SECTION A – CASE QUESTIONS (Total: 50 marks)

Answer 1(a)

To: Mr. Peter CHAN, Director, PHL

From: Accounting Manager, PHL
c.c.: L.P. LEE, Mary CHEUNG, Paul WONG (Directors)
Date: dd/mm/yyyy

I refer to your e-mail dated 18 June 2007 regarding your queries about the summary
consolidated financial statements for PHL for the year ended 31 March 2007.

The explanation for the accounting treatment of the sales of materials from SIL to OAL and
the investment property held by PHL is as follows:

Elimination of the profit arising from the sales made by SIL to OAL

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

In order to achieve this objective, the financial statements of member companies of our
Group, i.e. PHL and SIL, are combined and certain adjustments are made to the combined
statements.

OAL is an associate of the Group since PHL holds 30% interest in OAL.

For the purpose of PHL’s consolidated financial statements, the Group should use the
equity method of accounting to account for its investment in OAL.

HKAS 28 Investments in Associates requires that the profits resulting from the transactions
between the Group and OAL are recognised in PHL’s financial statements only to the
extent of unrelated investors’ interests in the OAL.

The Group should not recognise its share of the profit (i.e. 30%) for the sales made by SIL
to OAL until OAL resells the goods to an independent party.

Therefore, the Group’s (PHL and SIL as a group) 30% share in the unrealised profits
resulting from those transactions between SIL and OAL included in OAL’s inventory at 31
March 2007 should be eliminated from PHL’s consolidated financial statements.

Since SIL is a member of the Group, the elimination is still required even though PHL did
not take part in the transactions directly.

Module A (May 2007 Session) Page 1 of 13

Property occupied by SIL

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 PHL alone (i.e. not from the perspective of PHL and SIL as a
group), the property leased by PHL to SIL is investment property since it meets the
definition of an investment property.

Therefore, the property should be classified and accounted for as an investment property
in the balance sheet of PHL.

However, in the consolidated financial statements of PHL, the property does not qualify as
investment property because, from the perspective of the group as a whole, the property is
owner-occupied.

The property is an owner-occupied property from the perspective of the group as a whole
since it is held for use by SIL in supply of goods and for administrative purposes.

Therefore, the property has been reclassified as property, plant and equipment in PHL’s
consolidated financial statements.

Please refer to the annex for detailed calculation of the balance of investment in OAL as
shown in the consolidated balance sheet and also the worksheet for the consolidated
balance sheet as at 31 March 2007.

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

Best regards

XXX

Module A (May 2007 Session) Page 2 of 13

Answer 1(b)(i)

(Figures are in $’000 unless otherwise specified)

CJ1
Dr Share capital 20,000
Dr Reserves 4,000
Dr Property, plant and equipment 2,000
Dr Goodwill{20,000-[(20,000+4,000+2,000)x60%]} 4,400
Cr Investment in subsidiary 20,000
Cr Minority interest [(20,000+4,000+2,000)x40%] 10,400

Being elimination of investment in subsidiary against the subsidiary’s share capital and
pre-acquisition reserves at the date of acquisition and recognition of goodwill and minority
interest in assets and liabilities.

Answer 1(b)(ii)

Additional depreciation due to fair value adjustment of equipment at acquisition of SIL

CJ2
Dr Profit or loss – depreciation [2,000/8] 250
Cr Property, plant and equipment
– accumulated depreciation 250

Being additional depreciation charge on the equipment for the year ($2,000,000/8) as a
result of revaluation of the assets to fair value on acquisition.

Reclassification of investment property to property, plant and equipment

CJ3A
Dr Property, plant and equipment 54,900
Cr Investment property 54,900

Being reclassification of investment property to owner-occupied property from the

perspective of a group.

CJ3B
Dr Profit or loss – depreciation [54,900/50] 1,098
Cr Property, plant and equipment
– accumulated depreciation 1,098

Being depreciation of the owner-occupied property from the perspective of a group.

Module A (May 2007 Session) Page 3 of 13

Equity accounting of interest in OAL

CJ4
Dr Investment in associate 1,440
Cr Profit or loss – shares of profit
in associate [(7,800 - 3,000) x 30%] 1,440

Being recognition of the group’s share of post-acquisition profit in associate.

Elimination of unrealised profit in inventories

CJ5A
Dr Profit or loss – shares of profit in associate 30
Cr Investment in associate
[($500,000 x 25/125) x 30%] 30

Being elimination of unrealised profit on inventories of OAL at balance sheet date.

CJ5B
Dr Profit or loss – cost of sales 400
Cr Inventory [$2,000,000 x 25/125] 400

Being elimination of unrealised profit on inventories of PHL at balance sheet date.

Minority Interest

Profit of SIL for the year 13,700*

Fair value adjustment (250)
13,450
40% minority interest 5,380

CJ6
Dr Retained profit – profit or loss 5,380
Cr Minority interest 5,380

Being classification of retained profit as minority interest.

* This include minority interest’s share of profit of sales from SIL to PHL and OAL. The
elimination of unrealised profit of inventories held by PHL and OAL at the balance sheet
date will not affect the minority interest.

Intragroup rental transaction

Dr Profit or loss – rental income 3,000

Cr Profit or loss – rental expenses 3,000

Being elimination of intragroup rental transaction.

Module A (May 2007 Session) Page 4 of 13

Answer 1(b)(iii)

Deferred tax liabilities arising from valuation adjustment of equipment of SIL

At 1 April 2006

CJ7A
Dr Goodwill (300 x 60%) 180
Dr Minority interest (300 x 40%) 120
Cr Deferred tax liabilities (2,000 x 15%) 300

Being deferred tax liabilities arising on the valuation adjustment of assets acquired in a
business combination, allocated to the group as goodwill and to the minority interest.

For the year ended 31 March 2007

CJ7B
Dr Deferred tax liabilities (250 x 15%) 37.5
Cr Profit or loss - tax expenses 37.5

Being reversal of deferred tax liabilities on the valuation adjustment of assets acquired in a
business combination.

CJ7C
Dr Retained profit – profit or loss (37.5 x 40%) 15
Cr Minority interest 15

Being classification of retained profit as minority interest.

CJ7D
Dr Deferred tax asset (400 x 15%) 60
Cr Profit or loss - tax expenses 60

Being deferred tax asset arsing from the elimination of the unrealised profit on inventories
of PHL.

For the purpose of this suggested solution, it is assumed that elimination of unrealised
profit in the associate OAL will not result in deferred taxation (or that the amount is not
material.)

Module A (May 2007 Session) Page 5 of 13

 PHL SIL CJ1 CJ2 CJ3 CJ4 CJ5 CJ6 CJ7 Consolidated
$'000 $'000
Non-current assets
Goodwill 4,400 180 4,580
Investment property 54,900 (54,900) -
Property and equipment 5,000 32,500 2,000 (250) 53,802 93,052
Investment in subsidiary 20,000 (20,000) -
Investment in associate 10,000 1,440 (30) 11,410
89,900 32,500 109,042
Current assets
Inventories 11,500 6,000 (400) 17,100
Receivables 1,800 4,200 6,000
Deferred tax 60 60
Cash 800 4,000 4,800
14,100 14,200 27,960
104,000 46,700 137,002
Capital and reserves
Issued capital (40,000) (20,000) 20,000 (40,000)
Retained profit: opening (15,000) (4,000) 4,000 (15,000)
Profit for the year (14,200) (13,700) 250 1,098 (1,440) 430 (98) (27,660)
Re-classify as minority interest 5,380 15 5,395
Retained profit (29,200) (17,700) (77,265)
Minority interest (10,400) (5,380) 105 (15,675)
(69,200) (37,700) (92,940)
Non-current liabilities
Deferred tax (262) (262)
Liabilities (34,800) (9,000) (43,800)
(104,000) (46,700) (137,002)

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

Module A (May 2007 Session) Page 6 of 13

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

Answer 2(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) whole 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.

Answer 2(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 per cent 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 per cent 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 per cent 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 ten, 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.

Module A (May 2007 Session) Page 7 of 13

Answer 2(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
decision 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 makers shall be
reported for that segment.

Answer 2(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.

Answer 3(a)

Loan to Borrower A

Under HKAS 39.63, if there is objective evidence that an impairment loss on loan and
receivables carried at amortised cost has been incurred, the amount of the loss is
measured as the difference between the asset's carrying amount and the present value of
estimated future cash flows (excluding future credit losses that have not been incurred)
discounted at the financial asset's original effective interest rate.

The default in payment of interest as well as repayment of principal at 30 November 2006

is objective evidence that the loan may be impaired.

Total outstanding principal and interest due as at 30 November 2006:

= HK$20,000,000 x (1 + 12%)2.5
= HK$26,550,644

Module A (May 2007 Session) Page 8 of 13

Under the revised terms, HK$26,550,644 will be due on 30 November 2008. Discounted
this amount at the original effective interest rate, the present value would be:

HK$26,550,644 / (1 + 12%)2
= HK$21,166,010

Therefore, even if WCL expects that the loan and accrued interests will be fully recovered
in future years according to the revised terms (i.e. there will be no future credit losses), the
present value of the future cash flow is lower than the carrying amount of the loan and
accrued interest at 30 November 2006. Therefore an impairment loss should be
recognised.

Impairment loss recognised at 30 November 2006:

= HK$21,166,010 – 26,550,644
= HK$5,384,634

Answer 3(b)

Loan to Borrower B

When an entity retains the contractual rights to receive the cash flows of the financial
asset, but assumes a contractual obligation to pay the cash flows to one or more entities,
the entity treats the transaction as a transfer of a financial asset if, and only if, all of the
three conditions set out in HKAS 39.19 are met.

WCL has an obligation to pay the full amount of the principal and accrued interest to the FI
even if it is unable to collect the amount from Borrower B.

WCL is prohibited by the terms of the transfer contract from selling or pledging the loan to
Borrower B other than as security to the FI for the obligation to pay the principal and
accrued interest.

WCL has an obligation to remit the amounts it collects on behalf of the FI within 3 days,
which is not considered a material delay. In addition, WCL is not entitled to reinvest the
amounts collected, except for investments in cash or cash equivalents during the short
settlement period from the collection date to the required date of remittance to the FI, and
interest earned on such investments is passed to the FI.

Accordingly, WCL cannot treat the sale of the loan to the FI as transfer of a financial asset
as the first condition set out in HKAS 39.19 has not been met and WCL cannot
derecognise the loan to Borrower B as a financial asset.

Module A (May 2007 Session) Page 9 of 13

Answer 4(a)

The financial statements of Fortune Limited

Payment for redundancy of staff of HK$1,850,000

Under HKAS 19.133, a redundancy payment is a termination benefit which should be

recognised as a liability and an expense when, and only when, an entity is demonstrated
to be committed to either:

(i) terminating the employment of an employee or group of employees before the

normal retirement date; or

(ii) providing termination benefits, as a result of an offer made in order to encourage

voluntary redundancy.

Under HKAS 19.134, an entity is demonstrably committed to a termination when, and only
when, the entity has a detailed formal plan for the termination, and is without realistic
possibility of withdrawal.

The issue of redundancy notices to the staff of Fortune Limited immediately after the date
when Broom Limited has taken control over Fortune Limited has given rise to a
construction obligation since that day and as at 31 December 2006.

Accordingly, a provision of HK$1,850,000 should be recognised as an expense in the

income statement of 2006 and a liability in the balance sheet as at 31 December 2006 of
Fortune Limited.

Payment to two directors for retrenchment

HK$2,400,000 (2 x HK$1,200,000) is recognised as an expense in the income statement

of 2006.

Payment for cancellation of options granted to managing director

According to HKFRS 2.28, if the entity cancels or settles a grant of equity instruments
during the vesting period (other than a grant cancelled by forfeiture when the vesting
conditions are not satisfied):

(i) 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.

Unrecognised share compensation expense as at 31 October 2006:

= HK$180,000 / 36 x (36 -14)
= HK$110,000

DR EXPENSE HK$110,000
CR EQUITY HK$110,000

Module A (May 2007 Session) Page 10 of 13

(ii) Any payment made to the employee on the cancellation or settlement of the grant
shall be accounted for as the repurchase of any equity interest, i.e. as a reduction
from equity, except to the extent that the payment exceeds the fair value of the equity
granted, measured at the repurchase date. Any such excess shall be recognised as
an expense.

As the consideration paid for the cancellation, i.e. HK$210,000, is higher than the fair
value of the equity granted as at 31 October 2006 of HK$200,000, HK$10,000 is
recognised as an expense while HK$200,000 is deducted from equity.

DR EXPENSE HK$10,000
DR EQUITY HK$200,000
CR CASH HK$210,000

Answer 4(b)

The consolidated financial statements of Broom Limited

Payment for redundancy of staff of HK$1,850,000

Redundancy of staff by Fortune Limited whose execution is conditional upon its being
acquired by Broom Limited, is not, immediately before the business combination, a
present obligation of Fortune Limited.

Nor is it a contingent liability of Fortune Limited immediately before the combination.

Accordingly, Broom Limited should not recognise a liability for such redundancies as part
of allocating the cost of the combination.

The provision of HK$1,850,000 should be recognised as a post acquisition expense in

Broom Limited’s consolidated income statement of 2006 and a liability in their consolidated
balance sheet as at 31 December 2006.

Payment to two directors for retrenchment

The payment that Fortune Limited is contractually required to make to its two directors in
the event that it is acquired in a business combination is a present obligation of Fortune
Limited that is regarded as a contingent liability until it becomes probable that a business
combination will take place.

In accordance with HKFRS 3.42, when the business combination is effected, that liability
of Fortune Limited is recognised by Broom Limited as part of allocating the cost of the
combination.

The payment of HK$2,400,000 should not be recognised as a post acquisition expense in

Broom Limited’s consolidated income statement of 2006.

Module A (May 2007 Session) Page 11 of 13

Payment for cancellation of options granted to managing director

The cancellation on 31 October 2006 of share options granted to the managing director
was occurred prior to the acquisition date, i.e. 1 November 2006, and therefore, the
agreed payment of HK$210,000 was an existing liability of Fortune Limited at the
acquisition date.

Accordingly, Broom Limited should recognise the liability of HK$210,000 as part of

allocating the cost of the combination.

The payment of HK$210,000 should not be recognised as a post acquisition expense in

Broom Limited’s consolidated income statement of 2006.

Payment for due diligence exercise

The fee for the due diligence exercise on Fortune Limited’s financial statements is a cost
directly attributable to the business combination.

Accordingly, Broom Limited should recognise HK$300,000 as part of the cost of the
acquisition of Fortune Limited instead of as an expense when incurred.

Answer 5(a)

Research and development contract

Under HKAS 18.20, when the outcome of a transaction involving the rendering of services
(in this case, PMT is to provide research and development services to WY) can be
estimated reliably, revenue associated with the transaction shall be recognised by
reference to the stage of completion of the transaction at the balance sheet date.

Under HKAS 18.26, when the outcome of a transaction involving the rendering of services
cannot be estimated reliably, revenue shall be recognised only to the extent of the
expenses recognised that are recoverable.

The non-refundable up-front payment received without any corresponding performance or

delivery should be treated as an advance from WY and recognised as performance
occurring over the term of the contract.

Milestone payments received are recognised as revenue over the period from the
achievement of the milestone to the end of the contract, similar to the treatment of the
non-refundable up-front fee.

To estimate the stage of completion, PMT may use one of the following methods to
measure the proportion of the services performed:

(i) surveys of work performed;

(ii) services performed to date as a percentage of total services to be performed; or

(iii) the proportion that costs incurred to date bear to the estimated total costs of the
transaction.

Module A (May 2007 Session) Page 12 of 13

PMT may also take the view that successful completion of the clinical trials and delivery of
the first pilot unit are specific acts that are much more significant than any other acts.

In such a case, the recognition of revenue is postponed until the significant act is executed.

That is, PMT should recognise HK$3,500,000 (less any amount previously recognised
when the outcome could not be reliably estimated) as revenue upon successful completion
of the clinical trials, and HK$1,500,000 upon the delivery of the first pilot unit.

Answer 5(b)

Government grant

The HK$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 HK$25,000,000
acquisition cost of the equipment, on a systematic basis.

PMT may either set up the government grant as deferred income of HK$10,000,000 and
amortise it over eight years on a straight-line basis; or

PMT may deduct the government grant of HK$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 HK$15,000,000.

* * * END OF EXAMINATION PAPER * * *

(ANSWERS)

Module A (May 2007 Session) Page 13 of 13