Module A

Financial Reporting

Answers

The suggested answers are longer than what candidates are expected to give in the examination.
The purpose of the suggested answers is meant to help candidates in their revision and learning.
The suggested answers may not contain all the correct points and candidates should note that
credit will be awarded for valid answers which may not fully covered in the suggested answers.
SECTION A – CASE QUESTIONS

Answer 1

To : Directors
From : Miranda Chan, Accounting Manager
Date : dd/mm/yyyy
Subject : Appropriate accounting treatment for the partial disposal of AVL

I refer to your query regarding the accounting treatment for the partial disposal of AVL.

Partial disposal of AVL (associate) while maintaining significant influence

While HKFRS 10 requires a partial disposal of a subsidiary in which the parent does not lose
control to be accounted for as an equity transaction, this principle does not extend to that of
a partial disposal of an associate where the investor does not lose significant influence.
HKAS 28 should apply to the investment in associate (“AVL”) rather than HKFRS 10.

AVL, as an associate is not part of the group as defined in HKFRS 10. Therefore, the partial
disposal of the associate is not a transaction with equity owners. Instead, it is a transaction
(i.e. disposal) with third parties from the perspective of the group.

Accordingly, the proportionate cost of investment of the associate disposed should be

derecognised with the gain or loss on disposal to be recognised in the profit or loss in the
consolidated financial statements.

Reclassification of revaluation gain of debts instruments

The revaluation reserves of AVL as at 1 April 2015 solely consists of gain on property
revaluations, while the revaluation reserves of AVL as at 31 March 2019 consists of gain on
property revaluations amounting to HK$70,000,000 and changes in the fair value of debt
instruments at fair value through other comprehensive income amounting to HK$30,000,000.

Paragraph 25 of HKAS 28 states that if an entity’s ownership interest in an associate is

reduced, but the investment continues to be classified as an associate, the entity shall
reclassify to profit or loss the proportion of the gain or loss that had previously been recognised
in other comprehensive income relating to that reduction in ownership interest if that gain or
loss would be required to be reclassified to profit or loss on the disposal of the related assets
or liabilities.

Gain on property revaluations is an item that will not be reclassified to profit or loss, while
change in the fair value of debt instruments at fair value through other comprehensive income
is an item that may be reclassified to profit or loss.

Module A (December 2019 Session) Page 1 of 15

As a result, with the disposal of 10% of AVL, the group realised a gain of 10% of
HK$30,000,000, which had already been included in revaluation reserves. This gain
(HK$3,000,000) should be transferred from revaluation reserves to profit for the year. Thus,

HK’000 HK’000
Dr Revaluation reserves 3,000
Cr Gain from derecognition of debt instrument 3,000
at fair value through other comprehensive
income (profit for the year)

Gain on partial disposal of investment in AVL

Gain on disposal in separate financial statements

HK$’000
Sales proceeds 70,000
Less: cost of investment HK$66m x 10% / 50% (13,200)
56,800

Gain on disposal in consolidated financial statements

HK$’000
Sales proceeds 70,000
Less: carrying amount of investment HK$281.6m x 10% / 50% (56,320)
13,680

AVL before and after disposal

HK$’000 HK$’000
Cost 66,000
Share of post-acquisition profits and revaluation
reserves
(540,000 – 100,000) x 50% 220,000

Less: amortization of fair value adjustments

(60,500 – 55,000) x 4/5 (4,400) 215,600
AVL before disposal 281,600
10% disposed out of 50% (56,320)
AVL after disposal 225,280

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

Best Regards,
Miranda Chan

Module A (December 2019 Session) Page 2 of 15

Answer 2

PBL’s existing headquarter building

Paragraph 6 of HKFRS 5 states that an entity shall classify a non-current asset as held for
sale if its carrying amount will be recovered principally through a sale transaction rather than
through continuing use.

For this to be the case, the asset must be available for immediate sale in its present condition
subject only to terms that are usual and customary for sales of such assets and its sale must
be highly probable.

The sale should be expected to qualify for recognition as a completed sale within one year
from the date of classification, and actions required to complete the plan should indicate that
it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.

Events or circumstances may extend the period to complete the sale beyond one year. An
extension of the period required to complete a sale does not preclude an asset from being
classified as held for sale if the delay is caused by events or circumstances beyond the entity’s
control and there is sufficient evidence that the entity remains committed to its plan to sell the
asset.

Since PBL will continue to use the building until construction of PBL’s new headquarter
building is completed, PBL does not intend to transfer the existing headquarter building to a
buyer until after construction of new headquarter building is completed.

The delay in the timing of the transfer of the existing headquarter building is imposed by PBL
which is not caused by events or circumstances beyond PBL’s control. This demonstrates
that the headquarter building is not available for immediate sale.

Therefore, PBL’s existing headquarter building should not be classified as non-current asset
held for sales as at 31 March 2019.

Answer 3

Interest charge in relation to the construction of the new manufacturing facility

HKAS 23 states that an entity shall capitalise borrowing costs that are directly attributable to
the acquisition, construction or production of a qualifying asset as part of the cost of that asset.

A qualifying asset is an asset that necessarily takes a substantial period of time to get ready
for its intended use or sale. Since the construction of the new manufacturing facility located
in Zhejiang is expected to take three years to complete, it is considered as a qualifying asset.

Borrowing costs are interest and other costs that an entity incurs in connection with the
borrowing of funds.

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To the extent that PBL borrows funds specifically for the purpose of obtaining a qualifying
asset, PBL shall determine the amount of borrowing costs eligible for capitalisation as the
actual borrowing costs incurred on that borrowing during the period less any investment
income on the temporary investment of those borrowings.

The commencement date for capitalisation is the date when the entity first meets all of the
following conditions:

(a) it incurs expenditures for the asset;

(b) it incurs borrowing costs; and
(c) it undertakes activities that are necessary to prepare the asset for its intended use or
sale.

Since the bank loan of HK$120,000,000 with an effective interest rate at 5% per annum was
taken out and fully drawn on 1 July 2018, PBL can commence to capitalise the interest starting
from 1 July 2018. The total interest charge for the year ended 31 March 2019 was
HK$4,500,000 (HK$120,000,000 x 5% x 9/12).

However, interest income was also earned at 2% on the unapplied fund during the period as
follows:

HK$’000
HK$120m – HK$60m = HK$60m x 2% x 3/12 = 300
HK$60m – HK$40m = HK$20m x 2% x 3/12 = 100
400

Therefore, the amount of interest to be capitalised for the year ended 31 March 2019 is:
Total interest charge HK$4,500,000 less investment income HK$400,000 = HK$4,100,000.

The adjustment required would be:

HK$’000 HK$’000
Dr Property, plant and equipment 4,100
Cr Interest charge (PBL’s profit for the year) 4,100

Answer 4

Research and development

According to paragraph 57 of HKAS 38, an intangible asset arising from development (or from
the development phase of an internal project) shall be recognised if, and only if, an entity can
demonstrate all of the following:

(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.

Module A (December 2019 Session) Page 4 of 15

(c) Its ability to use or sell the intangible asset.

(d) How the intangible asset will generate probable future economic benefits. Among
other things, the entity can 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) The availability of adequate technical, financial and other resources to complete the
development and to use or sell the intangible asset.

(f) Its ability to measure reliably the expenditure attributable to the intangible asset during
its development.

Laboratory costs to convert traditional chemotherapy into oral form

Since the conversion of traditional chemotherapy into the oral form has yet to be proven
successful, the technical feasibility criterion is not met, and the HK$3,000,000 must be
expensed and cannot be capitalised as intangible assets so as to carry forward to a future
accounting period.

Targeted therapy medication

As the targeted therapy medication is a new product, costs incurred until the medication
developed meets all the above mentioned criteria are expensed. In this case, determining
the technical feasibility of the medication is the key issue.

Regulatory approval should be considered in determining the technical feasibility of

completing the medication, especially the process involved and the likelihood of obtaining the
government approval. If it is determined that the likelihood of obtaining the government
approval is remote, then it may be difficult to argue that it is technically feasible.

However, if PBL is confident that it will obtain government approval and has evidence to
support this, PBL may argue that it is technically feasible to complete the medication so that
it will be available for sale; then, the ability to use or sell the medication, as an intangible
asset, and how the medication will generate probable future economic benefits, will be the
key criteria to consider.

Module A (December 2019 Session) Page 5 of 15

Answer 5

Worksheet for the consolidated statement of financial position of PBL as at 31 March 2019:

PBL SML J1 J2 J3 J4 J5 E1 E2 Q1a Q1b Q1c Consolidated

Figures in HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
credit are
shown in ( )
Property,
plant and
equipment 849,100 300,000 2,000 (1,500) 1,149,600
Intangible
assets 274,000 140,000 414,000
Investment
in SML 260,000 - (260,000) -
Investment 13,200
in AVL 66,000 201,700 13,900 (13,200) (56,320) 225,280
Goodwill 36,800 36,800
4.5%
debenture
loan (125,000) (125,000)
Bank loan at
5% p.a. (120,000) (120,000)
Other net
assets 50,000 40,000 (1,200) 70,000 158,800
Total net
assets 1,254,100 480,000 1,739,480

Module A (December 2019 Session) Page 6 of 15

 PBL SML J1 J2 J3 J4 J5 E1 E2 Q1a Q1b Q1c Consolidated
Figures in HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
credit are
shown in ( )
R/E at 1
April 2018 (220,000) (200,000) 16,000 1,125 18,400 (161,700) (546,175)
Profit for the 37,000 56,800 (3,000)
year (44,100) (30,000) 250 (35,800) 2,855 (13,900) (56,800) (13,680) (100,375)
Revaluation
reserves (60,000) (30,000) 10,000 2,000 (40,000) 3,000 (115,000)
(1,254,100) (480,000) (1,691,550)
Non-
controlling
interests (24,800) 125 (20,400) (2,855) (47,930)
Total equity (1,739,480)

Module A (December 2019 Session) Page 7 of 15

 Answer 5

Consolidation journal entries (All figures in HK$’000)

J1 Elimination of investment in SML

Dr Share capital 220,000
Dr Retained earnings 16,000
Dr Revaluation reserves 10,000
Dr Property, plant and equipment 2,000
Dr Goodwill 36,800
Cr Investment in SML 260,000
Cr Non-controlling interests (10%) 24,800

J2 Additional depreciation for fair value adjustment in SML

Dr Retained earnings (2,000 x 5/8) x 90% 1,125
Dr Non-controlling interests (10%) 125
Dr Depreciation (current year profit) 250
Cr Property, plant and equipment 1,500
(Accumulated depreciation)

J3 Intragroup sales of inventory from SML to PBL

Dr Sales (current year profit) 37,000
Cr Cost of sales (current year profit) 35,800
Cr Inventory 1,200

J4 NCI share of post-acquisition retained earnings of and revaluation reserves of

SML up to 31 March 2018
Dr Retained earnings 18,400
(10% x (200,000 – 16,000)
Dr Revaluation reserves 2,000
(10% x (30,000 – 10,000))
Cr Non-controlling interests 20,400

J5 NCI share of current year profit of SML

Dr Profit to NCI (10% x (30,000 – 250 – 1,200)) 2,855
Cr Non-controlling interests 2,855

E1 PBL’s share of post-acquisition retained earnings and revaluation reserves of AVL

up to 31 March 2018
Dr Investment in associate (AVL) 201,700
Cr Retained earnings 161,700
[(50% x (410,000 – 80,000) – 3,300*)]
Cr Revaluation reserves (50% x (100,000 40,000
– 20,000))
* (60,500 – 55,000) / 5 years = 1,100 per year

Module A (December 2019 Session) Page 8 of 15

 E2 PBL’s share of current year profit of AVL for the year ended 31 March 2019
Dr Investment in associate (AVL) 13,900
Cr Share of profit of associate (current 13,900
year profit [(50% x 30,000) – 1,100]

Accounting entries on recognising gain on disposal

Q1a: In the separate financial statements (31 March 2019)

HK’000 HK’000
Dr Cash 70,000
Cr Cost of investment in AVL 13,200
$66m x 10% / 50%
Cr Gain on disposal (current year profit) 56,800

Consolidation adjustment in the consolidated financial statements (31 March 2019)

Q1b: HK’000 HK’000

Dr Investment in AVL 13,200
Dr Gain on disposal (current year profit) 56,800
Cr Gain on disposal (current year profit) 13,680
Cr Investment in associate (AVL) 56,320

Net: Dr Gain on disposal 43,120, Cr Investment in AVL 43,120

With the disposal of 10% of AVL, the group realised a gain of 10% of $30,000,000, which
had already been included in revaluation reserves. This gain ($3,000,000) should be
transferred from revaluation reserves to profit for the year.

Q1c: HK’000 HK’000

Dr Revaluation reserves 3,000

Cr Gain from derecognition of debt 3,000

instrument at fair value through other
comprehensive income (profit for the
year)

Module A (December 2019 Session) Page 9 of 15

 Reconciliation of AVL after disposal as at 31 March 2019

before after
HK$’000 HK$’000
Book value of net assets of associate 275,000 x 40/50 220,000
50% x 550,000
Remaining fair value adjustments 1,100 x 40/50 880
5,500 x 1/5
Goodwill 5,500 x 40/50 4,400
66,000 – 60,500
281,600 (56,320) 225,280

Reconciliation of non-controlling interests in SML as at 31 March 2019

SML 10% NCI
HK$’000 HK$’000
Book value of net assets of SML 480,000 x 10% 48,000
Unrealised profit on intragroup transaction (1,200) x 10% (120)
Remaining fair value adjustments 500 x 10% 50
2,000 x 2/8
479,300 47,930

* * * END OF SECTION A * * *

Module A (December 2019 Session) Page 10 of 15

SECTION B – ESSAY / SHORT QUESTIONS

Answer 6(a)

(i) 10% ordinary shares in Ai Limited (“AL”)

This is an equity investment.

Under HKFRS 9, generally, investment in equity investment would have been measured at
fair value through profit or loss unless it makes an irrevocable election at initial recognition to
present subsequent changes in fair value in other comprehensive income. (HKFRS 9
para. 4.1.4)

(ii) Convertible bond issued by Cyborg World Limited (“CWL”)

Under HKFRS 9 para. 4.3.2, if a hybrid contract contains a host that is an asset within the
scope of the standard, then the classification and measurement requirements under
HKFRS 9 should be applied to the entire hybrid contract.

The conversion feature should not be separated, and as a result, the contractual terms of the
contract as a whole do not give rise solely to payments of principal and interest (“SPPI”) on
the principal amount outstanding of the bond.

The return of the bond is not just consideration for the time value of money and credit risk. It
also reflects value of CWL’s equity.

Therefore, the convertible bond is to be classified as at fair value through profit or loss in its
entirety.

Answer 6(b)

We disagree with management’s view.

Even though it is a strategic long term investment, based on the discussion in Answer 6(a)
above, such investments can only be stated at fair value.

There is no provision under HKFRS 9 to measure the investment at cost, although in limited
circumstances, cost may be an appropriate estimate of fair value. That may be the case if
insufficient more recent information is available to measure fair value, or if there is a wide
range of possible fair value measurements and cost represents the best estimate of fair value
within that range. (HKFRS 9 para. B.5.2.3)

In AL’s case, while it has been acquired for close to one year, given the changes in expectation
about its technical product’s milestones being achieved, even though it is an unlisted start-up,
it is unlikely that cost would be representative of fair value.

Module A (December 2019 Session) Page 11 of 15

Answer 7(a)

A lease is a contract, or part of a contract, that conveys the right to use an asset for a period
of time in exchange for consideration.

Key elements that need to be considered in order to conclude whether a lease exists include
whether:

(a) there is an identified asset;

(b) there is the right to control; and
(c) it is for a period of time.

Contract signed in January 2019

This contract contains a lease and the reasons are as follow:

(1) Identified asset

The contract explicitly specifies a designated room for CPL’s use.

It is physically distinct as it is a separate room and ALL does not have any substitution rights.

Therefore, there is an identified asset.

(2) Right to control

The designated area is for CPL’s exclusive use and it has full discretion on the usage of the
warehouse space throughout the contract period.

Even though CPL needs to share part of profits arising from the sales of its products, that
requirement does not prevent CPL from having the right to obtain substantially all the
economic benefits from the use of the warehouse space.

This is because the cash flows arising from those sales are considered to be economic
benefits that CPL obtains from use of the retail space, a portion of which it then pays to ALL
as consideration for the right to use that space. (HKFRS 16 para. B23)

Also, the term that limits the type of products that CPL can store in the warehouse is a
protective right that defines the scope of CPL’s right of use but does not, in isolation, prevent
CPL from having the right to direct the use of the warehouse space. (HKFRS 16 para. B30)

Therefore, CPL has the right to control the designated warehouse space as it has the right to
obtain substantially all economic benefits from the use of the asset and to direct the use of
the asset.

Module A (December 2019 Session) Page 12 of 15

(3) A period of time

The contract also has a specified non-cancellable period of 5 years.

Therefore, the contract signed in January 2019 contains a lease.

Contract signed in May 2019

For this contract, the asset is not explicitly or implicitly identified, as ALL can put CPL’s goods
anywhere in the warehouse up to 2,000 sq. ft.

The total area of the warehouse is 14,000 sq. ft., 2,000 sq. ft. represents 14% of that area
which is not substantially all of the capacity. Even if we include 7,000 sq. ft. that was leased
under the January 2019 contract, the total (2,000 + 7,000 = 9,000 sq. ft.) only represents about
64% of the floor area, which is still not substantially all of the capacity.

Therefore, there is no “identified asset”, and the May 2019 contract does not contain a lease.

Answer 7(b)

Accounting treatment of the payments under the January 2019 contract

At the commencement date, CPL should recognise a lease liability at the present value of the
lease payments that are not paid at that date. The lease payments shall be discounted using
the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot
be readily determined, CPL shall use its incremental borrowing rate.

The monthly fee of HK$420,000 includes payment for warehouse management services,
which is a non-lease component, on top of leasing the specific areas which is then a lease
component.

For a contract that contains a lease component and one or more non-lease components, the
lessee shall allocate the consideration in the contract to each lease component on the basis
of the relative stand-alone price of the lease component and the aggregate stand-alone price
of the non-lease components. (HKFRS 16 para. 13)

Alternatively, CPL can apply the practical expedient to elect not to separate the non-lease
components from the lease components, and instead account for them as a single lease
component. (HKFRS 16 para. 15)

The variable fee is dependent on usage so it is to be recognised in profit or loss as incurred,

unless the costs are included in the carrying amount of another asset applying other applicable
financial reporting standards. (HKFRS 16 para. 38)

Alternatively, the variable fee might be considered to be a non-lease component as it relates

to goods handling services so it is to be recognised in profit or loss as incurred.

Module A (December 2019 Session) Page 13 of 15

Answer 8(a)

FEL is considered to have an obligation to compensate the plaintiff that arises from the traffic
accident which happened during the year ended 31 March 2019. Therefore, a provision
would need to be recognised.

The amount recognised as provision shall be the best estimate of the expenditure required to
settle the present obligation at the end of the reporting period. (HKAS 37 para. 36)

Where a single obligation is being measured, the individual most likely outcome may be the
best estimate of the liability. (HKAS 37 para. 40)

With reference to the lawyers’ view, assuming the case is expected to be closed within one
year so that discounting effect is immaterial, it would appear that HK$12 million is the most
likely outcome for the estimated damages and there is an over-provision of HK$2 million.

The incremental legal costs should be included in the provision as FEL has done given the
accident and the claim arose during the financial year ended 31 March 2019.

HK$3 million represents future operating losses which do not meet the definition of a liability
and the general recognition criteria. (HKAS 37 para. 63-64) The amount should have been
excluded from the amount of provision.

Where some or all of the expenditure required to settle a provision is expected to be

reimbursed by another party, the reimbursement shall be recognised when, and only when, it
is virtually certain that reimbursement will be received if the entity settles the obligation. The
reimbursement should be treated as a separate asset. (HKAS 37 para. 53)

While it is correct for FEL to recognise the reimbursement as it is virtually certain for FEL to
receive it, it should have been treated as a separate asset rather than being offset against the
provision.

In terms of disclosures, what FEL did was inadequate. Apart from the table showing the
movement in the amount of provision during the year, for each class of provision, an entity
shall disclose:

- A brief description of the nature of the obligation and the expected timing of any resulting
outflows of economic benefits.

- An indication of uncertainties about the amount or timing of those outflow.

- The amount of any expected reimbursement, stating the amount of any asset that has
been recognised for that expected reimbursement.

FEL would also need to consider the disclosure of information about the assumptions it makes
about the future, and major sources of estimation uncertainty at the end of the reporting period
that have a significant risk of resulting in a material adjustment to the carrying amounts of
assets and liabilities within the next financial year. (HKAS 1 para. 125)

Module A (December 2019 Session) Page 14 of 15

Answer 8(b)

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. (HKAS 21 para. 21-22)

Accordingly, upon initial recognition of the new truck on 31 December 2018, we would apply
the spot exchange rate of 1:0.88 on that day.

Under HKAS 21, non-monetary items which are carried at historical cost are not
re-translated. (HKAS 21 para. 23)

Since the truck is a non-monetary item, it would continue to be reported based on the spot
exchange rate on the date of acquisition (i.e. 1:0.88).

The new truck would have been depreciated based on its depreciable amount, which is equal
to cost minus residual value. As the cost was translated based on the spot exchange rate on
the date of acquisition (i.e. 1:0.88) and will not be re-translated, the depreciation would have
been calculated on that basis as well.

Answer 8(c)

What Hugo did was unethical.

His integrity is questionable, as he instructed the Finance Manager to create fraudulent journal
entries to arrive at a desired accounting outcome.

His objectivity is compromised when he allowed bias and conflict of interest to override
professional and business judgement when he tried to manipulate the accounting results for
the benefit of his girlfriend’s father at the expense of the shareholders of the company.

Hugo did not maintain confidentiality of FEL’s information when he talked to his girlfriend about
the company’s profits, which was not yet announced.

He also did not exercise due care when he blatantly instructed Hayden to not follow the
applicable technical and professional standards when preparing the company’s financial
records.

His behaviour was also not professional, as what he did was not in compliance with relevant
laws and regulations, thus discrediting the reputation of the profession if the news spreads
out.

* * * END OF EXAMINATION PAPER * * *

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