ordinary shareholders
Weighted average number of ordinary shares outstanding during the period

Both of the terms within this calculation require further explanation.


HKAS 1.4.1 Profit attributable to ordinary shareholders
33.12,14,16
The profit or loss attributable to ordinary shareholders for a period is calculated as:
 profit after all items of income and expense (including tax and non-controlling interests),
less
 profit after tax attributable to irredeemable preference shareholders, including preference
dividends and differences arising on the settlement of preference shares.
Note that the adjustment above only related to irredeemable preference shares since amounts
relating to preference shares classified as debt (redeemable preference shares) are included in
profit or loss for the period.
Preference dividends deducted from profit consist of the following:
(a) Preference dividends on non-cumulative preference shares declared in respect of the period.
(b) Preference dividends for cumulative preference shares required for the period, whether or
not they have been declared (excluding those paid/declared during the period in respect of
previous periods).
If an entity purchases its own preference shares for more than their carrying amount the excess
should be treated as a return to the preference shareholders and deducted from profit or loss
attributable to ordinary equity holders.

Example: Profit attributable to ordinary shareholders


Sunwin Co. is a listed company with the following shares in issue at 31 December 20X0:
Number of shares
Ordinary shares 100 million
Irredeemable cumulative preference shares 10 million
Redeemable preference shares 20 million

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22: 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 per annum
 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

HKAS 33.19- 1.4.2 Weighted average number of ordinary shares


24
The number of ordinary shares used should be the weighted average number of ordinary shares
outstanding during the period. This figure therefore reflects changes in capital during the period
due to new share issues and so on.
The time-weighting factor is the number of days the shares were outstanding compared with the
total number of days in the period. A reasonable approximation is usually adequate.
Shares are usually included in the weighted average number of shares from the date
consideration is receivable which is usually the date of issue. HKAS 33 does provide the
following guidance on the application of this rule:

Consideration Start date for inclusion

In exchange for cash When cash is receivable


On the voluntary reinvestment of dividends on ordinary or The dividend payment date
preference shares
As a result of the conversion of a debt instrument to ordinary Date interest ceases accruing
shares
In place of interest or principal on other financial instruments Date interest ceases accruing
In exchange for the settlement of a liability of the entity The settlement date
As consideration for the acquisition of an asset other than cash The date on which the
acquisition is recognised
For the rendering of services to the entity As services are rendered

Ordinary shares issued as purchase consideration in an acquisition should be included as of the


date of acquisition because the acquired entity's results will also be included from that date.

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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).

1.5 Weighted average number of ordinary shares: the effect of


changes in capital
Where there is a change in the share capital structure of an entity, the issue with regard to earnings
per share is ensuring that like is compared with like. This will become more clear as you read
through sections 1.5.1 to 1.5.3 and work the examples within them.
1.5.1 New share issues and share buy backs
Where new shares are issued at market price the number of shares will increase and there is a
corresponding increase in resources which may be utilised to generate profits.
Where ordinary shares are issued but not fully paid, they are treated in the calculation of basic
earnings per share as a fraction of an ordinary share to the extent that they were entitled to
participate in dividends during the period relative to a fully paid ordinary share. Therefore, if
2 million shares are issued, but only half of the issue price is paid and therefore the shareholder is
entitled to only 50% of a dividend, then only 1 million shares (i.e. 50%  2 million) are included in
the calculation of weighted average number of shares.
Where a share buy back takes place, there is a reduction in the number of shares and a
corresponding decrease in resources available to generate profits (as cash is paid by the entity to
the selling shareholders).
In both of these cases, therefore, EPS after the share issue or buy back can be compared on a like
for like basis with EPS before the event as the increase (or decrease) in the numerator of the EPS
fraction corresponds to the increase (or decrease) in the denominator of the fraction.

Example: Issue of ordinary shares at full market price


The profit after tax of AB Co. for the year ended 31 December 20X5 was $3,000,000.
At 31 December 20X4 the company had in issue 1,000,000 ordinary shares.
On 1 July 20X5, AB Co. issued 400,000 ordinary shares at the full market price for cash.
What is the basic EPS for the year ended 31 December 20X5?

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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.

Example: Issue of ordinary share by bonus issue


The profit of CD Co. for the year ended 31 December 20X6 was $5,600,000. For the year ended
31 December 20X7 this increased to $7,000,000.
The company had issued share capital of 1,000,000 ordinary shares as at 31 December 20X6.
On 1 July 20X7, CD Co. issued 400,000 ordinary shares fully paid by way of capitalisation of
reserves in the proportion of 2 for 5.
What is the basic EPS of CD Co. for both years?

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

511
Financial Reporting

Calculation using the tabular approach may prove easier to use in examples where there is more
than one issue in the year.
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.

HKAS 33, 1.5.3 Rights issues


Appendix
A.A2 A rights issue of shares is an issue of new shares to existing shareholders at a price below the
current market value. The offer of new shares is made on the basis of x new shares for every y
shares currently held, e.g. a 1 for 3 rights issue is an offer of one new share at the offer price for
every three shares currently held.
As the issue price is below market value, a rights issue is treated as a combination of an issue at
fair value and a bonus issue.
In order to calculate the weighted average number of shares when there has been a rights issue,
an adjustment factor is required:
Pre rights issue price of shares
Adjustment factor =
Theoretical ex - rights price (TERP)

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

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22: Earnings per share | Part C Accounting for business transactions

Required
Calculate the theoretical ex-rights value per share and the basic EPS for each of the years 20X2
and 20X3.

Solution
1 Theoretical ex-rights price is calculated as:

100,000  $8.00  + (20,000  $5.00) = 900,000


= $7.50
120,000 120,000

An alternative calculation is:


$
Old shares 5 @ $8.00 = 40.00
New shares 1 @ $5.00 = 5.00
6 45.00 therefore $45.00/6 = $7.50

2 The adjustment factor is therefore $8.00/$7.50


3 The weighted average number of ordinary shares for 20X3 is therefore calculated as:

1 January – 28 February 100,000 shares  $8.00  2/12 17,778


$7.50
1 March – 31 December 120,000 shares  10/12 100,000
Weighted average 117,778

1 Basic EPS for 20X3 is therefore $720,000/117,778 shares = $6.11


2 Basic EPS for 20X2 as originally reported is $600,000/100,000 shares = $6.00
3 Basic EPS for 20X2 as adjusted is $6.00  $7.50/$8.00 = $5.63

Self-test question 1
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
to 60% dividends until such time as the share is fully paid on
31 December 20X1.
1 August 20X2 1 for 7 rights issue at $3.55. The issue was fully subscribed and the market
price of a share immediately prior to the issue was $3.65.
Profits for the years ended 31 December 20X1 and 20X2 are $4,981,500 and $6,165,200
respectively.

Required
(a) What is the basic earnings per share as reported in 20X1 and 20X2?
(b) What is the restated 20X1 basic earnings per share figure for inclusion in the 20X2 financial
statements?
(The answer is at the end of the chapter)

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Financial Reporting

1.6 Diluted EPS


Topic highlights
Diluted EPS is calculated by 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.

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.
HKAS 33.44 1.6.2 Calculation of diluted earnings per share
Diluted earnings per share is calculated as:
Profits in basic EPS + effect on profit of dilutive potential ordinary shares
Number of shares in basic EPS + dilutive potential ordinary shares

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.

HKAS 1.6.3 Impact of potential ordinary shares on profits


33.33,35
The earnings calculated for basic EPS should be adjusted by the post-tax (including deferred tax)
effect of converting potential ordinary shares.

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22: Earnings per share | Part C Accounting for business transactions

Adjustments may include:


 any dividends on dilutive potential ordinary shares that were deducted to arrive at earnings
for basic EPS.
 interest recognised in the period for the dilutive potential ordinary shares.
 any other changes in income or expenses (fees and discount, premium accounted for as
yield adjustments) that would result from the conversion of the dilutive potential ordinary
shares.
The conversion of some potential ordinary shares may lead to changes in other income or
expenses. For example, the reduction of interest expense related to converting some convertible
loan stock and the resulting increase in net profit for the period may lead to an increase in the
expense relating to a non-discretionary employee profit-sharing plan. When calculating diluted
EPS, the profit or loss for the period is adjusted for any such consequential changes in income or
expense.
HKAS 1.6.4 Impact of potential ordinary shares on weighted average number of
33.36,39,40
shares
The number of shares calculated for basic EPS should be increased by the weighted average
number of ordinary shares that would be issued on the conversion of all the dilutive potential
ordinary shares into actual ordinary shares in issue.
It should be assumed that dilutive ordinary shares were converted into ordinary shares at the
beginning of the period or, if later, at the actual date of issue.
There are two other points:
(a) The computation assumes the most advantageous conversion rate or exercise rate from
the standpoint of the holder of the potential ordinary shares.
(b) A subsidiary, joint venture or associate may issue potential ordinary shares that are
convertible into either ordinary shares of the subsidiary, joint venture or associate, or
ordinary shares of the reporting entity. If these potential ordinary shares have a dilutive effect
on the consolidated basic EPS of the reporting entity, they are included in the calculation of
diluted EPS.
HKAS 33.45- 1.6.5 Share options
47A
Share options are potential ordinary shares which will not impact future profits. Therefore only the
denominator (i.e. number of shares) is affected in the diluted earnings per share calculation.
The exercise price of share options is generally lower than the market value of a share, and
therefore any exercise of options is viewed as an issue of shares at full (average) market value and
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.

Example: A listed company has issued share options


The profit after tax of XY Ltd for the year ended 31 December 20X3 was $3,000,000.
Capital structure
Issued share capital as at 31 December 20X2: 2,000,000 ordinary shares.
On 1 January 20X3, XY Ltd issued 50,000 share options each of which entitled the holder to one
ordinary share on payment of $2. The average fair value of one ordinary share during 20X3 was
$4.

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Financial Reporting

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.

Example: Share options (continued)


Assume that in the above example, the share options in issue have been awarded to employees
and $15,000 expense has not yet been recognised in accordance with HKFRS 2.

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
Diluted EPS is therefore based on 2,021,250 shares:
$3,000,000
Diluted EPS (20X3) = = $1.48
2,021,250

HKAS 33.49- 1.6.6 Convertible instruments


50
Convertible loan stock may be dilutive or anti-dilutive. In order to ascertain which the case is, a
stand-alone earnings per share amount should be calculated as:
Post tax interest saved on conversion of loan stock
Maximum number of potential ordinary shares in respect of the stock

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.

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22: Earnings per share | Part C Accounting for business transactions

Example: Loan stock


Ollivander Co. has a basic earnings per share of 45c for the year ended 30 April 20X1, based on
30 million shares.
The company has in issue $4 million 5% loan stock convertible into ordinary shares at a rate of
20 per $100 in 20X9.
Ollivander pays tax at a rate of 26%.
What is Ollivander’s diluted earnings per share for the year ended 30 April 20X1?

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 2
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
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)

517
Financial Reporting

HKAS 33.52 1.7 Diluted EPS: contingently issuable ordinary shares


Contingently issuable shares may form:
 part of the consideration for the acquisition of another entity. In this case they will only be
issued if certain targets are met in the future.
 a performance reward for senior staff members, payable if certain targets are met.
With regard to the calculation of EPS, the following apply in respect of contingently issuable
shares:
(a) Until such time as the shares are issued they should not be taken into account when
calculating basic EPS.
(b) They should be taken into account when calculating diluted EPS if the conditions leading to
their issue have already been satisfied. If the conditions are not satisfied, the number of
contingently issuable shares used in the diluted EPS calculation is the number of shares if
the end of the period were the end of the contingency period.
(c) Contingently issuable shares are included from the beginning of the period (or from the date
of the contingent share agreement, if later).
Restatement is not permitted if the conditions are not met when the contingency period expires.
For example, Company A issued contingently issuable ordinary shares (CIOS) on 1 July 20X7. The
conditions are satisfied on 1 July 20X9.

Year ended Basic EPS Diluted EPS

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.

Restatement of 20X7 and 20X8's diluted EPSs is not permitted.

HKAS 33.53 1.7.1 Contingent on future earnings


The condition for contingent issue may be achieving or maintaining a specified level of earnings for
a particular period.
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.

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22: Earnings per share | Part C Accounting for business transactions

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.

Example: Contingently issuable shares


QQ Co. had 20,000,000 ordinary shares outstanding as at 1 January 20X6. On 1 July 20X6, it
acquired a business from YY Co.. In accordance with the agreement, the initial consideration of
$20 million is to be satisfied by the issue of 1,000,000 ordinary shares in QQ Co. and, if the
average annual profit of the business acquired for the following three financial years ending 31
December 20X8 is more than $8 million, additional shares should be issued to YY Co. at 1 July
20X9. The number of shares to be issued will be calculated as follows:
Average annual profit – $8,000,000
20
The audited financial statements of the business for the year ended 31 December 20X6, 20X7 and
20X8 report a profit of $12,000,000, $5,000,000 and $4,000,000 respectively.
Required
Calculate the weighted average number of shares (WANOS) to use when calculating basic and
diluted EPS of QQ Co. for each of the three years ended 31 December 20X6, 20X7 and 20X8.

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
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

519
Financial Reporting

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..

HKAS
33.66.68,69
1.8 Presentation
An entity should present on the face of the statement of profit or loss and other comprehensive
income the basic and diluted EPS for profit and loss:
 from continuing operations
 for the period
for each class of ordinary share that has a different right to share in the net profit for the period.
The basic and diluted EPS should be presented with equal prominence for all periods presented.
If an entity is reporting a discontinued operation, the basic and diluted EPS for the discontinuing
operation must also be presented.
Disclosure must still be made where the EPS figures (basic and/or diluted) are negative (i.e. a loss
per share).

1.9 Significance of earnings per share


EPS is one of the most frequently quoted statistics in the financial analysis of listed companies.
Because of the widespread use of the price/earnings (P/E) ratio as a yardstick for investment
decisions, it has become increasingly important. Since the P/E ratio is calculated as the market
price per share divided by the EPS, it is important that a standard method of calculating EPS is
used by all quoted companies.

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22: Earnings per share | Part C Accounting for business transactions

It seems that reported and forecast EPS can, through the P/E ratio, have a significant effect on a
company's share price. Thus, a share price might fall if it looks as if EPS is going to be low. This
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.

1.10 Limitations of EPS


Although EPS is an important ratio, it does have a number of limitations. Users of the ratio should
be aware of these limitations and the opportunities for manipulation:
 Its calculation is complex and may not be understood by non-accountants.
 It is based on historic profits, which may not be indicative of future profits.
 It is affected by accounting policy and changes in policy.
 It ignores risk; the maximisation of EPS does not guarantee benefits or capital growth to
shareholders.
 It does not take account of the capital structure of an entity, so is not directly comparable
between two companies.
 It is open to manipulation by share buy-backs which increase EPS, but also increase a
company's risk by increasing its borrowings.

521
Financial Reporting

Topic recap

HKAS 33 Earnings Per Share

Earnings per share is a measure of the amount of profits earned


by a company for each ordinary share

Basic EPS Diluted EPS

Basic EPS profit + effect on profit


Profit/loss attributable to ordinary shareholders
of dilutive potential ord shares
Weighted average ordinary shares
No of shares in basic EPS + dilutive
potential ordinary shares

Profit/loss attributable to Weighted average ordinary Options:


ordinary shareholders shares Ÿ No effect on profit
Ÿ Increase no of shares by
"free" shares

Profit X Time apportion calculation Convertible loan


for new share issues stock/preference shares:
Amounts attributable (X) Ÿ Increase profit by post-tax
to irredeemable interest saved
preference share Ÿ Increase no of shares
holders __
X
Bonus issue: Adjust
number of shares before
issue by: Contingently issuable
ordinary shares are only
No of shares after issue taken into account if conditions
No of shares before issue leading to their issue are
satisfied.

Rights issue: Adjust number of 1 Check if potential


shares before issue by: ordinary shares are
individually dilutive or
Pre-rights issue share price anti-dilutive
Theoretical ex-rights price 2 Add in dilutive potential
ordinary shares one at a
time starting with the
most dilutive
Theoretical ex-rights price: 3 Diluted EPS is the
Market value of ordinary shares pre rights issue lowest calculated EPS
+ proceeds of rights issue figure at any stage.
No of shares post rights issue

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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22: Earnings per share | Part C Accounting for business transactions

Answers to self-test questions

Answer 1
(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

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

(b) Restated 20X1 basic EPS


3.64
81c  = 80.78c
3.65

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Financial Reporting

Answer 2
$29,295,000
Basic EPS = = 63 cents
46.5 million

Consider dilutive effects of options:


Proceeds raised on exercise: 100,000  $3.20 = $320,000
Therefore, shares issued at market value: $320,000/$4.20 = 76,190
"Free" shares: 100,000 – 76,190 = 23,810
Consider dilutive effect of loan stock:
Post tax interest saving ($10m  6%  75%) = $450,000
Additional shares ($10m/$100  22) = 2,200,000
(note that the worst case conversion scenario is assumed)
EPS of this instrument is therefore 20.45 cents. As this is less than basic EPS, the instrument is
dilutive and should be taken into account in the calculation of diluted EPS.
Diluted EPS is therefore 61.05c:
Basic 29,295,000 63.00c
46,500,000

With options 29,295,000 62.97c


46,500,000 + 23,810

With loan stock 29,295,000 + 450,000 61.05c


46,500,000 + 23,810 + 2,200,000

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22: Earnings per share | Part C Accounting for business transactions

Exam practice

Silver Coin Holdings Limited 23 minutes


Silver Coin Holdings Limited reported the following information in relation to the results and equity
structure for each of the years ended 30 June 20X8 and 20X9:
Year ended 30 June 20X8 20X9
Profit for the year (before interest expense) $32,800,000 $8,000,000
Equity structure:
Ordinary shares ("OS") 220,000,000 228,500,000
Redeemable, convertible preference shares ("PS") issued 3,000,000 2,000,000
on 1 July 20X7
Cumulative annual dividend of $0.30 per share
Convertible into eight ordinary shares per preference share
Outstanding share options 1,000,000 1,000,000
Average market price of one ordinary share during the year $1.80 $1.65
The PS were issued at $10 which represented the then market price on the date of issue.
1,000,000 PS were converted into OS on 1 January 20X9. 500,000 ordinary shares were issued to
new investors at $1.40 per share on 1 October 20X8. No dividend was declared by the company
during the year ended 30 June 20X8, $0.45 dividend was declared to PS holders on 31 December
20X8.
All 1,000,000 share options, with exercise price for one ordinary share at $1.50 per option, were
granted to employees on 1 July 20X6. Each grant is conditional upon the employee working for the
company over two years.
The company did not have other borrowings outstanding during both the two years ended 30 June
20X9.
Required
(a) Calculate the basic earnings per share for each of the years ended 30 June 20X8 and 20X9.
(7 marks)
(b) Calculate the diluted earnings per share for the year ended 30 June 20X9. (6 marks)
(Total = 13 marks)
(Note. Tax effect is ignored and a reasonable approximation of the weighted average number of
shares by the number of months that the shares are outstanding as a proportion of the total months
in a year is adequate.)
HKICPA February 2010 (amended)

525
Financial Reporting

526
chapter 23

Operating segments

Topic list

1 HKFRS 8 Operating Segments


1.1 Objective of HKFRS 8
1.2 Scope of HKFRS 8
1.3 Definitions
1.4 Identifying reportable segments
1.5 Disclosures
1.6 Key criticisms of HKFRS 8
1.7 Summary of HKFRS 8

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.

527
Financial Reporting

Learning outcomes

In this chapter you will cover the following 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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23: Operating segments | Part C Accounting for business transactions

1 HKFRS 8 Operating Segments


Topic highlights
HKFRS 8 Operating Segments requires that a listed entity identifies reportable operating segments
and discloses financial information in respect of them.

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.

1.1 Objective of HKFRS 8


An entity should disclose information to enable users of its financial statements to evaluate the
nature and financial effects of the business activities in which it engages and the economic
environments in which it operates.

HKFRS 8.2 1.2 Scope of HKFRS 8


HKFRS 8 applies only to entities:
 whose equity or debt securities are traded in a public market (i.e. on a stock exchange); or
 which is in the process of listing securities in a public market.
It also applies to group financial statements where the parent meets the above criteria. In group
accounts, only consolidated segmental information needs to be shown.

HKFRS 8.5,7 1.3 Definitions


HKFRS 8 provides one definition:

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.

1.4 Identifying reportable segments


Topic highlights
Reportable segments are operating segments or aggregation of operating segments that meet
the "10% test".

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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).

HKFRS 8.12 1.4.1 Aggregation of operating segments


Two or more operating segments below the thresholds may be aggregated to produce a reportable
segment if the segments have similar economic characteristics, and the segments are similar in:
 the nature of the products and services
 the nature of the production processes
 the type or class of customer for their products and services
 the methods used to distribute their products or provide their services
 if applicable, the nature of the regulatory environment (e.g. banks).

HKFRS 1.4.2 Quantitative thresholds


8.13,15,19
An entity should report separate information about each operating segment that:
(a) has been identified as meeting the definition of an operating segment, and
(b) segment total is 10% or more of total:
(i) revenue (internal and external)
(ii) profits for all segments reporting a profit (or all segments in loss if greater), or
(iii) assets
At least 75% of total external revenue must be reported by operating segments. Where this is not
the case, additional segments must be identified (even if they do not meet the 10% thresholds).
Operating segments that do not meet any of the quantitative thresholds may be reported
separately if management believes that information about the segment would be useful to users of
the financial statements.
HKFRS 8 suggests that there may be a limit to the number of reportable segments that an entity
separately discloses before information becomes too detailed. It suggests that when the number of
reportable segments increases above ten, the entity should consider whether a practical limit has
been reached.

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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23: 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)

1.4.3 Decision tree to assist in identifying reportable segments


The following decision tree will assist in identifying reportable segments.

Management to identify
operating segments reporting

Yes Aggregate
Any operating segments meet segments if
all aggregation criteria? desired
No

Yes Any operating segments meet the


quantitative threshold of ≥ 10% total
revenue / 10% total profit (or loss if
greater) / 10% total assets?
No

Aggregate Yes Any remaining operating


segments if segments meet a majority of
desired aggregation criteria?

No
Do identified reportable Yes
segments account for 75% of
the total external revenue?

No

Report additional segment

These are reportable Aggregate remaining segments


segments to be disclosed into "all other segments"

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

531
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-
24,28,33,34
1.5 Disclosures
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) Types of products and services from which each reportable segment derives its
revenues
(b) Financial information; for each reportable segment the entity must disclose:
(i) profit or loss
(ii) total assets
(iii) total liabilities
The following further items must also be disclosed if they are 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, assets and liabilities Share of profit of associates/joint ventures equity
accounted
Profit or loss (as reported to chief operating
decision maker)
Income tax expense
(1)
Non-current assets
Investments in associates/joint ventures

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23: Operating segments | Part C Accounting for business transactions

A reconciliation of the total of each of the above material items to the entity's reported
figures is required.
(c) External revenue from external customers for each product and service (unless the cost of
developing this information would be excessive).
(d) Geographical information

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.
(e) 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.

Illustration: Disclosure example from HKFRS 8


Car All
parts Software Finance other Totals
$'000 $'000 $'000 $'000 $'000
Revenues from external
(a)
customers 8,000 21,500 5,000 1,000 35,500
Intersegment revenues – 4,500 – – 4,500
Interest revenue 1,250 2,500 – – 3,750
Interest expense 950 1,800 – – 2,750
(b)
Net interest revenue – – 1,000 – 1,000
Depreciation and
amortisation 300 1,550 1,100 – 2,950
Reportable segment profit 270 3,200 500 100 4,070
Other material non-cash
items:
Impairment of assets 200 – – – 200
Reportable segment assets 7,000 15,000 57,000 2,000 81,000
Expenditure for reportable
segment non-current
assets 1,000 1,300 600 – 2,900
Reportable segment
liabilities 4,050 9,800 30,000 – 43,850
Notes
(a) Revenues from segments below the quantitative thresholds are attributable to four operating
segments of the company. Those segments include a small property business, an
electronics equipment rental business, a software consulting practice and a warehouse

533
Financial Reporting

leasing operation. None of those segments has ever met any of the quantitative thresholds
for determining reportable segments.
(b) The finance segment derives a majority of its revenue from interest. Management primarily
relies on net interest revenue, not the gross revenue and expense amounts, in managing
that segment. Therefore, as permitted by HKFRS 8, only the net amount is disclosed.

1.5.2 Suggested proforma


Information about profit or loss, assets and liabilities
Segment Segment Segment All other Inter Entity
A B C segments segment total
Revenue – external
customers X X X X – X
Revenue – inter segment X X X X X –
X X X X (X) X
Interest revenue X X X X (X) X
Interest expense (X) (X) (X) (X) X (X)
Depreciation and
amortisation (X) (X) (X) (X) – (X)
Other material non-cash
items X/(X) X/(X) X/(X) X/(X) X/(X) X/(X)
Material income/expense
(HKAS 1) X/(X) X/(X) X/(X) X/(X) X/(X) X/(X)
Share of profit of
associate/JVs X X X X – X
Segment profit before tax X X X X (X) X
Income tax expense (X) (X) (X) (X) – (X)
Unallocated items X/(X)
Profit for the year X
Segment assets X X X X (X) X
Investments in X X X X – X
associate/JVs
Unallocated assets X
Entity's assets X
Expenditures for
reportable assets X X X X (X) X
Segment liabilities X X X X (X) X
Unallocated liabilities X
Entity's liabilities X

Information about geographical areas


Country of Foreign Total
domicile countries
Revenue – external customers X X X
Non-current assets X X X

1.6 Key criticisms of HKFRS 8


(a) Some commentators have criticised the "managerial approach" as leaving segment
identification too much to the discretion of the entity.
(b) The managerial approach may mean that financial statements of different entities are not
comparable.

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23: Operating segments | Part C Accounting for business transactions

(c) The segments may include operations with different risks and returns.
(d) There is no defined measure of segment profit or loss.

1.7 Summary of HKFRS 8


HKFRS 8 is a disclosure standard which applies only to listed companies:
 Segment reporting is necessary for a better understanding and assessment of:
– past performance
– the economic environment
– informed judgments
 HKFRS 8 adopts the managerial approach to identifying segments.
 The standard gives guidance on how segments should be identified and what information
should be disclosed for each.
It also sets out requirements for related disclosures about products and services, geographical
areas and major customers.

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Financial Reporting

Topic recap

HKFRS 8 Operating Segments

Requires that a listed entity identifies reportable operating segments and


discloses financial information in respect of them

Operating segment is a component of an entity:


Ÿ That engages in business activities from which it may earn revenues and
incur expenses
Ÿ Whose results are regularly reviewed by the entity's chief operating decision
maker
Ÿ For which discrete financial information is available

Reportable segments Disclosures

A segment is reportable if:


1 it meets the definition of an operating Ÿ General information about segments
segment Ÿ Financial information for each
2 the segment total ≥ 10% of total: segment:
- revenue – Profit or loss
- profits (for all segments in profit, or all – Total assets
in loss if greater), or – Total liabilities
- assets – Other items reported to the chief
operating decision maker
Ÿ External revenue
Ÿ Geographical information
Ÿ Reliance on major customers
If reportable segments do not make up ≥
75% total external revenue, additional
segments not meeting the 10% test are
reported.

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23: Operating segments | Part C Accounting for business transactions

Answer to self-test question

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).

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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

538
chapter 24

Interim financial reporting

Topic list

1 HKAS 34 Interim Financial Reporting


1.1 Objective
1.2 Scope
1.3 Definitions
1.4 Minimum components
1.5 Form and content
1.6 Periods covered
1.7 Materiality
1.8 Recognition and measurement principles
1.9 Applications of the recognition and measurement principles
1.10 Use of estimates
1.11 HK(IFRIC) Int-10 Interim Financial Reporting and Impairment

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.

539
Financial Reporting

Learning outcomes

In this chapter you will cover the following 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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24: Interim financial reporting | Part C Accounting for business transactions

1 HKAS 34 Interim Financial Reporting


Topic highlights
HKAS 34 does not mandate which entities should publish an interim financial report. For entities
that do publish such reports, it lays down principles and guidelines for their production. However, it
is up to government and regulators to decide what specific rules should apply to Hong Kong.

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.

HKAS 34.1 1.2 Scope


The standard does not make the preparation of interim financial reports mandatory for any
company, taking the view that this is a matter for governments, securities regulators, stock
exchanges or professional accountancy bodies to decide within each country. HKICPA encourages
publicly traded entities to provide interim financial reports that conform to the recognition,
measurement, and disclosure principles set out in this standard.
The standard recommends that in respect of public listed companies,
(a) an interim financial report should be produced by such companies for at least the first six
months of their financial year (i.e. a half year financial report)
(b) the report should be available no later than 60 days after the end of the interim period.
Thus, a company with a year ending 31 December should prepare an interim report for the half
year to 30 June and this report should be available before the end of August.

541
Financial Reporting

HKAS 34.4 1.3 Definitions


The following definitions are used in HKAS 34.

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)

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,
16A,19 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.
In addition to disclosing significant events and transactions, an entity should include the following in
its interim financial statements:
(a) A statement that the same accounting policies and methods of computation are followed
in the interim statements as compared with the most recent annual financial statements. If
any policy or method has changed, a description of the nature and effect of the change is
required.
(b) Explanatory comments on the seasonality or "cyclicality" of operations.

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24: Interim financial reporting | Part C Accounting for business transactions

(c) The nature and amount of items affecting assets, liabilities, equity, net income or cash
flows, that are unusual, because of their nature, size or incidence.
(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.
The kinds of disclosure required may include corrections of prior period errors, inventory write
downs and the acquisition and disposal of items of property, plant and equipment.
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.

Self-test question 1
Give some examples of the type of disclosures required according to the above list of explanatory
notes.
(The answer is at the end of the chapter)

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Financial Reporting

HKAS 34.20 1.6 Periods covered


As required by the standard, financial information for the following periods or as at the following
dates should be provided in interim financial reports:
(a) Statement of financial position data as at the end of the current interim period, and
comparative data as at the end of the most recent financial year.
(b) Statement of profit or loss and other comprehensive income data for the current interim
period and cumulative data for the current year to date, together with comparative data for
the corresponding interim period and cumulative figures for the previous financial year.
(c) Statement of changes in equity data should be for both the current interim period and for
the year to date, together with comparative data for the corresponding interim period, and
cumulative figures, for the previous financial year.
(d) Statement of cash flows data should be cumulative for the current year to date, with
comparative cumulative data for the corresponding interim period in the previous financial
year.

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 34.28 1.8 Recognition and measurement principles


HKAS 34 strongly emphasises the recognition and measurement principles and the guidelines for
their practical application. The guiding principle is that identical recognition and measurement
principles should be used in an entity's interim and annual financial statements.
To illustrate, a cost that is not regarded as an asset in the year-end statement of financial position
should not be treated so in the statement of financial position for an interim period, Likewise, an
accrual of income or expense for a transaction that has not been incurred (or a deferral of income
or expense) is not suitable for interim reporting, just as it is for year-end reporting.
A remeasurement of the amounts that were reported in a financial statement of a previous interim
period may have to be carried out in a later interim period or at the year-end because of the
application of this recognition and measurement principle. Disclosure of the nature and amount of
any significant reassessments is required.
HKAS 34.37 1.8.1 Revenues received occasionally, seasonally or cyclically
The revenue recognition principle should be applied consistently in both interim and year-end
reports. Revenue which is not recurring i.e. received as an occasional item, or of seasonal or
cyclical nature, should not be anticipated or deferred in the annual financial statements, as well as
in the interim financial statements.
HKAS 34.39 1.8.2 Costs incurred unevenly during the financial year
Anticipation or deferral of these costs (i.e. recorded as accruals or prepayments) is done only if it
would be appropriate to do so in the annual financial statements.
To illustrate, it would not be appropriate to anticipate expenses which have not yet been incurred
e.g. part of the cost of a major advertising campaign happening later in the reporting year, where
no expenses have been incurred. On the other hand, it would be necessary to anticipate a rental
cost of a property where the rental is paid in arrears.

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HKAS 34 1.9 Applications of the recognition and measurement principles


Illustrative
examples Specific applications of the recognition and measurement principles are provided in an appendix
Section B
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.
1.9.2 Cost of a planned major periodic maintenance or overhaul
In the absence of a legal or constructive obligation to carry out major periodic maintenance or
overhaul, the cost of this kind of work in the later phase of the year must not be anticipated in an
interim financial statement. The fact that a maintenance or overhaul is planned and is carried out
annually is not a justification for the anticipation of the cost in an interim financial report.
1.9.3 Other planned but irregularly-occurring costs
Likewise, no accrual is to be made in an interim report for costs such as charitable donations or
employee training costs which are planned to be incurred later in the year. These costs are
considered as discretionary, even if they occur regularly and are planned.
1.9.4 Year-end bonus
Unless there is a legal or constructive obligation to pay a year-end bonus (e.g. a contractual
obligation, or a regular past practice) and a reliable measure on the size of the bonus, such a
bonus should not be provided for in an interim financial statement.

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.

1.9.5 Holiday pay


The same principle is to be applied to holiday pay. An accrual must be made for any unpaid
accumulated holiday pay in the interim financial report if the holiday pay is an enforceable
obligation on the employer.
1.9.6 Non-monetary intangible assets
Expenses might be incurred during an interim period on items that might or will generate non-
monetary intangible assets. According to HKAS 38 Intangible Assets, with the exception of those

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Financial Reporting

costs that constitute part of the cost of an identifiable intangible asset, other costs relating to the
generation of non-monetary intangible assets (e.g. development expenses) should be recognised
as an expense when incurred. Costs that were initially recognised as an expense cannot be treated
as part of the cost of an intangible asset in a later period. The same approach should be adopted in
interim financial statements as mentioned in HKAS 34. That is to say, unless a cost will eventually
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 2
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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1.9.10 Inventory valuations


Inventories should be valued in the same manner in both interim reports and final accounts, though
the valuation in interim reports may rely more heavily on estimates.
The net realisable value of inventories should be estimated from selling prices and the related
costs to complete and dispose of at interim dates.

Example: Inventory valuation


Callcut is currently preparing interim financial statements for the half year to 30 June 20X1. The
price of its products tends to vary. At 30 June 20X1, it has inventories of 500,000 units, at a cost
per unit of $5.00. The net realisable value of the inventories is $4.50 per unit at 30 June 20X1.
The expected net realisable value of the inventories at 31 December 20X1 is $5.10 per unit.
Required
How should the value of the inventories be reflected in the interim financial statements?
Solution
The value of the inventories in the interim financial statements at 30 June 20X1 is the lower of cost
and NRV at 30 June 20X1. This is:
500,000  $4.50 = $2.25m

HKAS 34.41 1.10 Use of estimates


It is vital that accounting information must be reliable and free from material error. However, a
certain degree of accuracy and reliability might have to be sacrificed for the sake of timeliness and
cost-benefits. This is particularly true where much less time can be devoted to the preparation of
interim financial statements than at the financial year end. The standard therefore recognises that
estimates for assessing values or even some costs will have to be used, to a greater extent, in
interim financial reporting than in year-end reporting.
An appendix to HKAS 34 gives some examples of the use of estimates.
(a) Inventories. An entity might not need to carry out a full inventory count at the end of each
interim period. Instead, it may be sufficient to estimate inventory values using sales margins.
(b) Provisions. An entity might employ outside experts or consultants to advise on the
appropriate amount of a provision, as at the year end (for example, a provision for
environmental or site restoration costs). It will probably be inappropriate to employ an expert
to make a similar assessment at each interim date. Similarly, an entity might employ a
professional valuer to revalue non-current assets at the year end, whereas at the interim
date(s) the entity will not rely on such experts.
(c) Income taxes. The rate of income tax (tax on profits) will be calculated at the year end by
applying the tax rate in each country/jurisdiction to the profits earned there. At the interim
stage, it may be sufficient to estimate the rate of income tax by applying the same "blended"
estimated weighted average tax rate to the income earned in all countries/jurisdictions.
The principle of materiality applies to interim financial reporting, as it does to year-end reporting.
In assessing materiality, it needs to be recognised that interim financial reports will rely more
heavily on estimates than year-end reports. Materiality should be assessed in relation to the interim
financial statements themselves, and should be independent of "annual materiality" considerations.
If an estimate of an amount reported in an interim period changes significantly during the second
period of the financial year but a separate financial report is not published for that second period,
the nature and amount of that change in estimate should be disclosed in a note to the annual
financial statements for that financial year.

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Financial Reporting

1.11 HK(IFRIC) Int-10 Interim Financial Reporting and Impairment


There is a prominent conflict about the recognition and reversal in financial statements of
impairment losses on goodwill and certain financial assets between the requirements of HKAS 34
Interim Financial Reporting and those in other standards. HK(IFRIC) Int-10 concludes the following:
(a) An entity must not reverse an impairment loss recognised in a previous interim period in
respect of goodwill or an investment in either an equity instrument or a financial asset carried
at cost.
(b) An entity must not extend this consensus by analogy to other areas of potential conflict
between HKAS 34 and other standards.

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Topic recap

HKAS 34 Interim Financial Reporting

Ÿ Lays down the principles and guidelines for production of


interim financial statements
Ÿ Does not mandate which entities should produce them

Minimum components:
Ÿ Condensed statement of financial position
Ÿ Condensed statement of profit or loss and other
comprehensive income
Ÿ Condensed statement of changes in equity
Ÿ Condensed statement of cash flows
Ÿ Selected notes
Ÿ 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.

Recognition and measurement principles:

Ÿ Should be identical to those applied in the annual


financial statements
Ÿ Seasonal revenue is not anticipated/deferred
Ÿ Unevenly incurred costs are not anticipated/
deferred unless appropriate.

Example applications of recognition and measurement


principles:
Ÿ No accrual made for planned costs in second half of
year e.g. maintenance or overhaul
Ÿ No accrual made for year-end bonus unless there is a
legal or constructive obligation to pay
Ÿ Include an income tax expense based on an
estimated average annual tax rate for the year

Estimates for assessing values or costs will have to be used


to a greater extent in interim financial reporting than in year-
end financial reporting, e.g.
Ÿ Estimation of inventory values in the place of a full
inventory count
Ÿ Using management estimates in interim reports to
measure revaluations or provisions rather than
external experts.

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Financial Reporting

Answers to self-test questions

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 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.

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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)

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chapter 25

Presentation of financial
statements
Topic list

1 Reporting financial performance


1.1 HKAS 1 Presentation of Financial Statements
1.2 Statement of financial position
1.3 Statement of profit or loss and other comprehensive income
1.4 Statement of changes in equity
1.5 Other aspects of HKAS 1
2 Current developments

Learning focus

HKAS 1 affects all entities and you must be familiar with the requirements of the standard.

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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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

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1 Reporting financial performance


Topic highlights
HKAS 1 (Revised) provides guidance on the content and format of a set of financial statements.

HKAS 1.10 1.1 HKAS 1 Presentation of Financial Statements


HKAS 1 (Revised) states that a complete set of financial statements includes the following:
(a) A statement of financial position as at the end of the period.
(b) A statement of profit or loss and other comprehensive income for the period.
(c) A statement of changes in equity for the period.
(d) A statement of cash flows for the period.
(e) Notes, comprising a summary of significant accounting policies and other explanatory
information.
(f) Comparative information in respect of the preceding period.
(g) A statement of financial position as at the beginning of the preceding period when an entity
applies an accounting policy retrospectively or makes a retrospective restatement of items in
its financial statements, or when it reclassifies items in its financial statements.
These financial statements must be clearly identified and distinguished from other information in
the same published document.
The statement of cash flows is dealt with in Chapter 19 of this Learning Pack; the statements of
financial position, profit or loss and other comprehensive income and changes in equity are
considered in more detail in later sections of this chapter.
1.1.1 Terminology
HKAS 1 was revised in 2007 and some of the names of the main financial statements were
changed. The title 'statement of comprehensive income' was further changed to be 'statement of
profit or loss and other comprehensive income' by a 2011 amendment to the standard.
The use of the new terms listed above is not mandatory; and in practice, an entity may continue to
use the 'old' titles such as "balance sheet" instead of "statement of financial position". The
following table lists the old names alongside the new:

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

1.1.2 Performance reporting


HKAS 1 (Revised) focuses on aggregating transactions with similar characteristics and therefore
requires that changes in equity are classified as one of two types, and reported accordingly:
(a) Changes in equity arising from transactions with owners in their capacity as owners (e.g.
dividends and share issues) are reported in the statement of changes in equity.
(b) Changes in equity arising from all other transactions are reported in the statement of profit
or loss and other comprehensive income.

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Financial Reporting

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

HKAS 1.38, 1.1.3 Comparative information


38A
Other than where HKFRS permit otherwise, comparative information should be presented for the
preceding period for all amounts reported in the current period’s financial statements. Comparative
narrative information should also be provided where this is relevant to an understanding of the
current period’s financial statements.
As a minimum, an entity should present:
 Two statements of financial position
 Two statements of profit or loss and other comprehensive income
 Two statements of cash flows
 Two statements of changes in equity, and
 Related notes.
HKAS 1.40A, 1.1.4 Additional statement of financial position
40B
HKAS 1 (Revised) requires that a statement of financial position is presented as at the beginning of
the preceding period when an entity:
(i) applies an accounting policy retrospectively, makes a retrospective restatement of items in
its financial statements or reclassifies items in its financial statements, and
(ii) the retrospective application or restatement or the reclassification has a material effect on
the information in the statement of financial position at the beginning of the preceding period.
In effect, this will result in the presentation of three statements of financial position when there is a
material prior period adjustment: one at the end of the current period, one at the end of the
preceding period and one at the start of the preceding period.

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1.2 Statement of financial position


1.2.1 Proforma
The HKAS 1 (Revised) format is given below.
ABC GROUP – STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER
20X9 20X8
$'000 $'000
ASSETS
Non-current assets
Property, plant and equipment 350,700 360,020
Goodwill 80,800 91,200
Other intangible assets 227,470 227,470
Investments in associates 100,150 110,770
Investments in equity investments measured at fair value
through other comprehensive income 142,500 156,000
901,620 945,460
Current assets
Inventories 135,230 132,500
Trade receivables 91,600 110,800
Other current assets 25,650 12,540
Cash and cash equivalents 312,400 322,900
564,880 578,740
Total assets 1,466,500 1,524,200

EQUITY AND LIABILITIES


Equity attributable to owners of the parent
Share capital 650,000 600,000
Retained earnings 243,500 161,700
Other components of equity 10,200 21,200
903,700 782,900
Non-controlling interests 70,050 48,600
Total equity 973,750 831,500
Non-current liabilities
Long-term borrowings 120,000 160,000
Deferred tax 28,800 26,040
Long-term provisions 28,850 52,240
Total non-current liabilities 177,650 238,280

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

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Financial Reporting

HKAS 1.2.2 Disclosure requirements


1.54,55,58,59
As a minimum HKAS 1 (Revised) requires that the statement of financial position (balance sheet)
includes the following:
(a) Property, plant and equipment
(b) Investment property
(c) Intangible assets
(d) Financial assets (excluding amounts shown under (e), (h) and (i))
(e) Investments accounted for using the equity method
(f) Biological assets
(g) Inventories
(h) Trade and other receivables
(i) Cash and cash equivalents
(j) The total of assets classified as held for sale and assets included in disposal groups
classified as held for sale in accordance with HKFRS 5 Non-current Assets Held for Sale and
Discontinued Operations
(k) Trade and other payables
(l) Provisions
(m) Financial liabilities (excluding amounts shown under (k) and (l))
(n) Liabilities and assets for current tax, as defined in HKAS 12 Income Taxes
(o) Deferred tax liabilities and deferred tax assets, as defined in HKAS 12
(p) Liabilities included in disposal groups classified as held for sale in accordance with HKFRS 5
(q) Non-controlling interests, presented within equity, and
(r) Issued capital and reserves attributable to owners of the parent
Additional line items should be presented when they are relevant to an understanding of an entity's
position. In deciding whether additional items should be presented separately, HKAS 1 (revised)
requires that assessment is made of:
 the nature and liquidity of assets
 the function of assets within the entity, and
 the amounts, nature and timing of liabilities.
Where different measurement bases are used for different classes of assets (e.g. historic cost or
revalued amount), the standard suggests that their nature or function differs and they should be
presented separately.
In addition, HKAS 1 (revised) requires that the line items presented in the statement of financial
position are further sub-classified in a manner appropriate to the entity's operations either in the
statement of financial position or in the notes.
HKAS 1.2.3 Current / non-current classification
1.60,66,69,72,
74,75 An entity must present current and non-current assets, and current and non-current liabilities,
as separate classifications in the statement of financial position except where a presentation
based on liquidity provides more relevant and reliable information. In this case, all assets and
liabilities should be presented broadly in order of liquidity.

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HKAS 1 (Revised) provides the criteria for classification of an asset or liability as current. Any other
items are classified as non-current:

Current asset Current liability

(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.

End of reporting Agreement to Date financial Settlement date


period refinance on long- statements <12 months after
term basis authorised for issue the reporting period

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.

Condition of loan End of reporting Lender agrees not Date financial


agreement period to enforce payment statements
breached. Long- resulting from approved for issue
term liability breach
becomes payable
on demand
However, if the lender has agreed by the end of reporting period to provide a period of grace
ending at least 12 months after the reporting period within which the entity can rectify the
breach and during that time the lender cannot demand immediate repayment, the liability is
classified as non-current.
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.

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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.

HKAS
1.10,10A
1.3 Statement of profit or loss and other comprehensive income
HKAS 1 (Revised) allows the presentation of the statement of profit or loss and other comprehensive
income in one of two ways:
(a) As a single statement ("the statement of profit or loss and other comprehensive income")
(b) As two statements:
(i) A statement of profit or loss
(ii) A statement which details other comprehensive income
1.3.1 Proforma: single statement
The following proforma shows the format of the statement of profit or loss and other comprehensive
income where a single statement is used.

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25: Presentation of financial statements | Part C Accounting for business transactions

Illustration: Statement of profit or loss and other comprehensive income (single


statement) given in HKAS 1
ABC GROUP – STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 DECEMBER 20X9 (SINGLE STATEMENT)
20X9 20X8
$'000 $'000
Revenue 390,000 355,000
Cost of sales (245,000) (230,000)
Gross profit 145,000 125,000
Other income 20,667 11,300
Distribution costs (9,000) (8,700)
Administrative expenses (20,000) (21,000)
Other expenses (2,100) (1,200)
Finance costs (8,000) (7,500)
Share of profit of associates 35,100 30,100
Profit before tax 161,667 128,000
Income tax expense (40,417) (32,000)
Profit for the year from continuing operations 121,250 96,000
Loss for the year from discontinued operations – (30,500)
Profit for the year 121,250 65,500
Other comprehensive income:
Items that will not be reclassified to profit or loss
Gains on property revaluation 933 3,367
Actuarial gains (losses) on defined benefit pension plans (667) 1,333
Share of other comprehensive income of associates 400 (700)
Income tax relating to items that will not be reclassified to profit or (350) (2,100)
loss
Items that may be reclassified to profit or loss
Exchange differences on translating foreign operations 5,334 10,667
Cash flow hedges (24,667) 22,667
Income tax relating to items that may be reclassified to profit or 5,017 (7,234)
loss

Other comprehensive income for the year, net of tax 14,000) 28,000
Total comprehensive income for the year 107,250 93,500
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

1.3.2 Proforma: two statements


The two statement approach to the statement of profit or loss and other comprehensive income is
shown in the following illustration:

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Financial Reporting

Illustration: Statement of profit or loss and other comprehensive income (in two
statements) given in HKAS 1
ABC GROUP – STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X9
20X9 20X8
$'000 $'000
Revenue 390,000 355,000
Other income 20,667 11,300
Changes in inventories of finished goods and work in
progress (115,100) (107,900)
Work performed by the entity and capitalised 16,000 15,000
Raw material and consumables used (96,000) (92,000)
Employee benefits expense (45,000) (43,000)
Depreciation and amortisation expense (19,000) (17,000)
Impairment of property, plant and equipment (4,000) –
Other expenses (6,000) (5,500)
Finance costs (15,000) (18,000)
Share of profit of associates 35,100 30,100
Profit before tax 161,667 128,000
Income tax expense (40,417) (32,000)
Profit for the year from continuing operations 121,250 96,000
Loss for the year from discontinued operation – (30,500)
PROFIT FOR THE YEAR 121,250 65,500
Profit attributable to
Owners of the parent 97,000 52,400
Non-controlling interests 24,250 13,100
121,250 65,500
Earnings per share (in currency units)
Basic and diluted 0.46 0.30
ABC GROUP – STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
20X9 20X8
$'000 $'000
PROFITS FOR THE YEAR 121,250 65,500
Other comprehensive income:
Items that will not be reclassified to profit or loss
Gains on property revaluation 933 3,367
Actuarial gains (losses) on defined benefit pension plans (667) 1,333
Share of other comprehensive income of associates 400 (700)
Income tax relating to items that will not be reclassified to (350) (2,100)
profit or loss
Items that may be reclassified to profit or loss
Exchange differences on translating foreign operations 5,334 10,667
Cash flow hedges (24,667) 22,667
Income tax relating to items that may be reclassified to profit 5,017 (7,234)
or loss

Other comprehensive income for the year, net of tax (14,000) 28,000
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 107,250 93,500

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20X9 20X8
$'000 $'000
Total comprehensive income attributable to
Owners of the parent 85,800 74,800
Non-controlling interests 21,450 18,700
107,250 93,500

HKAS 1.81A, 1.3.3 Disclosure requirements


82, 85-87,99
In addition to the profit or loss section and other comprehensive income section, the following
should be presented in the statement of profit or loss and other comprehensive income:
(a) Profit or loss
(b) Total other comprehensive income
(c) Comprehensive income for the period, being the total of profit or loss and other
comprehensive income.
The profit or loss section should include line items that present the following amounts for the
period:
(a) Revenue
(b) Gains and losses arising from the derecognition of financial assets measured at amortised
cost
(c) Finance costs
(d) Share of the profit or loss of associates and joint ventures accounted for using the equity
method
(e) If a financial asset is reclassified so that it is measured at fair value, any gain or loss arising
from a difference between the previous carrying amount and its fair value at the
reclassification date
(f) Tax expense
(g) A single amount for the total of discontinued operations.
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
Additional line items, headings and subtotals should also be presented when such presentation is
relevant to an understanding of the entity's financial performance. In order to determine whether
additional lines are necessary, an entity should consider materiality and the nature and function of
items of income and expense.
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.
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.

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Financial Reporting

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.
HKAS 1. 82A, 1.3.4 Presentation of other comprehensive income
90-91, 94
Other comprehensive income items should be presented classified by nature and grouped into
those items which, in accordance with other HKFRS,
(a) will not be reclassified subsequently to profit or loss, and
(b) 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.

HKAS 1.4 Statement of changes in equity


1.106,106A
The statement of changes in equity provides a reconciliation of the shareholders' funds brought
forward and shareholders' funds carried forward. Shareholders' funds consist of ordinary share
capital, share premium, revaluation reserve, retained earnings and any other components of equity.
The following should be disclosed:
(a) Total comprehensive income for the period, showing separately the total amounts
attributable to owners of the parent and to the non-controlling interests.
(b) For each component of equity, the effects of retrospective application or retrospective
restatement recognised in accordance with HKAS 8, and
(c) For each component of equity, a reconciliation between the carrying amount at the beginning
and the end of the period, separately disclosing changes resulting from:
(i) profit or loss;
(ii) other comprehensive income; and
(iii) transactions with owners in their capacity as owners, showing separately contributions
by and distributions to owners, and changes in ownership interests in subsidiaries that
do not result in a loss of control.
An analysis of the other comprehensive income reported in the statement of changes in equity
must be provided either:
 within the statement of changes in equity itself, or
 in the notes to the accounts.
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.

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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

Dividends – (10,000) – – – – (10,000) – (10,000)


Total
comprehensive
income for the
year – 53,200 6,400 16,000 (2,400) 1,600 74,800 18,700 93,500

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

Dividends – (15,000) – – – – (15,000) – (15,000)

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 1
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:

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Financial Reporting

BALANCE SHEET AT 31 DECEMBER 20X9


$ $
Non-current assets 525,000
Long term receivable 10,000
535,000
Current assets
Inventories 31,200
Receivables 56,450
Cash 10,900
98,550
633,550
Share capital and reserves
Ordinary share capital (40,000 shares) 40,000
Profits reserve 379,540
419,540
Liabilities
Current liabilities 114,010
Loan stock 20Y6 100,000
214,010
633,550

INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X9


$
Turnover 1,235,000
Cost of sales (740,000)
Administrative expenses (267,020)
Distribution and other expenses (115,230)
Operating profit 112,750
Interest payable (7,400)
Profit before tax 105,350
Tax (33,700)
Profit after tax 71,650
Dividends (25,000)
Retained profit 46,650

The following information is also relevant:


(a) The accountant has prepared a working schedule of non-current assets as follows:
Land and Fixtures and
buildings fittings Patent Total
$ $ $ $
Cost b/f 700,000 200,000 30,000 930,000
Additions – 15,000 – 15,000
Cost c/f 700,000 215,000 30,000 945,000
Depreciation b/f 337,500 60,000 2,500 400,000
Charge for year 12,500 5,000 2,500 20,000
Depreciation c/f 350,000 65,000 5,000 420,000
Carrying value 350,000 150,000 25,000 525,000

There have been no disposals of non-current assets in the period.


(b) A property was to be revalued at the end of the reporting period to $600,000. The property
had cost $400,000 including $80,000 in respect of land. Depreciation on the property at the

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25: Presentation of financial statements | Part C Accounting for business transactions

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)

1.5 Other aspects of HKAS 1


As well as prescribing the format and content of the financial statements, HKAS 1 provides
guidance on the general features of financial statements.
HKAS 1.5.1 True and fair view and compliance with HKFRS
1.15,16,18,19,
20,23 Financial statements must present a true and fair view of the financial position, performance and
cash flows of an entity. In other words, they must faithfully represent the effects of transactions and
other events in accordance with the basic principles of the Conceptual Framework.
The application of HKFRS and additional disclosure where necessary is presumed to result in a
true and fair view, and an entity which complies with HKFRS should state this fact in the notes to
the accounts. Inappropriate accounting treatments are not rectified either by disclosure of the
accounting policies used or by notes or explanatory material.
In extremely rare circumstances, compliance with a requirement of an HKFRS or HK(IFRIC) may
be so misleading that it would conflict with the objective of financial statements set out in the
Conceptual Framework, in which case the entity shall depart from that specific requirement.
In the case of such a departure, the entity must disclose the following:
1 That management has concluded that the financial statements present fairly the entity's
financial position, financial performance and cash flows.
2 That it has complied with applicable HKFRS except that it has departed from a particular
requirement to achieve a true and fair view.
3 Full details of the departure, and
4 The impact on the financial statements for each item affected and for each period presented.
If the relevant regulatory framework prohibits departure from the requirement, the entity shall, to the
maximum extent possible, reduce the perceived misleading aspects of compliance by disclosing:
1 The relevant HKFRS, the nature of the requirement and the reason why complying with the
requirement is misleading.
2 For each period presented, the adjustments to each item in the financial statements that
would be necessary to achieve a true and fair view.

HKAS 1.25 1.5.2 Going concern


As part of the process of preparing financial statements, the management of an entity should
assess the entity's ability to continue as a going concern.
Where doubt exists as to this ability, any uncertainties should be disclosed.

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Financial Reporting

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.

HKAS 1.5.3 Materiality and aggregation


1.29,30
HKAS 1 provides the following definition of material:

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))

The standard requires that:


(a) each material class of similar items is presented separately
(b) items of a dissimilar nature or function should be presented separately unless they are
immaterial
If a line item in the financial statements is not individually material, it is aggregated with other items;
an item which is not sufficiently material to warrant separate presentation in an individual statement
may warrant separate presentation in the notes.
HKAS 1.5.4 Disclosure of accounting policies
1.117,122
An entity must provide a summary of accounting policies and within it disclose the following:
(a) The measurement basis (or bases) used in preparing the financial statements, and
(b) The other accounting policies used that are relevant to an understanding of the financial
statements.
An entity must disclose, in the summary of significant accounting policies and/or other notes, the
judgments made by management in applying the accounting policies that have the most
significant effect on the amounts of items recognised in the financial statements.
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

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25: Presentation of financial statements | Part C Accounting for business transactions

1.5.7 Other matters


As well as those matters covered above, HKAS 1 (Revised) also requires the following:
(a) The accrual basis of accounting is used in the preparation of all financial statements except
for the statement of cash flows.
(b) Assets and liabilities and income and expenses are not offset unless permitted or required
by another HKFRS.
(c) A complete set of financial statements including comparative is presented at least annually.
(d) The presentation and classification of items in the financial statements is consistent from one
period to the next unless another presentation or classification becomes more appropriate or
an HKFRS requires another presentation or classification.
(e) Except when HKFRS permit or require otherwise, an entity shall disclose comparative
information in respect of the previous period for all amounts reported in the current period's
financial statements.

2 Current developments
In 2004, together with FASB, the IASB started a project to develop a standard to replace both
IAS 1 Presentation of Financial Statements and IAS 7 Statement of Cash Flows. The Boards' goal
is to reassess the layout of the main financial statements, together with how information is
aggregated in order to improve the usefulness of the information provided in an entity's financial
statements to help users make decisions in their capacity as capital providers.
The project is currently on hold while the Boards engage in outreach activities to ascertain
constituents' requirements from such a standard.

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Financial Reporting

Topic recap

HKAS 1 Presentation of Financial Statements

A complete set of financial statements includes:


Ÿ Statement of financial position at the end of the period
Ÿ Statement of profit or loss and other comprehensive income for the period
Ÿ Statement of changes in equity for the period
Ÿ Statement of cash flows for the period
Ÿ Notes to the financial statements
Ÿ Comparative information in respect of the preceding period
Ÿ Statement of financial position at the start of the preceding period when material
retrospective adjustment has taken place

Statement of financial Statement of profit or loss Statement of changes in


position and other comprehensive equity
income

Minimum disclosure Minimum disclosure Reconciliation of each


requirements requirements component of equity b/f and
c/f

Separately classified current Other comprehensive Disclose:


and non-current assets and income and related tax Ÿ Total comprehensive
liabilities effects must be grouped into: income attributable to
Ÿ amounts that will parent/NCI
Current include assets and not be reclassified Ÿ Retrospective
liabilities expected to be to profit or loss adjustments
realised/settled in the normal Ÿ amounts that may Ÿ Transactions with
operating cycle or expected be reclassified to owners in their capacity
to be realised/settled within profit or loss as owners
12 months

All other items are classified


as non-current

Shares and reserves


disclosures including:
Ÿ number of shares
in issue
Ÿ rights of each class of
shares
Ÿ nature and purpose of
each reserve

Other aspects of HKAS 1:


Ÿ Financial statements must present a true and fair view; this is presumed to result when an entity
complies with HKFRS
Ÿ In extremely rare circumstances the requirements of an HKFRS may be departed from; disclosure of
the departure is required
Ÿ Any uncertainties regarding going concern should be disclosed
Ÿ A summary of accounting policies must be disclosed
Ÿ Key assumptions and measurement uncertainty should be disclosed

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Answer to self-test question

Answer 1
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

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Financial Reporting

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR CHINATEA


CO. FOR THE YEAR ENDED 31 DECEMBER 20X9
$
Revenue 1,235,000
Cost of sales (740,000)
Gross profit 495,000
Distribution costs (115,230)
Administrative expenses (267,020)
Finance costs (7,400)
Profit before tax 105,350
Income tax expense (33,700)
Profit for the year 71,650
Other comprehensive income that will not be reclassified to profit or loss
Gains on property revaluation (W1) 380,000
Income tax relating to components of other comprehensive income (95,000)
Other comprehensive income for the year, net of tax 285,000
Total comprehensive income for the year 356,650

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

Depreciation b/f 337,500 60,000 2,500 400,000


Charge for year 12,500 5,000 2,500 20,000
Revaluation (180,000) – – (180,000)
Depreciation c/f 170,000 65,000 5,000 240,000
Carrying value
730,000 150,000 25,000 905,000

The revaluation surplus recognised as other comprehensive income is therefore $380,000


($200,000 + $180,000).

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2 New share issue


As the new share issue is made from the proceeds of previous share issues (ie share capital), no
reserves transfer is necessary. This transaction is therefore not evident in the statement of
changes in equity.
Within the financial statements, however, the company must disclose the number of shares in issue
at the current and previous year ends, being:
– 40,000 at 31 December 20X9
– 30,000 (3/4  40,000) at 31 December 20X8.

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Financial Reporting

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 market 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

Additional information provided:


(i) The property, plant and equipment are being depreciated as follows:
Buildings 5% per annum straight line
Plant and equipment 25% per annum diminishing balance
Depreciation of buildings is considered an administrative cost while depreciation of plant and
equipment should be treated as a cost of sale.
(ii) On 31 March 20X3 the land was revalued to $24,000,000.
(iii) Income tax for the year to 31 March 20X3 is estimated at $161,000. Ignore deferred tax.

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25: Presentation of financial statements | Part C Accounting for business transactions

(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 2 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)

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Financial Reporting

576
Part D

Group financial statements

The emphasis in this section is on the application of accounting standards relating to


consolidation. As prospective certified public accountants, it is important for you to be
equipped with sound professional knowledge and skills in resolving consolidation issues.
The purpose of this section is to develop your knowledge about the application of the relevant
accounting standards to prepare consolidated financial statements, to account for associates
and joint ventures and to handle difficult situations like acquisitions and the disposal of
subsidiaries.

577
Financial Reporting

578
chapter 26

Principles of consolidation

Topic list

1 Introduction to group accounting


1.1 Single economic entity and purpose of consolidated accounts
1.2 Group companies
1.3 Definitions
1.4 Levels of investment
2 Principles of consolidation
2.1 Control
2.2 Consolidated accounts
2.3 Consolidation procedures
3 Disclosure of interests in other entities
3.1 Disclosure of consolidated subsidiaries
3.2 Disclosure of unconsolidated subsidiaries (investment entities)
4 HKFRS 3 (revised) Business Combinations
4.1 Scope of HKFRS 3 (revised)
4.2 Definitions
4.3 Accounting for a business combination
5 Goodwill
5.1 Consideration transferred
5.2 Non-controlling interests
5.3 Fair value of identifiable assets acquired
5.4 Measurement period adjustments
5.5 Subsequent accounting
5.6 Disclosures

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.

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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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
4.03.01 Identify and describe the concept of a group as a single economic
entity
4.03.02 Define a subsidiary and when a group should start and stop
consolidating a subsidiary
4.03.03 Explain what constitutes control and the impact of potential voting
rights
4.03.04 Describe the reasons why the directors of a 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 statements
4.03.06 Explain the importance of eliminating intra-group transactions
4.03.07 Explain the importance of uniform accounting policies and
coterminous year ends in the preparation of consolidated accounts
4.03.08 Apply the appropriate accounting treatment of consolidated goodwill
4.06 Business combinations 3
4.06.01 Explain the scope of business combinations in accordance with
HKFRS 3 (revised)
4.06.02 Identify business combination and the difference between
acquisition of asset and business
4.06.03 Determine the acquisition date of an acquisition
4.06.04 Identify the identifiable assets (including intangibles) and liabilities
acquired in a business combination
4.06.05 Explain the recognition principle and measurement basis of
identifiable assets and liabilities and the exception
4.06.06 Explain what contingent consideration is and how to account for it
initially and subsequently
4.06.07 Explain how to account for acquisition-related costs, including those
related to issue debt or equity securities
4.06.08 Determine what is part of the business combination transaction and
the consideration
4.06.09 Calculate goodwill (including bargain purchase) and account for it
4.06.11 Account for non-controlling interest when the subsidiary has
negative equity balance
4.06.12 Explain and account for measurement period adjustments
4.10 Financial statement disclosure requirement 3
4.10.01 Disclose the relevant information for business combinations
occurred during and subsequent to the reporting period

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26: Principles of consolidation | Part D Group financial statements

1 Introduction to group accounting


Topic highlights
A group of companies develops when a parent company buys one or more subsidiaries. The group
should be regarded as a single economic entity for the purposes of accounting.

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.

1.1 Single economic entity and purpose of consolidated accounts


As groups grow, there is likely to be a very high level of buying and selling activity between group
companies (intra-group sales). Often such sales do not take place at market prices. Similarly one
group company may lend to another without charging interest or one company may provide
management services to another free of charge.
These group transactions distort the individual financial statements of each group company,
making it difficult for a user of the accounts to understand the performance and position of the
group as a whole.
Furthermore, where there are a large number of group companies, there may be many individual
sets of financial statements. Shareholders in the parent company (and so, by definition, the group)
cannot be expected to digest each individual set of financial statements in order to gain an
understanding of the group overall.
Therefore, financial statements are prepared for the group as a single economic entity. In other
words a single statement of financial position is prepared which combines the position of the parent
and all its subsidiaries and a single statement of profit or loss and other comprehensive income is
prepared which combines the performance of the parent and all its subsidiaries. Since a single
entity cannot transact with itself, the effects of any intra-group transactions are stripped out of these
consolidated financial statements.
Users of the accounts are therefore able to understand the position and performance of the group
as a result only of its transactions with parties outside the group.
The single economic entity concept and production of consolidated accounts is an example of the
concept of substance over form, whereby the commercial substance of the group of companies as
a whole has more relevance from an accounting perspective than the position of the individual
companies as legal entities.

1.2 Group companies


Above we have considered a group of companies to consist of a parent company and one or
more subsidiary companies which are controlled by the parent company. It is true that
consolidated financial statements are only prepared where a parent company has at least one
subsidiary, however other investments, including associates and joint arrangements may also be
identified and must be represented in the consolidated financial statements.

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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.

1.4 Levels of investment


Before we move on to discuss the principles of consolidation, the following table is useful in
summarising different types of group investment and how they are accounted for.

Required treatment in group


Investment Criteria accounts
Subsidiary Control Full consolidation (HKFRS 3
(revised)/HKFRS 10)
Associate Significant influence Equity accounting (HKAS 28)
Joint arrangement Contractual arrangement Equity accounting (HKFRS 11/HKAS
(joint venture) 28)
Investment which is none Asset held for accretion of As for single company accounts per
of the above wealth HKFRS 9

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26: 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.

HKFRS 10 Consolidated Financial Statements is applied in the preparation and presentation of


consolidated financial statements. It provides guidance on establishing a parent-subsidiary
relationship and prescribes the principles of consolidation.

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.
HKAS 27.14- 2.1.1 HKAS 27 (revised) definition of control
15
Control is defined in HKAS 27 (revised) as the power to govern the financial and operating
policies of an entity so as to obtain benefits from its activities.
The standard expanded on this definition to state that a control relationship is presumed to exist
where the parent owns, directly or indirectly through subsidiaries, more than half the voting
power of an entity, unless it can be demonstrated that such ownership does not constitute
control. In other words a company which holds more than 50% of voting shares in another
company controls that company.
The standard also lists the following situations where control exists, even when the parent owns
only 50% or less of the voting power of an entity.
(a) The parent has power over more than 50% of the voting rights by virtue of agreement with
other investors.
(b) The parent has power to govern the financial and operating policies of the entity by statute or
under an agreement.
(c) The parent has the power to appoint or remove a majority of members of the board of
directors (or equivalent governing body).

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Financial Reporting

(d) The parent has power to cast a majority of votes at meetings of the board of directors (or
equivalent governing body).
HKFRS 10.6, 2.1.2 HKFRS 10 definition of control
8
HKFRS 10, issued in June 2011 provides an amended definition, and identifies three separate
elements of control.
HKFRS 10 states that an investor controls an investee if and only if it has all of the following:
(a) Power over the investee (see below)
(b) Exposure, or rights, to variable returns from its involvement with the investee (see below),
and
(c) The ability to use its power over the investee to affect the amount of the investor’s returns
(see below).
If there are changes to one or more of these three elements of control, then an investor should
reassess whether it controls an investee.
HKFRS 2.1.3 Power
10.10-12, 14,
B11, B15, Power is defined as existing rights that give the current ability to direct the relevant activities
B18
of the investee. There is no requirement for that power to have been exercised.
Relevant activities may include:
 selling and purchasing goods or services
 managing financial assets
 selecting, acquiring and disposing of assets
 researching and developing new products and processes
 determining a funding structure or obtaining funding.
In some cases assessing power is straightforward, for example, where power is obtained directly
and solely from having the majority of voting rights or potential voting rights, and as a result the
ability to direct relevant activities.
In other cases, assessment is more complex and more than one factor must be considered.
HKFRS 10 gives the following examples of rights, other than voting or potential voting rights, which
individually, or alone, can give an investor power:
 Rights to appoint, reassign or remove key management personnel who can direct the
relevant activities
 Rights to appoint or remove another entity that directs the relevant activities
 Rights to direct the investee to enter into, or veto changes to transactions for the benefit of
the investor
 Other rights, such as those specified in a management contract.
HKFRS 10 suggests that the ability rather than contractual right to achieve the above may also
indicate that an investor has power over an investee.
An investor can have power over an investee even where other entities have significant influence
or other ability to participate in the direction of relevant activities.
HKFRS 2.1.4 Returns
10.15, B57
An investor must have exposure, or rights, to variable returns from its involvement with the investee
in order to establish control.
This is the case where the investor's returns from its involvement have the potential to vary as a
result of the investee's performance.

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26: Principles of consolidation | Part D Group financial statements

Returns may include:


 dividends
 remuneration for servicing an investee's assets or liabilities
 fees and exposure to loss from providing credit support
 returns as a result of achieving synergies or economies of scale through an investor
combining use of their assets with use of the investee's assets
HKFRS 2.1.5 Link between power and returns
10.17, B59
In order to establish control, an investor must be able to use its power to affect its returns from its
involvement with the investee. This is the case even where the investor delegates its decision
making powers to an agent.

HKFRS 10.19 2.2 Consolidated accounts


Where a parent controls one or more subsidiaries, HKFRS 10 requires that consolidated financial
statements are prepared to include all subsidiaries, both foreign and domestic other than:
 those held for sale in accordance with HKFRS 5
 those held under such long-term restrictions that control cannot be operated.
The rules on exclusion of subsidiaries from consolidation are necessarily strict, because this is a
common method used by entities to manipulate their results. If a subsidiary which carries a large
amount of debt can be excluded, then the gearing of the group as a whole will be improved. In
other words, this is a way of taking debt out of the consolidated statement of financial position.
HKFRS 10 is clear that a subsidiary should not be excluded from consolidation simply because it is
loss making or its business activities are dissimilar from those of the group as a whole. HKFRS 10
rejects the latter argument: exclusion on these grounds is not justified because better information
can be provided about such subsidiaries by consolidating their results and then giving additional
information about the different business activities of the subsidiary, e.g. under HKFRS 8 Operating
Segments.
HKFRS 10.4 2.2.1 Exemption from preparing group accounts
A parent need not present consolidated financial statements in the following circumstances:
(a) If all of the following apply:
(i) It 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 parent not presenting consolidated financial
statements
(ii) Its securities are not publicly traded
(iii) It is not in the process of issuing securities in public securities markets, and
(iv) The ultimate or intermediate parent publishes consolidated financial statements that
comply with International Financial Reporting Standards.
(b) If the parent is an investment entity which is required to measure its subsidiaries at fair value
through profit or loss (see below).
A parent that does not present consolidated financial statements must comply with the HKAS 27
(2011) rules on separate financial statements.

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Financial Reporting

HKFRS 2.2.2 Investment entities


10.27-33
HKFRS 10 was amended in December 2012 to address the issue of investment entities. An
investment entity is defined as an entity that:
(a) obtains funds from one or more investors for the purpose of providing those investors with
investment management services;
(b) commits to its investors that its business purpose is to invest funds solely for returns from
capital appreciation, investment income or both; and
(c) measures and evaluates the performance of substantially all of its investments on a fair
value basis.
Investment entities therefore include private equity organisations, venture capital organisations,
pension funds and other investment funds.
Prior to the amendment, entities such as these were required to apply HKFRS 10 and consolidate
all subsidiaries which they control. Investors and other users of the accounts felt, however, that
this did not result in useful information; the most useful and relevant information would be to
recognise investments at fair value.
As a result, HKFRS 10 is amended to require that investment entities measure subsidiaries at fair
value through profit or loss rather than consolidate them.
This requirement applies only to the subsidiaries of an investment entity which do not provide
services which relate to the investment entity’s activities. Subsidiaries which provide investment-
related services are consolidated as normal.

2.3 Consolidation procedures


Topic highlights
Consolidated financial statements are prepared by combining the assets; liabilities, income and
expenses of a parent and its subsidiaries on a line by line basis and cancelling any intra-group
amounts.
Financial statements prepared to the same date should be used.

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.

HKFRS 10. 2.3.1 Preparation of consolidated financial statements


22, B86
Consolidated financial statements are prepared by combining the financial statements of the parent
and its subsidiaries on a line by line basis. Practically, this involves adding together the parent's
and its subsidiaries' assets, liabilities, income and expenses. In addition:
 the carrying amount of the parent's investment in each subsidiary and the parent's proportion
of equity in each subsidiary are eliminated.
 non-controlling interests representing the equity of subsidiaries which does not belong to the
parent are recognised.
The application of these procedures is considered in more detail in the next chapter.
HKFRS 2.3.2 Intra-group transactions
10.B86
As the consolidated financial statements are prepared for a group as a single economic entity,
intra-group balances and transactions should be eliminated as part of the consolidation process.
As we have already said, these amounts may be distorted due to the group relationship, and so
may result in the presentation of misleading group performance or position.

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26: Principles of consolidation | Part D Group financial statements

To take an example, assume that a group company bought an asset from a non-group company
paying the market price of $100 and sold this to another group company for $300, so making a
$200 profit. The second company then sold the asset to a third group company for $600, so making
a $300 profit. If the effects of this intra-group transaction were not eliminated from the consolidated
accounts, assets and profits would both be overstated by $500.
HKRS 10, 2.3.3 Coterminous year end
B92,93
In most cases, all group companies will prepare accounts to the same reporting date. One or more
subsidiaries may, however, prepare accounts to a different reporting date from the parent and the
bulk of other subsidiaries in the group.
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
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.

3 Disclosure of interests in other entities


HKFRS 12.7 HKFRS 12 Disclosure of Interests in Other Entities was issued in June 2011 as part of the
"package of five standards" relating to consolidation. It removes all disclosure requirements from
other standards relating to group accounting and provides guidance applicable to consolidated
financial statements.

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Financial Reporting

The standard requires disclosure of:


(a) the significant judgments and assumptions made in determining the nature of an interest in
another entity or arrangement, and in determining the type of joint arrangement in which an
interest is held
(b) information about interests in subsidiaries (including those which are not consolidated as a
result of the investment entity exception), associates, joint arrangements and structured
entities that are not controlled by an investor.
Disclosures requirements in respect of associates and joint arrangements are given in Chapter 28.

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.

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26: Principles of consolidation | Part D Group financial statements

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.
(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.

HKFRS 3.2 Disclosure of unconsolidated subsidiaries (investment


12.19A-G
entities)
An investment entity is required to disclose:
(a) the fact that the exception to consolidation is applied and that subsidiaries are instead
measured at fair value through profit or loss
(b) details of each unconsolidated subsidiary including name, place of business and proportion
of ownership interest held

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Financial Reporting

(c) the nature and extent of any significant restrictions on the ability of an unconsolidated
subsidiary to transfer funds to the investment entity
(d) any current commitments or intentions to provide support to an unconsolidated subsidiary
(e) details of non-contractual support provided to an unconsolidated subsidiary in the period
(f) the terms of any contractual arrangements that may require the provision of financial support
to an unconsolidated subsidiary
(g) details of non-contractual support provided in the period to an unconsolidated structured
entity that the investment entity did not control but which resulted in control being achieved.

4 HKFRS 3 (revised) Business Combinations


Topic highlights
HKFRS 3 (revised) provides guidance on the measurement of net assets acquired in a business
combination, the non-controlling interest and goodwill arising on a business combination.

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

HKFRS 3.2 4.1 Scope of HKFRS 3 (revised)


HKFRS 3 (revised) applies to business combinations, defined as transactions in which an
acquirer obtains control of one or more businesses. It does not apply to:
 the formation of a joint venture
 the acquisition of an asset or group of assets that does not constitute a business
 a combination between entities or businesses under common control
 the acquisition of a subsidiary that is required to be measured at fair value through profit or
loss by an investment entity.
Where a group of assets and liabilities is purchased which does not constitute a business, the
assets and liabilities are recognised in the purchaser's financial statements in accordance with
relevant standards including HKAS 16 and HKAS 38. The cost of the group is allocated to the
individual identifiable assets and liabilities on the basis of their fair values at the date of acquisition.
Goodwill does not arise on such a purchase.

HKFRS 3, 4.2 Definitions


Appendix A
In addition to those definitions seen earlier in the chapter, HKFRS 3 (revised) provides the
following:

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26: Principles of consolidation | Part D Group financial statements

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.
Contingent consideration. Usually, an obligation of the acquirer to transfer additional assets or
equity interests to the former owners of an acquiree as part of the exchange for control of the
acquiree if specified future events occur or conditions are met.
Goodwill is an asset representing the future economic benefits arising from other assets acquired
in a business combination that are not individually indentified and separately recognised.
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.
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, or
(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.
(HKFRS 3 (revised))

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

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Financial Reporting

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.
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.

HKFRS 4.3.3 Recognising and measuring assets, liabilities and the


3.10,11,18
non-controlling interests
The acquirer should recognise at the acquisition date:
 Identifiable assets acquired
 Liabilities assumed
 Non-controlling interest
 Goodwill
In doing so, the acquirer should apply the recognition criteria of the Conceptual Framework. This
may result in the acquirer recognising some assets and liabilities that the acquiree had not
previously recognised, for example intangible assets generated internally by the acquiree.
The identifiable assets recognised should be measured at fair value at the acquisition date.
The application of these principles is seen in more detail in section 5 of this chapter.
HKFRS 3.32 4.3.4 Recognising and measuring goodwill
Goodwill is measured as the excess of the fair value of consideration transferred plus the
amount of non-controlling interests over the fair value of identifiable net assets of the
acquiree on the acquisition date.

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In some cases this will result in a positive amount of goodwill; in others a negative amount is
calculated, referred to as a gain on a bargain purchase.
The elements of the calculation of goodwill are considered in more detail in the next section of this
chapter.
Where an acquisition is achieved in steps, there may be an extra element to the calculation; step
acquisitions are considered in a later chapter.

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.

As we saw in Chapter 8, goodwill is created by good relationships between a business and its
customers, a good reputation, customer base, and other intangible elements. It is not usually
valued in the accounts of a business at all, however it is likely to arise in:
 the financial statements of an individual company where that company buys an
unincorporated business
 consolidated financial statements where a parent company buys a subsidiary.
As we saw earlier, goodwill arising on a business combination is calculated as:
$
Consideration transferred X
Amount of any non-controlling interests X
Less: net acquisition-date fair value of identifiable assets acquired
and liabilities assumed (X)
X
We shall consider each of the elements of the calculation in turn.
HKFRS 3.37
5.1 Consideration transferred
Consideration or payment transferred to achieve a controlling share in another business may take
a number of forms including:
 cash
 other assets
 ordinary or preference instruments
 debt instruments
Consideration may be immediate or deferred. Where it is deferred, payment may be contingent
upon an event, or upon the acquiree attaining certain financial or non-financial goals.
The basic principle of HKFRS 3 (revised) is that consideration transferred in a business
combination should be measured at fair value.

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Financial Reporting

HKFRS 3.39- 5.1.1 Contingent consideration


40
Contingent consideration is defined by HKFRS 3 (revised) as:
 an obligation of the acquirer to transfer additional assets or equity interests to the former
owners of an acquiree as part of the exchange for control of the acquiree if specified future
events occur or conditions are met, or
 the right of the acquirer to the return of previously transferred consideration if specified
conditions are met.
Therefore, contingent consideration may be a liability/equity (in the first case) or an asset (in the
second case) of the acquirer.
Contingent consideration is a part of many transactions where there are substantial uncertainties
about how the acquired business will perform post-transaction.
A common example of a contingent consideration liability is an earn-out clause, with future
additional payments of consideration conditional on reaching milestones, or on the level of sales or
profitability.
A contingent consideration asset may arise if the acquiree fails to meet targets, fails to pass
regulatory reviews or fails to meet covenants and the former owners are therefore required to
return to the acquirer consideration already paid.
Under HKFRS 3 (revised), contingent consideration is to be recognised at acquisition-date fair
value as part of the consideration transferred. Fair value may be estimated through the use of a
number of different methods.
Example: Contingent consideration (1)
Anderson Co. acquires all of the ordinary share capital of Potter Co. for $100m on 1 January
20X1. In addition, the purchase agreement stipulates that a further payment will be required
dependent on the earnings of Potter Co. post acquisition. The terms of the contract call for
additional cash consideration to be paid two years after the acquisition in the event that Potter
Co.’s earnings exceed $5m in each of the next two years subject to an earnings cap of $7m. For
earnings in excess of $5m, Anderson Co. is required to pay 20% of the excess to the previous
shareholders. In this situation, the minimum amount that could be paid is nil and the maximum is
$0.4m (($7m – $5m)  20%).
Management have used a simulation model to ascertain the fair value of the contingent
consideration and estimated it to be $0.25 million.
On the acquisition date the fair value of the identifiable net assets of Potter Co. was $96m.
(a) What goodwill arises on the acquisition of Potter Co.?
(b) State how the investment in Potter Co. is recorded in the individual financial statements of
Anderson Co. in the year ended 31 October 20X1.
Solution
(a)
$'000
Cash consideration 100,000
Fair value of contingent consideration 250
Fair value of identifiable net assets of acquiree (96,000)
Goodwill 4,250

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(b) 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
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) Account for the change under HKFRS 9 if the consideration is in the form of a financial
instrument, for example loan notes.
(ii) Account for the change under HKAS 37 if the consideration is in the form of cash.
(iii) An equity instrument is not remeasured.

Example: Contingent consideration (2)


To continue with the above example, assume the following:
(a) Further information has been received by the management of Anderson Co. on 1 June 20X1
which has led them to re-assess the acquisition date fair value of the contingent
consideration to be $0.2m.
(b) At the end of the first year of the earnout period, Potter Co. reports earnings of $8 million.
The fair value of contingent consideration in relation to the second year at this stage is
estimated to be $0.1m.
Considering each of these separately, how are the calculation of goodwill and Anderson Co.’s
journal to recognise the investment in Potter Co. affected?
Solution
(a) In this instance the goodwill arising in Potter Co. is remeasured:
$'000
Cash consideration 100,000
Fair value of contingent consideration 200
Fair value of identifiable net assets of acquiree (96,000)
Goodwill 4,200
Anderson Co. should therefore have recorded the investment in Potter Co. by:
$'000 $'000
DEBIT Investment 100,200
CREDIT Cash 100,000
Liability for contingent consideration 200

Adjustment to the original acquisition journal made is therefore required:

$'000 $'000
DEBIT Liability for contingent consideration 50
CREDIT Investment 50

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Financial Reporting

(b) In this instance, goodwill is not remeasured because the change in the estimated fair value
of contingent consideration is due to events which took place after the acquisition date; it
remains at the acquisition date amount of $4.25m. The liability in Anderson’s financial
statements is, however adjusted to reflect the new estimate of the amount of contingent
consideration payable:
Payable in respect of: $'000
Year 1 (($7m – $5m)  20%) 400
Year 2 100
500
Therefore:
$'000 $'000
DEBIT Profit or loss (500 – 250) 250
CREDIT Liability for contingent consideration 250

HKFRS 3.51 5.1.2 Pre-existing relationships


All consideration transferred will need to be carefully analysed to determine whether it is really part
of the business combination transaction. Pre-existing relationships between the acquirer and the
acquiree will need to be accounted for separately from the business combination. For example, the
acquirer may have a payable balance due to the acquiree, which is effectively settled through the
business combination. Where the former owners or employees receive payments, a number of
factors have been included to assist the identification of whether this is for future services or not,
and should be accounted for as compensation.

HKFRS 3.53 5.1.3 Acquisition-related costs


Under HKFRS 3 (revised) costs relating to an acquisition must be recognised as an expense
at the time of the acquisition. They are not regarded as an asset or as part of the cost of
acquisition. Costs of issuing debt or equity are to be accounted for under the rules of HKFRS 9
(Chapter 18, sections 2.6 and 4).

HKFRS 3.19 5.2 Non-controlling interests


The revised HKFRS 3 views the group as an economic entity. This means that it treats all
providers of equity including non-controlling interests as shareholders in the group, even if
they are not shareholders in the parent. It is for this reason that the non-controlling interests form
part of the calculation of goodwill.
The question now arises as to how it should be valued.
HKFRS 3 (revised) applies a different rule to the measurement of the non-controlling interest
depending on whether or not the relevant shareholders are entitled to a proportionate share of the
entity’s net assets in the event of liquidation.
Where holders of the non-controlling interest are entitled to a proportionate share of the net assets
on a liquidation, HKFRS 3 (revised) requires that the non-controlling interest in the acquiree is
measured either at:
 fair value or
 the non-controlling interests' proportionate share of the acquiree's identifiable net assets.
Where holders of the non-controlling interest are not entitled to a proportionate share of the net
assets on a liquidation, the non-controlling interest should be measured at fair value.
The non-controlling interests measured at fair value will be different from the non-controlling
interests measured at proportionate share of the acquiree's net assets. The difference is
goodwill attributable to the non-controlling interests. This will become more apparent when we see
some examples.

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26: Principles of consolidation | Part D Group financial statements

HKFRS 5.2.1 Measurement at fair value


3.B44-45
The non-controlling interest is measured at its fair value, determined on the basis of a quoted price
in an active market for equity shares not held by the acquirer or, if this is not available, by using
another valuation technique.
The amount of consideration transferred by an acquirer is not usually indicative of the fair value of
the non-controlling interests, because consideration transferred by the acquirer will generally
include a control premium. Therefore, it is not normally appropriate to determine the fair value of
the acquired business as a whole or that of the non-controlling interests by extrapolating the fair
value of the acquirer's interest. Hence, adopting this option means that additional time and
expertise may be needed to determine the fair value of the non-controlling interests.
The result of the application of the fair value method is that recognised goodwill represents all of
the goodwill of the acquired business, not just the acquirer's share.

Example: Fair value option


Entity B has 40% of its shares publicly traded on an exchange. Entity A purchases the
60% non-publicly traded shares in one transaction, paying $630,000. Based on the trading price of
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

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Financial Reporting

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.

5.2.2 Choice of method


Where available, the choice of measurement method for the non-controlling interests is made for
each business combination (rather than being an accounting policy choice).
It will require management to carefully consider their future intentions regarding the acquisition of
the non-controlling interests, as, where less than 100% of the acquired business is purchased, the
two methods will potentially result in significantly different amounts of goodwill.
Measuring the non-controlling interest at fair value may prove to be a difficult exercise, however
there are benefits:
 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 29, 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.

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26: Principles of consolidation | Part D Group financial statements

The following table summarises the impact at various stages of the two methods of measuring the
non-controlling interest:

Fair value Proportion of net assets

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.

HKFRS
3.11,12,18,
5.3 Fair value of identifiable assets acquired
HKFRS 13. 9- HKFRS 3 (revised) requires that the net assets of the acquiree on the acquisition date are
33,76, 81, 86
measured at fair value for inclusion within the consolidated financial statements and the goodwill
calculation except in limited, stated cases. The assets and liabilities must:
(a) meet the definitions of assets and liabilities in the Conceptual Framework.
(b) be part of what the acquiree (or its former owners) exchanged in the business combination
rather than the result of separate transactions.
HKFRS 13 Fair Value Measurement provides extensive guidance on how the fair value of assets
and liabilities should be established.
This standard requires that the following are considered in determining fair value:
1 The asset or liability being measured
2 The principal market (i.e. that where the most activity takes place) or where there is no
principal market, the most advantageous market (i.e. that in which the best price could be
achieved) in which an orderly transaction would take place for the asset or liability.
3 The highest and best use of the asset or liability and whether it is used on a standalone
basis or in conjunction with other assets or liabilities.

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Financial Reporting

4 Assumptions that market participants would use when pricing the asset or liability.
Having considered these factors, HKFRS 13 provides a hierarchy of inputs for arriving at fair value.
It requires that level 1 inputs are used where possible:
Level 1 Quoted prices in active markets for identical assets that the entity can access at the
measurement date.
Level 2 Inputs other than quoted prices that are directly or indirectly observable for the asset.
Level 3 Unobservable inputs for the asset.
Fair values may be incorporated into the books of the acquiree in either of the following ways:
(a) The subsidiary company might incorporate any necessary revaluations in its own books
of account. In this case, we can proceed directly to the calculation of goodwill and in turn the
consolidation, taking asset values and reserves figures straight from the subsidiary
company's statement of financial position.
(b) The revaluations may be made as a consolidation adjustment without being
incorporated in the subsidiary company's books. In this case, we must make the necessary
adjustments to the subsidiary's statement of financial position as a working. Only then can
we proceed to the consolidation. Such adjustments are normally incorporated into the
goodwill working, as shown in the following example.

Example: Fair value adjustments


Polly Co. acquired 75% of the 20,000 ordinary shares of Surrey Co. on 1 September 20X8 for
$51,000. At that date the fair value of Surrey Co.'s non-current assets was $23,000 greater than
their carrying amount, and the balance of retained earnings was $21,000. The non-controlling
interests are measured as a proportion of the net assets of the acquiree.
Calculate the goodwill arising on the business combination.

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:
$
Share capital (100,000 shares) 100,000
Retained earnings 249,000
Revaluation reserve 50,000

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26: Principles of consolidation | Part D Group financial statements

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%.
What goodwill arises on the acquisition of the controlling interests in Small Co., assuming that the
non-controlling interests is measured at fair value?
(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
HKFRS 5.3.3 Contingent liabilities
3.23,56
Contingent liabilities of the acquiree are recognised if their fair value can be measured reliably.
A contingent liability must be recognised even if the outflow is not probable, provided there is a
present obligation.
This is a departure from the normal rules in HKAS 37; contingent liabilities are not normally
recognised, but only disclosed.
After their initial recognition, the acquirer should measure contingent liabilities that are recognised
separately at the higher of:
(a) the amount that would be recognised in accordance with HKAS 37
(b) the amount initially recognised

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Financial Reporting

HKFRS 3.29 5.3.4 Reacquired rights


If the acquirer reacquires a right that it had previously granted to an acquiree (for example, the use
of a trade name), the right will be recognised as an identifiable intangible asset, separately from
goodwill.
HKFRS 3.27 5.3.5 Indemnification assets
Indemnification assets, such as an indemnity for an uncertain tax position or contingent liability, are
recognised and measured based on the same measurement principles and assumptions as the
related liability.
HKFRS 5.3.6 Other exceptions to the recognition or measurement principles
3.24,26,30,31
HKFRS 3 (revised) requires that the relevant standard is applied in measuring and recognising the
following:
(a) Deferred tax: use HKAS 12 values.
(b) Employee benefits: use HKAS 19 values.
(c) Share-based payment: use HKFRS 2 values.
(d) Assets held for sale: use HKFRS 5 values.

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.
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.

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26: Principles of consolidation | Part D Group financial statements

Example: Measurement period adjustments


Yeltsin Co. acquired 100% of Johnson Co. on 1 March 20X1, agreeing to pay cash consideration of
$78 million. The provisional fair value allocated to the net assets of Johnson Co. at the acquisition
date was $71 million, however the management of Yeltsin Co. have engaged third party experts in
order to reliably measure the fair value of the intangible assets of Johnson Co. at this date.
The reporting date of Yeltsin Co. is 30 June 20X1, and at this date the third party experts have not
yet concluded their work.
On 18 August 20X1, the experts report to management that the fair value of one of Johnson’s
intangible assets is $2m greater than the provisional value allocated to it. They also confirm the
presumption that the asset has an indefinite useful life.
Required
Calculate the value of goodwill recognised in the financial statements of the Yeltsin Group on
30 June 20X1 and 30 June 20X2.

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.
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.

603
Financial Reporting

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)

5.5 Subsequent accounting


Topic highlights
Purchased positive goodwill is retained in the statement of financial position as an intangible
asset under the requirements of HKFRS 3 (revised). It must then be reviewed for impairment
annually.
A bargain purchase is reassessed. If a bargain purchase remains, it is recognised as a gain in
profit or loss.

5.5.1 Positive goodwill


Positive goodwill acquired in a business combination is recognised as an asset and is initially
measured at cost. Cost is the excess of the cost of the combination over the acquirer's interest in
the net fair value of the acquiree's identifiable assets, liabilities, and contingent liabilities.
After initial recognition goodwill acquired in a business combination is measured at cost less any
accumulated impairment losses. It is not amortised. Instead it is tested for impairment at least
annually, in accordance with HKAS 36 Impairment of Assets.

HKFRS 3.34- 5.5.2 Bargain purchase


36
A bargain purchase arises when the net of the acquisition-date amounts of the identifiable assets
acquired and the liabilities assumed exceeds the consideration transferred. It may also be referred
to as negative goodwill.
Before recognising a gain on a bargain purchase, the acquirer must reassess whether it has
correctly identified all of the assets acquired and all of the liabilities assumed and must
recognise any additional assets or liabilities that are identified in that review. The acquirer must
then review the procedures used to measure the amounts this HKFRS requires to be recognised at
the acquisition date for all of the following:
(a) The identifiable assets acquired and liabilities assumed
(b) The non-controlling interests in the acquiree, if any
(c) The consideration transferred
The purpose of this review is to ensure that the measurements appropriately reflect all the available
information as at the acquisition date.
5.5.3 Non-controlling interests at the end of reporting period
It is important to realise that the measurement of the non-controlling interests (NCI) only applies at
the date of acquisition. Subsequent to acquisition, the fair value of the subsidiary's net assets will
have changed. The non-controlling interests at a given reporting date can therefore be calculated
either by:
(a) calculating the NCI proportion of the net assets of the acquiree at the reporting date. 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 and adding this to NCI as
measured at the acquisition date.

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26: Principles of consolidation | Part D Group financial statements

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

Non-controlling interests at 31 December 20X7


Non-controlling interests at acquisition 222,000 250,000
Share of retained profits (30%  $100,000) 30,000 30,000
252,000 280,000

Proportion of net assets Fair value


method method
$ $
Or
Share of net assets at reporting date
30%  ($740,000 + $100,000) 252,000 252,000
Goodwill ($250,000 – (30%  $740,000)) – 28,000
252,000 280,000

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.

605
Financial Reporting

Self-test question 3
Abacus prepares accounts to 31 December. On 1 September 20X7 Abacus acquired 6 million
shares in Knowledge Co. (KC) at $2.00 per share. At that date KC produced the following interim
statement of financial position:
Non-current assets $m $m
Property, plant and
equipment (Note 1) 16.0
Current assets
Inventories (Note 2) 4.0
Receivables 2.9
Cash in hand 1.2
8.1
Current liabilities
Trade payables 3.2
Provision for taxation 0.6
Bank overdraft 3.9
[[[[[(((((7.7)
Non-current liabilities
Long-term loans (4.0)
Net assets 12.4
Equity
Share capital (8m shares) 8.0
Reserves 4.4
12.4
Notes
1 The following information relates to the property, plant and equipment of KC at 1 September
20X7.
$m
Gross replacement cost 28.4
Net replacement cost 16.6
Economic value 18.0
Net realisable value 8.0
The property, plant and equipment of KC at 1 September 20X7 had a total purchase cost to
KC of $27.0 million. They were all being depreciated at 25% per annum pro rata on that cost.
This policy is also appropriate for the consolidated financial statements of Abacus. No non-
current assets of KC which were included in the interim financial statements drawn up as at
1 September 20X7 were disposed of by KC prior to 31 December 20X7. No non-current
asset was fully depreciated by 31 December 20X7.
2 The inventories of KC which were shown in the interim financial statements are raw materials
at cost to KC of $4 million. They would have cost $4.2 million to replace at 1 September
20X7. Of the inventory of KC in hand at 1 September 20X7, goods costing KC $3.0 million
were sold for $3.6 million between 1 September 20X7 and 31 December 20X7.
3 On 1 September 20X7 Abacus took a decision to rationalise the group so as to integrate KC.
The costs of the rationalisation were estimated to total $3.0 million and the process was due
to start on 1 March 20X8. No provision for these costs has been made in any of the financial
statements given above.
4 The non-controlling interests are measured as a proportion of the net assets of the acquiree.

606
26: Principles of consolidation | Part D Group financial statements

Required
Compute the goodwill on consolidation of KC that will be included in the consolidated financial
statements of the Abacus group for the year ended 31 December 20X7, explaining your treatment
of the items mentioned above. You should refer to the provisions of relevant accounting standards.
(The answer is at the end of the chapter)

HKFRS 3.59-
63
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
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 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.

607
Financial Reporting

Topic recap

Principles of consolidation

Levels of investment

Subsidiary Associate Joint arrangement Investment


Ÿ control Ÿ significant Ÿ contractual Ÿ accretion of wealth
Ÿ consolidate influence arrangement Ÿ financial asset
Ÿ equity account Ÿ equity account Chapter 18
Chapter 28 Chapter 28

HKFRS 10 Consolidated Financial


HKFRS 3 Business Combinations
Statements

Control is established where an investor Goodwill:


has: Consideration transferred X
1 power over the investee Non-controlling interests X
2 exposure to variable returns from its Fair value of net assets of acquiree (X)
involvement with the investee X
3 the ability to use the power to affect
returns

Consideration:
Ÿ Contingent consideration included at
fair value
Ÿ Payment in respect of pre-existing
Consolidated financial statements must relationships is not part of
be prepared for all subsidiaries under the consideration
Ÿ Acquisition-related costs are
control of a parent other than those held
for sale. recognised as an expense

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. Ÿ Fair value adjustments are either
recognised by the acquiree or made as
a consolidation adjustment.
Ÿ Provisions for future losses/
Consolidation procedures:
restructuring are not recognised
Ÿ The parent's and subsidiaries'
Ÿ Intangible assets are recognised if
financial statements are combined
identifiable
on a line by line basis.
Ÿ Contingent liabilities are recognised at
Ÿ Intra-group balances and
fair value if reliable
transactions are eliminated.
Ÿ Adjustments must be made where a
subsidiary has a different year-end
Ÿ Positive goodwill is recognised as an
from a parent.
Ÿ Uniform accounting policies are
asset and tested for impairment
applied. annually
Ÿ Negative goodwill is reviewed and is
Ÿ A subsidiary is included from the
date on which control is obtained. then recognised as a gain on bargain
purchase.

608
26: Principles of consolidation | Part D Group financial statements

Answers to self-test questions

Answer 1
$ $
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
Book value 399,000
Land 60,000
Provision (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.

Answer 2
STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER
20X7 – EXTRACT $

Property, plant and equipment (W) 285,000

WORKING
Provisional value of asset 300,000
Depreciation (300,000 / 5 years)  3/12 (15,000)
285,000

STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X8 20X7


20X8 – EXTRACT $ $

Property, plant and equipment (W)


300,000 380,000

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

609
Financial Reporting

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 $5,000
being the difference between the depreciation charge as recognised in the 20X7 financial
statements, based on the provisional value and the depreciation charge for 20X7 based on the fair
value (HK$'000):
$'000 $'000
DEBIT Property, plant and equipment 95
DEBIT Depreciation expense 5
CREDIT Goodwill 100

Answer 3
Goodwill on consolidation of Knowledge Co.
$m $m
Consideration ($2.00  6m) 12.0
Non-controlling interests ($13.2m  25%) 3.3
15.3
Group share of fair value of net assets acquired
Share capital 8.0
Pre-acquisition reserves 4.4
Fair value adjustments
Property, plant and equipment ($16.6m – $16.0m) 0.6
Inventories ($4.2m – $4.0m) 0.2
(13.2)
Goodwill 2.1
Notes on treatment
1 Share capital and pre-acquisition profits represent the book value of the net assets of KC at
the date of acquisition. Adjustments are then required to this book value in order to give the
fair value of the net assets at the date of acquisition. For short-term monetary items, fair
value is their carrying value on acquisition.
2 The fair value of property, plant and equipment should be determined by market value or, if
information on a market price is not available (as is the case here), then by reference to
depreciated replacement cost, reflecting normal business practice. The net replacement cost
(i.e. $16.6m) represents the gross replacement cost less depreciation based on that amount,
and so further adjustment for extra depreciation is unnecessary.
3 Raw materials should be valued at replacement cost. In this case that amount is $4.2 million.
4 The rationalisation costs cannot be reported in pre-acquisition results under HKFRS 3
(revised) as they are not a liability of KC at the acquisition date.

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26: 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)

611
Financial Reporting

612
chapter 27

Consolidated accounts:
accounting for subsidiaries
Topic list

1 Consolidated financial statements


1.1 Mechanics of consolidation
2 Consolidated statement of financial position
2.1 Goodwill
2.2 Group reserves
2.3 Non-controlling interests
2.4 Fair value adjustments
2.5 Intra-group transactions
3 Consolidated statement of profit or loss and other comprehensive income
3.1 Non-controlling interests
3.2 Intra-group transactions
3.3 Mid-year acquisitions
4 Recap of simple consolidation techniques
5 Complex groups
5.1 Vertical groups
5.2 D-shaped groups

Learning focus

Group accounting is relevant to many entities. You should be able to perform a simple
consolidation.

613
Financial Reporting

Learning outcomes

In this chapter you will cover the following learning outcomes:

Competency
level
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

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

1 Consolidated financial statements


Topic highlights
Consolidated financial statements are prepared by adding together the parent and subsidiary's
assets, liabilities, income and expenses and eliminating the cost of the investment in the subsidiary
against the parent's equity in the subsidiary.

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.

1.1 Mechanics of consolidation


The basic mechanics of consolidation seen in the last chapter were as follows:
(a) Add together the parent's and subsidiaries' assets, liabilities, income and expenses on a line
by line basis, eliminating any intra-group balances or transactions.
(b) Eliminate the carrying amount of the parent's investment in each subsidiary and the parent's
proportion of equity in each subsidiary.
(c) Recognise non-controlling interests representing the equity of subsidiaries which does not
belong to the parent where relevant.
In this chapter we shall apply these rules to both the consolidated statement of financial position
and consolidated statement of profit or loss and other comprehensive income in turn.

2 Consolidated statement of financial position


Topic highlights
The consolidated statement of financial position includes only the parent's share capital.

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.

Example: Consolidated statement of financial position


Let us assume that the parent company buys all of the ordinary shares in the subsidiary for
$100,000:
STATEMENTS OF FINANCIAL POSITION AT ACQUISITION DATE
Parent Subsidiary Adjustments Consolidated
$ $ $ $
Non-current assets 160,000 90,000 250,000
Investment in subsidiary 100,000 - (100,000) -
Current assets 58,000 30,000 88,000
318,000 120,000 338,000

615
Financial Reporting

Share capital 100,000 30,000 (30,000) 100,000


Retained earnings 180,000 70,000 (70,000) 180,000
Liabilities 38,000 20,000 58,000
318,000 120,000 338,000

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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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

Goodwill is calculated as:


$
Consideration 3,800
Net assets of B Co. (3,500)
300
CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO AS AT 31 DECEMBER
20X7
Consolidated
A Co. B Co. Adjustments A Co.
$ $ $ $
Non-current assets 4,000 3,200 – 7,200
Investment in B Co. 3,800 – (3,800) –
Goodwill – – 300 300
Current assets 2,400 500 – 2,900
10,200 3,700 10,400
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
Current liabilities 300 200 – 500
10,200 3,700 10,400
Note. Consolidation adjustments are memoranda only, they are not part of bookkeeping
procedures in the individual company's accounting records.
Consolidation adjustment
$ $
DEBIT Share capital 3,000
Pre-acquisition reserves (B Co.) 500
Goodwill on consolidation 300
CREDIT Cost of investment 3,800
To recognise the acquisition of B Co and goodwill arising

2.2 Group reserves


Topic highlights
Group reserves are calculated as all of the parent company's reserves plus the group share of the
post-acquisition reserves in the subsidiary.

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.

Example: Group retained earnings


This example continues from the previous example (Goodwill) but has moved on a year, during
which time B Co. has made post-acquisition profits of $200.

617
Financial Reporting

STATEMENTS OF FINANCIAL POSITION OF A CO. AND B CO. AT 31 DECEMBER 20X8


A Co. B Co.
$ $
Non-current assets 5,000 3,500
Investment in B Co. 3,800 –
Current assets 2,000 800
10,800 4,300
Represented by:
Share capital 8,000 3,000
Reserves 1,900 700
9,900 3,700
Current liabilities 900 600
10,800 4,300
CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO AS AT 31 DECEMBER 20X8
Consolidated
A Co. B Co. Adjustments A Co.
$ $ $ $
Non-current assets 5,000 3,500 – 8,500
Investment in B Co. 3,800 – (3,800) –
Goodwill – – 300 300
Current assets 2,000 800 – 2,800
10,800 4,300 11,600
Represented by:
Share capital 8,000 3,000 (3,000) 8,000
Reserves 1,900 700 (500) 2,100
9,900 3,700 10,100
Current liabilities 900 600 – 1,500
10,800 4,300 11,600

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.

2.3 Non-controlling interests


Topic highlights
The non-controlling interests are shown in the equity and liabilities section of the consolidated
statement of financial position. The acquisition date measurement (fair value or a proportion of net
assets) increases by the non-controlling interest's share of post-acquisition reserves.

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.

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

Example: Non-controlling interests (1)


This example is based on the same information as that previously, but we shall assume that A Co.
acquires only 2,400 of the 3,000 shares of B Co., and that the non-controlling interests are
measured as a proportion of the net assets of the subsidiary.
Note that in this example the statement of financial position is being prepared at the acquisition
date.
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
Goodwill working
Consideration 3,800
Non-controlling interests at date of acquisition ($3,500  20%) 700
4,500
Less: net assets of B Co.
Share capital 3,000
Reserves 500
(3,500)
Goodwill 1,000
CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO AS AT 31 DECEMBER 20X7
Consolidated
A Co. B Co. Adjustments A Co.
$ $ $ $
Non-current assets 4,000 3,200 – 7,200
Investment in B Co. 3,800 – (3,800) –
Goodwill – – 1,000 1,000
Current assets 2,400 500 – 2,900
10,200 3,700 11,100
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 – – 700 700
Current liabilities 300 200 500
10,200 3,700 11,100

619
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.

Example: Non-controlling interests (2)


Again, this example is based on the same information as previous worked examples but this time
we'll assume that A Co. acquires only 2,400 of the 3,000 shares of B Co. and the fair value of the
20% non-controlling interests was $950. The non-controlling interest is measured at fair value at
the acquisition date.
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
GOODWILL WORKING
Consideration 3,800
Non-controlling interests (at fair value) 950
4,750
Less: Net assets of B Co.
Share capital 3,000
Reserves 500
(3,500)
Goodwill 1,250
CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO. AS AT 31 DECEMBER 20X7

Consolidated
A Co. B Co. Adjustments A Co.
$ $ $ $
Non-current assets 4,000 3,200 – 7,200
Investment in B Co. 3,800 – (3,800) –
Goodwill – – 1,250 1,250
Current assets 2,400 500 – 2,900
10,200 3,700 11,350

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27: 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.

2.3.1 Non-controlling interests and post acquisition profits


Now we shall consider how a non-controlling interest impacts the mechanics of the consolidation
when we also have post acquisition retained earnings to consider.

Example: NCI and post acquisition profits (1)


This example is based on the same information as previous worked examples but now assume
that:
 A Co. acquires only 2,400 of the 3,000 shares of B Co.
 The non-controlling interests are measured as a proportion of the net assets of the
subsidiary
 B Co. has made post-acquisition profits of $200.

621
Financial Reporting

On 31 December 20X8, the statements of financial position of A Co. and B Co. are as follows:
A Co. B Co.
$ $
Non-current assets 5,000 3,500
Investment in B Co. 3,800 –
Current assets 2,000 800
10,800 4,300
Represented by:
Share capital 8,000 3,000
Reserves 1,900 700
9,900 3,700
Current liabilities 900 600
10,800 4,300

CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO. AS AT 31 DECEMBER 20X8

Adjustment Adjustment Consolidated


A Co. B Co. (i) (ii) A Co.
$ $ $ $ $
Non-current assets 5,000 3,500 – – 8,500
Investment in B Co. 3,800 – (3,800) – –
Goodwill – – 1,000 – 1,000
Current assets 2,000 800 – – 2,800
10,800 4,300 12,300
Represented by:
Share capital 8,000 3,000 (3,000) – 8,000
Reserves 1,900 700 (500) (40) 2,060
9,900 3,700 10,060
Non-controlling interests – – 700 40 740
Current liabilities 900 600 – – 1,500
10,800 4,300 12,300

(i) Goodwill working


$ $
Consideration 3,800
Non-controlling interests at date of acquisition ($3,500  20%) 700
4,500
Less: net assets of B Co.
Share capital 3,000
Reserves 500
(3,500)
Goodwill 1,000

(ii) Post-acquisition profits in B Co.

Post-acquisition profits of B Co. 200


NCI share of post acquisition profits of B Co. (20%  $200) 40

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

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.

Example: NCI and post acquisition profits (2)


Use the same information as the previous examples but this time assume that:
 A Co. acquires only 2,400 of the 3,000 shares of B Co.
 the non-controlling interest at acquisition is measured at fair value of $950
 B Co. has made a post-acquisition profit of $200.
On 31 December 20X8, the statements of financial position of A Co. and B Co. are as follows:
A Co. B Co.
$ $
Non-current assets 5,000 3,500
Investment in B Co. 3,800 –
Current assets 2,000 800
10,800 4,300
Represented by:
Share capital 8,000 3,000
Reserves 1,900 700
9,900 3,700
Current liabilities 900 600
10,800 4,300
CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO. AS AT 31 DECEMBER
20X8

Adjustment Adjustment Consolidated


A Co. B Co. (i) (ii) A Co.
$ $ $ $ $
Non-current assets 5,000 3,500 – – 8,500
Investment in B Co. 3,800 – (3,800) – –
Goodwill – – 1,250 – 1,250
Current assets 2,000 800 – – 2,800
10,800 4,300 12,550

623
Financial Reporting

Adjustment Adjustment Consolidated


A Co. B Co. (i) (ii) A Co.
$ $ $ $ $
Represented by:
Share capital 8,000 3,000 (3,000) 8,000
Reserves 1,900 700 (500) (40) 2,060
9,900 3,700 10,060
Non-controlling – – 950 40 990
interest
Current liabilities 900 600 - 1,500
10,800 4,300 12,550

(i) Goodwill working


$ $
Cost of investment 3,800
Non-controlling interests (fair value) 950
4,750
Less: net assets of B Co.
Share capital 3,000
Reserves 500
(3,500)
Goodwill 1,250
(ii) Post-acquisition profits in B Co.
$
Post-acquisition profits in B Co. 200
NCI share of post acquisition profits of B Co. (20%  $200) 40

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

To recognise the acquisition of B Co. and resulting goodwill and NCI


(ii)
DEBIT Reserves 40
CREDIT Non-controlling interests 40
To allocate the NCI share of post-acquisition profits in B Co.

2.4 Fair value adjustments


Topic highlights
Where the book value of the subsidiary's assets and liabilities at the acquisition date is not equal to
fair value, adjustment must be made on consolidation.

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

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.

Example: Fair value adjustments


A Co. acquired 800 shares of B Co. representing 80% of the share capital on 1 January 20X7 when
B Co.'s reserves were $300. The statements of financial position of A Co. and B Co. as at 31
December 20X7 were as follows:
A Co. B Co.
$ $
Non-current assets, at cost 3,200 1,500
Less: Accumulated depreciation (1,000) (400)
2,200 1,100
Investment in B Co. 1,300 –
Current assets 800 500
4,300 1,600
Represented by:
Share capital 3,000 1,000
Reserves 700 400
3,700 1,400
Current liabilities 600 200
4,300 1,600

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.

APPROACH TO QUESTION AND WORKINGS


1 Set up a consolidation schedule
2 Calculate the acquisition date fair value adjustment:
$
Carrying amount at 31 December 20X7 1,100
Add back 1 year’s depreciation (10%  1,500) 150
1,250
Fair value of non-current assets at date of acquisition (1,400)
Fair value adjustment at date of acquisition (150)
Consolidation journal $ $
DEBIT Non-current assets 150
CREDIT Reserves 150
To recognise fair value adjustment on consolidation

625
Financial Reporting

3 Calculate goodwill on consolidation:


$ $
Consideration 1,300
Non-controlling interests at date of acquisition
($1,450  20%) 290
1,590
Less: net assets of B Co.
Share capital 1,000
Reserves 300
Fair value adjustment 150
1,450
Goodwill 140

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)
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

NCI share of post acquisition reserves (20%  50) 10

Consolidation journal $ $
DEBIT Reserves 10
CREDIT Non-controlling interest 10
To allocate the non-controlling interest share of B Co.’s post-acquisition profits

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF A CO. AS AT 31 DECEMBER


20X7
Adjustments Consolidated
A Co. B Co. 2 3 4 5 A Co.
$ $ $ $ $ $ $
Non-current 3,200 1,500 150 4,850
assets

Accumulated (1,000) (400) (50) (1,450)


depreciation
2,200 1,100 3,400
Investment in 1,300 - (1,300) -
B Co.
Goodwill 140 140
Current 800 500 1,300
assets

4,300 1,600 4,840


Represented
by:
Share capital 3,000 1,000 (1,000) 3,000
Reserves 700 400 150 (450) (50) (10) 740
Non-
controlling 290 10 300
interests
Current
liabilities 600 200 800
4,300 1,600 4,840
Note that there is no revaluation reserve in the consolidated statement of financial position since
there is none in A Co.'s books, and that in B Co.'s books is a fair value adjustment on acquisition
with no post-acquisition movement.

2.5 Intra-group transactions


Topic highlights
Intra-group balances and any unrealised profits must be eliminated on consolidation.

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).

627
Financial Reporting

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.

Example: Unrealised profit in stock


A Co. acquired 100% of the share capital of B Co. on 1 January 20X7 when the reserves of B Co.
were $40. During the year ended 31 December 20X7, B Co. sold goods to A Co. at a price of $40
to include a 25% margin.
At 31 December 20X7, A Co. had half of these goods in stock. The inventory and reserves reported
in the accounts of A Co. and B Co. as at 31 December 20X7 were:
A Co. B Co.
$ $
Inventory 54 42
Reserves 100 50
The profit recorded by B Co. on sale of the goods to A Co. is $40  25% = $10. From the viewpoint
of the group, $5 is unrealised and should be eliminated from B Co's profits prior to consolidation.
Consolidation adjustment
$ $
DEBIT B Co.'s Reserves 5
CREDIT Inventory 5
To eliminate the unrealised profit in inventory.
Consolidated inventory = $54 + $42 – $5 = $91
Consolidated reserves = $100 + ($50 – $40– $5)  100% = $105
Note that in this case there is no non-controlling interest. If there had been, the group share of
unrealised profits is deducted from group reserves and the non-controlling interests share is
deducted from the non-controlling interests in the statement of financial position.
Had A Co. been the selling company, this is not an issue, and all of the unrealised profit is
deducted from group reserves.

2.5.3 Intra-group transfers of non-current assets


It is common for group companies to transfer non-current assets from one to another depending on
where they are needed. Often the transferor makes a profit on such a transaction. As above, this
profit is unrealised until such time as the non-current asset is sold outside the group and therefore
it must be eliminated on consolidation.
Here there is also the extra complication of depreciation, which must, for the purpose of the
consolidated accounts, be based on the original cost of the asset to the group.

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

Example: Intra-group transfers of non-current assets


A Co. acquired 80% of the share capital of B Co. on 1 January 20X6. On 1 January 20X8,
A Co. sold non-current assets which were acquired on 1 January 20X7 at $80,000 to B Co. for
$90,000. Both A Co. and B Co. provide depreciation at 10% on cost per annum.
$
Original cost 80,000
Less: accumulated depreciation (8,000)
Carrying amount at date of transfer 72,000
Selling price to B Co. (90,000)
Profit recorded in A Co. books 18,000
On 31 December 20X8, the consolidation adjustment on excess depreciation charge by B Co. from
the viewpoint of the group is:
$
Accumulated depreciation provided in the books of B Co. ($90,000  10%) 9,000
Accumulated depreciation since transfer based on cost of non-current assets
(8,000)
of the group ($80,000  10%)
Excess depreciation charge 1,000
Therefore, relevant consolidation adjustments are:
$ $
DEBIT Consolidated reserves 18,000
CREDIT Consolidated non-current assets 18,000
To eliminate the unrealised profit on sale of non-current assets.
DEBIT Consolidated accumulated depreciation 1,000
CREDIT Consolidated reserves 1,000
To eliminate excess depreciation charged as a result of intra-group transfer of non-current
asset.

3 Consolidated statement of profit or loss and other


comprehensive income
Topic highlights
A consolidated statement of profit or loss and other comprehensive income is prepared by adding
across income and expenses on a line by line basis. Profit and total comprehensive income are
allocated to the non-controlling interests and owners of the group.

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.

3.1 Non-controlling interests


Where a subsidiary is partially owned, the relevant proportion of its profits and other
comprehensive income must be allocated to the non-controlling interests.
Both the profit or loss and total comprehensive income attributable to the non-controlling interests
and the owners of the parent should be shown separately at the end of the consolidated statement
of profit or loss and other comprehensive income.

629
Financial Reporting

3.2 Intra-group transactions


Topic highlights
Intra-group income and expenditure is cancelled on consolidation. Any unrealised profits must also
be eliminated.

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 is 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. The following example illustrates this.

Example: Intra-group trading


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 300 200
Cost of sales (180) (120)
Gross profit 120 80
During the year 20X7, B Co. sold goods to A Co. for $40, making a profit of $10. At the year end
half of the goods remained in inventory, therefore there is an unrealised profit of $5.
Consolidation adjustments:
(i) $ $
DEBIT Revenue 40
CREDIT Cost of sales 40
To cancel intra-group sales.
(ii) $ $
DEBIT Cost of sales 5
CREDIT Inventory (SOFP) 5
To eliminate the unrealised profit in inventory.
The consolidated statement of profit or loss should be:
A Co. B Co. Adjustment Adjustment Consolidated
(i) (ii) A Co.
$ $ $ $ $
Revenue 300 200 (40) 460
Cost of sales (180) (120) 40 (5) (265)
Gross profit 120 80 195

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.

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

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
Operating expenses (270) (180)
Operating profit 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.
The consolidated statement of profit or loss should be:

A Co. B Co. Adjustment (i) Adjustment (ii) Consolidated


A Co.
$ $ $ $ $
Revenue 500 400 900
Cost of sales (220) (140) (360)
Gross profit 280 260 540
Other income 90 30 (80) 40
Operating (270) (180) 8 (442)
expenses
Operating 100 110 138
profit

3.3 Mid-year acquisitions


Topic highlights
Where a subsidiary is acquired mid-year, its results must be pro-rated prior to consolidation.

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.

631
Financial Reporting

Example: Mid-year acquisitions


The statements of profit or loss of A Co. and B Co. for the year ended 31 December 20X7 are
given below:
A Co. B Co.
$ $
Revenue 300 200
Cost of sales (180) (120)
Gross profit 120 80
Administrative and distribution expenses (40) (30)
Profit before taxation 80 50
Taxation (15) (8)
Profit after tax 65 42
A Co. acquired 70% of the ordinary share capital of B Co. on 1 April 20X7.
The consolidated statement of profit or loss for the year ended 31 December 20X7 is:

A Co. B Co. Calculation Consolidated


A Co.
$ $ $
Revenue 300 200 ($300 + $200  9/12) 450
9
Cost of sales (180) (120) ($180 + $120  /12) (270)
Gross profit 120 80 180
Administrative and
distribution expenses (40) (30) ($40 + $30  9/12) (63)
Profit before taxation 80 50 117
Taxation (15) (8) ($15 + $8  9/12) (21)
Profit after taxation 65 42 96

Available to:
Owners of the parent (bal. fig.) 87
Non-controlling interests ($42  9  30% 9
12
96

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

4 Recap of simple consolidation techniques


The summary given below is very brief but it encompasses all the major rules which must be
applied when preparing consolidated financial statements.

Approach to consolidated statement of financial position


1 Prepare a consolidation working schedule
2 Calculate and record in the schedule, as a consolidation adjustment, any fair value
adjustment at the acquisition date. Recognising or increasing a liability will result in a debit to
reserves; recognising or increasing an asset will result in a credit to reserves.
3 Calculate goodwill and record the adjustment journal in the schedule:
DEBIT Goodwill
DEBIT Share capital
DEBIT Reserves
CREDIT Investment
CREDIT NCI
4 Calculate and record in the schedule any post-acquisition depreciation resulting from an
acquisition date fair value adjustment.
DEBIT Reserves
CREDIT Property, plant and equipment
5 Calculate and record in the schedule any unrealised profit in inventory or non-current assets:
DEBIT Reserves
CREDIT Inventory / Non-current asset
6 Eliminate any intra-group balances such as loans, current accounts and cash in transit.
7 Calculate the NCI share of post-acquisition profits in the subsidiary and allocate these to the
NCI.
DEBIT Reserves
CREDIT NCI
8 Add across the consolidation schedule.
The balances which are left should represent:
 Assets 100% P plus 100% S +/- adjustments
 Share capital: P only.
 Reserves: 100% P plus group share of post-acquisition retained reserves of S less
consolidation adjustments.
 Non-controlling interests:
Proportion of net assets method: NCI share of S's consolidated net assets
Fair value method: NCI share of S's consolidated net assets plus NCI share of goodwill
 Liabilities 100% P plus 100% S +/- adjustments

633
Financial Reporting

Approach to consolidated statement of profit or loss and other comprehensive income


1 Set up a consolidation working schedule, pro-rating the subsidiary’s results in the case of a
mid-year acquisition.
2 Eliminate intra-group sales and purchases
3 Eliminate unrealised profits in inventory
4 Eliminate any intragroup dividends received and paid
5 Allocate profits between the parent and non-controlling interest.
Note:
Pre-acquisition dividends
There are two ways to calculate the pre-acquisition element of a dividend:
 To the extent that post-acquisition profits are insufficient to cover the dividend, the
distribution must be out of pre-acquisition profits. This method is more commonly used in
practice.
 Apportion the dividend on a time basis between the pre- and post-acquisition periods,
so that only post-acquisition dividends are taken to P's reserves.
– For pre-acquisition dividends: Debit Dividend receivable/cash, Credit Cost of
investment.
– For post-acquisition dividends: Debit Dividend receivable/cash, Credit Reserves.

Now try the following questions to practise the topics listed above.

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

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

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)

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

635
Financial Reporting

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

The following information is also available:


(a) Okay purchased 360,000 of the 450,000 shares in Chestnut some years ago when that
company had a credit balance of $105,000 in retained earnings. The goodwill had been
impaired and was fully written off through profit or loss by 30 September 20X7.
(b) For the purpose of the acquisition, the land of Chestnut was revalued at $120,000 in excess
of its book value. This was not reflected in the accounts of Chestnut. Land is not
depreciated.
(c) At 30 September 20X8 Chestnut owed Okay $15,000 for goods purchased.
(d) The inventory of Chestnut includes goods purchased from Okay at a price which includes a
profit to Okay of $10,500.
(e) 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.
Required
Prepare the consolidated statement of financial position for Okay as at 30 September 20X8
(ignoring tax).
(The answer is at the end of the chapter)

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

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

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)

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

5.1 Vertical groups


Vertical groups are those where there is a sub-subsidiary, for example:
P
90%

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.

637
Financial Reporting

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

5.1.1 Goodwill calculation


Goodwill in the sub-subsidiary is calculated from the perspective of the parent company, and
therefore includes only the parent's share of the cost of the investment in the sub-subsidiary and
calculations based on the effective shareholdings.

Example: NCI as proportion of net assets


Tremendous owns 80% of the shares in Fabulous, and has done for many years. On
1 January 20X1, Fabulous acquired a 70% holding in Excellent at a cost of $9 million. On that date
the fair value of the net assets of Excellent was $8 million (made up of $3m ordinary shares and
$5m retained earnings).
What goodwill arises in the Tremendous consolidated financial statements at 31 December 20X1
on the acquisition of Excellent, assuming that the non-controlling interest is measured as a
proportion of net assets of the acquiree?
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.

Example: NCI at fair value


The facts are as for the example above, however the NCI in Excellent is now measured at fair
value based on a share price of $3.50.

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

638
27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

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.

Example: Non-controlling interest


The facts are as in the first example above (NCI measured as a proportion of net assets), and the
retained earnings of Excellent as at 31 December 20X1 are $6.2 million.
(a) What is the non-controlling interest in respect of Excellent in both the statement of financial
position at 31 December 20X1 and statement of profit or loss then ended?
(b) What share of Excellent's retained earnings are included in the group retained earnings
balance?
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

Statement of profit or loss


Non-controlling interest in profit 528
(b) Retained earnings
Share of Excellent's retained earnings 56% (6.2m – 5m) 672

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

1,340 930 670

Share capital 600 400 300


Reserves 400 300 100
1,000 700 400
Current liabilities 340 230 270
1,340 930 670

639
Financial Reporting

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.
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)

5.2 D-shaped groups


D-shaped groups are those where a parent company controls a subsidiary and the parent company
and subsidiary together control a further subsidiary:

P
80%

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

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

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?

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
Below are the statements of financial position of Sigma, Pi and Delta as at 31 December 20X5.
Sigma Pi Delta
$'000 $'000 $'000
Investments
300,000 shares in Pi 450
25,600 shares in Delta 35
230,400 shares in Delta 316

Current assets 869 660 574


1,354 976 574

Share capital 600 400 320


Retained earnings 400 356 180
1,000 756 500
Current liabilities 354 220 74
1,354 976 574

641
Financial Reporting

1 Sigma acquired its interest in Pi on 1 January 20X2 when the balance on the retained
earnings was $140,000.
2 Sigma and Pi acquired their respective interests in Delta on 1 January 20X4 when the
balance on the retained earnings was $80,000.
3 It is group policy to value the non-controlling interests at fair value at the date of acquisition.
The fair value of the non-controlling interests in Pi on 1 January 20X2 was $145,000. The fair
value of the 38% non-controlling interests in Delta on 1 January 20X4 was $160,000.
4 Sigma, Pi and Delta constitute separate cash generating units. The year end impairment test
revealed impairment losses of $15,000 re Delta's recognised goodwill, but none of the other
CGUs were affected.
5 Pi has 400,000 shares in issue and Delta has 320,000 shares in issue.
Required
Prepare the consolidated statement of financial position as at 31 December 20X5.
(The answer is at the end of the chapter)

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

Topic recap

Accounting for subsidiaries – basic groups

Consolidated statement of financial Consolidated statement of profit or loss


position and other comprehensive income

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.

Calculate NCI: NCI in profits:


NCI at acquisition date X Profits of subsidiary X
NCI share post acq'n reserves X Adjustments X/(X)
X X

NCI at acquisition is either: × NCI%


Ÿ proportion of net assets in
subsidiary, or
Ÿ fair value

Calculate group reserves:


P's reserves X
Group share of S's post acq'n
reserves X
Adjustments X/(X)
X

Adjust subsidiary's net assets at Fair value adjustments may result in


acquisition/in SOFP for fair value additional depreciation on
adjustments at acquisition consolidation

Intra-group balances are eliminated Intra-group income and expenditure is


eliminated

Unrealised profits are eliminated against Unrealised profits are eliminated against
the selling company's reserves the selling company’s profits

643
Financial Reporting

Complex groups

Vertical D-shaped
P P
80%
80%
40% S1
S1
40%
70%
S2
S2

Ÿ Consolidated financial Ÿ Consolidated financial


statements include assets, statements include assets,
liabilities and results of P, S1 liabilities and results of P, S1
and S2 and S2
Ÿ Goodwill calculation in S1 is Ÿ Goodwill calculation in S1 is
as normal as normal
Ÿ Goodwill calculation in S2 Ÿ Goodwill calculation in S2
based on group effective based on group effective
holding of 56%; cost = 80% of holding of 72%; cost = 80% of
the cost of S1's investment in the cost of S1's investment in
S2 S2
Ÿ NCI and group reserves Ÿ NCI and group reserves
calculations in respect of S2 calculations in respect of S2
are also based on group are also based on group
effective holding effective holding

644
27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

Answers to self-test questions

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
BOOTIE GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR THE YEAR ENDED 31 DECEMBER 20X8
$'000
Revenue (5,000 + 1,000 – 100) 5,900
Cost of sales (2,900 + 600 – 100 + 20) 3,420
Gross profit 2,480
Other expenses (1,700 + 320) 2,020
Net profit 460
Income tax (130 + 25) 155
Profit for the year 305
Profit attributable to:
Owners of the parent 294
Non-controlling interests (55  20%) 11
305
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED
31 DECEMBER 20X8
$'000
Opening balance (balancing figure) 2,408
Group profit for the year 294
Dividends (130)
Closing balance 2,572
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X8
$'000 $'000
Assets
Non-current assets (1,920 + 200) 2,120
Current assets
Inventory (500 + 120 + 80) 700
Trade receivables (650 – 100 + 40) 590
Bank and cash (390 + 35) 425
1,715
3,835

645
Financial Reporting

$'000 $'000
EQUITY AND LIABILITIES
Equity
Share capital (Bootie only) 2,000
Retained earnings (W) 572
Shareholders' funds 2,572
Non-controlling interests (20%  300) 60
2,632
Current liabilities
Trade payables (910 + 30) 940
Dividend payable: Bootie Co. 100
to non-controlling interests in Goose Co. (40  20%) 8
Income tax (130 + 25) 155
1,203
3,835
WORKING
Group retained earnings
Bootie Goose
$'000 $'000
Per question 400 200
Closing inventory in transit (at cost) 80
Inter company sale (100)
Dividend receivable ($40  80%) 32
Share of Goose’s profit ($200  80%) 160
Group net owned profits 572
This working is, of course, only necessary when you are not required to prepare the consolidated
statement of profit or loss and other comprehensive income. Here, it serves as a proof of the
consolidated statement of profit or loss and other comprehensive income as well as of the reserves
figure in the statement of financial position.

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

646
27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

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.
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.

647
Financial Reporting

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
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

648
27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

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
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

649
Financial Reporting

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

Share capital 600


Reserves (W3) 559
1,159
Non-controlling interests (W4) 255
1,414
Current liabilities (340 + 230 + 270) 840
2,254

WORKINGS
1 Group structure
Alpha
1.1.X2
300,000= 75%
400,000
Beta Non-controlling interests 25%

1.1.X3 240,000= 80%


300,000
Gamma Group effective interest (80%  75%) 60%
... Non-controlling interests 40%
100%
2 Goodwill
Beta Gamma
$'000 $'000 $'000 $'000

Consideration transferred 450 (320  240


Non-controlling interests (480  25%)/(360  40%) 120 75%) 144

Fair value of identifiable net assets at


acquisition:
Share capital 400 300
Reserves at 1.12.20X2/1.12.20X3 80 60
(480) (360)
90 24
Impairment losses (see below) (30)
60 24

84

650
27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

Impairment losses – Beta $'000


"Notional" goodwill (gross*) (90 
100
75 ) 120
Net assets 700
820
Recoverable amount (780)
Impairment loss (gross) 40
Impairment loss recognised (net) (40  75%) 30
* Where non-controlling interests are measured at the date of acquisition at the
proportionate share of the fair value of the acquiree's identifiable assets
acquired and liabilities assumed (i.e. not at "full" fair value), part of the
calculation of the recoverable amount of the CGU relates to the unrecognised
non-controlling interest share of the goodwill.
For the purpose of calculating the impairment loss, the carrying amount of the
CGU is therefore notionally adjusted to include the non-controlling interests in
the goodwill by grossing it up.
The resulting impairment loss calculated is only recognised to the extent of the
parent's share.
This adjustment is not required where non-controlling interests are measured
at fair value at acquisition.
3 Consolidated reserves
Alpha Beta Gamma
$'000 $'000 $'000
Per question 400 300 100
Reserves at acquisition (W2) (80) (60)
220 40
Group share of post acquisition reserves:
Beta (220  75%) 165
Gamma (40  60%) 24
Group impairment losses to date (W2) (30)
559

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

651
Financial Reporting

(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

Consideration transferred 450 (320  240


Non-controlling interests (500  25%)/(360  125 75%) 144
40%)

FV of identifiable net assets at


acq'n:
Share capital 400 300
Reserves at 1.12.20X3 100 60
(500) (360)
75 24

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:
ALPHA GROUP CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT
31 DECEMBER 20X5
$'000
Goodwill (from above) 99
Current assets (890 + 610 + 670) 2,170
2,269
Share capital 600
Reserves (from above) 574
1,174
Non-controlling interests (W4) 255
1,429
Current liabilities (340 + 230 + 270) 840
2,269

652
27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

Non-controlling interests working – same result, figures in bold have changed


Beta Gamma
$'000 $'000
NCI at acquisition (W2) 125 144
NCI share of post acquisition reserves:
Beta ((W3) 200  25%) 50
Gamma ((W3) 40  40%) 16
Less: NCI share of investment in Gamma (320  25%) (80)
95 160

255

Answer 5
SIGMA CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X5
$'000
Goodwill (W2) 72
Current assets (869 + 660 + 574) 2,103
2,175

Share capital 600


Retained earnings (W3) 615
1,215
Non-controlling interests (W4) 312
1,527
Current liabilities (354 + 220 + 74) 648
2,175

WORKINGS
1 Group structure

Sigma
1.1.X2
300,000 75% 1.1.X4
400,000
Pi 25,600 = 8%
1.1.X4 320,000
230,400 72%
320,000
Delta

Sigma's effective interest in Delta [(75%  72% = 54%) indirect + 8% direct] 62%

... Non-controlling interests 38%


100%

653
Financial Reporting

2 Goodwill
Pi Delta
$'000 $'000 $'000 $'000
Consideration transferred – Sigma 450 35
(316 
Consideration transferred – Pi 237
75%)
Non-controlling interests (at "full" fair value) 145 160

Fair value of identifiable NA at acq'n:


Share capital 400 320
Retained earnings 140 80
(540) (400)
55 32
Impairment losses to date (-) (15)
55 17

Total goodwill 72

3 Retained earnings
Sigma Pi Delta
$'000 $'000 $'000
Per question 400 356 180
Retained earnings at acquisition (W2) (140) (80)
216 100
Group share of post acquisition retained earnings:
Pi (216  75%) 162
Delta (100  62%) 62
Group share of impairment losses to date (W2) (9)
(15  62%)
615
4 Non-controlling interests
Pi Delta
$'000 $'000
NCI at acquisition (W2) 145 160
NCI share of post acquisition retained earnings: -
Pi ((W3) 216  25%) 54 -
Delta ((W3) 100  38%) 38
Less: NCI in investment in Delta (316  25%) (79)
NCI share of impairment losses to date (W2) (15  38%) (6)
120 192

312

654
27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

Exam practice

Smart Computer Limited 22 minutes


On 1 October 20X9, Smart Computer Limited (SCL) acquired an 80% interest in Breakthrough Disc
Company (BDC) at a consideration of HK$72 million. Fair value of BDC shares at that date was
HK$45 each.
The carrying amount of identifiable net assets of BDC reported on its statement of financial position
at the date of acquisition was HK$42 million. Other than the property, plant and equipment with a
carrying amount of HK$60 million and fair value of HK$76 million, there were no differences
between the carrying amount and the fair value for all other reported assets and liabilities.
An internally generated intangible asset with fair value of HK$8 million was identified. Both the
property, plant and equipment and the intangible asset have an estimated useful life of 10 years
from the date of acquisition.
Post-acquisition profit reported by BDC before adjustment of depreciation and amortisation
attributable to fair value up to 1 April 20Y0 was HK$8 million.
SCL adopts the accounting policy to measure any non-controlling interests in the acquiree at fair
value.
Required
Assuming that BDC is not subject to income tax in any jurisdiction,
(a) calculate the amount of goodwill recognised for the acquisition. (7 marks)
(b) calculate the amount of non-controlling interests in BDC as at 1 April 20Y0 to be reflected in
the consolidated statement of financial position of SCL.
(5 marks)
(Total = 12 marks)
HKICPA December 2010 (amended)

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

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Financial Reporting

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

Other comprehensive income:


Gain on revaluation of property (net of deferred tax) 50 20 10
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 426 375 120

Dividends paid in the year (from post-acquisition profits) 250 50 20


The following information is relevant to the preparation of the group financial statements of the
Bailey group:
1 The fair value difference in Hill relates to property, plant and equipment being depreciated
through cost of sales over a remaining useful life of 10 years from the acquisition date.
2 During the year ended 31 December 20X9, Hill sold $200 million of goods to Bailey. Three
quarters of these goods had been sold by the year end. The profit on these goods was
40% on sales price. There were no opening inventories of intragroup goods nor any
intragroup balances at the year end.
3 It is the group's policy to value non-controlling interests at fair value at the date of acquisition.
The fair value of the non-controlling interests in Hill at 1 January 20X6 was $450 million.
4 Cumulative impairment losses on recognised goodwill in Hill at 31 December 20X9
amounted to $20 million, of which $15 million arose during the year. It is the group's policy to
recognise impairment losses on positive goodwill in administrative expenses. No impairment
losses have been necessary on the investment in Campbell.

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27: Consolidated accounts: accounting for subsidiaries | Part D Group financial statements

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)

657
Financial Reporting

658
chapter 28

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
2.3 HKAS 31 Interests in Joint Ventures
3 Disclosure requirements
3.1 Nature, extent and financial effects of an entity’s interests in joint arrangements and associates
4 Current developments

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.

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Financial Reporting

Learning outcomes

In this chapter you will cover the following learning outcomes:

Competency
level
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 Joint arrangements 3
4.08.01 Define a joint arrangement
4.08.02 Explain the difference among joint 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

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28: 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 26, 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

HKAS 1.1 Definitions


28(2011).3
HKAS 28 (2011) provides a number of definitions:

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))

HKAS 28 1.1.1 Significant influence


(2011).5-6
Significant influence is defined as the "power to participate", but not to "control" (which would make
the investment a subsidiary).
Significant influence can be determined by the holding of voting rights (usually attached to shares)
in the entity. HKAS 28 (2011) states that if an investor holds 20% or more of the voting power of
the investee, it can be presumed that the investor has significant influence over the investee,
unless it can be clearly shown that this is not the case.
Significant influence can be presumed not to exist if the investor holds less than 20% of the voting
power of the investee, unless it can be demonstrated otherwise.
The existence of significant influence is evidenced in one or more of the following ways:
(a) Representation on the board of directors (or equivalent) of the investee
(b) Participation in the policy making process
(c) Material transactions between investor and investee
(d) Interchange of management personnel
(e) Provision of essential technical information

661
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.
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.
(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.
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.

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28: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements

1.4 Application of the equity method


Topic highlights
The equity method should be applied in the consolidated accounts:
 Statement of financial position: include investment in associate at cost plus (or minus) the
group's share of the associate's post-acquisition retained total comprehensive income
 Statement of profit or loss and other comprehensive income: include group share of
associate's profit after tax and other comprehensive income

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

1.4.1 Consolidated statement of financial position


The investment in associates recognised in the consolidated statement of financial position is
initially measured at cost. This amount will increase (decrease) each year by the amount of the
group's share of the associate's total comprehensive income retained for the year.
The group share of the associate's reserves is also included within the group reserves figure in the
equity section of the consolidated statement of financial position.

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
2 record dividend income
$ $
DEBIT Cash (25%  $20,000) 5,000
CREDIT Investment income from shares in associates 5,000
Unless there is an impairment the investment remains held at cost of $100,000 in Panda’s
statement of financial position permanently.

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Financial Reporting

Consolidated accounts
In the consolidated accounts of Panda Co. equity accounting principles will be applied, and
therefore:
 in the consolidated statement of financial position the investment is carried at cost plus
Panda's share of Aardvark's retained profits
 Panda's share of Aardvark's profits is included in the consolidated statement of profit or loss
and other comprehensive income (25%  $80,000 = $20,000)
 Panda's share of the dividend paid by Aardvark (25%  $20,000 = $5,000) is already
included in Panda's profits and therefore only $15,000 is brought in as a consolidation
adjustment by:
$ $
DEBIT Investment in associates 15,000
Investment income 5,000
CREDIT Share of profits of associates 20,000
The asset "Investment in associates" is then stated at $115,000, being cost plus the group share of
post-acquisition retained profits.

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.
PRO-FORMA CONSOLIDATED STATEMENT OF PROFIT OR LOSS (FOR ILLUSTRATION)
$'000
Revenue 2,000
Cost of sales 800
Gross profit 1,200
Distribution costs and administrative expenses 500
700
Interest and similar income receivable 50
750
Finance costs (40)
710
Share of profit (after tax) of associate 30
Profit before taxation 740
Income tax expense – parent company and subsidiaries 240
Profit for the year 500

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28: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements

$'000
Profit attributable to:
Owners of the parent 480
Non-controlling interests 20
500

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)

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:

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Financial Reporting

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 entries 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)

1.5 Consolidation adjustments


Topic highlights
Intra-group transactions with an associate are not cancelled but the group share of any unrealised
profit is eliminated. Fair value adjustments may also be required.

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.

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28: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements

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.
The double entry is as follows, 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%
For upstream transactions (associate sells to parent/subsidiary) where the parent holds the
inventories.
OR
DEBIT Cost of sales of parent/subsidiary PUP  A%
CREDIT Investment in associate PUP  A%
For downstream transactions (parent/subsidiary sells to associate) where the associate holds the
inventory.

Example: Downstream transaction


P Co., a parent with subsidiaries, holds 30% of the equity shares in A Co. During the year,
P Co. makes sales of $100,000 to A Co. at cost plus a 25% mark-up. At the year-end, A Co. has all
these goods still in inventories.
25
P Co. has made an unrealised profit of $20,000 ($100,000  /125) on its sales to the associate A.
The group's share of this is 30%, i.e. $6,000. This must be eliminated.
The double entry is:
$ $
DEBIT P: Cost of sales 6,000
CREDIT Investment in associate (A) 6,000
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.

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Financial Reporting

HKAS 28 1.5.2 Transfers of non-current assets


(2011).28-29
Where a parent company transfers a non-current asset to an associate (a downstream transaction)
or an associate transfers a non-current asset to its parent company (an upstream transaction),
again only the group share of the unrealised profit (including any additional depreciation charge
related to the asset) is eliminated.
Where downstream transactions provide evidence of an impairment loss to an asset, such a loss is
recognised in full by the group. Where upstream transactions provide evidence of an impairment
loss to an asset, the investor recognises its share of the loss.
HKAS 28 1.5.3 Fair value adjustments
(2011).32
As we have already said, on acquisition of an associate, the cost of the investment is notionally
allocated to the fair value of the net assets acquired.
Where a fair value adjustment is made for the purposes of this exercise, appropriate adjustments to
the investor's share of the associate's profits or losses after acquisition are also made to account,
for example, for depreciation of the depreciable assets based on their fair values at the acquisition
date.

HKAS 28
(2011).38-39
1.6 Losses in an associate
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.

Example: Carrying amount


The Letters Group has a 40% associate investment in Alpha Co which cost $500,000 on 1 January
20X2, including a premium representing notional goodwill. The results of Alpha Co. in recent years
have been as follows:
Year ended 31 December Retained total comprehensive income
$
20X2 100,000
20X3 (1,000,000)
20X4 (500,000)
20X5 100,000
20X6 500,000
What is the carrying amount of the investment in Alpha Co. in each of these years in the
consolidated financial statements of the Letters Group?

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28: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements

Solution
31 December 20X2 $500,000 + (40%  $100,000) $540,000
31 December 20X3 $540,000 + (40%  ($1m)) $140,000
31 December 20X4 $140,000 + (40%  ($500,000)) Nil
($60,000 losses unrecognised)
31 December 20X5 –$60,000 + (40%  $100,000) Nil
($20,000 losses unrecognised and
unrecovered)
31 December 20X6 –$20,000 + (40%  $500,000) $180,000

1.7 Impairment losses


HKAS 39 sets out a list of indications that a financial asset (including an associate) may have
become impaired (see Chapter 18). Any impairment loss is recognised in accordance with HKAS
36 Impairment of Assets for each associate individually. An impairment loss is not allocated to any
asset, including goodwill, that forms part of the carrying amount of the investment in associate.
Accordingly, any reversal of that impairment loss is recognised in accordance with HKAS 36 to the
extent that the recoverable amount of the investment subsequently increases.

1.8 Indirect investment in an associate


Where the investment in an associate is held by a subsidiary in which there is a non-controlling
interest, the non-controlling interests shown in the consolidated financial statements of the group
should include the non-controlling interests of the subsidiary's interest in the results and net
assets of the associated company.
This means that the group accounts must include the "gross" share of net assets and total
comprehensive income in accounting for the non-controlling interests separately. For example,
we will suppose that P Co. owns 80% of S Co. which owns 25% of A Co., an associate of P Co..
The relevant amounts for inclusion in the consolidated financial statements would be as follows:
CONSOLIDATED STATEMENT OF PROFIT OR LOSS
Operating profit (P 100% + S 100%)
Share of profit after tax of associate (A 25%)
Tax (P 100% + S 100%)
Non-controlling interests (S 20% + A 5%*)
Retained profits (P 100% + S 80% + A 20%)
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Investment in associated company (figures based on 25% holding)
Non-controlling interests
((20%  shareholders' funds of S) + (5%*  post-acquisition retained earnings of A))
Group retained earnings ((100%  P) + (80%  post-acquisition of S) + (20%  post-acquisition
of A))
* 20%  25% = 5%

2 Joint arrangements
Topic highlights
A joint venture is a contractual arrangement where two or more parties jointly control an economic
activity.

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Financial Reporting

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)

HKFRS 11.7- 2.1.1 Joint control


13
The definition above specifically refers to a contractually agreed sharing of control and states that
this exists only when decisions about the relevant activities require the unanimous consent of the
parties sharing control. Where there is no contractual arrangement to establish joint control, or
where there is a contractual arrangement but unanimous consent is not required to make
decisions, then there is no joint control.
HKFRS 11 makes additional points about joint control:
 No single party controls the arrangement on its own
 A party with joint control of an arrangement can prevent any of the other parties from
controlling the arrangement
 An arrangement can be a joint arrangement even if not all parties have joint control; some
parties to a joint arrangement may participate but not have joint control
 Judgment should be applied when assessing whether a party has joint control of an
arrangement.

Example: Joint control


Three parties establish an arrangement. Abacus has 50% of the voting rights in the arrangement,
Bacchus has 30% and Cornelius has 20%. The contractual arrangement between the parties
specifies that at least 75% of votes are required to make decisions about relevant activities of the
arrangement.

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28: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements

In this case, Abacus can block a decision, however does not control the arrangement alone as it
needs the agreement of Bacchus. Therefore, Abacus and Bacchus have joint control of the
arrangement as decisions about relevant activities cannot be made without them agreeing.
Cornelius is a participating party to the arrangement, however does not have joint control.

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.

2.2 HKFRS 11 Joint Arrangements


Topic highlights
Joint arrangements are classified as either joint operations or joint ventures.
HKFRS 11 classes joint arrangements as either joint operations or joint ventures. The classification
of a joint arrangement as a joint operation or a joint venture depends upon the rights and
obligations of the parties to the arrangement.

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.

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Financial Reporting

Self-test question 3
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)

HKFRS 2.2.1 Accounting for joint operations


11.20, 26
HKFRS 11 requires that a joint operator recognises line-by-line the following in relation to its
interest in a joint operation:
(a) Its assets, including its share of any jointly held assets
(b) Its liabilities, including its share of any jointly incurred liabilities
(c) Its revenue from the sale of its share of the output arising from the joint operation
(d) Its share of the revenue from the sale of the output by the joint operation, and
(e) 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.

HKFRS 2.2.2 Accounting for joint ventures


11.24, 26
In its consolidated financial statements, HKFRS 11 requires that a joint venturer recognises its
interest in a joint venture as an investment and accounts for that investment using the equity
method in accordance with HKAS 28 (2011) Investments in Associates and Joint Ventures unless
the entity is exempted from applying the equity method (see section 1.2 which is also applicable to
joint ventures).
In its separate financial statements, a joint venturer should account for its interest in a joint venture
in accordance with HKAS 27 (2011) Separate Financial Statements (see Chapter 26 section 2.3.6).
2.2.3 Application of HKAS 28 (2011) to joint ventures
The consolidated statement of financial position is prepared by:
 including the interest in the joint venture at cost plus share of post-acquisition total
comprehensive income
 including the group share of the post-acquisition total comprehensive income in group
reserves
The consolidated statement of profit or loss and other comprehensive income will include:
 the group share of the joint venture's profit or loss
 the group share of the joint venture's other comprehensive income.
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.

HKAS 28 2.2.3 Transactions between a joint venturer and a joint venture


(2011), 28-29
Upstream transactions
A joint venturer may sell or contribute assets to a joint venture so making a profit or loss. Any
such gain or loss should, however, only be recognised to the extent that it reflects the substance of
the transaction.
Therefore:
 Only the gain attributable to the interest of the other joint venturers should be recognised in
the financial statements.

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28: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements

 The full amount of any loss should be recognised when the transaction shows evidence that
the net realisable value of current assets is less than cost, or that there is an impairment
loss.
Downstream transactions
When a joint venturer purchases assets from a joint venture, the joint venturer should not recognise
its share of the profit made by the joint venture on the transaction in question until it resells the
assets to an independent third party, i.e. until the profit is realised.
Losses should be treated in the same way, except losses should be recognised immediately if they
represent a reduction in the net realisable value of current assets, or a permanent decline in the
carrying amount of non-current assets.
Self-test question 4
AB Co. contributes inventories to a 50:50 joint venture it has undertaken with CD Co.. The
historical cost of the inventories is recorded in AB Co.'s books of account at $1m.
What gain or loss should AB Co. recognise in its financial statements when the fair value (net
realisable value) of the inventories is estimated at the date of transfer and recorded by the joint
venture as:
(a) $1.2 million?
(b) $0.8 million?
(The answer is at the end of the chapter)

2.3 HKAS 31 Interests in Joint Ventures


Topic highlights
HKAS 31 was the standard on joint ventures in force before HKFRS 11 was issued and HKAS 28
revised. It specified three types of joint venture: jointly controlled operations, jointly controlled
assets and jointly controlled entities.

HKAS 31 specified three main types of joint venture:


 Jointly controlled operations
 Jointly controlled assets
 Jointly controlled entities
The following characteristics were common to all types of joint venture:
 Two (or more) venturers are bound by a contractual arrangement
 The contractual relationship establishes joint control
The following table summarises the differences between these types of joint venture, and details
the accounting treatment required by HKAS 31 in each case:

Type of joint venture Characteristics Accounting treatment

Jointly controlled  No separate entity In its own financial statements a


operations (JCOs) established venturer recognises:
 Venturers provide own  assets it controls
assets and resources and
 liabilities it incurs
incur own expenses and
liabilities  expenses it incurs
 Revenues and expenses of  its share of income
the JCO are shared among earned from the JCO.
the venturers.

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Financial Reporting

Jointly controlled  No separate entity In its own financial statements a


assets (JCAs) established venturer recognises its share of:
 Venturers jointly control  the jointly controlled assets
assets purchased /
 liabilities incurred with
contributed for use within
other venturers in
the joint venture.
relation to the JCA
 Each venturer may take a
 income generated by the
share of the output from the
JCA and expenses
assets and each bears an
incurred.
agreed share of expenses.

Jointly controlled  Separate entity is  Separate financial


entities (JCEs) established statements are
maintained for the JCE
 This JCE controls the joint
venture’s assets, incurs  In venturers’ separate
liabilities and expenses and financial statements the
earns income investment is accounted
for in accordance with
 Venturers share the results HKAS 27 (2011).
and sometimes the output
of the JCE  In venturers’
consolidated financial
statements, the
investment is accounted
for using either one of
two methods:
– equity accounting
(HKAS 28 (2011))
– proportionate
consolidation
(see below)

2.3.1 Proportionate consolidation


Proportionate consolidation differs from normal consolidation in that only the group share of
assets and liabilities, income and expenses are brought into the financial statements. There is
therefore no non-controlling interest.
According to HKAS 31, this treatment reflects the substance and economic reality of the
arrangement, being that the venturer has control over its share of future economic benefits through
its share of the assets and liabilities of the venture.

2.3.2 Summary of changes between HKAS 31 and HKFRS 11/HKAS 28 (2011)


The main changes to the old rules are:
 The definitions have changed to reduce the ‘types’ of joint arrangements to two: joint
operations and joint ventures
 The existing policy choice of proportionate consolidation for jointly controlled entities has
been eliminated
 Equity accounting (as per HKAS 28 (2011)) is mandatory for participants in joint
ventures

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28: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements

 HKAS 28 now includes joint ventures as well as associates, and was renamed
accordingly.
 Joint operations will be accounted for much like joint assets or joint operations are currently.

3 Disclosure requirements
HKFRS 12.7, An entity should disclose information about significant judgments and assumptions made in
20-23 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.

3.1 Nature, extent and financial effects of an entity's interests in


joint arrangements and associates
For each joint arrangement and associate that is material to the reporting entity the following
should be disclosed:
(a) The name of the joint arrangement or associate.
(b) The nature of the entity's relationship with the joint arrangement or associate.
(c) The principal place of business/country of incorporation of the joint arrangement or
associate.
(d) The proportion of ownership interest held by the entity/proportion of voting rights held.
For each joint venture and associate that is material to the reporting entity the following should be
disclosed:
(a) Risks associated with an entity's interests in joint ventures and associates.
(b) Whether the investment in the joint venture or associate is measured using equity method or
fair value.
An entity should disclose:
(a) commitments that it has relating to its joint ventures separately from the amount of other
commitments
(b) contingent liabilities incurred relating to its interests in joint ventures or associates,
separately from the amount of other contingent liabilities.

4 Current developments
The IASB issued two exposure drafts in relation to joint arrangements and associates in December
2012. These propose minor amendments to IFRS 11 (HKFRS 11) and IAS 28 (2011) (HKAS 28
(2011)):
 Acquisition of an Interest in a Joint Operation proposes to amend IFRS 11 (and so HKFRS
11) such that a joint operator would apply the relevant principles for business combination
accounting in IFRS (HKFRS) 3 when acquiring an interest in a joint operation that constitutes

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Financial Reporting

a business. The relevant principles include measurement of identifiable net assets at fair
value and recognition of acquisition related costs as expenses as incurred.
 Sale or Contribution of Assets Between an Investor and its Associate or Joint Venture
proposes to amend IAS 28 (2011) (and so HKAS 28 (2011)) so that where an investor sells
or contributes assets that constitute a business (per the IFRS (HKFRS) 3 definition), any
gain or loss is recognised in full rather than in part as is currently required.

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28: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements

Topic recap

HKAS 28 Associates HKFRS 11 Joint Arrangements

An entity over which an investor has An arrangement of which at least 2 parties


significant influence which is neither a have joint control, i.e.:
subsidiary nor an interest in a joint Ÿ There is a contractual agreement to
venture. share control, and
Ÿ Decisions about relevant activities
require the unanimous consent of the
parties sharing control.

Significant influence:
Ÿ Power to participate but not control
Ÿ Presumed where investor holds ≥ 20%
voting shares Joint Venture Joint Operation
Ÿ 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.

Apply the Equity method


Recognise line by
line the investor's
share of:
Ÿ assets
CSOFP: investment recognised at cost + Ÿ liabilities
the investor's share of post-acquisition total Ÿ revenue
comprehensive income – impairment Ÿ expenses
losses. In separate and
consolidated
CSPLOCI: Investor's share of profit or loss financial statements.
and other comprehensive income
recognised.

Ÿ Intra-group transactions are not


cancelled
Ÿ Fair value adjustments may be required
Ÿ Gains and losses resulting from
“upstream” and “downstream”
transactions are recognised only to the
extent of unrelated investors' interests
in the associate or joint venture
Ÿ When downstream transactions provide
evidence of a reduction in the net
realisable value of assets/an
impairment loss, losses shall be
recognised in full by the investor.

Disclosures:
Ÿ How joint control or significant influence over another entity has been determined
Ÿ How the type of joint arrangement is determined when the arrangement is structured through a
separate vehicle
Ÿ The nature, extent and financial effects of interests in joint arrangements and associates
Ÿ The nature of, and changes in, risks associated with interests in joint ventures and associates.

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Financial Reporting

Answers to self-test questions

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

Parent and Adjustment 1 Adjustment 2 Group


subsidiaries
$'000 $'000 $'000 $'000
Property, plant 400 400
and equipment
Interest in 80 30 12 122
associate
Loan to associate 30 (30) -
Current assets 190 190
712
Share capital 200 200
Retained 500 12 512
earnings
712
Consolidation adjustments
1 Loan to associate
DEBIT Interest in associate 30
CREDIT Loan to associate 30
To transfer the loan to become part of the investment in associate
2 Post acquisition retained earnings
DEBIT Interest in associate 20% x (120-60) 12
CREDIT Retained earnings 12

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28: 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) 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).

Answer 4
(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.

679
Financial Reporting

Exam practice

Asia Polyethylene 90 Minutes


Assume that you are Miss Charmaine Yuen, the accounting manager of Asia Polyethylene Limited
(APE), which is a company incorporated in Hong Kong. APE and its subsidiaries (APE Group) are
principally engaged in the production and distribution of high density polyethylene (HDPE) which is
widely used for the production of plastic bags, bottle caps and fluid containers in Hong Kong. Now,
APE intends to expand its business for the production and distribution of HDPE worldwide.
Brazil Polyethylene (BPE) and Curitiba Polyethylene (CPE)
On 1 April 20X2, APE, BPE and CPE (the parties), which are not related companies, signed an
agreement in which they have agreed the terms according to which they will conduct the
manufacturing and distribution of HDPE worldwide. The parties have agreed to conduct
manufacturing and distribution activities according to the details described below:
Diadema Polyethylene (DPE)
The parties have agreed to undertake the manufacturing and distribution activity by establishing a
new incorporated entity, DPE, in which APE has a 60% ownership interest and hence 60% voting
rights, BPE has 20% and CPE has 20%. The contractual agreement specifies that at least 90% of
the voting rights are required to make decisions about activities that significantly affect the returns
of DPE. In accordance with the agreement, DPE would manufacture and distribute the HDPE in
various overseas countries according to the needs of the various markets where DPE sells the
product. The contractual arrangement among APE, BPE and CPE did not specify that the parties
have rights to the assets, and obligations for the liabilities, relating to DPE.
Embu Polyethylene (EPE) and Fatima Polyethylene (FPE)
APE acquired 80% of the shares of EPE for HK$26.55 million on 1 April 20W9. At the acquisition
date, EPE’s reported retained earnings were HK$12.25 million. The excess of APE’s acquisition
cost over its share of EPE’s book value was assigned to plant and equipment that had a fair value
of HK$2.5 million greater than book value and a remaining life of five years at the acquisition date,
and the balance to goodwill. Non-controlling interests are to be measured at their fair value at the
acquisition date, i.e. HK$6 million. The investment in EPE is carried at cost. There has been no
change in the share capital of EPE since the date of acquisition.
On 1 April 20X1, APE acquired 30% of the ordinary shares in FPE for HK$7.45 million. FPE
should be accounted for as an associate. The book value of FPE’s net assets was the same as
their fair value as at the acquisition date. There has been no change in the share capital of FPE
since the date of acquisition.

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28: Consolidated accounts: accounting for associates and joint arrangements | Part D Group financial statements

An extract of the financial statements of the three companies for the year ended
31 March 20X2 is shown below.

APE EPE FPE


HK$'000 HK$'000 HK$'000
Sales 80,000 35,750 18,000
Cost of sales (55,000) (24,500) (12,000)
Other income (including gain on disposal and
EPE’s dividend) 3,700 – –
Depreciation expense (8,000) (1,700) (400)
Interest expense (5,900) (1,600) (550)
Other expenses (3,800) (4,200) (2,850)
Profit for the year 11,000 3,750 2,200
Retained earnings, 1 April 20X1 44,000 22,500 11,250
Dividends declared (3,500) (1,250) –
Retained earnings, 31 March 20X2 51,500 25,000 13,450

Plant and equipment, net 43,000 19,000 10,800


Investment in EPE, cost 26,550 – –
Investment in FPE, cost 7,450 – –
Other investments 20,750 1,250 –
Inventory 41,250 20,000 10,400
Receivables 10,000 11,000 9,000
Cash and cash equivalents 7,500 8,750 5,800
156,500 60,000 36,000

Share capital 30,000 15,000 7,500


Retained earnings 51,500 25,000 13,450
Payables 75,000 20,000 15,050
156,500 60,000 36,000
On 1 April 20X1, APE held inventory of HK$2.5 million purchased from EPE during the year ended
31 March 20X1; these goods had been manufactured by EPE at a cost of HK$1.6 million. During
the year ended 31 March 20X2, EPE sold goods costing HK$6 million to APE for HK$9 million.
APE sold the inventory of HK$2.5 million on hand at the beginning of the year, but held 35% of its
current year’s purchases from EPE on 31 March 20X2.
APE sold plant and equipment at a transfer price of HK$10 million (with an original carrying amount
of HK$8 million) to FPE on 1 April 20X1. On that date, that plant and equipment had a remaining
useful life of five years.
Bankrupt Customer
APE has a financial year end of 31 March 20X2 and the financial statements are to be authorised
for issue on 15 June 20X2. On 15 May 20X2, it was discovered that a customer owing HK$650,000
had gone into bankruptcy. The adjustments, if necessary, have not been recorded in the draft
financial statements listed above.
Ms. Pindy Lee, a director of APE is concerned about the implications of the above transactions and
information. She wonders if it is necessary for APE to take into account the results of the above
investments, arrangements and events and if it may make a difference in the consolidation
process.

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Financial Reporting

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)

HKICPA December 2012 (amended)

682
chapter 29

Changes in group
structures

Topic list 2.3 Preparation of the consolidated financial


statements
1 Disposals 2.4 Increased shareholding in subsidiary
1.1 Types of disposal
3 Merger accounting for common control
1.2 Full disposal of a subsidiary
combinations
1.3 Partial disposal of subsidiary: subsidiary
3.1 Introduction
to subsidiary
3.2 The principles
1.4 Partial disposal of subsidiary: subsidiary
3.3 The procedures
to associate
3.4 Accounting period covered by a newly
1.5 Partial disposal of subsidiary: subsidiary
formed parent
to financial asset
3.5 Disclosures in addition to those required
1.6 Reclassification adjustments
by applicable HKFRS
1.7 Full disposal of associate
3.6 Earnings per share
1.8 Partial disposal of associate: associate
to financial asset 4 HK(IFRIC) Int-17 Distributions of Non-cash
1.9 Disclosure requirements on the disposal Assets to Owners
of an investment 4.1 The issue
4.2 Key provisions
2 Step acquisitions
2.1 Application of acquisition accounting
2.2 Calculation of goodwill when control is
acquired

Learning focus

The acquisition and disposal of investments in group companies is a common occurrence in


business. The "clean" transactions that we have already seen where a controlling
shareholding is purchased on one date are not always how an acquisition is achieved.
Gradual (or step) acquisitions are common and you must be able to deal with both these and
disposals – either of a whole investment or part of an investment.

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Financial Reporting

Learning outcomes

In this chapter you will cover the following 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

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29: 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.

1.1 Types of disposal


The type of disposal may be categorised as one of the following, each of which we shall deal with
in turn in this chapter:
 Full disposal of a subsidiary
 Partial disposal of a subsidiary such that the investment remains a subsidiary
 Partial disposal of a subsidiary such that the investment becomes an associate
 Partial disposal of a subsidiary such that the investment becomes a financial asset
 Full disposal of an associate
 Partial disposal of an associate such that the investment becomes a financial asset
Before considering each type of disposal in turn, we must consider the issue of loss of control.
HKFRS 3 (revised) and HKFRS 10 do not consider the second situation above to be a disposal, as
control is not lost. This situation is therefore accounted for in a different way from other partial
disposals.
1.1.1 Loss of control or significant influence
HKFRS consider a disposal to involve the loss of control or significant influence; this has been
referred to as "crossing an accounting boundary". The date of disposal is therefore the date on
which control or significant influence is lost.

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Financial Reporting

The diagram below may help you visualise the boundary:

HKFRS 9 HKAS 28 (2011) / HKFRS 10


HKFRS 11

10% Loss of control but retaining financial


asset

40%
Loss of control but retaining an
associate or a jointly controlled entity

Loss of significant influence or joint


10%
control but retaining a financial asset

0% Passive 20% Significant 50% Control 100%


influence / joint
control

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 either at cost 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.

HKFRS 10.25 1.2 Full disposal of a subsidiary


Topic highlights
Where a subsidiary is disposed of in full a gain or loss on disposal is recognised in the parent's
individual and the consolidated accounts. The amount of the gain or loss will be different in the
individual and the consolidated accounts. The results of the subsidiary are consolidated to the date
of disposal.

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.

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29: Changes in group structures | Part D Group financial statements

1.2.1 Gain or loss in parent company's accounts


The gain or loss on disposal in the parent company's individual accounts is relatively
straightforward. Proceeds are compared with the carrying value of the investment sold:
$
Fair value of consideration received X
Less: carrying value of investment disposed of (X)
Profit/(loss) on disposal X/(X)

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.
1.2.3 Preparation of the consolidated financial statements
Where there has been a full disposal of a subsidiary during the accounting period:
(a) That subsidiary is not recognised in the statement of financial position at the period end, nor
is any non-controlling interest
(b) The results of the subsidiary are included in the consolidated statement of profit or loss and
other comprehensive income only until the date on which control is lost
(c) The non-controlling interests in profit and total comprehensive income represents the NCI
share of these amounts only until control is lost
If the subsidiary is classified as a discontinued operation per HKFRS 5 the consolidated
statement of profit or loss and other comprehensive income should include in one line "Profit for
the period from discontinued operations", being the group profit on disposal plus the
subsidiary's profit for the year to disposal.

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 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.
What gain is reported
(a) in Land Co.'s individual accounts?
(b) in the Land Group consolidated accounts?
(The answer is at the end of the chapter)

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Financial Reporting

HKFRS 10.23 1.3 Partial disposal of subsidiary: subsidiary to subsidiary


Topic highlights
Where control is not lost on the disposal of shares there is no gain or loss in the consolidated
accounts; instead the transaction results in an adjustment to shareholders' funds.

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.

1.3.1 Adjustment to shareholders' equity


The adjustment to shareholders' equity is calculated as the difference between the proceeds
received and the change in the non-controlling interests as a result of the transaction.

Example: Adjustment on disposal


Manta Co. acquired 90% of Ray Co. in 20X6 and at this time goodwill was calculated as $65,000
using the proportion of net assets method to value the non-controlling interests. Goodwill has been
impaired by $15,000 since acquisition.
On 31 August 20X9 Manta Co. disposed of a 20% holding in Ray Co. for $120,000; on this date the
net assets of Ray Co. were $560,000.
What adjustment is required as a result of the disposal?

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 Proceeds 120,000
CREDIT NCI 112,000
Shareholders' equity ($120,000 – $112,000) 8,000

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29: Changes in group structures | Part D Group financial statements

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.
What adjustment is required to shareholders' equity on the disposal?
(The answer is at the end of the chapter)

1.3.2 Preparation of the consolidated financial statements (subsidiary to


subsidiary)
In the statement of financial position:
 the non-controlling interests are based on the year-end percentage
 goodwill on acquisition is unchanged as a result of the partial sale of the shareholding
 parent's equity is adjusted as above
In the statement of profit or loss and other comprehensive income:
 the subsidiary's results are included for the whole accounting period
 the non-controlling interests are based on pro-rated profits and total comprehensive income
 there is no profit or loss on disposal.

HKFRS 10.25 1.4 Partial disposal of subsidiary: subsidiary to associate


Topic highlights
Where a subsidiary becomes an associate or financial asset, a gain or loss is recognised in the
consolidated accounts. This includes the gain on the shares disposed of and the revaluation of the
shares retained.

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.
1.4.1 Gain in the consolidated accounts
Where control is lost, the gain in the consolidated accounts is calculated as:
$ $
Proceeds X
Fair value of interest retained X
X
Less: net assets of subsidiary recognised prior to disposal
Net assets X
Goodwill X
Non-controlling interests (X)
(X)
Profit / loss X/(X)

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Financial Reporting

It may seem odd that the fair value of the interest retained forms part of this calculation, but this is
because the gain is essentially made up of two parts:
 A realised gain on the shares disposed of
 An unrealised gain on the revaluation of the shares retained to fair value.
The following example will help you to see this.

Example: Gain or loss


Ives Group acquired 95% holding in Hunt Co. in 20X6, which it held until 31 May 20X9 when a 55%
shareholding was sold for $670,000, so reducing Ives Group's investment to 40%.
At the disposal date the net assets of Hunt Co. were $900,000, goodwill arising on acquisition had
been fully impaired and the fair value of a 40% interest in Hunt was $390,000.
The non-controlling interests are valued using the proportion of net assets method.
Required
What gain or loss arises on the disposal?
$ $
Proceeds 670,000
Fair value of interest retained 390,000
1,060,000
Less: Amounts recognised prior to disposal
Net assets of Hunt 900,000
Goodwill (fully impaired) –
NCI at disposal (5%  $900,000) (45,000)
(855,000)
Gain on disposal 205,000
The gain can be analysed as follows:
Gain on disposal
$
Proceeds 670,000
Net assets disposed of ($900,000  55%) (495,000)
175,000
Gain on revaluation of retained interest
Fair value of retained interest 390,000
Net assets retained ($900,000  40%) (360,000)
30,000

1.4.2 Preparation of the consolidated financial statements (subsidiary to


associate)
In the statement of financial position:
 The interest in the associate is equity accounted for based on the year-end shareholding.
For this purpose, the cost of the investment is taken to be the fair value of the interest
retained at the date the investment became an associate holding.
In the statement of profit or loss and other comprehensive income:
 The results of the investment are pro-rated and:
– consolidated until the disposal date
– equity accounted thereafter
 The gain or loss on disposal, calculated as above is recognised.

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29: Changes in group structures | Part D Group financial statements

Example: Partial disposals


Linda Co. bought 100% of the voting share capital of Vivi Co. on its incorporation on
1 January 20X2 for $160,000. Vivi Co. earned and retained $240,000 from that date until
31 December 20X7. At that date the statements of financial position of the company and the group
were as follows:
Linda Co. Vivi Co. Consolidated
$'000 $'000 $'000
Investment in Vivi 160 – –
Other net assets 1,000 500 1,500
1,160 500 1,500
Share capital 400 160 400
Reserve 560 240 800
Current liabilities 200 100 300
1,160 500 1,500
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.
On 1 January 20X8 Linda Co. sold 40% of its shareholding in Vivi Co. for $280,000. The profit on
disposal (ignoring tax) in the financial statements of the parent company is calculated as follows:
Linda
$'000
Fair value of consideration received 280
Carrying value of investment (40%  160) (64)
Profit on sale 216
We now move on to calculate the adjustment to equity for the group financial statements.
Because only 40% of the 100% subsidiary has been sold, leaving a 60% subsidiary, control is
retained. This means that there is no group profit on disposal in profit or loss for the year.
Instead, there is an adjustment to the parent's equity, which affects group reserve.
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.)

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Financial Reporting

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.

Solution: Associate status


Using the above example, assume that Linda Co. sold 60% of its holding in Vivi Co. for $440,000.
The fair value of the 40% holding retained was $200,000. The gain or loss on disposal in the books
of the parent company would be calculated as follows:
Parent
company
$'000
Fair value of consideration received 440
Carrying value of investment (60%  160) (96)
Profit on sale 344
This time control is lost, so there will be a gain in group profit or loss, calculated as follows:
$'000
Fair value of consideration received 440
Fair value of investment retained 200
Less: Net assets of Vivi Co. at date control lost (400)
Group profit on sale 240
(Note. There was no goodwill arising on the acquisition, otherwise this goodwill would be deducted
in the calculation.)
The statements of financial position would now appear as follows:
Linda Co. Vivi Co. Consolidated
$'000 $'000 $'000
Investment in Vivi (Note 1) 64 -– 200
Other assets 1,440 500 1,440
1,504 500 1,640
Share capital 400 160 400
Retained earnings (Note 2) 904 240 1,040
Current liabilities 200 100 200
1,504 500 1,640

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29: Changes in group structures | Part D Group financial statements

Notes
1 The investment in Vivi is at fair value in the group accounts. It is equity accounted based on
the fair value at the date control was lost plus the share of post-acquisition retained earnings.
As yet there are no retained earnings because control has only just been lost at
31 December 20X7.
2 Linda's reserves are $560,000 + the profit on sale of $344,000 i.e. $904,000. Group retained
earnings are $800,000 (per question) plus group profit on the sale of $240,000, i.e.
$1,040,000.

HKFRS 10.25 1.5 Partial disposal of subsidiary: subsidiary to financial


asset
As in the case of a partial disposal which results in a subsidiary holding becoming an associate,
where a subsidiary becomes a financial asset, control is lost. Therefore, a gain or loss on disposal
is recognised in the consolidated financial statements.
This is calculated using the same method as that shown in section 1.4.1. In other words, the
retained investment is revalued to fair value and the gain or loss on this revaluation forms part of
the overall gain or loss on disposal.
Again, the gain or loss for inclusion in the parent company's own financial statements is the
difference between the proceeds and the carrying amount of the investment sold.
1.5.1 Preparation of the consolidated financial statements (subsidiary to
financial asset)
In the statement of financial position:
 the investment is recognised at its fair value at the date of disposal
 thereafter it is accounted for in accordance with HKFRS 9.
In the statement of profit or loss and other comprehensive income:
 the results of the investment are pro-rated and consolidated until the date of disposal
 thereafter only dividend income is included
 a gain or loss on disposal is recognised.

HKFRS 1.6 Reclassification adjustments


10.B98-99
Where control of a subsidiary is lost, any amounts recognised in other comprehensive income at
the date of disposal in relation to the subsidiary should be accounted for in the same way as if the
parent company had directly disposed of the assets that they relate to.
Therefore, where the subsidiary holds financial assets at fair value through other comprehensive
income then on disposal, the amounts of other comprehensive income recorded in the consolidated
accounts in relation to these are reclassified to profit or loss (recycled) and form part of the gain on
disposal.
If the subsidiary holds revalued assets, the revaluation surplus previously recognised in
consolidated other comprehensive income should be transferred to group retained earnings.

Example: Reclassification adjustments on loss of control


In 20X7, 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. Of this, $15,000 was
reported in profit or loss and $5,000, relating to financial assets held at fair value through other
comprehensive income, was reported within other comprehensive income. A then disposed of 75%

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Financial Reporting

of its equity interest for cash consideration of $115,000. The resulting 25% equity interest is
classified as an associate under HKAS 28 (2011) and has a fair value of $38,000.
The gain recognised in profit or loss on disposal of the 75% equity interest is:
$
Fair value of consideration received 115,000
Fair value of residual interest 38,000
Gain previously reported in other comprehensive income 5,000
158,000
Less: net assets and goodwill derecognised (145,000)
Gain 13,000

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.
(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)

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29: Changes in group structures | Part D Group financial statements

1.7 Full disposal of associate


Topic highlights
Where an associate is fully or partially disposed of, a gain or loss is recognised in the consolidated
financial statements. The gain or loss on a partial disposal includes the revaluation of the retained
investment.

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

1.8 Partial disposal of associate: associate to financial asset


Where part of an associate shareholding is disposed of such that it becomes a financial asset (for
example, a 40% holding becomes a 10% holding), then significant influence is lost.
In this case a gain arises in the parent company's financial statements, calculated as before, and a
gain is also calculated in the consolidated financial statements, calculated as:
$ $
Proceeds X
Fair value of interest retained X
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)
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.

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Financial Reporting

1.8.1 Preparation of the consolidated financial statements (associate to


financial asset)
In the statement of financial position:
 the investment is recognised at its fair value at the date of disposal
 thereafter it is accounted for in accordance with HKFRS 9.
In the statement of profit or loss and other comprehensive income:
 the group share of the associate's results is included to the date of disposal
 thereafter only dividend income is included
 a gain or loss on disposal is recognised.

1.9 Disclosure requirements on the disposal of an investment


HKFRS 12 Disclosure of Interests in Other Entities requires particular disclosures where there is a
change in ownership of a subsidiary.
Where there is a change in ownership that does not result in a loss of control, a schedule must be
presented that shows the effects on equity attributable to owners of the parent of the change in
ownership interest.
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.

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).

2.1 Application of acquisition accounting


It is important to realise acquisition accounting is only applied on the date that control is achieved
and therefore goodwill does not arise until this time. The date on which subsidiary status is
achieved is therefore referred to as the acquisition date.

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29: Changes in group structures | Part D Group financial statements

Earlier in the chapter we looked at "crossing the accounting boundary" in the context of disposals.
The same "accounting boundary" principle applies to acquisition accounting:

HKFRS 9 HKAS 28 (2011) HKFRS 10


/ HKFRS 11

10%

40%

0% Passive 20% Significant 50% Control 100%


influence/
joint control

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

Example: Financial asset under HKFRS 9 becomes a subsidiary


A acquired a 75% controlling interest in B in two stages.
1 In 20X3, A acquired a 15% equity interest for cash consideration of $10,000. A classified the
interest as financial assets at fair value through other comprehensive income in accordance
with HKFRS 9. From 20X3 to the end of 20X7, A reported fair value increases of $2,000 in
other comprehensive income (OCI).

697
Financial Reporting

2 In 20X8, A acquired a further 60% equity interest for cash consideration of $60,000.
A identified net assets of B with a fair value of $80,000. A elected to measure non-controlling
interests at their share of net assets. On the date of acquisition, the previously-held 15%
interest had a fair value of $12,500.
$
In 20X8, A will include $2,500 in profit or loss, being:
Gain on "disposal" re-measurement of 15% investment to fair value ($12,500 500
– $12,000)
Gain previously reported in OCI ($12,000 – $10,000) 2,000
Total 2,500
In 20X8, A will measure goodwill as follows:
Fair value of consideration given for controlling interests 60,000
Non-controlling interests (25%  $80,000) 20,000
Fair value of previously-held interest 12,500
92,500
Less: fair value of net assets of acquiree (80,000)
Goodwill 12,500

Example: Associate becomes a subsidiary


C acquired a 75% controlling interest in D in two stages.
1 In 20X3, C acquired a 40% equity interest for cash consideration of $40,000.
C classified the interest as an associate under HKAS 28 (2011). At the date that C acquired
its interest, the fair value of D's identifiable net assets was $80,000. From 20X3 to 20X7,
C equity accounted for its share of undistributed profits totalling $5,000, and included its
share of revaluation gain of $3,000 in other comprehensive income (OCI). Therefore, in
20X7, the carrying amount of C's interest in D was $48,000.
2 In 20X8, C acquired a further 35% equity interest for cash consideration of $55,000.
C identified net assets of D with a fair value of $110,000. C elected to measure non-
controlling interests at fair value of $30,000. On the date of acquisition, the previously-held
40% interest had a fair value of $50,000.
In 20X8 (ignoring any profits earned prior to the acquisition), C will include $2,000 in profit or loss,
being:
$
Fair value of previously-held interest 50,000
Less: carrying amount under HKAS 28 (2011) 48,000
Gain on disposal of investment in associate 2,000
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.
In 20X8, 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

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29: Changes in group structures | Part D Group financial statements

2.3 Preparation of the consolidated financial statements


As we saw earlier in the chapter, a mid-year change in the status of an investment requires that its
results are pro-rated and accounted for accordingly.
2.3.1 Financial asset to subsidiary
When a financial asset becomes a subsidiary:
 in the consolidated statement of financial position the investment is consolidated based upon
the year-end shareholding; goodwill is recognised on the acquisition.
 in the consolidated statement of profit or loss and other comprehensive income:
– Until the date on which control was achieved, only dividend income is shown
– After the date on which control was achieved, results are consolidated.
2.3.2 Associate to subsidiary
When an associate becomes a subsidiary:
 again, in the consolidated statement of financial position the investment is consolidated
based upon the year-end shareholding; goodwill is recognised on the acquisition.
 in the consolidated statement of profit or loss and other comprehensive income:
– Until the date on which control was achieved, the investment's results are equity
accounted
– After the date on which control was achieved the results are consolidated.

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.

Example: Increase of shareholding in subsidiary


A parent owns an 80% interest in a subsidiary which has net assets of $4,000. The carrying
amount of the non-controlling interests is $800. The parent acquires an additional 10% interest
from the non-controlling interests for $500. The adjustment required is:

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Financial Reporting

$
Fair value of consideration paid (500)
Decrease in NCI in net assets at date of transaction (10%  $4,000) 400
Adjustment to parent's equity (100)
The parent accounts for this directly in consolidated equity as follows:
$ $
DEBIT Equity – non-controlling interests 400
Equity – controlling interests 100
CREDIT Cash 500

Example: Parent acquires non-controlling interest


In 20X8, A acquired a 75% equity interest in B for cash consideration of $90,000. B's identifiable
net assets at fair value were $100,000. The fair value of the 25% non-controlling interests (NCI)
was $28,000. Goodwill, on the two alternative bases for measuring non-controlling interests at
acquisition, is calculated as follows:
NCI at NCI at
% of net assets fair value
$ $
Fair value of consideration 90,000 90,000
Non-controlling interests 25,000 28,000
115,000 118,000
Fair value of net assets 100,000 100,000
Goodwill 15,000 18,000
In the subsequent years, B increased net assets by $20,000 to $120,000. This is reflected in the
carrying amount within equity attributed to non-controlling interests as follows:
NCI at NCI at
% of net assets fair value
$ $
Non-controlling interests at acquisition 25,000 28,000
Increase (25%  $20,000) 5,000 5,000
Carrying amount 30,000 33,000
In 20X8, A then acquired the 25% equity interest held by non-controlling interests for cash
consideration of $35,000. The adjustment to equity will be:
NCI at NCI at
% of net assets fair value
$ $
Fair value of consideration 35,000 35,000
Carrying amount of non-controlling interests 30,000 33,000
Negative movement in parent equity 5,000 2,000
As indicated in HKFRS 3 (revised 2008), the reduction in equity is greater where the option was
taken to measure non-controlling interests at acquisition date as a proportionate share of the
acquiree's identifiable net assets. The treatment has the effect of including the non-controlling
interest's share of goodwill directly in equity. This outcome will always occur where the fair value
basis is greater than the net asset basis at acquisition date.

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29: Changes in group structures | Part D Group financial statements

Example: Parent acquires part of a non-controlling interest


The facts are as in the previous example: The parent acquires non-controlling interests above
except that, rather than acquire the entire non-controlling interests, A acquires an additional 15%
equity interest held by non-controlling interests for cash consideration of $21,000. The adjustment
to the carrying amount of non-controlling interests will be:
NCI at NCI at
% of net assets fair value
$ $
Balance as in the previous example 30,000 33,000
Transfer to parent (15/25) 18,000 19,800
10% interest carried forward 12,000 13,200*
The adjustment to equity will be:
Fair value of consideration 21,000 21,000
Change to non-controlling interests (as above) 18,000 19,800
Negative movement 3,000 1,200

* 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 4
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)

Example: Step acquisition of a subsidiary


Happy acquired 25% of the 800,000 shares of Frankie on 1 January 20X8 for $2,020,000 when
Frankie's reserves were standing at $5,800,000. The fair value of Frankie's identifiable assets and
liabilities at that date was $7,200,000. Both Happy and Frankie are stock market listed entities.
At 31 December 20X8, the fair value of Happy's 25% stake in Frankie was $2,440,000.
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 acquired on that date) giving Happy control over Frankie. The

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Financial Reporting

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 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.

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29: 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 + (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

Had 25% Acquired 35% Consol in


associate SOFP
25% + 35%
with 40%
= 60%
NCI
Subsidiary
Part (ii)
30 31
1 January September December
20X9 20X9 20X9

SOCI
Consolidate
3
 /12

Had 25% Acquired 35% Consol in


financial asset SOFP
25% + 35%
with 40%
= 60%
NCI
Subsidiary

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Financial Reporting

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 an AFSFA) (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

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29: Changes in group structures | Part D Group financial statements

$'000
Fair value at date control obtained (200,000 shares  $14.375) 2,875
Cost (2,020)
855
Note. The profit would be the same whether the available-for-sale 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
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

Land (9,400 – (800 + 7,800)) 800 – 800


(b) (i) Current assets (14,900 – 1,200) = $13,700,000
(ii) Non-controlling interests
$'000
Net assets at year end per question 8,700
Fair value adjustment (W8) 800
9,500
 30% = $2,850,000
Consolidated reserves
$'000
Per part (a) 40,660
Adjustment to parent's equity on acq'n of 10% (W) (250)
40,410
Note. No other figures in the statement of financial position are affected.
WORKING
Adjustment to parent's equity on acquisition of additional 10% of Frankie
$'000
Fair value of consideration paid (1,200)
Decrease in NCI in net assets at acq'n (9,500  10%) 950
(250)

Example: Step acquisition of a subsidiary with non-controlling interest at fair value


The facts are the same as in the previous example, except that group policy is to measure non-
controlling interests at the date of acquisition at fair value. The fair value of the non-controlling
interests at acquisition was $4,600,000.

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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 + (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)

1 January 30 September 31 December


20X9 20X9 20X9

SOCI
9
Associate – Equity account  /12 Consolidate
3
 /12

Had 25% Acquired 35% Consol in


associate SOFP
25% + 35%
with 40%
= 60%
NCI
Subsidiary

Part (ii)

1 January 30 September 31 December


20X9 20X9 20X9

SOCI
Consolidate
3
 /12

Had 25% Acquired 35% Consol in


financial asset SOFP
25% + 35%
with 40%
= 60%
NCI
Subsidiary

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29: Changes in group structures | Part D Group financial statements

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

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 355
investment (Note)
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

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Financial Reporting

4 Consolidated reserves (if previously held as financial assets) (ii)


Happy Frankie
$'000 $'000
Per question 40,720 7,900
Profit on derecognition of investment (Note) 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

Note. Profit on derecognition of 25% investment


$'000
Fair value at date control obtained (200,000 shares  $14.375) 2,875
Cost (2,020)
855

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

3 Merger accounting for common control combinations


3.1 Introduction
Topic highlights
A key issue involved in a business combination is to determine whether a particular arrangement
should be classified as an acquisition or a merger (pooling of interests or uniting of interests).

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

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29: Changes in group structures | Part D Group financial statements

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.

3.2 The principles


The concept underlying the use of merger accounting to account for a common control combination
is that no acquisition has occurred and there has been a continuation of the risks and benefits to
the controlling party (or parties) that existed prior to the combination. Use of merger accounting
recognises this by accounting for the combining entities or businesses as though the separate
entities or businesses were continuing as before.
In applying merger accounting, financial statement items of the combining entities or businesses for
the reporting period in which the common control combination occurs, and for any comparative
periods disclosed, are included in the consolidated financial statements of the combined entity as if
the combination had occurred from the date when the combining entities or businesses first came
under the control of the controlling party or parties.
Where the combining entities or businesses include an entity or a business previously acquired
from a third party, the financial statement items of such entity or business are only included in the
consolidated financial statements of the combined entity from the date of the previous acquisition
using the acquisition values recognised at that date.
A single uniform set of accounting policies is adopted by the combined entity. Therefore, the
combined entity recognises the assets, liabilities and equity of the combining entities or businesses
at the carrying amounts in the consolidated financial statements of the controlling party or parties
prior to the common control combination. If consolidated financial statements were not previously
prepared by the controlling party or parties, the carrying amounts are included as if such
consolidated financial statements had been prepared, including adjustments required for
conforming the combined entity's accounting policies and applying those policies to all periods
presented. These carrying amounts are referred to below as existing book values from the
controlling parties' perspective. There is no recognition of any additional goodwill or excess of

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Financial Reporting

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.

3.3 The procedures


In the consolidated financial statements under merger accounting:
1 No adjustment is required to the carrying values of the assets and liabilities of the acquired
company on consolidation, except to achieve uniformity of accounting policies of the
combining companies.
2 There is no distinction between pre- and post-acquisition reserves. The distributable
reserves of the acquired company are not capitalised and remain distributable.
3 The consolidated statement of profit or loss includes the results of each of the combining
entities or businesses from the earliest date presented (i.e. including the comparative period)
or since the date when the combining entities or businesses first came under the control of
the controlling party or parties, where this is a shorter period, regardless of the date of the
common control combination. The consolidated statement of profit or loss also takes into
account the profit or loss attributable to the non-controlling interests recorded in the
consolidated financial statements of the controlling party.
4 Comparative figures should be presented as if the companies had been combined
throughout the previous period and at the previous reporting date unless the combining
entities or businesses first came under common control at a later date.
5 No amount is recognised as consideration for goodwill or excess of acquirer's interest in the
net fair value of acquiree's identifiable assets, liabilities and contingent liabilities over cost at
the time of common control combination, to the extent of the continuation of the controlling
party or parties' interests.
6 Expenditure incurred in relation to a common control combination that is to be accounted for
by using merger accounting is recognised as an expense in the period in which it is
incurred. Such expenditure includes professional fees, registration fees, costs of furnishing
information to shareholders, and salaries and other expenses involved in achieving the
common control combination. It also includes any costs or losses incurred in combining
operations of the previously separate businesses.
7 Consolidation is performed in accordance with HKFRS 10. The principal consolidation
entries are as follows:
(a) The effects of all transactions between the combining entities or businesses, whether
occurring before or after the common control combination, are eliminated; and
(b) Since the combined entity will present one set of consolidated financial statements, a
uniform set of accounting policies is adopted which may result in adjustments to the
assets, liabilities and equity of the combining entities or businesses.

3.4 Accounting period covered by a newly formed parent


A common control combination may be effected by setting up a new parent which acquires the
issued shares or equity of the combining entities or businesses in exchange for the issue of its own
shares. In such cases, the first accounting period of the new parent will frequently be a period of
less than a year, ending on the reporting date chosen for the group. This will normally be the
existing reporting date of one or more of the combining entities or businesses.
Frequently, the date of formation of the new parent will not coincide with the beginning or end of
the group's accounting periods. Strictly, if the parent is a Hong Kong incorporated company, the

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29: Changes in group structures | Part D Group financial statements

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.

3.5 Disclosures in addition to those required by applicable


HKFRS
Entities applying AG5 in accounting for a common control combination using the principles of
merger accounting shall disclose in their consolidated financial statements the fact that this
Guideline has been used.
Entities shall disclose the accounting policy applied in accounting for a common control
combination by using the principles of merger accounting. Details of the accounting policy shall
include, but not be limited to, a discussion of the specific principles and bases applied under
merger accounting.
Bearing in mind the necessity of showing a true and fair view, entities applying AG5 shall disclose
in their consolidated financial statements significant details of the common control combinations.
For each common control combination accounted for by using merger accounting, the following
information shall be disclosed:
(a) The names of the combining entities (other than the reporting entity);
(b) The date of the common control combination;
(c) The composition of the consideration and fair value of the consideration other than shares
issued;
(d) The nature and amount of significant accounting adjustments made to the net assets and net
profit or loss of any entities or businesses to achieve consistency of accounting policies, and
an explanation of any other significant adjustments made to the net assets and net profit or
loss of any entity or business as a consequence of the common control combination; and
(e) A statement of the adjustments to consolidated reserves.

3.6 Earnings per share


Ordinary shares issued as part of a common control combination which is accounted for using
merger accounting are included in the calculation of the weighted average number of shares
for all periods presented because the consolidated financial statements of the combined entity are
prepared as if the combined entity had always existed. Therefore, the number of ordinary shares
used for the calculation of basic earnings per share in a common control combination which is
accounted for using merger accounting is the aggregate of the weighted average number of shares
of the entity whose shares are outstanding after the combination.

Example: Merger accounting


Pear has three subsidiaries, Xero, Yoho and Apex.
Pear acquired 100% of Xero for $28,000 many years ago. At that time, Pear recorded goodwill of
$13,000 and fair value of identifiable assets acquired of $15,000 (which is equal to the then
carrying amounts of the assets acquired).
Pear set up Yoho with a party outside the group, Shareholder S, many years ago. Pear's cost of
investment in Yoho was $15,000, being 75% of the share capital of Yoho.
On 1 January 20X0, Pear formed a new entity, Apex, through share capital injection of $20,000.

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Financial Reporting

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.

Before the business After the business


combination combination

Pear Pear
New parent 85%
entity
Apex

100% 100% 75%


100% 100%
Apex Xero Yoho Xero Yoho

The statements of profit or loss of Apex, Xero and Yoho for the year ended 31 December 20X1 are:
Apex Xero Yoho
$ $ $

Revenue 3,000 40,000 50,000


Profit or loss (5,000) 20,000 20,000

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 – –

Other assets 13,000 13,000 100,000 120,000


Net assets 13,000 246,000 100,000 120,000
Capital 20,000 253,000 10,000 20,000
Accumulated profits (losses) (7,000) (7,000) 90,000 100,000

13,000 246,000 100,000 120,000

* 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.

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29: Changes in group structures | Part D Group financial statements

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

Capital 20,000 10,000 20,000


Accumulated profits (losses) (2,000) 70,000 80,000
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 $

Revenue 3,000 40,000 50,000 93,000

Profit or loss (5,000) 20,000 20,000 35,000


Attributable to the 5,000 (Y1) (5,000)
former non-controlling
interests in Yoho
Attributable to the 30,000
equity holders of
Apex

Adjustment
Y1 Being an adjustment to reflect the profit attributable to the non-controlling interests in Yoho
prior to the combination. ($20,000  25%)

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Financial Reporting

The consolidated statement of financial position of Apex as at 31 December 20X1 is:


Apex Xero Yoho Adjustments Consolidated
$ $ $ $ Adj $
Goodwill 13,000 (X1) 13,000
Investment in (113,000) (X3) –
Xero and Yoho 233,000 – – (120,000) (Y5)
Other assets 13,000 100,000 120,000 233,000

Net assets 246,000 100,000 120,000 246,000

Capital 253,000 10,000 20,000 (10,000) (X3) 253,000


(20,000) (Y5)
Other reserve – – – (85,000) (X3) (160,000)
(75,000) (Y5)
Retained earnings (7,000) 90,000 100,000 (5,000) (X2) 153,000
(25,000) (Y4)
246,000 100,000 120,000 246,000

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

Profit or loss (3,000) 15,000 12,000 24,000


Attributable to the 3,000 (Y1) (3,000)
non-controlling
interests
Attributable to the 21,000
equity holders of
Apex

Adjustment
Y1 Being an adjustment to reflect the profit attributable to the non-controlling interests in Yoho
prior to the combination ($12,000  25%).

714
29: Changes in group structures | Part D Group financial statements

The consolidated statement of financial position of Apex as at 31 December 20X0 is:


Apex Xero Yoho Adjustments Consolidated
$ $ $ $ Adj $
Goodwill 13,000 (X2) 13,000
Investment in Xero 203,000 (1) –
and Yoho – – – (113,000) (X4)
(90,000) (Y5)
Other assets 18,000 80,000 100,000 198,000
Net assets 18,000 80,000 100,000 211,000
Capital
20,000 10,000 20,000 203,000 (1) 223,000
(10,000) (X4)
(20,000) (Y5)
Other reserve – – – (85,000) (X4) (160,000)
(75,000) (Y5)
Non-controlling interests 25,000 (Y5) 25,000
Retained earnings (2,000) 70,000 80,000 (5,000) (X3) 123,000
(20,000) (Y5)
18,000 80,000 100,000 211,000
Note: The comparative figures are restated as if the entities had been combined at the previous
end of reporting period. The consolidated share capital represents the share capital of Apex
adjusted for the share capital issued for the purposes of the business combination.
Adjustments
1 Being an adjustment to push back the capital issued for the purposes of the business
combination ($203,000, of which $113,000 relating to Xero and $90,000 relating to Yoho).
The aim of the consolidated financial statements in merger accounting is to show the
combining entities' results and financial positions as if they had always been combined.
Consequently, the share capital in respect of 14,000 shares issued for the purposes of the
business combination has to be shown as if it had always been issued.
Relating to Xero:
X2 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).
X3 Being an adjustment to eliminate the accumulated profits of Xero generated prior to the
original acquisition of Xero by Pear ($5,000).
X4 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.
Relating to Yoho:
Y5 Being an adjustment to eliminate the share capital of Yoho against the related investment
cost of Apex. Prior to the business combination, Pear only had 75% equity interest in Yoho.
Non-controlling interests of $25,000 were recorded as at 31 December 20X0. An adjustment
of $75,000 has been made to a separate reserve in the consolidated financial statements of
Apex.
Earnings per share
Based on the same facts as per the above example, the calculation of basic earnings per share for
each period presented in the consolidated financial statements of Apex is based on the
consolidated profit (excluding the profit attributable to the non-controlling interests), and on the
40,000 shares (comprising 20,000 shares of Apex in issue throughout the two years ended
31 December 20X1 and 20,000 shares of Apex issued on 31 December 20X1 as consideration for
the equity interests in Xero and Yoho).

715
Financial Reporting

4 HK(IFRIC) Int-17 Distributions of Non-cash Assets to


Owners
4.1 The issue
Topic highlights
When an entity declares a distribution and has an obligation to distribute the assets concerned to
its owners, it must recognise a liability for the dividend payable.

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?

4.2 Key provisions


4.2.1 When to recognise a dividend payable
The liability to pay a dividend shall be recognised when the dividend is appropriately authorised
and is no longer at the discretion of the entity, which is the date:
(a) when declaration of the dividend, e.g. by management or the board of directors, is approved
by the relevant authority, e.g. the shareholders, if the jurisdiction requires such approval, or
(b) when the dividend is declared, e.g. by management or the board of directors, if the
jurisdiction does not require further approval.
4.2.2 Measurement of a dividend payable
An entity shall measure a liability to distribute non-cash assets as a dividend to its owners at the
fair value of the assets to be distributed.
If an entity gives its owners a choice of receiving either a non-cash asset or a cash alternative, the
entity shall estimate the dividend payable by considering both the fair value of each alternative and
the associated probability of owners selecting each alternative.
At the end of each reporting period and at the date of settlement, the entity shall review and adjust
the carrying amount of the dividend payable, with any changes in the carrying amount of the
dividend payable recognised in equity as adjustments to the amount of the distribution.
4.2.3 Accounting for any difference between the carrying amount of the
assets distributed and the carrying amount of the dividend payable
when an entity settles the dividend payable
When an entity settles the dividend payable, it shall recognise the difference, if any, between the
carrying amount of the assets distributed and the carrying amount of the dividend payable in profit
or loss.
4.2.4 Presentation and disclosures
An entity shall present the difference as a separate line item in profit or loss.
An entity shall disclose the following information, if applicable:
(a) The carrying amount of the dividend payable at the beginning and end of the period; and

716
29: Changes in group structures | Part D Group financial statements

(b) The increase or decrease in the carrying amount recognised in the period as result of a
change in the fair value of the assets to be distributed.
If, after the end of a reporting period but before the financial statements are authorised for issue, an
entity declares a dividend to distribute a non-cash asset, it shall disclose:
(a) the nature of the asset to be distributed;
(b) the carrying amount of the asset to be distributed as of the end of the reporting period; and
(c) the estimated fair value of the asset to be distributed as of the end of the reporting period, if
it is different from its carrying amount, and the information about the method used to
determine that fair value required by HKFRS 7.

717
Financial Reporting

Topic recap

Changes in group structures

Disposals

Subsidiary Associate

Full disposal: Full disposal:


Ÿ Gain/loss in parent's SPLOCI Ÿ Gain/loss in parent's SPLOCI
Ÿ Gain/loss in consolidated SPLOCI Ÿ Gain/loss in consolidated SPLOCI
Ÿ Investment not included in CSOFP Ÿ Investment not included in CSOFP
Ÿ Consolidate subsidiary's results in CSPLOCI to Ÿ Equity account associate's results in
disposal date CSPLOCI to disposal date

Part disposal: subsidiary → subsidiary: Part disposal: associate → financial


Ÿ Gain/loss in parent's SPLOCI asset:
Ÿ No gain/loss in consolidated SPLOCI Ÿ Gain/loss in parent's SPLOCI
Ÿ Instead adjust equity by: Ÿ Gain/loss in consolidated SPLOCI
Ÿ Investment in CSOFP at fair value of
FV of consideration received X retained investment on disposal date
Change in NCI in net assets (X) Ÿ Equity account for results to disposal
X/(X) date then include dividend income.
Ÿ NCI in CSOFP based on year end NCI%
Ÿ NCI in CSPLOCI calculated by pro-rating results
of subsidiary

Part disposal: subsidiary → associate


Ÿ Gain/loss in parent's SPLOCI
Ÿ Gain/loss in consolidated SPLOCI
Ÿ Equity account for investment in CSOFP (cost =
fair value of retained investment on disposal date)
Ÿ Pro-rate subsidiary's results and consolidate/equity
account in CSPLOCI.

Part disposal: subsidiary → financial asset


Ÿ Gain/loss in parent's SPLOCI
Ÿ Gain/loss in consolidated SPLOCI
Ÿ Investment in CSOFP at fair value of retained
investment on disposal date
Ÿ Consolidate results to disposal date then include
dividend income.

Group gain on disposal of Parent company gain on Group gain on disposal of


subsidiary disposal of investment associate
Consideration X Consideration X Consideration X
FV ret'd interest X Carrying value of FV ret'd interest X
Net assets X investment Cost of inv't X
Goodwill X disposed of (X) Post acq profits X
NCI (X) X Impairment (X)
(X) (X)
X/(X) X/(X)

718
29: Changes in group structures | Part D Group financial statements

Step acquisitions

Financial asset → subsidiary Associate → subsidiary Subsidiary → subsidiary

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

Goodwill arises when control is attained:


Consideration transferred X
Non-controlling interest X
Fair value of previously held interest X
X
Fair value of net assets acquired (X)
Goodwill X

Merger accounting

Apply AG5 Merger Accounting for


Common Control Transactions

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.

No distinction between No goodwill is


pre and post recognised.
acquisition reserves.

719
Financial Reporting

Answers to self-test questions

Answer 1
Land Co.'s accounts $'000
Fair value of consideration received 1,200
Less: carrying value of investment disposed of (980)
Profit on disposal 220

Consolidated accounts $'000 $'000


Fair value of consideration received 1,200
Less: net assets of subsidiary at disposal date 1,000
goodwill at disposal date 45
non-controlling interests at disposal date (20%  $1m) + $5,000 (205)
(840)
Group profit 360

Answer 2
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

$ $
DEBIT Cash 40,000
CREDIT Non-controlling interests 36,000
Parent's equity 4,000
Note that there is no adjustment to the carrying amount of goodwill of $25,000 because control has
been retained.

720
29: Changes in group structures | Part D Group financial statements

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
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 182 182
disposal
Tax (45) (36) (81)
108 90 380
Owners of 108 90 (18) 182 362
parent
NCI 18 18
380

WORKINGS
1 Goodwill
$'000
Consideration transferred 324
NCI: 20%  (180 + 180) 72
396
Net assets (180 + 180) (360)
36

Consolidation adjustment journal $'000 $'000


DEBIT Goodwill 36
DEBIT Share capital 180
DEBIT Reserves 180
CREDIT Investment 324
CREDIT Non-controlling interest 72
To recognise the acquisition and related goodwill and non-controlling interest.

721
Financial Reporting

2 Allocate profits between acquisition date and disposal date to NCI


$
Post-acquisition profits (360 – 180) 180,000
NCI share (20%) 36,000
Of these, $18,000 (90,000 x 20%) relate to the current year
Consolidation adjustment journal (SOFP) $'000 $'000
DEBIT Reserves 36
CREDIT Non-controlling interest 36
To allocate the NCI share of post-acquisition profits
In addition 20% of the profits of Fanny Co arising in the year are allocated to the NCI:
Consolidation adjustment journal (SPL) $'000 $'000
DEBIT Profits attributable to owners of parent 18
CREDIT Non-controlling interest in profit 18
To allocate the NCI share of post-acquisition profits in the current year
3 Profit on disposal of Fanny Co
$'000 $'000
Fair value of consideration received 650
Less: net assets at disposal 540
Goodwill 36
NCI (540  20%) (108)
(468)
182

Consolidation adjustment journal (SPL) $'000 $'000


DEBIT Cash 650
DEBIT NCI 108
DEBIT Disposal date liabilities of Fanny 100
CREDIT Goodwill 36
CREDIT Disposal date current assets of Fanny 370
CREDIT Disposal date non-current assets of Fanny 270
CREDIT Reserves 182
To recognise the group gain on disposal of Fanny Co.

722
29: Changes in group structures | Part D Group financial statements

(b) Partial disposal: subsidiary to subsidiary (80% to 60%)


CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 30 SEPTEMBER 20X8
Noel Fanny Adjustment Adjustment Disposal Consolidated
1 (part (a) 2 (part (a)
$'000 $'000 $'000 $'000 $'000 $'000
Non-current 360 270 630
assets
Investment 324 (324)
Goodwill 36 36
Current assets 370 370 160 900
1,566
Share capital 540 180 (180) 540
Reserves 414 360 (180) (36) 52 610
NCI 72 36 108 216
Current 100 100 200
liabilities
1,566
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

Consolidation adjustment journal (SPL) $'000 $'000


DEBIT Current assets (cash) 160
CREDIT NCI 108
CREDIT Reserves 52
(c) Partial disposal: subsidiary to associate (80% to 40%)
1 Profit on disposal
$'000 $'000
Fair value of consideration received 340
Fair value of 40% investment retained 250
Less: Net assets when control lost
((540 – (90  3/12)) 517.5
Goodwill (part (a)) 36
NCI (517.5  20%) (103.5)
(450)
140

723
Financial Reporting

2 Group reserves
Noel Fanny 40%
Reserves Fanny Reserve
$'000 $'000 $'000
At date of disposal 414
Group profit on disposal (W1) 140
Fanny: share of post acquisition
earnings (157.5  80%) 126
Fanny: share of post acquisition
earnings (22.5  40%) 9
689
At date of disposal
(360 – (90  3/12))/per question 414 337.5 360.0
Retained earnings at acquisition/
on disposal 414 (180.0) (337.5)
157.5 22.5
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

3 Retained investment – at $250,000 fair value.

Answer 4
(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

724
29: Changes in group structures | Part D Group financial statements

(b) Profit on derecognition of investment


$m
Fair value at date control obtained 130
Cost (120)
10

725
Financial Reporting

Exam practice

Most Capital Limited 54 minutes


Assume that you are Ms. Pindy Lee, the accounting manager of Most Capital Limited ("MCL").
MCL is a company incorporated and listed in Hong Kong and is principally engaged in the
manufacturing of sanitary ware.
As at 1 April 20X7, MCL had two subsidiaries, First Successful Limited ("FSL") and Second
Winning Limited ("SWL"). A summary of the acquisitions of these subsidiaries by MCL is as follows:
Retained
% Cost of earnings at Net assets at
Date of acquisition acquired investment acquisition date acquisition date
$'000 $'000 $'000
FSL 31 March 20X6 70 20,000 15,000 25,000
SWL 31 March 20X6 60 10,000 7,000 15,000
The fair value of the identifiable net assets of these subsidiaries at the respective date of
acquisition was the same as the carrying amount of those assets. All goodwill arising on the
acquisitions was found to be fully impaired so was written off in the consolidated financial
statements for the year ended 31 March 20X7.
The retained earnings of MCL, FSL and SWL, as at 31 March 20X7, were $32 million,
$20 million and $8 million respectively. The companies did not have any reserves other than
retained earnings. The details of the issued share capital of MCL, FSL and SWL as at 31 March
20X7 are as follows:
Issued Number of
capital shares
$ million million
MCL 60 10
FSL 10 5
SWL 8 8
MCL made a rights issue of one share for every two ordinary shares that was fully exercised on
1 January 20X8. The exercise price was $9 per share and the fair value of one ordinary share of
MCL immediately before the rights issue was $12. The issued share capital of FSL and SWL has
not changed since their acquisition by MCL.

726
29: Changes in group structures | Part D Group financial statements

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:

727
Financial Reporting

To: Pindy LEE, Accounting Manager, MCL


From: Faria LEE (Director)
c.c.: Beverly CHOW, Emily WILSCON, Charmaine YUEN (Directors)
Date: 18 May 20X8
Consolidated financial statements of MCL as at 31 March 20X8
Could you please clarify the following points relating to MCL's draft consolidated financial
statements which I have just reviewed.
(a) So far as I understand, we have already disposed of all our plant and equipment. I am not
aware that we have purchased any new plant and equipment. Why is there still an amount
of HK$12 million of plant and equipment in the consolidated statement of financial position?
(b) I find two new items, namely an "Investment in an associate" in the consolidated balance
sheet and a "Share of profit of an associate" in the consolidated statement of profit or loss
for the year ended 31 March 20X8. Why are these items with the consolidated financial
statements?
(c) I note that the amount of gain on disposal of our investment in SWL as shown in our
separate statement of profit or loss and that in the consolidated statement of profit or loss
are different. Why is there such a difference?
(d) I note that MCL made a rights issue during the year. Will this have any impact on the EPS of
MCL for the year?
I would appreciate your clarification in time for the upcoming board meeting.
Best regards,
Faria

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 HK$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)

728
chapter 30

Consolidation of foreign
operations

Topic list

1 HKAS 21 The Effects of Changes in Foreign Exchange Rates


1.1 Objective
1.2 Definitions
2 Foreign currency transactions in individual company accounts
2.1 Foreign currency transactions: initial recognition
2.2 Foreign currency transactions: settlement before the period end
2.3 Foreign currency transactions: settlement after the period end
2.4 Recognition of exchange differences
3 Consolidation of foreign operations
3.1 Introduction
3.2 Translation of financial statements to presentation currency
3.3 Exchange differences
3.4 Further matters relating to the consolidation of foreign operations

Learning focus

We conclude the coverage of group accounts with a chapter on consolidating foreign


subsidiaries.
The issue of foreign currency, be it recording a few foreign currency transactions or
consolidating several foreign currency subsidiaries, is relevant to a large number of
companies. It is therefore important that you understand how transactions and financial
statements are translated, and how the resulting exchange differences are recognised.
Once the translaton has been done, the general principles of consolidation apply.

729
Financial Reporting

Learning outcomes

In this chapter you will cover the following 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

730
30: Consolidation of foreign operations | Part D Group financial statements

1 HKAS 21 The Effects of Changes in Foreign Exchange


Rates
Topic highlights
HKAS 21 provides accounting guidance on the translation of foreign currency transactions and
foreign currency financial statements. It prescribes which exchange rates should be used and how
exchange differences are recognised.

HKAS 21.1-2 1.1 Objective


An entity may be involved in foreign activities in two ways:
(a) It may be involved in transactions in foreign currencies, such as buying or selling goods.
For example, an Indian company might buy materials from Canada, pay for them in US
dollars, and then sell its finished goods in Germany receiving payment in Euros, or perhaps
in some other currency. If the company owes money in a foreign currency at the end of the
accounting year, or holds assets which were bought in a foreign currency, those liabilities or
assets must be translated into the local currency (in this Learning Pack $), in order to be
shown in the books of account.
(b) It may have foreign operations, for example an overseas subsidiary. This subsidiary is
likely to trade, and keep accounts, in its own local currency. However, in order to consolidate
its results into the group accounts, its financial statements must be translated into the
currency in which the group reports.
HKAS 21 provides guidance on how foreign currency transactions should be translated and
accounted for, and how the financial statements of foreign operations should be translated into a
presentation currency prior to consolidation.
In particular, the standard considers:
 which exchange rate to use, and
 how exchange differences should be recognised in the financial statements.
Sections 2 and 3 of this chapter deal with foreign currency transactions in individual companies and
the translation of foreign currency financial statements. First, however, we must consider a number
of important definitions.

HKAS 21.8 1.2 Definitions


The following definitions are given within HKAS 21:

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.

731
Financial Reporting

Key terms (cont'd)


Closing rate is the spot exchange rate at the end of the reporting period.
Monetary items are units of currency held and assets and liabilities to be received or paid in a
fixed or determinable number of units of currency.
Foreign operation is 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.
Net investment in a foreign operation is the amount of the reporting entity's interest in the net
assets of that operation. (HKAS 21)

1.2.1 Functional and presentation currencies


As defined above, the functional currency of an entity is the currency of the primary economic
environment in which the entity operates, in other words the currency in which it normally spends
and receives cash.
Each entity should determine its functional currency and measure its results and financial position
in that currency.
For most individual companies the functional currency will be the currency of the country in which
they are located and in which they carry out most of their transactions.
Regardless of its functional currency, an entity can choose any currency to be its presentation
currency i.e. the currency in which the financial statements are presented.
HKAS 21.9- 1.2.2 Determining functional currency
10
HKAS 21 states that the following primary indicators should be considered in determining functional
currency:
(a) The currency that mainly influences sales prices for goods and services (often the
currency in which prices are denominated and settled)
(b) The currency of the country whose competitive forces and regulations mainly determine
the sales prices of its goods and services
(c) The currency that mainly influences labour, material and other costs of providing goods
or services (often the currency in which prices are denominated and settled)
The following secondary factors may also provide evidence of an entity's functional currency:
(d) The currency in which funds from financing activities (raising loans and issuing equity) are
generated
(e) The currency in which receipts from operating activities are usually retained
HKAS 21.11 1.2.3 Determining whether a foreign operation has the same functional
currency as the parent
Where a parent has a foreign operation a number of factors are considered in order to decide
whether the functional currency is the same as that of the parent:
(a) Whether the activities of the foreign operation are carried out as an extension of the
parent, rather than being carried out with a significant degree of autonomy.
(b) Whether transactions with the parent are a high or a low proportion of the foreign
operation's activities.
(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.

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30: Consolidation of foreign operations | Part D Group financial statements

Where these indicators are mixed, management must use judgment, giving priority to factors (a) –
(c) in section 1.2.2 above.

Example: Foreign operation


State in each of the following cases whether the foreign operation has the same functional currency
as the parent:
(a) Lomas Co. operates in Thailand, selling goods manufactured by its parent company Real
Co., based in Hong Kong. All sales proceeds are remitted to Real Co. on a monthly basis.
(b) Ariadne Co. operates in South Africa. It imports 30% of the goods it sells from its Australian
parent company Thor Co.; the remainder come from third party suppliers. Ariadne usually
maintains cash reserves in South African Rand, however as a result of expansion has
recently utilised these and supplemented them with borrowings from the Bank of South
Africa.

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, 1.2.4 Change in functional currency


35
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.

2 Foreign currency transactions in individual company


accounts
Topic highlights
Foreign currency transactions are initially translated at the spot rate on the transaction date.
Balances relating to monetary items are re-translated at the reporting date. An exchange gain or
loss may be recognised on re-translation and settlement.

It is increasingly common for individual entities to engage in transactions denominated in a foreign


currency. They may:
 sell to foreign customers
 buy from foreign suppliers
 borrow from foreign banks

733
Financial Reporting

In each of these instances the foreign currency transaction must be translated to the functional
currency of the entity before it is recorded in the accounts. Where a balance denominated in
foreign currency remains at the period end, this may require re-translating.

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

2.2 Foreign currency transactions: settlement before the period


end
When the outstanding foreign currency balance is settled, an exchange difference is likely to arise.
This is because exchange rates commonly fluctuate.
To consider the example given above, let's assume that the Singapore supplier is paid on 1 July,
and on this date the rate of exchange was SG$5 to $1. The local company is obliged to pay
SG$124,000, and can obtain this amount on 1 July for $24,800 (SG$124,000 ÷ 5). The company
has therefore made an exchange gain of $6,200, being the difference between the amount of the
payable in the books and the amount actually paid:
$ $
DEBIT Payables account 31,000
CREDIT Cash 24,800
Exchange gain 6,200

HKAS 21.23 2.3 Foreign currency transactions: settlement after the period end
Where a foreign currency balance is not settled before the end of the reporting period, it may
require re-translating for inclusion in the period end accounts.
HKAS 21 requires that foreign currency balances are classified as either monetary or non-
monetary for this purpose. Monetary items are cash or amounts that will be settled in cash, for
example receivables, payables and loans. Non-monetary items are balances such as non-current
assets and inventories which do not involve a transfer of cash.
The following rules apply at each period end:
(a) Monetary items are re-translated using the closing rate.
(b) Non-monetary items which are carried at historical cost are not re-translated (i.e. they
continue to be reported based on the spot exchange rate on the date of acquisition).
(c) Non-monetary items which are carried at fair value are not re-translated (i.e. they continue to
be reported based on the exchange rates that existed when fair value was determined).

734
30: 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

HKAS 21.28 - 2.4 Recognition of exchange differences


29
As we have seen, exchange differences arise where the exchange rate changes between the
transaction date and the reporting and settlement date.
These exchange differences should be recognised in profit or loss:
 Exchange differences relating to items settled in the period in which they arise are
recognised in that period.
 Exchange differences relating to items which are not settled in the period in which they arise
are recognised in more than one period:
– At each reporting date an exchange difference is recognised on re-translation
– At the settlement date a further exchange difference is recognised.
Exchange differences relating to trading items (such as receivables and payables) are usually
recognised as operating expenses or income, and exchange differences relating to financing are
usually recognised as part of interest expense or income.
HKAS 12 Income Taxes should be applied when there are tax effects arising from gains or losses
on foreign currency transactions. Where exchange losses are allowable expenses in a particular
jurisdiction, tax relief will be given. Exchange gains may be treated as taxable income.

735
Financial Reporting

Self-test question 1
FineRt is a retailer of artworks and sculptures. The company has a year end of 31 December 20X1
and uses $ as its functional currency. On 28 October 20X1, FineRt purchased 10 paintings from a
supplier for 920,000 pesas each, a total of 9,200,000 pesas.
Exchange rates were as follows:
28 October 20X1 $1:1.8 pesa
12 December 20X1 $1:1.9 pesa
31 December 20X1 $1:2.0 pesa
1 February 20X2 $1:2.4 pesa
FineRt sold seven of the paintings for cash on 12 December 20X1 with the remaining three
paintings being sold on 1 February 20X2. All 10 of the paintings were paid for by FineRt on
1 February 20X2.
Required
What accounting entries are made in respect of the payable amount on each of the key dates?
(The answer is at the end of the chapter)

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 Consolidation of foreign operations


Topic highlights
Individual group entities must translate their financial statements into a common group presentation
currency prior to consolidation by applying the method specified in HKAS 21.

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 26 to 29 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.
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

736
30: Consolidation of foreign operations | Part D Group financial statements

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.

HKAS 21.41 3.3 Exchange differences


The exchange difference arising on the translation of financial statements to the presentation
currency is due to:
 translating income/expense items at the exchange rates at the date of transactions (or
average rate), whereas assets/liabilities are translated at the closing rate
 translating the opening net investment (opening net assets) in the foreign entity at a
closing rate different from the closing rate at which it was previously reported
The exchange difference for inclusion within other comprehensive income can therefore be
calculated in the following way:
$ $
Opening net assets at closing rate X
Opening net assets at opening rate (X)
Exchange gain/(loss) X/(X)
Retained profits at closing rate X
Retained profits at average rate (X)
Exchange gain/loss X/(X)
Overall exchange gain/loss X/(X)

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.

Example: Exchange difference


Stockpot has a wholly-owned foreign subsidiary, Crockpot, with net assets at 1 January 20X1 of
N$800 million. Crockpot made a profit for the year ending 31 December 20X1 of N$280 million.
The functional currency of Crockpot is the N$.
Stockpot’s consolidated financial statements were prepared to 31 December 20X1 and the
presentation currency is Hong Kong dollars.
Exchange rates were as follows:
1 January 20X1 N$2.0:$1
31 December 20X1 N$3.0:$1
Average rate for 20X1 N$2.5:$1
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%?

737
Financial Reporting

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

Profit for the year at average rate N$280 @ 2.5 112


Profit for the year at 31 December 20X1 rate N$280 @ 3.0 93 19 loss
152 loss
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR STOCKPOT FOR THE YEAR ENDED 31 DECEMBER 20X1 (EXTRACT)
Other comprehensive income $m
Items that may be reclassified to profit or loss
Exchange difference on translating foreign operations (152)

CONSOLIDATED STATEMENT OF FINANCIAL POSITION FOR STOCKPOT AT 31


DECEMBER 20X1 (EXTRACT)

Foreign exchange reserve (152)

(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.

CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE


INCOME FOR STOCKPOT FOR THE YEAR ENDED 31 DECEMBER 20X1 (EXTRACT)
Other comprehensive income $m
Items that may be reclassified to profit or loss
Exchange difference on translating foreign operations (152)

Allocated to group (80%) (122)


Allocated to non-controlling interest (20%) (30)

CONSOLIDATED STATEMENT OF FINANCIAL POSITION FOR STOCKPOT AT 31


DECEMBER 20X1 (EXTRACT)

Foreign exchange reserve (122)


Non-controlling interest (30)

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30: Consolidation of foreign operations | Part D Group financial statements

Example: Translation of foreign subsidiary financial statements


Mariol Co. operates in Rhineland and has identified the Gilder as its functional currency. The
summarised financial statements of Mariol for the year ended 31 December 20X1 are as follows:
STATEMENT OF FINANCIAL POSITION Gilder 000
Property, plant and equipment 1,400
Current assets
Inventory 350
Receivables 500
Cash 160
2,410

Share capital 600


Retained earnings 1,350
Liabilities 460
2,410

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME


Revenue 3,500
Cost of sales (1,990)
Expenses (1,150)
Tax (170)
190

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.

739
Financial Reporting

Next the financial statements are translated:


STATEMENT OF FINANCIAL POSITION Gilder 000 Gilder 000 Exch. rate $'000
Property, plant and equipment 1,400 1:10 14,000
Current assets
Inventory 350 1:10 3,500
Receivables 500 + 240 718 1:10 7,180
– 22
Cash 160 1:10 1,600
2,628 26,280
Share capital 600 1:8.5 5,100
Retained earnings 1,350 + 1,568 β 13,124
240 – 22
Foreign exchange reserve (W) 3,456
Liabilities 460 1:10 4,600
2,628 26,280
STATEMENT OF PROFIT OR LOSS
AND OTHER COMPREHENSIVE
INCOME
Revenue 3,500 + 3,740 1:8 29,920
240
Cost of sales (1,990) 1:8 (15,920)
Expenses (1,150) 1:8 (9,200)
Exchange loss (0+22) (0+22) 1:8 (176)
Tax (170) 1:8 (1,360)
408 3,264
Other comprehensive income
Exchange gain on translation (W) 3,456
Total comprehensive income 6,720

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

3.4 Further matters relating to the consolidation of foreign


operations
HKAS 21.47 3.4.1 Goodwill and fair value adjustments
Goodwill arising under HKFRS 3 Business Combinations from the acquisition of a foreign operation
should initially be calculated in the functional currency of the subsidiary. It is then treated as an
asset of the foreign operation and should be translated at the closing rate each year.
Similarly, any fair value adjustments made on consolidation are treated as an asset or liability of the
foreign operation and are translated at closing rate each year.

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30: 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.

HKAS 3.4.2 Intragroup balances and exchange differences


21.32,45
When a parent has a foreign subsidiary, consolidation procedures are applied as normal.
Therefore, intra-group transactions and balances are eliminated.
However, transactions between parent and foreign subsidiary can lead to exchange gains and
losses in the individual books and records of each entity. These exchange gains and losses are
recognised in the profit or loss of each entity in accordance with the normal rules in transactions in
foreign currencies.
On consolidation any exchange gains and losses in the individual profit or loss of parent and
subsidiary which do not eliminate are reported in the consolidated profit or loss.
There is one exception to this rule: where exchange differences arise on a long term intra-group
loan from parent to subsidiary that is not planned or likely to be received or paid in the foreseeable
future.
In this case, the balance is regarded as part of the parent's investment in the foreign subsidiary.
Therefore, the exchange gain or loss arising on the translation of this balance, which was
recognised in the profit or loss in the parent's separate financial statements, is recognised in
other comprehensive income in the consolidated financial statements. This will require a
consolidation adjustment transferring the gain or loss from the parent's own profit or loss where it
was initially recognised to other comprehensive income in the consolidated accounts.
3.4.3 Different reporting dates
Because of different laws in different countries, it can happen that the foreign operation's reporting
date is different from that of the parent. In this case HKFRS 10 allows the use of the foreign
operation's accounts as at its own reporting date to be consolidated with the accounts of the parent

741
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 29.
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 2
Little was incorporated over 20 years ago, operating as an independent entity for 15 years until
20X1 when it was taken over by Large. Large's directors decided that the local expertise of Little's
management should be utilised as far as possible, and since the takeover they have allowed the
subsidiary to operate independently, maintaining its existing supplier and customer bases. Large
exercises "arm's length" strategic control, but takes no part in day-to-day operational decisions.
The statements of financial position of Large and Little at 31 March 20X7 are given below. The
statement of financial position of Little is prepared in francos (F), its reporting currency.
Large Little
$'000 $'000 F'000 F'000
Non-current assets
Property, plant and equipment 63,000 80,000
Investments 12,000 –
75,000 80,000

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30: Consolidation of foreign operations | Part D Group financial statements

Large Little
$'000 $'000 F'000 F'000
Current assets
Inventories 25,000 30,000
Trade receivables 20,000 28,000
Cash 6,000 5,000
51,000 63,000
126,000 143,000
Equity
Share capital 30,000 40,000
Retained earnings 35,000 34,000
Revaluation reserve – 6,000
65,000 80,000
Non-current liabilities
Long-term borrowings 20,000 25,000
Deferred tax 6,000 10,000
26,000 35,000
Current liabilities
Trade payables 25,000 20,000
Tax 7,000 8,000
Bank overdraft 3,000 –
35,000 28,000
126,000 143,000

NOTES TO THE STATEMENTS OF FINANCIAL POSITION


1 Investment by Large in Little
On 1 April 20X1 Large purchased 36,000,000 of the 40,000,000 shares in Little for 72 million
francos. The accumulated profits of Little at that date were 26 million francos. There was no
impairment of goodwill.
2 Intra-group trading
Little sells goods to Large, charging a mark-up of one-third on production cost. At 31 March
20X7, Large held $1 million (at cost to Large) of goods purchased from Little in its inventories.
The goods were purchased during March 20X7 and were recorded by Large using an
exchange rate of $1 = 5 francos. (There were minimal fluctuations between the two currencies
during March 20X7.) At 31 March 20X6, Large's inventories included no goods purchased from
Little. On 29 March 20X7, Large sent Little a cheque for $1 million to clear the intra-group
payable. Little received and recorded this cash on 3 April 20X7.
3 Accounting policies
The accounting policies of the two companies are the same, except that the directors of Little
have decided to adopt a policy of revaluation of property, whereas Large includes all
properties in its statement of financial position at a depreciated historical cost. Until 1 April
20X6, Little operated from rented warehouse premises. On that date, the entity purchased a
leasehold building for 25 million francos, taking out a long-term loan to finance the purchase.
The building's estimated useful life at 1 April 20X6 was 25 years, with an estimated residual
value of nil, and the directors decided to adopt a policy of straight line depreciation. The
building was professionally revalued at 30 million francos on 31 March 20X7, and the
directors have included the revalued amount in the statement of financial position. No other
property was owned by Little during the year.
Large measures non-controlling interests at acquisition at the proportionate share of the fair
value of the subsidiary's net assets.

743
Financial Reporting

4 Exchange rates
Date Exchange rate
Francos to $1
1 April 20X1 6.0
31 March 20X6 5.5
31 March 20X7 5.0
Average rate for the year to 31 March 20X7 5.2
Average rate for the dates of acquisition of closing inventory 5.1
Required
(a) Explain (with reference to relevant accounting standards to support your argument) how the
financial statements (statement of financial position and statement of profit or loss) of Little
should be translated into $ for the consolidation of Large and Little.
(b) Translate the statement of financial position of Little at 31 March 20X7 into $ and prepare the
consolidated statement of financial position of the Large group at 31 March 20X7.
Note. Ignore any deferred tax implications of the property revaluation and the intra-group trading.
(The answer is at the end of the chapter)

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30: Consolidation of foreign operations | Part D Group financial statements

Topic recap

HKAS 21 The Effects of Changes in


Foreign Exchange Rates

Functional currency (FC) is the currency of the primary economic


environment in which the entity operates
Presentation currency (PC) is the currency in which the financial
statements are presented.

To determine functional currency, primary factors:


Ÿ Currency that influences sales prices
Ÿ Currency of country whose regulations/competition determines
sales prices
Ÿ Currency that influences costs

Individual company accounts Consolidated accounts

Apply spot rate to transactions Translate foreign subsidiary accounts to presentation currency
before recording in the accounts

At period end retranslate monetary Statement of financial position:


items at closing rate → exchange all assets and liabilities at closing rate
difference

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

Recognise exchange differences in Exchange difference arises:


profit or loss
Opening net assets at opening rate X
Opening net assets at closing rate X
X/(X)
Retained profit at average rate X
Retained profit at closing rate X
X/(X)
X/(X)

Recognise exchange difference in other comprehensive income of


subsidiary.

Goodwill/FV adjustments are calculated in functional currency and


translated at closing rate each year. Exchange differences are
recognised in other comprehensive income of group.

Some exchange differences on intragroup balances will not be


eliminated on consolidation; these are reported in group profit or
loss.

On disposal of foreign subsidiary, cumulative exchange


differences in reserves are reclassified to profit or loss.

745
Financial Reporting

Answers to self-test questions

Answer 1
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
DEBIT Payable 511,111
CREDIT Exchange gain 511,111
1 February 20X2
On the settlement date, an exchange gain arises, being the difference between the cash required
to purchase 9.2 million pesas and the carrying value of the payable extinguished:
DEBIT Payable 4,600,000
CREDIT Cash (9.2m/2.4) 3,833,333
Exchange gain 766,667

Answer 2
(a) From the information in the question it is clear that Little operates on a largely independent
basis from Large with its own supplier and customer bases and no day-to-day part being
played by Large in operational decisions. Therefore, the cash flows of Little will not have a
day-to-day impact on those of Large. As such HKAS 21 The Effects of Changes in Foreign
Exchange Rates requires that the financial statements of Little for consolidation purposes
should be translated using the presentation currency or closing rate method. Under this
method the statement of financial position assets and liabilities are translated at the closing
rate of exchange on the reporting date and the statement of profit or loss is translated at an
average rate of exchange for the year. Any exchange differences are not reported in the
statement of profit or loss, as they have no impact on the cash flows of the group, but
instead are reported in other comprehensive income.

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30: Consolidation of foreign operations | Part D Group financial statements

(b) TRANSLATION OF LITTLE STATEMENT OF FINANCIAL POSITION INTO $


F'000 Rate $'000
Non-current assets
Property, plant and equipment
(80,000 – 6,000 revaluation adjustment) 74,000 5 14,800
Current assets
Inventories 30,000 5 6,000
Trade receivables 28,000 5 5,600
Cash 5,000 5 1,000
137,000 27,400
Equity
Share capital 40,000 6 6,667
Revaluation surplus (6,000 – 6,000) –
Pre acquisition retained reserves 26,000 6 4,333
Post acquisition retained reserves
(34,000 – 26,000) 8,000 Bal 3,800
74,000 14,800
Non-current liabilities
Long-term borrowings 25,000 5 5,000
Deferred tax 10,000 5 2,000
Current liabilities
Trade payables 20,000 5 4,000
Tax 8,000 5 1,600
137,000 27,400

WORKINGS
1 Group structure
Investment in Little = 36,000/40,000 = 90%

Large
36,000
1.4.X1 90%
40,000
Little
Pre-acquisition retained earnings 26 million francos
2 Goodwill
F'000 F'000 Rate $'000
Consideration transferred (12,000  6) 72,000 6 12,000
Non-controlling interest
(66,000  10%) 6,600 6 1,100
Share capital 40,000
Pre acquisition ret'd earnings 26,000
(66,000) (11,000)
At 1.4.20X1 12,600 6 2,100
Foreign exchange gain – Bal 420
At 31.3.20X7 12,600 5 2,520

747
Financial Reporting

(i) Consolidation journal ($'000):


DEBIT Share capital (40,000/6) 6,667
DEBIT Pre-acquisition retained earnings (26,000/6) 4,333
DEBIT Goodwill 2,100
CREDIT Non-controlling interest 1,100
CREDIT Investment 12,000
(ii) Retranslation of goodwill:
DEBIT Goodwill 420
CREDIT Retained earnings 420
3 Post acquisition retained earnings
$'000
Little – post acquisition 3,800
Allocated to NCI (10%) 380
Consolidation journal ($'000):
DEBIT Retained earnings 380
CREDIT NCI 380
4 Cash in transit
Cash in transit of $1m is treated as if received by Little, therefore ($'000):
DEBIT Cash 1,000
CREDIT Trade receivables 1,000
5 Unrealised profit
As mark-up is one-third, this means that 25% of the cost to Large is profit. So the unrealised
profit on the inventory of 1,000 is 25%, i.e. 250.
The seller is Little and therefore part of the unrealised profit is attributable to the NCI ($'000):
DEBIT Retained earnings (90%  250) 225
DEBIT NCI (10%  250) 25
CREDIT Inventory 25

748
30: Consolidation of foreign operations | Part D Group financial statements

Consolidation schedule
Large Little W2(i) W2(ii) W3 W4 W5 Consolidated
$'000 $'000 $'000 $'000 $'000 $'000 $'000 $'000
Property, plant 63,000 14,800 77,800
and equipment
Investment 12,000 (12,000) -
Goodwill - - 2,100 420 2,520
Inventory 25,000 6,000 (250) 30,750
Trade 20,000 5,600 (1,000) 24,600
receivables
Cash 6,000 1,000 1,000 8,000
126,000 27,400 143,670

Share capital 30,000 6,667 (6,667) 30,000


Retained
earnings
Post-acqn 35,000 3,800 420 (380) (225) 38,615
Pre-acqn - 4,333 (4,333) -
Non-controlling - - 1,100 380 (25) 1,455
interest
Long term 20,000 5,000 25,000
borrowings
Deferred tax 6,000 2,000 8,000
Trade 25,000 4,000 29,000
payables
Tax 7,000 1,600 8,600
Overdraft 3,000 - 3,000
126,000 27,400 143,670

749
Financial Reporting

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)

750
Answers to exam practice
questions

751
Financial Reporting

752
Answers to exam practice questions

Chapter 1 Legal environment


The statement given by the executive director is incorrect.
Section 123 of the Companies Ordinance requires every company to prepare a statement of
financial position which gives a true and fair view of the state of affairs of the company as at the
end of its financial year and a statement of profit or loss and other comprehensive income which
gives a true and fair view of the company for the financial year.
Directors are responsible for ensuring that the financial statements are accurate and presented in
accordance with the laws and regulations (e.g. Companies Ordinance and Rules governing the
Listing of Securities of The Stock Exchange of Hong Kong Limited) that apply to the company.
Directors of a company must take all reasonable steps to ensure that proper books and accounts
are kept so as to give a true and fair view of the state of affairs of the company, and explain its
transactions.
The role of the directors carries a high level of responsibility in respect of financial reporting although
they can employ a professional accountant and delegate the task to the professional accountant.
The statement given by the financial controller is incorrect.
The financial controller, being a professional accountant in business, involved in the preparation
and reporting of the financial or management information made public and used by others inside or
outside the listed company is expected to observe the same fundamental principles set out in the
Code of Ethics for Professional Accountants (the "Code") and the same standards of behaviour
and competence as applied to other certified public accountants who work in practising offices.
Section 320.1 of the Code states that a professional accountant in business should prepare or
present the financial information fairly, honestly and in accordance with relevant professional
standards so that the information will be understood in its context.
Section 320.2 states that a professional accountant in business who has responsibility for the
preparation or approval of the general purpose financial statements of an employing organisation
should ensure that those financial statements are presented in accordance with the applicable
financial reporting standards.
HKAS 36.10 requires that irrespective of whether there is any indication of impairment, an entity
shall test goodwill acquired in a business combination for impairment annually. A failure to perform
such impairment tests for the purpose of the preparation of the financial statements constitutes
non-compliance with financial reporting standards.
If the failure was due to the threats to compliance with the fundamental principles, section 320.6 of
the Code states that where it is not possible to reduce the threat to an acceptable level, a
professional accountant in business should refuse to remain associated with information they
consider is, or may be, misleading.

Chapter 2 Financial reporting framework


Question 1
The statement is incorrect.
HKAS 1.15 states that financial statements shall present a true and fair view of the financial
position, financial performance and cash flows of an entity. A true and fair view requires the faithful
representation of the effects of transactions, other events and conditions in accordance with the
definitions and recognition criteria for assets, liabilities, income and expenses set out in the
Conceptual Framework for Financial Reporting (the "Conceptual Framework"). The application of
HKFRSs, with additional disclosure when necessary, is presumed to result in financial statements
that achieve a true and fair view.

753
Financial Reporting

S.4.1 of the Conceptual Framework states that the financial statements are normally prepared on
the assumption that an entity is a going concern and will continue in operation for the foreseeable
future. Hence, it is assumed that the entity has neither the intention nor the need to liquidate or
curtail materially the scale of its operations.
If such an intention or need exists, the financial statements may have to be prepared on a different
basis and, if so, the basis used should be disclosed.
HKAS 1.25 states that an entity shall prepare financial statements on a going concern basis unless
management either intends to liquidate the entity or cease trading, or has no realistic alternative
but to do so.
HKAS 10.14 states that an entity shall not prepare its financial statements on a going concern
basis if management determine after the reporting period either that it intends to liquidate the entity
or to cease trading or has no realistic alternative but to do so.
Under the historical cost basis, 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.
Under the current financial reporting standards, elements of financial statements can be / are
required to be measured at a base other than historical cost. Fair value measurement is
allowed/required for certain assets and liabilities, which may be above or below the value
measured on historical cost basis. Furthermore, inventories should be measured at the lower of
cost and net realisable value according to HKAS 2. Net realisable value is the estimated selling
price of an item of inventory less estimated costs to complete and sell it.
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.

754
Answers to exam practice questions

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).

Chapter 3 Small company reporting


(a) Pursuant to paragraph 21 of the SME-FRF, when an entity has previously qualified for
reporting under the SME-FRF it will only cease to qualify for reporting under the SME-FRF
when the entity is not an SME for two consecutive reporting periods.
STL qualified for reporting under the SME-FRF from the date it was established up to the
year ended 31 December 20W9.
STL failed to meet two out of three of the size test criteria for the year ended 31 December
20X0, as the total annual revenue was greater than HK$50 million and STL had over 50
employees. Despite this, it still qualified for reporting under SME-FRF for the year.
STL met two out of three of the size test criteria for the year ended 31 December 20X1
since, both total annual revenue and total assets were less than HK$50 million. Therefore it
still qualified for reporting under the SME-FRF for the year.
(b) STL is eligible to prepare its financial statements under HKFRS for Private Entities as it does
not have public accountability and publishes general purpose financial statements for
external users.
(c) The statement is partially correct / incorrect.
Section 17.15 of the HKFRS for Private Entities requires that an entity measures all items of
property, plant and equipment after initial recognition at cost less any accumulated
depreciation and any accumulated impairment losses. Therefore, accounting for impairment
is appropriate.
Only the cost model is allowed. The revaluation model is not an option for the subsequent
measurement of property, plant and equipment.
(d) In accordance with paragraph 22 of the SME-FRF, and Section 1.3 of the HKFRS for Private
Entities, an entity has public accountability for the purposes of the SME-FRF or HKFRS for
Private Entities if it is in the process of issuing publicly traded equity or debt securities.
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.

755
Financial Reporting

Chapter 4 Non-current assets held for sale and


discontinued operations
HKAS 36.18 defines the recoverable amount as the higher of an asset's or cash generating unit's
fair value less costs to sell and its value in use.
Rocket Running Limited ("RR") as a disposal group with an estimated fair value less costs
to sell of HK$85,000,000
HKFRS 5.23 requires an impairment loss recognised for a disposal group to reduce the carrying
amount of the assets in the group that are within the scope of the measurement requirements of
the HKFRS, in order of allocation set out in HKAS 36.104 and 122.
The allocation of the impairment loss is as follows:
Carrying amount Allocation of Carrying
reported impairment amount after
immediately loss allocation of
before impairment
classification as loss
held for sale

HK$'000 HK$'000 HK$'000


Goodwill 2,400 (2,400) –
Intangible assets 12,500 (1,007) 11,493
Property, plant and
equipment 48,300 (3,893) 44,407
Inventories 16,600 16,600
Trade receivables 4,500 4,500
Financial assets held for
trading 8,000 8,000
TOTAL 92,300 (7,300) 85,000

An impairment loss of HK$7,300,000 (HK$92,300,000 less HK$85,000,000) should be recognised


when the group is initially classified as held for sale.
The impairment loss reduces the amount of goodwill first. The residual loss is allocated to other
non-current assets to which the measurement requirements of HKFRS 5 are applicable pro rata
based on the carrying amounts of these assets (i.e. intangible assets and property, plant and
equipment).
Closure of the retailing operation of Soft Walking Limited ("SW") and abandonment of non-
current assets
Super Shoes Limited should not classify the non-current assets of SW as held for sale that are to
be abandoned as their carrying amount would be recovered principally through continuing use.
There is an indication that the assets of SW may be impaired and the recoverable amount should
be estimated in accordance with HKAS 36.18 to 23.
Irrespective of whether there is any indication of impairment, goodwill should be tested for
impairment annually in accordance with HKAS 36.80 to 99.

756
Answers to exam practice questions

The recognition of impairment loss is as follows:


Carrying amount Impairment Carrying
reported loss amount after
immediately recognised allocation of
before impairment impairment
loss
HK$'000 HK$'000 HK$'000
Goodwill 2,700 (2,700) –
Property, plant and
equipment 18,800 (18,800) –
Inventories 6,400 (2,560) 3,840
Trade receivables 1,300 1,300
TOTAL 29,200 (24,060) 5,140

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.

Chapter 5 Property, plant and equipment


Hotel Property One
Land use right is accounted for as an operating lease under HKAS 17.
Carrying amount as at 31 December 20X5
= RMB45,000,000  (1 – 2.5/75)
= RMB43,500,000.
An owner-managed hotel is owner-occupied property, rather than investment property.
Accordingly, the building is treated as property, plant and equipment under HKAS 16 and
measured by the cost model.
Cost of the building (capitalised the amortisation of land cost over the development period)
= RMB303,000,000 + [45,000,000  1.5/75]
= RMB303,900,000.
Accumulated depreciation up to 31 December 20X5 (1 full year)
= RMB303,900,000/ 50  1
= RMB6,078,000.
Carrying amount as of 31 December 20X5
= RMB303,900,000 – 6,078,000
= RMB297,822,000.
Hotel Property Two
The land use right is accounted for as an operating lease under HKAS 17.
Carrying amount as of 31 December 20X5
= RMB48,000,000  (1 – 2.25/60)
= RMB46,200,000.

757
Financial Reporting

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).

Chapter 6 Investment property


Building A – Warehouse
As a warehouse for storage of inventories, it was accounted for as property, plant and equipment
under HKAS 16 prior to the vacating of the warehouse.
At 31 December 20X7, this building should continue to be classified as property, plant and
equipment after removal of the inventories to the new production plant in Shenzhen as CLL has no
intention of selling it.
Accordingly, the building is carried at cost less any accumulated depreciation and any accumulated
impairment loss.
Cost less accumulated depreciation: $20 million  (1– (8/30)) = $14.67 million.
As the fair value of the building ($28 million) is higher than the cost less accumulated depreciation
($14.67 million), no impairment is recognised.
Building B – Director's quarter
As a director's quarter, it was formerly accounted for as property, plant and equipment under
HKAS 16 prior to being vacated.
At 31 December 20X7, this building should be classified as a non-current asset held for sale under
HKFRS 5 as its carrying amount will be recovered principally through a sale transaction rather than
through continuing use.
The building was available for immediate sale in its present condition subject only to the terms that
are usual and customary for sales of such assets as it had already been vacated.
Also, as the management of CLL had made the decision to sell the building in a board meeting and
appointed a property agent to actively identify potential buyers, it can assume that a sale is highly
likely.
At 31 December 20X7, the building should be measured at the lower of carrying amount and fair
value less costs to sell.
Carrying amount = $36 million  (1 – (10/30)) = $24 million.
Fair value less costs to sell = $22 million  (1 – 0.5%) = $21.89 million.
Accordingly, Building B is stated at $21.89 million on the statement of financial position as at
31 December 20X7.
Building C – Earning rental income
As a building held for earning rental income, it was accounted for as investment property under
HKAS 40 prior to being vacated.
As in the case of Building B, this building should be classified as a non-current asset held for sale
under HKFRS 5.

758
Answers to exam practice questions

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.

Chapter 7 Government grants


The $10,000,000 government grant falls under the requirements of HKAS 20 Accounting for
Government Grants and Disclosure of Government Assistance, which defines government grants
as 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.
According to HKAS 20, PMT should not recognise the grant until there is reasonable assurance
that it will comply with the conditions attaching to them and the grants will be received.
That is, if PMT has no plan, or it is unlikely that PMT will meet the employment targets within the
next four years, PMT should not recognise the government grant.
If there is reasonable assurance that PMT will comply with the conditions, PMT should recognise
the government grant as income over the periods necessary to match the grant with the related
costs which it is intended to compensate, i.e. the $25,000,000 acquisition cost of the equipment, on
a systematic basis.
PMT may either set up the government grant as deferred income of $10,000,000 and amortise it
over eight years on a straight line basis; or
PMT may deduct the government grant of $10,000,000 in arriving at the carrying amount of the
equipment for its research and development centre, i.e. the initial carrying amount of the equipment
would be $15,000,000.

Chapter 8 Intangible assets and impairment of assets


YM is required to assess at each reporting date whether there is any indication that an asset may
be impaired. If any such indication exists, YM must estimate the recoverable amount of the asset.
The closure of the production plant and return of the leasehold land to the government is
considered as an indicator of possible impairment of assets for YM, i.e. a significant change with an
adverse effect on the entity has taken place in the period or is expected to in the near future with
the result that the asset's expected use or useful life will change.
An impairment test of assets, other than inventories in this case, involves comparing the carrying
amount of the asset with its recoverable amount.
HKAS 36.2a specifies that inventories are outside the scope of the standard. Instead the
requirements of HKAS 2 are applied. This requires inventories to be measured at the lower of cost
and net realisable value.
Net realisable value is the estimated selling price of an item of inventory less estimated costs to
complete and sell it.
Building and infrastructure:
This should be presented as property, plant and equipment rather than an asset available for sale,
as it is to be abandoned.

759
Financial Reporting

The recoverable amount at 31 May 20Y1 is the higher of:


 fair value less costs to sell = nil
 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.
An impairment loss must be recognised calculated as the excess of $23.8 million over the
estimated value in use.
The provision for dismantling must be increased to $3 million by September 20Y1. Assuming the
time value of money for the four months from June to September 20Y1 is ignored, an additional
$1.5 million is therefore recognised.
Production equipment:
This is presented as property, plant and equipment as YM do not plan to dispose of it.
The recoverable amount at 31 May 20Y1 is equal to the carrying amount of $48 million.
No impairment loss is recognised as YM can continue to use the equipment in another
manufacturing plant.
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.

760
Answers to exam practice questions

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.

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:
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

761
Financial Reporting

Year Balance of lease Annual lease Interest Balance of lease


net investment payment 12.93% net investment
at 1 Jan at 31 Dec at 31 Dec
$ $ $ $
20X7 227,500 53,069 22,554 196,985
20X8 196,985 53,069 18,608 162,524
20X9 162,524 53,069 14,153 123,608
20Y0 123,608 53,069 9,121 79,660
20Y1 79,660 53,069 3,438 30,029
(c) Journal entries that TMI should make for each of the years ended 31 December 20X7 and
20X8:
20X7 $ $
DEBIT Lease payment receivable 227,500
CREDIT Revenue 227,500
To record the revenue and the lease payment receivable for the
finance lease of the equipment.
DEBIT Cost of sales 200,000
CREDIT Inventory 200,000
To record the cost of sales for the finance lease of the equipment.
DEBIT Cash 53,069
CREDIT Lease payment receivable 53,069
To record the receipt of the lease payment.
DEBIT Lease payment receivable 22,554
CREDIT Interest income 22,554
To record the interest income for the year recognised at the
implicit rate.
20X8
DEBIT Cash 53,069
CREDIT Lease payment receivable 53,069
To record the receipt of the lease payment.
DEBIT Lease payment receivable 18,608
CREDIT Interest income 18,608
To record the interest income for the year recognised at the
implicit rate.

Chapter 10 Inventories
Adjustment
Add to Subtract
inventory from inventory
Item Explanation value value
$ $
(a) Cost $2,885. Net realisable value $(3,600 – 921) = 206
$2,679. The inventory should be valued at the lower of
cost and NRV. Since NRV is lower, the original
valuation of inventories (at cost) will be reduced by
$(2,885 – 2,679)

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Answers to exam practice questions

(b) Inventory issued on sale or return and not yet accepted 1,500
by the customer should be included in the valuation
and valued at the lower of cost and NRV, here at $5
each (cost)
(c) The cost ($7.30) is below the current and foreseeable
selling price ($10 or more) which is assumed to be the
NRV of the item. Since the current valuation is at the
lower of cost and NRV, no change in valuation is
necessary
1,500 206
$ $
Original valuation of inventories, at cost 153,699
Adjustments and corrections:
To increase valuation 1,500
To decrease valuation (206)
1,294
Valuation of inventories for the annual accounts 154,993

Chapter 11 Provisions, contingent liabilities and


contingent assets
(a) Under HKAS 37, 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, and 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.
According to HKAS 37.19, it is only those obligations arising from past events that exist
independently of the reporting entity's future actions that are recognised as provisions.
The provision for the late delivery penalty is a provision for future operating losses as the
delivery date of the 7,000,000 units of rechargeable battery is 31 August 20X8.
Since the delivery will be expected on 10 September 20X8, the compensation per unit will be
$0.1 per unit (10 days  $0.01) and the total compensation will be $700,000.
This compensation will reduce the expected gross profit, but will not result in an onerous
contract for DCL.
Accordingly, no provision is required for this late delivery penalty as at 30 June 20X8.
(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.

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Financial Reporting

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.

Chapter 12 Construction contracts


(a) The statement is incorrect.
HKAS 11.22 states that when the outcome of a construction contract can be estimated
reliably, contract revenue and contract costs associated with the construction contract shall
be recognised as revenue and expenses respectively by reference to the stage of
completion of the contract activity at the end of reporting period.
HKAS 11.25 states that the recognition of revenue and expenses by reference to the stage
of completion of a contract is often referred to as the percentage of completion method.
Under this method, contract revenue is matched with the contract costs incurred in reaching
the stage of completion, resulting in the reporting of revenue, expenses and profit which can
be attributed to the proportion of work completed.
This method provides useful information on the extent of contract activity and performance
during a period.
Even when the outcome of a construction contract cannot be estimated reliably, revenue
shall be recognised only to the extent of contract costs incurred that it is probable will be
recoverable and contract costs shall be recognised as an expense in the period in which
they are incurred. (HKAS 11.32)
Under both circumstances, an expected loss on the construction contract shall be
recognised as an expense immediately when it is probable that total contract costs will
exceed total contract revenue. (HKAS 11.22, 32 and 36)
(b) It is considered that the outcome of the Waterfall Golf Villa construction contract can be
estimated reliably as:
(i) 1 the total contract revenue can be measured reliably.
2 evidence/indicator: contract sum has been agreed upfront between VC and the
employer.
(ii) 1 it is probable that the economic benefits associated with the contract will flow to
the entity.
2 evidence/indicator: VC has collected the contracted instalment from the
employer on time.
(iii) 1 both the contract costs to complete the contract and the stage of contract
completion at the end of reporting period can be measured reliably.
2 evidence/indicator: the information given indicated that VC has reassessed the
total costs against with the original bid estimate and forecast that the total cost
would increase because the price of construction material has been 15% higher
than the price in the budget. Besides, it is stated that 60 units have been

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Answers to exam practice questions

completed and the remaining 20 units are expected to be completed in the last
quarter of 20X9.
(iv) 1 the contract costs attributable to the contract can be clearly identified and
measured reliably so that actual costs incurred can be compared with prior
estimates.
2 evidence/indicator: same as (iii).
The stage of completion of the contract may be determined by reference to:
(i) the proportion that contract costs incurred for work performed to date bear to the
revised estimated total contract costs.
(ii) completion of a physical proportion of the contract work (i.e. 60 units completed and
20 units in progress).
For the year ended 30 June 20X9, the contract revenue and contract costs shall be
recognised as revenue and expenses respectively by reference to the stage of completion as
determined above at 30 June 20X9 less the contract revenue and contract costs that were
recognised in the prior year.
For the year ended 30 June 20X8, revenue should have been recognised only to the extent
of contract costs incurred that it is probable will be recoverable and contract costs should
have been recognised as an expense in the prior year in which they were incurred.
For financial statements presentation, where contract costs incurred to 30 June 20X9 plus
recognised profits exceed (less than) progress billings, the surplus is shown as amounts due from
(to) customers for contract work. Amounts billed for work performed but not yet settled by the
customer are included in the statement of financial position as receivable, while amounts received
before the related work is performed are included as a liability, as advances received.

Chapter 13 Share-based payment


(a)
On 1 July 20X1
DEBIT Staff expense HK$960,000
CREDIT Equity – share-based payment HK$960,000
{240  8,000  HK$(8 – 7.50)}
On 30 April 20X2
DEBIT Equity – Share-based payment HK$40,000
DEBIT Cash HK$600,000
CREDIT Capital/Equity HK$640,000
(10  8,000  HK$0.5) and (10  8,000  HK$7.5)
On 30 June 20X2
DEBIT Staff expense HK$1,836,000
CREDIT Equity – share-based payment HK$1,836,000
(240  85%  12,000  HK$1.5 / 2)
(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.

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Financial Reporting

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.
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.

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Answers to exam practice questions

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.

Chapter 15 Income taxes


(a) Current tax computation
Current tax for the year: HK$43,122,000  18% = HK$7,761,960
Current tax payable at 30 September 20X2: HK$7,761,960 – HK$4,600,000
= HK$3,161,960
(b) Deferred tax computation
Deferred tax charge for the year:
Temporary difference on plant and equipment:
Carrying amount = HK$94,334,000 – HK$15,933,000
= HK$78,401,000
Tax base = HK$(94,334,000 – 4,388,000 – 38,500,000) + (HK$4,388,000  (1–10%))
= HK$51,446,000 + HK$3,949,200
= HK$55,395,200
Taxable temporary difference = HK$78,401,000 – 55,395,200 = HK$23,005,800
Alternative method for calculation of temporary difference:
Depreciation allowance of HK$38,500,000
Less: Deprecation charged to P/L of HK$15,933,000
Add: Depreciation charged to P/L attributable to non-deductible item of HK$438,800
(HK$4,388,000  10%)
= HK$23,005,800
Deductible temporary difference on government grant: HK$9,600,000 – HK$1,200,000
= HK$8,400,000
Deductible temporary difference on warranty provision: HK$4,200,000 – HK$1,248,000
= HK$2,952,000
Net taxable temporary difference: HK$23,005,800 – HK$8,400,000 – HK$2,952,000
= HK$11,653,800
Deferred tax charge and liabilities recognised = HK$11,653,800  20%
= HK$2,330,760

767
Financial Reporting

(c) Tax reconciliation for the year ended 30 September 20X2:


Reconciliation at 18% Reconciliation at 20%
Profit before tax HK$54,018,000 HK$54,018,000
HK$ HK$
Tax thereon 9,723,240 10,803,600
Tax effect on non-taxable income (187,020) (207,800)
[HK$1,039,000]
Tax effect on non-deductible expense 323,424 359,360
[HK$1,358,000 + (HK$4,388,000  10%)]
Tax effect on 2% tax rate deduction N/A (862,440)
[HK$43,122,000  2%]
Deferred tax recognised at different tax 233,076 N/A
rate [HK$11,653,800  2%]
Tax charge for the year 10,092,720 10,092,720
(HK$7,761,960 + 2,330,760)

Chapter 16 Employee benefits


(a) New treatment of actuarial gains and losses
Statement of financial position
On moving to the new standard, an entity which currently defers actuarial gains and losses
may have to recognise a higher pension deficit (or lower surplus) in the statement of financial
position. This may impact those entities practically in terms of compliance with debt
covenants.
On an ongoing basis, the amount reported in the statement of financial position will be more
volatile, as the smoothing effects of deferring a proportion of gains/losses is disallowed.
Statement of profit or loss and other comprehensive income
Total comprehensive income will also become more volatile when the new rules are
adopted, as there is no option to defer a proportion of actuarial gains and losses.
The change will be more marked for those entities which previously recognised actuarial
differences in profit or loss, since not only will the amounts recognised increase, but they will
also be recognised in other comprehensive income rather than profit or loss. This should
result in less volatile profits but more volatile total comprehensive income.
(b) (i)
Obligation Assets Net (SOFP) Net
$'000 $'000 $'000 (SPLOCI)
$'000
20X8 b/f 20,000 20,000 -
Net interest at 8% 1,600 1,600 -
Current service cost 1,250 1,250
Past service cost 1,000 1,000
Benefits paid (987) (987)
Contributions paid in 1,000

22,863 21,613
Remeasurement losses 137 (113) 250

20X8 c/f 23,000 21,500 1,500

768
Answers to exam practice questions

20X9 b/f 23,000 21,500


Net interest at 9% 2,070 1,935 135
Current service cost 1,430 1,430
Settlement (5,700) (5,400) See below
Benefits paid (1,100) (1,100)
Contributions paid in 1,100

19,700 18,035
Remeasurement losses 700 (195) 895

20X9 c/f 20,400 17,840 2,560

 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

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME


20X8 20X9
Profit or loss $'000 $'000
Current service cost 1,250 1,430
Past service cost 1,000 -
Gain on settlement - (100)
Net interest - 135

Other comprehensive income


Remeasurement loss on defined pension plan 250 895

Chapter 17 Borrowing costs


(a)
For the year ending 31 December 20X3:
HK$
HK$40 million  10/12  6.5% 2,166,667
HK$40 million  6/12  6.5% 1,300,000
HK$40 million  2/12  6.5% 433,333
Total borrowing cost capitalised 3,900,000

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Financial Reporting

For the year ending 31 December 20X4:


HK$
HK$120 million  6/12  6.5% 3,900,000
HK$40 million  4/12  6.5% 866,667
Total borrowing cost capitalised 4,766,667
(b) Depreciation is the systematic allocation of the depreciable amount of an asset over its
useful life. In order to comply with the requirements of HKAS 16 relating to deprecation, it is
necessary to identify:
 The parts (components) of each item of property, plant and equipment that are to be
depreciated separately, such as the structure of the hotel building, furniture and
fixtures and equipment that can be considered as significantly different components.
 The cost of each separately depreciable component.
 The amount eligible for capitalisation.
 The estimated residual value of each separately depreciable component, which is
likely to be immaterial in most instances.
 The length of time during which the component will be commercially useful to the
entity taking into consideration the expected physical wear and tear, obsolescence,
and legal or other limits on the use of the assets, for example the length of the
operating lease term.
 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 x 6/12]
= HK$4,173,333 + HK$2,782,222
= HK$6,955,555

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Answers to exam practice questions

Chapter 18 Financial instruments


(a) (i) A fixed rate bank loan exposes the borrower to fair value interest rate risk, i.e. the
change in market interest rate will affect the fair value of the bank loan.
A variable rate bank loan exposes the borrower to cash flow interest rate risk, i.e. the
change in market interest rate will affect the cash flow of the bank loan with an
increase or decrease in payment of loan interest.
(ii) A hedging instrument is a designated derivative or (for a hedge of the risk of changes
in foreign currency exchange rates only) a designated non-derivative financial asset or
non-derivative financial 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 hedged item is a recognised asset, liability, unrecognised firm commitment, highly
probable forecast transaction or net investment in a foreign operation that exposes the
entity to risk of changes in fair value or future cash flows and is designated as being
hedged.
Hedge accounting recognises the offsetting effect on profit or loss of changes in the
fair values of the hedging instrument and the hedged item. The objective is to ensure
that the gain or loss on the hedging instrument is recognised in profit or loss in the
same period when the item that is being hedged affects profit or loss.
Without adopting the hedge accounting, the hedging instrument, if it is a derivative, will
normally be measured at fair value through profit or loss. The hedged item may adopt
a different accounting treatment under HKFRS which results in a mis-match of the
effects of changes in the fair value.
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.

771
Financial Reporting

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.

Chapter 19 Statements of cash flows


(a) Chong Co.
EXTRACT FROM THE STATEMENT OF CASH FLOWS FOR THE YEAR ENDED
31 OCTOBER 20X7
$'000
Cash flows from operating activities
Profit before tax (W1) 266
Depreciation charge for the year (W2) 76
Loss on disposal of assets (W3) 4
Finance charge 15
Redemption penalty 8
Operating profit before changes in working capital 369
Increase in receivables (61)
Increase in payables 66
Cash generated from operations 374
Interest paid (12)
Income tax paid (W4) (52)
Net cash flow from operating activities 310

(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

772
Answers to exam practice questions

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).
W1 Calculation of "profit before tax"
$'000
Retained profit at 31.10.X7 224
Retained profit at 31.10.X6 86
Increase in retained profit during the year 138
Add dividend paid 40
Profit for the year 178
Tax charge in statement of profit or loss 88
Profit for the year before tax 266

W2 Calculation of depreciation charge for the year


$'000
Accumulated depreciation: at 31.10.X7 276
at 31.10.X6 232
Net increase for the year 44
Depreciation on disposals 32
Depreciation charge for the year 76
W3 Calculation of profit or loss on disposal
$'000
Proceeds from disposal 16
Cost of assets 52
Less depreciation 32
20
Loss on disposal 4

W4 Tax paid calculation

Opening balances: $'000


Deferred tax 44
Income tax 32
76
Tax charge 88
164
Closing balances:
Deferred tax 72
Income tax 40
112

Tax paid 52

773
Financial Reporting

W5 Calculation of net capital expenditure


$'000
Closing balance 31.10.X7 1,240
Opening balance 31.10.X6 1,016
224
Cost of disposals 52
Capital expenditure during year 276
Less proceeds from disposal of assets 16
260
W6 Calculation of bond repayment
$'000
Liability at start of year 280
Add amortised interest (Finance charge $15,000 – cash paid 3
$12,000)
283
Redemption penalty 8
291
Liability at year end 120
171

Chapter 20 Related party disclosures


(a) Company B: (Yes) Mrs. Kwok, a joint venturer of Company B, is:
a member of the key management personnel of Company A [HKAS 24.9 (b) (vi)] OR a close
member of the family of Mr. Kwok who controls Company A [HKAS 24.9 (b) (vi)]
(b) Company C: (Yes) A wholly owned subsidiary of GIL. Company A is an associate of GIL
[HKAS 24.9(b)(ii)]
(c) Company D: (Yes) Being wholly owned by Mr. Ma, a member of the key management
personnel of Company A [HKAS 24.9 (b) (vi)]
(d) Company E: (Yes) Mr. Kwok, the controlling shareholder of Company A, is the husband of
Mrs. Kwok, who is a key management personnel of Company E. [HKAS 24.9 (b) (vii)]
(e) GIL: (Yes) Company A is an associate of GIL [HKAS 24.9 (b) (ii)]
(f) Mr. Ma: (Yes) A member of the key management personnel of Company A [HKAS 24.9
(a)(iii)]
(g) Ms. Chan: (No) Not a person or a close member of the family of a person as set out in
HKAS 24.9 (a)
(h) Mr. Wang: (No) Not a person or a close member of the family of a person as set out in
HKAS 24.9 (a)

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Answers to exam practice questions

Chapter 21 Accounting policies, changes in


accounting estimates and errors; events
after the reporting period
(a) This is an adjusting event under HKAS 10. SW should reverse the recognition of the HK$8
million sales during the year ended 31 March 20X2 and record the inventory as the lower of
cost and net realisable value after considering the rework cost.
The notice from the customer on 3 April 20X2 has indicated that the goods received on 25
March 20X2 were not accepted. This is an event after the reporting period that provides
evidence of circumstances (the condition of goods) that existed at the end of reporting
period.
SW accepted the complaint of the customer and has replaced the goods shipped after the
reporting period.
The customer confirmed only the acceptance of the replaced goods, which was after the
reporting period.
(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.

775
Financial Reporting

Chapter 22 Earnings per share


(a) Year ended 30 June 20X8:
Profit attributable to ordinary shareholders =
$32,800,000 – (3,000,000  $0.3) = $31,900,000
Weighted average number of ordinary shares outstanding for the year = 220,000,000
Basic earnings per share = $31,900,000 / 220,000,000 = 14.5 cents
Year ended 30 June 20X9:
Profit attributable to ordinary shareholders =
$8,000,000 – (3,000,000  $0.15 + 2,000,000  $0.15) = $7,250,000
(Or
Profit attributable to ordinary shareholders =
$8,000,000 – (1,000,000  $0.15 + 2,000,000  $0.3) = $7,250,000)
Weighted average number of ordinary shares outstanding for the year =
(220,000,000  3/12) + (220,500,000  3/12) + (228,500,000  6/12)
= 224,375,000
(Or
Weighted average number of ordinary shares outstanding for the year =
(220,000,000  12/12) + (500,000  9/12) + (8,000,000  6/12)
= 224,375,000)
Basic earnings per share = $7,250,000 / 224,375,000 = 3.231 cents
(b) Year ended 30 June 20X9:
The potential impact of preference share conversion on earnings:
$750,000/ (1,000,000  8  6/12 + 2,000,000  8) = $0.0375
No adjustment to the preference share dividend as the earnings per incremental share is
higher than the basic earnings per share (3.231 cents) and therefore considered anti-dilutive.
Adjusted profit attributable to ordinary shareholders = $7,250,000
Adjusted weighted average number of ordinary shares:
No adjustment for the conversion of the preference shares
Weighted average number of shares under option = 1,000,000
Weighted average number of shares that would have been issued at average market price:
(1,000,000  $1.5) / $1.65 = 909,091
Weighted average number of shares assumed to be issued for nil consideration: (1,000,000
– 909,091) = 90,909
Weighted average number of ordinary shares used to calculate diluted earnings per share:
224,375,000 + 90,909 = 224,465,909
Diluted earnings per share = $7,250,000 / 224,465,909 = 3.230 cents

776
Answers to exam practice questions

Chapter 23 Operating segments


(a) The conclusion is incorrect. The entity does not have a free choice. HKFRS 8.5 states an
operating segment is a component of an entity:
(i) that engages in business activities from which it may earn revenue and incur
expenses (including revenues and expenses relating to transactions with other
components of the same entity),
(ii) 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
(iii) for which discrete financial information is available.
(b) A reportable segment consists of an operating segment, or an aggregation of two or more
operating segments, that exceed the quantitative thresholds specified in HKFRS 8.13.
In general, an entity shall report separately information about an operating segment that
meets any of the following quantitative thresholds:
(i) Its reported revenue, including both sales to external customers and intersegment
sales or transfers, is 10% or more of the combined revenue, internal and external, of
all operating segments.
(ii) The absolute amount of its reporting profit or loss is 10% or more of the greater, in
absolute amount, of (i) the combined reported profit of all operating segments that did
not report a loss and (ii) the combined reported loss of all operating segments that
reported a loss.
(iii) Its assets are 10% or more of the combined assets of all operating segments.
Operating segments that do not meet any of the quantitative thresholds may be considered
reportable, and separately disclosed, if management believes that information about the
segment would be useful to users of the financial statements.
HKFRS 8.19 states that there may be a practical limit to the number of reportable segments
that an entity separately discloses beyond which segment information may become too
detailed. Although no precise limit has been determined, as the number of segments that are
reportable increases above 10, the entity should consider whether a practical limit has been
reached. An evaluation should be made of the criteria adopted by the management for
aggregation to determine if an appropriate aggregation of operating segments has been
performed.
Accordingly, it is possible for an entity to report 12 reportable segments.
(c) The conclusion is incorrect. HKFRS 8 does not require that segment information be provided
in accordance with the same generally accepted accounting principles used to prepare the
financial statements.
According to HKFRS 8.25, the amount of each segment item reported shall be the measure
reported to the chief operating decision maker for the purposes of making decisions about
allocating resources to the segment and assessing its performance.
Adjustments and elimination made in preparing an entity's financial statements and
allocations of revenues, expenses and gains or losses shall be included in determining
reported segment profit or loss only if they are included in the measure of the segment profit
or loss that is used by the chief operating decision maker.
Similarly, only those assets and liabilities that are included in the measures of the segment
assets and segment liabilities that are used by the chief operating decision maker shall be
reported for that segment.

777
Financial Reporting

(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.

Chapter 24 Interim financial reporting


(a) 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
$4.5 million should be recognised in the interim financial statements at 30 June 20X4.
(b) The value of the inventories in the interim financial statements at 30 June 20X4 is the lower
of cost and NRV at 30 June 20X4. This is:
100,000  $1.20 = $120,000
(c) 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 30%. The
taxation charge in the interim financial statements will be $1.8 million.

Chapter 25 Presentation of financial statements


AZ CO. STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR
THE YEAR ENDED 31 MARCH 20X3
$'000
Revenue 124,900
Cost of sales (W1) (94,200)
Gross profit 30,700
Distribution costs (W1) (9,060)
Administrative expenses (W1) (17,535)
Other expenses (W1) (121)
Finance income 1,200
Finance costs [60 + (18,250  7%)] (1,338)
Profit before tax 3,846
Income tax expense (161)
Profit for the year 3,685
Other comprehensive income:
Items that will not be reclassified to profit or loss
Gain on land revaluation 4,000
Total comprehensive income for the year 7,685
Other expenses represent the cost of a major restructuring undertaken during the period.

778
Answers to exam practice questions

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

779
Financial Reporting

2 Property, plant and equipment


Land Buildings P&E Total
$'000 $'000 $'000 $'000
Cost b/d 20,000 30,300 3,720 54,020
Acc'd depreciation b/d – (6,060) (1,670) (7,730)
20,000 24,240 2,050 46,290
Depreciation charge for year:
$30,300  5% – (1,515) (1,515)
($3,720 – $1,670)  25% (513) (513)
20,000 22,725 1,537 44,262
Revaluation (balancing figure) 4,000 – – 4,000
CV c/d 24,000 22,725 1,537 48,262

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.

Chapter 26 Principles of consolidation


Consolidated goodwill
$'000
AB (W1) 11,350
CD (W2) 2,916
14,266
WORKINGS
1 Goodwill on acquisition of AB
$'000 $'000
Purchase consideration 14,700
NCI share (W3) 3,400
Less: Net fair value of identifiable assets and liabilities acq'd:
Net tangible assets (1,000 + 2,850) 3,850
Brand name 2,900
(6,750)
Goodwill on acquisition 11,350

780
Answers to exam practice questions

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

Fair value = 200,000  $17


= $3,400,000
4 NCI at acquisition of CD
Number of shares = 100,000 – 60,000
= 40,000
Fair value = 40,000  $35
= $1,400,000

Chapter 27 Consolidated accounts: accounting for


subsidiaries
Smart Computer Limited
(a) The amount of goodwill is calculated as follows:

Consideration transferred: HK$72 million

Amount of non-controlling interests: HK$45  2,000,000  20% = HK$18 million

Identifiable net assets of BDC acquired:

Net carrying amount in the books of BDC = HK$42 million

Fair value adjustments:

Property, plant and equipment = HK$76 – HK$60 million = HK$16 million

Intangible asset = HK$8 million

Net of the acquisition date amounts of the identified assets acquired and the liabilities
assumed = HK$[42 + 16 + 8] million = HK$66 million

Goodwill acquired = HK$[72 + 18 – 66] million = HK$24 million

(b) Non-controlling interests in BDC as at 1 April 20Y0 to be reflected in the consolidated


statement of financial position of SCL:

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

781
Financial Reporting

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

Non-controlling interest of 20% = HK$18 million + [HK$6.8 million  20%]


= HK$19.36 million
Bailey
BAILEY GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X9
Non-current assets $m
Property, plant and equipment (2,300 + 1,900 + (W2) 100 – (W6) 40) 4,260
Goodwill (130 – 20 (W2)) 110
Investment in associate (225 + (W3) 18) 243
4,613
Current assets (3,115 + 1,790 – (W4) 20) 4,885
9,498
Equity attributable to owners of the parent
Share capital 1,000
Reserves (3,430 + 1,800 - (W2) 440 – (W2) 12 + (W3) 18 – (W4) 12 – (W5) 544
- (W6) 24) 4,216
5,216
Non-controlling interests ((W2) 450 – (W2) 8 – (W4) 8 + (W5) 544 – (W6) 16)
962
6,178
Non-current liabilities (350 + 290) 640
Current liabilities (1,580 + 1,100) 2,680
9,498

782
Answers to exam practice questions

BAILEY GROUP
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR THE YEAR ENDED 31 DECEMBER 20X9
$m
Revenue (5,000 + 4,200 – (W4) 200) 9,000
Cost of sales (4,100 + 3,500 + (W6) 10 – (W4) 200 + (W4) 20) (7,430)
Gross profit 1,570
Distribution costs and administrative expenses (320 + 175 + (W2) 15) (510)
Share of profit of associate (W3) 22
Profit before tax 1,082
Income tax expense (240 + 170) (410)
Profit for the year 672
Other comprehensive income:
Gain on revaluation of property (net of deferred tax) (50 + 20) 70
Share of other comprehensive income of associate (W3) 2
Other comprehensive income, net of tax 72
Total comprehensive income for the year 744
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.

783
Financial Reporting

(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)
$m
Share of post acquisition retained reserves ((330-270)  30%) 18
Consolidation adjustment journal ($m)
DEBIT Investment in Campbell 18
CREDIT Reserves 18
To recognise the group share of Campbell’s post acquisition reserves.
In the SPLOCI, the group share of Campbell’s profit and OCI in the year is recognised by
($m):
CREDIT Share of profit of associate (110 × 30% × 8/12) 22
CREDIT Share of OCI of associate (10  30%  8/12) 2
These two credit entries together total $24million. The group share of the post-acquisition
dividend paid by Campbell (30% x $20m = $6m) is deducted from this amount to give the
total credit entry made to reserves in the SOFP in the journal above.
4 Intragroup sales and URP
Intragroup sales are $200m and the resulting URP is $20m (1/4 x 200m x 40%)
Consolidation adjustment journal ($m)
DEBIT Revenue 200
CREDIT Cost of sales 200
To eliminate intragroup sales in the SPLOCI
And
DEBIT Cost of sales 20
CREDIT Inventory 20
To eliminate the URP.
The debit entry is split between the NCI and group and therefore in the SOFP the debit
entries are:
DEBIT Reserves (60% x 20) 12
DEBIT NCI (40% x 20) 8
The $8m attributable to the NCI also reduces NCI profits in the SPLOCI.

784
Answers to exam practice questions

5 Post acquisition reserves of subsidiary (Hill)


Hill
$m
Per question 1,800
Pre-acquisition (440)
1,360
NCI share of post-acquisition reserves:
1,360  40% 544

6 Fair value adjustment (Hill)


At acquisition Movement Year end
1/1/X6 X6, X7, X8, X9 31/12/X9
$m $m $m
Property, plant and equipment 100 * (40) 60
(W2) (1,040 – 500 – 440)

Goodwill (W2) Reserves (W4) Add to PPE


Add 1 year to
cost of sales
* additional depreciation = 100  4/10 = 40
Consolidation adjustment journal ($m)
DEBIT Reserves (60% x 40) 24
DEBIT NCI (40% x 40) 16
CREDIT PPE 40
To recognise depreciation on the fair value adjustment in the SOFP.
In the SPLOCI the current year depreciation of $10m is recognised by debiting cost of sales.
40% ($4m) is allocated to the NCI.

Chapter 28 Consolidated accounts: accounting for


associates and joint arrangements
To : Ms. Pindy Lee, Director of APE
From : Charmaine Yuen, Accounting Manager
Date : dd/mm/yyyy
Subject : Various investments, bankrupt customer and consolidated financial statements of APE
I refer to your queries regarding the various investments and the bankrupt customer and their
impact on the consolidated financial statements of APE.
(a) Applicable financial reporting standard
The arrangement for the investment in DPE has three parties: APE has 60% of the voting rights in
DPE, BPE has 20% and CPE has 20%. The contractual arrangement among APE, BPE and CPE
specifies that at least 90% of the voting rights are required to make decisions about the relevant
activities of DPE. Even though APE can block any decision, APE cannot control DPE because it
needs the agreement of both BPE and CPE.
Since we cannot control DPE, it is not a subsidiary of APE.
The terms of the contractual arrangement requiring at least 90% of the voting rights to make
decisions about the relevant activities imply that APE, BPE and CPE have joint control of DPE
because decisions about the relevant activities of DPE cannot be made without APE, BPE and
CPE agreeing. Thus it has implicitly specified that APE, BPE and CPE are required to agree
unanimously to decisions about the relevant activities of the arrangement.

785
Financial Reporting

HKFRS 11 defines joint control as the contractually agreed sharing of control of an arrangement,
which exists only when decisions about the relevant activities (i.e. activities that significantly affect
the returns of the arrangement) require the unanimous consent of the parties sharing control.
In this case, DPE shall be considered as a joint arrangement as it is an arrangement of which two
or more parties have joint control. The agreement sets up the terms under which APE, BPE and
CPE conduct the manufacturing and distribution of HDPE. These activities are undertaken through
joint arrangements whose purpose is either the manufacturing or the distribution of HDPE.
Therefore, HKFRS 11 Joint Arrangements is to be applied by all entities (APE, BPE and CPE) that
are a party to this joint arrangement.
General principles
HKFRS 11 requires a party to a joint arrangement to determine the type of joint arrangement in
which it is involved by assessing its rights and obligations arising from the arrangement.
HKFRS 11 classifies joint arrangements into two types - joint operations and joint ventures. APE
should determine the type of joint arrangement in which it is involved by considering its rights and
obligations.
Diadema Polyethylene (DPE)
APE, BPE and CPE carry out the manufacturing and distribution activities through DPE, whose
legal form confers separation between the parties and the entity.
In addition, the contractual arrangement dealing with the manufacturing and distribution activity did
not specify that the parties have rights to the assets, and obligations for the liabilities, relating to
DPE.
There are no contractual arrangements and no other facts and circumstances that indicate that the
parties have rights to substantially all the economic benefits of the assets relating to DPE or that
the parties have an obligation for the liabilities relating to that arrangement. DPE is a joint venture.
A joint venture is defined in HKFRS 11 as a joint arrangement whereby the parties that have joint
control of the arrangement (i.e. APE, BPE and CPE as joint venturers) have rights to the net assets
of the arrangement.
HKFRS 11 requires a joint venturer to recognise an investment and to account for that investment
using the equity method in accordance with HKAS 28 Investments in Associates and Joint
Ventures, unless the entity is exempted from applying the equity method as specified in that
standard.
Therefore, the parties (APE, BPE and CPE) should recognise their rights to the net assets of DPE
as investments in joint ventures and account for them using the equity method.

(b) Bankrupt customer


HKAS 10 Events after the Reporting Period 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.
Two types of events can be identified:
 those that provide evidence of conditions that existed at the end of the reporting period
(adjusting events after the reporting period); and
 those that are indicative of conditions that arose after the reporting period (non-adjusting
events after the reporting period).
HKAS 10 specifies that the receipt of information after the reporting period indicating that an asset
was impaired at the end of the reporting period is an adjusting event after the reporting period that
requires an entity to adjust the amounts recognised in its financial statements.

786
Answers to exam practice questions

The bankruptcy of a customer that occurs after the reporting period usually confirms that a loss
existed at the end of the reporting period on an accounts receivable and therefore APE needs to
adjust the carrying amount of the accounts receivable. Therefore, it is an adjusting event.
On the basis of this objective evidence about the existence of impairment in the account receivable,
APE should recognise the impairment (bad debt) losses for the year ended 31 March 20X2.
DEBIT Other expenses (impairment) HK$650,000
CREDIT Receivables HK$650,000
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,
Charmaine Yuen
(c) (i) APE – Worksheet for the Consolidated Statement of Profit or Loss and Other
Comprehensive Income for the year ended 31 March 20X2

APE EPE DEBIT Ref CREDIT Consolidated


HK$'000 HK$'000 HK$'000 HK$'000 HK$'000
Sales 80,000 35,750 9,000 6 106,750
Cost of sales (55,000) (24,500) 5 900 (70,650)
6 7,950
Other income
(including gain on
disposal and EPE’s
dividend) 3,700 – 1,000 3 2,100
600 E2
Depreciation
expense (8,000) (1,700) 500 2 (10,200)
Interest expense (5,900) (1,600) (7,500)
Other expenses (3,800) (4,200) 650 1(c) (8,650)
Share of profits of E1 660 780
FPE
E2 120
Profit for the year 11,000 3,750 12,630

Profit attributable
to:
Owners of the
parent 12,010
Non-controlling
interests 620 7 620
12,630

787
Financial Reporting

(c) (ii) APE – Worksheet for the Consolidated Statement of Financial Position as at
31 March 20X2

APE EPE DEBIT Ref CREDIT Consolidated


HK$'000 HK$'000 HK$'000 HK$'000 HK$'000
Plant and
equipment, net 43,000 19,000 2,500 1,2 1,500 63,000
Investment in
EPE, cost 26,550 – 1 26,550 –
Investment in E1,
FPE 7,450 – 660 E2 480 7,630
Goodwill – – 2,800 1 2,800
Other
investments 20,750 1,250 22,000
Inventory 41,250 20,000 6 1,050 60,200
Receivables 10,000 11,000 1(c) 650 20,350
Cash and cash
equivalents 7,500 8,750 16,250
156,500 60,000 192,230

Share capital 30,000 15,000 15,000 1 30,000


Retained
earnings 51,500 25,000 59,190
Non-controlling
interests – – 8,040
Payables 75,000 20,000 95,000
156,500 60,000 192,230

788
Answers to exam practice questions

(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

789
Financial Reporting

Journal entries and reconciliations are not required


HK$'000 HK$'000
CJE 1 Elimination of investment in EPE
DEBIT Share capital 15,000
DEBIT Retained earnings 12,250
DEBIT Goodwill 2,800
DEBIT Plant and equipment 2,500
CREDIT Investment in EPE 26,550
CREDIT Non-controlling interests (SOFP) 6,000

CJE 2 Past and current depreciation on undervalued plant and equipment


DEBIT Opening retained earnings =2,500k/5  2  80% 800
DEBIT Non-controlling interests (SOFP) = 2,500k/5  2 
20%NCI 200
DEBIT Depreciation=2,500/5 years 500
CREDIT Accumulated depreciation 1,500

CJE 3 Eliminate dividend income


DEBIT Dividend income (1,250k x 80%) 1,000
DEBIT Non-controlling interests (SOFP) (1,250k  20% NCI) 250
CREDIT Dividends declared 1,250

CJE 4 Assign post-acquisition RE to NCI


DEBIT Opening retained earnings (1/4/20W9 to 31/3/20X1) 2,050
CREDIT Non-controlling interests (SOFP) 2,050
Assign post-acquisition RE to NCI 20%  (RE 31/3/20X1 22,500k – pre-acq 12,250k)

CJE 5 Realisation of opening unrealised profit in inventory


DEBIT Opening retained earnings 80% 720
DEBIT Non-controlling interests (SOFP) 20% NCI 180
CREDIT Cost of sales (2,500k – 1,600k) 900

CJE 6 Elimination of intercompany sale of inventory


DEBIT Sales 9,000
CREDIT Cost of sales 7,950
CREDIT Inventory 35% unsold x (9,000k – 6,000k) 1,050

CJE 7 Allocate current profit for the year to non-controlling interests


DEBIT Non-controlling interests (PL) 620
CREDIT Non-controlling interests (SOFP) 620

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

NCI = 6,000k – 200k – 250k + 2,050k – 180k + 620k = 8,040k

790
Answers to exam practice questions

EA1 Share of FPE’s current year post-acquisition profits


DEBIT Investment in FPE (2,200k  30%) 660
CREDIT Share of profits of FPE 660

EA2 Elimination of intercompany sales of PPE (10,000k–8,000k)  4 years / 5 years


unrealised  30% Associate

DEBIT Gain on disposal* 600


CREDIT Investment in FPE 480
CREDIT Share of profits of associates 120

Reconciliation of NCI as at 31 March 20X2


HK$'000
NCI’s share of EPE’s net assets at book value
(15,000k + 25,000k)  20% 8,000
NCI’s share of EPE’s FV adjustment (unamortised)
(2,500k  2/5)  20% 200
NCI’s share of implicit goodwill
(6,000k – 20%  29,750k) 50
Less: NCI’s share of unrealised profit of upstream sale
(9,000k – 6,000k)  35% unsold  20% NCI (210)
8,040

Reconciliation of Investment in FPE as at 31 March 20X2


HK$'000
Share of FPE’s net assets at book value
(7,500k + 13,450k)  30% 6,285
Share of implicit goodwill
(7,450k – 30%  (7,500k+11,250k)) 1,825
Less: unrealised profit on intercompany sales of PPE (480)
7,630

*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

DEBIT Share of profits of FPE* 480


CREDIT Investment in FPE 480

791
Financial Reporting

Chapter 29 Changes in group structures


To: Faria LEE (Director), MCL
From: Pindy LEE, Accounting Manager, MCL
c.c.: Beverly CHOW, Emily WILSCON, Charmaine YUEN (Directors)
Date: dd/mm/yyyy
I refer to your email dated 18 May 20X8 regarding your queries about the draft consolidated
financial statements for MCL as at 31 March 20X8.
(a) Plant and equipment
In accordance with HK(SIC)-Int 27, we are required to evaluate the substance of the
transaction with the bank which involves the legal form of a lease.
Since the overall economic effect of the transactions cannot be understood without reference
to the series of transactions as a whole, it is concluded that the series of the sale and the
lease is linked and shall be accounted for as one transaction.
The sale and leaseback arrangement with the bank does not, in substance, involve a sale as
MCL retains substantially all the risks and rewards incident to ownership of the underlying
asset and enjoys substantially the same rights to its use as before the arrangement.
If the legal form is ignored, the substance of the arrangement is a financing arrangement in
which the seller-lessee (MCL) borrows money from the lessor (the bank) using the asset as
security.
Since MCL's risks and rewards incident to owning the plant and equipment have not
substantively changed, the amount of $12 million of plant and equipment should remain in
the consolidated statement of financial position.
(b) The investment in SWL from 31 March 20X7 to 31 March 20X8
1 Status before and after the disposal
Before the disposal, MCL held 60% of the issued shares of SWL.
In accordance with HKFRS 10, control is presumed to exist:
 power is achieved through holding the majority of votes
 MCL has exposure to variable returns from the investment (such as dividends)
 it is assumed that voting power can be used to affect these returns.
Therefore, SWL was a subsidiary of MCL at 31 March 20X7, and MCL was a parent at
that date.
After the disposal of 2,400,000 shares in SWL, MCL held a 30% interest in SWL in
total.
MCL had significant influence, but not control, over SWL from the date of the disposal,
i.e. 30 September 20X7.
Thereafter, SWL was classified as an associate under HKAS 28 Investments in
Associates and Joint Ventures from the date that it ceased to be a subsidiary.
2 The effect of disposal on MCL's financial statements
MCL's remaining 30% investment in SWL should be accounted for using the equity
method in MCL's consolidated financial statements under which the investment would
initially be recognised at cost as of 30 September 20X7.
The fair value of the investment at the date that SWL ceased to be a subsidiary, i.e.
30 September 20X7, shall be regarded as the cost on initial measurement.

792
Answers to exam practice questions

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

793
Financial Reporting

Theoretical ex-rights price to identify the bonus factor:


The theoretical ex-rights fair value per share is calculated by adding the aggregate fair value
of the shares immediately prior to the exercise of the rights to the proceeds from the exercise
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

Chapter 30 Foreign currency transactions


Question 1
HOME GROUP – CONSOLIDATED STATEMENT OF PROFIT OR LOSS
FOR YEAR ENDED 31 JULY 20X6
$'000
Revenue (3,000 + 270.8 (W2) – (50/2.4)) 3,250.0
Cost of sales (2,400 + 229.2 (W2) – (50/2.4)) (2,608.4)
Gross profit 641.6
Distribution costs (32 + 17.1 (W2)) (49.1)
Administrative expenses (168 + 36.3 (W2)) (204.3)
Impairment of goodwill (W3) (1.9)
Exchange difference (W4) 1.3
Finance costs (15 + 4.2 (W2)) (19.2)
Profit before tax 368.4
Income tax (102 – 4.2 (W2)) (97.8)
Profit for year 270.6

794
Answers to exam practice questions

Workings
1 Group structure
Home

1.8.X4 100%

Foreign Pre-acquisition reserves = 180,000 Crowns


2 Translation of Foreign
Foreign Exchange Foreign
Crowns 000 rate $'000
Revenue 650 2.4 270.8
Cost of sales (550) 2.4 (229.2)
Distribution costs (41) 2.4 (17.1)
Administrative exp (87) 2.4 (36.3)
Finance costs (10) 2.4 (4.2)
Income tax (credit) 10 2.4 4.2
3 Goodwill
Crowns Crowns Rate $
Consideration transferred 204,000 1.7 120,000
Less fair value of net assets
acquired
Share capital 1,000
Reserves 180,000
(181,000) 1.7 (106,471)
At 1 August 20X4 23,000 1.7 13,529
Impairment loss: 20% (4,600) 2.4 (1,917)
Exchange difference balance (3,248)
At 31 July 20X6 18,400 2.2 8,364
4 Exchange difference on plant
As the payable is a monetary liability, it must be retranslated at the closing rate at the year
end and the exchange difference recognised in profit or loss:
$
Payable at closing rate (32,000 florins/1.6) 20,000
Original payable (32,000 florins/1.5) (21,333)
Reduction in payable = exchange gain (1,333)

795
Financial Reporting

796
Question bank – questions

797
Financial Reporting

798
Question bank – questions

SECTION A – Case questions


Question 1 90 minutes
Assume that you are Mr. Ricky Cheung, the accounting manager of Pacific Limited ("PCF"). PCF is
a conglomerate listed on the Stock Exchange of Hong Kong with many subsidiaries. PCF acquired
the equity interest in Sanata Limited ("SNT") by two successive purchases with details as follows:
Date Acquisition cost paid Fair value of SNT as an entity % acquired
HK$ HK$

1 April 20X9 6,000,000 24,000,000 25%


31 March 20Y0 26,000,000 40,000,000 65%
The financial year of both PCF and SNT ends on 31 March. The fair value of non-controlling
interests is measured as a proportionate interest in the fair value of the subsidiary as an entity.
Information relating to SNT is as follows:
1 April 20X9 1 April 20X9 31 March 20Y0 31 March 20Y0
Book value Fair value Book value Fair value
HK$ HK$ HK$ HK$

Intangibles – 3,600,000 – 3,200,000


Inventory 2,000,000 2,400,000 4,000,000 4,800,000
Other net assets 18,000,000 18,000,000* 24,000,000 24,000,000*
Net identifiable assets 20,000,000 24,000,000* 28,000,000 32,000,000*
Share capital 8,000,000 8,000,000
Retained earnings 12,000,000 20,000,000
20,000,000 28,000,000
* The fair values of other net assets and net identifiable assets are stated before considering the
impact of deferred tax. Following the business combination, the tax bases of the assets and
liabilities of SNT remain unchanged.
The net profit of SNT for the year ended 31 March 20Y0 was HK$8,000,000. The intangibles of
SNT had a remaining useful life of 6 years from 1 April 20X9 and all inventories were sold within
two months from the year end. Both PCF and SNT did not declare any dividends during the year
ended 31 March 20Y0. The accounting policy of PCF is to account for the investment in associates
at cost in its separate financial statements.
Customer loyalty programme
SNT is a regional chain of convenience stores. It operates a customer loyalty programme and it
grants programme members loyalty points when they spend a specified amount on foodstuffs.
Programme members can redeem the points for further foodstuffs. The points have no expiry date.
Before 1 April 20X8, the entity granted 200,000 points. Management expected 180,000 of these
points to be redeemed. Management has measured the fair value of each loyalty point to be HK$1.
During the year ended 31 March 20X9, 81,000 of the points were redeemed in exchange for
foodstuffs. In the year ended 31 March 20Y0, management revised its expectations. It expected
190,000 points to be redeemed altogether. During the year, 90,000 points were redeemed.
You have prepared the draft consolidated financial statements of PCF for the year ended
31 March 20Y0. After you sent these draft consolidated financial statements to PCF's directors for
review, one of the directors, who is not a certified public accountant, sent you an email as follows:

799
Financial Reporting

To: Ricky Cheung, Accounting Manager, PCF


From: Emily Chen (Director)
c.c.: David Ip, Susan Tse, Richard Chung (Directors)
Date: 18 May 20Y0
Consolidated financial statements of PCF as at 31 March 20Y0
Could you please clarify the following points relating to PCF's draft consolidated financial
statements which I have just reviewed.
(A) I find that there is an item called "gain on step acquisition" in the consolidated financial
statements. You told me that it is somewhat related to the remeasurement of the previously
held equity interest in SNT at its acquisition-date fair value. What is it all about?
(B) I find that there are intangibles in the consolidated financial statements that I cannot find in
the financial statements of PCF and SNT.
(C) It seems to me that goodwill is the difference between the amount that I paid and the value
that I obtained from the investment. However, I cannot obtain the goodwill figure that you
computed in the consolidated financial statements.
(D) I know that there will be tax-effect entries for fair value adjustments. However, why is this tax
effect affecting the value of the goodwill?
(E) I find that portion of the revenue from the sales of foodstuffs by SNT has not been
recognised in the same period as the sales are made. You told me that it is due to the
customer loyalty programme. What is it all about?
I would appreciate your clarification for the upcoming board meeting.
Best regards,
Emily

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

800
Question bank – questions

Question 2 90 minutes
Assume that you are Mr. David Li, the accounting manager of City Limited ("City"). City is a
company incorporated and listed in Hong Kong and is principally engaged in the manufacturing of
electronic products. The draft consolidated financial statements for the year ended 31 March 20X8
are shown as follows:
CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE
INCOME FOR THE YEAR ENDED 31 MARCH 20X8
Notes HK$'000
Revenue 2,348,314
Cost of sales (2,044,510)
Gross profit 303,804
Interest income 5,306
Selling and distribution costs (44,868)
Administrative expenses (136,085)
Loss on disposal of an associate (e) (7,888)
Finance costs (4,974)
Profit before tax (a) 115,295
Income tax expense (14,758)
Profit for the year 100,537
Other comprehensive income:
Exchange differences on translating foreign operations (g) 310
Total comprehensive income for the year 100,847
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 20X8
20X8 20X7
Notes HK$'000 HK$'000
Non-current assets
Property, plant and equipment (b) 115,568 114,170
Investment in an associate (e) – 11,748
Club membership (d) 1,956 1,956
Pledged bank deposits (f) 6,582 6,232
124,106 134,106
Current assets
Inventories 270,726 346,984
Trade receivables, deposits and prepayments 719,128 670,522
Pledged bank deposits (f) 2,322 13,522
Bank balances and cash 234,026 143,472
1,226,202 1,174,500
Current liabilities
Trade payables and accrued charges 675,602 708,524
Amount due to a related party 48,634 37,862
Tax liabilities 7,898 10,580
Obligations under finance leases – due within one year 220 2,690
Bank borrowings – due within one year 76,482 83,006
808,836 842,662
Net current assets 417,366 331,838
Total assets less Current liabilities 541,472 465,944
Equity
Share capital and reserves (c) 524,774 449,618
Total equity 524,774 449,618

801
Financial Reporting

Non-current liabilities
Obligations under finance leases – due after one year – 216
Bank borrowings – due after one year 10,412 8,908
Deferred tax liabilities 6,286 7,202
16,698 16,326
541,472 465,944
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 MARCH
20X8
Translation Share
Share Share Retained of foreign option Total
capital premium profits operations reserve equity
$'000 $'000 $'000 $'000 $'000 $'000

At 31 March 20X7 160,490 154,490 284,821 590 3,717 449,618


Total comprehensive income
for the year – – 100,537 310 – 100,847

Exercise of share options 4,118 4,050 – – (4,050) 68

Recognition of equity-settled
share-based payment – – – – 333 333

Final dividend paid in respect of


20X7 – – (16,990) – – (16,990)

Interim dividend paid in


respect of 20X8 – – (9,102) – – (9,102)
At 31 March 20X8 164,608 158,540 359,266 900 – 524,774

Additional information
(a) Profit before tax
20X8 20X7
HK$'000 HK$'000
Profit before tax has been arrived at after charging:
Depreciation 32,036 26,748
Equity-settled share-based payment expense 333 3,717
Loss on disposal of property, plant and equipment 802 436
Impairment loss recognised on trade receivables 210 –
(b) Property, plant and equipment
HK$'000
Cost
At 31 March 20X7 219,792
Additions 34,240
Disposals (2,898)
At 31 March 20X8 251,134
Depreciation
At 31 March 20X7 105,622
Charge for the year 32,036
Eliminated on disposals (2,092)
At 31 March 20X8 135,566
Carrying amounts
At 31 March 20X8 115,568

At 31 March 20X7 114,170

802
Question bank – questions

(c) Pursuant to the service agreement between City and a director of City dated 1 May 20X6, an
option to subscribe for 6,800,000 shares in the Company at an exercise price equal to
HK$0.01 per share (the "Pre-IPO Share Option") was granted to the director. The Pre-IPO
Share Option, which serves as an incentive for the director, shall be exercised during the
period from 1 May 20X7 to 31 December 20X8 and the option holder has to be in
employment with City when he exercises the options. The estimated fair value of the Pre-
IPO Share Option at the date of grant is HK$4,050,000.
(d) The club membership represents entrance fees paid to golf clubs held on a long-term basis.
It is considered by the management of City as having an indefinite useful life.
(e) On 1 April 20X7, City disposed of its entire 20 per cent interest in an associate for a cash
consideration of HK$3,860,000, resulting in a loss on disposal of HK$7,888,000.
(f) As at 31 March 20X8, bank deposits of HK$8,904,000 had been pledged to secure City's
banking facilities in terms of short-term bank borrowings and long-term borrowings.
(g) Exchange differences arising on translation of foreign operations recognised directly in
equity for the year ended 31 March 20X8 were made on the translation of the financial
statements of the 100 per cent owned foreign subsidiaries. The exchange gains/(losses)
were found to be made up as follows:
HK$'000
Inventories 120
Trade receivables 140
Trade payables (40)
Cash 90
After you sent these draft consolidated financial statements to City's directors for review, a new
director who has just joined the board sent you an email as follows:

To: David LI, Accounting Manager


From: Janice CHEUNG (Director)
c.c.: Michelle CHOW, Julian LIN, Fiona MERRILL (Directors)
Date: 18 May 20X8
Consolidated financial statements of City as at 31 March 20X8
Could you please clarify the following points relating to City's draft consolidated financial
statements which I have just reviewed?
(A) So far as I understand, cash is cash. Why is there a total of three items showing our bank
deposits and cash in the consolidated statement of financial position? Also, I cannot find the
consolidated statement of cash flows. Please send it to me again.
(B) I note that the amount of the item "Club membership" has remained the same throughout the
two years in the consolidated statement of financial position. I believe that non-current
assets should be subject to depreciation and amortisation. Why does the amount of this item
remain the same?
(C) I have also found an item "Equity-settled share-based payment expense" in the note to profit
before tax. As we are only issuing equity to the employees, how would it affect the profit
before tax? Why is HK$333,000 recognised as an expense in 20X8 while the total estimated
fair value is HK$4,050,000?
I would appreciate your clarification in time for the upcoming board meeting.
Best regards,
Janice

803
Financial Reporting

Required
(a) Prepare a memorandum in response to the issues raised by Ms. Janice Cheung. In your
memorandum, you should:
(i) discuss the reasons for the classification of bank deposits and cash into three items as
shown in the consolidated statement of financial position; (8 marks)
(ii) discuss the accounting treatment of the "Club membership"; and (7 marks)
(iii) discuss, with appropriate calculations, the accounting treatment of the "Equity-settled
share-based payment expense". (8 marks)
(b) Prepare an annex to your memorandum showing the consolidated statement of cash flows
for the year ended 31 March 20X8. (27 marks)
(Total = 50 marks)
HKICPA September 2008 (amended)

Question 3 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

Other comprehensive income:


Exchange differences on translating foreign subsidiaries (Note 6) 5,000
Total comprehensive income for the year 20,850

Profit for the year attributable to:


Owners of PWE 13,950
Non-controlling interests 1,900
15,850

Total comprehensive income for the year attributable to:


Owners of PWE 17,950
Non-controlling interests 2,900
20,850

804
Question bank – questions

Statements of Financial Position (extract)

PWE Consolidated SJL


31 Mar 20X2 31 Mar 20X1 at acquisition
HK$’000 HK$’000 HK$’000
ASSETS
Non-current assets
Property, plant and equipment (Note 3) 279,500 244,500 35,500
Prepaid land lease payment 21,600 22,200 –
Goodwill (Note 4) 9,000 7,500 –
Investment in associates 16,000 15,500 –
Certificate of deposit (Note 7) 7,500 – –
Current assets
Trade and other receivables 44,000 47,250 10,250

Cash and cash equivalents 1,000 9,000 1,250


(Note 8)
Total assets 378,600 345,950 47,000

EQUITY AND LIABILITIES


Share capital (Note 2) 95,000 65,000 13,000
Retained earnings 58,900 53,200 10,500
Other reserves (Note 5) 104,000 100,000 17,000
257,900 218,200 40,500
Non-controlling interest 27,500 18,600 –
Total equity 285,400 236,800 40,500
Current liabilities
Trade and other payables 34,900 56,650 4,500
Interest payable 1,250 500 –
Taxation payable 7,050 7,000 2,000
Non-current liabilities
Bank loans 50,000 45,000 –
Total equity and liabilities 378,600 345,950 47,000

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.

805
Financial Reporting

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.
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:

To: Vincent Lee, Accounting Manager, PWE


From: Fatima Choi (Director)
c.c.: Jason Lam, Andy Cheng, Nick Chan (Directors)
Date: 16 May 20X2
Re: Consolidated financial statements of PWE as at 31 March 20X2
Could you please clarify the following points relating to PWE’s draft consolidated financial
statements which I have just reviewed.
(A) I find that you have deducted HK$7,500,000 from our cash and bank balances and
separately included it as “certificate of deposit”. The way you have done it reduces our
reported cash and cash equivalents a lot. You should not do so! It is even worse that you
included it as a non-current asset. The way you have done that not only significantly
reduces our reported cash and cash equivalent but also results in net current liability. I don't
want people to think that we have liquidity problems. I demand you adjust the cash and cash
equivalent by adding back this "certificate of deposit".
(B) You told me that various HKFRSs have been issued but we have not applied them. Why
don’t we apply those HKFRSs as they have been issued? Do we need to tell our
shareholders on this matter?
(C) I find that PWE have acquired a new subsidiary and therefore goodwill arises. How should
we disclose this acquisition of a subsidiary in our consolidated financial statements? How do
you calculate the amount of goodwill?
(D) I find that it is difficult to obtain the figures in the consolidated statement of cash flows. Can
you tell me more about how you arrive at each figure?
Please clarify and adjust in time for the upcoming board meeting.
Best regards,
Fatima

806
Question bank – questions

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)

Question 4 90 minutes
Assume that you are Mr. David Lee, the accounting manager of Ultimate Holdings Limited ("UHL").
UHL is a company incorporated in Hong Kong and is principally engaged in the trading of toys in
Hong Kong.
On 31 March 20X5, UHL acquired 20 per cent of the issued share capital of Successful Toys
Limited ("STL"), a retail chain store incorporated in Hong Kong. The cost of the investment was
seven million Hong Kong Dollars (HK$7,000,000), which UHL paid all in cash. This 20 per cent
shareholding enables UHL to exercise significant influence on STL. On 31 March 20X5, the fair
value of STL's identifiable assets was HK$20,000,000, and the carrying amount of those assets
was HK$15,200,000. STL had no liabilities or contingent liabilities at that date. The following shows
STL's statement of financial position at 31 March 20X5 together with the fair values of the
identifiable assets:
Carrying amounts Fair values
HK$'000 HK$'000
Plant and equipment (net) 11,200 16,000
Net current assets 4,000 4,000
15,200 20,000
Issued equity:
1,000,000 ordinary shares 10,000
Retained earnings 5,200
15,200
During the year ended 31 March 20X6, STL reported a profit of HK$12,000,000 but did not pay any
dividends. In addition, the fair value of STL's plant and equipment further increased to
HK$20,000,000.
On 31 March 20X6 the fair value of the 20 per cent stake in STL was HK$10,000,000.
On 31 March 20X6, UHL acquired a further 50 per cent of the issued share capital of STL thereby
obtaining control. The cost of investment was thirty million Hong Kong Dollars (HK$30,000,000),
which UHL paid all in cash. At 31 March 20X6, STL had a contingent liability of HK$1,000,000
regarding a lawsuit with a supplier. STL expects to settle the case by March 20X7 by paying
around the amount claimed.

807
Financial Reporting

The following shows the statements of financial position of UHL and STL at 31 March 20X6
together with the fair values of STL's identifiable assets at that date:
UHL STL STL
Carrying amounts Fair values
HK$'000 HK$'000 HK$'000
Land lease premium 10,000 – –
Property, plant and equipment (net) 21,000 9,800 20,000
Investment in a subsidiary 37,000 – –
Net current assets 9,000 17,400 17,400
77,000 27,200 37,400
Issued equity:
Ordinary shares 65,000 10,000
Retained earnings 12,000 17,200
77,000 27,200
UHL has adopted an accounting policy to depreciate and amortise plant and equipment using the
straight line method over a 10-year life with no residual value. Non-controlling interests are
measured using the proportion of net assets method.
UHL has no investment other than STL.
The fair values of STL's assets at 31 March 20X5 and subsequent changes in the fair values have
not been reflected in STL's financial statements.
You have a draft set of consolidated financial statements of UHL for the year ended 31 March
20X6. After you have sent them to UHL's directors for review, one of the directors, who is not a
certified public accountant, sends you an email as follows:

To: David Lee, Accounting Manager, UHL


From: Danielle Wong (Director)
c.c.: Crystal Ho, Stephen Lee, Christopher Yung (Directors)
Date: 18 May 20X6
Consolidated financial statements of UHL as at 31 March 20X6
Could you please clarify the following points relating to UHL's draft consolidated financial
statements which I have just reviewed.
(A) So far as I understand, the company owns a warehouse in the New Territories and an office
in Kowloon. I am not aware that we have purchased or leased any land. Why is there an item
"Land lease premium" in the consolidated statement of financial position?
(B) In last year's financial statements, I see an item "Investment in an associate" of an amount of
HK$7,000,000 in the statement of financial position. This item disappeared in the current
year's "consolidated" statement of financial position as at 31 March 20X6. Interestingly, I find
an item "Share of profit of an associate" in the "consolidated" statement of profit or loss for
the current year. Is there something wrong with the financial statements? What does the
term "consolidated" mean?
(C) In your notes to the consolidated statement of cash flows describing assets and liabilities
acquired in business combination, there is an item "Provision for contingent liabilities" of
HK$1,000,000 under current liabilities assumed. I recall that in the financial statements of
some listed companies I have read, contingent liabilities are in fact not liabilities. They are
only disclosed in the notes. Why do we treat them as a liability in our accounts?
(D) What is "Goodwill"?
I would appreciate your clarification in time for the upcoming board meeting.
Best regards,
Danielle

808
Question bank – questions

Required
(a) Prepare a memorandum in response to the issues raised by Ms. Danielle Wong. In your
memorandum, you should:
(i) discuss the reasons for the item "Land lease premium" in the consolidated statement
of financial position; (5 marks)
(ii) discuss how UHL should account for its interest in STL from 31 March 20X5 to
31 March 20X6. For this purpose, you should explain (1) the treatments of the 20 per
cent interest in STL in UHL's statement of financial position at 31 March 20X5; (2) the
effect of the 50 per cent interest acquired at 31 March 20X6 on the status of STL and
(3) the meaning of "consolidated" financial statements; (10 marks)
(iii) determine the carrying amount of the 20 per cent interest in STL at 31 March 20X6
(i.e. before the acquisition of the 50 per cent interest at 31 March 20X6); (5 marks)
(iv) discuss why the "contingent liability" is recognised as a liability in UHL's consolidated
statement of financial position; and (5 marks)
(v) discuss why goodwill is recognised in UHL's consolidated statement of financial
position and its implications for financial statements in future. You should also
demonstrate the calculation of the carrying amount of the goodwill as at 31 March
20X6. (10 marks)
(b) Prepare an annex to your memorandum showing the consolidated statement of financial
position as at 31 March 20X6. Ignore deferred taxation. (Alternatively, you may list the
consolidation journals necessary for the purpose of drafting the consolidated statement of
financial position.) (15 marks)
(Total = 50 marks)
HKICPA September 2006 (amended)

Question 5 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.

809
Financial Reporting

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: 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
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

810
Question bank – questions

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

Share capital 32,000,000 16,000,000


Retained earnings 46,000,000 25,000,000
Revaluation surplus 10,000,000 2,200,000
88,000,000 43,200,000
Trade and other payables 47,600,000 13,600,000
Long-term loan 50,000,000 20,000,000
185,600,000 76,800,000
You have prepared the draft consolidated financial statements of PPY for the year ended 31 March
20Y0. After you sent these draft consolidated financial statements to PPY’s directors for review,
one of the directors, who is not a certified public accountant, sent you an email as follows:

To: Tommy Lau, Accounting Manager, PPY


From: Gabriel Wong (Director)
c.c.: Renee Ho, Chris Wong, Adrian Cheung (Directors)
Date: 8 May 20Y0
Consolidated financial statements of PPY as at 31 March 20Y0
Could you please clarify the following points relating to PPY's draft consolidated financial
statements which I have just reviewed.
(A) I am puzzled about the investment property. The figure that was found in the PPY's
statement of financial position was not the same as that in the consolidated one.
(B) I find that it is difficult to obtain the figures in the consolidated statement of financial position.
Can you tell me more about how you arrived at each figure?
I would appreciate your clarification for the upcoming board meeting.
Best regards,
Gabriel

811
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)

Question 6 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.

812
Question bank – questions

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
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:

To: Ricky Lam, Accounting Manager, STL


From: Sunny Sun (Director)
c.c.: Susan Chow, Emily Tsim, Rachael Lau (Directors)
Date: 18 September 20X9
Consolidated financial statements of STL as at 30 June 20X9
Could you please clarify the following points relating to STL's draft consolidated financial
statements which I have just reviewed.
(a) I have not found any goodwill in either of the financial statements of STL and MNL. Why is
there such an item in the consolidated statement of financial position?
(b) It seems to be a good idea to invest in the joint venture. By contributing our machinery to the
joint venture, a gain on disposal will be recorded. Do you agree?
(c) I note that you have made tax-effect entries for adjustments for intragroup transactions. As
tax is charged on individual entities, why have these tax effect entries been made?
(d) I note that the amount of sales from STL to ERL has not been eliminated. Why don't we
eliminate all these sales as ERL is our investee? Did we overstate our profit, particularly
when ERL has not resold all the inventory transferred from STL?
I would appreciate your clarification in time for the next board meeting.
Best regards,
Sunny

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)

813
Financial Reporting

(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)

Question 7 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.

814
Question bank – questions

(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.
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

EQUITY AND LIABILITIES


Share capital 19,000 1,000 4,000 24,000
Retained earnings
At 31 March 20Y0 16,000 10,000 6,500 32,500
For the year ended 31 March 20Y1 8,000 1,000 2,400 11,400
43,000 12,000 12,900 67,900
Non-current liability
Debenture - 2,000 1,000 3,000
Current liability
Accounts payable 4,000 1,000 4,200 9,200
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

815
Financial Reporting

SECTION B – Short / Essay questions


Question 8 18 minutes
(a) Mr. K. Chow is a member of the Hong Kong Institute of Certified Public Accountants
("HKICPA"). His brother, Mr. V. Chow, is also a member of HKICPA and acts as an
independent non-executive director and the chairman of the audit committee of a company
listed on the Stock Exchange of Hong Kong Limited. For the audit committee meeting to be
held next week, Mr. V. Chow received a copy of draft audited annual financial statements for
the year ended 30 June 20X9 (the "Accounts") which reported a significant increase in profit.
They discussed the company's financial performance and position with reference to the
information shown in the Accounts. Mr. K. Chow acquired shares in the company on the
following day.
Required
Discuss the appropriateness of behaviours of both Mr. K. Chow and his brother, Mr. V. Chow
in the context of Code of Ethics for Professional Accountants of HKICPA. (5 marks)
(b) "No goodwill is recognised in the financial statements prepared under merger accounting for
a business combination under common control. However, goodwill can still appear in the
consolidated financial statements after applying merger accounting for a business
combination under common control." Discuss. (5 marks)
(Total = 10 marks)
HKICPA February 2010

Question 9 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.

816
Question bank – questions

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 10 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 11 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.

817
Financial Reporting

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 12 11 minutes
Cleantech Motor Limited ("CML") was 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. 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 13 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
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.

818
Question bank – questions

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 14 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

819
Financial Reporting

Question 15 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 16 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)

820
Question bank – answers

821
Financial Reporting

822
Question bank – answers

SECTION A – Case questions


Answer 1
To: Ms. Chen, Director of PCF
From: Ricky Cheung, Accounting Manager, PCF
c.c.: David Ip, Susan Tse, Richard Chung (Directors)
Date: dd/mm/yyyy
Subject: Report on business combination
I refer to your email dated 18 May 20Y0 regarding your queries about the draft consolidated
financial statements for PCF as at 31 March 20Y0.
(a) Effect of business combination on the 25 per cent equity interest in SNT
On 1 April 20X9, PCF acquired the 25 per cent equity interest in SNT at a cost of
$6,000,000. Thus the investment in SNT would be stated initially at cost, i.e. $6,000,000.
On 31 March 20Y0, PCF obtained control of SNT in which it held an equity interest
immediately before the acquisition date.
HKFRS 3 (revised) Business Combinations refers to such a transaction as a "business
combination achieved in stages", sometimes also referred to as a "step acquisition".
In accordance with paragraph 42 of HKFRS 3 (revised), in a business combination achieved
in stages, the acquirer shall remeasure its previously held equity interest in the acquiree at
its acquisition-date fair value and recognise the resulting gain or loss, if any, in profit and
loss.
On consolidation, PCF should then remeasure this 25 per cent equity interest at its
acquisition-date fair value and recognise the resulting gain or loss in profit and loss.
A business combination should not have any effect at the level of separate financial
statements. The investment in SNT should simply be accounted for at cost in the separate
financial statements of PCF, i.e. $6,000,000 + $26,000,000 = $32,000,000.
Gain on step acquisition at consolidation level
Since PCF had a 25 per cent equity interest in SNT during the year ended 31 March 20Y0,
PCF had significant influence over SNT and thus PCF had to account for SNT's profit for the
year ended 31 March 20Y0 using the equity method at consolidation level (HKAS 28 (2011)
Investments in Associates and Joint Ventures):
$
Net profit of SNT for the year ended 31 March 20Y0 8,000,000
Less: amortisation of intangibles ($3.6m / 6 years) (600,000)
Less: cost of sales from revalued inventory (400,000)
Adjusted net profit for SNT 7,000,000
The carrying amount of the previously held equity interests at consolidated level would be
equal to:
$
The original acquisition cost for the 25% interest 6,000,000
Plus: share of profit after acquisition (25%  $7,000,000) 1,750,000
The carrying amount of previously held interests at consolidated level 7,750,000

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

823
Financial Reporting

(b) Recognition of intangibles


The recognition principle under HKFRS 3 (revised) states that "as of the acquisition date, the
acquirer shall recognise, separately from goodwill, the identifiable assets acquired, the
liabilities assumed and any non-controlling interest in the acquiree".
Accordingly, the acquirer should recognise an acquiree's intangible assets separately from
goodwill, if the recognition criteria are met, i.e.:
 to qualify for recognition as part of applying the acquisition method, the identifiable
assets acquired and liabilities assumed must meet the definitions of assets and
liabilities in the Conceptual Framework for Financial Reporting at the acquisition date.
 in addition, to qualify for recognition as part of applying the acquisition method, the
identifiable assets acquired and liabilities assumed must be part of what the acquirer
and the acquiree (or its former owners) exchanged in the business combination
transaction rather than the result of separate transactions.
Paragraph 13 of HKFRS 3 (revised) states that "the acquirer's application of the recognition
principle and conditions may result in recognising some assets and liabilities that the
acquiree had not previously recognised as assets and liabilities in its financial statements".
For example, the acquirer recognises the acquired identifiable intangible assets, such as a
brand name, a patent or a customer relationship, that the acquiree did not recognise as
assets in its financial statements because it developed them internally and charged the
related costs to expense.
An intangible asset is identifiable if it meets either the separability criterion or the contractual-
legal criterion.
 An intangible asset that meets the contractual-legal criterion is identifiable even if the
asset is not transferable or separable from the acquiree or from other rights and
obligations.
 The separability criterion means that an acquired intangible asset is capable of being
separated or divided from the acquiree and sold, transferred, licensed, rented or
exchanged, either individually or together with a related contract, identifiable asset or
liability.
An intangible asset that the acquirer would be able to sell, license or otherwise exchange for
something else of value meets the separability criterion even if the acquirer does not intend
to sell, license or otherwise exchange it.
An acquired intangible asset meets the separability criterion if there is evidence of exchange
transactions for that type of asset or an asset of a similar type, even if those transactions are
infrequent and regardless of whether the acquirer is involved in them.
An intangible asset that is not individually separable from the acquiree or combined entity
meets the separability criterion if it is separable in combination with a related contract,
identifiable asset or liability.
Since goodwill is a payment for anticipated benefits that are not capable of being individually
identified and separately recognised, it is inappropriate for an identifiable intangible asset to
be subsumed in goodwill.
Thus an acquirer should recognise an intangible asset of the acquiree in the consolidated
financial statements if it meets the definition of an intangible asset and its fair value is
included in the exchange transaction relating to the business combination.

824
Question bank - answers

(c) Amount of goodwill as at 31 March 20Y0


$
Fair value of consideration transferred 26,000,000
Amount of non-controlling interest (10%  $40,000,000) 4,000,000
Fair value of the previously held interest (25%  $40,000,000) 10,000,000
40,000,000
Less: Fair value of SNT's recognised net identifiable assets (32,000,000)
Goodwill 8,000,000

(d) Deferred tax


HKAS 12 requires the recognition of deferred tax liabilities or deferred tax assets on taxable
or deductible temporary differences. Temporary differences arise when the tax bases of the
identifiable assets acquired and liabilities assumed are not affected by the business
combination or are affected differently (paragraph 19).
Paragraph 18 of HKAS 12 states that temporary differences arise when the identifiable
assets acquired and liabilities assumed in a business combination are recognised at their fair
values in accordance with HKFRS 3 (revised) Business Combinations, but no equivalent
adjustment is made for tax purposes.
When the carrying amount of an asset is increased to fair value but the tax base of the asset
remains at cost to the previous owner, a taxable temporary difference arises which results in
a deferred tax liability. The resulting deferred tax liability increases goodwill.
In Hong Kong, the Inland Revenue Department does not allow reductions in the carrying
amount of goodwill as a deductible expense in determining taxable profit. Moreover, the cost
of goodwill is often not deductible when a subsidiary disposes of its underlying business.
Therefore, goodwill has a tax base of nil. Any difference between the carrying amount of
goodwill and its tax base of nil is a taxable temporary difference.
However, HKAS 12 does not permit the recognition of the resulting deferred tax liability
because goodwill is measured as a residual.
In this case:
 the carrying amount of the inventory ($4,000,000) is increased to its fair value
($4,800,000) but the tax base will remain at cost,
 a taxable temporary difference ($800,000) arises,
 which results in a deferred tax liability of 16%  $800,000
 = $128,000 and this affects the amount of goodwill.
A temporary difference may also arise on initial recognition of an asset or liability, for
example if part or all of the cost of an asset is not deductible for tax purposes
(paragraph 22).
In this case:
 intangibles are recognised at $3,200,000 which will not be deductible for tax purposes,
 a taxable temporary difference of $3,200,000 arises.
 Thus in accounting for the business combination, a deferred tax liability of 16% 
$3,200,000
 = $512,000 should be recognised and this affects the amount of goodwill.

825
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

826
Question bank - answers

Year ended 31 March 20Y0


In the year ended 31 March 20Y0, the management of SNT revised its expectations. It
expected 190,000 points to be redeemed altogether. This revised estimate of the total
number of points expected to be redeemed shall be used.
During this year, 90,000 points are redeemed, bringing the total number redeemed to 81,000
+ 90,000 = 171,000 points.
The cumulative revenue to date = (cumulative number of points redeemed / revised estimate
of total number of points expected to be redeemed)  $200,000.
Thus, the cumulative revenue that SNT recognises is (171,000 points / 190,000 points) 
$200,000 = $180,000.
SNT has recognised revenue of $90,000 in the year ended 31 March 20X9, so the amount of
revenue to be recognised in the year ended 31 March 20Y0
= cumulative revenue to date – cumulative revenue recognised to date
= $180,000 – $90,000
= $90,000
I hope the above explanation has answered your questions. Please feel free to contact me if
you have further queries.
Best regards,
Ricky Cheung

Answer 2
To: Janice Cheung (Director)
From: David Li, Accounting Manager
c.c.: Michelle Chow, Julian Lin, Fiona Merrill (Directors)
Date: dd/mm/yyyy
I refer to your email dated 18 May 20X8 regarding your queries about the draft consolidated
financial statements for City as at 31 March 20X8.
(a) (i) Pledged bank deposits
HKAS 1 requires the face of the statement of financial position to include a line item
that presents the cash and cash equivalents.
HKAS 7 states that cash comprises cash on hand and demand deposits while 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.
Since pledged bank deposits are not readily convertible to known amounts of cash
without an insignificant risk of changes in value, they are not included in the cash and
cash equivalents.
HKAS 1 also specifies that additional line items, headings and subtotals shall be
presented on the face of the statement of financial position when such presentation is
relevant to an understanding of the entity's financial position.
Paragraph 14 of HKFRS 7 requires an entity to disclose:
 the carrying amount of financial assets it has pledged as collateral for liabilities
or contingent liabilities, including amounts that have been reclassified in
accordance with HKFRS 9; and
 the terms and conditions relating to its pledge.

827
Financial Reporting

Paragraph 31 of HKFRS 7 requires an entity to disclose information that enables


users of its financial statements to evaluate the nature and extent of risks arising from
financial instruments to which the entity is exposed at the reporting date.
Pledged bank deposits and their relevant financial liability create a potentially
significant exposure to risks and hence their terms and conditions warrant disclosure.
The amounts represent deposits pledged to banks to secure banking facilities granted
to the Group. This denotes that as at 31 March 20X8, bank deposits of HK$8,904,000
(20X7: HK$19,754,000) had been pledged to secure City's banking facilities.
HKAS 1 requires that an asset shall be classified as current when it satisfies any of
the following criteria:
(a) it is expected to be realised in, or is intended for sale or consumption in, the
entity's normal operating cycle;
(b) it is held primarily for the purpose of being traded;
(c) it is expected to be realised within 12 months after the end of the reporting
period; or
(d) it is cash or a cash equivalent (as defined in HKAS 7 Statement of Cash Flows)
unless it is restricted from being exchanged or used to settle a liability for at
least 12 months after the end of the reporting period.
All other assets shall be classified as non-current. Therefore, the bank deposits and
cash should be classified into three items in accordance with the nature of the amount,
i.e. cash and cash equivalents, pledged bank deposits classified as current assets and
pledged bank deposits classified as non-current assets.
The amounts denote that deposits amounting to HK$2,322,000 (20X7:
HK$13,522,000) have been pledged to secure short-term bank borrowings and are
therefore classified as current assets; and the remaining deposits amounting to
HK$6,582,000 (20X7: HK$6,232,000) have been pledged to secure long-term
borrowings and are therefore classified as non-current assets.
The pledged bank deposits will be released and reclassified from "Pledged bank
deposits" to "Bank balances and cash" upon settlement of the relevant bank borrowings.
(ii) Club membership
The club membership represents entrance fees paid to clubs held on a long-term
basis. Typically, it is recognised as an intangible asset since it is an identifiable non-
monetary asset without physical substance.
The accounting for an intangible asset is based on its useful life. An intangible asset
with a finite useful life is amortised, and an intangible asset with an indefinite useful life
is not. Therefore, an entity shall assess whether the useful life of an intangible asset is
finite or indefinite.
HKAS 38 requires an intangible asset to be regarded as having an indefinite useful life
when, based on an analysis of all of the relevant factors, there is no foreseeable limit to
the period over which the asset is expected to generate net cash inflows for the entity.
The term "indefinite" does not mean "infinite". The useful life of an intangible asset reflects
only that level of future maintenance expenditure required to maintain the asset at its
standard of performance assessed at the time of estimating the asset's useful life, and the
entity's ability and intention to reach such a level. A conclusion that the useful life of an
intangible asset is indefinite should not depend on planned future expenditure in excess of
that required to maintain the asset at that standard of performance.
Since there is no foreseeable limit to the period over which the club membership is
expected to generate net cash inflows for City, the management of City considered the
club membership as having an indefinite useful life.

828
Question bank - answers

An intangible asset with an indefinite useful life should not be amortised. Therefore,
the club membership, which is considered by the management of the Group as having
an indefinite useful life, will not be amortised until the useful life is determined to be
finite upon reassessment of the useful life annually by the management.
The useful life of the club membership should be reviewed each reporting period to
determine whether events and circumstances continue to support an indefinite useful
life assessment for that asset. If they do not, the change in the useful life assessment
from indefinite to finite should be accounted for as a change in an accounting
estimate.
As a result, the club membership with indefinite useful life is carried at cost less any
identified impairment loss and is tested for impairment annually.
During the year ended 31 March 20X8, the club membership shall be tested for
impairment by comparing its carrying amount with its recoverable amount. If the
recoverable amount exceeds the carrying amount, the management can conclude that
no impairment loss needed to be charged for the current year and hence the carrying
amount of the club membership remains the same throughout the two years.
As an intangible asset assessed as having an indefinite useful life, HKAS 38 requires
City to disclose the carrying amount of the club membership and the reasons
supporting the indefinite useful life assessment.
(iii) Equity-settled share-based payment transactions – Share options granted to
employees of the Group
HKFRS 2 defines equity-settled share-based payment transactions as transactions in
which the reporting entity receives goods or services as consideration for equity
instruments of the entity, which equity instruments can include shares or share
options.
For equity-settled share-based payment transactions, the entity shall measure the
goods or services received, and the corresponding increase in equity, directly, at the
fair value of the goods or services received, unless that fair value cannot be estimated
reliably. If the entity cannot estimate reliably the fair value of the goods or services
received, the entity shall measure their value, and the corresponding increase in
equity, indirectly, by reference to the fair value of the equity instruments granted.
There is a general assumption that transactions with employees cannot be reliably
measured on the basis of the value of the services being provided. Therefore,
transactions with employees are typically measured at the fair value of the equity
instruments being granted.
The grant date is 1 May 20X6. The requirement for the holder to be in employment
with City when he exercises the options is effectively a vesting condition.
The vesting date should be 1 May 20X7, which is the first date that the option holder is
entitled to exercise the options. The options vest over the one year ending 1 May
20X7.
Since the options vest over the one year ending 1 May 20X7, it is presumed that the
services to be rendered by the director as consideration for the options will be
received in the one year vesting period.
Therefore, City should recognise 335/365 (335 days out of 365 days) of the services
to be received as an expense during the year ended 31 March 20X7 with a
corresponding increase in equity (share option reserve).
The amount should be measured by reference to the fair value of the options as at
1 May 20X6, i.e. the fair value of services received determined by reference to the fair
value of share options granted at the grant date is expensed on a straight-line basis over
the vesting period, with a corresponding increase in equity (share option reserve).

829
Financial Reporting

Therefore, City recognised the total expense of HK$333,000 (HK$4,050,000  30/365)


for the year ended 31 March 20X8 (20X7: HK$3,717,000 (HK$4,050,000  335/365))
in relation to share options granted by the Company.
At the end of each reporting period, City should revise its estimates of the number of
options that are expected to ultimately vest. The impact of the revision of the
estimates is recognised in profit or loss, with a corresponding adjustment to share
option reserve.
At the time when the share options are exercised, the amount previously recognised in
share option reserve shall be transferred to share capital. Thus, HK$4,050,000 has
been transferred from the share option reserve to the share capital account as shown
in the consolidated statement of changes in equity.
I hope the above explanation has answered your questions. Please feel free to contact
me if you have further queries.
Best regards
David LI
(b) CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 MARCH 20X8
HK$'000
Operating activities
Profit before tax 115,295
Adjustments for:
Finance costs 4,974
Share-based payment expense 333
Depreciation 32,036
Impairment loss recognised on trade receivables 210
Interest income (5,306)
Loss on disposal of property, plant and equipment 802
Loss on disposal of an associate 7,888
Operating cash flows before movements in working capital 156,232
Decrease in inventories
(270,726 – exchange difference 120) – 346,984 76,378
Increase in trade receivables, deposits and prepayments
(719,128 – exchange difference 140) + impairment 210 – 670,522 (48,676)
Decrease in trade payables and accrued charges
(675,602 – exchange difference 40) – 708,524 (32,962)
Increase in amount due to a related party (48,634 – 37,862) 10,772
Cash generated from operating activities 161,744
Tax paid (current 10,580 + deferred 7,202 + expense 14,758 – closing
current 7,898 – closing deferred 6,286) (18,356)

Net cash from operating activities 143,388


Investing activities
Purchases of property, plant and equipment (34,240)
Proceeds on disposal of property, plant and equipment
(2,898 – 2,092) – 802 4
Proceeds on disposal of an associate (Note e) 3,860
Decrease in pledged bank deposits (6,582 + 2,322) – (6,232 + 13,522) 10,850
Interest received 5,306
Net cash used in investing activities (14,220)

830
Question bank - answers

HK$'000
Financing activities
Repayment of obligations under finance leases (2,690 + 216) – 220 (2,686)
Proceeds on issue of shares (note c) 68
Repayment of bank borrowings (83,006 + 8,908) – (76,482 + 10,412) (5,020)
Dividends paid (16,990 + 9,102) (26,092)
Interest paid (4,974)
Net cash used in financing activities (38,704)

Net increase in cash and cash equivalents 90,464


Effect of foreign exchange rate changes (Note g) 90
Cash and cash equivalents at the beginning of the year 143,472
Cash and cash equivalents at the end of the year
representing bank balances and cash 234,026

Alternatively, candidates may present Statement of Cash Flows by using direct method:
HK$'000
Cash generated from operating activities:
Cash receipts from customers
(670,522 + 2,348,314 – (719,128 – exchange gain 140
+ impairment loss 210)) 2,299,638
Cash paid to suppliers and employees (Note 1) (2,137,894)
Cash generated from operating activities 161,744

Note 1 Cash paid to suppliers and employees


Opening inventories + purchases – closing inventories = cost of sales
346,984 + purchases – (270,726 – exchange gain 120) = 2,044,510
thus purchases = 1,968,132
HK$'000
Opening trade payables and accrued charges 708,524
Opening amount due to a related party 37,862
Purchases 1,968,132
Selling and distribution costs 44,868
Administrative expenses 136,085
less: share-based payment expense (333)
less: depreciation (32,036)
less: impairment loss recognised on trade receivables (210)
less: loss on disposal of property, plant and equipment (802)
less: closing trade payables and accrued charges (675,602)
add: exchange difference 40
less: closing amount due to a related party (48,634)
2,137,894

831
Financial Reporting

Answer 3
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.

832
Question bank - answers

 Objectivity - A professional accountant should not allow bias, conflict of interest


or undue influence of others to override professional or business judgments. It
would not be objective if I included the certificate of deposit as cash and cash
equivalents with the mere intention to present a better financial position.
 Professional Competence and Due Care - A professional accountant should act
diligently and in accordance with applicable technical and professional
standards when providing professional services. I must act diligently in
accordance with the accounting standards and thus I cannot allow the inclusion
of the certificate of deposit as cash equivalents.
 Professional Behaviour - A professional accountant should comply with relevant
laws and regulations and should avoid any action that discredits the profession.
I cannot compromise with an action that discredits our profession. Thus I cannot
include the certificate of deposit as cash equivalents.
Therefore, in this case, if the intention is merely for the purpose of increasing the amount of
cash and cash equivalents to be presented in the statement of financial position, it would not
be ethical and it would not be acceptable under the Code of Ethics for Professional
Accountants.
Having considered all these issues, I would suggest, as an alternative course of action,
that we may provide a disclosure note to show the total amount of cash and bank deposits
and highlight the fact that the total amount of cash and bank deposits actually did not drop
significantly (20X2: HK$8,500,000, 20X1: HK$9,000,000).
(b) Disclosure requirement as various HKFRSs are not early adopted
According to paragraph 30 of HKAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors, when an entity has not applied a new HKFRS that has been issued
but is not yet effective, the entity shall disclose:
(a) this fact (i.e. PWE has not applied the new HKFRS because it has been issued but is
not yet effective); and
(b) known or reasonably estimable information relevant to assessing the possible impact
that application of the new HKFRS will have on the entity’s financial statements in the
period of initial application.
Therefore, PWE has to disclose:
(a) the title of the new HKFRS;
(b) the nature of the impending change or changes in accounting policy (e.g. HKFRS 9
Financial Instruments (as issued in November 2009) introduces new requirements for
the classification and measurement of financial assets. HKFRS 9 Financial
Instruments (as revised in November 2010) adds requirements for financial liabilities
and for derecognition);
(c) the date by which application of the HKFRS is required (e.g. HKFRS 9 Financial
Instruments is effective for annual periods beginning on or after 1 January 2015, with
earlier application permitted);
(d) the date at which it plans to apply the HKFRS initially; and
(e) either:
(i) a discussion of the impact that the initial application of the HKFRS is expected
to have on the entity’s financial statements; or
(ii) if that impact is not known or reasonably estimable, a statement to that effect.

833
Financial Reporting

(c) Cash flow effects of the acquisition of SJL


According to paragraph 39 of HKAS 7 Statement of Cash Flows, the aggregate cash flows
arising from obtaining control of subsidiaries shall be presented separately and classified as
investing activities.
In particular, PWE should disclose, in aggregate, in respect of obtaining control of SJL during
the period each of the following:
(a) the total consideration paid (HK$34,000,000);
(b) the portion of the consideration consisting of cash and cash equivalents
(HK$4,000,000);
(c) the amount of cash and cash equivalents in the subsidiary over which control is
obtained (HK$1,250,000); and
(d) the amount of the assets and liabilities other than cash or cash equivalents in the
subsidiary over which control is obtained, summarised by each major category.
The net cash outflow arising on the acquisition and the fair value of the assets acquired and
liabilities assumed were as follows:
HK$'000 HK$'000
Total consideration paid 34,000
Fair value of non-controlling interests (20%) 8,000
42,000
Property, plant and equipment 35,500
Trade and other receivables 10,250
Cash and cash equivalents 1,250
Trade and other payables (4,500)
Taxation payable (2,000)
Less: Fair value of identifiable net assets 40,500
Goodwill 1,500

Total consideration paid 34,000


Non-cash consideration – fair value of shares issued (30,000)
Cash consideration paid 4,000
Less: Cash and cash equivalents of SJL (1,250)
Cash outflow on acquisition, net of cash acquired 2,750
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,
Vincent Lee
(d) Consolidated Statement of Cash Flows of PWE for the year ended 31 March 20X2
HK$'000 HK$'000
Operating activities
Profit before tax 16,900
Adjustments for:
Depreciation 32,600
Impairment loss recognised in respect of trade receivables 711
Loss on disposal of property, plant and equipment 2,500
Release of prepaid land lease payments 600
Finance costs 2,300
Exchange loss arising on translating foreign currency bank loans 1,260
Exchange loss arising on translating foreign currency bank deposits 500
Share of profits of associate (1,650)

834
Question bank - answers

HK$'000 HK$'000
Operating profits before working capital changes 55,721

Decrease in trade and other receivables


(44,000 – (47,250 – impairment 711) – exchange 4,500 –
new 10,250) 17,289
Decrease in trade and other payables
(34,900 – 56,650 – exchange 1,500 – new 4,500) (27,750)
Cash generated from operations 45,260
Interest paid (500 + SPLOCI 2,300 – 1,250) (1,550)
Tax paid (7,000 + SPLOCI 1,050 + new 2,000 – 7,050) (3,000)
Net cash from operating activities 40,710
Investing activities
Acquisition of subsidiary, net of cash acquired (c)
(4,000 – 1,250) (2,750)
Increase in certificate of deposit (7,500)
Dividend received from associate (W1) 1,150
Purchase of property, plant and equipment (W2) (61,100)
Proceeds from disposal of property, plant and equipment 26,500
Net cash used in investing activities (43,700)
Financing activities
New bank loans raised (W3) 3,740
Dividend paid to non-controlling interest (W4) (2,000)
Dividend paid (W5) (8,250)
Net cash used in financing activities (6,510)
Net decrease in cash and cash equivalents (9,500)
Cash and cash equivalents at beginning of period 9,000
Effect of exchange rate changes on cash and cash equivalents
(exchange gain on translation of foreign subsidiaries 2,000 –
exchange loss on foreign currency bank deposits 500) 1,500
Cash and cash equivalents at end of period 1,000
Workings: (All figures in HK$‘000)
W1 Opening investment in associates 15,500 + SPLOCI 1,650 – dividend = closing
16,000, thus dividend received from associates = 1,150
W2 Opening PPE 244,500 + addition – depreciation 32,600 – disposal 29,000 + new
35,500 = closing 279,500, thus addition = 61,100
W3 Opening bank loans 45,000 + new bank loans raised + translation loss 1,260 = closing
bank loans 50,000, thus new bank loans raised = 3,740
W4 Opening NCI 18,600 + new 8,000 + SPLOCI 2,900 – dividend to NCI = closing 27,500,
thus dividend to NCI = 2,000
W5 Opening retained earnings and other reserves (53,200+100,000) + SPLOCI 17,950 –
dividend = closing (58,900+104,000), thus dividend paid = 8,250

835
Financial Reporting

Answer 4
To: Danielle WONG (Director), UHL
From: David LEE, Accounting Manager, UHL
cc: Crystal HO, Stephen LEE, Christopher YUNG (Directors)
Date: dd/mm/yyyy
I refer to your email dated 18 May 20X6 regarding your queries about the draft consolidated
financial statements for UHL as at 31 March 20X6 and the proforma consolidated statement of
financial position as at 31 March 20X5.
(a) (i) Land lease premium
The "Land lease premium" refers to the land element of our warehouse and office.
Although we have purchased the warehouse and the office, a significant amount of the
purchase considerations was paid for the land element.
With very few exceptions, all lands in Hong Kong are owned by the Government and
leased out for a limited period. That is, the warehouse and office were built on land
under a government lease.
For the purpose of lease classification, the land and buildings elements of a lease of
land and buildings are considered separately.
A characteristic of land is that it normally has an indefinite economic life.
Since the land title will not pass to the leasing company by the end of the lease term,
the company normally does not receive substantially all of the risks and rewards
incidental to ownership of the land.
When the land has an indefinite economic life, the land element is normally classified
as an operating lease unless the title is expected to pass to the lessee by the end of
the lease term. The lease of land is therefore classified as an operating lease.
The "Land lease premium" of HK$10,000,000, which represents a part of the
payments made for the acquisition of the warehouse and office, is accounted for as an
operating lease of the land, representing prepaid lease payments that are amortised
over the lease term.
(ii) The investment in STL from 31 March 20X5 to 31 March 20X6
1 At 31 March 20X5
At 31 March 20X5, UHL held only 20 per cent of the issued shares of STL. UHL
had significant influence, but not control over STL.
Therefore, STL was classified as an associate under HKAS 28 (2011)
Investments in Associates and Joint Ventures.
UHL's 20 per cent investment in STL should be accounted for using the equity
method under which the investment would initially be recognised at cost of
HK$7,000,000 at 31 March 20X5.
2 The effects of acquiring a further 50 per cent interest in STL at 31 March
20X6
After the acquisition of a further 50 per cent interest in STL, UHL holds a total of
70 per cent interest in STL.
HKFRS 10 defines a subsidiary as an entity that is controlled by another entity.
The key element is "control" which means power over the investee, exposure or
rights to variable returns from the investee and the ability to use power to affect
the returns.
In accordance with HKFRS 10, the elements of control are presumed to exist
since UHL directly owns more than one half of the voting rights of STL.

836
Question bank - answers

Therefore, STL was a subsidiary of UHL at 31 March 20X6, and UHL was a
parent at that date.
In accordance with HKFRS 10 and the Companies Ordinance, UHL, as a parent
company, shall present consolidated financial statements for the year ended
31 March 20X6 in addition to its separate financial statements.
3 The meaning of "consolidated" financial statements
Consolidated financial statements are the financial statements of a group
presented as those of a single economic entity.
In preparing the consolidated financial statements, UHL combines the financial
statements of UHL and STL line by line by adding together like items of assets,
liabilities, equity, income and expenses.
In order that the consolidated financial statements present financial information
about the group as that of a single economic entity, a number of consolidation
adjustments are made to the combined financial statements.
For example, the carrying amount of UHL's investment in STL is eliminated
against STL's equity at the date of acquisition, resulting in, among other items, a
goodwill balance in the consolidated statement of financial position.
Moreover, UHL's 20 per cent investment in STL from 1 April 20X5 to 31 March
20X6 should be accounted for using the equity method in the consolidated
financial statements for the year ended 31 March 20X6.
In UHL's separate financial statements for the year ended 31 March 20X6, the
investment in STL would continue to be accounted for at cost.
(iii) Carrying amount of the 20 per cent interest in STL in the consolidated statement
of financial position of UHL at 31 March 20X6
During the period from 1 April 20X5 to 31 March 20X6 (before the acquisition of the
further 50 per cent), the investment in 20 per cent equity interest in STL 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 UHL's share of STL's profit or
loss after the date of acquisition. UHL's share of STL's profit or loss will be recognised
in UHL's consolidated profit or loss.
The carrying amount of the 20 per cent interest in STL at 31 March 20X6 was
determined as follows:
HK$'000
Cost of investment at 1 April 20X5 7,000
Share of profits for the year ended 31 March 20X6
(20%  HKD12,000,000) 2,400
Depreciation adjustment for the year
[20%  (HKD16,000,000 – HKD11,200,000)]/10 years (96)
Carrying amount of investment in associate (STL) at 31 March 20X6 9,304*

837
Financial Reporting

* Alternatively:
HK$'000
Share of net assets at 31 March 20X6
(20%  HKD27,200,000) 5,440
Balance of fair value adjustment
(20%  (HKD16,000,000 – HKD11,200,000)  9 / 10) 864
Balance of goodwill at 31 March 20X6
(HKD7,000,000 – 20%  HKD20,000,000) 3,000
Carrying amount of investment in associate (STL) at
31 March 20X6 9,304

(iv) According to HKAS 37 Provisions, Contingent Liabilities and Contingent Assets, a


contingent liability is:
1 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
2 a present obligation that arises from past events but is not recognised
because:
 it is not probable that an outflow of resources embodying economic
benefits will be required to settle the obligation; or
 the amount of the obligation cannot be measured with sufficient reliability.
It is right that, in accordance with HKAS 37, UHL should not recognise a contingent
liability. A contingent liability should be disclosed, unless the possibility of an outflow of
resources embodying economic benefits is remote.
However, since the further acquisition of the 50 per cent of STL constitutes a business
combination, which is defined by HKFRS 3 (revised) Business Combinations as the
bringing together of separate entities or businesses into one reporting entity, UHL
should also apply HKFRS 3.
In accordance with HKFRS 3 (revised), UHL (as the acquirer) should recognise STL's
contingent liabilities separately at the acquisition date if, at that date, the fair value of
the contingent liabilities can be measured reliably.
Although STL's contingent liability of HK$1,000,000 was not recognised by STL
before the business combination, that contingent liability has a fair value, the
amount of which reflects market expectations about any uncertainty surrounding the
possibility that an outflow of resources embodying economic benefits will be required
to settle the possible or present obligation. As a result, the existence of STL's
contingent liabilities has the effect of lowering the price that UHL is prepared to pay
for the controlling interest in STL. UHL has, in effect, been paid to assume an
obligation in the form of a reduced purchase price for the controlling interest in STL.
(v) Goodwill on consolidation
The "goodwill" in the consolidated financial statements represents the payment made
by UHL on acquisition of the controlling interest in STL in anticipation of future
economic benefits from assets that are not capable of being individually identified and
separately recognised.
It is measured as the residual cost of the business combination after recognising
STL's identifiable assets, liabilities and contingent liabilities.
In accordance with HKFRS 3, UHL should, at the acquisition date, recognise the
goodwill acquired in the business combination with STL as an asset; and initially
measure that goodwill at its cost.

838
Question bank - answers

The investment in STL is a business combination involving more than one exchange
transaction since it occurred in stages by successive share purchases.
However, goodwill is only calculated when control is first achieved, in this case on
31 March 20X6.
After initial recognition at 31 March 20X6, UHL should measure goodwill at cost less
any accumulated impairment losses.
UHL should test the goodwill for impairment annually, or more frequently if events or
changes in circumstances indicate that it might be impaired, in accordance with
HKAS 36 Impairment of Assets. Since UHL acquired the goodwill at 31 March 20X6,
no impairment loss need to be recognised as at that date.
The calculation of the goodwill at 31 March 20X6 is as follows:
HK$'000
Cost of investment for the 50% acquired at 31 March 20X6 30,000
Non-controlling interest (30%  (37,400,000 – 1,000,000)) 10,920
Fair value of previously held 20% stake 10,000
50,920
Net assets at 31 March 20X6 (36,400)
Goodwill 14,520

I hope the above explanation has answered your queries. Please feel free to contact me if
you have further queries.
Best regards
David Lee
(b) CONSOLIDATED STATEMENT OF FINANCIAL POSITION OF UHL AS AT 31 MARCH 20X6
UHL STL Adjust Note Consolidated
HK$'000 HK$'000 HK$'000 HK$'000
Net assets
Land lease premium 10,000 – – 10,000
Property, plant and
equipment 21,000 9,800 10,200 1 41,000
Investment in a
subsidiary 37,000 – (37,000) –
Goodwill – – 14,520 2 14,520
Net current assets 9,000 17,400 (1,000) 25,400
77,000 27,200 (13,280) 90,920

Issued equity 65,000 10,000 (10,000) 65,000


Retained earnings 12,000 17,200 (14,200) 3 15,000
Non-controlling interest – – 10,920 4 10,920
77,000 27,200 (13,280) 90,920
Notes
(1) HK$20,000,000 – 9,800,000
(2) Answer 4 (a)(v)
(3) – Pre-acquisition retained earnings of STL = HK$17,200,000
+ equity method profits HK$2,400,000
– HK$96,000
+ gain on fair value of 20% stake HK$696,000 (HK$10,000,000 – HK$9,304,000)
(4) 30%  (HK$37,400,000 – HK$1,000,000)

839
Financial Reporting

CJ 1
No consolidation adjustment is required at 31 March 20X5. However, it is possible to analyse
the balance of investment in an associate by putting through a consolidation journal as
follows:
HK$'000 HK$'000
DEBIT Investment in an associate –
share of equity at date of acquisition 3,040
Investment in an associate – fair value adjustments
(HK$16,000,000 – HK$11,200,000)  20% 960
Investment in an associate – goodwill 3,000
CREDIT Investment in an associate – costs of acquisition 7,000
Being analysis of investment in an associate for consolidation purposes.
CJ 2
DEBIT Investment in an associate – share of post acquisition
profit of an associate (HK$12,000,000  20%) 2,400
CREDIT Profit or loss – share of post acquisition profit of an associate 2,400
Being recognition of UHL's share of STL's profit for the year.
CJ 3
DEBIT Profit or loss – share of post acquisition profit of an associate
(HK$960,000/10 years) 96
CREDIT Investment in an associate 96
Being recognition of depreciation adjustment for the year.
CJ 4
DEBIT Share capital 10,000
Retained earnings 17,200
Property, plant and equipment
(HK$20,000,000 – 9,800,000) 10,200
Goodwill 14,520
CREDIT Net current assets (Provision for STL's contingent liability) 1,000
Non-controlling interests (HK$36,400,000  30%) 10,920
Investment in an associate [See Answer 4 (a)(iii)] 9,304
Retained earnings (HK$10,000,000 – HK$9,304,000) 696
Investment in a subsidiary 30,000
DEBIT Investment in an associate** 7,000
CREDIT Investment in a subsidiary** 7,000
Being elimination of share capital, pre-acquisition reserves against cost of investment and
recognition of goodwill and non-controlling interest in assets and liabilities.
**This eliminates the effect of the transfer from the cost of the 20 per cent investment in STL
as investment in an associate to an investment in a subsidiary made at the entity level of
UHL.

840
Question bank - answers

Answer 5
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

841
Financial Reporting

(b) Annex
(i) Worksheet for the consolidated statement of profit or loss and other
comprehensive income

PPY SFL Eliminations Consolidated


DEBIT CREDIT
HK$ HK$ (HK$) working(s) (HK$) HK$
Sales 80,000,000 38,400,000 4,800,000 W7 113,600,000
Cost of sales (51,200,000) (25,600,000) 640,000 W7 4,800,000 (72,490,000)
250,000 W2/W6 400,000
Gross profit 28,800,000 12,800,000 41,110,000
Other income
(Dividend
income) 1,280,000 – 1,280,000 W3 –
Distribution costs (3,000,000) (2,300,000) (5,300,000)
Administrative
expenses (5,000,000) (2,500,000) (7,500,000)
Finance costs (5,760,000) (1,120,000) (a) 600,000 (6,280,000)
Profit before tax 16,320,000 6,880,000 22,030,000
Income tax
expense (3,520,000) (2,080,000) 66,000 W6/W7 105,600 (5,519,150)
W2 41,250
Profit for the year 12,800,000 4,800,000 16,510,850

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

Profit attributable to:


Owners of the parent 15,632,680
Non-controlling interests 878,170 W4 878,170
16,510,850
Total comprehensive income attributable to:
Owners of the parent 878,170 W4 22,592,680
Non-controlling interests 240,000 W4a 1,118,170
23,710,850

842
Question bank - answers

(ii) Worksheet for consolidated statement of financial position

PPY SFL Eliminations Consolidated


DEBIT CREDIT
HK$ HK$ (HK$) working(s) (HK$) HK$
Property, plant
and equipment,
net 40,000,000 7,600,000 600,000 (a) 54,200,000
6,000,000 (b)
Investment
properties 20,800,000 12,000,000 (b) 6,000,000 26,800,000
Investment in
SFL, at cost 25,600,000 – W1 25,600,000 –
Goodwill – – 1,530,000 W1 1,530,000
Other intangible
assets, net – 11,200,000 2,500,000 W1/W2 750,000 12,950,000
Deferred tax
asset – – 105,600 W7 105,600
Inventories 51,200,000 21,600,000 W7 640,000 72,160,000
Trade and other
receivables 25,000,000 14,000,000 39,000,000
Cash and cash
equivalents 23,000,000 10,400,000 33,400,000
185,600,000 76,800,000 240,145,600

Share capital 32,000,000 16,000,000 16,000,000 W1 32,000,000


Retained
earnings 46,000,000 25,000,000 56,071,480
Revaluation
surplus 10,000,000 2,200,000 11,760,000
88,000,000 43,200,000 99,831,480
Non-controlling
interests – – W1 6,017,500 8,825,370
100,000 W2 16,500
320,000 W3/W4 878,170
W4a 240,000
W5 1,960,000
W5a 200,000
80,000 W6 13,200
Deferred tax
liability 123,750 W2/W1 412,500 288,750
Trade and other
payables 47,600,000 13,600,000 61,200,000
Long term loan 50,000,000 20,000,000 70,000,000
185,600,000 76,800,000 49,816,020 49,816,020 240,145,600

843
Financial Reporting

WORKING:
Reconciling consolidated retained earnings and consolidated revaluation surplus

PPY SFL Eliminations Consolidated


DEBIT CREDIT
HK$ HK$ (HK$) working (HK$) HK$
Retained
earnings,
1 April 20X9 36,400,000 21,800,000 400,000 W2 66,000 43,638,800
320,000 W6 52,800
12,000,000 W1
1,960,000 W5
Profit for the
year
attributable to
the owners of
the parent 12,800,000 4,800,000 15,632,680
Dividends
declared (3,200,000) (1,600,000) W3 1,600,000 (3,200,000)
Retained
earnings,
31 March 20Y0 46,000,000 25,000,000 56,071,480

PPY SFL DEBIT Eliminations CREDIT Consolidated


HK$ HK$ (HK$) working (HK$) HK$
Revaluation
surplus, 1 April
20X9 4,000,000 1,000,000 200,000 W5a 4,800,000
Revaluation for
the year 6,000,000 1,200,000 6,960,000
Revaluation
surplus,
31 March 20Y0 10,000,000 2,200,000 11,760,000

844
Question bank - answers

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

W2 - Past and current amortisation on revalued intangible assets


DEBIT Opening retained earnings (2.5m/10  2  80%) 400,000
DEBIT Non-controlling interests (2.5m/10  2  20%) 100,000
DEBIT Amortisation (2.5m/10) 250,000
CREDIT Accumulated amortisation 750,000

DEBIT Deferred tax liability (750,000  16.5%) 123,750


CREDIT Opening retained earnings (400,000  16.5%) 66,000
CREDIT Non-controlling interests (100,000  16.5%) 16,500
CREDIT Tax expense (250,000  16.5%) 41,250

W3 - Eliminate dividend income


DEBIT Dividend income (1,600,000  80%) 1,280,000
DEBIT Non-controlling interests (1,600,000  20%) 320,000
CREDIT Dividends declared 1,600,000

W4 - Current income to Non-controlling interests


DEBIT Non-controlling interests (SPLOCI) 878,170
CREDIT Non-controlling interests (SOFP) 878,170
HK$
Profit of SFL before adjustment 4,800,000
Add: previous year's unrealised profit now realised (1.2m – 0.8m) 400,000
Tax effects on previous year's unrealised profit (400,000  16.5%) (66,000)
Less: current year's unrealised profit (40%  (4.8m – 3.2m)) (640,000)
Tax effects on current year unrealised profit (640,000  16.5%) 105,600
Less: amortisation on revalued intangible assets (250,000)
Tax effects on amortisation on revalued intangible assets
(250,000  16.5%) 41,250
Adjusted profit 4,390,850
Non-controlling interests' share (20%) 878,170

845
Financial Reporting

W4a - Current revaluation surplus to Non-controlling interests


HK$ HK$
DEBIT Non-controlling interests (SPLOCI) (1,200,000  20%) 240,000
CREDIT Non-controlling interests (SOFP) 240,000

W5 - Assign post-acquisition Retained Earnings to Non-controlling interests


DEBIT Opening retained earnings (from 1 April 20X7 to
31 March 20X9) [20%  (21.8m-12m)] 1,960,000
CREDIT Non-controlling interests (SOFP) 1,960,000

W5a - Assign post-acquisition revaluation surplus to Non-controlling interests


DEBIT Opening revaluation surplus (from 1 April 20X7 to
31 March 20X9) [20%  (1m-0m)] 200,000
CREDIT Non-controlling interests 200,000

W6 - Realisation of opening unrealised profit in inventory


DEBIT Opening retained earnings 320,000
DEBIT Non-controlling interests 80,000
CREDIT Cost of sales 400,000

DEBIT Tax expense (400,000  16.5%) 66,000


CREDIT Opening retained earnings (320,000  16.5%) 52,800
CREDIT Non-controlling interests (80,000  16.5%) 13,200

W7 - Elimination of intercompany sale of inventory


DEBIT Sales 4,800,000
CREDIT Cost of sales 4,800,000
DEBIT Cost of sales (1.6m  40%) 640,000
CREDIT Inventory 640,000
DEBIT Deferred tax asset (640,000  16.5%) 105,600
CREDIT Tax expense 105,600

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

NCI's share @ 20% 8,825,370

846
Question bank - answers

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 6
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

Goodwill acquired = $30 million


Contribution to joint venture
In accordance with HKAS 28 (2011), when a venturer contributes assets to a joint venture,
recognition of any portion of a gain or loss from the transaction shall reflect the substance of the
transaction.
In applying to non-monetary contributions to a joint venture in exchange for an equity interest in the
joint venture, HKAS 28 (2011) states that a venturer shall recognise in profit and loss for the period
the portion of a gain or loss attributable to the equity interests of the other venturers except when
the contribution transaction lacks commercial substance.

847
Financial Reporting

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

848
Question bank - answers

STL's share of ERL's current year profit


According to HKAS 28 (2011), if an investor holds, directly or indirectly, 20% or more of the voting
power of the investee, it is presumed that the investor has significant influence. Thus ERL would be
regarded as an associate of STL.
The equity method would be applicable whereby the investment in ERL would be initially
recognised at cost and adjusted thereafter for the post-acquisition change in STL's share of ERL's
net assets. STL's profit or loss will include STL's share of the profit or loss of ERL.
Since STL has transferred the significant risks and rewards of ownership of the inventories to the
associate, the transaction should be recognised as sales. Thus no elimination of sales is required.
Nonetheless, HKAS 28 (2011) requires that profits and losses resulting from "upstream" (sales of
assets from an associate to the investor) and "downstream" (sales of assets from the investor to an
associate) transactions between an investor (including its consolidated subsidiaries) and an
associate are recognised in the investor's financial statements only to the extent of unrelated
investors' interests in the associate.
Therefore, the investor's share in the profits and losses resulting from these transactions should be
eliminated. When STL sells goods to ERL (an associate), STL should not recognise its share of the
profit or loss from the transaction in its consolidated financial statements until the goods or assets
have been resold to an independent party.
STL's share of any unrealised profit or loss in the inventories that were retained by ERL at the end
of the reporting period is eliminated as follows:
ERL's profit for the year ended 30 June 20X9 = $41,000,000
STL's share = $41,000,000  25% = $10,250,000
Less: Elimination of unrealised profit (after tax) on intercompany transaction
Total unrealised profit: $15,000,000  20/120  1/2 = $1,250,000

STL's share = $1,250,000  25% = $312,500


Less: Tax effect $312,500  16% = $50,000
Elimination of unrealised profit (after tax) $312,500 – $50,000 = $262,500
Thus STL's share of ERL's adjusted profit = $10,250,000 – $262,500 = $9,987,500
I hope the above explanation has answered your questions. Please feel free to contact me if you
have further queries.
Best regards
Ricky Lam

849
Financial Reporting

Answer 7
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.

850
Question bank - answers

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

should be recognised as a gain or loss in profit or loss attributable to the parent.


The corresponding consolidation journal entry is summarised as below:
$m $m
DEBIT Investment in AMR 9.6
DEBIT Non-controlling interest 4.8
DEBIT Debenture of AMR 2
DEBIT Accounts payable of AMR 1
CREDIT PPE of AMR 9
CREDIT Inventory of AMR 3
CREDIT Accounts receivable of AMR 2
CREDIT Cash of AMR 1
CREDIT Goodwill 1.5
CREDIT Gain on disposal 0.9

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

(b) Investment in CDS


The issue of shares by CDS to MSL has reduced GRL's interest in CDS from 66 per cent to
60 per cent. Since GRL holds more than 50 per cent of the voting power of CDS, there is a
presumption that GRL has retained control of CDS and hence CDS should remain as a
subsidiary.
Paragraph 23 of HKFRS 10 Consolidated Financial Statements states that "changes in a
parent’s ownership interest in a subsidiary that do not result in a loss of control are
accounted for as equity transactions’’ (i.e. transactions with owners in their capacity as
owners).
This means that no gain or loss from these changes should be recognised in profit or loss. It
also means that no change in the carrying amounts of the subsidiary’s assets (including
goodwill) or liabilities should be recognised as a result of such transactions.
This adopted approach is consistent with the fact that non-controlling interests are treated as
a separate component of equity.
In such circumstances, the carrying amounts of the controlling and non-controlling interests
shall be adjusted to reflect the changes in their relative interests in the subsidiary.
Previously, the carrying amount of NCI = 34% of $12.9 million = $4,386,000
After the transaction, NCI = 40% of ($12.9 + $5.5) million = $7,360,000
Thus, NCI increases by $7,360,000 – $4,386,000 = $2,974,000

851
Financial Reporting

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

852
Question bank - answers

EQUITY AND LIABILITIES


Adjustment
GRL AMR CDS DEBIT CREDIT Group
$'000 $'000 $'000 ref $'000 $'000 ref $'000
Share capital 19,000 1,000 4,000 W1 4,000 19,000

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

Non-controlling - - - (a) 4,800 3,400 W1 7,360


interests
986 W4
2,974 (b)
4,000 W5
800 W6
Non-current liability
Debenture - 2,000 1,000 (a) 2,000 1,000
Current liability
Accounts payable 4,000 1,000 4,200 (a) 1,000 8,200
47,000 15,000 18,100 65,700

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

Goodwill W1 5,400 5,400

Investment in AMR 7,500 - 7,500 (a) -


Investments in CDS 12,000 - 12,000 W1 -
Investment in (a) 9,600 9,600
associate
Current assets
Inventory 5,900 4,200 W2 500 500 W1 10,100

Accounts receivable 2,200 1,500 3,700


Cash 1,000 2,000 (b) 5,500 8,500
47,000 18,100 65,700

853
Financial Reporting

Adjustment
GRL CDS DEBIT CREDIT Group
$'000 $'000 $'000 $'000 $'000
Share capital 19,000 4,000 W1 4,000 19,000

Retained earnings 24,000 8,900 W1 6,500 500 W2 27,614


W3 500 100 W3
W4 986 1,200 (a)
900 (a)

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

Purchase consideration 7,500 12,000


NCI (10m  40%) 4,000 (10m  34%) 3,400
11,500 15,400
Fair value of net identifiable (1m + 9m) (4m + 6.5m – 0.5m)
assets 10,000 10,000
Goodwill 1,500 5,400
Journal entries not required by the question
(All figures in $'000)
W1 Elimination of investment in CDS

DEBIT Share capital 4,000


DEBIT Retained earnings 6,500
DEBIT Goodwill 5,400
CREDIT Inventory 500
CREDIT Investment in CDS 12,000
CREDIT Non-controlling interests (NCI) 3,400 (4,000 + 6,500 –
500)  34%

W2 Impairment of inventory (fair value realisation)

DEBIT Inventory 500


CREDIT Retained earnings 500

854
Question bank - answers

W3 Adjustment of 20Y0 unrealised profit in plant (downstream)

DEBIT Retained earnings 500 (2,500 – 2,000)


CREDIT Plant 500
DEBIT Acc. depreciation 100 (500 / 5 years)
CREDIT Retained earnings 100

W4 Allocation of post-acquisition profit to NCI of CDS

DEBIT Retained earnings 986 (2,400 + inventory 500)


 34%
CREDIT NCI 986

If AMR is included in the consolidation worksheet:

W5 Elimination of investment in AMR

DEBIT Share capital 1,000


DEBIT Retained earnings 9,000
DEBIT Goodwill 1,500
CREDIT Investment in AMR 7,500
CREDIT NCI 4,000 (1,000 + 9,000)  40%

W6 Allocation of post-acquisition profit to NCI of AMR

DEBIT Retained earnings 800 (11,000 – 9,000)  40%


CREDIT NCI 800

855
Financial Reporting

SECTION B – Short / Essay questions


Answer 8
(a) In accordance with the Code of Ethics for Professional Accountants of HKICPA (the "Code"):
Mr. V. Chow, as the independent non-executive director of the listed company, should
consider the need to maintain confidentiality of information within the listed company.
Mr. V. Chow should not disclose the confidential information contained in the draft audited
financial statements of the listed company to Mr. K. Chow without proper and specific
authority.
Both Mr. K. Chow and Mr. V. Chow should not use confidential information acquired as a
result of professional and business relationships to their personal advantage or the
advantage of third parties.
Both Mr. K. Chow and Mr. V. Chow should comply with relevant laws and regulations and
should avoid any action that discredits the profession.
The trading of shares by Mr. K. Chow would constitute insider dealing under the Securities
and Futures Ordinance.
Insider dealing in relation to the listed securities of a corporation takes place when, inter alia,
a person who is "connected with the corporation" and who is knowingly in possession of
"relevant information" deals in listed securities of the corporation or counsels or procures
another person to do so knowing or having reasonable cause to believe that such person
would deal in them. Relevant information is specific information about a corporation which is
not generally known to persons accustomed or likely to deal in the listed securities of that
corporation but which would materially affect the price of the securities if it were.
(b) Goodwill can still be recognised in the financial statements prepared under merger
accounting for a business combination under common control.
The concept underlying the use of merger accounting to account for a common control
combination is that no acquisition has occurred and there has been a continuation of the
risks and benefits to the controlling party (or parties) that existed prior to the combination.
The net assets of the combining entities or businesses are consolidated using the existing
book value from the controlling parties' perspective.
The assets and liabilities of the acquired entity or business should be recorded at the book
values as stated in the financial statements of the controlling party.
That is, it will require recording of:
– the fair value of the identifiable assets and liabilities of the acquired entity or business
at the date of original acquisition from third parties by the controlling party.
– any remaining goodwill arising on the previous acquisition and non-controlling interest
recorded in the consolidated financial statements of the controlling party.
There is no recognition of any additional goodwill or excess of acquirer's interest in the net
fair value of the acquiree's identifiable assets, liabilities and contingent liabilities over cost at
the time of common control combination to the extent of the continuation of the controlling
party or parties' interest.

856
Question bank - answers

Answer 9
(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:

Year ended Payments


HK$ million
30 June 20Y0 12.00
30 June 20Y1 12.00
30 June 20Y2 12.00
30 June 20Y3 212.00

Present value at 30 June 20X9 discounting at original effective interest rate of 8% is


HK$186.75 million.
As the difference between the amortised cost of the bank loan at the date of modification, 30
June 20X9 (HK$200 million) and the present value of the new bank loan, discounted by the
original effective interest rate (HK$186.75 million), is less than 10 per cent ([HK$200 million –
HK$186.75 million]/ HK$200 million  100% = 6.625%), the modification is not considered as
extinguishment of the original bank loan.
No gain or loss is recognised for the modification and the carrying amount of the bank loan is
still HK$200 million.
The bank loan was originally repayable on 30 June 20Y0 and classified as current liability.
The modification of the maturity date of the bank loan results in such liability to be settled
more than 12 months after the reporting period. Accordingly, it is classified as non-current
liability in the statement of financial position as at 30 June 20Y0.
(b) In accordance with AG35 of HKAS 32, an entity may amend the terms of a convertible
instrument to induce early conversion, for example by offering a more favourable conversion
ratio or paying other additional consideration in the event of conversion before a specific
date. The difference, at the date the terms are amended, between the fair value of the
consideration the holder receives on conversion of the instrument under the revised terms
and the fair value of the consideration the holder would have received under the original
terms is recognised as a loss in profit or loss.

857
Financial Reporting

Journal entries that HDL should make on 30 June 20X9:

HK$ HK$

DEBIT Expense 18,500,000


CREDIT Convertible bonds equity reserve 18,500,000

To record the amendment of the terms of conversion (100  (2,500,000 – 2,000,000) 


HK$0.45) – HK$4,000,000.

DEBIT Convertible bonds 96,296,296


Interest payable 4,000,000
Convertible bonds equity reserve 25,633,058
CREDIT Share capital 125,929,354
To record the conversion of the bonds under the amended terms of conversion and waive
interest payable.

Answer 10
(a) Share-based compensation expense for the year ended 31 March 20X9:

= [(2,000,000 / 4  HK$8)] + [(2,000,000 / 4  HK$8) / 2] + [(2,000,000 / 4  HK$8) / 3] +


[(2,000,000 / 4  HK$8) / 4]
= HK$4,000,000 + HK$2,000,000 + HK$1,333,333 + HK$1,000,000 = HK$8,333,333

Share-based compensation expense for the year ended 31 March 20Y0:

= [(2,000,000 / 4  HK$8) / 2] + [(2,000,000 / 4  HK$8) / 3] + [(2,000,000 /4  HK$8) / 4]


= HK$2,000,000 + HK$1,333,333 + HK$1,000,000 = HK$4,333,333
(b) Accounting implication of cancellation of unvested awarded share options on 1 April 20Y0:
According to HKFRS 2.28, 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) 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) 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.
Share-based compensation expense originally to be recognised from 1 April 20Y0 to
31 March 20Y2:
= [(2,000,000 / 4  HK$8) / 3] + [(2,000,000 / 4  HK$8) / 4  2]
= HK$1,333,334 + HK$2,000,000 = HK$3,333,334

858
Question bank - answers

OR

Accumulated compensation expense recognised up to 31 March 20Y0:


HK$8,333,333 + HK$4,333,333 = HK$12,666,666

[(2,000,000  HK$8) – HK$12,666,666] = HK$3,333,334


Payment exceeds the fair value of the share options granted and cancelled, measured at
1 April 20Y0:
= HK$5,500,000 – [(2,000,000 / 4  2)  HK$5]
= HK$500,000

Total compensation expense recognised upon cancellation of unvested awarded share


options on 1 April 20Y0 = HK$3,333,334 + HK$500,000 = HK$3,833,334
(c) According to HK(IFRIC) – Int 11 para. 8, provided that the share-based arrangement is
accounted for as equity-settled in the consolidated financial statements of the parent, the
subsidiary shall measure the services received from its employees in accordance with the
requirements applicable to equity-settled share-based payment transactions, with a
corresponding increase recognised in equity as a contribution from the parent.

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 11
(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

= HK$[44.4 + 41.2 + 38.1 + 35.3 + 588] million


= HK$747 million

The initial carrying amount of the equity component of the CB:


= HK$(800 – 747) million = HK$53 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:

HK$[(747 million  1.08) – (800 million  6%)]  [1 + (0.08 × 4/12)]


= HK$(806.76 – 48) million  1.027
= HK$779 million

859
Financial Reporting

Journal entries for the conversion of CB into shares on 1 April 20Y0:


HK$m HK$m
DEBIT Convertible Bond – liability 779
DEBIT Equity – conversion option 53
CREDIT Share capital 832
CREDIT

(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 12
CML did not have public accountability as it was not an issuer of securities and it was not in the
process of issuing publicly traded equity or debt securities.
In terms of size test, CML met the following two quantitative conditions:
 The entity had no revenue, i.e. annual revenue did not exceed HK$50 million, for the year.
 The entity did not have assets in excess of HK$50 million at 31 December 20X9.
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.

860
Question bank - answers

Answer 13
(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.

(b) (i) The chief operating officer of PBL is incorrect.


In this case, PBL is entering into an arrangement with a finance house to sell three
machines at a profit and then lease them back over a five-year term.
In order to establish the accounting treatment of this transaction, it is necessary to
decide whether this is a sale and leaseback arrangement within the scope of HKAS
17. If so, it will be necessary to establish whether the lease arrangement is finance or
operating in nature.
HK(SIC)-Int 27 deals with evaluating the substance of transactions involving the legal
form of a lease. It states that HKAS 17 applies when the substance of an arrangement
includes the conveyance of the right to use an asset for an agreed period of time. It
further states that the following indicators demonstrate that an arrangement may not,
in substance, involve a lease under HKAS 17:
(a) An entity retains all of the risks and rewards incidental to ownership of an
underlying asset and enjoys substantially the same rights to its use as before
the arrangement; and
(b) An option is included on terms that make its exercise almost certain.
Risks and rewards
 The remaining estimated useful life for the assets is six years while the lease
term is five years, which can be interpreted as the major part of the economic
life of the asset.
 PBL has an option to buy the machines from EFL for $50,000 at the end of the
five-year lease term.

861
Financial Reporting

 Assuming the purchase option is exercised, gross payments in respect of the


agreement over five years total $22,550,000. The present value of this
minimum lease payment is approximately $18,010,000 at a discount rate of 8
per cent. This is considered to be substantially equal to the fair value of the
leased assets.
The substance and economic reality are therefore that PBL has not transferred
substantially all the risks and rewards incidental to ownership of the machines to the
lessor.
Almost certainly exercisable option
As the current fair value of the machines (with a remaining six-year useful life) is
$18,000,000, it is reasonable to consider that the $50,000 option price at the end of
the lease is sufficiently lower than fair value at the date the option becomes
exercisable that the option will be exercised by PBL.
It can therefore be concluded that the transaction is not within the scope of HKAS 17.
Rather than a sale and leaseback transaction, it is a means whereby the finance
house provides finance to PBL using the assets as security.
Accounting treatment
As the transaction is classified as a financing transaction, the $17 million proceeds
received are recognised as a financial liability in accordance with HKFRS 9.
Tutorial note
If this transaction were within the scope of HKAS 17 (if, for example there were no
repurchase option) it would be accounted for as a sale and finance leaseback. The
original asset with carrying amount of $15 million would be derecognised and a
finance lease asset and liability of $17 million would be recognised and accounted for
in line with the requirements of HKAS 17.
The profit of $2 million would be deferred and amortised over the lease term.
(b) (ii) If the lease term is shortened to three years with an annual future lease payment of
$4,000,000 and without PBL's option to buy the machines from EFL:
 The total lease payment would be $12,000,000, the present value of which
would not be substantially equal to the fair value of the leased assets
($18,000,000) nor the proceeds received ($17,000,000).
 PBL would not retain the ownership of the machines nor have an option to
purchase the machines at the end of the lease term.
In this case the transaction would be treated as a sale and operating leaseback. A
$4 million operating lease expense would be recognised in each of the three years of
the lease.
As the sale price of $17,000,000 is below fair value of $18,000,000, the profit,
calculated as the difference between $17,000,000 and $15,000,000, would be
recognised immediately in profit or loss.

Answer 14
(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.

862
Question bank - answers

 Liability component shown as a non-current liability:


PV of eight semi-annual interest payments of $20 million and redemption of $1,000
million at 31 December 20Y5 (market interest rate 2.5 per cent per semi-annual) =
$964.15 million.
 Equity component:
$35.85 million [$1,000 – 964.15 million] (ignoring the tax effect).
(b) Calculation of the earnings per share of MG for the year ending 31 December 20Y2,
assuming the estimated profit is $800 million, is as follows:
Rights issue
With the rights issue, the number of shares of MG used for the computation of EPS will
increase to 1,200 million.
The EPS calculated based on an estimated profit of $800 million will decrease from $0.8
($800/1,000) to $0.67 ($800/1,200) per share.
Convertible bond
The convertible bond will not affect the number of shares for the basic EPS calculation, but
will decrease the profit for the year 20Y2 due to interest payments (ignoring the tax effect):
$m
April 20Y2 interest $964.15  2.5% 24.10
October 20Y2 interest ($964.15 + 24.10 – 20)  2.5% 24.21
48.31
The basic EPS calculated based on an estimated profit of $751.69 million ($800 million –
$48.31 million) will decrease from $0.8 ($800 / 1,000) to $0.752 ($751.69 / 1,000) per share.
The convertible bonds are dilutive with an individual EPS of $0.386 ($48.31 million / 125
million shares).
Diluted EPS is therefore calculated as $0.711 (($751.69 + $48.31) / (1,000 + 125))
(c) The disclosure of financial risk under HKFRS 7
HKFRS 7.33 requires MG to disclose the financial instruments'
(a) exposure to risk and how it arises,
(b) its objectives, policies and processes for managing the risk and the methods used to
measure the risk and
(c) any changes of (a) and (b) from the previous period.
The convertible bonds are at a fixed rate and subject to fair value interest rate risk, as an
increase / decrease of the market interest rate will increase/decrease the fair value of the
convertible bonds.
HKFRS 7.39(a) requires the preparation of a maturity analysis for the convertible bonds that
shows the remaining contractual maturities, analysed by time bands showing the contractual
undiscounted cash payments and allocated to the earliest period in which MG can be
required to pay.
HKFRS 7.39(c) requires MG to describe in the financial statements how the management of
MG manages the liquidity risk inherent in the items disclosed in the maturity analysis.

863
Financial Reporting

Answer 15
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 16
(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

864
Question bank - answers

Taxable temporary difference:


Carrying amount – tax base
= $14,375,000 – $11,900,000 = $2,475,000
Deferred tax liability:
(1)
$2,475,000  25% = $618,750
1 Deferred tax assets and liabilities shall be measured at the tax rates that are expected
to apply to the period when the asset is realised or the liability is settled, based on tax
rates (and tax laws) that have been enacted or substantively enacted by the reporting
date. 20X3 is the first profit-making year for GP, the company will have full tax
exemption for 20X3 and 20X4, and then be subject to 50% reduction for 20X5 to 20X7
(i.e. 12%). Afterward, the tax rate is 25%. As the taxable temporary difference will be
reversed after 20X7, the tax rate applied for deferred tax computation is 25%.
(b) Journal entries to record the deferred income taxes at 31 December 20X8 for GP's
consolidated financial statements:
$ $
DEBIT Deferred tax – Statement of profit or loss 137,500
CREDIT Deferred tax liability 137,500
Carrying amount of the printing machine at 31 December 20X8:
$20,000,000  [1 – (5.5 years/16 years)] = $13,125,000
Tax base at 31 December 20X8:
$20,000,000  [1 – (1 – 0.1)  (5.5 years/10 years)] = $10,100,000
Taxable temporary difference:
Carrying amount – tax base
= $13,125,000 – $10,100,000 = $3,025,000
Deferred tax liability:
$3,025,000  25% = $756,250
Increase in deferred tax liability in 20X8:
= $756,250 – $618,750 = $137,500
(c) Amount of deferred taxes to be shown on GP's consolidated statement of financial position
at 31 December 20X8:
Deferred tax asset $500,000
Deferred tax liability $756,250
GP's deferred tax asset cannot be offset against the deferred tax liability of BP as the two
entities' income taxes are NOT levied by the same taxation authority.

865
Financial Reporting

866
Glossary of terms

867
Financial Reporting

868
Glossary of terms

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.
Actuarial gains and losses comprise:
(a) Experience adjustments (the effects of differences between the previous actuarial
assumptions and what has actually occurred)
(b) The effects of changes in actuarial assumptions.
Amortised cost of a financial asset or financial liability. 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.
Antidilution. 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.
Asset. Any tangible or intangible possession which has value. 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.
Asset ceiling is the present value of any economic benefits available in the form of refunds from a
defined benefit pension plan or reductions in future contributions to the plan.
Assets. Probable future economic benefits obtained or controlled by a particular entity as a result
of past transactions or events. Assets are rights or other access to future economic benefits
controlled by an entity as a result of past transactions or events.
Associate. An entity, including an unincorporated entity such as a partnership, over which the
investor has significant influence and that is neither a subsidiary nor an interest in a joint venture.
Borrowing costs. Interest and other costs incurred by an entity in connection with the borrowing of
funds.
Break-up basis. Financial statements are prepared on the break-up basis where an entity is not
assessed to be a going concern. Assets and liabilities may be measured and presented differently
from in financial statements prepared on the going concern basis.
Carrying amount. The amount at which an asset is recognised after deducting any accumulated
depreciation (amortisation) and accumulated impairment losses thereon.
Cash. Comprises cash on hand and demand deposits.
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.

869
Financial Reporting

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.
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.
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.
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.
Contingent consideration. Usually, an obligation of the acquirer to transfer additional assets or
equity interests to the former owners of an acquiree as part of the exchange for control of the
acquiree if specified future events occur or conditions are met.
Contingent liability
(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.

870
Glossary of terms

Contingent rent. 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).
Contingent share agreement. An agreement to issue shares that is dependent on the satisfaction
of specified conditions.
Contingently issuable ordinary shares. Ordinary shares issuable for little or no cash or other
consideration upon the satisfaction of specified conditions in a contingent share agreement.

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 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.
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 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.
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.
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.

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Financial Reporting

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.
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.
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.
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.

872
Glossary of terms

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.
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 model. 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.
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.
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

873
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.
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.
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.
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.
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.

874
Glossary of terms

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.
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.
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.

875
Financial Reporting

(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.
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.
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.

876
Glossary of terms

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.
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.
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).

877
Financial Reporting

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.
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.
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.
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 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.

878
Glossary of terms

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.
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).

879
Financial Reporting

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.
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
 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. A present obligation which satisfies the rest of
the definition of a liability, even if the amount of the obligation has to be estimated.
Qualifying asset. An asset that necessarily takes a substantial period of time to get ready for its
intended use or sale.
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.

880
Glossary of terms

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. The higher of an asset's fair value less costs to sell and its value in use.
Related party. is 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:

(a) actuarial gains and losses


(b) the return on plan assets, excluding amounts included in net interest on the defined benefit
liability (asset); and
(c) any change in the effect of the asset ceiling, excluding amounts included in net interest on
the net defined benefit liability (asset).
Reporting entity. An entity for which there are users who rely on the financial statements as their
major source of financial information about the entity.
Research. Original and planned investigation undertaken with the prospect of gaining new
scientific or technical knowledge and understanding.
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.

881
Financial Reporting

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.
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.
Share-based payment transaction. 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.
Short-term employee benefits. Employee benefits (other than termination benefits) that are due
to be settled within 12 months after the end of the period in which the employees render the related
service.
Significant influence. The power to participate in the financial and operating policy decisions of an
entity, but is not control or joint control over those policies. Significant influence may be gained by
share ownership, statute or agreement.
Solvency. The availability of cash over the longer term to meet financial commitments as they fall
due.
Spot exchange rate. The exchange rate for immediate delivery.
Subsidiary. An entity, including an unincorporated entity such as a partnership, that is controlled
by another entity (known as the parent).
Substance over form. The principle that transactions and other events are accounted for and
presented in accordance with their substance and economic reality and not merely their legal form.
Tax base of an asset or liability. The amount attributed to that asset or liability for tax purposes.
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.
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).
Temporary differences. 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.

882
Glossary of terms

Termination benefits. Employee benefits payable as a result of either an:


(a) entity's decision to terminate an employee's employment before the normal retirement date
(b) employee's decision to accept voluntary redundancy in exchange for those benefits
Timeliness. An enhancing characteristic which means having information available in time to be
capable of influencing decisions.
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.
Useful life. 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.
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 estimated future cash flows expected to arise from the
continuing use of an asset and from its disposal at the end of its useful life.
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.
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.
Vesting period. The period during which all the specified vesting conditions of a share-based
payment arrangement are to be satisfied.

883
Financial Reporting

884
Index

885
Financial Reporting

886
Note: Key Terms and their page references are given in bold

Conceptual Framework for Financial


A Reporting (the Conceptual Framework), 36
Accounting Bulletins ("ABs"), 32, 37 Conceptual nature of employee benefit costs,
Accounting Guideline 5 (AG5), 709 357
Accounting Guidelines, 37 Confidentiality, 40
Accounting Guidelines ("AGs"), 32, 37 Consolidated financial statements, 582
Accounting policies, 489 Construction contract, 248
Accounting profit, 319 Constructive obligation, 230
Accounting standards and choice, 35 Contingent asset, 229
Acquiree, 591 Contingent consideration, 591
Acquirer, 591 Contingent liability, 229
Acquisition, 492 Contingent rent, 192
Active market, 156 Contingent rights and obligations, 397
Actuarial gains and losses, 360 Contingent share agreement, 507
Amortised cost, 411 Contingently issuable ordinary shares,
Antidilution, 507 507
Approved share registrars, 29 Control, 478, 582
Asset, 52, 149 Corporate governance, 9
Asset ceiling, 359 Corporate Governance Committee of the
Assets held for sale, 88 Hong Kong Institute of CPAs, 10
Associate, 344, 582, 661 Corporate Governance Disclosure in Annual
Associates and joint ventures, 464 Reports – A Guide to Current
Requirements and Recommendations for
Enhancement, 10
B Cost, 105, 125, 492, 493
Basis of provision of deferred tax, 335 Cost model, 108, 129
Borrowing costs, 383 Cost plus contract, 248
Business combinations, 583 Costs to sell, 91
Current cost, 57
Current developments, 60, 437
C Current tax, 319
Capital maintenance, 54
Carrying amount, 105, 125, 165 D
Cash, 449
Debt instruments, 15
Cash and cash equivalents, 449
Deductible temporary differences, 324,
Cash equivalents, 449
331
Cash flow hedge, 421
Deferred tax, 321
Cash flows, 447, 449
Cash generating unit, 172 Deferred tax assets, 324, 326
Change in accounting estimate, 489 Deferred tax liabilities, 324
Classification as assets held for sale, 88 Deferred taxation and business
Close members of the family of a person, combinations, 341
478 Defined benefit liability, 373
Closing rate, 732 Defined benefit plans, 358
Code of Ethics, 41 Defined contribution plans, 358
Code of Ethics for Professional Accountants, Depreciable amount, 109
39 Depreciable assets, 109
Depreciation, 109, 546
Companies listed on GEM, 38
Derecognition, 115
Companies listed on the Main Board, 38
Derivative, 396
Companies Ordinance, 7, 11, 15, 32, 38
Derivative instruments, 395
Company secretary, 14
Development, 153
Compliance with HKFRS, 57
Diluted EPS, 514
Compound financial instruments, 401
Dilution, 507
Conceptual framework, 42 Direct method, 452

887
Financial Reporting

Directors' responsibilities, 11
Disclosure of Interests in Other Entities, 35
G
Disclosure requirements for companies listed GAAP for Small and Medium-sized Entities,
on the GEM, 38 44
Disclosure requirements for companies listed Gains, 54
on the Main Board, 38 Generally Accepted Accounting Principles
Discontinued operation, 87, 94 (GAAP), 43
Disposal group, 87 Goodwill, 163, 591
Disposal of foreign entity, 742 Goodwill (HKFRS 3), 162
Goodwill and fair value adjustments, 740
E Government, 139
Government assistance, 139
Economic life, 192 Government grants, 139
Effective interest method, 411 Grant date, 268
Effective interest rate, 411 Grants related to assets, 139
Effectiveness, 422 Grants related to income, 139
Elements of financial statements, 51 Gross investment in the lease, 192
Embedded Derivatives, 418 Group, 582
Employee benefits, 358 Guaranteed residual value, 192
Entity specific value, 105
Equity, 52, 53 H
Equity instrument, 268, 396
Equity instrument granted, 268 Hedge effectiveness, 420
Equity method, 661, 663 Hedge of a net investment in a foreign
Ethics, 40 operation, 421
Event after the reporting period, 497 Hedged item, 420
Exchange difference, 731 Hedging, 420
Exchange rate, 731 Hedging instrument, 420
Exemption from preparing group accounts, Held for sale, 88
585 Highly probable sale, 88
Expenses, 54 Historical cost, 57
HK(IFRIC) Interpretations, 36
HK(IFRIC) Int-1 Changes in Existing
F Decommissioning, Restoration and Similar
Fair presentation, 57 Liabilities, 239
Fair value, 91, 105, 125, 139, 165, 215, 268, HK(IFRIC) Int-4 Determining whether an
295, 359, 396, 492, 591 Arrangement contains a Lease, 208
Fair value hedge, 421 HK(IFRIC) Int-5 Rights to Interests from
Fair value model, 125, 128, 129 Decommissioning Restoration and
Finance lease, 190 Environmental Rehabilitation Funds, 239
Financial asset, 396 HK(IFRIC) Int-10 Interim Financial Reporting
Financial instrument, 396 and Impairment, 548
Financial liability, 396 HK(IFRIC) Int-12 Service Concession
Financial position, 52 Arrangements, 302
Financial Reporting Council (FRC), 29 HK(IFRIC) Int-13 Customer Loyalty
Financial Reporting Standards Committee Programmes, 304
("FRSC") of the Hong Kong Institute of HK(IFRIC) Int-15 Agreements for the
CPAs, 33 Construction of Real Estate, 306
Financing activities, 449, 451 HK(IFRIC) Int-17 Distributions of Non-cash
Fixed price contract, 248 Assets to Owners, 716
Fixed production overheads, 216 HK(SIC) Interpretations, 36
Foreign currency, 546, 731 HK(SIC) Int-10 Government Assistance – no
Foreign operation, 732
specific relation to operating activities, 143
Forgivable loans, 139
HK(SIC) Int-15 Operating Leases –
Framework, 294
Incentives, 194
Functional currency, 731
HK(SIC) Int-21 Income Taxes – Recovery of
Future economic benefit, 52, 56
Revalued Non-depreciable Assets, 348

888
Index

HK(SIC) Int-25 Income taxes – Changes in HKFRS 13, 128, 129


the Tax Status of an Entity or its HKFRS 13 Fair Value Measurement, 35
Shareholders, 348 HKFRS for Private Entities, 72
HK(SIC) Int-27 Evaluating the Substance of HKICPA's Conceptual Framework, 45
Transactions in the Legal Form of a Lease, HK-Int 4 Lease – Determination of the length
207 of lease term in respect of Hong Kong
HK(SIC) Int-32 Intangible Assets – Website Land Leases, 208
Costs, 159 Hong Kong Accounting Standards, 34
HKAS 1 Presentation of Financial Hong Kong Exchanges and Clearing Limited
Statements, 404, 555 (HKEx), 29
HKAS 2 Inventories, 215 Hong Kong Financial Reporting Standards,
HKAS 7 Statement of Cash Flows, 448 32
HKAS 8 Accounting Policies, Changes in Hong Kong Institute of CPAs (HKICPA), 27
Accounting Estimates and Errors, 321, Hong Kong Insurance Authority (HKIA), 31
493, 602 Hong Kong Interpretations, 36
HKAS 8 Accounting Policies, Changes in Hong Kong legal framework, 5
Accounting Estimates and Errors, 489, 709 Hong Kong Monetary Authority (HKMA), 31
HKAS 10 Events after the Reporting Period, Hong Kong Partnerships Ordinance, 5
496
HKAS 11 Construction Contracts, 247, 307
I
HKAS 12 Income Taxes, 319, 404, 737
HKAS 16 Property, Plant and Equipment, Identifiable, 591
105 Impaired asset, 165
HKAS 17 Leases, 189, 207 Impairment loss, 105, 165
HKAS 18 Revenue, 294, 307, 308 Impracticable, 490
HKAS 19 Employee Benefits, 357 Inception of the lease, 192
HKAS 20 Government Grants, 139 Income, 54
HKAS 21 The Effects of Changes in Foreign Income Statement, 424
Exchange Rates, 731 Incremental costs, 191
HKAS 23 Borrowing Costs, 383 Indirect method, 452
HKAS 28 Investments in Associates and Indirect versus direct, 454
Joint Ventures, 661 Initial direct costs, 191
HKAS 33 Earnings Per Share, 507, 542 Inland Revenue Department, 5
HKAS 34 Interim Financial Reporting, 541 Intangible asset, 149
HKAS 36 Impairment of Assets, 164, 604 Integrity, 40
HKAS 37 Provisions, Contingent Liabilities Interest, royalties and dividends, 299
and Contingent Assets, 229 Interest rate implicit in the lease, 191
HKAS 38 Intangible Assets, 149 Interim financial report, 542
HKAS 39 Embedded Derivatives, 418 Interim period, 542
Interim reports, 38
HKAS 39 Hedging, 419
Intrinsic value, 268
HKAS 40 Investment Property, 125
Inventories, 215
HKFRS 2 Share-based Payment, 267
Investing activities, 449, 450
HKFRS 3 Business Combinations, 163, 344,
Investment, 582
590, 708
Investment entities, 586
HKFRS 7 Financial instruments
Investment products offered to the public, 29
Disclosures, 395, 430
Investment property, 125
HKFRS 8 Operating segments, 529 Investor Compensation Company Limited
HKFRS 9 Financial Instruments, 395 (ICC), 29
HKFRS 10, 35, 463, 477, 583, 584, 585, 586,
605, 614, 615, 685, 688, 696, 699, 710,
741 J
HKFRS 10 Consolidated Financial
Joint arrangement, 344, 582, 670
Statements, 239, 583
Joint control, 478, 670
HKFRS 11 Joint Arrangements, 35, 239, 583, Joint operation, 582, 670
671 Joint venture, 7, 582, 670
HKFRS 12 Disclosure of Interests in Other
Entities, 583

889
Financial Reporting

Options, warrants and their equivalents,


K 507
Key management personnel, 478 Ordinary shares, 507
Originating timing differences, 325
Owner-occupied property, 125
L
Lease, 190 P
Lease term, 191
Leasing, 189 Parent, 582
Lessee's incremental borrowing rate of Performance, 54
interest, 192 Permanent differences, 325
Lessor accounting, 201 Plan assets, 359
Liability, 52, 229 Post-employment benefit plans, 358
Liquidation, 18 Post-employment benefits, 358, 362
Listed companies, 29, 37 Potential ordinary share, 507
Long-term employee benefits, 358 Power, 582
Losses, 54 Present value, 57
Present value of a defined benefit, 359
Presentation currency, 731
M Presentation of assets held for sale, 93
Prior period errors, 489
Manufacturer or dealer lessors, 203
Professional Accountants Ordinance, 27
Material, 489, 568
Professional behaviour, 40
Materiality, 544
Professional competence and due care, 40
Measurement, 56
Pronouncements of the International
Measurement date, 269
Measurement of assets held for sale, 91 Accounting Standards Board (IASB), 32
Measurement of revenue, 295 Property, plant and equipment, 105
Prospective application, 490
Merger accounting for common control
Provision, 53, 229
combinations, 708
Purchased goodwill, 162
Minimum lease payments, 191
Monetary items, 732
Multi-employer plans, 359 Q
Qualifying asset, 383
N
Net interest on the defined benefit liability R
(asset), 359
Net investment in a foreign operation, 732 Realisable (settlement) value, 57
Net investment in the lease, 192 Realisable value, 57
Net realisable value, 215 Receivership, 18
Non-cancellable lease, 192 Recognition, 55
Non-controlling interest, 591 Recognition of items, 56
Recognition of the elements of financial
statements, 55
O Recoverable amount, 91, 105
Objectivity, 40 Recoverable amount of an asset, 165
Obligation, 53 Registration of charges, 15
Off-balance sheet finance, 206 Regular way purchase or sale, 414
Officers of companies, 14 Related party, 478
Offsetting a financial asset and a financial Related party transaction, 478
liability, 404 Relevant activities, 582
Remeasurements of the net defined
Onerous contract, 233
benefit liability (asset), 359
Operating activities, 449, 450
Rendering of services, 298
Operating lease, 125, 190, 193
Operating segment, 529 Reporting entity, 47
Research, 153

890
Index

Research and development costs, 152


Residual value, 105, 110
T
Restructuring, 17, 234 Tax, 546
Retrospective application, 490 Tax base, 324, 342
Retrospective restatement, 490 Tax expense (tax income), 319
Return on plan assets, 360 Tax planning opportunities, 333
Revaluation, 55 Taxable profit (tax loss), 319
Revaluation model, 108 Taxable temporary differences, 324
Revenue, 295 Temporary differences, 324
Reversal of an impairment loss, 178 Termination benefits, 358
Rights issue, 512 Transactions between a venturer and a joint
venture, 672
S Treasury shares, 402

Sale and leaseback transactions, 204


Securities and Futures Commission (SFC),
U
28 Unearned finance income, 192
Service concession arrangements, 302 Unguaranteed residual value, 192
Service cost, 359 Useful life, 109, 192
Settlement, 360 Users and their information needs, 47
Settlement value, 57
Share option, 268
Share split/reverse share split, 511 V
Share-based payment arrangement, 268 Value in use, 91, 165
Share-based payment transaction, 268 Variable production overheads, 216
Short-term employee benefits, 358 Vest, 269
Significant influence, 478, 582, 661 Vesting conditions, 269
SME-FRF and SME-FRS, 67 Vesting period, 269
Sole trader business, 5
Spot exchange rate, 731
Statutory reporting, 16 W
Stock Exchange of Hong Kong, 27
Winding up, 18
Subsidiary, 582

891
Financial Reporting

892
Notes
Financial Reporting
Notes
Financial Reporting
Notes
Financial Reporting
Notes
Financial Reporting
Notes
Financial Reporting
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