SECTION A – CASE QUESTIONS (Total: 50 marks)

Answer the following ONE compulsory question which relates to the Case below. Marks will be
awarded for logical argumentation and appropriate presentation of the answers.

CASE

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 2007, 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
Date of % Cost of earnings at Net assets at
acquisition acquired investment acquisition date acquisition date
HK$'000 HK$'000 HK$'000
FSL 31 March 2006 70 20,000 15,000 25,000
SWL 31 March 2006 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.

The retained earnings of MCL, FSL and SWL, as at 31 March 2007, 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 2007 are as follows:

Issued Number of Par value

capital shares per share
HK$ million million HK$
MCL 60 10 6
FSL 10 5 2
SWL 8 8 1

MCL made a rights issue of one share for every two ordinary shares that was fully exercised on
1 January 2008. 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.

Module A (February 2008 Session) Page 1 of 8

The following table summarises information from the three companies’ income statements for the
year ended 31 March 2008:

MCL FSL SWL

HK$'000 HK$'000 HK$'000
Turnover 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 for the year 18,000 7,000 4,000

On 30 September 2007, MCL sold 2.4 million shares in SWL for $8 million. The gain on this
disposal has not been included in the above income statements.

On 31 March 2008, 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 2008 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 2008, 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 2008.

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.
SWL’s results for the six months ended 30 September 2007 were exactly half of its annual
results in the year ended 31 March 2008.

Module A (February 2008 Session) Page 2 of 8

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 2008.
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 e-mail as follows:

To: Pindy LEE, Accounting Manager, MCL

From: Faria LEE (Director)
c.c.: Beverly CHOW, Emily WILSCON, Charmaine YUEN (Directors)
Date: 18 May 2008

Consolidated financial statements of MCL as at 31 March 2008

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 balance sheet?

(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 income statement for the
year ended 31 March 2008. 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 income statement and that in the consolidated income statement 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 its
EPS of MCL for the year?

I would appreciate your clarification in time for the upcoming board meeting.

Best regards,

Faria

Module A (February 2008 Session) Page 3 of 8

Required:

Question 1 (50 marks – approximately 90 minutes)

(a) Prepare a memorandum in response to the issues raised by Ms. Faria LEE. In your
memorandum, you should:

(i) discuss the reasons for the amount of HK$12 million of plant and equipment
as shown in the consolidated balance sheet;
(5 marks)

(ii) 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)

(iii) discuss why the amount of the gain on disposal of the investment in SWL as
shown in the separate income statement and in the consolidated income
statement is different; and
(5 marks)

(iv) discuss with appropriate calculation, the impact of the rights issue on the
earnings per share of MCL for the year ended 31 March 2008.
(10 marks)

(b) Prepare an annex to your memorandum showing the consolidated income statement
for the year ended 31 March 2008. (Journal entries are not required.) Ignore
deferred taxation.
(20 marks)

* * * END OF SECTION A * * *

Module A (February 2008 Session) Page 4 of 8

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

Answer ALL of the following questions. Marks will be awarded for logical argumentation and
appropriate presentation of the answers.

Question 2 (10 marks – approximately 18 minutes)

(a) Explain the differences between the Hong Kong Financial Reporting Standards and
the Accounting Guidelines issued by the Hong Kong Institute of Certified Public
Accountants.
(5 marks)

(b) Explain how materiality (and immateriality) is related to the relevance of the financial
statements.
(5 marks)

Module A (February 2008 Session) Page 5 of 8

Question 3 (12 marks – approximately 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. 2003 was BP’s first
profit-making year. The standard tax rate for BP was 24% for the periods up to
31 December 2007. With the enactment of the new tax law during 2007, BP will be subject to
FEIT at 25% for the year beginning 1 January 2008. GP is subject to Hong Kong Profits Tax at
17.5%.

BP acquired a printing machine on 1 July 2003 at a cost of HK$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 2007 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 2008 for GP's consolidated financial statements with calculation
supporting the balances recorded.
(5 marks)

(c) Assuming GP has a deferred tax asset of HK$500,000 in respect of its own plant and
equipment at 31 December 2008, explain how the deferred taxes will appear on the
consolidated balance sheet at that date.
(2 marks)

Module A (February 2008 Session) Page 6 of 8

Question 4 (15 marks – approximately 27 minutes)

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

Building A Building B Building C

Usage Warehouse Director’s Earning rental
quarter income
Date of acquisition 1 January 2000 1 January 1998 1 January 2005
Cost of the building HK$20 million HK$36 million HK$18 million
Fair value of the building at HK$28 million HK$22 million HK$22 million
31 December 2007

In the board meeting held on 30 September 2007, 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 2007, 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 balance sheet classification of these three buildings and calculate the
respective amounts to be recognised on the balance sheet as at 31 December 2007.

(15 marks)

Module A (February 2008 Session) Page 7 of 8

Question 5 (13 marks – approximately 23 minutes)

Darren Company Limited (“DCL”) is engaged in the manufacture of batteries. On the unaudited
balance sheet as at 30 June 2008, it has recognised the following provisions as current
liabilities:

(a) A provision for late delivery penalty

In May 2008, DCL received a sales order for 7,000,000 units of rechargeable batteries for
which the agreed delivery date is 31 August 2008. It is expected that DCL would earn a
gross profit of HK$1 per unit. Due to a shortage in the supply of raw materials, at the
balance sheet date, the management realised that they could only supply the goods at the
earliest on 10 September 2008. According to the sales contract, DCL would compensate
the customer for late delivery at HK$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 2007. Due to a large backlog of sales orders,
the management decided to postpone the annual inspection until mid-September 2008.

(c) A provision for the loss on sales of aged finished goods

The products were manufactured in late 2006 with an expected normal usage period of 2
years from the date of production. Due to the short expiry period, they were sold at a
price below cost in July 2008.

(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)

* * * END OF EXAMINATION PAPER * * *

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