ON

QUALIFICATION PROGRAMME VOLUME 2

Professional Module 11
nal
Financial
1
Reporting
SECOND EDITION

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 FINANCIAL REPORTING

MODULE 11
FINANCIAL REPORTING
Qualification Programme

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 Second edition 2023

ISBN 9781394158904

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 T a b le of C ontents

TABLE OF CONTENTS

Module 11: Financial Reporting

VOLUME 1

PART A FINANCIAL REPORTING FRAMEWORK IN HONG KONG 1

CHAPTER 1: Financial Reporting Framework in Hong Kong
and the Related Implications for Business Activities 3

CHAPTER 2: F
 inancial Reporting Framework and Standard
for Small and Medium-Sized Entities, and
Financial Reporting Standard for Other Private
Entities in Hong Kong 53

PART B CONCEPT OF ETHICS WHERE IT IS APPROPRIATE TO

ADOPT ETHICAL STANCES FOR PROFESSIONAL
ACCOUNTANTS IN BUSINESS 103
CHAPTER 3: Code of Ethics for Professional Accountants 105

PART C: APPROPRIATE ACCOUNTING PRINCIPLES AND

CONCEPTS TO ACCOUNT FOR BUSINESS TRANSACTIONS 133
CHAPTER 4: Fair Value Measurement 135

CHAPTER 5: Revenue 179

CHAPTER 6: Inventories 269

CHAPTER 7: Property, Plant and Equipment 297

CHAPTER 8: Investment Property 361

CHAPTER 9: Leases 417

CHAPTER 10: Borrowing Costs 505

CHAPTER 11: Intangible Assets 527

CHAPTER 12: Financial Assets, Financial Liabilities and

Equity Instruments 579

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 FINANCIAL REPORTING

CHAPTER 13: Hedge Accounting 675

CHAPTER 14: Impairment of Assets 727

CHAPTER 15: Non-current Assets Held for Sale and

Discontinued Operations 833

CHAPTER 16: Accounting Policies, Changes in Accounting

Estimates and Errors 875

CHAPTER 17: Events after the Reporting Period 929

CHAPTER 18: Provisions, Contingent Liabilities and

Contingent Assets 955

VOLUME 2
CHAPTER 19: Income Taxes 1015

CHAPTER 20: Earnings per Share 1085

CHAPTER 21: Related Party Disclosures 1131

CHAPTER 22: Government Grants 1157

CHAPTER 23: Employee Benefits 1185

CHAPTER 24: Share-based Payments 1235

CHAPTER 25: Operating Segments 1311

CHAPTER 26: Other Business Transactions, including

Agriculture and Biological Assets, Insurance
Contracts, Mineral Resources and Service
Concession Arrangements 1341

CHAPTER 27: Financial Statements for an Individual Entity 1393

PART D GROUP FINANCIAL STATEMENTS WITH

COMPLEX GROUP STRUCTURES 1445
CHAPTER 28: Interim Financial Reporting 1447

CHAPTER 29: Business Combinations 1481

CHAPTER 30: Consolidated Financial Statements with

a Simple Group Structure 1557

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CHAPTER 31: Foreign Exchange and Consolidation

of Foreign Operations 1641

CHAPTER 32: Investments in Associates 1713

CHAPTER 33: Joint Arrangements 1775

CHAPTER 34: Consolidated Financial Statements with

Complex Group Structure 1817

CHAPTER 35: Merger Accounting for Common Control

Combinations1871

PART E CURRENT ISSUES AND DEVELOPMENTS

IN FINANCIAL REPORTING 1893
CHAPTER 36: Integrated Reporting/Sustainability Reporting 1895

Glossary of Terms 1923

Index1935

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 19
Income Taxes

CHAPTER TOPIC LIST

19.1 Overview 19.5 Presentation of Income Taxes

19.1.1 Scope 19.5.1 Tax Assets and Tax Liabilities
19.1.2 Terminology 19.5.2 Tax Expense Presentation
19.2 Current Taxes 19.6 Disclosure of Income Taxes
19.2.1 Current Tax Liabilities 19.6.1 Tax Reconciliation
19.2.2 Current Tax Assets 19.6.2 Other Disclosure
19.2.3 Measurement of Current Tax Requirements
19.3 Deferred Taxes 19.7 Interpretations Relating to
19.3.1 Tax Base Income Taxes
19.3.2 Temporary Differences 19.7.1 H K(SIC) Interpretation 25
19.3.3 Measurement of Income Taxes – Changes in the
Deferred Taxes Tax Status of an Enterprise or
19.4 Recognition of Current and its Shareholders
Deferred Taxes 19.7.2 HK(IFRIC) Interpretation 23
19.4.1 Items Recognised in Uncertainty over Income Tax
Profit or Loss Treatments
19.4.2 Items Recognised Outside
Profit or Loss

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT

FOR BUSINESS TRANSACTIONS
LO2.07: A
 ccount for, evaluate and advise on business transactions in accordance with Hong Kong
Financial Reporting Standards as they relate to: income taxes
2.07.01 Account for current tax liabilities
2.07.02 Account for income tax
2.07.03 Calculate the carrying amount and tax base
2.07.04 Calculate deferred tax amounts
2.07.05 Account for tax losses and tax credits
2.07.06 Explain the initial recognition exemption for deferred tax assets and liabilities
2.07.08 Illustrate when tax assets and liabilities can be offset
2.07.09 Prepare disclosure in respect of income taxes

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OPENING CASE

CATERONE

C aterOne Ltd (CaterOne) is a company offering social event and corporate catering services.
As part of these services, CaterOne provides food and beverage services as selected by the
customer from an expansive menu, including the use of fully qualified waiting staff. The food
is cooked and prepared at CaterOne’s premises and delivered to the customer’s requested
destination.

CaterOne has two premises it uses for its food preparation: one in Central, Hong Kong,
which primarily caters for corporate events, and another in Kowloon, Hong Kong, which caters
primarily for social events including weddings, birthdays and anniversaries. Each of these
premises contains a climate-controlled storage area, where the food ingredients and wines are
stored and a fully equipped industrial kitchen where the food is prepared. Currently, CaterOne
has one delivery truck at each of the premises, both of which are used to deliver the food and
beverages to the venue.

CaterOne’s financial reporting period ends 31 January, and its tax year ends 31 March.

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OVERVIEW

In Hong Kong, income taxes are payable (recoverable) on assessable profits generated
(adjusted losses incurred), calculated in accordance with taxation legislation. In Hong Kong, an
entity calculates its assessable profits (adjusted losses) and income tax payable (recoverable)
through filing a profits tax return prepared in accordance with the Inland Revenue Ordinance.
For accounting purposes, the amount of income taxes payable (income taxes recoverable)
by the entity for the current tax year is to be recognised as a current tax liability (current tax
asset) in the entity’s financial statements. A current tax liability or current tax asset is measured
using the profits tax rate that applies in the period for which the financial statements are
being prepared.

Some transactions and events an entity has engaged in may have future tax consequences.
For example, the economic benefits an entity will derive from using an existing asset (e.g. using
machinery to produce inventory for resale) in future periods will likely increase the entity’s
future assessable profits and, consequently, increase future income taxes payable. Similarly,
the economic benefits an entity will sacrifice upon settling an existing liability (e.g. paying
annual leave entitlements to employees) in future periods will increase the entity’s future
deductible expenses and reduce future income taxes payable. These future tax consequences
stem from temporary differences in the accounting and taxation treatment of such assets
and liabilities over their remaining existence. Such future tax consequences are referred to as
deferred taxes. Differing accounting and taxation treatments will result in the amount an asset
or liability is recognised for accounting purposes (i.e. its carrying amount) differing from the
amount at which the asset or liability is recognised for tax purposes (i.e. its tax base).

This chapter addresses how an entity is to account for the income tax consequences of
its transactions. In particular, you will gain an understanding of the accounting treatment for
current tax liabilities and current tax assets. Moreover, by the end of this chapter you should
be able to calculate the carrying amount and tax base of an asset and liability, thereby enabling
you to determine the related temporary difference (if any) and deferred tax amount. You
will also gain an understanding of how to account for tax losses and tax credits and identify
those instances in which deferred tax assets and liabilities are not recognised upon the initial
recognition of a related asset or liability, despite a temporary difference existing. By the end of
the chapter you should also be able to understand the recognition, presentation and disclosure
requirements pertaining to income taxes.

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1 9 . 1 OVERVIEW

This chapter examines how an entity is to account for, and the information to be disclosed
in relation to, the income tax consequences of its transactions and events. Such issues are
governed by HKAS 12 Income Taxes.

In this section, you will gain an understanding of the scope of HKAS 12 and be introduced
to terminology that will build your understanding of the prescribed accounting treatment for
income taxes.

19.1.1 Scope
HKAS HKAS 12 is to be applied in accounting for the current and future income tax consequences
12.1 of transactions and other events of an entity. For the purposes of HKAS 12, income taxes
include:

• Domestic and foreign taxes, where the amount of such taxes payable is based on an
entity’s taxable profits; and

HKAS • Other taxes (e.g. withholding taxes) payable by a subsidiary, associate or joint
12.2 arrangement on distributions to the entity.

19.1.2 Terminology
Throughout this chapter, you will be introduced to terminology pertinent to HKAS 12. Before
HKAS proceeding further, it will be beneficial to understand key introductory terms associated with
12.5, 6 accounting for income taxes:

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)

Current tax The amount of income taxes payable (recoverable) with respect to the
taxable profit (tax loss) for a period

Accounting profit The profit or loss for a period before deducting tax expense

Tax expense (tax income) The aggregate amount included in the determination of profit or loss
for the period with respect to current and deferred taxes
Tax expense (tax income) comprises current tax expense (current tax
income) and deferred tax expense (deferred tax income).

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1 9 . 2 CURRENT TAXES

HKAS From an accounting perspective, an entity’s income tax expense comprises its current tax
12.5 expense and deferred tax expense. Each component is calculated separately and then
aggregated to comprise income tax expense for the current period. The aim of this section is to
outline how an entity determines its current tax commitments (i.e. current tax liabilities) and
current tax entitlements (i.e. current tax assets) under the Inland Revenue Ordinance and to
outline how these are reported in accordance with HKAS 12.

19.2.1 Current Tax Liabilities

From a taxation law perspective, profits tax is payable by a Hong Kong entity on its assessable
profits for a tax year. Assessable profits is the difference between income that is assessable
and expenses that are deductible for tax purposes. The assessable profits of each tax year are
calculated by adjusting accounting profit in accordance with the Inland Revenue Ordinance as
in these examples:

• An entity may recognise revenue for accounting purposes, but for tax purposes, the
amount may be non-assessable. As such, an adjustment will be made by the entity to
exclude (i.e. subtract) the amount from accounting profit to derive assessable profits; or

• An expense recognised for accounting purposes may be non-deductible for tax

purposes, requiring the entity to adjust (i.e. add back) the amount to calculate
assessable profits.

Upon making all necessary adjustments to accounting profits in accordance with the Inland
Revenue Ordinance, an entity’s assessable profits is calculated.

The following formula in Exhibit 19.1 can be used as a simple guide to convert accounting
profit to assessable profits for a given period:

Accounting profit for the current period

Plus Non-deductible expenses
(i.e. expenses for accounting purposes that are not deductible for tax purposes)
Minus Deductible charges and allowances
(i.e. deductions for tax purposes that are not expenses for accounting purposes)
Minus Non-assessable income
(i.e. revenues for accounting purposes that are not assessable for tax purposes)
Equals Assessable profits for the current period

EXHIBIT 19.1 Steps to calculate assessable profits for the current period

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 Income T axes

The tax year (i.e. year of assessment) begins on 1 April of a year and ends on 31 March of
the following year.

A Hong Kong entity’s tax year may not align with its financial year for accounting purposes.
If this is the case, the assessable profits for the tax year are calculated by making adjustments
to the accounting profit for the financial year ending within that tax year.

Upon determining assessable profits for the period, profits tax is payable based on the
applicable profits tax rate. As the amount of tax reflects the current period tax consequences
of transactions or events within that period, it is referred to as current tax, defined as the
amount of income taxes payable (recoverable) with respect to the taxable profit (tax loss)
for a period.

HKAS In accordance with HKAS 12, in its current period financial statements, an entity is to
12.12 recognise a current tax liability for any unpaid current tax from the current and prior periods.

In Hong Kong, a provisional profits tax system applies. Assessable profits and,
consequently, profits tax payable cannot be determined until the end of the current period
(e.g. 20X8). During the current period (20X8), however, an entity makes provisional profits
tax payments calculated based on what the entity’s estimated profits tax payable will be at
period-end. Estimated profits tax payable for the current period (20X8) tends to be last period’s
(20X7’s) actual profits tax payable. When making a provisional profits tax payment during
the current period (20X8), the entity would record the following journal entry at the time
of payment:

Debit Credit
HK$ HK$
Current tax liability
Cash

In essence, tax payments made during the current period reduce an entity’s current tax
liability as determined at the end of the previous period. At the end of the current period,
profits tax payable is calculated and the following journal entry would occur:

Debit Credit
HK$ HK$
Current tax expense
Current tax liability

The amount of the above journal entry is that which ensures the current tax liability
recognised in the current period’s financial statements equals unpaid current tax from the
current and prior periods.

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Apply and Analyse 1

For its financial reporting period ended 31 January 20X5, CaterOne Ltd (CaterOne)
generates accounting profit of HK$12 million. On 1 February 20X5, CaterOne’s current tax
liability is HK$322,500, which reflects unpaid current taxes for periods prior to the 20X4–X5
financial reporting period.

Upon adjusting its accounting profit per the Inland Revenue Ordinance, CaterOne
calculates its assessable profits for the tax year ended 31 March 20X5 (i.e. the 20X4–X5 tax
year) as HK$10.55 million. On 1 May 20X5, the Inland Revenue Department issues a notice
of assessment stating profits tax payable for the 20X4–X5 tax year is HK$1,575,000.

During the financial reporting period ended 31 January 20X6, CaterOne made two
provisional tax payments:

1. HK$300,000, which was 25% of actual profits tax payable from the 20X3–X4 tax
year, paid on 15 February 20X5; and

2. HK$1,181,250, which was 75% of last period’s (i.e. the 20X4–X5 tax year) actual
profits tax payable, paid 15 November 20X5.

Prepare the tax-related journal entries for CaterOne for the reporting period ended
31 January 20X6.

Analysis

The payment of HK$300,000 is during the 20X4–X5 tax year but is based on using actual
profits payable for the 20X3–X4 tax year to estimate profits tax payable for 20X4–X5.
Importantly, it occurs within the financial reporting period ended 31 January 20X6. As such,
CaterOne would record the following journal entry on 15 February 20X5:

Debit Credit
HK$ HK$
Current tax liability 300,000
Cash 300,000

After this payment, current tax liability has a balance of HK$22,500.

On 1 May 20X5, CaterOne is to recognise profits tax payable of HK$1.575 million as

a current tax liability. As such, CaterOne would record the following journal entry on
1 May 20X5:

Debit Credit
HK$ HK$
Current tax expense 1,575,000
Current tax liability 1,575,000

After this entry, current tax liability has a balance of HK$1,597,500.

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Apply and Analyse 1 (continued)

The payment of HK$1,181,250 relates to the 20X4–X5 tax year. The amount is based
on using actual profits payable for the 20X4–X5 tax year and is used to estimate profits tax
payable for the 20X5–X6 tax year. As it occurs within the financial reporting period ended
31 January 20X6, CaterOne would record the following journal entry on 15 November 20X5:

Debit Credit
HK$ HK$
Current tax liability 1,181,250
Cash 1,181,250

After this entry, current tax liability has a balance of HK$416,250. Assuming no other
transactions or events are in relation to profits tax payable, this would be the amount
recognised as a current tax liability in the financial statements as of 31 January 20X6.

19.2.2 Current Tax Assets

Often, the amount of provisional profits tax paid does not correspond with the final amount of
profits tax payable. For example, the amount of provisional tax paid may exceed the Inland
Revenue Department’s assessment of the amount of profits tax payable for the current period.
If the amount paid by an entity with respect to the current and prior periods exceeds
HKAS the amount owed for those periods, the excess will be recognised as a current tax asset in the
12.12 entity’s financial statements for the current period.

Rather than generating assessable profits, an entity might incur an adjusted loss. An
adjusted loss arises when an entity’s deductible expenses exceeds its assessable income for the
HKAS period. HKAS 12 requires an entity recognise an asset for the benefit relating to an adjusted
12.12 loss that can be carried back to recover current tax paid from a prior period. Recognising an
HKAS asset is appropriate because the benefit will probably flow to the entity and the benefit can be
12.13 measured reliably. Hong Kong entities, however, are unable to carry back adjusted losses to
recover current tax paid from a previous period. As such, no asset is to be recognised.

19.2.3 Measurement of Current Tax

Under HKAS 12, entities are to measure current tax liabilities (current tax assets) for the current
and prior periods at the amount expected to be paid to (recovered from) the tax authorities
HKAS using the tax rates and laws enacted or substantively enacted by the end of the
12.46 reporting period.

In essence, an entity is to use the profits tax rate in effect at the end of the current period
to calculate its current tax liability or current tax asset. This tax rate may be:

• Enacted under existing taxation law; or

HKAS • Substantively enacted under proposed taxation law announced by the government, and
12.48 the announcement gives the proposed tax rate the effect of actual enactment.

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 FINANCIAL REPORTING

Illustrative Example 1
Under existing taxation law, incorporated Hong Kong businesses are subject to a profits
tax rate of 8.25% on the first HK$2 million profits earned and a profits tax rate of 16.50%
on remaining profits earned. As part of his election campaign, the Chief Executive of the
Hong Kong SAR Government announced on 15 January 20X2 that, if elected, the profits
tax rate for incorporated businesses would be reduced to 6% on the first HK$3 million
profits earned, with a profits tax rate of 12.50% on remaining profits earned. The
proposed change would take effect on 1 April 20X2.

SunRay Ltd (SunRay) is an incorporated Hong Kong business that has generated
assessable profits of HK$3.25 million for the reporting period ended 31 March 20X2.

Under HKAS 12, SunRay would calculate its current tax liability using the profits tax
rate currently in effect under existing taxation law. It cannot be argued that the election
promise made by the Chief Executive results in the proposed profits tax rates being
‘substantively enacted’ because the enactment of the proposed tax rates are subject to
future events (e.g. the Chief Executive being elected and, if elected, the legislative bill being
passed by the Legislative Council).

As such, SunRay’s current tax liability for its 20X1 assessable profits would equal
HK$371,250 ((HK$2,000,000 × 8.25%) + (HK$1,250,000 × 16.50%)).

Key Learning Point

It is essential to determine those income and expense items for which different accounting
and tax treatments exist to enable an entity to derive assessable profits from its
accounting profit for the current period.

Knowledge Check Question

Question 1
Anston Ltd (Anston) is a manufacturing business that reports a current tax liability of
HK$550,000 on 1 February 20X6. For the year ended 31 January 20X7, Anston generates
accounting profit of HK$6,180,000. The following items were included in the determination
of accounting profit for the 20X6–X7 financial reporting period:
• Interest revenue of HK$30,000, which is non-assessable for tax purposes;
• Depreciation expense of HK$350,000, which is non-deductible for tax purposes; and
• A penalty of HK$500,000 imposed by the Labour Department for an unsafe
workplace, which is non-deductible for tax purposes.
In addition, Anston is entitled to a capital allowance of HK$125,000 on its plant and
equipment, which is deductible for tax purposes.
The profits tax rate is 8.25% for the first HK$2 million assessable profits earned, and
16.50% thereafter. Provisional tax is ignored.

Required:

Prepare the journal entry to record current tax expense for the 20X6–X7 reporting period.

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1 9 . 3 DEFERRED TAXES

HKAS 12 prescribes how to account for the current and future tax consequences of:

(a) The future recovery (settlement) of the carrying amount of assets (liabilities) recognised
in an entity’s statement of financial position; and

HKAS 12. (b) Transactions and other events of the current period that are recognised in an entity’s
Objective financial statements.

Regarding point (a):

• If an entity recognises an asset (e.g. inventory), it expects to recover the carrying

amount of that asset in future reporting periods (e.g. when the inventory is sold). Such
recovery will generally increase the entity’s future assessable profits (i.e. by an amount
equal to the inventory’s selling price), resulting in larger future tax payments; and

• If an entity recognises a liability (e.g. annual leave provision), it expects to settle the
liability in the future (e.g. when the annual leave is taken by employees). To the extent
that settlement of the liability will be deductible to the entity (i.e. when the annual leave
is paid), future tax payments will be smaller than if settlement had no tax consequences
(i.e. if annual leave payments were non-deductible).

Regarding point (b), transactions or other events that an entity engages in may have
same period tax consequences. These are reflected in an entity’s current tax obligations and
entitlements and have been discussed in Section 19.2 of this chapter.

As such, the future recovery (settlement) of assets (liabilities) currently held by an entity
will have future tax consequences for the entity. Such future tax consequences are referred
to as deferred tax, and HKAS 12 requires an entity to recognise, in its current period financial
statements, the deferred tax consequences of the future realisation (settlement) of all assets
(liabilities) recognised at current period-end.

The future tax (i.e. deferred tax) consequences of recognised assets and liabilities stems
from temporary differences in the accounting and taxation treatment of such assets and
liabilities over their remaining existence. Temporary differences will persist (and have future tax
consequences) while the entity is continuing to recognise the assets and liabilities, ultimately
reversing when the entity no longer holds the assets and liabilities.

Differing accounting and taxation treatments will result in the amount an asset or liability
is recognised for accounting purposes (i.e. its ‘carrying amount’) differing from the amount at
which the asset or liability is recognised for tax purposes (i.e. its ‘tax base’).

The purpose of this section is to identify the tax base of an asset or liability, and upon doing
so, how this amount, in conjunction with the carrying amount of the asset or liability, is used to
calculate the deferred tax consequences that will arise upon the future recovery (settlement) of
the asset (liability).

19.3.1 Tax Base

HKAS The tax base of an asset or liability is the amount attributed to that asset or liability for tax
12.6 purposes. As such, for accounting purposes, it is necessary to determine the amount at which
an asset or liability, which is currently recognised in an entity’s financial statements, would be

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 FINANCIAL REPORTING

measured for tax purposes. Notionally, an entity must determine the amount at which an asset
or liability would be recognised in a statement of financial position prepared for tax purposes in
accordance with the Inland Revenue Ordinance.

How an entity calculates its tax base differs for assets and liabilities.

19.3.1.1 Tax Base of an Asset

HKAS The tax base of an asset is the amount that will be deductible for tax purposes against any taxable
12.7 economic benefits that will flow to an entity when it recovers the carrying amount of the asset.

The tax base of an asset is calculated as the asset’s carrying amount less any future taxable
HKAS amounts plus any future deductible amounts that are expected to arise from recovering the
12.7 asset’s carrying amount as of the end of the reporting period. This calculation is reflected in the
formula in Exhibit 19.2:

Carrying Future Future

Tax base
amount – taxable + deductible = of asset
of asset amounts amounts

EXHIBIT 19.2 Calculation of the tax base of an asset

HKAS If the economic benefits that will flow to an entity when it recovers the carrying amount of
12.7 the asset are non-taxable, the tax base of an asset equals its carrying amount.

Illustrative Example 2
Quartz Ltd (Quartz) recognises dividends receivable from its subsidiary with a carrying
amount of HK$100,000. Dividend income is non-taxable, and it does not give rise to future
deductible amounts because the dividend receivable is neither depreciable nor require an
HKAS outflow of resources (e.g. cash payments). The tax base of the dividends receivable equals
12.7 its carrying amount, that is, HK$100,000. This is reflected in the following formula:

Carrying amount Future taxable Future deductible Tax base

amounts amounts
– + =
HK$100,000 Nil Nil HK$100,000

Apply and Analyse 2

On 1 February 20X6, CaterOne purchases a temperature-controlled delivery van to transport
its prepared food to future catering engagements. The cost of the van is HK$925,000. For
accounting purposes, the van is depreciated on a straight-line basis over 10 years. For tax
purposes, CaterOne is entitled to an initial capital allowance deduction of 60% of the van’s
cost and a subsequent allowance of 10% of the van’s reducing value thereafter.

Revenue generated by recovering the carrying amount of the van through its use is
taxable to CaterOne. The van is expected to be disposed of for an amount less than cost,
with any loss on disposal subject to a balancing adjustment for tax purposes.

Determine the tax base of the delivery van as of 31 January 20X7 and 31 January 20X8.

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Apply and Analyse 2 (continued)

Analysis

Tax base as of 31 January 20X7

For accounting purposes, one year’s depreciation on the delivery van is HK$92,500
(HK$925,000/10 years), giving rise to a carrying amount of HK$832,500.

As revenue generated by recovering the carrying amount of the van is taxable, future
taxable amounts to be derived through using the van also equal HK$832,500.

For tax purposes, the one-off initial capital allowance deduction is HK$555,000
(HK$925,000 × 60%), giving rise to a tax written-down value of HK$375,000. In 20X7,
CaterOne is also entitled to the annual 10% allowance as the delivery van is in use during
20X7. The annual capital allowance deduction is HK$37,500 (HK$375,000 × 10%), resulting
in a total capital allowance deduction in 20X7 of HK$592,500 (HK$555,000 + HK$37,500)
and a tax written-down value of HK$332,500 (HK$925,000 − HK$592,500). The tax written
down value is the future deductible amounts for to the van whether deductible by way of
future capital allowances or by any loss on disposal.

Based on the preceding information, the tax base of the delivery van is:

Carrying amount Future taxable Future deductible Tax base

amounts amounts
– + =
HK$832,500 HK$832,500 HK$332,500 HK$332,500

Tax base as of 31 January 20X8

For accounting purposes, two year’s depreciation on the delivery van is HK$185,000
(HK$925,000/10 years × 2 years), giving rise to a carrying amount of HK$740,000.

As revenue generated by recovering the carrying amount of the van is taxable, future
taxable amounts to be derived through using the van also equal HK$740,000.

For tax purposes, the subsequent capital allowance deduction is HK$33,250

(HK$332,500 × 10%), giving rise to a tax written-down value of HK$299,250. This amount is
the future deductible amounts for to the van whether deductible by way of future capital
allowances or any loss on disposal.

Based on the preceding information, the tax base of the delivery van is:

Carrying amount Future taxable Future deductible Tax base

amounts amounts
– + =
HK$740,000 HK$740,000 HK$299,250 HK$299,250

19.3.1.2 Tax Base of a Liability

For all liabilities other than revenue received in advance, the tax base of the liability is its
HKAS carrying amount less any amount that would be deductible for tax purposes with respect to
12.8 that liability in future periods.

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 FINANCIAL REPORTING

The tax base of such liabilities is calculated as the liability’s carrying amount as of the end of
the reporting period less any future deductible amounts plus any future taxable amounts
HKAS expected to arise from settling the liability’s carrying amount as of the end of the reporting
12.8 period. This calculation is reflected in the formula in Exhibit 19.3:

Carrying Future Future

Tax base
amount – deductible + taxable = of liability
of liability amounts amounts

EXHIBIT 19.3 Calculation of the tax base of a liability

other than revenue received in advance

HKAS
For revenue received in advance, its tax base is its carrying amount less any amount of the
12.8 revenue that will not be taxable in future periods.

HKAS
The tax base of revenue received in advance is calculated as the liability’s carrying amount
12.8 less any amount of the revenue that will not be taxable in future periods. This calculation is
reflected in the formula in Exhibit 19.4:

Carrying
Amount that has already been Tax base
amount – included in assessable profits = of liability
of liability

EXHIBIT 19.4 Calculation of the tax base of revenue

received in advance

Illustrative Example 3
Vroom Ltd (Vroom) is a retailer of children’s mini dirt bikes. It offers customers a
warranty at the time of sale for all dirt bikes, which obliges Vroom to cover the cost of
repairs of any manufacturing defects on dirt bikes returned by customers within the first
six months of purchase.

At financial year-end, being 31 March 20X2, Vroom recognises its obligation to repair
detected defects as a warranty provision at an estimated amount of HK$120,000. This
amount represents Vroom’s best estimate of the costs it may incur to repair defects on dirt
bikes currently under warranty.

For tax purposes the costs of repairing defects are non-deductible until they are
incurred, giving rise to future deductible amounts of HK$120,000. That is, when the
warranty claims are made by customers and the repairs occur in the following period.
Future taxable amounts are nil because the warranty costs are future outflows of
resources and not future taxable income to be generated by Vroom.

Carrying amount Future deductible Future taxable Tax base

amounts amounts
– + =
HK$120,000 HK$120,000 Nil Nil

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 Income T axes

Apply and Analyse 3

On 15 January 20X8, CaterOne receives HK$65,000 to cater for a Chinese New Year event
that will occur on 8 February 20X8. The remaining amount will be paid to CaterOne after
the event occurs. As of 31 January 20X8, CaterOne has not performed any performance
obligations under HKFRS 15 in relation to the event.

For tax purposes, revenue is taxable when it has been earned.

Calculate the tax base of the deposit as of 31 January 20X8.

Analysis

The receipt of HK$65,000 by CaterOne constitutes revenue received in advance. To calculate

the tax base of this liability, the following formula is applied:

Carrying amount Amount that has already been Tax base

of liability included in assessable profits of liability
– =
HK$65,000 Nil HK$65,000

Because the HK$65,000 is non-taxable until it has been earned by CaterOne, it has not
been included in assessable profits. Once the event is complete and has been catered,
CaterOne will have earned the HK$65,000 and will be included as income assessable for
tax purposes.

19.3.2 Temporary Differences

HKAS HKAS 12 defines a temporary difference as the difference between the carrying amount of an
12.5 asset or liability in the statement of financial position and its tax base. The temporary
difference between the carrying amount of an asset or liability and its tax base may result in:

• Increased future tax payments, constituting a taxable temporary difference; or

• Decreased future tax payments, constituting a deductible temporary difference.

Each type of temporary difference will now be considered.

19.3.2.1 Taxable Temporary Differences

Recall that a potential future tax consequence of the future recovery (settlement) of assets
(liabilities) currently held by an entity is an increase in the entity’s future assessable profits,
resulting in larger future tax payments. The increase in future assessable profits constitutes
a taxable temporary difference, and the tax payable on the increased assessable profits is
recognised as a deferred tax liability.

Under HKAS 12, taxable temporary differences are defined as temporary differences that
HKAS will result in taxable amounts in determining taxable profit (tax loss) of future periods when the
12.5 carrying amount of the asset or liability is recovered or settled.

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 FINANCIAL REPORTING

Upon comparing the carrying amount and tax base of the asset or liability, a taxable
temporary difference exists in the instances in Exhibt 19.5:

Item Circumstances Elaboration Example

Asset Carrying amount Income that is assessable for tax purposes will flow to See CaterOne
> Tax base an entity as it recovers the carrying amount of the asset. ‘Apply and
The tax base of an asset is the amount of future Analyse 4’.
HKAS deductions an entity can claim for tax purposes as it
12.7 recovers the carrying amount of the asset.
As the future assessable income (i.e. the carrying
amount) exceeds the future deductions (i.e. the tax
base), the recovery of the asset will generate a net
future taxable amount (i.e. future assessable income −
future deductions = future taxable amount).
This amount is a taxable temporary difference.
Liability Carrying amount The tax base of a liability is its carrying amount less any See ShanTon
HKAS < Tax base amount that will be deductible for tax purposes with Ltd ‘Illustrative
12.8 respect to that liability. Example 4’.
Where its tax base exceeds its carrying amount, a future
taxable amount will arise when the liability is settled.
This amount is a taxable temporary difference.

EXHIBIT 19.5 Identifying a taxable temporary difference

In addition, a taxable temporary difference may arise in relation to deferred withholding

taxes on cross-border dividend distributions between entities. To elaborate, withholding tax
payable by the recipient of cross-border dividend distributions may be deferred under certain
circumstances (e.g. the dividend is reinvested in the dividend-paying company). The deferral
of the withholding tax will result in larger future tax payments in the period when the deferral
expires, thereby creating a taxable temporary difference for the dividend recipient.

Illustrative Example 4
ShanTon Ltd (ShanTon) is a Hong Kong retail company that holds a loan payable in
Singapore dollars. The loan was entered into on 1 January 20X4 for an amount of
SGD$5 million. Based on the prevailing exchange rate on 1 January 20X4, ShanTon
initially recognised the loan payable at HK$7.84 million. Due to exchange rate
fluctuations, at financial year-end (being 31 March 20X4), the carrying amount of the
loan payable is HK$7.318 million) giving rise to an unrealised foreign exchange gain of
HK$522,000. Exchange gains are only taxable when realised. As such, the repayment
of the HK$7.318 million carrying amount of the loan will give rise to future taxable
amounts of HK$522,000. Interest on the loan is not deductible for tax purposes.

To calculate the amount, and nature, of the temporary difference it is first necessary to
determine the tax base of the loan payable. The tax base is as follows:

Carrying amount Future deductible Future taxable Tax base

amounts amounts
– + =
HK$7,318,000 Nil HK$522,000 HK$7,840,000

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 Income T axes

Illustrative Example 4 (continued)

The temporary difference is the difference between the carrying amount of the loan
payable and its tax base. That is, HK$522,000 (HK$7,840,000 − HK$7,318,000). Based on
Exhibit 19.5, given the tax base of the loan payable exceeds its carrying amount, a taxable
temporary difference exists that reflects the future amount taxable upon repayment
of the loan.

Apply and Analyse 4

Continuing with the facts presented in relation to CaterOne’s delivery van, determine
the amount and nature of the temporary difference as of 31 January 20X7 and 31
January 20X8.

Analysis

Temporary difference as of 31 January 20X7

The temporary difference is equal to HK$500,000, which is the difference between the
carrying amount (HK$832,500) of the delivery van and its tax base (HK$332,500). Based on
Exhibit 19.5, given the carrying amount of the delivery van exceeds its tax base, a taxable
temporary difference exists that reflects the future amounts taxable as CaterOne recovers
the carrying amount of the van.

Temporary difference as of 31 January 20X8

The temporary difference is equal to HK$440,750, being the difference between the
carrying amount (HK$740,000) of the delivery van and its tax base (HK$299,250). Once
again, based on Exhibit 19.5, this difference constitutes a taxable temporary difference.

HKAS Under HKAS 12, a deferred tax liability is the amount of income tax payable (i.e. profits tax
12.5 payable) with respect to a taxable temporary difference. An entity is to recognise a deferred tax
liability in its current period statement of financial position for all taxable temporary
differences, except to the extent that the deferred tax liability arises from the initial recognition
of goodwill or the transaction is not a business combination, affects neither accounting profit
HKAS nor assessable profits and does not give rise to equal taxable and deductible temporary
12.15 differences.

Goodwill impairment is a non-deductible expense under the Inland Revenue Ordinance. As

such, goodwill has a tax base of nil. Though any difference between the carrying amount of
goodwill and its tax base is a taxable temporary difference, HKAS 12 does not permit the
HKAS recognition of the resulting deferred tax liability because goodwill is measured as a residual
12.21 and the recognition of the deferred tax liability would increase the carrying amount of goodwill.

There are other circumstances that will lead to a deferred tax liability not being recognised
(see Section 19.3.2.3).

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 FINANCIAL REPORTING

Apply and Analyse 5

Continuing with the facts presented in relation to CaterOne’s delivery van, determine the
deferred tax position as of 31 January 20X7 and 31 January 20X8. Assume a profits tax rate
of 16.50% for all assessable profits.

Analysis

As previously discussed, the amount by which the carrying amount of the delivery van
exceeds its tax base is a taxable temporary difference and the obligation to pay the
resulting income taxes in future periods is a deferred tax liability. As CaterOne recovers the
carrying amount of the van through its use, the taxable temporary difference will reverse
and CaterOne will generate assessable profits. This makes it probable that economic
HKAS benefits will flow from CaterOne in the form of future tax payments, thereby requiring
12.16 CaterOne to recognise at current period-end a deferred tax liability.

Deferred tax liability as of 31 January 20X7

As the taxable temporary difference is equal to HK$500,000, the deferred tax liability
equals HK$82,500 (HK$500,000 × 16.50%).

Deferred tax liability as of 31 January 20X8

As the taxable temporary difference is equal to HK$440,750, the deferred tax liability
equals HK$72,724 (HK$440,750 × 16.50%).

Please refer to Chapters 24, 30, 32 and 33 for a discussion of the taxable temporary
differences associated with share-based payments, investments in subsidiaries, branches and
associates and interests in joint ventures, respectively.

19.3.2.2 Deductible Temporary Differences

Another potential future tax consequence of the future recovery (settlement) of assets
(liabilities) currently held by an entity is that the entity’s future assessable profits are lower than
what they would have otherwise been, resulting in smaller future tax payments. For example,
to the extent that the future settlement of a liability will be deductible to the entity, future tax
payments will be smaller than if settlement was non-deductible for tax purposes. The reduction
in future assessable profits constitutes a deductible temporary difference, and the future tax
savings may be recognised as a deferred tax asset.

Under HKAS 12, deductible temporary differences are defined as ‘temporary differences
HKAS that will result in amounts that are deductible in determining taxable profit (tax loss) of future
12.5 periods when the carrying amount of the asset or liability is recovered or settled’.

Upon comparing the carrying amount and tax base of the asset or liability, a deductible
temporary difference exists in the instances in Exhibit 19.6:

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Item Circumstances Elaboration Example

Asset Carrying amount Income that is assessable for tax purposes will flow See Traders
< Tax base to an entity as it recovers the carrying amount of Ltd ‘Illustrative
the asset. The asset’s tax base represents the future Example 5’.
HKAS deductions an entity can claim while recovering the
12.7 carrying amount of the asset.
Because the future assessable income (i.e. the
carrying amount) is less than future deductions
(i.e. the tax base), recovery of the asset will generate
a ‘net’ future deductible amount.
This amount is the deductible temporary difference.
Liability Carrying amount Where a liability’s carrying amount exceeds its tax See Vroom
> Tax base base, a future deductible amount will arise when ‘Apply and
the liability is settled. Analyse 6’.
This amount is the deductible temporary difference.

EXHIBIT 19.6 Identifying a deductible temporary difference

Illustrative Example 5
Traders Ltd (Traders) recognises gross trade receivables of HK$57,000 and an allowance
for credit losses of HK$11,000. The related revenue of HK$57,000 has been included in
the calculation of assessable profits. Credit losses are deductible for tax purposes when
the contractual cash flow becomes irrecoverable.

To calculate the amount and nature of the temporary difference, the tax base of the
trade receivables must first be determined. The tax base is as follows:

Carrying amount Future taxable Future deductible Tax base

amounts amounts
– + =
HK$46,000 Nil HK$11,000 HK$57,000

The carrying amount is net of the allowance for receivables because this reflects the
amount expected to be recovered in the future. Future taxable amounts are nil because
the revenue is taxable when earned, that is, it has been included in the calculation of
assessable profits. The future deductible amounts represent expected credit losses, which
will be deductible in future periods when the contractual cash flow becomes irrecoverable.

The temporary difference is the difference between the carrying amount of the trade
receivables and its tax base, that is, HK$11,000. Based on Exhibit 19.5 and given that the
tax base of the trade receivables exceeds its carrying amount, a deductible temporary
difference exists that reflects the future amount deductible upon recovery of the
receivables.

As previously explained, deductible temporary differences reflect future deductible

amounts to an entity, with deferred tax assets representing the tax savings derived from these
future deductible amounts. However, for an entity to benefit from these future tax savings,

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 FINANCIAL REPORTING

it must derive future assessable profits. That is, these future deductible amounts will reduce
future profits tax payable only if profits tax is payable in the future. For profits tax to be payable
in the future, the entity must derive assessable profits. Without future assessable profits, no
reduction in future profits tax payable will occur (as profits tax is not payable); therefore, no
benefit to be derived from the future deductible amounts.

Following this logic, HKAS 12 requires an entity to recognise a deferred tax asset for all
deductible temporary differences but only to the extent that taxable profits (i.e. assessable
HKAS profits) will probably be available against which the deductible temporary difference can be
12.24, 27 utilised. As such, a deductible temporary difference may not give rise to a deferred tax asset.

Apply and Analyse 6

Continuing with the facts presented in relation to Vroom’s warranty provision, determine
the deferred tax position as of 31 March 20X2. Assume a profits tax rate of 16.50% for
all assessable profits and that Vroom will probably generate sufficient future assessable
profits for the entire deductible temporary difference to be utilised.

Analysis

Inherent in the recognition of the warranty provision is that its carrying amount will be
settled in future periods through an outflow of resources embodying economic benefits
from Vroom. When resources flow from Vroom, the amount will be deductible in
determining assessable profits of a period later than the period in which the warranty
provision is recognised, that is, 20X2. As such, a deductible temporary difference exists.
Accordingly, a deferred tax asset arises with respect to the profits tax that will be
recoverable (i.e. saved) in the future periods when the warranty costs are allowed as a
HKAS deduction in determining assessable profits, that is, when the warranty claims are made by
12.25 customers and the costs of repairing the defects are incurred.

As the deductible temporary difference is equal to HK$120,000, the deferred tax asset
equals HK$19,800 (HK$120,000 × 16.50%).

In assessing whether sufficient assessable profits will probably be available against which
a deductible temporary difference can be utilised, an entity is to first determine whether
sufficient taxable temporary differences exist, whose reversal will generate future taxable
amounts against which the future deductible amount (as reflected in the deductible temporary
difference) can be offset against.

These taxable temporary differences must:

• Relate to the same taxation authority and the same taxable entity to which the
deductible temporary difference relates; and

HKAS • Be expected to reverse in the same period as the expected reversal of the deductible
12.28(a) temporary difference.

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If insufficient taxable temporary differences exist, an entity may still recognise a deferred
tax asset but only to the extent that:

• There will probably be sufficient assessable profits (relating to the same taxation
authority and taxable entity) from sources other than taxable temporary differences
in the same period as the reversal of the deductible temporary difference. When
evaluating whether such assessable profits will be sufficient, an entity:

°° Compares deductible temporary differences with such future assessable profits

after excluding (i.e. adding back to future assessable profits) tax deductions
resulting from the reversal of those deductible temporary differences; and

°° Ignores (i.e. subtracts from future assessable profits) taxable amounts arising
from deductible temporary differences that are expected to originate in future
periods; or

HKAS • Tax planning opportunities exist that will enable the entity to create assessable profits
12.29 in appropriate periods.

Illustrative Example 6
For the financial year-end 31 March 20X4, the records of Quan Ltd (Quan) show the
following:

• The carrying amount of a warranty provision is HK$100,000. The tax base of

the warranty provision is nil because warranty costs are deductible when the
warranty claims are made by customers (see Vroom ‘Illustrative Example 3’ in
Section 19.3.1.2 for explanation). The warranty provision relates to a two-year
warranty offered by Quan, and customers are expected to make warranty claims
evenly over the two-year period; and

• The carrying amount of capitalised development costs is HK$125,000. The tax base
of such development costs is nil because they have been deducted from assessable
profits. For accounting purposes, the carrying amount of the development costs
will be amortised over the remaining two years of its useful life.

In relation to the warranty provision, a deductible temporary difference of HK$100,000

exists, which is the difference between the carrying amount (HK$100,000) and tax base
(nil). For a deferred tax asset to be recognised, it must be probable that assessable profits
will be available against which the deductible temporary difference can be utilised.

In making this assessment, the taxable and deductible temporary differences are
assumed to relate to the same taxation authority and the same taxation entity. Quan must
consider whether taxable temporary differences exist that, upon reversing, will generate
sufficient future assessable profits to enable Quan to utilise the deductible temporary
difference fully. In this case, a taxable temporary difference of HK$125,000 exists, which
is the difference between the carrying amount of the capitalised development costs
(HK$125,000) and its tax base (nil). This amount exceeds the amount of the deductible
temporary difference (HK$100,000). In addition, the taxable temporary difference relating
to the capitalised development costs is expected to reverse over the same period of time
as the reversal of the deductible temporary difference (i.e. two years).

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Illustrative Example 6 (continued)

A summary of the timing of the reversal of the deductible and temporary difference is
provided as follows:

20X4 20X5 20X6

Deductible temporary Future deductible Future deductible

difference amounts upon reversal amounts upon reversal

HK$100,000 HK$50,000 HK$50,000

20X4 20X5 20X6

Taxable temporary Future taxable Future taxable

difference amounts upon reversal amounts upon reversal

HK$125,000 HK$62,500 HK$62,500

As the summary indicates, the expected reversals of the taxable temporary difference
in 20X5 and 20X6 (HK$62,500, respectively) exceed the expected reversal of the deductible
temporary difference in each of these years (HK$50,000, respectively). As such, sufficient
assessable profits from the reversal of the taxable temporary difference will exist to enable
Quan to utilise the future deductions available fully upon the reversal of the deductible
temporary difference. Quan should, therefore, recognise a deferred tax asset for the
full deductible temporary difference as of 31 March 20X4. Assuming a profits tax rate of
16.50%, the deferred tax asset equals HK$16,500.

Apply and Analyse 7

For the financial year-end 31 March 20X7, the records of Pocus Ltd (Pocus) show the
following:

• Gross trade receivables are HK$210,000, with an allowance for credit losses
of HK$35,000. The HK$210,000 revenue has been included in the calculation
of assessable profits. Credit losses are deductible for tax purposes when the
contractual cash flow becomes irrecoverable. Given that Pocus offers credit terms
of 60 days, any contractual cash flows from the HK$210,000 sales that become
irrecoverable will occur next period;

• The carrying amount of a six-month loan payable denominated in SGD$ is

HK$86,000, following an unrealised foreign exchange gain of HK$14,000. Exchange
gains are only taxable when realised. Interest on the loan is non-deductible for
tax purposes;

• Assessable profits for the year ended 31 March 20X8 from sources other than
taxable temporary differences are expected to be nil; and

• Assume a profits tax rate of 16.5% on all assessable profits and that Pocus is
assessed for profits tax by only one taxation authority (i.e. Hong Kong profits tax,
as assessed by the Inland Revenue Department).

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Apply and Analyse 7 (continued)

Required

Determine whether Pocus can recognise a deferred tax asset as of 31 March 20X7. If Pocus
can recognise a deferred tax asset calculate the amount Pocus can recognise as a deferred
tax asset as of 31 March 20X7.

Analysis

In relation to the trade receivables, a deductible temporary difference of HK$35,000

exists, which is the difference between its carrying amount of HK$175,000 (HK$210,000 −
HK$35,000) and tax base of HK$210,000. The deductible temporary difference is expected
to reverse next period given the credit terms on outstanding receivables is 60 days.

In relation to the loan payable, a taxable temporary difference of HK$14,000 exists,

being the difference between the carrying amount (HK$86,000) and tax base (HK$100,000)
of the loan payable. The taxable temporary difference is expected to reverse next period,
as the loan is for six months.

For a deferred tax asset to be recognised, assessable profits will probably be available
against which the deductible temporary difference can be utilised.
Pocus first considers whether taxable temporary differences exist that, upon reversing,
will generate sufficient future assessable profits to enable to utilise all of the deductible
temporary difference. In this case, the amount of assessable profit arising from the
reversal of the taxable temporary difference (HK$14,000) in 20X8 is insufficient to absorb
all of the deductible amounts arising from the reversal of the deductible temporary
difference in 20X8 (HK$35,000). Moreover, there is insufficient assessable profits from
other sources to utilise the deductible temporary difference more (i.e. assessable profits
from sources other than taxable temporary differences is expected to be nil in 20X8).

As such, the amount of deferred tax asset that can be recognised by Pocus as of
31 March 20X7 is HK$2,310 (HK$14,000 × 16.50%). This results in HK$21,000 of the
deductible temporary difference being unrecognised as of 31 March 20X7.

In addition to the previous restrictions on the recognition of deferred tax assets,

other circumstances in which a deferred tax asset will not be recognised are discussed in
Section 19.3.2.3.

Please refer to Chapters 24, 30, 32 and 33 for a discussion of the deductible temporary
differences associated with share-based payments, investments in subsidiaries, branches and
associates and interests in joint ventures, respectively.

19.3.2.3 Initial Recognition of an Asset or Liability

Any difference between the carrying amount of an asset or liability in the statement of financial
position and its tax base, which gives rise to a temporary difference, may arise after an entity
first recognised the asset or liability. An example of this would be the purchase of an item of
machinery. At the time of initially recognising the machinery, its carrying amount and tax base
are generally equal to its cost price. The temporary difference subsequently arises due to
differences between the depreciation rate for accounting purposes and the capital allowance
rate for tax purposes.

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However, a temporary difference may arise on the initial recognition of an asset or

liability. How an entity accounts for such a temporary difference depends on the nature of the
transaction that led to the initial recognition of the asset or liability. To illustrate:
• An entity recognises a deferred tax liability or asset when the identifiable assets
acquired and liabilities assumed in a business combination are recognised for
accounting purposes at an amount different to their tax bases (e.g. the identifiable
assets acquired and liabilities assumed are recognised at their fair values at acquisition
date but their tax bases remain at cost to the previous owner). The resulting deferred
tax liability or asset is recognised as an identifiable liability or asset, respectively, at
HKAS 12.19, acquisition date, consequently affecting the amount of goodwill or the bargain
22(a), 66 purchase gain it recognises (see Chapter 29);
• If the transaction affects either accounting profit or assessable profits, an entity will
recognise any deferred tax liability or asset and will recognise the resulting deferred tax
expense or income in profit or loss (e.g. costs of intangible assets, such as development
costs, have been capitalised and are being amortised in profit or loss, but were
HKAS deducted for tax purposes when they were incurred (see Illustrative Example 6 in
12.22(b), 59 Section 19.3.2.2 relating to Quan); and
• If the transaction:

°° is not a business combination;

°° affects neither accounting profit nor assessable profits; and

°° does not give rise to equal taxable and deductible temporary differences (see
Illustrative Example 8)
• an entity will not be permitted to recognise a deferred tax liability or asset on any
temporary difference that may arise on the initial recognition of an asset or liability. If
an entity was permitted to recognise the deferred tax consequences of this immediate
temporary difference, it would adjust the carrying amount of the asset or liability by the
deferred tax amount. Such adjustments would render the entity’s financial statements
HKAS 12.15, less transparent. As such, HKAS 12 does not allow an entity to recognise the resulting
22(c), 24 deferred tax liability or asset either on initial recognition or subsequently.

Illustrative Example 7
Jasper Ltd (Jasper) acquires an asset at a cost of HK$9,000. Jasper intends to use the
asset throughout its useful life of three years and then dispose of it for a residual value
of nil. The acquisition cost is not immediately deductible for tax purposes. Jasper is also
not entitled to a capital allowance deduction or to a depreciation deduction in relation to
the asset. On disposal, any capital gain (capital loss) would not be taxable (deductible).

At the time of acquisition, a taxable temporary difference exists equal to the difference
between the asset’s carrying amount (HK$9,000) and its tax base (Nil). The asset’s tax base
is calculated as follows:

Carrying amount Future taxable Future deductible Tax base

amounts amounts
– + =
HK$9,000 HK$9,000 Nil Nil

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Illustrative Example 7 (continued)

Because (i) the asset acquisition is not part of a business combination, (ii) the
acquisition itself affects neither accounting profit nor assessable profits and (iii) it does not
give rise to equal taxable and deductible temporary differences, Jasper is not entitled to
recognise a deferred tax liability in relation to the initial recognition of the asset.

From the journal entry upon acquisition of the asset, the transaction does not evidently
affect accounting profit (as the entry relates to statement of financial position items only):

Debit Credit
HK$ HK$
Asset 9,000
Cash/Payables 9,000

Based on Exhibit 19.1, the transaction also does not affect assessable profits as no
adjustment would be made to accounting profit for that transaction to derive assessable profits.

Because the asset acquisition is not part of a business combination and the acquisition
itself affects neither accounting profit nor assessable profits, Jasper is not entitled to
recognise a deferred tax liability in relation to the initial recognition of the asset.

In addition, Jasper is not entitled to recognise a deferred tax liability at any stage over
the asset’s useful life.

A transaction that is not a business combination may lead to the initial recognition of an
asset and a liability and, at the time of the transaction, affect neither accounting profit nor
taxable profit. For example, at the commencement date of a lease, a lessee typically recognises
HKAS a lease liability and the corresponding amount as part of the cost of a right-of-use asset.
12.22A Illustrative Example 8 demonstrates how to deal with this situation.

Illustrative Example 8

Lease

An entity (Lessee) enters into a five-year lease of a building. The annual lease payments
are HK$1,000 payable at the end of each year. The interest rate implicit in the lease
cannot be readily determined. Lessee’s incremental borrowing rate is 5% per annum.
At the commencement date, applying HKFRS 16 Leases, Lessee recognises a lease liability
of HK$4,350 (measured at the present value of the five lease payments of HK$1,000,
discounted at the interest rate of 5% per year). Lessee measures the right-of-use asset
(lease asset) at HK$4,350 (the initial measurement of the lease liability).

Tax law

The tax law allows tax deductions for lease payments when an entity makes those
payments. Economic benefits that will flow to Lessee when it recovers the carrying amount
of the lease asset will be taxable. A tax rate of 20% is expected to apply to the period(s) when
Lessee will recover the carrying amount of the lease asset and will settle the lease liability.

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Illustrative Example 8 (continued)

After considering the applicable tax law, Lessee concludes that the tax deductions it
will receive for lease payments relate to the repayment of the lease liability.

Deferred tax on the lease liability and lease asset

At the commencement date, the tax base of the lease liability is nil because Lessee will
receive tax deductions equal to the carrying amount of the lease liability (HK$4,350). The
tax base of the lease asset is also nil because Lessee will receive no tax deductions from
recovering the carrying amount of the lease asset (HK$4,350). The differences between
the carrying amounts of the lease liability and the lease asset and their tax bases of nil
result in the following temporary differences at the commencement date:

(a) a taxable temporary difference of HK$4,350 associated with the lease asset; and

(b) a deductible temporary difference of HK$4,350 associated with the lease liability.

The initial recognition exemption from recognising a deferred tax asset and liability in
HKAS 12 does not apply because the transaction gives rise to equal taxable and deductible
temporary differences. Lessee concludes that it is probable that taxable profit will be
available against which the deductible temporary difference can be utilised. Accordingly,
Lessee recognises a deferred tax asset and a deferred tax liability, each of HK$870
(HK$4,350 × 20%), for the deductible and taxable temporary differences.

Under HKAS 32 Financial Instruments: Presentation, the issuer of a compound financial

instrument classifies the liability component as a liability and the equity component as equity.
In some tax jurisdictions, however, the tax base of the liability component on initial recognition
is equal to the initial carrying amount of the sum of the liability and equity components. As
such, the tax base of the liability component exceeds its carrying amount, giving rise to a
taxable temporary difference upon the initial recognition of the compound financial
instrument. Under HKAS 12 an entity must recognise the resulting deferred tax liability, with
HKAS the deferred tax charged directly to the equity component (see Section 19.4.2 for discussion of
12.23 how to recognise the deferred tax impact outside profit or loss).

19.3.2.4 Unused Tax Losses and Unused Tax Credits

A Hong Kong entity that incurs an adjusted loss in a tax year may carry that loss forward and
offset it against future assessable profits, thereby reducing future profits tax payable. Similarly,
a Hong Kong entity may be entitled to a tax credit (e.g. foreign tax credit) that can be deducted
from future profits tax payable. In either instance, an entity is to recognise a deferred tax asset
for the carryforward of unused tax losses and unused tax credits but only to the extent that
HKAS future assessable profits will probably be available against which the unused tax losses and
12.34 unused tax credits can be utilised.

The reasoning for this is the same as that of deductible temporary differences: no future
economic benefits will be derived by the entity in carrying forward unused tax losses or unused
tax credits unless future profits tax are payable by the entity. For profits tax to be payable, the
entity needs to derive assessable profits.

Though the basis on which deferred tax assets arising from unused tax losses and unused tax
credits are recognised is identical for deferred tax assets arising deductible temporary differences

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HKAS (i.e. future assessable profits will probably be available), HKAS 12 states the existence of unused
12.35 tax losses is strong evidence that future assessable profits may not be available.

If an entity has a history of recent tax losses, the entity will satisfy the probability criterion
only to the extent that:

• It has sufficient taxable temporary differences to utilise (in part or full) the unused tax
losses or unused tax credits; or

• There is other convincing evidence that sufficient assessable profits will be available
HKAS against which the unused tax losses or unused tax credits can be utilised (in part
12.35 or full) .

When assessing the probability that assessable profits will be available against which the
unused tax losses or unused tax credits can be utilised, HKAS 12 requires an entity to consider
the following criteria:

• Whether the entity has sufficient taxable temporary differences relating to the same
taxation authority and the same taxable entity, which will result in taxable amounts against
which the unused tax losses or unused tax credits can be utilised before they expire;

• Whether the entity will probably have assessable profits before the unused tax losses
or unused tax credits expire;
• Whether the unused tax losses result from identifiable causes, which are unlikely to
recur; and

• Whether tax planning opportunities (see paragraph 30 of HKAS 12) are available to the
HKAS entity that will create assessable profits in the period in which unused tax losses or
12.36 unused tax credits can be utilised.

HKAS To the extent that assessable profits will probably be unavailable against which the unused
12.36 tax losses or unused tax credits can be utilised, the deferred tax asset is not recognised.

Illustrative Example 9
The following information relates to Ipe Ltd (Ipe):

• As of 31 March 20X1, net trade receivables is HK$308,000, following an allowance

for credit losses of HK$40,000. The related revenue of HK$348,000 has already
been included in the calculation of assessable profits. Credit losses are deductible
for tax purposes when the contractual cash flow becomes irrecoverable. It is
expected all revenue related to the receivables will either be collected or become
irrecoverable in the next period;

• On 31 March 20X1, Ipe spent HK$50,000 on solar water heating installations for
its head office. For tax purposes, Ipe is entitled to a 100% immediate deduction
for the cost of the installations. For accounting purposes, Ipe will depreciate the
installations on a straight-line basis over a two-year period;

• Ipe does not have a history of adjusted losses;

• Adjusted losses can be carried forward indefinitely;

• There are no other transactions or events with tax consequences; and

• The profits tax rate is 16.50% on all assessable profits.

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Illustrative Example 9 (continued)

As of 31 March 20X1:

• A deductible temporary difference of HK$40,000 exists in relation to the

receivables, being the difference between the carrying amount (HK$308,000) and
tax base (HK$348,000) of receivables. This temporary difference is expected to
reverse in full next period, as that is when all debts will be settled; and

• A taxable temporary difference of HK$50,000 exists in relation to the installations,

being the difference between the carrying amount (HK$50,000) and tax base (Nil) of
the installations. This temporary difference is expected to reverse evenly over the
next two periods as the installations are depreciated.

As evident from earlier discussions in Section 19.3.2.2, as of 31 March 20X1, Ipe

recognises a deferred tax asset in relation to the receivables to the extent that assessable
profits will probably be available against which the deductible temporary difference can
be utilised. In making this assessment, Ipe first considers taxable temporary differences
that are expected to reverse in the same period as the expected reversal of the deductible
temporary difference.

In this case, though the entire HK$40,000 deductible temporary difference is expected to
reverse in 20X2, only HK$25,000 of the taxable temporary difference is expected to reverse in
20X2. Moreover, there are no assessable profits from sources other than taxable temporary
differences in 20X2. Based on this, as of 31 March 20X1, Ipe recognises a deferred tax asset in
relation to the deductible temporary difference equal to HK$4,125 (HK$25,000 × 16.50%).

The following is a summary of the reversal of the temporary differences present as of

31 March 20X1 and the resultant assessable profits of Ipe in each year of reversal:

31 March 20X2 31 March 20X3

HK$ HK$
Taxable temporary difference reversal 25,000 25,000
Deductible temporary difference reversal (40,000) –
Assessable profits (Adjusted losses) (15,000) 25,000

For the period ending 31 March 20X2, Ipe incurs an adjusted loss of HK$15,000. The
Inland Revenue Ordinance enables Ipe to carry forward adjusted losses indefinitely to
offset against future assessable profits. As of 31 March 20X2, to recognise a deferred tax
asset on Ipe’s entitlement to carry forward the adjusted loss, sufficient assessable profits
must probably be available against which the adjusted loss can be offset.
As evident from the above summary, sufficient assessable profits exist given that the
reversal of the taxable temporary difference in 20X3 (HK$25,000) generates future taxable
amounts fully absorbing the unused tax loss (HK$15,000). As such, as of 31 March 20X2,
Ipe recognises a deferred tax asset in relation to the adjusted loss equal to HK$2,475
(HK$15,000 × 16.50%).

As a side note, in 20X3, Ipe will offset the unused tax loss (HK$15,000) against
assessable profits (HK$25,000) giving rise to ‘assessable profits after adjusting for the
carryforward of unused tax losses’ equalling HK$10,000 (HK$25,000 − HK$10,000). This is
the amount for which profits tax will be payable in 20X3 giving rise to a current tax liability
in 20X3 equal to HK$1,650 (HK$10,000 × 16.50%).

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19.3.2.5 Reassessment of Unrecognised Deferred Tax Assets

At the end of each reporting period, an entity reassesses unrecognised deferred tax assets and
HKAS will recognise a previously unrecognised deferred tax asset to the extent that it has now
12.37 become probable that future taxable profit will allow the deferred tax asset to be recovered.

19.3.3 Measurement of Deferred Taxes

In measuring deferred tax assets and liabilities, the tax rate to use is dependent on when and
how the entity expects to recover or settle the carrying amount of its assets and liabilities.

19.3.3.1 When the Asset Is Realised or the Liability Is Settled

Under HKAS 12, deferred tax assets and liabilities are to be measured at the tax rates expected
to apply to the period when the asset is realised or the liability is settled based on tax rates
HKAS (or tax laws) that have been enacted or substantively enacted by the end of the current reporting
12.47 period. For example, if a change to the profits tax rate was enacted in the Inland Revenue
Ordinance and is effective in a future reporting period that corresponds with when a recognised
asset is realised or a recognised liability is settled, an entity will measure the deferred tax asset
and liability on any deductible or taxable temporary difference associated with the asset or
liability using the profit tax rate applicable in the future and not the current profits tax rate.

As is the case under Hong Kong’s two-tiered profits tax rate, when different tax rates apply
to different levels of assessable profits, deferred tax assets and liabilities are measured using
HKAS the average rates expected to apply to the assessable profit of the periods in which the
12.49 temporary differences are expected to reverse.

Illustrative Example 10
On 31 March 20X1, Sonic Ltd (Sonic) has taxable temporary differences of HK$1.2 million
expected to reverse evenly over the next three years (i.e. HK$400,000/year). Under
the Inland Revenue Ordinance, Sonic is subject to a profits tax rate of 8.25% on the
first HK$2 million profits earned and a profits tax rate of 16.50% on remaining profits
earned. Sonic expects to generate assessable profits of approximately HK$3 million,
HK$3.5 million, and HK$4 million in 20X2, 20X3 and 20X4, respectively.

The following table demonstrates how Sonic will measure the deferred tax
consequences of its temporary difference:

20X1 20X2 20X3 20X4

HK$ HK$ HK$
Profits before tax 3,000,000 3,500,000 4,000,000
Reversal of temporary differences 400,000 400,000 400,000
Taxable profits 3,400,000 3,900,000 4,400,000
Profits tax
HK$2 million @ 8.25% 165,000 165,000 165,000
Remainder @ 16.50% 231,000 313,500 396,000
396,000 478,500 561,000
Average tax rate 11.65% 12.27% 12.75%
Deferred tax balance (31/3/X1) 146,680 46,600 49,080 51,000

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Illustrative Example 10 (continued)

By way of explanation, Sonic estimates taxable profits of HK$3.4 million, HK$3.9 million
and HK$4.4 million in 20X2, 20X3 and 20X4, respectively, with these periods corresponding
with the three-year period during which Sonic’s taxable temporary difference is expected
to reverse. Based on these estimates and with the two-tiered profits tax rate, Sonic
calculates profits tax payable of HK$396,000, HK$478,500 and HK$561,000 in 20X2, 20X3
and 20X4, respectively. The average tax rate is measured each year based on profits tax
payable as a proportion of estimated taxable profits. To illustrate, in 20X2, the average
tax rate is 11.65% ((HK$396,000/HK$3,400,000) × 100%). This average tax rate is then
applied to the amount of the taxable temporary difference expected to reverse that
year. For example, the deferred tax consequences of the HK$400,000 taxable temporary
difference reversal in 20X2 is HK$46,600 (HK$400,000 × 11.65%). The sum of the deferred
tax consequences of the reversal of the taxable temporary difference in 20X2, 20X3 and
20X4 is the amount of the deferred tax liability to be recognised as of 31 March 20X1
(i.e. HK$46,600 + HK$49,080 + HK$51,000 = HK$146,680).
Source: https://www.hkicpa.org.hk/en/Tools/FAQ/Standards/HKFRS/HKAS-12-Income-Taxes.

19.3.3.2 The Manner in which the Asset Will Be Realised or the Liability Will Be Settled
The measurement of deferred tax assets and liabilities reflects the tax consequences that
would follow from the manner in which the entity expects to recover or settle the carrying
HKAS amount of its assets and liabilities. Such expectations are those formed at the end of the
12.51 current reporting period.

The manner in which an entity recovers (settles) the carrying amount of an asset (liability)
HKAS may affect the tax rate applicable when the entity recovers (settles) the carrying amount of the
12.51A(a)
asset (liability). In such cases, the entity measures deferred tax liabilities and deferred tax
HKAS assets using the tax rate consistent with the expected manner of recovery or settlement.
12.51A
For example, an entity may recover the carrying amount of an asset through use:
• The economic benefits the asset generates would be assessable income for tax
purposes and, in Hong Kong, subject to profits tax. As such, the tax rate that applies
to any deductible/taxable temporary difference on the asset to calculate deferred
tax asset/liability will be the profits tax rate expected to apply while the asset is
being used.

An entity may also recover the carrying amount of an asset by sale:

• The economic benefits the asset generates would not be assessable for tax purposes
because Hong Kong does not tax gains that are capital in nature, that is, capital gains
tax does not exist. As such, the tax rate applied to any deductible/taxable temporary
difference on the asset will be nil, resulting in no deferred tax asset/liability being
recognised.

If a deferred tax liability or deferred tax asset arises from an investment property measured
using the fair value model per HKAS 40 Investment Property, the carrying amount of the
investment property will be presumably recovered through sale. As such, the measurement of
the deferred tax liability or deferred tax asset will reflect the tax consequences of recovering

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the carrying amount of the investment property entirely through sale. This presumption is
rebutted if the investment property is depreciable and is held within a business model whose
HKAS objective is to consume all of the economic benefits of the investment property over time
12.51C rather than through sale.

HKAS If the presumption is rebutted, the requirements for recognition discussed in the preceding
12.51C first bullet point ‘through use’ are to be applied.

Illustrative Example 11
Future Holdings Ltd (Future) owns an investment property that cost HK$20 million. The
property is measured using the fair value model per HKAS 40 and has a current fair value
of HK$30 million. The property comprises land with a cost of HK$8 million, a fair value of
HK$12 million, a building with a cost of HK$12 million and a fair value of HK$18 million.
The land has an unlimited useful life and, as such, is not depreciable.

Cumulative capital allowance deductions of the building total HK$6 million. Unrealised
changes in the fair value of the investment property do not affect assessable profits. If
the investment property is sold for more than cost, the reversal of the cumulative capital
allowance deductions of HK$6 million will be included in assessable profits and taxed at
16.50%. For sale proceeds in excess of cost, capital gains tax law specifies a zero tax rate
(i.e. capital gains are exempt from tax).

Because the investment property is measured using the fair value model under
HKAS 40, a rebuttable presumption exists that Future will recover the carrying amount of
the investment property entirely through sale. Because the business model of Future will
consume substantially all of the economic benefits embodied in the investment property
through sale, the presumption will not be rebutted.

If the land is sold, its tax base will be HK$8 million, which is its cost, and there is a
taxable temporary difference of HK$4 million, which is the difference between its carrying
amount (i.e. fair value) and tax base (HK$12 million − HK$8 million). The tax base of the
building if it sold is HK$6 million, which is its cost less accumulated capital allowance
deductions (HK$12 million − HK$6 million), and there is a taxable temporary difference of
HK$12 million, which is the difference between its carrying amount (i.e. fair value) and tax
base (HK$18 million − HK$6 million).

The deferred tax liability is calculated as follows:

Taxable temporary Tax rate Deferred tax

difference liability
HK$ HK$
Cumulative capital 6,000,000 16.50% 990,000
allowance deduction
Proceeds in excess of cost 10,000,000 Nil –
Total 16,000,000 990,000

Source: HKAS 12.51C, Example.

HKAS
12.53, 54 HKAS 12 does not permit the discounting of deferred tax assets and liabilities.

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Key Learning Point

It is essential to determine whether the future recovery (settlement) of a currently held
asset (liability) will have future tax consequences by comparing the carrying amount
and tax base of the asset (liability). To the extent the comparison identifies a deductible
temporary difference or if unused tax losses or unused tax credits exist, forecasting the
amount and timing of future assessable profits will be necessary to establish whether a
deferred tax asset can be recognised.

Knowledge Check Questions

Question 2
Calculate the tax base of each of the following assets:
A Trade receivables have a carrying amount of HK$32,500 and are expected to be
recovered through payments from debtors. There are no expected credit losses. The
related revenue of HK$32,500 has been included in the calculation of assessable profits.
B An item of inventory was purchased during the year for HK$7,500. The cost of the
inventory for accounting and tax purposes is HK$7,500. The cost of the inventory
was included in the determination of assessable profits when purchased. At financial
year-end, the inventory is yet to be sold.
C Interest receivable has a carrying amount of HK$5,000. The related interest revenue is
tax exempt.

Question 3
Calculate the tax base of each of the following liabilities:
A Accrued wages has a carrying amount of HK$8,000. The related expense has been
deducted for tax purposes on an accrual basis.
B Loan payable has a carrying amount of HK$1.5 million. The repayment of the loan has
no tax consequences because principal and interest repayments are non-deductible for
tax purposes.
C Current liabilities include accrued fines and penalties with a carrying amount of
HK$50,000. Fines and penalties are non-deductible for tax purposes.

Question 4
GramTron Ltd (GramTron) purchased an item of machinery that would reduce its
greenhouse gas emissions from its production process by 20%. The cost of the machinery
was HK$250,000. Due to a recent government initiative, GramTron received a non-taxable
government grant of HK$50,000 to subsidise the purchase. For accounting purposes,
GramTron offsets the government grant against the cost of the machinery in calculating its
carrying amount. This is not permitted for tax purposes.
Determine the deferred tax consequences of the purchase of the item of machinery.
Assume a profits tax rate of 16.50%.

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Question 5
On 1 April 20X1, Transide Ltd (Transide) constructed a building to use as a warehouse
at a cost of HK$650,000. For accounting purposes, the building is depreciated on a
straight-line basis over 10 years. For tax purposes, Transide is entitled to an annual
capital allowance deduction of 4%. For the year ended 31 March 20X3, as a result of an
economic recession, Transide has undertaken an impairment review of all assets and
determined that the recoverable amount of the building was HK$375,000. The economic
recession has also contributed to a downturn in Transide’s operations and, consequently,
a drop in assessable profits. For the year ended 31 March 20X4, Transide estimates it will
generate assessable profits of HK$120,000 (after excluding tax deductions resulting from
the reversal of the deductible temporary difference in 20X4) but is expected to generate
adjusted losses for the foreseeable future thereafter.
What amount of deferred tax is recognised with respect to the building as of
31 March 20X3? Assume a profits tax rate of 16.50% and that no other temporary
differences exist.

Question 6
Remote Ltd (Remote) has the following deferred tax balances for the reporting period
ended 31 March 20X2:

Deferred tax asset HK$22,100

Deferred tax liability HK$39,800

On 15 April 20X2, the Inland Revenue Ordinance was amended to reduce the
profits tax rate from 16.50% to 12%, effective immediately. The previous rate and the
new rates apply to total assessable profits earned by Hong Kong entities during the
respective periods.
Prepare the journal entry on 15 April 20X2 for Remote to account for the change
in the profits tax rate. Assume the deferred tax balances relate to items recognised in
profit or loss.

1 9 . 4 RECOGNITION OF CURRENT
AND DEFERRED TAXES

HKAS HKAS 12 requires an entity to account for the current and deferred tax effects of a transaction
12.57 or event in a manner consistent with the accounting for the transaction or event. In particular,
the current and deferred tax effects of a transaction or event will be recognised in, or outside,
profit or loss depending on whether the transaction or event was recognised in, or outside,
profit or loss. The following section discusses this principle in greater detail.

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19.4.1 Items Recognised in Profit or Loss

An entity is to recognise current and deferred tax as income or an expense and is to be
included in profit or loss for the period except to the extent that the tax arises from:

• A transaction or event that is recognised, in the same or a different period, outside

profit or loss, either in other comprehensive income or directly in equity; or

• A business combination (other than the acquisition by an investment entity, as defined

HKAS in HKFRS 10 Consolidated Financial Statements, of a subsidiary that is required to be
12.58 measured at fair value through profit or loss) (see Chapter 29).

Most deferred tax liabilities and assets arise where income or an expense is included in
HKAS accounting profit in one period but is included in assessable profits (adjusted loss) in a different
12.59 period. The resulting deferred tax expense or deferred tax income is recognised in profit or loss.

Illustrative Example 12
Recall that, in relation to its delivery van, CaterOne will recognise a deferred tax liability of:

• HK$82,500 as of 31 January 20X7; and

• HK$72,724 as of 31 January 20X8.

The deferred tax liability has arisen due to differences in the timing of when the cost of
the delivery van is depreciated for accounting purposes and deductible for tax purposes.
As such, the resulting deferred tax is to be recognised in profit or loss.

The journal entry to recognise the deferred tax consequences of the delivery van as of
31 January 20X7 would be as follows:

Debit Credit
HK$ HK$
Income tax expense (deferred tax) 82,500
Deferred tax liability 82,500

The income tax expense (deferred tax) (i.e. deferred tax expense) would be recognised
in profit or loss.

The journal entry to recognise the deferred tax consequences of the delivery van as of
31 January 20X8 would be as follows:

Debit Credit
HK$ HK$
Deferred tax liability 9,776
Income tax expense (deferred tax) 9,776

The reduction in income tax expense (deferred tax) (i.e. deferred tax income) would
be recognised in profit or loss. The above journal entry reduces the deferred tax liability
balance to the amount to be recognised as of 31 January 20X8. That is, after this entry the
deferred tax liability balance is HK$72,724 (HK$82,500 − HK$9,776), which corresponds
with the amount that should be recognised as a deferred tax liability in light of the taxable
temporary difference that exists as of 31 January 20X8.

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As noted earlier, dividend income is non-taxable in Hong Kong, and it does not give rise to
future deductible amounts. However, in other jurisdictions, dividend income may give rise to
income tax consequences. In such circumstances, HKAS 12 requires that income tax
consequences are recognised when a liability to pay a dividend arises. This is because the
income tax consequences of dividends are linked more directly to past transactions or events
that generated distributable profits than to distributions to owners. Therefore, HKAS 12
requires the recognition of the income tax consequences of dividends in profit or loss, other
HKAS comprehensive income or equity according to where the entity originally recognised those past
12.57A transactions or events. (See Section 19.4.2 for discussion of items to be recognised in other
comprehensive income.)

19.4.2 Items Recognised Outside Profit or Loss

Rather than being recognised in profit or loss, HKFRSs require or permit particular items to be
recognised in other comprehensive income including, for example:

• A change in carrying amount arising from the revaluation of property, plant and
equipment (see Chapter 7); and

HKAS • Exchange differences arising on the translation of the financial statements of a foreign
12.62 operation (see Chapter 31).
Under HKAS 12, for items that are recognised, in the same or a different period, in other
HKAS comprehensive income, any current tax or deferred tax that relates to these items should be
12.61A recognised in other comprehensive income.

HKFRSs also require or permit particular items to be credited or charged directly to equity
including, for example:

• An adjustment to the opening balance of retained earnings resulting from either a

change in accounting policy that is applied retrospectively or the correction of an error
(see Chapter 16); and

HKAS • Amounts arising on initial recognition of the equity component of a compound financial
12.62A instrument (see Chapter 12).

Under HKAS 12, for items that are recognised, in the same or a different period, directly in
HKAS equity, any current tax or deferred tax that relates to these items is to be also recognised
12.61A directly in equity.

Illustrative Example 13
Continuing with the facts presented in relation to CaterOne’s delivery van, on 1 February
20X8, the delivery van is revalued to HK$1,000,000 in accordance with the provisions of
HKAS 16 Property, Plant and Equipment. CaterOne still expects to recover the carrying
amount of the delivery van through its use. The delivery van is not revalued for tax
purposes; therefore, the tax base of the delivery van is not adjusted.

Under HKAS 16, the revaluation increment is recognised in other comprehensive

income. As a result, under HKAS 12, CaterOne is required to recognise any tax
consequences arising from the revaluation in other comprehensive income also.

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Illustrative Example 13 (continued)

Recall that, immediately preceding the revaluation, the carrying amount of the delivery
van was HK$740,000. The carrying amount of the van is now HK$1 million, giving rise to a
revaluation increment of HK$260,000 (HK$1,000,000 − HK$740,000). Based on the profits
tax rate of 16.50%, the deferred tax impact of the revaluation increment is an increase in
deferred tax liability of HK$42,900 (HK$260,000 × 16.50%).

CaterOne would undertake the following journal entry on 1 February 20X8 to record
the increase in deferred tax liability:

Debit Credit
HK$ HK$
Other comprehensive income (revaluation of PPE) 42,900
Deferred tax liability 42,900

Evident from the journal entry, the deferred tax related to the revaluation of the
delivery van is recognised in other comprehensive income because, under HKAS 16, the
revaluation is recognised in other comprehensive income.

The deferred tax liability balance after the above entry is HK$115,624. As an alternate
way of explanation, immediately preceding the revaluation, the tax base of the delivery
van was HK$299,250, that is, HK$925,000 (initial cost) – HK$625,750 (accumulated capital
allowance deduction). The carrying amount of the van is now HK$1 million, giving rise to a
taxable temporary difference of HK$700,750 (HK$1,000,000 − HK$299,250). Based on the
profits tax rate of 16.50%, CaterOne is to recognise an ending deferred tax liability balance
of HK$115,624 (HK$700,750 × 16.50%).

Because the deferred tax liability balance on 31 January 20X8 is HK$72,724, CaterOne
would record the following journal entry on 1 February 20X8 to increase the deferred tax
liability to HK$115,624:

Debit Credit
HK$ HK$
Other comprehensive income (revaluation of plant, 42,900
property and equipment)
Deferred tax liability 42,900

Illustrative Example 14
Continuing with the facts previously presented, on 1 February 20X9, the delivery van is
revalued to HK$500,000 in accordance with the provisions of HKAS 16 Property, Plant
and Equipment. CaterOne still expects to recover the carrying amount of the delivery van
through its use. The delivery van is not revalued for tax purposes; therefore, the tax base
of the delivery van is not adjusted.

Under HKAS 16, the revaluation decrement is recognised in other comprehensive

income to the extent it reverses a previous revaluation increment. The amount by which
the revaluation decrement exceeds the previous revaluation increment will be recognised

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Illustrative Example 14 (continued)

in profit or loss. Similarly, under HKAS 12, CaterOne is required to recognise the tax
consequences arising from the revaluation decrement in other comprehensive income
(profit or loss) only for that portion of the revaluation decrement recognised in other
comprehensive income (profit or loss).

The carrying amount of the delivery van immediately preceding the revaluation
decrement was HK$875,000 (HK$1,000,000 (previously revalued amount) – HK$125,000
(HK$1,000,000/8 years remaining on useful life). The carrying amount of the van is
now HK$500,000, giving rise to a revaluation decrement of HK$375,000 (HK$875,000
− HK$500,000). Based on the profits tax rate of 16.50%, the deferred tax impact of the
revaluation decrement is a decrease in deferred tax liability of HK$61,875 (HK$375,000
× 16.50%). Of this amount, HK$42,900 relates to other comprehensive income and the
remaining HK$18,975 relates to profit or loss.

CaterOne would undertake the following journal entry on 1 February 20X9 to record
the decrease in deferred tax liability:

Debit Credit
HK$ HK$
Deferred tax liability 61,875
Other comprehensive income (revaluation of PPE) 42,900
Income tax expense (deferred) 18,975

Key Learning Point

It is important to establish whether an underlying transaction or event that has income
tax consequences is recognised in or outside profit or loss because this establishes if the
income tax consequences are recognised in or outside profit or loss.

Knowledge Check Questions

Question 7
On 1 April 20X4, Recnac Ltd (Recnac) purchases a retail shopping mall for HK$25 million
in Central Hong Kong, which it intends to manage. For accounting purposes, the shopping
mall is depreciated at 2% per annum on a straight-line basis. For tax purposes, Recnac is
entitled to a capital allowance deduction of 4% per annum.
On 1 April 20X7, Recnac revalues the shopping mall to HK$30 million for accounting
purposes. The shopping mall is not revalued for tax purposes: therefore, the tax base of
the mall is not adjusted.
Prepare the journal entry on 1 April 20X7 to record the deferred tax consequences of
the revaluation, assuming Recnac intends to recover the carrying amount of the shopping
mall through its use. Assume a profits tax rate of 16.50% on all assessable profits.

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Knowledge Check Questions (continued)

Question 8
How would you answer to Question 7 change if Recnac intends to recover the carrying
amount of the shopping mall through its sale and:
A There is no capital gains tax payable in Hong Kong on any capital gain derived from the
sale of the shopping mall; or
B Capital gains tax is payable in Hong Kong on any capital gain derived from the sale of the
shopping mall at a tax rate of 10%?

Question 9
On 1 January 20X4, Clean Motors Ltd (Clean Motors) recorded the following journal entry
upon the issuance of 1 million convertible bonds of HK$5 each:

Debit Credit
HK$ HK$
Cash 5,000,000
Liability 4,367,610
Share options (equity) 632,390

Determine the deferred tax consequences of the convertible bond issuance. Assume
a profits tax rate of 16.50% and that for tax purposes the liability is measured at the face
value of the convertible bonds.

1 9 . 5 PRESENTATION OF INCOME TAXES

In accordance with HKAS 1 Presentation of Financial Statements, current tax assets, current tax
liabilities, deferred tax assets and deferred tax liabilities are to be presented as separate line
items in an entity’s statement of financial position. Moreover, HKAS 1 requires tax expense
(tax income) to be presented as a single line item in an entity’s statement of profit or loss or in
the profit or loss section of an entity’s statement(s) of profit or loss and other comprehensive
income (see Chapter 27).

In addition to the HKAS 1 presentation requirements, HKAS 12 contains additional

presentation requirements with which an entity is to comply in the presentation of tax assets,
tax liabilities and tax expense. The HKAS 12 presentation requirements are discussed next.

19.5.1 Tax Assets and Tax Liabilities

There may be instances when an entity simultaneously has current tax liabilities and current
tax assets, and each satisfy the criteria for recognition in the entity’s financial statements.
Similarly, an entity may have deferred tax assets and deferred tax liabilities that, concurrently,
warrant recognition in an entity’s financial statements. Should either instance arise, HKAS 12

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specifies the criteria that, if satisfied, requires an entity to offset its tax assets and liabilities.
That is, to present within the entity’s financial statements its ‘net’ current tax and/or ‘net’
deferred tax position.

19.5.1.1 Offset
Current Taxes
Though current tax assets and current tax liabilities are separately recognised and measured,
an entity is required to offset current tax assets and current tax liabilities if, and only if,
the entity:

• Has a legally enforceable right to set off the recognised amounts; and

HKAS • Intends to settle on a net basis or to realise the asset and settle the liability
12.71 simultaneously.

An entity is considered to have a legally enforceable 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
HKAS
12.72 • The taxation authority permits the entity to make or receive a single net payment.

There may be instances where one entity in a consolidated group of entities has a
recognised current tax asset, and another entity in the group has a recognised current tax
liability. In preparing the consolidated financial statements of the group, a current tax asset
of one entity in the group is to be offset against a current tax liability of another entity in the
group if, and only if:

• The entities concerned have a legally enforceable right to make or receive a single net
payment; and

HKAS • The entities intend to make or receive such a net payment or intend to recover the
12.73 asset and settle the liability simultaneously.

If the above criteria are unsatisfied, current tax assets and current tax liabilities must be
separately presented with the consolidated financial statements (i.e. the entity’s statement of
financial position will have the following separate line items: current tax assets and current tax
liabilities).

Deferred Taxes
An entity is required to offset deferred tax asset and deferred tax liabilities if, and only if:

• The entity has a legally enforceable right to offset current tax assets and current tax
liabilities; and

• The deferred tax assets and the deferred tax liabilities relate to income taxes levied
by the same taxation authority on either:

°° The same taxable entity; or

°° Different taxable entities, which intend either to settle current tax liabilities and
assets on a net basis or to realise the assets and liabilities simultaneously in each
HKAS future period in which significant amounts of deferred tax liabilities or assets are
12.74 expected to be settled or recovered.

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If the preceding criteria are unsatisfied, an entity is to present its deferred tax assets and
deferred tax liabilities separately within its financial statements (i.e. the entity’s statement of
financial position will have the following separate line items: deferred tax assets and deferred
tax liabilities).

Illustrative Example 15
Blossom Ltd (Blossom) receives an amended income tax assessment from the national
taxation authority, entitling Blossom to a tax refund of HK$50,000 due to a retrospective
change in tax law. At the time of receiving the notice of amended assessment, Blossom
recognises a current tax liability of HK$125,000 for an amount owing to the same
taxation authority. The notice of amended assessment states the tax refund will be
deducted from any amount owing by Blossom to the taxation authority, and if the
amount owing (refund) exceeds the refund (amount owing), the net amount will
be payable (receivable) at the next instalment date.

HKAS Under HKAS 12, the tax refund constitutes a current tax asset as the amount of income
12.12 tax paid by Blossom in a prior period exceeds the amount due. Blossom is required to set
off its current tax asset against its current tax liability because it:

• Has a legally enforceable right to set off the recognised amounts because

°° They relate to the same national taxation authority; and

°° The taxation authority permits Blossom to make a single payment at the next
instalment date; and

• Intends to settle on a net basis as per the notice of amended assessment.

As such, Blossom will present in its statement of financial position a net current tax
liability of HK$75,000.

19.5.2 Tax Expense Presentation

Consistent with the presentation requirements of HKAS 1, HKAS 12 requires the tax expense
HKAS (tax income) related to profit or loss from ordinary activities to be presented as part of profit or
12.77 loss in the statement(s) of profit or loss and other comprehensive income.

Key Learning Point

It is necessary to identify an entity’s legally enforceable rights to set off recognised tax
assets and liabilities, and the entity’s intentions on how they will settle or realise such tax
assets or liabilities because this establishes whether the entity is required to present its tax
assets on a ‘net’ basis in its statement of financial position.

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Knowledge Check Question

Question 10
Trot Ltd (Trot) is a Hong Kong-registered holding company that owns 100% of the following
two entities:
1. Trance Ltd (Trance), which is a company that operates within Hong Kong and
lodges a profits tax return with the Inland Revenue Ordinance; and

2. Fine Ltd (Fine), which is a Singapore-based company that lodges its tax return with
the Inland Revenue Authority of Singapore.

As of 31 March 20X3, each subsidiary had the following tax-related balances (in HK$):

Trance Limited Fine Limited

HK$ HK$
Current tax asset 32,500 –
Current tax liability – 61,800

Determine whether, in accordance with HKAS 12, Trot is able to offset the current tax
asset of Trance and the current tax liability of Fine in the group’s consolidated financial
statements.

1 9 . 6 DISCLOSURE OF INCOME TAXES

In addition to the recognition and presentation requirements pertaining to income taxes

discussed in earlier sections, HKAS 12 requires entities to disclose certain income tax-related
information in its notes to financial statements.

In general, the HKAS 12 disclosure requirements are to assist financial statement users
understand the:

• Relationship between an entity’s accounting profit and tax expense;

• Major components of an entity’s tax expense (tax income);

• The types of temporary differences, unused tax losses and unused tax credits that give
rise to the entity recognising deferred tax assets and deferred tax liabilities; and

• Details of deductible temporary differences, unused tax losses and unused tax credits
relating to unrecognised deferred tax assets.

A discussion of the specific disclosure requirements of HKAS 12 follows next.

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19.6.1 Tax Reconciliation

To assist financial statement users understand the relationship between an entity’s tax expense
and accounting profit, HKAS 12 requires an entity to provide an explanation of the relationship
between these two items by way of disclosure. The explanation is to be in the form of either or
both of the following:

• A numerical reconciliation between tax expense (income) and the product of accounting
profit multiplied by the applicable tax rate(s), disclosing also the basis on which the
applicable tax rate(s) is (are) computed; or

HKAS • A numerical reconciliation between the average effective tax rate and the applicable tax
12.81(c) rate, disclosing also the basis on which the applicable tax rate is computed.

Illustrative Example 16
Cathay Pacific Airways Ltd (Cathay Pacific) is an international airline registered and based
in Hong Kong, whose financial statements are prepared in accordance with HKFRSs.

Below is an extract of Cathay Pacific’s statement of profit or loss and other

comprehensive income for the year ended 31 December 2018. In accordance with HKAS 1
Presentation of Financial Statements, Cathay Pacific has presented its tax expense of HK$466
million as a single line item in its statement of profit or loss and other comprehensive
income. Cathay Pacific has also reported a profit before taxation of HK$3.243 billion.

Cathay Pacific Airways Limited

Consolidated Statement of Profit or Loss and Other Comprehensive Income
for the year ended 31st December 2018
2018 2017 2018 2017
Note HK$m HK$m US$m US$m
Operating profit/(loss) 2 3,595 (1,449) 461 (186)
Finance charges (2,457) (2,223) (315) (285)
Finance income 343 462 44 59
Net finance charges 3 (2,114) (1,761) (271) (226)
Share of profits of associates 1,762 2,630 226 337
Profit/(loss) before taxation 3,243 (580) 416 (75)
Taxation 4 (466) (308) (60) (39)
Profit/(loss) for the year 2,777 (888) 356 (114)
Non-controlling interests (432) (371) (55) (47)
Profit/(loss) attributable to the 2,345 (1,259) 301 (161)
shareholders of Cathay Pacific

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Illustrative Example 16 (continued)

HKAS 12 requires Cathay Pacific to disclose an explanation of the relationship between
its tax expense and accounting loss. Below is an extract of this explanation as disclosed in
its 2018 annual report. The particular form of this explanation is a numerical reconciliation
between ‘actual’ tax expense and the product of accounting loss multiplied by the
applicable tax rate (i.e. ‘notional’ tax income), as per the previous bullet point (a).

4. Taxation (continued)
A reconciliation between tax charge and accounting profit/(loss) at applicable tax
rates is as follows:
2018 2017
HK$m HK$m
Profit/(loss) before taxation 3,243 (580)
Notional tax calculated at Hong Kong profits tax rate of 16.5% (535) 96
(2017: 16.5%)
Expenses not deductible for tax purposes (198) (318)
Income not subject to tax 36 126
Effect of changes in effective tax rate and jurisdictional differences 395 (25)
Tax under-provisions arising from prior years (28) (114)
Tax losses not recognised (136) (73)
Tax charge (466) (308)

Further information on deferred taxation is shown in note 14 to the financial statements.

Evident from the above disclosure, Cathay Pacific’s tax expense is HK$466 million,
and the product of accounting loss multiplied by the Hong Kong profits tax rate is
HK$535 million (i.e. HK$3.243 billion × 16.50%). The note disclosure reconciles these two
amounts by providing the reason (e.g. expenses not deductible for tax purposes) and by
quantifying the impact of this reason on notional tax income. For example, the tax effect
of adding back expenses not deductible for tax purposes (as per Exhibit 19.1) is to increase
notional tax income by HK$198 million. After all adjustments have been made, Cathay
Pacific derives its tax expense figure of HK$466 million.

As per HKAS 12, the above extract also illustrates Cathay Pacific has disclosed the
applicable tax rate used to calculate notional tax income, namely, the Hong Kong profits
tax rate of 16.50%.
Source: Cathay Pacific Airways Limited, Annual Report 2018, p. 65 https://www.cathaypacific.com/content/dam/cx/
about-us/investor-relations/interim-annual-reports/en/2018_annual_report_en.pdf.

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Apply and Analyse 8

The following information relates to Walker Ltd (Walker) for the year ended 31 March 20X9:

• Profit before tax equals HK$2.568 million;

• Tax expense equals HK$402,463;

• Included in Walker’s statement of profit or loss and other comprehensive income

are the following items:

°° Dividend income of HK$110,000, which is not assessable for tax purposes;

°° A capital gain on disposal of land and buildings of HK$325,000; and

°° Fines for late lodgement of last period’s profits tax return of HK$225,000, which
is non-deductible for tax purposes; and

• The profits tax rate applicable for the year ended 31 March 20X9 is 16.50%,
increasing from 14% the previous year;

• A deferred tax liability totals HK$75,000 due to taxable temporary differences of

HK$535,714. The deferred tax liability relates to items recognised in profit or loss
and remains otherwise unchanged from the previous period.
Prepare the numerical reconciliation between tax expense and the product of
accounting profit multiplied by the applicable tax rate for Walker for the year ended
31 March 20X9.

Analysis

Profit before tax HK$2,568,000

Notional tax at Hong Kong profits tax rate of 16.50% HK$423,720
Fine not deductible for tax purposes HK$37,125
Income not assessable for tax purposes:
Dividend income (HK$18,150)
Capital gain on sale of land and buildings (HK$53,625) (HK$71,775)
Increase in deferred tax liability due to tax HK$13,393
rate increase
Tax expense HK$402,463

In relation to the above disclosure, the tax effect of the fine, not deductible for
tax purposes, is added to notional tax expense in the numerical reconciliation. This is
consistent with the approach in Exhibit 19.1; given non-deductible expenses are added
back to accounting profit to derive assessable profits, and the tax-effect of such expenses
is added back to notional tax expense (which is calculated from accounting profit) to derive
an actual tax expense (which is based on assessable profits). The tax effect of dividend
income (HK$110,000 × 16.50%) and capital gains (HK$325,000 × 16.50%) not assessable for
tax purposes are deducted from notional tax expense, while Walker’s tax obligations are
increased due to an increase in the profits tax rate (HK$535,714 × 2.50%).

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19.6.2 Other Disclosure Requirements

In addition to disclosing the relationship between tax expense (income) and accounting profit
by way of a numerical reconciliation of both amounts, an entity is required to separately
disclose (among others) the following:

• The major components of tax expense (income), which may include:

(i) Current tax expense (income);

(ii) Adjustments recognised in the period for current tax of prior periods;

(iii) The amount of deferred tax expense (income) relating to:

• The origination and reversal of temporary differences; and

• Changes in tax rates or the imposition of new taxes;

(iv) The amount of the benefit from a previously unrecognised tax loss, tax credit or
temporary difference of a prior period that is used to reduce:

• Current tax expense; and

• Deferred tax expense; and/or

(v) Deferred tax expense arising from the write-down, or reversal of a previous write-
down, of a deferred tax asset in accordance with paragraph 56;

• The aggregate current and deferred tax relating to items charged or credited directly
to equity;

• The amount of income tax relating to each component of other comprehensive income;

• An explanation of changes in the applicable tax rate(s) compared to the previous

accounting period;

• 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;

• Unused tax losses and unused tax credits (with respect to each type of temporary
difference):

(i) The amount of the deferred tax assets and liabilities recognised in the statement of
financial position for each period presented; and

(ii) The amount of the deferred tax income or expense recognised in profit or loss, if
this is not apparent from the changes in the amounts recognised in the statement
of financial position; and

• The amount of a deferred tax asset and the nature of the evidence supporting its
recognition, when:

°° 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

HKAS °° The entity has suffered a loss in either the current or preceding period in the tax
12.80–82 jurisdiction to which the deferred tax asset relates.

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Illustrative Example 17
Continuing with the Cathay Pacific (Illustrative Example 16), the following are extracts
of Cathay Pacific’s note disclosures on income taxes (in addition to its numerical
reconciliation between tax expense and accounting profit). As the extracts show, Cathay
Pacific discloses information specified in the preceding bullet points, where applicable, as
indicated by the arrows provided.

4. Taxation

2018 2017
HK$m HK$m
Current tax expenses
– Hong Kong profits tax 350 419
– overseas tax 225 201
– under-provisions for prior years 28 114
Deferred tax credit
– origination and reversal of temporary (137) (426)
differences (note 14)
466 308

Hong Kong profits tax is calculated at 16.5% (2017: 16.5%) on the estimated assessable
profits for the year. Overseas tax is calculated at rates of tax applicable in countries in
which the Group is assessable for tax. Tax provisions are reviewed regularly to take into
account changes in legislation, practice and the status of negotiations (see note 27(c) to the
financial statements).

Cathay Pacific’s above disclosure (in accordance with HKAS 12) shows that the tax
expense amount of HK$466 million comprises current tax expense of HK$603 million and
deferred tax credit (i.e. deferred tax income) of HK$137 million.

14. Deferred taxation

2018 2017
HK$m HK$m
Deferred tax assets:
– provisions (83) (76)
– tax losses (2,944) (2,919)
– cash flow hedges (3) (211)
– retirement benefits (55) 7
Deferred tax liabilities:
– accelerated tax depreciation 4,419 4,536
– investments in associates 1,125 1,021
Provision with respect to certain lease 9,926 9,534
arrangements
12,385 11,892

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Illustrative Example 17 (continued)

2018 2017
HK$m HK$m
Movements in deferred taxation comprise:
At 1st January 11,892 10,643
Impact on initial application of HKFRS 15 71 –
Movements for the year
(credited)/charged to profit or loss
– deferred tax credit (note 4) (137) (426)
– operating expenses 83 68
– (credited)/charged to other comprehensive income
– transferred to cash flow hedge reserve (note 6) 208 608
– transferred to retained profit (note 6) (41) 94
– initial cash benefit from lease arrangements 1,029 1,619
Current portion of provision with respect to certain lease (720) (714)
arrangements included under current liabilities – taxation
On 31st December 12,385 11,892

Deferred tax assets are recognised with respect to tax losses carried forward to the
extent that realisation of the related tax benefits through future taxable profits is probable.
The Group has unrecognised tax losses of HK$14,373 million (2017: HK$13.683 million) to
carry forward against future taxable profits. These amounts are analysed as follows:

2018 2017
HK$m HK$m
No expiry date 4,282 3,019
Expiring beyond 2021 10,091 10,664
14,373 13,683

Source: Cathay Pacific Airways Limited, Annual Report 2018, pp. 64; 76–7 https://www.cathaypacific.com/content/dam/
cx/about-us/investor-relations/interim-annual-reports/en/2018_annual_report_en.pdf.

Key Learning Point

It is necessary to disclose information that enables financial statement users to understand
the effect of current tax and deferred tax on an entity’s financial performance and financial
position, including a numerical reconciliation between actual tax and notional tax, either or
both on a dollar amount or tax rate basis.

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Knowledge Check Question

Question 11
Continuing with the Walker scenario, prepare the numerical reconciliation between the
average effective tax rate and the applicable tax rate for the year ended 31 March 20X9.

1 9 . 7 INTERPRETATIONS RELATING
TO INCOME TAXES

An entity is to apply the recognition and measurement requirements of HKAS 12 in accounting

for a current or deferred tax asset or liability. There is, however, additional guidance offered
to entities in the application of the general recognition and measurement requirements of
HKAS 12 to two specific areas: (1) changes in the tax status of an enterprise or its shareholders;
and (2) the uncertainty over income tax treatments. Each is considered in turn.

19.7.1 HK(SIC) Interpretation 25 Income Taxes – Changes in the Tax Status

of an Enterprise or its Shareholders
A change in the tax status of an entity or of its shareholders may include, for example:

• The public listing of an entity’s equity instruments;

• The restructuring of an entity’s equity; or

HK(SIC)-
Int 25.1 • A controlling shareholder’s move to a foreign country.

A change in the tax status of an entity or of its shareholders may have tax consequences for
HK(SIC)- an entity, as the entity may now be taxed differently, for example, the entity, as a result of the
Int 25.1 change, may lose or gain tax incentives or become subject to a different rate of tax.

The tax consequences of a change in the tax status of an entity or of its shareholders may
be current and/or deferred and are to be included in profit or loss for the period unless they
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 in which case the tax
consequences are to be credited or changed to equity; or

HK(SIC)-
• In amounts recognised in other comprehensive income in which case the tax
Int 25.2, 4 consequences are to be recognised in other comprehensive income.

19.7.2 HK(IFRIC) Interpretation 23 Uncertainty over Income Tax Treatments

There may be instances where there is uncertainty about the current or deferred tax
consequences of a particular transaction or event of an entity.

HK(IFRIC) Interpretation 23 Uncertainty over Income Tax Treatments (HK(IFRIC)-Int 23) clarifies
HK(IFRIC)- how an entity is to apply the recognition and measurement requirements in HKAS 12 when
Int 23.4 there is uncertainty over income tax treatments. HK(IFRIC)-Int 23 defines an uncertain tax

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 Income T axes

HK(IFRIC)- treatment as a tax treatment by an entity ‘for which there is uncertainty whether the relevant
Int 23.3(c) taxation authority will accept the tax treatment under tax law’. The following are examples of
tax-based decisions of an entity whose acceptability may be uncertain under tax law:

• Not to submit an income tax filing in a tax jurisdiction;

• Not to include particular in taxable profit; or

HK(IFRIC)-
Int 23.3(c) • To include a particular expense as deductible in determining taxable profit.

HK(IFRIC)- The resulting treatment is dependent on whether the entity considers the taxation
Int 23.9 authority will probably accept an uncertain tax treatment.

The table in Exhibit 19.7 outlines the differing accounting treatment of the uncertain tax
treatment:

Probability the taxation

authority will accept an
uncertain tax position Accounting treatment
Probable Determine the taxable profit (tax loss), tax bases, unused tax losses,
HK(IFRIC)- unused tax credits or tax rates consistently with the tax treatment
Int 23.10 used or planned in its income tax filing. An entity does not need to
adjust how it accounts for its current or deferred tax assets or
liabilities because existing conditions remain.
Not probable Reflect the effect of uncertainty in determining the related taxable
HK(IFRIC)- profit (tax loss), tax bases, unused tax losses, unused tax credits, or tax
Int 23.11 rates. An entity needs to adjust how it accounts for its current or
deferred tax assets or liabilities to reflect the effect of uncertainty.

EXHIBIT 19.7 Accounting treatment of uncertain tax treatment according to application of

probability criteria

The effect of uncertainty for each uncertain tax treatment is reflected by using either of the
following methods:

• The ‘most likely amount’ method, which uses the single most likely amount in a range of
possible outcomes to reflect the effect of uncertainty; or

HK(IFRIC)-
• The ‘expected value’ method, which uses the probability-weighted amounts in a range
Int 23.11 of possible outcomes.

Illustrative Example 18
In lodging its profits tax return for the year ended 31 March 20X7, Torrent Ltd (Torrent)
includes deductions for research expenditure relating to several distinct research and
development (R&D) activities undertaken during the year. Torrent has treated the
research expenditure on each type of R&D activity as ‘qualifying’ R&D expenditure,
giving rise to an accelerated depreciation for tax purposes. The taxation authority may
challenge those tax treatments.

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Illustrative Example 18 (continued)

Torrent notes that its tax treatment of each type of R&D activity is uncertain and
expects the taxation authority to examine its uncertain tax treatments collectively.
Therefore, under paragraph 6 of HK(IFRIC)-Int 23, Torrent concludes that considering the
tax treatments of all R&D activities together better predicts the resolution of uncertainty.
Torrent also concludes the taxation authority will probably not accept the tax treatments
and, therefore will be required to reflect the effect of uncertainty in recognising and
measuring current and deferred tax.

Torrent estimates the following probabilities of the possible amounts that might be
added back to assessable profits for the year for being non-deductible:

Estimated Probability Probability-weighted

non-deductible amount (%) amount
HK$ HK$
Outcome 1 Nil 10% Nil
Outcome 2 5,000 20% 1,000
Outcome 3 15,000 35% 5,250
Outcome 4 20,000 25% 5,000
Outcome 5 30,000 10% 3,000
100% 14,250

Additional information is as follows:

• Assessable profits for the year ended 31 March 20X7 is HK$1 million; and

• The profits tax rate is 16.50%.

Torrent uses the ‘expected value’ method which, based on Torrent’s above estimates,
gives rise to an estimated non-deductible amount of HK$14,250.

Torrent is required to incorporate this estimate into its recognition and measurement
of its current tax liability. In particular, Torrent is to add back the expected non-deductible
expense of HK$14,250 to its assessable profits of HK$1 million, giving rise to a current tax
liability of HK$167,351 (HK$1,014,250 × 16.50%).

There are no deferred tax consequences in this scenario, because no temporary

differences pertain to the research expenditure. Research expenditure is not capitalised
for accounting purposes, meaning there is no asset for which its carrying amount and tax
base may be calculated.

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Apply and Analyse 9

How would the answer to the Torrent question (Illustrative Example 17) differ if the ‘most
likely’ method was used to reflect the effect of uncertainty?

Analysis

If Torrent uses the ‘most likely’ method, Outcome 3 is the most likely outcome and the
resultant amount of HK$15,000 would be deemed to best predict the resolution of
uncertainty.

Under this method, Torrent would add back the most likely non-deductible amount of
HK$15,000 to its assessable profits of HK$1 million, giving rise to a current tax liability of
HK$167,475 (HK$1,015,000 × 16.50%).

Key Learning Point

It is essential to determine if there is uncertainty over whether the taxation authority will
accept the entity’s tax treatment of a transaction or event and, if so, whether the taxation
authority will or will not probably accept the uncertain tax position because this affects the
accounting treatment of income taxes.

Knowledge Check Questions

Question 12
On 1 March 20X1, Sprout Ltd (Sprout) purchases a separately identifiable intangible
asset for HK$275,000. Because the asset has an indefinite useful life, it is not amortised
for accounting purposes per HKAS 38 Intangible Assets. The tax law specifies that the
HK$275,000 is deductible for tax purposes, but the timing of deductibility is uncertain. That
is, uncertainty is over whether the HK$275,000 is fully deductible at the time of purchase or
is to be apportioned over an extended period of time.
For the year ended 31 March 20X1 Sprout has deducted the entire HK$275,000 in
calculating assessable profits. Sprout, however, concludes the taxation authority will
probably not accept this tax treatment. Instead, Sprout expects the taxation authority will
require Sprout to apportion the HK$275,000 deductible amount, probably over a ten-
year period.
Additional information is as follows:
• Assessable profits for the year ended 31 March 20X1 as lodged by Sprout in its
income tax filing, is HK$1.35 million;
• The presence (if any) of temporary differences as of 31 March 20X1 are only in
relation to the intangible asset; and
• The profits tax rate is 16.50%.
Apply the requirements of HK(IFRIC)-Int 23 to determine whether, and if so, how
Sprout is to account for uncertainty over its income tax treatment of its intangible asset on
current tax.

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Knowledge Check Questions (continued)

Question 13
Apply the requirements of HK(IFRIC)-Int 23 to determine whether, and if so how, Sprout
is to account for uncertainty over its income tax treatment of its intangible asset on
deferred tax.

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SUMMARY

• Profits tax is payable on an entity’s assessable profits for the period and is referred to as
current tax.

• Under HKAS 12, an entity will recognise a current tax liability for any unpaid current tax
from the current and prior periods. An increase in current tax liability from the immediately
preceding prior period to the current period would give rise to current tax expense.

• Under HKAS 12, if the amount paid by an entity, with respect to the current and prior periods,
exceeds the amount owed for those periods, then the excess will be recognised as a current
tax asset.

• Temporary differences reflect differences in the timing of when HKFRSs and taxation
authorities recognise transactions or events in the calculation of accounting profits and
assessable profits, respectively.

• A taxable temporary difference is identified as existing when an asset’s (liability’s) carrying

amount (tax base) exceeds its tax base (carrying amount). The taxable temporary difference is
equal to the difference between the carrying amount and tax base.

• A deductible temporary difference is identified as existing when an asset’s (liability’s) tax base
(carrying amount) exceeds its carrying amount (tax base). The taxable temporary difference is
equal to the difference between the carrying amount and tax base.

• Under HKAS 12, an entity is to recognise a liability that encapsulates the future tax
consequences of its taxable temporary differences. It is called a deferred tax liability and is
calculated as:

°° Taxable temporary difference × Tax rate.

• Under HKAS 12, an entity is to recognise an asset that encapsulates the future tax
consequences of its deductible temporary differences but only to the extent it is probable that
assessable profits will be available against which the deductible temporary difference can be
utilised. It is called a deferred tax asset and is calculated as:

°° Deductible temporary difference × Tax rate.

• An entity also recognises a deferred tax asset for the carryforward of unused tax losses
and unused tax credits but only to the extent that future assessable profits will probably be
available against which the unused tax losses and unused tax credits can be utilised. The
deferred tax asset is calculated as:

°° Unused tax loss/credit × Tax rate.

• An entity is to separately disclose (among others):

°° The major components of tax expense (income);

°° An explanation of the relationship between tax expense (income) and accounting profit; and

°° 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.

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MIND MAP

DISCLOSURE REQUIREMENTS TEMPORARY DIFFERENCES

Disclosure includes Differences between the carrying amount
• Major components of tax expense (income); of an asset or liability in the statement of
• The aggregate current and deferred tax financial position and its tax base
relating to items that are charged or • Taxable temporary differences → when an
credited directly to equity; asset’s (liability’s) carrying amount (tax
• The amount of income tax relating to each base) exceeds its tax base (carrying amount).
component of other comprehensive income; • Deductible temporary differences → when
• An explanation of the relationship between an asset’s (liability’s) tax base (carrying
tax expense (income) and accounting profit; amount) exceeds its carrying amount (tax
• An explanation of changes in the applicable base).
tax rate(s) compared to the previous • The tax base of an asset or liability is the
accounting period; amount attributed to that asset or liability
• Details of recognised and unrecognised for tax purposes.
amounts; and
• Details in respect of each type of temporary DEFERRED TAX LIABILITIES
difference, unused tax losses and unused Definition
tax credits. • The amounts of income taxes payable in
CURRENT TAX future periods in respect of taxable
INCOME TAXES
temporary differences.
Definition (HKAS 12)
Calculation
• The amount of income taxes payable
• Taxable temporary difference x applicable
(recoverable) in respect of the taxable
tax rate.
profit (tax loss) for a period.
Recognition
Calculation
• Recognise:
• Assessable profits for the period x applicable
- A deferred tax liability for all taxable
tax rate.
temporary differences, except for the
Recognition initial recognition of:
• Recognise in current period financial
° Goodwill; or
statements:
° Of an asset or liability in a transaction
- A current tax liability for any unpaid which: (i) is not a business combination;
current tax from the current and prior periods; and (ii) at the time of the transaction,
- A current tax asset if the amount paid in affects neither accounting profit nor
respect of the current and prior periods taxable profit or taxable loss; and
exceeds the amount owed for those periods; and - Deferred tax expense or income in
- Current tax expense or income in (outside) (outside) profit or loss if the underlying
profit or loss if the underlying transaction transaction is recognised in (outside)
is recognised in (outside) profit or loss. profit or loss.
Measurement Measurement
• Applicable tax rate is the profits tax rate • At the tax rates expected to apply to the
enacted at the end of the current reporting period when the asset is realised or the
period. liability is settled;
Presentation • Using average rates when different tax
• Current tax assets and liabilities that exist rates; and
simultaneously are to be presented on a • Based on expected recovery (assets) or
‘net’ basis if the entity: settlement (liabilities).
- Has a legally enforceable right to set off the
DEFERRED TAX ASSETS
recognised amounts; and
- Intends either to settle on a net basis, or to Definition
realise the asset and settle the liability • The amounts of income taxes recoverable
simultaneously. in future periods in respect of: deductible
temporary differences; the carryforward of
unused tax losses; and the carryforward
of unused tax credits.
Calculation
• Deductible temporary difference/Unused tax
loss/Unused tax credit x applicable tax rate.
Recognition
• Recognised in current period financial
statements for:
- All deductible temporary differences if
taxable profit is probable, unless arising
from the initial recognition of an asset or
liability in a transaction that:
° Is not a business combination; and
° At the time of the transaction, affects
neither accounting profit nor taxable
profit or taxable loss;
- The carryforward of all unused tax losses
and tax credits if taxable profit is probable.
Measurement
• As per ‘Deferred Tax Liabilities’.
Presentation
• ‘Net’ basis if current tax is presented on a
‘net’ basis if certain criteria are met.

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Answers to Knowledge Check Questions

Question 1
To determine current tax expense for the 20X6–X7 reporting period, first calculate
assessable profits for the 20X6–X7 tax year. Using the steps outlined in Exhibit 19.1,
assessable profits are as follows:

HK$6.18 million (Accounting profit)

Plus HK$850,000 (HK$350,000 + HK$500,000)
(i.e. expenses for accounting purposes that are non-deductible for tax purposes)
Minus HK$125,000
(i.e. deductions for tax purposes that are not expenses for accounting purposes)
Minus HK$30,000
(i.e. revenues for accounting purposes that are not assessable for tax purposes)
Equals HK$6.875 million (Assessable profits)

Profits tax payable on HK$6.875 million is HK$969,375 ((HK$2 million × 8.25%) +

(HK$4.875 million × 16.50%)) and represents current tax expense for the 20X6–X7 reporting
period. Current tax expense would be recorded with the following journal entry:

Debit Credit
HK$ HK$
Current tax expense 969,375
Current tax liability 969,375

Question 2
A. The tax base of trade receivables is as follows:

Carrying amount Future taxable Future deductible Tax base

amounts amounts
– + =
HK$32,500 Nil Nil HK$32,500

Because the related revenue has been included in assessable profits, no future taxable
amounts are associated with the receivables. In addition, no future deductible amounts
are given; therefore, all contractual cash flows should be recovered. As such, the tax
base equals the carrying amount.

B. The tax base of inventory is as follows:

Carrying amount Future taxable Future deductible Tax base

amounts amounts
– + =
HK$7,500 HK$7,500 Nil Nil

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The future recovery of the carrying amount of the inventory, which will occur when it is
sold, will generate future taxable amounts. No future deductible amounts are related
to the inventory, as the deduction (equal to the cost of the inventory purchased) arose
when the inventory was purchased. Therefore, the tax base is nil.

C. The tax base of interest receivable is as follows:

Carrying amount Future taxable Future deductible Tax base

amounts amounts
– + =
HK$5,000 Nil Nil HK$5,000

Because interest revenue is tax exempt, future taxable amounts are nil. There are no
future deductible amounts in relation to the interest receivable. As such, the tax base
equals the carrying amount.

Question 3
A. The tax base of accrued wages is as follows:

Carrying amount Future deductible Future taxable Tax base

amounts amounts
– + =
HK$8,000 Nil Nil HK$8,000

As the related expense has been deducted for tax purposes, there are no future
deductible amounts associated with the accrued wages. No future taxable amounts are
related to the accrued wages. Therefore, the tax base equals the carrying amount.

B. The tax base of loan payable is as follows:

Carrying amount Future deductible Future taxable Tax base

amounts amounts
– + =
HK$1,500,000 Nil Nil HK$1,500,000

As principal and interest payments on the loan are non-deductible for tax purposes,
future deductible amounts are nil. No future taxable amounts are related to the loan
payable. As such, the tax base equals the carrying amount.

C. The tax base of accrued fines and penalties is as follows:

Carrying amount Future deductible Future taxable Tax base

amounts amounts
– + =
HK$50,000 Nil Nil HK$50,000

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As fines and penalties are not deductible for tax purposes, future deductible amounts
are nil. No future taxable amounts are related to the loan payable. Therefore, the tax
base equals the carrying amount.

Question 4
Upon initial recognition of the item of machinery a deductible temporary difference exists
because the machinery’s carrying amount of HK$200,000 (HK$250,000 − HK$50,000)
is less than its tax base of HK$250,000. The difference arises because the non-taxable
government grant is deducted from the cost of the machinery in arriving at the machinery’s
carrying amount, but this is not permitted for tax purposes.
The resulting deferred tax asset of HK$8,250 (HK$50,000 × 16.50%) is not recognised
by GramTron because it arises from the initial recognition of the machinery in a
transaction that:
• Is not a business combination; and
• Affects neither accounting profit nor assessable profits at the time of the transaction.
The latter bullet point is evident from the following journal entry GramTron would
record upon the occurrence of the transaction (i.e. the purchase of the machinery), which
relates to statement of financial position items only:

Debit Credit
HK$ HK$
Machinery 50,000
Cash/Payables 50,000

Based on the above, GramTron would not recognise any deferred tax in relation to the
machinery.

Question 5
Immediately preceding the impairment review, the carrying amount of the building
for accounting purposes is HK$520,000 (HK$650,000 (cost) - HK$130,000 (depreciation
of HK$650,000/10 years × 2 years)). In accordance with HKAS 36 Impairment of Assets
(HKAS 36), Transide is required to impair the building to its recoverable amount of
HK$375,000, giving rise to an impairment loss of HK$145,000 (HK$520,000 − HK$375,000).
Following the impairment, the carrying amount of the building is HK$375,000.
The tax base of the building is as follows:

Carrying amount Future taxable Future deductible Tax base

amounts amounts
– + =
HK$375,000 HK$375,000 HK$598,000 HK$598,000

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The future taxable amounts reflect the taxable economic benefits Transide will
generate as it recovers the carrying amount of the building through its use. The future
deductible amounts represents the remaining capital allowance deductions Transide can
claim on the cost of the building (also known as the tax written-down value of the building).
The annual capital allowance deduction is HK$26,000 (HK$650,000 × 4%). Therefore, the
future deductible amounts is calculated as follows:

31 March 20X2 (Yr 1) 31 March 20X3 (Yr 2)

Cost HK$650,000 HK$650,000
Accumulated capital allowance (HK$26,000) (HK$52,000)
Tax written-down value
Future deductible amounts HK$624,000 HK$598,000

Following its impairment, the tax base of the building (HK$598,000) exceeds its carrying
amount (HK$375,000), giving rise to a deductible temporary difference of HK$223,000 and
a deferred tax asset of HK$36,795 (HK$223,000 × 16.50%). To recognise the deferred tax
asset, it must probable that sufficient assessable profits will be available against which the
deductible temporary difference can be utilised. Transide must first determine whether
sufficient taxable temporary differences exist, whose reversal will generate future taxable
amounts against which the future deductible amount (as reflected in the deductible
temporary difference) can be offset against. In this case, there are no taxable temporary
differences.
Transide next must consider whether there will be sufficient assessable profits from
sources other than taxable temporary differences in the same period as the reversal of the
deductible temporary difference. For the year ended 31 March 20X4, Transide expects to
generate assessable profits of HK$120,000 after excluding tax deductions resulting from
the reversal of the deductible temporary difference that year. For future periods, it is not
probable that sufficient assessable profits will be available against which the remaining
deductible temporary difference can be utilised, as Transide expects to generate adjusted
losses for the foreseeable future.
Based on the above, Transide is to recognise a deferred tax asset only for the portion
of the deductible temporary difference expected to be utilised, which is HK$19,800
(HK$120,000 × 16.50%). The journal entry on 31 March 20X3 would be as follows:

Debit Credit
HK$ HK$
Deferred tax asset 19,800
Income tax expense (deferred tax) 19,800

Refer to Chapter 14 (Impairment of Assets) to gain an understanding of how to account

for impairment.

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Question 6
Deferred tax assets and liabilities must be measured at the tax rates enacted so as to apply
when the related temporary differences reverse. Therefore, Remote is required to adjust
current deferred tax balances to reflect the new profits tax rate of 12%. To do this, first
convert each deferred tax balance (measured using the previous tax rate) to the amount of
the temporary differences upon which the deferred tax balance is calculated:
• Deductible temporary differences giving rise to deferred tax asset = HK$133,939
(HK$22,100/0.165); and
• Taxable temporary differences giving rise to deferred tax liability = HK$236,364
(HK$39,000/0.165).

Deferred tax asset Deferred tax liability

HK$ HK$
Current deferred tax balance 22,100 39,000
Adjustment for change in profits tax rate (6,027) (10,636)
((16.5%-12%) × Relevant temporary difference)
Restated deferred tax balance 16,073 28,364

The journal entry on 15 April 20X2 to reflect this adjustment is as follows:

Debit Credit
HK$ HK$
Deferred tax liability 10,636
Deferred tax asset 6,027
Income tax expense (deferred tax) 4,609

Question 7
Immediately preceding the revaluation on 1 April 20X7, the carrying amount of the
shopping mall is HK$23.5 million (i.e. HK$25 million (initial cost) – HK$1.5 million
(accumulated depreciation equal to HK$25 million × 2% × 3 years)). Revaluing the
shopping mall to HK$30 million gives rise to a revaluation increment of HK$6.5 million
(HK$30,000,000 − HK$23,500,000). The revaluation increment is recognised in other
comprehensive income per HKAS 16 Property, Plant and Equipment and, as a result, under
HKAS 12 Income Taxes, Recnac must recognise any tax consequences arising from the
revaluation in other comprehensive income also. Based on the profits tax rate of 16.50%,
the deferred tax impact of the revaluation is an increase in deferred tax liability equal to
HK$1,072,500 (HK$6.5 million × 16.50%).
Recnac would record the following journal entry on 1 April 20X7:

Debit Credit
HK$ HK$
Other comprehensive income (revaluation of PPE) 1,072,500
Deferred tax liability 1,072,500

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Question 8
A. The tax base of the shopping mall is HK$22 million (i.e. HK$25 million (initial cost) −
HK$3 million (accumulated capital allowance deduction equal to HK$25 million × 4%
× 3 years)). The carrying amount of the shopping mall is HK$30 million, giving rise to
a taxable temporary difference of HK$8 million. As the accumulated capital allowance
deduction of HK$3 million will be included in assessable profits but sale proceeds in
excess of cost will be non-taxable, the deferred tax liability is calculated as follows:

Taxable temporary Tax rate Deferred

difference tax liability
HK$ HK$
Cumulative capital allowance deduction 3,000,000 16.50% 495,000
Proceeds in excess of cost 5,000,000 Nil –
Total 8,000,000 495,000

Recnac would record the following journal entry on 1 April 20X7:

Debit Credit
HK$ HK$
Other comprehensive income (revaluation of PPE) 495,000
Deferred tax liability 495,000

B. The accumulated capital allowance deduction (of HK$3 million) and the amount by
which the sale proceeds exceed cost (HK$5 million) will be included in assessable
profits. Therefore, the deferred tax liability is calculated as follows:

Taxable temporary Tax rate Deferred

difference tax liability
HK$ HK$
Cumulative capital allowance deduction 3,000,000 16.50% 495,000
Proceeds in excess of cost 5,000,000 10.00% 500,000
Total 8,000,000 995,000

Recnac would record the following journal entry on 1 April 20X7:

Debit Credit
HK$ HK$
Other comprehensive income (revaluation of PPE) 995,000
Deferred tax liability 995,000

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Question 9
Upon initial recognition of the convertible bonds, a taxable temporary difference exists.
Evident from the journal entry to initially recognise the corporate bonds, the carrying
amount of the liability component is HK$4,367,630. The tax base of the liability, however, is
equal to the sum of the liability and equity components (i.e. the face value of HK$5 million).
The amount by which the tax base of the liability component exceeds the carrying amount
(HK$5,000,000 − HK$4,367,360 = HK$632,390) constitutes a taxable temporary difference,
giving rise to a deferred tax liability of HK$104,344 (HK$632,390 × 16.50%). Under HKAS
12, the deferred tax liability is charged directly to the equity component as reflected by the
following journal entry:

Debit Credit
HK$ HK$
Other comprehensive income (Share options) 104,344
Deferred tax liability 104,344

Question 10
Under HKAS 12, Trot is unable to set off Trance’s current tax asset against Fine’s current
tax liability in the group’s consolidated statement of financial position. Trance and Fine do
not have a legally enforceable right to make a single net payment of HK$29,300 (HK$61,800
− HK$32,500) because the tax-related balances relate to income taxes levied by different
taxation authorities. As such, Trot will separately present a current tax asset of HK$32,500
and a current tax liability of HK$61,800 in the consolidated statement of financial position.

Question 11
The numerical reconciliation between the average effective tax rate and the applicable tax
rate for Walker for the year ended 31 March 20X9 is as follows:

Applicable tax rate 40.00%

Fine not deductible for tax purposes 1.45%a
Income not assessable for tax purposes:
Dividend income (0.71%)b
Capital gain on sale of land and buildings (2.09%)c (2.80%)
Increase in deferred tax liability due to tax rate increase 0.52%d
Average effective tax rate 39.17%
a
(HK$37,125/HK$2,568,000) × 100.
b
(HK$18,150/HK$2,568,000) × 100.
c
(HK$53,625/HK$2,568,000) × 100.
d
(HK$13,393/HK$2,568,000) × 100.

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Question 12
As Sprout concludes that the taxation authority will probably not accept its tax treatment
HK(IFRIC)- of the intangible asset, Sprout is required to reflect the effect of the uncertainty in
Int 23.11 determining its assessable profits.
Sprout is to reflect the effect of uncertainty for its tax treatment by using the method
that it expects will best predict the resolution of the uncertainty. As Sprout expects that the
taxation authority will likely require Sprout to apportion the HK$275,000 deductible
HK(IFRIC)- amount over a 10-year period, the possible outcomes are concentrated on one value. As
Int 23.11 such, the ‘most likely’ method is the most appropriate method to use. Under this method,
Sprout is entitled to an annual deduction of HK$27,500.
Torrent would add back to its assessable profits of HK$1,350,000 the non-deductible
amount of HK$247,500 (HK$275,000 − HK$27,500), giving rise to a current tax liability of
HK$263,588 (HK$1,597,500 × 16.50%).

Question 13
Under HK(IFRIC)-Int 23, Sprout is required to use the ‘most likely’ method because it is
HK(IFRIC)- required to make consistent estimates for current and deferred taxes when an uncertain
Int 23.12 tax treatment affects both. Upon applying the ‘most likely’ method, a taxable temporary
difference of HK$27,500 exists equal to the difference between the carrying amount of the
intangible asset (HK$275,000, which is the cost of the intangible asset given it is not
amortised) and its tax base (HK$247,500, which represents the future deductible amounts
on the intangible asset). A deferred tax liability of HK$4,358 exists.

EXAM PRACTICE

Home Sweet Home Ltd (Home) is a retail company offering a range of household appliances
and furniture, including dining tables, lounge suites and kitchen appliances such as ovens and
dishwashers and bathroom products such as baths and vanities. It operates predominantly an
online retail business, with an online shopping platform offered on the company’s website; it
also has one ‘mega’ retail store located in Hong Kong where customers can see the products
before ordering. Home promotes its products through regular segments on Hong Kong’s
television shopping channel. As part of its marketing campaign, Home offers a money-back
guarantee to any dissatisfied customer who returns a product within the first six months
of purchase.

The following information is relevant for the period ended 31 March 20X4:

A. Home purchased the ‘mega’ retail store on 1 April 20X1 for HK$10 million. For
accounting purposes, the retail store is depreciated on a straight-line basis over
20 years. For tax purposes, Home is entitled to a capital allowance deduction of 4%
per annum;

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B. On 1 April 20X2, Home purchases a block of commercial land in Kowloon East for
HK$12 million for the purpose of building a second retail store. The land is currently
vacant. Home is neither entitled to depreciate the land for accounting purposes, nor
entitled to a capital allowance deduction for the land. However, any proceeds on selling
the land are taxable. On 31 March 20X4, Home revalues the land to HK$14.5 million
for accounting purposes. The land is not revalued for tax purposes. Home intends to
construct a retail store on the land within the next 12 months;

C. Home recognises gross trade receivables of HK$180,000 and an allowance for credit
losses of HK$9,000. Allowance for credit losses had an opening balance of HK$4,000.
The related revenue is assessable for tax purposes when earned, and credit losses are
deductible for tax purposes when the contractual cash flows become irrecoverable. The
amount of HK$7,500 becomes irrecoverable during the current period;

D. Home is entitled to dividends of HK$50,000 from a company it has invested in, which
Home recognises as dividends receivable in its 20X4 financial statements. Dividend
income is non-taxable;

E. During the current period, Home purchased inventory of HK$3.45 million from local
manufacturers, with this amount being the cost of the inventory for accounting and tax
purposes. The cost of the inventory is deductible for tax purposes when purchased.
At financial year-end, the inventory balance is HK$1.725 million. Inventory on hand
at the beginning of the period was HK$610,000;

F. Home paid a fine of HK$225,000 to Hong Kong’s Consumer Council due to a breach of
consumer protection laws;

G. Home recognises a warranty provision as of 31 March 20X4 at an estimated amount of

HK$175,000, which reflects the outflows Home may incur to refund customers, whose
products are currently under warranty. For tax purposes, the costs of refunds are
non-deductible until the warranty claims are made. For the 20X4 period, Home paid
HK$75,000 in refunds to customers. Warranty provision had an opening balance of
HK$90,000;

H. Home made two provisional tax payments during the year ended 31 March 20X4:

1. HK$125,000, which was 25% of actual profits tax payable from the 20X2–X3 tax year,
paid on 15 May 20X3; and

2. HK$375,000, which was 75% of actual profits tax payable from the 20X2–X3 tax year,
paid on 15 November 20X3;

I. Accounting profit for the year ended 31 March 20X4 is HK$2.5 million. This amount
incorporates income and expenses from the above items, where applicable;

J. Home calculates its average profits tax rate at 12.375%. Home expects this tax rate to
remain unchanged into the foreseeable future;

K. As of 1 April 20X3, Home recognises a current tax liability of HK$510,000, a deferred tax
liability of HK$95,000, and a deferred tax asset of HK$24,750;

L. All profits taxes are payable to, or recoverable from, the Inland Revenue Department,
which permits settlement on a net basis; and

M. Home is a single taxable entity.

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 FINANCIAL REPORTING

Required

QUESTION 1
Calculate the assessable profits of Home for the period ended 31 March 20X4.

QUESTION 2
Account for, with calculations and illustrations by way of journal entries, provisional tax
payments and current tax expense for the period ended 31 March 20X4.

QUESTION 3
Account for, with calculations and illustrations by way of journal entries, the deferred tax
consequences of the preceding transactions and events as of 31 March 20X4.

QUESTION 4
Prepare an extract of Home’s statement of financial position as of 31 March 20X4 in
accordance with the presentation requirements of HKAS 12.

QUESTION 5
Prepare the following note disclosures to accompany Home’s financial statements for the
period ended 31 March 20X4 in accordance with the disclosure requirements of HKAS 12:

• The major components of tax expense (income);

• Deferred tax with respect to each type of temporary difference; and

• Deferred tax recognised in profit or loss and each component of other

comprehensive income.

ANSWERS TO EXAM PRACTICE

QUESTION 1
HK$ HK$
Accounting profit for the period 4,500,000

Plus: Non-deductible expenses

Depreciationa 500,000
Expected credit losses b
12,500

Cost of goods soldc 2,335,000

Fine 225,000
Warranty expensed 160,000 3,232,500

Minus: Deductible claims

Capital allowancese (400,000)

Credit losses (7,500)

Inventory purchases (3,450,000)
Warranty costs (75,000) (3,932,500)

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 Income T axes

HK$ HK$
Minus: Non-assessable income
Dividend income (50,000)

Equals: Assessable profits for the period 3,750,000

a
HK$10,000,000/20 years = HK$500,000.
b
 losing balance of allowance for credit losses + Irrecoverable contractual cash flows − Opening balance of allowance
C
for credit losses (i.e. HK$9,000 + HK$7,500 − HK$4,000).
c
 pening balance of inventory + Purchases − Closing balance of inventory (i.e. HK$610,000 + HK$3,450,000 −
O
HK$1,725,000).
d
 losing balance of provision for warranties + Warranty claims paid − Opening balance of provision for warranties
C
(i.e. HK$175,000 + HK$75,000 − HK$90,000).
e
HK$10,000,000 × 4% = HK$400,000.

QUESTION 2
The provisional tax payment on 15 May 20X3 would give rise to the following journal entry:

Debit Credit
HK$ HK$
Current tax liability 125,000
Cash 125,000

The provisional tax payment on 15 November 20X3 would give rise to the following
journal entry:

Debit Credit
HK$ HK$
Current tax liability 375,000
Cash 375,000

Profits tax payable on HK$3.75 million is HK$453,750 ((HK$2 million × 8.25%) +

(HK$1.75 million × 16.50%)) and represents current tax expense for the period. Current tax
expense would be recorded with the following journal entry:

Debit Credit
HK$ HK$
Current tax expense 453,750
Current tax liability 453,750

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 FINANCIAL REPORTING

QUESTION 3
Statement of financial Carrying Tax base Taxable Deductible
position item amount temporary temporary
difference difference
HK$ HK$ HK$ HK$
Retail store 8,500,000 a
8,800,000 b
300,000
Land 14,500,000 12,000,000 c
2,500,000
Trade receivables (net) 171,000 180,000d 9,000
Dividend receivables 50,000 50,000 e
Nil Nil
Inventory 1,725,000 Nilf 1,725,000
Warranties provision 175,000 Nilg 175,000

Total 4,225,000 484,000

a
Carrying amount = Cost (HK$10,000,000) − Accumulated depreciation (HK$10,000,000/20 years × 3 years).
b
 arrying amount − Future taxable amounts + Future deductible amounts = Tax base (i.e. HK$8,500,000 −
C
HK$8,500,000 + HK$8,800,000 = HK$8,800,000).
Nota bene: Future deductible amounts represent the tax written down value of the retail store (i.e. HK$10,000,000 −
(HK$10,000,000 × 4% per annum × 3 years)).
c
The tax base of the land is based on taxable amount on sale (per HKAS 12, paragraph 51B).
d
 arrying amount − Future taxable amounts + Future deductible amounts = Tax base (i.e. HK$171,000 − Nil + HK$9,000
C
= HK$180,000).
e
 arrying amount − Future taxable amounts + Future deductible amounts = Tax base (i.e. HK$50,000 –Nil + Nil =
C
HK$50,000).
f
 arrying amount − Future taxable amounts + Future deductible amounts = Tax base (i.e. HK$1,725,000 − HK$1,725,000
C
+ Nil = Nil).
g
 arrying amount − Future deductible amounts + Future taxable amounts = Tax base (i.e. HK$175,000 − HK$175,000 +
C
Nil = Nil).
Nota bene: The fine was paid, rather than incurred, during the period ended 31 March 20X4. Therefore, there is no
‘accrued fines and penalties’ liability, which exists that requires carrying amount and tax base calculations. Recognition
of a deferred tax asset in relation to total deductible temporary differences of HK$484,000 is only to the extent that
sufficient future assessable profits will probably be available against which the deductible temporary differences can
be utilised. In making this assessment, Home first determines whether sufficient taxable temporary differences exist,
whose reversal will generate future taxable amounts against which the reversing deductible temporary differences can
be offset against.

Evident from the above table, taxable temporary differences (HK$4.225 million) exceed
deductible temporary differences (HK$484,000), indicating sufficient future assessable
profits will be available. Moreover, these taxable temporary differences must:

• Relate to the same taxation authority (i.e. the Inland Revenue Department) and
the same taxable entity (i.e. Home) to which the deductible temporary differences
relate; and

• Be expected to reverse in the same period as the expected reversal of the deductible
temporary differences. For example, it would be expected all inventory on hand will
be sold next period, which would likely coincide with when the deductible temporary
differences arising from trade receivables and the warranties provision would reverse.
Moreover, it would be expected that the land will generate assessable profits for an
extended period of time when the retail store is operational that is likely to exceed the
remaining useful life on the existing ‘mega’ store.

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 Income T axes

Home will recognise a deferred tax asset of HK$59,895 on total deductible temporary
differences of HK$484,000 (HK$484,000 × 12.375%). Because the opening deferred tax
asset balance is HK$24,750, Home would record the following journal entry to increase the
deferred tax asset to HK$59,895:

Debit Credit
HK$ HK$
Deferred tax asset 35,145
Income tax expense (deferred tax) 35,145

Home is to recognise a deferred tax liability of HK$522,844 on total taxable temporary

differences of HK$4,225,000 (HK$4.225 million × 12.375%). Of this amount, HK$309,375
relates to the taxable temporary difference arising on the revaluation of the land
(HK$2.5 million × 12.375%). As the revaluation increment is recognised outside profit or
loss (i.e. in other comprehensive income), Home is required to recognise the deferred tax
consequences arising from the revaluation outside profit or loss (i.e. in other comprehensive
income) also. The remainder is to be recognised as deferred tax expense.

As the opening deferred tax liability balance is HK$95,000, Home would record the
following journal entry to increase the deferred tax liability to HK$522,844:

Debit Credit
HK$ HK$
Other comprehensive income (revaluation of land) 309,375
Income tax expense (deferred tax) 118,469
Deferred tax liability 427,844

QUESTION 4
Home has a legally enforceable right to offset a current tax asset against a current tax
liability because:

• They both relate to income taxes levied by the Inland Revenue Department; and

• The Inland Revenue Department permits Home to settle on a net basis.

Though a current tax asset and current tax liability do not concurrently exist in this
instance, Home will be required to offset its deferred tax asset against its deferred tax
liability if, in addition to satisfying the previous conditions, the deferred tax asset and
deferred tax liability relate to income taxes levied by the same taxation authority on the
same taxable entity. In this case:

• They both relate to income taxes levied by the Inland Revenue Department; and

• Home is a single taxable entity.

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 FINANCIAL REPORTING

Based on the preceding information, an extract of Home’s statement of financial position

as of 31 March 20X4 would be as follows:

Statement of financial position as of

31 March 20X4 (extract)
Current liabilities HK$
Current tax liability 463,750a
Deferred tax liability (net) 4,629,499b

a
 npaid current tax from prior periods (HK$510,000 − HK$125,000 −
U
HK$375,000) + Unpaid current tax from the current period (HK$453,750).
b
 losing balance of deferred tax liability (HK$522,844) − Closing balance of
C
deferred tax asset (HK$59,895).

QUESTION 5
The following disclosure relates to the major components of tax expense (income):

Major components of tax expense (income) HKAS 12 paragraph HK$

Current tax expense (income) HKAS 12.80(a) 453,750
Deferred tax expense relating to the origination HKAS 12.80(c) 118,469
and reversal of temporary differences
Deferred tax income relating to the origination HKAS 12.80(c) (35,145)
and reversal of temporary differences
Tax expense (income) 537,074

Nota bene: The reference to each relevant HKAS 12 paragraph is for illustrative purposes only and is not required
to be disclosed under HKAS 12.

The following disclosure relates to deferred tax with respect to each type of temporary
difference as per HKAS 12.81(g)(i):

Deferred taxation with respect to each

type of temporary difference HK$
Deferred tax assets:
• Retail store (37,125)
• Trade receivables (1,134)
• Warranties provision (21,656)
Deferred tax liabilities
• Revaluation of land 309,375
• Inventory 213,469
Deferred tax liability (net) 462,949

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 Income T axes

The following disclosure relates to deferred tax recognised in profit or loss and each
component of other comprehensive income as per HKAS 12.81(g)(ii) and HKAS 12.81(ab),
respectively:

Movements in deferred taxation comprise: HK$

Deferred tax liability (net) as of 1 April 20X3 70,250
Movements for the year:
(Credited) charged to profit or loss:
• (Deferred tax income) (35,145)
• Deferred tax expense 118,469
Charged to other comprehensive income:
• Revaluation of land 309,375
Deferred tax liability (net) as of 31 March 20X4 462,949

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M11_c19.indd 1084 11/7/2022 5:48:07 PM
 20
Earnings per Share

CHAPTER TOPIC LIST

20.1 Overview 20.3.3 Adjustment to Shares

20.1.1 Scope 20.3.4 Dilutive Potential Ordinary
20.1.2 Terminology Shares

20.2 Measurement: Basic EPS 20.4 Use of EPS as a Performance

20.2.1 Earnings
Measure
20.2.2 Shares 20.5 Presentation and Disclosure
20.3 Measurement: Diluted EPS 20.5.1 Presentation
20.3.1 Objective 20.5.2 Disclosure
20.3.2 Adjustment to Earnings

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT

FOR BUSINESS TRANSACTIONS
LO2.11: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: Earnings per share
2.11.01 Explain the meaning and significance of a company’s earnings per share
2.11.02 Calculate the earnings per share, including the impact of a bonus issue, a rights issue and
an issue of shares at full market value
2.11.03 Explain the relevance of a company’s diluted earnings per share
2.11.04 Illustrate the limitations of using earnings per share as a performance measure
2.11.05 Prepare disclosure in respect of earnings per share

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 Earnings per Share

OPENING CASE

RED FISH LIMITED

R ed Fish Limited (Red Fish) is a blood products company that produces and sells plasma,
coagulation factors and immunoglobulins. It operates from Hong Kong and sells its
products around the Asia-Pacific region.

As of 1 January 20X2, Red Fish has 20 million ordinary shares on issue that are traded on
the Hong Kong stock exchange. On 15 March 20X2, Red Fish issues another 5 million ordinary
shares at the prevailing market value. On 31 December 20X2, Red Fish has 25 million ordinary
shares on issue.

Red Fish has a research policy that required funding arranged through a 1 July 20X0 issue
of 300,000 Convertible Cumulative Preference Shares (CCPSs) each with a face value of HK$100
and a nine-year duration. Holders have the option to redeem the CCPSs for cash or convert
the CCPSs to ordinary shares on 30 June 20X9. The terms of conversion provide for one
ordinary share to be issued in place of each CCPS. The holders of CCPSs are entitled to receive
a fixed return of 3% per annum plus an amount equal to any dividend rate paid to ordinary
shareholders. The cumulative nature of the CCPSs means that, if the 3% return is not paid in
any given year, that amount accumulates (without interest) and is due to holders when there is
a dividend to ordinary shareholders or when:

• The CCPSs are redeemed on 30 June 20X9 for cash; or alternatively

• The CCPSs are converted on 30 June 20X9 into ordinary shares based on their HK$100
face value plus any accumulated returns and less a 10% discount to the market price of
ordinary shares.

Red Fish has made moderate profits in recent years that have all been reinvested in the
business. Red Fish has not paid a dividend to its ordinary shareholders or its CCPS holders for
three years because it is in a growth phase and decided to retain the funds rather than issue
new capital. Accordingly, Red Fish has also not paid the 3% fixed return to holders of CCPSs
since they were issued on 1 July 20X0.

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 FINANCIAL REPORTING

OVERVIEW

Earnings per Share (EPS) is a widely quoted performance measure often used by securities
analysts in conjunction with other information. It is calculated as an entity’s profits (i.e. earnings
displayed in the numerator) for a period (usually a year or a half-year) divided by a measure of
the number of an entity’s units of ownership (i.e. shares displayed in the denominator). This
Chapter generally refers to the case of a company with shares; however, the same principles
apply to entities, such as trusts that have unitholders rather than shareholders.

Actual EPS is often compared with an analyst’s target EPS to gain a sense of whether
a company has met expectations. If the current year EPS for Red Fish is larger than last
year’s reported EPS, it could be a sign that each Red Fish share is producing a greater return
for shareholders. EPS might also be used to help measure senior company executives’
performance and may form part of the formula for determining their performance-based
remuneration. Accordingly, accounting for EPS and being able to understand its significance
and limitations is important to a range of stakeholders who may seek an accountant’s advice.

Basic EPS might be compared with share price to provide a broad indication of the
extent to which earnings (past and expected future earnings) are reflected in the market’s
assessment of the shares. In the case of an entity that is seeking to list, basic EPS could be
compared with the proposed application price for each share to help determine if it is priced
fairly. Diluted EPS seeks to indicate how earnings would be diluted if new shares from the
exercise of existing derivatives, such as options or convertible bonds, were to be issued.
Accordingly, diluted EPS might be used by Red Fish shareholders to gauge the potential for
the company’s profits having to be spread over a greater number of shares if the CCPSs were
converted into ordinary shares.

Different types of share issues can also have a differential impact on the calculation of
EPS. For example, though Red Fish recently issued five million ordinary shares at the prevailing
market value, companies sometimes issue shares at a discount to the market value. In these
cases, the consideration received that can be employed in the business is not commensurate
with the number of shares issued and means that past year EPS calculations need to be
adjusted to make them comparable with EPS calculated in the year of the discounted
share issue.

A comparison of EPS among companies within the same industry might be a useful
indicator of relative performance. However, a comparison of EPS among companies in
different industries might not be as useful because each industry will be subject to different
conditions. For example, EPS would generally not be a useful indicator of relative performance
between a company that manufactures televisions and a company such as Red Fish, which is

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 Earnings per Share

researching and developing new blood products for the pharmaceutical market. The television
manufacturer may have a stable share base and steady earnings, and a company, such as
Red Fish, may have an expanding share base (as it seeks new capital) and may generate only
moderate profits or possibly losses as it seeks to grow.

EPS is likely to be of greatest relevance to existing and potential ordinary shareholders and
their advisers. Although calculations of EPS may be useful for other users, calculations of EPS
do not directly cater for the perspectives of other types of existing and potential equity holders,
such as preference shareholders or debtholders.

2 0 . 1 OVERVIEW

This Chapter addresses the determination of earnings per share (EPS) under HKAS 33 Earnings
per Share (HKAS 33).

EPS is a ratio of company earnings to the number of the company’s shares, usually
expressed as cents per share. EPS has been used as a performance indicator ever since
publicly listed companies became a common form of business structure. Historically there
have been various ways in which the EPS was determined. The objective of HKAS 33 is to
establish the principles that facilitate a common basis for determining EPS, which facilitates
the comparability of EPS across companies. Other HKFRSs address how earnings (i.e. profits or
losses) are determined; accordingly, the focus of HKAS 33 (and therefore this chapter) is on the
denominator (the number of shares) in the EPS calculation.

20.1.1 Scope
HKAS 33 applies to any entity, such as a company or unit trust, that:

• Has shares or units traded in a public market; or

• Is in the process of filing its financial statements with a regulator with the purpose of
issuing shares or units to be traded in a public market.

Public markets include, for example, the Stock Exchange of Hong Kong (SEHK), Shanghai
Stock Exchange (SSE) and the New York Stock Exchange (NYSE). Public markets can also include
‘over-the-counter’ markets that are open to the public and, for example, might be operated by a
major securities trading firm.

HKAS 33 applies to consolidated financial statements prepared in compliance with HKFRSs

and to separate parent entity financial statements prepared in compliance with HKFRSs.

20.1.2 Terminology
Given that the focus of HKAS 33 is on ‘number of shares’, the key terms pertinent to this
chapter are ‘ordinary shares’ (which are distinguished from ‘preference shares’) and ‘potential
ordinary shares’ (such as ‘call options’).

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 FINANCIAL REPORTING

HKAS 33 applies to both shares and other forms of ownership instruments. HKAS 33 refers
to equity holders and shareholders. This chapter refers mainly to shares and shareholders.
HKAS
33.5 Ordinary shares are subordinate to all other classes of an entity’s issued securities. They
might be only a subset of all the instruments classified as equity in accordance with HKAS 32
Financial Instruments: Presentation. (For more information on classifying financial instruments,
refer to Chapter 12.)

HKAS 33 uses the term ‘preference shares’ to identify shares with special rights not
possessed by ordinary shares and, therefore, superior to ordinary shares. This could include
the right to participate in cumulative dividends before ordinary shareholders are entitled to
dividends or to receive returns of capital in priority before ordinary shareholders. In practice,
some instruments that are preference shares within the meaning of HKAS 33 are called by a
different name, e.g. ‘perpetual capital securities’.

‘Potential ordinary shares’ are instruments that give the holder the right to ordinary
HKAS
shares and may include options, warrants or other instruments such as convertible notes
33.5 issued by the company to acquire ordinary shares. Although they are not (yet) ordinary shares,
they are used in the calculation of what is referred to as ‘diluted EPS’, but not in the calculation
of what is referred to as ‘basic EPS’.

2 0 . 2 MEASUREMENT: BASIC EPS

Basic EPS is measured by dividing ‘profit or loss’, which is attributable to ordinary shareholders
(or, where the entity is a group of entities with non-controlling interests, profit or loss
attributable to ordinary shareholders of the parent entity’) by the ‘weighted average number of
ordinary shares on issue’ during the reporting period:

Profit/loss attributable to ordinary shareholders of the pa

arent entity
Weighted average number of ordinary shares on issue

20.2.1 Earnings
The numerator used in measuring basic EPS is ‘profit or loss attributable to ordinary
shareholders of the parent entity’. In the case of a consolidated group, the shareholders for
the purposes of HKAS 33 do not include any minority shareholders that might exist as a result
of one of the company’s subsidiaries being partly owned by another entity. This is because the
focus of EPS is on the parent entity shareholders and their interests in the group’s earnings,
but the minority interest shareholders only have an interest in an entity within the group,
i.e. a different entity from the group.

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 Earnings per Share

When an entity has ‘discontinued operations’ in accordance with HKFRS 5 Non-current Assets
held for Sale and Discontinued Operations (see Chapter 15), two separate earnings amounts are
used to measure two separate basic EPS amounts:

1. Profit or loss from continuing operations attributable to ordinary shareholders of the

parent entity; and

2. Profit or loss from the discontinued operations attributable to ordinary shareholders of

the parent entity.

When an entity makes a loss, the EPS would be measured using that loss and could be
referred to as a loss per share.

20.2.1.1 Profit or Loss Attributable to Ordinary Shareholders of the Parent Entity

For the purpose of calculating basic EPS, the profit or loss attributable to ordinary
shareholders of the parent entity includes all items of income and expense attributable to
HKAS ordinary shareholders of the parent entity that are recognised in a period in accordance with
33.12 accounting standards. This includes tax expenses and any ‘dividends’ on those preference
shares classified as liabilities in accordance with HKAS 32. Other preference shares might have
characteristics that lead them to be classified as equity instruments in accordance with
HKAS 32; however, they also represent a competing class of equity to ordinary shareholders
from an EPS perspective. Accordingly, as illustrated in Exhibit 20.2, any non-principal payments
on preference shares, whether classed as liabilities or equity in accordance with HKAS 32,
HKAS represent an expense (akin to interest expense) for the purpose of determining the
33.13 numerator.

In the context of HKAS 33, all the existing instruments that are classed as equity and are not
ordinary shares are referred to as ‘preference shares’.

In calculating basic EPS, the profit or loss attributable to ordinary shareholders of the
parent entity needs to be adjusted for the after-tax amounts of any preference dividends,
HKAS differences arising on the settlement of preference shares and other similar effects of
33.14 preference shares classified as equity in the statement of financial position. The adjustment for
the after-tax amounts of preference dividends is determined as:

• The after-tax amount for any preference dividends on non-cumulative preference

shares declared in respect of the period; and

• The after-tax amount of the preference dividends for cumulative preference shares that
the entity is obligated for, whether those dividends have been declared. This is because
a feature of cumulative preference shares is that the dividends for each period are
required to be paid at some stage even though they may not have been declared.

In determining earnings for the purposes of calculating basic EPS, any return on preference
shares that is paid from retained earnings and does not have tax deducted, is adjusted for tax
because, had ordinary shares been the only source of equity, the return on the preference
shares would have been a tax-deductible interest cost.

This is demonstrated in the flowchart in Exhibit 20.1.

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 FINANCIAL REPORTING

Is the financial instrument (other than

ordinary shares) classified as equity,
based on HKAS 32?

YES NO

Does the equity instrument have a No further action required. The costs
cumulative return to the holder that (if any) associated with the instrument
the entity must pay, whether declared (such as interest) would already be
in that period or not? expenses affecting profit or loss.

YES NO

The instrument has a non-cumulative

Profit or loss is adjusted for the
return to the holder that the entity
after-tax impact of any declared return
declares each period. Profit or loss is
and undeclared returns relating to
adjusted for the after-tax impact of the
that period (as if they were expenses)
declared return (as if it were an expense)
for the purposes of calculating EPS.
for the purposes of calculating EPS.

EXHIBIT 20.1 Flowchart for determining earnings for calculating EPS

Accordingly, in calculating EPS (see Exhibit 20.2), an entity that has preference shares
cannot simply use the profit or loss attributable to ordinary shareholders of the parent entity
that is presented in the financial statements. Adjustments are required to acknowledge the
entitlements to earnings for the period attributable to any shareholders other than ordinary
shareholders in order to determine the earnings that are relevant to ordinary shares.

Profit attributable to the ordinary shareholders of the parent company

2017 2016
HK$m HK$m
Profit attributable to shareholders of the parent company 10,798 2,479
Dividend payable on preference shares classified as equity (90) (90)
Coupon payable on capital securities classified as equity (1,025) (1,090)
Year ended 31 December 9,683 1,299

From statement of profit or loss and other Adjustments necessary to ‘Earnings’ used in the
comprehensive income determine ‘earnings’ calculation of basic EPS

EXHIBIT 20.2 Example earnings used in the calculation of EPS (Source: HSBC Plc 2017 Annual Report.)

Illustrative Example 1
In addition to its ordinary shares, Brown Bear Limited (Brown Bear) has 50,000
convertible preference shares on issue that have a face value of HK$10 each and paid
a 5% preference dividend in 20X2, which based on HKAS 32, is presented as a return
to equity holders in the financial statements. Given that any returns to convertible
preference shareholders are unavailable for ordinary shareholders, Brown Bear
cannot use the profit attributable (all) shareholders in calculating EPS without making
adjustments relating to the 50,000 convertible preference shares on issue.

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 Earnings per Share

Illustrative Example 1 (continued)

Had these convertible preference shares been classified as debt, an interest expense net
of tax would have been incurred amounting to HK$20,875 (HK$500,000 5% = HK$25,000
adjusted for tax at 16.5% of HK$4,125). Accordingly, HK$20,875 is deducted from Brown
Bear’s profit or loss for the purposes of determining profit or loss attributable to ordinary
shareholders of the parent entity for measuring basic EPS.

Convertible securities classified as debt would not involve an adjustment to earnings

because the profit or loss would already incorporate an interest expense.

An entity might issue preference shares for a discount on the nominal face value on the
basis that the shares will provide no dividends or a low initial dividend. Alternatively, an entity
might issue preference shares for a premium on the basis that the shares will provide an
above-market dividend at some stage; the premium compensates the entity for having to pay
above-market dividends. These discounts or premiums must be amortised to retained earnings
using the effective interest method and treated as a preference dividend for the purposes of
HKAS determining profit or loss attributable to ordinary shareholders of the parent entity in
33.15 calculating basic EPS.

Illustrative Example 2
Rodent Limited (Rodent) issues 10,000 preference shares with a face value of HK$150
and a 10-year duration that pay no dividends. Each preference share is issued
for HK$100.

The effective interest rate is 4.138% (rounded). Accordingly, in the first year in which
the preference shares are issued, HK$41,378 (10,000 preference shares HK$100
4.138%) would be regarded as a preference dividend. Given that any returns to preference
shareholders are unavailable for ordinary shareholders, Rodent cannot simply use the
profit-attributable shareholders in calculating EPS without first making adjustments
relating to the 10,000 preference shares on issue.

HK$34,551 (HK$41,378 less 16.5% tax of HK6,827) would be treated as an expense for
the purposes of measuring Rodent’s EPS.

An entity may repurchase some or all of its preference shares. If there is a difference
between the carrying amount of the preference shares and the amount for which they are
repurchased or converted to ordinary shares, adjustments to earnings would be needed for the
purposes of calculating EPS (Exhibit 20.3).

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 FINANCIAL REPORTING

Effectively represents a Excess is deducted

> transfer of earnings to from profit or loss
greater preference shareholders to for the purposes of
Amount paid than the detriment of the ordinary calculating basic
Carrying
by the entity shareholders EPS
amount of
to repurchase
preference Effectively represents a Deficit is added to
preference
< shares in transfer of earnings to profit or loss for
shares (or to
less the entity’s ordinary shareholders to the the purposes of
convert them
than statement detriment of the preference calculating basic
into ordinary
of financial shareholders EPS
shares)
position
= No impact on ordinary No adjustment to
equals shareholders profit or loss

EXHIBIT 20.3 Adjustment of earnings for calculating EPS

Any excess would be deducted from and any deficit would be added to profit or loss
HKAS attributable to ordinary shareholders of the parent entity for the purpose of calculating
33.16–18 basic EPS.

Illustrative Example 3
Lorikeet Limited (Lorikeet) is keen to rationalise its capital structure. To facilitate the
buy-back of 2,000 preference shares with a face value of HK$100, Lorikeet repurchases
them for HK$106 per share.

The effect of the repurchase is to reduce earnings in the period by HK$12,000 (HK$6
2,000 preference shares) for the purposes of calculating EPS because, from an EPS
perspective, it is the equivalent of Lorikeet making a loss on the repurchase of its debt.

Key Learning Point

Earnings, for the purpose of calculating basic EPS, is the profit or loss attributable to
ordinary shareholders of the parent entity and includes all items of income and expense
attributable to ordinary shareholders of the parent entity that are recognised in a period
in accordance with accounting standards. In calculating basic EPS, the profit or loss
attributable to ordinary shareholders of the parent entity may be adjusted for preference
shares.

20.2.2 Shares
HKAS 33 requires the denominator for basic EPS to be determined as the weighted average
number of ordinary shares on issue during the reporting period.

Entities often issue or buy back ordinary shares at amounts that correspond to
their prevailing market value when they are issued or bought back, which is among the
circumstances addressed in Section 20.2.2.1. Alternatively, entities might issue or buy back
ordinary shares at amounts that do not correspond to their prevailing market value when
they are issued or bought back, which is the circumstance addressed in Section 20.2.2.2.

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 Earnings per Share

The distinction between the different circumstances is important because there are different
impacts on determining the weighted average number of ordinary shares used in comparative
information.

20.2.2.1 Weighted Average Number of Ordinary Shares

The weighted average number of ordinary shares outstanding during a period takes into
HKAS account the number of ordinary shares outstanding when the period begins, adjusted for
33.20 ordinary shares bought back or issued during the period based on a time-weighting.

HKAS The weighting occurs from the time the consideration for shares acquired or redeemed is
33.21 due, which would ordinarily be the date of issue or redemption.

Illustrative Example 4
Regarding Red Fish Limited (Red Fish) for the year from 1 January 20X2 to 31 December
20X2:

• As of 1 January 20X2, there were 20 million ordinary shares on issue

• On 15 March 20X2, another 5 million ordinary shares at the then prevailing market
value were issued; and
• As of 31 December 20X2, there were 25 million ordinary shares on issue.

Time weighting Shares × weighting Weighted average

20 million ordinary 100% 20 million shares 23,986,301
shares on issue as at ordinary shares
1 January 20X2 for the purpose of
calculating basic EPS
5 million shares issued 291 days divided by 3,986,301 shares
on 15 March 20X2 365 daysa = 79.7%
(roundedb)

Notes:
a
 his example uses the number of days outstanding in a year to determine the time weighting; however, for
T
­simplicity, the number of months outstanding in a year can be used when relevant, such as when the t­ ransactions
take place at beginning or end of a month.
b
Although the factor was rounded to 0.797, the number of shares has not been rounded.

Some entities have on issue mandatorily convertible instruments, i.e. they will
automatically convert into ordinary shares based only on the simple passage of time. Even
though they are not yet converted to currently issued ordinary shares, they are regarded
HKAS as being issued for the purposes of determining the weighted average number of ordinary
33.23 shares for calculating basic EPS. The rationale is that because these instruments will
inevitably convert into ordinary shares, they should be regarded as already being on issue.

Some entities have on issue contingently issuable shares, i.e. shares will be issued
when one or more events take place. For example, the issue of such shares might be
contingent on the entity achieving a revenue level. They are treated as outstanding and are
HKAS not included in determining the weighted average number of ordinary shares for
33.24 measuring basic EPS until the time when all necessary events have occurred.

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Illustrative Example 4 (continued)

Sometimes ordinary shares are issued as consideration for the acquisition of a
business. These are included in the weighted average number of ordinary shares from the
HKAS date of acquisition of the business because this is the time from which earnings from the
33.22 business would be included in the acquirer’s earnings.

Illustrative Example 5
Red Fish Limited (Red Fish) acquired a business from Kestrel Limited (Kestrel) on 1 July
20X2. Part of the consideration for acquiring the business was 50,000 ordinary shares in
Red Fish. In addition, Red Fish agreed that if the business generated revenue in excess
of HK$10 million for the period ending 31 December 20X3, Red Fish would issue 20,000
more of its ordinary shares to Kestrel.

To calculate its basic EPS, for the year from 1 January 20X2 to 31 December 20X2,
Red Fish would include 25,205 shares (50,000 shares 184 days divided by 365 days) in
determining the weighted average number of ordinary shares for measuring basic EPS.
The contingently issuable shares would be ignored at this time because it has yet to be
established that the acquired business has generated revenue in excess of HK$10 million
for the period ending 31 December 20X3.

For the year from 1 January 20X3 to 31 December 20X3, the business acquired from
Kestrel generates HK$11 million, and Red Fish would include an additional 20,000 shares in
determining the weighted average number of ordinary shares for measuring basic EPS.

20.2.2.2 Changes in Capital

If the number of ordinary shares on issue changes at amounts that correspond to their
prevailing market values when they are issued or bought back, under HKAS 33, the resulting
EPS for the current period of the changed number of shares is regarded as being comparable
with EPS amounts reported in the past. In these circumstances, HKAS 33 assumes the
additional resources from a share issue, or the reduction of resources resulting from a
share buy-back, compensate appropriately for the increased or reduced number of shares
on issue. That is, HKAS 33 assumes the numerator and denominator in the EPS are affected
proportionately.

In contrast, the number of ordinary shares on issue can change without a corresponding
change in resources, i.e. without consideration.

In these circumstances and under HKAS 33, the current period EPS is not regarded as being
comparable with EPS amounts reported in the past. This is because any additional resources
from a share issue, or any reduction of resources resulting from a share buy-back, are
disproportionate and do not compensate appropriately for the increased or reduced number of
shares on issue. In these cases, the weighted average number of ordinary shares outstanding
HKAS during the period and, importantly, for all comparative periods presented need to be adjusted to
33.27 take account of the changed number of shares to enable a meaningful comparison of EPS over
the periods reported.

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 Earnings per Share

Examples of changes in the number of ordinary shares without there being a corresponding
change in resources include:

• A share ‘split’; for example, for every one share held, shareholders receive two shares.
The directors of a company might decide to do this when the share price is high in the
context of the market in which the shares are traded because, all else being equal, a
share split should result in a proportionate decrease in share price

• A reverse share split such that: for example, for every 10 shares held, shareholders
receive one share. The directors of a company might decide to do this when the share
price is low in the context of the market in which the shares are traded

• A rights issue with a bonus element; for example, for every five shares held,
shareholders receive one share on payment of an amount that is less than the market
value of the share; the directors of a company might decide to do this when the
company requires a quick injection of capital.

HKAS In a rights issue, when the exercise price is less than the fair value of the shares, the rights
33.A2 include a ‘bonus element’. Rights issues are often offered to all existing shareholders. In which
case, the number of shares used in calculating EPS for all periods before the rights issue is the
number of ordinary shares outstanding before the issue multiplied by an adjustment factor
and determined as the fair value of the shares prior to the rights issue divided by the
theoretical ex-rights price per share.

Fair value of shares immediately prior to exercise

of rights plus proceeds from exercise of rights
Theoretical ex-rights price per share
Number of shares outstanding after the
exercise of rights

Fair value of per share prior to exercise of rights

Adjustment factor
Theoretical ex-rights price per share

Illustrative Example 6
Echidna Limited (Echidna) reported profit or loss attributable to ordinary shareholders of
the parent entity of HK$100 million in the year ending 31 December 20X1 and presented
one comparative year of profit or loss information in its financial statements. Echidna’s
share price as of 1 January 20X2 is HK$50.

As of 1 January 20X2, Echidna issues one ordinary share for every seven shares already
owned for a price of HK$40 per share, i.e. a bonus element of HK$10 or one-fifth of the
market price (fair value). The HK$10 per share represents the disproportionate change
in resources resulting from the share issue. Prior to the rights issue, 70 million ordinary
shares are on issue. All shareholders take up all their rights taking the number of shares
on issue from 70 million to 80 million.

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Illustrative Example 6 (continued)

In its 20X1 financial statements, Echidna reported basic EPS of HK$1.43 (HK$100 million
divided by 70 million shares). However, in its 20X2 financial statements, Echidna would
show restated basic EPS for 20X1 (i.e. the comparative year) of HK$1.39 (calculated as
HK$100 million divided by 72 million shares – being 70 million shares plus one fifth of
10 million new shares).

In terms of the factor described in HKAS 33.A2, the calculation would be as follows.

Fair value of shares immediately prior to exercise of rights

plus proceeds from exercise of rights HK$3, 900, 000, 000
Theoretical ex-rights (70 million shares HK K$50 plus 10 million shares HK$40)
price per share Number of shares outstanding after the exercise
of the rights 80 million shares

HK
K$48.75
Fair value of per share prior to exercise of rights of HK$50
Adjustment factor
Theoretical ex-rights price per share of HK$48.75

1.025641*
* Rounded.

The 20X1 reported basic EPS of HK$1.43 would be adjusted as follows for inclusion as
the 20X1 comparative EPS in the 20X2 financial statements.

Earnings of HK$100 million divided by 70 million shares adjusted by 1.025641. That is,
HK$100 million divided by 71,794,872 shares (70 million 1.025641) = HK$1.39.

Apply and Analyse 1 – Adapted from HKAS 33 Illustrative Examples,

Example 4
Owl Limited (Owl) is developing a line of binoculars and decided to fund the necessary
research and development through a rights issue on 1 July 20X5 to all of its ordinary
shareholders.

Owl’s share price on 1 July 20X5 is HK$32 and one right is available for every five shares
held. Each right is priced at HK$29. Owl has 10 million ordinary shares as of 1 January 20X5.

Owl’s financial year ends on 31 December 20X5 and the rights must be taken up by 25
August 20X5. All the rights are taken up.

Owl’s profit or loss attributable to ordinary shareholders is HK$98,500,000 in 20X5

(HK$87,600,000 in 20X4).

Explain the impact of the rights issue in the current year and for the 20X4 EPS
presented as comparative information.

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 Earnings per Share

Apply and Analyse 1 (continued)

Analysis

The current financial year is affected by the rights issue in proportion to the time the rights
are outstanding and the prior year EPS presented in the financial statements need to be
adjusted to be comparable with the current year EPS. The necessary calculations can be
performed by determining the relevant theoretical ex-rights price of Owl’s shares.

Fair value of shares immediately prior to exercise of rights

plus proceeds from exercise of rights HK$378, 000, 000
Theoretical (10 million shares HK$32 plus 2 million shares HK$29)
ex-rights price per share Number of shares outstanding after the exercise
of the rights 12 million shares

HK$31.50

Fair value of per share prior to exercise of rights of HK$32

Adjustment factor
Theoretical ex-rights price per share of HK$31.50

1.015873 *
*
Rounded, but with a sufficient number of decimal places to achieve an accurate calculation.

20X5 EPS

10,653,099 shares would be used in calculating the 20X5 EPS, determined as:

Period before the shares are Period after the shares are
issued in respect of the rights issued in respect of the rights
10 million shares 1.015873 12 million shares 98 days/365 days
(the factor) 267 days/365 days
7,431,181 shares 3,221,918 shares 10,653,099 shares

EPS for 20X5 would be HK$9.25 (rounded) (HK$98,500,000 profit or loss attributable to
ordinary shareholders divided by 10,653,099 shares).

20X4 adjusted EPS

The original 20X4 calculation would have resulted in an EPS of HK$8.76 (HK$87,600,000
profit or loss attributable to ordinary shareholders divided by 10 million shares).

The adjusted 20X4 calculation to be used as a comparative number in the 20X5

financial statements is rounded to HK$8.62 (HK$87,600,000 profit or loss attributable
to ordinary shareholders divided by the product of 10 million shares multiplied by the
1.015873 (the factor)).
(Source: based on HKAS 33 Illustrative Examples, Example 4)

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Key Learning Point

The term ‘shares’, for the purpose of calculating basic EPS, means the average number of
ordinary shares, weighted for the time they are outstanding during the reporting period.

Knowledge Check Questions

Question 1
Identify which of the following amounts is used as earnings for the purposes of measuring
EPS in accordance with HKAS 33.
A Profit or loss before tax attributable to ordinary shareholders of the parent entity.
B Profit or loss before tax and interest attributable to ordinary shareholders of the
parent entity.
C Profit or loss attributable to ordinary shareholders of the parent entity.
D Profit attributable to ordinary shareholders of the parent entity but not a loss
attributable to ordinary shareholders of the parent entity.

Question 2
A company has 5,000 non-cumulative preference shares on which it pays a 2.5%
dividend from retained earnings at the end of each year. Identify which of the following
explains how the preference shares affect earnings used to calculate EPS in accordance
with HKAS 33.
A Earnings are adjusted for the after-tax impact of the 2.5% dividend as if it had been a
tax-deductible interest payment.
B The preference shares do not affect earnings used to measure EPS because the dividend
is distributed from retained earnings.
C Earnings are adjusted for the 2.5% dividend without alteration for the impact of tax
because dividends are not tax deductible.
D Earnings are not adjusted because the 2.5% dividend on the preference shares is not
cumulative.

Question 3
1,000 new ordinary shares are issued 30 days before the end of the reporting period.
Identify which of the following statements explains how the new ordinary shares are
factored into the existing number of ordinary shares to measure EPS in accordance with
HKAS 33.
A By adding the 1,000 newly issued ordinary shares to the existing number of shares.
B By assuming the 1,000 newly issued ordinary shares had been issued in the middle of
the period and, therefore, adding 500 ordinary shares to the existing number of shares.
C The 1,000 newly issued ordinary shares would be ignored for the purposes of the current
period EPS because they were issued so late in the period.
D By adding the 1,000 newly issued ordinary shares weighted for the 30 days they have
been on issue over the total number of days in the period to the existing number
of shares.

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 Earnings per Share

Knowledge Check Questions (continued)

Question 4
At the beginning of the current reporting period, a company has a rights issue under
which shareholders are granted one ordinary share for every five ordinary shares held
in exchange for half the prevailing market value. Assuming all the rights are taken up by
shareholders, identify the adjustments required to past period EPS amounts.
A All past period EPS amounts presented are adjusted for the impact of the rights issue,
i.e. being one additional share for every five ordinary shares on issue.
B All past period EPS amounts presented are adjusted for the impact of the rights issue,
i.e. being one additional share for every 10 ordinary shares on issue.
C Only the one past period EPS amount presented is adjusted for the impact of the rights
issue, i.e being one additional share for every 10 ordinary shares on issue.
D There are no adjustments to past period EPS amounts presented because consideration
was paid in exchange for the shares acquired under the rights issue.

2 0 . 3 MEASUREMENT: DILUTED EPS

Diluted EPS is measured by dividing profit or loss attributable to ordinary shareholders of the
parent entity, adjusted for the effects of converting dilutive potential ordinary shares, by the
total of the weighted average number of ordinary shares on issue during the reporting period
plus the dilutive effect of potential ordinary shares:

Profit / loss attributable to ordinary shareholders of the p arent entity

/ Effect of converting dilutive potential orddinary shares
Weighted average number of ordinary shares on n issue Dilutive potential ordinary shares

20.3.1 Objective
In addition to the basic EPS, HKAS 33 requires an entity to calculate and present diluted EPS,
HKAS 33.31 which accounts for the effects of all dilutive potential ordinary shares. A ‘potential ordinary
HKAS 33.5 share’ is a financial instrument or other contract that may entitle its holder to ordinary shares.

Though the basic EPS is calculated as earnings divided by the existing share base, the
diluted EPS seeks to indicate the extent to which earnings would need to be spread over
a greater number of shares had new ordinary shares been on issue for the period as if
existing dilutive potential ordinary shares had been exercised or converted. It attempts to
provide an indicator of the implications for existing shareholders if, hypothetically, all the
company’s dilutive potential ordinary shares has been converted into ordinary shares and were
outstanding during the period. This involves adjusting the earnings and the weighted average
number of shares as if the dilutive potential ordinary shares had been converted.

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20.3.2 Adjustment to Earnings

In determining adjusted profit or loss attributable to ordinary shareholders of the parent entity
for the purpose of measuring diluted EPS, an entity adjusts for the after-tax effect of:

• Any ‘dividends’ or other similar returns on dilutive potential ordinary shares already
deducted in arriving at profit or loss attributable to ordinary shareholders of the
parent entity;

• Any interest on dilutive potential ordinary shares that has been recognised in finance
costs; and

HKAS • Any other income or expense impacts that would result from assuming the conversion
33.33 of dilutive potential ordinary shares.

These adjustments are made because, if dilutive ordinary shares were converted, the above
impacts on earnings would no longer occur. The ordinary shares into which they would have
been converted would instead participate in profit or loss attributable to ordinary shareholders
of the parent entity.

Illustrative Example 7
Red Fish has 300,000 Convertible Cumulative Preference Shares (CCPSs) with a face value
of HK$100 that might convert to 300,000 ordinary shares. The CCPS holders are entitled
to receive a fixed return of 3% plus any dividend rate paid to ordinary shareholders.
Although Red Fish has not paid the 3% return in 20X2, the cumulative nature of the
CCPSs means that the 20X2 3% dividend accumulates and is due to CCPS holders
and payable when there is a dividend to ordinary shareholders. Accordingly, in 20X2,
although the 3% return is not paid to CCPS holders, it would have been accrued and
recognised as an expense in determining profit or loss for 20X2.

For the purposes of this example, the relevant tax rate is 16.5%.

For the purposes of this illustration, assuming the CCPSs are dilutive, in measuring the
20X2 diluted EPS, Red Fish’s earnings would be adjusted upwards by HK$900,000 (300,000
CCPSs multiplied by face value of HK$100 multiplied by 3%) because, once the CCPSs are
converted, that amount would no longer be recognised as an expense.

If the 3% return had been incurred for tax purposes (regarded as a tax deduction
by the Inland Revenue Department), a tax effect would also have occurred. The tax
adjustment to earnings would be HK$751,500 (300,000 CCPSs multiplied by face value of
HK$100 multiplied by 3% = HK$900,000 less 16.5% tax of HK$148,500).

In contrast, to the extent the 3% is accrued for accounting purposes but not tax
purposes (i.e. not regarded as a tax deduction by the Inland Revenue Department), there
would be no adjustment for tax.

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20.3.3 Adjustment to Shares

In determining adjusted weighted average number of shares for the purpose of calculating the
HKAS diluted EPS, an entity adjusts for the number of ordinary shares that would have been on issue
33.36 had all the dilutive potential ordinary shares been converted. In making this calculation,
the entity:

• Deems the conversion to have taken place at the beginning of the reporting period;
or the date the dilutive potential ordinary shares were issued if that occurred during
the period;

• Makes the adjustments separately for each period, i.e. the annual period is not a
weighted average of interim period computations;

• Adjusts for dilutive potential ordinary shares that lapsed during the period based on the
proportion of the reporting period before they lapsed;

• Assumes the most advantageous basis of conversion from the perspective of the holder
of the potential ordinary shares when more than one basis for conversion exists; and

• Accounts for any dilutive potential ordinary shares of the parent entity that may have
been issued by subsidiary or associated entities.

The above factors are all designed to show a dilutive EPS that takes a worst-case view of
how EPS would be affected if dilutive derivatives were exercised/converted. Diluted EPS can be
regarded is a form of a warning sign for existing and potential ordinary shareholders because it
helps them to identify what the impact of potential ordinary shares might be on EPS.

Illustrative Example 8
Wombat Limited (Wombat) is preparing its financial statements for the year ending
31 December 20X2 and has, or had, on issue the following dilutive potential ordinary
shares:

• 5,000 options issued on 1 January 20X2 that were convertible into 5,000 ordinary
shares but lapsed on 30 June 20X2;

• 8,000 options that convert into 8,000 ordinary shares and were issued on
1 October 20X2; and

• 1,000 convertible notes with a face value of HK$200 and note holders can choose
to convert them on either of the two possible bases: (1) each note converts into a
fixed number of ordinary shares, being 10 shares for each note; or (2) each note
converts into HK$200 worth of ordinary shares.

As of 31 December 20X2, Wombat’s ordinary shares traded for HK$19.23.

Regarding the 5,000 options that lapsed on 30 June 20X2, Wombat would include
2,479 additional shares relating to the number of days the options were outstanding in
20X2 (181 days divided by 365 days and then multiplied by 5,000 options) for calculating
diluted EPS. This is alternatively determined as 6 months divided by 12 months and then
multiplied by 5,000 options.

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Illustrative Example 8 (continued)

Regarding the 8,000 options that commenced on 1 October 20X2, Wombat would
include 1,995 additional shares relating to the number of days the options were
outstanding in 20X2 (91 days divided by 365 days and then multiplied by 8,000 options)
for calculating diluted EPS. This is alternatively determined as 3 months divided by
12 months and then multiplied by 8,000 options.

Regarding the 1,000 convertible notes, conversion basis (1) would result in 10,000 new
ordinary shares (1,000 notes 10 shares); under conversion basis, (2) each note would
convert to 10.4 new ordinary shares (HK$200 divided by HK$19.23), which would mean
a total of 10,400 ordinary shares (1,000 10.4). Wombat would include 10,400 additional
shares for measuring diluted EPS because the conversion basis (2) is the most dilutive.

Key Learning Point

Earnings, for the purposes of calculating diluted EPS, is the profit or loss attributable to
ordinary shareholders of the parent entity adjusted for the impact on profit or loss that
would arise if the dilutive potential ordinary shares had been converted.

20.3.4 Dilutive Potential Ordinary Shares

HKAS Not all potential ordinary shares will impact on the calculation of diluted EPS. Only those
33.41 potential ordinary shares that are dilutive are factored into the calculation. That is, potential
ordinary shares that are antidilutive would not be factored into the calculation of diluted EPS.

The benchmark for determining whether potential ordinary shares are dilutive or
HKAS antidilutive is the potential impact of conversion on profit or loss from continuing operations
33.42–43 attributable to the parent entity (Exhibit 20.4).

If the conversion of potential ordinary shares would:

Decrease basic EPS Increase basic EPS

(or increase loss per share) (or decrease loss per share)
from continuing operations from continuing operations

Those potential ordinary shares would be Those potential ordinary shares would be
regarded as dilutive and therefore are regarded as antidilutive and therefore are
included in the calculation of diluted EPS excluded from the calculation of diluted EPS

EXHIBIT 20.4 Determining whether potential ordinary shares are dilutive

or antidilutive (Source: HKAS 33.43)

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 Earnings per Share

The rationale behind these requirements is that holders of potential ordinary shares will
act rationally and only convert their potential ordinary shares into ordinary shares if that would
be to their economic advantage where economic advantage is deemed to be indicated by
claims on earnings. That is, potential ordinary shareholders would only choose to convert their
instruments into ordinary shares if that were to effectively result in them gaining some value
to the detriment of existing ordinary shareholders. This is consistent with dilutive EPS always
taking a worst-case view of how EPS would be affected if dilutive derivatives were exercised
and/or converted.

HKAS If more than one series of potential ordinary shares exist, each series is considered
33.44 separately and not in aggregate. The sequence in which they are considered is also important.
HKAS 33 requires the most dilutive potential ordinary shares (based on earnings per
incremental share) to be considered first, followed by the next most dilutive, with the least
dilutive to be considered last. This has the effect of maximising the dilutive impact on EPS for
diluted EPS to be most effective as a form of a warning sign for existing and potential ordinary
shareholders in identifying what the impact of potential ordinary shares might be.

20.3.4.1 Options, Warrants and Their Equivalents

In the context of HKAS 33, options and warrants are instruments that provide the holder with a
right to ordinary shares, usually on payment of a contractually identified exercise price.
An entity assumes that dilutive options and warrants will be exercised, with the assumed
HKAS proceeds treated as having been received from issuing ordinary shares at the average market
33.45 price during the reporting period. The difference between the number of ordinary shares that
would be issued under the options or warrants and the number of ordinary shares that would
have been issued for the proceeds based on the average market price represents the number
of ordinary shares issued for no consideration. This reflects an assumption underpinning
HKAS 33 that consideration earns a return equivalent to the EPS on existing ordinary shares.
Instead of adjusting both earnings and the number of ordinary shares, HKAS 33 requires shares
issued for the average market price to be ignored. Only shares issued for no consideration are
included in calculating diluted EPS (Exhibit 20.5).

No. of shares purchasable • Not dilutive

@average market price • Excluded from basic & diluted EPS
calculations
Proceeds from
100% option exercise

• Potentially dilutive
No. of ‘free’ shares* • No. potential ordinary shares to
included in diluted EPS calculation

* No. of free shares = No. shares issued on exercise of the options – No. shares that would have been issued
if the cash payable to excercise the options had been used to buy new shares on-market instead.

EXHIBIT 20.5 Number of potential ordinary shares to include in the diluted

EPS calculation

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Put another way, each dilutive option or warrant is effectively being regarded as
constituting two separate contracts:

1. One contract for ordinary shares issued at average market price, which is not included
in the denominator to measure diluted EPS; and

2. One contract for ordinary shares issued for no consideration, which is included in the
denominator to measure diluted EPS.

Illustrative Example 9
Raven Limited (Raven) has 100,000 options outstanding that were issued on 1 January
20X3, which can be converted into one ordinary share per option on payment of HK$9.50
by 31 December 20X3.

Raven had 1,500,000 ordinary shares on issue throughout 20X2. Raven’s profit or loss
from continuing operations attributable to the parent entity for the year ending 31 December
20X2 is HK$2 million. Raven’s average share price over the year to 31 December 20X2 was
HK$12.

100,000 options HK$9.50 exercise price = HK$950,000

HK$950,000 divided by the HK$12 average share price for 20X2 = 79,167 shares

Accordingly, the 100,000 options effectively constitute two contracts:

1. One contract to acquire 79,167 ordinary shares at the HK$12 average share price
for the period: and

2. Another contract to receive 20,833 ordinary shares for no consideration.

That is, notionally, if the 100,000 options had been exercised at a price of HK$9.50 per
ordinary share, there would have been 20,833 more ordinary shares on issue for which no
consideration had been received because the option exercise price per share is below the
average share price for 20X2.

Basic EPS is HK$1.33 (HK$2 million divided by 1,500,000 ordinary shares).

Diluted EPS would be HK$1.32 (HK$2 million divided by 1,520,833 ordinary shares),
which means the options are dilutive because HK$1.32 is less than HK$1.33.

A company might use options to acquire goods or services. A typical example would be
options issued to the entity’s employees as part of their remuneration. HKFRS 2 Share-based
Payment applies in these cases, and the exercise price for the purposes of determining
HKAS
whether, and to what extent, they are dilutive should include their fair value measured under
33.47A HKFRS 2 (see Chapter 24). The fair value includes the value attributable to the
services provided.

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 Earnings per Share

Illustrative Example 10
Cassowary Limited (Cassowary) pays its CEO partly in shares and has determined the
value of her services to be rendered as consideration for 25,000 options to acquire
shares at a cost of HK$5 per share is HK$100,000. The options were issued on 1 January
20X2. As at the reporting date, 31 December 20X2, the CEO need only keep working in
her role until 31 December 20X3 to qualify for the options. That is, she needs to meet no
other performance hurdle to be awarded the options.

The exercise price of each option taking into account the consideration relating to
services rendered is HK$9 per share (HK$100,000/25,000 = HK$4 plus HK$5 in cash).

Employees are often issued with options that only vest with the employees on meeting
some condition. When the condition is simply time-based (a service condition as defined in
Appendix A of HKFRS 2), they are included in measuring diluted EPS when they are dilutive even
though they may only vest with the employee once they have been employed for a further
HKAS period. When the condition is meeting some future target that is based, for example, on sales
33.48 or profit, the options are considered to be contingently issuable shares as discussed in
Section 20.3.4.3.

20.3.4.2 Convertible Instruments

Convertible instruments typically pay a return to the holder. The return may be paid
periodically or accumulated to be paid at a later stage.

HKAS These instruments are only dilutive when their total contractual return divided by the total
33.50 number of ordinary shares to which they would convert is less than basic EPS. That is, if the
assumed return from converting the instruments, using basic EPS as a benchmark, is greater
than the return from not converting them, the holders would rationally want to hold the
ordinary shares rather than the convertible instruments.

Illustrative Example 11
Red Fish has on issue 300,000 Convertible Cumulative Preference Shares (CCPSs) with
a face value of HK$100 and a 10-year duration. The terms of conversion provide for
one ordinary share to be issued in place of each CCPS. The CCPS holders are entitled
to receive a fixed return of 3% plus any dividend paid to ordinary shareholders. The
cumulative nature of the CCPSs means that, if the 3% return is not paid in any given year,
that amount accumulates and is due to holders when there is a dividend to ordinary
shareholders or when:

• CCPSs are redeemed on 30 June 20X9; or alternatively

• CCPSs are converted on 30 June 20X9 into ordinary shares based on their HK$100
face value plus any accumulated dividends and less a 10% discount to the market
price of ordinary shares.

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 FINANCIAL REPORTING

Illustrative Example 11 (continued)

In year ending 31 December 20X2, Red Fish made a profit attributable to ordinary
shareholders of the parent entity of HK$25 million.

Based on earlier Illustrative Examples:

• the weighted average number of ordinary shares for Red Fish in 20X2 is 23,986,301
shares (refer to the Illustrative Example 4 on Red Fish in Section 20.2.2.1); and

• the 3% return on CCPSs in 20X2 (assuming here that it is not regarded as a tax
deduction by the Inland Revenue Department and, therefore, not adjusted for tax)
is HK$900,000 (refer to the Illustrative Example 7 on Red Fish in Section 20.3.2).

Basic EPS is HK$1.04 (HK$25 million divided by 23,986,301 ordinary shares).

Adjusted profit for the purpose of calculating diluted EPS would be HK$25 million plus
HK$900,000 = HK$25,900,000

Adjusted share base for the purpose of calculating diluted EPS would be 23,986,301
shares plus 300,000 shares on CCPSs conversion = 24,286,301 shares

Diluted EPS, as if the CCPSs were converted, would be the adjusted profit of
HK$25,900,000 divided by the adjusted share base of 24,286,301 shares = HK$1.07.
However, HK$1.07 is greater than HK$1.04. Accordingly, in 20X2, the CCPSs are antidilutive,
and therefore, their potential impact on the number of ordinary shares would not be
included in measuring diluted EPS.

Apply and Analyse 2 – Adapted from HKAS 33 Illustrative Examples,

Example 9
You have been asked to identify and explain the order in which potential ordinary shares
that are dilutive would be factored into the calculation of diluted EPS for The Cicada
Company Limited (TCCL).

TCCL provides the following information:

• Profit attributable to ordinary shareholders of HK$3,600,000

• 1,000,000 ordinary shares outstanding for the whole reporting period

• HK$50 average market price of shares during the period

• 250,000 options to acquire ordinary shares (one for one) at an exercise price of
HK$45

• 175,000 convertible bonds with a face value of HK$200 that convert to five ordinary
shares and are paid a return of 2% (tax deductible)

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 Earnings per Share

Apply and Analyse 2 (continued)

• 50,000 convertible preference shares with a par value of HK$100 that convert
into three ordinary shares and each receive a dividend of HK$5 per year (not tax
deductible)

• the prevailing tax rate is 16.5%.

All the potential ordinary shares are on issue for the whole of the period.

Analysis

Increase in earnings and ordinary shares on assumed conversion of potential

ordinary shares

Calculations Earnings Ordinary Earnings per

increase shares incremental
HK$ increase share
nil nil
250,000 25,000 (shares
(HK$50 – HK$45) issued for no
Options divided by HK$50 consideration)
Convertible bonds 175,000 HK$200 HK$584,500 HK$0.668
2% (1 – 0.165)
175,000 5 shares 875,000
Convertible 50,000 HK$5 HK$250,000 a
HK$1.667
preference shares
50,000 3 shares 150,000
a
Rounded.

Accordingly, the order in which the potential ordinary shares would be included
in calculating diluted EPS from most dilutive to least dilutive is: (1) the options; (2) the
convertible bonds; and (3) the convertible preference shares.

Calculation of diluted EPS

Earnings Ordinary shares Per share

HK$ HK$
As reported 3,600,000 1,000,000 3.60
Options nil 25,000 a
3.51 Dilutive
3,600,000 1,025,000
Convertible bonds 584,500 875,000 a
2.20 Dilutive
4,184,500 1,900,000
Convertible 250,000 150,000 a
2.86 Anti-dilutive
preference shares
4,434,500 2,050,000
a
Rounded.

Because the convertible preference shares increase the EPS, they are antidilutive and
are not included in the calculation of diluted EPS.

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 FINANCIAL REPORTING

Key Learning Point

The term ‘shares’, for the purposes of calculating diluted EPS, means the average number
of ordinary shares, weighted for the time they are outstanding during the reporting period
adjusted for the impact of dilutive potential ordinary shares that would arise if they had
been converted.

20.3.4.3 Contingently Issuable Shares

HKAS Contingently issuable ordinary shares are those that are issuable for little or no cash or other
33.5 consideration; instead, they convert on satisfying specified conditions set out in a contract.
For example, a contingency might be attaining and/or maintaining a particular sales or profit
level or share price over a number of periods. Other types of contingency conditions might
include opening a number of retail sites or achieving a production level.

The flowchart in Exhibit 20.6 outlines the requirements of HKAS 33 depending on whether
contingency conditions are satisfied or not:

Are the conditions satisfied (that is, has the

event(s) occurred)?

YES NO

Contingently issuable ordinary shares are The number of contingently issuable shares
included in the calculation of diluted EPS. included in measuring diluted EPS is based on
If the conditions are satisfied during a the number of shares that would be issuable
reporting period, it is assumed the contingently as if the end of the reporting period were the
issuable shares are on issue from the beginning end of the contingency period.
of the period. Or, if the contract started during For example, an earnings condition might be
the period, from the contract date (HKAS 33.52). met at reporting year end, but the contingency
period continues for another year. The dilutive
effect of the contingently issuable shares would
be included in diluted EPS (but not basic EPS)
in the current year even though it is not yet
known whether the condition will be met at the
following year end (HKAS 33.53).

EXHIBIT 20.6 Flowchart for whether contingency conditions are satisfied

HKAS
Prior period EPSs are not restated even if the contingency conditions are subsequently not
33.52 met. This is because HKAS 33 regards the diluted EPS calculated as at a past period end to be a
fair reflection of the dilutive impact that potential ordinary shares were expected to have at
that time, and the change between dilutive EPS from one period to the next period might
provide useful information about an entity’s changing capital structure.

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 Earnings per Share

Illustrative Example 12
House Limited acquires Flooring Limited on 30 September 20X2 for cash plus 250,000
contingently issuable shares. For the 250,000 contingently issuable shares to be issued
to the vendors, Flooring Limited must achieve a production of two million linear metres
of engineered timber flooring over two successive years: in the year ending 31 December
20X3 and in the year ending 31 December 20X4.

For the year ending 31 December 20X3, Flooring Limited has produced 2.2 million
linear metres of engineered timber flooring. In the context of the 31 December 20X3
financial statements, because the condition relating to that year is met at year-end, the
measurement of diluted EPS for House Limited will include the 250,000 contingently
issuable shares. (Although it could be viewed as if half the condition is met (one year of
production of two million linear metres of flooring), all the contingently issuable shares
are included in calculating diluted EPS. This reflects that diluted EPS is intended to show a
worst-case view.)

Because the actual issue of the contingently issuable shares remains contingent on
achieving production of at least two million linear metres of engineered timber in the year
ending 31 December 20X4, they are not included in measuring basic EPS for 20X2.

20.3.4.4 Contracts that May Be Settled in Ordinary Shares or Cash

An entity may have the option of settling an obligation by issuing its shares or paying cash.
HKAS In measuring diluted EPS, the most dilutive perspective is taken to show a worst-case view of
33.58 dilution and the obligation is assumed to be settled with shares when the impact is dilutive.
HKAS If the obligation is interest-bearing, the earnings would need to be adjusted in measuring
33.59 diluted EPS.

When the entity that is owed the obligation has the option of receiving either shares or
HKAS cash, the obligated entity would assume its creditor will choose to settle in shares for the
33.60 purposes of measuring diluted EPS.

Knowledge Check Questions

Question 5
An entity has 10,000 convertible bonds on issue that pay a fixed return to bondholders.
Identify the steps taken in calculating diluted EPS in accordance with HKAS 33.
A Determine whether the convertible bonds are dilutive, and if so, include 10,000 shares in
the denominator; there is no need to adjust for the fixed return because that will not be
paid once the bonds convert.
B Add the number of dividends that would have been paid to bondholders as if they had
been converted into ordinary shares into the numerator and include 10,000 shares in
the denominator.
C Add the fixed return into the numerator and include 10,000 shares in the denominator.
D Determine whether the convertible bonds are dilutive, and if so, add the fixed return into
the numerator and include 10,000 shares in the denominator.

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 FINANCIAL REPORTING

Knowledge Check Questions (continued)

Question 6
An entity with a calendar-year reporting period issues options to acquire its shares on
30 June 20X3 (halfway through its reporting period). Those options have an exercise price
that is 60% of the average share price for the reporting period. Identify how the options
are factored into the calculation of diluted EPS in accordance with HKAS 33.
A The number of shares that would effectively be issued for no consideration would be
included in the denominator, weighted by 50% for the period they were outstanding
during the reporting period.
B The number of shares that would effectively be issued for no consideration would be
included in the denominator.
C The number of shares that would be issued when the options are converted would be
included in the denominator and the numerator adjusted for the earnings that would
have been generated on the proceeds from the options being exercised.
D The number of shares that would be issued when the options are converted would be
included in the denominator, weighted by 50% for the period they were outstanding
during the reporting period, and the numerator would be adjusted for the earnings that
would have been generated on the proceeds from the options being exercised.

Question 7
At the reporting date, an entity has 90,000 contingently issuable shares that would convert
to ordinary shares in a year’s time if the entity’s revenue exceeds HK$100 million in the
forthcoming year. Revenue for the current year exceeds HK$100 million. Identify how basic
and diluted EPS are calculated at the reporting date in accordance with HKAS 33.
A The 90,000 contingently issuable shares are included in the denominator in calculating
basic and diluted EPS;
B Basic EPS is unaffected by the contingently issuable shares; the 90,000 contingently
issuable shares are included in the denominator in calculating diluted EPS;
C The estimated number of contingently issuable shares is included in the denominator
in calculating basic EPS; the total number of 90,000 contingently issuable shares are
included in the denominator in calculating diluted EPS; and
D Basic EPS is unaffected by the contingently issuable shares; the 90,000 contingently
issuable shares are included in the denominator in calculating diluted EPS to the
extent that it is expected the entity’s revenue will exceed HK$100 million in the
forthcoming year.

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 Earnings per Share

2 0 . 4 USE OF EPS AS A PERFORMANCE MEASURE

EPS is only one metric that is widely used as an indicator of an entity’s performance. Other
metrics include:

• operating cash flow per share

• net tangible book value per share

• percentage return on equity

• percentage return on assets

• price earnings ratio (could be based on average or period-end market price)

EPS is sometimes used to help assess an entity’s performance over time – some investors
generally prefer to see steady growth in EPS.

EPS is sometimes used to help assess whether one entity’s shares are overpriced or
underpriced relative to another entity’s shares. For example, all other things being equal, if
Entities A and B report similar EPSs and Entity A has a market value 20% higher than Entity B, it
might indicate that Entity A is overpriced relative to Entity B.

Diluted EPS relative to basic EPS can be a useful indicator of the extent to which parties
other than the existing shareholders could gain access to an entity’s future earnings and/or
wealth to the detriment of existing shareholders. If diluted EPS is much lower than basic EPS,
this could prompt a potential buyer of the shares to investigate the entity’s capital structure to
gain a better understanding of the nature and likely effects of the dilutive instruments.

EPS is unlikely to be useful on its own as a financial analysis tool.

In addition, depending on the circumstances, some significant criticisms of EPS could limit
its usefulness, including the following.

• The weighted average number of an entity’s ordinary shares during the year may not
be relevant to some users of financial statements, particularly when the number of
shares as at the reporting date is materially higher or lower than the weighted average.
This could occur when large share issues or large share buy backs occur late in the
reporting period;

• Some investors question the relevance of including a weighting for shares that lapsed
during the reporting period in determining the weighted average number of an entity’s
ordinary shares. They consider that, because it is known at the reporting date that
those shares have lapsed, they should be ignored in measuring EPS;

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 FINANCIAL REPORTING

• Some investors question the relevance of including contingently issuable shares in

determining the denominator for measuring diluted EPS when all the conditions
for issuing the shares have not been met (yet). Others would argue their relevance
depends on the nature of the conditions;

• The weighted average market price of an entity’s ordinary shares during the year, which
is used in a number of ways as an input to calculating diluted EPS, might not represent
the share’s recent price because that price may have been adversely affected, or
favourably affected, by recent events; and

• EPS is often not a useful way in which to compare entities operating in different
industries or different geographic locations. A biotechnology company in a growth
phase might have a low EPS or a loss per share because it has high research spending;
an established retailer might have a high EPS because it has a solid customer base and
is still using fully depreciated fixtures and fittings. It would be unwise to place too much
reliance on the relative EPS for the biotechnology company and retailer as a basis for
investment decisions.

2 0 . 5 PRESENTATION AND DISCLOSURE

HKAS 33 has some specific requirements on where and how prominently, EPS amounts must
be presented.

20.5.1 Presentation
As illustrated in Exhibit 20.7, basic and diluted EPS from continuing operations attributable to
HKAS the ordinary shareholders of the parent entity must be presented with equal prominence on
33.66 the face of the statement of profit or loss and other comprehensive income. This is one of the
few occasions in the HKFRSs that an amount that is not a specific line item in the financial
statements is specifically required to be presented on the face of the financial statements. This
reflects the significance that investors attach to EPS amounts and the importance of evaluating
EPS amounts in conjunction with the financial statements. Most amounts that are not specific
line items in the financial statements can be shown on the face or in notes at the entity’s
discretion. From the perspective of HKAS 33, the basic and diluted measures of EPS should be
considered together; requiring their presentation together with equal prominence helps to
achieve this.

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 Earnings per Share

2016 2015
Note US$’000 US$’000
(Restated)

Profit attributable to owners of the Company arises from:

– Continuing operations 9,000 14,661
– Discontinuing operations 9,472 (1,892)

18,472 12,769
Earning per share form continuing and discontinued
operations attributable to owners of the company
for the year (expressed in US cent per share)
Basic and diluted EPS are
presented with equal
Basic earnings per share 29
prominence, showing From continuing operations 0.9 1.4
separately (1) EPS relating to EPS is
From discontinued operations 0.9 (0.2) disclosed for
the continuing operations
attributable to the ordinary 1.8 1.2
all periods
From profit for the year
shareholders of the parent presented
entity and (2) EPS relating to Diluted earnings per share 29
the discontinued operations From continuing operations 0.9 1.4
From discontinued operations 0.9 (0.2)

From profit for the year 1.8 1.2

EXHIBIT 20.7 Example disclosure on the face of the statement of comprehensive income
(Source: Luen Thai Holdings Limited 2016 Annual Report.)

When basic and diluted EPS are the same, only one amount needs to be presented,
provided the same amount relates to basic and diluted EPS. However, if a separate diluted EPS
is relevant only for one period, it must be presented for all periods for which a statement of
profit or loss and other comprehensive income exists.

When an entity has more than one class of ordinary shares with different rights to share
in profits, the basic and diluted EPS are presented for all classes. The two classes may share
equally in profits, but only one class has voting rights.

HKAS Basic and diluted EPS must be presented with equal prominence and for all periods for
33.67 which statements of comprehensive income are presented.

When an entity has discontinued operations, separate basic and diluted EPS are shown for
HKAS the discontinued operations and may be presented on the face of the statement of profit or
33.68 loss and other comprehensive income or in the notes to the financial statements, for example,
in the note that explains the discontinued operations or in the note that contains the other
disclosures about EPS (see Section 20.5.2).

HKAS The same presentation requirements apply whether the amounts are positive EPS or
33.69 negative EPS (losses per share).

20.5.2 Disclosure
As illustrated in Exhibit 20.8 below, an entity must disclose the building blocks used in
calculating EPS. These include:

• Amounts used as the numerators in calculating basic and diluted EPS; i.e. earnings
amounts, which must be reconciled to profit or loss attributable to the parent entity for
the period; and

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 FINANCIAL REPORTING

• The numbers of shares used as the denominators in calculating basic and diluted EPS;
i.e. the weighted average numbers of ordinary shares, which must be reconciled
HKAS between basic and diluted EPS showing the effect of each class of instruments
33.70 affecting EPS.

9 Earnings per share

Basic earnings per ordinary share is calculated by dividing the profit attributable to ordinary shareholders of the parent company
by the weighted average number of ordinary shares outstanding, excluding own shares held. Diluted earnings per ordinary share
is calculated by dividing the basic earnings, which require no adjustment for the effects of dilutive potential ordinary shares, by the
weighted average number of ordinary shares outstanding, excluding own shares held, plus the weighted average number of
ordinary shares that would be issued on conversion of dilutive potential ordinary shares.

Profit attributable to the ordinary shareholders of the parent company

2017 2016 2015
$m $m $m
Profit attributable to shareholders of the parent company 10,798 2,479 13,522
Dividend payable on preference shares classified as equity (90) (90) (90)
Coupon payable on capital securities classified as equity (1,025) (1,090) (860)
Year ended 31 Dec 9,683 1,299 12,572

Basic and diluted earnings per share

2017 2016 2015

Number Per Number Per Number Per
Profit of shares share Profit of shares share Profit of shares share
Footnote $m (m) $ $m (m) $ $m (m) $
Basic 1 9,683 19,972 0.48 1,299 19,753 0.07 12,572 19,380 0.65
Effect of dilutive potential ordinary shares 100 92 137
Diluted 1 9,683 20,072 0.48 1,299 19,845 0.07 12,572 19,517 0.64
1 Weighted average number of ordinary shares outstanding (basic) or assuming dilution (diluted).
The number of anti-dilutive employee share options excluded from the weighted average number of dilutive potential ordinary
shares is nil (2016: 10 million; 2015: 7 million).

EXHIBIT 20.8 Example EPS disclosures in the notes to the financial statements (Source: HSBC Holdings
Plc 2017 Annual Report.)

HKAS
33.70 An entity must also disclose the following:

• Any instruments, such as contingently issuable shares, that might potentially dilute
basic EPS in the future, but were not included in measuring diluted EPS because they
were antidilutive in the period(s) presented; and

• A description of ordinary share transactions or potential ordinary share transactions

not disclosed that happened after the reporting period end and would have changed
the numbers of shares used to measure either or both of basic and diluted EPS if the
transactions had occurred before the reporting period ended. This might include a large
share issue or large conversion of potential ordinary shares into ordinary shares early
in the new year. Most entities would include this information with their statement of
changes in equity.

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 Earnings per Share

An entity might choose to disclose other types of EPS amounts in addition to showing the
HKAS basic and diluted EPS calculated as required by HKAS 33. However, HKAS 33 imposes strict
33.73 limitations on how such other types of EPS amounts can be calculated and disclosed. Any other
EPS must be:

• Calculated using the weighted average number of ordinary shares determined in

accordance with HKAS 33, i.e. only the numerator can be different

• Disclosed for basic and diluted EPS with equal prominence; and

• Disclosed with an indication of the basis on which the numerator has been determined,
including whether it is before or after tax. When it is not reported as a line item in the
statement of profit or loss and other comprehensive income, a reconciliation is needed
between the numerator used and a reported line item.

For example, an entity might wish to show EPS based on earnings before interest and taxes
(EBIT). The entity would divide EBIT by the weighted average number of ordinary shares used
in accordance with HKAS 33 for basic and diluted EPS and, if EBIT does not appear as a line
item in the statement of profit or loss and other comprehensive income, the entity would show
a reconciliation between EBIT and profit or loss attributable to ordinary shareholders of the
parent entity.

Key Learning Point

Basic and (when applicable) diluted EPS from continuing operations attributable to the
ordinary shareholders of the parent entity must be presented with equal prominence
on the face of the statement of profit or loss and other comprehensive income. When
discontinued operations exist, basic and (when applicable) diluted EPS from discontinued
operations attributable to the ordinary shareholders of the parent entity must be
presented either on the face of the statement of profit or loss and other comprehensive
income or must be presented in the notes.

Ethics in Practice
As noted in the overview, EPS is sometimes used to help measure senior company
executives’ performance and may form part of the formula for determining their
performance-based remuneration. Accordingly, there can be heightened awareness
among senior managers around the EPS calculation.

Basic and diluted EPS are particularly sensitive to judgements made about the
numerator and denominator. A relatively small change to earnings or the weighted
average number of ordinary (or potential ordinary) shares can make a significant
difference to the trendline of performance based on EPS.

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Ethics in Practice (continued)

Professional accounting judgements made about the factors that can affect the EPS
calculation are made with utmost objectivity. Senior management (including when relevant
those responsible for establishing performance benchmarks for an entity) is made aware
of the relative significance of basic and diluted EPS.

When the accountant is asked to advise on using EPS measures as a basis for
assessing management performance, it is relevant to identify the different perspectives on
performance gained by examining not just one measure of performance but potentially
multiple measures. In doing so, the accountant would need to be aware of the potential
short-comings of basic and diluted EPS as performance measures.

The remuneration sub-committee of the board of directors of Lama Limited (Lama)

asks its Chief Accountant, Jian Leow, to advise on the ways in which EPS might be best
used as a measure for helping to determine the CEO’s annual bonus. Jian Leow is familiar
with Lama’s capital structure, which includes ordinary shares and substantial levels of
convertible preference shares and options.

The remuneration sub-committee has indicated that the CEO favours having his
performance based on the trend for basic EPS growth alone, and the sub-committee is
attracted to the simplicity of that approach.

Jian Leow determines that the trendline for basic EPS has shown a relatively steady
improvement over recent years, the trendline for diluted EPS has been far more volatile.
In particular, he notes that the convertible preference shares are currently highly dilutive
and represent a substantial portion of Lama’s operating capital. Jian Leow should advise
the remuneration sub-committee that, given the complex nature of Lama’s capital
structure, the use of basic EPS on its own is unlikely to provide a fair and reasonable
representation of Lama’s performance from the perspective of Lama’s shareholders.

Knowledge Check Questions

Question 8
An entity has profit from continuing operations attributable to the ordinary shareholders
of the parent entity of HK$1 million and a loss from a discontinued operation of
HK$400,000. Identify which of the following best describes the way in which basic and
diluted EPS should be presented in accordance with HKAS 33.
A Four EPS amounts would need to be presented on the face of the statement of profit or
loss and other comprehensive income: basic EPS for continuing operations; diluted EPS
for continuing operations; basic EPS for the discontinued operation; and diluted EPS for
the discontinued operation;
B Basic EPS for continuing operations and diluted EPS for continuing operations need to
be presented on the face of the statement of profit or loss and other comprehensive
income. Basic EPS for the discontinued operation and diluted EPS for the discontinued
operation need to be presented on the face of the statement of profit or loss and other
comprehensive income or in a note;

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 Earnings per Share

Knowledge Check Questions (continued)

C Basic EPS for continuing operations and diluted EPS for continuing operations need to
be presented on the face of the statement of profit or loss and other comprehensive
income. Only basic EPS for the discontinued operation needs to be presented on the
face of the statement of profit or loss and other comprehensive income or in a note;
diluted EPS for the discontinued operation is irrelevant; and
D Four EPS amounts would need to be presented either on the face of the statement of
profit or loss and other comprehensive income or be presented in a note; basic EPS
for continuing operations; diluted EPS for continuing operations; basic EPS for the
discontinued operation; and diluted EPS for the discontinued operation.

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 FINANCIAL REPORTING

SUMMARY

HKAS 33 requires any entity, such as a company or unit trust, that has shares or units traded
in a public market or is in the process of filing its financial statements with a regulator with the
purpose of issuing shares or units to be traded in a public market to calculate and present basic
and diluted EPS for the current and comparative reporting periods.

• If there are discontinued operations, basic and diluted EPS must be calculated for continuing
operations and for the discontinued operations (that is, four EPS amounts).

° Basic and diluted EPS from continuing operations must be presented with equal
prominence on the face of the statement of profit or loss and other comprehensive
income and basic and diluted EPS from the discontinued operations can be presented with
equal prominence on the face or in a note.

• Basic and diluted EPS are used as performance indicators by potential and existing
shareholders and may be used as a benchmark for senior management performance.

• Diluted EPS is a form of warning to potential and existing shareholders designed to show a
worst-case view of how EPS would be affected if all dilutive potential ordinary shares were
exercised or converted into ordinary shares.

• Basic EPS is calculated by taking

° ‘profit or loss attributable to ordinary shareholders of the parent entity’ (earnings),

adjusted for the after-tax impacts of any preference share dividends and other similar
items classified as equity; divided by the weighted average number of ordinary shares on
issue during the reporting period.

• Diluted EPS is calculated by dividing adjusted earnings by the weighted average number
of ordinary shares on issue during the reporting period adjusted for dilutive potential
ordinary shares.

° Earnings are adjusted by removing the impact of any dividends or interest included in
determining earnings; and

° Potential ordinary shares are dilutive when they would reduce basic EPS (or increase loss
per share). Potential ordinary shares include bonds, preference shares and options that
would result in the issued of more ordinary shares if they were converted.

• Ordinary shares that would be issued if a contingency were met are included in calculating
basic and diluted EPS when the contingency conditions are met. If the conditions are
unsatisfied, contingently issuable shares are included in calculating diluted EPS to the
extent they would be issuable as if the end of the reporting period were the end of the
contingency period.

• When a rights issue exists at less than the prevailing market price of ordinary shares or a
share split, past EPS amounts presented are adjusted to reflect the watering down of the
ordinary share base to make them comparable with the current year EPS amounts.

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 Earnings per Share

MIND MAP

BASIC EPS SCOPE

Determine ‘earnings’–profit or loss Entities listed on public markets
attributable to parent entity ordinary Entities in the process of listing on public
shareholders. ‘Earnings’ might differ from markets
what is reported in the statement of
comprehensive income DILUTED EPS
Determine the weighted average number A ‘worst-case’ view of how basic EPS is
of ‘ordinary shares’ impacted by other financial instruments
Identify when there have been changes in on issue
capital without corresponding changes Identify ‘potential ordinary shares’ and
in resources and adjust weighted average determine those that are dilutive
number of ordinary shares EARNINGS PER (e.g. issued call options, convertible
SHARE (HKAS 33) instruments, contingently issuable shares)
Adjust earnings for any returns on dilutive
ordinary shares e.g. add back any related
interest expense
Adjust weighted average number of
ordinary shares for dilutive potential
ordinary shares

PRESENTATION AND DISCLOSURE

Basic and diluted EPS presented with equal
prominence
Basic and diluted EPS presented for
continuing operations and, when relevant,
also for the discontinued operations
USE OF EPS AS A PERFORMANCE MEASURE Disclosure of amounts used–numerator
and denominator
EPS has both advantages and limitations
Adjust comparative EPS amounts to
as a performance measure
provide meaningful comparisons

Answers to Knowledge Check Questions

Question 1
Answers A and B are incorrect. The amount included as earnings is after-tax net profit or
loss attributable to ordinary shareholders of the parent entity.
Answer C is correct. HKAS 33 specifies that the amount included as earnings is the profit or
loss attributable to ordinary shareholders of the parent entity.
Answer D is incorrect. The calculated EPS may be negative (a loss per share), reflecting that
the entity has made a loss during the period.

Question 2
Answer A is correct. HKAS 33 specifies that EPS is calculated from the perspective of the
ordinary shareholders, and distribution of profit to any other group of stakeholders (in this
case non-cumulative preference shareholders) is treated as if it were an expense.
Answers B and D are incorrect. The earnings need to be adjusted for any distribution of
profit to any group of stakeholders other than ordinary shareholders.
Answer C is incorrect. If the preference dividend had been an expense, it would have
been deductible for tax purposes, and the impact on earnings attributable to ordinary
shareholders would be the net-of-tax impact.

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 FINANCIAL REPORTING

Question 3
Answer A is incorrect. Answer A would imply the new ordinary shares were on issue for the
entire reporting period, which is not the case.
Answer B is incorrect. Answer B would imply the new ordinary shares were on issue since
the middle of the reporting period, which is not the case.
Answer C is incorrect. The impact of the new ordinary shares needs to be incorporated into
the EPS calculation in the period in which the issue takes place (even if this occurs late in
the year).
Answer D is correct. HKAS 33 specifies that EPS is calculated using the weighted average
number of ordinary shares outstanding, with the weighting based on the amount of time
they have been on issue relative to the whole reporting period.

Question 4
Answer A is incorrect. Answer A wrongly implies that no consideration was paid for the
shares issued as a result of the rights being exercised.
Answer B is correct. HKAS 33 specifies that, to the extent consideration for shares
issued is disproportionate to their market value, they do not compensate appropriately
for the increased number of shares on issue and all comparative period EPS
amounts presented need to be adjusted. The extent to which the consideration is
disproportionate to their market value can be viewed as two shares being issued for
every 10 held, with one share being issued for full consideration and one share being
issued for no consideration.
Answer C is incorrect. Answer C wrongly ignores that an entity may present EPS for more
than one past period, and HKAS 33 requires all past period EPS presented to be adjusted.
Answer D is incorrect. Answer D wrongly implies that full consideration was paid for the
shares issued as a result of the rights being exercised.

Question 5
Answer A is incorrect. Answer A wrongly ignores the impact of the return on the
convertible bonds.
Answers B and C are incorrect. Answers B and C fail to acknowledge the need to assess
whether the convertible bonds are dilutive to determine whether they are included
in calculating EPS. Answer B also adds the wrong amount (notional dividends) to the
numerator; the correct amount is the actual fixed return to convertible bond holders.
Answer D is correct. HKAS 33 specifies that only dilutive potential ordinary shares are
included in the denominator used to calculate diluted EPS and any returns on the
convertible bonds (when they are dilutive) are adjusted as if they were not expenses but
returns to shareholders.

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 Earnings per Share

Question 6
Answer A is correct. HKAS 33 specifies that to the extent shares would have been issued for
no consideration in the event that dilutive potential ordinary shares were converted into
ordinary shares, they are incorporated in the denominator used to calculate diluted EPS.
HKAS 33 specifies that impact of conversion would be weighted for the time the dilutive
potential ordinary shares have been on issue.
Answers B and C are incorrect. Answers B and C fail to acknowledge the need for the
impact of conversion to be weighted for the time the dilutive potential ordinary shares
have been on issue. In addition, Answer C wrongly suggests that the total number of
ordinary shares (rather than only those issued for no consideration) are included in the
denominator to calculate diluted EPS and wrongly suggests that the numerator would
be adjusted.
Answer D is incorrect. Answer D wrongly suggests that the total number of ordinary shares
(rather than only those issued for no consideration) are included in the denominator to
calculate diluted EPS and wrongly suggests that the numerator would be adjusted.

Question 7
Answer A is incorrect. Answer A wrongly includes the contingently issuable shares in
calculating basic EPS.
Answer B is correct. HKAS 33 specifies that, if the contingency is not met, contingently
issuable shares are not included in calculating basic EPS. However, for the purposes of
calculating diluted EPS the end of the reporting period is treated as if it were the end of the
contingency period.
Answer C is incorrect. Answer C wrongly includes an estimated number of contingently
issuable shares in calculating basic EPS.
Answer D is incorrect. Answer D wrongly implies that the basis for including the
contingently issuable shares in calculating diluted EPS is the whether the contingency is
expected to be met.

Question 8
Answer A is incorrect. Answer A wrongly suggests that basic and diluted EPS for the
discontinued operation must be presented on the face of the statement of profit or loss
and other comprehensive income.
Answer B is correct. HKAS 33 specifies that basic and diluted EPS for continuing operations
are presented on the face of the statement of profit or loss and other comprehensive
income, and basic and diluted EPS for the discontinued operation can be presented on the
face of the statement of profit or loss and other comprehensive income or in a note.
Answer C is incorrect. Answer C wrongly suggests that diluted EPS for the discontinued
operation need not be disclosed.
Answer D is incorrect. Answer D wrongly suggests that basic and diluted EPS for continuing
operations can be presented in a note.

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 FINANCIAL REPORTING

EXAM PRACTICE

QUESTION 1
Bluetongue Paint (Bluetongue) is currently the biggest selling brand in Hong Kong. On 17 July
20X7, Rock Wallaby Limited (RWL) acquires the Bluetongue paint manufacturing business
from Lizard Limited (Lizard) for cash and 20 million RWL ordinary shares. Under the
acquisition arrangement, Lizard will receive a further 10 million RWL ordinary shares
contingent on Bluetongue remaining the biggest selling paint brand in Hong Kong for
the year to 31 December 20X8 and for the year to 31 December 20X9 based on industry
statistics.

RWL makes a rights issue on 8 March 20X8 available in respect of RWL’s 100 million
ordinary shares on issue as of 1 January 20X7. For every nine ordinary shares held, one
additional share can be acquired for HK$5. The RWL share price on 8 March 20X8 is HK$7.

Further information:

• RWL’s profit or loss from continuing operations attributable to ordinary

shareholders of the parent entity for the financial year ended 31 December 20X7 is
HK$52 million.

Required:
(a) Calculate RWL’s basic and diluted earnings per share (EPS) attributable to ordinary
shareholders for the consolidated financial statements for the financial year ended
31 December 20X7.

(b) Management of RWL has asserted the rights issue has no impact on the comparative
basic EPS disclosed in RWL’s consolidated financial statements for the year ending
31 December 20X8. Analyse if this assertion is true.

(c) During 20X8, a competitor launched an aggressive marketing campaign to promote its
paint brand as a better performer. As a result, management of RWL is no longer certain
that the industry statistics will reflect Bluetongue as the biggest selling paint brand in
Hong Kong for the year to 31 December 20X8. As part of gaining an understanding of
the impact of this possible change in circumstances, management of RWL has asked
you to explain what would happen with the diluted EPS disclosures in the consolidated
financial statements for the year ended 31 December 20X8 if Bluetongue were no
longer the biggest selling paint brand in Hong Kong in that year.

QUESTION 2
Quickstep Limited (Quickstep) has experienced strong profit growth and expects this to
continue. It operates in a rapidly growing industry and has paid a steady dividend of HK$3
per share per year for many years.

Quickstep has 15 million ordinary shares on issue as of 1 January 20X1. Quickstep’s

capital structure also includes 2 million convertible bonds issued on 1 June 20X0, which
have a face value of HK$100. Each bond converts to one ordinary share on 31 May 20X9.
The convertible bonds are entitled to receive a cumulative return of 2% each year when a

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 Earnings per Share

dividend is paid to ordinary shareholders. However, if no dividend were paid to ordinary

shareholders, the preference bondholders would not receive their 2% return and that
amount would accumulate and be due to bondholders whenever there is a dividend to
ordinary shareholders or when they are converted (in 20X9). The 2% return is tax deductible
to Quickstep.

On 1 July 20X1, Quickstep issues one million options to acquire ordinary shares that
have an exercise price of HK$95 and an exercise date of 30 June 20X8. Quickstep also issues
one million additional options to acquire ordinary shares on 5 January 20X2.

Other information:

• The weighted average price of Quickstep’s ordinary shares over the period since
1 July 20X1 was HK$103.

• Quickstep’s profit attributable to ordinary shareholders for the financial year

ended 31 December 20X1 from continuing operations is HK$75 million, and its loss
attributable to ordinary shareholders from discontinued operations is HK$5 million.

• Quickstep has a policy of presenting three statements of comprehensive income:

one for the current year and two prior period statements of comprehensive
income. Quickstep has a policy of disclosing an EPS based on earnings before
interest, depreciation and tax.
• The relevant tax rate applying to Quickstep is 16.5%.

Required:

(a) Determine which, if any, of the potential ordinary shares on issue are dilutive for the
financial year ended 31 December 20X1.

(b) Calculate diluted EPS for the financial year ended 31 December 20X1 for profit
attributable to ordinary shareholders from continuing operations and for profit
attributable to ordinary shareholders from discontinued operations.

(c) Rob, a new member of Quickstep’s finance team, is responsible for preparing the EPS
disclosures in Quickstep’s financial statements for the year ended 31 December 20X1.
Rob has asked if you would be able to assist by identifying for him

(i) the main factors Quickstep needs to be aware of to present its basic and diluted
EPS in its financial statements for the year ended 31 December 20X1 in accordance
with HKAS 33 Earnings per Share.

(ii) at least three key disclosures that Quickstep would need to be made in the notes to
the financial statements with respect to the presented EPS amounts under HKAS 33.

(d) Mr. Lim, a board director of Quickstep, has commented to you that the analysts did
not appear to be overly interested in Quickstep’s EPS during the recently held analyst
presentation. Draft an email to explain to Mr. Lim the significance and limitations of EPS
for an analyst of Quickstep’s financial statements.

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 FINANCIAL REPORTING

ANSWERS TO EXAM PRACTICE

QUESTION 1
(a) Calculate the basic and diluted EPS for the year ended 31 December 20X7.

To calculate its basic EPS, RWL will need to determine its weighted average number of
ordinary shares outstanding for the year ended 31 December 20X7 and its earnings for
the period:

Weighted average number of ordinary shares outstanding

for the year ended 31 December 20X7
Time Shares Calculation Weighting Result
As at 1 January 20X7 100,000,000 365 days/365 days 100.00% 100,000,000
From 17 July 20X7 20,000,000 167 days/365 days a
45.75% a
9,150,685
109,150,685
a
Rounded.

Earnings for the year ended 31 December 20X7

HK$52 million, being RWL’s profit or loss from continuing operations attributable to
ordinary shareholders of the parent entity for the year

Calculation – basic EPS

Basic EPS = HK$52,000,000 divided by 109,150,685 ordinary shares = HK$0.48

To calculate its diluted EPS, in addition to the information above, RWL will need to
determine the weighted average number of potential ordinary shares and the impact of
those potential ordinary shares on earnings for the period.

Weighted average number of shares used in the diluted EPS calculation

The contingently issuable shares relating to the acquisition of Bluetongue are potential
ordinary shares. The weighted average number of outstanding contingently issuable
shares is added to the weighted average number of ordinary shares used in the basic
EPS calculation to determine the denominator used in the diluted EPS calculation
given that RWL’s acquisition of Bluetongue occurred on 17 July 20X7 when relevant,
the contingently issuable shares are included in calculating diluted EPS from that date:
Since the contingency condition is met for 20X7 (i.e. Bluetongue is the biggest selling
paint brand in Hong Kong based on industry statistics), the contingently issuable shares
are included in calculating diluted EPS for 20X7.

Weighted average number of ordinary shares used in the basic 109,150,685

EPS calculation
plus: Weighted average number of potential ordinary shares
Time Shares Calculation Weighting
From 17 July 20X7 10,000,000 167 days/365 days a
45.75% a
4,575,342
113,726,027
a
Rounded.

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 Earnings per Share

Earnings used in the diluted EPS calculation

The contingently issuable shares relating to the acquisition of Bluetongue do not have
any effect on the earnings used in the basic EPS calculation. Accordingly, earnings of
HK$52 million is included as the numerator in the calculation.

Calculation – diluted EPS

Diluted EPS = HK$52,000,000 divided by 113,726,027 ordinary shares = HK$0.46

(The potential ordinary shares are dilutive because their conversion decreases the
earnings per share.)

(b) Calculation of adjusted basic EPS.

To determine whether management’s assertion that the rights issue has no impact on
its comparative EPS calculation is true, the adjusted basic EPS will need to be calculated.

In terms of the factor described in HKAS 33.A2, the calculation would be as follows.

Fair value of shares immediately prior to exercise

of rights plus proceeds from exercise of rights HK$755, 555, 555
Theoretical (100 million shares HK$7 plus 11111
, ,111 shares* HK$5)
ex-rights price per share Number of shares outstanding after the exercise
of the rights 111,111111
, shares

HK
K$6.8

Fair value of per share prior to exercise of rights of HK$7

Adjustment factor
Theoretical ex-rights price per share of HK$6.8
1.029412

* Note: Each nine shares is entitled to one right – 100 million shares / 9 = 11,111,111 rights.

The 20X7 reported basic EPS of HK$0.48 would be adjusted as follows for inclusion
as the 20X7 comparative EPS in subsequent financial statements.

Earnings of HK$52,000,000 divided by 109,150,685 shares adjusted by 1.029412.

That is, HK$52,000,000 divided by 112,360,999 (109,150,685 shares 1.025641)
= HK$0.46.

IMPORTANTLY: As the basic EPS for 20X7 as shown in the 20X7 consolidated
financial statements is HK$0.48 (HK$52,000,000 divided by 109,150,685), management’s
assertion that the rights issue has no impact on its comparative EPS calculation
is not true.

(c) Effect on diluted EPS if Bluetongue is no longer the biggest selling paint brand in
Hong Kong.

If, by 31 December 20X8, Bluetongue were no longer the biggest selling paint brand in
Hong Kong, the contingently issuable shares would not be regarded as dilutive because
the contingency condition is not met at that date. The diluted EPS presented in the
consolidated financial statements for the year ended 31 December 20X8 would include

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 FINANCIAL REPORTING

an amount for diluted EPS for 20X8 that does not take account of the contingently
issuable shares; however, the diluted EPS for 20X7 would remain unaffected (and still
include the impact of the contingently issuable shares). The diluted EPS calculated as
at 31 December 20X7 was a fair reflection of the dilutive impact that potential ordinary
shares were expected to have at that time and HKAS 33 does not permit the retroactive
adjustment of diluted EPS in respect of contingently issuable shares.

QUESTION 2
(a) Determining which series of potential ordinary shares are dilutive:

The potential ordinary shares on issue in respect of year ended 31 December 20X1 are
the one million options issued on 1 July 20X1 and the two million convertible bonds
issued on 1 June 20X0. For the potential ordinary shares to be dilutive, they must
decrease Quickstep’s basic EPS from continuing operations. Accordingly, the basic EPS
must first be calculated:

Quickstep’s basic EPS = the profit attributable to ordinary shareholders for the
financial year ended 31 December 20X1 of HK$75 million divided by 15 million ordinary
shares = HK$5.

In accordance with HKAS 33, in determining whether potential ordinary shares

are dilutive, each issue or series of potential ordinary shares is considered separately,
and in sequence from the most dilutive to the least dilutive (based on the impact per
incremental share). Hence, the options are assessed first as they do not affect the
numerator of the calculation:

Options to acquire ordinary shares

(1) 1 million options HK$95 exercise price = HK$95 million HK$95,000,000
(2) HK$95 million divided by the HK$103 average share price for 20X1 a
922,330
(3) T
 he 1 million options effectively constitute two contracts: 77,670
• one contract to acquire 922,330 ordinary shares at the HK$103 average
share price for the period
• another contract to receive 77,670 ordinary shares for no consideration
(2) plus (3) 1,000,000
(4) Issued ordinary shares of 15 million plus shares for no consideration 15,077,670
(5) E
 PS diluted by the 77,670 ordinary shares for no consideration would be a
HK$4.9742
profit of HK$75 million divided by (4)
The amount at (5) is less than basic EPS – so the options are dilutive
a
Rounded.

Next, the convertible bonds are assessed to determine if they are dilutive:

Convertible bonds
(1) two million convertible bonds with a face value of HK$100 HK$200,000,000
(2) Bond annual interest = HK$200 million multiplied by 2% HK$4,000,000
(3) Adjust for tax at 16.5% HK$660,000
(4) Adjustment for bond return net of tax ((2) minus (3)) HK$3,340,000

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 Earnings per Share

Convertible bonds
(5) A
 djusted profit of HK$75 million plus net of tax adjustment for HK$78,340,000
bond return
(6) Issued ordinary shares of 15 million plus shares for no consideration in 17,077,670
respect of options plus converted bonds
(7) EPS diluted by the converted bonds ((5) divided by (6)) a
HK$4.5873
The amount at (7) is less than basic EPS – so the convertible bonds
are dilutive
a
Rounded.

(b) Calculation of diluted EPS for the financial year ended 31 December 20X1 in respect
of profit attributable to ordinary shareholders from continuing operations and from
discontinued operations.

Based on the answers to question 2(a), we know that the options and the convertible
bonds are dilutive.

Diluted EPS Continuing Discontinued

operations operations
(1.1) Profit (loss) attributable to ordinary shareholders HK$75,000,000 (HK$5,000,000)
(1.2) Impact on earnings of assumed exercise of options nil nil
(1.3) Impact on earnings of assumed bond conversion HK$3,340,000 nil
(see Q2(a) answer)
(1.3) Adjusted earnings/(losses) HK$78,340,000 (HK$5,000,000)
(2.1) Ordinary shares on issue as at 1 January 20X1 15,000,000 15,000,000
(2.2) Incremental shares from assumed exercise of 77,670 77,670
options (see Q2(a) answer)
(2.3) Incremental shares from assumed bond conversion 2,000,000 2,000,000
(see Q2(a) answer)
(2.3) Adjusted weighted ordinary shares 17,077,670 17,077,670
(3) D
 iluted diluted EPS/(loss per share) attributable to a, c
HK$4.5873 b,c
(HK$0.2928)
ordinary shareholders
a
HK$78,340,000 divided by 17,077,670 shares
b
HK$5,000,000 divided by 17,077,670 shares
c
Rounded.

(c) Presentation and disclosure of EPS in the financial statements.

(i) Main factors that Quickstep needs to be aware of in presenting its basic and diluted
EPS for the financial year ended 31 December 20X1:

• Basic and diluted EPS need to be presented on the face of the statement of
profit or loss and other comprehensive income.

• Basic and diluted EPS need to be presented with equal prominence.

• Basic and diluted EPS need to be presented for continuing operations and basic
and diluted EPS need to be presented for the discontinued operations with
equal prominence.

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 FINANCIAL REPORTING

• Basic and diluted EPS each need to be presented for three years because
Quickstep presents two prior year statements of comprehensive income.

• Quickstep’s EPS that is based on earnings before interest, depreciation and tax
can only be disclosed in the notes to the financial statements and would need
to be shown on a basic and diluted basis with equal prominence and calculated
using the same weighted average numbers of shares used for the HKAS
33-compliant EPS amounts.

(ii) Disclosures that must be presented include:

• Quickstep’s issue of 1 million additional options to acquire ordinary shares on

5 January 20X2.

• The amount of earnings used in calculating Basic EPS.

• The amount of earnings used in calculating Diluted EPS.

• The number of shares Quickstep used in calculating Basic EPS.

• The number of shares Quickstep used in calculating Diluted EPS.

(d) Significance and limitations of EPS for an analyst of Quickstep’s financial statements.

Subject: Analysts’ interest in Quickstep’s EPS

Dear Mr. Lim,

For an analyst of Quickstep’s financial statements, the significance and limitations of

EPS include:

• Diluted EPS, relative to Basic EPS, can be a useful gauge of the possible impacts
of potential ordinary shares on existing ordinary shareholders’ interests in
Quickstep’s future earnings.

• The focus of EPS is existing and potential ordinary shareholders and EPS does
not cater directly for analysts taking the perspectives of other types of existing
and potential equity holders or debt holders.

• Basic and Diluted EPS are only one type of metric that would be used by an
analyst with an interest in Quickstep’s ordinary shares and would be used in
conjunction with all the other financial information available to the analyst.

• Quickstep is operating in a rapidly growing industry and EPS uses past profits
and can be regarded as being a backward-looking measure of performance
and may be limited in its relevance since Quickstep is experiencing strong
profit growth.

• A comparison of EPS between Quickstep with other companies within the

same industry may be a useful indicator of relative performance; however, a
comparison of EPS between Quickstep and companies in different industries
may not be useful because they face different operating conditions and
different capital requirements.

Kind regards,

(Candidate)

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 21
Related Party
Disclosures

CHAPTER TOPIC LIST

21.1 Overview 21.3 Disclosure

21.1.1 Scope 21.3.1 All Entities
21.1.2 Terminology 21.3.2 Key Management Personnel
21.2 Identifying Related Parties 21.3.3 
Provision of Key Management
Personnel Services
21.2.1 Person (or a Close Member
21.3.4 Government Related Entities
of that Person’s Family)
21.2.2 Entity
21.2.3 Not Related Parties

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT

FOR BUSINESS TRANSACTIONS
LO2.09: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: Related party disclosures
2.09.01 Explain the parties that may be related to a business entity
2.09.02 Explain the importance of identifying related parties
2.09.03 Prepare disclosures in respect of related party transactions

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 R elated P arty D isclosures

OPENING CASE

HOMEFITTINGS

H omeFittings Co. (HomeFittings), operating in China, is a supplier of furniture and fittings

for newly built homes. The shares of HomeFittings are 100% owned by HomeConstruction
Co. (HomeConstruction), the largest home construction company operating in Asia.
HomeConstruction controls HomeFittings. In turn, HomeConstruction is 75% owned and is
controlled by YourWorldConstruction Co. (YourWorldConstruction).

HomeFittings holds:

• 100% of the shares issued by NewHomeStyles Co. (NewHomeStyles), and controls

NewHomeStyles;

• 50% of the shares in HomeMaintenance Co. (HomeMaintenance), and jointly controls

HomeMaintenance; and

• 30% of the shares issued by TileSupplies Co. (TileSupplies), and has significant influence
over TileSupplies.

Throughout the year ended 31 December 20X9, NewHomeStyles provided home styling
services to HomeFittings. HomeFittings purchased tiles from TileSupplies on trade credit, and
HomeFittings sold kitchen fittings to HomeMaintenance.

Mr. Koh is the non-executive chair of the board of directors of HomeFittings.

The HomeFittings group structure is shown in Exhibit 21.1, with the indicated proportionate
shareholdings. HomeFittings prepares stand-alone separate financial statements and
consolidated financial statements.

YourWorldConstruction

75%

HomeConstruction

100%

HomeFittings

50% 30%
100%

HomeMaintenance NewHomeStyles TileSupplies

Group

EXHIBIT 21.1 Group structure of HomeFittings

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 FINANCIAL REPORTING

OVERVIEW

There is a broad spectrum of possible relationships an entity might have with other parties, and
those relationships can manifest themselves in different ways. HKAS 24 (Revised) Related Party
Disclosures identifies particular types of relationships (those with ‘related parties’) about which it
requires specific minimum information to be disclosed in financial statements.

For example, entities commonly conduct parts of their business through subsidiaries,
joint ventures and associates. Through its investment, an entity can affect the financial and
operating policies of such investees. These investments create a related party relationship,
which can affect the profit or loss and financial position of the investee and investor. A related
party is not limited to a business entity; a related party can also be a person (including a close
member of that person’s family) who controls or has significant influence over an entity, or who
is a member of an entity’s key management personnel.

Related parties might enter into transactions that unrelated parties would not (e.g. a parent
may provide an interest free loan to a subsidiary). Conversely, they may refrain from certain
transactions because of relationships (e.g. a subsidiary may no longer transact with an external
trading partner where its parent acquires a fellow subsidiary that is engaged in the same
activities as the former trading partner).

The objective of HKAS 24 (Revised) is 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 or outstanding balances with them. Keep this objective in mind when identifying
whether a party is a related party and the consequential disclosures to be made.

2 1 . 1 OVERVIEW

HKAS 24 (Revised) Related Party Disclosures sets out disclosure requirements for related party
relationships, and transactions and outstanding balances with related parties. The purpose
of the disclosures is to draw attention to the possibility that the entity’s reported financial
position and results may have been affected by the existence of related parties and by material
transactions or outstanding balances with them.

In this section, you will develop an understanding of the scope of HKAS 24 (Revised) and the
common terminology used in the Standard and throughout this chapter.

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21.1.1 Scope
HKAS 24 (Revised) is applied in:

• Identifying related party relationships and transactions;

• Identifying outstanding balances, including commitments, between an entity and its

related parties;

• Identifying the circumstances in which disclosure of related party relationships,

transactions and balances is required; and
HKAS
24.2 • Determining the disclosures to be made about those items.

The disclosures specified by HKAS 24 (Revised) apply to every set of financial statements
presented by the entity, whether individual, separate or consolidated. Any related party
transactions and outstanding balances an entity has with group, associated or other related
parties are required to be disclosed in the individual and separate financial statements, where
they are prepared. However, in the consolidated financial statements, intragroup transactions
and outstanding balances are eliminated on consolidation (see Chapter 30). Accordingly,
such related party transactions and outstanding balances are not required to be disclosed in
consolidated financial statements.

Illustrative Example 1
HomeFittings prepares separate and consolidated financial statements. During the year
20X9, HomeFittings received home styling services from its 100% owned subsidiary,
NewHomeStyles.

In HomeFittings’ separate financial statements, disclosure of transactions and

outstanding balances (including commitments) with NewHomeStyles are required.

In HomeFittings’ consolidated financial statements, intragroup transactions and

outstanding balances are eliminated as part of the consolidation process. Accordingly,
transactions and outstanding balances with NewHomeStyles are not disclosed in the
consolidated financial statements. However, other disclosures about related parties might
be required, as considered later in this chapter.

21.1.2 Terminology
• Related party: a person or entity ‘related’ to the entity that is preparing its financial
statements. Although the term ‘related’ is not explicitly defined, this definition is
supported by lists of types of relationships for identifying the persons or entities
related parties of a reporting entity (refer Section 21.2). One type of related party is ‘key
management personnel’.

• Key management personnel: That person (or 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.

• 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. A related
party transaction could be transacted on arms’-length terms or otherwise.

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2 1 . 2 IDENTIFYING RELATED PARTIES

HKAS 24 (Revised) provides guidance on identifying which persons and entities are a related
party of an entity. Based on the facts and circumstances of a relationship, an entity is required
to determine whether it is dealing with a related party.

A related party is a person or entity that is related to the entity that is preparing its
financial statements (‘reporting entity’) (HKAS 24.9). Although not explicitly stated in HKAS 24
(Revised), that person or entity might be related for the entire period, or for only part of the
period (e.g. a newly appointed director).

As detailed in Sections 21.2.1 and 21.2.2, the term ‘related’ is effectively defined by way
of a list of relationships that would indicate one entity (a person or an entity) is related to the
reporting entity. Though HKFRSs are principles-based standards, the list of relationships noted
might be thought of as a practical solution to dealing with a complex issue and achieving a
reasonable level of consistency across entities within the context of the objective of HKAS 24
(Revised).

The following lists are not the only instances in which a related party relationship exists;
HKAS other examples of related party relationships might exist. An entity must direct its attention to
24.10 the substance of the relationship and not merely the legal form; for example, irrespective of the
title attributed to employees through their legally enforceable employment contract, if they
have authority and responsibility for planning, directing and controlling the activities of the
entity, they would be a related party.

This section outlines which persons and entities are considered related parties of an entity
and which are not related parties for the purposes of HKAS 24 (Revised).

21.2.1 Person (or a Close Member of that Person’s Family)

HKAS A person or a close member of that person’s family is related to a reporting entity in the
24.9(a) scenarios in Exhibit 21.2 (persons in bolded text are related parties of the reporting entity).

Close members of the family of a person are family members who may be expected
to influence, or be influenced by, that person in their dealings with the entity and will
always include:

• that person’s children and spouse or domestic partner;

• children of that person’s spouse or domestic partner; and

HKAS
24.9 • dependants of that person or that person’s spouse or domestic partner.

This definition is expressed in a principle-based manner and does not provide an

exhaustive list of all possible persons who might be ‘close members’. For example, other family
members, including parents and grandparents, could qualify depending on the assessment
of specific facts and circumstances. Professional judgement is required in making that
assessment.

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Related party relationship Example

1. Has control or joint control of the reporting entity.
A person has control over the reporting entity when Person A Person A Entity X
the person is exposed, or has rights, to variable
returns from its involvement with the entity and Joint
has the ability to affect those returns through its Control control
power over the entity (see Chapter 30).
Reporting Reporting
entity entity

2. Has significant influence over the reporting entity.

A person has significant influence over the entity Person A
when the person has the power to participate in
the financial and operating policy decisions of the
Significant
entity, but that power is insufficient to give the influence
person control or joint control over those policies
(see Chapter 32). Reporting
entity

3. Is a member of the key management personnel

(KMP) of the reporting entity or of a parent of the
Person A
reporting entity.

KMP

Reporting
entity

EXHIBIT 21.2 Examples of related parties to a person

KMP includes all executive and non-executive directors and those other personnel having
authority and responsibility for planning, directing and controlling the activities of the entity.
An entity’s KMP is not necessarily the highest paid employees of that entity. For example,
non-executive directors often receive less compensation than many full-time employees who
are not key management personnel.

21.2.2 Entity
HKAS An entity, as distinct from a person, is related to a reporting entity if any of the following
24.9(b) conditions applies in Exhibit 21.3 (entities in bolded text are examples of related parties of the
reporting entity; there may be other related parties in each illustrated scenario).

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Related party relationship Example

1. The entity and the reporting entity
Group
are members of the same group,
which means that each parent,
Parent
subsidiary and fellow subsidiary is
related to the others.

Reporting
Subsidiary
entity

2. One entity is an associate or joint

venture of the other entity (or
Investor Investor Entity X
an associate or joint venture of a
member of a group of which the Joint
other entity is a member). Significant control
influence

Reporting Reporting
entity entity

3. Both entities are joint ventures of

the same third party.
Entity X Entity Y Entity Z

Joint Joint
control control

Reporting Joint
entity venture

4. One entity is a joint venture of a

third entity, and the other entity is an
Entity X Entity Y
associate of the third entity.
Joint Significant
control influence

Reporting
Associate
entity

5. The entity is a post-employment

benefit plan for the benefit of Post-
employment
employees of either the reporting benefit plan
entity or an entity related to the
reporting entity. If the reporting
entity is itself such a plan, the
sponsoring employers are also
Reporting
related to the reporting entity. entity

EXHIBIT 21.3 Examples of related parties to an entity

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Related party relationship Example

6. The entity is controlled or jointly
controlled by a person identified in
Person A Entity Y Person A
Section 21.2.1.
Joint
Control KMP control KMP

Reporting Reporting
Entity X Entity X
entity entity

7. A person or a close member of that

person’s family who has control
Person
or joint control of the reporting
entity has significant influence over
Significant
the entity or is a member of the Control influence
KMP of the entity (or of a parent of
the entity).
Reporting
Entity X
entity

8. The entity, or any member of a group

of which it is a part, provides KMP
Entity X
services to the reporting entity or to
the parent of the reporting entity.
KMP services

Reporting
entity

EXHIBIT 21.3 (continued)

Illustrative Example 2
In HomeFittings separate financial statements, the following are related parties:

• YourWorldConstruction – because YourWorldConstruction and HomeFittings are

members of the same group (HKAS 24 [Revised] para. 9[b][i]);

• HomeConstruction – because HomeConstruction and HomeFittings are members

of the same group (HKAS 24 [Revised] para. 9[b][i]);

• NewHomeStyles – because NewHomeStyles and HomeFittings are members of the

same group (HKAS 24 [Revised] para. 9[b][i]);

• TileSupplies – because TileSupplies is an associate of HomeFittings (HKAS 24

[Revised] para. 9[b][ii]):

• HomeMaintenance – because HomeFittings has joint control over

HomeMaintenance (HKAS 24 [Revised] para. 9[b][ii]);

• Mr. Koh and close members of his family (e.g. his spouse) – because he is a member
of the KMP of the reporting entity (HomeFittings) (HKAS 24 [Revised] para. 9[a][iii]).

For HomeFittings consolidated financial statements, all the above are related to the
group except for NewHomeStyles, which is a wholly owned subsidiary with intragroup
transactions and outstanding balances that are eliminated on consolidation.

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21.2.3 Not Related Parties

HKAS 24 (Revised) helpfully clarifies that the following are not related parties:

• Two entities simply because they have a director or other member of a KMP in
common or because a member of a KMP of one entity has significant influence over the
other entity.

• Two joint venturers simply because they share joint control of a joint venture.

• Providers of finance, trade unions, public utilities, and departments and agencies of a
government that do 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) –
for example, a local government might not approve an entity’s application to build a
new residential tower.

• A customer, supplier, franchisor, distributor or general agent with whom an entity

HKAS transacts a significant volume of business, simply by virtue of the resulting economic
24.11 dependence (however, other standards might require separate disclosure of significant
transactions and resulting economic dependence where such disclosure is relevant to
an understanding of an entity’s financial statements – refer to Chapter 28).

The exclusions have the effect of narrowing the scope of parties that might otherwise be
thought to meet the definition of a ‘related party’, thereby reducing the level of disclosure that
might otherwise be thought to be required by HKAS 24 (Revised).

Key Learning Point

An entity’s related parties may change from period to period.

Knowledge Check Questions

Question 1
Auto Bits & Pieces Co (ABP) owns 100% of and, therefore, controls and consolidates
Auto Lubricants Co (AL). AL owns 100% of Raw Car Materials Co (RCM). AL also has a 30%
interest in a listed entity to which it applies the equity method of accounting. ABP is also an
equal partner in a joint venture.
Identify which entities are related parties for the purposes of ABP’s:
• Separate Financial Statements; and
• Consolidated Financial Statements
A Separate financial statements: AL, RCM, associate and joint venture
Consolidated financial statement: associate and joint venture

B Separate financial statements: associate and joint venture

Consolidated financial statement: AL, RCM, associate and joint venture

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Knowledge Check Questions (continued)

C Separate financial statements: AL, associate and joint venture
Consolidated financial statement: AL, RCM

D Separate financial statements: AL, RCM, associate and joint venture

Consolidated financial statement: AL, RCM, and joint venture

Question 2
Mr. Koh owns 100% of the shares in Travel Today Co (Travel Today) and is also a member
of the KMP of Your Adventures Co (Your Adventures). For Travel Today’s financial
statements, explain whether Your Adventures a related party.

Question 3
Identify which of the following would not be related parties:
A A person owns 85% of, and controls, a company; and
The controlled company

B Two joint venture partners

C A director of a parent company; and
The subsidiary of the parent company

D An entity that provides KMP services; and

The entity that receives those services

2 1 . 3 DISCLOSURE

HKAS 24 (Revised) is a disclosure Standard. The required disclosures supplement the

disclosures required by national company legislation (e.g. Section 383 of the Hong Kong
Companies Ordinance requires the disclosure of director emoluments, and Chapter 14A of the
Hong Kong Listing Rules requires disclosure of connected transactions with connected persons)
and supplement other accounting standards (e.g. HKAS 1 Presentation of Financial Statements
and HKFRS 12 Disclosure of Interests in Other Entities).

As noted in Section 21.1, given that related parties may affect the financial position
and profit or loss of an entity, users of financial statements must be aware of related party
relationships and transactions, outstanding balances and commitments with such parties.

The disclosure of information about related parties and their dealings with the reporting
entity can sometimes be contentious. Related parties might be concerned about privacy (e.g.
their individual level of compensation), or the entity might be concerned about giving away
commercial information, and users might want detailed information that will allow them
to comprehensively assess the implications of the related parties. Determining the extent
of disclosure to make in practice can be tricky, as the identification of related parties and
disclosure of related party transactions can involve significant judgement.

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What is reported by the media in relation to an entity (e.g. fraud by a member of the KMP)
is not always captured in the financial statements because such information might not be
material to an understanding of the financial position and profit or loss of the entity.

This section considers the required disclosures under the following headings in turn: all
entities, KMP, the provision of KMP services and government related entities.

21.3.1 All Entities

21.3.1.1 Parent-Subsidiary Relationships
To enable users of financial statements to understand the structure and effects of related party
relationships, the Standard requires the disclosure of relationships between a parent and its
subsidiaries irrespective of whether there have been transactions between them. Consistent
with this, HKFRS 12 Disclosure of Interests in Other Entities specifies disclosures in relation to
interests in subsidiaries (see Chapter 34).

A subsidiary is required to disclose the name of its parent entity and, if different from the
parent, the name of the ultimate controlling party. Where the parent entity or ultimate parent
HKAS entity does not produce consolidated financial statements available for public use, an entity
24.13 must disclose the name of its next most senior parent that does. The next most senior parent is
HKAS the first parent in the group above the immediate parent that produces consolidated financial
24.16 statements available for public use.

Illustrative Example 3
As the parent of HomeFittings is not the ultimate controlling party, HomeFittings must
disclose the name of its parent and ultimate controlling party. Assuming the ultimate
controlling party produces consolidated financial statements available for public use,
HomeFittings would make the following disclosure in the notes to its financial statements:
The next senior parent of HomeFittings Co is HomeConstruction Co. The parent of
HomeConstruction Co, and the ultimate controlling party, is YourWorldConstruction Co.

21.3.1.2 Related Party Transactions

Where transactions with a related party have occurred during a period, an entity must disclose
the nature of the related party relationship as well as information about the transactions
and outstanding balances (including commitments) necessary for a user of the financial
statements to understand the potential effect of the relationship on the financial statements.
At a minimum, an entity must disclose:

• The amount of the transactions;

• The amount of outstanding balances, including commitments, and:

°° their terms and conditions, including whether they are secured, and the nature of
the consideration to be provided in settlement; and

°° details of any guarantees given or received;

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• Provisions for doubtful debts related to the amount of outstanding balances; and

HKAS • The expense recognised during the period in respect of bad or doubtful debts due from
24.18 related parties.

HKAS 19 Employee Benefits does not provide explicit guidance on the measurement of the
amount of transactions and outstanding balances; rather, the amounts would be expected to
be derived from the measurement requirements in other Standards.

It is incorrect to think of related party transactions as being those transacted at other than
arm’s-length prices. The basis of the pricing is not part of the definition of related parties, and
the purposes for disclosure are broader than enabling users to detect any lack of commerciality
in transactions.

Examples of related party transactions include:

• Purchases or sales of goods (finished or unfinished);

• Purchases or sales of property and other assets;

• Rendering or receiving of services;

• Leases;

• Transfers of research and development;

• Transfers under licence agreements;

• Transfers under finance arrangements (including loans and equity contributions in cash
or in kind);

• Provision of guarantees or collateral;

• Commitments to do something if a particular event occurs or does not occur in

the future, including executory contracts (contracts under which neither party has
performed any of its obligations or both parties have partially performed their
obligations to an equal extent) (recognised and unrecognised) (see Chapter 1); and

HKAS • Settlement of liabilities on behalf of the entity or by the entity on behalf of that
24.21 related party.

The list of related party transactions is broad and would include regular sales and
purchases between related parties. For example, a director of a retail supermarket
that purchases fruit and vegetables from that supermarket is an example of related party
transactions even if they are made on terms equivalent to those that prevail in arm’s length
transactions. HKAS 24 (Revised) does not provide any specific exemptions for the disclosure of
information about such transactions. However, it clarifies that related party transactions made
HKAS on the same terms as arm’s-length transactions should only be described as such if those terms
24.23 can be substantiated. Furthermore, in deciding the types of disclosures to make to comply with
the Standard, considering the purpose of the disclosures is important; that is, to draw attention
to the possibility that an entity’s financial position and profit or loss may have been affected by
the existence of related parties and by transactions and outstanding balances, including
commitments, with such parties.

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Related party disclosures are required to be disclosed separately for each of the following:

• The parent;

• Entities with joint control of, or significant influence over, the entity;

• Subsidiaries;

• Associates;

• Joint ventures in which the entity is a joint venturer;

• KMP of the entity or its parent; and

HKAS
24.19 • Other related parties.

Key Learning Point

HKAS 24 (Revised) does not require related party transactions and balances to be disclosed
at an individual related party granularity.

Apply and Analyse 1

Throughout the year ended 31 December 20X9, NewHomeStyles has provided home
styling services to HomeFittings at a cost of HK$2.1 million, and HK$1.8 million remained
outstanding at the end of the year. Furthermore, HomeFittings purchased tiles from
TileSupplies on credit for HK$2.8 million with 50% remaining outstanding at the end
of the year.

During the year, HomeFittings sold kitchen fittings to HomeMaintenance at a

discount to market price of 10%. The kitchen fittings were sold for HK$1.7 million and
HomeMaintenance owed HomeFittings HK$1.1 million as at 31 December 20X9.

All outstanding debtors and creditors are due to be settled by 31 March 20Y0 and, in
relation to the amounts receivable from HomeMaintenance, no expenses were recognised
during the year for bad or doubtful debts.

Prepare the related party disclosures required in HomeFittings’s 31 December 20X9

separate financial statements in relation to the above transactions and outstanding
balances (assume all amounts are zero for the comparative year).

Analysis

For HomeFitting’s annual separate financial statements, it determines that

NewHomeStyles, TileSupplies and HomeMaintenance are related parties (refer to
Illustrative Example 2 in Section 21.2.2). Accordingly, it must disclose details of the related
party transactions.

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Apply and Analyse 1 (continued)

HomeFittings makes the following disclosures in the notes to its financial statements.

Trade sales Trade Amounts due Amounts due

purchases from related to related
parties parties
20X9 20X8 20X9 20X8 20X9 20X8 20X9 20X8
HK$m HK$m HK$m HK$m HK$m HK$m HK$m HK$m
Subsidiaries – – 2.1 – – – 1.8 –
Associates 2.8 – 1.4 –
Joint ventures 1.7 – – – 1.1 – – –

Sales to joint ventures were made at a discount of 10% of market price.

The amounts due to and from related parties are unsecured and are due to be settled
in cash within three months. In relation to the amounts due from related parties, there are
no provisions for doubtful debts and no expenses were recognised in the period for bad or
doubtful debts.

21.3.2 Key Management Personnel

An entity is required to disclose the total compensation of its key management personnel
(KMP), but not for each individual, because it is arguably not necessary to achieve the objective
of HKAS 24 (Revised) and for each of the following:

• Short-term employee benefits

• Post-employment benefits

• Other long-term benefits

• Termination benefits
HKAS
24.17 • Share-based payment

Compensation of the KMP is required as:

• The fundamental principle underlying HKAS 24 (Revised) is that related party

transactions must be disclosed, and KMP are related parties; and

• It is relevant to decisions made by users of financial statements as the structure and

IAS amount of compensation are major drivers in the implementation of a business’s
24.BC9 strategy.

Compensation includes all employee benefits (as defined in HKAS 19) (see Chapter 23)
including employee benefits to which HKFRS 2 Share-based Payment (see Chapter 24) applies.
HKAS Employee benefits are all forms of consideration paid, payable or provided by the entity, or on
24.9 behalf of the entity, in exchange for services rendered to the entity.

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Although HKAS 24 (Revised) does not explicitly specify how the amounts to be disclosed are
to be measured, it is reasonable to presume they would be measured consistent with HKAS 19
and HKFRS 2. This may differ from what might be reported elsewhere about an executive’s
salary. For example, post-employment benefits are captured by the disclosure as they accrue
under financial reporting requirements but might not be reported in other public documents
until the executive leaves the company.

The disclosure of KMP compensation, in part, overlaps with the requirements of

Section 383 of the Hong Kong Companies Ordinance. Section 383 requires, in the notes to the
financial statements, the disclosure of directors’ emoluments, retirement benefits, termination
benefits and consideration provided to or receivable by third parties for making available
the services of directors. For further information, refer to Accounting Bulletin 3 (Revised):
Guidance on Disclosure of Directors’ Remuneration. As a result, many entities combine the
disclosures required by Section 383 with the disclosures required by HKAS 24 (Revised) to avoid
duplication. Furthermore, listed entities must disclose director emoluments by name. (Refer to
paragraph 24, Appendix 16, HKEx Main Board Listing Rules.)

Illustrative Example 4
HomeFittings made the following disclosure in relation to compensation of KMP in its
consolidated financial statements for the year ended 31 December 20X9.

Compensation of KMP

20X9 20X8
HK$’000 HK$’000
Short-term benefits 5,106 4,905
Post-employment benefits 468 461
Other long-term benefits 67 59
Termination benefits 430 378
Share-based payment 659 754
6,730 6,557

21.3.3 Provision of Key Management Personnel Services

An entity might receive KMP services from another entity, often referred to as a ‘management
or administrative entity’. In this case, the entity receiving the KMP services is not required to
HKAS disclose the compensation paid by the management entity to the management entity’s
24.17A employees or directors.

HKAS However, amounts incurred by the entity in relation to the management entity for the
24.18A provision of KMP services are required to be disclosed. For example, HomeFittings may
outsource responsibilities that would otherwise be fulfilled by a non-executive director to a
separate entity that specialises in providing oversight and management of the implementation
of strategy for entities within the construction industry. In its financial statements, HomeFittings
would disclose the amount incurred in relation to the management entity for the KMP services.

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21.3.4 Government Related Entities

A reporting entity is exempt from the disclosure requirements in relation to related party
transactions and outstanding balances (including commitments) (refer to Section 21.3.1) with:

• A government that has control, joint control or significant influence over the reporting
entity; and

HKAS • Another entity that is a related party because the same government has control or joint
24.25 control of, or significant influence over, the reporting entity and the other entity.

If a reporting entity applies the exemption, it must disclose:

• The name of the government and the nature of its relationship with the reporting
entity; and

• Information in sufficient detail to enable users of the financial statements to

understand the effect of related party transactions on its financial statements,
including:

°° the nature and amount of each individually significant transaction; and

HKAS °° for other transactions that are collectively significant, a qualitative or quantitative
24.26 indication of their extent.

The above exemption is provided because:

• It can be difficult to identify other government-related entities;

• The cost of providing the disclosures might outweigh the benefits for users of the
increased information. The disclosures are extensive for transactions that are
unaffected by the relationship;

• Some entities are unaware their transactions are with other government related
entities, and therefore, the disclosure would be incomplete;

• Excessive disclosures of transactions that are unaffected by the relationship might

obscure information about transactions that are affected by the relationship; and

• Some governments establish entities to compete with each other, and therefore,
IAS transactions between the parties are likely to be conducted as if they are
24.BC34 unrelated parties.

Illustrative Example 5
TransitionHousing Co (TransitionHousing) is a provider of discounted residential
accommodation for people in need. The entity is 30% owned by a government body, and
the remaining 70% is owned by a private equity firm. The same government body has
joint control over PublicEngineering Co (PublicEngineering), an engineering company
that designs high-capacity accommodation. TransitionHousing and PublicEngineering are
related parties as the government body has significant influence and joint control over
each company, respectively.

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Illustrative Example 5 (continued)

Private equity Government

70% Significant influence (30%) Joint control (50%)

TransitionHousing PublicEngineering
Design services

During the year ended 31 December 20X5, PublicEngineering provided services to

TransitionHousing in relation to the design of two separate residential buildings. The
costs of the services were HK$0.2 million and HK$0.4 million and HK$0.3 million remained
outstanding at 31 December 20X5. This represents 10% of the total cost of engineering
services received by TransitionHousing for the year.

As TransitionHousing and PublicEngineering are related to each other by way of

the government body’s investments, TransitionHousing is exempt from providing the
disclosures noted in Section 21.3.1.2 (in relation to the related party transactions). Instead,
TransitionHousing will disclose:

• The nature of its relationship with the government body; and

• A qualitative or quantitative indication of the extent of the transactions with

PublicEngineering (on the basis that TransitionHousing determines that the
transactions with PublicEngineering are collectively, but not individually,
significant). For example, TransitionHousing might disclose the following in its
financial statements:

TransitionHousing is 30% owned by a government body. During the year ended

31 December 20X5, TransitionHousing received design services totaling HK$0.6m from
an entity that is jointly controlled by the government body.

Knowledge Check Questions

Question 4
Sparky Co (Sparky) is 100% owned by Windy Co (Windy). Windy is 80% owned and
controlled by Dusty Co (Dusty). No transactions occurred between the three entities during
the financial year ended 31 December 20X8. When preparing Sparky’s 20X8 financial
statements, identify which entity/entities it must disclose the name of.
A Windy
B Windy and Dusty
C Dusty
D Neither Windy or Dusty

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Knowledge Check Questions (continued)

Question 5
The trainee accountant for Mining & Exploration Co has drafted the following disclosure
related to compensation of its KMP.

B Anderson K Chung P Rutgers

20X9 20X8 20X9 20X8 20X9 20X8
HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
Short-term benefits 2,132 2,242 2,387 2,323 2,205 2,383
Post-employment benefits 184 160 183 187 181 157
Other long-term benefits 21 32 37 28 22 21
Termination benefits 26 – – – – –
Share-based payment 253 274 209 219 255 268
Total 2,616 2,708 2,816 2,757 2,663 2,829

While reviewing the draft financial statements, P Rutgers was concerned with the
disclosure and requested that the trainee accountant reconsider the requirements of the
accounting standard.
Determine what changes can be made to the disclosure to meet the minimal
requirements of HKAS 24 (Revised).

Question 6
Crocogator Co (Crocogator) is a growing company and currently outsources many of its
key manager roles to Alodile Co (Alodile). Identify the disclosure required to be made by
Crocogator in relation to the KMP services received from Alodile.
A The total compensation paid by Alodile to its employees and disaggregated by:
short-term, benefits, post-employment benefits, other long-term benefits, termination
benefits and share-based payment.
B The total compensation paid to Alodile’s employees.
C The total amount incurred by Crocogator for the KMP services received from Alodile.
D Crocogator is not required to make any disclosures in relation to the provision of KMP
services by Alodile.

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SUMMARY

• HKAS 24 (Revised)’s objective is to ensure disclosures necessary to draw attention to the

possibility that an entity’s financial position and profit or loss may have been affected by
the existence of related parties and by transactions and outstanding balances (including
commitments) with related parties.

• HKAS 24 (Revised) specifies the disclosure requirements for related party relationships.

• A related party is a person or entity that is related to the entity that is preparing its financial
statements. The relationship can arise through various means, including control, joint control,
significant influence, common control, key management and familial connections.

• A 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.

• KMP is that person (or 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.

• Entities are required to disclose the name of its parent company and, if different from the
parent, the name of the ultimate controlling party. Where the parent company or ultimate
parent company does not produce consolidated financial statements available for public use,
an entity must disclose the name of its next most senior parent that does.

• Where a related party transaction occurs, an entity must disclose the nature of the related
party transaction and information about the transaction and outstanding balances (including
commitments).

• Entities must disclose the total compensation of its KMP and separately by the following:
short-term employee benefits, post-employment benefits, other long-term benefits,
termination benefits and share-based payments.

• Where a reporting entity receives KMP services from another entity (management entity),
the reporting entity is required to disclose the amounts incurred for the provision of
the services.

• Depending on the related party relationship, certain exemptions and substitute disclosures
are required for related party transactions and outstanding balances (including commitments)
with a government. Markedly, an entity is not required to disclose the nature and amount of
every related party transaction with a government; instead, it must disclose only those that
are significant. For collectively significant transactions, an entity must disclose a quantitative
or qualitative indication of its extent.

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 R elated P arty D isclosures

MIND MAP

SCOPE SEPARATE vs CONSOLIDATED FINANCIAL

STATEMENTS
Identifying
• Related party relationships and transactions; Separate financial statements
• Outstanding balances (including commitments) • Intragroup transactions are not eliminated
between an entity and its related parties; and are therefore disclosed
• Circumstances in which disclosure are Consolidated financial statements
requited; and • Intragroup transactions are eliminated and
• Determining the disclosures to be made in therefore not disclosed
relation the above
IDENTIFYING RELATED PARTIES
DISCLOSURE RELATED PARTY
DISCLOSURES Related party is a person or entity that
Relationships (HKAS 24) is related to the entity that is preparing
• Parent company, and if different, ultimate its financial statements person (‛related’ –
controlling party not defined, requires professional judgement)
• Nature of related party relationship • Persons (refer to HKAS 24 pars 9[a])
Transactions - Close member of the family of a person
• Information about transactions and outstanding (’family’ – not defined, requires
balances (including commitments) professional judgement)
• Total and disaggregated KMP compensation - Key management personnel
• Total compensation paid to management • Entities (refer to HKAS 24 pare 9[b])
entity for provision of key management • Not related parties (refer to HKAS 24 para 11)
personnel services
Government related entities
• Substitute disclosures for certain relationships

Answers to Knowledge Check Questions

Question 1
Answer A is correct. AL is a subsidiary of ABP and is, therefore, a related party (HKAS 24
[Revised] para 9[b][i]). RCM is a subsidiary of AL and is, by extension, a related party of ABP
(HKAS 24 [Revised] para 9[b][i]). Associates and joint ventures of the group are also related
parties of ABP (HKAS 24 [Revised] para 9[b][ii]). Accordingly, for ABP’s separate financial
statements, transactions and outstanding balances with AL and RCM are not eliminated,
and therefore, AL and RCM (and the associate and joint venture) are related parties.
However, for ABP’s consolidated financial statements, transactions and outstanding
balances with AL and RCM are eliminated, and therefore, AL and RCM are not related
parties, but the associate and joint venture continue to be related parties.

50%
ABP

100% Joint venture

30%
AL

100% Associate

RCM

Group

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 FINANCIAL REPORTING

Answer B is incorrect. Although the associate and joint venture are related parties for both
types of ABP’s financial statements, AL and RCM are related parties for ABP’s separate
financial statements, but not for its consolidated financial statements.
Answer C is incorrect. RCM is a related party for ABP’s separate financial statements but
not for the consolidated financial statements. The associate and joint venture are related
parties for the separate and consolidated financial statements of ABP. AL is not a related
party for ABP’s consolidated financial statements.
Answer D is incorrect. The associate is a related party for the separate and consolidated
financial statements of ABP. AL and RCM are related parties for ABP’s separate financial
statements but not for its consolidated financial statements.

Question 2
Yes, Your Adventures is a related party of Travel Today because Mr. Koh controls Travel
Today and is a member of Your Adventure’s key management personnel (HKAS 24
[Revised] para 9[b][vi]).

Question 3
Answers A, C and D are incorrect. These are all examples of related parties (HKAS 24
[Revised] para 9[a][i], para 9[a][iii] and para 9[b][viii], respectively).
Answer B is correct. Two joint venture partners are not related parties simply because they
share joint control of a joint venture (HKAS 24 [Revised] para 11[b]).

Question 4
Answer A is incorrect. Sparky must also disclose the name of its ultimate controlling party
(Dusty) because it differs from its parent (Windy).
Answer B is correct. As Sparky’s ultimate controlling party (Dusty) differs from its parent
company (Windy), Sparky is required to disclose the name of its parent company and its
ultimate controlling party, irrespective of whether there have been transactions with them
(HKAS 24 [Revised] para 13).
Answer C is incorrect. Sparky must also disclose the name of its parent (Windy).
Answer D is incorrect. Sparky is required to disclose the name of its parent company
(Windy) and its ultimate controlling party (Dusty), irrespective of whether there have been
transactions with them.

Question 5
The disclosure is currently drafted in a way that separates the compensation by key
manager. HKAS 24 (Revised) does not require the disclosure of key management
personnel compensation by the key manager; however, the disclosure by key manager
(name) may be required by Section 383(1) of the Hong Kong Companies Ordinance and
Appendix 16 paragraph 24 of the Main Board Listing Rules. Mining & Exploration Co is
required to disclose the total amount for each category of compensation, which could be
presented as follows.

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 R elated P arty D isclosures

20X9 20X8
HK$’000 HK$’000
Short-term benefits 6,724 6,948
Post-employment benefits 548 504
Other long-term benefits 80 81
Termination benefits 26 –
Share-based payment 717 761
8,095 8,294

The previous disclosure of key management personnel compensation is the minimum

requirement of HKAS 24 (Revised), however, other disclosures in relation to key
management personnel may be required by the Hong Kong Companies Ordinance and the
Main Board Listing Rules.

Question 6
Answer A is incorrect. Crocogator is not required to disclose (in total or disaggregated by
category) the amounts paid or payable to Alodile’s employees related to the provision of
key management personnel services. This information would likely not be available to
Crocogator in any case. This disclosure is only required in relation to a reporting entity’s
own key management personnel compensation.
Answer B is incorrect. Crocogator is not required to disclose the total amounts paid or
payable to Alodile’s employees related to the provision of key management personnel
services. This information would likely not be available to Crocogator in any case. This
disclosure (including a disaggregation by category) is only required in relation to a
reporting entity’s own key management personnel compensation.
Answer C is correct. Crocogator is only required to disclose the total amount incurred by
Crocogator for the key management personnel services received from Alodile (HKAS 24
[Revised] para 18A).
Answer D is incorrect. Crocogator is required to disclose the total amount of compensation
paid or payable to Alodile for the key management personnel services.

EXAM PRACTICE

QUESTION 1
SunFlower Co (SunFlower) runs a business that grows flowers in bulk for distribution to
florists throughout mainland China. SunFlower has two directors, who are the only key
management personnel: Mary Thomas, who holds a 55% share in the company (which gives
her control) and Abigail Heart, who holds a 20% share in the company (which gives rise to
significant influence). A local government entity also holds a 20% share in the company, and
the remaining 5% of shares are held by one external investment firm.

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 FINANCIAL REPORTING

Abigail Heart also has a 30% shareholding (which gives her significant influence) in
China’s largest florist, YourRoses Co (YourRoses), which is a major customer of SunFlower.
Abigail is not involved in the day-to-day running of YourRoses. Mary Thomas is a non-
executive director of a laptop manufacturer, CompactBook Co (CompactBook).

Mary’s husband, Rohan Thomas, owns 100% of the shares and is the sole director of a
private company, TableDesigns Co (TableDesigns), which designs, manufactures and sells
custom-made tables.

The following transactions occurred in the year ended 31 December 20X8:

• TableDesigns leased a vacant office space owned by SunFlower, paying a total of

HK$0.5 million in rent. TableDesigns owed SunFlower HK$0.2 million in accrued rent
as at 31 December 20X8.

• YourRoses provided SunFlower with trimming tools, totalling HK$0.3 million. As at

31 December 20X8 SunFlower owes YourRoses HK$0.2 million in relation to those
trimming tools.

• Sunflower granted a three-year interest free HK$1 million loan to Abigail Heart.
Abigail has pledged her investment property as security for the loan.

• The government entity sold land to SunFlower for HK$2.3 million. As of 31 December
20X8, SunFlower owed the government entity $HK1.5 million in relation to the land.
• SunFlower distributes flowers weekly to each of the government entity’s 17 offices,
at a price of HK$500 per premises.

• In accordance with HKAS 19 and HKFRS 2, SunFlower recognised the following

amounts as directors’ remuneration in 20X8:

Mary Thomas Abigail Heart

20X8 20X8
HK$’000 HK$’000
Cash salary 789 712
Bonus 69 72
Pension costs 12 11
Shares 31 34
Total 901 829

Required:

(a) Identify which parties are related to SunFlower in accordance with the definition and
lists of relationships in HKAS 24 (Revised).

(b) Identify the transactions that would give rise to related party disclosures and the
transactions that would not give rise to related party disclosures.

(c) Based on the information provided, prepare the disclosures.

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 R elated P arty D isclosures

ANSWERS TO EXAM PRACTICE

QUESTION 1
(a) Related parties of Sunflower

Based on the definition of ‘related party’, which includes lists of related parties in
paragraph 9 of HKAS 24 (Revised), the following are related parties of SunFlower:

• Mary Thomas: because she controls SunFlower (HKAS 24 [Revised] para 9[a][i]) and
is a member of SunFlower’s key management personnel (HKAS 24 [Revised] para
9[a][iii]);

• Rohan Thomas: because he is a close family member of Mary Thomas (HKAS 24

[Revised] para 9[iii]);

• Government entity: because it has significant influence over SunFlower (HKAS 24

[Revised] para 9[b][ii]);

• Abigail Heart: because she has significant influence over SunFlower (HKAS 24
[Revised] para 9[a][ii]) and is a member of SunFlower’s key management personnel
(HKAS 24 [Revised] para 9[a][iii]);

• CompactBook: because Mary Thomas, who controls SunFlower, is a member of the

key management personnel of CompactBook (being a non-executive director) (HKAS
24 [Revised] para 9[b][vi]); and

• TableDesigns: because it is controlled by Rohan Thomas, who, as noted above, is a

close family member of Mary Thomas (HKAS 24 [Revised] para 99[b][vi]).

Although the question has not asked you to identify which parties would not be
captured by the relationships listed in HKAS 24 [Revised], YourRoses is not captured
as a related party of SunFlower. Abigail Heart has significant influence over YourRoses,
but that company would only be captured if Abigail Heart had control over SunFlower,
which she does not. (Mary Thomas has control.)

(b) Transactions giving rise to related party disclosures

A 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.

The following are related party transactions of SunFlower:

• The rent agreement between TableDesigns and SunFlower (HKAS 24 [Revised]

para 21[d]);

• The interest free loan to Abigail Heart (HKAS 24 [Revised] para 21[g]);

• The sale of land from the government entity (HKAS 24 [Revised] para 21[b]);

• The sale of flowers to the government entity (HKAS 24 [Revised] para 21[a]); and

• The employment services provided to SunFlower by its directors (HKAS 24 [Revised]

para 21[c]).

The sale of trimming tools from YourRoses to SunFlower would not be a required
related party disclosure as YourRoses is not a related party of Sunflower (refer to
question 1).

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 FINANCIAL REPORTING

(c) Related party disclosures

Related party transactions (HKAS 24 [Revised] para 18)

During the year the Company rented a property to TableDesigns. As of 31 December

20X8, HK$0.2 million is owed by TableDesigns for accrued rent. The outstanding
amount is unsecured and is due to be settled in cash within 12 months.

The Company provided a three-year HK$1 million interest-free loan to its director,
Abigail Heart. The entire amount remains outstanding as at 31 December 20X8 and is
secured against Abigail’s investment property.

The Company purchased land for HK$2.3 million from a government entity that has
significant influence over the Company. The land will be used to grow seasonal flowers.

The total amount of these transactions in the year was as follows:

Property Loan Land Amounts due Amounts due

rental purchase from related to related
parties parties
20X8 20X7 20X8 20X7 20X8 20X7 20X8 20X7 20X8 20X7
HK$m HK$m HK$m HK$m HK$m HK$m HK$m HK$m HK$m HK$m
Key – – 1.0 – – – 1.0 – – –
management
personnel

Entities with – – – – 2.3 – – – 1.511 –

significant
influence over
the Company

Other related 0.5 – – – – – 0.2 – – –

parties
1
Note: The disclosure of outstanding balances with related government entities is not required but has been disclosed for illustrative
purposes.

Other than the transactions noted above, the Company continues to sell bunches of
flowers weekly to each of the government entity’s offices. For transactions with related
government entities that are collectively significant, but not individually significant, an
entity may provide a qualitative indication of its extent.

Remuneration of key management personnel (HKAS 24 [Revised] para 17)

The remuneration of key management personnel of the group is set out below:

20X8 20X7
HK$’000 HK$’000
Short-term benefits 1,642 x,xxx
Post-employment benefits 23 x,xxx
Share-based payment 65 x,xxx
1,730 x,xxx

The above disclosure of key management personnel compensation is the minimum

requirement of HKAS 24 (Revised); however, other disclosures in relation to key
management personnel may be required by the Hong Kong Companies Ordinance and
the Main Board Listing Rules.

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 22
Government Grants

CHAPTER TOPIC LIST

22.1 Overview 22.2.7 Repayment of

22.1.1 Scope Government Grants
22.1.2 Terminology 22.3 Government Assistance
22.2 Recognition and Measurement 22.3.1  K(SIC) Int-10 Government
H
of Government Grants Assistance: No Specific
22.2.1 Capital Approach Relation to Operating
22.2.2 Income Approach Activities
22.2.3 Non-monetary 22.3.2 Examples Excluded
Government Grants from HKAS 20
22.2.4 Forgivable Loan from 22.4 Presentation and Disclosure of
Government Government Grants
22.2.5 Government Loan at 22.4.1  resentation of Grants
P
a Below-market Rate Related to Assets
of Interest 22.4.2 Presentation of Grants
22.2.6 Grants as a Compensation Related to Income
for Expenses or Losses 22.4.3 Disclosure of
Already Incurred or Government Grants
for the Purpose of
Giving Immediate
Financial Support

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT

FOR BUSINESS TRANSACTIONS
LO2.01: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: Government grants
2.01.01 Define government grants
2.01.02 Account for government grants (including government loan at a below-market rate
of interest)
2.01.03 Explain the recognition criteria for government grants
2.01.04 Explain and describe the different presentation methods available for government grants
related to assets
2.01.05 Explain and describe the different presentation methods available for government grants
related to income
2.01.06 Prepare disclosure in respect of government grants

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OPENING CASE

CWAVES FERRY HOLDING COMPANY LIMITED

C Waves Ferry Holding Company Limited (CWaves) is a publicly listed company on the
Hong Kong Stock Exchange (HKEx). The entity started as a manufacturer of boat parts for
commercial shipping and transportation watercraft, and it has steadily expanded into new
sectors. Though CWaves still manufactures boat parts, the entity has a number of primary
revenue-generating activities, including its ferry service, which it operates in Hong Kong
Harbour, Sok Kwu Wan, Shenzhen and Macau. CWaves also has significant business operations
comprising the management of office buildings, godowns, port infrastructure, travel agencies
and hotels in various parts of the world.

The entity’s overall financial performance has been solid in recent years. Several of its
activities continue to grow although these activities have been subject to fluctuating profits in
recent years due to varying interest rates, foreign exchange rates and other industry-related
factors. One of the constant well-performing components of the business is the ferry service,
which has operated for the past three years since the Hong Kong SAR Government granted an
exclusive licence to operate particular services in the region. The significance of the business
to the people of Hong Kong is that the entity also received various forms of assistance from
the government, which require recognition, measurement and disclosure in the company’s
financial statements. These issues are discussed in this chapter.

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OVERVIEW

Companies may rely on local, regional, national or international governments for assistance in
developing their business and in undertaking operating activities. The nature and extent of this
assistance can vary widely. For example, it may be provided to several companies at the same
time, such as the right to use roads, bridges, or other items of infrastructure. The assistance
might also be entity-specific, resulting in the direct transfer of resources from government to
the entity, often with associated conditions or restrictions imposed on the entity’s operating
activities. In the latter instances, a number of recognition, measurement and disclosure issues
arise, which are the subject of this chapter.

HKAS 20 Accounting for Government Grants and Disclosure of Government Assistance adopts
an approach to the recognition of government grants based on the association between the
grants received and the costs incurred by the entity for which the grants are intended to
compensate. In the case of CWaves, this is an important consideration because the entity has
received various forms of government assistance in recent years. In applying HKAS 20, CWaves
management must determine whether this assistance meets the definition of government
grants under HKAS 20 and, if so, when the grants should be recognised, how they are to be
measured and what disclosures in relation to grants and other forms of government assistance
are required.

In this chapter, you will gain an understanding of the various complexities involved with
the recognition, measurement and disclosure of government grants and other forms of
government assistance. This includes understanding what forms of assistance are captured
under HKAS 20 and how and why conditions imposed on a recipient entity by the government
when providing assistance are relevant in determining how recognition should appropriately
occur. By the end of this chapter, you should understand and appreciate the objective of the
guidance outlined in HKAS 20 and be able to apply the relevant accounting requirements in
preparing information relating to government grants and other assistance to enable users
to better understand the overall financial position and performance of the entity and better
predict the amounts, timing and risks of an entity’s future cash flows.

2 2 . 1 OVERVIEW

This chapter focuses on the accounting for, and disclosure of, government grants and the
disclosure of other forms of government assistance in accordance with HKAS 20. In this section,
you will gain an understanding of the scope of and terminology used in HKAS 20.

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 G o v ernment Grants

HKAS 20 prescribes the recognition of government grants in income over the period
in which the recipient entity recognises the expenses for which the grants are intended to
compensate. HKAS 20 also provides guidance on how government grants are to be measured
as well as how such grants and any other forms of government assistance received or
receivable should be disclosed.

22.1.1 Scope
HKAS
20.2 HKAS 20 states that the following are not included within the scope of the Standard: :

• Special problems arising in accounting for government grants in financial statements

reflecting the effects of changing prices or in supplementary information of a
similar nature;

• Government assistance provided for an entity in the form of benefits available in

determining taxable profit or loss or are determined on the basis of income tax liability.
Examples of such benefits are income tax holidays, investment tax credits, accelerated
depreciation allowance and reduced income tax rates;

• Government participation in the ownership of the entity; and

HKAS
20.2 • Government grants covered by HKAS 41 Agriculture.

22.1.2 Terminology
Before proceeding, it is important to develop a solid understanding of some key terms set out
in HKAS 20.

HKAS Forgivable loans are loans which the government undertakes to waive repayment of under
20.3 certain prescribed conditions.

HKAS Government refers to government, government agencies and similar bodies whether local,
20.3 national or international.

HKAS Government assistance includes any action by a government designed to provide an

20.3 economic benefit specific to an entity or range of entities qualifying under certain criteria. Such
HKAS assistance may take a variety of forms, which can vary in the nature of assistance provided and
20.4 the conditions attaching to the assistance. An example of the specific conditions that may be
imposed is to require the recipient entity to continue to operate within a particular industry or
in a specific, perhaps under-developed, region or area.

Government grants are assistance by government in the form of entity-specific transfers

HKAS of resources in return for past or future compliance with certain conditions relating to the
20.3 operating activities of the entity. Government grants are often referred to by other names
including subsidies, subventions or premiums.

Grants related to assets are government grants whose primary condition is that an entity
qualifying for them should purchase, construct or otherwise acquire long-term assets.
HKAS Additional conditions may be attached to the grant, restricting the type or location of the assets
20.3 or the periods during which they are to be acquired or held.
HKAS
20.3 Grants related to income are government grants other than those related to assets.

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 FINANCIAL REPORTING

Apply and Analyse 1

One example of government assistance received in recent years by CWaves involved the
Hong Kong SAR Government granting an exclusive licence to operate its ferry services in the
region. The licence is unconditional in that the government does not impose any conditions
or restrictions on CWaves. It is also non-transferable, and it is granted free of charge for
a period of 10 years. Explain whether the licence qualifies as a government grant.

Analysis

The transfer of the licence to CWaves is an example of a government grant and would
come within the scope of HKAS 20. The licence is transferred free of charge and imposes
no restrictions on CWaves operations. The conditions surrounding the grant have some
impact on the manner in which the grant should be recognised in the financial statements.
We will cover these issues in detail later in the chapter.

If on the other hand, the licence was granted as a result of a public competitive bidding
process, even though the entity winning the bid may still be required to comply with
particular conditions specified by the government, it would typically not be considered to
be a government grant under HKAS 20.

Key Learning Point

Transactions with a government that cannot be distinguished from the normal trading
activities of the entity are excluded from the definition of government grants under HKAS 20.

Knowledge Check Questions

Question 1
Identify the response below which best describes government grants as defined
under HKAS 20.
A A government grant is paid in cash by a government to an entity in return for past
or future compliance with specified conditions relating to the operating activities of
the entity.
B A government grant is assistance provided unconditionally from a government in the
form of a transfer of resources to an entity.
C A government grant is resources transferred to an entity by a government which are
most commonly associated with the requirement to comply with specified conditions
relating to the operating activities of the entity.
D A government grant is any type of assistance from the government to the entity from
which the entity has benefited directly.

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Knowledge Check Questions (continued)

Question 2
During the year, an entity provided catering services to the local government offices under
a contract that represented around 25% of the recipient entity’s annual revenue. The
government imposes a number of quality and efficiency controls on the firm. The firm
provides services to the government at a similar rate to its other large customers.
From the following statements, identify which best describes whether (and why) the above
contract should not be treated as a government grant under HKAS 20.
A The revenue from the contract is not a government grant because it is associated with
a number of restrictions on the recipient entity.
B The revenue from the contract is not a government grant because it is associated with
a number of restrictions on the recipient entity and the total amount represents a
significant portion of the recipient entity’s revenue.
C The revenue from the contract is not a government grant because the services are
provided to a local government office.
D The revenue from the contract is not a government grant, because no entity-specific
assistance is provided to the entity other than a payment for services provided under
normal business conditions.

2 2 . 2 RECOGNITION AND MEASUREMENT

OF GOVERNMENT GRANTS

Government grants should not be recognised until there is reasonable assurance that:

• The grants will be received; and

• The entity will comply with any conditions attaching to the grant.

The receipt of the grant does not provide conclusive evidence that the conditions attaching
to the grant have been or will be satisfied. Further, the manner in which the grant is received,
such as in cash or in another form such as the forgiveness of a loan, does not affect the
accounting method to be adopted.

As a general principle, HKAS 20 requires that government grants be recognised in profit or

HKAS loss on a systematic basis over the periods in which the entity incurs the costs for which the
20.12 grants are intended to compensate. Where government grants are awarded unconditionally,
without placing any restrictions on the entity’s future activities and not requiring it to incur any
future costs, the grant is recognised in income in the period in which the grant becomes
receivable.

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Two broad approaches to accounting for government grants are discussed in HKAS 20: the
capital approach and the income approach. HKAS 20 requires that the income approach should
be adopted in the recognition of grants. This means that 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 costs for which the grant is intended to compensate. The two
approaches, along with various other issues relating to the recognition and measurement of
government grants are examined in the remainder of this section.

22.2.1 Capital Approach

Under the capital approach, the grant is recognised directly in the statement of financial
position rather than being recognised in the profit and loss statement over one or more
reporting periods. The rationale for this approach, outlined in HKAS 20, is as follows:

• Government grants are not earned by the entity per se but instead represent a type of
incentive provided by government without related costs; and

• Government grants represent a form of finance for the entity.

The arguments against this approach are implicit in the grounds for its alternative and are
set out immediately below.

22.2.2 Income Approach

An alternative to the capital approach is the income approach, which is the approach adopted
in HKAS 20. Under this approach, the grant is recognised in profit or loss over one or more
reporting periods. The grounds for supporting this approach are outlined in HKAS 20 as follows:

• Government grants are receipts from a source other than shareholders; hence, they
should not be recognised directly in equity but should be recognised in profit or loss in
appropriate periods;

• Government grants are rarely provided without imposing some form of obligation or
restriction on the recipient entity, the compliance with which will likely impose costs on
the entity. As a consequence, the grants should 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; and

• Because income taxes and other taxes are accounted for as expenses, it is logical
to account for government grants, which are an extension of fiscal policies, in
profit or loss.

The income approach as outlined above is not applied on a cash basis; rather, it is applied
in a manner consistent with the accrual accounting assumption set out in HKAS 1 Presentation
of Financial Statements. Accordingly, recognising grants in income, based solely on the amounts
received in cash, is only acceptable where no reasonable basis exists for allocating the grants to
more than one period.

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Apply and Analyse 2

CWaves is a manufacturer of commercial boat parts. CWaves has purchased certain plant
and equipment at a cost of HK$25 million in 20X8, which have anticipated useful lives of
five years. Depreciation is recognised on a straight-line basis.

The provincial government has agreed to subsidise part of these costs, up to

HK$10 million. The subsidy is conditional on certain production targets being achieved
within the next three years. The set production targets are expected to be met. The related
grants have been received by CWaves in 20X5.

There is reasonable assurance that CWaves would comply with the conditions attached
to the received grants.

Advise CWaves’ management as to the appropriate accounting treatment and

presentation in the financial statements for the year ended 31 December 20X5 for each of
the above events in accordance with the relevant financial reporting standards.

Analysis

HKAS CWaves should not recognise the grant until there is reasonable assurance the company
20.7 will comply with the attached conditions and the grant is received.
Regarding the grants related to depreciable assets, if reasonable assurance exists that
CWaves will comply with the conditions, the grants are recognised in profit or loss over the
periods in which depreciation expense on those assets is recognised, corresponding to the
useful lives of the assets (see Section 22.2.3.1 for further discussion). For details on related
presentation issues, see Section 22.4.

Key Learning Point

Government grants are to be recognised in profit or loss on a systematic basis over the
relevant accounting periods in which the recipient entity incurs the costs for which the
grant is intended to compensate.

22.2.3 Non-monetary Government Grants

Grants may take the form of a transfer of a non-monetary asset, such as land, buildings or other
resources. In such instances, the entity will normally assess the fair value of the non-monetary
asset received or receivable and account for the asset and the grant at that value.

HKAS An alternative approach permitted under HKAS 20 is to recognise the grant and the asset at
20.23 a nominal amount (which may be zero). This approach would fail to recognise the appropriate
periodic depreciation of the non-monetary asset and fail to recognise the offsetting income
effect of the government grant. The accounting would be as if no (or a less significant) asset
existed. It could also be argued to be problematic if the asset becomes subject to impairment,
revaluation and adjustments for residual value estimates, situations not contemplated in the
giving of the grant.

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HKAS 20 is an old standard that does not reflect fully the concepts set out in the Conceptual
Framework nor the asset and income recognition principles specified in other accounting
standards.

22.2.3.1 Depreciable Assets

Grants related to depreciable assets are usually recognised in profit or loss over the periods
and in the same proportions in which depreciation on those assets is recognised.

22.2.3.2 Non-depreciable Assets

Grants related to non-depreciable assets may also require the fulfilment of certain obligations.
In such instances, these grants are recognised in income over the periods in which the costs
of meeting those obligations are incurred. For example, a grant involving the provision of land
may be made conditional upon the recipient entity constructing a building on the land. In such
instances, recognising the grant over the period in which the building is depreciated may be
appropriate.

Apply and Analyse 3

The government has granted CWaves the exclusive licence to operate its ferry services
in the region. The licence is non-transferable and is granted free of charge for a period
of 10 years.

Let us assume that under the terms outlined by the government when granting the
licence, CWaves must satisfy a range of requirements relating to the provision of a minimum
number of monthly services for each route, the efficient operation of those services as
measured by average travel time and the operation of a safe and well-maintained passenger
fleet measured by regularity of maintenance and monitored by regular, surprise government
inspections and periodic reviews of the entity’s health and safety records over the next
10 years. Failure to meet key targets agreed with the government may lead to the licence
being revoked. By attaching such conditions to the grant, the government can have some
confidence in the quantity and quality of the ferry services offered, and as a result, the ferry
services have proven to be very popular with the travelling public.

Determine how CWaves should account for the licence.

Analysis

The conditional granting of the licence constitutes a government grant under HKAS 20.
When the licence is granted, the entity must recognise an intangible asset in accordance
with HKAS 38 Intangible Assets and deferred income . Under HKAS 38, the entity may choose
to record these items at their fair value. Further, the restrictions associated with the grant
and the possibility that the licence could be revoked for non-compliance suggest the grant
of the licence would be recognised as income over the period in which the performance
conditions are required to be met, in this case, the 10-year period to which the licence
relates. In such instances, the intangible asset would be amortised over the same period.

Alternatively, under HKAS 20, the entity may choose to recognise the asset at a nominal
amount plus any expenditure directly attributable to preparing the asset for its intended
use. In such instances, little or no amortisation would be recorded.

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22.2.4 Forgivable Loan from Government

HKAS Under HKAS 20, a forgivable loan can be treated as a government grant when there is
20.10 reasonable assurance the entity will be able to meet the terms for forgiveness of the loan.
(HKFRS 9.3.3 sets down the requirements for de-recognition of a financial liability.) When this
condition is satisfied, the liability relating to the loan is reduced to zero and the remaining
balance of the loan is recognised as a government grant. Where the loan forgiveness is
unconditional, the grant is recognised in income in the period in which the grant is forgiven or
becomes forgivable. Where restrictions continue to apply in association with the forgiveness of
the loan, the government grants must be recognised in profit or loss on a systematic basis over
the periods in which the restrictions continue to apply.

22.2.5 Government Loan at a Below-market Rate of Interest

The provision of a government loan to an entity would not, on its own, fall within the HKAS
20 definition of a government grant. However, the benefit derived from a government loan
at no interest or at an interest rate below the market rate of interest is considered to be a
government grant under HKAS 20.

Though the benefit from a government loan at a concessional rate of interest is accounted
for under HKAS 20, the loan should be measured in accordance with HKFRS 9 Financial
Instruments (see Chapter 12). In such instances, the benefit shall be measured as the difference
HKAS between the initial carrying value of the loan determined in accordance with HKFRS 9 and the
20.10A proceeds received.

Apply and Analyse 4

Assume CWaves receives a loan from the government to encourage the company to
develop and run non-profit ferry routes to two smaller towns on the southeast coast.
Given that these routes are likely to be loss making for at least the first three years, the
company had been reluctant to do this but has been swayed by the provision from the
government of an interest-free loan to fund the development of infrastructure (channel
dredging to ensure the water is deep enough and developing pier facilities) for the route.
The interest-free loan of HK$850,000 is for three years.

At the time the loan was made, the market rate of interest for loans of this size is
4% per year. The loan is particularly attractive to CWaves because no future performance
conditions are attached to the loan.

Determine whether CWaves has received a government grant.

Analysis

The company must first calculate the present value of the loan as an indication of fair
value. The present value calculation is provided below:

HK$850,000/(1.04)3 HK$755,647.

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Apply and Analyse 4 (continued)

(The calculation of the present value of the loan is beyond the scope of this chapter.
It is provided here to demonstrate the presence of, and accounting for, the government
grant associated with the loan.)

The difference between the present value and the actual amount received (HK$94,353)
is the benefit received from the loan being interest free. This amount is to be treated as
a government grant in line with HKAS 20. Given there are no specified future conditions
associated with the grant, this amount is to be recognised in income in the first period in
which the loan is received or receivable. The recording of the loan is shown below:

Debit Credit
HK$ HK$
Bank 850,000
Government loan 755,647
Government grant income 94,353

Where government loans are provided at concessional interest rates, a similar

approach is used. The fair value of the loan is calculated and compared to the proceeds
received. The benefit from the concessional interest rate is a government grant and is
treated in accordance with HKAS 20. Where future conditions are attached to the loan, the
benefit is recognised in income over the period in which the related costs are incurred.
Where no such conditions exist, the benefit is recognised in income in the period in which
the loan was provided.

Key Learning Point

A loan from the government is treated as a government grant where it is forgivable and
forgiveness is reasonably assured. The benefits derived from a government loan at a
concessional interest rate also meets the definition of a government grant.

22.2.6 Grants as a Compensation for Expenses or Losses Already Incurred

or for the Purpose of Giving Immediate Financial Support
Under HKAS 20, grants received as compensation for expenses or losses, which an entity has
incurred, and grants given merely to provide immediate financial support where there are no
foreseeable related costs should be recognised in profit or loss in the period in which they
become receivable.

22.2.7 Repayment of Government Grants

Where a grant is required to be repaid, it should be accounted for as a change in an accounting
estimate. This is significant because the change should be accounted for prospectively in line
with HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. In such instances,

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in accordance with HKAS 20, the entity must disclose the nature and amount of such a change
and recognise the change as follows:

• Repayment of a grant related to income: first apply against any unamortised deferred
income that exists in relation to the grant, recognising any excess as an expense; and

• 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. Any 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
HKAS
the repayment may require a reassessment of the asset’s recoverable amount and
20.33 possibly recognition of an impairment of the new carrying amount of the asset.

Knowledge Check Questions

Question 3
Identify which one of the following statements is correct regarding the recognition and
measurement of government grants.
A A government grant that does not impose specified future performance conditions on
the recipient is recognised as income on a systematic basis over the duration of the
project for which the grant is received to compensate.
B A government grant of a non-monetary asset is generally measured at the fair value of
the benefits received or receivable.
C A government grant that does not impose specified future performance conditions on
the recipient is recognised as income either when the grant proceeds are receivable or
on a systematic basis over the duration of the project for which the grant was received to
compensate, based on the accounting policy choice made by the entity.
D Government grants received before the income recognition criteria are satisfied are
recognised in income when the grant proceeds are received.

Question 4
On 1 July 20X7, an entity receives HK$750,000 from the Hong Kong SAR Government to
build a manufacturing plant in a town on the outer edge of Shenzhen. The grant is provided
on a conditional basis, requiring the entity to construct a manufacturing plant on the site
with the plant meeting a range of specific environmental and safety targets within 10 years.
The government also requires the plant begin operations prior to 30 June 20X8. If any of
these conditions are not met, the entity may be required to refund the full amount to the
government. There is reasonable assurance that the conditions relating to environmental and
safety targets will be met. The company estimates the useful life of the plant to be 40 years.

Required:
Assume the entity began operations at the plant on 1 June 20X8. Briefly explain how
the information above would be recorded in the recipient entity’s financial statements.
Compare your explanation to the accounting treatment you would suggest if the
government, instead, requires the entity to maintain an employment workforce of at least
200 full-time employees for the first two years of operations of the plant and that this
condition is not reasonably assured to be met.

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Knowledge Check Questions (continued)

Question 5
On 1 January 20X5, GMP Company (GMP) received a grant of HK$8.5 million from the
Hong Kong SAR Government for the purpose of operating an early childhood learning
programme over two years. 75% of the costs of operating the programme were expected
to be incurred in its first year. Some conditions were attached to the grant relating to
health and safety, the nature and extent of enrolments and the learning outcomes
achieved. There is reasonable assurance that the conditions will be met.
In early January 20X6, the government has realised that GMP has not met all of the
conditions specified in the grant documentation and has asked for HK$5.1 million to be
refunded. GMP repaid this by the end of January 20X6.

Required:
Prepare the accounting entries required by GMP in the year ended 31 December 20X5 and
any relevant entries during 20X6.

2 2 . 3 GOVERNMENT ASSISTANCE

This section sets out the accounting for particular forms of government assistance.

22.3.1 HK(SIC) Int-10 Government Assistance: No Specific Relation to

Operating Activities
Government assistance may be provided that has no direct association with the operating
activities of the entity, for example, to provide long-term support of business activities in
certain regions or industry sectors. This might involve transfers of resources by governments to
entities, which:

• Operate in a specific industry;

• Continue to operate in newly privatised industries; and

• Commence or continue to operate in underdeveloped areas.

Any government assistance that meets the definition of a ‘government grant’ specified
under HKAS 20 must be accounted for in accordance with the standard. Even where no
association exists between the assistance provided and the operating activities of the entity,
this does not preclude the grant from meeting the definition of government grants in HKAS 20.
In such instances, the grant should be accounted for in accordance with HKAS 20 and should
not be credited directly to shareholders’ interest.

22.3.2 Examples Excluded from HKAS 20

The definition of government grants provided in HKAS 20 excludes certain forms of
government assistance, which cannot reasonably have a value placed upon them. Also

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excluded are transactions with government, which cannot be distinguished from the normal
trading transactions of the entity.

An example of assistance that may be unreasonably valued is the provision of a guarantee

that a certain percentage of government procurement by a particular department will be
sourced from a particular entity. Providing a reasonable valuation is difficult where such
assistance cannot be directly associated with past, present, or future cash flows.

An example of assistance that cannot readily be distinguished from the normal trading
transactions of the entity is the purchase by government of financial advisory services from
local professional services businesses. The purchase of services provides a benefit to the
entities, but if the purchase is at normal business rates, any attempt to segregate the normal
trading activities from government assistance could be arbitrary.

In the above instances, the entity may need to disclose the nature, extent and duration of
the assistance to provide useful information to users of financial statements.

Knowledge Check Question

Question 6
In 20X1, a senior team from a local educational institution attended a major research
and practitioner conferences focussing on social investment to address global poverty.
The team attended to promote its latest research, which focussed on the development
of a prioritisation framework and the building of infrastructure to provide resources for
those in dire need. To promote potential interest from overseas agencies and investors
and to demonstrating credentials that may attract future foreign students, the national
government provided free support to the team, which included data for and feedback
on the development of the prioritisation framework and help for the students to secure
a space at the event and make travel and logistical arrangements. The government also
provided letters of introduction to key overseas contacts and additional advice as to how
the framework might best be presented given the likely audience.

Required:
Explain the approach the company should take in accounting for the assistance provided
by government in this instance.

2 2 . 4 PRESENTATION AND DISCLOSURE

OF GOVERNMENT GRANTS

This section sets out the presentation and disclosure requirements applying to grants related
to assets and grants related to income.

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22.4.1 Presentation of Grants Related to Assets

Where government grants are made relating to assets, including non-monetary assets at fair
value, the entity has the following presentation options in the statement of financial position:

• Recognise the grant as deferred income; and

HKAS
20.24 • Deduct the grant in arriving at the carrying amount of the asset.

Both methods recognise the grant in the income statement on a systematic basis over
time but differ in the specifics of their approach. The deferred income method recognises the
grant as deferred income that is then recognised in income over the useful life of the asset. The
alternative method deducts the grant in calculating the carrying amount of the asset. The grant
is then recognised in profit or loss over the useful life of the asset as reduced depreciation
expense. Under HKAS 20, the two alternatives are considered as equally acceptable.

However, in choosing between the above approaches, entities should consider the
implications for other accounting policies and for disclosure. For example, if other assets in the
same class as the asset in question are revalued to fair value, the second approach could be
problematic.

Illustrative Example 1
In the year ended 31 December 20X4, Hépíng Company (Hépíng) receives a grant of
HK$950,000 toward the cost of a new building in a remote area outside Macau. The total
cost of the building is HK$6,200,000, and the purchase is completed on 30 June 20X4. The
property is to be depreciated at an annual rate of 2% on cost.

The management of the entity seeks your assistance. It is uncertain about how best
to present this information in the year-end financial statements. It is aware of the two
options under HKAS 20 and that the options will affect the financial statements in different
ways and has asked for your assistance to show these impacts. It asks you to prepare the
information under both approaches for the years ending 31 December 20X4, 20X5 and
20X6, assuming that expected profits before grants, depreciation, interest and taxation for
those years will be HK$2.37 million, HK$2.66 million and HK$3.04 million.

Approach (a) – Treating the government grant as deferred income

20X4 20X5 20X6

HK$000 HK$000 HK$000
Profits
Profit before interest, grant, depreciation 2,370 2,660 3,040
and taxation
Depreciationa (62) (124) (124)
Government grant 9.5 19 19
Profit before interest and taxation 2,317.5 2,555 2,935

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Illustrative Example 1 (continued)

Statement of financial position at year end (extract)

HK$000 HK$000 HK$000

Non-current asset at cost 6,200 6,200 6,200
Acc Depreciation (62) (186) (310)
Carrying amount 6,138 6,014 5,890
Liabilities – Deferred Income a

Grant 940.5 921.5 902.5

a
Depreciation is calculated at 2% on a straight-line basis based on the total cost of
the building. Depreciation is recognised for a half year in 20X4. The year-end balance
of deferred income is calculated as the opening balance less the amount recognised
in income during that year.

Approach (b) – Reducing the cost of the asset

20X4 20X5 20X6

HK$000 HK$000 HK$000
Profits
Profit before interest, grant, 2,370 2,660 3,040
depreciation and taxation
Depreciationa (52.5) (105) (105)
Profit 2,317.5 2,555 2,935
a
Depreciation is calculated at 2% on a straight-line basis, based on the carrying
amount of the building after deducting the grant, i.e. 2% * (HK$6,200,000 −
HK$950,000) = HK$105,000. Half-year depreciation is recognised in 20X4.

Statement of financial position at year end (extract)

HK$ HK$ HK$

Non-current asset at cost 5,250 5,250 5,250
Acc Depreciation (52.5) (157.5) (262.5)
Carrying amount 5,197.5 5,092.5 4,987.5

Key Learning Point

For government grants related to assets, the recipient entity may: (i) set up the grant as
deferred income and recognise the grant in income systematically over the life of the asset;
or (ii) deduct the grant in determining the carrying amount of the asset.

22.4.2 Presentation of Grants Related to Income

Under HKAS 20, government grants related to income are to be presented as income in
calculating profit or loss. There are two alternative methods of presentation acceptable
under HKAS 20:

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1. Presenting the grant either separately or under a general heading such as ’other
income’; and
HKAS
20.29 2. Deducting the grant from the related expense.

Though both methods are acceptable under HKAS20, this issue has been the subject
of some controversy. Proponents of the first approach argue that it is less helpful for users
interested in assessing performance if expenses and revenues are offset. Proponents of the
second approach argue that offsetting is acceptable in this setting because the expenses are
unlikely to have been incurred if the grant was not provided and, as such, not offsetting the
related revenue and expense would be misleading.

The view taken in HKAS 20, is that either method is acceptable and that further disclosure
about the grant may assist a proper understanding of the financial statements. Applying
HKAS
HKAS 20, separate disclosure of the effect of grants on any items of revenue or expense is
20.31 typically appropriate. Further information about disclosure is covered in the next section.

Since HKAS 20 was first issued, the question of set-off has been addressed in the
accounting for financial instruments (e.g. HKAS 32.42). Companies would need to consider the
consistency of their accounting policies when considering the alternatives set out above. Also,
HKAS 1 requires that entities shall not offset assets and liabilities, or income and expenses,
unless specifically required or permitted by a HKAS.
Exhibit 22.1 provides a diagram that summarises the recognition and measurement
treatment for government grants.

Government Grants

Grants relating to assets Grants relating to income

Deduct from For past costs For costs to be

Deferred income
carrying amount incurred incurred

Recognise in income Recognise in income

Recognise in income on a systematic basis
immediately on a systematic basis

EXHIBIT 22.1 Accounting treatment for government grants

22.4.3 Disclosure of Government Grants

HKAS 20 requires the following matters to be disclosed in the financial statements:

• The accounting policy adopted for government grants, including the methods of
presentation adopted in the financial statements;

• The nature and extent of government grants recognised in the financial statements
and an indication of other forms of government assistance from which the entity has
directly benefited; and

HKAS • Unfulfilled conditions and other contingencies attaching to government assistance that
20.39 have been recognised in the financial statements.

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Apply and Analyse 5

Recall that CWaves received a loan from the government to encourage the company to
develop and run non-profit ferry routes to two smaller towns on the south east coast.
The loan was provided interest-free to fund the development of infrastructure (channel
dredging to ensure the water is deep enough and developing pier facilities) for the route.
The loan of HK$850,000 is interest free for a period of three years.

At the time the loan was made, the market rate of interest for loans of this size is
4% per year. The loan is particularly attractive to CWaves because no future performance
conditions are attached to the loan.

Prepare the disclosures CWaves might make in respect of the loan.

Analysis

In preparing the year-end financial statements, the entity must set out the relevant
accounting policy in respect of the loan and provide sufficient information about the
nature and extent of government grants recognised in the financial statements. Based on
the information provided, the disclosures below meet the requirements of HKAS 20.

Accounting policy: Government grants are not recognised as income until there is
reasonable assurance that the company will comply with the conditions attached to them
and that the grants will be received.

Government grants: An interest-free loan of HK$850,000 is received from the

government during the year. The loan is for a period of three years. The loan meets the
definition of a government grant and is, therefore, accounted for in accordance with
HKAS 20. The purpose of the loan is to fund the development of infrastructure (channel
dredging to ensure the water is deep enough and developing pier facilities) for the
company to develop and run additional ferry routes to two smaller towns on the south
east coast. The fair value of the benefit of the interest-free loan is HK$94,353. Consistently
with the requirements of HKAS 20, because no specified future performance conditions
are associated with the grant, the benefit of the loan is recognised in income in the
current year.

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Knowledge Check Question

Question 7
On 1 July 20X5, a small engineering company receives notification that it will be awarded
a grant of HK$340,000. The only condition attached to the grant is that the company
must employ an apprentice for two years and have that apprentice complete his or her
apprenticeship by the end of those two years. If these conditions are not met at any
time during the year, the grant will be required to be repaid, on a proportionate basis,
depending on the remaining time in the two-year period.
The company receives the funds on 1 August 20X5 and employs an apprentice on
a two-year contract on 1 September 20X5. The apprentice’s salary is agreed to be
HK$204,000 in the first year of employment and HK$226,000 in the second year.
The company’s accounting policy is to present grant income as a separate item of
revenue in the financial statements.

Required:

(a) Explain how the entity should recognise income from the grant.

(b) Prepare appropriate accounting policy note disclosures and extracts from
the entity’s financial statements relating to the grant for the year ended
31 December 20X5.

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SUMMARY

• HKAS 20 provides guidance on the accounting for, and disclosure of, government grants and
the disclosure of other forms of government assistance. Government assistance relating
income tax, agriculture and transfers of resources that result in government participation in
the ownership of the entity are not within the scope of HKAS 20.

• Under HKAS 20, government grants exclude government assistance not specific to an
entity or group of entities and that cannot reasonably have a value placed upon them and
exclude transactions with government that cannot be distinguished from the normal trading
transactions of the entity.

• Grants may take the form of a transfer of a non-monetary asset, such as land, buildings or
other resources. In such instances, the entity would normally assess the fair value of the non-
monetary asset and account for the asset and the grant at that value.

• Government grants should not be recognised until there is reasonable assurance the grants
will be received and the entity will comply with any conditions attaching to the grant. Further,
the manner in which the grant is received, such as in cash or as forgiveness of a loan does not
affect the accounting method to be adopted. Where government assistance is in the form of
a forgivable loan, a grant is recognised when there is reasonable assurance that the entity will
be able to meet the terms for the forgiveness of the loan.

• Government grants must be recognised in profit or loss on a systematic basis over the
periods in which the entity incurs the costs for which the grants are intended to compensate.
Where no such future costs are imposed on the recipient entity, the grant should normally be
recognised in income in the period in which it was first received or receivable.

• Where government grants are made relating to assets, including non-monetary assets at fair
value, the entity may either set the grant up as deferred income or may deduct the grant in
arriving at the carrying amount of the asset. The deferred income method recognises the grant
initially as deferred income in the statement of financial position and subsequently recognises
the deferred income in profit or loss over the useful life of the asset. The alternative method
deducts the grant in calculating the carrying amount of the asset. The grant is then recognised
in profit or loss over the useful life of the asset as reduced depreciation expense.

• Under HKAS 20, government grants related to income are to be presented as income in
calculating profit or loss. There are two alternative methods of disclosure that are acceptable
under HKAS 20: (i) presenting the grant either separately as an item of income or under a
general heading such as ‘other income’; or (ii) offsetting the grant income against the expense
for which the grant was provided to compensate.

• When an entity receives a government grant, it must disclose: (i) the accounting policy
adopted for government grants, including the methods of presentation adopted in the
financial statements; (ii) the nature and extent of government grants recognised in
the financial statements and an indication of other forms of government assistance from
which the entity has directly benefited; and (iii) unfulfilled conditions and other contingencies
attaching to government assistance that have been recognised.

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MIND MAP

OVERVIEW GOVERNMENT ASSISTANCE

The accounting for and disclosure of Assistance by government in the form of
government grants and the disclosure entity-specific transfers of resources in
of other forms of government assistance. return for past or future compliance with
Government assistance relating income certain conditions relating to the operating
tax, agriculture or transfers of resources activities of the entity.
that result in government participation Excludes government assistance that is not
in the ownership of the entity are not GOVERNMENT specific to an entity, assistance that cannot
within the scope of HKAS 20. GRANTS HKAS 20 reasonably be valued and transactions with
government that cannot be distinguished
PRESENTATION AND DISCLOSURE OF from the normal trading transactions of
GOVERNMENT GRANTS the entity.
Government grants relating to assets, RECOGNITION AND MEASUREMENT OF
including non-monetary assets at fair value, GOVERNMENT GRANTS
may be disclosed in the statement of
financial position either by: i) recognising Recognised in income when there is
the grant as deferred income; or ii) deducting reasonable assurance that the grants will
the grant in arriving at the carrying amount be received and that the entity will comply
of the asset. with any conditions attaching to the grant.
Government grants related to income are to The receipt of the grant, of itself, does not
be presented as a income in calculating profit provide conclusive evidence that the
or loss, either by: (i) presenting the grant conditions attaching to the grant have been,
separate item of income or under a general or will be, satisfied.
heading such as ‘other income’; or (ii) by The manner in which the grant is received,
deducting the grant from the related expense. such as in cash, or as forgiveness of a loan,
When grants are received, the entity must does not affect the accounting method to
disclose: (i) the accounting policy adopted be adopted.
for government grants and the methods Government assistance via forgivable loans,
of presentation adopted in the financial are recognised as grants when there is
statements; (ii) the nature and extent of reasonable assurance that the entity will be
government grants recognised in the financial able to meet the terms for the forgiveness
statements and an indication of other forms of the loan.Where grants are received in the
of government assistance from which the form of a transfer of a non-monetary asset,
entity has directly benefited; and (iii) unfulfilled the entity would normally assess the fair
conditions and other contingencies attaching to value of the non-monetary asset and account
government assistance that has been recognised. for the asset and the grant at that value.
Grants related to depreciable assets are
usually recognised in the profit or loss over
the periods and in the same proportions in
which depreciation on those assets is
recognised.
Grants that relate to non-depreciable assets
are recognised in income over the periods in
which any associated costs are incurred in
meeting any obligations attached to the grant.
Where a loan is provided by a government
at a below market rate of interest, the
benefit from the concessional interest rate
is to be recognised as a government grant.
Where a grant is required to be repaid, it
should be accounted for as a change in an
accounting estimate.

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 G o v ernment Grants

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. A government grant may the transfer of cash or the provision
of other non-monetary resources. Such grants may also be provided on an
unconditional basis.
Answer B is incorrect. Government grants do involve the transfer of resources to an entity,
but they may or may not be provided on an unconditional basis.
Answer C is correct. (Refer to the definition of government grants contained in HKAS 20.3.)
Answer D is incorrect. Though a key requirement of the HKAS 20 definition of government
grants is that the entity must have benefitted directly, the HKAS 20 definition excludes
various forms of assistance. For example, government assistance relating to income tax,
agriculture and transfers of reserves that result in government participation in the equity
of the entity are excluded from HKAS 20.

Question 2
Answer A is incorrect. The presence of restrictions does not indicate whether a government
grant should be recognised. Government grants may be associated with restrictions, or
they may be provided on an unconditional basis.
Answer B is incorrect. That the revenue represents a significant portion of the recipient
entity’s revenue is irrelevant in determining the existence of a government grant.
Answer C is incorrect. That the services are provided to the local government office does
not preclude the revenue from the contract from being classified as a government grant.
HKAS The requirements of HKAS 20 apply to assistance from a government, government
20.3 agencies and similar bodies at the local, national or international levels.
Answer D is correct. This is not a government grant because it does not appear the
government is providing any specific benefit to the entity over and above the purchase
of services under normal business conditions. If, for example, the entity provided
these services to the government at a surcharge of 20% over the normal rate for such
services, the surcharge amount may represent a government grant to be accounted for
under HKAS 20.

Question 3
Answer A is incorrect. The length of the project is irrelevant. The conditions, if any, imposed
on the recipient entity are key to determining if the grant must be recognised over more
than one period.
Answer B is correct. Government grants in the form of non-monetary assets are generally
measured at fair value although they can be measured at a nominal amount.
Answer C is incorrect. The policies the entity adopts are irrelevant in determining the
period in which the grant should be recognised in income.
Answer D is incorrect. Government grants should not be recognised in income until the
criteria for income recognition are satisfied.

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 FINANCIAL REPORTING

Question 4
The grant received should be recognised as deferred income on 1 July 20X7 (i.e. debit
cash and credit deferred income) because a condition of the grant is that the plant
begin operations by 30 June 20X8. From 1 June 20X8, when the plant is operational, in
accordance with HKAS 20, the grant should be recognised as income systematically over
the useful life of the plant because it is reasonably assured that the entity will satisfy the
remaining conditions attached to the grant.
The period over which the grant should be recognised in income may change where
additional conditions are imposed, such as maintaining a certain employment level
and where it may not be reasonably assured the entity will meet the conditions. In the
alternative scenario suggested, an additional requirement was imposed that a workforce
of at least 200 full-time positions be maintained for the first two years of operations, and it
is not reasonably assured this condition will be met. In this case, the grant will instead be
recognised as income on a systematic basis over the remaining useful life of the plant after
those conditions have been met because the conditions specified that any breach during
that time would result in a full repayment of the grant.

Question 5
1 January 20X5

Debit Credit
HK$ HK$
Bank 8,500,000
Deferred income – grant 8,500,000
To record receipt of grant.

31 December 20X5

Debit Credit
HK$ HK$
Deferred income – grant (75% × HK$8.5m) 6,375,000
Grant income (profit or loss) 6,375,000
To recognise grant income in the period in which 75% of the costs were incurred.

January 20X6

Debit Credit
HK$ HK$
Deferred income – granta 2,125,000
Grant refund (operating expenses) 2,975,000
Bank 5,100,000
To record part-repayment of grant

a
The portion of the grant yet to be recognised as income at repayment date
(HK$8,500,000 – HK$6,375,000).

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 G o v ernment Grants

Question 6
The entity-specific assistance provided by the government results in the transfer of
resources to the entity. Even though no additional future conditions are attached to the
assistance, this assistance would appear to fall within the definition of a government grant
in HKAS 20. At the same time, it would appear that the nature and type of assistance are
such that the entity cannot reasonably place a value on what is received. In such instances,
in accordance with HKAS 20, the entity must disclose the nature and extent of duration of
the assistance to provide useful information to users of the financial statements.

Question 7
(a) In accordance with the requirements of HKAS 20, the entity should recognise the
grant as income when there is reasonable assurance that the entity will comply
with any conditions attached to the grant and will receive the grant.

The second condition is met on 1 August 20X5 when the entity received the
grant monies. At this point, it is unclear whether the company will comply with the
requirement to employ an apprentice, so recognition of any of the grant as income
at that point is inappropriate. At that date, the accounting entry would be debit
cash and credit deferred income.
The first condition (i.e. compliance with the requirement to employ an
apprentice) is met on 1 September 20X5. From this date, the grant may be
recognised as income on a systematic basis as income over the two-year
conditional period. This is appropriate because, though the requirement to repay
the grant remains over the entire period, the amount required to be repaid for
non-compliance reduces proportionately with the passage of time.
(b) Accounting policy note disclosures and financial statement extracts:

Accounting policy: Government grants are not recognised until there is reasonable
assurance that the company will comply with the conditions attached to it and
that the grants will be received. Government grants toward employment costs are
recognised as income over the period necessary to match them to the related costs
and are deducted in reporting the related expense.
Government grants: A grant of HK$340,000 was received from the government
during the year. The conditions attached to the grant require the entity to fund the
employment of an apprentice for a two-year period and require that apprentice
complete the apprenticeship at the end of those two years. If these conditions are
not met at any time during the year, the grant must be repaid, on a proportionate
basis, depending on the remaining time in the two-year period.
In accounting for the grant, the company must recognise income from the
grant on a systematic basis over the period in which the costs are incurred for
which the grant is intended to compensate. In this case, the relevant costs are the
staff costs for the apprentice.

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Financial statement extracts

Statement of profit or loss for the year ended 31 December 20X5

HK$
Grant incomea 53,767

Statement of financial position on 31 December 20X5

HK$
Current liabilities
Deferred grant incomeb 167,101
Long-term liabilities
Deferred grant incomec 119,132

WORKINGS
a
Grant recording in income, in the year ending December 31, 20X5:

HK$204 , 000/(HK$204 , 000 HK$226, 000) HK$340, 000 4 /12months HK$53, 767
b
Current liabilities due within one year:

HK$204 , 000/(HK$204 , 000 HK$226, 000) HK$340, 000 8/12months HK$107, 535

HK$226, 000/(HK$204 , 000 HK$226, 000) HK$340, 000 4 /12months HK$59, 566

Total current liabilities on 31 December 20X4: HK$167,101

c
Long-term liabilities − after one year

HK$340,000 (HK$167,101+HK$53,767) HK$119,132

EXAM PRACTICE

QUESTION 1
On 1 January 20X4, an entity received HK$4.8 million from the government of the Hong Kong
SAR Government as an incentive to establish a manufacturing plant in a remote location.
The useful life of the plant is expected to be 10 years. The assistance provided by the
government was conditional on the entity meeting a number of requirements, including:
the completion of the plant’s construction within the year; the beginning of commercial
production by 1 January 20X5; and the attainment of various other requirements relating
to the carbon emissions and the safety of the workers over the next 10 years. If these
conditions are not met during the first five years, the entire amount is to be refunded.

Required

Explain how the entity should recognise and measure the government grant in accordance
with the requirements of HKAS 20.

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 G o v ernment Grants

QUESTION 2
MHL Group conducts research and development projects in Country X. It recently decided to
build a new research and development facility in a fast-growing regional centre. The cost of
the facility is estimated at HK$50 million and its useful life is expected to be 25 years. On the
basis that the facility would directly provide employment opportunities to local residents and
would stimulate economic development in the region, MHL Group entered into negotiations
with the provincial government for financial support for the development. The government
decided to provide MHL Group with a five-year, interest-free loan of HK$25 million,
conditional on MHL Group’s constructing the facility and continuing to operate it for the
period of its estimated useful life. Failure to meet these conditions will result in a refund
of the grant, in whole or in part. MHL expects to commence the development on 1 January
20X6, at which time the term of the government loan will commence. The market rate of
interest at this time is expected to be 4%.

Required

Advise the appropriate accounting treatment and the presentation of the interest-free loan
from the provincial government in MHL Group’s financial statements as at 1 January 20X6.
Prepare the journal entries required to record the loan. In addition, state whether your
suggested treatment changes if the loan is provided at below-market rates of interest.

ANSWERS TO EXAM PRACTICE

QUESTION 1
The HK$4.8 million 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, the entity should not recognise the grant until reasonable
assurance exists that it will comply with the conditions attached to them and that the grants
will be received.

The grant has been received, but the information provides no indication of the likelihood
that the conditions will be satisfied and, because the grant is potentially refundable for non-
compliance, recognition in income at the time of receipt is inappropriate. Accordingly, the
grant will be recognised as a deferred income upon initial receipt.

If the conditions will probably be satisfied, the grant should be recognised on a

systematic basis over the expected useful life of the manufacturing plant, i.e. 10 years,
commencing on 1 January 20X5. If the conditions will probably not be met, the grant
should remain as deferred income until reasonable assurance exists that the conditions
will be met after which time the grant should be recognised over the remaining useful life
of the manufacturing plant. If the entity is unable to meet the reasonable assurance test
throughout the term of the grant, recognition of the grant in income will be deferred until
the conditions attaching to the grant have been satisfied.

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QUESTION 2
Interest-free loan from government

According to HKAS 20, the benefit of an interest-free government loan is defined as assistance
by the 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.

In this case, the loan is recognised and measured in accordance with the existing accounting
standard for financial instruments, and the benefit of the interest-free loan is measured as the
difference between the initial carrying value of the loan and the proceeds received. The benefit
should be accounted for as a government grant in accordance with HKAS 20.

Before recording the loan, the company must first calculate the present value of the loan
as an indication of fair value. The present value calculation is provided below:

HK$ 25, 000, 000/(1.04 )5 HK$ 20, 548,178 .

The difference between the present value and the amount received (HK$4,451,822) is
the benefit received from the loan being interest free. The initial recording of the loan is
shown below:

Debit Credit
HK$ HK$
Bank 25,000,000
Government loan 20,548,178
Deferred income (government grant) 4,451,822

To determine the period over which the benefits of the interest-free loan should be
recognised in income, the MHL Group must consider the conditions and obligations that
must be met when identifying the costs for which the benefit of the loan is intended to
compensate. According to HKAS 20, MHL Group should recognise the grant only when
reasonable assurance exists that it will comply with the conditions attaching to the grant and
the grant will be received.

In this case, the second recognition requirement specified in paragraph 7 of HKAS 20

has been met as the grant has been received. In relation to the first recognition requirement
specified in paragraph 7 of HKAS 20, the loan has been granted to the company on condition
that the research and development facility is constructed by MLH Group and operated by it
for the estimated useful life of the facility. If it is not reasonably assured that MLH Group will
meet those conditions, it should not recognise the government grant in income.

If reasonable assurance exists that MHL Group will comply with the specified conditions,
it should recognise the government grant in income on a systematic basis over the periods
in which the entity recognises as expenses the related costs for which the grant is intended
to compensate. As the grant relates to a depreciable asset, in accordance with the guidance
in paragraph 17 of HKAS 20, the grant should be recognised in income over the periods
and in the proportions in which depreciation expense on the asset is recognised.

If the loan was provided at a concessional rate of interest, the calculation of the fair
value of the loan and, therefore, the benefit involved would change. Other requirements in
relation to the recognition and measurement remain the same as above.

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 23
Employee Benefits

CHAPTER TOPIC LIST

23.1 Overview 23.3.2 Defined Contribution Plans

23.1.1 Scope 23.3.3 Defined Benefit Plans
23.1.2 Terminology 23.4 Other Long-term Employee
23.2 Short-term Employee Benefits Benefits
23.2.1 Short-term Employee 23.4.1 R ecognition and Measurement
Benefits: Recognition and 23.4.2 Other Long-term Employee
Measurement Benefits Disclosure
23.2.2 Short-term Employee 23.5 Termination Benefits
Benefits Disclosure 23.5.1 Recognition and Measurement
23.3 Post-Employment Benefits 23.5.2 Termination Benefits
23.3.1 D
 istinction between Defined Disclosure
Contribution and Defined
Benefit Plans

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO23: A
 PPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT
FOR BUSINESS TRANSACTIONS
LO23.01: A
 ccount for, evaluate and advise on business transactions in accordance with Hong
Kong Financial Reporting Standards as they relate to: Employee Benefits
5.01.01 Define employee benefits
5.01.02 Apply the recognition and measurement principles in respect of employee benefits, including
termination benefits
5.01.03 Account for defined contribution plans
5.01.04 Account for defined benefit plans
5.01.05 Explain the difference between defined contribution plans and defined benefit plans
5.01.06 Prepare disclosure in respect of employee benefits

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 Employee B enefits

OPENING CASE

F ast Limited (Fast) is a warehousing company located in Hong Kong, importing goods and
distributing them in short time frames to customers throughout Hong Kong.

Fast’s financial year is from 1 January to 31 December. Fast employs 250 employees, and
the average salary is HK$155,000 per annum.

Fast’s employees are entitled to employee benefits as follows:

• 10 days of paid annual leave each financial year;

• 5 days of paid sickness allowance each financial year; and

• 10 weeks of paid maternity leave for new mothers.

Fast’s employees are entitled to a long service payment if employed under a continuous
contract for at least five years.

Fast has not entered into a formal arrangement with employees to pay a bonus.
Nonetheless, it has paid a bonus of 2% of profit each year for the past 10 years.

Fast operates a Mandatory Provident Fund (MPF) Scheme for employees not previously
covered by the defined benefit retirement plan. Under the MPF, Fast and its employees are
required to make contributions to the plan at 5% of the employees’ relevant income, subject to
a cap of monthly relevant income of HK$30,000. Contributions to the plan vest immediately.

Fast is also the employer sponsor of a defined benefit pension fund for some of its
employees. All of the employees who are members of the fund have been employed by Fast for
over 20 years.

Star Limited (Star) is a subsidiary of Fast. Fast acquired Star because it operates a similar
business to Fast, and synergies between the two businesses were expected to add to
profitability. Star’s financial year is also from 1 January to 31 December.

Star has 100 employees, each of whom are entitled to five working days of paid sick leave
for each year. Star has entered into a profit-sharing plan with its employees, requiring it to pay
a specified proportion of its profit for the year to employees who serve throughout the year.

In June 20X9, Fast reconsiders the synergies available through the operations of the two
businesses and determined that one of Star’s warehouses is no longer required and will close
it at the end of the following April. This will impact 50 of Star’s employees who will not be
re-employed in the group.

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 FINANCIAL REPORTING

OVERVIEW

For most organisations, employees are one of their most important resources, often referred
to as human capital, and their salary and/or wages and other benefits are a significant expense.
This means accounting appropriately for the benefits that employers pay to, or on behalf of,
their employees is often key to preparing relevant and reliable financial statements.

Employees provide service to their employer and, in return, receive a range of employment
benefits: salary or wages, bonuses, paid annual leave, sickness allowance and pension fund
contributions to name just a few. For the employer, accounting for these benefits could seem
straightforward but, in reality, involves significant professional judgement and, therefore, raises
the potential for differing accounting treatment between entities.

Considering the case of Fast, if an employee has four weeks of paid annual leave owed
at year-end, should Fast recognise this as a liability? Should it be classified as current
and/or non-current? And how should this liability be measured: at face value or discounted to
present value? Even more complex is accounting for benefits, such as termination or severance
pay, which is only payable in certain circumstances, or such as employer contributions to
pension funds. This topic is further complicated by different employee benefit laws in different
jurisdictions, such as Hong Kong compared to mainland China or other countries in Asia.

This chapter focuses on the recognition, measurement and disclosure of employee

benefits by the reporting entity that is the employer. You will gain an understanding of the
issues involved in recognising and measuring employee benefits in general purpose financial
statements. You should also appreciate the objective and extent of disclosures an entity needs
to make about employee benefits to help users of its financial statements understand the
nature and amount of employee costs and the impact on financial performance. You should
also appreciate employee benefit related liabilities or assets, associated uncertainties and how
these impact on the entity’s financial position now and in the future.

2 3 . 1 OVERVIEW

In this chapter, you will learn about how an employing entity must account for employee
HKAS 19 benefits as set out in HKAS 19 Employee Benefits.

The objective of HKAS 19 is to establish the principles an entity should apply to report
useful information to users of its general purpose financial statements about the nature,
amount, timing and uncertainty of expenses and liabilities (or assets) arising from its use of the
services provided by its employees.

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 Employee B enefits

In this section, you will gain an understanding of the employee benefits to which HKAS 19
applies and be introduced to some of the terminology relevant to applying the principles in
the Standard.

23.1.1 Scope
Employees receive a range of benefits from their employer in exchange for their services. These
may include wages, salaries, paid annual leave and sick leave, and non-monetary benefits, such
as cars, retirement benefits or termination benefits. HKAS 19 addresses how the employer,
as the reporting entity, should account for providing these benefits in return for the services
provided by its employees.

To ensure all employee benefits are captured appropriately, regardless of how they are
paid, the scope of HKAS 19 is deliberately broad. The coverage of HKAS 19 includes:

• Who can be paid?

°° All individuals receiving employee benefits, including full-time, part-time,

HKAS permanent, casual or temporary employees, and it covers all staff, directors and
19.7 managers; and

°° Benefits can be provided directly to the employee or can be paid to others such as
HKAS their spouse or children, other dependents or beneficiaries, retirement funds or
19.6 insurance companies.

• How can they be paid?

HKAS
19.6
°° Benefits may be settled in payments in cash or in kind.

• What are they paid for?

°° Employee benefits the definition of which is all forms of consideration given by an

HKAS entity in exchange for service rendered by employees or for the termination of
19.8 employment.

HKAS This means HKAS 19 applies to all employee benefits. The only exception is for share-based
19.2 payments, as they are covered by HKFRS 2 Share-based Payment.

Key Learning Point

HKAS 19 addresses accounting for employee entitlements by the employer. This is the
reporting entity. It is important to differentiate this from accounting by other parties, such
as employees or retirement plans.

23.1.2 Terminology
Over the course of this chapter, you will be introduced to terminology particular to HKAS 19.
HKAS However, as it will be useful to understand some of the key terms and concepts before going
19.8 further into the chapter, and they are explained in Exhibit 23.1.

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Expected to be settled wholly before 12 months

after the end of the annual reporting period in which
Short-term employee benefits
the employees render the related service (other than
termination benefits).

All forms of
consideration Payable after the completion of employment (other than
given by an Employee benefits Post-employment benefits termination benefits and short-term employee benefits).
entity in
exchange
for service
rendered by
employees All employee benefits other than short-term employee
Other long-term employee
or for the benefits, post-employment benefits and termination
benefits
termination of benefits.
employment.

Provided in exchange for the termination of an

Termination benefits
employee’s employment.

Post-employment benefit plans

Plans under which an entity pays fixed contributions
into a separate fund and has no legal or constructive Defined contribution Formal or informal
obligation to pay further contributions if the fund does plans arrangements
not hold sufficient assets to pay all employee benefits. under which an
entity provides
post-employment
Post-employment benefit plans other than defined Defined benefit plans benefits for one or
contribution plans. more employees.

Net
defined
benefit
liability
(asset)

Deficit or surplus, that is, present value

of the defined benefit obligation less
the fair value of the plan assets.

EXHIBIT 23.1 Overview of key terms used in HKAS 19

2 3 . 2 SHORT-TERM EMPLOYEE BENEFITS

An employee benefit, other than a termination benefit, is short-term only when it is expected to
HKAS be settled wholly before 12 months after the end of the annual reporting period in which the
19.8 employees render the related services.

Some benefits, such as wages or salaries, are likely to be paid to employees as they earn
them throughout the year or shortly after the end of the year. As it is reasonable to expect any
accrued wages and salaries to be settled within 12 months of the end of the annual reporting
period, they are normally classified as short-term employee benefits.

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 Employee B enefits

Some benefits, such as paid annual leave, require more judgement, and the classification as
short-term or long-term will vary between entities.

Consider these two scenarios and their outcomes:

Scenario 1: In Company X, employees are entitled to accumulate paid annual leave;

however, Company X has a policy of strongly encouraging employees to take their full leave
allowance each financial year or as soon as practicable after the end of the year. Historically,
employees follow the employer’s policy.

In this case, it is reasonable to expect any accumulated annual leave at year-end will be
used by employees within the next 12 months; accordingly, the amount would be classified as a
short-term employee benefit.

Scenario 2: In Company Y, employees are entitled to accumulate paid annual leave.

Historically, not all employees take all their leave each financial year, and some accumulate
leave balances of up to three years’ worth of leave.

In this case, it is reasonable to expect the accumulated annual leave at year end will not be
wholly used by employees within the next 12 months; accordingly, the annual leave balance
would not be classified as a short-term employee benefit.

This differentiation is important because it impacts how the liability is measured and how
it is classified in the statement of financial position. If an employee benefit is not expected
to be settled wholly before 12 months after the end of the annual reporting period in which
the employees rendered the related service, it will be classified and measured as a long-term
employee benefit (see Section 23.4).

23.2.1 Short-term Employee Benefits: Recognition and Measurement

23.2.1.1 All Short-term Employee Benefits
When an employee has rendered service to an entity during an accounting period and has
HKAS received or will receive short-term employee benefits in return, the entity accounts for the
19.11 benefit as illustrated in Exhibit 23.2.

Expense unless required or

permitted to be included in
an asset by another HKFRS
(e.g. inventory, property plant
and equipment)

Amount already paid

Expense = Total
for the period (other
amount of benefit
expected to be – than consideration = Liability
paid in advance,
paid for service
i.e. prepayment)

Measured at Measured at
undiscounted undiscounted
amount amount

EXHIBIT 23.2 Accounting for all short-term benefits

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Although measuring and recognising an expense and liability for short-term employee
benefits is mostly straightforward, HKAS 19 provides guidance for two slightly more
complicated areas: short-term paid absences and profit-sharing arrangements and bonus
plans. These are explained below.

23.2.1.2 Short-term Paid Absences

An employee may be entitled to short-term paid absences for a range of reasons. Typically, in
Hong Kong, these include:

• Annual leave;

• Maternity leave; and

• Sickness allowance.

HKAS The accounting treatment for these short-term absences depends on whether they are
19.15, 18 accumulating or non-accumulating and vesting or non-vesting. You must understand these
terms before tackling the accounting treatment.

Accumulating paid absences: employees can carry forward any leave they have earned but
not yet taken at the end of the reporting period year and use it in future periods.

Non-accumulating paid absences: employees cannot carry forward the leave they have
earned but not yet taken at the end of the reporting period.
Vesting paid absences: accumulating paid absences (as defined above), employees are
entitled to a cash payment for unused entitlement on leaving the entity.

Non-vesting paid absences: accumulating paid absences (as defined above) that will lapse
when an employee leaves the entity.

Apply and Analyse 1

Fast’s employees are entitled to short-term paid absences as follows:

1. 10 days of paid annual leave each year, which accrues so any unused leave is
carried forward to the next financial period and/or paid to the employee in cash
when they leave Fast’s employment;

2. Five days of paid sickness allowance each year, and any unused sickness allowance
can be carried forward into the next financial period. When an employee leaves,
he or she is not entitled to receive any unused allowance in cash; and
3. 10 weeks of paid maternity leave for new mothers, paid on their return to work
provided they have taken maternity leave of at least 10 weeks.

For each of these absences, determine whether the absence is accumulating or

non-accumulating. For any accumulating absences, also determine whether the absence is
vesting or non-vesting.

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Apply and Analyse 1 (continued)

Analysis

1. Paid annual leave: accumulating and vesting

• Accumulating as can be carried forward and used in future periods

• Vesting as the unused entitlement is paid as cash when an employee leaves

the entity

2. Paid sickness allowance: accumulating and non-vesting

• Accumulating as can be carried forward and used in future periods

• Non-vesting as lapses (not paid in cash) when an employee leaves the entity

3. Paid maternity leave: non-accumulating

• Non-accumulating as is tied to a specific event and cannot be carried forward to a

future period

• As it is non-accumulating, by definition cannot be vesting

HKAS Now that the terminology has been clarified, the next step is to determine the accounting
19.13, 16 treatment for short-term paid absences. This is illustrated in Exhibit 23.3.

Recognise when the Measure at the additional

Is the short-term Yes employees render (undiscounted) amount the entity
paid absence service that increases expects to pay as a result of the
accumulating? their entitlement to unused entitlement at the end of
future paid absences the reporting period

No

This means Vesting paid Non-vesting paid absences

Recognise as an expense recognising an absences are are measured based on the
when the absence occurs expense during the expected to be amount expected to be paid–that
period the employee paid in full and is, considering the amount of
Measure at undiscounted earns the unused so are measured unused entitlement expected to
amount entitlement, and a at the amount of be taken prior to an employee
liability for this at the unused leaving
the end of the period entitlement

EXHIBIT 23.3 Accounting for short-term paid absences

Illustrative Example 1
Fast’s employees are entitled to short-term paid absences as follows:

• 10 days of paid annual leave each financial year, which accrues so any unused leave
is carried forward to the next financial period and/or paid to employees in cash when
they leave. (Fast expects its employees to have fewer than three days annual leave
accrued at the end of year financial year, which must be used within six months.)

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Illustrative Example 1 (continued)

• Five days of paid sickness allowance each financial year, and any unused sickness
allowance can be carried forward into the next financial period. When employees
leave, they are not entitled to receive any unused allowance in cash. Fast has a
policy of allocating sickness allowance first to the current year’s entitlement and
then to any balance brought forward from the previous year, that is, accounting for
sickness allowance on a last-in, first-out (LIFO) basis.

• 10 weeks of paid maternity leave for new mothers, paid on their return to work
provided they have taken maternity leave of at least 10 weeks.

At Fast’s year-end, 31 December 20X8, employees have the following unused absences:

• Unused annual leave entitlements average two days per employee.

• Unused sickness allowance averages seven days per employee. Fast anticipates,
based on past experience, that 100 employees will take fewer than five days sick
leave in the next financial year, 80 are anticipated to take eight days and 70 are
anticipated to take 10 days.

• Additionally, Fast paid maternity leave totaling HK$200,000 for absences that
occurred during the year to 31 December 20X8.

Fast employs 250 employees, and the average salary is HK$155,000 per annum.

The liability for short-term employee absences at 31 December 20X8 is calculated

as follows:

Rationale Calculation Total

HK$
Annual Accumulating and vesting, expected 250 (employees) × 2 (days) 212,329
leave to be settled wholly by 31 December × HK$155,000/365 (average
liability 20X9. Recognise the liability, salary)
measured at the amount due (not
discounted).
Sick leave Accumulating and non-vesting, so 100 (employees) × 0 (days) 250,548
liability recognise the liability, measured at × HK$155,000/365 (average
the amount expected to pay, taking salary) = nil
into account the possibility the 80 (employees) × (8–5) (days)
employees may leave before they × HK$155,000/365 (average
use the accumulated non-vesting salary) = HK$101,918
entitlement.
70 (employees) × (10–5) (days)
On a LIFO basis, so only include × HK$155,000/365 (average
the amount expected to pay in the salary) = HK$148,630
future, which exceeds the sickness
allowance accrued in the future.
Maternity Non-accumulating, so recognise nil
leave as an expense when the absence
occurs.
Total 462,877

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Illustrative Example 1 (continued)

The adjusting journal entry to recognise the liability for short-term paid absences at
31 December 20X8 is:

Debit Credit
HK$ HK$
31.12.x8 Employee expense 462,877
Accrued employee expense (liability) 462,877
Being recognition of the liability for unused leave balances at year-end (assuming the liability
balance at the start of the year is zero).

When the employees take this leave in the future, the liability will be reduced rather than
an expense being recognised.

Debit Credit
HK$ HK$
Date Accrued employee expense (liability) xx
Cash xx
Being leave payment relating to accrued balance from prior year.

This treatment results in the expense being recognised in the period the employee
renders the service to the entity, which is not necessarily the period in which the
entitlement is paid.

23.2.1.3 Profit-sharing and Bonus Plans

In addition to their normal salary and wages, and paid absences, employees may receive a
profit-share or bonus from their employer:

• If the profit-share or bonus is paid in the period it is earned by the employee, the entity
recognises the amount as an expense (or includes it in the cost of an asset): Dr expense
(or cost of asset), Cr cash.

• If the profit-share or bonus is to be paid in a subsequent period, it is recognised as an

expense (or is included in the cost of an asset) and a liability: Dr expense (or cost of
asset), Cr liability, provided:

°° The employer has a present obligation to pay the profit-share or bonus; and

°° The entity can reliably estimate the amount to be paid.

HKAS If these conditions are not met, the amount is expensed (or included in the cost of an asset)
19.19 when it is paid.

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This means an entity has to satisfy two criteria to recognise a profit-share or bonus
payment to an employee:

1. Is there a present obligation?

• HKAS 19 applies the same concept of present obligation as explained in Chapter 18:
Provisions, Contingent Liabilities and Contingent Assets;

• A present obligation exists if the entity has no realistic alternative but to make the
payments; and

• This can arise from a legal or constructive obligation.

2. Can the entity reliably estimate the amount to be paid?

• HKAS 19 contains guidance to assist entities to assess whether the amount can be
measured reliably:

°° There are formal terms in a plan containing a formula for determining the amount;

°° The entity determines the amount before the financial statements are
authorised for issue; or
HKAS
19.22
°° Past practice gives clear evidence of the amount.

HKAS Where the obligation arises from a constructive obligation, when measuring the amount
19.21 payable, reflect on the possibility that some employees may leave without receiving the bonus.

As for all short-term employee benefits, profit-shares and bonuses are only classified as
short-term benefits and accounted for in accordance with this section if they are expected to be
settled wholly before 12 months after the end of the annual reporting period. If the entity
HKAS anticipates settling after this time, they are classified as other long-term employee benefits
19.24 (see Section 23.4).

Illustrative Example 2
Fast has not entered into a formal arrangement with employees to pay a bonus.
Nonetheless, it has paid a bonus of 2% of profit each year for the past 10 years, settled
by the end of March in the following year. The year-end for Fast is 31 December 20X8.
It has not indicated this practice will change.

1. Is there a present obligation?

In this situation, employees have a valid expectation they will receive the bonus,
and therefore, Fast has no realistic alternative but to pay. Fast’s past practice
of paying a bonus of 2% of profit each year is clear evidence of a constructive
obligation as described in HKAS 19.

2. Can the entity reliably estimate the amount to be paid?

Fast must recognise a liability for the amount of the bonus at 31 December 20X8.
Because the amount is expected to be settled within three months after year-end,
it will be a short-term employee entitlement. When measuring the amount payable,
Fast will need to reflect on the possibility that some employees may leave without
receiving the bonus. This is likely to be reliably estimated based on past years.
Therefore, Fast can reliably estimate the amount to be paid.

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23.2.2 Short-term Employee Benefits Disclosure

HKAS 19 requires no specific disclosures about short-term employee benefits. Information
about these benefits may need to be disclosed by other HKAS/FRSs, for example:

• HKAS 24 (Revised) Related Party Disclosures requires disclosures about employee

benefits for key management personnel; and

• HKAS 1 Presentation of Financial Statements requires disclosure of employee benefits

expense.

Knowledge Check Questions – Adapted from HKAS 19

Illustrative Examples

Question 1
1. Star Limited (Star) is finalising its financial statements and determining the
appropriate accounting treatment for sick leave. These are the relevant facts:
Star has 100 employees, who are each entitled to five working days of paid sick leave
for each year. Unused sick leave may be carried forward but when employees leave,
they are not entitled to receive any unused allowance in cash. Star has a policy of
allocating sickness allowance first to the current year’s entitlement and then to any
balance brought forward from the previous year, that is, accounting for sickness
allowance on a last-in, first-out (LIFO) basis. On 31 December 20X8, the average
unused entitlement is two days per employee. Star expects, on the basis of experience,
that 92 employees will take no more than five days of paid sick leave in 20X9 and the
remaining eight employees will take an average of six and a half days each.
Explain how should Star account for the sick leave in accordance with HKAS 19.

Question 2
2. Star is finalising its financial statements and determining the appropriate
accounting treatment for its profit-sharing plan. These are the relevant facts:
Star has entered into a profit-sharing plan with its employees, requiring it to pay a
specified proportion of its profit for the year to employees who serve throughout
the year. If no employees leave during the year, the total profit-sharing payments
for the year will be 3% of profit. Star estimates that staff turnover will reduce the
payments to 2.5% of profit.
Explain how Star should account for the profit-sharing plan in accordance with HKAS 19.

2 3 . 3 POST-EMPLOYMENT BENEFITS

As well as receiving benefits while they are being employed, employees may receive a variety
of benefits from their previous employer after they have left as a result of their employment.
These benefits may be paid directly to the ex-employee, or paid by a third party, often a

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pension fund or insurance company. These are referred to as post-employment benefits and
may include:

• Retirement benefits, such as pensions and/or lump sum payments on retirement; and

HKAS • Other post-employment benefits such as post-employment life insurance or

19.26 medical care.

This section focuses on post-employment benefit plans, whereby an employer has an

arrangement to provide post-employment benefits to its employees, most commonly
retirement payments and pensions. These benefits can be provided directly by the entity or
HKAS through a separate entity, such as a pension fund that receives contributions and pays
19.26 benefits.

Key Learning Point

HKAS Post-employment benefit plans are classified as defined contribution plans or as defined
19.27 benefit plans, depending on the economic substance of the plan.

Accounting for post-employment benefit plans is the area of employee benefits that has
caused the most challenges and controversy for preparers and users of financial reports,
regulators and standard setters.

23.3.1 Distinction between Defined Contribution and Defined

Benefit Plans
To account appropriately for post-employment plans, differentiating between defined
contribution and defined benefit plans is essential. HKAS 19 provides guidance on this
HKAS distinction. Refer to the description of the terminology in Section 23.1.2, which is also illustrated
19.28–30 in Exhibit 23.4.

Entity (employer) has agreed to provide certain

benefits to employee post-employment. Entity
Entity (employer) contributes (employer)’s contribution to fund is not limited
agreed amount to fund to an agreed amount

Employee may Employee may

Defined contribution
contribute to Defined benefit plan contribute to
plan
fund fund

Post-employment (pension) Post-employment (pension) payment

payment to employee is based to employee is based on agreement to
on contributions and investment provide agreed benefits to current and
returns former employees
Employee bears risks* Employer bears risks*

*The risks associated with a post-employment plan are:

1. actuarial risk: benefits will be less than expected; and
2. investment risk: assets invested will be insufficient to meet expected benefits.

EXHIBIT 23.4 Distinguishing between defined contribution and defined benefit plans

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 Employee B enefits

Illustrative Example 3
Most employees are members of Fast’s Mandatory Provident Fund (MPF) Scheme. Under
the MPF, Fast is required to make contributions to the plan at 5% of the employees’
relevant income.

Is the MPF a defined contribution plan or a defined benefit plan?

This is a defined contribution plan as Fast is committed to paying an agreed amount

to the MPF.

Some employees are members of Fast’s defined benefit plan. Fast has agreed that
these employees are entitled to predetermined pension payments from the fund, and Fast
is obliged to ensure the fund is fully funded so it can pay the pensions when they fall due.

Does Fast’s defined benefit plan meet the HKAS 19 definition of a defined benefit plan?

Yes, because Fast has an agreement with the employees that they will receive a
predetermined amount from the fund, and Fast is committed to fully funding the fund so it
can make the payments.

Knowledge Check Question

Question 3
Identify which one of the following arrangements indicates a post-employment plan is a
defined contribution plan in accordance with HKAS 19.
A An entity contributes to a pension fund based on a plan benefit formula that is not
linked solely to the amount of contributions and requires the entity to provide further
contributions if assets are insufficient to meet the benefits in the plan benefit formula.
B The entity has guaranteed, indirectly through a plan or directly, a specified return on
contributions to employees when they retire.
C An entity has a history of increasing benefits for former employees when they retire to
keep pace with inflation even though there is no legal obligation to do so.
D An entity has committed to pay 5% of an employee’s salary into a pension fund
each year.

23.3.2 Defined Contribution Plans

As you have learned, a defined contribution plan is an arrangement whereby the employer
pays fixed contributions into a separate fund and has no legal or constructive obligation to
HKAS make further contributions if the fund does not hold sufficient assets to pay all employee
19.8 benefits. An employer-sponsored Mutual Provident Fund (MPF) in Hong Kong is an. example of
a defined contribution fund. Employers and employees pay contributions to a fund based on
the employee’s salary. The employer has no further obligations towards the fund.

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23.3.2.1 Recognition and Measurement

Accounting for employer contributions to defined contribution plans is straightforward because
HKAS the entity’s obligation for each period is determined by the amounts to be contributed for that
19.50 period (Exhibit 23.5).

Expense unless required or

permitted to be included in
an asset by another HKFRS
(e.g. inventory)

Expense = Total Amount already paid

amount of contribution for the period (other
payable in return for – than consideration = Liability
the employees’ service paid in advance =
in the financial period prepayment)

Measured at undiscounted amount, if expected

to be settled wholly within 12 months of the
end of the annual reporting period. Discounted
if expected to be settled later.

EXHIBIT 23.5 Accounting for defined contribution plans by the employer

23.3.2.2 Disclosure
As accounting for the employer’s contribution to defined benefit plans is relatively
HKAS straightforward, the only disclosure required by HKAS 19 is the amount recognised as
19.53 an expense.

HKAS An entity may also need to disclose contributions to defined benefit contribution plans for
19.54 key management personnel in accordance with HKAS 24.

Illustrative Example 4
Fast operates a Mandatory Provident Fund (MPF) Scheme for employees who are not
members of Fast’s defined benefit scheme. Under the MPF, Fast and its employees
are each required to make contributions to the plan at 5% of the employees’ relevant
income, subject to a cap of monthly relevant income of HK$30,000. Contributions to
the plan vest immediately. Fast does not have any other obligation to make payments
under the MPF.

During the 20X8 financial year, Fast paid mandatory contributions of HK$1,250,000 to
the MPF trustees in relation to contributions due for the year. The December contribution
of HK$121,500 is outstanding as of 31 December 20X8, and is due by 10 January 20X9.

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 Employee B enefits

Illustrative Example 4 (continued)

Throughout the year, the mandatory contributions are accounted for as follows:

Debit Credit
Monthly, totalling HK$ HK$
Employee expense 1,250,000
Cash 1,250,000
Being recognition of employer mandatory contributions to the MPF scheme trustee.

The liability at year end is expected to be wholly settled by 10 January 20X9, so is

accounted for as follows:

Debit Credit
HK$ HK$
31.12.x8 Employee expense 121,500
Accrued employee expense (liability) 121,500
Being recognition of the liability for mandatory contribution outstanding at year-end.

Employers are also likely to withhold the 5% employee contribution from the
employees’ pay each week or month and remit this amount to the trustee on behalf of the
employee. This is an in-substance payment of the employees’ salaries and wages, but to
the third party for their benefit, rather than directly to the employee. Therefore, it is not an
employer contribution to a defined contribution fund in accordance with HKAS 19.

Extract: Notes to the financial statements

Fast Limited

Financial statements for the year ended 31 December 20X8

• PROFIT BEFORE TAXATION

Profit before taxation is arrived at after charging/(crediting):

Staff costs

20X8 20X7
HK$ HK$
Contributions to defined contribution retirement plan 1,371,500 xxx

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23.3.3 Defined Benefit Plans

HKAS A defined benefit plan is defined by HKAS 19 as a post-employment benefit plan other than a
19.8 defined contribution plan.

This is a deliberately broad definition to ensure all arrangements are included if the
employer has any legal or constructive obligation to make further contributions should the
fund not hold sufficient assets to pay all employee benefits.

Although most employees in Hong Kong are members of an MPF, some employees
are members of an employer-sponsored defined benefit plan, normally resulting from
arrangements put in place prior to MPF’s being introduced. Internationally, defined benefit
plans are uncommon and are typically for government employees or long-standing employees
of companies.

Where there is a defined benefit plan, the benefits received by an employee do not depend
solely on contributions to the fund and earnings on investments made by the fund. Rather, the
benefit the employee is entitled to generally depends on other factors, such as years of service
or final average salary on retirement. For example, an employer may have an agreed with
employees that they will receive a pension of 80% of their ending salary for the rest of their life.
Therefore, the amount of benefit that the employee will receive is defined. The employer will
likely need to vary contributions to the fund to ensure the fund can meet the commitment to
the employee.

In some instances, entities meet their obligation to the defined benefit retirement plan in a
HKAS way that is referred to as ‘unfunded’. This means no fund is separate; instead, the employer
19.56 intends to pay benefits directly from the entity’s own funds when they fall due.

Alternatively, the employer makes contributions to a separate fund throughout the

employee’s employment. The relationship among the employer, defined benefit fund and
employees is illustrated in Exhibit 23.6. Understanding this relationship will assist you to
understand the principles of accounting by an employer when a defined benefit fund exists.

Entity (employer) obliged Contributions by the employer vary as

to contribute to fund they are based on actuarial assumptions
used to estimate the ultimate cost of
funding the pensions:
• Demographic assumptions about
Defined benefit fund (separate legal variables including mortality,
entity) disability, employee turnover
Employee may • Financial assumptions including
contribute to Net assets reflect contributions plus discount rate, benefit levels, taxes
fund investment returns, less
administration costs and pension
payments

Post-employment (pension) payment to

employee is based on agreed formula
(usually salary and years of service)

EXHIBIT 23.6 Relationship among the employer, defined benefit plan and employees

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 Employee B enefits

23.3.3.1 Recognition and Measurement

Accounting for defined benefit plans is complex:

• Actuarial assumptions are required to measure the employer’s obligation to the fund,
and therefore, the expense; and

HKAS • Obligations are measured on a discounted basis because they may be settled many
19.55 years after the employees render the related service.

HKAS 19 is concerned with how the employer recognises and measures three elements in
its financial statements relating to defined benefit plans:

1. Net defined benefit liability (asset) arising from a deficit (surplus) in the fund;

2. Expense in the profit and loss statement, comprising:

a. Service cost, being the increase in the present value of the defined benefit
obligation resulting from employee service in the current period (or adjustment for
past periods);

b. Net interest on the net defined benefit liability; and

3. Remeasurements of the liability (asset) recognised in other comprehensive income:

a. Actuarial gains and losses; and

b. Return on plan assets.

Key Learning Point

HKAS 19 is concerned with accounting for a defined benefit plan by the entity that is the
employer and sponsor of the plan, and it revolves around the employer’s obligations
arising in relation to the plan. HKAS 19 is not concerned with accounting by other entities
such as the fund, or by employees.

HKAS
Accounting by the entity for defined benefit plans is a four-step process illustrated in
19.57 Exhibit 23.7.

HKAS 19 contains rules and guidance to assist with the more complex aspects of applying
these steps, which are outlined in the following sections. You will see there is an overall
illustrated example at the end of Section 23.3.3.6 bringing the steps and the guidance together
into one example.

Actuarial Valuation Method

The first part of Step 1 is to make a reliable estimate of the ultimate cost to the entity of the
benefit that employees have earned in return for their services in the current and prior periods.
(This is the defined benefit obligation.) The portion of this amount, attributable to the current
period is also needed because this is the current service cost in Step 3.

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 FINANCIAL REPORTING

This is the amount the

• Follow 3 steps to determine the deficit or surplus in the plan: employees are expected to be
1. Estimate the ultimate cost to the entity of the benefit that paid from the retirement plan,
employees have earned in return for their services in the current based on their employment
and prior periods (this is the defined benefit obligation); to date, to the extent of the
2. Discount the defined benefit obligation to present value; and employing entity’s obligation
Step 1: determine 3. Deduct the fair value of any plan assets from the present value
the deficit (surplus) Apply a discount rate as
of the defined benefit obligation.
explained in 3.3.1.5

The asset ceiling is the present

• If Step 1 determined a deficit, recognise this as a liability. value of the reduction in future
• If Step 1 determined a surplus, limit the recognition of a defined contributions, or a cash refund,
Step 2: determine benefit to the asset ceiling. arising from the surplus – see
the amount of the 3.3.1.3
net defined benefit
liability (asset)
Current service cost is the
amount of benefit attributed
to the current period, using
the plan’s benefit formula – see
3.3.1.3
• The expense comprises:
These result from a plan
1. Current service cost1;
amendment orcurtailment – see
2. Any past service cost and gain or loss on settlement; and
Step 3: determine 3.3.1.6
3. Net interest on the net defined benefit liability (asset).
amounts to be
recognised as Results from the change in the
expense measurement of the liability
(P&L) (asset) during the period due
to the passage of time rather
than other factors

• Remeasurement of the net defined benefit liability (asset) comprising:

1. Actuarial gains and losses2;
2. Return on plan assets3; and Certain adjustments are to be
Step 4: determine 3. Any change in the effect of the asset ceiling.
amounts to be recognised in OCI and not P&L
recognised in OCI

1.  ervice cost is defined in HKAS 19 as ‘(a) current service cost, which is the increase in the present
S
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.’
2.  ctuarial gains and losses is defined in HKAS 19 as ‘changes in the present value of the defined benefit
A
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.’
3.  eturn on plan assets is defined in HKAS 19 as ‘interest, dividends and other income derived from the
R
plan assets, together with the realised and unrealised gains or losses on the plan assets, less: (a) any
costs 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.’

EXHIBIT 23.7 Four-step process for an entity to account for defined benefit plans

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 Employee B enefits

The ultimate cost of a defined benefit plan is uncertain because it may be influenced by
many variables, such as final salaries, employee turnover and mortality, employee
contributions and medical cost trends. This means it is necessary to apply an actuarial valuation
HKAS method to measure the present value of the defined benefit obligation, relating to the service
19.57 of the employees to date.

Determining the Deficit (Surplus)

As Step 1 involves complex concepts you may be unfamiliar with, more explanation and a
simple worked example is included here.

As explained in 23.3.3.1.1, determining the defined benefit obligation is an actuarial

valuation so beyond the scope of your studies.

The discount rate is also determined by an actuary, as explained in 23.3.1.5. Note that the
HKAS whole of the defined benefit obligation is discounted to present value, even if part is expected
19.69 to be settled within 12 months of reporting date.

Plan assets are the assets held by the defined benefit fund. In simple terms, plan assets are
the assets available in the fund that have been accumulated from contributions and investment
income and are available to pay the employee benefits when they are due. HKAS 19 provides
guidance on measuring plan assets:

• Plan assets exclude unpaid contributions due from the entity to the fund as well as any
non-transferable financial instruments issued by the entity and held by the fund;

• Plan assets are reduced by any liabilities of the fund that do not relate to employee
benefits, for example, trade payables; and

• Where plan assets include qualifying insurance policies that exactly match the amount
and timing of some or all of the benefits payable under the plan, the fair value of those
insurance policies is deemed to be the present value of the related obligations (subject
HKAS 19.114 to any reduction required if the amounts receivable under the insurance policies are
and 115 not recoverable in full).

Illustrative Example 5
Fast is the employer sponsor of a defined benefit pension fund for some of its
employees. For this example, assume the plan provides a lump sum benefit to each
employee who is a member of the plan of HK$100,000 payable on retirement for each
year of service. The actuarial valuation for the defined benefit obligation is HK$500,000.
An appropriate discount rate is 5% and the employee is expected to retire in five years.
The fair value of plan assets is HK$350,000.

Calculation of the deficit (surplus):

Defined benefit obligation = HK$500,000

This is then discounted to PV = [HK$500,000/(1.05)5)] = HK$391,757

Deduct the plan assets from the discounted obligation = HK$391,757 − HK$350,000

Deficit = HK$41,757

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 FINANCIAL REPORTING

Attributing Benefit to Periods of Service

Attributing the defined benefit to the appropriate period of service is important in accounting
HKAS for defined benefit plans. Normally this is done by using the plan’s benefit formula to attribute
19.70, 71 the benefit to the period in which the employee provides the service that results in the benefit.

Calculating this is beyond the scope of your studies.

Illustrative Example 6 (Adapted from HKAS 19.71)

Fast is the employer sponsor of a defined benefit pension fund for some of its
employees. For this example, assume the plan provides a lump sum benefit to each
employee who is a member of the plan of HK$100,000 payable on retirement for each
year of service.

• Amount of benefit attributed to each year of the employee’s service to date:

HK$100,000 per year;

• Defined benefit obligation: Number of years of service, counted from when

the employee started work with the entity to the end of the reporting period,
discounted to present value (HK$100,000 × years of service, discounted to PV); and

• Current service cost: amount attributable to the current period (HK$100,000,

discounted to PV).

Actuarial Assumptions

HKAS Actuarial assumptions are required to determine the cost of defined benefit post-employment
19.76 benefits are illustrated in Exhibit 23.8.

Demographic assumptions about the future characteristics of current and former employees
eligible for benefits:
• Mortality;
• Rates of employee turnover, disability and early retirement;
• Proportion of plan members with dependants who will be eligible for benefits;
Actuarial assumtions

• Proportion of plan members who will select each form of payment option available; and
• Claim rates under medical plans.

Financial assumtions, based on market expectations:

• Discount rate;
• Benefit levels, excluding any cost of the benefits to be met by employees, and future salary;
• Medical benefits-future medical costs, including claim handling costs (i.e. the costs that will
be incurred in processing and resolving claims, including legal and adjuster’s fees); and
• Taxes payable by the plan on contributions relating to service before the reporting date or
on benefits resulting from that service.

EXHIBIT 23.8 Actuarial assumptions

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 Employee B enefits

HKAS 19 provides additional guidance on the assumptions relating to mortality, discount

rate, salaries, benefits and medical costs, as detailed in the following section.

If there are actuarial gains or losses, for example, where changes in actuarial assumptions
result in a remeasurement of the net defined benefit liability (asset), the impact is recognised in
the other comprehensive income (OCI).

Actuarial Assumptions: Requirements

Contained in HKAS 19 is guidance on the actuarial assumptions that need to be applied in the
actual valuations:

• Mortality table: rather than applying a standard mortality table, HKAS 19 requires
HKAS entities to make their best estimate of mortality rates, for example, by considering
19.81 expected changes in mortality, such as mortality improvements.

• Discount rate: the rate used to discount the defined benefit obligation to
present value is:

°° For currencies where there is a deep market in corporate bonds, determine the rate
with reference to market yields at the end of the reporting period on high quality
corporate bonds.

HKAS °° For currencies without a deep market in corporate bonds, determine the rate with
19.83 reference to government bonds.

• Salaries, benefits and medical costs: defined benefit obligations need to be measured
on a basis that reflects:

°° The benefits set out in the terms of the plan at the end of the reporting period, or
constructive obligations that go beyond those terms; and
HKAS
19.87
°° Any estimated future salary increases that affect the benefits payable.

Past Service Cost

The change in the present value of the defined benefit obligation resulting from an amendment
HKAS or curtailment is regarded as a past service cost, and the adjusting amount is included in
19.102 profit or loss.

For example, an entity changes the pension payable from 60% of retirement salary to 55%
of retirement salary. This is an example of a plan amendment, and the change in the present
value of the defined benefit obligation is a past service cost, recognised in the profit and loss.

Gains and Losses on Settlement

A settlement occurs when an entity enters into a transaction that eliminates all further legal or
constructive obligations for part or all of the benefits provided under a defined benefit plan.

For example, an employer makes a one-off transfer of significant employer obligations

under the plan to an insurance company through the purchase of an insurance policy. The
employer no longer has an obligation to the fund because the insurance company is now
responsible for ensuring the employees receive their entitlements.

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 FINANCIAL REPORTING

HKAS The gain or loss on a settlement must be recognised when the settlement occurs and is
19.110 calculated as illustrated in Exhibit 23.9.

Determined on the
date of settlement

Present value of Settlement price,

the defined (including any plan Gain or loss
benefit obligation – assets transferred = on settlement
being settled and payments made)

EXHIBIT 23.9 Gain or loss on settlement

Asset Ceiling (Limit)

Referring to Exhibit 23.7, the defined benefit liability (asset) that is presented in the entity’s
statement of financial position is calculated as the present value of the defined benefit
obligation, less the plan assets.

If this calculation determines a surplus (i.e. plan assets > PV defined benefit obligation), the
entity needs to consider the extent to which it should recognise an asset with reference to the
asset ceiling, the definition of which is the present value of economic benefits in the form of
HKAS reductions in future contributions to the plan or cash refunds from the plan, resulting from
19.8, .65 the surplus.

By applying this rule, a defined benefit asset satisfies the definition of an asset. The asset
reflects future economic benefits arising from the defined benefit plan, both economic benefits
arising from the entity making lower contributions to the fund in the future than it would have
anticipated based on employee service and economic benefits arising from the receipt of cash
from the fund. The effect of the asset ceiling is to limit the asset to the amount of benefit the
entity will realise.

Although being aware of these complex issues is important, candidates are not required to
calculate the asset ceiling or prepare accounting treatments beyond what is in this guide.

Employee Contributions
Another issue to highlight is the impact of employee contributions, which was also the subject
of changes to HKAS 19 (2011). These are complex issues, and candidates are only expected to
have an awareness of the accounting treatments for employee contributions.

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 Employee B enefits

Some defined benefit plans require employees to contribute to the cost of the plan, which
results in a reduction in the cost of the benefits to the entity. Accounting for these contributions
is summarised in Exhibit 23.10.

Contributions from third parties

Set out in the formal terms of the plan (or arise from a constructive
Discretionary
obligation that goes beyond those terms)

Linked to service Not linked to

service (e.g.
reduce a deficit)

Dependent on the Independent of the

number of years of number of years of
service service

Reduce service cost Reduce service cost in

Reduce service cost
by being attributed the period in which Affect
on payment to
to the periods of the related service is remeasurements
the plan
service rendered

The dotted line indicates an entity is permitted to choose either accounting.

EXHIBIT 23.10 Accounting treatment for employee contributions

23.3.3.2 Presentation and Disclosure

An entity must disclose information that:

• Explains the characteristics of its defined benefit plans and risks associated with them;

• Identifies and explains the amounts in its financial statements arising from its defined
benefit plans; and

HKAS • Describes how its defined benefit plans may affect the amount, timing and uncertainty
19.135 of the entity’s future cash flows.

Given the complexity of accounting for defined benefit plans and that the amounts are
often material, in particular, defined benefit liabilities, it is unsurprising HKAS 19 contains
extensive guidance on disclosure. However, rather than providing a prescriptive checklist of
disclosures, it permits the entity to apply professional judgement in determining how much
detail is required, the emphasis to place on each of the requirements, the extent of aggregation
or disaggregation and whether users of the financial statements need additional information to
evaluate the quantitative information disclosed.

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 FINANCIAL REPORTING

Illustrative Example 7

Accounting for a Defined Benefit Plan

Star Limited (Star) has a defined benefit plan for its senior managers. Members of the
plan are entitled to 10% of their average salary for every year of service.

The following information is available about the plan.

HK$’000
31 December 20X1
Present value of defined benefit obligation at 31 December 20X1 260,000
Fair value of the plan assets at 31 December 20X1 300,000
Asset ceiling at 31 December 20X1 42,000
Interest rate used to measure the defined benefit obligation at 7%
31 December 20X1

1 January 20X2
Past service costs 50,000

Year ended 31 December 20X2

Current service cost 40,000
Contributions received by the fund 45,000
Benefits paid by the fund Nil
Return on plan assets 8,000
Actuarial gain resulting from changes in the discount rate, 14,700
31 December 20X2
Present value of defined benefit obligation at 31 December 20X2 357,000
Fair value of plan assets at 31 December 20X2 374,000
Asset ceiling at 31 December 20X2 25,000
Interest rate used to measure the defined benefit obligation at 8%
31 December 20X2

Additional information:

• The estimate of current service cost is based on actuarial advice and provided by
the fund manager;

• Actuarial advice has been obtained for the present value of the defined benefit
obligation on 31 December 20X1 and 31 December 20X2;

• On 1 January 20X2, Star revised its defined benefits and increased the entitlement
to 11% of average salary. The revision to the defined benefit plan resulted in an
increase in the defined benefit obligation of HK$50 million on 1 January 20X2;

• During the year ended 31 December 20X2, Star contributed HK$48 million to the
fund. All the contributions to the fund are paid by Star;

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 Employee B enefits

Illustrative Example 7 (continued)

• The discount rate used to measure the defined benefit obligation was increased
from 7% to 8% on 31 December 20X2, resulting in a decrease of HK$14.7 million in
the present value of the defined benefit obligation; and

• The fair value of plan assets is derived from valuations performed by Hong & Ching
Valuers as of 31 December 20X2.

Working:

Net defined benefit liability (asset) at 31 December 20X1:

HK$’000
Present value of defined benefit obligation at 31 December 20X1 260,000
Fair value of the plan assets at 31 December 20X1 300,000
Surplus (260,000 – 300,000) 40,000
Asset ceiling at 31 December 20X1 42,000
Net defined benefit asset at 31 December 20X1 40,000

Because the surplus is lower than the asset ceiling, the whole of the surplus can be
recognised as the net defined benefit asset.

Apply the four-step process at 31 December 20X2

Step 1: Determine the deficit or surplus of the fund at 31 December 20X2

HK$’000
Present value of defined benefit obligation at 31 December 20X2 357,000
Fair value of the plan assets at 31 December 20X2 374,000
Surplus 17,000

Step 2: Determine the amount of the net defined benefit liability (asset)

HK$’000
Surplus 17,000
Asset ceiling at 31 December 20X2 25,000
Net defined benefit asset at 31 December 20X2 17,000

Because the surplus is lower than the asset ceiling, the whole of the surplus can be
recognised as the defined benefit asset.

Step 3: Determine the amounts to be recognised in profit or loss

The expense comprises: HK$’000

1. current service cost This information is provided. This represents the 40,000
increase in the present value of the defined benefit
obligation resulting from employee service in the
current period

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 FINANCIAL REPORTING

Illustrative Example 7 (continued)

The expense comprises: HK$’000

2. any past service cost and This information is provided. This arose as a result 50,000
gain or loss on settlement increased entitlement to 11% of average salary on
1 January 20X2.
3. net interest on the net This is 7% applied to the revised net benefit liability 700
defined benefit liability on 1 January 20X2:
(asset) Revised net benefit liability:
• Net asset at 31 December 20X1: HK$40 million
• Less adjustment to the past service cost on
1 January 20X2: (HK$50 million)
Revised net benefit liability on 1 January 20X2:
(HK$10 million)
Interest at 7%: HK$700,000
As the balance is a liability, the interest is a debit/
expense. If the balance is an asset, the interest will
be a credit against this account.
7% is the appropriate interest rate as this was
the rate for the year. Applying accrual accounting
conceptually, interest is accrued throughout the
year, not at year-end.
Total expense for the 90,700
20X2 year

Step 4: Determine the amount of the remeasurements to be recognised in other

comprehensive income (OCI)

Remeasurement of the net HK$’000

defined benefit liability
(asset) comprises:
1. actuarial gains and losses This information is provided and it is a gain 14,700
due to the increase in the discount rate
applied. Because the discount rate is higher,
the present value of the defined benefit
obligation is lower and a credit is recorded
against the account.
2. return on plan assets This information is provided. This is the 8,000
increase in the fair value of the assets
in the fund.
3. any change in the effect of the Although the asset ceiling increased, this had 0
asset ceiling no impact as the asset ceiling is higher than
the surplus.
Total amount recognised in OCI 22,700
for the 20X2 year

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 Employee B enefits

Illustrative Example 7 (continued)

The overall impact of these steps is summarised in the following table, which includes
the debits and credits that Star would apply when posting the journals during 20X2:

Star Limited defined benefit worksheet for the year ended 31 December 20X2
Star Limited Defined benefit
fund workings
P&L OCI Bank Net Defined Plan
HK$’000 HK$’000 HK$’000 defined benefit asset
benefit obligation (debit)
asset (credit) HK$’000
(liability) HK$’000
HK$’000
Balance at 40,000 (260,000) 300,000
31 December 20X1
Past service cost Dr 50,000 (50,000)
Revised balance at (310,000) 300,000
1 January 20X2
Net interest @ 7% Dr 700 (21,700) 21,000
Net defined
benefit liability
(310,000 – 300,000)
× 7%
Current service Dr 40,000 (40,000)
cost
Contributions to Cr (45,000) 45,000
the fund
Benefits paid by 0 0
the fund
This is a
transaction
between the fund
and the employee,
so has no impact
on Star
Return on plan Cr (8,000) 8,000
assets
Actuarial gain on Cr (14,700) 14,700
remeasurement
of defined benefit
obligation
Journal entrya Dr 90,700 Cr (22,700) Cr (45,000) Cr (23,000)
Balance at Dr 17,000 (357,000) 374,000
31 December 20X2
Adjustment for NA
asset ceiling
Net balance Dr 17,000
a
Journal entry in Star to recognise the impact of transactions with the defined benefit plan on 31 December 20X2.

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 FINANCIAL REPORTING

Illustrative Example 7 (continued)

Debit Credit
HK$000 HK$000
Defined benefit expense (P&L) 90,700
Defined benefit expense (OCI) 22,700
Cash at bank 45,000
Net defined benefit asset (liability) 23,000

Knowledge Check Questions

Question 4
Identify which one of the following is recognised and measured by the employer (the
reporting entity) in accordance with HKAS 19.
A The net assets of a defined benefit plan through which an entity provides pensions for its
employees.
B The defined benefit liability arising from a deficit relating to a defined benefit plan
through which an entity provides pensions for its employees.
C The net assets of a defined contribution plan through which an entity provides pensions
for its employees.
D The amount payable by a defined contribution fund as a pension to retired employees.

Question 5
Identify which one of the following statements does NOT correctly reflect the requirements
of HKAS 19.
A Actuarial assumptions are critical in measuring an entity’s balances in connection with a
defined benefit fund.
B The financial impact of actuarial gains and losses are recognised in OCI.
C The current and past service cost is recognised in profit and loss (P&L).
D The employer’s obligations to a post-employment plan are based solely on the plan’s
benefit formula.

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 Employee B enefits

2 3 . 4 OTHER LONG-TERM EMPLOYEE BENEFITS

Long-term employment benefits are benefits for services provided by employees in the current
period, or earlier, that won’t be settled for at least 12 months after the end of the period. Some
of the employee benefits you have considered, such as annual leave, may fall into this category
if they are to be settled after more than 12 months.

Another type of employee benefit that should be considered here is long service leave
or payment. This is an employee entitlement in various jurisdictions around the world.
In Hong Kong, in accordance with the Employment Ordinance, Cap.57, an employee employed
under a continuous contract for at least five years is eligible for long service payment if:

• They are dismissed (except by reasons of redundancy or summary dismissal due to the
employee’s serious misconduct);

• Their fixed term employment contract expires without being renewed;

• They die during employment;

• They have been issued a certificate in a specified form by a registered medical

practitioner or a registered Chinese medicine practitioner, certifying they are
permanently unfit for their present job and they resign; and

• They are aged 65 or above and resign on the grounds of old age.

Payment is generally calculated as 2/3 of the last month’s wages, multiplied by the
quantifiable years of service.

23.4.1 Recognition and Measurement

HKAS Accounting for other long-term benefits is a simplified version of accounting for
19.154 post-employment benefits because there is usually less uncertainty involved.

The same principles apply in that the amount the employee has earned to date is
recognised as it is earned. In the case of long-term benefits, the liability in the employer’s
statement of financial position will be non-current and discounted to the present value of the
obligation, which is the amount the entity (employer) expects to pay.

If the benefits arise from a long-term employee benefit plan, other than those covered, the
HKAS
entity must account for them by applying the same accounting treatment as for defined
19.155 benefit plans.

More commonly the benefits will not arise from a plan; instead, they will arise from
benefits, such as paid absences the employer expects to settle in more than 12 months,
for example, long service leave. In this case, they are accounted for in accordance with
HKAS
19.156 Exhibit 23.11:

• The present value of the obligation recognised as a non-current liability; and

• The movement in the liability recognised in P&L unless another HKFRS requires
a different treatment. This is different from defined benefit plans because
remeasurements are always through P&L and not through OCI.

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 FINANCIAL REPORTING

Profit or loss Statement of financial position

Expense Defined benefit liability (asset)

=
Net interest on Remeasurement
Service
the defined of the net
cost (paras
66–112) + benefit liability + defined benefit
(asset) (paras liability (asset)
123–126) (paras 127–130)

Measured at the present

value of the amount the
entity expects to pay

Service cost is defined in HKAS 19 as:

• Current service cost, which is the increase in the present value of the
defined benefit obligation resulting from employee service in the
current period;
• 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
• Any gain or loss on settlement.

EXHIBIT 23.11 Accounting for other long-term benefits

Illustrative Example 8
Fast’s employees are entitled to a long service payment of 2/3 of their final month’s
salary multiplied by the number of years of service if employed under a continuous
contract for at least five years and:

• They die during employment;

• They have been issued a certificate in a specified form by a registered medical

practitioner or a registered Chinese medicine practitioner, certifying they are
permanently unfit for their present job and resign; and

• They are aged 65 or above and resign on the grounds of old age.

Fast employs 250 employees, and the average salary is HK$155,000 per annum. On
average, they have been employed for four years. Fast estimates, based on its historical
data, that 10% of employees become entitled to a long service leave payment connected
with their death or resignation when they have been employed on average for eight years.
For the purpose of this example, assume Fast has not made any contributions to an MPF
for the employees.

Fast applies an inflation rate of 3% to salaries and wages and a discount rate of 4%
based on advice from its actuaries.

The long service payment liability at the end of the prior year was HK$150,000.

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 Employee B enefits

Illustrative Example 8 (continued)

Applying the steps:

1. Estimate the number of employees who are expected to become eligible for long
service payment

250 employees × 10% probability of being paid the benefit = 25

2. Estimate the projected wages and salaries at the time the long service payment is
expected to be paid

HK$155,000 per annum, inflated for four years (being the difference between
the average service to date and average service when they receive the benefit:
HK$155,000 × (1.03)4 = HK$174,452

3. Determine the accumulated benefit

25 × HK$174,452/12 × 2/3 = HK$242,294

Estimated Estimated
Benefit is 2/3
number of monthly
of salary
employees salary

4. Measure the present value of the accumulated benefit.

HK$242, 294
HK$242,294 discounted to present value: = HK$207,107
(1.04 )4

Long service leave payment liability: HK$207,107.

5. Recognise an expense for the movement in the liability from the prior period.

The expense comprises the service cost and impact of the remeasurement of the
liability and is the difference between the liability at the end of the prior year and the end
of this year (HK$207,107 − HK$150,000) = HK$57,107.

23.4.2 Other Long-term Employee Benefits Disclosure

No specific disclosures about other long-term employee benefits are required by HKAS 19.
Information about these benefits may need to be disclosed by other HKAS/FRSs, for example:

• HKAS 24 (Revised) Related Party Disclosures requires disclosures about employee

benefits for key management personnel; and

• HKAS 1 Presentation of Financial Statements requires disclosure of employee benefits

expense.

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 FINANCIAL REPORTING

2 3 . 5 TERMINATION BENEFITS

Termination benefits are employee benefits provided in exchange for the termination of an
employee’s employment. The employing entity provides benefits to the employee in exchange
for termination. This may be a lump sum payment or some other benefit such as higher
pension payments.

The HKAS 19 requirements for accounting for termination benefits apply to situations
where the event that gives rise to an obligation is the termination of employment rather than
HKAS the rendering of employee service and is the result of the entity’s decision to terminate
19.159 employment. This does not include an employee’s decision to resign.

In Hong Kong, in accordance with the Employment Ordinance, Cap.57, employees

employed under a continuous contract for at least 24 months are eligible for severance
payment if:

• They are dismissed by reason of redundancy;

• Their fixed term employment contract expires without being renewed due to
redundancy; or

• They are laid off.

Like a long service payment in Hong Kong, a severance payment is generally calculated as
2/3 of the last month’s wages, multiplied by the quantifiable years of service.

23.5.1 Recognition and Measurement

A liability and expense for termination benefits arises due to the decision of the entity to
terminate one or more employees and is required to be recognised at the earlier of:

• When the entity can no longer withdraw the offer of those benefits; and

• When the entity recognises costs for a restructuring that is within the scope of HKAS 37
and involves the payment of termination benefits.

The termination benefits must be measured when they are first recognised, applying the
principles for measuring short-term and long-term benefits discussed earlier in this chapter.
This is illustrated in Exhibit 23.12:

Termination benefits expected

Yes Apply the same measurement
to be settled wholly before 12
requirements as for short-term
months after the end of the
employee benefits
annual reporting period

No

Apply the same measurement

requirements as for other
long-term employee benefits

EXHIBIT 23.12 Accounting for termination benefits

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 Employee B enefits

HKAS Alternatively, if the termination benefits are an enhancement to post-employment benefits,

19.169 the entity must apply the requirements for post-employment benefits.

Apply and Analyse 2 – Adapted from HKAS 19.170

In June 20X9, Star decides to close a warehouse in 10 months and, at that time, terminate
the employment of all the employees at the warehouse. Because Star needs the expertise
of the employees at the warehouse to complete some contracts, it announces a plan of
termination as follows.

• Each employee who stays and renders service until the closure of the warehouse
will receive on the termination date a cash payment of HK$100,000; and

• Employees leaving before closure of the warehouse will receive HK$80,000. This
exceeds the statutory minimum severance payment.

At the date of announcing the plan for termination, Star believes it cannot withdraw
the offer.

50 employees work at the warehouse. At the time of announcing the plan, the entity
expects 10 of them to leave before closure. Therefore, the total expected cash outflows
under the plan are HK$4.8 million (i.e. 10 × HK$80,000 + 40 × HK$100,000).

How much of the payment is a termination payment, and how much payment for
service in accordance with HKAS 19?

Analysis

As required by HKAS 19, the entity accounts for benefits provided in exchange for
termination of employment as termination benefits, and it accounts for benefits provided
in exchange for services as short-term employee benefits.

Termination Benefits

The benefit provided in exchange for termination of employment is HK$80,000 per

employee. This is the amount that Star would have to pay for terminating employment
even if the employees stay and render service until closure of the warehouse or they leave
before closure. Even though the employees can leave before closure, the termination of all
employees’ employment is a result of Star’s decision to close the warehouse and terminate
their employment (i.e. all employees will leave employment when the warehouse
closes). Therefore, Star recognises a liability of HK$4 million (i.e. 50 × HK$80,000) for the
termination benefits provided in accordance with the employee benefit plan at the earlier
of when the plan of termination is announced and when Star recognises the restructuring
costs associated with the closure of the warehouse.

Benefits Provided in Exchange for Service

The incremental benefits that employees will receive if they provide services for the full
10-month period are in exchange for services provided over that period. Star accounts
for them as short-term employee benefits because Star expects to settle them before
12 months after the end of the annual reporting period. In this example, discounting is not
required, so an expense of HK$80,000 (i.e. the remaining HK$800,000 ÷ 10) is recognised in
each month during the service period of 10 months, with a corresponding increase in the
carrying amount of the liability.

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23.5.2 Termination Benefits Disclosure

No specific disclosures about termination benefits are required by HKAS 19. Note that
information about these benefits may need to be disclosed by other HKFRSs, for example:

• HKAS 24 (Revised) Related Party Disclosures requires disclosures about employee

benefits for key management personnel; and

• HKAS 1 Presentation of Financial Statements requires disclosure of employee benefits

expense.

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 Employee B enefits

SUMMARY

• HKAS 19 specifies the accounting for employee benefits by the employer entity.

• The scope of HKAS 19 is broad, with the intention of including all employee benefits and all
employees regardless of how or when the benefits are settled or the title or employment
contract of the employee.

• Short-term employee benefits are recognised because the employee earns them, and any
liability at the reporting date is recognised at its nominal amount.

• Short-term employee benefits include short-term paid absences and profit sharing and
bonus plans.

• Post-employment benefit plans are classified as defined contribution plans or defined

benefit plans.

• Accounting for defined contribution plans is relatively straightforward because the (employer)
entity’s obligation is restricted to the fixed contributions it pays into the fund.

• Accounting for defined benefit plans is more complex because the (employer) entity’s
obligation is to fund the plan so it can meet the payments promised to employees when they
retire, often many years in the future.

• Other long-term benefits must be recognised at the present value of the expected payment,
based on the employee’s service to date.

• Termination benefits are paid to employees on or after their termination by the employer and
need to be separated from benefits paid to employees as a result of their service.

• An entity discloses detailed information about defined benefit plan obligations and expenses
although fewer disclosure requirements exist about obligations and expenses arising in
relation to other employee benefits.

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MIND MAP

SCOPE POST-EMPLOYMENT BENEFIT PLANS

Employee benefits are all forms of Formal or informal plans under which an
consideration given by an (employer) entity provides benefits for employees
entity in exchange for services rendered,
DEFINED CONTRIBUTION PLANS
or for the termination of employment
Includes all employee benefits other than (Employer) entity pays fixed contributions
those covered by HKFRS 2 Share-based into a fund and has no legal or constructive
payments obligation to pay fuller contributions
Recognised as an expense when the
SHORT-TERM EMPLOYEE BENEFITS
employees render the service, and a
Employee benefits expected to be settled liability for any outstanding amounts,
within 12 months after the end of the not discounted unless it is expected the
period when employees render the service outstanding amount will be settled in
Recognised as an expense and a liability more than 12 months
for any outstanding amounts, not DEFINED BENEFIT PLANS
EMPLOYEE BENEFITS
discounted
(HKAS 19) Accounting for defined benefit plans is
Includes compensated absences,
complex
profit-sharing and bonus schemes
• Actuarial assumptions are required to
if short-term
measure the obligation and the expense
OTHER LONG-TERM EMPLOYEE BENEFITS • Obligations are measured on a discounted
Employee benefits expected to be settled basis because they may be settled many
more than 12 months after the end of the years after the employees render the
period when employees render the service related service
Discount the liability to present value Accounting is a four-step process
1. Determine the deficit (surplus)
Includes compensated absences, 2. Determine the amount of the net defined
profit-sharing and bonus schemes also benefit liability (asset)
long service payment if long-term 3. Determine amounts is be recognised as
TERMINATION PAYMENTS expense (P&L)
4. Determine amounts to be recognised in OCI
Applies when the event that gives rise to
an obligation is the termination of
employment rather than employee
service, and is the result of the entity’s
decision to terminate
Recognised when the entity is committed
to the termination
Measured when they are first recognised,
applying the principles for measuring short
and long-term benefits

Answers to Knowledge Check Questions

Question 1
Star expects it will pay an additional 12 days of sick pay as a result of the unused
entitlement that has accumulated as of 31 December 20X8 (one and a half days each, for
eight employees). Therefore, Star recognises a liability equal to 12 days of sick pay.

Question 2
Star recognises a liability on 31 December 20X8 and an expense in the 31 December 20X8
year of 2.5% of profit.

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 Employee B enefits

Question 3
Answers A, B and C are incorrect. They all describe arrangements whereby the entity’s
obligation is not limited to the amount it agrees to contribute to the fund. This satisfies
the definition of a defined benefit plan (being plans other than defined contribution plans)
(HKAS 19.8) and in substance the employer bears the risks (HKAS 19.29).
Answer D is correct. The entity pays fixed contributions into a separate fund and has no
legal or constructive obligation to make further contributions if the fund does not hold
HKAS sufficient assets to pay all employee benefits. This satisfies the definition of a defined
19.28 contribution plan (HKAS 19.8) and in substance the employees bear the risks.

Question 4

HKAS Answer B is correct. The net defined benefit liability (asset) is the deficit or surplus,
19.8 adjusted for any effect of limiting a net defined benefit asset to the asset ceiling. This
relates to the amount the employer entity will need to contribute to the plan to make good
the deficit based on the employees’ service to date.
Answers A, C and D are incorrect because reporting by employee benefit plans is irrelevant
under HKAS 19, which covers accounting by the entity that is the employer. Accounting by
HKAS the fund is covered by HKAS 26 Accounting and Reporting by Retirement Benefit Plans, which
19.3 is beyond the scope of this module.

Question 5
Answer A is incorrect. Many actuarial assumptions are the basis for measuring the net
defined benefit liability (asset) and expense.
Answer B is incorrect. The financial impact of actuarial gains and losses is recognised
in OCI.
Answer C is incorrect. Current and past service cost is recognised in P&L.
Answer D is correct. When an entity is considering its obligations in relation to a
post-employment benefit plan, these include legal and constructive obligations.

EXAM PRACTICE

QUESTION 1
You have recently taken up a new job as financial controller of C&C Limited (C&C), an
unlisted company registered in Hong Kong. You are currently analysing C&C’s accounting
treatment of employee entitlements in preparation for the 31 December 20X8 financial
year-end. These financial statements will be audited and issued by 31 March 20X9.

This is what you have learned about the entitlements of C&C’s employees:

1. C&C currently has a staff of 250 permanent employees, and this number is not
anticipated to change prior to 31 December 20X8.

2. Employees are paid at the end of each fortnight. This means they will be paid on
24 December 20X8 and again on 7 January 20X9.

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 FINANCIAL REPORTING

3. Each permanent employee is entitled to 14 days of paid annual leave each financial
year, which accrues so any unused leave is carried forward to the next financial period
and/or paid to employees in cash when they leave.

4. Each permanent employee is entitled to five days of paid sickness allowance each
financial year, and any unused sickness allowance can be carried forward into the next
financial period. When employees leave, they are not entitled to receive any unused
allowance in cash.

5. C&C Limited has not entered into a formal arrangement with employees to pay a
bonus. Occasionally, it pays a bonus to staff, typically between HK$100 and HK$5,000,
at the discretion of the senior management team. This is usually determined and
announced in January each year based on a combination of factors including employee
performance and C&C’s profit for the preceding year.

Required:

For each of the preceding points listed, describe the appropriate accounting treatment.
If this is dependent on further information, describe the potential accounting treatments
and outline the additional information you would need to obtain to confirm the accounting
treatment. Provide specific references to HKAS 19 Employee benefits in your answer.

QUESTION 2
[This question is a continuation of Question 1.]

You have obtained additional information in relation to C&C’s employee entitlements for
the 31 December 20X8 financial year-end. The total number of employees on 31 December
20X8 is 275.

1. The employee’s average salary is HK$150,000 per year. Employees are paid at the
end of each fortnight. This means they were paid on 24 December 20X8 and on
7 January 20X9.

2. Each employee is entitled to 14 days of paid annual leave each financial year, which
accrues so any unused leave is carried forward to the next financial period and/
or paid to the employee in cash when they leave. On 31 December 20X8, based on
past practice and C&C’s staff policy, that 250 employees are expected to use their
accrued leave within 20X9. The average number of accrued days for these employees
is four. The remaining 25 employees, who for various reasons have been permitted
to accrue their leave indefinitely, on average take their leave within two years of the
end of the financial year and have on average accrued 10 days of paid annual leave on
31 December 20X8. The liability recognised for these 25 employees on 31 December
20X7 is HK$70,000.

3. Each permanent employee is entitled to five days of paid sickness allowance each
financial year, and any unused sickness allowance can be carried forward into the next
financial period. When employees leave, they are not entitled to receive any unused
allowance in cash. C&C has a policy of allocating sickness allowance first to the current
year’s entitlement and then to any balance brought forward from the previous year,
that is, on last-in, first-out (LIFO) basis. Based on C&C’s employee database, each year
employees accrue more sickness allowance than they use.

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 Employee B enefits

4. C&C Limited has not entered into a formal arrangement with employees to pay a
bonus. Occasionally, it pays a bonus to staff, typically between HK$100 and HK$5,000
at the discretion of the senior management team. On 31 January 20X9, C&C announced
the total employee bonus for the 20X8 year would be HK$500,000 to be paid in the next
fortnight’s pay.

C&C’s actuaries have advised an appropriate inflation rate is 3% and discount rate is 5%.

Required:

Prepare the adjusting journal entries for C&C’s employee benefits as of 31 December
20X8. Assume all payments during the year have been appropriately expensed. Show all
calculations.

QUESTION 3
[This question is a continuation of Questions 1 and 2.]

Your financial team has now prepared draft disclosures based on the journals you
prepared for employee benefits for 31 December 20X8. When you question them about the
disclosures, they provide the following information. Assume all amounts are material.

Statement of Financial Performance

Explanation: No separate disclosure of employee benefits expense is required in the

statement or notes as C&C presents the statement of financial performance using a
classification based on function.

Draft accounting policy note

Employee benefits

Short-term employee benefits

Salaries, annual bonuses and paid annual leave are accrued in the year in which the
associated services are rendered by employees. These benefits are classified as short-term
employee benefits.

Explanation: Long-term employee benefits are not material so not separately disclosed.

Draft note: Critical accounting judgements in applying the company’s accounting policies

In the process of applying the company’s accounting policies, management has made the
following accounting judgements:

Sources of estimation uncertainty

In calculating any long-term employee benefits, C&C has applied an inflation rate of 3% and
discount rate of 5%.

Explanation: These are estimates so need to be disclosed.

Key management personnel remuneration (note omitted)

Explanation: Remuneration for key management personnel is included in employee costs

throughout the statement of financial performance and, therefore, is not required to be
disclosed separately in accordance with HKAS 19 Employee Benefits.

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Required:

Review the draft disclosures and explanations and recommend four corrections to comply
with relevant HKFRS.

QUESTION 4
Swan Limited (Swan) operates a retirement plan for its employees. Under the plan, Swan makes
contributions to the plan at 5% of the employees’ relevant income. Contributions to the plan
vest immediately. Swan currently has no obligation to the plan beyond its 5% contribution.

Swan’s directors are concerned that employee turnover is too high and are considering a
proposal by the Human Resources Director to add a guarantee to the retirement plan, such
that employees who are employed by Swan for at least 10 years are entitled to a HK$1,000
payment per month from the plan in addition to any other payments.

As Finance Director, you have been asked to explain the implications of this proposed
amendment on Swan’s financial statements.

Required:

Prepare a board paper explaining the accounting treatment of the current arrangement and
the impact of the proposed amendment in accordance with HKAS 19 Employee Benefits.

QUESTION 5
[This question is a continuation of Question 4.]

Swan operates a retirement plan for its employees. Under the plan, Swan and its
employees are each required to make contributions to the plan at 5% of the employees’
relevant income. Contributions to the plan vest immediately. Swan currently has no
obligation to the plan beyond its 5% contribution.

Swan’s directors are concerned that employee turnover is too high, and on 1 January
20X8, it added a guarantee to the retirement plan, such that employees who are employed
by Swan for at least 10 years are entitled to a HK$1,000 payment per month from the plan,
in addition to any other payments.

The following information is relevant to the 31 December 20X8 financial statements:

HK$’000
Year ended 31 December 20X8
Net defined benefit liability calculated at 1 January 20X8, prior to 10,000
adjusting for the past service cost
Past service cost arising from plan amendment 20,000
Current service cost 50,000
Contributions received by the fund 50,000
Benefits paid by the fund 30,000
Return on plan assets 8,000
Present value of defined benefit obligation at 31 December 20X8 390,000
Fair value of plan assets at 31 December 20X8 346,500
Asset ceiling at 31 December 20X8 (HK$30 million 20X1) 25,000
Interest rate used to measure the defined benefit obligation at 5%
31 December 20X8

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 Employee B enefits

Additional information:

• The estimate of current service cost is based on actuarial advice and provided by
the fund manager;

• Actuarial advice has been obtained for the present value of the defined benefit
obligation on 31 December 20X8;

• During the year ended 31 December 20X2, Swan contributed HK$50 million to the
fund. Swan paid all of the contributions to the fund;

• The fair value of plan assets is derived from valuations performed by reputable
valuers as of 31 December 20X8; and

• No actuarial gain or loss has been identified for the 20X8 financial year.

Required:

Calculate the journal entries for Swan’s retirement plan as of 31 December 20X8. Show all
calculations.

ANSWERS TO EXAM PRACTICE

QUESTION 1
Item Accounting treatment Additional information
required (if any)
1. employees ‘Employees’ includes all individuals Whether there are any casual or
receiving employee benefits, including temporary employees in addition to
full-time, part-time, permanent, casual, the number provided.
HKAS or temporary employees, and covers all Confirm directors and managers
19.7 staff, directors and managers. are included in the permanent
employees.
2. fortnightly The amount payable is recognised as an
salary expense.
The amount accrued for the period from
25 December 20X8 to 31 December
HKAS 20X8 is recognised as a current liability,
19.11 not discounted.
HKAS 3. paid This is an accumulating and vesting paid Determine whether/how many
19.15, 18 annual absence. employees take the annual leave
leave An employee benefit, other than a within 12 months of the end of the
termination benefit, is short-term only financial year in which it is earned.
when it is expected to be settled wholly If appropriate, establish how much
before 12 months after the end of the is expected to be settled within
HKAS annual reporting period in which the 12 months and how much after.
19.8 employees render the related services. If it is more than 12 months,
Short-term paid absence: recognise establish appropriate inflation and
when the employees render service that discount rates.
increases their entitlement to future Confirm whether casual or
paid absences. Measure at the temporary employees are entitled to
additional (undiscounted) amount the paid annual leave.
entity expects to pay as a result of the
HKAS unused entitlement at the end of the
19.13, 16 reporting period.

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Item Accounting treatment Additional information

required (if any)
Long-term paid absence: recognise in
profit and loss (P&L) as the service cost,
HKAS net interest on the liability and
19.156 remeasurement of the liability.
Effectively this means to recognise an
expense for when the employees render
service that increases their entitlement
to future paid absences and measure at
the present value of the amount the
entity expects to pay.
HKAS 4. paid This is an accumulating and non-vesting Determine C&C’s accounting policy
19.15, 18 sickness paid absence. for sickness allowance (FIFO or LIFO).
allowance It is to be measured as the amount C&C If the accounting policy is to account
expects to pay as a result of the for the sickness allowance on a
accumulated entitlement on FIFO basis, determine whether and
31 December 20X8; because it is how many employees will take the
non-vesting, measurement will include sickness allowance within 12 months
HKAS the possibility of employees leaving of the end of the financial year in
19.15, 16 prior to using the entitlement. which it is earned. If appropriate,
If it is determined that C&C should establish how much is expected to
recognise accumulated sickness be settled within 12 months and how
allowance, the measurement and much after.
recognition requirements will be the If the accounting policy is to account
same as for annual leave. for the sickness allowance on a
LIFO basis, determine how many
employees are expected to take
more sick leave than their annual
allowance. If a sickness allowance
is to be accrued, determine
whether and how many employees
will take the sickness allowance
within 12 months of the end of the
financial year in which it is earned.
If appropriate establish how much
is expected to be settled within
12 months and how much after.
If it is more than 12 months,
establish appropriate inflation and
discount rates.
Confirm whether casual or
temporary employees are entitled to
paid sickness allowance leave.
5. bonus Although the bonus is discretionary and
the amount is not certain on
31 December 20X8, it is determined and
announced prior to the financial
statements being authorised for issue.
HKAS Therefore, it should be recognised as an
19.19 expense and a liability.

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 Employee B enefits

QUESTION 2
Workings Rationale Calculation Liability
Salaries accrual Accrue for the amount payable for 275 (employees) × HK$793,269
25 December to 31 December 20X8 HK$150,000 (average
(inclusive). salary)/26 (number of
fortnightly payments per
year) × 7/14 (days owing
as a proportion of next
fortnightly pay)
Annual leave 250 employees 250 (employees) × 4/365 HK$410,959
liability Accumulating and vesting, expected (days) × HK$150,000
to be settled wholly by 31 December (average salary)
20X9. Recognise the liability,
measured at the amount due (not
discounted).
Annual leave 25 employees Liability: HK$28,863
liability Accumulating and vesting, expected 25 (employees) × 10/365
to be settled within two years. (days) × HK$150,000 ×
Recognise the liability, measured (1.03)2 (average salary
at the present value of the amount when expected to settle)/
expected to pay, and an expense to (1.05)2 (discount rate) =
recognise the service cost, interest HK$98,863
and remeasurement of the liability. Deduct opening liability
The restatement of the liability and (HK$70,000)
corresponding expense has been
calculated by measuring the liability
rather than expense components.
Sickness Accumulating and non-vesting, so No amount to be Nil
allowance recognise the liability, measured at recognised as a liability as
liability the amount expected to pay. the amount expected to
LIFO basis so only include the be paid in the 20X9 year is
amount expected to pay in the less than the amount to be
future, which exceeds the sickness accrued in the 20X9 year.
allowance accrued in the future.
Bonus As C&C is committed to this and the HK$500,000
amount determined prior to the
financial statements being finalised,
it must be accrued on 31 December
20X8. Short-term benefit is not
discounted.

The adjusting journal entries to recognise these liabilities on 31 December 20X8 are:

Debit Credit
HK$ HK$
31.12.x8 Employee expense: salary 793,269
Accrued employee expense (current liability) 793,269
Being recognition of the current liability for accrued salaries at year-end.

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 FINANCIAL REPORTING

Debit Credit
HK$ HK$
31.12.x8 Employee expense: annual leave 410,959
Accrued employee expense (current liability) 410,959
Being recognition of the current liability for the short-term annual leave liability at year-end.

Debit Credit
HK$ HK$
31.12.x8 Employee expense: bonus 500,000
Accrued employee expense (current liability) 500,000
Being recognition of the current liability for bonus as at year-end.

Debit Credit
HK$ HK$
31.12.x8 Employee expense: annual leave 28,863
Accrued employee expense (non-current liability) 28,863
Being recognition of the movement in the non-current liability for employee benefits at year-end.

QUESTION 3
Disclosure Correction required
Statement of financial HKAS 1 Presentation of Financial Statements requires disclosure of employee
HKAS performance benefits expense, whatever the classification of expenses used in the
1.104 financial statements.
Accounting policy note ‘All of these benefits are classified as short-term employee benefits’ is not
correct because the question states that all the employee benefit amounts
are material.
Replace with ‘where payment or settlement is expected within 12 months
these amounts are stated at their undiscounted amount’.
Include a note:
‘Long-term employee benefits
Paid annual leave is accrued in the year in which the associated services
are rendered by employees. Where payment or settlement is deferred
these amounts are stated at their present values.’
HKAS Critical accounting Although the long-term employee benefit liability is based on an
19.154 judgements accounting estimate/judgement, there is little uncertainty involved and,
therefore, does not require disclosure.
Key management HKAS 24 (Revised) Related Party Disclosures requires disclosures about
personnel remuneration employee benefits for key management personnel. HKAS 19 reiterates the
need to include these disclosures.

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 Employee B enefits

QUESTION 4
Board paper prepared by: Finance Director

This board paper explains the treatment required by HKAS 19 Employee Benefits should
the board adopt the proposal to add a guarantee to C&C employee retirement plan, such
that employees who are employed by Swan for at least 10 years are entitled to a HK$1,000
payment per month from the plan, in addition to any other payments.

Current position

Swan Limited (Swan) operates a retirement plan for its employees. Under the plan scheme,
Swan and its employees are required to make contributions to the plan at 5% of the
employees’ relevant income. Contributions to the plan vest immediately. Swan currently has
no obligation to the plan beyond its 5% contribution.

This satisfies the HKAS 19 Employee Benefits definition of a Defined Contribution Plan, as
Swan pays fixed contributions to the fund and has no legal or constructive obligations to pay
further contributions if the fund does not hold sufficient assets to pay all employee benefits.

As a result, the contributions payable by Swan for each financial year are included in
the employee cost expense. If any of this amount is outstanding at year-end, the amount
outstanding is included as a current liability (as it will be paid shortly after year-end).

Implications of the proposal

The addition of a guarantee to the plan means that Swan can no longer classify the plan as
a defined contribution plan because it will be obliged to pay further contributions if the fund
does not hold sufficient assets to pay the guaranteed benefit. This is referred to under HKAS
19 as a defined benefit plan.

Accounting for a defined benefit plan is far more complex than a defined
contribution plan.

1. Swan will need to obtain and apply actuarial assumptions to measure the defined
benefit obligation (the ultimate cost to the entity of the defined benefit that employees
have earned in return for their services in the current and prior periods)

2. This obligation will need to be measured on a discounted basis because payments may
be settled many years after the employees render the related service

3. The amount of fund assets needs to be calculated and compared to the amount
available to Swan to potentially reduce payments (the asset ceiling)

4. From this, the net defined benefit liability or asset is calculated, representing the
amount Swan has to pay to make good any shortfall in the fund or will benefit from in
the case of a surplus.

The expense comprises current service cost, any past service cost and gain or loss
on settlement and the net interest on the net defined benefit liability (asset). Although
remeasurement of the net defined benefit liability (asset) is included in OCI, more volatility
may appear in the published results.

In the year of change, the amendment to the plan will result in recognising the past
service cost of employees as an expense.

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 FINANCIAL REPORTING

QUESTION 5
Workings

Apply the four-step process at 31 December 20X8.

Step 1: Determine the deficit or surplus of the fund at 31 December 20X8.

HK$’000
Present value of defined benefit obligation at 31 December 20X8 390,000
Fair value of the plan assets at 31 December 20X8 346,500
Deficit 43,500

Step 2: Determine the amount of the net defined benefit liability (asset).

HK$’000
Net defined benefit liability at 31 December 20X8 43,500

Because the defined benefit obligation is higher than the plan assets, the deficit is
recognised as the defined benefit liability.

Step 3: Determine the amounts to be recognised in profit or loss.

The expense comprises: HK$’000

1. current service cost This information is provided 50,000
2. any past service cost and This information is provided 20,000
gain or loss on settlement
3. net interest on the This is 5% applied to the net benefit liability 1,500
net defined benefit at 1 January 20X8 (balance at 1/1/X8 as given
liability (asset) in the question, plus the past service cost
adjustment as this additional HK$20,000
resulted from a change on 1/1/X8):
HK$30 million × 5% = HK$1,500,000
Total expense for the 20X8 year 71,500

Step 4: Determine the amount of the remeasurements to be recognised in other

comprehensive income (OCI).

Remeasurement of the net HK$’000

defined benefit liability (asset)
comprises:
1. actuarial gains and losses 0
2. return on plan assets This information is provided. 8,000
3. any change in the effect of the Although the asset ceiling increased, 0
asset ceiling this had no impact.
Total amount recognised in OCI for 8,000
the 20X8 year

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 Employee B enefits

The overall impact of these steps is summarised in the table below, which includes the
debits and credits that Swan will apply when putting through the journals during 20X8.

Swan Limited defined benefit worksheet

P&L OCI Bank Net defined
HK$’000 HK$’000 HK$’000 benefit asset
(liability)
HK$’000
Balance on 1 January 20X8 (10,000)
Past service cost Dr 20,000 Cr (20,000)#
Revised balance at 1 (30,000)
January 20X8
Net interest at 5% Dr 1,500 Cr (1,500)#
Current service cost Dr 50,000 Cr (50,000)#
Contributions to the fund Cr (50,000) Dr 50,000#
Benefits paid by the fund Not a transaction with Swan
Return on plan assets Cr (8,000) Dr 8,000#
Actuarial gain or loss nil
Journal entry Dr 71,500 Cr (8,000) Cr (50,000) Cr (13,500)
(sum of #)
Balance on Cr (43,500)
31 December 20X8
Adjustment for NA
asset ceiling
Net balance Cr (43,500)

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M11_c23.indd 1234 10/27/2022 9:49:40 PM
 24
Share-based Payments

CHAPTER TOPIC LIST

24.1 Overview 24.5 Modifications, Cancellations

24.1.1 Scope and Settlements
24.1.2 Terminology 24.5.1 Modifications
24.5.2 Cancellations and
24.2 Recognition
Settlements
24.3 Equity-settled Share-based
24.6 Share-based Payment
Payment Transactions:
Transactions with Cash
Measurement
Alternatives
24.3.1 F air Value of the Goods or
24.6.1 Share-based Payment
Services Received
Transactions in Which the
24.3.2 Fair Value of the Equity
Terms of the Arrangement
Instruments Granted
Provide the Counterparty
24.3.3 Treatment of Vesting
with a Choice of Settlement
Conditions
24.6.2 Share-based Payment
24.3.4 Treatment of Non-vesting
Transactions in Which the
Conditions
Terms of the Arrangement
24.3.5 Treatment of a Reload
Provide the Entity with a
Feature
Choice of Settlement
24.4 Cash-Settled Share-based
24.7 Share-based Payment
Payment Transactions:
Transactions among
Measurement
Group Entities

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 FINANCIAL REPORTING

24.7.1 Share-based Payment 24.8.1 Equity-settled Share-based

Transactions Where a Parent Payment Transactions
Entity Grants Its Own Equity 24.8.2 Cash-settled Share-based
Instruments to Employees of Payment Transactions
a Subsidiary 24.8.3 Share-based Payment
24.7.2 Share-based Payment Transactions among
Transactions Where a Group Entities Where a
Subsidiary Grants Its Group Recharge
Employees Rights to Equity 24.8.4 Share-based Payment
Instruments of the Parent Transactions among Group
24.7.3 Share-based Payment Entities Where No Group
Transactions Where a Recharge Exists
Parent Entity Pays Cash to 24.9 Disclosures
the Subsidiary’s Employees 24.9.1 N ature and Extent of
Based on the Share Price Share-based Payment
of the Parent’s Equity Arrangements
Instruments 24.9.2 Determination of Fair Value
24.8 Current and Deferred Tax 24.9.3 Effect on Profit or Loss and
Arising from Share-based Financial Position
Payment Transactions

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 S hare -b ased P a y ments

LEARNING OUTCOMES

PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT

FOR BUSINESS TRANSACTIONS
LO2.03: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: Share-based payments
2.03.01 Account for share-based payment transactions
2.03.02 Account for equity-settled and cash-settled share-based payment transactions
2.03.03 Account for share-based payment transactions with cash alternatives
2.03.04 Account for unidentified goods or services in a share-based payment transaction
2.03.05 Account for share-based payment transactions among group entities
2.03.06 Prepare disclosure in respect of share options

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 FINANCIAL REPORTING

OPENING CASE

SUN ENERGY

S un Energy Limited (Sun Energy), an unlisted entity, was incorporated on 1 January 2015
by Thomas Lau and Sandy Leung. On incorporation, an initial equity investment of
HK$10 million was made by Jason Chan, a high net-worth venture capital investor.

Thomas and Sandy met while studying solar engineering at university and share a vision of
further converting Hong Kong’s energy usage from the current focus on non-renewable energy
sources, such as coal, to using more solar energy. Thomas and Sandy aim to achieve this
through the design, production and sale of ‘Sun Seeker’ a compact, transportable and low-cost
solar panel. Their goal is that by 2030 Sun-Seeker will dominate the apartment market in Hong
Kong. Since incorporation, Sun Energy has grown and now employs 30 full-time staff, consisting
mainly of engineers. This team has designed a prototype of the Sun Seeker, and last month the
company was successful in obtaining a worldwide patent over the product.

Most of the initial equity funding from Jason Chan has been utilised in the design and
patent process. Although happy with progress made to date, Jason is unwilling to inject
additional equity funding into the business at this stage. As a result, Sun Energy does not have
the financial resources to fund neither the remaining research and development process nor
the funding or expertise to manufacture and distribute the Sun Seeker on a large scale.

For a company, such as Sun Energy, issuing shares or share options to employees and
suppliers in exchange for goods and services can be an effective way of funding ongoing
operations without utilising cash.

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OVERVIEW

2 4 . 1 OVERVIEW

This chapter considers the requirements of HKFRS 2 Share-based Payment. The objective of the
standard is to specify the reporting of share-based payment transactions, including the effects
HKFRS 2.1 on profit or loss and financial position.

In this section, you will gain an understanding of the scope of HKFRS 2 and the key
terminology used within the standard.

24.1.1 Scope
A share-based payment transaction is one in which an entity acquires or receives goods or
HKFRS 2.5 services. Goods can include inventories, consumables, property, plant and equipment,
intangible assets, or other non-financial assets. Services include those rendered by employees
and parties other than employees, for example, consultancy services.
HKFRS 2.2 HKFRS 2 deals with three forms of share-based payments. These three forms and the
essential features of each form are summarised in Exhibit 24.1.

Form Features
Equity-settled share-based payment Transactions in which the entity receives goods or services as
transaction consideration for its own equity instruments (including shares
or share options).
Cash-settled share-based payment Transactions in which the entity acquires goods or services
transaction by incurring a liability to transfer cash or other assets to the
supplier of those good or services for amounts based on the
value of equity instruments (including shares or share options).
Share-based payment transaction Transactions in which the entity receives or acquires goods or
with cash alternatives services, and the terms of the arrangement provide the entity
or the supplier (or employee) with a choice of whether the
transaction is settled in cash or equity.

EXHIBIT 24.1 Forms and features of share-based payment transactions

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Illustrative Example 1
Nelson Limited (Nelson) is an entity listed on the Stock Exchange of Hong Kong (SEHK).
Nelson is a commodity trader, buying and selling commodities, such as copper, iron
ore and gold. During the year ended 31 March 20X9, Nelson undertook the following
transactions:

1. On 1 June 20X8, Nelson granted 500 shares to its employees, provided they remain
employed by Nelson for at least the next 12 months.

This is an equity-settled share-based payment. Nelson’s employees will receive

500 shares if they provide the required period of service to Nelson.

2. On 1 April 20X8, Nelson awarded a cash bonus to all employees equal to 1,000
times the increase in Nelson’s share price over the next 12 months, provided they
remain employed by Nelson for the next 12 months. The share price at 1 April 20X8
was HK$45 and on 31 March 20X9 was HK$52.

This is a cash-settled share-based payment. Each employee still employed on

31 March 20X9 will receive HK$7,000 (calculated based on the increase in the share
price of HK$7 per share × 1,000).

3. On 1 March 20X9, Nelson granted 500 options to the CFO, conditional on the CFO
remaining employed for three years. When the options are exercised, the CFO will
have the choice of receiving cash or shares.

This transaction falls into the ‘share-based payment transaction with cash
alternatives’ category of share-based payment as the CFO has a choice of
settlement.

The following transactions are specifically excluded from the scope of HKFRS 2:

HKFRS • Transactions where the counterparty acts in its capacity as a shareholder (rather than
2.4 as a supplier or employee);

• Transactions where the share-based payment is issued as consideration in a business

HKFRS combination accounted for under HKFRS 3 Business Combinations or on the formation of
2.5 a joint venture accounted for in accordance with HKFRS 11 Joint Arrangements; and

• Transactions where the share-based payment is issued as consideration for the

HKFRS acquisition of a good or service under a contract that is accounted for as a financial
2.5 instrument under HKFRS 9 Financial Instruments.

Illustrative Example 2
During the year ended 31 March 20X9, Nelson also undertook the following transactions:

1. On 1 January 20X9, Nelson announced a rights issue to all shareholders. Under

this issue, shares are offered at a discount of 12% of their market price. There
are no conditions attached to the shares. Bill Lee, who is both a shareholder and
employee of Nelson, purchases his entitlement to shares under the offer.

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Illustrative Example 2 (continued)

Because this offer is made to all shareholders, Bill is acting in his capacity as a
shareholder rather than an employee. Therefore, this transaction is not a share-
based payment in the scope of HKFRS 2.

2. On 1 February 20X9, Nelson purchased 1,000 tonnes of iron ore in exchange for
10,000 ordinary shares. Delivery and exchange occurred on 28 February 20X9, and
by 31 March 20X9, Nelson had sold the iron ore to a major steel producing client.

As the iron ore was not for Nelson’s own use the contract is a financial
instrument, and therefore, the transaction is not a share-based payment in the
scope of HKFRS 2.

24.1.2 Terminology
HKFRS
2, App. A HKFRS 2 defines key terms relevant to share-based payments. Many of these terms will be
introduced throughout the remainder of this chapter. Before continuing, however, it is useful to
ensure an understanding of the following key terms.

The term employee encompasses individuals who are regarded as employees for legal
or tax purposes as well as individuals who render services similar to those rendered by
employees. The term employee encompasses all management personnel, including
non-executive directors.

An equity instrument is a contract that evidences a residual interest in the assets of an

entity after deducting all of its liabilities. (Throughout this chapter, this term is used to refer to
the shares or share options issued under a share-based payment arrangement.)

A share-based payment arrangement is an agreement between the entity and another

party that entitles the other party to receive equity instruments of the entity or cash or other
assets of the entity for amounts that are based on the value of equity instruments of the entity.

A share-based payment transaction is a transaction in which the entity receives goods or

services from the supplier of those goods or services (including an employee) in a share-based
payment arrangement.

To vest means to become an entitlement. Under a share-based payment arrangement,

the right of the employee or supplier to receive a share-based payment vests when their
entitlement is no longer conditional on the satisfaction of any vesting conditions.

Key Learning Point

Share-based payment arrangements may be settled by an entity issuing equity instruments
or by a payment in cash (or other assets) for an amount based on the price or value of the
entity’s equity instruments.

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Knowledge Check Questions

Question 1
Identify which of the following is NOT a share-based payment transaction for ABC
Limited (ABC).
A On 31 December 20X8, ABC acquired a trademark from a competitor in exchange for
1,000 shares in ABC. The share price on that date was HK$20.
B On 1 September 20X8, ABC acquired inventory from a key supplier and incurred a
liability based on the price of 1,000 ABC shares. The share price on that date was HK$18.
C On 15 March 20X9, ABC issued 500 options to employees. These options are exercisable if
the employees remain employed for a period of two years after the issue date.
D On 1 January 20X9, ABC awarded a cash bonus of HK$500 to all employees provided they
remain employed by ABC for the next six months. This amount is equal to 10 times the
share price of HK$50 on 1 January 20X9.

Question 2
On 1 January 20X9, Salt Limited (Salt) acquired a controlling interest in Pepper Limited
(Pepper) from Spicy Limited (Spicy). As consideration, Salt transferred 10,000 of its ordinary
shares to Spicy. Explain whether this transaction is a share-based payment transaction
under HKFRS 2.

2 4 . 2 RECOGNITION
HKFRS
2.7–9 HKFRS 2 sets out the recognition criteria for share-based payments. These criteria are
presented in Exhibit 24.2.

Goods When obtained

Timing
Services When received

Expense
Recognition
(debit)
Asset
(if goods/services qualify as asset)

Equity
(for equity-settled share-based payment)
Recognition
(credit)
Liability
(for cash-settled share-based payment)

EXHIBIT 24.2 Recognition of share-based payments

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It is important to understand that expenses arise from share-based payments not because
it is costly to issue shares, but rather because the entity receives an asset in exchange for the
shares and that asset is consumed immediately or over time. It is the consumption of the asset
that causes the expense.

When recording the debit side of a share-based payment transaction, an expense will be
recognised in most cases. For example, most services are consumed as they are provided.
Conceptually, the service received is an asset for a short period. Where goods are consumed
over a time or sold at a later date (e.g. inventories), an asset may be recognised initially, with
subsequent recognition as an expense as the asset is consumed or sold. In some cases, goods
or services may not be consumed or sold, but an expense may need to be recognised because
the goods or services may not qualify for recognition as an asset. For example, in the case of
Sun Energy, if the company were to enter into share-based payment transactions while the Sun
Seeker project was still in the research phase, an expense would need to be recognised as the
amounts would not qualify for recognition under HKAS 38 Intangible Assets.

When recording the credit side of an equity-settled share-based payment transaction, the
specific equity account used will depend on the type of equity instrument issued. If a share is
issued the credit will be recorded against share capital, whereas if a share option is issued, the
credit will be recorded against a reserve account (e.g. a share-based payment reserve).

Illustrative Example 3
Sun Energy entered into the following share-based payment transactions during the year
ended 31 March 20X9:

1. On 1 January 20X9, during the research phase for the Sun Seeker, Sun Energy
purchased 20,000 polycrystalline cells from a supplier in exchange for 1,000
ordinary Sun Energy shares. The fair value of the polycrystalline cells was
HK$300,000. Because the cells were being used in the research phase of the
project, they could not be recognised as an asset under HKAS 38 Intangible Assets
because the cost incurred in acquiring them cannot be deferred (see Chapter 14).
Accordingly, the cost must be expensed.

This transaction is an equity-settled share-based payment transaction and will

be accounted for by Sun Energy as follows:

Date Description Debit Credit

HK$ HK$
01.01.X9 Research expense 300,000
Share capital 300,000
Recognition of equity-settled share-based payment

2. On 1 April 20X8, Sun Energy issued 1,000 share appreciation rights to each of its
30 full-time employees. These rights are conditional on the employees remaining
in the employment of Sun Energy for 12 months (i.e. until 1 April 20X9). The share
appreciation rights entitle each employee who meets the employment condition
to a cash payment on 1 April 20X9 based on increases in Sun Energy’s share price
over the 12-month period. Sun Energy’s share price increased by HK$2.50 over the
20X8–X9 financial year, and all 30 employees remain employed at 31 March 20X9.

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Illustrative Example 3 (continued)

This transaction is a cash-settled share-based payment transaction and will be
accounted for by Sun Energy as follows:

Date Description Debit Credit

HK$ HK$
31.03.X9 Salary and wages expense 75,000
Share-based payment liability 75,000
Recognition of cash-settled share-based payment
Calculated as: HK$2.50 × 1,000 rights × 30 employees

Note: Share appreciation rights are covered in more detail in Section 24.4 of this chapter.

Key Learning Point

In most cases, share-based payment transactions will result in the recognition of an
expense unless the goods or services received qualify for recognition as an asset.

Knowledge Check Question

Question 3
Identify which of the following statements is INCORRECT.
A When an entity receives goods under a share-based payment transaction, the entity will
recognise an expense unless the item qualifies for recognition as an asset.
B Equity-settled share-based payment transactions will result in an increase in equity.
C A share-based payment transaction, where an entity issues shares in exchange for
services provided by employees, will be recognised when the shares are issued.
D Cash-settled share-based payment transactions will result in an increase in liabilities.

2 4 . 3 EQUITY-SETTLED SHARE-BASED PAYMENT

TRANSACTIONS: MEASUREMENT

As previously noted in Exhibit 24.1, an equity-settled share-based payment transaction

is one in which the entity receives goods or services as consideration for its own equity
instruments. As further illustrated in Exhibit 24.2, an equity-settled share-based payment
transaction will result in the recognition of an expense unless the item qualifies for recognition
as an asset. When recognising an equity-settled share-based payment transaction, the
measurement basis depends on whether the transaction is with an employee or a non-
employee. The specific requirements are summarised in Exhibit 24.3 and are discussed in more
detail in Sections 24.3.1 and 24.3.2.

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Counterparty Employee Non-employee

Can the fair value of goods and No Yes No (rare)
services be reliably measured?
Measurement basis Fair value of equity Fair value of goods Fair value of equity
instruments granted or services received instruments granted
Measurement date Grant date Date goods or services received
Recognition date Date services received Date goods or services received
(as discussed in Section 24.2)

EXHIBIT 24.3 Measurement principles for equity-settled share-based payment transactions

24.3.1 Fair Value of the Goods or Services Received

HKFRS HKFRS 2 requires the entity to measure a share-based payment transaction based on the fair
2.10 value of the goods and services received unless that fair value cannot be estimated reliably.
HKFRS In the case of non-employees (e.g. suppliers of goods or services), there is a rebuttable
2.13 presumption that the fair value of the goods or service received can be reliably determined;
so, in most cases, share-based payment transactions with non-employees are measured with
reference to the fair value of those goods or services. The first transaction in Illustrative
Example 3 at the end of Section 24.2 (where Sun Energy purchased polycrystalline cells from a
supplier) contains an example of this type of equity-settled share-based payment.

When a share-based payment transaction is measured based on the fair value of goods or
HKFRS service received, measurement must take place on the date the goods are obtained or the
2.13 services are provided and the transaction should be recognised as the goods are obtained or
services provided.

HKFRS 2 recognises rare cases may occur when the rebuttable presumption that the fair
value of the goods or services received from non-employees can be reliably determined is
HKFRS
inappropriate. In such cases, the transaction is measured based on the fair value of the equity
2.13 instruments granted. This measurement basis is discussed in the next section.

Furthermore, if the fair value of goods and services received from non-employees appears
to be less than the fair value of the equity instruments granted, this indicates other goods or
services that cannot be identified have been (or will be) received by the entity. In such cases,
the unidentifiable goods or services will be measured as the difference between the fair value
HKFRS of the equity instruments granted and the fair value of the identifiable goods or services
2.13A received.

24.3.2 Fair Value of the Equity Instruments Granted

In cases where the fair value of the goods and services received cannot be estimated reliably,
HKFRS the transaction must be measured by reference to the fair value of the equity
2.10 instruments granted.

HKFRS 2 requires entities to measure all share-based payment transactions with employees
by reference to the fair value of the equity instruments granted. This is due to the practical
HKFRS difficulties that can arise when attempting to determine the fair value of services provided by
2.11–12 employees. For share-based payment transactions with employees, the fair value of the equity
instrument is determined at the grant date. The grant date is when the entity and the

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counterparty have a shared understanding of the terms and conditions of the arrangement and
have entered into a legally enforceable agreement.

As discussed in Section 24.3.1, rare cases may occur when transactions with non-employees
HKFRS
are measured based on the fair value of the equity instruments granted due to an inability to
2.13 reliably determine the fair value of the goods or services received. In such cases, the fair value
of the equity instrument is determined when the goods or services are received (rather than at
the grant date as is the case for employees).

HKFRS 2 requires that the fair value of equity instruments granted be measured based on
HKFRS
market prices if available, taking into consideration the terms and conditions on which those
2.16 equity instruments were granted. For a listed entity issuing ordinary shares that are subject to
the same terms and conditions as those that apply to traded instruments, determination of the
fair value is reasonably straightforward.

For unlisted entities, such as Sun Energy, the determination of the fair value of equity
HKFRS
instruments granted is more complicated. If market prices are unavailable, a valuation
2.17 technique must be used to estimate the fair value of the equity instruments granted. HKFRS 2
does not prescribe a valuation technique, but the use of option-pricing models, such as the
Black-Scholes-Merton and Binomial models are commonplace. A detailed understanding of
these valuation models is beyond the scope of this chapter. The important point to bear in
mind is when used, they are to be designed to estimate fair value.

24.3.3 Treatment of Vesting Conditions

In some cases, share-based payments are granted unconditionally. For example, at financial
year end, Sun Energy could grant shares to employees for services rendered during the
financial year. In this case, the employees can retain the grant even if they resign from Sun
Energy immediately after receiving the grant.

In most cases, however, share-based payment arrangements (especially with employees)

are normally subject to one or more conditions. These conditions determine when or whether
the employee becomes entitled to a share-based payment. The accounting for a share-based
payment is affected by different types of conditions, which can affect the timing of recognition
and/or measurement of a share-based payment.

Conditions included in share-based payment arrangements are classified as vesting

conditions or non-vesting conditions. A vesting condition is defined as a condition that
HKFRS
determines whether the entity receives the services that entitle the counterparty to receive
2, App A cash, other assets, or equity instruments of the entity. In the case of an equity-settled
share-based payment arrangement, the meeting of a vesting condition will result in the issue of
shares or share options by the entity.

Vesting conditions are classified as service or performance conditions. Performance

conditions are further sub-classified into non-market and market conditions. Exhibit 24.4
illustrates how to determine the classification of these conditions.

Each of these conditions is discussed in detail in the following sections.

HKFRS
The period during which all the specified vesting conditions are to be satisfied is referred to
2, App.A as the vesting period. In the case of an employee providing services to an entity, this may refer
to the period over which the services are provided to the entity. HKFRS 2 sets out that the

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Does the condition determine whether the entity receives the services that entitle the counterparty
to the share-based payment?

YES NO

Vesting condition Non-vesting condition

Does the condition require only a specified period

of service to be completed?

YES NO

Performance
Service condition
condition

Is the condition related to the market price of the

entity’s equity instruments?

YES NO

Non-market
Market condition
condition

EXHIBIT 24.4 Classification of conditions in a share-based payment arrangement

HKFRS
2.15 expense (or asset) and corresponding increase in equity are recognised over the vesting period,
as illustrated in Exhibit 24.5.

Grant Vesting
date date

Vesting period

Recognise the expense (or asset) and

increase in equity over the vesting period

EXHIBIT 24.5 Recognition of share-based

payment expense (or asset)

24.3.1.1 Service Condition

As indicated in Exhibit 24.4, where a condition in a share-based payment arrangement only
requires a specified period of service to be completed, the vesting condition is described as a
service condition.

Service conditions are not considered when estimating the fair value of the equity
HKFRS instruments. Rather, the service condition is accounted for by adjusting the number of equity
2.19 instruments included in the measurement of the transaction amount. This means the amount
recognised in the financial statements for the services received is based on the number of

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equity instruments that eventually vest. It also means that if a vesting condition is not met, then
the counterparty’s right to receive the equity instruments will be forfeited, and no amount will
be recognised in the financial statements.

Where the service period extends beyond the reporting period, entities are required to
estimate the number of equity instruments expected to vest during the vesting period in
calculating the amount recognised for goods or services received during the reporting period.
HKFRS
Where subsequent information indicates that the number of equity instruments expected to
2.20 vest differs from previous estimates, the estimate should be revised. Consistent with HKAS 8
Accounting Policies, Changes in Accounting Estimates and Errors, these revisions of prior year
estimates are made on a prospective basis.

Illustrative Example 4 – Adapted from HKFRS 2 Illustrative Guidance

Example 1A
On 1 April 20X6, Black Limited (Black) granted 100 share options to each of its 500
employees. Each grant is conditional on the employee remaining employed by Black for
the next three years (until 31 March 20X9). At grant date, Black estimates that the fair
value of each share option is HK$15.

At grant date, Black estimates that 15% of the employees will leave during the
three-year vesting period and will, therefore, forfeit their rights to the share options
(in other words, the rights to the options will not vest). This estimate is not revised over the
three-year vesting period.

1 April 20X6 – grant date

No journal entry is required at the grant date because the employees have not provided any
services to the entity.

31 March 20X7 – end of year 1

Black will calculate remuneration expense for year 1 as follows:

100 × 500 × 85% × HK$15 × 1/3 years = HK$212,500

Number of Number of Percentage Fair value Portion of Remuneration

equity employees of of equity service expense for
instruments at grant date employees instrument period that year 1
granted to expected to at grant date has been met
each meet service
employee condition
(100% – 15%)

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31 March 20X8 – end of year 2

Black will calculate its remuneration expense for year 2 as follows:

100 × 500 × 85% × HK$15 × 2/3 years – HK$212,500 = HK$212,500

Number of Number of Percentage Fair value Portion of Remuneration Remuneration

equity employees of of equity service expense for expense for
instruments at grant date employees instrument period that year 1 year 2
granted to expected to at grant date has been met
each meet service
employee condition
(100% – 15%)

31 March 20X9 – end of year 3

On 31 March 20X9, (the vesting date) 425 of the 500 employees are still employed by Black. This
means that Black’s estimate that 15% of employees would leave was accurate.

Black will calculate its remuneration expense for year 3 as follows:

100 × 425 × HK$15 – HK$425,00 = HK$212,500

Number of Number of Fair value Remuneration Remuneration

equity employees of equity expense for expense for
instruments who met instrument year 1 and 2 year 3
granted to service at grant date (cumulative)
each condition
employee for SBP to
vest

The journal entry to record the share-based payment at the end of each year is as follows:

Date Description Debit Credit

HK$ HK$
31.03.XY Salary and wages expense 212,500
Share-based payment reserve (equity) 212,500
Recognition of equity-settled share-based payment

In the preceding example, the estimate of employee departures did not change over the
three-year vesting period and the actual number of departures was identical to that which
was estimated at the grant date. Although possible, this is uncommon in practice. Illustrative
Example 5 demonstrates how an equity-settled share-based payment transaction with a service
condition is affected when changes occur in the estimate of employee departures and actual
employee departures during the vesting period.

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Illustrative Example 5
On 1 April 20X6, White Limited (White) granted 1,000 share options to each of its 250
employees. Each grant is conditional on the employee remaining employed by White for
the next three years (until 31 March 20X9). At grant date, White estimates that the fair
value of each share option is HK$5.

At grant date, White estimates that 25 employees will leave during the three-year
vesting period and will, therefore, forfeit their rights to the share options.

31 March 20X7 – end of year 1

During the year ended 31 March 20X7, eight employees resigned. This was fewer than expected.
In light of this, White decided to revise its estimate of total employee departures over the three-
year period from 25 employees to 22 employees.

White will calculate remuneration expense for year 1 as follows:

1,000 × 250 – 22 × HK$5 × 1/3 years = HK$380,000

Number of Number of Number of Fair value Portion of Remuneration

equity employees employees of equity service expense for
instruments at grant date currently instrument period that year 1
granted to expected to at grant date has been met
each depart
employee before
vesting date

31 March 20X8 – end of year 2

During the year ended 31 March 20X8, six more employees resigned (bringing total departures to
14). As a result, White further revised its estimate of total employee departures from 22 employees
to 20 employees.

White will calculate remuneration expense for year 2 as follows:

1,000 × 250 – 20 × HK$5 × 2/3 years – HK$380,000 = HK$386,667

Number of Number of Number of Fair value Portion of Remuneration Remuneration

equity employees employees of equity service expense for expense for
instruments at grant date currently instrument period that year 1 year 2
granted to expected to at grant date has been met
each depart
employee before
vesting date

31 March 20X9 – end of year 3

During the year ended 31 March 20X9, 10 more employees resigned (bringing total departures
to 24). As a result, a total of 226 employees met the service condition for the share-based
payment to vest.

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White will calculate remuneration expense for year 3 as follows:

1,000 × 226 × HK$5 – HK$766,667 = HK$363,333

Number of Number of Fair value Remuneration Remuneration

equity employees of equity expense for expense for
instruments who met instrument year 1 and 2 year 3
granted to service at grant date (cumulative)
each condition
employee for SBP to
vest

The calculations over the three-year vesting period can be summarised as follows:

Year Calculation Remuneration Equity at end

expense for of the period
the period
HK$ HK$
31 March 20X7 1,000 × (250 − 22) × HK$5 × 1/3 380,000 380,000
31 March 20X8 1,000 × (250 − 20) × HK$5 × 2/3 386,667 766,667
31 March 20X9 1,000 × 226 × HK$5 363,333 1,130,000

As can be seen in the table above, at the end of each reporting period, the cumulative
expense is adjusted to reflect the number of equity instruments ultimately expected to vest.
This process is commonly referred to as ‘truing up’.

24.3.1.2 Performance Conditions

In addition to meeting a service requirement, many share-based payment arrangements are
conditional on the achievement of a performance condition; for example, in the Sun Energy
case, the issue of shares to Thomas and Sandy was conditional on obtaining a patent for
the Sun Seeker. Performance conditions are classified as being either non-market or market
conditions. Exhibit 24.6 illustrates the different types of performance conditions.

Performance condition
(counterparty required to complete a period of service and meet
specified performance targets)

Non-market condition Market condition

(related to the entity’s own operations or activities) (related to the market price of the entity’s equity instruments)
Examples: Examples:
• The entity needs to achieve a specified revenue, • The share price needs to increase by at least a specified
EBITDA, profit or EPS target (as an absolute amount percentage over a specified period of time for the SBP
or a percentage increase) to vest
• The entity needs to achieve a specified non-financial • The entity’s share price needs to meet a target on at least
performance target – for example, a specified one day in a specified period
market share • The share price needs to increase by more than a share
• The entity needs to decrease the error rate in a certain index over a specified period
area – for example, health and safety, CO2 emissions • The total shareholder return needs to meet a specified
percentage increase over a specified period

Not reflected in grant date fair value Reflected in grant date fair value

EXHIBIT 24.6 Performance conditions in share-based payment arrangements

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The inclusion of a performance condition in a share-based payment arrangement will result

in the length of the vesting period varying according to when the performance condition is
satisfied. When estimating the length of the expected vesting period, HKFRS 2 requires entities
HKFRS
to determine the most likely outcome of the performance condition to account for the
2.15(b) share-based payment arrangement.

Non-market Conditions
As can be seen in Exhibit 24.6, non-market conditions are not considered when estimating the
grant date fair value of the equity instruments issued; rather they are taken into consideration by
HKFRS
adjusting the number of equity instruments included in the measurement of the share-based
2.19 payment transaction. This treatment is consistent with the treatment demonstrated in Illustrative
Examples 4 and 5 relating to the preceding service conditions (for Black and White).

Illustrative Example 6 – Adapted from HKFRS 2 Illustrative

Guidance Example 2
On 1 April 20X6, Blue Limited (Blue) granted 500 share options to each of its 75
employees. Each grant is conditional on the employee remaining employed by Blue for
the next three years (until 31 March 20X9) and is subject to the performance conditions
specified below being met. At grant date, Blue estimates that the fair value of each share
option is HK$10.

The vesting conditions allow the shares to vest as follows:

• On 31 March 20X7 (the end of year 1), if the company’s earnings have increased by
more than 15%;

• On 31 March 20X8 (the end of year 2), if the company’s earnings have increased by
more than 12% averaged across the two-year period; and

• On 31 March 20X9 (the end of year 3), if the company’s earnings have increased by
more than 10% averaged across the three-year period.

31 March 20X7 – end of year 1

During the year ended 31 March 20X7, Blue’s earning increased by 13% and six employees
resigned. Management expects that earnings will increase at a similar rate in the 20X8 financial
year and that four more employees will leave.

As the increase in earnings was less than 15%, the condition for the grants to vest on
31 March 20X7 has not been met. Based on management’s expectation that earnings will
increase at a similar rate in the 20X8 financial year, the shares are expected to vest at the end
of 31 March 20X8 (because a two-year average of 13% is higher than the required 12% two-year
average to vest).

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Blue will calculate its remuneration expense for year 1 as follows:

500 × 75 – 6 – 4 × HK$10 × 1/2 years – HK$162,500

Number of Number of Number of Number of Fair value Portion of Remuneration

equity employees employees additional of equity expected expense for
instruments at grant date who have employees instrument vesting year 1
granted to already left expected to at grant date period that
each depart has been met
employee before
vesting date

31 March 20X8 – end of year 2

During the year ended 31 March 20X8, Blue’s earning increased by 10% and five employees
resigned. Management expects that earnings will increase by at least 9% in the 20X9 financial
year and that three more employees will leave.

The two-year average increase in earnings is 11.5% (13% in year 1 + 10% in year 2). As this
was less than 12%, the conditions to vest at 31 March 20X8 have not been met.

Based on management’s expectation that earnings will increase by at least 9% in the 20X9
financial year, the expected three-year average increase in earnings is 10.7% (13% in year 1 +
10% in year 2 and 9% in year 3). Based on this calculation, the shares are now expected to vest
at the end of 31 March 20X9.

Blue will calculate its remuneration expense for year 2 as follows:

500 × 75 – 11 – 3 × HK$10 × 2/3 years – HK$162,500 = HK$40,833

Number of Number of Number of Number of Fair value Portion of Remuneration Remuneration

equity employees employees additional of equity REVISED expense for expense for
instruments at grant date who have employees instrument expected year 1 year 2
granted to already left expected to at grant date vesting
each (6 in year 1 depart period that
employee and before has been met
5 in year 2) vesting date

31 March 20X9 – end of year 3

During the year ended 31 March 20X9, Blue’s earning increased by 10% and two employees
resigned.

The three-year average increase in earnings is 11% (13% in year 1 + 10% in year 2 + 10% in
year 3). Because this is more than 10%, the conditions to vest on 31 March 20X9 have been met.

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Blue will calculate its remuneration expense for year 3 as follows:

500 × 75 – 13 × HK$10 – HK$203,333 = HK$106,667

Number of Number of Number of Fair value Remuneration Remuneration

equity employees employees of equity expense for expense for
instruments at grant who have left instrument year 1 and 2 year 3
granted to date (6 in year 1; at grant date (cumulative)
each 5 in year 2 and
employee 2 in year 3)

The pro forma journal entry to record the share-based payment at the end of each year is
as follows:

Date Description Debit Credit

HK$ HK$
31.03.xx Salary and wages expense xxx
Share-based payment reserve (equity) xxx
Recognition of equity-settled share-based payment

At the end of each reporting period, the cumulative expense is adjusted to reflect the number
of years in which the equity instruments are expected to vest, a process referred to as ‘truing up’.

Non-market Conditions Where the Exercise Price Is Variable

Where an entity issues share options under a share-based payment arrangement, the
agreement may include a performance condition that results in the exercise price of the share
options varying.

Illustrative Example 7 – Adapted from HKFRS 2 Illustrative

Guidance Example 4
On 1 April 20X6, Green Limited (Green) granted 2,000 share options with an exercise
price of HK$50 to Bill Brush, a senior employee. The grant is conditional on Bill remaining
employed by Green for the next three years (until 31 March 20X9). At grant date, Green
estimates that the fair value of each share option is HK$15 (with an exercise price of HK$50).

Under the agreement, if the earnings of Green increase by an average of 10% per year
over the vesting period, the exercise price of the share options will fall to HK$40. If the
exercise price is HK$40, the estimated fair value of the options will be HK$20.

31 March 20X7 – end of year 1

During the year ended 31 March 20X7, Green’s earnings increased by 13%. Management
expects that earnings will increase at a similar rate over the next two years.

With an average increase in earnings of 13%, the exercise price of each share option will fall
to HK$40, and the fair value of each option will increase to HK$20.

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Because the performance condition is a non-market condition, the effect of the

performance condition is not considered when estimating the fair value of the options at the
grant date. Instead, Green will estimate the fair value of the share options at grant date and
then revise the outcome over the vesting period to reflect the outcome of the performance
condition.

Green will calculate its remuneration expense for year 1 as follows:

2,000 × HK$20 × 1/3 years = HK$13,333

Number of Fair value Portion of Remuneration

equity of equity service expense for
instruments instrument period that year 1
granted based on has been
current met
expectation about
increase in earnings
over vesting period

(Note that there is only one employee is in this example, so we do not need to estimate the
number of employees.)
31 March 20X8 – end of year 2

During the year ended 31 March 20X8, Green’s earnings increased by 11%. Management still
expects to achieve the earnings target.

The expected exercise price and fair value of each share option remains unchanged
from year 1.

Green will calculate its remuneration expense for year 2 as follows:

2,000 × HK$20 × 2/3 years – HK$13,333 = HK$13,334

Number of Fair value Portion of Remuneration Remuneration

equity of equity service expense for expense for
instruments instrument period that year 1 year 2
granted based on has been
current met
expectation about
increase in earnings
over vesting period

31 March 20X9 – end of year 3

During the year ended 31 March 20X9, Green’s earnings increased by 5%. The earnings target
has not been achieved so the exercise price will be HK$50. The fair value of each option,
therefore, will be HK$15.

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Green will calculate its remuneration expense for year 3 as follows:

2,000 × HK$15 – HK$26,667 = HK$3,333

Number of Fair value Remuneration Remuneration

equity of equity expense for expense for
instruments instrument year 1 and year 3
granted based on year 2
actual earnings
over vesting period

Apply and Analyse 1

Assume that Bill Brush resigned from Green on 31 March 20X8 (at the end of year 2).

Explain how Bill’s resignation and departure will affect the share-based payment
arrangement and prepare the relevant journal entry to record any impact on Green’s
financial statements.

Analysis

Bill’s departure from Green on 31 March 20X8 means he has not satisfied the service
condition under the share-based payment agreement, that is, he has not remained employed
for a period of three years. This means the share options are forfeited and will not vest.

HKFRS In such circumstances, no amount will be recognised in the financial statements for
2.19 services received on a cumulative basis. As a result, the expense recognised in year 1 will
need to be reversed in year 2.

The journal entry required at 31 March 20X8 is, therefore, as follows:

Date Description Debit Credit

HK$ HK$
31.03.X8 Share-based payment reserve (equity) 13,333
Salary and wages expense 13,333
Reversal of cumulative expense due to vesting conditions not being met

Market Conditions

HKFRS A key difference between non-market and market vesting conditions is that market conditions are
2.21 taken into consideration when estimating the fair value of equity instruments at grant date. This
means that goods or services received from a counterparty that satisfy all other vesting conditions
(e.g. a service condition) are recognised regardless of whether the market condition is satisfied.

If a market condition is unmet and the share options do not vest, they will lapse. In this
case, the amount in the share-based payment reserve account relating to the recognition of
remuneration expense can remain in that account or can be transferred to retained earnings,
depending on the entity’s accounting policy.

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Illustrative Example 8 – Adapted from HKFRS 2 Illustrative

Guidance Example 5
On 1 April 20X6, Red Limited (Red) granted 2,000 share options to Amber Andrews,
a senior employee. The share price of Red on this date was HK$30. The grant is
conditional on:

• Amber remaining employed by Red for the next three years (until 31 March
20X9); and

• The share price increasing to at least HK$45 by 31 March 20X9.

Using an option-pricing model that considers the possibility that the share price target
will be achieved and that the possibility it will not be achieved, Red estimates the fair value
of the options at grant date to be HK$17.

31 March 20X7 – end of year 1

During the year ended 31 March 20X7, Red’s share price increased to HK$35. Management
expects that the share price will increase at a similar rate over the next two years, and the
share price target will be met.

Red will calculate its remuneration expense for year 1 as follows:

2,000 × HK$17 × 1/3 years = HK$11,333

Number of Fair value Portion of Remuneration

equity of equity service expense for
instruments instrument period that year 1
granted determined at has been
grant date met

31 March 20X8 – end of year 2

During the year ended 31 March 20X8, Red’s share price increased to HK$38. Management
expects the share price will increase at a similar rate over the next 12 months, and the share
price target will be met.

Red will calculate its remuneration expense for year 2 as follows:

2,000 × HK$17 × 2/3 years – HK$11,333 = HK$11,334

Number of Fair value Portion of Remuneration Remuneration

equity of equity service expense for expense for
instruments instrument period that year 1 year 2
granted determined at has been
grant date met

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31 March 20X9 – end of year 3

During the year ended 31 March 20X9, Red’s share price increased to HK$46, meaning the
share price target has been met.

Red will calculate its remuneration expense for year 3 as follows:

2,000 × HK$17 – HK$22,667 = HK$11,333

Number of Fair value Remuneration Remuneration

equity of equity expense for expense for
instruments instrument year 1 and year 3
granted determined at year 2
grant date

The pro forma journal entry to record the share-based payment at the end of each year is
as follows:

Date Description Debit Credit

HK$ HK$
31.03.XY Salary and wages expense xxx
Share-based payment reserve (equity) xxx
Recognition of equity-settled share-based payment

Apply and Analyse 2

Part A
Assume that Amber Andrews resigned from Red on 31 March 20X8 (at the end of year 2).

Explain how Amber’s resignation and departure will affect the share-based payment
arrangement and identify any impact on Red’s financial statements for the year ended
31 March 20X8.

Analysis

If Amber resigns at the end of year 2, it will mean the service condition under the share-
based payment arrangement has not been satisfied and the share options will be forfeited.

The salary and wages expense and share-based payment reserve of HK$11,333
recorded during the year ended 31 March 20X7 will be reversed during the year ended
31 March 20X8.

Part B

Assume that Amber met the service condition and the share price on 31 March 20X9 was
HK$42. Explain how this would affect the share-based payment arrangement and identify
any impact on Red’s financial statements for the year ended 31 March 20X9.

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Apply and Analyse 2 (continued)

Analysis

With a share price of HK$42 at 31 March 20X9, it means that the market condition has
not been met. Given that Amber has met the service condition by remaining employed
by Red until at least 31 March 20X9, the expense in respect of services provided by her
is recognised in the financial statements, notwithstanding the market condition is not
satisfied. This means that the expense will not be reversed.

Because the share options do not vest, and the market condition was not met, the options
will lapse. Red can choose to leave the cumulative HK$34,000 in the share-based payment
reserve account or can transfer it to retained earnings, depending on its accounting policy

The flowchart in Exhibit 24.7 summarises the recognition requirements for equity-settled
share-based payment arrangements with performance and/or service conditions. Pay
particular attention to the differing treatment at the lowest level of the flowchart.

Has the service condition under the SBP

arrangement been met?

YES NO

Performance conditions under

the SBP arrangement

No performance Non-market based Market based

conditions performance conditions performance conditions

Recognise over the

Recognise over the
vesting period
Recognise over the vesting period if the Reverse any cumulative
irrespective of whether
vesting period non-market condition is amounts previously
the market condition
expected to be satisfied recorded
is satisfied

EXHIBIT 24.7 Summary of recognition requirements for equity-settled share-based payment

arrangements with performance and/or service conditions

24.3.4 Treatment of Non-vesting Conditions

The term non-vesting condition is not defined in HKFRS 2 but can be understood to be any
condition that does not meet the definition of a vesting condition.

As displayed in Exhibit 24.4, a non-vesting condition is unrelated to the requirement for the
counterparty to deliver services to the entity. Despite this, a non-vesting condition determines
whether or not the counterparty will receive the share-based payment under an agreement.

Examples of non-vesting conditions include:

• Non-compete clauses – for example, a requirement that the employee not be employed
by a competitor within two years after vesting date

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• Post-vesting transfer restrictions – for example, a requirement for an employee to hold

a share for a specified period of time after the vesting date

• A target based on a commodity index

• The employee having to make a contribution toward the exercise of a share-based

payment award

HKFRS
Like market conditions, non-vesting conditions are reflected in the fair value of the equity
2.21A instruments at grant date. Also like a market condition, a non-vesting condition results in the

Illustrative Example 9
On 1 April 20X8, Sun Energy granted 40,000 share options to Lionel Lee, a senior engineer
working for the company, on the condition that Lionel does not compete with Sun Energy for
a period of at least three years. The fair value of the share options on 1 April 20X8 is HK$8.

The non-compete clause is a non-vesting condition because it does not depend on

Lionel providing any services to Sun Energy. The following entry will be recorded by Sun
Energy on the grant date of 1 April 20X8:

Date Description Debit Credit

HK$ HK$
01.04.X8 Salary and wages expense 320,000
Share-based payment reserve (equity) 320,000
Recognition of equity-settled share-based payment (40,000 × HK$8)

Even if Lionel leaves Sun Energy and goes to work for a competitor within the
three-year non-compete period, the expense will remain.

recognition of an expense regardless of whether or not the non-vesting condition is satisfied.

The following flowchart summarises the impact of vesting and non-vesting conditions on
the determination of the fair value of equity instruments issued under an equity-settled share-
based payment arrangement.

24.3.5 Treatment of a Reload Feature

A reload feature is a feature within a share-based payment arrangement that provides for an
automatic grant of additional share options whenever the option holder exercises previously
HKFRS granted options using the entity’s shares, rather than cash, to satisfy the exercise price. Any
2.22 options issued under a reload feature are accounted for as a grant of new options.

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Type of condition

Vesting Non-vesting

Service Performance

Market Non-market

NOT taken into account Take into account NOT taken into account Taken into account
when determining when determining when determining when determining
fair value* fair value fair value* fair value

* These conditions are taken into consideration by adjusting the number of equity instruments included in the measurement
of the share-based payment transaction.

EXHIBIT 24.8 Impact of vesting and non-vesting conditions on the determination of the fair value
of equity instruments issued under an equity-settled share-based payment arrangement

Knowledge Check Questions

Use the following information to answer questions 4–6.

On 1 April 20X6, Dragon Limited (Dragon) granted 200 share options to each of its
50 employees. Each grant is conditional on the employee working for the company for the
next three years. The fair value of each share option at grant date is HK$25. At grant date,
Dragon estimates that six of its employees will leave during the vesting period.

The following table summarises the actual employee departures and revised estimates
of employee departures across the vesting period:

Year Actual employee Total forecast

departures departures
31 March 20X7 4 8
31 March 20X8 3 10
31 March 20X9 2 N/A
Total actual departures 9

Question 4
Calculate the expense recognised by Dragon for the year ended 31 March 20X7.
A HK$70,000
B HK$73,333
C HK$76,667
D HK$83,333

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Knowledge Check Questions (continued)

Question 5
Prepare the journal entry to recognise the share-based payment for the 20X8 financial year.

Question 6
Calculate the expense recognised by Dragon for the year ended 31 March 20X9.

Question 7
Identify which of the following is NOT a market condition.
A Total shareholder return needs to increase by at least 10% over two years.
B The share price needs to exceed HK$45 on at least three days in the current financial year.
C Total market share needs to increase by at least 8% over three years.
D The share price needs to increase by at least 8% over three years.
Use the following information to answer questions 8–9.

On 1 April 20X6, Lucky 8 Limited (Lucky 8) granted 50 share options to each of its 200
employees. Each grant is conditional on the employee working for the company for the
next three years. The fair value of each share option at grant date is HK$25. The vesting
conditions allow the share options to vest as follows:

At the end of the year Condition

31 March 20X7 If earnings have increased by more than 15%, then the share options
will vest on 31 March 20X7
31 March 20X8 If earnings have increased by an average of 12% across the two-year
period, then the share options will vest on 31 March 20X8
31 March 20X9 If earnings have increased by an average of 9% across the three-year
period, then the share options will vest on 31 March 20X9

On 31 March 20X7:

• Actual increase in earnings was 12%

• Actual employee departures totalled four

• Anticipated increase in earnings for the year ended 31 March 20X8 is 10%

• Anticipated increase in earnings for the year ended 31 March 20X9 is 8%

• Anticipated departures during the year ended 31 March 20X8 is three

• Anticipated departures during the year ended 31 March 20X9 is five

On 31 March 20X8:

• Actual increase in earnings was 15%

• Actual employee departures totalled three

• Anticipated increase in earnings for the year ended 31 March 20X9 is 9%

• Anticipated departures during the year ended 31 March 20X9 is four

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Knowledge Check Questions (continued)

Question 8
Calculate the expense recognised by Lucky 8 for the year ended 31 March 20X7.
A HK$78,333
B HK$80,417
C HK$117,500
D HK$120,625

Question 9
Calculate the expense recognised by Lucky 8 for the year ended 31 March 20X8.

2 4 . 4 CASH-SETTLED SHARE-BASED PAYMENT

TRANSACTIONS: MEASUREMENT

As discussed in Section 24.1.1, a cash-settled share-based payment transaction is one in

which the entity acquires goods or services by incurring a liability to transfer cash or other
assets to the supplier of those good or services for amounts based on the value of equity
instruments.

For example, Sun Energy may grant share appreciation rights to employees as part of their
remuneration package. Under such an arrangement the employees will become entitled to
receive the intrinsic value of the right on the settlement date. HKFRS 2 defines the intrinsic
HKFRS value as the difference between the fair value of the shares and the price that is required to be
2, App A paid for those shares. This intrinsic value represents the increase in Sun Energy’s share price
between the grant date and the settlement date.

Consider the second transaction in Illustrative Example 3, which was discussed earlier in
Section 24.2. As can be seen in the journal entry provided, this type of share-based payment
transaction results in the recognition of a liability for Sun Energy. (For further discussion on this
concept, refer to Section 24.2.)

Measurement requirements for cash-settled share-based payment transactions differ from

those discussed in Section 24.3 for equity-settled share-based payment transactions. For a
cash-settled share-based payment transaction, the fair value of the liability is remeasured at
HKFRS the end of each reporting period and on the settlement date. Any changes in the fair value of
2.30 the liability are recognised in profit or loss. For equity-settled share-based payment
transactions, the fair value is determined at grant date and remeasurement does not occur.

The accounting for the effects of vesting conditions for cash-settled share-based payment
HKFRS transactions follows the approach used for equity-settled share-based payment transactions as
2.33A-33D summarised in Exhibit 24.8.

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Illustrative Example 10 – Adapted from HKFRS 2 Illustrative Guidance

Example 12
On 1 April 20X4, Orange Limited (Orange) issued 100 share appreciations rights to each
of its 500 employees, with the condition that the employees remain employed for the
next three years (until 31 March 20X7). Employees have two more years (until 31 March
20X9) to exercise the rights and will receive a cash payment equal to the intrinsic value of
the share appreciation rights at the date of exercise.

31 March 20X5 – end of year 1

The fair value of the share appreciation rights on 31 March 2015 was HK$14.40. During the year
ended 31 March 20X5, 35 employees left, and Orange estimates that 60 more employees will
leave during years 2 and 3.

Orange will calculate its liability and remuneration expense for year 1 as follows:

100 × 500 – 95 × HK$14.40 × 1/3 years = HK$194,400

Number of Number Total expected Fair value Portion of Increase in

share of employees departures of share service liability and
appreciation at grant date before appreciation period that remuneration
rights granted vesting date rights has been met expense for
to each (30 + 65) at 31 march year 1
employee 20X5

The journal entry to record the share-based payment on 31 March 20X5 is as follows:

Date Description Debit Credit

HK$ HK$
31.03.X5 Salary and wages expense 194,400
Share-based payment liability 194,400
Recognition of cash-settled share-based payment

31 March 20X6 – end of year 2

The fair value of the share appreciation rights on 31 March 20X6 was HK$15.50. During the year
ended 31 March 20X6, 40 employees left, and Orange estimates that 25 more employees will
leave during year 3.

Orange will calculate the increase in its liability and remuneration expense for year 2 as follows:

100 × 500 – 100 × HK$15.50 × 2/3 years – HK$194,400 = HK$218,933

Number of Number of Total Fair value Portion of Opening Increase in

share employees expected of share service balance liability and
appreciation at grant date departures appreciation period that of liability remuneration
right granted before rights at has been met expense for
to each vesting date 31 March 20X6 year 2
employee (40 + 60)

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The closing balance in the liability account on 31 March 20X6 is HK$413,333.

The journal entry to record the share-based payment on 31 March 20X6 is as follows:

Date Description Debit Credit

HK$ HK$
31.03.X6 Salary and wages expense 218,933
Share-based payment liability 218,933
Recognition of cash-settled share-based payment

31 March 20X7 – end of year 3

The fair value of the share appreciation rights on 31 March 20X7 was HK$18.20. During the year
ended 31 March 20X7, 22 employees left (bringing total departures over the three years to 97).
Also, 150 employees exercised their rights on 31 March 20X7 and received the intrinsic value of
HK$15 per right.

Orange will calculate its cash payment in relation to rights exercised during the year
as follows:

100 × 150 × HK$15.00 = HK$225,000

Number of Employees Intrinsic value Cash payment

share who have at exercise made at end
appreciation exercised date of year 3
rights granted the rights
to each this year
employee

Orange will calculate its increase in the liability as follows:

100 × 500 – 97 – 150 × HK$18.20 – HK$413,333 = HK$47,127

Number of Number of Total actual Employees Fair value Opening Increase in

share employees departures who have of share balance of liability
appreciation at grant date before exercised appreciation liability for year 3
rights vesting the rights rights at
granted to date 31 March 20X7
each
employee

As can be seen from the above calculation, the liability is calculated with reference to the
rights that are yet to be exercised. The closing balance in the liability account on 31 March 20X7
is HK$460,460.

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The journal entry to record the share-based payment on 31 March 20X7 is as follows:

Date Description Debit Credit

HK$ HK$
31.03.X7 Salary and wages expense a
272,127
Cash 225,000
Share-based payment liability 47,127
Recognition of cash-settled share-based payment
a
The debit to salary and wages expense is the balancing item in the journal.

31 March 20X8 – end of year 4

The fair value of the share appreciation rights on 31 March 20X8 was HK$21.40. Also,
140 employees exercised their rights on 31 March 20X8 and received the intrinsic value of
HK$20 per right.

Orange will calculate its cash payment in relation to rights exercised during the year
as follows:

100 × 140 × HK$20.00 = HK$280,000

Number of Employees Intrinsic value Cash payment

share who have at exercise made at end
appreciation exercised date of year 4
rights granted the rights
to each this year
employee

Orange will calculate a decrease in its liability as follows:

100 × 500 – 97 – 290 × HK$21.40 – HK$460,460 = (HK$218,640)

Number of Number of Total actual Employees Fair value Opening Decrease in

share employees departures who have of share balance of liability for
appreciation at grant date before exercised appreciation liability year 4
rights vesting the rights rights at
granted to date (150 + 140) 31 March 20X8
each
employee

The closing balance in the liability account on 31 March 20X8 is HK$241,820.

The journal entry to record the share-based payment on 31 March 20X8 is as follows:

Date Description Debit Credit

HK$ HK$
31.03.X8 Salary and wages expense 61,360
Share-based payment liability 218,640
Cash 280,000
Recognition of cash-settled share-based payment

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31 March 20X9 – end of year 5

The remaining 113 employees exercised their rights on 31 March 20X9 and received the
intrinsic value of HK$25 per right.

Orange will calculate its cash payment in relation to rights exercised during the year
as follows:

100 × 113 × HK$25.00 = HK$282,500

Number of Employees Intrinsic value Cash payment

share who have at exercise made at end
appreciation exercised date of year 5
rights granted the rights
to each this year
employee

Now that all rights have been exercised, the remaining liability of HK$241,820 must be
removed from the financial statements.

The journal entry to record the share-based payment on 31 March 20X9 is as follows:

Date Description Debit Credit

HK$ HK$
31.03.X9 Salary and wages expense 40,680
Share-based payment liability 241,820
Cash 282,500
Recognition of cash-settled share-based payment

The calculations over the five-year period can be recognised as follows:

Year Calculation Remuneration Liability at end

expense for the of the period
period
HK$ HK$
31 March 20X5 100 × (500 − 95) × HK$14.40 × 1/3 194,400 194,400
31 March 20X6 100 × (500 − 100) × HK$15.50 × 2/3 218,933 413,333
31 March 20X7 100 × (500 − 97 − 150) × HK$18.20 + 47,127 460,460
100 × 150 × HK$15.00 (exercised) 225,000
31 March 20X8 100 × (500 − 97 − 290) × HK$21.40 + (218,640) 241,820
100 × 140 × HK$20.00 (exercised) 280,000
31 March 20X9 n/a (241,820) –
100 × 113 × HK$25.00 (exercised) 282,500

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Knowledge Check Question

Question 10
Identify which of the following statements are INCORRECT.
A Market and non-market conditions are taken into consideration when determining the
fair value of a share appreciation right.
B The intrinsic value of a share appreciation right represents the increase in the entity’s
share price between the grant date and the settlement date.
C For a cash-settled share-based payment transaction, the fair value of the liability is
remeasured at the end of each reporting period and also at the settlement date, and any
changes in the fair value of the liability are recognised in profit or loss.
D Where an employee does not meet a service condition within a cash-settled share-based
payment arrangement, any cumulative expense recognised will be reversed.

2 4 . 5 MODIFICATIONS, CANCELLATIONS
AND SETTLEMENTS

Sometimes an entity might choose to modify or cancel a share-based payment agreement

before it vests. This may occur because the share price of an equity instrument has dropped
so far below the exercise price that it is unlikely that it will ever be exercised or because the
vesting conditions have become too onerous. In such cases, an entity may replace the original
vesting conditions with less onerous conditions.

This section discusses the requirements of HKFRS 2 in relation to modifications,

cancellations and settlements.

24.5.1 Modifications
HKFRS If an entity modifies an equity-settled share-based payment agreement, it must recognise, at a
2.27 minimum, the cost of the original agreement as if it had not been modified. The incremental
effects of a modification to an equity-settled share-based payment agreement are accounted
for in accordance with Exhibit 24.9.

An entity may also modify a share-based payment agreement in a way that results in a
change in classification from an equity-settled share-based payment arrangement to a cash-
settled share-based payment arrangement (or vice versa). Modifications of this nature are
outside the scope of this chapter.

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Type of modification If beneficial to employee If not beneficial to

employee
A change in the fair If the modification results in an increase If the modification results in a
HKFRS value of the equity in the fair value, then the entity must decrease in the fair value, then
2.B44(a) instruments granted include the incremental fair value over ignore.
HKFRS the modified vesting period, measured at
2.B43(a) the date of modification.
A change in the number If the modification increases the number If the modification decreases the
of equity instruments of equity instruments granted, then the number of equity instruments
HKFRS granted entity must recognise the fair value of the granted, then apply cancellation
2.B44(b)
additional equity instruments granted rules for the equity instruments
HKFRS over the modified vesting period, cancelled. (Cancellations are
2.B43(b) measured at the date of modification. discussed in Section 25.5.2.)
Other modifications (e.g. If the vesting period is reduced or a If the vesting period is increased
HKFRS a change to a service or non-market condition is removed, then or a non-market condition is
2.B44(c) non-market condition) the entity must take this into account added, then ignore.
HKFRS when applying the process outlined in
2.B43(c) Section 24.3.

EXHIBIT 24.9 Accounting for modifications to equity-settled share-based payment agreements

Illustrative Example 11 – Adapted from HKFRS 2 Illustrative

Guidance Example 7
On 1 April 20X6, Pink Limited (Pink) granted 100 share options to each of its 500
employees, with the condition the employees remain employed for the next three years
(until 31 March 20X9). The fair value of the share options at grant date is HK$15.

March 20X7 – end of year 1

During the year ended 31 March 20X7, 40 employees left, and Pink estimates 70 more
employees will leave during years 2 and 3.

Pink will calculate its remuneration expense for year 1 as follows:

100 × 500 – 110 × HK$15 × 1/3 years = HK$195,000

Number of Number of Number of Fair value Portion of Remuneration

equity employees employees of equity service expense for
instruments at grant date currently instrument period that year 1
granted to expected to at grant date has been met
each depart before
employee vesting date
(40 + 70)

31 March 20X8 – end of year 2

Due to a fall in the share price since 1 April 20X6, Pink decided to reprice the share options on
1 April 20X7. At this date, the fair value of the original share options granted is HK$5, and the
fair value of the repriced options is HK$8. The vesting date for the repriced share options is the
same as the original share options (i.e. 31 March 20X9).

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During the year ended 31 March 20X8, 30 employees left, and Pink estimates 35 more
employees will leave during year 3.

Pink will calculate its remuneration expense for year 2 as follows:

Original options

100 × 500 – 105 × HK$15 × 2/3 years – HK$195,000 = HK$200,000

Number of Number of Number of Fair value Portion of Remuneration Remuneration

equity employees employees of equity service expense for expense for
instruments at grant date currently instrument period that year 1 year 2 for
granted to expected to at grant date has been met original share
each depart before options
employee vesting date
(40 + 30 + 35)

Repriced options

100 × 500 – 105 × HK$3 × 1/2 years = HK$59,250

Number of Number of Number of Incremental Portion of Remuneration

equity employees employees value per remaining expense for
instruments at grant date currently share option service period year 2 for
granted to expected to ($8–$5) at date of repriced share
each depart before repricing options
employee vesting date
(40 + 30 + 35)

The incremental fair value of HK$3 is the difference between the fair value of the modified
HKFRS equity instrument and that of the original equity instrument, both estimated at the date of the
2.B43(a) modification.

Total remuneration expense

HK$200,000 + HK$59,250 = HK$259,250

Remuneration Remuneration Total

expense for expense for remuneration
year 2 for year 2 for expense for
original share repriced share year 2
options options

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31 March 20X9 – end of year 3

During the year ended 31 March 20X9, 28 employees left.

Pink will calculate its remuneration expense for year 3 as follows:

100 × 500 – 103 × HK$18 – HK$454,250 = HK$260,350

Number of Number of Number of Fair value Remuneration Remuneration

equity employees employees of original expense for expense for
instruments at grant who departed share options year 1 + 2 year 3
granted to date before plus incremental (cumulative)
each vesting date fair value
employee (40 + 30 + 28) of repriced
options (15 +3)

The calculations over the three-year vesting period are recognised as follows:

Year Calculation Remuneration Equity at end of

expense for the the period
period
HK$ HK$
31 March 20X7 100 × (500 − 110) × HK$15 × 1/3 195,000 195,000
31 March 20X8 100 × (500 − 105) × HK$HK15 × 259,250 454,250
2/3 +
100 × (500 − 105) × HK$3 × 1/2
31 March 20X9 100 × (500 − 103) × HK$18 260,350 714,600

24.5.2 Cancellations and Settlements

Cancellation or settlement of an equity instrument during the vesting period is accounted for as
HKFRS an acceleration of vesting, meaning the entity immediately recognises the remaining amount
2.28(a) that would otherwise have been recognised over the remainder of the vesting period.

If the entity cancels a share-based payment agreement, then employees will most likely
expect to receive some form of compensation for the cancellation. Payments made on the
cancellation of a share-based payment agreement are accounted for in accordance with HKFRS
2.28(b). These requirements are set out in Exhibit 24.10.

Type of share-based payment arrangement

Equity-settled Cash settled

Deduction from equity Expense

(up to the fair value of equity (excess of fair value of equity Extinguishment of
instruments granted, remeasured instruments granted, remeasured the liability
at repurchase
Deduction date)
from equity at repurchase date)

EXHIBIT 24.10 Accounting for payments made on cancellation of a share-based

payment agreement

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HKFRS
If new equity instruments are issued to replace the cancelled equity instruments, they are
2.28(c) accounted for as a modification of the cancelled share-based payment arrangement.

Illustrative Example 12
On 1 April 20X6, Happy Valley Limited (Happy Valley) granted 5,000 share options to its
CFO Henry Leung, with the condition that Henry remains employed for the next three
years (until 31 March 20X9). The fair value of the share options at grant date was HK$20.

31 March 20X7 – end of year 1

Happy Valley will calculate its remuneration expense for year 1 as follows:

5,000 × HK$20 × 1/3 years = HK$33,333

Number of Fair value Portion of Remuneration

equity of equity service period expense for
instruments instrument that has year 1
granted determined at been met
grant date

31 March 20X8 – end of year 2

By 31 March 20X8, the fair value of the share options has increased to HK$27. Happy Valley
offers to cancel the arrangement by paying a pro-rata compensation payment to Henry based
on the current fair value of the share options. Henry accepts the offer, and payment is made on
31 March 20X8.

Happy Valley will calculate its remuneration expense for year 2 as follows:

HK$100,000 – HK$33,333 = HK$66,667

Total expense Remuneration Remuneration

under expense for expense for
arrangement year 1 year 2
(5,000 × HK$20)

Happy Valley will calculate its compensation payment to Henry as follows:

5,000 × HK$27 × 2/3 years = HK$90,000

Number of Fair value Portion of Compensation

equity of equity service period on cancellation
instruments instrument that has
granted at cancellation been met
date

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The journal entries to record the share-based payment at 31 March 20X8 are as follows:

Date Description Debit Credit

HK$ HK$
31.03.X8 Salary and wages expense 66,667
Share-based payment reserve (equity) 66,667
Recognition of accelerated expense on cancellation of share-based payment
arrangement

Date Description Debit Credit

HK$ HK$
31.03.X8 Share-based payment reserve (equity) 90,000
Cash 90,000
Recognition of compensation on cancellation of share-based payment arrangement

Because the compensation paid is less than the fair value of the share options measured at
repurchase date of HK$135,000 (5,000 × HK$27), the entire amount of the payment is recorded
as a deduction (debit) against equity.

In Illustrative Example 12, the share-based payment arrangement was cancelled by the
HKFRS entity. An employee could cancel a share-based payment arrangement. This could occur
2.28A because an employee chooses not to meet a non-vesting condition.

Apply and Analyse 3

On 1 April 20X6, Kowloon Limited (Kowloon) granted 1,000 shares for no consideration to
its COO Michael Jones, with the following conditions:

• Michael remains employed for the next three years (until 31 March 20X9).

• Michael acquires and holds another 1,000 participation shares until the
vesting date.

The fair value of the shares at grant date was HK$10.

On 31 March 20X8, Michael sold the participation shares.

Explain how Kowloon will account for the share-based payment arrangement.

Analysis

For the year ended 31 March 20X7, Kowloon recognises remuneration expense of
HK$3,333 (being 1,000 × HK$10 × 1/3).

The requirement for Michael to hold the participation shares over the vesting period
represents a non-vesting condition. The sale of the participation shares by Michael, on
31 March 20X8, means this non-vesting condition has not been met, which will result in
the cancellation of the share-based payment arrangement under HKFRS 2.28A. As a result
of the cancellation, Kowloon is required to accelerate the recognised amount under the
arrangement. On this basis, Kowloon recognised remuneration expense of HK$6,667
(being HK$10,000 − HK$3,333) for the year ended 31 March 20X8.

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Key Learning Point

Identifying the difference between a cancellation and a forfeiture can be difficult. Being
able to distinguish between these is important because the accounting treatment for each
is different. As discussed earlier in this chapter, when an employee resigns before the end
of the vesting period, the termination of the share-based payment arrangement will be
treated as a forfeiture, which requires the reversal of any amounts recognised under the
arrangement. Conversely, under a cancellation, the entity accelerates the recognition of
any unrecognised amounts.

Knowledge Check Questions

Question 11
Stanley Limited (Stanley) is a company that sells electric bicycles. On 1 April 20X6, Stanley
granted 5,000 share options to each member of its 20-member sales team, with the
following conditions:

• The employees remain employed for the next three years (until 31 march 20x9).
• The sales team sells more than 50,000 electric bicycles over the three-year
vesting period.

The fair value of the share options at grant date was HK$12.
On 31 March 20X8, Stanley increased the sales target to 100,000 units. By 31 March
20X9, 15 employees were still employed, and Stanley had sold 75,000 units.
Identify which of the following is NOT correct.

A The modification to the share-based payment arrangement on 31 March 20X8 will be

ignored when accounting for the arrangement.
B Because the revised sales target units were not met, Stanley will reverse any cumulative
expense at 31 March 20X9.
C Even though the revised sales target was not met, Stanley must recognise a cumulative
expense of HK$900,000 over the three-year vesting period.
D The share options will be forfeited because the revised sales target was not met.

Question 12
On 1 April 20X6, Shek O Limited (Shek O) granted 1,000 share options to its COO Sandy
Lau, with the condition that Sandy remains employed for the next three years (until 31
March 20X9). The fair value of the share options at grant date was HK$15.
By 31 March 20X8, the fair value of the share options had increased to HK$20 and was
projected to increase further over the next twelve months. Shek O offered to cancel the
arrangement by paying Sandy HK$25,000. Sandy accepted the offer, and payment was
made on 31 March 20X8.
Prepare the the journal entry to record the compensation paid to Sandy at 31
March 20X8.

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2 4 . 6 SHARE-BASED PAYMENT TRANSACTIONS

WITH CASH ALTERNATIVES

Some share-based payment arrangements may provide the entity or the counterparty with the
HKFRS choice of having the transaction settled in cash (or other assets) or by the issue of equity
2.34 instruments.

The accounting treatment for such share-based payment arrangements depends on which
party has the choice of settlement. Exhibit 24.11 summarises these treatments.

Who has choice of settlement?

Counterparty has choice Entity has choice

Does the entity have an

obligation to deliver cash
or other assets?

YES NO

Treat as a compound Treat as cash Treat as equity

financial instrument settled settled

EXHIBIT 24.11 Share-based payment arrangements with

a choice of settlement

Each of these scenarios is discussed in detail in the following section.

24.6.1 Share-based Payment Transactions in Which the Terms

of the Arrangement Provide the Counterparty with a Choice
of Settlement
If the counterparty has the right to choose whether the share-based payment arrangement is
settled in cash (or other assets) or by issuing equity instruments, a compound financial
instrument arises. The debt component represents the counterparty’s right to demand
HKFRS payment in cash, and the equity component represents their right to demand settlement in
2.35 equity instruments.

24.6.1.1 Measurement
Measurement of the equity component of the compound financial instrument depends on
whether the counterparty is an employee or non-employee (Exhibit 24.12).

Where the counterparty is a non-employee, the fair value of the compound financial
instrument is determined by reference to the fair value of the goods or services received, and
the equity component is calculated as the difference between the fair value of the instrument
HKFRS as a whole and the fair value of the debt component. Measurement of all components takes
2.35 place on the date that the goods or services are received.

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Fair value of
Fair value of
compound financial – debt component = Equity component
instrument

EXHIBIT 24.12 Measurement of equity component

where the counterparty is a non-employee

Where the counterparty is an employee, the equity component is calculated as the

HKFRS
difference between the fair value of the equity alternative and the fair value of the cash
2.36–37 alternative, measured at grant date (Exhibit 24.13).

Fair value of Fair value of

equity alternative – cash alternative = Equity component

EXHIBIT 24.13 Measurement of equity component

where the counterparty is an employee

This differing treatment, depending on whether the counterparty is an employee or

non-employee, arises because the fair value of services received from employees cannot be
reliably measured.

24.6.1.2 Accounting Over the Term of the Share-based Payment Arrangement

Over the term of the share-based payment arrangement, an entity is required to separately
HKFRS account for each component of the compound financial instrument, as shown in Exhibit 24.14,
2.38 regardless of whether the counterparty is an employee or non-employee:

Accounted for in accordance with the requirements

Equity
applying to equity-settled share-based payment
component
transactions (see Section 24.3)

Accounted for in accordance with the requirements

Debt
applying to cash-settled share-based payment
component
transactions (see Section 24.4)

EXHIBIT 24.14 Accounting for components of a compound

financial instrument in a share-based payment arrangement

24.6.1.3 Accounting on the Settlement Date

HKFRS
2.39 On settlement, the debt component is required to be remeasured to fair value.

HKFRS The accounting treatment on the settlement depends on whether the counterparty decides
2.39-40 to take settlement in cash or shares. Exhibit 24.15 summarises these treatments.

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Method of settlement

Cash Equity

The debt component

The equity component
The cash payment is transferred directly to
remains within equity
applied in settlement of equity, as consideration
(but may be transferred
the debt component for equity instruments
within equity)
issued

EXHIBIT 24.15 Settlement of share-based payment arrangements

where the counterparty has a choice of settlement

Illustrative Example 13 – Adapted from HKFRS 2 Illustrative Guidance

Example 13
On 1 April 20X6, Crimson Limited (Crimson) granted its Managing Director, John Tang, the
right to choose either 5,000 phantom shares (i.e. a right to a cash payment equivalent
to the value of 5,000 shares) or 6,000 ordinary shares. The grant is conditional on John
remaining employed for the next three years (until 31 March 20X9).

If John chooses the share alternative, he must hold the shares until at least 31 March 20Y2.

The share price of the ordinary shares at grant date was HK$50 per share. After taking
into consideration the post-vesting transfer restrictions, Crimson estimates the grant date
fair value of the equity alternative to be HK$48 per share.

Calculation of the fair value of the equity component at grant date is as follows:

Fair value of equity alternative 6,000 ordinary shares × HK$48 $288,000

Fair value of cash alternative 5,000 phantom shares × HK$50 $250,000
Fair value of equity component $38,000

31 March 20X7 – end of year 1

The share price of the ordinary shares on 31 March 20X7 was HK$52 per share.

Crimson will calculate its remuneration expense for year 1 as follows:

The journal entry to record the share-based payment on 31 March 20X7 is as follows:

5,000 × HK$52 × 1/3 years + 38,000 × 1/3 years = HK$99,334

Number of Fair value Portion of Equity Portion of Remuneration

phantom of ordinary service period component service period expense for
shares shares at that has that has year 1
end of year 1 been met been met

Debt component = HK$86,667 Equity component = HK$12,667

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Date Description Debit Credit

31.03.X7 Salary and wages expense 99,334
Share-based payment liability 86,667
Share-based payment reserve (equity) 12,667
Recognition of share-based payment arrangement with settlement choice

31 March 20X8 – end of year 2

The share price of the ordinary shares on 31 March 20X8 was HK$55 per share.

Crimson will calculate its remuneration expense for year 2 as follows:

5,000 × HK$55 × 2/3 years + 38,000 × 2/3 years – HK$99,334 = HK$109,332

Number of Fair value Portion of Equity Portion of Remuneration Remuneration

phantom of ordinary service period component service period expense for expense for
shares shares at that has that has year 1 year 2
end of year 2 been met been met

Debt component = HK$183,333 Equity component = HK$25,333

The journal entry to record the share-based payment at 31 March 20X8 is as follows:

Date Description Debit Credit

HK$ HK$
31.03.X8 Salary and wages expense 109,332
Share-based payment liability 96,666
Share-based payment reserve (equity) 12,666
Recognition of share-based payment arrangement with settlement choice

31 March 20X9 – end of year 3

The share price of the ordinary shares on 31 March 20X9 was HK$60 per share.

Crimson will calculate its remuneration expense for year 3 as follows:

5,000 × HK$60 + 38,000 – HK$208,666 = HK$129,334

Number of Fair value Equity Remuneration Remuneration

phantom of ordinary component expense for expense for
shares shares at year 1 + 2 year 3
end of year 3

Debt component = HK$300,000

The journal entry to record the remuneration expense under the share-based payment
arrangement on 31 March 20X9 is as follows:

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Date Description Debit Credit

HK$ HK$
31.03.X9 Salary and wages expense 129,334
Share-based payment liability 116,667
Share-based payment reserve (equity) 12,667
Recognition of share-based payment arrangement with settlement choice

If John chooses to receive cash, the following entry will be made on 31 March 20X9:

Date Description Debit Credit

HK$ HK$
31.03.X9 Share-based payment liability 300,000
Cash 300,000
Cash settlement of share-based payment

In this event, the options will lapse. The amount in the share-based payment reserve
account can remain in that account or be transferred to retained earnings, depending on the
entity’s accounting policy.

If John chooses to receive ordinary shares the following entry will be made on 31 March 20X9:

Date Description Debit Credit

HK$ HK$
31.03.X9 Share-based payment liability 300,000
Share-based payment reserve (equity) 300,000
Equity settlement of share-based payment

The calculations over the three-year vesting period can be summarised as follows:

Liability component

Year Calculation Remuneration Liability at end of

expense for the the period
period
HK$ HK$
31 March 20X7 5,000 × HK$52 × 1/3 86,667 86,667
31 March 20X8 5,000 × HK$55 × 2/3 96,666 183,333
31 March 20X9 5,000 × HK$60 116,667 300,000

Equity component

Year Calculation Remuneration Equity at end of the

expense for the period
period
HK$ HK$
31 March 20X7 HK$38,000 × 1/3 12,667 12,667
31 March 20X8 HK$38,000 × 2/3 12,666 25,333
31 March 20X9 HK$38,000 12,667 38,000

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Compound financial instrument (total)

Year Remuneration Remuneration Total remuneration

expense on liability expense on equity expense
component component
HK$ HK$ HK$
31 March 20X7 86,667 12,667 99,334
31 March 20X8 96,666 12,666 109,332
31 March 20X9 116,667 12,667 129,334

24.6.2 Share-based Payment Transactions in Which the Terms

of the Arrangement Provide the Entity with a Choice of Settlement
As presented in Exhibit 24.11, in cases where the entity has the choice of settlement, the
accounting treatment depends on whether or not the entity has a present obligation to
deliver cash.

If, and to the extent that the entity has incurred a liability to settle in cash, the transaction
HKFRS will be accounted for as a cash-settled share-based payment transaction in accordance with the
2.42 guidance set out in Section 24.4.

If, and to the extent that no such liability has been incurred, the transaction will be
HKFRS accounted for as an equity-settled share-based payment transaction in accordance with the
2.43 guidance set out in Section 24.3.

HKFRS When determining whether an obligation can deliver cash, consideration is given to factors,
2.41 such as the entity’s stated policy and past practice.

Where the transaction is classified as an equity-settled transaction the accounting

treatment on the settlement is summarised in Exhibit 24.16.

Has the entity selected the settlement alternative with the higher fair value at
the date of settlement?

No Yes

Entity elects to settle Entity elects to settle in

in cash equity instruments

No further accounting
Accounted for as a
required (other than a Recognise an additional
repurchase of an equity
possible transfer from expense for the excess
instrument (as a
one component of value given
deduction from equity)
equity to another)

EXHIBIT 24.16 Settlement of share-based payment transaction where the entity has
choice of settlement and the transaction is classified as an equity-settled share-
based payment transaction

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Apply and Analyse 4

On 1 April 20X8, Beige Limited (Beige) granted a share-based payment to its Finance
Director Claudia Matthews, with the condition that Claudia remains employed for the
next 12 months (until 31 March 20X9). On 1 April 20X9, Beige will have the choice of
settling in cash or by issuing equity instruments. On 1 April 20X8, Beige has no intention
of settling in cash.

Fair values on 1 April 20X8 and 20X9 are as follows:

1 April 20X8 1 April 20X9

Cash alternative HK$30,000 HK$36,000
Equity alternative HK$35,000 HK$39,000

Prepare the journal entries on 31 March 20X8 and 1 April 20X9 based on the following:

(a) Beige chooses to settle in cash

(b) Beige chooses to settle by issuing equity instruments

Analysis

Because Beige has no intention of settling in cash on the grant date, the transaction is
accounted for as an equity-settled share-based payment transaction.

Based on this, the entry on 1 April 20X8, regardless of how the transaction will actually
be settled, is as follows:

Date Description Debit Credit

HK$ HK$
1.04.X8 Salary and wages expense 35,000
Share-based payment reserve (equity) 35,000
Recognition of equity-settled share-based payment arrangement

The entry on 1 April 20X9 (settlement date) will depend on how Beige chooses to settle.

Settlement in cash

Given that the fair value of the cash alternative is lower than the fair value of the equity
alternative on the settlement date, the settlement will be accounted for as the repurchase
of an equity instrument (refer to Exhibit 24.16).

The journal entry required on 1 April 20X9 would be as follows:

Date Description Debit Credit

HK$ HK$
01.04.X9 Share-based payment reserve (equity) 36,000
Cash 36,000
Settlement of equity-settled share-based payment transaction in cash

Settlement by issuing equity instruments

Given that the fair value of the equity alternative is higher than the fair value of the cash
alternative at the settlement date, the settlement will result in the recognition of an

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 FINANCIAL REPORTING

Apply and Analyse 4 (continued)

expense for the additional value (refer to Exhibit 24.16).

The journal entry required on 1 April 20X9 would be as follows:

Date Description Debit Credit

HK$ HK$
01.04.X9 Salary and wages expense 3,000
Share-based payment reserve (equity) 3,000
Recognition of additional expense on the settlement

Knowledge Check Question

Question 13
On 1 April 20X8, Baci Limited (Baci) granted a share-based payment to its Finance Director
Luca Martens, with the condition that Luca remain employed for the next 12 months (until
31 March 20X9). On 1 April 20X9, Baci will have the choice of settling in cash or by issuing
equity instruments. On 1 April 20X8, Baci has no intention of settling in cash.
Fair values on 1 April 20X8 and 20X9 are as follows:

1 April 20X8 1 April 20X9

Cash alternative HK$30,000 HK$38,000
Equity alternative HK$35,000 HK$36,000

On 1 April 20X9, Baci decides to settle by issuing equity instruments.

Identify which of the following statements correctly describes the impact on salary and
wages expense on the settlement date.
A There will be no impact on the salary and wages expense on the settlement date.
B Baci will recognise HK$1,000 salary and wages expense on the settlement date for the
increase in the fair value of the equity.
C Baci will recognise HK$2,000 salary and wages expense on the settlement date for the
difference between the fair value of the cash alternative and equity alternative on the
settlement date.
D Baci will recognise HK$3,000 salary and wages expense on the settlement date for the
difference between the fair value of the equity alternative at grant date and the cash
alternative on the settlement date.

2 4 . 7 SHARE-BASED PAYMENT TRANSACTIONS

AMONG GROUP ENTITIES

In consolidated groups, the group commonly operates a single employee share scheme
that covers several subsidiaries. Such transactions affect the separate (individual) financial
statements of the parent, subsidiary and the consolidated financial statements of the group.

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Three common scenarios include the following:

1. Share-based payment transactions where a parent entity grants its own equity
instruments to employees of a subsidiary;

2. Share-based payment transactions where a subsidiary grants its employees rights to

equity instruments of the parent; and

3. Share-based payment transactions where a parent entity pays cash to the subsidiary’s
employees based on the share price of the parent’s equity instruments.

As a general principle, the entity receiving the goods or services measures the goods or
services received as an equity-settled share-based payment transaction when:

(a) The awards granted are its own equity instruments, or

HKFRS
2.43B (b) The entity has no obligation to settle the share-based payment transaction.

Each of these are discussed in the following section.

24.7.1 Share-based Payment Transactions Where a Parent Entity Grants

Its Own Equity Instruments to Employees of a Subsidiary
The first type of share-based transaction among group entities we discuss is a transaction
where a parent entity grants its own equity instruments to employees of a subsidiary.

Illustrative Example 14
Consider the following scenario for the P Limited Group:

o P issu
ares t e
emplo s shares t
es sh P Limited
P issu yees of S1 yees o
emplo of S2

S1 Limited S2 Limited
Employees Employees
provide provide
services to S1 services to S2

P Limited, the parent of the P Limited Group grants shares to the employees of S1 and
S2. The grants are conditional on the employees remaining employed by S1 and S2 for at
least two years after the grant date.

This transaction will affect the consolidated and separate (individual) financial
statements as follows:

Financial statements How affected

P Limited Group As the group is receiving the services and issuing the equity instruments,
consolidated financial the transaction will be reflected in the consolidated financial statements
statements as an equity-settled share-based payment (and the treatment will be
consistent with that discussed in Section 24.3).
P Limited separate Even though P Limited does not receive the services directly, this is still
financial statements an equity-settled share-based payment transaction for P Limited because
HKFRS 2.43C, (the ‘settling’ entity) it is issuing equity instruments and the receiving entity is part of the
HKFRS 2.B54 same group.
S1 and S2 Limited Even though S1 and S2 Limited are not issuing equity instruments, this
HKFRS 2.43B, individual financial is still an equity-settled share-based payment transaction for S1 and S2
HKFRS 2.B53 statements (the Limited because the shares are being issued by another group entity.
‘receiving’ entities)

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 FINANCIAL REPORTING

Apply and Analyse 5 – Adapted from HKFRS 2 Illustrative Guidance

Example 14
On 1 April 20X8, Tangerine Limited (Tangerine) granted 200 shares to each of 100
employees of its subsidiary Tangelo Limited (Tangelo). The grant is conditional on the
employees remaining employed by Tangelo until at least 31 March 20X9.

The fair value of the shares at grant date is HK$30.

On 31 March 20X9, 90 employees were still employed by Tangelo.

Prepare the journal entries at 31 March 20X9 for:

• Tangerine;

• Tangelo; and

• The consolidated financial statements.

Based on the following:

(a) Tangerine does not require Tangelo to pay for the equity instruments needed to
settle the share-based payment transaction; and

(b) Tangerine does require Tangelo to pay for the equity instruments needed to settle
the share-based payment transaction.

Analysis

The parent (Tangerine) and subsidiary (Tangelo) are required to account for this
transaction as an equity-settled share-based payment transaction in accordance with the
requirements covered in Section 24.3 of this chapter.

The value of the share-based payment transaction on 31 March 20X9 is calculated

as follows:

200 × 90 × HK$30 = HK$540,000

Number of Number of Fair value

equity employees of equity
instruments who met instrument
granted service at grant date
to each condition
employee

(a) If Tangerine does not require Tangelo to pay for the equity instruments needed
to settle the share-based payment transaction, the journal entries recorded at
31 March 20X9 will be as follows:

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Apply and Analyse 5 (continued)

In the books of Tangerine (the parent)

Date Description Debit Credit

HK$ HK$
31.03.X9 Investment in Tangelo (subsidiary) 540,000
Share capital (equity) 540,000
Recognition of group equity-settled share-based payment transaction by parent

In the books of Tangelo (the subsidiary)

Date Description Debit Credit

HK$ HK$
31.03.X9 Salary and wages expense 540,000
Equity (contribution by parent) 540,000
Recognition of group equity-settled share-based payment transaction by
subsidiary

The following entry will be recorded in the consolidated financial statements of the
Tangerine Group on 31 March 20X9 in accordance with HKFRS 10 Consolidated Financial
Statements.

Date Description Debit Credit

HK$ HK$
31.03.X9 Equity (contribution by parent) 540,000
Investment in Tangelo (subsidiary) 540,000
Elimination of effects of group share-based payment transaction

(b) If Tangerine does require Tangelo to pay for the equity instruments needed to
settle the share-based payment transaction (in other words, there is a group
recharge), the journal entries recorded at 31 March 20X9 would be as follows:

In the books of Tangerine (the parent)

Date Description Debit Credit

HK$ HK$
31.03.X9 Receivable from Tangelo 540,000
Share capital (equity) 540,000
Recognition of group equity-settled share-based payment transaction by parent

In the books of Tangelo (the subsidiary)

Date Description Debit Credit

HK$ HK$
31.03.X9 Salary and wages expense 540,000
Payable to Tangerine 540,000
Recognition of group equity-settled share-based payment transaction by
subsidiary

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Apply and Analyse 5 (continued)

Though a group recharge exists and Tangelo is required to make a payment to
Tangerine in relation to the share-based payment transaction, it is still classified as an
HKFRS
equity-settled share-based payment transaction by Tangelo because Tangelo is not the
2.43D party issuing the equity-instruments.

The following entries will be recorded in consolidated financial statements of the

Tangerine Group on 31 March 20X9 in accordance with HKFRS 10 Consolidated Financial
Statements.

Date Description Debit Credit

HK$ HK$
31.03.X9 Equity (contribution by parent) 540,000
Investment in Tangelo (subsidiary) 540,000
Elimination of effects of group share-based payment transaction

Date Description Debit Credit

HK$ HK$
31.03.X9 Payable to Tangerine 540,000
Receivable from Tangelo 540,000
Elimination of intragroup payable and receivable arising from share-
based payment transaction

24.7.2 Share-based Payment Transactions Where a Subsidiary Grants Its

Employees Rights to Equity Instruments of the Parent
The second type of share-based transaction among group entities we discuss is where a
subsidiary grants its employees rights to equity instruments of the parent.

Illustrative Example 15
Consider the following scenario for the P Limited Group:

P Limited

Employees Employees
provide provide
services to S1 services to S2
S1 Limited S2 Limited
S1 issues share S2 issues share
options in options in
P to employess P to employess

S1 and S2 Limited, subsidiaries of the P Limited Group, grant share options in P Limited
to their employees. The grants are conditional on the employees remaining employed by
S1 and S2 for at least two years after the grant date.

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Illustrative Example 15 (continued)

This transaction will affect the consolidated and separate (individual) financial
statements as follows:

Financial statements How affected

P Limited Group As the group is receiving the services and issuing the equity instruments,
consolidated financial the transaction will be reflected in the consolidated financial statements
statements as an equity-settled share-based payment (and the treatment will be
consistent with that discussed in Section 24.3).
P Limited separate There is no transaction for P Limited and, therefore, no impact on P
financial statements Limited’s separate financial statements.
(the ‘settling’ entity)
S1 and S2 Limited Though S1 and S2 Limited are not making a cash payment to its
HKFRS
individual financial employees, this is a cash-settled share-based payment transaction for
2.43B(a)–(b), statements (the S1 and S2 Limited because neither of the conditions in paragraph 43B
HKFRS 2.B55 ‘receiving’ entities) have been met.

24.7.3 Share-based Payment Transactions Where a Parent Entity Pays

Cash to the Subsidiary’s Employees Based on the Share Price
of the Parent’s Equity Instruments
The final type of share-based transaction among group entities we discuss is where a parent
entity pays cash to the subsidiary’s employees based on the share price of the parent’s equity
instruments.

Illustrative Example 16
Consider the following scenario for the P Limited Group:

P pay
based s
on th cash to e
of S1
yees struments P Limited e pric m
p lo
to em equity in e of P ployees o
s cash ’s ’s equ f
ity in S2 based
P pay price of P strum
e
on th ents

S1 Limited S2 Limited
Employees Employees
provide provide
services to S1 services to S2

P Limited, the parent of the P Limited Group, grants share appreciation rights to
the employees of S1 Limited and S2 Limited. The grant is conditional on the employees
remaining employed by S1 and S2 for at least two years after the grant date.

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Illustrative Example 16 (continued)

This transaction will affect the consolidated and separate (individual) financial
statements as follows:

Financial statements How affected

P Limited Group As the group is receiving the services and making the cash payment, the
consolidated financial transaction will be reflected in the consolidated financial statements as a
statements cash-settled share-based payment (and the treatment will be consistent
with that discussed in Section 24.4).
P Limited separate Though P Limited does not receive the services directly, this is still a
HKFRS
2.43C,
financial statements cash-settled share-based payment transaction for P Limited because
HKFRS (the ‘settling’ entity) P Limited is making a cash payment based on the price of its equity
2.B58 instruments and the receiving entity is part of the same group.
S1 and S2 Limited Though S1 and S2 are not issuing equity instruments, this is still an
HKFRS
2.43B(b), individual financial equity-settled share-based payment transaction for S1 and S2 because
HKFRS statements (the S1 and S2 do not have an obligation to settle the transaction with their
2.B57
‘receiving’ entities) employees.

Knowledge Check Question

Question 14
Identify which of the following statements is correct in relation to group share-based
payment transactions where a parent issues equity instruments to employees of a
subsidiary.
A The transaction is not a share-based payment transaction for the parent because it is not
the party receiving the services.
B The transaction is not a share-based payment transaction for the subsidiary because it is
not the party issuing the equity instruments.
C The transaction is a share-based payment transaction for the parent and will result in
the parent recognising remuneration expense in respect of services the subsidiary has
received from employees.
D The transaction is a share-based payment transaction for the subsidiary and will result in
the subsidiary recognising an increase in equity.

2 4 . 8 CURRENT AND DEFERRED TAX ARISING

FROM SHARE-BASED PAYMENT
TRANSACTIONS

The impact on current and deferred tax depends on the type of share-based payment
transaction and the tax treatment under Hong Kong tax law.

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24.8.1 Equity-settled Share-based Payment Transactions

24.8.1.1 Income Tax Treatment
The remuneration expense recognised for accounting purposes in an equity-settled share-
based payment transaction is not an outgoing or expense incurred under Hong Kong tax law
and, therefore, is not deductible for tax purposes.

24.8.1.2 Impact on Current and Deferred Tax

As the expense is not deductible, it is not a temporary difference. The annual remuneration
expense must be added back to profit before tax when calculating the current tax liability for
the year. As the difference is not a temporary difference, no impact occurs on deferred taxes.

24.8.2 Cash-settled Share-based Payment Transactions

24.8.2.1 Income Tax Treatment
Remuneration expenses recognised for accounting purposes in a cash-settled share-based
payment transaction (e.g. when an entity issues share appreciation rights) are deductible
when the employee becomes unconditionally entitled to the payment (i.e. at the vesting date).
Remuneration expense arising after the vesting date (due to changes in the intrinsic value of
the rights) is deductible in the year the remuneration expense is recognised.

24.8.2.2 Impact on Current and Deferred Tax

During the vesting period, the annual remuneration expense must be added back to profit
before tax when calculating the current tax liability for the year. A temporary difference will
arise due to the difference between the carrying amount and tax base of the share-based
payment liability (the tax base is zero). This will result in the recognition of a deferred tax asset.

In the year that the equity instruments vest, a deduction is made from profit before tax
based on the carrying amount of the share-based payment liability when calculating the current
tax liability. As the rights are exercised, the temporary difference will reverse, resulting in a
reversal of the deferred tax asset.

24.8.3 Share-based Payment Transactions among Group Entities Where

a Group Recharge

24.8.3.1 Income Tax Treatment

A tax deduction for the recharge is available to the subsidiary when the recharge is made.

The receipt by the parent where there is a group recharge is not assessable to the parent. It
is considered a capital receipt.

24.8.3.2 Impact on Current and Deferred Tax

Prior to the recharge being made, the annual remuneration expense recognised by the
subsidiary must be added back to profit before tax when calculating the current tax liability for
the subsidiary. A temporary difference will arise due to the difference between the carrying
amount and tax base of the payable owing to the parent prior to the recharge (the tax base is
zero). This will result in the recognition of a deferred tax asset, which will be reversed when the
recharge is made.

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24.8.4 Share-based Payment Transactions among Group Entities Where

No Group Recharge Exists

24.8.4.1 Income Tax Treatment

The remuneration expense recognised by the subsidiary for accounting purposes in an equity-
settled share-based payment transaction is not outgoing or expense incurred and, therefore, is
not deductible for tax purposes.

24.8.4.2 Impact on Current and Deferred Tax

Because the expense is not deductible, it is not a temporary difference. The annual remuneration
expense must be added back to profit before tax when calculating the current tax liability for the
year. As the difference is not a temporary difference, there is no impact on deferred taxes.

HKAS 12 Income Taxes provides guidance on current and deferred tax arising from share-
based payment transactions. Specifically, HKAS 12 sets out the accounting treatment that is
HKAS applicable in jurisdictions where an entity is entitled to a tax deduction on remuneration paid in
12.68A–68C shares, share options, or other equity instruments. As previously discussed, such a deduction is
unavailable under Hong Kong tax law and, therefore, these paragraphs do not apply.

Knowledge Check Questions

Question 15
Lemon Limited (Lemon) has an equity-settled share-based payment arrangement with
its employees. The current year salary and wages expense under the arrangement is
HK$400,000, and the cumulative amount in equity is HK$1,000,000. The tax rate is 16.5%.
Identify which of the following statements is correct based on Hong Kong tax rules.
A The salary and wages expense is not deductible for tax purposes and, therefore, is not a
temporary difference.
B The arrangement will result in an increase in Lemon’s deferred tax asset account of
HK$66,000 during the year.
C The arrangement will result in a deferred tax liability of HK$165,000 for Lemon.
D The arrangement will result in a tax deduction of HK$400,000, which will reduce Lemon’s
current tax by HK$66,000 in the current year.

Question 16
Pomelo Limited (Pomelo) has issued share appreciation rights to its employees. The
current year salary and wages expense relating to the issue is HK$400,000, and the
cumulative amount in the share-based payment liability account is HK$1,000,000. The
rights will vest in two-years’ time. The tax rate is 16.5%. Identify which of the following
statements is correct based on Hong Kong tax rules.
A The salary and wages expense is not deductible for tax purposes and is, therefore, not a
temporary difference.
B The arrangement will result in an increase in Pomelo’s deferred tax asset account of
HK$66,000 during the year.
C The arrangement will result in a deferred tax liability of HK$165,000 for Pomelo.
D The arrangement will result in a tax deduction of HK$400,000, which will reduce
Pomelo’s current tax by HK$66,000 in the current year.

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2 4 . 9 DISCLOSURES

The three principles in Exhibit 24.17 underpin the disclosure requirements in HKFRS 2.

Disclosure principle HKFRS 2 paragraphs

The nature and extent of share-based payment arrangements 44–45
How the fair value of goods or services received, or the fair value of equity 46–49
instruments granted during the period, was determined
The effect of share-based payment transactions on the entity’s profit or loss 50–52
for the period and on its financial position

EXHIBIT 24.17 Principles underpinning HKFRS 2 disclosure requirements

Each of these principles is discussed separately in the following section.

24.9.1 Nature and Extent of Share-based Payment Arrangements

An objective of the disclosure requirements in HKFRS 2 is to provide information to assist
HKFRS financial report users to understand the nature and extent of share-based payment
2.44 arrangements that existed during the reporting period.

Paragraph 45 specifies the disclosures necessary to give effect to this principle.

Exhibit 24.18 summarises these requirements.

HKFRS 2 paragraph Disclosure

45(a) A description of each type of share-based payment arrangement that

existed during the period, including general terms and conditions, vesting
requirements, the maximum term and method of settlement.

45(b) The number and weighted average exercise price of share options for each
of the following groups:
(i) Outstanding at the beginning of the period;
(ii) Granted during the period;
(iii) Forfeited during the period;
(iv) Exercised during the period;
(v) Expired during the period;
(vi) Outstanding at the end of the period; and
(vii) Exercisable at the end of the period.

45(c) Weighted average share price of all share options exercised during the period.

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

EXHIBIT 24.18 Disclosure requirements in relation to the nature and extent of share-based
payment arrangements

Exhibit 24.19 shows an extract of the disclosure made by Tencent Holdings Limited in its
2018 Annual Report in response to these requirements.

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HKFRS 2.45(a) disclosure

33 SHARE-BASED PAYMENTS
(a) Share option schemes

The Company has adopted five share option schemes, namely, the Pre-IPO Option
Scheme, the Post-IPO Option Scheme I, the Post-IPO Scheme II, the Post-IPO Option
Scheme III and the Post-IPO Option Scheme IV.

The Pre-IPO Option Scheme, the Post-IPO Option Scheme I and the Post-IPO Option
Scheme II expired on 31 December 11, 23 March 2014 and 16 May 2017, respectively. On
the expiry of these schemes, no further options would be granted under these schemes,
but the options granted prior to such expiry continued to be valid and exercisable in
accordance with provision of the schemes.

In respect of the Post-IPO Option Scheme III and the Post-IPO Option Scheme IV that
continue to be in force, the Board may, at its discretion, grant options to any qualifying
participants to subscribe for shares in the Company, subject to the terms and conditions
stipulated therein. The exercise price must be in compliance with the requirement under
the Rules Goveming the Listing of Securities on the Stock Exchange. In addition, the
option vesting period is determined by the Board provided that it is not later than the
last day of a 10-year period for the Post-IPO Option Scheme III and a 7-year period for the
Post-IPO Option Scheme IV after the date of grant of option.

HKFRS 2.45(b) disclosure

33 SHARE-BASED PAYMENTS (Cont’d)

(a) Share option schemes (Cont’d)

(i) Movement in share options

Movements in the number of share options outstanding and their related weighted
average exercise prices are as follows:

Post-IPO Post-IPO Option Post-IPO Option Total

Scheme II Scheme III Scheme IV
Average No. of Average No. of Average No. of No. of
exercise options exercise options exercise options options
price price price
HK$ HK$ HK$ HK$ HK$ HK$ HK$
At 1 January 179.90 55,510,248 31.70 2,500,000 273.80 9,155,860 67,166,108
2018
Granted – – – – 405.73 27,723.850 27,723,850
Exercised 110.85 (3,966,835) 31.70 (2,500,000) 272.36 (424,414) (6,891,249)
Lapsed/ 136.67 (44,403) – – 298.36 (178,062) (222,465)
forfeited
At 31 185.25 51,499,010 – – 374.52 36,277,234 87,776,244
December
2018
Exercisable
as at
31 December 160.50 22,419,156 – – 274.86 1,760,025 24,179,181
2018

EXHIBIT 24.19 Tencent Holdings Annual Report 2018 disclosures on nature and extent of share-
based payment arrangements

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Post-IPO Post-IPO Option Post-IPO Option Total

Scheme II Scheme III Scheme IV
Average No. of Average No. of Average No. of No. of
exercise options exercise options exercise options options
price price price
HK$ HK$ HK$ HK$ HK$ HK$ HK$
At 1 January 120.95 31,247,436 31.70 2,500,000 – – 33,747,436
2017
Granted 225.44 28,526,215 – – 273.79 9,219,035 37,745,250
Exercised 49.05 (4,102,812) – – – – (4,102,812)
Lapsed/ 142.65 (160,591) – – 272.36 (63,175) (223,766)
forfeited
At 31 179.90 55,510,248 31.70 2,500,000 273.80 9,155,860 67,166,108
December
2017
Exercisable
as at
31 December 118.70 13,152,006 31.70 1,250,000 – – 14,402,006
2017

During the year ended 31 December 2018, 3,215,800 options were granted to an
executive director of the Company (2017: 5,250,000) options were granted to an executive
director of the Company).

HKFRS 2.45(c) disclosure

As a result of the options exercised during the year ended 31 December 2018, 6,891,249
ordinary shares (2017: 4,102,812 ordinary shares) were issued by the Company (Note
31). The weighted average price of the shares at the time these options were exercised
was HK$399.37 per share (equivalent to approximately RMB325.67 per share) (2017:
HK$286.46 per share (equivalent to approximately RMB248.41 per share)).

HKFRS 2.45(d) disclosure

33 SHARE-BASED PAYMENTS (Cont’d)

(a) Share options schemes (Cont’d)

(ii) Outstanding share options

Details of the expiry dates, exercise prices and the respective numbers of share options
which remained outstanding as at 31 December 2018 and 2017 are as follows:

Number of share options

Expiry Date Range of exercise 31 December 31 December
price 2018 2017
HK$ HK$ HK$
7 years commencing from the date of 37.80–49.76 22,875 1,633,050
grant of options 112.30–174.86 23,504,535 25,386,768
(Post-IPO Option Scheme II and 225.44–272.36 36,475,949 37,556,725
Post-IPO Option Scheme IV) 354.00–386.60 5,191,480 –
403.16–444.20 22,581,405 89,565
87,776,244 64,666,108

EXHIBIT 24.19 (continued)

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Number of share options

Expiry Date Range of exercise 31 December 31 December
price 2018 2017
HK$ HK$ HK$
10 years commencing from the date of
grant of options
(Post-IPO Option Scheme III) 31.70 – 2,500,000
87,776,244 67,166,108

The outstanding share options as of 31 December 2018 were divided into two to five tranches on an equal basis as
at their grant dates. The first tranche can be exercised after a specified period ranging from ten months to three
years from the grant date, and then the remaining tranches will become exercisable in each subsequent year.

Source: Tencent Holdings Annual Report 2018 (http://cdc-tencent-com-1258344706.image.myqcloud.com/storage/

uploads/2019/11/09/da62661e976ea6cf64551dc5cdf079ea.pdf).

EXHIBIT 24.19 (continued)

24.9.2 Determination of Fair Value

Another objective of the disclosure requirements in HKFRS 2 is to provide information to assist
HKFRS financial report users to understand how the fair value of goods or services received, or the fair
2.46 value of equity instruments granted, during the period was determined.

Where the fair value of goods or services has been measured indirectly (i.e. by reference
to the fair value of the equity instruments granted), paragraph 47 requires the disclosures in
Exhibit 24.20.

HKFRS 2 paragraph Disclosure

47(a) 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, including:
(i) The option pricing model used and inputs to that model, including
weighted average share price, exercise price, expected volatility,
option life, expected dividends, the risk-free interest rate and any
other relevant inputs;
(ii) How expected volatility was determined; and
(iii) Whether and how other features of the option grant were
incorporated into the measurement of fair value, such as a market
condition.

47(b) For other equity instruments granted (other than share options), the
number and weighted average fair value of those equity instruments at
the measurement date, along with information on how that fair value was
measured, including:
(i) If the fair value was not determined on the basis of an observable
market, how it was determined;
(ii) Whether and how expected dividends were incorporated into the
measurement of fair value; and
(iii) Whether and how other features of the equity instruments granted
were incorporated into the measurement of fair value.

EXHIBIT 24.20 Disclosure requirements in relation to the determination of fair values for
share-based payment arrangements

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HKFRS 2 paragraph Disclosure

47(c) For share-based payment arrangements modified during the period:

(i) An explanation of the modifications;
(ii) The incremental fair value granted (because of those
modifications); and
(iii) Information on how the incremental fair value was measured.

EXHIBIT 24.20 (continued)

Exhibit 24.21 shows an extract of the disclosure made by Tencent Holdings Limited in its
2018 Annual Report in response to these requirements.

HKFRS 2.47(a) disclosure

(iii) Fair value of options

The directors of the company have used the Binomial Model to determine the fair value
of the options as at the respective grant dates, which is to be expensed over the relevant
vesting period. The weighted average fair value of options granted during the year ended
31 December 2018 was HK$127.43 per share (equivalent to approximately RMB103.46
per share) (2017: HK$71.30 per share (equivalent to approximately RMB62.86 per share)).

Other than the exercise price previously mentioned, significant judgment on

parameters, such as risk free rate, dividend yield and expected volatility, are required to be
made by the directors in applying the Binomial Model, which are summarised as below.

2018 2017
Weighted average share price at the grant date HK$405.00 HK$236.88
Risk free rate 1.77%–2.27% 1.39%–1.68%
Dividend yield 0.24%–0.25% 0.26%–0.34%
Expected volatility (Note) 30.00% 30.00%
Note: The expected volatility, measured as the standard deviation of expected share price returns,
is determined based on the average daily trading price volatility of the shares of the Company.

Source: Tencent Holdings Annual Report 2018 (http://cdc-tencent-com-1258344706.image.myqcloud.com/­

storage/uploads/2019/11/09/da62661e976ea6cf64551dc5cdf079ea.pdf).

EXHIBIT 24.21 Tencent Holdings Annual Report 2018 disclosures on determination of fair values
for share-based payment arrangements

24.9.3 Effect on Profit or Loss and Financial Position

The final objective of the disclosure requirements in HKFRS 2 is to provide information to assist
HKFRS financial report users to understand the effects of share-based payment transactions on the
2.50 entity’s profit or loss for the period and on its financial position.

To give effect to the preceding principle, paragraph 51 requires the disclosures in

Exhibit 24.22.

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HKFRS 2 paragraph Disclosure

51(a) Total expense recognised for the period arising from share-based payment
transactions, including separate disclosure of the portion arising from equity-
settled share-based payment transactions.
51(b) For liabilities arising from share-based payment transactions:
(i) The total carrying amount at the end of the period; and
(ii) The total intrinsic value at the end of the period for liabilities for
which the counterparty’s right to cash had vested by the end of the
reporting period (e.g. share appreciation rights).

EXHIBIT 24.22 Disclosure requirements in relation to the effect on profit or loss and financial position

Exhibit 24.23 shows an extract of the disclosure made by Tencent Holdings Limited in its
2018 Annual Report in response to these requirements.

HKFRS 2.51(a) disclosure

13 EMPLOYEE BENEFITS EXPENSES

2018 2017
RMB’Million RMB’Million
Wages, salaries and bonuses 28,236 24,194
Contributions to pension plans (Note) 2,553 1,934
Share-based compensation expenses 7,900 6,253
Welfare, medical and other expenses (Note) 3,355 2,400
Training expenses 109 85
42,153 34,866
Source: Tencent Holdings Annual Report 2018 (http://cdc-tencent-com-1258344706.image.
myqcloud.com/storage/uploads/2019/11/09/da62661e976ea6cf64551dc5cdf079ea.pdf).

EXHIBIT 24.23 Tencent Holdings Annual Report 2018 disclosures on effect of profit and loss and
financial position for share-based payment arrangements

Knowledge Check Question

Question 17
Identify which of the following disclosures are NOT required by HKFRS 2.
A An entity’s policy on accounting for share-based payments.
B Total expense recognised for the period arising from share-based payment transactions,
including separate disclosure of the portion arising from equity-settled share-based
payment transactions.
C A description of each type of share-based payment arrangement that existed during the
period, including general terms and conditions, vesting requirements, the maximum term
and method of settlement.
D 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.

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SUMMARY

• HKFRS 2 Share-based Payment deals with the recognition and measurement of share-based
payment transactions. A share-based payment is an arrangement in which an entity receives
or acquires goods or services as consideration for, or based on the price of, its own equity
instruments.

• Share-based payment transactions result in an entity recognising an expense, unless the

goods or services received qualify for recognition as an asset.

• Share-based-payment transactions can be equity-settled or cash-settled. An equity-settled

share-based payment transaction is one in which the entity issues equity instruments as
consideration for goods or services received. A cash-settled share-based payment transaction
is one where the entity incurs a liability to transfer cash (or other assets) for amounts based
on the value of equity instruments.

• The measurement of an equity-settled share-based payment transaction depends on whether

the counterparty is an employee or non-employee. Where the counterparty is an employee,
the transaction is measured by reference to the fair value of the equity instruments granted
at the grant date. Where the counterparty is a non-employee the transaction is measured by
reference to the fair value of the goods or services received.

• Cash-settled share-based payment transactions are measured at the fair value of the liability
and are remeasured at the end of each reporting period, and on the settlement date.

• Where a share-based payment arrangement includes a service condition and/or a non-market

performance condition, the annual expense is calculated based on the number of equity
instruments expected to vest.

• Market performance conditions and non-vesting conditions within a share-based payment

arrangement are reflected in the grant date fair value of the instrument.

• Where a share-based payment arrangement is modified in a way that is beneficial to the

employee, the modification is accounted for over the modified vesting period. Modifications
nonbeneficial to the employee are ignored.

• Where an equity-settled share-based payment is cancelled or settled, there will be a deduction

from equity, with any excess recognised as an expense.

• Where a cash-settled share-based payment is cancelled or settled, there will be an

extinguishment of the liability.

• For share-based payments with cash alternatives, the accounting treatment depends on
who has the choice of settlement. Where the counterparty has the choice of settlement,
the transaction will be accounted for as a compound financial instrument. If the entity has
the choice of settlement, the transaction will be accounted for a cash-settled share-based
payment transaction where an obligation exists to deliver cash or an equity-settled share-
based payment transaction where no obligation to deliver cash exists.

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• For share-based payments among group entities, the entity receiving the goods or services
will classify the transaction as equity-settled or cash-settled by assessing the nature of the
awards granted and its rights and obligations.

• For share-based payments among group entities, the entity settling the transaction will
classify the transaction as equity-settled only if it is settled by issuing equity instruments.
Otherwise, it will classify the transaction as a cash-settled transaction.

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MIND MAP
EQUITY-SETTLED SHARE-BASED PAYMENT RECOGNITION
TRANSACTIONS
Timing–When goods obtained or services
Measurement received
• Employees–Fair value of equity instruments Debit–Expense (unless qualifies for
granted at grant date recognition as an asset)
• Non-employees–Fair value of goods or
services received at date received Credit
• Equity, if equity settled
Vesting conditions • Liability, if cash settled
• Service conditions and non-market
performance conditions–Use best estimate CASH-SETTLED SHARE-BASED PAYMENT
of number of instruments expected to vest TRANSACTIONS
• Market-based performance conditions– Measurement
Reflected in grant date fair value • Fair value of liability remeasured at end of
Non-vesting conditions each reporting period and at settlement
• Reflected in grant date fair value Vesting conditions
MODIFICATIONS, CANCELLATIONS AND • Service conditions and non-market
SETTLEMENTS SHARE-BASED performance conditions–Use best estimate
PAYMENTS of number of instruments expected to vest
Modifications (HKFRS 2) • Market-based performance conditions–
• If beneficial to employee–take effect of Reflected in grant date fair value
modification into account over modified
Non-vesting conditions
vesting period
• Reflected in grant date fair value
• If not beneficial to employee-ignore
Cancellation and settlement SHARE-BASED PAYMENT TRANSACTIONS
• If equity settled–deduction from equity, WITH CASH ALTERNATIVES
with any excess recognised as expense
If counterparty has the choice of settlement
• If cash settled–extinguishment of liability
• Account as a compound financial statement
SHARE-BASED PAYMENT TRANSACTIONS If entity has a choice
AMONG GROUP ENTITIES • If entity has an obligation to deliver cash,
Receiving entity classifies transaction by treat as cash settled
assessing nature of awards granted and • If entity does not have obligation to deliver
rights and obligations cash, treat as equity settled
Settling entity classifies as equity settled
only when issuing equity instruments

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. Intangible assets acquired in exchange for shares are within the
scope of HKFRS 2.
Answer B is incorrect. As the amount payable is based on the price of the shares this is a
share-based payment within the scope of HKFRS 2.
Answer C is incorrect. Shares granted to employees in exchange for services rendered are
within the scope of HKFRS 2.
Answer D is correct. Although the payment to the employees is linked to service, the
payment is not based on the share price of ABC, but is a fixed amount of HK$500 that will
be paid to employees regardless of whether the share price increases or decreases over
the six months.

Question 2
This is not an example of a share-based payment transaction under HKFRS 2. The
transaction described is an example of a business combination and, therefore, will be
accounted for under HKFRS 3 Business Combinations.

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Question 3
Answer A is incorrect. The debit side of a share-based payment transaction will result in the
recognition of an expense unless the item qualifies for recognition as an asset.
Answer B is incorrect. Equity-settled share-based payment transactions do result in an
increase in equity.
Answer C is correct. A share-based payment transaction where an entity issues shares in
exchange for services provided by employees will be recognised as the employees provide
the service, not when the shares are issued.
Answer D is incorrect. Cash-settled share-based payment transactions do result in an
increase in liabilities.

Question 4
Answer A is correct. This is calculated as follows:

200 × 50 – 8 × HK$25 × 1/3 years = HK$70,000

Number of Number of Number of Fair value Portion of Remuneration

equity employees employees of equity service expense for
instruments at grant currently instrument period that year 1
granted to date expected to at grant has been
each depart before date met
employee vesting date

Answer B is incorrect. You need to use the estimated total departures at the end of year 1
rather than at grant date.
Answer C is incorrect. You need to use the estimated total departures at the end of year 1
rather than only the departures during that year.
Answer D is incorrect. You need to consider the estimated total departures when
determining the number of employees who are likely to meet the service condition.

Question 5
The journal entry is as follows.
Date Description Debit Credit
HK$ HK$
31.03.X8 Salary and wages expense 63,333
Share-based payment reserve (equity) 63,333
Recognition of equity-settled share-based payment

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The amount is calculated as follows:

200 × 50 – 10 × HK$25 × 2/3 years – HK$70,000 = HK$63,333

Number of Number of Number of Fair value Portion of Remuneration Remuneration

equity employees employees of equity service expense for expense for
instruments at grant date currently instrument period that year 1 year 2
granted to expected to at grant date has been met
each depart before
employee vesting date

You need to use the estimated total departures at the end of year 2 when calculating
expected number of employees who will meet the service period. Additionally, because the
equity instrument issued is a share option, the credit cannot go against share capital, but
should be recorded against the share-based payment reserve (equity).

Question 6
The expense recognised by Dragon for the year ended 31 March 20X9 is HK$71,667. This is
calculated as follows:

200 × 50 – 9 × HK$25 – HK$133,333 = HK$71,667

Number of Number of Total actual Fair value Remuneration Remuneration

equity employees departures of equity expense for expense for
instruments at grant before instrument year 1 + 2 year 3
granted to date vesting date at grant (cumulative)
each date
employee

Question 7
Answer A is incorrect. This is an example of a market condition as it relates to the market
price of an entity’s equity instruments.
Answer B is incorrect. This is an example of a market condition as it relates to the market
price of an entity’s equity instruments.
Answer C is correct. Market conditions are those related to the price of the entity’s equity
instruments. Market share is not related to the price of equity instruments, but rather is
related to the internal operations of the entity.
Answer D is incorrect. This is an example of a market condition as it relates to the market
price of an entity’s equity instruments.

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Question 8
Answer A is correct. This is calculated as follows:

50 × 200 – 4 – 8 × HK$25 × 1/3 years = HK$78,333

Number of Number of Number of Number of Fair value Portion of Remuneration

equity employees employees additional of equity expected expense for
instruments at grant date who have employees instrument vesting year 1
granted to already left expected to at grant date period that
each depart has been met
employee before
vesting date
(3 in year 2 and
5 in year 3 )

The share options will not vest on 31 March 20X7 because actual earnings in year 1 of
12% are lower than the benchmark of 15% for the share options to vest at the end of year 1.
On 31 March 20X7, the share options are not expected to vest on 31 March 20X8 (end
of year 2) because the two-year expected average increase in earnings of 11% (year 1
actual of 12% and year 2 estimate of 10%) is lower than the benchmark average of 12%
across the two years for the share options to vest at the end of year 2.
However, the share options are expected to vest on 31 March 20X9 (end of year 3).
This is because the three-year expected average increase in earnings of 10% (year 1 actual
of 12%; year 2 estimate of 10% and year 3 estimate of 8%) is higher than the benchmark
average of 9% across the three years for the share options to vest at the end of year 3.
Therefore, the portion of the expected vesting period that has been met on 31 March
20X7 is 1/3, and the expected number of departures needs to account for expected
departures in years 2 and 3.
Answer B is incorrect. The expected employee departures in year 3 also need to be
considered.
Answer C is incorrect. The expected vesting period is three years, not two years.
Answer D is incorrect. The expected employee departures in year 3 also need to be
considered, and the expense needs to be calculated over three years, not two years.

Question 9
The expense recognised by Lucky 8 for the year ended 31 March 20X8 is HK$162,917. This
is calculated as follows:

50 × 200 – 4 – 3 × HK$25 – HK$78,333 = HK$162,917

Number of Number of Number of Number of Fair value Remuneration Remuneration

equity employees employees additional of equity expense for expense for
instruments at grant date who have employees instrument year 1 year 2
granted to already left expected to at grant date
each depart
employee before
vesting date
(3 in year 2 only)

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The share options have vested on 31 March 20X8 because the two-year average
increase in earnings of 13.5% (year 1 actual of 12% and year 2 actual of 15%) is higher than
the benchmark average of 12% across the two years for the share options to vest at the
end of year 2.

Question 10
Answer A is correct. Only market conditions are considered when determining the fair
value of a share appreciation right.
Answer B is incorrect. The statement provided for option B is correct. The correct answer
is A because only market conditions are considered when determining the fair value of a
share appreciation right. Refer to Exhibit 24.8.
Answer C is incorrect. The statement provided for option C is correct. The correct answer
is A as only market conditions are considered when determining the fair value of a share
appreciation right. Refer to Exhibit 24.8.
Answer D is incorrect. The statement provided for option D is correct. The correct answer
is A as only market conditions are considered when determining the fair value of a share
appreciation right. Refer to Exhibit 24.8.

Question 11
Answer A is incorrect. An increase in the sales target is not beneficial to the employee and,
therefore, it is ignored when accounting for the share-based payment arrangement under
HKFRS 2.B44(c).
Answer B is correct. Though the revised sales target has not been met, Stanley will still
need to recognise the cost of the original agreement as if it has not been modified under
HKFRS 2.27.
Answer C is incorrect. Though the revised sales target has not been met, Stanley will still
need to recognise the cost of the original agreement as if it has not been modified under
HKFRS 2.27.
Answer D is incorrect. The share options will be forfeited.

Question 12
The journal entry is as follows.
Date Description Debit Credit
HK$ HK$
31.03.X8 Share-based payment reserve (equity) 20,000
Remuneration expense 5,000
Cash 25,000
Recognition of compensation on cancellation of share-based payment
arrangement

Under HKFRS 2.28(b), payments made on the cancellation of a share-based payment

arrangement are accounted for as a deduction from equity except to the extent that the
repayment exceeds the fair value of the equity instruments granted, measured at the
repurchase date. Any such excess shall be recognised as an expense. The fair value of
the share options measured at the repurchase date is HK$20,000 (1,000 × HK$20). As the
payment made to Sandy was for HK$25,000 the excess of HK$5,000 is an expense.

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Question 13
Answer A is correct. Because Baci does not intend to settle in cash, the transaction
is classified as an equity-settled share-based payment transaction. By issuing equity
instruments, Baci has chosen the settlement alternative with the lower fair value on
the settlement date. According to HKFRS 2.43(b), no further entry is required on the
settlement date.
Answer B is incorrect. Because Baci does not intend to settle in cash, the transaction
is classified as an equity-settled share-based payment transaction. By issuing equity
instruments, Baci has chosen the settlement alternative with the lower fair value on
the settlement date. According to HKFRS 2.43(b), no further entry is required on the
settlement date.
Answer C is incorrect. Because Baci does not intend to settle in cash, the transaction
is classified as an equity-settled share-based payment transaction. By issuing equity
instruments, Baci has chosen the settlement alternative with the lower fair value on
the settlement date. According to HKFRS 2.43(b), no further entry is required on the
settlement date.
Answer D is incorrect. Because Baci does not intend to settle in cash, the transaction
is classified as an equity-settled share-based payment transaction. By issuing equity
instruments, Baci has chosen the settlement alternative with the lower fair value on
the settlement date. According to HKFRS 2.43(b), no further entry is required on the
settlement date.

Question 14
Answer A is incorrect. HKFRS 2.43C identifies this as a share-based payment transaction
even though the parent is not the party receiving the services.
Answer B is incorrect. HKFRS 2.43B identifies this as a share-based payment transaction
even though the subsidiary is not the party issuing the equity instruments.
Answer C is incorrect. The transaction will result in the parent recognising an increase in
their investment in the subsidiary.
Answer D is correct. HKFRS 2.B53 requires the subsidiary to recognise an increase in equity
because of the transaction.

Question 15
Answer A is correct. The remuneration expense recognised for accounting purposes in an
equity-settled share-based payment transaction is not an outgoing or expense incurred
and, therefore, is not deductible for tax purposes. Because the expense is not deductible, it
is not a temporary difference.
Answer B is incorrect. The remuneration expense recognised for accounting purposes in
an equity-settled share-based payment transaction is not an outgoing or expense incurred
and, therefore, is not deductible for tax purposes. The annual remuneration expense must
be added back to profit before tax when calculating the current tax liability for the year.
Answer C is incorrect. The remuneration expense recognised for accounting purposes in
an equity-settled share-based payment transaction is not an outgoing or expense incurred
and, therefore, is not deductible for tax purposes. Because it is not a temporary difference,
there is no impact on deferred taxes.

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Answer D is incorrect. The remuneration expense recognised for accounting purposes in

an equity-settled share-based payment transaction is not an outgoing or expense incurred
and, therefore, is not deductible for tax purposes. Because it is not a temporary difference,
there is no impact on deferred taxes.

Question 16
Answer A is incorrect. Remuneration expenses recognised for accounting purposes in
a cash-settled share-based payment transaction are deductible when the counterparty
becomes unconditionally entitled to the payment (i.e. at the vesting date).
Answer B is correct. During the vesting period for a cash-settled share-based payment
transaction a temporary difference will arise due to the difference between the carrying
amount and tax base of the share-based payment liability (the tax base is zero). This will
result in the recognition of a deferred tax asset. As the current year increase in the share-
based payment liability account is HK$400,000, there will be an increase in the deferred tax
liability of HK$66,000 (HK$400,000 × 16.5%).
Answer C is incorrect. A temporary difference will arise due to the difference between the
carrying amount and tax base of the share-based payment liability (the tax base is zero).
This will result in the recognition of a deferred tax asset and not a deferred tax liability.
Answer D is incorrect. Remuneration expenses recognised for accounting purposes in
a cash-settled share-based payment transaction are deductible when the counterparty
becomes unconditionally entitled to the payment (i.e. at the vesting date). During the
vesting period, the annual remuneration expense must be added back to profit before tax
when calculating the current tax liability for the year.

Question 17
Answer A is correct. Disclosure of an entity’s accounting policies is required under HKAS8
Accounting Policies, Changes in Accounting Estimates and Errors.
Answer B is incorrect. This disclosure is required under HKFRS 2.51(a).
Answer C is incorrect. This disclosure is required under HKFRS 2.45(a).
Answer D is incorrect. This disclosure is required under HKFRS 2.47(a).

EXAM PRACTICE

QUESTION 1
Expanding Horizons Limited (EHL) has just appointed Sally Lam, a new National Sales &
Marketing Manager. The company is considering issuing shares to Sally by entering into a
share-based payment agreement with her. The board of directors of EHL is contemplating
incorporating one or more of the following conditions into the agreement.

1. Sally will need to remain employed by EHL for a minimum of four years after the grant
date for the shares to vest.

2. EHL needs to achieve a national market share of at least 10% over the four years for the
shares to vest. Management expects this target to be achieved.

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3. The share price of EHL needs to increase by more than 15% over four years for the
shares to vest.

4. If the shares vest, Sally will be required to hold the shares for at least 12 months after
the vesting date.

The board of EHL has stated it is keen to structure the share-based payment agreement
with Sally in such a way that any impacts on profit or loss are kept to a minimum.

Required:

Advise the board of EHL how each of its four proposed conditions will affect the accounting
for the share-based payment arrangement and advise the board on which conditions it
should incorporate into its agreement with Sally.

QUESTION 2
Heeler Limited (HL) is the parent entity in the Heeler Group, and Terrier Limited (TL) is
a subsidiary within the group. On 1 April 20X5, HL granted Thomas Tran, the Managing
Director of TL, share options to purchase 200,000 ordinary shares in HL for an exercise price
of HK$2.50 per share. The fair value of each share option at the grant date was HK$5. The
grant is conditional on Thomas remaining employed by TL for at least four years.

The share options vested on 31 March 20X9 and can be exercised at any time before
31 March 20Y1.
HL’s policy is that no recharge is made for such share-based payment transactions.

Required:

Advise the appropriate accounting treatment, with journal entries, for the share-based
payment made by HL, in the individual financial statements of HL and TL and in the
consolidated financial statements of the HL for the year ended 31 March 20X9.

QUESTION 3
On 1 April 20X6, Shaolin Limited (Shaolin) granted 500 share appreciation rights to each of
its 100 employees. Each grant is conditional on the employees working for the company for
the next two years.

The following table summarises the actual employee departures and revised estimates
of employee departures across the vesting period:

Year Actual employee Total forecast

departures departures
31 March 20X7 4 8
31 March 20X8 3 N/A
Total actual departures 7

Employees who meet the service condition can exercise their rights at any time over the
12 months after the vesting date. The following table summarises the number of employees
who exercised their rights at each relevant reporting date:

Year Number of employees

who exercised rights
31 March 20X8 45
31 March 20X9 48

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The following table summarises the fair value and intrinsic value of the share
appreciation rights over the five-year period.

Year Fair value Intrinsic value

31 March 20X7 HK$9.70
31 March 20X8 HK$12.20 HK$10.50
31 March 20X9 HK$13.00

Required:

(a) Explain why this arrangement is considered to be a share-based payment arrangement

and classify the share-based payment transaction in accordance with HKFRS 2.
(b) Account for the share-based payment transaction by illustrating the amounts to be
recognised during the period from 1 April 20X6 to 31 March 20X9 and the journal
entries for the year ended 31 March 20X9.

ANSWERS TO EXAM PRACTICE

QUESTION 1
Given that the proposed arrangement will result in EHL issuing shares in exchange for Sally
providing services to the entity, the proposed share-based payment agreement between
EHL and Sally is an equity-settled share-based payment transaction with an employee.
This transaction will require EHL to recognise salary and wages expense across the vesting
period, with a corresponding increase in equity. The impact of each of the proposed
conditions is discussed in the table that follows.

# Detail HKFRS Accounting treatment (incl. impact on profit)

2 category
1 Sally will need to Service condition If this condition is incorporated into the agreement,
remain employed (vesting EHL will recognise salary and wages expense across
by EHL for a condition) the four-year service period as Sally is providing
minimum of four services to EHL (with a corresponding increase in
years after the equity). The amount recognised will be determined
grant date for the by reference to the fair value of the shares at the
shares to vest grant date. If Sally leaves within the four-year
service period, the shares will be forfeited and any
expense recognised will be reversed.
2 EHL needs to Non-market Like the service condition previously discussed, if
achieve a national based this condition is incorporated into the agreement,
market share of at performance EHL will recognise salary and wages expense across
least 10% over the condition the four-year service period as Sally provides
four years for the (vesting services to EHL (with a corresponding increase in
shares to vest condition) equity). This is based on management continuing
to expect the target will be achieved. The amount
recognised will be determined by reference to the
fair value of the shares at the grant date. If EHL’s
national market share target of at least 10% is
achieved at the end of the four years, the shares
will be issued to Sally. If EHL’s national market share
at the end of the four years is not at least 10% the
shares will be forfeited and any expense recognised
will be reversed.

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 FINANCIAL REPORTING

# Detail HKFRS Accounting treatment (incl. impact on profit)

2 category
3 The share price Market-based A key difference between market and non-market
of EHL needs to performance vesting conditions is that market conditions
increase by more condition accounted for when estimating the fair value of
than 15% over (vesting equity instruments at grant date. This means that
four years for the condition) if all other vesting conditions are satisfied (e.g. a
shares to vest service condition), the salary and wages expenses
are recognised regardless of whether or not the
market condition is satisfied.
4 If the shares Non-vesting Like market conditions, non-vesting conditions are
vest, Sally will be condition reflected in the fair value of the equity instruments
required to hold the at grant date. Also, like a market condition, a non-
shares for at least vesting condition results in the recognition of an
12 months after the expense regardless of whether or not the non-
vesting date vesting condition is satisfied.

Recommendation to the board of EHL: Given that the board’s stated intention is to
structure the share-based payment agreement with Sally in such a way that any impacts on
profit or loss are kept to a minimum, I recommend it incorporate conditions 1 and 2 into
the agreement but not incorporate conditions 3 and 4. In this way, if Sally leaves within four
years or the market share target is not achieved, there will be no impact on profit.

QUESTION 2
Individual financial statements of HL (the parent)

Even though HL does not receive the services directly, this is classified as an equity-settled
share-based payment transaction for HL because HL is issuing equity instruments and the
receiving entity (TL) is part of the same group (HKFRS 2.43C and HKFRS 2.B54). HL is required
to measure its obligations in accordance with the requirements applicable to equity-settled
share-based payment transactions (HKFRS 2.B54).

The following entry will be recorded in the books of HL at 31 March 20X9:

Date Description Debit Credit

HK$ HK$
31.03.X9 Investment in TL (subsidiary) 250,000
Share-based payment reserve (equity) 250,000
Recognition of group share-based payment transaction by parent (200,000
× HK$5 × ¼)

Individual financial statements of TL (the subsidiary)

Even though TL is not issuing equity instruments the transaction is a share-based payment
transaction for TL because the shares are being issued by another group entity (HKFRS
2.43A). TL is required to measure the services received from its employees in accordance
with the requirements applicable to equity-settled share-based payment transactions
because the entity has no obligation to settle the share-based payment transaction
(HKFRS 2.43B(b) and HKFRS 2.B53). The following entry will be recorded in the books of TL
at 31 March 20X9:

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 S hare -b ased P a y ments

Date Description Debit Credit

HK$ HK$
31.03.X9 Salary and wages expense 250,000
Equity (contribution by parent) 250,000
Recognition of group share-based payment transaction by subsidiary

Consolidated financial statements of the Heeler Group (the group)

Because the group is receiving the services and issuing the equity instruments, the impact
of this transaction in the consolidated financial statements will be consistent with the
treatment if HL issued equity instruments to its own employees. Where a share-based
payment transaction involves multiple entities within a consolidated group, the effects of
such transactions must be eliminated in accordance with HKFRS 10 Consolidated Financial
Statements. The following entry will be recorded in consolidated financial statements of the
Heeler Group at 31 March 20X9:

Date Description Debit Credit

HK$ HK$
31.03.X9 Equity (contribution by parent) 250,000
Investment in Terrier (subsidiary) 250,000
Elimination of effects of group share-based payment transaction

QUESTION 3
(a) This arrangement is a share-based payment arrangement because the cash payment
made to the employees is determined by reference to the fair value of Shaolin’s
equity instruments. Specifically, the transaction is a cash-settled share-based payment
transaction because Shaolin is acquiring services from the employees by incurring a
liability to transfer cash to the employees for amounts based on the value of its shares.

Year Calculation Remuneration Liability at end

expense for of the period
the period
HK$ HK$
31 March 20X7 500 × (100 − 8) × HK$9.70 × 1/2 223,100 223,100
31 March 20X8 500 × (100 − 7 − 45) × 69,700 292,800
HK$12.20 +
500 × 45 × HK$10.50 (exercised) 236,250
31 March 20X9 n/a (292,800) –
500 × 48 × HK$13.00 (exercised) 312,000

(b) The journal entry to record the share-based payment at 31 March 20X9 is as follows:

Date Description Debit Credit

HK$ HK$
31.03.X9 Salary and wages expense 19,200
Share-based payment liability 292,800
Cash 312,000
Recognition of cash-settled share-based payment

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 25
Operating Segments

CHAPTER TOPIC LIST

25.1 Overview 25.3 Reportable Segment Disclosures

25.1.1 Scope 25.3.1 General Information
25.1.2 Terminology 25.3.2 Information about Profit or
25.2 Reportable Segments Loss, Assets and Liabilities
25.3.3 Reconciliations
25.2.1 Aggregation Criteria
25.2.2 Quantitative Thresholds 25.4 Entity-wide Disclosures

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT

FOR BUSINESS TRANSACTIONS
LO2.12: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to operating segments
2.12.01 Define operating segments
2.12.02 Explain when operating segments should be aggregated and disaggregated
2.12.03 Illustrate the nature of segmental information to be disclosed
2.12.04 Prepare disclosure in respect of operating segments and appropriate entity-wide information

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 Operating Segments

OPENING CASE

CWAVES

C Waves Ferry Holding Company Limited (CWaves) is a publicly listed company on the
Hong Kong Stock Exchange (HKEx). The entity has a number of primary revenue-generating
activities, including its ferry service, which it operates in Hong Kong Harbour, Sok Kwu
Wan, Shenzhen and Macau. CWaves also has significant business operations involving the
management of office buildings, godowns, port infrastructure, travel agencies and hotels in
various parts of the world. The ferry service and various business activities are individually
so significant for the company that they are each managed by a senior vice president, who
reports directly to the Chief Executive Officer (CEO). The CEO’s role is to make strategic and
operational decisions in respect to the activities. These activities also are the foundation for
the development and implementation of the strategic and operational priorities for the entity
each year.

CWaves has a 31 December year-end and has 10 wholly owned subsidiaries, which it
consolidates for the purpose of reporting under Cap.622 s379(2) of the Hong Kong Companies
Ordinance and HKFRS 10 Consolidated Financial Statements.

The entity’s overall financial performance has been solid in recent years. Several of its
activities continue to grow, although these activities have been subject to fluctuating profits in
recent years due to varying interest rates, foreign exchange rates and other industry-related
factors. One of the constant, well-performing components of the business is the ferry service.
With its regional focus and constant customer demand, the ferry service is somewhat isolated
from much of the volatility affecting the company’s financial returns. The headquarters for the
ferry services is Macau, the same location from which the business activities involving port
infrastructure are made and managed.

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OVERVIEW

When we examine an annual report, we are seeing the overall financial performance and
position of the entity that is determined after aggregating the results of each of the different
parts of the operations. This high-level aggregation creates challenges for the subsequent
analysis and interpretation of the results because some variation will exist in the relative
performance and risks of the different parts of the business. This creates the need for
detailed disclosures about the different parts of the business, which we refer to as ‘segment
reporting’.

Segment reporting involves the reporting of selected information about the operating
segments of an entity in the notes to the financial statements. The objective of segment
reporting is to provide users of financial statements with detailed insights into the financial
results for important operating units of the entity to assist more informed assessments of the
financial effects of business activities in which it engages and the economic environments in
which it operates.

Though the objective behind segment reporting is relatively intuitive, there are various
issues to consider in determining what segment information particular entities should include
in their financial statements. For example, in the case of CWaves, the main operating segments
must be identified, and management must also determine the information to be disclosed
about those segments in its financial statements. CWaves management must also determine
how the segment results should be measured.

In this chapter, you will gain an understanding of the various complexities involved with
identifying operating segments and determining the information to be disclosed. This includes
understanding the information that must be disclosed for each segment as well as the
appropriate measurement approaches to be used for in making those disclosures. By the end
of this chapter, you should understand and appreciate the objective of segment reporting and
be able to apply the relevant accounting requirements in preparing segment information to
assist users to better understand the overall financial position and performance of the entity
and better predict the amounts, timing and risks of an entity’s future cash flows.

2 5 . 1 OVERVIEW

This chapter focuses on the preparation of segment information in financial statements in

HKFRS 8 accordance with HKFRS 8 Operating Segments. HKFRS 8 utilises a principles-based approach to

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 Operating Segments

the identification of segments and the preparation of relevant disclosures. Under this
approach, segment disclosures are required to be prepared in a way that aligns with how the
entity understands and evaluates the performance of the components of its business. By doing
so, segment information should provide a better link between the financial statements and the
other information reported in the annual report such as management commentaries provided
in the Management Discussion and Analysis.

In this section, you will gain an understanding of the nature and focus of the requirements
in HKFRS 8. Several key concepts are introduced to provide a solid basis for the subsequent
development of your understanding and application of the requirements in HKFRS 8.

25.1.1 Scope
HKFRS 8 applies to the financial statements of:

• Entities with publicly traded debt or equity instruments; and

HKFRS • Entities that file financial statements with regulators for the purposes of issuing any
8.2 class of instruments in a public market in the future.

If an entity is not required to apply HKFRS but chooses to provide segment information, this
does not trigger the need to apply the full requirements of HKFRS 8. When segment disclosures
HKFRS provided are not in compliance with HKFRS 8, they must not be referred to as ‘segment
8.3 information’.

25.1.2 Terminology
Before proceeding, it is important to develop a solid understanding of some key terms and
concepts set out in HKFRS 8 in relation to segment reporting.

25.1.2.1 Chief Operating Decision Maker (CODM)

The Chief Operating Decision Maker (CODM) refers to a function, rather than a specific
HKFRS position, within an entity. Its key distinguishing feature is its role to allocate resources to, and
8.7 assess the performance of, the entity’s operating segments. The CODM of an entity may be an
individual, such as the chief executive officer or chief operating officer. Alternatively, more than
one person may perform the role of the CODM. For example, in its 2019 annual report, Qantas
Airways Ltd referred to its ‘Chief Operating Decision-Making Bodies’ and identified its CEO,
Group Management Committee and Board of Directors as fulfilling these roles for segment
reporting.

By employing the CODM concept, the resulting segment disclosures should enable users to
understand the business ‘through the eyes of management’. Incorporating this approach as the
basis for segment reporting has several benefits, which include making it easier for companies
IFRS to provide more timely segment information and enhanced consistency with the management
8.BC6 discussion and analysis or other annual report disclosures.

25.1.2.2 Operating Segment

The definition of an operating segment is a central component of the requirements in HKFRS 8.
Exhibit 25.1 summarises the steps to follow for identifying whether a component of an entity is
an operating segment.

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HKFRS Does the entity component engage in business activities NO

8.5a from which it may earn revenues or incur expenses?

YES

Are the component’s operating results regularly reviewed NO

HKFRS by the CODM to make resource allocation decisions and Not an operating segment
8.5b assess its performance?

YES

HKFRS Is discrete financial information about the component NO

8.5c readily available?

YES

Operating segment exists.

Evaluate whether the segment is reportable.

EXHIBIT 25.1 Identifying an operating segment

The guidance provided in HKFRS 8 seeks to ensure segment information is reported in a

way that reflects how the entity thinks about and manages the components of its operations,
rather than providing a list of detailed rules and thresholds to follow in identifying segments.

Note the use of the term ‘may’ regarding the earning of revenues. An operating segment
may engage in business for which it is yet to generate revenue, as may be the case for a
HKFRS start-up operation. That no revenue has been earned at the reporting date is irrelevant in
8.5 determining the existence of an operating segment.

Generally, operating segments will be managed by a key staff member who will work
HKFRS closely with, and be accountable to, the CODM in planning, managing and evaluating the
8.9 operations and performance of the segment.

Some parts of an entity may not be operating segments because revenues earned by some
HKFRS functions within the entity (e.g. corporate headquarters) may be incidental to overall operations
8.6 such that the definition of an operating segment may not be satisfied.

Finally, some entities may describe their business activities in different ways that do not fit
perfectly with the guidance in HKFRS 8. For example, the CODM may hold some managers of
segments accountable for combinations of different outcomes, such as particular products or
service lines globally, with other managers accountable for all operations within a specific
country or region. Where the CODM regularly reviews the different combinations of results and
where all information is available, the entity should report its segment information in line with
HKFRS the core principle in HKFRS 8, that is to assist more informed assessments of the financial
8.10 effects of entity’s business activities and the economic environments in which it operates.

Illustrative Example 1
CWaves appears to have a number of potential operating segments. It operates ferry
services in the region, and has a number of international business activities in office
buildings, godowns, port infrastructure, travel agencies and hotels.

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Illustrative Example 1 (continued)

In determining whether these activities represent operating segments, we can draw
on the information provided at the beginning of the chapter. For example, we are told
these are the ‘primary revenue-generating activities’ of the entity, so the first test in
HKFRS 8 would appear to be satisfied. These activities also provide the ‘foundation for the
development and implementation of the strategic and operational priorities’ of the entity,
which suggests that discrete information in respect of each activity is available and used
frequently by the CEO. (From the case facts, we can see that each activity is managed by
a senior vice president who reports on each activity directly to the CEO. As the CEO’s role
is to make strategic and operational decisions in managing the entity’s activities, the CEO
appears to be the CODM for CWaves.)

On the basis of the information provided in the case, it would appear that the key
activities mentioned represent the operating segments of CWaves.

The next step is to determine whether the operating segments are reportable segments,
which dictates the nature and extent of disclosures required. We explore in detail the definition
and application of the reportable segment concept in Section 25.2.

Knowledge Check Question

Question 1
Identify which one of the following statements is true.
A The CODM for the purposes of segment reporting is the most senior decision maker in
the organisation.
B An operating segment is a component of an entity that engages in business from which
it may have earned revenue prior to the reporting date.
C Where an entity is not required to apply HKFRS 8 but chooses to provide segment
disclosures, it must still apply the requirements set out in in the Standard.
D HKFRS 8 excludes those segments that generate a large proportion of their revenues
from sales to other operating segments of the entity.

2 5 . 2 REPORTABLE SEGMENTS

Reportable segments are operating segments about which HKFRS 8 requires separate
segment information to be disclosed in the financial statements.

An operating segment that satisfies a 10% threshold test based on the total amounts
of any of revenues, profits (or losses) or assets for all operating segments qualifies as a

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reportable segment under HKFRS 8. Individual operating segments that fall below the 10% test
can, under certain conditions, be aggregated for reporting purposes.

In general terms, HKFRS 8 identifies reportable segments in a manner that simultaneously:

• Allows aggregation of individual operating segments with similar characteristics and

information content to avoid disclosure of immaterial information; and

• Requires sufficient information about an entity’s operating segments to be reported by:

° requiring disaggregation of business activities, such that any individually material

operating segment, determined by using a 10% threshold (see following text), must
be the subject of segment disclosures; and

° imposing a minimum collective threshold (based on external revenues) for the

extent to which operating segments are the subject of segment disclosures.

25.2.1 Aggregation Criteria

Two or more operating segments may be aggregated into a single operating segment if:

• Aggregation is consistent with the core principle of disclosing information for evaluating
the nature and financial effects of the entity’s business activities and the economic
environments in which the entity operates;
• They exhibit ‘similar economic characteristics’; and

• The segments are similar in each of the following respects:

° the nature of their products and services;

° the nature of their production processes;

° the type or class of customer for their products and services;

° the methods used to distribute their products or provide their services; and

HKFRS ° if applicable, the nature of the regulatory environment, for example, banking,
8.12 insurance or public utilities.

Under HKFRS 8, two or more operating segments will exhibit similar long-term financial
HKFRS performance (e.g. long-term average gross margins) if they have ‘similar economic
8.12 characteristics’. However, gross margin is only one indicator and several other proxies might
include return on assets, net profit margin, EBITDA and any other information regularly used
by the CODM.

The rationale for aggregating segments for segment reporting is to remove unnecessary
detail from the notes, making the information easier for users to access and understand.
Take for example, the individual ferry routes of CWaves. Even if each route were managed
individually and reviewed by the CODM for resource allocation decisions (that is, each route
is itself an operating segment), none of the specific routes are likely to be large enough to
meet the quantitative tests for a reportable segment. Where the different services have similar
economic characteristics, aggregation for segment reporting is permitted under HKFRS 8 where
it provides useful information to users.

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 Operating Segments

25.2.2 Quantitative Thresholds

The tests for identifying reportable segments are based on the size of the segment revenues,
profits (or losses) and assets. Applying HKFRS 8, a reportable segment is an operating segment
if it meets any of the following quantitative thresholds:

• Its reported revenue, including both sales to external customers and intersegment sales
HKFRS and transfers, is 10% or more of the combined revenue, internal and external, of all
8.13(a) operating segments.

• The absolute amount of its reported 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
HKFRS not report a loss and (ii) the combined reported loss of all operating segments that
8.13(b) reported a loss.
HKFRS
8.13(c) • Its assets are 10% or more of the combined assets of all operating segments.

HKFRS In addition, operating segments that fail to meet any of the quantitative thresholds may be
8.13 deemed reportable if management believes the resulting disclosures are useful to users.

Further important guidance on the identification of reportable segments is provided in

HKFRS 8 and is summarised below:

• Information about operating segments that each fail to meet any of the quantitative
thresholds may be combined to produce a reportable segment only if the operating
segments have similar economic characteristics and share a majority of the aggregation
criteria listed in (a) – (e) in Section 25.2.1.

• Total external revenue reported in respect of operating segments must constitute at

least 75% of total entity revenue. Because this test focuses on ‘external revenue’, it is
usually applied based on consolidated revenue where relevant. This is in contrast with
the revenue test for determining the existence of a reportable segment. If operating
HKFRS segment revenue is below this amount, additional operating segments are identified as
8.15 reportable segments until at least 75% of total revenue is included.

• Information about other business activities and operating segments that are not
HKFRS reportable must be combined and disclosed in an ‘all other segments’ category,
8.16 showing the sources of the revenue in that category.

• Where a component of an entity has previously satisfied the reportable segment

definition and management believes it remains of continuing significance, segment
HKFRS information must be reported separately even if it no longer meets the threshold
8.17 tests.

• Where a reportable segment is newly identified in the current period, comparative prior
period segment data must be restated for consistency with the current reportable
HKFRS segments unless the comparative information is unavailable or would be excessively
8.18 costly to develop.

HKFRS • To avoid overly detailed segment disclosures, no more than 10 reportable segments
8.19 should be used.

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Apply and Analyse 1

Information for the identified operating segments of CWaves is provided below.

Operating segment Segment revenue Segment profit/(loss) Segment assets

HK$m HK$m HK$m
Office buildings 1,000 (40) 270
Godowns 345 (30) 40
Port infrastructure 200 10 78
Travel agencies 1,867 220 450
Hotels 1,100 160 390
Ferry service 420 40 165
Other activities (various) 999 (45) 130
Totals 5,931 315 1,523

Determine which of the above represent reportable segments for CWaves.

Analysis
To determine the existence of reportable segments, each activity is assessed against the
quantitative thresholds in HKFRS 8. The absolute value of the segments that reported a
profit is HK$430 million, whereas the absolute value of the loss results is HK$115 million.
Because the absolute value of the segment profits is larger, this is the figure used in the
‘profit’ threshold test.

In this exercise, we have applied each threshold test set out in HKFRS 8 to each
segment. Satisfying at least one test results in identifying an operating segment as a
reportable segment.

Business Activities

• Office buildings generate 16.9% of total revenue, provide 9.3% of segment profit
(absolute value) and represent 17.7% of total assets

• Godowns generate 5.8% of total revenue, provide 7.0% of segment profit (absolute
value) and represent 2.6% of total assets

• Port infrastructure generates 3.4% of total revenue, provide 2.3% of segment profit
(absolute value) and represents 5.1% of total assets

• Travel agencies generate 31.5% of total revenue, provide 51.2% of segment profit
(absolute value) and represent 29.5% of total assets

• Hotels generate 18.5% of total revenue, provide 37.2% of segment profit (absolute
value) and represent 25.6% of total assets

• Ferry service generates 7.1% of total revenue, provides 9.3% of segment profit
(absolute value) and represents 10.8% of total assets

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 Operating Segments

Apply and Analyse 1 (continued)

The analysis is summarised below:

Segment revenue Segment profit/(loss) Segment assets

≥10% of total ≥10% of absolute ≥10% of total
revenue profit/(loss) assets
Office buildings ✓ ✗ ✓
Godowns ✗ ✗ ✗
Port infrastructure ✗ ✗ ✗
Travel agencies ✓ ✓ ✓
Hotels ✓ ✓ ✓
Ferry service ✗ ✗ ✓

The reportable segments identified through applying the quantitative thresholds

tests are office buildings, travel agencies, hotels and ferry service. In other words,
only the activities involving godowns and port infrastructure fail to meet any of the
quantitative thresholds in HKFRS 8, which suggest they would not represent reportable
segments.

However, the revenue from the four reportable segments represents less than 75%
of total entity revenue. As a result, CWaves must identify additional operating segments
as reportable segments until the 75% threshold is satisfied. Consequently, CWaves also
identifies the business activities involving godowns, the next largest component of the
entity in terms of revenue, as a reportable segment. The revenue from five reportable
segments now represents 79.8% of total revenue and no further reportable segments
need to be identified.

The remaining components of the business are not individually large enough to
satisfy the 10% threshold test and, consequently, are combined and disclosed as ‘all other
segments’.

Even though the business activities involving port infrastructure are not large enough
to independently satisfy the quantitative thresholds in HKFRS 8 and consequently may be
combined with other activities into ‘all other segments’, the port infrastructure segment
could still be:

• Reported separately where considered useful to users; or

• Aggregated with another component and that combined segment meets the
quantitative thresholds to be a reportable segment.

Regarding the first of these possibilities, recall that each component in the table is
separately managed and the segment information appears to be used by the CODM. As
a result, the activities involving port infrastructure may still be reported separately where
this reflects the information regularly used by the CODM and management considers the
information to be useful to users.

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Apply and Analyse 1 (continued)

If the activities involving port infrastructure are not reported separately, they might
still qualify as a reportable segment when aggregated with another non-reportable
segments (instead of simply being part of ‘all other segments’). To determine this, the
key test is whether port infrastructure activities have similar economic characteristics
to any of the other non-reportable segments. They would also need to share a majority
of the aggregation criteria identified in Section 25.2.1. Although a cursory review of the
information provided indicates different financial results for the port infrastructure
activities compared with other components, more information is required.

The Implementation Guidance accompanying HKFRS 8 provides practical guidance in

the form of a decision tree to assist in identifying reportable segments. That decision tree is
reproduced as Exhibit 25.2.

Identify operating segments based

on management reporting system

YES Aggregate
Do some operating segments
segments
meet all aggregation criteria?
if desired

NO

YES Do some operating segments

meet the quantitative thresholds?

NO

Aggregate YES Do some remaining operating

segments segments meet a majority of the
if desired aggregation criteria?

NO

Do identified reportable YES

segments account for 75%
of the entity’s revenue?

NO

Report additional segment if external revenue of

all segments is less than 75% of the
entity’s revenue

These are reportable Aggregate remaining segments into

segments to be disclosed ‘all other segments’ category

EXHIBIT 25.2 Decision tree for identifying reportable segments

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 Operating Segments

Knowledge Check Questions

Question 2
Jia Ren Ltd is a retail organisation with a number of geographical operating segments
(based on the location of the entity’s operations, which are reviewed discretely by the
company’s CODM). The following information relates to the year ended 31 March 20X9:

External revenue Profit/(loss) Assets

HK$’000 HK$’000 HK$’000
UK 546,000 49,000 290,800
Other Europe 722,000 63,000 329,800
Middle East 124,000 (4,600) 63,400
Africa 156,000 (11,000) 76,000
Totals 1,548,000 96,400 760,000

Explain to Feng, the CEO of Jia Ren Ltd, which of the operating segments are reportable
segments for the year ended 31 March 20X9. In doing so, demonstrate your knowledge
of HKFRS 8 by applying its criteria for identifying reportable segments, interpreting the
interrelationships between those criteria and showing the computations necessary to
arrive at your conclusions.
For simplicity, this explanation should be based on current period amounts only, that
is, it is assumed that no operating segments should be identified as reportable segments
solely because they were identified as such in the immediately preceding period and are of
continuing significance.

Question 3
The table below details the revenue projections for the major operating segments of the
Zheng Group for the next three years. The Fangsong, Nial and Huay operating segments
align with the group’s primary product lines and have been identified as reportable
segments of the Group. All segment revenues are earned from external customers.

Fangsong Nial Huay Total Other Total entity

business units revenue
HK$m HK$m HK$m HK$m HK$m HK$m
Year 1 75 160 320 555 250 805
Year 2 110 140 275 525 175 700
Year 3 230 250 375 855 315 1,170

Assist Wang, the CEO of the Zheng Group, by indicating in which of years 1 to 3 is the
Zheng Group likely to need to identify a further reportable segment.

Question 4
Explain when the results of two or more operating segments may be aggregated for the
purpose of segment reporting. Describe what benefit, if any, the aggregation of segment
results provide for the users of the financial statements.

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2 5 . 3 REPORTABLE SEGMENT DISCLOSURES

For each reportable segment, a number of disclosures are required under HKFRS 8. These
disclosures include general information about the setup and operation of the segments and
information about segment revenues, expenses, profits/losses, assets and liabilities. The
rationale for these disclosures is to assist financial statement users to evaluate the nature and
HKFRS financial effects of the business activities in which it engages and the economic environments in
8.20 which it operates.

25.3.1 General Information

For each reportable segment, the entity shall provide detail about:

HKFRS • The basis on which the segments are organised and managed, including whether this is
8.22(a) based on products and services, geographic areas or a combination of factors;
HKFRS
8.22(aa) • The approach taken where any aggregation of segments has occurred; and
HKFRS
8.22(b) • The primary sources of segment revenues.

The sample in Exhibit 25.3 sets out how a fictitious airline might disclose information
about the bases on which its operations are identified, organised and managed and about the
primary sources of its segment revenues.

The Group identifies four reportable segments on the basis of the internal financial reports
that are provided to and regularly reviewed by the Group’s Chief Operating Decision Maker
(CODM) to allocate resources and assess performance of the segment. The reportable
segments are based on the nature of the services provided and geographic areas in which
those services are provided. The major revenue earning asset is the aircraft fleet which
is used for passenger and non-airline services. The passenger services are provided for
travel throughout Australasia, the Americas and Europe, while the non-airline services
are provided domestically only. The non-airline segment includes mainly catering, ground
handling, aircraft ramp handling services and cargo terminal operations. This results in the
identification of the following reportable segments for financial reporting purposes:

• Passenger services – Domestic

• Passenger services – Europe

• Passenger services – The Americas

• Non-airline services

EXHIBIT 25.3 Illustrative HKFRS 8 disclosure

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25.3.2 Information about Profit or Loss, Assets and Liabilities

Disclosure requirements for each reportable segment are based on the information regularly
provided to and used by the CODM in assessing the performance of, and allocating resources
to, segments. This will include segment profit or loss, and normally also measures of segment
assets, liabilities, revenues and expenses.

HKFRS Specific additional disclosures are also required for information regularly provided to the
8.23 CODM, regardless of whether it is included in the calculation of segment profit and loss. These
disclosures include a breakdown by segment of revenue from external customers and
intersegment transactions, separate disclosure for interest revenue and interest expense and
depreciation and amortisation, along with any other material non-cash expense items.
Disclosures are also required in relation to:

• Other material items of income and expense;

• Income tax;

• Investments in associates and joint ventures accounted for by the equity method (their
amount and the entity’s share of profit or loss); and
HKFRS
8.23–24 • Certain additions to non-current assets.

HKFRS Financial information disclosed for segments should be measured in the same way as the
8.25 information is measured when it is provided to the CODM. This includes adjustments and
eliminations made in preparing an entity’s financial statements and allocations of revenues,
expenses, and gains or losses included in determining reported segment profit or loss only if
they are included in the segment’s profit or loss information used by the CODM. Similarly, only
the asset and liability information used by the CODM shall be reported for that segment. Where
HKFRS amounts are allocated to reported segment profit or loss, assets or liabilities, this shall be done
8.25 on a reasonable basis.

Applying the measurement approach outlined in HKFRS 8 should make it easier and
quicker for entities to produce segment information. However, one additional implication is
that entities retain some discretion in measuring segment information and need not apply
accounting standards when measuring segment revenues, expenses, assets or liabilities. This
also means that segment information may not necessarily be measured and reported on the
same basis the entity uses in preparing its financial statements.

To overcome these challenges, the following additional disclosures are required to assist
the interpretation of the information disclosed:
HKFRS
8.27(a) • The basis of accounting for any transactions between reportable segments;

HKFRS • The nature of any differences between the measurements of the reportable segments’
8.27(b)–(d) profits or losses, assets and liabilities and those of the entity; and

• The nature and impact of any changes from prior periods in the measurement methods
HKFRS used to determine reported segment profit or loss and the effect, if any, of those
8.27(e) changes on the measure of segment profit or loss.

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Illustrative Example 2
The following illustration provides an example of the quantitative segment disclosures
CWaves may make in accordance with the requirements of HKFRS 8. (In this illustration,
CWaves has separately identified port infrastructure as a separate reportable segment.)

a
Current Business activities Totals
year
Build- Go- Port Travel Hotels Ferry All
ings downs infra- agencies services other
structure segments
HK$m HK$m HK$m HK$m HK$m HK$m HK$m HK$m
Revenues
from external 1,000 345 158 1,367 1,100 420 999 5,389
customers

lntersegment
– – 42 500 – – – 542
revenues

Interest
28 – 17 52 51 – – 148
revenue

Interest
14 – 6 30 28 – – 78
expense

Net interest
– 45 – – – – – 45
revenue

Depreciation
and 35 14 19 49 25 15 – 157
amortisation

Reportable
(40) (30) 10 220 160 40 (45) 315
segment profit

Other material
non-cash
– 200 – – – – – 200
items:
impairment

Reportable
270 40 78 450 390 165 130 1,523
segment assets

Expenditures
for reportable
300 700 500 800 600 – – 2,900
segment non-
current assets

Reportable
segment 120 15 42 320 110 41 75 723
liabilities
HKFRS
8.18 a
Under HKFRS 8 comparative segment disclosures are also required.

In Illustrative Example 2, did you notice that CWaves also discloses information about ‘all
other segments’? But what activities are included in ‘all other segments’? In accordance with
HKFRS 8, CWaves must disclose additional information about the activities that are reported as
‘All other segments’.

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For example, CWaves may make the following note disclosure:

‘All other segments’ comprises corporate headquarter operations and three minor
business components of CWaves: a watercraft sales and rental business, a financial
services consulting practice and a SCUBA instruction business. None of these
components individually meet any of the quantitative thresholds for determining
reportable segments”.

In addition, entities customarily disclose the approach used to measure the segment
results. Exhibit 25.4 provides an example from the 2019 Annual Report of Qantas Airways Ltd.

‘External segment revenue is reported by operating segments as follows:

• Net passenger revenue is reported by the operating segment that operated

the relevant flight or provided the relevant service. For Qantas Airlines, where a
multi-sector ticket covering international and domestic travel is sold, the revenue is
reported by Qantas International and Qantas Domestic on a pro-rata basis using an
industry standard allocation process.

• Other revenue is reported by the operating segment that earned the revenue’.

EXHIBIT 25.4 The approach used to measure segment results (Source: Qantas Airways Limited 2019
Annual Report.)

25.3.3 Reconciliations
General purpose financial statements must be prepared in accordance with the recognition and
measurement requirements set out in HKFRSs. However, segment disclosures are prepared
based on the information prepared for and used by the CODM. As a consequence, HKFRS 8
requires the entity to reconcile key financial results for total segments to the relevant total
amounts for the entity. The requirements in HKFRS 8 regarding reconciliations are shown in
Exhibit 25.5.

Reconciliation required Explain reasons for difference

Total segment revenues to total entity revenues ✓
Total segment profit and loss to total entity profit/loss ✓
Total segment assets to entity assets ✓
Total segment liabilities to total entity liabilities ✓
Every other material item to the relevant item for the entity ✓
HKFRS
8.28 Reconciliations are not required at the individual segment level.

EXHIBIT 25.5 Reconciliations of segment results

In each reconciliation, all material reconciling items shall be separately identified and
described, including the differences arising from different accounting policies used in
measuring segment results and the effects of transactions between segments, which are
eliminated when consolidated statements are prepared.

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For example, a reconciliation of total segment revenues and total entity revenues might
look like the reconciliation illustrated in Exhibit 25.6:

HK$
Revenues:
Total revenues for reportable segments x,xxx
Other revenues x,xxx
Elimination of intersegment revenues (x,xxx)
Entity’s revenues x,xxx

EXHIBIT 25.6 Reconciliation of segment revenues

Knowledge Check Question

Question 5
Explain the rationale for requiring the reconciliation of segment totals to the totals for
the whole entity, and identify three common reasons why these totals may differ in any
particular period.

2 5 . 4 ENTITY-WIDE DISCLOSURES

Under HKFRS 8, additional financial and non-financial entity-wide disclosures are required to
assist users to understand the risks faced by the entity regardless of whether the CODM uses
this information for evaluation and decision making. These disclosures are required by all
HKFRS entities subject to HKFRS 8, including those with only one reportable segment, but are not
8.31 repeated if provided in respect of reportable segments.
HKFRS
8.32–34 The disclosures required are summarised in Exhibit 25.7.

An entity discloses:
Revenues from external customers for each product and service, or each group of similar
✓ products and services Required unless the
information is not available
✓ Detailed geographical information in respect of revenues from external customers and too costly to provide.

✓ Detailed geographical information in respect of non-current assets

The existence only. The identity
✓ The extent of its reliance on ‘major customers’ for 10% or more of total revenues of major customers need not
be disclosed.

EXHIBIT 25.7 Entity-wide disclosures

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For example, an entity might make the disclosure shown in Exhibit 25.8 as part of disclosing
information about the geographical source of its revenues and the geographical location of its
non-current assets (amounts included for illustration only).

Revenues Non-current assets

20X9 20X8 20X9 20X8
HK$m HK$m HK$m HK$m
North Asia
Hong Kong and Mainland China 50,000 46,000 12,132 11,120
Japan, Korea and Taiwan of China 9,500 8,766 8,000 9,800
India, Middle East and Sri Lanka 3,760 3,670 5,600 5,400
Southwest Pacific and South Africa 5,800 5,460 2,000 3,200
Southeast Asia 7,650 7,680 3,435 3,820
Europe 8,460 8,000 400 760
North America 12,500 11,054 10,000 9,060
Total 97,670 90,630 41,567 43,160

EXHIBIT 25.8 Example disclosure of detailed geographical information about revenues

from external customers and non-current assets

Knowledge Check Question

Question 6
Explain why providing additional entity-wide disclosures can assist users of the financial
statements to better understand the risks facing an entity.

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SUMMARY

• HKFRS 8 specifies the information required about operating segments.

• Under HKFRS 8, segment reporting is to provide users of financial statements with detailed
insights into the financial performance and position for important operating units of the entity
to assist more informed assessments of the nature and financial effects of business activities
in which it engages and the economic environments in which it operates.

• Operating segments are those components of an entity that engage in business activities
from which it may earn revenues and incur expenses; whose operating results are regularly
reviewed by the entity’s CODM to make decisions about resources to be allocated to the
segment and assess its performance; and for which discrete financial information is available.

• The CODM refers to a function performed by one or more individuals within an entity.

• Reportable segments are those operating segments that satisfy a 10% threshold test based
on the size of their assets, revenues or profits (or losses). Also, total external revenue of
reportable segments must sum to at least 75% of total entity revenue.

• For each reportable segment, various disclosures are required for segment revenues, profits
and losses, assets and liabilities. The disclosure requirements will generally depend on the
nature and extent of information regularly provided to and used by the CODM. Additional
disclosures should be made to clarify how the segment results were derived. These
disclosures include how the segments were identified, the nature of activities of the segments
and how the segment results were measured. Reconciliations of segment results to the
corresponding amounts in the entity financial statements are also required.

• Additional financial and non-financial entity-wide disclosures are also required for all entities
subject to HKFRS 8, including those entities with only one reportable segment.

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MIND MAP

OVERVIEW AND SCOPE REPORTABLE SEGMENTS

Segment reporting is required to reflect Aggregation of segments is possible
the way the company thinks about and Operating segments that satisfy any of
manages its business. three threshold tests based on revenues,
• Financial statements of companies whose profits/losses and assets
debt or equity securities are publicly
traded, or where future trade is intended SEGMENT
• Narrower than the public accountability REPORTING
concept HKFRS 8
Chief Operating Decision Maker
• Allocates resources to and assess
performance of segments
• Function, not a specific role
• May refer to more than one person
Operating segments
• May earn revenue/incur expense
• Results are regularly reviewed by the CODM
• Results are available
REPORTABLE SEGMENT DISCLOSURES ENTITY-WIDE DISCLOSURES
Reportable segments are operating Additional non-financial, disclosures where
segments that satisfy threshold tests not otherwise provided relating to segment
They may earn revenue/incur expense products and services, revenue and assets
by geographical region and any reliance
Results are regularly reviewed by the CODM
on major customers.
Results are available and include
information on:
• Revenue, profit/loss, assets and liabilities
• Explain 75% of external (consolidated)
revenues
• Reconciliations required for assets,
liabilities, profits

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. The CODM has responsibility for managing the operating segments.
The CODM refers to a function, not a position, and may not necessarily be the most senior
decision-maker in the organisation.
Answer B is correct. HKFRS 8 specifically indicates that segments are components of
a business from which the entity may have earned revenue. The use of the term ‘may’
indicates it need not have earned revenue before the reporting date as may be the case for
a start-up operation.
Answer C is incorrect. The presentation of segment information does not trigger the
need to apply the full requirements of HKFRS 8 as long as incomplete or otherwise
non-conforming segment information is not described as ‘segment information’.
Answer D is incorrect. Segments that generate considerable revenue from intersegment
transactions are not excluded under HKFRS 8.

Question 2
To advise Feng as to the reportable geographical segments, it is necessary to check
whether any of the quantitative thresholds outlined in HKFRS 8.13 are met:
• The operating segment’s reported revenue, including sales to external customers
and intersegment sales or transfers, is 10% or more of the combined revenue,
internal and external, of all operating segments;

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• The absolute amount of its reported profit or loss is 10% or more of the greater, in
absolute amount, of (i) the combined reported profit of all operating segments that
do not report a loss; and (ii) the combined reported loss of all operating segments
that report a loss; and
• Its assets are 10% or more of the combined assets of all operating segments.

To qualify as a reportable segment an operating segment need only meet one of

the threshold tests in HKFRS 8. For illustration purposes, we apply each test to each
segment below.
UK: generates 35.3% of total revenue, provides 43.8% of segment profit (absolute
value) and represents 38.3% of total assets. UK is a reportable segment.
Other Europe: generates 46.6% of total revenue, provides 56.3% of segment
profit (absolute value) and represents 43.4% of total assets. Other Europe is a
reportable segment.
Middle East: generates 8.0% of total revenue, provides 4.1% of segment profit (absolute
value) and represents 8.3% of total assets. Middle East is not a reportable segment.
Africa: generates 10.1% of total revenue, provides 9.8% of segment profit (absolute
value) and represents 10.0 of total assets. Africa is a reportable segment.
HKFRS 8 requires additional operating segments to be identified as reportable
segments if the reportable segments identified under the quantitative threshold tests
generate total external revenue of less than 75% of the entity’s revenue. Because the
three reportable segments previously identified have external revenue that sums to
92.0% of the entity’s revenue (i.e. HK$1,424,000), there is no need to identify any further
reportable segments.

Question 3
Under HKFRS 8, additional reportable segments must be identified until at least 75% of
total entity revenue is explained by segment revenue from external sources.

Fangsong Nial Huay Total Other Total entity % of

business revenue total
units revenue
HK$m HK$m HK$m HK$m HK$m HK$m
Year 1 75 160 320 555 250 805 68.9
Year 2 110 140 275 525 175 700 75.0
Year 3 230 250 375 855 315 1,170 73.1

To assist this calculation, an additional column is added to the right-hand side of the
table. This shows the percentage of total revenue explained by segment revenues in each
instance. By doing so, we can see that in years 1 and 3, the forecast segment revenues
represent less than 75% of total entity revenues. In these years, it is likely that one or more
additional reportable segments will need to be identified.

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Question 4
Under HKFRS 8, the aggregation of two or more operating segments is permitted where:
• Aggregation is consistent with the core principle of disclosing information for
evaluating the nature and financial effects of the entity’s business activities and the
economic environments in which the entity operates;
• The segments have similar economic characteristics; and
• The segments are similar in each of the following respects:
° the nature of their products and services;
° the nature of their production processes;
° the type or class of customer for their products and services;
° the methods used to distribute their products or provide their services; and
° if applicable, the nature of the regulatory environment, for example, banking,
insurance or public utilities.

By doing so, the resulting segment disclosures will assist users to better evaluate
the current performance and prospects of the entity. If segments are aggregated where
economic characteristics are dissimilar, important information will likely be lost. Further,
by aggregating the results of segments in line with HKFRS 8, the disclosures are less likely
to be cluttered with unnecessary detail, making the information easier to access and
understand.

Question 5
General purpose financial statements must be prepared in accordance with the
recognition and measurement requirements set out in HKFRSs. At the same time, segment
disclosures are prepared on a fundamentally different basis, meaning according to the
information prepared for and used by the CODM. As a consequence, the two sets of
information must be reconciled in accordance with HKFRS 8.
Key reasons why the information might differ in any particular period are where:
(i) different accounting policies are used in measuring segment amounts and deriving total
entity amounts; (ii) transactions have occurred between segments which are eliminated
when entity (e.g. consolidated) financial statements are prepared; or (iii) entity amounts
(e.g. assets or expenses) are not allocated to any reportable segment because either
there is no reasonable basis for allocation or the amounts pertain to immaterial operating
segments collectively displayed as ‘all other segments’.

Question 6
A key objective of requiring entity-wide disclosures is to enhance the transparency in
relation to entity totals. By receiving information about the key sources of revenue
by product and service, revenues and non-current assets by geographic location and
by reliance on major customers, users of financial statements can understand the
entity’s potential level of exposure. Likewise, users of the information can also assess
the measures the entity has taken to mitigate potential losses should adverse market
conditions develop.

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EXAM PRACTICE

QUESTION 1
Styledesign, a listed clothing manufacturer, trades in five business areas that 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 20X9 are as follows.

(Assume no operating segments should be identified as reportable segments solely because

they were identified as such in the immediately preceding period and are of continuing
significance).

Operating segment information as at 31 December 20X9

Revenue Total Profit/(Loss) Assets Liabilities

External Internal
HK$m HK$m HK$m HK$m HK$m HK$m
Ladies’ fashion:
Asia 561 17 578 41 310 149
Rest of world 142 13 155 6 98 49
Men’s fashion 599 8 607 39 104 75
Children’s fashion 224 – 224 (29) 310 129
Sportswear 124 13 137 8 129 102
Uniforms 185 39 224 (21) 445 192
Totals 1,835 90 1,925 44 1,396 696

Zen, the CEO of Styledesign, has asked for assistance in addressing the following three
specific aspects of segment reporting:

(a) Outline how segment disclosures can potentially lead to managers being more
accountable.

(b) Apply the threshold tests contained in HKFRS 8 to determine which of the above
segments constitute ’reportable’ operating segments under HKFRS 8 Operating
Segments for the year ending 31 December 20X9. Justify your conclusions by providing
appropriate calculations.

(c) Determine whether any of the segments can be aggregated. If you require additional
information to do so, identify the types of information required.

QUESTION 2
(a) Segment disclosures are widely regarded as useful disclosures in financial reports
because of the extent to which they disaggregate financial information into meaningful
groupings. Explain briefly, giving examples, how and why disaggregating entity totals
into operating segments can provide useful information.

(b) Explain how segment reporting may give rise to concerns about comparability of the
information being reported. In doing so, indicate briefly how the reconciliations required
for segment reporting help to improve the comparability of reporting by the entity.

(c) When should information be disclosed as part of ‘all other segments’ information as
opposed to presented as part of a reconciliation?

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QUESTION 3
Review the segment information below for Lin Cheng Ltd.

Revenue by customer location

External Internal Total Hong Kong Oceania Other
HK$m HK$m HK$m HK$m HK$m HK$m
Retail sales (bakery) 264 – 264 166 69 29
Online sales (bakery) 14 – 14 14 – –
Catering services 96 14 110 104 6 –
(business)a
Catering services 22 – 22 22 – –
(non-business)a
Manufacturing (bakery) 6 74 80 76 4 –
Publishing – books 64 – 64 30 24 10
and magazines
Publishing – website 6 – 6 6 – –
Leasing – offices 16 – 16 16 – –
Leasing – 25 10 35 24 6 5
manufacturing sites
Adjustments – (98) (98) (98) – –
Total reported 513 – 513 360 109 44
a
The long-term gross margins for these segments have been almost identical for a number of years.

(a) Prepare a reconciliation of revenue for segments to total entity revenue in accordance
with HKFRS 8. In doing so, by applying the concepts in HKFRS 8 to the facts in the
example, explain the basis for any decisions you make regarding how the segment
revenue information is presented.

(b) Prepare a note showing a breakdown of revenue by geographical location.

ANSWERS TO EXAM PRACTICE

QUESTION 1
(a) Segment disclosures provide greater detail about key components of the business,
which might otherwise be locked up in the aggregated results for the entity. As a
consequence, financial results for segments can be clearly observed and evaluated.
Further, segments are identified based on the way the CODM thinks about and
manages the entity, and a manager will often have responsibility for each segment.
This enables clear lines of accountability to be developed.

(b) To identify the reportable segments, the threshold tests in HKFRS 8 must be applied
(see the following).

Revenues: (HKFRS 8.13(a))

The threshold test for each segment’s revenues is its comparison with total segment
revenues (internal and external). Using this test, the components Ladies’ Fashion (Rest

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 FINANCIAL REPORTING

of the World) and Sportswear would not qualify as reportable segments.

Profit (loss): (HKFRS 8.13(b))

The next test is based on reported profit or loss. The absolute value of the segments
that reported a profit is HK$94 million, whereas the absolute value of the loss results
is HK$50 million. Because the absolute value of the segment profits is larger, this is the
figure we use. Using this test, the components Ladies’ Fashion (Rest of the World) and
Sportswear do not qualify as reportable segments.

Assets: (HKFRS 8.13(c))

All segments, with the exception of Ladies’ Fashion (Rest of the World), Men’s Fashion
and Sportswear, qualify as reportable segments under the assets threshold test.

Finally, although liabilities information is provided, this is not explicitly listed as a

threshold test for identifying the existence of a reportable segment.

Segment revenue Profit/(loss) Segment assets

≥10% of total ≥ 10% of absolute ≥10% of total
revenue profit/loss assets
Ladies’ fashion
Asia ✓ ✓ ✓
Rest of the world ✗ ✗ ✗
Men’s fashion ✓ ✓ ✗
Children’s fashion ✓ ✓ ✓
Sportswear ✗ ✗ ✗
Uniforms ✓ ✓ ✓

To summarise, the segments Ladies’ Fashion (Rest of the World) and Sportswear
operations do not meet any of the threshold tests in HKFRS 8.13 for identifying the
existence of reportable segments. Before firmly excluding these operating segments
from the required set of reportable segments, determine whether the ‘75% of the
entity’s revenue’ test in HKFRS 8.15 would be met after their exclusion. If these two
operating segments were excluded, the amount of total external revenue reported
by reporting segments would be HK$1,569 million, which is 85.5% of total external
revenue of HK$1,835 million. Therefore, HKFRS 8.15 does not preclude excluding these
two operating segments from the reportable segments of Styledesign.

(c) To voluntarily aggregate the results for two or more segments under HKFRS 8 to better
meet the core principle of that HKFRS, the segments must have similar economic
characteristics and be similar in all of the nature of products and services and
production processes, of type or class of customer, of the nature of the regulatory
environment and of the methods used to distribute the products. On the surface, the
most likely segments to aggregate would be those focusing on Ladies’ Fashion, although
the financial results for the two lines seem different. HKFRS 8 does not elaborate
on what is meant by ‘similar economic characteristics’, but it does indicate that two
segments with similarly long-term average gross margins are likely to have ‘similar

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 Operating Segments

economic characteristics’. In this case, we do not have information about long-term

gross margins for the segments. From the information given, we can, however, calculate
Net Profit Margin (profit/total revenue) for both segments: Asia: 7.1%; and Rest of
the World 3.1%. Basic calculations for return on assets (profit/total assets) also reveal
different results for the segments: Asia 13.22%; and Rest of the World 6.1%. Also, it is
unclear which countries are included in the ’Rest of the World’ category in the table,
so it is also difficult to judge whether they are likely to satisfy the additional criteria
outlined in HKFRS 8 relating to the nature of production the means of distribution and
the type or class of customer. Consequently, given the aggregation criteria previously
outlined, it is difficult to see how the financial results for segments in different countries
could be similar enough to justify aggregation.

To overcome these difficulties, more information is needed. This might include

more detailed financial metrics for the segments (including their correlation) over
several years to ascertain the degree of similarity and more information about the
countries included in the ‘Rest of the World’ category.

QUESTION 2
(a) When we examine a set of financial statements, we are seeing the overall financial
performance and position of the entity that is determined after aggregating the
elements of each of the different parts of the operations. This high-level aggregation
creates challenges for the analysis and interpretation of the amounts reported because
some variation probably exists in the relative performance of the different parts of the
business. This creates the need for detailed segment disclosures. An obvious example
is where revenues are broken down by product, service or geographical location of
customers. We can see which segments may be driving the results and which segments
may be underperforming.

(b) Disclosures in accordance with HKFRS 8 are based on the information regularly
provided to and used by the CODM. This means that entities retain some discretion
in measuring segment information (including allocations of amounts to segments)
and need not apply the requirements of accounting standards when measuring
segment revenues, expenses, assets, or liabilities. By implication, this also means
segment information need not necessarily be measured and reported on the same
basis as the entity might use in preparing its financial statements. Different entities
will likely use different methods to report segment information, thereby also impeding
comparability between entities. In preparing reconciliations, differences between
segments amounts and entity amounts are identified and disclosed. This enables a
better understanding of the effects of different accounting policies and intersegment
transactions, thereby providing enhanced comparability and a clearer picture of entity
metrics across time. At the same time, the reconciliations are not required for each
reportable segment; they are only required for the total of all segments. This means
that concerns regarding comparability may not be fully addressed by the preparation
of reconciliations.

(c) The ‘all other segments’ classification is used where one or more business activities
or operating segments is not, or does not form, part of a reportable segment (HKFRS

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 FINANCIAL REPORTING

8.16). Reconciliations are provided to explain key differences between the totals
for the reportable segments and the totals for the whole entity. Those differences
encompass:

• Business activities and operating segments included in ’all other segments’;

• Differences between how segment totals and entity totals are measured. These
‘measurement’ differences arise from differences between accounting policies
applied to the segments and the whole entity, and entity amounts (e.g. assets or
expenses) not being allocated to any reportable segment, for example, where there
is no reasonable basis for the allocation; and

• Intersegment transactions, which are eliminated when entity (e.g. consolidated)

financial statements are prepared.

QUESTION 3
(a) Reconciliation of reportable segments’ revenue to total entity revenue in accordance
with HKFRS 8.28(a) is shown below. The amount of detail exceeds that required by
HKFRS 8.28 and is provided to show how the amounts were determined. (For simplicity,
reportable segments are identified in this example by applying the 10% threshold test
solely to revenues.)

Revenue Retail Manufac- Publish- Catering All other Adjust- Company

sales turing ing segments ments
HK$m HK$m HK$m HK$m HK$m HK$m HK$m
External 264 6 64 118 61 – 513
Internal – 74 – 14 10 (98) –
Total 264 80 64 132 71 (98) 513

Additional Explanation:

For reporting purposes, the totals for business and non-business catering activities
can be aggregated where the activities possess similar economic characteristics and
the other aggregation criteria outlined in HKFRS 8.12 are satisfied. The information
provided in the question indicates similar gross margins for the segments in recent
years, which is a possible indicator of ‘similar economic characteristics’. Where this is
the case and if we were to assume the additional criteria outlined in HKFRS 8.12 are
met, the results for the segments may be aggregated for financial reporting purposes.

Online sales are not aggregated with retail sales because it is difficult determine
how they could have similar economic characteristics, that is, where the cost structure
and the factors affecting demand and supply are likely to vary.

Total revenues (including revenue from internal sales) are HK$611 million.
Revenue from online sales, leasing activities and website publishing activities
individually represent fewer than 10% of total revenues and, as such, fail the threshold
test in HKFRS 8.13 used to identify reportable segments. Therefore, based on
operating segment revenues, the reportable segments are identified as Retail Sales,
Manufacturing, Publishing (books and magazines), and Catering. Because the combined
external revenues of the four identified reportable segments represent more than

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 Operating Segments

75% of total entity revenues, no additional reportable segments need to be identified

to meet the requirements of HKFRS 8.15. Results for online sales, leasing activities and
website publishing activities must be combined and disclosed as ’all other segments’
(except for any of them separately disclosed on the grounds of relevance to users).

(b) Revenue by geographical location

Geographical Information

Revenue from external customers HK$m

Hong Kong 360
Oceania 109
Other countries 44
Total 513

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 26
Other Business Transactions, including
Agriculture and Biological Assets,
Insurance Contracts, Mineral Resources
and Service Concession Arrangements

CHAPTER TOPIC LIST

26.1 Agriculture and Biological 26.3.4 M easurement of Exploration

Assets and Evaluation (E&E) Assets
26.1.1 Scope 26.3.5 Presentation of Exploration
26.1.2 Terminology and Evaluation (E&E) Assets
26.1.3 Recognition and Measurement 26.3.6 Impairment of Exploration
of Agriculture Transactions and Evaluation (E&E) Assets
26.1.4 Current Developments 26.3.7 Current Developments
26.2 Insurance Contracts 26.4 Service Concession Arrangements
26.2.1 Terminology 26.4.1 N ature of Service Concession
26.2.2 Recognition and Measurement Arrangements
under HKFRS 17 26.4.2 Scope
26.3 Mineral Resources 26.4.3 Recognition and
26.3.1 Scope Measurement of Service
26.3.2 Terminology Concession Arrangements
26.3.3 Recognition of Exploration Consideration
and Evaluation (E&E) Assets 26.4.4 Current Developments

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT

FOR BUSINESS TRANSACTIONS
LO2.14: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: agriculture
2.14.01 Define biological asset and agricultural produce
2.14.02 Describe the recognition of biological asset and agricultural produce
LO2.15: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: insurance contracts
2.15.01 Define insurance contract
2.15.02 Describe recognition and measurement of insurance contract
LO2.16: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: exploration for and evaluation of mineral
resources
2.16.01 Define exploration and evaluation expenditures
2.16.02 Describe elements of cost of exploration and evaluation assets
2.16.03 D
 escribe measurement of exploration and evaluation assets on initial recognition and
subsequent measurement (i.e. cost model or revaluation model)
2.16.04 Explain presentation of exploration and evaluation assets
2.16.05 Explain when and how to assess impairment of exploration and evaluation assets
LO2.17: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: service concession arrangements
2.17.01 Describe typical features of service concession arrangements
2.17.02 D
 escribe the accounting treatment of operators for public-to-private service concession
arrangements

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OPENING CASE

LUCKY PASTORAL COMPANY

T his chapter covers four diverse topics. The opening case relates to two of those: agriculture
and the exploration and evaluation (E&E) of mineral resources. Other examples are given
for each of the other topics in the later sections of this chapter.

A Hong Kong-registered company, Lucky Pastoral Company (‘Lucky’), owns a 10,000-hectare

beef cattle property located in outback Australia. The property runs about 6,500 head of cattle,
including 2,000 Angus breeding cows.

Five years ago, Lucky decided to reduce its reliability on the beef industry and to diversify
into another suitable agricultural interest. Following significant research, Lucky decided to
diversify into olive oil with a plantation of 7,000 olive trees on a 100-hectare plantation adjacent
to a river running through the existing property. The olive trees are maturing and the first
harvest is expected to take place in the coming autumn. Given its geographical isolation, Lucky
has established an on-site olive oil processing facility and plans to produce bottles of extra
virgin olive oil for sale and distribution to a major supermarket chain.

Three years ago, the government completed a number of geological surveys and maps
of possible mineralised material in the northern end of Lucky’s property. This has shown a
potential for discovery of large deposits of iron oxide copper gold (IOCG) (copper gold). As soon
as the studies commenced, Lucky successfully applied for exploration leases across the entire
property. The purpose of these applications was two-fold: first to ensure Lucky could control
the impact of any exploration and/or mining activity on the land and agricultural activities on
the property and, second, to participate in any potentially successful mining activities.

Lucky has employed a geologist and an accountant to ensure the strict terms and
conditions of the exploration lease are followed and sufficient E&E activity is taking place when
required.

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OVERVIEW

The International Accounting Standards Board (IASB) and the International Accounting
Standards Committee (IASC) before it resisted developing industry-based standards for a long
time. This was due to concerns the issuing of specialist standards would:

• Potentially result in divergence away from the International Financial Reporting

Standards (IFRS) principles included in the general standards; and

• Encourage other industry bodies to demand a specialised industry specific standard for
their industry.

However, following that resistance, the IASC issued IAS 41 Agriculture in 2000 and that
standard was subsequently incorporated into IFRS by the IASB. It was issued in Hong Kong as
HKAS 41, based on IAS 41, and later incorporated into the adoption of IFRS in Hong Kong. That
industry standard was followed by HKFRS 4 Insurance Contracts (superseded by HKFRS 17, as
of 2023) and HKFRS 6 Exploration for and Evaluation of Mineral Resources, both issued in 2004.
Though specialised, the IASB has been careful to restrict the scope of these standards to
the unique issues of those industries, and this has resulted in those standards being largely
adopted without ambiguity and conflict with other IFRS requirements.

HK(IFRIC) Interpretation 12 Service Concession Arrangements is a specific interpretation

issued to address the growing trend for private enterprise entities to construct infrastructure
used by the public and will revert to government ownership after a predetermined
period of time.

These industry specialist standards are discussed at a high level in this chapter.

2 6 . 1 AGRICULTURE AND BIOLOGICAL ASSETS

HKAS 41 Agriculture introduced a fair value model to agricultural accounting.

26.1.1 Scope
HKAS 41 must be applied to the following three aspects of accounting for agricultural activities:

1. Biological assets except for bearer plants (such as fruit trees and oil palms). Refer to
Section 26.1.2 for definitions, including that of bearer plants and biological assets;

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2. Agricultural produce but only at the point of harvest. The standard does not deal with
the processing of agricultural produce after harvest, for example, the processing of
grapes into wine by a vintner who has grown the grapes. This is deemed to be similar
to other inventory processes and accordingly agricultural processes post-harvest are
addressed by HKAS 2 Inventories or another applicable standard, and;

3. Government grants which are either:

°° Unconditional and related to a biological asset measured at fair value less costs
to sell, or

°° Conditional and related to a biological asset measured at fair value less costs to sell
and the conditions attached to the grant are met.

This standard does not apply to:

• Land related to agricultural activity, for example freehold land owned (see
HKAS 16 Property, Plant and Equipment and HKAS 40 Investment Property – refer to
Chapters 7 and 8);

• Bearer plants related to agricultural activity (see HKAS 16 – refer to Chapter 7).
However, the standard applies to the produce on those bearer plants;

• Government grants related to bearer plants (see HKAS 20 Accounting for Government
Grants and Disclosure of Government Assistance – refer to Chapter 22); and

HKAS • Intangible assets related to agricultural activity, for example leases of properties used
41.2 for agricultural purposes (see HKAS 38 Intangible Assets – refer to Chapter 11).

26.1.2 Terminology
Biological asset is a living animal or plant.

Biological transformation comprises the processes of growth, degeneration, production

and procreation that cause qualitative or quantitative changes in a biological asset.

Agricultural activity is the management by an entity of the biological transformation

and harvest of biological assets for sale or for conversion into agricultural produce or into
additional biological assets.

Agricultural activity covers a diverse range of activities, including, for example, raising
livestock, forestry, annual or perennial cropping, cultivating orchards and plantations,
floriculture and aquaculture (including fish farming). Certain common features exist within this
diversity:

• Capability to change. Living animals and plants are capable of biological transformation;

• Management of change. Management facilitates biological transformation by

enhancing, or at least stabilising, conditions necessary for the process to take place
(e.g. nutrient levels, moisture, temperature, fertility and light). Such management
distinguishes agricultural activity from other activities. For example, harvesting from
unmanaged sources (such as ocean fishing and deforestation) is not agricultural
activity; and

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 FINANCIAL REPORTING

• Measurement of change. The change in quality (e.g. genetic merit, density, ripeness, fat
cover, protein content and fibre strength) or quantity (e.g. progeny, weight, cubic
metres, fibre length or diameter and number of buds) brought about by biological
HKAS transformation or harvest is measured and monitored as a routine management
41.6 function.

Agricultural produce is the harvested produce of the entity’s biological assets.

Bearer plant is a living plant that:

• Is used in the production or supply of agricultural produce;

• Is expected to bear produce for more than one period; and

• Has a remote likelihood of being sold as agricultural produce except for incidental scrap
sales (refer to later text for further discussion).

The following are not bearer plants:

• Plants cultivated to be harvested as agricultural produce (e.g. trees grown for use
as lumber);

• Plants cultivated to produce agricultural produce when there is more than a remote
likelihood that the entity will also harvest and sell the plant as agricultural produce; and

• Annual crops (e.g. maize and wheat).

Bearer plants no longer used to bear produce may be cut down and sold as scrap
(e.g. firewood). Selling bearer plants as scrap does not prevent the plant from being defined as
a bearer plant.

Harvest is the detachment of produce from a biological asset or the cessation of a

biological asset’s life processes.

The table below (Exhibit 26.1) provides examples of biological assets, agricultural produce
and products that are the result of processing after harvest.

Biological assets Agricultural produce Products that are the result

of processing after harvest
Sheep Wool Yarn, carpet
Trees in a timber plantation Felled trees Logs, lumber
Beef cattle Beef Hamburgers
Sugarcane Harvested cane Sugar
Grape vines a
Picked grapes Wine
a
HKAS G
 rape vines meet the definition of a bearer plant and are, therefore, within the scope of HKAS 16. However, the result-
41.4 ing produce of grapes are within the scope of HKAS 41.
EXHIBIT 26.1 Examples of biological assets, agricultural produce and resulting products

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Illustrative Example 1
Having regard to the information provided in the Lucky case study, Lucky’s finance
manager has identified the accounting standard that applies to each of Lucky’s
agricultural assets.

Agricultural Applicable standard Explanation

asset
Land HKAS 16 Property, Plant and Land is specifically scoped out of HKAS 41
Equipment (Note: if Lucky held Agriculture even if it is used for agricultural
the property as an investment purposes.
property, HKAS 40 Investment
Property would apply)
Cattle HKAS 41 Agriculture Although the Angus breeding cows, owned
by Lucky, have calves (and, therefore, exhibit
similar characteristics as bearer plants
as they bear produce for more than one
season), they were specifically excluded
from the recent amendment to HKAS 41 to
treat bearer plants as a fixed asset within
scope of HKAS 16. Therefore, they are not
classified as bearer plants.
Olive trees HKAS 16 Property, Plant and These are bearer plants.
Equipment
Olives HKAS 41 Agriculture Agricultural produce to the point of harvest
is within scope of HKAS 41.
Olive oil (in vat) HKAS 2 Inventories Agricultural produce processed in any way
post-harvest is considered to be inventory.
Given the oil is the result of pressing olives,
it is considered to be inventory.
Olive oil (bottled) HKAS 2 Inventories As the olive oil is generated by a post-harvest
process (the pressing of the olives), it is
considered to be inventory.

26.1.3 Recognition and Measurement of Agriculture Transactions

HKAS 41 establishes when biological assets and agricultural produce should be brought to
account (recognised) as assets and how they should then be measured.

26.1.3.1 Recognition
Recognition of a biological asset or agricultural produce should occur when:

• The entity controls those assets as a result of past events;

• That future economic benefits associated with the asset will probably flow to the
entity; and

• The fair value or cost of the asset can be measured reliably.

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 FINANCIAL REPORTING

Control of biological asset or agricultural produce may be evidenced by recognition of legal

ownership. The future benefits are normally assessed by measuring the significant physical
attributes, for example, the type and weight of cattle or the quality and quantity of the crop.

26.1.3.2 Measurement
Under HKAS 41, a biological asset is to be measured at ’fair value less costs to sell’:

• On initial recognition (i.e. at the point of harvest); and

• At the end of each reporting period.

The value of the biological asset determined under HKAS 41 will become part of the
inventory cost when the agricultural produce commences processing and is accounted for by
HKAS 2 or another applicable standard.

Costs to sell are the incremental costs directly attributable to the disposal of an asset
(excluding finance costs). Examples of costs to sell include legal costs, direct costs of bringing
the asset into condition for sale (including removal or dismantling the asset) and transactional
taxes (such as stamp duty).

The following costs are not to be included in the cash flows used to estimate fair
value include:

• Finance costs (e.g. interest and any other bank fees); and
• Re-establishment costs where biological assets are required to be replaced after
harvest (e.g. any costs of remediating the land, costs of replacing trellises and
HKAS other support structures or the cost of replanting trees in a plantation following
41.22 harvesting).

Apply and Analyse 1

Lucky’s herd of 5,000 Angus cattle comprises 2,000 breeding cows. These cows were
acquired at auction by Lucky for HK$7,000 each. There are no costs to buy the breeding
cows and no costs to sell.

Explain to Lucky’s finance manager how to recognise and measure the acquisition of
Lucky’s breeding cows.

Analysis

The breeding cows are considered to be a biological asset in accordance with the
definitions provided by HKAS 41. Biological assets are required by HKAS 41 to be measured
at fair value less costs to sell.

As the cows were acquired at public auction, the cost of HK$7,000 per head is an
accurate representation of fair value. With no costs to sell, the fair value less costs to sell is
HK$7,000 per head or HK$14,000,000 for all 2,000 breeding cows (2,000 * HK$7,000).

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Apply and Analyse 1 (continued)

The journal to recognise the acquisition of the breeding cows is:

Debit Credit
HK$ HK$
Biological Asset (Angus breeding cows) 14,000,000
Bank 14,000,000

26.1.3.3 Gains and Losses

Biological Asset
A gain or loss arising on initial recognition of a biological asset will arise when there is difference
between the total costs incurred to acquire the assets and the fair value less costs to sell.

Losses may arise on initial recognition of a biological asset because either:

• Costs to sell must be deducted from the fair value in determining the carrying amount
of a biological asset. Depending on the type of asset and the market place they are sold
in, those costs could be significant; or

• The fair value is below the cost (e.g. if the timber industry has collapsed, plantation
timber may be worthless and therefore below cost).

A gain may arise on initial recognition of a biological asset, such as when a calf is
born to a cow.

Subsequently, such gains and losses will stem from changes in fair value less costs to
sell for those assets. Any gain or loss is included in the statement of profit or loss and other
comprehensive income for the period in which it arises.

Apply and Analyse 2

Using the same facts as the preceding example, assume costs to sell exist and these
comprise advertising costs of HK$10, sales commission costs of HK$20 and an Australian
government meat levy cost of HK$20 per head.

Explain to Lucky’s finance manager how to recognise and measure the acquisition of
Lucky’s breeding cows.

Analysis

Lucky paid HK$14 million for the 2,000 breeding cows (2,000 * HK$7,000). The expected
costs to sell total HK$50 per head resulting in a fair value less cost to sell per head of
HK$6,950 or HK$13.9 million for the 2,000 breeding cows.

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Apply and Analyse 2 (continued)

Therefore, a loss of HK$100,000 is recorded on initial recognition as follows:

Debit Credit
HK$ HK$
Biological Asset (Angus breeding cows) 13,900,000
Fair value loss on initial recognition of breeding cows 100,000
Bank 14,000,000

Apply and Analyse 3

Using the same facts as the example above, assume at the end of year 1 that the fair
value less costs to sell for each of the breeding cows is now HK$7,150 (being a fair value
of HK$7,200 less costs to sell of HK$50) resulting in the value of the breeding cows
HK$14.3 million (2,000 * $7,150).

Explain to Lucky’s finance manager how to recognise and measure the change in fair
value of Lucky’s breeding cows.

Analysis

The fair value less costs to sell for the breeding cows at the previous reporting date
was HK$13.9 million. This compares to the current fair value less costs to sell of
HK$14.3 million, a gain in value of HK$400,000.

Therefore, a gain of HK$400,000 is recorded in year 2 as follows:

Debit Credit
HK$ HK$
Biological Asset (Angus breeding cows) 400,000
Fair value gain on remeasurement of breeding cows 400,000

Agricultural Produce
Any gain or loss arising on initial recognition of agricultural produce at fair value less costs to
sell is included in the statement of profit or loss and other comprehensive income for the
period in which it arises. This may arise, for example, on initial recognition of agricultural
HKAS produce as a result of harvesting (gain) or where there is a difference between the standing
41.28 value of the crop before harvest and the value once harvested (gain or loss).

26.1.3.4 Government Grants

To support their industry, some entities may receive assistance in the form of a grant from
the government. Some government grants related to biological assets are within the scope

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of HKAS 41; the accounting for other government grants is specified by HKAS 20 Accounting
for Government Grants and Disclosure of Government Assistance (see Chapter 22). The types of
government grants related to biological assets within the scope of HKAS 41 and the applicable
accounting are summarised in Exhibit 26.2.

Unconditional government
• HKAS 41 applicable
grant related to a biological
asset measured at its fair • Recognised in profit or loss when, and only when, the
value less costs to sell government grant becomes receivable

Conditional government
• HKAS 41 applicable
grant related to a biological
asset measured at its fair • Recognised in profit or loss when, and only when, the
value less costs to sell conditions attached to the government grant are met

• HKAS 20 applicable
Government grant • Recognised when there is reasonable assurance that:
relating to bearer plants (i) the entity will compy with the grant conditions and
(ii) the grant will be received

EXHIBIT 26.2 Types of government grants and associated accounting

Illustrative Example 2
Lucky was provided with an ‘emerging industry’ government grant to assist with the costs
of planting the olive tree plantation. The grants are designed to encourage property
owners to diversify into new value-added industries such as olive trees.

A condition of the grant is that property owners employ local unemployed people
between the ages of 18 and 25 to plant the olive trees and that a certified return is
submitted to the government to prove this condition has been satisfied. The grant is
paid as soon as planting is completed to assist property owners with their cash flow. It is
calculated as a fixed contribution per labour hour incurred. If the necessary conditions
are found to have been unmet following receipt of the grant, it must be repaid to the
government.

To account correctly for the government grant, Lucky must determine what type of
grant has been issued. In this case, the grant is conditional and relates to a biological
asset measured at fair value less costs to sell. HKAS 41 is, therefore, applicable to this
government grant.
When the grant is received from the government, Lucky will record the following
journal entry:

Debit Credit
HK$ HK$
Cash
Performance obligation

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 FINANCIAL REPORTING

Illustrative Example 2 (continued)

When the conditions of the grant are satisfied, Lucky recognises the government grant
in profit and loss:

Debit Credit
HK$ HK$
Performance obligation
Government grant income

26.1.4 Current Developments

At the time of writing, there was no project in relation to IAS 41 Agriculture on the IASB
work plan.

Knowledge Check Questions

Question 1
Identify which of the following is NOT considered an agricultural activity.
A Oyster farming
B Ocean fishing
C Pearl farming
D Fish farming

Question 2
Identify which of the following meets the definition of agricultural produce.
A Dairy cattle
B Milk
C Cheese
D Yoghurt

Question 3
Identify which of the following is NOT considered to be an agricultural produce.
A Timber
B Sugar
C Wool
D Milk

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Knowledge Check Questions (continued)

Question 4
Identify which of the following statements is incorrect.
A Management facilitates biological transformation.
B Management is a key part of the definition of agricultural activity under HKAS 41.
C There is a link between management and control of a biological asset.
D Management is a key part of the recognition criteria for biological assets and
agricultural produce.

Question 5
Rural Co received a HK$100,000 grant from the government on 1 July 20X6. One of the
conditions attached to the grant was that Rural Co had to continue farming in the same
location for the following two years; otherwise, the grant would have to be returned in full.
Prepare the journal entry to record the receipt of the grant.

A Debit Credit
HK$ HK$
Cash 100,000
Government grant income 100,000

B Debit Credit
HK$ HK$
Cash 100,000
Government grant income 50,000
Performance obligation 50,000

C Debit Credit
HK$ HK$
Cash 100,000
Performance obligation 100,000

D No entry is required as the grant is conditional and cannot be recognised until the
conditions attached to the grant are met.

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2 6 . 2 INSURANCE CONTRACTS

Insurers accumulate risks in exchange for premiums from multiple policyholders and create
diversified portfolios of insurance contracts. This risk-bearing service is essential to the effective
functioning of the economy and personal financial security. Without the ability to transfer risk
to a well-diversified insurer, many businesses would be unable to operate and many individuals
would be unable to plan for their own financial future. For example:

• A property developer may be unprepared to proceed with constructing an office tower

if it had to retain 100% exposure to all the associated risks, including public liability,
worker injury, theft and project delays; and

• Individuals may be unable to insure against the risk of serious illness and disability,
which may limit their preparedness to buy a house, start a family or establish a business.

Due to the fundamental role that insurers play in society, useful information about insurers’
activities, including information in financial reports for investors and other users, is crucial.

Conventionally, the insurance industry is divided into two broad business categories:

1. General or property and casualty insurance business, which involves insuring damage
to property (e.g. to a building or motor vehicle), loss of profits (e.g. due to fire or flood)
or loss of income (e.g. due to disability). Health, medical and travel insurance products
are also usually included in this category.

2. Life insurance business, which involves insuring against premature death or insuring
to preserve a retirement income matching a person’s longevity through the payment
of annuities. Some life insurance products are part of a broader contract that involves
providing investment services to policyholders.

Entities provide all of the above types of insurance; others specialise in particular types of
insurance.

This chapter introduces HKFRS 17 Insurance Contracts.

HKFRS 17 applies to periods beginning on or after 1 January 2023.

HKFRS 17 sets out a comprehensive set of principles for the recognition and measurement
of insurance contracts and the presentation of and disclosure of information about insurance
contracts in the financial statements.

HKFRS 17 applies to:

• Insurance contracts an entity issue;

HKFRS
• Investment contracts with discretionary participation features it issues, provided the
17.3 entity also issues insurance contracts.

This section introduces the initial recognition requirement and measurement approaches
under HKFRS 17. It does not cover other aspects in HKFRS 17 such as the level of aggregation of
insurance contracts, subsequent measurement, modification and derecognition, accounting for
onerous contracts and investment contracts with discretionary participation features.

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26.2.1 Terminology
HKFRS 17 introduces a number of terms, including the following, to help address the specific
issues that arise in the insurance industry.

1. Insurance contract: A contract under which one party (the issuer) accepts significant
insurance risk from another party (the policyholder) by agreeing to compensate the
policyholder if a specified uncertain future event (the insured event) adversely affects
the policyholder.

2. Policyholder: A party that has a right to compensation under an insurance contract if

an insured event occurs.

3. Financial risk: The risk of a possible future change in one or more of a specified
interest rate, financial instrument price, commodity price, currency exchange rate,
index of prices or rates, credit rating or credit index or other variable, provided in the
case of a non-financial variable that the variable is not specific to a party to the contract.

4. Insurance risk: Risk, other than financial risk, transferred from the holder of a contract
to the issuer.

5. Insured event: An uncertain future event covered by an insurance contract that creates
insurance risk.

6. Investment component: The amounts that an insurance contract requires the entity
to repay to a policyholder in all circumstances, regardless of whether an insured
event occurs.

7. Insurance contract services: The following services that an entity provides to a

policyholder of an insurance contract:

(a) coverage for an insured event (insurance coverage);

(b) for insurance contracts without direct participation features, the generation of an
investment return for the policyholder, if applicable (investment-return service); and

(c) for insurance contracts with direct participation features, the management of
underlying items on behalf of the policyholder (investment-related service).

8. Insurance contract with direct participation features: An insurance contract for

which, at inception:

(a) the contractual terms specify that the policyholder participates in a share of a
clearly identified pool of underlying items;

(b) the entity expects to pay to the policyholder an amount equal to a substantial share
of the fair value returns on the underlying items; and

(c) the entity expects a substantial proportion of any change in the amounts to be paid
to the policyholder to vary with the change in fair value of the underlying items.

HKFRS 17 9. Insurance contract without direct participation features: An insurance contract

App A that is not an insurance contract with direct participation features.

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26.2.2 Recognition and Measurement under HKFRS 17

The following discussion is simplified for learning purposes in this learning pack.

Coverage Period
HKFRS 17 defines coverage period as:

The period during which the entity provides insurance contract services. This period includes
the insurance contract services that relate to all premiums within the boundary of the
insurance contract.

Determining the coverage period is crucial in applying HKFRS 17 because it determines the
extent of the cash flows used in recognising and measuring insurance liabilities and the periods
over which estimated profits should be allocated.

Illustrative Example 4
Cirrus Insurance Company (Cirrus) sells May Yong a house insurance policy that covers
her for damage to her house or theft of house contents for a premium of HK$1,200.

The contract states that cover commences on 1 May 20X0 and ends on 30 April 20X1,
meaning that damage to May Yong’s house or theft of house contents arising from events
occurring within this one-year period are insured events.

This is an insurance contract because one party (Cirrus) accepts significant insurance
risk from another party (May Yong) by agreeing to compensate May Yong if a specified
uncertain future event (damage to May Yong’s house or theft of her house contents)
adversely affects May Yong.

May Yong makes a valid claim for theft of a laptop from her house that occurred on
15 March 20X1. This is within the coverage period, and Cirrus must recognise a claim
liability until it settles the claim with May Yong; e.g. by replacing the laptop or paying her
compensation for her loss.

The existing contract coverage period is a year to 30 April 20X1. In the event a theft
occurs in May Yong’s house after 30 April 20X1, any loss would not be covered by Cirrus
unless May Yong enters into a further contract covering the period after 30 April 20X1.

Illustrative Example 5
Stratus Insurance Company (Stratus) sells Wai Construction Company (Wai) a
construction risks insurance policy that would pay the costs associated with accidents
affecting workers and the theft of materials on a particular construction site for the
duration of the construction period. Construction is expected to commence on 1 June
20X1 and be completed on 31 May 20X4.

Annual premiums of HK$100,000 are due from Wai on 1 June each year for three years.
Cancellation or termination of the insurance contract is not allowed.

Although the premiums are annual, Stratus must keep insuring Wai for the expected
total period of construction. Accordingly, the construction risks insurance policy provides
three years of coverage.

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Initial Recognition
Under HKFRS 17, entities account for the insurance contracts they issue on an aggregated
basis. Contracts are classified into portfolios of insurance contracts that expose the insurer to
similar risks and are managed together.

To help ensure insurance contracts are recognised as soon as an insurer takes on

insurance risk, HKFRS 17 requires a group of insurance contracts to be recognised from the
earliest of when:

• Coverage begins and

• The first payment from a policyholder becomes due.

Note: We have simplified these discussions for learning purpose in this learning pack.

Entities may issue contracts that include both insurance services and other components
that are not related to insurance services such as an investment feature. If the non-
insurance components are not distinct from the insurance component and, provided the
contract includes ‘significant’ insurance risk, the whole contract is accounted for as an
insurance contract.

Insurance Liabilities
Under HKFRS 17, insurance liabilities can be regarded as relating to remaining (future) coverage
and/or incurred claims.

A liability for remaining coverage is an insurer’s obligation to handle and pay valid claims
under its existing insurance contracts for insured events that may occur during the unexpired
portion of the coverage period. It also includes the obligation to pay amounts under its
existing insurance contracts that relate to insurance contract services not yet provided or any
investment components or other amounts that are not related to the provision of insurance
contract services and that have not been transferred to the liability for incurred claims.

A liability for incurred claims is an insurer’s obligation to handle and pay valid claims for
insured events that have occurred, including those that are estimated to have occurred but
have not been reported to the insurer, and other incurred insurance expenses. It also includes
the obligation to pay amounts that relate to insurance contract services that have already been
provided or any investment components or other amounts that are not related to the provision
of insurance contract services and that are not in the liability for remaining coverage.

Fulfilment Cash Flows Approach

The core measurement approach in HKFRS 17 requires insurance contract liabilities and
assets to be measured under HKFRS 17 based on estimates of fulfilment (future) cash flows
discounted when relevant. This approach would ordinarily be applied to multiyear insurance
contracts and to any insurance contracts with material liabilities for incurred claims. The
‘fulfilment cash flows approach’ is a term used in this chapter to refer to the approach required
by paragraphs 32 to 52 of HKFRS 17. The term has been coined to facilitate the explanation of
the requirements. HKFRS 17 does not use such a term.

An insurer initially measures the liability for remaining coverage for a group of contracts
as the total of the fulfilment cash flows, which incorporate future premiums, claims and claims
handling costs relating to expected future events, a risk adjustment, acquisition cash flows
(e.g. commissions paid to agents), an adjustment for the time value of money when relevant
and any contractual service margin (see below).

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An insurer measures the liability for incurred claims for a group of contracts as the
fulfilment cash flows relating to claims, claim handling costs arising from past events and other
associated costs expected to be paid for incurred claims.

The risk adjustment reflects the compensation the insurer requires to bear the uncertainty
associated with the amounts and timing of estimated cash flows. This amount would make
the insurer indifferent between fulfilling a liability with a range of possible outcomes arising
from its insurance contracts and fulfilling a liability generating fixed cash flows with the
same expected present value. For example, the risk adjustment would be the compensation
required to make an insurer indifferent between an insurance liability with a 50% chance of
being HK$300,000 and a 50% chance of being HK$900,000, compared with a fixed liability of
HK$600,000.

The cash inflows and outflows will often be expected to occur over a number of periods, in
which case they must be discounted to a present value to represent a relevant obligation as of
the reporting date. The discount must reflect the time value of money and the liability’s cash
flows and liquidity characteristics.

The contractual service margin is the component within a liability for remaining coverage
that represents unearned profit the insurer recognises in future as it provides insurance
contract services to policyholders. It is effectively a residual amount, that is the difference at
initial recognition between the estimated present value of fulfilment cash inflows and fulfilment
cash outflows. The contractual service margin ensures no upfront profit recognition exists
when an insurance contract is issued and ensures that the carrying amount of insurance
liabilities will reflect the insurer’s obligation to provide future service, which should be an
amount at least equal to the fulfilment cash flows.

At each reporting date subsequent to the initial measurement, an insurer must remeasure
its insurance liabilities in the light of its fulfilment (future) cash flow estimates based on current
information.

The remeasurement of the liability for remaining coverage includes reductions relating to
the allocation to profit or loss of:

• An amount of the contractual service margin for a group of insurance contracts to

reflect the services provided in respect of the group of insurance contracts in the
period; and

• Revenue in respect of the coverage provided by the group of insurance contracts in the
period (relating to the release from risk).

Illustrative Example 6
Genitus Insurance Company (Genitus) sells an insurance policy that would pay
HK$2,000,000 to Jim’s family in the event that Jim was unable to work. The contract
provides insurance cover for up to 30 years provided Jim continues to pay the annual
premiums of HK$15,000. In addition, a proportion of Jim’s premiums are invested in a
pool of equity securities managed by Genitus for a percentage fee. Gains and losses on
the pool of equity securities (less Genitus’ fees) are allocated to his account. In the event
that Jim stops paying premiums, he will cease to have insurance coverage, and will be

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Illustrative Example 6 (continued)

paid the balance in his account. This contract provides Jim with insurance coverage and
participation in returns from underlying items. Accordingly, this is an insurance contract
with direct participation features.

Insurers sometimes incur significant costs in acquiring insurance contracts. Acquisition

HKFRS
cash flows directly attributable to groups of insurance contracts that have been recognised
17.28A are included in the insurance liability and would affect the amount of the contractual service
HKFRS margin. Acquisition cash flows that have been paid before the related group of insurance
17.28B contracts have been recognised are recognised as an asset. The asset is derecognised when
HKFRS the acquisition cash flows are included in the measurement of the related group of insurance
17.28C contracts.

Premium Allocation Approach

The premium allocation approach is the simplified method to measure the liability for
remaining coverage for insurance contracts. The premium allocation approach can only be
applied to measure insurance contracts when:
• The insurer reasonably expects the approach would produce materially the same
liability for remaining coverage as the core fulfilment cash flows approach; or
HKFRS
17.34 • The coverage period of each contract in the group is one year or less.

The premium allocation approach is permitted under these conditions on the basis that it
would provide the opportunity for many insurers to minimise the costs of applying HKFRS 17
without affecting the relevance and reliability of the accounting outcomes.

The premium allocation approach involves initially measuring an insurance liability as

the premiums, if any, received at initial recognition less any insurance acquisition cash flows
relevant at that date. HKFRS 17 also permits the insurer to choose to recognise all acquisition
HKFRS cash flows immediately as an expense if the coverage period of each contract in the group at
17.59(a) initial recognition is no more than one year. Accordingly, if this option is taken, the initial liability
HKFRS for remaining coverage is simply the amount of any premiums received. HKFRS 17 permits the
17.28B insurer to recognise any acquisition cash flows paid before the recognition of the related group
HKFRS of insurance contracts as an asset. The asset is derecognised when the acquisition cash flows
17.55(a)(iii)1 are included in the measurement of the related group of insurance contracts.
HKFRS
17:55(b) At each reporting date subsequent to initial measurement, an insurer:

• Increases its insurance liabilities for any premiums received in the period;

• Reduces its insurance liabilities for premiums recognised as revenue in the period for
the promised services provided to policyholders in that period; and

• Adjusts its insurance liabilities for acquisition cash flows.

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Illustrative Example 7
Dome Insurance Company (Dome) sells annual house and contents insurance that covers
the policyholder for the costs of repairing damage to their house or the theft of, or
damage to, house contents.

Because the coverage period is a year, Dome chooses to apply the premium
allocation approach.

Coverage commences on 31 March 20X0 for all the contracts Dome issues on that day
as follows:

• 110 contracts under which policyholders have paid HK$800 each;

• 105 contracts under which policyholders have agreed to pay HK$800 by

30 July 20X0; and

• 100 contracts under which policyholders have paid HK$400 and agreed to pay a
further HK$400 by 30 July 20X0.

There are no acquisition costs.

The insurance liability initially recognised on 31 March 20X0 would be HK$128,000

IFRS (110 contracts × HK$800 + 100 contracts × HK$400). The premiums yet to be received are
17.BC20 not initially included in measuring the liability.

Knowledge Check Questions

Question 6
Identify which of the following best describes how contractual service margins are initially
determined in accordance with HKFRS 17.
A The difference between premiums received and expected incurred claims when a
contract is issued.
B The difference between expected fulfilment cash inflows and expected fulfilment cash
outflows when a contract is issued.
C The difference between the expected fulfilment cash inflows and the risk adjustment
when a contract is issued.
D The difference between the expected fulfilment cash flows and claims incurred when a
contract is issued.

Question 7
Identify which of the following best describes when the premium allocation approach can
be applied in accordance with HKFRS 17.
A When both of the following conditions apply: (i) the coverage period is a year or less and
(ii) the premium allocation approach is expected to result in materially the same liability
for remaining coverage as the fulfilment cash flows approach.

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Knowledge Check Questions (continued)

B When all premiums are received at the time insurance contracts are issued and the
premium allocation approach is expected to result in materially the same liability for the
remaining coverage because the fulfilment cash flows approach and the coverage period
is a year or less.
C When the coverage period is a year or less.
D When one of the following conditions apply: (i) the coverage period is a year or less or
(ii) the premium allocation approach is expected to result in materially the same liability
for the remaining coverage as the fulfilment cash flows approach.

Question 8
Identify which of the following best describes how risk margins are measured in
accordance with HKFRS 17.
A The compensation the insurer requires to bear the uncertainty associated with the
amounts and timing of estimated cash flows.
B The compensation the insurer requires to bear the uncertainty associated with
the amounts and timing of estimated cash flows relating to the liability for
remaining coverage.
C The compensation the insurer requires to bear the uncertainty associated with the
amounts and timing of estimated cash flows relating to the liability for incurred claims.
D The compensation the policyholder requires to bear the uncertainty associated with the
amounts and timing of estimated cash flows.

2 6 . 3 MINERAL RESOURCES

There is little specific guidance for the accounting for extractive industries. Indeed, in a
number of standards, accounting for extractive industries is specifically scoped out (HKAS 2
(Revised) Inventories, HKAS 16 Property, Plant and Equipment and HKAS 38 Intangible Assets).
This leaves preparers with little choice but to go back to basics by applying HKAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors to use the Conceptual Framework, an
analogous IFRS or pronouncements of other standards setting bodies employing a similar
framework.
HKFRS 6 Exploration for and Evaluation of Mineral Resources was released in 2004 as an
interim measure to address a limited number of issues related to exploration and evaluation
(E&E) activities; however, no significant changes have been made to it since that time.

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26.3.1 Scope
HKFRS 6 is not applicable to expenditures incurred:

• Before the entity has obtained the legal rights to explore a specific area; and

• After the technical feasibility and commercial viability of extracting a mineral resource
has been demonstrated and approved by the appropriate management approval
HKFRS process (usually management or board approval depending on the size of the capital
6.5 required to develop the mine).

The life cycle of an extractive site can be shown and described as in Exhibit 26.3.

Mine Life Cycle–Identification to Operation

Accounting Evaluation Evaluation

Identification Exploration Development Operation
Phase (Feasibility) (Design)

In scope of
No Yes Yes Yes No No
HKFRS 6?

Mine cycle
Generative Exploration Evaluation Feasibility Build Operate
phase

To identify a The search for To determine Preparation of The Ongoing

suitable area mineral resources, if the mineral detailed report establishment extraction and
of interest to including minerals, deposit is of selected of access to the processing of
conduct further oil, natural gas and economically development deposit or field, minerals
exploration similar viable to and operational construction of
and evaluation non-regenerate develop options to processing
activities resources after the provide sufficient facilities, mine
entity has obtained information for camps,
Purpose
the legal rights to investment transport routes
explore in a specific approval and equipment
area and other
preparation
required for
commercial
production

Analysis of Analysis of Review of all Preparation of Construction Extraction and

public topographical, project data feasibility studies of shafts, processing of mineral
geoscientific geological, combined with to underground resource and reserves
information geochemical and knowledge form comprehensively drives and in accordance with the
including geophysical studies. similar deposits analyse the permanent mine plan to the point
magnetic, or operations to selected excavations, where the mine is no
radiometric Field work, including identify technical development roads and longer economically
and contour prospecting, issues that will option for a tunnels, viable and the mine
maps, images exploratory drilling require further mineral deposit. advance enters the closure
and survey and trenching are planning. This includes removal of phase.
data as well as conducted to detailed overburden Exploration activities
historical delineate likely Preparation of assessments of and waste rock, may continue on the
Activities exploration zones of a pre-feasibility the operational, and drilling of tenement to identify
data publicly mineralisation. study to financial, oil or natural additions to existing
reported. describe the marketing, social gas wells. reserves (extensional
range of options and regulatory Commencement exploration) which
for the technical factors relevant of mining to the use the existing access
and economic to demonstrating point of the and infrastructure as
viability of a that extraction is mine and plant well as new resources
mineral project. economically being to define resources
viable. commissioned. that require new
assess infrastructure
but use the same
processing facilities.

EXHIBIT 26.3 Life cycle of an extractive site

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26.3.2 Terminology
Given the limited scope of HKFRS 6, only a few defined terms exist:

Exploration and evaluation (E&E) assets comprises E&E expenditures that have been
capitalised as assets in accordance with the entity’s accounting policy.

Exploration and evaluation (E&E) expenditures are costs incurred by an entity

in connection with the exploration for and evaluation of mineral resources before the
technical feasibility and commercial viability of extracting a mineral resource has been
demonstrated.

Exploration and evaluation (E&E) of mineral resources is the process of searching

for mineral resources, including minerals, oil, natural gas and similar nonregenerative
resources after the entity has obtained legal rights to explore in a specific area as well as
the determination of the technical feasibility and commercial viability of extracting the
mineral resource.

26.3.3 Recognition of Exploration and Evaluation (E&E) Assets

The overall principles for recognising exploration and evaluation (E&E) assets are outlined in
paragraphs 6 and 7 of HKFRS 6.
When an entity is developing its E&E accounting policy, it must apply paragraph 10
of HKAS 8. Paragraph 10 of HKAS 8 states that in the absence of a standard specifically
applied to a transaction, other event, or condition, management is to use its judgement
in developing and applying an accounting policy. The accounting policy drafted by
management must produce financial information, which is compliant with the conceptual
framework in that it is:

• Relevant to the economic decision-making needs of users; and

• Reliable, in that the financial statements:

°° Represent faithfully the financial position, financial performance and cash flows of
the entity;

°° Reflect the economic substance of transactions, other events and conditions, and
not merely the legal form;

°° Are neutral, that is, free from bias;

°° Are prudent; and

HKFRS
6.6
°° Are complete in all material respects.

However, entities are exempt from applying paragraphs 11 and 12 of HKAS 8 for the
recognition and measurement of E&E assets. This is, however, subject to complying with
HKFRS paragraphs 9 and 10 of HKFRS 6, which provide guidance on what should be included in the
6.7 cost of E&E assets. Refer to Section 26.3.4 for further discussion.

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These requirements can be shown more simply as follows (Exhibit 26.4):

HKFRS 6 paragraph 6 HKFRS 6 paragraph 7

Do not apply HKAS 8 paragraph 11

Apply HKAS 8 paragraph 10 Management shall refer to the requirements in
In the absence of a standard that specifically HKFRSs dealing with similar and related issues,
applies to a transaction, other event or the definitions, recognition criteria and
condition, management is to use its judgement measurement concepts for assets, liabilities,
in developing and applying an accounting policy income and expenses in the Conceptual
Framework

Do not apply HKAS 8 paragraph 12

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 para 11

EXHIBIT 26.4 Summary of requirements in paragraphs 6 and 7 of HKFRS 6

HKFRS 6 does not describe the various E&E accounting policy options; however, other IFRS
compliant countries have provided more guidance in their adoption of the standard as to what
the accounting policy choices for E&E costs may be as shown in Exhibit 26.5.

Expense all Capitalise all Partially capitalise

exploration exploration all exploration
and evaluation and evaluation and evaluation
expenditures expenditures expenditures

Policy options

EXHIBIT 26.5 Possible accounting policies for E&E costs

The determination of the overall accounting policy for the treatment of E&E assets is
entirely up to management, providing it is consistently applied throughout the group and from
one period to the next.

26.3.4 Measurement of Exploration and Evaluation (E&E) Assets

If an entity chooses to adopt a policy where E&E expenditures are capitalised or partially
capitalised, certain principles must be followed.

26.3.4.1 Measurement at Recognition

HKFRS
6.8 All E&E assets are to be initially measured at cost.

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26.3.4.2 Elements of Cost of Exploration and Evaluation (E&E) Assets

When determining the accounting policy, to be applied when recognising an E&E asset, an
entity must consider the types of expenditure to be incurred and how directly that expenditure
is related to the actual lease or leases (associated with the specific mineral resources).
Examples of expenditures that might be included in the initial measurement of E&E assets for a
specific area under review include:

• Acquisition of rights to explore;

• Topographical, geological, geochemical and geophysical studies;

• Exploratory drilling;

• Trenching;

• Sampling; and

HKFRS • Activities in relation to evaluating the technical feasibility and commercial viability of
6.9 extracting a mineral resource.

HKFRS Entities must also include the cost of rehabilitating and restoring the land being explored to
6.10 its original condition (or as legally required) in the measurement of any E&E asset.

26.3.4.3 Measurement after Recognition

As is the case for assets accounted for under HKAS 16 or HKAS 38, entities may apply either the
HKFRS revaluation model to the E&E assets after recognition or may continue to recognise
6.11 them at cost.

Apply and Analyse 4

Using the facts from the Lucky Pastoral Company (Lucky) case study, identify when Lucky
should begin capitalising E&E costs incurred on the property in accordance with HKFRS 6.

Analysis

HKFRS 6 can only be applied to E&E costs, which have been incurred after the entity has
obtained the legal right to explore a specific area. Therefore, as soon as the exploration
permits have been granted to Lucky, E&E costs can be capitalised. All costs incurred prior
to this point must be expensed.

If a capitalisation policy or part of a capitalisation policy of E&E costs has been adopted,
capitalisation must stop when either:

• The technical feasibility and commercial viability of extracting a mineral resource

has been demonstrated and approved by the appropriate management approval
process; or

• The E&E results for the area of interest have shown that the resources are not
considered to be economically viable and the area is abandoned. At this point, all
capitalised costs need to be the subject of an impairment charge.

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26.3.5 Presentation of Exploration and Evaluation (E&E) Assets

Once E&E assets are recognised and measured, the next issue is how they should be presented
in the statement of financial position.

26.3.5.1 Classification of Exploration and Evaluation (E&E) Assets

HKFRS E&E assets may be classified as tangible or intangible assets according to the nature of the
6.15 assets acquired.

For example, the cost of acquiring an exploration lease (a right) is considered a measure
of an intangible asset; in contrast, the costs of the purchase of fixed assets used to conduct
drilling and sampling are considered to be a measure of a tangible asset.

Classification of assets needs to be consistent within and between periods.

26.3.5.2 Reclassification of Exploration and Evaluation (E&E) Assets

Following the establishment of the technical feasibility and commercial viability of extracting a
mineral resource, E&E assets (whether classified as tangible or intangible) need to be:

• Assessed for impairment and any impairment loss recognised in the statement of
financial performance; and

HKFRS • Reclassified as an asset under construction and no longer subject to the requirements
6.17 of HKFRS 6.

26.3.6 Impairment of Exploration and Evaluation (E&E) Assets

As with other non-monetary assets recognised in the statement of financial position, capitalised
E&E assets are subject to an impairment testing regime.

26.3.6.1 Recognition
Specific impairment rules have been mandated for E&E assets in HKFRS 6 regardless of
whether the assets are classified as tangible or intangible. These differ to the impairment
testing requirements for tangible and intangible assets required by HKAS 36. The differences
can be shown as follows (Exhibit 26.6).

The facts and circumstances which may indicate there is impairment may include:

• The right to explore in the specific area has expired during the period or is due to
expire in the near future and is not expected to be renewed;

• No discovery of commercially viable quantities of mineral resources has occurred, and

the entity has decided to discontinue such activities in the specific area; and

HKFRS • Planned development or sale of the specific area is unlikely to recover the carrying
6.20 amount of the E&E asset.

This impairment testing approach only applies while the area being explored is considered
to be in the E&E stage. Following the establishment of the technical feasibility and commercial
viability of extracting a mineral resource, E&E assets are transferred into other asset categories
(e.g. assets under construction) and impairment testing reverts back to that required
by HKAS 36.

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Comparison of
impairment testing
requirements from ...
HKAS 36 and HKFRS 6

Impairment testing Impairment testing

under HKAS 36 under HKFRS 6

Tangible assets and Indefinite life intangible Tangible and intangible

amortising intangible assets and intangible Goodwill exploration and
assets assets not yet available evaluation assets
for use

Test for impairment Assessment when facts

Assessment at the end
annually (at any time Test for impairment and circumstances
of each reporting period
during the year, annually suggest that the
if indicators exist
providing it is at the carrying amount of an
same time each year) exploration and
and assessment at the evaluation asset may
end of each reporting exceed its recoverable
period if indicators exist amount

EXHIBIT 26.6 Impairment testing under HKAS 36 versus HKFRS 6

26.3.6.2 Measurement
When an entity undertakes an impairment test due to facts and circumstances suggesting this
HKFRS is required, an entity shall measure, present and disclose any resulting impairment loss in
6.18 accordance with HKAS 36.

Any resulting impairment loss is recognised as an expense.

26.3.7 Current Developments

The International Accounting Standards Board (IASB) is exploring whether to develop
requirements or guidance to improve an entity’s disclosures about its exploration and
evaluation expenditure and activities. The IASB is also exploring whether to remove the
temporary status of IFRS 6 Exploration for and Evaluation of Mineral Resources.

The IASB is researching what information users of financial statements need about
exploration and evaluation expenditure and activities, why they do not currently get that
information, and the costs and benefits of requiring an entity to provide that information.

Knowledge Check Questions

Question 9
Identify which of the following is NOT included as part of the initial cost of E&E assets.
A Exploratory drilling
B Mining acquisition rights
C Trenching
D Pre-exploration survey fees

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Knowledge Check Questions (continued)

Question 10
If an entity capitalises costs incurred during the E&E phase, prepare the entry to record an
obligation for removal and restoration incurred during the E&E phase of a mining project.

A Debit Credit
HK$ HK$
E&E asset
E&E expense

B Debit Credit
HK$ HK$
E&E expense
Provision for removal and restoration

C Debit Credit
HK$ HK$
Removal and restoration expense
E&E asset

D Debit Credit
HK$ HK$
E&E asset
Provision for removal and restoration

Question 11
If an entity capitalises costs incurred during the E&E phase, prepare the journal entry
required to recognise depreciation on a drilling rig that is being used in the exploration
phase of a mining project.

A Debit Credit
HK$ HK$
Depreciation expense – drilling rig
Accumulated depreciation: drilling rig

B Debit Credit
HK$ HK$
Intangible E&E asset
Accumulated depreciation: drilling rig

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Knowledge Check Questions (continued)

C Debit Credit
HK$ HK$
Depreciation expense – drilling rig
Intangible E&E asset

D Debit Credit
HK$ HK$
Intangible E&E asset
Depreciation expense: drilling rig

2 6 . 4 SERVICE CONCESSION ARRANGEMENTS

Traditionally, governments or other public sector organisations have constructed, operated

and maintained public infrastructure, for example, roads, bridges, tunnels, prisons, airports,
hospitals, telecommunications networks, water distribution facilities and energy supply
companies.

An increasing demand for public facilities has led to alternative funding models being
adopted in some countries. This has resulted in arrangements with private enterprises to fund
and construct public facilities and then to operate those facilities as a revenue generating
enterprise for a predetermined time before the ownership of those facilities revert back to
public ownership.

As a result of this new ownership model of public facilities, the International Financial
Reporting Interpretations Committee (IFRIC) agreed it needed to issue accounting guidance
to the operators of those facilities, and HK(IFRIC)-Int 12 Service Concession Arrangements was
issued in 2006.

This chapter focuses solely on the accounting from the operator’s perspective.

26.4.1 Nature of Service Concession Arrangements

A service concession is generally a long-term arrangement agreed to by a grantor and an
operator. It could be to construct, operate and maintain a new piece of infrastructure or to
upgrade an existing piece of infrastructure (e.g. to widen a road, build a new wing on a hospital
HK IFRIC- or increase the capacity of a network). The life cycle of a typical service concession arrangement
Int 12.2–3 can be shown as follows in Exhibit 26.7.

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Contract is agreed between public sector entity (grantor) and private sector
(operator). Contract defines; what will be constructed, prices to be levied by
the operator and the terms of handover of the asset back to public sector entity.

Private sector operator will construct the new infrastructure or upgrade

existing infrastructure.

The operator provides the service to the public on behalf of the public services
entity. It must be responsible for at least some of the management of the
infrastructure and related services and not merely act as an agent of the grantor.

The operater is paid for its services over the period of the arrangement and must
comply with performance standards, mechanisms for adjusting prices and
arrangements for arbitrating disputes.

The operator is obliged to transfer the infrastructure to the grantor in a specified

condition at the end of the period of the arrangement, for little or no
consideration, irrespective of which party initially financed it.

EXHIBIT 26.7 Life cycle of a service concession arrangement

26.4.2 Scope
HK(IFRIC)-Int 12 only applies to the accounting by operators for public-to-private service
concession arrangements if

• The grantor controls or regulates which services the operator must provide with the
infrastructure, to whom it must provide them and at what price, and

Either:

• The grantor controls any significant residual interest in the infrastructure at the
end of the term of the arrangement through ownership, beneficial entitlement or in
some other form; or

HK(IFRIC)- • The infrastructure is used in a public to private service concession arrangement for
Int 12.5 its entire useful life.

The interpretation applies to:

• Infrastructure the operator constructs for the purpose of the service arrangement;

• Infrastructure the operator acquires from a third party for the purpose of the service
arrangement; and

HK(IFRIC)- • Infrastructure to which the grantor gives the operator access for the purpose of the
Int 12.7 service arrangement.

HK(IFRIC)- HKAS 16 is applied to the accounting for the derecognition of infrastructure that was owned
Int 12.8 by a private operator prior to any contractual agreement with a public service.

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Illustrative Example 13
A typical example of a service concession arrangement is the Western Harbour Crossing
built to link Kowloon West with Hong Kong Island. It is a dual three-lane tunnel
crossing Victoria Harbour, which was completed for a cost of HK$7.5 billion in 1997 for
the Hong Kong SAR Government (the grantor) by the Western Harbour Tunnel Company
(WHTC) (the operator) under a build-operate-transfer (service concession) model for a
30-year period by WHTC (1993 to 2023), which includes the construction period.

Under the build-operate-transfer model, WHTC and the government agreed on the
tolls to be charged (e.g. the fee per private car was HK$30 per car) as well as an adjustment
mechanism to ensure the WHTC rate of return was capped at 16.5% for the first three
years after the tunnel opened. Following that period, the operator can apply for an
increase to the toll on six specified dates during the franchise period. The Western Harbour
tunnel will be handed back to the government by WHTC on August 2023.

This arrangement meets the definition of a service concession arrangement addressed

by HK(IFRIC)-Int 12.5:

• The arrangement is of a public-to-private nature, this being a government service

effectively outsourced to a private entity;
• The Hong Kong SAR Government (the grantor) controls the service provided by WHTC
(the operator) to whom this service is provided and at the price which is charged;

• WHTC (the operator) is responsible for the management of the tunnel; and

• The Hong Kong SAR Government (the grantor) controls a significant residual
interest in the tunnel at the end of the 30-year period.

26.4.3 Recognition and Measurement of Service Concession

Arrangements Consideration
Infrastructure within the scope of this interpretation is not to be recognised as property, plant
HK(IFRIC)- and equipment by the operator because the operator only has the right to operate the
Int 12.11 infrastructure and not the right to direct or control the use of the infrastructure.

HK(IFRIC)- For the purposes of HK(IFRIC)-Int 12, the operator acts as a service provider for one or both
Int 12.12 of the following services: construction or upgrade services and/or operation services.

The operator must recognise and measure revenue for each type of service it performs
in accordance with HKFRS 15 (see Chapter 5). For each contract identified, the operator
must assess the services promised to identify the performance obligations in accordance
with the requirements of HKFRS 15. The transaction price of the contract is allocated to each
performance obligation and revenue is then recognised by the operator as the performance
obligation is satisfied.

26.4.3.1 Construction Phase: Construction or Upgrade Services

HK(IFRIC)- Consideration received or receivable for the construction phase by an operator must be recognised
Int 12.15–17 at fair value and will be classified as either rights to a financial asset or an intangible asset.

This can be shown as in Exhibit 26.8.

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Construction phase
receivable will be
classified as either:

Financial Asset Intangible Asset

If there is an unconditional
If there is a right (a licence) to
contractual right to receive
charge users of the public
a specified amount of cash or
service a fee to use that
another financial asset from
service
or at the direction of the grantor

EXHIBIT 26.8 Construction phase receivables

The classification of consideration as a financial asset or an intangible asset shall be

determined by the contract terms and any relevant contract law.

Illustrative Example 14
Prior to finalising the contract with the Hong Kong SAR Government to construct the
tunnel, WHTC management is considering what is the most appropriate financial
structure to negotiate with the government. It is analysing whether it should seek either:

• A one-off unconditional payment of HK$10 billion from the government when

control of the tunnel is transferred to government in 1997 (at the end of the
construction phase), or

• A licence to charge users a toll for the remainder of the contract period (1997 to 2023).

The accountant for WHTC has asked you for advice on how to account for both of these
scenarios assuming the total construction cost of the tunnel is expected to be HK$7.5 billion.
If the toll road option is selected:

• Total operating costs for the operational phase of the contract period are budgeted
to be HK$1 billion; and

• Total revenue for the entire contract is budgeted to be HK$12 billion.

Financial Asset

If WHTC has an unconditional right to receive a specified amount of cash from the
government, the accounting entries recognised over the course of the construction
period are as follows:

Debit Credit
HK$ HK$
Contract asset 7.5 billion
Cash at bank 7.5 billion
Journal to recognise costs incurred over the course of four-year construction period but
immediately prior to completion

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Illustrative Example 14 (continued)

Debit Credit
HK$ HK$
Costs of construction 7.5 billion
Contract asset 7.5 billion
Journal to recognise costs incurred on tunnel project (when performance obligations
completed and revenue can be recognised)

Debit Credit
HK$ HK$
Financial asset (receivable from Hong Kong SAR Government) 10 billion
Construction revenue 10 billion
Journal to recognise revenue and associated receivable from Hong Kong SAR Government
(when performance obligations completed and revenue can be recognised)

The net effect on the statement of profit or loss and other comprehensive income
of the first option (receiving a one-off unconditional payment received at the end of the
construction phase) is a profit of HK$2.5 billion.

Intangible Asset

WHTC has a right to a licence to charge users a toll for the remainder of the contract
period (1997 to 2023). Control of the tunnel is transferred to the government at the end
of the 30-year period in 2023. It is assumed that one performance obligation is identified
in the contract (an agreement to build and operate the western harbor tunnel) and that
performance obligation will be satisfied over time.

Management has suggested the selection of costs incurred (an input method) as the
most appropriate measurement of progress to assess the satisfaction of the performance
obligation.

The journal entries to be recorded over the course of the construction phase are
as follows:

Debit Credit
HK$ HK$
Costs of construction 7.5 billion
Cash at bank 7.5 billion
Journal to recognise costs incurred over the course of four-year construction period

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Illustrative Example 14 (continued)

Debit Credit
HK$ HK$
Intangible asset 10.6 billion
Revenue 10.6 billion
Journal to recognise revenue and associated intangible asset generated over the course
of the construction phase (calculated based on costs incurred during construction phase
as a proportion of total costs over the 30-year period or HK$7.5 billion/(HK$7.5 billion +
HK$1 billion) * HK$12 billion = HK$10.6 billion)

The net effect on the statement of profit or loss and other comprehensive income of
the second option (a licence to charge users a toll for the remainder of the contract period)
is a profit of HK$3.1 billion.

26.4.3.2 Operational Phase

HK(IFRIC)- The operator shall account for operation services in accordance with the five steps of HKFRS 15
Int 12.20 (see Chapter 5).

If the operator has a contractual obligation to either of the options below, it must recognise
these obligations in accordance with HKAS 37 Provisions, Contingent Liabilities and Contingent
Assets (see Chapter 18):

• Maintain the infrastructure to a specified level of serviceability; or

• Restore the infrastructure to a specified condition before it is handed over to the

grantor at the end of the service arrangement.
As required by HKAS 37, these provisions shall be measured at the best estimate of the
HK(IFRIC)- expenditure that would be required to settle the present obligation at the end of each
Int 12.21 reporting period.

Illustrative Example 15
Assume the same facts as the preceding licencing option.

The journal entries to be recorded over the operational phase are as follows:

Debit Credit
HK$ HK$
Costs of operation 1 billion
Cash at bank 1 billion
Journal to recognise operational costs incurred over the operational period of the contract

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Illustrative Example 15 (continued)

Debit Credit
HK$ HK$
Cash 1.4 billion
Operational revenue 1.4 billion
Journal to recognise cash received of HK$1.4 billion from tolls and associated revenue
earned over the operational period of the contract

In addition, amortisation expense over the course of the operational period of the
contract of $HK10.6 billion would be recognised each period.

26.4.3.3 Borrowing Costs Incurred by the Operator

Only borrowing costs attributable to an intangible asset (i.e. a right to charge users of the public
service) may be capitalised during the construction phase of the arrangement in accordance
with HKAS 23 Borrowing Costs (see Chapter 10). Borrowing costs incurred for arrangements
HK(IFRIC)- where there is an unconditional contractual right to receive a specified amount of cash or
Int 12.22 another financial asset must be expensed.

26.4.4 Current Developments

There are no current developments in the accounting for service concession arrangements
from an operator perspective. As previously noted, there is discussion on service concession
accounting for grantors but this applies only to public sector entities.

Knowledge Check Questions

Question 12
Identify which of the following infrastructure is not within the scope of HK(IFRIC)-Int 12.
A Infrastructure to be constructed by a private sector entity under contract to a public
sector entity
B Infrastructure to be upgraded by a private sector entity under contract to a public
sector entity
C Infrastructure owned by a private sector entity and then acquired by a public
sector entity
D Infrastructure to be operated by a private sector entity under contract to a public
sector entity

Question 13
Identify which of the following is NOT a common feature of a service concession
arrangement.
A The arrangement is of a public service nature.
B The contract sets the initial price to be levied by the operator and regulates the price
revisions over the period of the service arrangement.

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Knowledge Check Questions (continued)

C The operator is responsible for at least some of the management of the infrastructure.
D The operator retains ownership of the infrastructure at the end of contractual period.

Question 14
ABC Ltd (ABC) is constructing bridge for the Hong Kong SAR Government with an
unconditional contractual right to receive HK$500 million at the direction of the grantor.
The grantor has little, if any, discretion to avoid payment. Describe the asset that should be
recognised once the construction is completed.
A Intangible asset
B Financial asset
C Property, plant and equipment
D Contract asset

Question 15
Prepare the entry to record the right to charge a toll fee in the future during the
construction of a tollway.

A Debit Credit
HK$ HK$
Financial asset
Cash

B Debit Credit
HK$ HK$
Intangible expense
Intangible asset

C Debit Credit
HK$ HK$
Intangible asset
Restoration and rehabilitation liability

D Debit Credit
HK$ HK$
Intangible asset
Construction revenue

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SUMMARY

Agriculture and Biological Assets

• HKAS 41 Agriculture must be applied to the following three aspects of accounting for
agricultural activities:

1. Biological assets, except for bearer plants;

2. Agricultural produce at the point of harvest; and

3. Some government grants relating to agriculture.

• An entity shall recognise a biological asset or agricultural produce when, and only when:

°° The entity controls the asset as a result of past events;

°° Future economic benefits associated with the asset will probably flow to the entity; and

°° The fair value or cost of the asset can be measured reliably.

• A biological asset shall be measured at fair value less costs to sell:

°° On initial recognition; and

°° At the end of each reporting period.

Insurance Contracts

• An insurance contract involves an entity accepting significant insurance risk by agreeing to

compensate a policyholder if specified uncertain future events adversely affect them.

• Insurance contracts must be sub-grouped into (potentially) three groups: (i) contracts that
are onerous at initial recognition; (ii) contracts that have no significant possibility of becoming
onerous at initial recognition; and (iii) other contracts.

• The coverage period for an insurance contract is from issue to the time when the insurer has
the practical ability to reprice the risks and level of benefits of the contract.

• Insurance liabilities usually comprise liabilities for remaining coverage and liabilities for
incurred claims.

• Insurance liabilities are measured using current information based on the estimated
fulfilment cash flows under insurance contracts although a simplified basis (the premium
allocation approach) is available to measure liabilities for remaining coverage in specified
circumstances.

• However, there is no upfront profit recognition. Any expected profit is recognised over the
periods in which services are provided to policyholders.

• Insurance revenue is recognised as coverage is provided to policyholders.

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Mineral Resources

• HKFRS 6 is not applicable to expenditures incurred:

°° Before the entity has obtained the legal rights to explore a specific area; and

°° After the technical feasibility and commercial viability of extracting a mineral resource
are demonstrable and approved by an appropriate management approval process.

• Management shall use its judgement in developing and applying an exploration and
evaluation accounting policy.

• Policies do not need to be developed with reference to other authoritative requirements

and guidance where no standard applies specifically to that item (in accordance with HKAS 8
Accounting Policies, Changes in Accounting Estimates and Errors).

• All exploration and evaluation assets shall be initially measured at cost.

• Subsequent to initial measurement at cost, assets may be measured using the revaluation or
cost model.

• Impairment assessments must be performed when facts and circumstances suggest the
carrying amount of an exploration and evaluation asset may exceed its recoverable amount.

Service Concession Arrangements

• HK(IFRIC)-Int 12 only applies to the accounting by operators for public-to-private service
concession arrangements if the grantor controls or regulates which services the operator
must provide with the infrastructure, to whom it must provide them, and at what price; and

°° The grantor controls any significant residual interest in the infrastructure at the end
of the term of the arrangement through ownership, beneficial entitlement or in some
other form; or

°° The infrastructure is used in a public-to-private service concession arrangement for its

entire useful life.

• Consideration received or receivable for the construction phase by an operator must be

recognised at fair value and will be classified as rights to either:

°° A financial asset if there is an unconditional contractual right to receive a specified

amount of cash or another financial asset from or at the direction of the grantor and the
grantor has little, if any, discretion to avoid payment; or

°° An intangible asset if there is a right (a licence) to charge users of the public service a fee
to use that service.

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MIND MAP

MINERAL RESOURCES AGRICULTURE

Key matters to be aware of Key matters to be aware of
• Only applies to accounting for expenditure • Only applies to agricultural produce,
in the Exploration and Evaluation phase biological assets and certain agricultural
• Entity’s accounting policy is to also be related government grants
determined by management having regard • Does not apply to bearer plants that
to HKAS 8 and the Conceptual Framework are scoped into HKAS 16
• Exploration and evaluation assets must be • Agricultural produce and biological assets
OTHER BUSINESS
reviewed for impairment when facts and are generally measured at fair value less
TRANSACTIONS
circumstances suggest that the carrying costs to sell
amount of an E&E asset may exceed its • Unconditional government grants are
recoverable amount recognised immediately in profit or loss,
whereas conditional government grants are
SERVICE CONCESSION ARRANGEMENTS
deferred until all conditions are satisfied
Key matters to be aware of
INSURANCE
• Interpretation only applies to accounting
by operators of public-to-private service Key matters to be aware of
concession arrangements • Involves an insurer bearing significant
• Arrangements must meet certain criteria to insurance risk. Insurance risk ≠ financial risk
be scoped into this interpretation • Insurance contract liabilities = Current Value
• Infrastructure within the scope of the measure. Measurement is based on current
interpretation is not to be recognised as the information
operator's PPE because the operator has no • No up-front profit recognition–any expected
right to control the asset profit recognised when services are provided
• Consideration received or receivable by the to policyholders
operator may be rights to either a financial • Insurance contract revenue recognised
asset or an intangible asset as an insurer provides coverage to
policyholders

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. It is an agricultural activity as a result of the biological transformation
process being managed by the entity through specific farming activities.
Answer B is correct. The biological transformation of ocean fish is not subject to
management facilitating the conditions necessary for that transformation. As a result, it
does not satisfy the definition of an agricultural activity.
Answer C is incorrect. It is an agricultural activity because of the biological transformation
process being managed by the entity through specific farming activities.
Answer D is incorrect. It is an agricultural activity because of the biological transformation
process being managed by the entity through specific farming activities.

Question 2
Answer A is incorrect. It is an agricultural product, which has been processed after harvest.
Answer B is correct. It is the only product listed, which is produce at the point of harvest.
Answer C is incorrect. It is an agricultural product, which has been processed after harvest.
Answer D is incorrect. It is an agricultural product, which has been processed after harvest.

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Question 3
Answer B is correct. Sugar is an agricultural produce, which has been processed after the
point of harvest.
Answer A is incorrect. Timber is an agricultural produce, which is unprocessed and still at
the point of harvest.
Answer C is incorrect. Wool is an agricultural produce, which is unprocessed and still at
the point of harvest.
Answer D is incorrect. Milk is an agricultural produce, which is unprocessed and still at the
point of harvest.

Question 4
Answer A is incorrect. This is a true statement regarding the Management of Change in
paragraph 6 (b) of HKAS 41 (criteria defining agricultural activity). Management facilitate
biological transformation by providing or enhancing the conditions necessary for biological
change to take place.
Answer B is incorrect. This is a true statement regarding one of the common features,
which defines a diverse range of agricultural activities. Examples of Management of
Change could be providing adequate soil and other conditions to successfully grow a crop
or providing sufficient food, water and health needs to raise animals.
Answer C is incorrect. This is a true statement regarding one of the recognition criteria
in paragraph 10 of HKAS 41. Paragraph 10(a) of HKAS 41 requires the entity to control
the asset as part of past events as one of the three criteria to recognise a biological asset
or agricultural produce. Control may be proven by demonstration of legal ownership of
animals by microchip, land ownership, or leasing arrangements and cropping contracts
for crops.
Answer D is correct. ‘Management is a key part of the recognition criteria for biological
assets and agricultural produce’ is not one of the three recognition criteria in accordance
with paragraph 10 of HKAS 41. The three recognition criteria specified by paragraph 10
are: (i) the entity controls the asset as a result of past events; (ii) future economic benefits
associated with the asset will probably flow to the entity, and (iii) the fair value or the cost
of the asset can be measured reliably.

Question 5
Answer A is incorrect. Government grant income cannot be recognised on a conditional
grant until the terms and conditions of the grant have been satisfied in accordance with
paragraph 35 of HKAS 41.
Answer B is incorrect. It is incorrect to apportion the revenue between revenue and the
performance obligation. In accordance with paragraph 35 of HKAS 41, government grant
income cannot be recognised on a conditional grant until the terms and conditions of the
grant have been satisfied.

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Answer C is correct.

Debit Credit
HK$ HK$
Cash 100,000
Performance obligation 50,000

Because this government grant is conditional on the entity satisfying certain terms and
conditions, the grant cannot be recognised as income until those conditions have been
satisfied. The credit entry is therefore to a performance obligation liability account.
Answer D is incorrect. The obligation to meet the terms and conditions of the government
grant must be recognised as a liability given the cash has been received.

Question 6
Answer A is incorrect. The risk adjustment (that is part of fulfilment cash flows) has
been ignored.
Answer B is correct. The contractual service margin is effectively deferred expected profit,
which is measured as the difference between expected future cash outflows and expected
future cash outflows.
Answer C is incorrect. The risk adjustment is part of fulfilment cash flows, not a separate
feature of insurance contract cash flows.
Answer D is incorrect. The (expected) incurred claims are part of fulfilment cash flows, not
a separate feature of insurance contract cash flows.

Question 7
Answer A is incorrect. Only one of the conditions needs to be met for an insurer to be
eligible to apply the premium allocation approach to the contracts.
Answer B is incorrect. The receipt of premiums at the time insurance contracts are issued
is not a condition that is relevant to whether an insurer is eligible to apply the premium
allocation approach to the contracts.
Answer C is incorrect. A coverage period of a year or less is only one of the conditions
under which an insurer would be eligible to apply the premium allocation approach to the
contracts.
Answer D is correct. The premium allocation approach can be applied when either
the coverage period is a year or less or the premium allocation approach is expected
to result in materially the same liability for remaining coverage as the fulfilment cash
flows approach.

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Question 8
Answer A is correct. The compensation the insurer requires to bear the uncertainty
associated with the amounts and timing of estimated cash flows is how risk margins are
measured in accordance with HKFRS 17.
Answer B is incorrect. It fails to acknowledge the insurer also requires compensation to
bear the uncertainty associated with the amounts and timing of estimated cash flows
relating to the liability for incurred claims.
Answer C is incorrect. It fails to acknowledge the insurer also requires compensation to
bear the uncertainty associated with the amounts and timing of estimated cash flows
relating to the liability for remaining coverage.
Answer D is incorrect. The policyholder perspective is irrelevant.

Question 9
Answer A is incorrect. This is exploration and evaluation (E&E) cost is eligible for
capitalisation in the exploration and evaluation asset.
Answer B is incorrect. This E&E cost is eligible for capitalisation in the exploration and
evaluation asset.
Answer C is incorrect. This E&E cost is eligible for capitalisation in the exploration and
evaluation asset.
Answer D is correct. This cost occurs prior to obtaining legal rights to explore a specific area.

Question 10
Answer A is incorrect. Although the debit entry is correct, paragraph 11 of HKFRS 6
requires an entity to recognise a liability (not a credit to an expense account) for removal
and restoration incurred as a result of exploration and evaluation (E&E) activities.
Answer B is incorrect. Although the credit entry is correct (paragraph 11 of HKFRS 6
requires an entity to recognise a liability for removal and restoration incurred because
of E&E activities), the debit entry should be recognised as an E&E asset and not an
expense to the statement of profit or loss in accordance with the stated management
accounting policy.
Answer C is incorrect. The debit entry should be recognised as an E&E asset and not an
expense to the statement of profit or loss in accordance with the stated management
accounting policy and paragraph 11 of HKFRS 6, which requires an entity to recognise a
liability (not a credit to an asset account) for removal and restoration incurred as a result of
exploration and evaluation activities.
Answer D is correct. Paragraph 11 of HKFRS 6 requires an entity to recognise a liability for
removal and restoration incurred as a result of E&E activities. As the accounting policy is
to capitalise costs as an exploration and evaluation asset, the cost is capitalised into the
exploration and evaluation asset.

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Question 11
Answer A is incorrect. In this case, the accounting policy is to capitalise exploration and
evaluation (E&E) costs; therefore, any depreciation expense is capitalised in the E&E asset
and not directly to the statement of profit or loss.
Answer B is correct. Paragraph 16 states that to the extent a tangible asset is consumed
in developing an intangible asset, the amount reflecting that consumption is part of the
cost of the intangible asset; therefore, the depreciation of the drilling rig is included in
the E&E asset.
Answer C is incorrect. The depreciation is to be capitalised in the E&E asset, and the credit
entry must be reflected as accumulated depreciation for the depreciating drilling rig asset
in accordance with HKAS 16.
Answer D is incorrect. Although the debit entry correctly capitalises the depreciation
expense into the E&E asset, the credit entry must be reflected as accumulated depreciation
for the depreciating drilling rig asset in accordance with HKAS 16.

Question 12
Answer A is incorrect. This situation is specifically included in this IFRIC as outlined in
paragraph 7(a) of HK(IFRIC)-Int 12.
Answer B is incorrect. This situation is specifically included in this IFRIC as outlined
in paragraph 7(a) and 12 of HK(IFRIC)-Int 12.
Answer C is correct. This situation is specifically excluded from this IFRIC as outlined in
paragraph 8 of HK(IFRIC)-Int 12.
Answer D is incorrect. This situation is specifically included in this IFRIC as outlined
in paragraph 7(b) of HK(IFRIC)-Int 12.

Question 13
Answer A is incorrect. One of the features described in paragraph 3 of HK(IFRIC)-Int 12
is that a feature of these arrangements is the public service nature of the obligation
undertaken by the operator.
Answer B is incorrect. One of the features described in paragraph 3 (c) of HK(IFRIC)-Int 12 is
that a feature of the service arrangement is the contract sets the initial prices to be levied
by the operator.
Answer C is incorrect. One of the features described in paragraph 3 (b) of HK(IFRIC)-Int 12
is that a feature of the service arrangement is the operator is responsible for at least some
of the management of the infrastructure.
Answer D is correct. One of the features described in paragraph 3 (d) of HK(IFRIC)-Int 12
is that the operator is obliged to hand over the infrastructure to the grantor in a specified
condition at the end of the period of the arrangement.

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Question 14
Answer A is incorrect. An intangible asset is the right to receive a right to charge users of
the public service as defined in paragraph 17 of HK(IFRIC)-Int 12.
Answer B is correct. There is an unconditional contractual right to receive cash at the
direction of the grantor for the constructions services and the grantor has little, if any,
discretion to avoid the payment HK(IFRIC)-Int 12.
Answer C is incorrect. The contractual service arrangement does not convey the right
to control the use of the public service to the operator as outlined in paragraph 11 of
HK(IFRIC)-Int 12.
Answer D is incorrect. A contract asset is defined by HKFRS 15 as an entity’s right to
consideration in exchange for goods or services that the entity has transferred to a
customer. In this case, no goods or services have transferred to a customer.

Question 15
Answer A is incorrect. This incorrectly recognises the right as a financial asset whilst
correctly recognising the outflow of cash incurred to construct the tollway.
Answer B is incorrect. You have incorrectly recognised the debit as an intangible
expense and incorrectly identified the outflow of cash has as a credit to the intangible
asset account.
Answer C is correct. This correctly identified the right to receive future income as an
intangible asset while recognising the associated construction revenue from the tollway.
Answer D is incorrect. Although this correctly identified the right as an intangible asset,
you have incorrectly identified the outflow of cash has as a credit to restoration and
rehabilitation liability account.

EXAM PRACTICE

QUESTION 1
Paddock to Plate (P to P) is an innovative new regional restaurant concept in which all the
produce used in the meals served in the restaurant are grown on site. P to P acquired land
adjacent to the restaurant and conducted the following activities to supply food to the
restaurant kitchen in the last 12 months:

Activity Assets on hand at year-end

Beef cattle Cattle: beef meat
Milking cows Milking cows: milk and butter
Pigs Pigs: pork meat and prosciutto
Chickens Chickens: chicken meat and eggs
Trout (wild) Whole fish
Apple, apricot and cherry trees Trees and their produce (apples, apricots and cherries)

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Activity Assets on hand at year-end

Raspberries (planted) Raspberry canes and raspberries
Blackberries (wild) Blackberry vines and blackberries
Carrots, parsnips and turnips Carrots, parsnips and turnips
Lettuce, tomatoes and cucumber Lettuce, tomatoes and cucumbers and pickles
Wheat Bags of wheat, flour and bread
Mushrooms (wild) Mushrooms

Required

As part of the preparation of the year-end accounts, your manager has asked you to identify
the accounting standard applicable to each asset on hand, including explaining why.

QUESTION 2
Housewise Insurance (Housewise) sells lenders’ mortgage insurance (LMI) through a number
of banks. In the event borrowers are unable to pay their housing loan, Housewise covers the
bank for any difference between the loan balance and the proceeds from selling the house.

The Housewise actuary has analysed LMI contracts sold over the previous decade and
prepared a report that highlights the following information for the period 1 January 20X0 to
31 December 20X0. In strict legal terms, the contracts have a term that matches the loans,
which is an average of 30 years.

(i) Up-front premiums received: HK$100 million

(ii) Expected claims: 20X0: HK$0 – 20X1: HK$2 million; 20X2: HK$9 million – 20X4:
HK$18 million – 20X5: HK$13 million – 20X6: HK$8 million – 20X7: HK$5 million – 20X8:
HK$3 million – 20X9-expiry: HK$0.

(iii) Risk adjustment: HK$30 million

(iv) The net realisable value of the houses after year 20X9 is expected to exceed the balance
of the loans.

Required:

(a) Assuming discounting does not apply, determine the contractual service margin.

(b) Identify the coverage period over which the contractual service margin should be
recognised and explain your answer.

(c) Explain whether you think the LMI contracts are eligible to be accounted for using the
premium allocation approach and provide your reasons.

QUESTION 3
Goldfinger Ltd (Goldfinger) has a working gold mine in Indonesia (Miner’s Dream) and has
acquired a nearby exploration lease on 1 January 20X0 from the Indonesian government
for HK$1.25 million. Preliminary geoscientific studies show exciting prospects for this lease
and, if successful, could use the existing crushing and processing infrastructure of the
existing mine.

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In the six months to 30 June 20X0, Goldfinger has incurred a number of costs on the
lease as follows:

Item Value HK$

Specialised drilling rig 500,000
Vehicle 60,000
Topographical and geological studies 125,000
Vegetation clearing costs 75,000
Access road 200,000
Geologist costs: 50% of time, shared with Miner’s Dream (timesheets available) 140,000
Miners Dream management time (estimation only; no timesheets available) 50,000
1,150,000

Goldfinger has an exploration and evaluation (E&E) policy of capitalising all costs until
the area has reached a stage, which permits a reasonable assessment of the existence or
otherwise of commercially recoverable reserves.

Other relevant facts to be considered are:

• The exploration lease is for five years;

• All Goldfinger fixed assets are depreciated over 10 years; and

• The estimated restoration cost for the lease is estimated to be HK$250,000

(net present value).

Required:

You are Goldfinger’s Group Accountant and have been asked to prepare a memo for Miner’s
Dream’s finance manager which:
(a) provides a summary of the costs, which can be capitalised in accordance with HKFRS 6
and Goldfinger’s accounting policy; and

(b) prepare the journal entries required to record the expenditure incurred.

QUESTION 4
Best Bridges Ever (BBE), a Hong Kong-listed company has been contracted by the Hong Kong
SAR Government to upgrade the Lai Chi Kok Bridge. Construction is scheduled to start in the
next 12 months and is expected to take three years to complete at a cost of HK$135 million.
BBE will be entitled to charge a toll on the bridge for a period of 30 years and, given the
difficulty of the upgrade, has been able to negotiate with the government that BBE can
determine the initial toll price without government approval although the government will
regulate any subsequent price revisions after year 5 of the contract period. At the end of the
30-year period, the bridge will be handed back to the government for a consideration value
of 10% of the final construction cost.

Required:

Review the facts of BBE arrangement and using the criteria outlined in HK (IFRIC)-Int 12
describe whether or not the arrangement is a service concession arrangement.

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ANSWERS TO EXAM PRACTICE

QUESTION 1
Assets on hand Standard applicable
Cattle
Live cattle HKAS41 Agriculture because these are classified as biological assets
Beef meat HKAS41 Agriculture because this is classified as agricultural produce

Milking cows
Milking cows HKAS41 Agriculture because these are classified as biological assets
Milk HKAS41 Agriculture because this is classified as agricultural produce
Butter HKAS 2 Inventories because this is agricultural produce (milk), which has been
processed into butter
Pigs
Live pigs HKAS41 Agriculture because these are classified as biological assets
Pork meat HKAS41 Agriculture because this is classified as agricultural produce
Prosciutto HKAS2 Inventories because this is agricultural produce (pork), which has been
processed into prosciutto

Chickens
Live chickens HKAS41 Agriculture because these are classified as biological assets
Chicken meat HKAS41 Agriculture because this is classified as agricultural produce
Eggs HKAS41 Agriculture because this is classified as agricultural produce

Whole fish (trout) HKAS41 does not apply because this is not a managed food source and
is, therefore, not an agricultural activity. HKAS 2 Inventories does apply,
however, because the fish is an inventory item in the pantry and must be
accounted for. Will be recognised at nil cost or a small cost (for fishing and
preparation time).

Trees and their produce (apples, apricots and cherries)

Fruit trees HKAS16 Property, Plant and Equipment because the fruit trees are
bearer plants
Apples, apricots HKAS41 Agriculture because this is classified as agricultural produce
and cherries
Raspberry canes
Raspberry canes HKAS16 Property, Plant and Equipment because the raspberry canes are
bearer plants
Raspberries HKAS41 Agriculture because this is classified as agricultural produce

Blackberry vines
Blackberry vines HKAS41 is not applicable because this is not a managed biological asset. No
specific standard is applicable to this because it is part of the property value,
which is accounted for under HKAS 16 Property, Plant and Equipment

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Assets on hand Standard applicable

Blackberries HKAS 41 does not apply because this is not a managed food source and
is, therefore, not an agricultural activity. HKAS 2 Inventories does apply,
however, because the blackberries are an inventory item in the pantry
and must be accounted for. Will be recognised at nil cost or a small cost
(for picking time).
Carrots, parsnips HKAS41 Agriculture because this is classified as agricultural produce
and turnips

Lettuce, tomatoes HKAS41 Agriculture because this is classified as agricultural produce

and cucumbers
Pickles HKAS2 Inventories because this is agricultural produce (tomatoes), which has
been processed into pickles
Bags of wheat, flour and bread
Bags of wheat HKAS41 Agriculture because this is classified as agricultural produce
Flour HKAS2 Inventories because this is agricultural produce (wheat), which has
been processed into flour
Bread HKAS2 Inventories because this is agricultural produce (wheat), which has
been processed into flour and then used as the primary ingredient in the
restaurant bread

Mushrooms (wild) HKAS41 does not apply because this is not a managed food source and is,
therefore, not an agricultural activity. HKAS2 Inventories does apply, however,
because the mushrooms are an inventory item in the pantry and must be
accounted for. Will be recognised at nil cost or a small cost (for picking time).

QUESTION 2
(a) Premiums less the fulfilment cash flows = contractual service margin.

Premiums Claims Risk adjustment Contractual service

margin
HK$100 million 20X1: HK$2 million HK$30 million
20X2: HK$9 million
20X4: HK$18 million
20X5: HK$13 million
20X6: HK$8 million
20X7: HK$5 million
20X8: HK$3 million
HK$100 million HK$58 million HK$30 million HK$12 million

(b) The coverage period would be from the initial recognition of the contracts in 20X0 to
20X8, a period of nine years. No coverage is expected to be provided after nine years
even though some of the loans may still be outstanding for up to 30 years.

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(c) The LMI contracts probably cannot be accounted for by applying the premium
allocation approach because the risk adjustment indicates a significant level of
variability of fulfilment cash flows and the coverage period in nine years (well above the
one-year automatic eligibility threshold). When the level of variability of fulfilment cash
flows is significant and the coverage period is lengthy, the contracts will probably be
ineligible for the premium allocation approach [HKFRS 17.54].

QUESTION 3
Memo

To: Miner’s Dream Finance Manager

From: Goldfinger’s Group Accountant

Date: 15 July 20X0

Re: Capitalisation of exploration and evaluation costs

With respect to the costs incurred on the newly acquired exploration lease, I have
examined the list of costs incurred on the lease and advise that the following costs can be
capitalised as an exploration and evaluation (E&E) cost in accordance with the Goldfinger
accounting policy:

Item Value HK$ Notes

Acquisition of exploration lease 1,250,000 (i)
Specialised drilling rig depreciation 50,000 (ii)
Vehicle depreciation 6,000 (iii)
Topographical and geological studies 125,000 (i)
Vegetation clearing costs 75,000 (i)
Access road 200,000 (i)
Geologist costs (50% of time: shared with Miner’s Dream, timesheets 140,000 (i)
available)
Miners Dream management time (estimation only, no timesheets available) – (iv)
Restoration and rehabilitation 250,000 (v)
2,096,000

Explanatory notes

(i) Directly associated with the search for specific mineral resources and is, therefore,
capitalised as an E&E asset

(ii) Specialised drilling rig: In accordance with HKFRS6.16 and to the extent a tangible
asset is consumed in developing an intangible asset, the amount reflecting that
consumption is part of the cost of the intangible asset. Therefore, in calculating the
value of the E&E asset, depreciation of the drilling rig must be included. Although
the depreciation policy states that assets should be depreciated over 10 years, given

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that the life of the lease is only five years, the drilling rig must be depreciated over the
lesser of the term of the lease and the depreciable life, which is the expected period
of economic benefit. The depreciation for the six months is, therefore, calculated as:
(HK$500,000/5)/2 = HK$50,000

(iii) Vehicle: as for drilling rig. Depreciation calculated as: (HK$60,000/5)/2 = HK$6,000

(iv) Management time: These costs are generally considered to be insufficiently attributable
to be capitalised as an asset unless timesheets are kept or staff are working solely on
one project)

(v) Restoration and rehabilitation: In accordance with HKFRS 6.11, an entity recognises any
obligations for removal and restoration that are incurred during a particular period
as a consequence of having undertaken the E&E of mineral resources. Therefore, the
cost of restoration of the exploration lease must be factored into the exploration and
evaluation asset.

Journal entries to be booked to recognise expenditure on exploration lease are as follows:

Debit Credit
HK$ HK$
Exploration and evaluation asset (Intangible asset) 2,096,000
Cash 1,790,000
Accumulated depreciation Drilling rig 50,000
Accumulated depreciation Vehicle 6000
Restoration and rehabilitation provision 250,000
(Journal to recognise capitalisation of E&E costs, which meet the capitalisation criteria
in accordance with HKFRS 6 and Goldfinger accounting policy)

Debit Credit
HK$ HK$
Drilling Rig (Tangible asset) 500,000
Cash 500,000
(Journal to recognise capitalisation of drilling rig as a tangible asset)

Debit Credit
HK$ HK$
Vehicle (Tangible asset) 60,000
Cash 60,000
(Journal to recognise capitalisation of vehicle as a tangible asset)

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QUESTION 4
Common features of service concession arrangements are outlined in paragraph 3 of
HK (IFRIC)-Int 12. An assessment of these against the facts of Best Bridges Ever (BBE)
contract to upgrade the Lai Chi Kok Bridge is as follows:

Paragraph 3 criteria Application of BBE facts

The service arrangement contractually obliges the Yes, the upgraded bridge will be available to
operator to provide the services to the public on all members of the public on behalf of the
behalf of the public sector entity. government.
The party that grants the service arrangement Yes, the grantor is the Hong Kong SAR
(the grantor) is a public sector entity, including Government.
a governmental body or a private sector entity
to which the responsibility for the service has
been devolved.
The operator is responsible for at least some of Yes, BBE will manage the Lai Chi Kok Bridge for
the management of the infrastructure and related the 30-year duration of the contract.
services and does not merely act as an agent on
behalf of the grantor.
The contract sets the initial prices to be levied by No, BBE has the contractual right to set the
the operator and regulates price revisions over the initial toll price although the government
period of the service arrangement. can regulate any price revisions after a five-
year period.
The operator is obliged to hand over the No, BBE is contractually obliged to receive
infrastructure to the grantor in a specified consideration of 10% of the final construction
condition at the end of the period of the cost when it hands the bridge back to the
arrangement for little or no incremental Hong Kong SAR Government. There is also no
consideration irrespective of which party initially specified condition that the bridge must be in
financed it. prior to handover.

As a result of failing to meet two of the common features of a service concession

arrangement, the BBE arrangement cannot be classified as a service concession
arrangement and will not be accounted for in accordance with HK (IFRIC)-Int 12.

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 27
Financial Statements
for an Individual Entity

CHAPTER TOPIC LIST

27.1 Financial Statements for an 27.4 Statement of Changes in Equity

Individual Entity Overview
27.5 Notes
27.1.1 Scope
27.1.2 Terminology 27.6 Statement of Cash Flows
27.1.3 General Features of Financial 27.7 Disclosure of Significant
Statements Judgement and Accounting
27.2 Statement of Financial Position Estimates
27.2.1 Information to be Presented 27.8 Prepare and Practice Appraising
in the Statement of Financial Disclosure of Accounting Policy
Position and Required Items
27.2.2 Current/Non-current 27.8.1 Companies Ordinance’s
Classification of Assets and Requirements
Liabilities 27.8.2 Directors’ Emoluments
27.2.3 Notes to the Statement of and AB 3
Financial Position 27.8.3 Listing Rules Requirements
27.3 Statement of Profit or Loss and
27.9 Current Developments
Other Comprehensive Income
27.9.1 C lassification of Debt with
27.3.1 Information to be Presented
Covenants as Current or
in the Profit or Loss Section or
Non-current
the Statement of Profit or Loss
27.9.2 Primary Financial Statements
27.3.2 Information to be Presented
27.9.3 Disclosure Initiative – Targeted
in the Other Comprehensive
Standards-level Review of
Income Section
Disclosures
27.9.4 Supplier Finance Arrangements

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO4: PREPARE, PRESENT AND APPRAISE GROUP FINANCIAL STATEMENTS WITH
COMPLEX GROUP STRUCTURES
LO4.01: C
 onstruct the financial statements for an individual entity in accordance with Hong Kong
Financial Reporting Standards and statutory reporting requirements
4.01.01 Construct the statement of financial position, and the statement of profit or loss and
other comprehensive income
4.01.02 Construct and explain the contents and purpose of the statement of changes in equity
4.01.03 Construct and explain the contents and purpose of the statement of cash flows
4.01.04 Explain the importance to disclose significant judgement and accounting estimates
4.01.05 Prepare and appraise disclosure in respect of accounting policy and items required by
the Hong Kong Financial Reporting Standards, New Companies Ordinance, and other
rules and regulations

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 Financial S tatements for an I ndi v idual Entit y

OPENING CASE

OCEAN BAY LIMITED

O cean Bay Limited (Ocean Bay) is a retail company, with stores located in Hong Kong,
selling a range of furniture for the home and office. Ocean Bay has been established in
Hong Kong for over 40 years. The current Chief Financial Accountant has been with Ocean Bay
since the first store was opened. However, senior management of Ocean Bay is concerned
that due to the impending retirement of the Chief Financial Accountant, the professional skills
of the Chief Financial Accountant have not been maintained over recent years, for example,
they lack of any ongoing professional development undertaken by the current Chief Financial
Accountant.

You are a university graduate and have completed the Qualification Programme of the
Hong Kong Institute of Certified Public Accountants (HKICPA) and are a qualified CPA. You
have been employed by Ocean Bay to ensure the financial statements prepared by Ocean Bay
satisfy the Hong Kong Financial Reporting Standards (HKFRSs) issued by HKICPA. Unfortunately,
the financial statements issued by Ocean Bay in recent years have been deficient in meeting
HKFRSs, and you have been employed to help ensure the financial statements are compliant
with HKFRSs.

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OVERVIEW

Financial statements prepared for internal reporting purposes do not satisfy the requirements of
external general purpose financial reporting, so they must be converted into financial statements
prepared in accordance with the requirements of HKAS 1 Presentation of Financial Statements.

HKAS 1 prescribes the presentation requirements for a complete set of financial

statements, including guidelines as to their structure and content. A complete set of financial
statements comprises:

• A statement of financial position as at the end of the period;

• A statement of profit or loss and other comprehensive income for the period;

• A statement of changes in equity for the period;

• A statement of cash flows for the period;

• Notes comprising a summary of material accounting policy information and other

explanatory information; and

• A statement of financial position as of the beginning of the earliest comparative period

when certain changes are made retrospectively or items in the financial statements are
reclassified.

Although HKAS 1 does not prescribe a specific order or format for these financial
statements, HKAS 1 does require the disclosure of certain items in the financial statements.
In addition, notes comprising a summary of accounting policies and other information must
also be disclosed. By prescribing a basis for the presentation of financial statements, HKAS 1
attempts to improve the comparability with an entity’s financial statements from previous
periods and with the financial statements prepared by other entities. The information required
by HKAS 1 to be provided in a complete set of financial statements is designed to make the
statements useful to a wide range of users for decision-making purposes. HKAS 1 requires
certain information to be presented in the notes and prescribes the order in which notes are
normally presented.

2 7 . 1 FINANCIAL STATEMENTS FOR AN

INDIVIDUAL ENTITY OVERVIEW

This chapter discusses the reporting requirements of HKAS 1 Presentation of Financial

Statements that prescribe the basis for the presentation of a statement of financial position, a
statement of profit or loss and other comprehensive income, a statement of changes in equity
and related notes.

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 Financial S tatements for an I ndi v idual Entit y

Recall from Chapter 1, the concepts of the essential elements of financial statements
(e.g. assets, liabilities, etc.) are provided in the Conceptual Framework for Financial Reporting
(2018) (Conceptual Framework) issued by the HKICPA in 2018.

Hong Kong companies are also required by Section 379 of the Hong Kong Companies
Ordinance (CO) to prepare financial statements for each financial year. According to Section 380
of the CO, these financial statements must present a true and fair view. They must also comply
with the requirements of the Accounting Disclosures found in Schedule 4 to the CO.

Note, in this chapter, the terms company/entity and companies/entities will be used
interchangeably.

27.1.1 Scope
HKAS 1 applies to an entity when preparing and presenting general purpose financial statements
HKAS 1.2 in accordance with Hong Kong Financial Reporting Standards (HKFRSs). HKFRSs are standards
and Interpretations issued by the HKICPA. They comprise:

• Hong Kong Financial Reporting Standards;

• Hong Kong Accounting Standards; and

HKAS 1.7 • Interpretations.
HKAS 1 is not the only standard a company must follow when presenting financial
statements. Other HKFRSs set out the recognition, measurement and disclosure requirements
HKAS 1.3 for specific transactions and other events. For example, when interim financial statements are
prepared in accordance with HKAS 34 Interim Financial Reporting, HKAS 1 does not apply, apart
from HKAS 1.15–35, that is, the general features of financial statements, such as, going concern,
HKAS 1.4 accrual basis of accounting, and so on. (see Chapter 28).

27.1.2 Terminology
HKAS 1 applies to an entity presenting general purpose financial statements in accordance with
HKFRSs. General purpose financial statements (referred to as ‘financial statements’) are
those intended to meet the needs of users who are not in a position to require an entity to
HKAS 1.7 prepare reports tailored to their particular information needs.

A complete set of financial statements comprises:

• A statement of financial position as at the end of the period;

• A statement of profit or loss and other comprehensive income for the period;

• A statement of changes in equity for the period;

• A statement of cash flows for the period;

• Notes, comprising material accounting policy information and other explanatory

information, that is, comparative information in respect of the preceding period; and

• 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
HKAS 1.10 statements.

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Notes contain information additional to that presented in the statement of financial

position, statement of profit or loss and other comprehensive income, statement of changes in
HKAS 1.7 equity and statement of cash flows. Notes provide narrative descriptions or disaggregation of
items presented in the financial statements and information about items that do not qualify for
recognition in those statements.

An entity identifies the information that is useful to the primary users of the general-­
purpose financial statements by making appropriate materiality judgements. The term
material refers to information that, if omitted, misstated, or obscured, could reasonably be
expected to influence decisions that the primary users of general-­purpose financial statements
make on the basis of those financial statements, which provide financial information about
a specific reporting entity. Information is obscured if it is communicated in a way that would
have a similar effect for primary users of financial statements to omitting or misstating that
information.

The materiality of information is assessed in the context of the financial statements taken
as a whole. Information may be material:

• due to its nature and/or magnitude; and

• either individually, or in combination with other information.

Key Learning Point

A complete set of financial statements includes the following financial statements:
statement of financial position, statement of profit or loss and other comprehensive
income, statement of changes in equity and statement of cash flows.

A complete set of financial statements also includes notes comprising a summary of

material accounting policy information and other explanatory material.

27.1.3 General Features of Financial Statements

HKAS 1 does not change the recognition, measurement or disclosure of specific transactions and
other events required by other HKFRSs, but affects the presentation of owner changes in equity
and of comprehensive income. For example, HKAS 1 requires an entity to present, in a
statement of changes in equity, all owner changes in equity (e.g. dividends distributed to
shareholders, issue of share capital). All non-owner changes in equity (e.g. changes in a
revaluation surplus, which are regarded as comprehensive income) are required to be presented
in one statement of comprehensive income or in two statements (a separate income statement
HKAS 1 and a statement of comprehensive income). Components of comprehensive income are not
IN5, IN6 permitted to be presented in the statement of changes in equity.

HKAS 1 outlines eight general features of a complete set of financial statements (Exhibit 27.1).

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 Financial S tatements for an I ndi v idual Entit y

Accrual basis
Going concern
of accounting

True and fair view and Materiality and

compliance with HKFRSs aggregation

Complete Set of Financial Statements

Consistency of
Offsetting
presentation

Comparative
Frequency of reporting
Information

EXHIBIT 27.1 Features of a complete set of financial statements

27.1.3.1 True and Fair View and Compliance with HKFRSs

HKAS 1 requires entities that comply with HKFRSs to make an explicit and unreserved statement
HKAS 1.16 of such compliance in the notes.

Financial statements are required to present a true and fair view of an entity’s financial
position, financial performance and cash flows. Applying HKFRSs, with additional disclosures if
HKAS 1.15 necessary, is presumed to result in financial statements providing a true and fair view.

In rare circumstances, compliance by a company with an HKFRS may cause the financial
statements to be so misleading that it would conflict with the objectives of financial statements
set out in the Framework, but the relevant regulatory framework prohibits departure from
the requirement. In these circumstances, the company is required, to the maximum extent
possible, reduce the perceived misleading aspects of compliance by disclosing:

• The title of the HKFRS in question, the nature of the requirement, and the reason why
management has concluded that complying with that requirement is so misleading
in the circumstances that it conflicts with the objective of financial statements set out
in the Framework; and

• For each period presented, the adjustments to each item in the financial statements
HKAS 1.23 that management has concluded would be necessary to achieve a true and fair view.

However, if the relevant regulatory framework requires, or otherwise does not prohibit,
such a departure, then a company shall disclose that:

• Management has concluded the financial statements present the entity’s financial
position, financial performance and cash flows fairly;

• It has complied with applicable HKFRSs except that it has departed from a particular
requirement to achieve a true and fair view;

• The title of the HKFRS from which the entity has departed, the nature of the departure,
including the treatment that the HKFRS would require, the reason why that treatment
would be so misleading in the circumstances that it would conflict with the objective of
financial statements set out in the Framework, and the treatment adopted; and

• For each period presented, the financial effect of the departure on each item in the
HKAS 1.20 financial statements would have been reported in complying with the requirement.

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27.1.3.2 Going Concern

Financial statements are normally prepared on the assumption that the reporting entity will
Framework continue to operate for the foreseeable future. This is known as the going concern assumption
3.9 or the continuity assumption. Hence, financial statements for an entity are prepared on a going
concern basis unless management intends to liquidate the entity or cease trading or has no
realistic alternative but to do so. If management is aware of material uncertainties that may
cast doubt on the entity’s ability to continue as a going concern, these uncertainties must be
disclosed. If the going concern basis is not used in the preparation of the financial statements,
this must be disclosed together with the basis used and the reason the entity is not regarded as
HKAS 1.25 a going concern. For example, if a company is expected to be liquidated, assets will be
measured at their expected sale price (‘liquidation sale’) rather than, say, cost or fair value. In
assessing the going concern assumption, management takes into account information about
HKAS 1.26 the future, which may extend 12 months and beyond from the end of the reporting period.

27.1.3.3 Accrual Basis of Accounting

HKAS Financial statements are to be prepared using the accrual basis of accounting except for cash
1.27 flow information. Under accrual accounting, elements of the financial statements (income,
HKAS expenses, assets, liabilities and equity) are recognised when they satisfy the definition and
1.28 recognition criteria of those elements in the Framework (see Chapter 1 for more details).

27.1.3.4 Materiality and Aggregation

Each material class of similar items must be presented separately in the financial statements.
HKAS Items of a dissimilar nature or function are to be presented separately unless they are
1.29 immaterial.

Financial statements result from processing a number of transactions. The final stage in the
process of aggregation and classification is the presentation of condensed and classified data in
the form of line items in the financial statements or in the notes. If the amount for these line
items is immaterial, it is aggregated with other similar items either in the financial statements
HKAS 1.30 or in the notes. An entity must decide, taking into consideration all relevant facts, how it
HKAS 1.30A aggregates information in the financial statements.

Furthermore, some HKFRSs specify information that is required to be disclosed in the

HKAS financial statements and notes. However, an entity is not required to provide these disclosures
1.31 if the information resulting from that disclosure is not material.

Alternatively, an entity may also provide additional disclosure if compliance with an HKFRS
HKAS is considered to be insufficient to enable users to understand the impact of particular
1.31 transactions on the entity’s financial performance and financial position.

27.1.3.5 Offsetting
HKAS Assets and liabilities, and income and expenses, are not permitted to be offset unless required
1.32 or permitted by a HKFRS. For example, HKAS 32 Financial Instruments: Presentation does permit,
in some cases when various conditions are satisfied, the offsetting of a financial asset with a
financial liability. Offsetting, it is argued, detracts from the ability of users to understand the

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entity’s transactions and to assess the entity’s future cash flows. However, measuring assets net
HKAS of valuation allowances, for example, accounts receivable less allowances for doubtful debts is
1.33 not offsetting.

Offsetting is appropriate when netting any income with related expenses arising from the
same transaction or from similar transactions, for example:

• Gains and losses on the disposal of a non-current asset (i.e. sale proceeds less the
carrying amount of the asset and related selling expenses);

• Expenditure relating to a provision recognised in accordance with HKAS 37 Provisions,

Contingent Liabilities and Contingent Assets and reimbursed under a contractual
arrangement with a third party (such as a supplier’s warranty agreement) may be
netted against the related reimbursement; and

• Netting gains and losses from similar transactions (such as foreign exchange gains and
HKAS
losses). However, if the gains and losses are material, they cannot be offset but must be
1.34, 1.35 reported separately.

Note that HKAS 12 Income Taxes permits the offsetting of current tax assets and current tax
liabilities and deferred tax assets and deferred tax liabilities subject to certain conditions. See
Chapter 19 for more discussion on this issue.

27.1.3.6 Frequency of Reporting

HKAS HKAS 1 requires an entity to prepare a complete set of financial statements (including
1.36 comparative information) at least annually. In some cases, instead of using a financial year-end
HKAS of 30 June or 31 December, some entities may prefer to report for a 52-week period, which is
1.37 permitted.

If an entity changes the end of its reporting period and presents financial statements for a
period longer or shorter than one year, the entity must disclose:

• The reason for using a longer or shorter period; and

HKAS • That comparative amounts for the financial statements are not entirely comparable
1.36 because of the different lengths of reporting periods.

27.1.3.7 Comparative Information

Comparability refers to information that enables users to identify similarities and differences
between two (or more) sets of financial statements. Disclosure of comparative financial
information is required with respect to the preceding period (i.e. the previous reporting period)
for all amounts required to be reported in the current period’s financial statements.
HKAS Comparative information for narrative and descriptive information is also required if it is
1.38 relevant to understanding the current period’s financial statements. The requirement to
HKAS present comparative information means that an entity will, as a minimum, present two
1.38A statements for each financial statement and related notes. For example, the statement of
financial position will disclose information for two years, that is, the current year and the
previous year.

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In some cases, events disclosed as narrative information in previous periods may still be
unresolved in the current period, such as details of a legal dispute. Even though there may have
HKAS been no developments in the current period, this continues to be relevant, and users need to
1.38B know about steps taken to resolve the uncertainty.

In some circumstances, comparative information needs to be reclassified or adjusted. For

example, if the presentation or classification of items in the financial statements is changed,
HKAS comparative information must also be reclassified and the nature, amount of and reason for
1.41 the reclassification must be disclosed. Reclassification is not necessary if this is ‘impracticable’;
for example, an entity may not have collected data in previous periods in a way that allows
reclassification. In this case, the reason for not reclassifying the comparative amounts and the
HKAS nature of the adjustments that would have been made if the amounts were reclassified must
1.42 be disclosed.

In addition, comparative information is adjusted for changes in accounting policy or

corrections of errors in accordance with HKAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors (see Chapter 16).

Three statements of financial position (and two each of the other statements and related
notes) must be presented when a company does the following:

• Applies an accounting policy retrospectively;

• Makes a retrospective restatement of items in its financial statements; or

• Reclassifies items in its financial statements.

HKAS In all cases, this has a material effect on the information in the statement of financial position
1.40A at the beginning of the previous period.

The above three statements of financial position must be presented at:

• the end of the current period;

• the end of the preceding period; and

HKAS
1.40B • the beginning of the preceding period.
HKAS
1.40C However, related notes are not required for this third statement of financial position.
As noted previously in Section 27.1.1, the third statement of financial position (the beginning of
the preceding period) forms part of a complete set of financial statements.

HKAS An entity may present additional comparative information in addition to the minimum
1.38C required provided that the additional information is prepared in accordance with HKFRSs.
For example, an entity may present a third statement of profit or loss and other comprehensive
income (thereby presenting the current period, the preceding period and one additional
comparative period). Furthermore, the entity will then be required to present, in the notes to
HKAS the financial statements, the comparative information related to that additional statement of
1.38D profit or loss and other comprehensive income.

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Apply and Analyse 1

Ocean Bay purchased certain motor vehicles at a cost of HK$100,000 in 20X7. The motor
vehicles have anticipated useful lives of five years. However, the cost of the motor vehicles
was recorded incorrectly as repairs and maintenance. This error was discovered during
20X9. This information was brought to your attention by the Chief Financial Accountant.
Advise what should do to the Chief Financial Accountant.

Analysis

Ocean Bay should present a third statement of financial position at the beginning of the
HKAS preceding period when the retrospective restatement has a material effect on the
1.40A information in the statement of financial position at the beginning of the preceding period.

Accordingly, the financial statements of Ocean Bay for the year ended 31 December
20X9 should include three statements of financial position as of 1 January 20X8,
31 December 20X8 and 31 December 20X9.

HKAS Ocean Bay should also disclose the information required by HKAS 1, namely, the nature,
1.41 amount of and reason for the reclassification. However, the related notes for the opening
HKAS statement of financial position as of 1 January 20X8 are not required. Certain disclosures
1.40C
are also required by HKAS 8 following the discovery of this error (see Chapter 16).

27.1.3.8 Consistency of Presentation

The presentation and classification of items in the financial statements must be consistent from
one period to the next unless:

• A significant change in the entity’s operations has occurred;

• A review of its financial statements indicates a change in presentation or classification is

warranted to provide more relevant information; or
HKAS
1.45 • A change in presentation or classification is required by another accounting standard.

A change in the presentation of the financial statements by an entity should be made only if
the revised presentation provides information that is reliable and more relevant to users and is
HKAS likely to continue. When the presentation is changed, comparative information is reclassified in
1.46 accordance with HKAS 1.41 and 42.

27.1.3.9 Identification of the Financial Statements

Entities often use their Annual Report as a public relations document and provide information
in addition to the financial statements. This may include a chairman’s report and a review of the
company operations. Annual Reports are usually available from a company’s website, and the
information they provide in addition to financial statements is worth noting.

The financial statements of an entity are to be clearly identified and distinguished from
HKAS
other information in the same published document because accounting standards apply only
1.49, 50 to information in the financial statements.

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An entity is required to clearly identify each financial statement and the notes. In addition,
the following information must be displayed prominently:

• The name of the entity or some other means of identification, and any change of name
since the preceding reporting period;

• Whether the financial statements cover the individual entity or a group of entities;

• The date of the end of the reporting period or the period covered by the set financial
statements or notes;

• The presentation currency as defined in HKAS 21 The Effects of Changes in Foreign

Exchange Rates, that is, currency used in the financial statements. This is usually
Hong Kong dollars; however, some companies present their financial statements in
other currencies, such as US dollars; and
HKAS
1.51 • The level of rounding used in the presentation of amounts in the financial statements.

Key Learning Point

The following are the eight general features of financial statements:

1. true and fair view and compliance with HKFRSs;

2. going concern;

3. accrual basis of accounting;

4. materiality and aggregation;

5. offsetting;

6. frequency of reporting;

7. comparative information; and

8. consistency of presentation.

The financial statements and notes must be clearly identified in the entity’s Annual Report.

Knowledge Check Questions

Question 1
HKFRS 16 Leases requires lessors to make various disclosures of any finance leases.
However, if the amount involved was HK$10,000 for the one and only finance lease of the
lessor and total assets of the lessor were HK$100 million, identify which of the following
statement describes the disclosure required by HKFRS 16 for the lessor’s finance lease.
A It must be in accordance with the specific requirements of HKFRS 16.
B It requires reclassification of the lease as an operating lease in accordance with HKFRS 16.
C It could be ignored.
D It offsets the lease asset against accounts payable.

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Knowledge Check Questions (continued)

Question 2
An entity is subject to a claim for damages from customers due to defective goods sold in
the period before the current reporting period. The entity is denying any responsibility. The
court case has not have been resolved during the current reporting period as the results of
tests on the goods have not been provided by experts to the court. Identify the disclosure
required by the entity in the current period.
A No disclosure is required because the court case is unresolved.
B The entity should explain in the notes reasons why the court case remains unresolved at
the end of the current period.
C The entity should record an estimated liability.
D No disclosure is required as the entity is denying any responsibility for the damages.

2 7 . 2 STATEMENT OF FINANCIAL POSITION

The statement of financial position provides information regarding the financial position of
the entity as of the end of the reporting period. Asset, liability and equity items are summarised
in the statement of financial position to determine an entity’s financial position. For more
discussion on assets, liabilities and equity, including definitions and recognition criteria as
contained in the Conceptual Framework for Financial Reporting (2018) (Conceptual Framework)
see Chapter 1. The HKAS 1 disclosure requirements for the statement of financial position are
considered in the following section.

27.2.1 Information to be Presented in the Statement of Financial Position

Exhibit 27.2 that follows is adapted from the illustrative statement of financial position
HKAS
contained in the Implementation Guidance to IAS 1 Presentation of Financial Statements and
1.54, 55 highlights the disclosure required by HKAS 1. Relevant HKAS 1 paragraph numbers that require
certain items to be disclosed in the statement of financial position are also provided in
Exhibit 27.2.

A few observations can be made from Exhibit 27.2:

• Assets and liabilities are classified as either current or non-current. Further discussion
of the current and non-current classification of assets and liabilities is found in
Section 27.2.2.

• In presenting the statement of financial position of a company, the headings and

subheadings should be followed to the extent that the items exist in the company
under consideration. Additional subheadings could be provided, such as a subheading
in non-current assets for development costs capitalised, but this is unnecessary.
Provision of additional subheadings depends on the disclosure policies of the company
concerned.

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HKAS • HKAS 1 requires the presentation of additional items, headings and subtotals when it is
1.55 considered relevant to an understanding of the company’s financial position. Whether
to present additional items separately is based on an assessment of:

°° The nature and liquidity of assets;

°° The function of assets within the entity; and

HKAS
1.58
°° The amounts, nature and timing of liabilities.

HKAS 1
51(a), 51(b) XYZ Group
10(a), 49 Statement of Financial Position
51(c) as at 31 December 20X9
38 20X9 20X8
51(d), 51(e) HK$’000 HK$’000
ASSETS
60 Non-current assets
54(a) Property, plant and equipment 350,700 360,020
54(c) Goodwill 80,800 91,200
54(c) Other intangible assets 137,470 140,470
54(b) Investment property 40,000 40,000
54(f) Biological assets 20,000 20,000
54(o), 56 Deferred tax 30,000 27,000
54(e) Investments in associates 100,150 110,770
54(d) Investments in equity instruments 142,500 156,000
901,620 945,460
60 Current assets
54(g) Inventories 135,230 132,500
54(h) Trade receivables 91,600 110,800
55 Other current assets 25,650 12,540
54(i) 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
54(r), 78(e) Share capital 650,000 600,000
54(r), 78(e) Retained earnings 243,500 161,700
54(r), 78(e) Other components of equity 10,200 21,200
903,700 782,900

EXHIBIT 27.2 Illustrative presentation of the statement of financial position, including

comparative amounts

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HKAS 1
51(a), 51(b) XYZ Group
10(a), 49 Statement of Financial Position
51(c) as at 31 December 20X9
38 20X9 20X8
51(d), 51(e) HK$’000 HK$’000
54(q) Non-controlling interests 70,050 48,600
Total equity 973,750 831,500
60 Non-current liabilities
54(m) Long-term borrowings 120,000 160,000
54(o), 56 Deferred tax 28,800 26,040
54(l) Long-term provisions 28,850 52,240
Total non-current liabilities 177,650 238,280
60 Current liabilities
54(k) Trade and other payables 115,100 187,620
54(m) Short-term borrowings 150,000 200,000
54(m) Current portion of long-term borrowings 10,000 20,000
Current tax payable 35,000 42,000
54(n) Short-term provisions 5,000 4,800
54(l)
Total current liabilities 315,100 454,420
Total liabilities 492,750 692,700
Total equity and liabilities 1,466,500 1,524,200

Source: HKAS 1.
EXHIBIT 27.2 (Continued)

27.2.2 Current/Non-current Classification of Assets and Liabilities

HKAS All assets and liabilities are required to be classified as current or non-current unless a liquidity
1.60 presentation is appropriate to provide more relevant and reliable information. HKAS 1 requires
an entity to disclose the amount expected to be recovered or settled after more than 12 months
for each asset and liability line item that combines amounts expected to be recovered or settled:

• no more than 12 months after the reporting period, and

HKAS
1.61 • more than 12 months after the reporting period.

For some entities, such as financial institutions, assets and liabilities may be presented in
increasing or decreasing order of liquidity if this provides information that is reliable and more
HKAS relevant than a current and non-current presentation because these entities do not supply
1.63 goods and services within a clearly defined operating cycle.

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27.2.2.1 Current Assets

HKAS 1 requires an entity to classify an asset as current when:

• It expects to realise the asset, or intends to sell or consume it, in its normal operating
cycle (see below);

• It holds the asset primarily for the purpose of trading;

• It expects to realise the asset within 12 months after the reporting period; or

• The asset is cash or a cash equivalent (as defined in HKAS 7 Statement of Cash Flows)
unless the asset is restricted from being exchanged or used to settle a liability for at
least 12 months after the reporting period.
HKAS
1.66 An entity shall classify all other assets as non-current.

The operating cycle of an entity is the time between the acquisition of assets for
processing and their realisation in cash or cash equivalents. When the entity’s normal operating
cycle is not clearly identifiable, it is assumed to be 12 months. Current assets include assets
(such as inventories and trade receivables) that are sold, consumed or realised as part of the
normal operating cycle even when they are not expected to be realised within 12 months after
the reporting period. Current assets also include assets held primarily for the purpose of
HKAS trading; examples include some financial assets that meet the definition of held for trading in
1.68 HKFRS 9 and the current portion of non-current financial assets.

27.2.2.2 Current Liabilities

HKAS 1 requires liabilities to be classified by an entity as current when:

• It expects to settle the liability in its normal operating cycle;

• It holds the liability primarily for the purpose of trading;

• The liability is due to be settled within 12 months after the reporting period; or
• It does not have the right at the end of the reporting period to defer settlement of the
liability for at least twelve months after the reporting period.
HKAS
1.69 All other liabilities are required to be classified as non-current.

HKAS 1 also requires that financial liabilities must be classified as current when they are due
to be settled within 12 months even if the original term was for a period longer than 12 months
HKAS and an agreement to refinance or to reschedule the payments is completed after the end of the
1.72 reporting period and before the financial statements are authorised for issue. However, if, under
the terms of an existing loan facility, the entity has discretion to refinance or ‘roll over’ its
HKAS obligations for at least 12 months after the reporting period, the liability can continue to be
1.72A classified as non-current, provided the right to defer settlement has substance and the right
HKAS exists at the end of the reporting period. If the entity has no such right, it does not have to
1.73 consider the potential to refinance the obligation and classifies the obligation as current.

If an entity breaches a condition of a long-term loan during the reporting period with the
effect that the loan becomes payable on demand, the loan will be classified as a current
liability even if the lender had agreed after the reporting period and before the financial
statements were issued not to demand payment due to the breach. At the end of the
reporting period, the entity does not have the right to defer payment for at least 12 months
after that date; hence, the loan is classified as current. However, the loan is classified as
non-current if the lender agreed, by the end of the reporting period, to allow the entity at

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 Financial S tatements for an I ndi v idual Entit y

HKAS least 12 months to rectify the breach and during which time the lender cannot demand
1.74, 75 immediate repayment. Classification of a liability is not affected by the likelihood that the
entity will exercise its right to defer settlement of the liability for at least twelve months after
the reporting period. If a liability meets the criteria for classification as non-current, it is
classified as non-current even if:

–– management intends or expects the entity to settle the liability within twelve months
after the reporting period, or

HKAS –– even if the entity settles the liability between the end of the reporting period and the
1.75A date the financial statements are authorised for issue.

If the following events occur between the end of the reporting period and the date the
financial statements are authorised for issue, those events will be disclosed as ‘non-adjusting
events’ in accordance with HKAS 10 Events after the Reporting Period (see Chapter 17):

• Refinancing on a long-term basis of a liability classified as current;

• Rectification of a breach of a long-term loan arrangement classified as current;

HKAS • The granting by the lender of a period of grace to rectify a breach of a long-term loan
1.76 arrangement classified as current; and

• Settlement of a liability classified as non-current.

When classifying a liability as current or non-current, an entity interprets the term
‘settlement’ as referring to a transfer to the counterparty that results in the extinguishment of
the liability. The transfer could be in the form of:

(a) cash or other economic resources – for example, goods or services; or

HKAS
1.76A (b) the entity’s own equity instruments.

However, terms of a liability that could, at the option of the counterparty, result in its
settlement by the transfer of the entity’s own equity instruments would not affect its
classification as current or non-current if, applying HKAS 32 Financial Instruments: Presentation,
HKAS the entity classifies the option as an equity instrument, recognising it separately from the
1.76B liability as an equity component of a compound financial instrument.

27.2.3 Notes to the Statement of Financial Position

Exhibit 27.3 provides examples of additional disclosures required for statement of financial
position line items.

HKAS 1 Statement of Financial Disclosures required

Position line item
78(a) Property, plant and Items classified by class as described by HKS 16 Property,
equipment Plant and Equipment: for example, land, land and buildings,
HKAS machinery, ships, aircraft, motor vehicles, furniture and
16.37 fittings, and office equipment (see Chapter 7)
78(b) Receivables Disaggregated into receivables from trade customers,
receivables from related parties, prepayments and other
amounts

EXHIBIT 27.3 Examples of additional disclosures for items presented in the statement of
financial position

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HKAS 1 Statement of Financial Disclosures required

Position line item
78(c) Inventories Disaggregated into classifications, such as merchandise,
finished goods, work in progress, supplies and materials, in
accordance with HKAS 2 Inventories (see Chapter 6)
78(d) Provisions Disaggregated into provisions for employee benefits and
other items (see Chapter 18)
78(e) Equity capital and reserves Disaggregated into various classes of paid-in capital, share
premium and reserves
79(a) For each class of share (i) The number of shares authorised;
capital (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 (Note: under Section 135 of the new Hong Kong
Companies Ordinance (Cap.622), the concept of nominal
value was abolished; thus, shares do not have a par
value);
(iv) A reconciliation of the number of shares outstanding at
the beginning and at the end of the period;
(v) The rights, preferences and restrictions attaching to
that class, including restrictions on the distribution of
dividends and the repayment of capital;
(vi) Shares in the entity held by the entity or by its
subsidiaries or associates; and
(vii) Shares reserved for issue under options and contracts
for the sale of shares, including the terms and amounts.
79(b) Reserves A description of the nature and purpose of each reserve.

EXHIBIT 27.3 (Continued)

Exhibit 27.4 provides an example disclosure of share capital required by HKAS 1.79(a).

20X9 20X8
No. of HK$’000 No. of HK$’000
Shares (‘000) Shares (‘000)
Ordinary shares, issued and fully paid
At 1 January 180,000 360,000 180,000 360,000
Bonus issue 18,000 – – –
Shares repurchased (1,000) – – –
Shares issued under share option scheme 3,000 12,000 – –
Transfer from capital reserve – 1,000 – –
At 31 December 200,000 373,000 180,000 360,000

EXHIBIT 27.4 Example of disclosure of share capital

The ordinary shares of the company do not have a par value in accordance with Section 135
of the Hong Kong Companies Ordinance (CO).

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Key Learning Point

The information to be presented in the statement of financial position includes, as a
minimum, prescribed asset, liability and equity items. A required order or format for the
statement of financial position is not prescribed, but guidance is provided in HKAS 1.
All assets and liabilities are usually classified as either current or non-current.

Knowledge Check Questions

Question 3
Amaya Ltd (Amaya) has breached a provision relating a long-term loan during the current
reporting period (with the effect that the loan becomes payable). Identify how Amaya is
required to classify the loan liability.

Question 4
The following are assets and liabilities of a boat and ship building company at 31 December
20X8:
A Specialist steel that is used in the construction of warships. The steel is left over from a
recently completed order; it is unlikely to be used within 12 months as the company has
no current orders for warships.
B Two completed small fishing boats that are available for sale to the general public.
C An amount of HK$6 million due from a customer that has contracted the company to
build a tugboat. HK$3.7 million of the HK$6 million has been billed to the customer.
D A part complete tourist boat that the company intends to offer for sale to local river
cruise companies when complete. The boat is likely to take 14 months to complete.

Required

Explain how these assets should be presented in the statement of financial position of the
boat and shipbuilding company at 31 December 20X8.

2 7 . 3 STATEMENT OF PROFIT OR LOSS AND

OTHER COMPREHENSIVE INCOME

The statement of profit or loss and other comprehensive income provides information
regarding the financial performance of the entity for the reporting period. Income,
expenses and other comprehensive income (e.g. movements in asset revaluation surplus)
are summarised in the statement of profit or loss and other comprehensive income to
determine an entity’s total comprehensive income, the usual measure of an entity’s financial
performance.

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 FINANCIAL REPORTING

An entity has a choice as to how to present the statement of profit or loss and other
comprehensive income. The choices are as follows:

• A single statement of profit or loss and other comprehensive income, with profit or loss
and other comprehensive income presented in two sections, and the two sections are
to be presented together with the profit or loss section presented first followed directly
by the other comprehensive income section; or

HKAS • A separate statement of profit or loss immediately followed by a statement of

1.10A comprehensive income, which shall begin with profit or loss.

In addition to the profit or loss and other comprehensive income sections, the statement of
profit or loss and other comprehensive income (or statement of comprehensive income) shall
present the following:

• Profit or loss;

• Total other comprehensive income; and

HKAS • Comprehensive income for the period, being the total of profit or loss and other
1.81A comprehensive income.

Furthermore, disclosure of the following allocations of profit or loss and other comprehensive
income is also required:
• Profit or loss attributable to the non-controlling interests and owners of the parent; and

HKAS • Comprehensive income attributable to the non-controlling interests and owners of the
1.81B parent (see Chapter 30 that deals with non-controlling interests and parent entity).

The aggregation of ‘profit or loss’ and ‘other comprehensive income’ is referred to as total
comprehensive income and represents the change in equity during a period resulting from
HKAS transactions and other events other than those changes resulting from transactions with
1.7 owners in their capacity as owners or shareholders.

In summary, this may be expressed as follows:

Total comprehensive income Profit or Loss (Income Expenses) Other

(changes in equity other than comprehensive income (income and expense
transactions with shareholders) items not recognised in profit or loss)

27.3.1 Information to be Presented in the Profit or Loss Section or

the Statement of Profit or Loss
Exhibit 27.5 that follows provides an illustrative example of a statement of profit or loss and
other comprehensive income contained in HKAS 1 (adapted from IAS 1 Presentation of Financial
Statements, Implementation Guidance). Relevant HKAS 1 paragraph numbers that require
certain items to be disclosed in the statement of profit or loss and other comprehensive
income are also provided in Exhibit 27.5. The example is based on:

• A single statement of profit or loss and other comprehensive income;

• Expenses classified according to function; and

• Items of other comprehensive income are disclosed before the related tax effects.

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HKAS 1
51(a), 51(b) XYZ Group
10(b), 10A, 49 Statement of Profit or Loss and Other Comprehensive Income
51(c) for the year ended 31 December 20X9
38 20X9 20X8
51(d), 51(e) HK$’000 HK$’000
82(a) Revenue 390,000 355,000
99, 103 Cost of sales (245,000) (230,000)
85, 103 Gross profit 145,000 125,000
85, 103 Other income 20,667 11,300
99, 103 Distribution costs (9,000) (8,700)
99, 103 Administrative expenses (20,000) (21,000)
99, 103 Other expenses (2,100) (1,200)
82(b) Finance costs (8,000) (7,500)
82(c) Share of profit of associates 35,100 30,100
85 Profit before tax 161,667 128,000
82(d) Income tax expense (40,417) (32,000)
85 Profit for the year from continuing operations 121,250 96,000
82(ea) Loss for the year from discontinued operations – (30,500)
81A(a) PROFIT FOR THE YEAR 121,250 65,500
At this point, this would conclude the first statement (a statement of
HKAS profit or loss) if two separate statements were to be prepared in
1.10A accordance with HKAS 1.
81A(b) Other comprehensive income
82A(a)(i) Items that will not be reclassified to profit or loss 933 3,367
Gains on property revaluation (24,000) 26,667
Investments in equity instruments (667) 1,333
Remeasurements of defined benefit pension plans
Share of gain (loss) on property revaluation of associates 400 (700)
90-91 Income tax relating to items that will not be reclassified 5,834 (7,667)
(17,500) 23,000
82A(a)(ii) Items that may be reclassified subsequently to profit or loss
Exchange differences on translating foreign operations 5,334 10,667
Cash flow hedges (667) (4,000)
90-91 Income tax relating to items that may be reclassified (1,167) (1,667)
3,500 5,000
81A(b) Other comprehensive income for the year, net of tax (14,000) 28,000
81A(c) TOTAL COMPREHENSIVE INCOME FOR THE YEAR 107,250 93,500
81B(a) Profit attributable to:
81B(a)(ii) Owners of the parent 97,000 52,400
81B(a)(i) Non-controlling interests 24,250 13,100
121,250 65,500

EXHIBIT 27.5 Illustrative presentation of statement of profit or loss and other comprehensive
income

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HKAS 1
51(a), 51(b) XYZ Group
10(b), 10A, 49 Statement of Profit or Loss and Other Comprehensive Income
51(c) for the year ended 31 December 20X9
38 20X9 20X8
51(d), 51(e) HK$’000 HK$’000
81B(b) Total comprehensive income attributable to:
81B(b)(ii) Owners of the parent 85,800 74,800
81B(b)(i) Non-controlling interests 21,450 18,700
107,250 93,500
Earnings per share (HK$):
Basic and diluted 0.46 0.30
Note: (i) details of earnings per share are disclosed pursuant to the requirements of
HKAS 33 Earnings per Share (see Chapter 20 for more details); and (ii) details regarding
‘other comprehensive income’ is discussed in Section 27.3.2.
Alternatively, items of other comprehensive income could be presented in the statement
of profit or loss and other comprehensive income net of tax as follows:
Other comprehensive income for the year, after tax 20X9 20X8++
82A(a)(i) Items that will not be reclassified to profit or loss
Gains on property revaluation 600 2,700
Investments in equity instruments (18,000) 20,000
Remeasurements of defined benefit pension plans (500) 1,000
Share of gain (loss) on property revaluation of associates 400 (700)
(17,500) 23,000
82A(a)(ii) Items that may be reclassified subsequently to profit or loss
Exchange differences on translating foreign operations 4,000 8,000
Cash flow hedges (500) (3,000)
3,500 5,000
81A(b) Other comprehensive income for the year, net of tax (14,000) 28,000

EXHIBIT 27.5 (Continued)

HKAS 1 does not prescribe a required order or format for the profit or loss section or the
HKAS statement of profit or loss (the same as was noted previously with the statement of financial
1.82 position). Profit or loss before income tax expense is not required to be disclosed. However, this
additional line item is included in the examples that follow in this chapter as companies usually
disclose this item. Additional line items, headings and subtotals can be included in the profit or
HKAS loss section and or the statement of profit or loss (and other comprehensive income) when it is
1.85 considered relevant to an understanding of the entity’s financial performance.

HKAS Separate disclosure of the nature and amount of material items of income and expenses is
1.97 required by HKAS 1. Disclosure of these items is considered essential if users are to understand
the financial statements and make effective economic decisions. HKAS 1 provides circumstances
that would give rise to the separate disclosure of such items of income and expense:

• The write-down of inventories to net realisable value or of property, plant and

equipment to recoverable amount, and any reversal of such write-downs;

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• Restructuring of company operations and reversals of any provisions for

restructuring costs;

• Disposals of items of property, plant and equipment;

• Disposals of investments;

• Discontinued operations;

• Litigation settlements; and

HKAS
1.98 • Other reversals of provisions.

Entities are required to present an analysis of expenses recognised in profit or loss using a
HKAS classification based on their nature or function, whichever provides information that is reliable
1.99 and more relevant as follows:

• The nature of expense method (see Exhibit 27.6), for example, depreciation,
purchases of materials, transport costs, employee benefits and advertising costs.
HKAS This method is simple to apply because no allocations of expenses to functional
1.102 classification are required, or

HK$ HK$
Revenue x
Other income x
Changes in inventories of finished goods and work in progress (x)
Raw materials and consumables used (x)
Employee benefits expense (x)
Depreciation and amortisation expense (x)
Other expenses (x)
Total expenses (x)
Profit before income tax x

EXHIBIT 27.6 Classification of expenses using the nature of expense method

• The function of expense (or ‘cost of sales’) method (see Exhibit 27.7), for example,
expenses classified according to their function as part of cost of sales or, for example,
as distribution costs or administrative expenses. This method may provide more
HKAS
relevant information to users, but allocating costs to functions may require arbitrary
1.103 allocations and judgement.

HK$
Revenue x
Cost of sales (x)
Gross profit x
Other income x
Distribution costs (x)
Administrative expenses (x)
Other expenses (x)
Profit before income tax x

EXHIBIT 27.7 Classification of expenses using

the function of expense method

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 FINANCIAL REPORTING

The choice between the function of expense method and the nature of expense method
depends on historical and industry factors and the nature of the entity. Both methods provide
HKAS information and each method has merit for different types of entities. Management should
1.105 select the method that provides the most relevant and reliable information.

27.3.2 Information to be Presented in the Other Comprehensive

Income Section
Other comprehensive income comprises items of income and expenses (including
HKAS reclassification adjustments) that are not recognised in profit or loss as required or permitted
1.7 by other HKFRSs. Components of other comprehensive income may include:

• Changes in a revaluation surplus (see Chapters 7 and 11);

• Measurements of defined benefit plans (see Chapter 23);

• Gains and losses arising from translating the financial statements of a foreign operation
(see Chapter 33); and

• Gains and losses on financial assets measured at fair value through other comprehensive
income in accordance with HKFRS 9 (see Chapter 12).

A company is required to disclose the amount of income tax relating to each item of other
HKAS comprehensive income either in the statement of profit or loss and other comprehensive
1.90 income or in the notes. However, the company may present items of other comprehensive
HKAS income either net of related tax effects, or before related tax effects, with one amount shown
1.91 for the aggregate of income tax relating to the items. As items of profit or loss are generally
disclosed before tax, this approach is also followed for items of other comprehensive income in
this chapter (unless stated otherwise).

27.3.2.1 Reclassification
Companies are required, when disclosing items in the other comprehensive income, to present
as separate line items:

(a) Items of other comprehensive income (except for (b) below) classified by nature; and

(b) The share of the other comprehensive income of associates and joint ventures
accounted for by using the equity method;

and for (a) and (b) disclose whether:

• The items will not be reclassified subsequently to profit or loss. (Reclassification

adjustments are covered in the following section); and

HKAS • The items will be reclassified subsequently to profit or loss at some time in the future
1.82A when specific conditions are met.

Examples of items that will not to be reclassified to profit or loss include:

• Surplus on revaluation of land and buildings held for use; and

• Net gain/loss on equity instruments designated at fair value through other comprehensive
income.

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Examples of items that are likely to be reclassified as profit or loss include:

• Exchange differences from translating the financial statements of a foreign

operation; and

• Net gain/loss on cash flow hedges.

27.3.2.2 Reclassification Adjustments

HKAS A company is required to disclose reclassification adjustments relating to components of
1.92 other comprehensive income. Reclassification adjustments are amounts recognised in other
HKAS comprehensive income in previous years (or the current year), but are reclassified (or ‘recycled’)
1.7 to the current period’s profit or loss.

A reclassification adjustment is included with the related component of other

comprehensive income in the period that the adjustment is reclassified to profit or loss.
Those unrealised gains must be deducted from other comprehensive income in the period in
HKAS which the realised gains are reclassified to profit or loss to avoid ‘double counting’ of the gain,
1.93 that is, including them in total comprehensive income twice. Conversely, losses previously
recognised in other comprehensive income are added back to other comprehensive income in
the period they are recognised in profit or loss.

Key Learning Point

HKAS 1 has taken an all-inclusive approach to the determination of profit or loss. Entities
may present either a single statement of profit or loss and other comprehensive income
or may present two separate statements, a statement of profit or loss and statement of
comprehensive income.

Information to be presented either in the statement of profit or loss and other

comprehensive income or in the notes includes:
• Each material income and expense item;

• An analysis of expenses using a classification based on either the nature of

expenses method or the function of expenses (or ‘cost of sales’) method; and

• Items of other comprehensive income, including reclassification adjustments.

Knowledge Check Question

Question 5
Identify which of the following items are required to be disclosed separately on the face of
the statement of profit or loss and other comprehensive income by HKAS 1.
I. Rent expense
II. Revenue
III. Finance costs

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Knowledge Check Question (continued)

IV. Share of the profit or loss from associates and joint ventures accounted for using
the equity method
V. Audit and non-audit fees
VI. Tax expense
VII. Profit or loss

2 7 . 4 STATEMENT OF CHANGES IN EQUITY

Transactions involving the entity and shareholders (e.g. dividends, share issues) must
be disclosed in the statement of changes in equity; other non-owner changes in equity
(e.g. revaluations of property, plant and equipment) can only be disclosed in the statement of
profit or loss and other comprehensive income.

Exhibit 27.8 provides an example of a statement of changes in equity contained in HKAS 1.

Relevant HKAS 1 paragraph numbers that require certain items to be disclosed in the statement
of changes in equity are also provided in Exhibit 27.8.

HKAS 1

51(a), 51(b) XYX Group

10(c), 49 Statement of Changes in Equity
51(c) for the year ended 31 December 20X9

106(d) Share Retained Translation Investments Cash Revaluation Total Non- Total
capital earnings of foreign in equity flow surplus controlling equity
operations instruments hedges interests

51(d), 51(e) HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000

38 Balance at 600,000 118,100 (4,000) 1,600 2,000 – 717,700 29,800 747,500

1 January
20X8

106(b), 110 Changes in – 400 – – – – 400 100 500

accounting
policy

Restated 600,000 118,500 (4,000) 1,600 2,000 – 718,100 29,900 748,000

balance

Changes in
equity for
20X8

106(d)(iii), Dividends – (10,000) – – – – (10,000) – (10,000)

107

106(a) Total – 53,200 6,400 16,000 (2,400) 1,600 74,800 18,700 93,500
comprehensive
income for the
year

EXHIBIT 27.8 Statement of changes in equity

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HKAS 1

51(a), 51(b) XYX Group

10(c), 49 Statement of Changes in Equity
51(c) for the year ended 31 December 20X9

106(d) Share Retained Translation Investments Cash Revaluation Total Non- Total
capital earnings of foreign in equity flow surplus controlling equity
operations instruments hedges interests

51(d), 51(e) HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000

Balance at 600,000 161,700 2,400 17,600 (400) 1,600 782,900 48,600 831,500
31 December
20X8

Changes in
equity for
20X9

106(d)(iii) Issue of share 50,000 – – – – – 50,000 – 50,000

capital

106(d)(iii), Dividends – (15,000) – – – – (15,000) – (15,000)

107

106(a) Total – 96,600 3,200 (14,400) (400) 800 85,800 21,450 107,250
comprehensive
income for the
year

Transfer to – 200 – – – (200) – – –

retained
earnings

106(d) Balance at 650,000 243,500 5,600 3,200 (800) 2,200 903,700 70,050 973,750
31 December
20X9

EXHIBIT 27.8 (Continued )

Key Learning Point

The statement of changes in equity provides details of the entity’s changes in equity
items for the period: total comprehensive income, each component of equity (including
details of movements during the period resulting from profit or loss), other comprehensive
income, share capital, dividends and transfers between equity accounts.

Knowledge Check Question

Question 6
Identify which of the following items are included in a statement of changes in equity.
I. Opening and closing balances
II. Total comprehensive income for the period
III. New share issues
IV. Dividends paid
V. For each component of equity, the effects of retrospective application or
retrospective restatement in accordance with HKAS 8

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2 7 . 5 NOTES

Notes are provided to help users understand the information provided in the financial
statements. The notes that accompany the financial statements must be presented in a
HKAS systematic manner, with appropriate cross-referencing to each related item in the financial
1.113 statements.

The notes must present information about the basis of preparation of the financial
HKAS
1.112(a), statements and the specific accounting policies used and must disclose information required
112(b) by HKFRSs not presented elsewhere in the financial statements.

HKAS The notes must also disclose information not presented in the financial statements but
1.112(c) which is relevant to an understanding of the financial statements. This does not mean
information shown in the financial statements cannot be repeated in the notes. The
requirement HKAS 1 to present in the notes relevant information not presented elsewhere in
the financial statements is an important overall requirement to ensure that companies present
all information necessary for the assessment of financial performance and financial position,
but it is a paragraph that watchdogs, such as the Hong Kong Securities and Futures
Commission, probably find difficult to enforce.

Examples of systematic ordering or grouping of the notes include:

• Giving prominence to the activities the entity considers to be most relevant to

understand its financial performance and financial position;

• Grouping together information about assets measured similarly, for example, assets
measured at fair value; and

• Following the order of line items as presented in the financial statements

°° Statement of compliance with HKFRSs;

°° Material accounting policy information applied;

°° Supporting information for items presented in the financial statements in the order
in which each financial statement and each line item is presented; and
HKAS
1.114
°° Other disclosures, such as contingent liabilities (see Chapter 18).

The material accounting policy information applied in the preparation of the financial
statements is usually presented as the first note (‘Note 1’) to the financial statements. This note
should include the following information in addition to a statement of compliance with HKFRSs.

The material accounting policy information applied in the preparation of the financial
statements is usually presented as note 1 to the financial statements, including the statement
of compliance with HKFRSs.

HKAS 1 requires an entity to present its material accounting policy information in the notes.
This should include:

• The measurement basis (or bases) used in preparing the financial statements; and

HKAS • The other accounting policies used that are relevant to an understanding of the
1.117 financial statements.

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Any judgements made by management when applying the entity’s accounting policies that
HKAS have the most significant effect on amounts recognised in the financial statements must also
1.122 be disclosed. For example, for some entities it will be possible to state that the measurement
basis is exclusively historical cost or exclusively fair value. But for most it will be necessary to
list several measurement bases (e.g., property, plant and equipment is carried at historical cost,
all derivatives are marked to fair value, the carrying amount of impaired financial assets are
carried net of expected losses, investment properties are carried at fair value etc. The key to
determining the policies to be shown is the requirement to show the accounting policies that
enable users to understand the financial statements. This does not mean that all policies have
to be shown. Judgement will be required in applying HKAS 1.

2 7 . 6 STATEMENT OF CASH FLOWS

HKAS HKAS 1 notes that cash flow information provides users with a basis to assess an entity’s ability
1.111 to generate cash and the needs of the entity to utilise those cash flows. Full details reading the
preparation and disclosure of cash flow information is set out in HKAS 7 Statement of
Cash Flows.
According to HKAS 7, cash flows activities are reported in the statement of cash flows and
are classified into the following categories:

• Cash flows from operating activities;

• Cash flows from investing activities; and

HKAS
7.10 • Cash flows from financing activities.

Exhibit 27.9 provides a summary of cash flow items that typically fall into each of the
classifications for operating, investing and financing activities.

Cash inflows Cash outflows

OPERATING ACTIVITIES From sale of goods or To suppliers for goods
(generally associated services To employees for services
with revenues and From royalties, fees, To other persons/entities for other operating
expenses) commission and other costs
revenue
To lenders for interest and other borrowing
costs (or financing activity)
To government for income and other taxes
To other persons/entities for materials and
contracts

EXHIBIT 27.9 Typical cash inflows and cash outflows classified by activity

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 FINANCIAL REPORTING

Cash inflows Cash outflows

INVESTING ACTIVITIES From sale of property, plant To purchase property, plant and equipment
(generally movements and equipment To purchase shares and debentures of other
in non-current assets) From sale of shares and entities
debentures of other entities To make loans or advances to other entities
From repayment of
advances and loans by other
entities
From interest received
(or operating activity)
From dividends received
(or operating activity)
FINANCING ACTIVITIES From issue of shares To shareholders for share buy-backs and
(generally movements From issuing debentures, redemption of preference shares
in non-current liabilities notes To owners for dividends paid (or operating
and equity) From borrowings (loans, activity)
mortgages) To debenture holders for redemption of debt
To lenders for repayment of borrowings
To lessors for reduction of a finance liability

EXHIBIT 27.9 (Continued )

The illustrative examples of HKAS 7 set out typical formats for the presentation of the
HKAS statement of cash flows. Exhibit 27.10 shows the statement from an entity other than a
7. App A financial institution, for example, a company that manufactures goods or provides non-financial
HKAS services. HKAS 7 requires that the statement includes separate disclosure of the major classes
7.21 of cash flows. Furthermore, certain cash flows must be disclosed as separate items, for
HKAS example, interest received, dividends received, interest paid, dividends paid, and income taxes
7.31, 35
HKAS paid. Currently, HKAS 7 allows entities choices as to how to present cash flows arising from
7.33, 34 interest and dividends. However, the International Accounting Standards Board (IASB) is
proposing to remove the current choices available to entities (see Section 27.9). HKAS 7
generally requires that cash flows are reported on a gross basis such that netting of cash
receipts and cash payments is not allowed, for example, proceeds from borrowings must be
HKAS disclosed separately from repayment of borrowings and interest received cannot be set off
7.21 against interest paid.
HKAS
7.6 HKAS 7 defines cash as cash on hand and demand deposits. Cash equivalents are defined
as short-term, highly liquid investments that are readily convertible into known amounts of
cash, and which are subject to an insignificant risk of changes in value. According to HKAS 7,
HKAS cash equivalents are held for the purpose of satisfying short-term monetary commitments
7.7 rather than investment or other purposes.

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XYZ Limited
Statement of Cash Flows
for the year ended 31 December 20X8
20X8
HK$’000
Cash flows from operating activities
Profit before taxation 3,350
Adjustments for:
Depreciation 450
Foreign exchange loss 40
Investment income (500)
Interest expense 400
3,740
Increase in trade and other receivables (500)
Decrease in inventories 1,050
Decrease in trade payables (1,740)
Cash generated from operations 2,550
Interest paid (270)
Income taxes paid (900)
Net cash from operating activities 1,380
Cash flows from investing activities
Acquisition of subsidiary X net of cash acquired (550)
Purchase of property, plant and equipment (350)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 200
Net cash used in investing activities (480)
Cash flows from financing activities
Proceeds from issue of share capital 250
Proceeds from long-term borrowings 250
Payment of finance lease liabilities (90)
Dividends paid (1,200)
Net cash used in financing activities (790)
Net increase in cash and cash equivalents 110
Cash and cash equivalents at 1 January 20X8 120
Cash and cash equivalents at 31 December 20X8 230

EXHIBIT 27.10 Typical format for the statement of cash flows using
the indirect method of presentation

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 FINANCIAL REPORTING

Cash includes notes and coins held and deposits with other entities that can be withdrawn
on demand. Cash equivalents include low-risk bank and non-bank bills and money market
deposits with a maturity of three months or less from date of acquisition. A short term of three
months or less is consistent with these investments being readily convertible into cash and
subject to insignificant risk of changes in value.

So that users of financial statements can evaluate changes in liabilities arising from financial
activities, including changes arising from both cash flows and non-cash changes, an entity shall
disclose the following:

• Changes from financing cash flows;

• Changes arising from obtaining or losing control of subsidiaries or other businesses;

• The effect of changes in foreign exchange rates;

• Changes in fair values; and

HKAS
7.44A, 44B • Other changes.

One way to fulfil the disclosure requirements of HKAS 7.44A and HKAS7.44B is by providing a
reconciliation between the opening and closing balances in the statement of financial position
HKAS 7.44D for liabilities arising from financing activities changes. Such a disclosure is shown in Exhibit 27.11,
HKAS 7. App C which illustrates one possible way of providing the disclosures required by HKAS 7.

20X1 Cash Non-cash changes 20X2

flows
Acquisition Foreign Fair
exchange value
movement changes
HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
Long-term borrowings 22,000 (1,000) – – – 21,000
Short-term borrowings 10,000 (500) – 200 – 9,700
Lease liabilities 4,000 (800) 300 – – 3,500
Assets held to hedge (675) 150 – – (25) (550)
long-term borrowings
Total liabilities from 35,325 (2,150) 300 200 (25) 33,650
financing activities

EXHIBIT 27.11 Reconciliation of liabilities arising from financing activities

Exhibit 27.11 shows only current period amounts. Corresponding amounts for the preceding
period are required to be presented in accordance with HKAS 1.

For more details on the preparation, methods of calculating operating cash flows and
disclosure for the statement of cash flows, refer to Module 6 Chapter 21.

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2 7 . 7 DISCLOSURE OF SIGNIFICANT JUDGEMENT

AND ACCOUNTING ESTIMATES

At the end of the reporting period, an entity is required to disclose details about the
assumptions it makes about the future and other major sources of estimation uncertainty that
may cause material adjustments to the carrying amount of assets and liabilities in the following
HKAS financial year. In respect of those assets and liabilities, the notes shall include details of their
1.125 nature and their carrying amount as at the end of the reporting period.

HKAS 1 does not apply to assets and liabilities with carrying amounts measured at fair
values based on a quoted price in an active market for an identical asset or liability. Although
fair values may change materially over the next financial year, these changes would not arise
HKAS from assumptions or other sources of estimation uncertainty at the end of the
1.128 reporting period.

The assumptions about the future and other sources of measurement uncertainty relate to
estimates that require management’s most difficult, subjective, or complex judgements. These
HKAS judgements become more subjective and complex as the number of variables and assumptions
1.127 affecting the possible future resolution of the uncertainties increases. To help users of financial
statements understand judgements made by management about the future, HKAS 1 provides
the following examples of the types of disclosures made by an entity:

• The nature of the assumption or other estimation uncertainty;

• The sensitivity of carrying amounts to the methods, assumptions and estimates

underlying their calculation, including the reasons for the sensitivity;

• The expected resolution of an uncertainty and the range of reasonably possible

outcomes within the next financial year in respect of the carrying amounts of the assets
and liabilities affected; and

HKAS • An explanation of changes made to past assumptions concerning those assets and
1.129 liabilities, if the uncertainty remains unresolved.

Apply and Analyse 2

Ocean Bay traditionally estimates its allowance for doubtful debts as 2% of credit sales
for the year. However, an analysis by Ocean Bay’s Chief Financial Accountant (CFO) during
20X9 reveals that Ocean Bay has traditionally underestimated debts that become bad.
Consequently, the CFO has decided to estimate allowance for doubtful debts based
on an aged analysis of receivables as at the end of each reporting period, beginning
31 Decembers 20X9. The change in the method for estimating the allowance for bad debts

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Apply and Analyse 2 (continued)

has caused a significant increase in the allowance. Advise Ocean Bay as to whether HKAS 1
has any impact of the decision to change the estimation of allowance for doubtful debts,
and if applicable, the note that should be prepared in accordance with HKAS 1.

Analysis

1. The determination of the allowance of doubtful debts was previously based

on 2% of credit sales. However, as this method has underestimated debts that
subsequently became bad, Ocean Bay has decided to estimate allowance for
doubtful debts based on an aged analysis of receivables as at the end of each
reporting period. Accordingly, a note is required in relation to this estimation
uncertainty of determining the allowance of doubtful debts according to para. 125
of to HKAS 1 (see Note XX).

2. A suitable note in accordance with HKAS 1 is as follows:

Note XX Sources of estimation uncertainty

A change in the method for estimating the allowance for receivables has been
made due to the ongoing underestimation of debts that become bad. The
allowance for receivables has been revised upward for the current reporting
period. This revised estimate has increased the allowance for receivables
as at 31 December 20X9 by HK$XXX. The carrying amount of receivables at
31 December 20X9 is HK$XXX. The company is uncertain as to the likely economic
conditions in the future, but will continue to monitor closely all credit applications
from new customers and payments from existing customers.

Examples of assumptions that may be disclosed by an entity pursuant to HKAS 1 when

future-oriented estimates are necessary to measure the recoverable amount of assets for
assessing the impairment of these assets (see Chapter 14 for more details) include:

• Future interest rates;

• Future changes in salaries;

• Future changes in prices affecting other costs; and

• Useful lives.

Key Learning Point

In the notes, an entity must disclose information about assumptions concerning the future
and other key sources of estimation uncertainty at the end of the reporting period

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Knowledge Check Question

Question 7
ABC Ltd provides a warranty on all the products it sells and will rectify any product
defects arising within 24 months from the date of sale. Each year, the warranty provision
is determined on the basis of recent claims by customers. However, in the current year,
ABC Ltd has introduced new technology into its manufacturing process and believes this
technology, together with an upgrading of the manufacturing process used by ABC Ltd, will
produce manufactured products that will be of a higher quality and this will lead to lower
warranty claims in the future. Hence, recent claims experiences may not be indicative of
future claims.
Explain whether the introduction by ABC Ltd of new technology and upgrading
the manufacturing process and the possible implications for warranty claims have any
consequences for note disclosures required by HKAS 1. Draft a suitable note in relation to
this estimation uncertainty.

2 7 . 8 PREPARE AND PRACTICE APPRAISING

DISCLOSURE OF ACCOUNTING POLICY
AND REQUIRED ITEMS

The following section describes the requirements for the preparation and practice of appraising
disclosure according to the New Companies Ordinance, Hong Kong Reporting Standards and
Hong Kong Stock Exchange listing rules.

27.8.1 Companies Ordinance’s Requirements

Hong Kong companies are required by Hong Kong Companies Ordinance (CO), Cap.622, Part 9
Accounts and Audit (ss.357 – 452) to make certain disclosures regarding financial statements
which are now considered. All section references that follow relate to the CO.

CO Directors of a company must prepare for each financial year statements that comply with
s.379(1) Sections 380 and 383 of the CO.

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

Furthermore, the financial statements must also comply with any other requirements of the
CO
CO in relation to the financial statements and the accounting standards applicable to the
s.380(4) financial statements.

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27.8.1.1 True and Fair View (and Departure of True and Fair View If Needed)
When compliance with Section 380 would be insufficient to give a true and fair view, the
CO financial statements must contain all additional information necessary for the financial
s.380(5) statements to give a true and fair view. In this case, the financial statements:

(a) Must depart from Section 380 to the extent necessary for it to give a true and
fair view; and
CO
s.380(6) (b) Must contain the reasons for, and the particulars and effect of, the departure.

For more discussion on the concept of ‘true and fair view’, see Section 27.1.3.1.

27.8.1.2 Statutory Backing of Accounting Standards (and Explicit Statement Disclosure

Requirement)
CO,
Schedule 4, The financial statements for a financial year must state whether they have been prepared in
‘Accounting
Disclosures’, accordance with the applicable accounting standards, and if not, the particulars of and the
Part 1 reasons for any material departure from those standards.

27.8.1.3 Reporting Exemption

Certain companies (e.g. private companies and companies limited by guarantee) may fall
within what is called a ‘reporting exemption’ under the CO. A reporting exemption means
an exemption from some of the requirements for the contents of the directors’ report and
financial statements. For more discussion on the conditions to be satisfied for a reporting
exemption and its implications for companies, see Chapter 2.

27.8.1.4 Directors’ Report and Business Review

Directors of a company are required to prepare a directors’ report or each financial year that
CO s.388(1) complies with ss.390 and 543(2) and Schedule 5. The directors’ report must contain the names
CO s.390(1)
of every person who was a director during the financial year.
A directors’ report must contain particulars of any other matter that is material for the
CO members’ appreciation of the state of the company’s affairs and must contain the disclosure of
s.390(2) which will not, in the directors’ opinion, be harmful to the business of the company.

CO A directors’ report must be approved by the directors and must be signed on the directors’
s.391(1) behalf by a director or by the company secretary.

According to the CO, Schedule 5, ‘Contents of Directors’ Report: Business Review’:

A directors’ report for a financial year must contain a business review that consists of the
following:

• A fair review of the company’s business;

• A description of the principal risks and uncertainties facing the company;

• Particulars of important events affecting the company that have occurred since the end
of the financial year; and
CO, Schedule
5, para. 1 • An indication of likely future development in the company’s business.

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To the extent necessary for an understanding of the development, performance or position

of the company’s business, a business review must include:

• An analysis using financial key performance indicators;

• A discussion on:

°° The company’s environmental policies and performance; and

°° The company’s compliance with the relevant laws and regulations that have a
significant impact on the company; and

• An account of the company’s key relationships with its employees, customers, suppliers
CO Schedule and others who have a significant impact on the company and on which the company’s
5, para. 2 success depends.

Schedule 5 does not require the disclosure of any information about impending
CO Schedule developments or matters during negotiation if the disclosure would, in the directors’ opinion,
5, para. 3 be seriously prejudicial to the company’s interests.

To provide guidance on the preparation of a business review under Section 388 and
Schedule 5 of the CO, the HKICPA has prepared Accounting Bulletin 5 (AB 5) entitled, ‘Guidance
for the Preparation and Presentation of a Business Review under the Hong Kong Companies
Ordinance (Cap.622)’.
According to para. 15 of AB 5, business reviews prepared and presented for the purposes
of compliance with Schedule 5 should be consistent with the following guiding principles:

• The review should set out an analysis of the business through the eyes of the board of
directors;

• The scope of the review should be consistent with the scope of the financial statements;

• The review should complement as well as supplement the financial statements, in order
to enhance the overall corporate disclosure;

• The review should be understandable; and

• The review should be balanced and neutral, dealing even-handedly with both good and
bad aspects.

27.8.1.5 Approvals
A statement of financial position that forms part of any financial statements must be approved
CO by the directors and signed by two directors on the directors’ behalf, or in the case of a
s.387(1) company having only one director, by the director.

CO The names of the directors who signed the statement of financial position on the directors’
s.387(2) behalf must also be provided.

27.8.2 Directors’ Emoluments and AB 3

According to Section 383(1), the financial statements for a financial year must contain, in the
notes to the statements, the information about the following:

(a) The directors’ emoluments, which are amounts paid to or receivable by a person with
respect to services provided during the financial year while he or she was a director of

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the company, for example, salaries, fees, bonuses, other benefits whether in cash or
otherwise (in the case of non-cash benefits, the amount disclosable is the estimated
money value of the non-cash benefit);

(b) The directors’ retirement benefits, which are amounts paid to or receivable by a
person in connection with their retirement as a director who earned the entitlement
to the retirement benefits by providing services while he or she was a director of the
company, for example, any lump sum, allowance, gratuity, periodical payment or other
like benefits;

(c) Payments made or benefits provided with respect to the termination of the service of
directors, whether in the capacity of directors or in any other capacity while directors;

(d) Loans in favour of directors of the company and entities connected with such directors;

(e) Material interests of directors in transactions, arrangements or contracts entered into

by the company; and

(f) Consideration provided to or receivable by third parties for making available the
services of a person as director or in any other capacity while director – (this would
include the estimated money value if the payments are not in cash).

To assist with compliance with Section 383, Accounting Bulletin 3 (AB 3) ‘Guidance on
Disclosure of Directors’ Remuneration’, has been developed by the HKICPA. It provides general
reference on the requirements of the CO and Cap.622G with respect to the disclosure of
directors’ remuneration in the notes to the financial statements.

Illustrative Example 1 – Adapted from Appendix to AB3

The note below provides an illustrative example of the disclosure of directors’
emoluments by an unlisted company. For listed companies, para. 24 of Appendix 16
to the Main Board Listing Rules of The Stock Exchange of Hong Kong Limited requires
companies to show the names of directors when providing details of directors’
emoluments.

Note X: Directors’ Emoluments

Emoluments of the company’s directors disclosed pursuant to Section 383 of the CO

(Cap.622) and the company’s (Disclosure of Information about Benefits of Directors)
regulation (Cap.622G) is as follows:

20X2 20X1
HK$ HK$
Directors’ emoluments for services as directors of the company and its
subsidiary undertakings
Directors’ fees 50,000 40,000
Other emoluments in connection with the management of the affairs of 3,000,000 2,500,000
the company and its subsidiary undertakings

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 Financial S tatements for an I ndi v idual Entit y

Illustrative Example 1 (continued)

20X2 20X1
HK$ HK$
Amount paid to third parties for making available the services of persons 250,000 120,000
as directors
Payments in respect of termination of service 600,000 –
Retirement benefits given to retired directors 15,000 12,000
3,915,000 2,672,000

Other emoluments previously disclosed include the estimated money value of

accommodation provided by the company to the directors and their families. The
money value of the accommodation is estimated to be the annual market rental of
the accommodation less any amounts paid for by the directors personally and not
reimbursed by the company.*

In connection with a financing arrangement, the company paid HK$120,000 in both

20X2 and 20X1 to Company Z for the services of Mr. A as a director of the company. In
20X2, the company also paid HK$130,000 to its holding company for the services of Ms B
as a director of the company.

The retirement benefits given to retired directors consist primarily of continuing

medical coverage under the company’s group insurance plan. The money value is
estimated based on the premiums paid for the cover provided to the retired directors.*

Payments in respect of termination of service were paid by the following parties:

20X2 20X1
HK$ HK$
The company 500,000 –
Subsidiary undertakings of the company 100,000 –
600,000 –

The payments with respect to termination of service disclosed above includes the
estimated money value of the company’s car, which was given to the director as part of
his severance package. This amount has been estimated based on the second-hand value
of the car, taking into account its condition at the time of transfer of ownership.*
* When benefits other than cash are given to directors, the regulation requires the nature of the benefits to be
disclosed. It may also be useful to disclose how the estimated money value is calculated. However, it is unneces-
sary to separately disclose the amounts of non-cash benefits.

27.8.3 Listing Rules Requirements

Companies whose shares are traded on The Stock Exchange of Hong Kong are required under
listing rules to provide certain financial information to HKEx. Some of these disclosures are now
considered.

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27.8.3.1 Appendix 14
Appendix 14 Corporate Governance Code and Corporate Governance Report – sets out the
principles of good corporate governance and two levels of recommendations: (1) code
provisions; and (2) recommended best practices. Companies are expected to comply with,
but may choose to deviate from, the code provisions. The recommended best practices are
for guidance only. Companies may also devise their own code on corporate governance on
the terms they consider appropriate. The Corporate Governance Report must contain all the
information set out in para. G to Q of Appendix 14. Any failure to do so will be regarded as a
breach of the Exchange Listing Rules.

27.8.3.2 Appendix 16
In addition to compliance with the CO and accounting standards, listed companies are also
required by Appendix 16 Disclosure of Financial Information to disclose certain financial (and
non-financial) information. Examples of the disclosures required by Appendix 16 include the
following:

• Basic financial information

Where applicable, a company should include a statement by the directors as to the

reasons for any significant departure from an accounting standard (para. 5).

• Information in annual reports

In the case of any issue for cash of equity securities (including securities convertible
into equity securities), a company shall disclose various details, such as the reasons for
making the issue and the classes of equity securities issued (para. 11).

Brief biographical details of its directors and senior managers, such as name, age
and position held (para. 12).

Particulars (nature and extent) of any transaction, arrangement or contract of

significance with a director or, if there has been no such transaction, arrangement or
contract, a statement of that fact (para. 15).

If net income shown in the financial statements differs materially from any profit
forecast published by the company, the company must include an explanation of the
difference (para. 18).

A summary, in the form of a comparative table, of the published results and of the
assets and liabilities of the group for the last five financial years (para. 19).

Where company’s properties held for development and/or sale or for investment
purposes exceeds 5% of the relevant ratio (e.g. the assets ratio, i.e. property held
for development/total assets), the company shall include various details, such as the
address and, if in the course of construction, the stage of completion and expected
completion date (para. 23).

Information in respect of the five highest paid individuals during the financial year
(para. 25).

Various details in addition to the information required under the relevant

accounting standard in respect of pension schemes, such as a brief outline of how
contributions are calculated or benefits funded (para. 26).

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A discussion and analysis of the group’s performance during the financial year and
the material factors underlying its results and financial position (para. 32).

• Information to accompany interim reports

An interim report in respect of the first six months of its financial year, unless that
financial year is of six months or less (para. 37).

Except where a change in accounting policy is required by an accounting standard

issued during the interim period, a company must prepare its interim report in
accordance with the same accounting standards that it adopted in the preparation of its
most recent published annual financial statements (para. 38).

A discussion and analysis of the group’s performance in the interim period and any
supplementary information, which is necessary for a reasonable appreciation of the
interim results (para. 40).

Where the accounting information given in an interim report has not been audited
that fact must be stated (para. 43).

• Information to accompany preliminary announcements of results for the financial year

A company shall publish a preliminary announcement of its results, which has been
agreed with its auditors and which includes certain information, for example:

°° the statement of financial position and the statement of profit or loss and other
comprehensive income with comparative figures;

°° where there are any significant changes in accounting policies, a statement of that
fact must be made; and

°° where there are prior period adjustments due to correction of material errors, a
statement of that fact must be made (para. 45).

• Information to accompany preliminary announcements of Interim results

The statement of financial position and the statement of profit or loss and other
comprehensive income with comparative figures for the first six months of each
financial year.

A statement as to if the interim results have been reviewed by external auditors or

the audit committee of the company.

Full details of any disagreement by the auditors or the audit committee with the
accounting treatment adopted by the company (para. 46)

• Information to accompany listing documents and circulars

Financial statements and a discussion and analysis of the group’s performance (paras.
47 and 48).

27.8.3.3 Appendix 27
With Appendix 27 Environmental, Social and Governance Reporting Guide, a company must
disclose the following information as detailed in Appendix 27 (see Chapter 36):

• Environmental;

°° Emissions

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°° Use of Resources

°° The Environment and Natural Resources

• Social – Employment and Labour Practices, Operating Practices, Community; and

• Corporate governance – is addressed separately in the Corporate Governance Code

(see Section 27.8.3.1).

2 7 . 9 CURRENT DEVELOPMENTS

27.9.1 Classification of Debt with Covenants as Current or Non-current

Following issue by the IASB of the amendments Classification of Liabilities as Current or
Non-current (2020 amendments), which amendments have been reflected in Section 27.2.2
above, the IASB observed there to be an aspect to its amendments that it had not fully
considered as part of its deliberations. The IASB project Classification of Debt with Covenants as
Current or Non-current is expected to further amend those 2020 amendments, to clarify how
an entity’s compliance with debt covenant conditions after the reporting date (e.g., the debt
covenant testing point is 31 March 20X1, but reporting date is 31 December 20X0) impacts its
reporting date classification of debt as a current or non-current liability.

In November 2021, IASB published the Exposure Draft Non-current Liabilities with Covenants
(proposed amendments to IAS 1). The Exposure Draft aims to improve the information an entity
provides when its right to defer settlement of a liability for at least twelve months is subject to
compliance with conditions, in addition to addressing concerns about the classification of such
a liability as current or non-current.

27.9.2 Primary Financial Statements

In response to investors’ concerns about the comparability and transparency of companies’
performance reporting, the IASB is undertaking a project considering presentation and
disclosure in financial statements, with a focus on the statement of profit or loss. In December
2019, the IASB published the Exposure Draft General Presentation and Disclosures, which
proposes a new IFRS Standard on presentation and disclosures in financial statements.

The project proposals include:

• new subtotals and new categories for presentation of financial information within the
statement of profit or loss;

• specification of the starting point for the indirect method of reporting cash flows from
operating activities; and

• specification of the classification of interest and dividend cash flows.

When finalised, this IFRS is expected to supersede IAS 1 Presentation of Financial Statements.
IAS 7 Statements of Cash Flows will continue to apply, with amendment. Other standards
expected to be impacted by this project include IAS 34 Interim Financial Statements, IAS 33
Earnings per Share, IFRS 12 Disclosure of Interests in Other Entities, IAS 8 Accounting Policies,
Changes in Accounting Estimates and Errors and IFRS 7 Financial Instruments: Disclosures.

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At the time of publishing, the IASB is continuing its re-­deliberations of the exposure draft
proposals. It has not identified an indicative issue date for any final proposals.

27.9.3 Disclosure Initiative – Targeted Standards-level Review

of Disclosures
In response to feedback received on its Discussion Paper Disclosure Initiative – Principles of
Disclosure, the IASB decided to undertake a project to review the current IFRS disclosure
requirements of certain standards. The objective of the project is to improve how the IASB
develops and drafts disclosure requirements to enable more useful information to be provided
to users of financial statements.

As part of this project, in March 2021, the IASB published the Exposure Draft Disclosure
Requirements in IFRS Standards – A Pilot Approach. The Exposure Draft proposes a new approach
for the IASB to apply when developing disclosure requirements in individual standards. Its
aim is to require preparers to apply more judgement rather than adopt a ‘disclosure checklist’
mentality. Under the approach (termed ‘Guidance’), the IASB proposes to require entities to
comply with:

• overall disclosure objectives that describe the overall information needs of users of
financial statements; and
• specific disclosure objectives that describe the detailed information needs of users of
financial statements.

Specific disclosure objectives will be supplemented with explanations of what the

information provided to meet those objectives is intended to help users of financial statements
do. Examples of items of information an entity may, or in some cases is required to, disclose to
satisfy the objective will be identified.

To illustrate how disclosures might look under the new approach, as part of that Exposure
Draft, the IASB has proposed replacement disclosure requirements for IFRS 13 Fair Value
Measurement and IAS 19 Employee Benefits.

The comment period for the Exposure Draft ended in January 2022. During the comment
period, 50 companies participated in fieldwork by applying the proposed disclosure
requirements for either or both of IFRS 13 and IAS 19.

The IASB met on 21 February 2022 to discuss feedback from preparer fieldwork participants
and users of financial statements on the Exposure Draft Disclosure Requirements in IFRS
Standards – A Pilot Approach.

27.9.4 Supplier Finance Arrangements

The IASB is undertaking a narrow scope standard-­setting project in response to feedback
and input received that suggests that the information entities provide about supplier finance
arrangements applying existing IFRS requirements does not meet all investor information
needs. In November 2021, the IASB published the Exposure Draft Supplier Finance Arrangements
that proposes to amend IAS 7 Statement of Cash Flows and IFRS 7 Financial Instruments:
Disclosures. The IASB is seeking feedback by 28 March 2022.

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SUMMARY

• A complete set of financial statements comprises:

(a) A statement of financial position;

(b) A statement of profit or loss and other comprehensive income;

(c) A statement of changes in equity;

(d) A statement of cash flows;

(e) Notes comprising a summary of material accounting policy information and other
explanatory material;

(f) Comparative information in respect of the preceding period; and

(g) May also include a statement of financial position as of the beginning of the earliest
comparative period when certain retrospective adjustments and reclassifications
are made.

• The following are the eight general features of financial statements:

1. True and fair view and compliance with HKFRSs;

2. Going concern;

3. Accrual basis of accounting;

4. Materiality and aggregation;

5. Offsetting.

6. Frequency of reporting;

7. Comparative information; and

8. Consistency of presentation.

• The information to be presented in the statement of financial position includes prescribed

asset, liability and equity items.

• A required order or format for the statement of financial position is not prescribed, but
guidance is provided in HKAS 1.

• All assets and liabilities are usually classified as current or non-current. An entity’s operating
cycle, which is the key to classification as current or non-current, may be longer than
12 months.

• HKAS 1 has taken an all-inclusive approach to the determination of profit or loss.

• Entities may present either a single statement of profit or loss and other comprehensive
income or two separate statements, a statement of profit or loss and a statement of
comprehensive income.

°° The information to be disclosed in the statement of profit or loss and other

comprehensive income includes ‘profit or loss’ and ‘other comprehensive income’ and
does not have to follow any prescribed order or format.

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• Information to be presented either in the statement of profit or loss and other comprehensive
income or in the notes includes:

°° Each material income and expense item;

°° An analysis of expenses using a classification based on the nature of expenses method or

the function of expenses (or ‘cost of sales’) method; and

°° Items of other comprehensive income, including reclassification adjustments.

• The statement of changes in equity provides details of the entity’s changes in equity items for
the period, that is, total comprehensive income, each component of equity including details
of movements during the period resulting from profit or loss, other comprehensive income,
share capital, dividends and transfers between equity accounts.

• The statement of cash flows explains the movement in the cash balance of the entity for
the reporting period, that is, the changes from the opening balance of cash to the closing
balance of cash.

• Notes are normally presented in the following order:

1. Statement of compliance with HKFRSs;

2. Material accounting policy information applied;

3. Information relating to items in the financial statements; and

4. Other disclosures.

• In the notes, an entity must disclose information about assumptions concerning the future
and other key sources of estimation uncertainty at the end of the reporting period.

• Various reporting disclosures are required by the CO.

• Accounting Bulletins issued by the HKICPA provide assistance when complying with CO
reporting requirements.

• For listed companies, additional disclosures are imposed by the HKEx.

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MIND MAP
SCOPE AND TERMINOLOGY GENERAL FEATURES OF FINANCIAL STATEMENTS
HKAS 1 applies to an entity when preparing True and fair view and compliance with HKFRSs
and presenting general purpose financial • Going concern
statements in accordance with HKFRSs • Accrual basis of accounting
Complete set of financial statements • Materiality and aggregation
• Statement of financial position • Offsetting
• Statement of profit or loss and other • Frequency of reporting
comprehensive income • Comparative information
• Statement of changes in equity a statement • Consistency of presentation
of cash flows Must disclose prominently: name of entity;
• Notes comprising material accounting policy whether an individual entity or a group of
information and other explanatory information entities; date of the reporting period;
• Comparative information in respect of the presentation currency used and level
preceding period of rounding
• Statement of financial position as at the
beginning of the preceding period when STATEMENT OF PROFIT OR LOSS AND OTHER
an entity applies an accounting policy COMPREHENSIVE INCOME
restatement of items retrospectively, or
when it reclassifies items in its financial Provides information regarding the financial
statements performance of the entity for the reporting
period
STATEMENT OF FINANCIAL POSITION PRESENTATION Minimum number of items to be disclosed
OF FINANCIAL
Provides information regarding the financial STATEMENTS Two sections
position of the entity as at the end of the • Profit or loss is the total of income less
reporting period expenses, excluding the items of other
Minimum number of 18 items to be disclosed comprehensive income
• Other comprehensive income comprises
Assets/liabilities to be classified as items of income and expense (including
current/non-current based on operation reclassification adjustments) that are not
cycle which is usually 12 months recognised in profit or loss as required or
Notes to provide further subclassifications permitted by other HKFRSs.
of line items presented Expenses to be classified according to nature
of expenses or function of expenses
OTHER DISCLOSURE REQUIREMENTS
Companies Ordinance STATEMENT OF CHANGES IN EQUITY
HKEx Listing Rules Provides information to users regarding
changes in an entity’s net assets
NOTES
Discloses
Provided to help users understand information • Total comprehensive income
in the financial statements • Each component of equity, including details
Provide information not presented in the of movements during the period resulting
financial statements from profit or loss
• Other comprehensive income
Normally presented in the following order
• Share capital
• Statement of compliance with HKFRSs
• Dividends and transfers between equity
• Material accounting policy information applied
accounts
• Supporting information relating to items in
the financial statements STATEMENT OF CASH FLOWS
• Other disclosures Provides information explaining the movement
- Assumptions concerning the future and other in the cash balance of the entity for the
key sources of estimation uncertainty reporting period
- Contingent liabilities
- Dividend details Cash flows classified as cash flows from
• Operating activities
• Investing activities
• Financing activities

Answers to Knowledge Check Questions

Question 1

HKFRS Answer A is incorrect. Specific disclosure required by a HKFRS is not required if the
1.31 information resulting from that disclosure is not material.
Answer B is incorrect. HKFRS 16 does not permit the reclassification of leases according
to the amount involved. According to HKFRS 16, a finance lease is one that transfers
substantially all the risks and rewards incidental to ownership of an underlying asset.

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Answer C is correct. The disclosure required by HKFRS 16 could be ignored as the amount
involved is not material (HK$1,000/HK$100 million = 0.01%). An entity need not provide a
specific disclosure required by a HKFRS if the information resulting from that disclosure is
HKFRS not material. This is the case even if the HKFRS contains a list of specific requirements or
1.31 describes them as minimum requirements.
HKAS Answer D is incorrect. An entity shall not offset assets and liabilities or income and
1.32 expenses unless required or permitted by an HKFRS. Offsetting a lease asset against
accounts payable is not permitted by HKFRS 16.

Question 2

HKAS Answer A is incorrect. The entity should explain in the notes reasons why the court case
1.38B remains unresolved at the end of the current period.
Answer B is correct. In this case, the entity should explain in the notes reasons why the
court case remains unresolved at the end of the current period. Users may benefit from
the disclosure of information that the uncertainty existed at the end of the preceding
HKAS period and from the disclosure of information about the steps that have been taken during
1.38B the period to resolve the uncertainty.
Answer C is incorrect. It is unlikely the entity has a present obligation to transfer an
economic resource, thus failing to meet the definition of a liability in the Framework
HKAS (para. 4.26). The entity should explain in the notes reasons why the court case remains
1.38B unresolved at the end of the current period.
HKAS Answer D is incorrect. The entity should explain in the notes reasons why the court case
1.38B remains unresolved at the end of the current period.

Question 3
Amaya should classify the liability as current because, at the end of the reporting period,
HKAS it does not have an unconditional right to defer its settlement for at least 12 months after
1.74 that date.

Question 4
(a) The specialist steel is raw material inventory. It will be used within the normal
operating cycle of the company, and therefore, it is classified as a current asset.
Because no orders for warships exist, the company should assess whether the
inventory might be impaired.

(b) The completed fishing boats are finished goods inventory. They are held for the
purpose of being traded and are expected to be sold in the normal operating cycle
of the company. Therefore, they are classified as current assets even if a sale is not
expected within 12 months.

(c) The amount due from a customer forms part of trade and other receivables. It is
expected to be realised in the normal operating cycle of the company and is,
therefore, classified as current. It is irrelevant to classification and recognition that
part of the HK$6 million has been billed and part has not.

(d) The part complete boat is work in progress inventory. Even though it will take
14 months to complete and possibly even longer to sell, it is classified as a current
asset because the inventory is subject to a sale in the ordinary course of business.

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Question 5
The following items are required to be disclosed by HKAS 1:
HKAS 1.82(a) • II Revenue
HKAS 1.82(b) • III Finance costs
• IV Share of the profit or loss from associates and joint ventures accounted for using
HKAS 1.82(c) the equity method
HKAS 1.82(d) • VI Tax expense
HKAS
1.81A(a) • VII Profit or loss

Question 6
The following items are all required to be disclosed by HKAS 1:
HKAS 1.106(d) • I Opening and closing balances
HKAS 1.106(a)
• II Total comprehensive income for the period
HKAS
1.106(d)(iii) • III New share issues
HKAS • IV Dividends paid
1.106(d)(iii),
107 • V For each component of equity, the effects of retrospective application or
HKAS
1.106(b), 110
retrospective restatement in accordance with HKAS 8

Question 7
The determination of the warranty in previous years has been based on recent claims by
customers, but these claims may change due to an expected improvement in the quality of
products manufactured as a result of changes in the manufacturing process introduced in
the current year. Accordingly, a note is required in relation to this estimation uncertainty of
determining the provision for warranty claims according to HKAS 1.125. An example of this
note follows:
ABC Ltd makes provisions under the warranties it gives on the sale of its products taking
into account the company’s recent claim experience. However, in the current year, ABC
Ltd has introduced new technology into its manufacturing process and upgraded the
manufacturing process. ABC Ltd believes these changes will produce manufactured
products that will be of a higher quality and this will lead to lower warranty claims in the
future. Hence, recent claims experiences may not indicate future claims that it will receive
in respect of past sales. Any increase or decrease in the provision would affect profit or
loss in future years.

EXAM PRACTICE

QUESTION 1
Hong Ltd is a small manufacturing company. It held a net investment in a foreign operation,
called Kong Ltd. The foreign currency gains and losses on translation of the financial
statements of Kong Ltd are recognised in other comprehensive income and accumulated
in the ‘foreign currency translation reserve’ in equity in accordance with HKAS 21 The
Effects of Changes in Foreign Exchange Rates. On 1 January 20X5, Hong Ltd disposed of its
net investment in Kong Ltd at a loss of HK$56,000. At that time, the accumulated credit in

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 Financial S tatements for an I ndi v idual Entit y

the ‘foreign currency translation reserve’ in relation to the net investment in Kong Ltd was
HK$30,000 of which HK$10,000 had been recognised in the year ended 31 December 20X4.
HK$20,000 was due to translation gains recognised prior to 20X4. There was no income
tax associated with the accumulated foreign currency gain. Hong Ltd revalued land in
accordance with the fair value measurement basis permitted by HKAS 16 Property, Plant and
Equipment, resulting in a gain of HK$36,000 net of tax for the year ended 31 December 20X5
(20X4: HK$24,000). These were the only items of other comprehensive income for the year
ended 31 December 20X5 and the year ended 31 December 20X4.

Profit or loss details provided by Hong Ltd for 20X5 and 20X4 are as follows:

20X5 20X4
HK$’000 HK$’000
Revenue 1,960 1,480
Cost of sales (800) (600)
Selling and administrative expenses (420) (400)
Finance costs (200) (200)
Income tax expense (200) (80)

Required:

Prepare a statement of profit or loss and other comprehensive income for Hong Ltd for the
year ended 31 December 20X5.

QUESTION 2
An extract of the trial balance of Black Hole Ltd at 30 June 20X9 was as follows:

Debit Credit
HK$ HK$
Share capital (HK$2 ordinary shares fully paid) 200,000
General reserve 25,000
Retained earnings (1 July 20X8) 128,400
Revaluation surplus 85,000
Land 220,000
Buildings 380,000

Dividends paid 20,000

Dividends declared 10,000
Transfer to general reserve 25,000

Additional information

(a) During the year, 50,000 shares were issued at an issue price of HK$2 each, payable in
full on application.

(b) On 30 June 20X9, the directors revalued land and buildings. The revaluation was based
on an independent valuation and was based on fair values. The carrying amounts of land
and buildings before the revaluation were HK$195,000 and HK$350,000, respectively.

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 FINANCIAL REPORTING

(c) Profit for the year ended 30 June 20X9 was HK$55,600.

(d) The company tax rate is 16.5%.

Required:

Prepare a statement of changes in equity for Black Hole Ltd for the year ended 30 June 20X9,
according to the requirements of HKAS 1 (comparative information is not required).

ANSWERS TO EXAM PRACTICE

QUESTION 1

HONG LTD
Statement of profit or loss and other comprehensive income
for the year ended 31 December
20X5 20X4
HK$’000 HK$’000
Revenue 1,960 1,480
Cost of sales (800) (600)
Selling and administrative expenses (420) (400)
Finance costs (200) (200)
Reclassification of foreign currency gain on translation of financial
statements of net investment in foreign operation 30 –
Loss on disposal of net investment (56) –
Profit before taxation 514 280
Income tax expense (200) (80)
Profit for the year 314 200
Other comprehensive income
Items that will not be reclassified to profit or loss:
Gain on revaluation of land, net of tax 36 24
36 24
Items that may be reclassified subsequently to profit or loss:
Foreign currency gain on translation of foreign operations – 10
Reclassification adjustment for gains on translation of foreign
operations (30) –
(30) 10
Other comprehensive income for the year, net of tax 6 34
Total comprehensive income for the year 320 234

Prior to the disposal of the net investment in Kong Ltd, Hong Ltd had accumulated
foreign currency gains of HK$30,000 (as at 1 January 20X5) on the translation of the
financial statements of Kong Ltd. The foreign currency gain had been recognised in other
comprehensive income over several periods, including an amount of HK$10,000, which was

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 Financial S tatements for an I ndi v idual Entit y

recognised in 20X4. Now that Hong Ltd has disposed of its net investment in Kong Ltd on
1 January 20X5, the accumulated foreign currency gain of HK$30,000 must be reclassified
to profit. To avoid double counting of the foreign currency gain, it is deducted from other
comprehensive income and added to profit. Thus, the reclassification adjustment of
HK$30,000 has no net effect on total comprehensive income in 20X5 because it increases
profit by HK$30,000 and decreases other comprehensive income by the same amount.

QUESTION 2

BLACK HOLE LTD

Statement of Changes in Equity
for the year ended 30 June 20X9
Share General Revalu. Retained Total
capital reserve surplus earnings
HK$ HK$ HK$ HK$ HK$
Balance at 1 July 20X8 100,000 – 39,075 128,400 267,475
Total comprehensive income
for the year – – a
45,925 55,600 101,525
Issue of share capital b
100,000 – – – 100,000
Dividend paid – ordinary – – – (20,000) (20,000)
Dividend declared – ordinary – – – (10,000) (10,000)
Transfer to general reserve – 25,000 – (25,000) –
Balance at 30 June 20X9 200,000 25,000 85,000 129,000 439,000

(Comparative information must be disclosed in respect of the preceding period for all amounts reported in the current
period’s financial statements in accordance with HKAS 1.38. However, this information is not provided in the question.)
a
 K$45,925 = revaluation of land and buildings net of tax consequences (see HKAS 12 Income Taxes, Chapter 19)
H
calculated as follows:
Land: HK$220,000 − HK$195,000 = HK$25,000
Buildings: HK$380,000 − HK$350,000 = HK$30,000
Total revaluation = HK$25,000 + HK$30,000 = HK$55,000
Tax = 16.5% × HK$55,000 = HK$9,075
Net of tax = HK$55,000 − HK$9,075 = HK$45,925
b
HK$100,000 = HK$2 × 50,000 shares

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M11_c27.indd 1444 10/28/2022 3:42:04 PM
 Part D
Group Financial
Statements with
Complex Group
Structures

Chapter 28 Interim Financial Reporting

Chapter 29 Business Combinations
Chapter 30 C
 onsolidated Financial Statements with a Simple Group
Structure
Chapter 31 Foreign Exchange and Consolidation of Foreign Operations
Chapter 32 Investments in Associates
Chapter 33 Joint Arrangements
Chapter 34 C
 onsolidated Financial Statements with Complex Group
Structure
Chapter 35 Merger Accounting for Common Control Combinations

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M11_c28.indd 1446 11/7/2022 5:54:43 PM
 28
Interim Financial
Reporting

CHAPTER TOPIC LIST

28.1 Overview 28.3 Disclosure in Annual Financial

28.1.1 Scope Statements
28.1.2 Terminology 28.4 Recognition and Measurement
28.2 Content of an Interim Financial 28.4.1 S ame Accounting Policies as
Report Annual Financial Statements
28.2.1 M inimum Components of an 28.4.2 Revenues Received Seasonally,
Interim Financial Report Cyclically or Occasionally
28.2.2 Form and Content of Interim 28.4.3 Costs Incurred Unevenly
Financial Statements during the Financial Year
28.2.3 Significant Events and 28.4.4 Use of Estimates
Transactions 28.4.5 Examples of Applying
28.2.4 Other Disclosures Recognition and
28.2.5 Contrasting Content of an Measurement Principles
Interim Financial Report to 28.4.6 Impairment in Interim
the Annual Financial Report Financial Reporting
28.2.6 Periods for which Interim (HK(IFRIC)-Int 10)
Financial Statements Are 28.5 Restatement of Previously
Required to be Presented Reported Interim Periods
28.2.7 Materiality

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT

FOR BUSINESS TRANSACTIONS
LO2.13: Describe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: interim financial reporting
2.13.01 Explain the circumstances in which interim financial reporting is required
2.13.02 Explain the purpose and advantages of interim financial reporting
2.13.03 Apply the principles of recognition and measurement in interim financial statements
2.13.04 P
 repare disclosure in respect of interim financial statements including seasonality
in the interim financial statements

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 Interim Financial R eporting

OPENING CASE

CWAVES FERRY HOLDING COMPANY LIMITED

I ntroduced in Chapter 25, CWaves Ferry Holding Company Limited (CWaves) is a publicly listed
company on the Hong Kong Stock Exchange (HKEx). The company operates many businesses
and has various significant investments in the region. One of these businesses involves
operating ferry services in Hong Kong Harbour, Sok Kwu Wan, Shenzhen and Macau, for which
it holds an exclusive licence from the Hong Kong SAR Government. Other significant business
activities and investments of CWaves involve building, owning and managing a range of office
buildings, godowns, port infrastructure, travel agencies and hotels. CWaves’ management
is conscious that to some extent its operations are seasonal – particularly its ferry services.
As such, CWaves’ revenues fluctuate from month to month.

During the six-month interim reporting period, CWaves acquired items of property, plant
and equipment and construction in progress. In addition, some items of property, plant and
equipment were written off during the interim period.

In addition to its annual financial statements, CWaves prepares interim financial reports
for the half year (as at June 30). The interim financial statements are presented in condensed
format and are prepared in accordance with Hong Kong Financial Reporting Standards
(HKFRSs). As CWaves has a number of reportable segments, its interim report includes a
segment note.

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 FINANCIAL REPORTING

OVERVIEW

Interim financial reporting refers to the preparation of financial reports for a period shorter
than one full year. The accounting standard containing guidance for the preparation of interim
financial reports is HKAS 34 Interim Financial Reporting.

The objective of interim financial reporting is to update the entity’s most recent annual
financial report. Consistent with this, interim financial reports should only contain note
disclosures that assist users to understand financial performance and changes in financial
position since the last annual report, eliminating the need to reproduce disclosures contained
in the previous annual report.

HKAS 34 provides guidance on disclosure, recognition and measurement in order for

interim reports to be prepared in accordance with HKFRSs. However, HKAS 34 does not
mandate the preparation of interim financial reports, nor how often those reports should be
produced. Requirements to produce interim financial reports are typically found in regulations
produced by governments, stock exchanges, securities regulators and accountancy bodies. As
such, unless a regulator specifies otherwise, entities can choose whether the interim financial
reports are produced as a complete set of financial reports or in condensed form.

In this chapter, you will gain an understanding of the various issues involved with preparing
interim financial reports. Though the objective behind interim reporting is relatively intuitive,
there are various recognition, measurement and disclosure issues to consider in preparing
these reports. We explore these issues by drawing examples from companies that prepare
interim financial reports as well as from our opening case study company CWaves. The purpose
is not to provide an exhaustive list of steps to follow in preparing the reports; the purpose is
to provide an understanding of the principles of recognition and measurement and a sense of
the nature and types of disclosures required and how these reports relate to the information
contained in annual financial reports.

2 8 . 1 OVERVIEW

This chapter focuses on the preparation of interim financial reports in accordance with HKAS 34
Interim Financial Reporting.

Typically, HKFRSs are written from an annual reporting context, and therefore, a separate
Standard that addresses interim reporting issues is necessary. Traditionally, the generally
accepted minimal frequency of financial reporting is annually. However, the preparation of

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 Interim Financial R eporting

financial reports annually is not timely enough for some users. In response, many entities are
required to, or elect to, produce interim financial reports.

HKAS 34 applies where entities elect or are required to produce interim financial reports in
accordance with HKFRSs. Entities retain some discretion as to the format of the interim reports,
which can be produced as a complete set of financial reports, or in condensed form.

In this chapter, you will gain an understanding of the nature and focus of the requirements
in HKAS 34. One particularly challenging aspect of HKAS 34 is the balance between treating
an interim period and its financial report as a stand-alone report and as a report linked to the
annual report. HKAS 34 does this by specifying recognition and measurement requirements
for interim periods as accounting periods in their own right, by expressing those requirements
within the context of the annual period in which the interim period resides and by specifying
associated disclosures.

28.1.1 Scope
HKAS 34 specifies the recognition and measurement principles to be applied, and the minimum
HKAS disclosures to be made, in the preparation of interim reports. HKAS 34 applies where entities
34.1 elect or are required to produce such reports in accordance with HKFRSs.

An entity is not precluded from complying with HKFRSs in its annual financial report even if
it does not comply with HKAS 34 in its interim financial report. Furthermore, where interim
HKAS reports are required but not prepared, this also does not affect the potential HKFRS compliance
34.2 of the entity’s annual financial report.

28.1.2 Terminology
An understanding of several key terms will assist you in working through this chapter.

HKAS An interim financial report is a financial report containing either a ‘complete set of
34.4 financial statements’ or a ‘set of condensed financial statements’ for an ‘interim period’.
HKAS
34.4 An interim period is a financial reporting period shorter than a full financial year.

A complete set of financial statements is defined in HKAS 1 Preparation of Financial

Statements and includes the following components:

• A statement of financial position as at the end of the period, a statement of profit or

loss and other comprehensive income for the period, a statement of changes in equity
for the period and a statement of cash flows for the period;

• Notes, comprising a summary of material accounting policy information and other

explanatory information; and
HKAS 34.5
HKAS 1.10 • Comparative information in respect of the preceding period.

This chapter does not focus on the preparation of a complete set of financial statements
as that is the subject of Chapter 27. The focus of this chapter is on the preparation of interim
financial statements (including accompanying notes).

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 FINANCIAL REPORTING

A condensed financial statement includes, at a minimum, the same financial

statements as are found in a ‘complete set of financial statements’ except that it is only
necessary to include each of the headings and subtotals that were included in the entity’s
most recent annual financial statements (along with comparative information) and selected
HKAS 34.8 explanatory notes as required by HKAS 34. Additional line items or notes are only required if
and 10 their omission would make the condensed interim financial statements misleading, bearing in
mind the interim report can be read in the context of the most recent, more fulsome,
annual report.

Throughout this chapter, the terms interim financial report and interim financial statement
will be used interchangeably unless where it is indicated otherwise.

A full financial year usually means the 12-month period for which annual financial reports
are typically prepared.

Knowledge Check Question

Question 1
Identify which one of the following statements about interim financial reports is true.
A All entities in Hong Kong are required to prepare interim financial reports.
B Interim financial reports must be prepared every half year.
C Interim financial reports may be presented as a complete set of financial statements or
as a condensed set of financial statements.
D An interim financial report should be formatted in precisely the same way as the most
recent annual financial report for the entity.

28.2 CONTENT OF AN INTERIM FINANCIAL

REPORT

When an entity provides a complete set of financial statements as part of its interim financial
report, the report must be prepared in accordance with HKAS 1 Presentation of Financial
Statements. If the interim report is provided in a condensed format, HKAS 34 will apply.
HKAS Regardless of format, HKAS 1 contains some general guidance that applies to all interim
34.15–35 reports. The key guidance applicable to the preparation of interim financial reports is shown in
Exhibit 28.1.

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 Interim Financial R eporting

Interim Financial Report

Full Condensed
financial statements financial statements

Prepared in accordance with Prepared in accordance with

HKAS 1 HKAS 34

Also subject to
additional guidance

General guidelines in HKAS 1 – regardless of format relate to:

• True and fair view (HKAS 1–15);
• Accounting policy choice (HKAS 1.16–24);
• Going concern basis (HKAS 1.25–26);
• Accrual basis (HKAS 1.27–28);
• Materiality (HKAS 1.29–31); and
• Offsetting (HKAS 1.32–35).
These general guidelines are not considered further in this chapter.

EXHIBIT 28.1 Interim financial reporting guidance in HKFRSs

28.2.1 Minimum Components of an Interim Financial Report

Under HKAS 34, an interim financial report must include, at a minimum, the following
components:

• A condensed statement of financial position;

• A condensed statement or condensed statements of profit or loss and other

comprehensive income;

• A condensed statement of changes in equity;

• A condensed statement of cash flows; and
HKAS
34.8 • Selected explanatory notes.

The titles for the statements mentioned above are indicative only, and entities are able to
HKAS depart from these titles in preparing interim financial statements so long as the titles used are
34.5 appropriate.

28.2.2 Form and Content of Interim Financial Statements

Where condensed interim financial statements are prepared, they must contain the same
primary headings as provided in the most recent annual financial statements and use the same
HKAS 34.10, accounting policies and methods of computation in the most recent annual financial
16A(a) statements. The term same primary headings refers to the main headings or titles used in
preparing the financial statements. For a more detailed understanding of the term and its
associated implications, refer to Section 28.2.5.

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 FINANCIAL REPORTING

Where a complete set of financial statements is presented as the interim financial

statements, HKAS 34 permits disclosure of a lower level of detailed information and requires
fewer additional disclosures to be made compared with annual financial statements and
accompanying notes.

For example, Exhibit 28.2 illustrates the disclosure Caaves mipht include in its interim
financial report about its accounting policies rather than the detail normally included in its
annual financial report:

Note X Accounting Policies

Except as previously described, the accounting policies applied by CWaves for these
interim condensed consolidated financial statements are consistent with those described
on pages xx to yy of CWaves’ Annual Report and Accounts 20X7, as are the methods of
computation.

EXHIBIT 28.2 Illustrative disclosure – accounting policies

Entities covered by HKAS 33 Earnings per Share (those whose shares are either traded or
HKAS potentially traded on a public market) must also disclose both basic and diluted earnings per
34.11 share in interim financial reports. Issues in relation to earnings per share are covered in detail
in Chapter 20.

28.2.3 Significant Events and Transactions

HKAS 34 requires the interim report to include an explanation of events and transactions that
are significant to an understanding of the changes in financial position and performance for
the entity since the end of the last annual reporting period. Only this level of information is
HKAS needed because users of the interim report will have access to the most recent annual
34.15A financial report.

HKAS 34 provides a non-exhaustive list of items that, if significant, would need to be

disclosed in the interim report because of their relevance to users. Some examples of the items
specifically mentioned include:

HKAS • Impairments and write-downs to key assets and any reversals of those impairments/
34.15B(a–b) write-downs;
HKAS
34.15 B(d–e)
• Acquisitions, disposals and commitments to purchase items of property, plant and
equipment; and
HKAS
34.15B(j) • Related party transactions.

Illustrative Example 1 shows possible interim period disclosures in respect of CWaves’

property, plant and equipment. Comparative interim period information must be presented,
where material.

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 Interim Financial R eporting

Illustrative Example 1
CWaves made large purchases of property, plant and equipment of HK$96,854,800 and
wrote off plant of HK$17,118,000 in the interim period. CWaves has determined it should
disclose information about these purchases in its interim financial reports.

The note disclosures the company has prepared are reproduced below.

Note X. Property, Plant and Equipment

(a) Acquisition of property, plant and equipment and construction

in progress

During the interim reporting period, the CWaves Group acquired items of
property, plant and equipment and construction in progress with a cost of
HK$96,854,800.

(b) Write off of property, plant and equipment

Property, plant and equipment with a net book value of approximately

HK$17,118,000 was written off during the interim period.

In the case of CWaves, purchases for the interim period in the previous year are not
material. As such, the disclosure of comparative information for this note is not required.

28.2.4 Other Disclosures

As well as disclosing significant events and transactions, entities must include various additional
disclosures in the notes directly or by cross-reference. In particular, disclosures may be
incorporated by cross-reference from the interim financial statements to other statements
produced by the entity, such as management commentary or risk report, provided the other
HKAS statement is available to users of the interim financial statements on the same terms and at the
34.16A same time as the interim financial statements. The objective of requiring these disclosures is to
enhance the usefulness of the interim financial reports in a number of ways.

Some examples of these additional disclosure requirements are provided in Exhibit 28.3.

HKAS 34 Content Rationale

guidance
Accounting The same accounting policies and Provides users with a context for
policies computation practices are used as reading and understanding the financial
in the most recent annual financial information
statements unless they have
changed in which case a description
of the nature and effect of the
change is provided

EXHIBIT 28.3 Other disclosures in interim financial reports

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 FINANCIAL REPORTING

HKAS 34 Content Rationale

guidance
Key activities and Seasonality and cyclicality of Assists users to understand the
events affecting operations, the nature and amount comparability of the information better
financial of items that are unusual by way of and to form expectations about future
statement items their nature, size or incidence financial performance
Debt and Issues, repurchases and Assists the assessment of the solvency
equity items repayments of debt and equity of the entity
securities and dividends
paid (aggregate or per share)
separately for ordinary shares and
other shares
Segment Where the entity is required to Enables a greater understanding of the
revenues, profits prepare segment disclosures components of the business that appear
and losses and under HKFRS 8 Operating Segments to be driving the overall results
reconciliations (Recognition, measurement and
disclosure issues relating to
operating segments are covered in
detail in Chapter 25.)
Changes to The effect of changes, including Enables a better understanding of
the entity’s business combinations, the factors that influence the entity’s
composition subsidiaries, long-term investments financial position at the interim
reporting date while also assisting a
better understanding of the risks and
opportunities facing the entity

EXHIBIT 28.3 (Continued )

Entities are also required to disclose that the interim financial report is in compliance with
HKAS HKAS 34. An interim financial report is not permitted to be described as complying with HKFRSs
34.19 unless it complies with all HKFRSs requirements.

28.2.5 Contrasting Content of an Interim Financial Report to the Annual

Financial Report
Some of the similarities and differences in the content of interim and annual financial reports
may be intuitive, and others may be less so. For example, interim financial reports for most
companies are considerably, sometimes up to 70%, shorter than the annual financial reports.
Also, a range of specific note disclosures are made in interim reports to assist a greater
understanding of financial performance and changes in financial position since the entity’s
most recent annual financial report. These will include details of significant events and
transactions that have occurred during the interim period.

To comply with HKAS 34, the primary headings in the interim financial statements must be
the same as those used in the most recent annual financial statements, which does not mean
that each line item within interim financial statements must be the same as those in the annual
financial statements. HKAS 34 requires only the primary headings to be the same, enabling
entities to provide more or less detail in the interim reports depending on what the entity
deems is most useful to users of the information. Exhibit 28.4 illustrates this by reference to
the calculation of operating cash flows in the annual report for HSBC Holdings Plc for the year
ended 31 December 2017 and its interim report for the subsequent six-month period ended

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 Interim Financial R eporting

30 June 2018 where the same primary headings are used in both statements, but different
levels of detail are provided.

Extract from the consolidated statement of cash flows in HSBC Holdings Plc 2017 annual report:

Consolidated statement of cash flows for the year ended 31 December

2017 2016
$m $m
Profit before tax 17,167 7,112
Adjustments for non-cash items:
Depreciation, amortisation and impairment 1,862 5,212
Net gain from investing activities (1,152) (1,215)
Share of profits in associates and joint ventures (2,375) (2,354)
(Gain)/Loss on disposal of subsidiaries, businesses, associates and (79) 1,743
joint ventures
Loan impairment losses gross of recoveries and other credit risk 2,603 4,090
provisions
Provisions including pensions 917 2,482
Share-based payment expense 500 534
Other non-cash items included in profit before tax (381) (207)
Elimination of exchange differences (21,289) 15,364
Operating profit before working capital changes (2,227) 32,761
Changes in operating assets and liabilities
Change in net trading securities and derivatives (10,901) 4,395
Change in loans and advances to banks and customers (108,984) 52,868
Change in reverse repurchase agreements – non-trading (37,281) (13,138)
Change in financial assets designated at fair value (5,303) (1,235)
Change in other assets (6,570) (6,591)
Change in deposits by banks and customer accounts 102,211 (8,918)
Change in repurchase agreements – non-trading 41,044 8,558
Change in debt securities in issue (1,369) (23,034)
Change in financial liabilities designated at fair value 8,508 17,802
Change in other liabilities 13,514 8,792
Dividends received from associates 740 689
Contributions paid to defined benefit plans (685) (726)
Tax paid (3,175) (3,264)
Net cash from operating activities (10,478) 68,959

Source: HSBC Annual Report and Accounts 2017.

EXHIBIT 28.4 Illustrative disclosure – presentation of operating cash flows in annual vs. interim
reports (indirect method)

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 FINANCIAL REPORTING

Extract from the consolidated statement of cash flows in HSBC Holdings Plc 2018 interim
financial report:

Consolidated statement of cash flows

Half-year to
30 Jun 2018 30 Jun 2017
$m $m
Profit before tax 10,712 10,243
Adjustments for non-cash items:
Depreciation and amortisation 946 863
Net gain from investing activities 85 (764)
Share of profit in associates and joint ventures (1,381) (1,183)
Loss on disposal of associates, joint ventures, subsidiaries and – (79)
businesses
Change in expected credit losses gross of recoveries and other 680 N/A
credit impairment charges
Loan impairment losses gross of recoveries and other credit risk N/A 1,018
provisions
Provisions including pensions 1,244 186
Share-based payment expense 274 267
Other non-cash items included in profit before tax (899) (157)
Operating profit before working capital changes 11,661 10,394
Change in operating assets (89,986) (115,324)
Change in operating liabilities 84,594 109,828
Elimination of exchange differences (11,816) (16,208)
Dividends received from associates 126 589
Contributions paid to defined benefit plans (103) (351)
Tax paid (1,116) (810)
Net cash from operating activities (6,640) (11,882)

Source: HSBC Interim Report 2017.

EXHIBIT 28.4 (Continued )

The notes accompanying interim and annual financial statements have significant
differences. In the case of HSBC Holdings Plc, for example, the material accounting policy
information note in the interim financial report for the six months ending 30 June 2018 contains
many of the same sub-headings as the corresponding note in the entity’s annual report for the
year ending 31 December 2017 but is less than half the length.

Further, in the annual report, the note contains detailed information on accounting policies
used for consolidating subsidiaries, recognising and measuring key items of income and
expense and the recognition and measurement of financial instruments. The corresponding
note in the interim report states that, unless indicated otherwise, the accounting policies used
in the interim condensed financial statements are consistent with those in the entity’s most
recent annual financial report (see Illustrative Example 1 in Section 28.2.3).

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 Interim Financial R eporting

For entities required to prepare interim financial reports for the first time, a number of
decisions are required for those reports to comply with HKFRSs. For example, when CWaves
was first required to prepare interim financial reports, CWaves’ management would have
needed to make a decision about the format of the report. Some issues an entity must consider
in the preparation of its first interim financial report are highlighted in the following Apply and
Analyse exercise.

Apply and Analyse 1

The CEO of Uptown Ltd (Uptown) is seeking advice on whether the following items
are most appropriately disclosed in the interim financial report, the annual financial
report or both:

• basis for consolidation;

• changes to investments in associates and subsidiaries;

• dividends declared to shareholders;

• earnings per share;

• events and transactions involving related parties;

• the valuation approach for property, plant and equipment;

• going concern basis used in preparing the financial report;

• a list of subsidiaries, joint ventures and associates; and

• consistent accounting policies in interim/annual reports.

Identify for the CEO whether these items are commonly disclosed in the interim
financial report, annual financial report or in both.

Analysis

The following table is prepared to assist the CEO.

Disclosure likely in:

Interim Annual
financial financial
reports reports Explanation
Basis for consolidation ✓ ✓ Commonly disclosed in interim
and annual financial statements.
Changes to investments ✓ ✓
Such disclosures are important for
in associates and
assisting financial statement users
subsidiaries
to understand annual financial
Dividends declared to ✓ ✓ performance and financial position at
shareholders year end and to understand financial
performance and changes in financial
Earnings per share ✓ ✓
positions during the interim period.
Events and transactions ✓ ✓
involving related parties

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 FINANCIAL REPORTING

Apply and Analyse 1 (continued)

Disclosure likely in:

Interim Annual
financial financial
reports reports Explanation
The valuation approach ✓ Commonly disclosed in the annual
for property, plant financial reports and typically need not
and equipment be disclosed in interim financial reports
to avoid repetition and because these
Going concern basis ✓
disclosures do not provide specific
used in preparing the
information to assist an understanding
financial report
of financial performance in the interim
A list of subsidiaries, joint ✓ period or changes in financial position.
ventures and associates
Consistent accounting ✓ Disclosure required to provide
policies in interim/ comparable information for users to
annual reports understand financial performance
for the interim period and changes to
financial position since the most recent
annual financial position.

28.2.6 Periods for which Interim Financial Statements are Required to

be Presented
The following tables summarise the guidance provided in HKAS 34 in respect of interim reports
produced half-yearly (Exhibit 28.5) and quarterly (Exhibit 28.6) for a 31 December reporter.

Interim reports produced half-yearly

for an entity with a 31 December year end
Financial statement Interim report Comparative
Statement of financial position As at the end of the current As at the end of the immediately
interim period preceding financial year
Entity producing statement as at: 30 June 20X1 31 December 20X0
Statement of profit or loss and For the current interim period For the comparable interim
other comprehensive income and cumulatively for the current periods (current and year-to-date)
financial year to date of the immediately preceding
financial year
Entity producing statement for: 6 months ended 30 June 20X1 6 months ended 30 June 20X0
Statement of changes in equity Cumulatively for the current Cumulative year-to-date period
financial year to date of the immediately preceding
financial year
Entity producing statement for: 6 months ended 30 June 20X1 6 months ended 30 June 20X0
Statement of cash flows Cumulatively for the current For the comparable year-to-
financial year to date date period of the immediately
preceding financial year
Entity producing statement for: 6 months ended 30 June 20X1 6 months ended 30 June 20X0

EXHIBIT 28.5 Half-yearly interim report dates and comparative periods

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 Interim Financial R eporting

The preceding comparative dates apply regardless of whether the interim financial reports
are prepared as a set of condensed financial statements or as a complete set of financial
statements with accompanying notes. For half-yearly reporting, only one interim financial
report is required each year, as the second half-yearly interim financial report is replaced by the
annual financial report.

Exhibit 28.6 provides information on interim financial reporting dates and comparative
periods for reports that are produced on a quarterly basis and assuming the current interim
reporting date is 30 June 20X1.

Interim reports produced quarterly

for an entity with a 31 December year end
Financial statement Interim report Comparative
Statement of financial position As at the end of the current As at the end of the immediately
interim period preceding financial year
Entity producing statement as at: 30 June 20X1 31 December 20X0
Statement of profit or loss and other For the current interim period For the comparable interim
comprehensive income and cumulatively for the current periods (current and year-
financial year to date to-date) of the immediately
preceding financial year
Entity producing statement for: 3 months ended 30 June 20X1 3 months ended 30 June 20X0
6 months ended 30 June 20X1 6 months ended 30 June 20X0
Statement of changes in equity Cumulatively for the current Cumulative year-to-date period
financial year to date of the immediately preceding
financial year
Entity producing statement for: 6 months ended 30 June 20X1 6 months ended 30 June 20X0
Statement of cash flows Cumulatively for the current For the comparable year-to-
financial year to date date period of the immediately
preceding financial year
Entity producing statement for: 6 months ended 30 June 20X1 6 months ended 30 June 20X0
3 months ended 30 June 20X1 3 months ended 30 June 20X0

EXHIBIT 28.6 Quarterly interim report dates and comparative periods

Entities whose business is highly seasonal are encouraged to produce financial information
HKAS
for the 12 months to the end of the interim period along with comparative information for the
34.21 prior 12-month period in addition to the information outlined in Exhibits 28.5 and 28.6.
The objective of doing so is to provide users with sufficient information to understand the
impacts of seasonality on the results.

28.2.7 Materiality
Entities must assess the materiality of the items to be disclosed in interim financial statements.
HKAS Though this general requirement also applies to annual financial statements, materiality in
34.23 interim reports must be assessed with respect to the interim figures, not the full year figures.

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 FINANCIAL REPORTING

Knowledge Check Question

Question 2
Identify which one of the following statements about interim financial reporting is
not correct.
A Where interim financial reports are prepared as a complete set of financial statements,
HKAS 1 provides primary guidance.
B HKAS 1 is a primary source of guidance where interim financial reports are prepared in
condensed form.
C HKAS 1 provides some guidance, regardless of the format of the interim financial
statements.
D Entities with publicly traded securities are encouraged to produce interim financial
reports at least half-yearly.

2 8 . 3 DISCLOSURE IN ANNUAL FINANCIAL

STATEMENTS

Entities typically do not produce an interim financial report for the final interim period of a
financial year, with information relating to the final interim period included; instead, entities
produce an interim financial report as part of the annual financial report. As a consequence,
HKAS 34 requires certain disclosures in the notes to the annual financial statements to assist
users to understand the financial performance and changes in financial position for the entity
since the most recent interim report (if one was prepared).

Where an estimate of an amount reported in an earlier interim period has changed

significantly during the final interim period that either:

• has a material effect in the current period; or

• is expected to have such an effect in future periods.

HKAS HKAS 34 requires the nature and amount of that change in estimate to be disclosed in a
34.26–27 note to the annual financial statements for that year.

These disclosures are intended to be narrow in scope, relating only to the change in
HKAS estimate. Entities are not required to include additional interim period financial information in
34.27 the notes accompanying the annual financial statements. In such cases, materiality will
generally be determined by reference to the current interim period financial data rather than
by the financial data for the entire year.

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Apply and Analyse 2

Higher value non-current assets owned by CWaves include its fleet of passenger ferries
(12 in total), which are a crucial part of its ability to provide ferry services in the region.
Because each ferry is acquired for the different routes and conditions, and the ferries
are separately material relative to the dollar value of total assets, the company regularly
undertakes an impairment test to each vessel just prior to preparing its interim and annual
financial statements. In preparing its interim financial report, the entity notes the following
information in respect of its oldest vessel, the 26-metre, 220-passenger Hăilún, which was
built in 20X1. The carrying value of the ferry prior to any impairment is HK$19.65 million.

At the interim reporting date, the company determines the vessel’s value in use to be
HK$20.1 million, based on the projections for passenger numbers and likely ticket prices
for the remaining useful life of the vessel. In calculating this amount, the company notes
its exclusive licence to operate in the region, and therefore, does not foresee any major
disruptions to customer demand in the near future.

As the value in use of the ferry is higher than its carrying amount, it is unnecessary to
determine the ferry’s fair value for the purposes for considering whether impairment is
present. Because the carrying amount of the ferry is less than its value in use, the ferry
is not impaired, and consequently, the company reports this asset at its present carrying
value of HK$19.65 million in its interim financial report.

However, in the months after CWaves produces its interim financial report and prior
to its annual financial report, the government unexpectedly grants two additional licences
to competitor companies to operate passenger ferries on the same route as the Hăilún,
beginning in the first quarter of the next financial year. Up until now, CWaves has held an
exclusive licence to operate in the region and this is a key assumption on which estimates
of ticket sales, and value in use, were made.

Determine how the additional licences impact CWaves’ next annual financial report.

Analysis

In preparing its next annual financial report, the company must consider the impact of
the additional licences on CWaves’ ferry asset, taking into account the likely implications
of greatly increased competition for passenger demand and ticket price, almost certainly
leading to lower estimates of value in use and a possible impairment loss in the last six
months of the current annual reporting period. Where impairment is present, additional
note disclosures would be required in the annual financial statements to indicate the
nature and amount of the change in the estimate of the carrying amount of the ferry. This
must be done by reference to the current interim period financial data rather than the
financial data for the entire year.

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Knowledge Check Question

Question 3
Downtown Limited (Downtown) prepares half-yearly and annual financial statements. In
the last quarter of its annual reporting period, Downtown suffered damage to one of its
warehouses in which it stores its inventory. A major storm accompanied by high winds
caused a section of the roof of the warehouse to come off entirely, with the result being
significant damage to the contents of the warehouse.
Identify the estimates Downtown would typically make in recognising and measuring
the warehouse and its contents in the interim financial report. Determine the potential
questions the company should investigate to establish whether any changes to those
estimates and associated disclosures are required in the preparation of its next annual
financial report.

2 8 . 4 RECOGNITION AND MEASUREMENT

In general, HKAS 34 requires the same definition, recognition and measurement approaches
and techniques to be applied in the same way in an interim period as in an annual period.
In addition, two more conditions guide the application of recognition and measurement in
interim reports:

1. Interim financial statements are prepared as if the interim period is a stand-alone

period rather than as a part of an annual period; and

2. Interim financial statements are prepared on the basis that the interim period is an
integral part of the annual period.

An implication of the first condition is that, for income and expenses to be recognised in
interim financial statements, the related inflows and outflows of assets and liabilities must
have taken place by the reporting date. Further, items are only recognised in the interim
statement of financial position if they meet the relevant definition and recognition criteria
of assets or liabilities at that date. For example, deferring costs incurred in an interim period
that are associated with an anticipated future intangible asset would be inappropriate where
the existence of that asset cannot be confirmed at the date of the interim report even if it is
expected to be confirmed later in the annual reporting period.

An implication of the second condition can be seen for income tax where amounts
recognised in an interim period are dependent on annual conditions (i.e. annual income
because of the way the income tax laws apply). In such instances, it is necessary to take account
of annual estimates in determining the amount of income tax to recognise in an interim period.
In these cases, it would be inappropriate to ignore the annual context within which the interim
period resides as to do so would not provide useful information to users of the interim financial
report. Such issues are further examined in the following section.

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28.4.1 Same Accounting Policies as Annual Financial Statements

Entities are required to apply the same accounting policies in interim financial reports as are
applied in the most recent annual financial statements. An exception to this requirement is
where accounting policy changes are made because the entity‘s most recent annual financial
statements will apply to the next annual financial statements.

28.4.2 Revenues Received Seasonally, Cyclically or Occasionally

Some entities will generate revenues unevenly through the year. These revenues may be
seasonal, cyclical or occasional. This unevenness can arise as a result of a range of factors. For
example, retail organisations often generate more of their revenue in certain interim periods
compared with other periods within a year. Other examples of cyclical or occasional revenues
might include dividends, royalties and government grants. Such revenues are to be recognised
only when they meet the definition and recognition criteria for revenues that is, when they
HKAS occur, and shall only be anticipated or deferred in the interim report if anticipation or deferral
34.37–38 would be appropriate in the entity’s annual financial statements. Guidance contained in
HKAS 34 is summarised in Exhibit 28.7.

Component Treatment under HKAS 34

Seasonal revenue The entity records revenue for the interim period that is based on the
definition and recognition criteria for revenue. To clarify the seasonal
nature of its revenue, the entity could include, as additional information,
disclosure of revenue for the 12 months to the end of the most recent
interim period.
Cyclical revenue Where an entity has held the same portfolio of investments for some time,
(e.g. dividend Income) it may be almost certain to receive a dividend payment in the second half
of the calendar year. In such instances, the entity’s right to receive the
dividend is not established until the second half of the calendar year. As a
result, according to HKAS 34, the entity is unable to recognise any income
from dividends in its interim financial statements for the six months
ending 30 June of the current calendar year.
Occasional revenue In the case of income from royalties, the income may have been earned
(e.g. royalty income) and the required flows of assets have occurred. In such instances, an
entity may be able to recognise an amount of revenue from royalties on
an accrual basis in a way that reflects the content of the contract on which
the royalty payments were based, consistent with the definition and
HKAS recognition criteria for income. Such an accrual would be appropriate in
34.37–38 the entity’s annual financial statements.

EXHIBIT 28.7 HKAS 34 guidance

These requirements are relevant to CWaves, whose revenues from its ferry services are
seasonal, fluctuating during the year with changes in weather conditions. Exhibit 28.8 illustrates
the note disclosure that management of CWaves might include in its interim report about the
seasonality of its revenues:

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 FINANCIAL REPORTING

Note X. Seasonality of operations – ferry services

CWaves Ferry Services, which is one of the group’s reportable segments, experiences
15 to 30% lower sales in the January to March each year relative to the other months due
to the decreased retail demand for services resulting largely from fluctuating weather
conditions. Each year the group anticipates this fall in demand and manages available
resources appropriately, including reducing the number of mid-week services and also by
managing part-time and casual staff. As a result of these fluctuations, the group typically
reports lower revenues (and segment results in case of the Ferry Services segment) for
the first half of the calendar year instead of the second half.

EXHIBIT 28.8 Illustrative disclosure – seasonality of revenues

28.4.3 Costs Incurred Unevenly during the Financial Year

Costs incurred unevenly throughout a year are anticipated or deferred for interim reporting
purposes only if it would be appropriate to anticipate or defer that type of cost in the annual
financial statements under the same circumstances. Costs that meet the definition of expenses
and recognition criteria are fully recognised in the interim financial statements when incurred.
Under some specific conditions, certain costs for which the relevant outflows of assets have,
strictly speaking, not yet occurred prior to the end of the interim period must be recognised
on an accrual basis in the interim financial statements where those relate to the entire year.
A number of examples can be used to illustrate the manner in which certain costs incurred
unevenly are dealt with in interim financial reports in accordance with HKAS 34.

Many companies plan major periodic maintenance expenditure at certain times during the
year. Suppose such expenditure is planned to occur in the last six months of the current annual
reporting period. When preparing the interim financial report for the first half year, such
HKAS expenditure is not to be brought into the financial statements unless a legal or constructive
34.B2 obligation exists to make that expenditure as at the date of the interim financial report.
Now instead, suppose the major maintenance expenditure was undertaken in the first interim
period of the year, perhaps to take advantage of the downturn in demand, as is the case with
CWaves in the January to March period. In such instances, assuming the maintenance
expenditure is required for the vessels to continue to operate for the remainder of the year, the
expenditure can be deferred and amortised over the life of the maintenance, provided they
meet the definition and recognition criteria specified in HKAS 16 Property, Plant and Equipment.
HKAS That is, future economic benefits associated with the item will probably flow to the entity; and
16.7 the cost of the item can be measured reliably.

HKAS This can be compared with other examples of uneven costs, such as year-end bonus
34.B34 payments paid to employees. The nature of year-end bonus payments may vary widely.
For example, some payments are made to employees as a result of continued employment; in
other cases, such payments might be earned by employees based on the achievement of
monthly, quarterly or annual operating targets. Such payments might possibly be purely
discretionary. Bonus payments to be made at year-end can only be anticipated and recognised
in interim financial reports where: (i) a legal or constructive obligation exists to make the
HKAS payment at the interim reporting date; (ii) the entity has no realistic alternative but to make the
34.B5–B6 payments; and (iii) a reliable estimate of the obligation can be made. Accordingly, an annual
bonus that is, say, 1% of annual profit that has a history of being paid might meet the criteria,

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 Interim Financial R eporting

and therefore, need to be recognised in the first half-year interim report as simply 1% of the
half-year profit. The key is the existence of a legal or constructive obligation. As such, in
instances where the bonus is paid only if annual profit exceeds a certain amount for the year,
say HK$50 million, it is difficult to see how such an obligation would exist at the interim report
date if year to date profit as at the interim report date was less than this amount as the
obligation will be triggered by CWaves operating in a future period.

28.4.4 Use of Estimates

The recognition and measurement of financial statement items in annual and interim reports
require the use of estimates, although to save time and cost for preparers, HKAS 34 allows the
greater use of estimates in preparing financial reports for interim periods. HKAS 34 requires
measurement procedures adopted for interim financial reporting purposes result in reliable
HKAS information, and that sufficient information be disclosed to assist users to understand how
34.41 financial elements have been recognised and measured.

HKAS 34, HKAS 34 provides several examples of the use of estimates in interim reports, including the
App. C reporting inventory at interim dates. Under HKAS 34, to save time and cost, though full stock
taking and valuation may be undertaken at financial year-end, making estimates at interim
dates based on sales margins may be sufficient. Where such items are recognised and
measured in one interim period and the estimate changes in a subsequent interim period of
that financial year, the original estimate is changed in the subsequent interim period either,
depending on the direction of the change, by accrual of an additional amount of loss or by
reversal of the previously recognised amount. The amounts reported in the interim financial
HKAS report for the first interim period for the year are not retrospectively adjusted, but the nature
34.16A(d), 26 and amount of any significant changes in estimates must be disclosed.

28.4.5 Examples of Applying Recognition and Measurement Principles

HKAS 34 provides a number of examples of the application of recognition and measurement
principles in interim reporting, some of which we consider in the remainder of this section.
First, we consider a summary table, which refers to some examples in HKAS 34 along with
specific references to the standard indicating where such guidance can be found (Exhibit 28.9).
This is followed by additional explanation and a worked example.

Item Recognition and measurement HKAS 34 reference

approach in interim financial reports
Major planned periodic Estimate and recognise if a legal or 32, B2–B7
maintenance or overhaul; constructive obligation exists that can be
Provisions; Year-end staff reliably measured and for which no realistic
bonuses; Contingent alternative exists but to transfer resources
lease payments
Intangible assets; Vacation/ Recognise and measure using the same B8, B10, B24,
holiday pay and other approach as used in the annual financial B25, B29–31
compensated absences; statements, although in the case of items,
Inventories; Depreciation/ such as inventories, HKAS34 allows the
amortisation; Foreign currency greater use of estimates in valuing than
translation gains/losses would normally be the case in annual
financial reporting

EXHIBIT 28.9 Recognition and measurement in interim reports

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 FINANCIAL REPORTING

Item Recognition and measurement HKAS 34 reference

approach in interim financial reports
Inventory write-downs Based on inventory selling prices and B26
disposal costs as at interim report date
Interim income tax expense Recognise using the tax rate that would be B12–22
applicable to expected total annual earnings;
that is, the estimated average annual
effective income tax rate applied to the
pre-tax income of the interim period

EXHIBIT 28.9 (Continued )

A common issue in the preparation of interim financial statements is the calculation of

income tax. In interim financial reports, an entity is required to recognise income tax expense
based on the estimated average annual effective income tax rate applied to the interim period
pre-tax income. A specific example follows.

Illustrative Example 2
Assume that Midtown Limited (Midtown) prepares interim financial reports on a
quarterly basis and expects to earn uneven profits during the year as follows:

First Second Third Fourth Total

Quarter Quarter Quarter Quarter
Predicted taxable HK$365,000 HK$597,000 HK$482,000 HK$859,000 HK$2,303,000
profit each quarter

Assume also that the relevant tax rates are as follows:

Marginal Tax Rate

(per dollar)
First HK$2,000,000 taxable profit 8.25%
Taxable profit > HK$2,000,000 16.5%

The tax calculation for the year would be as follows:

HK$2,000,000 * 8.25% = HK$165,000

HK$303,000 * 16.5% = HK$49,995
Total income tax payable = HK$214,995

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 Interim Financial R eporting

Illustrative Example 2 (continued)

This represents an estimated average income tax rate of HK$214,995/HK$2,303,000 =
9.335% (rounded). This is the rate at which Midtown will recognise income tax in its
quarterly interim financial reports in accordance with HKAS 34.30(c). For example,
see below:

Quarter 1 Quarter 2 Quarter 3 Quarter 4

Income HK$34,073 HK$55,730 HK$44,995 HK$80,188
tax expense
Calculation 365,000 * 9.335% 597,000 * 9.335% 482,000 * 9.335% 859,000 * 9.335%

Note in the above calculation, the income tax expense recognised in each quarter is
based on the estimated average annual income tax rate (9.3%) and not the stated marginal
rate (8.25%). This results in an income tax expense amount of HK$34,073 in quarter 1,
instead of HK$32,588 (HK$365,000 * 8.25%).

Where a tax loss has been incurred in a previous period and is appropriately carried
HKAS forward by the entity, this is to be included in the computation of the estimated average
34.B21 income tax rate.

28.4.6 Impairment in Interim Financial Reporting (HK(IFRIC)-Int 10)

Under HKAS 36 Impairment of Assets, an entity is required to assess goodwill for impairment at
the end of each reporting period and, if required, recognise an impairment loss in accordance
with HKAS 36 (see Chapter 14).

Applying HKAS 34, entities must apply the same impairment testing, recognition, and
reversal criteria at an interim date as they would at the end of their financial year under the
same circumstances. HKAS 34 also states that the frequency of an entity’s reporting (annual,
HKAS half-yearly or quarterly) shall not affect the measurement of its annual results, which infers that
34. 28 measurements for interim reporting purposes shall be made on a year-to-date basis.

However, at the end of a subsequent reporting period, conditions may have changed such
that the impairment loss in the interim reports may have been reduced or avoided had the
impairment assessment been made only at the end of the annual reporting period. This creates
HKAS
an issue in the preparation of the annual financial statements because HKAS 36 prohibits the
34.124 subsequent reversal of any prior period impairment losses recognised for goodwill.

HK (IFRIC)-
In such cases, HK (IFRIC)-Int 10 Interim Financial Reporting and Impairment applies, requiring
Int 10.8 that the entity not reverse the impairment loss recognised in any prior interim period. In doing
so, HK (IFRIC)-Int 10 addresses an apparent inconsistency between the requirements of
HKAS 36 and HKAS 34.

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Knowledge Check Questions

Question 4
Gladys Lau oversees CWaves’ investments in Travel Agencies. Under her employment
contract, Gladys receives a bonus of 2% of annual (calendar year) salary, when revenue
earned on the investments exceeds HK$1.5 million. Since its inception, the company has
adopted a practice of paying employee bonuses based on year-to-date performance at the
interim date where 70% or more of the annual target has been reached by that date.
By the end of 30 June 20X1, investment income from Travel Agencies had reached
HK$1,200,000, with revised projections indicating annual revenue of at least HK$1.8 million.
Gladys’ current monthly salary is HK$60,000.
Calculate the amount recognised as an expense in CWaves’ interim financial
statements for the first six months of the year with respect to the salary bonus for Gladys.

Question 5
CWaves has provided you with some information in the lead-up to the preparation of its
interim financial report for the six months to 30 June 20X1. Its profit before tax for the
six-month period to 30 June 20X1 is HK$1.8 million. The business is seasonal and the profit
before tax for the next six months to 31 December 20X1 is predicted to be HK$2.35 million.
Income tax is calculated as 8.25% of reported annual profit before tax if it does
not exceed HK$2 million. If annual profit before tax exceeds HK$2 million, the tax rate
increases to 16.5% for every additional dollar of profit generated above HK$2 million.
Calculate the income tax expense reported in the interim financial statements in
accordance with HKAS 34.

2 8 . 5 RESTATEMENT OF PREVIOUSLY REPORTED

INTERIM PERIODS

HKAS 34 provides guidance where accounting policies in interim reports are changed. Such
changes are reflected by the following:

• Restating the financial statements of prior interim periods of the current financial year
and the comparable interim periods of any prior financial years that will be restated in
the annual financial statements in accordance with HKAS 8 Accounting Policies, Changes
in Accounting Estimates and Errors; or

• When it is impracticable to determine the cumulative effect at the beginning of the

financial year of applying a new accounting policy to all prior periods, adjusting the
financial statements of prior interim periods of the current financial year and
HKAS comparable interim periods of prior financial years to apply the new accounting policy
34.43 prospectively from the earliest date practicable.

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 Interim Financial R eporting

As an example, Exhibit 28.10 illustrates disclosure of a change in accounting policy with

respect to an entity’s change in presentation of its foreign exchange exposure on its financial
instruments in its interim financial report for the six months ended 30 June 20X8.

Prior to 20X8, foreign exchange exposure on some financial instruments designated at

fair value was presented in the same line in the income statement as the underlying fair
value movement on these instruments. In 20X8, the presentation of the entire effect of
foreign exchange exposure has been grouped in profit or loss and presented within ‘Net
income from financial instruments held for trading or managed on a fair value basis’.
Comparative data has been represented.

EXHIBIT 28.10 Illustrative disclosure: change in accounting policy

Knowledge Check Question

Question 6
Identify which one of the following best describes an entity’s additional responsibility when
preparing a third-quarter interim financial report where a change in an accounting policy is
made on the last day of that quarter.
A No additional explanation and disclosure is required
B Retrospective application is required to all pre-change interim periods where practicable
C Application of the changed policy to current and future interim periods only
D Application to future interim periods only

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SUMMARY

• HKAS 34 does not mandate the preparation of interim financial reports, but provides guidance
on disclosure, recognition and measurement that must be complied with if interim reports
can claim compliance with HKFRSs.

• Entities can determine whether the interim financial reports are produced as a complete set
of financial statements or as a set of condensed financial statements. Where interim financial
reports are prepared as a complete set of financial statements, HKAS 34 requires them to
be prepared in accordance with HKAS 1 Presentation of Financial Statements. If the interim
report is provided as a condensed set of financial statements, specific HKAS 34 requirements
apply. Regardless of format, HKAS 1 contains some general guidance that applies to all
interim reports.

• Condensed interim financial statements must contain the same primary headings, accounting
policies and methods of computation as used in the most recent annual financial statements.

• The primary objective of interim financial reports is to provide sufficient information to enable
understanding of the interim financial position and performance. As a result, income and
expenses are typically measured on a year-to-date basis, and anticipation and deferral of
income and costs are appropriate only to the extent this would be appropriate in the annual
financial statements in the same circumstances.

• The use of estimates is inevitable in the preparation of annual and interim financial reports,
although greater use is expected in interim reporting.

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MIND MAP

OVERVIEW AND SCOPE CONTENT OF AN INTERIM FINANCIAL REPORT

Interim reports shall provide information Interim reports may be presented as a
to enable assessments of financial position complete set of financial reports or
and performance and the interim period. a condensed set of financial statements
Interim reports provide an update to the • Where prepared in condensed form,
information contained in the most recent HKAS 34 applies.
annual financial statements. • Where produced as a complete set of
financial statements, in accordance with
Interim financial reports are not mandatory
HKAS 1.
under HKAS 34.
Additional guidance in HKAS 1 applies to all
Minimum disclosure requirements are set
interim financial reports.
out and additional guidance provided on
recognition and measurement where Minimum components of condensed interim
interim reports are prepared in accordance financial statements include
to HKFRSs. • Each of the headings and subtotals included
in its most recent annual financial statements.
DISCLOSURE IN ANNUAL FINANCIAL • Selected explanatory notes as required by
STATEMENTS INTERIM FINANCIAL HKAS 34.
REPORTING
Interim reports must include an explanation Materiality in interim financial reporting is
HKAS 34
of events and transactions that are to be assessed based on interim financial
significant to an understanding of the data not data for the year.
changes in financial position and
performance for the entity since the
end of the last annual reporting period.
Preparers should assume that users of the
interim report will have access to the most
recent financial report of the entity and this
RECOGNITION AND MEASUREMENT
principle should guide decisions as to what
note disclosures provide. Interim financial position and financial
Relevant comparative information is performance shall be measured on
required to be disclosed. a year-to-date basis.
Uneven costs or revenues are recognised
RESTATEMENT OF PREVIOUSLY REPORTED when they occur and shall only be
INTERIM PERIODS anticipated or deferred in the interim
report if anticipation or deferral would be
Where items are recognised and measured
appropriate in the entity's annual financial
in one interim period and the estimate
statements in the same circumstances.
changes in a subsequent interim period
of that financial year, retrospective Year-to-date measures might result in the
adjustments of comparable amounts in greater use of estimates than is the case
prior interim periods and additional with annual financial reporting.
disclosures of the impacts of the change
are required.

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. HKAS 34 does not require all entities in Hong Kong to prepare
interim financial reports.
Answer B is incorrect. HKAS 34 does not mandate the frequency of interim financial
reports although it encourages entities with publicly traded securities to report at least as
of the end of the first half of an annual reporting period.
Answer C is correct. Entities that elect or are required to prepare interim financial reports
may elect to produce them as a complete set of financial statements or as a set of
condensed financial statements.
Answer D is incorrect. Entities need not format the interim statements in the same way as
the most recent annual financial statements. For example, the interim financial statements
may be in condensed form.

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Question 2
The question asks for the option that is not correct.
Answer A is incorrect. HKAS 1 provides primary guidance when interim financial reports
are prepared as a complete of financial statements. Because this is a correct statement,
it is the incorrect answer to this question.
Answer B is correct. HKAS 34 is the primary source of authority where interim financial
reports are produced as a set of condensed financial statements. Although HKAS 1
provides some guidance, and therefore, has some relevance, it is not the primary source of
guidance for reports in this format. Because this is an incorrect statement, it is the correct
answer to this question.
Answer C is incorrect. HKAS 1 provides general guidance as outlined in HKAS 1.15-35 (see
Exhibit 28.1 of this chapter) that applies regardless of the format of the interim financial
report. Because this statement is correct, it is the incorrect answer to this question.
Answer D is incorrect. HKAS 34 encourages entities with publicly traded securities to
prepare interim financial reports at least as of the end of the first half of their annual
reporting periods (HKAS 34.1). Because this is a correct statement, it is the incorrect
answer to this question.

Question 3
The estimates made by the company relate to the recognition and measurement of
the warehouse and the inventory stored within it. Consistent with HKAS 2 Inventories
and HKAS 16 Property, Plant and Equipment (and covered in detail in Chapters 6 and
7 respectively), in accounting for the warehouse and its contents, various estimates
are required with respect to fair value, estimated value in use, and for the warehouse
estimates that are also needed to determine the appropriate periodic depreciation charge.
Any changes to these estimates may warrant additional disclosure in the next annual
financial report.
To determine the possibility that further disclosure may be needed in the next annual
financial report, a key factor to consider is how significant the damage is to the company
assets concerned and the extent to which implications exist for the fair value and value in
use of the assets. In doing so, the company might explore a range of questions, including
the following:
Warehouse
• Does any implication exist for the storage capacity of the warehouse that could in
turn affect estimates of value in use?
• Will the repairs to the warehouse be expensed in the current period or deferred and
depreciated, and if the latter, over what period will depreciation be charged?
• Does the damage affect the potential fair value of the warehouse should the entity
wish to sell the warehouse in the foreseeable future?

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The preceding questions will assist the entity to determine whether any additional
disclosures might be required in respect of the recognition and measurement of the
warehouse.
Inventory:
In recognising and disclosing inventory in financial statements, key information items
required are the cost of the inventory and the net realisable value of the inventory. In this
case, cost is not affected. Relevant additional questions relating to the inventory held in the
warehouse focus on whether net realisable value might change and include:
• To what extent the damage has implications for the realisable value of any inventory.
Does this have any direct implications for the lower of cost and net realisable value
test required to be applied under HKAS 2?
Depending on the information uncovered in response to the preceding questions, the
entity will be better placed to determine whether additional disclosure is required for these
assets in the next annual financial statements.

Question 4
Under paragraph B6 of HKAS 34, a bonus is anticipated for interim reporting purposes
if, and only if, (a) the bonus is a legal obligation or past practice would make the bonus
a constructive obligation for which the entity has no realistic alternative but to make the
payments, and (b) a reliable estimate of the obligation can be made.
The requirement to pay the bonus is contained in Gladys Lau’s employment contract.
Clearly, the revenue earned to interim date does not create the contractual obligation to
pay the bonus. It does appear, however, that CWaves’ prior practice of paying employee
bonuses where year-to-date performance is 70% or more of annual targets creates
a constructive obligation in this case. As a result, it appears that a bonus of 2% of
Gladys Lau’s year-to-date salary at interim report date should be recognised as a salary
bonus, that is:

2% * HK$60, 000 per month * 6 months HK$7, 200

Question 5
Total income tax expense on CWaves profits are estimated to be HK$4.15 million:

8.25 % * HK$2 m = HK$165,000

16.5% * HK$2.15 m = HK$354,750
Total income tax expense: HK$519,750

Average annual effective tax rate: HK$519,750/HK$4.15 million = 12.52% (rounded)

Therefore, income tax to be recognised by the entity in its interim financial report is
HK$1.8 million * 12.52% = HK$225,360 (HK$225,434 without rounding).

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Question 6
Answer A is incorrect. HKAS 34.16A(a) requires additional disclosure and computation
where an accounting policy is changed.
Answer B is correct. Where an accounting policy is changed, the entity is required to
HKAS restate the financial statements of prior interim periods of the current financial year and
34.16A(a) the comparable interim periods of any prior financial years.
HKAS Answer C is incorrect as application is required to all prior interim periods and comparable
34.16A(a) interim periods of prior years.
HKAS Answer D is incorrect as application is required to all prior interim periods and comparable
3416A(a) interim periods of prior years. A rationale for it is provided in HKAS 34.45.

EXAM PRACTICE

QUESTION 1
Rosty Corporation (Rosty) is in the process of preparing its financial statements for the first
quarter of 20X2 and has asked your advice as to how to report several items. These items
include the following events that took place during the first quarter of 20X2:

(a) Rosty changed its depreciation method on machinery with an initial cost of
HK$100 million from the reducing balance method to the straight-line method to align
better with the depreciation policy adopted across the group. The company had owned
the asset for two years prior to the start of 20X2. The reducing balance depreciation
rate it had used thus far was 20% per annum, resulting in a written-down value of
HK$64 million at the beginning of 20X2. On 1 January 20X2, the company decided to
change to the straight-line method of depreciation and charge depreciation at a rate of
10% per year. Estimates of useful life and scrap value were not changed.

(b) Rosty pays its executives a bonus at year-end of eight percent of revenue to a maximum
of HK$12 million annual revenue, which is only payable if annual revenue exceeds
HK$7 million. The business is seasonal. Revenue for the three months ended 31 March
20X2 was HK$5 million. In the past, the company has always paid employee bonuses at
the first interim date whenever year-to-date revenue has reached 50% or more of the
annual target. Rosty estimates its revenue for the full year will be HK$19 million.

(c) On 1 January 20X2, Rosty incurred major expenditure for re-tooling its manufacturing
plants in order to be able to fulfil a major customer order over the remainder of the
year. The total cost incurred by the entity was HK$1,200,000. After taking some initial
time to implement new processes and controls on the re-tooled sites, including staff
training, the company envisages that at least one half of the order will be satisfied in the
third quarter of the year and the remainder satisfied equally across the other quarters.

Required:

For each of the events above, explain how that event should be reported on Rosty’s
statement of profit or loss for the three months ended 31 March 20X2, and calculate the
impact on the statement of financial position at 31 March 20X2.

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QUESTION 2
‘If an entity publishes a set of condensed financial statements in its interim financial report,
those condensed statements shall include, at a minimum, each of the headings and
HKAS subtotals that were included in its most recent annual financial statements and the selected
34.10 explanatory notes as required by this Standard . . .’.

Required:

(a) Explain why HKAS 34 does not require interim financial statements to be formatted
identically to the entity’s annual financial statements.

(b) Outline how materiality is applied in interim financial reports in accordance with
HKAS 34. Give a specific example of how this approach helps avoid ‘misleading
inferences’.

(c) Explain briefly how the objective of interim financial reporting results in the use
of different techniques and approaches for recognising, measuring and disclosing
information in interim financial reports compared with techniques used in annual
financial statements. Give examples to support your explanation.

ANSWERS TO EXAM PRACTICE

QUESTION 1
(a) Change in depreciation method

Under HKAS 8, paragraph 32, this is treated as a change in accounting estimates. Under
HKAS 8, the company must disclose the nature and amount of the change in accounting
estimate, including the effect of the change on the financial results in the current period
and where practical, future periods. The following requirements in HKAS 8 (paragraphs
36–37) are relevant for determining the what is required:

• The effect of a change in an accounting estimate shall be recognised prospectively

by including it in profit or loss in: (a) the period of the change, if the change affects
that period only; or (b) the period of the change and future periods, if the change
affects both; and

• To the extent that a change in an accounting estimate gives rise to changes in

assets and liabilities, or relates to an item of equity, it shall be recognised by
adjusting the carrying amount of the related asset, liability or equity item in the
period of the change.

In light of the above and based on the information provided, adjustments are
required to interim profit and loss and the carrying amount of the asset involved.

Under the previous (reducing balance) approach, the carrying value of the asset at the
beginning of 20X2 is HK$64 million (reducing balance depreciation charged at 20% for two
years) and depreciation charged on that asset in the first quarter of 20X2 would have been
HK$3.2 million (HK$64 million * 20% * ¼) under the old policy. Depreciation for the first
quarter of the prior year (20X1) under the previous approach was HK$4 million, based on
a written-down value at the beginning of 20X1 of HK$80 million: (HK$80 million * 20% * ¼).
Had straight-line depreciation been charged from the outset, the depreciation charged
in the first quarter of 20X1 would have been HK$2.5 million (HK$100 million * 10% * ¼),

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 FINANCIAL REPORTING

which under the straight-line method is the same as the straight-line depreciation for the
first quarter of the current year under the new policy. This results in a written-down value
at the end of March, 20X2 of HK$77.5 million (HK$100 million − (HK$100 million* 10% *
2 years) − (HK$100 million * 10% * ¼))

In preparing interim reports for the three months ending March 31, 20X2 , the entity
must provide a description of the nature and effect of the change because the choice of
depreciation method has changed and is consistent with HKAS 34.16A(a, d). Based on
the information in the question, the following quantitative information should also be
disclosed.

New policy Previous policy

HK$m HK$m
Comparative carrying amount 31 December 20X1 64.0 80.0
Carrying amount 31 March 20X2 60.8 77.5
Comparative Depreciation Quarter 1, 20X1 4.0 2.5
Depreciation Quarter 1, 20X2 3.2 2.5

(b) Executive bonus

The revenue for the first interim period has not reached the annual target, so there is
no legal (contractual) obligation to pay the bonus at interim date. At the same time, the
company has historically paid such bonuses based on year-to-date performance where
interim revenue is 50% or more of the annual target. As such, it would appear that a
constructive obligation exists, and a bonus should be accrued for the first quarter based
upon the revenue of the quarter, not the estimate of revenue for the year. Bonus expense
is, therefore, 8% X HK$5 million or HK$400,000, for the first quarter. On March 31 20X1,
the liability for the accrued bonus would be reported as a current liability of HK$400,000.

(c) Re-tooling activity

Because the re-tooling benefits the entity over the entire year, this expense is
accounted for over that period. Also, as the pattern of sales to which the re-tooling
relates is seasonal and can be estimated, it is reasonable to use a units of production-
based approach to allocate the expense to each quarter, which will allocate the expense
in the same proportion as the sales expected to be satisfied across the year. In this
case, we are told that one-half of the order is expected to be satisfied in the third
quarter, leaving the remaining one-half to be met over the remaining three quarters of
the year (one-sixth per quarter). As such, it would seem reasonable to defer 5/6 of the
total amount of the expenditure (HK$1 million) at the end of the first interim period and
recognise that amount in expense across the remaining quarters as follows:

Quarter 2 Quarter 3 Quarter 4

HK$ HK$ HK$
Deferred expenditure 1,000,000 800,000 200,000
(beginning balance)
*Expense 200,000 600,000 200,000
Deferred expenditure 800,000 200,000 0
(closing balance)
*Calculation 1,200,000 * 1/6 1,200,000 * 1/2 1,200,000 * 1/6

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QUESTION 2
(a) Format of interim financial statements compared to annual financial statements

Under HKAS 34, an entity is required to use the same accounting policies and financial
statement headings and subtotals as are used in the most recent annual financial
statements. Additional line items must only be included if their omission would make
the financial statements misleading.

The rationale for this approach is to provide users sufficient information to enable
an understanding of financial position and performance for the interim period,
updating that information provided in the most recent annual report, which is also
available to users. To do so, a degree of consistency in the use of policies, headings and
subtotals is required. At the same time, balancing the costs and benefits of financial
reporting, HKAS 34 allows a lower level of detail to be disclosed in interim financial
reports, reducing the need for interim reports to be formatted identically to the
annual report.

(b) Materiality in interim financial reports

Materiality in interim financial reporting is required to be assessed based on interim

financial data and not on annual data. The goal of interim reporting is to provide
information relevant to an understanding of the financial position as at the end and
performance of the entity for the interim period. The quantitative assessment of
materiality based on the larger totals typically contained in annual financial statements
might result in the non-disclosure of key information and inclusion in summary
disclosures such as ‘other current assets’, which may mislead users.

(c) Impact of the objective of interim financial reporting on techniques and approaches for
recognising, measuring and disclosing information in interim financial reports

The objective of interim financial reporting is to provide financial information about the
entity that is useful in assisting users to understand changes to financial position as at
the end and financial performance for the interim period. When preparing an interim
financial report in accordance with HKAS 34, interim financial reports should contain
only that information that assists users in understanding changes to financial position
and performance of the interim period because users have access to the most recent
annual financial report.

The objective of interim financial reporting has a number of implications for

techniques and approaches to recognition, measurement and disclosure of information
in interim financial reports.

An example of recognition is the manner in which materiality is calculated (based

on interim figures) because if based on annual information, the result might be the non-
disclosure of key information that would be otherwise useful for the stated objective of
interim reporting.

An example of measurement is provisions. In preparing annual financial reports,

determination of the appropriate amount of some provisions might be complex, costly
and time-consuming, often involving the use of the services of outside experts to assist
in the annual calculations. HKAS 34 (Appendix C, which contains various other examples
as well) enables entities when preparing interim reports to reduce time and cost by

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 FINANCIAL REPORTING

updating prior annual provision calculations rather than engaging outside experts to
perform new calculations.

Many key note disclosures need not be included in interim financial reports to
avoid repeating the information contained in the most recent annual report where
those policies are the same as those applied in the most recent annual report. This
includes the going concern basis of reporting and key approaches to measuring
financial statement items, with interim reports more likely to contain disclosures only
where changes to those measurement approaches have taken place in preparing the
interim reports.

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 29
Business
Combinations

CHAPTER TOPIC LIST

29.1 Overview 29.4 Identifying What Is Part of

29.1.1 Scope the Business Combination
29.1.2 Terminology Transaction
29.1.3 Identifying a Business 29.4.1 Acquisition-related Costs
Combination 29.4.2 Deferred Tax Arising from a
Business Combination
29.2 The Acquisition Method
29.2.1 Identifying the Acquirer 29.5 Subsequent Measurement and
29.2.2 The Acquisition Date Accounting
29.2.3 Recognising and Measuring 29.5.1 Recognised
the Identifiable Assets Contingent Liability
Acquired, Liabilities 29.5.2 Contingent Consideration
Assumed and any Non- 29.5.3 Reacquired Rights
controlling Interests 29.5.4 Indemnification Assets

29.3 Measuring Goodwill or a Gain

from a Bargain Purchase
29.3.1 Consideration Transferred
29.3.2 Recognising and Measuring
Goodwill or a Gain from a
Bargain Purchase
29.3.3 Measurement Period
Adjustments

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LEARNING OUTCOMES

PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT

FOR BUSINESS TRANSACTIONS
LO2.07: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: Income Taxes
2.07.07 Account for deferred tax relating to investments in subsidiaries, associates and joint ventures
PRINCIPAL LO4: PREPARE, PRESENT AND APPRAISE GROUP FINANCIAL STATEMENTS WITH
COMPLEX GROUP STRUCTURES
LO4.02: C
 onstruct the financial statements for a group in accordance with Hong Kong Financial
Reporting Standards and statutory reporting requirements: Business combinations
4.02.01 Evaluate and explain a business combination and the difference between acquisition of
asset, and of a business
4.02.02 Analyse the acquisition date of an acquisition and explain when control is obtained to
determine the date of acquisition
4.02.03 Classify the identifiable assets (including intangibles) and liabilities acquired in a business
combination
4.02.04 Apply the recognition principle to identifiable assets and liabilities
4.02.05 Apply measurement basis to identifiable assets and liabilities
4.02.06 Account for contingent consideration initially and subsequently
4.02.07 Explain how to account for acquisition-related costs, including those related to issue of debt
or equity securities
4.02.08 Describe what is part of the business combination transaction and the consideration
4.02.09 Account for measurement period adjustments

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 B usiness Combinations

OPENING CASE

SOLEIL GROUP

T he Soleil Group operates an extensive global logistics network across 600 locations in more
than 50 countries. The group provides a diverse range of transport and logistics solutions
covering road, air, sea and rail to meet global supply chain needs. The ultimate parent entity in
the group is Soleil Limited (Soleil). Soleil is listed on the Hong Kong Stock Exchange.

Soleil is always on the lookout for strategic expansion opportunities. This may involve
acquiring existing businesses to enter new geographical markets, eliminate local competition,
introduce new service offerings to the group’s customers, or improve its back-end operational
capabilities. Soleil is mindful that, to remain a market leader, it needs to invest in technology
ensuring its employees have access to appropriate technology platforms that make it easier
for its people to perform their roles and allowing Soleil to optimise its delivery network and
leverage its online and in-store service offerings.

Soleil is presently conducting due diligence on two possible acquisition targets: Star Reach
Limited (SRL) and Polaris Limited (Polaris). SRL is a junior mobile app development company
that has recently developed a proprietary real-time book-and-track mobile app. Soleil believes
acquiring the app could significantly improve its customer experience and, thus, give it a
competitive advantage to its competitors. Polaris is a boutique courier delivery service owning
several shop fronts in locations that Soleil has observed to directly compete with Soleil-owned
operations.

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OVERVIEW

Entities, including companies, might use merger and acquisition (M&A) activity as a way of
growing. M&A activity might be an effective way of removing competition, creating market
access for products, quickly (or more cheaply) acquiring skills or technology, exploiting
scalability or underperformance, or gaining access to a different geographical market.

M&A activity involves the purchase of potential. This is reflected in an acquirer being willing
to pay more than the current value of identifiable tangible and intangible net assets of the
business acquired. This extra amount paid is goodwill, which is a residual asset that represents
the value of the potential the purchaser sees in the acquiree or in the synergy between the
acquirer and the acquiree.

As many companies undertake some form of M&A activity in their lifetime, it is important to
understand the effect of M&A activity on an acquirer’s financial reporting obligations, financial
performance and financial position. For example, how will Soleil’s business acquisitions affect
the financial statements it prepares? How much ‘goodwill’ does Soleil place on the target
company? Therefore, accountants must know how to account for M&A activity.

HKFRS 3 (Revised) Business Combinations is the main standard that specifies the accounting
at the time a merger or acquisition occurs. In particular, HKFRS 3 (Revised) requires what is
called the ‘acquisition method’ to be applied to a ‘business combination’ irrespective of whether
the combination comes about via a merger or an acquisition. The acquisition method is a way
of dealing with the fact that a business combination involves a group of assets and (usually)
liabilities, and knowing how to account for each of those assets and liabilities at the date of
acquisition is necessary.

In this chapter, you will learn the accounting for business combinations. By the end of
this chapter, you should understand what a business combination is and how to distinguish
between an acquisition of a group of assets or the acquisition of a business. You should be
able identify the date of acquisition and apply the acquisition method at that date to account
for the business combination, including the treatment of acquisition-related costs and
contingent consideration. You should be able to recognise what should be treated as part of
the business combination transaction (including deferred tax implications) and how much was
paid for the business, including in situations when more information comes to light after the
acquisition date.

For simplicity, this chapter adopts a tax rate of 16.5% unless otherwise stated.

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2 9 . 1 OVERVIEW

The accounting for acquisitions that are business combination transactions is addressed in
HKFRS 3 (Revised) Business Combinations. For the purposes of accounting under HKFRSs, a
business combination includes takeover and M&A activity where one of the combining entities
obtains control of the other.

In this section, you will be introduced to the scope of HKFRS 3 (Revised) and some of the
terminology that features commonly in the context of business combinations.

29.1.1 Scope
HKFRS HKFRS 3 (Revised) Business Combinations applies to a transaction or other event that meets the
3(R).2 definition of a business combination, with limited exceptions. A business combination involves
an entity obtaining control of a business and is described further in Section 29.1.3.
Combinations described as ‘true mergers’ or ‘mergers of equals’, those involving only mutual
HKFRS
3(R).App A, entities and those achieved by contract alone can be business combinations within the scope of
HKFRS 3.BC58 HKFRS 3 (Revised).

These business combinations are outside the scope of the accounting specified by HKFRS 3
(Revised):

• A business combination involving entities under common control (‘BCUCC’ or ‘common

control transaction’) is a business combination where the entities involved remain
controlled by the same ultimate party before and after the combination and that control
is not transitory, for example, as in the case of a group restructure. Common control
transactions are arguably different in nature from other business combinations, therefore,
different accounting requirements may be appropriate, as the group’s financial position
and performance does not economically change before and after the combination.

In the absence of an HKFRS specifically addressing the accounting for common

HKFRS
3(R).2, B1, control transactions, some entities elect to apply ‘merger accounting’ to such
HK AG5 transactions (see Chapter 35).

Exhibit 29.1 illustrates an example BCUCC.

• Business combinations by investment entities, where the investment must be

measured at fair value through profit or loss: In some cases, an ‘investment entity’
(e.g. a unit trust or mutual fund) might obtain control of a business through investment
in a subsidiary. Such transactions are outside the scope of HKFRS 3 (Revised) to the
extent HKFRS 10 Consolidated Financial Statements requires the acquired subsidiary to
HKFRS be measured at fair value through profit or loss. Investment entities (including a
3(R).2 definition) are discussed in Chapter 34.

Some expansion activity will not result in an entity gaining control over another entity’s
business. This might occur, for example, when the voting rights acquired are insufficient to give
rise to ‘control’ or when the acquisition involves the purchase of an asset (or a collection of
assets and liabilities) rather than a business. Such activity is not within the scope of HKFRS 3,

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Before restructure After restructure

Parent A Parent A
100% 100%
100%

Company B Company B Company C

100%

Company C

In this example, Company C was wholly-owned by Company B before a restructure.

The restructure involved Parent A acquiring Company C from Company B such that
Company B and Company C are now ‘sister’ companies.

The acquisition of Company C by Parent A from Company B is an example of a business

combination involving entities under common control.

EXHIBIT 29.1 Example of a business combination involving

entities under common control

but is covered elsewhere: HKFRS 11 Joint Arrangements (see Chapter 33); HKAS 28 (2011)
HKFRS Investments in Associates and Joint Ventures (see Chapter 32); or HKAS 16 Property, Plant and
3(R).2 Equipment (see Chapter 7).

HKFRS The accounting for the formation of a joint arrangement in the financial statements of the
3(R).2 joint arrangement is also outside the scope of the business combination standard.

29.1.2 Terminology
An appreciation of the bolded terms is useful to understanding the accounting applicable
to a business combination and whether the transaction is within scope of the HKFRS and
this chapter.

An acquirer is the entity that obtains control of the acquiree. The acquiree must be a
business for the transaction to be termed a business combination, that is, the acquiree must
have an integrated set of activities and assets capable of being conducted and managed for
the purpose of providing goods and services to customers, generating investment income
(such as dividends or interest), or generating other income from ordinary activities. An acquirer
controls the acquiree when the following three features are present from the perspective of
the acquirer: (1) power; (2) exposure, or rights to, variable returns; and (3) the ability to use that
power to affect the amount of the acquirer’s returns.

A business combination is accounted for by applying the acquisition method. This involves:

• Identifying the acquirer;

• Determining the acquisition date (the date on which control is obtained);

• Recognising and measuring the identifiable assets acquired, the liabilities assumed and
any non-controlling interest; and

• Recognising and measuring goodwill or a gain from a bargain purchase.

Where an acquirer obtains control of the acquiree through the acquisition of equity
instruments (e.g. shares), the business combination involves two separate legal entities: the
parent (the acquirer), which is the entity that would normally ‘sit on top of’ or own/control a

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subsidiary and a wholly or partially owned subsidiary (the acquiree), which is the controlled
entity. The parent and subsidiary form a group, which is an economic entity consisting of a
parent and one or more of its subsidiaries for which consolidated financial statements are
normally subsequently prepared by the legal acquirer. The acquired assets and liabilities,
and any goodwill arising on the acquisition, are recognised by the acquirer in its consolidated
financial statements and not directly in its separate financial statements. The preparation and
presentation of consolidated financial statements is addressed in Chapter 30.

Where a business combination is effected through the acquisition of underlying net assets,
the business combination involves one entity (the acquirer) acquiring a business (acquiree) that
is not a separate legal entity but instead is the underlying net assets of an entity. In such cases,
the assets and liabilities acquired, and any goodwill arising on the acquisition, are recognised
by the acquirer directly as part of its financial statements. The acquirer’s financial statements
are not consolidated financial statements because only a single entity is involved.

29.1.3 Identifying a Business Combination

HKFRS HKFRS 3 (Revised) defines a business combination as a transaction or other event in which an
3(R).App A acquirer obtains control of one or more businesses.

To be a business combination, a transaction or other event must have the following

features: a business must be acquired and the acquirer must control the business after the
acquisition.

In practice, a business combination may bring together two or more combining entities
(e.g. two parties combine by setting up a new company). However, this module presumes that
only two parties are involved in any business combination.

29.1.3.1 Acquisition of a Business

A business is an integrated set of activities and assets that is capable of being conducted and
managed by a market participant to:
• Provide goods and services to customers;

• Generate investment income (such as dividends or interest); or

HKFRS 3(R).
App A, B11
• Generate other income from ordinary activities.
HKFRS
3(R).B9 A business may, but does not necessarily need to, also include liabilities. A business
typically consists of three elements:

1. Inputs: Inputs are the economic resources that create or can contribute to creating
outputs when one or more processes are applied to it. For example, the inputs to the
manufacture of a table (the output) would include any design patent, the raw materials
and the organised workforce, tools and machinery to manufacture it.

2. Processes: A process is any system, standard, protocol, convention or rule that, when
applied to an input or inputs, creates or can contribute to the creation of outputs.
Processes include strategic management processes, operational processes (e.g. the
procedure to construct a table at the manufacturing plant) and resource management
processes (e.g. hiring protocols). Processes typically are documented.

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The intellectual capacity of an organised workforce having the necessary skills

and experience and that follows rules and conventions may provide the processes
capable of being applied to inputs to contribute to the creation outputs. Backoffice
administrative systems, such as accounting, billing and payroll are not typically
processes considered to contribute to the creation of outputs because such systems
are not applied to inputs.

3. Outputs: Outputs are the result of inputs and processes applied to those inputs
that provide goods or services to customers and that generate investment or other
income from ordinary activities. Manufactured inventory (e.g. manufactured tables)
is an example of an output. Other examples include agricultural produce (such as
picked grapes) or reports produced by a skilled workforce (such as audit reports or
consultancy advice).

Outputs are not required for an integrated set of activities to qualify as a business; for
HKFRS
3(R).B7, example, a business may be in a development or other early stage where it has not yet started
B8, B12A generating revenue from outputs.

The assessment as to whether a business has been acquired is based on consideration of

the activities and assets acquired in their current state and condition. The focus is on what has
been acquired rather than what the acquirer intends to do with the activities and assets it
acquires. This market participant perspective’ is an objective approach, which is expected to
prevent similar transactions from being accounted for differently. Introducing an acquirer’s
intentions (e.g. if the acquirer intended to scrap the business acquired), while arguably
providing useful information to users of the financial statements, would have introduced
subjectivity to the accounting and could lead to the same acquisition being accounted for
HKFRS
3(R).B8, differently by different acquirers. Under current HKFRSs, the acquirer’s intentions toward the
HKFRS
3.BC21G, assets and liabilities acquired are reflected in the post-business combination accounting (i.e.
BC21K the ongoing accounting) for the assets and liabilities acquired.

A business includes at least an input and a substantive process that together significantly
contribute to the ability to create outputs. That is, not all associated inputs and processes need to
be transferred nor must outputs be present for an integrated set of activities and assets to be
HKFRS considered a business. For example, an acquirer might not acquire the inventory management
3(R).B8,
HKFRS system of another operation (possibly because it intends to apply its own inventory management
3.BC21I system to the products). This does not necessarily mean a business has not been acquired.

Exhibit 29.2 describes some examples of acquisitions of businesses and acquisitions of assets.
When studying these examples, in all instances, the acquirer has acquired inputs (in the form of
assets), and the acquirer in the ‘not a business’ examples has not also acquired accompanying
‘processes’ to convert those inputs into outputs. This could be for reasons as varied as the
acquiree not operating a business or the acquirer not needing to acquire the processes.

Business Not a business

Acquisition of a hotel, including its systems and Acquisition of a hotel building
access to its workforce
Acquisition of the life insurance business arm of Acquisition of life insurance contracts from an
an insurance company insurance company

EXHIBIT 29.2 Examples of acquisition of a business vs acquisition of assets

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So, what is a substantive process? A process is substantive if it is not minor or ancillary

HKFRS
within the context of all the processes required to create outputs. That is, the process must be
3(R).B12D critical to the ability to create outputs. The presence of an organised workforce is an indicator
HKFRS
of a substantive process, and the workforce may be assessed as performing a critical function if
3(R).B12D the acquirer is likely to encounter difficulties in replacing it.

Key Learning Point

The existence of a substantive process distinguishes a business from a set of activities and
assets that is not a business.

HKFRS 3(R).
Exhibit 29.3 identifies features of a substantive process. Hence, these features must also be
B12B–B12C present in the business.

Where activities and assets acquired Where activities and assets acquired do
include outputs: not include outputs:
• the process is critical to continue producing • the process is critical to develop or convert
outputs and acquired inputs into outputs and
• inputs include an organised workforce with • inputs include an organised workforce with
the necessary skills, knowledge or experience the necessary skills, knowledge or experience
to perform that process to perform that process and
or
• the process significantly contributes to the
ability to continue producing outputs and

• the process is unique, scarce, or cannot be • inputs include other assets that the workforce
replaced without significant cost, effort or can develop or convert into outputs
delay in the ability to produce outputs (e.g. intellectual property and other economic
resources and rights that could be used to
develop future outputs, e.g, technology,
in process research and development,
real estate)

EXHIBIT 29.3 Features of a substantive process/business

HKFRS
The continuation of revenue does not on its own indicate that a business has been
3(R).B8A acquired.,

Key Learning Point

In many cases, an integrated set of activities and assets will not be a business if it does
not include an organised workforce with the necessary skills, knowledge or experience to
perform the related processes.

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Illustrative Example 1
Boot Limited (Boot) is a real estate developer and property manager. It purchases
an office building, the floor space of which is fully leased to tenants. As part of the
acquisition, Boot acquires those tenancy leases and assumes the contracts for
outsourced building cleaning and security, which form part of the agreed services under
the tenancy arrangements. The service contracts will continue to be fulfilled by the
existing contractors.

To determine whether it has acquired a business, Boot must assess whether it

has acquired inputs and has at least a substantive process that together significantly
contributes to the ability to create outputs.

Inputs

Boot acquires inputs in the form of the building and lease contracts and acquires a
workforce through the outsourced service contracts. Accordingly, the first criterion (inputs)
for there to be a business is met.

Substantive process

Boot acquires processes in the form of cleaning and security processes performed by the
outsourced personnel.

Boot observes that the activities and assets acquired include outputs in the form of
rental revenues from the tenancy leases. Therefore, for the second criterion (substantive
process) to be met, Boot must have regard to the features of a substantive process
identified in HKFRS 3 (Revised) where outputs are present.

Boot considers the two possible feature sets that demonstrate that the acquired
process is a substantive process (see the left-hand column in Exhibit 29.3):

1. The process is critical to continue producing outputs, and inputs include an

organised workforce with the necessary skills, knowledge or experience to perform
that process. In the context of all the processes to create outputs from the assets
acquired, the cleaning and security processes performed by the outsourced
personnel (the organised workforce) are ancillary or minor compared to processes,
for example, that secure and manage tenants or that collect and process rental
payments or the overall building management. That is, the cleaning and security
processes are not critical to continue producing rental revenues. Accordingly, this
feature set is not met.

2. The process significantly contributes to the ability to continue producing outputs

and is unique, scarce or cannot be replaced without significant cost, effort or delay
in the ability to produce outputs. The cleaning and security processes are unlikely
to be assessed as significantly contributing to the ability to continue to produce
outputs as they are ancillary or minor compared to other relevant processes. As
these processes are commonly available, they are also not unique or scarce and
can likely be replaced without any significant cost, effort or delay. Accordingly, this
feature set is not met.

Consequently, Boot determines that the activities and assets it has acquired does not
include any substantive process.

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Illustrative Example 1 (continued)

As such, Boot concludes it has not acquired a business. Rather, it has acquired
separate assets (lease contracts, building) that must be accounted for under the applicable
accounting standards (HKFRS 16 Leases and HKAS 40 Investment Property). In this example,
Boot also acquired liabilities in the form of obligations under the assumed cleaning
and security services contracts, which also must be accounted for under a relevant
accounting standard.

Illustrative Example 2
Assume Boot takes over the employment contracts of the existing personnel with
responsibility for securing and managing tenants and building operations on a day-to-
day basis. Boot does not acquire the existing software, which manages employee payroll
or tenant details as it intends to migrate these details onto its own systems.

In this case, Boot has additionally acquired leasing, tenant and building management
processes through its ‘acquisition’ of an organised workforce (input) with the necessary
skills, knowledge and experience to perform those processes. Boot determines these
processes, when applied to the inputs acquired, are critical to continue producing rental
revenues. This is because these employees have the ability to secure tenancies for the
acquired building and manage the tenancy (including collecting rentals and resolving
disputes and issues) and the building operations (e.g. utilities, maintenance, cleaning),
which are critical to enable the set of assets acquired to be operated together as
a business.

As such, Boot determines the activities and assets it has acquired include at least one
substantive process. Consequently, in this case, Boot concludes it has acquired a business.

Apply and Analyse 1

Soleil is considering acquiring Star Reach Limited (SRL) primarily to acquire its recently
developed proprietary real-time book-and-track mobile app. Soleil’s due diligence to
date has revealed that SRL has a workforce of four people, three of whom are friends
and co-owners of the company and decide the direction and operation of the company
together on an as-needs basis. Two work mainly on app development, and one has
oversight of the day-to-day responsibilities of running an operation. SRL’s assets and
liabilities are minimal, comprising computers, mobile phones, software and patent and
trade payables. SRL currently only has the single patented product ready for market. It
has another app in the early stages of development, and that app will reward users for
watching advertisements.

The book-and-track mobile app can be customised by company-operators to suit their

operations. SRL plans to monetise the app by licencing use of the app to organisations and
by offering customisation and a helpline service. The founders have recently hired a new
employee with prior relevant marketing and sales experience whose primary responsibility

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Apply and Analyse 1 (continued)

is to secure and manage customers. The product has been showcased at various venues;
however, no one has yet entered into a contract with SRL for its use.

Soleil is considering its options for gaining control of the app. Two alternatives being
considered are purchasing SRL’s equity or offering to purchase the app rather than
licencing it from SRL. If equity in SRL was purchased, the current co-owners would be
bonded to work for the company for a period of five years as part of the purchase terms
and conditions.

Advise Soleil on the applicable accounting if SRL were to purchase rights to the app
versus purchasing SRL’s equity.

Analysis

(i) Purchase of rights to the app

If Soleil were to purchase the app, it would account for the acquisition of the intangible
asset(s), being patented software, initially at cost in accordance with the requirements
of HKAS 38 Intangible Assets (see Chapter 11).

(ii) Purchase of SRL’s equity

The accounting depends on whether, by purchasing the entity, Soleil acquires a
business rather than merely a collection of assets (including the rights to the app) and
liabilities. This assessment is not predicated on whether SRL is currently operating as
a business but on whether Soleil, by purchasing SRL, will acquire an integrated set of
activities and assets that is capable of being conducted and managed for the purpose
of earning a return.

For a business to be present, Soleil must acquire inputs and at least one substantive
process and maybe outputs.

Input(s)

Soleil will acquire inputs in the form of SRL’s assets, including computers, mobile phones,
software, in process research and development (IPR&D) and a patent. Soleil will also
acquire an organised workforce with the necessary skills, knowledge, or experience
to perform that process as an input because the existing employees (including the
co-founders) will continue to work for the company.

Soleil will also acquire liabilities in the form of SRL’s trade payables. However, this is
discounted in the assessment of whether Soleil acquires a business as the existence of
liabilities does not automatically mean a business exists.

Process(es)

Soleil will acquire SRL’s operational process in the form of the activity by its app developer-
workforce for the next five years to develop and market app products using their
intellectual property and available technology. In addition, Soleil will acquire processes
related to other operational, strategic management and human resource decisions made
by the co-owners or to, the extent outsourced under an existing contract, by the accessible
organised workforce.

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Apply and Analyse 1 (continued)

Soleil observes that the activities and assets acquired do not include any outputs
because SRL has not begun generating any revenues from its assets. Therefore, for the
second criterion (substantive process) to be met, Soleil must pay attention to the features
of a substantive process identified in HKFRS 3 (Revised) where outputs are absent (refer
the right-hand column in Exhibit 29.3).

Soleil considers the activities and assets it acquires should include at least one
substantive process because:

• The processes by employees to develop future applications and to monetise the

book-and-track app are critical processes to convert the acquired inputs into
revenues (e.g. marketing processes, customisation processes);

• The acquired inputs include the intellectual capacity of SRL’s organised workforce,
who have the necessary skills, knowledge or experience to perform those
processes, and

• The inputs include in-process development on the advertising reward app that the
workforce can develop or convert into a future revenue stream for the company.

Considering the relevant facts and circumstances, Soleil will acquire a business if it
were to acquire SRL’s equity because Soleil will acquire inputs and at least one substantive
process as part of the acquisition. Consequently, if Soleil were to purchase SRL’s equity
from the current owners, it would account for the acquisition as a business combination in
accordance with the requirements of HKFRS 3 (Revised).

The remainder of this chapter describes how to apply business combination

accounting to the acquisition.

29.3.1.1 The Concentration Test

Concerning the costs and complexity of assessing whether an acquired set of activities and
HKFRS assets is a business, HKFRS 3 (Revised) permits acquirers, if they wish, to evaluate whether a
3(R).B7A business does not exist using a ‘concentration test’. Importantly, the concentration test cannot
and does not conclude whether a business is acquired but is a simplified method of concluding
if it has not (i.e. it is a negative assurance test). If the test is not met, the acquirer must still
consider the assessment described in Section 29.1.3.1 (a detailed assessment).

The concentration test is met (i.e. concludes that an acquired set of activities and assets is
HKFRS not a business) if substantially all of the fair value of the gross assets acquired is concentrated
3(R).B7B in a single identifiable asset or group of similar identifiable assets. HKFRS 3 (Revised) includes
guidance explaining what gross assets are considered in this test (not all assets acquired are
included), how to determine fair value (determined indirectly), and how to identify ‘single’ and
‘similar’ identifiable assets. The test is designed so it should return the same result as that the
acquirer had assessed the acquisition by way of a detailed assessment.

For the purposes of this module, candidates need only be aware that the concentration
test exists.

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29.1.3.2 Acquirer Controls the Business

For business combination accounting to apply, the acquirer must control the business after the
acquisition. HKFRS 10 provides guidance on how to establish whether an entity has obtained
HKFRS control over a business directly through the acquisition of net assets or indirectly through the
10.9 acquisition of equity instruments. Co-control together with other parties is not control.

‘Control’ exists when the following three features are present from the perspective of
the acquirer:

1. Power over the acquiree (the acquired entity or business);

2. Exposure, or rights to, variable returns; and

HKFRS
10.7 3. The ability to use that power to affect the amount of the acquirer’s returns.

Establishing that an acquirer controls a business acquired directly through the acquisition
of net assets would generally be straightforward because the acquirer directly assumes the
rights of ownership of the acquired assets and obligations for the liabilities. Accordingly, the
discussion in this section is more relevant to assessing whether an acquirer controls a business
through the acquisition of equity instruments in another entity.

The ongoing accounting when an entity has control over another entity – whether or not
via a business combination (e.g. Parent A holds 100% of the share capital of newly incorporated
Subsidiary B) – is discussed in Chapter 30. Though the elements of control are discussed in
this chapter, whether control is present is a continuous assessment affecting the ongoing
accounting beyond the business combination determination.

Key Learning Point

As becomes clear in this chapter, understanding whether control exists in a transaction,
which entity has the control, and when control is gained is crucial to the application of
business combination accounting and the financial statements subsequently prepared.
Misidentifying whether control is present can result in financial statements that
significantly misrepresent the economic entity’s results and its financial position. The
assessment of control is made having regard to objective and subjective evidence and as
such is subject to professional judgement.

Power
An acquirer (investor) has power over the acquiree (acquired business/investee) when the
HKFRS acquirer has rights that give it the current ability to direct activities of the acquiree that
10.10 significantly affect the acquirer’s returns (the relevant activities).
HKFRS
10.12, B9 Rights do not have to be exercised for power to be present, but must be substantive and
HKFRS must not solely protective in nature. When an acquirer assesses whether it has power over an
10.BC118 acquiree it must consider also the rights held by other parties.
HKFRS
10.10, B11 Relevant activities would normally be of an operating or financial nature as these are the
HKFRS types of activities that would normally affect an acquirer’s returns. Exhibit 29.4 lists examples of
10.B11–B12 possible relevant activities and decisions an entity could make about relevant activities.

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Examples of relevant activities

• Selling and purchasing of goods or services
• Managing financial assets during their life
• Selecting, acquiring and disposing of assets
• Researching and developing new products or processes
• Determining a funding structure
• Obtaining funding
Examples of decisions about relevant activities
• Establishing operating and capital decisions of the acquiree, including budgets
• Appointing and remunerating an acquiree’s key management personnel (e.g. the CEO) or service
providers and terminating their services or employment

EXHIBIT 29.4 Examples of relevant activities and decisions about relevant activities

An acquirer may be able to direct the acquiree’s relevant activities through various means.
Examples of an acquirer’s rights that can give rise to power over an acquiree include:

• Voting rights of an acquiree through equity instruments (e.g. shares);

• Potential voting rights (e.g. options and convertible notes) of an acquiree;

• Rights to appoint, reassign or remove members of an acquiree’s key management

personnel (e.g. the board of directors) who have the ability to direct the relevant
activities;

• Rights to appoint or remove another entity that directs the relevant activities (e.g. a
management entity);

• Rights to direct the acquiree to enter into or veto any changes to transactions for the
benefit of the acquirer; and

HKFRS • Other rights (such as decision-making rights specified in a management contract) that
10.11, B15 give the acquirer the ability to direct the relevant activities.

Key Learning Point

An acquirer does not need to hold voting rights (through ownership of an acquiree’s share
capital) before the conditions for control can be met.

Substantive Rights
The right must be substantive. That is, the acquirer must have the practical ability to exercise
HKFRS the right, and the rights must be exercisable when decisions about the direction of the relevant
10.B22, B24 activities need to be made. Examples of factors that may mean an acquirer does not have
substantive rights and, therefore, cannot have power over an acquiree include rights that:

• Cannot be exercised because of economic or other barriers (e.g. financial penalties or a

legal prohibition from exercising the right);

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• Require the agreement of more than one party before the right can be exercised
(e.g. the relevant activities are subject to direction by a liquidator, court, receiver,
regulator, administrator or government);

• If exercised, do not benefit the acquirer (e.g. a deeply out-of-the-money share

option); and
HKFRS
10.B23, B24 • Are not currently exercisable (e.g. unvested share options).

An example of a substantive right is an ordinary share entitling the holder to a vote on

relevant activities of the entity. Another example is an in-the-money vested share option for
which the holder has the practical ability to exercise the option.

Rights that are not currently exercisable may still be substantive. As previously mentioned,
regard as to whether the rights are exercisable when decisions about the direction of the
relevant activities need to be made. For example, a deeply in-the-money share option that
vests at a future point in time is not a currently exercisable right and would normally not
be a substantive right as decisions about the direction of the relevant activities need to be
made today. Conversely, a deeply in-the-money share option to acquire a future stake of
another company exercisable in 20 days is not a currently exercisable right but could still be
a substantive right if existing shareholders are not constitutionally able to take any action on
relevant activities in the next 20 days and the holder has the practical ability to exercise that
share option.
Protective Rights
The right must not be solely protective in nature. That is, the right must be not designed to
merely protect the interests of the holder without giving the holder power over the investee,
for example, the right to approve the issue of further equity instruments to new shareholders is
a protective right as the holder can prevent dilution of its share of the entity, but that right
HKFRS
10.14, alone cannot prevent the entity from acting in a manner that might otherwise dilute the value
B26–B27 of that shareholding.

Power with a Majority of the Voting Rights

When an acquiree has a range of operating and financing activities that affect the acquiree’s
returns and when substantive decision making with respect to these activities is required
HKFRS
continuously, it will generally be voting or similar rights that give an acquirer power individually
10.B16 or in combination with other arrangements.

An acquirer holding more than 50% of an acquiree’s voting rights (through ownership of
ordinary shares) would normally have power over the acquiree when:

• The relevant activities are directed by a vote of the holder of the majority of the voting
rights; or

HKFRS
• Most of the governing body members are appointed by a vote of the holder of that
10.B35 majority of the voting rights.

For example, a shareholder holding 100% of the share capital of a limited company
would normally have power over that other entity because, through its voting power, it can
effect whatever changes it wishes (e.g. change in company direction, new executive team
appointments, dividend distributions) to the company.

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Power without a Majority of the Voting Rights

An acquirer may have power over the acquiree even if it holds less than a majority of the
voting rights (de facto control). It regards its other contractual rights, the dominance of its
shareholding and other facts and conditions.

When assessing whether it has control in instances where it does not hold a majority of the
voting rights, the acquirer has other existing rights it (and other parties) hold, for example:

• A contractual arrangement between the acquirer and other vote holders that gives the
acquirer the ability to direct their vote;

• Rights arising from other contractual arrangements (e.g. an arrangement to provide key
management personnel services to the entity); and
HKFRS
10.B38–50 • Holdings of substantive potential voting rights.

The purpose and design of the potential voting right instrument and other involvement
between the acquirer and acquiree is considered, including the acquirer’s apparent
expectations and motives with regard to those holdings. When assessing whether these rights
give the acquirer power over the acquiree, the acquirer must also have the potential voting
rights held by others. For example, if all shareholders held potential voting rights proportionate
to their shareholding and were expected to exercise these rights, the acquirer’s holdings of
HKFRS
such potential voting rights will unlikely change the determination of whether power exists with
10.B47–50 the acquirer.

Where its rights through contractual arrangements are insufficient to enable it to conclude
it has control, the acquirer should consider whether its shareholding is sufficient for it to
conclude it has the practical ability to unilaterally direct the relevant activities of the acquiree. In
evaluating whether it has power over the acquiree, the acquirer must regard the absolute size
of its holding of voting rights and that holding relative to the size and dispersion of holdings of
the other vote holders. It considers:

• How large is its voting block? The greater the proportion of voting rights held, the more
likely the investor has power over the acquiree; and

• How many other vote holders would have to act together, voting as a block, to outvote
HKFRS
the investor? The greater the number, the less likely it is that it will be easy for those
10.B42 other parties to act together.

The acquirer may also need to consider facts and conditions, such as whether other
HKFRS
shareholders are passive in nature as demonstrated by voting patterns at previous
10.B42 shareholders’ meetings. In making this determination, the entity considers its relationships with
the acquiree and other evidence that may indicate it has more than a passive interest in the
HKFRS
acquiree, for example, shared key management personnel or operational dependency
10.B18–B20 indicators.

All relevant facts and circumstances should be considered when assessing whether power
is present. Greater weight is placed on evidence demonstrating an ability to direct the relevant
HKFRS
activities (e.g. appoint key management personnel or direct the entity to conduct transactions
10.B21 benefiting the acquirer).

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Apply and Analyse 2

Indigo Limited (Indigo) acquires 40% of the ordinary shares of Purple Limited (Purple). The
remaining Purple shareholding is held by 12 other shareholders, each holding 5% of the
ordinary share capital. Each ordinary share entitles the holder to one vote on company
matters, including ratifying dividend decisions and approving other relevant activities
of the company. 75% of shareholders must vote in favour to pass a decision for which
a shareholder vote is required (e.g. director elections, executive appointment/removal/
remuneration, share issues or buy-backs).

The following information is available:

• Purple’s records reveal that, historically, only three other shareholders have
participated at meetings. In the past, the other shareholders have generally
assigned their proxy vote to the Chair of the board of directors;

• Four of the six directors of Purple, including the Chair, are also executive directors
of Indigo; and

• A Purple shareholder has a call option to purchase 90% of Indigo’s holding in

Purple. The call option is not exercisable for another two years.

Analyse the evidence and determine whether Indigo has power over Purple.

Analysis

Indigo’s rights to 40% of the voting power of Purple is insufficient to enable Indigo to direct
the relevant activities of Purple because a 75% majority is required to approve decisions
about the relevant activities of the entity. However, Indigo may have de facto control of
Purple having in relation to other relevant facts and circumstances.

Power evidenced by other contractual rights held

Indigo considers whether other rights it or other parties hold would lend themselves to
determining whether it has power over Purple when considered in conjunction with its
shareholding. Indigo observes it has not entered into any contractual arrangements that
would give it power (e.g. an agreement with at least six other shareholders that they will
vote the same way as Indigo or the right to make all human resource decisions).

Indigo has issued a call option giving another party the right to purchase Indigo’s
shares in Purple. Because the call option is not currently exercisable, it is not a substantive
right held by the other party and will not impact Indigo’s assessment of whether it
presently has power over Purple.

Power evidenced by voting power

Indigo considers whether its shareholding relative to the size and holding of that of the
other shareholders is sufficient for it to conclude that it has power. Indigo observes that:

• It holds a substantial portion of the voting rights because it holds 40% of the shares
of Purple;

• Its 40% shareholding gives it significantly more voting rights than any other
shareholder; and

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Apply and Analyse 2 (continued)

HKFRS
3(R). • Six of the 12 other shareholders would have to vote together to outvote Indigo, as
B42(a) a 75% voting majority is required.

Though Indigo holds a large proportion of voting rights of the company, six
shareholders could act together to vote against Indigo (denying it a 75% majority) because
six is not a large number to envisage working together. Likewise, Indigo only needs
six shareholders to vote in the same manner as it has. Therefore, Indigo is unable to
conclusively determine from the absolute size of its holding and the relative size of the
other shareholdings that it has rights sufficient to dominate the voting so as to give it
power over Indigo.

Power evidenced by non-contractual facts and conditions

Because Indigo is unable to conclude from review of the dominance of its 40%
shareholding and its other contractual arrangements, it must consider whether other facts
and conditions support a conclusion of power over Purple. Indigo observes that:

• Nine shareholders are passive investors as demonstrated by their voting patterns

at previous shareholders’ meetings and historically generally assign their vote to
the Chair. As the Chair of Purple is also a director of Indigo, Indigo will unlikely be
able to direct the vote of up to 85% of the shares; and

• Indigo and Purple have several common key management personnel. As Indigo’s
directors are executive directors, they can be expected to operate as de facto
agents for Indigo’s benefit. Through its four common directors, Indigo can steer the
matters that come before shareholders (e.g. by filtering hiring recommendations or
rejecting management operating proposals).

These facts and conditions provide evidence of a relationship with the acquiree that
is more than a passive interest; that is, the evidence suggests that Indigo is likely to have
the practical ability to unilaterally direct the relevant activities of Purple following the
acquisition.

On balance, with all relevant facts and conditions considered, Indigo concludes it has
power over Purple (the current ability to direct relevant activities of Purple).

Exposure to Variability in Returns

An acquirer is exposed to variability in returns from its involvement with a business when its
HKFRS
10.15 returns from its involvement have the potential to vary positively and/or negatively as a result
HKFRS of that business’s performance. Generally, greater exposure is associated with the likelihood
10.B20 that the investor has control.

Consistent with the Conceptual Framework for Financial Reporting (2018) (Conceptual
HKFRS
10.B56 Framework), variability is assessed by reference to the substance of the arrangement rather
HKFRS than the legal form of the return. Exhibit 29.5 illustrates examples of returns and variability in
10.B56–57 those returns.

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Examples of returns Variability in the return

Fixed interest payments on a bond Despite being fixed payments, variability exists in
the return as the holder is exposed to the risk that
the entity is unable to make the payment
A fixed amount for performance fees for Despite the fee being for a fixed amount,
managing assets of the acquiree variability exists in the return as the holder is
exposed to performance risk of the acquiree,
which may affect the acquiree’s ability to
pay the fee
Dividends Variability exists in the return where the amount
of dividends is dependent on the acquiree’s
performance
Residual interest in net assets on liquidation Variability exists in the return as the extent of any
residual interest is dependent on the acquiree’s
performance

EXHIBIT 29.5 Examples of returns and variability in those returns

Ability to Use Power to Affect Returns

HKFRS
To have control, an acquirer must have the ability to use its power to affect the acquirer’s
10.17 returns from its involvement with the acquiree. That is, control requires a link between power
and returns.

An acquirer has the ability to use that power to affect the acquirer’s returns from its
HKFRS
involvement with the acquiree even where it has delegated its decision-making authority in
10.B58–59 whole or in part to another entity subsequent to the acquisition. For example, an acquirer has
the ability to use its power to affect its returns from its involvement with an acquiree when it is
able to make decisions about how much the acquiree declares as a dividend.

In some cases, the authority to direct relevant activities of the acquiree may reside with
another party. For example, consider the case of a managed fund where common practice is
for the fund to be established, marketed and managed by the fund manager (or its related
parties). A fund manager normally has wide discretion in deciding where/how to invest the
funds within the parameters of the fund’s investment mandate, and its related parties may be
also some of the unitholders of the fund. In many instances, the fund manager’s remuneration
is variable, set as a percentage of the funds under management, and the fund arrangements
may make it difficult or impossible for unitholders to remove the fund manager from its duties.
It is necessary to determine whether the investor acquiring units in the fund has rights that
give it power and, if so, whether having regard to the delegated decision making to the fund
manager, the investor retains the ability to use its power to affect its returns or whether it has
given up that ability. This will depend on an evaluation of the relationship among the investor,
the fund and other parties such as the other unitholders or the fund’s related parties.

An agent to whom decision making about relevant activities has been delegated (e.g. the
fund manager) is normally able to wield power to affect returns, but where the agent is acting
on behalf of the investor, the agent does not ‘have power’ and as such does not control the
entity. When determining whether an entity to whom decision making has been delegated

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(e.g. the fund manager) is an agent of the investor (e.g. the acquirer/ fund unitholders), the
following is considered:

• The scope of the entity’s decision-making authority over the investee. Over what
activities does the entity have decision-making authority and how much discretion
does it have in conducting these activities? Was the entity involved in the design of
the acquiree?

• The rights held by other parties. Do other parties (including the acquirer) hold rights
that can affect the ability of the entity to direct the relevant activities of the acquiree,
for example, rights to restrict the entity’s discretion by requiring its decisions to be
approved or rights to remove the entity (often called removal rights or kick out rights)?
Where removal rights are held, how many parties need to work together to effect a
removal of the entity?

• The remuneration to which the entity is entitled in accordance with the remuneration
agreement(s). The greater the magnitude of, and variability associated with, the
remuneration, the more likely the entity is a principal rather than an agent. An agent’s
remuneration will evidence compensation commensurate to the services rendered and
terms, conditions and payment that is usual in an arms’-length transaction for such
services; and

• The entity’s exposure (type and extent) to variability of returns from other interests that
it holds in the investee. Is the entity’s variability of returns from these holdings (and
HKFRS
remuneration) of such significance that the entity is more likely to be operating as a
10.B60–B72 principal rather than an agent?

Not all the preceding linkages are equal, but all should be considered, weighted as
HKFRS
10.B61, B65, appropriate to the situation under consideration. HKFRS 10 clarifies that the existence of
Application variable remuneration or other interests is not necessarily conclusive against the entity being
Examples
13–16 an agent; the exposure must be sufficiently significant to reach this determination. (I.e. in the
case of the fund manager previously described, the examples accompanying HKFRS 10 clarifies
that, in many instances, the fund manager is acting as an agent and does not control the entity.)

Where the entity is determined to be acting as an agent of the acquirer, the acquirer
continues to have the ability to use its power to affect the acquirer’s returns from its
involvement with the acquiree. Conversely, if the entity to whom the decision-making authority
has been delegated is acting as a principal, the acquirer will fail this element and will not control
the acquiree.

The preceding discussion has been presented from the viewpoint of the acquirer/investor.
However, Chapter 30 clarifies that the control relationship is important for determining
whether an entity is a parent. Therefore, the entity to whom decision making has been
delegated may be acting as a principal and have control; consequently, it prepares consolidated
financial statements even in the absence of any equity investment. Therefore, each entity
preparing financial statements must make its own assessment of control over other entities
and not just the acquirer/investor.

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Illustrative Example 3
Saturn Limited (Saturn) purchases 100% of the share capital of Pluto Limited (Pluto).

Pluto’s board of directors contracts out the day-to-day executive management of the
business to a third-party company, Starlight Limited (Starlight). Starlight reports monthly
on the business’s performance to the board of directors and must seek board approval for
any proposed expenses or asset purchases over a specified threshold. Pluto pays the third
party a fixed sum as remuneration for its services. The contract is for an initial five-year
period but can be terminated by either party on serving three months’ notice.

When assessing whether Saturn controls Pluto, Saturn must know whether it can use
its power to affect the amount of its returns. It makes this assessment in part by evaluating
whether it is a principal in the relationship. Here, the day-to-day financial and operating
decision making of Pluto has been outsourced to Starlight, which might instead be acting
as the principal. Should Starlight be determined to be acting as a principal, this would limit
Saturn’s ability to use its power to affect the amount of its returns.

In this case, Saturn assesses it is operating as a principal and that Starlight is operating
as its agent. This is primarily because Saturn (a single party) holds substantive rights
through its equity shareholding to enable it to compel the removal of Starlight without
cause. In addition, the following provides evidence that Starlight is operating as an agent:
• Starlight receives a fixed remuneration rather than, for example, payment that is
variable based on Pluto’s performance; and

• Starlight manages the company following the strategy set by the board of directors
and has to seek approval for expenditures above a specified threshold rather
than, for example, having wide discretionary decision-making powers over Pluto’s
relevant activities.

Key Learning Point

When determining whether control exists, the acquirer must have regard to not only what
rights it has and its ability to exercise those rights, but also rights and other arrangements
held by other parties.

Exhibit 29.6 summarises the two aspects that must be present for an acquisition to be a
business combination and the resultant applicable accounting.

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Does the acquirer

control the business?
• Power Recognise identifiable net
• Variable returns assets acquired directly in the
Does it give YES Account as a
YES • Ability to use power acquirer’s accounts at fair
access to a business combination
to affect returns value.* Recognise goodwill or
business? under HKFRS 3(R)
Acquisition of assets gain on bargain purchase.
NO (see Sections 2–4)
and liabilities • Inputs
• Processes NO Account for the assets and liabilites under
• Outputs applicable HKFRS (e.g. HKAS 16, HKAS 38)

Does the acquirer

control the business?
Recognise identifiable net
• Power assets acquired at fair value in
• Variable returns Account as a the consolidated financial
Does it give YES • Ability to use power YES
business combination statements.* Recognise
access to a to affect returns under HKFRS 3(R) goodwill on consolidation or
Acquisition of equity business?
NO gain on bargain purchase.
instruments • Inputs (see Sections 2–4)
• Processes NO Account for the investment under the
• Outputs applicable of HKFRS 9, HKFRS 11 or HKAS 28
(see Chapters 12, 32 and 33)
* Some exceptions

EXHIBIT 29.6 Summary of the accounting

Knowledge Check Questions

Question 1
Polaris Limited (Polaris) is a boutique courier delivery service owning several shopfronts
in locations that Soleil Limited (Soleil) has observed to directly compete with Soleil-owned
operations. Polaris has been providing its services for 10 years. On 1 December 20X0,
Soleil enters into a contractual arrangement with Polaris’s owners to purchase 80% of the
voting rights of Polaris through the acquisition of 80% of the share capital of the company.
Under the terms of the arrangement, Polaris’s employees, including senior management,
will continue working for the company, as employees of Soleil. Soleil does not intend to
rebrand Polaris, but will integrate Polaris’s backroom systems into Soleil’s as necessary to
enable Polaris to take advantage of more servicing opportunities.
Determine whether a business combination exists.

Question 2
Identify which of the following transactions is within the scope of HKFRS 3 (Revised).
A Alpha Limited (Alpha) is a manufacturer. It purchases a building for HK$20 million. The
building is currently tenanted and Alpha intends to continue renting out the building.
B Tequila Limited (Tequila) transfers control of its partly-owned operating subsidiary Gin
Limited to its wholly-owned operating subsidiary Aperol Limited.
C Amalfi Limited (Amalfi) restructures its operations by incorporating a new wholly-owned
company, Azur Limited (Azur). Azur acquires 100% of the equity of Amalfi’s wholly-owned
subsidiary operating Cinque Limited (Cinque) from Amalfi.
D Beta Limited’s (Beta) wholly-owned subsidiary, Big Bucks Limited (Big Bucks), is an
investment entity. Beta acquires a 51% interest in the HKSE-listed company, Xylon
Limited (Xylon). Beta intends to transfer control of Xylon to Big Bucks in the future.

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Knowledge Check Questions (continued)

Question 3
Candy Limited (Candy) acquires 80% of the Class B ordinary shares of Sweetie Limited
(Sweetie). The preference shares give Candy the right to a preferential dividend and
the right to vote on the special company resolutions, such as the further issue of new
securities. Class B shares do not have a right to vote on ordinary company resolutions,
such as the appointment of key management personnel, auditors or dividend. Determine
whether Candy controls Sweetie in the absence of any further information.

Question 4
First Class Limited (First Class), a multinational hotel group, acquires five operating hotels
from the struggling hotelier Bekpax Limited (Bekpax). As part of the acquisition, First Class
acquires the hotel buildings and their fixtures and fittings, the customer lists for the hotels
and its operational and some human resource processes and systems. First Class also
takes over the employment contracts of the hotel workforce including its managerial staff.
First Class intends to integrate these hotels into its portfolio by re-outfitting them to be
consistent with the First Class brand and by transferring payroll and other systems (e.g. the
room booking system) on to the group’s existing systems.
Evaluate whether First Class has entered into a business combination.

2 9 . 2 THE ACQUISITION METHOD

HKFRS 3 (Revised) requires the acquisition method be applied to all business combinations
within the scope of the HKFRS.
Generally stated, the acquisition method requires the acquirer to recognise all identifiable
assets acquired and liabilities assumed in the business combination at a value commensurate
to that placed on the item by a market participant (generally, fair values) on the acquisition
date and requires the acquirer to recognise goodwill (or a gain on bargain purchase) for the
difference between this value and the fair value of the consideration transferred.

Applying the acquisition method involves the following steps:

• Identifying the acquirer (who);

• Recognising and measuring the identifiable assets acquired, the liabilities assumed and
any non-controlling interests in the acquiree (what);

• Determining the acquisition date (when);

• Determining the consideration transferred (how); and

• Recognising and measuring goodwill or a gain from a bargain purchase by comparing

HKFRS the consideration transferred to the assets acquired, liabilities assumed and the share
3(R).5 of the business attributable to non-controlling interests.

This section discusses the first three steps: the Who, What and When of the transaction.
The last two steps addressing the How is discussed in Section 29.3. (The Why precedes the
transaction and is outside the scope of financial reporting.)

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29.2.1 Identifying the Acquirer

The first step in every business combination is identifying the acquirer, concluding on the
HKFRS question ‘Who has acquired a business?’ The acquirer will always be one of the combining
3(R).6 entities, including in instances described as ‘true mergers’ and ‘mergers of equal’. The acquirer
is the entity that gains control over the business acquired and often will be the entity holding
the ownership interest in the other entity (see Section 29.1.3.2). Identifying the acquirer can
become even more complex when more than two entities are involved in the business
combination, for example, a spin-off of part of the entity’s operations to a newly listed entity.

Under HKFRSs, the acquirer is treated as the continuing entity. Because the acquirer is the
continuing entity, much like in the acquisition of an item of plant, the acquirer’s pre-existing
assets and liabilities are not remeasured; but those of the acquiree are, reflecting the value
placed on them by the acquirer. That is, the transaction of acquiring a business is an insufficient
basis for triggering a remeasurement of all the pre-existing items held by the acquirer.

In many transactions, identifying the acquirer will be straightforward. HKFRS 3 (Revised)

provides guidance that, in a business combination effected primarily by:

HKFRS • The transfer of cash or other assets or by incurring liabilities: The acquirer is usually the
3(R).B14 entity that transfers the cash or other assets or incurs the liabilities; and
HKFRS
3(R).B15 • The exchange of shares: The acquirer is usually the entity that issues its shares.

For example, Soleil entered into a contractual arrangement with Polaris’s owners
to purchase 80% of the share capital of Polaris. Soleil is the acquirer (of Polaris) in that
arrangement, meaning Soleil is the entity that transfers cash or other assets to the existing
owners of Polaris in exchange for their equity.

Where identification of the acquirer might not be so straightforward (e.g. in a true merger),
HKFRS 3 (Revised) also suggests the acquirer is:

HKFRS • Usually the combining entity whose relative size is significantly greater than that of the
3(R).B16 other combining entity. ;
HKFRS
3(R).B17 • The combining entity that initiated the combination.

All relevant facts and circumstances must be considered in assessing which entity is the
acquirer. For example, where a combination is effected by the exchange of shares between the
acquirer and acquiree, one must regard each combining entity’s interests in the relative voting
rights and composition of the governing body and senior management after the business
HKFRS combination and the terms of the exchange of equity interests (the acquirer usually being the
3(R).B15 entity that paid a premium for the shares).

29.2.2 The Acquisition Date

Identifying the acquisition date responds to the question ‘When does the acquisition occur?’

The acquisition date is the date from which the acquirer starts accounting for the acquired
assets and liabilities assumed. That is, the accounting for the business combination occurs on
this date, which requires understanding the value of consideration transferred, assets acquired
and liabilities assumed on this date. The correct identification of the acquisition date is crucial
to faithfully representing the value of the assets and liabilities acquired to an acquirer’s owners.

The acquisition date of a business combination is not a particular date in the acquisition
process (e.g. signing date or settlement date), but is the date on which the acquirer obtains

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HKFRS control of the acquiree. In a business acquisition, the acquisition date is generally the closing
3(R).8
date of the deal; that is, the date on which the acquirer legally transfers the consideration,
HKFRS
3(R).9 acquires the assets and assumes the liabilities of the acquiree. However, as usual, all facts and
circumstances must be considered because the acquisition date may be earlier or later than
the closing date. For example, a contractual arrangement might provide that the acquirer
HKFRS
obtains control of the acquiree on a date before the closing date; in such an instance, the
3(R).9 acquisition date would precede the closing date.

Illustrative Example 4
On 1 December 20X0, Soleil enters into a contractual arrangement with owners of Polaris
to purchase 80% of the share capital of Polaris. The terms of the arrangement provide
that an initial payment of HK$5 million will be made at that time. Settlement will occur
following a period in which Solaris is able to request more information about Polaris
from the business to enable it to conduct further due diligence on the entity.

Settlement will be at 10am on 1 January 20X1, at which time Soleil and Polaris’s owners
will exchange instruments. That is, at this time, Polaris will transfer or become obligated for
the remainder of the contracted consideration to Polaris’s owners and Polaris’s owners will
transfer ownership of their equity to Soleil.
In this example, the acquisition date is 1 January 20X1. At this time, Soleil obtains the
ability to direct the relevant activities of Polaris and is affected by its performance through
the rights it holds via share ownership of the entity.

In this example, 1 December 20X0 is not the date of control because though Soleil may
have some exposure to Polaris’s performance at this time (e.g. the contract may provide
for a fixed payment that was based on estimates of Polaris’s future cash flows, but Polaris
suffers a significant downturn in operations or damage to its stores before settlement), it
does not have any current ability to direct Soleil’s relevant activities.

A different conclusion might have been reached if, for example, the parties had agreed
to terms giving Soleil non-contestable management rights before settlement such that it
gains control over Polaris at an earlier point in time (review Section 29.1.3.2).

29.2.3 Recognising and Measuring the Identifiable Assets Acquired,

Liabilities Assumed and any Non-controlling Interests
In a business combination, the acquirer gains control of additional assets and might also
assume additional liabilities. Applying the acquisition method requires identifying and valuing
the identifiable assets and liabilities acquired and any non-controlling interests. The value
attributed to the assets assumed and liabilities acquired form the initial cost of the assets and
liabilities in the books of the acquirer (if net assets were acquired directly) or its consolidated
financial statements (if the acquiree’s equity instruments were acquired and a parent-
subsidiary relationship exists; see Chapter 30) and are part of the determinants of any goodwill
or gain on bargain purchase arising on the acquisition.

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29.2.3.1 Recognition Principle

In applying the acquisition method to a business combination, an acquirer recognises the
following items on the acquisition date, separately from goodwill:

• All identifiable assets (whether tangible or intangible) acquired;

• All liabilities assumed; and

HKFRS
3(R).10, B31 • Any non-controlling interest in the acquiree.

As noted earlier, recognition may be directly in the acquirer’s own financial statements or in
its consolidated financial statements.

To qualify for recognition, the assets and liabilities must:

• Meet the definition of an asset or liability on the acquisition date; and

HKFRS 3(R).12,
• Be part of what the acquiree (or its former owners) transfers as part of the business
HKFRS 3.BC112 combination, rather than the result of separate transactions.

Limited exceptions to this recognition principle apply. See Section 29.2.3.3.

The recognition criteria emphasises measuring the acquisition-date values of the assets
acquired and liabilities assumed (rather than the cost of the acquiree) and accounting for each
HKFRS component determined to be part of the business combination (or otherwise) in accordance
3.BC114–BC115 with its economic substance. More assets (and possibly liabilities) will likely be recognised by an
acquirer following a business combination than those recognised by the acquiree prior to the
business combination.

The acquired assets and liabilities might be presently recognised or unrecognised in the
acquiree’s statement of financial position. Recognised identifiable assets typically include
cash, inventory, receivables, property, plant and equipment, and some intangible assets.
Unrecognised identifiable intangible assets may include internally developed trademarks
and customer lists. Acquired assets and liabilities include deferred tax assets and liabilities
relating to the acquiree’s assets and liabilities; these may be recognised or unrecognised by the
acquiree, for example, the acquirer may determine that unrecognised tax losses of the acquiree
are recoverable and consequently should be recognised.

Any value attributed in determining the acquisition price to items that do not qualify as assets
HKFRS
at the acquisition date or are not separately identifiable is subsumed into goodwill. Examples
3(R).B37–B38 include the value an acquirer may place on an assembled workforce or on potential new contracts.

In many business combinations, the tangible assets acquired will be recognised in the
acquiree’s statement of financial position. However, as discussed in Chapter 11, HKAS 38
Intangible Assets prohibits various intangible assets from being recognised in those financial
statements. Despite this, in a business combination, these intangible assets might now be
recognised. The identification (and measurement) of intangible assets that must be separately
recognised in a business combination is one of the more onerous aspects of the accounting for
a business combination.

Identifiable Intangible Assets in a Business Combination

An intangible asset is separately recognised in a business combination if it meets the definition
HKFRS 3(R).B31, of an asset and is identifiable. An intangible asset is identifiable if it meets either the
HKAS 38.12 contractual-legal criterion or separability criterion.

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These intangible assets are separately recognised by the acquirer when acquired in a
business combination, whether or not the asset is separately recognised by the acquiree who
recognises these assets in accordance with the recognition criteria specified by HKAS 38
(see Chapter 11). Under HKAS 38, an intangible asset can only be recognised if that expected
future economic benefits that are attributable to the asset will probably flow to the entity and
its cost can be reliably measured. For these criteria, as explained in Chapter 11, HKAS 38
prohibits the recognition by the acquiree in its own financial statements of research costs,
internally generated brands, mastheads, publishing titles, customer lists and items similar in
substance. An intangible asset acquired in a business combination, however, always satisfies
HKAS
38.21, 33, the probability recognition criterion and, where it meets the contractual-legal or separability
54, 63 criterion, the reliable measurement criterion.

The contractual-legal criterion is met if the acquirer controls assets held under contractual
rights (e.g. under a licencing arrangement) or legal rights (e.g. a trademark protected through
registration with the government or copyright). The contractual-legal criterion can be met even
if the asset is not transferable or separable from the acquiree or from other rights and
obligations. For example, Soleil recognises as separate assets a technology patent owned by
HKFRS
Polaris and any licence granted over that patent even if the patent and the related licence
3(R).B32 cannot be subsequently sold independently of each other.

The separability criterion is met where an acquired intangible asset is capable of:
• Being separated or divided from the acquiree; and
HKFRS
3(R).B33,
HKAS • Being sold, transferred, licenced, rented or exchanged, individually or together with a
38.12 related contract, identifiable asset or liability.

For example, though a customer relationship may be separable only in conjunction with
HKFRS
other assets or liabilities (e.g. a bank loan), the customer relationship can still meet the
3(R).B34 separability criterion to qualify as an identifiable intangible asset. (The definition of an asset
must be met before the relationship is recognised separately in applying the acquisition
method: The acquirer would still need to be able to control future economic benefits associated
with the relationship.)

When evaluating separability, an acquirer does not consider its intention to sell, licence or
HKFRS
exchange the intangible asset, but does consider whether evidence of exchange transactions
3(R).B33 for similar assets exists even if those transactions occur only infrequently.

Exhibit 29.7 lists examples of identifiable intangible assets acquired in a business

combination and the basis on which the identifiability criteria is normally met. Assets satisfying
the ‘contractual-legal’ criterion may be separable or, less commonly, fail the contractual-legal
HKFRS
3(R). basis but meet the separability criterion. In some cases, the asset could fail both criteria or the
IE16-IE44 intangible item might not meet the definition of an asset.

An entity would not normally have a legal or contractual right to a customer list. However,
such lists are commonly separately recognised in a business combination as customer lists
are frequently licenced or sold to other parties, meaning the separability criterion is met as
the list can be separated from the business and there is evidence of an exchange market for
similar assets (even if the list is considered to include unique data). Not all such lists qualify for
recognition, for example, a customer list where the acquirer is prohibited from monetising or
sharing the list cannot be said to be separable.

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Asset Basis
Trademarks, trade names, service marks, collective marks and certification marks Contractual
Trade dress (unique colour, shape or package design) Contractual
Newspaper mastheads Contractual
Internet domain names Contractual
Non-competition agreements Contractual
Customer lists Separable
Order or production backlog Contractual
Customer contracts and related customer relationships Contractual
Non-contractual customer relationships Separable
Plays, operas and ballets Contractual
Books, magazines, newspapers and other literary works Contractual
Musical works, such as compositions, song lyrics and advertising jingles Contractual
Pictures and photographs Contractual
Video and audio-visual material Contractual
Licensing, royalty and standstill agreements Contractual
Advertising, construction, management, service or supply contracts Contractual
Construction permits Contractual
Franchise agreements Contractual
Operating and broadcast rights Contractual
Servicing contracts, such as mortgage servicing contracts Contractual
Employment contracts Contractual
Use rights, such as drilling, water, air, timber cutting and route authorities Contractual
Patented technology Contractual
Computer software and mask works Contractual
Unpatented technology Separable
Databases, including title plants Separable
Trade secrets, such as secret formulas, processes and recipes Contractual

EXHIBIT 29.7 Example identifiable intangible assets

Exhibit 29.7 identifies an employment contract as an intangible asset that arises from
contractual rights. This asset is different to the assembled workforce. Although individual
employees might have employment contracts with the employer, the collection of employees
does not have an employment contract. As such, the assembled workforce asset does not arise
from contractual or legal rights as the acquirer does not have any contractual or legal right
(or control) over the future economic benefits inherent in that workforce’s efforts. Because a
HKFRS business cannot continue to operate without disruption after transferring an assembled
3.BC178 workforce, it also fails the separability criterion. Whether an asset exists in the first instance is
also questionable because an entity does not usually have sufficient control over the expected

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 FINANCIAL REPORTING

future economic benefits arising from an assembled workforce for it to meet the definition of
an intangible asset. (Note, though an intangible asset may be identifiable because of
materiality, it might be less common to see such separately recognised in a financial report.)

Sometimes, in an acquisition, the acquirer in effect reacquires a right granted to the

acquiree that may or may not have been previously recognised by the acquirer in accordance
with HKAS 38. For example, a franchisor who purchases the operations of its former franchisee
will reacquire the rights granted to the former franchisee to use the franchisor’s trade name.
These reacquired rights are identifiable intangible assets. Section 29.2.3.3 explains how they
are measured and accounted for.

In-process research and development (IPR&D) may qualify for separate recognition in a
HKAS
business combination. Costs spent on IPR&D following the acquisition are capitalised or
38.42 expensed in accordance with HKAS 38 even if there were IP ‘R’ costs capitalised on acquisition.

Key Learning Point

The list in Exhibit 29.7 highlights the range and diversity of possible recognisable intangible
assets in a business combination. Effort should be made to distinguish each asset to
faithfully represent the nature of the economic resource controlled rather than subsuming
it within goodwill. Failure to do so could result in misleading financial statements, including
the identification of goodwill rather than a gain on bargain purchase.

Key Learning Point

In practice, just because assets and liabilities are recognised by the acquiree does not
automatically mean the acquirer should recognise them, for example, the acquiree may
prepare financial statements in accordance with different accounting policies or may
have recognised assets or liabilities in error. The acquirer should evaluate whether the
conditions for recognition, including whether the definition of an asset or liability is met,
are met.

Classification of Assets Acquired and Liabilities Assumed

With limited exception, assets and liabilities recognised in a business combination are classified
(or designated) on the acquisition date as necessary to apply other HKFRSs. The classification is
HKFRS
unimportant for business combination accounting but is relevant to the subsequent accounting
3(R).15 applied by the acquirer to those assets and liabilities.

HKFRS
The classification is made based on the contractual terms, economic conditions, operating
3(R).15 and accounting policies, and other relevant conditions existing at the acquisition date. This
could result in differences between the classification applied in the acquiree’s financial
statements and the classification in the acquirer’s financial statements. For example, HKFRSs do
not permit an entity to change certain determinations made on initial recognition even where
conditions have changed, for example, whether an embedded derivative should be separated
from its host contract.

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One exception to this ‘at acquisition date’ principle exists: A lessor classifies a lease on the
basis of the contractual terms and other factors at the lease contract inception (see Chapter 9
to review how to make this classification). Where a modification that changes the lease
HKFRS
classification has occurred, the lessor bases its classification on the contractual terms and other
3(R).17 factors at the date of that modification. That is, in many cases, the acquirer could expect to
continue the HKFRS 16 classification determined by the acquiree.

Illustrative Example 5
As part of its acquisition of Ah Moy Limited (AML), Ro Tan Limited (RTL) gains control of
a parcel of shares traded on the Hong Kong Stock Exchange. AML has classified these
shares as ‘fair value through profit or loss’ in its financial statements.

RTL observes it similarly holds investments in listed shares, and it has classified its
shareholdings as ‘fair value through other comprehensive income’. For this reason, it
determines to similarly classify the listed shares acquired in the business combination.

Apply and Analyse 3

As part of its acquisition of Ai Wei Limited (AWL), Ro Tan Limited (RTL) acquires a head
office building. The building is surplus to RTL’s requirements as RTL intends to relocate
AWL’s head office staff and operations onto its existing premises. RTL’s management plans
to lease the building to tenants under operating leases.

Determine how RTL should classify the building on initial recognition.

Analysis

RTL cannot adopt the classification adopted by AWL in its financial statements of the
building as owner-occupied property. This is because RTL must base its classification on
the contractual terms, economic conditions, operating and accounting policies, and other
relevant conditions existing at the acquisition date. As RTL intends to generate a return
from the building via rents rather than use it as a head office building, RTL should instead
classify the building as investment property. Accordingly, RTL should subsequently apply
the fair value basis or cost basis specified by HKAS 40 Investment Property to measuring
the building, consistent with the accounting policy RTL has adopted for other investment
property in the same class.

29.2.3.2 Measurement Principle

HKFRS Generally, under the acquisition method, the identifiable assets acquired and the liabilities
3(R).18 assumed are measured at their acquisition date fair values. This enables users of the financial
HKFRS statements to better assess the cash-generating abilities of the identifiable net assets acquired
3.BC203 and to hold management accountable for the resources entrusted to it. HKFRS 13 Fair Value
Measurement specifies how fair value is to be determined (see Chapter 4). Remember that fair
value of an asset assumes its highest and best use by market participants; this principle
continues to apply in valuing the acquired assets even if the acquirer intends to use the asset

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 FINANCIAL REPORTING

HKFRS
defensively by preventing others from accessing it, for example, land purchased to prevent a
3(R).B43 competitor from using that site.

There are limited exceptions to valuing the acquired net assets at fair value (see
Section 29.2.3.3).

In practice, the carrying amount of various assets and liabilities at the acquisition date is
unlikely to be the same as their fair value. For example, the carrying amount of inventory or
property measured at cost is unlikely to be the same as its fair value. Similarly, the carrying
amounts of receivables or bank loans may differ from their fair values because of different
bad debt expectations or movements in market interest rates. However, for the purposes of
illustration, unless otherwise stated, this module adopts the following simplifications:

• The carrying amount of assets and liabilities at acquisition date can be equal to their
fair value; and

• Assets and liabilities are described as measured at fair value on acquisition, without
explicit acknowledgement that an exception from fair value measurement might apply
to certain assets and liabilities.

29.2.3.3 Exceptions to Recognition and Measurement Principle

There are limited exceptions to the requirement to recognise identifiable assets acquired
and liabilities assumed in a business combination at their acquisition date fair values. In most
instances, this is because, for various reasons, HKFRS 3 (Revised) requires the measurement
in other topic-specific HKFRSs that specify recognition and measurement requirements not
necessarily based on fair values be applied instead. Exhibit 29.8 summarises these exceptions.

Deferred Tax Assets and Deferred Tax Liabilities

The acquiree will have recognised deferred tax assets and deferred tax liabilities relevant to
its temporary differences and tax loss position. However, Chapter 19 indicates that there is
an initial recognition exemption from recognising certain temporary differences and only tax
losses that the acquiree considers probable of use are recognisable.

In addition, on applying business combination accounting, more intangible assets may be

recognised and the carrying amounts of the acquired assets and liabilities are reset to fair value
(or another basis as described in Exhibit 29.8).

So, when applying business combination accounting, the acquired deferred tax balances
must be reviewed and not simply carried across as there may be:

• Existing unrecognised temporary differences that now need to be recognised;

• More (or less) tax losses recognisable as the acquirer’s assessment of the recoverability
of those losses could differ to that of the former owners; and/or

• New temporary differences to recognise, reflecting the requirement to recognise all

identifiable net assets acquired and the carrying amount reset.

The tax consequences of effecting a business combination via a purchase of the net assets
of the business versus purchasing the equity interest in that operation may differ. Generally,
the tax base of assets and liabilities acquired via gaining control of the entity to which they
belong will not be reset on the change of ownership. However, those tax bases may be reset if
the assets and liabilities were acquired directly. So, care should be taken to understand the tax
impacts of the business combination.

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Exception relates to: HKFRS 3 requirement

Contingent liabilities Recognise a contingent liability assumed in a business
combination if the contingency is an unrecognised present
obligation that arises from past events and its fair value can be
reliably measured (see Chapter 18).
HKFRS The acquirer measures the contingent liability at its acquisition-
3(R).22-23 date fair value.
Leases in which the acquiree is Recognise the lease liability and right-of-use asset in accordance
the lessee with HKFRS 16 Leases.
Measure the lease liability at the present value of the remaining
lease payments as if the lease were a new lease at the
acquisition date (see Chapter 9).
HKFRS
Measure the right-of-use asset at the same amount as the lease
3(R).28A- liability, adjusted to reflect favourable or unfavourable terms of
28B the lease when compared with market terms. (see Chapter 9).
Income taxes Recognise deferred tax assets for all deductible temporary
differences and tax losses to the extent that taxable profit will
probably be available against which the deductible temporary
difference or tax loss can be utilised, as specified by HKAS 12
Income Taxes. There is no initial recognition exemption.
Recognise deferred tax liabilities for all taxable temporary
differences except for those arising from the initial recognition
of goodwill, as specified by HKAS 12. There is no other initial
recognition exemption.
HKFRS
3(R).24-
Measure the deferred tax balances in a manner similar to other
25, HKAS deferred tax balances, as specified by HKAS 12 (temporary
12.15, 24 difference × applicable tax rate) (see Chapter 19).
HKFRS Liabilities related to employee Recognise and measure liabilities in accordance with HKAS 19
3(R).26 benefit arrangements Employee Benefits (see Chapter 23).
HKFRS Share-based payment transactions Measure in accordance with HKFRS 2 Share-based Payment (see
3(R).30 Chapter 24).
Non-current assets and disposal Measure at fair value less costs to sell in accordance with HKFRS 5
HKFRS groups held for sale Non-current Assets Held for Sale and Discontinued Operations (see
3(R).31 Chapter 15).
HKFRS Insurance contracts Measure in accordance with HKFRS 17 Insurance Contracts (see
3(R).31A Chapter 26).
Contractual indemnity provided to Recognise an indemnification asset at the same time as the
the acquirer for the outcome of a indemnified item is recognised, measured at acquisition-date
contingency or uncertainty (e.g. the fair value. Where the indemnified item is subject to a
former owners of the acquiree place recognition and/or measurement exception, the indemnification
HKFRS a cap on the maximum amount the asset is recognised and measured using assumptions consistent
3(R).27-28 acquirer may need to pay in relation with those used to measure the indemnified item.
to an outstanding lawsuit)
Reacquired rights (e.g. a licence held Measure based on the remaining contractual term of the
by the acquiree before the business related contract, ignoring possible contract renewals (which
combination to use the acquirer’s may be included in the asset’s fair value if market participants
trademark) would have considered the extension). (A settlement gain or
HKFRS loss may arise as a similar item may now be priced differently
3(R).29
by the market.)

EXHIBIT 29.8 Exceptions to the general recognition and/or measurement principle in HKFRS 3

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 FINANCIAL REPORTING

Deferred Tax Exemption for Goodwill

HKFRS 3 (Revised) requires the acquirer to recognise deferred tax liabilities for all taxable
temporary differences on accounting for the business combination except for those deferred
tax liabilities arising from the initial recognition of goodwill. A deferred tax liability may arise,
for example, where the applicable tax legislation does not permit a reduction in the carrying
amount of goodwill as a deductible expense (i.e. the tax base of goodwill is resultantly zero).
The measure would be circular to determine because goodwill is measured as a residual, and
the recognition of the deferred tax liability would increase the carrying amount of goodwill.

Apply and Analyse 4

On 1 December 20X0, Soleil purchases 80% of the share capital of Polaris. At the
acquisition date, Polaris’s statement of financial position reveals the following:

HK$’000
Assets
Property, plant and equipment (net) 5,884
Intangible assets (net) 1,000
Deferred tax assets 50
Trade and other receivables 2,770
Allowance for doubtful debts (40)
Cash and cash equivalents 1,023
Total assets 10,687

Liabilities
Deferred tax liabilities 1,050
Provisions 887
Trade and other payables 1,068
Total liabilities 3,005

On review of Polaris’s assets and liabilities as of the acquisition date, Soleil identifies
the following:

• Polaris has unrecognised identifiable intangible assets in the form of a masthead

and customer list. Soleil has determined the fair value of the masthead as
HK$342,515 and the customer list as HK$119,760. The tax bases of the masthead
and customer list are nil, consistent with their tax bases in Polaris’s separate
financial statements as identified in accordance with the applicable tax regime; and

• One of Polaris’s properties is in a sought-after location, where market rentals have

doubled in the past two years. Soleil assesses the fair value of that property to be
HK$700,000 higher than the cost-based amount recognised by Polaris.

Soleil determines the carrying amounts of all other recognised assets and liabilities,
other than deferred tax, are equal to their fair values at the acquisition date.

The tax rate is 16.5%. Assume that the tax base and accounting cost of the assets and
liabilities acquired were the same on their initial recognition by Polaris, that is, there are no
initial recognition exemptions applicable to Polaris that would otherwise result in further

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Apply and Analyse 4 (continued)

deferred tax assets and deferred tax liabilities recognisable on acquisition of Polaris
by Soleil.

Calculate the total amount of the identifiable assets acquired and liabilities assumed in
the business combination.

Analysis

Identification of identifiable net assets acquired

In accounting for the business combination, Soleil recognises the various assets and
liabilities recognised by Polaris prior to the acquisition as well as the masthead and
customer list not previously recognised. These assets and liabilities are transferred as part
of the business combination as they are transferred to Soleil via its acquisition of the share
capital of Polaris.

The masthead and customer list are separately recognisable identifiable intangible
assets as Soleil:

• Controls the use of the masthead and customer list and can use them to generate
future economic benefits, that is, the items meet the definition of an asset; and

• Can separate and divest the masthead and customer list from Polaris, that is,
the assets meet the separability criterion, and hence, the assets are “identifiable”
intangible assets. Soleil assess these assets as separable from Polaris because, in
practice, evidence shows exchange transactions for such assets; therefore, they are
capable of being separated from the business and can be monetised.

Soleil recognises the acquired:

• Property, plant and equipment

• Intangible assets, including the masthead and customer list
• Deferred tax assets
• Trade and other receivables
• Cash and cash equivalents
• Deferred tax liabilities
• Provisions
• Trade and other payables

Soleil does not separately recognise the allowance for doubtful debts. This is because
the allowance reflects Polaris’s uncertainty about the collectability of the future cash flows
embodied by the trade receivable asset. The effect of this uncertainty is included in Soleil’s
estimate of the fair value of the receivable. Similarly, any accumulated depreciation or
HKFRS amortisation account would not be recognised as part of accounting for the business
3(R).B41 combination (i.e. the valuation allowance is reset to zero).

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Apply and Analyse 4 (continued)

Measurement of identifiable net assets acquired

The total amount of recognised identifiable assets acquired and liabilities assumed is:

HK$
Carrying amounts of Polaris’s recognised assets and liabilities at 7,682,000
acquisition date
plus: Adjustment to measure recognised property at fair value 700,000
less: Increase in related deferred tax liability (700,000 × 16.5%) (115,500)
plus: Fair value of masthead not recognised by Polaris 342,515
less: Increase in related deferred tax liability (342,515 × 16.5%) (56,515)
plus: Fair value of customer list not recognised by Polaris 119,760
less: Increase in related deferred tax liability (119,760 × 16.5%) (19,760)
Total ‘fair value’ of identifiable net assets acquired 8,652,500

By measuring the property at a fair value that is higher than its carrying amount
in the acquiree’s records, the acquirer expects to generate HK$700,000 in additional
future taxable income from that property. However, because Polaris owns and holds
the property, no change occurs to the deductions to be claimed on that property, which
remains limited to the written down tax base of the asset. Consequently, the property’s tax
base has not changed on the occurrence of the business combination.

As a result, a taxable temporary difference arises for the future tax implications of
that additional HK$700,000 included in the measurement of the property. That taxable
temporary difference is reflected as part of the acquisition accounting as a deferred tax
liability by applying an appropriate tax rate to that temporary difference.
The zero tax base of the identifiable intangible assets recognised on acquisition reflects
that the income earned when the asset is used will be taxable but no tax deductions will
be available against that income from the use of the asset. Hence, a related deferred tax
liability arises for the taxable temporary difference. The deferred tax balance is measured
using the tax rate applicable to the recovery or settlement of the temporary difference.
(In some tax jurisdictions, the tax base of the newly recognised intangible asset may differ
from the acquiree’s separate financial statements).

(Review Chapter 19 to understand how to calculate a temporary difference and

whether it gives rise to a deferred tax liability or deferred tax asset.)

Key Learning Point

Future tax implications of the acquired assets and liabilities in a business combination may
arise from newly recognised assets and liabilities or from already recognised assets and
liabilities. The manner in which the business combination is structured may dictate the tax
implications of the acquisition. Future tax implications attached to the assets and liabilities
acquired are part of the identifiable assets acquired and liabilities assumed in the business
combination.

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Contingent Liabilities and Contingent Assets

Chapter 18 explains that contingent liabilities are failed liabilities or possible liabilities.
A present obligation (a liability) may be unrecognised because the future outflow of resources
is not probable and/or the amount of the obligation is not reliably measurable (a failed liability)
and instead disclosed as a contingent liability.

In applying the acquisition method, HKFRS 3 (Revised) requires contingent liabilities to be

recognised and measured at the acquisition-­date fair value if:

• there is a present obligation that arises from past events; and

• its fair value can be measured reliably (HKFRS 3.23).

Thus, a contingent liability will be recognised even if the future outflow of economic
resources is not probable.

Does recognising a contingent liability make sense? Yes. The acquirer is assuming the risk
that settlement of that liability will result in an outflow of economic benefits.

Contingent liabilities that relate to possible obligations arising from past events whose
existence will be confirmed only by an uncertain future event(s) not wholly within the entity’s
HKFRS
control (see Chapter 18) are not recognised in a business combination. This is because the
3(R).22-23 definition of a liability is not yet met.
A contingent asset can never qualify for separate recognition as part of a business
HKFRS
combination because a contingent asset is only a possible asset, and as such, the definition of
3.23A an asset (condition for recognition; see Section 29.2.3.1) is unmet.

Apply and Analyse 5

Safe Bet Limited (Safe Bet) is finalising the details of its intended acquisition of FMT
Limited (FMT). In a discussion with FMT’s legal counsel, Safe Bet is made aware of an
existing lawsuit brought against FMT by a customer, who is suing for breach of contract.
Legal counsel advises that FMT was technically in breach of the contract, but based on the
extenuating circumstances and case precedent, the legal counsel thinks FMT has a strong
defendable position and can win the case. The lawsuit has been disclosed as a contingent
liability in FMT’s latest financial statements.

Analyse the contingent liability and determine how Safe Bet would treat it when
accounting for the business combination.

Analysis
The contingency relates to a present obligation as a result of a past event (entering
into the contract) that was not recognised by FMT because FMT believes an outflow
of resources embodying economics benefits will improbably be required to settle the
obligation. Because the contingency is an unrecognised present obligation that arises from
a past event (a liability) in accordance with HKFRS 3 (Revised), Safe Bet must recognise
the contingent liability as part of the identifiable liabilities it assumes in the business
combination transaction. The probability that an outflow will not occur is irrelevant.

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Apply and Analyse 5 (continued)

FMT may also not have recognised the contingency as a provision if it was unable
to reliably measure the extent of any eventual outflow. However, on recognition as part
of the business combination, Safe Bet must make a reliable estimate and measure the
contingency at its acquisition date fair value.

If FMT had disputed that the contract was breached, the contingency would relate to
a possible obligation arising from past events. In such an instance, Safe Bet would not
recognise a contingent liability when accounting for the business combination because the
definition of a liability is unmet.

Key Learning Point

Not all contingent liabilities are separately recognised in a business combination.

29.2.3.4 Measurement of Non-controlling Interests

A non-controlling interest (NCI) exists where the acquirer does not own all the acquiree’s share
capital in a business combination effected through the purchase of the acquiree’s equity. In
applying acquisition accounting, the acquirer must attribute an amount to NCI, representing
the NCI’s interest in the assets assumed and liabilities acquired.

At the acquisition date, the acquirer measures the NCI’s share of equity at:

• Fair value method (the full goodwill method): This method acknowledges that the
combined entity controls 100% of any value attributable to goodwill arising on the
business combination; or
• The NCI’s proportionate share in the amount of the acquiree’s identifiable assets and
liabilities recognised as a result of the business combination (the partial goodwill
HKFRS method): This method acknowledges only the value the acquirer places on any goodwill
3(R).19 attributable to it arising on the business combination.

These two options exist because the accounting standard setters were unable to agree on a
single measurement method. Although not described as such, the methods measure NCI at fair
value directly (full goodwill method) or indirectly (partial goodwill method, by referencing the
current values of the net assets acquired).

HKFRS The NCI is the present ownership interests in equity in a subsidiary that is not directly or
3(R).19 indirectly attributable to a parent. Hence, the NCI’s share of equity must entitle the holders to a
proportionate share of the subsidiary’s net assets in the event of liquidation and, consequently,
HKFRS does not include preference shares or other instruments classified as a financial liability in
3(R).19 accordance with HKAS 32. This module adopts the common conclusion that the NCI’s
proportionate share is determined with reference to the ordinary share capital of a subsidiary.

Where an acquiree elects to measure the NCI’s share of equity at fair value, the fair value of
the NCI’s share of equity is determined in accordance with HKFRS 13. In some cases, a quoted
price in an active market for the shares may be available (e.g. buying listed shares on a stock

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exchange). In other cases, a valuation technique will need to be employed. The fair value of the
NCI share of equity will not necessarily be calculated as the number of shares acquired
multiplied by the acquirer’s acquisition-date per-share price nor be equal to the NCI’s
proportionate share of the acquisition-date fair values of the identifiable assets and liabilities of
HKFRS
3(R).B44- the acquiree because, for example, the fair value attributable to the NCI may include a discount
B45 for the lack of control.

HKFRS
An acquirer makes the decision whether to measure NCI at fair value or as a proportionate
3(R).19 share of the acquired net assets on an acquisition-by-acquisition basis . The measurement of
NCI will impact the amount of goodwill or gain from bargain purchase recognised relating to
the business combination transaction, as illustrated in Section 29.3.2. Prima facie, it may
appear advantageous for an acquirer to always adopt the full goodwill method because, as
illustrated in Section 29.3.2, a higher goodwill asset is more likely to be recognised thereby
increasing net assets. However, if goodwill is impaired (see Chapter 14), the economic entity
may subsequently need to record an impairment loss and, consequently, report lower profits.

Knowledge Check Questions

Question 5
Peyton Limited (Peyton) is a Hong Kong incorporated company. On 30 September 20X0,
Omega Limited (Omega), a Mauritian company, acquires 90% of Peyton’s ordinary share
capital, giving it control of Peyton. At the acquisition date, the carrying amount of Peyton’s
recognised net assets is HK$4,161,800, including deferred tax liabilities of HK$100,000.
On review of its condition, Omega determines the fair value of plant and equipment
to be HK$50,000 lower than Peyton’s carrying amount. The carrying amounts of Peyton’s
other assets and liabilities are appropriate for recognition in consolidated financial
statements as of the acquisition date.
Omega’s tax rate is 15%. Peyton’s tax rate is 16.5%.
Calculate the total value Omega attributes to the identifiable assets acquired and
liabilities assumed in the business combination.

Question 6
Having regard to the business combination in Question 5, determine the amount
attributable to the NCIs in Peyton at acquisition date if Omega were to measure the NCI
as the proportionate share of the amount recognised for the identifiable net assets of the
subsidiary at the acquisition date.

Question 7
Identify which one of the following assets or liabilities acquired in a business combination
is not measured at its fair value on acquisition date.
A Factory building used in the acquiree’s operations
B Building owned by the acquiree is partially rented to tenants under 1–3-year leases
C Contingent liability relating to a present obligation of the acquiree to remediate land
D Head office building is actively marketed for sale at a price reflective of the current
market demand

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Knowledge Check Questions (continued)

Question 8
Identify which of the following are recognised assets acquired or liabilities assumed as part
of a business combination.
A Future restructuring costs that the acquirer expects to incur
B Obligation to repair or replace goods sold to customers under warranty
C Unpaid legal services received in connection with a business combination
D Financial guarantee provided by the acquiree to secure loan financing for its subsidiary.
Considering the subsidiary’s performance and cash position, the acquiree does not
expect to be required to pay any amounts under the guarantee

2 9 . 3 MEASURING GOODWILL OR A GAIN

FROM A BARGAIN PURCHASE

As described in Section 29.2, applying the acquisition method involves the following steps:

1. Identifying the acquirer;

2. Determining the acquisition date;

3. Recognising and measuring the identifiable assets acquired, the liabilities assumed and
any NCIs in the acquiree;

4. Determining the consideration transferred; and

5. Recognising and measuring goodwill or a gain from a bargain purchase.

Section 29.2 discusses who purchased what in the transaction and when the business
combination accounting applies. This section discusses how the business combination is
financed, including how the premium or discount paid for the business gives rise to goodwill or
a gain from bargain purchase. In addition, Section 29.3.3 discusses how information obtained
after the acquisition date affects the measurement of goodwill or discount arising in the
combination.

29.3.1 Consideration Transferred

The consideration transferred in exchange for the acquiree may be in the form of cash, other
assets or equity instruments of the acquirer may be by the acquirer assuming liabilities of the
acquiree, or may be a combination thereof. It may be a fixed stated amount and/or contingent
consideration.

With limited exceptions (which are beyond the scope of this Module), the consideration
transferred is measured as the sum of the acquisition-date fair values of:

• Assets transferred by the acquirer;

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• Liabilities incurred by the acquirer to former owners of the acquiree; and

HKFRS
3(R).37 • Equity interests (e.g. shares) issued by the acquirer.

HKFRS 13 explains how to establish fair value (see Chapter 4).

Shares of the acquirer issued as consideration are measured at their fair value on the
acquisition date regardless of when the shares are actually issued. The fair value of a listed
share typically is indicated by its quoted share price. However, in some cases where only equity
interests are exchanged, the acquisition-date fair value of the acquiree’s shares may be
determined to be more reliably measurable than the acquirer’s shares; for example, the fair
value of an acquiree’s listed shares could be reasonably expected to be more reliably
measurable than the fair value of its private company acquirer. In such cases, the HKFRS
HKFRS
requires the equity consideration be valued by reference to the acquisition-date fair value of
3(R).33 the acquiree’s shares rather than the shares issued by the acquirer.

Consideration transferred in a business combination may be made before or on acquisition

date or on deferred terms. Often, the amount of consideration transferred in exchange for a
business will vary subject to the achievement of certain performance targets or finalisation of
the completion accounts.

29.3.1.1 Deferred Consideration

The consideration transferred in exchange for a business combination may be made in part
on deferred terms. That is, control of the business may pass before full payment is made. In
such cases, the fair value of the consideration will differ from its face value; for example, the
fair value of HK$1 million payable in 24 months will be lower than the fair value of HK$1 million
payable immediately.

In accordance with HKFRS 3 (Revised), the amount included as consideration for the
purposes of applying the acquisition method of accounting to the business combination is
the fair value of the consideration on acquisition date (being less than HK$1 million). The
unwinding of the discount over time (to increase the deferred consideration liability to the
settlement amount) is a financing cost and is not part of the consideration paid for the business
combination.

29.3.1.2 Contingent Consideration

In setting the purchase price of a business acquisition, the parties may agree to a fixed
purchase price (e.g. using what is often referred to as a locked box mechanism) or may set a
preliminary purchase price that is subsequently adjusted using a price adjustment mechanism.
The price adjustment mechanism may be made by way of price adjustment clauses, such as
for net debt or working capital (i.e. the final purchase price is dependent on the completion
accounts, being the financial position of the acquiree on an agreed date), or for earn-out
clauses. Earn-out clauses are treated as contingent consideration in accordance with HKFRS 3
(Revised).

Contingent consideration is usually an obligation of the acquirer to transfer additional

HKFRS
assets or equity interests to the former owners of an acquiree as part of the exchange for
3(R).App A control of the acquiree if specified future events occur or conditions are met. For example, the
amount of consideration could be contingent on future performance (e.g. an additional cash
payment to the former shareholders based on post-acquisition revenues or on reaching a

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specific share price). In this case, payment is made at a later time and varies depending on the
extent to which the performance criteria defined in the purchase agreement are met. In some
HKFRS
cases, contingent consideration may give the acquirer the right to the return of previously
3(R).App A transferred consideration if specified conditions are met.

HKFRS
In accordance with HKFRS 3 (Revised), the consideration transferred in exchange for the
3(R).39 acquiree includes the estimated acquisition-date fair value of any contingent consideration. The
estimate of fair value reflects the extent to which the contingency is expected to be met based
on facts and circumstances available at the acquisition date. The calculation is not updated to
reflect the amounts actually paid once the contingency is resolved. Section 29.5 explains how to
account for changes in the measurement of the contingency up to its settlement or
extinguishment.

As an example based on acquisition date facts and circumstances, if an acquirer concludes

that a profit target and associated earn-out is not expected to be met, the acquirer will not
price the earn-out in full, and it will be prepared to pay for the business. Instead, it would price
an amount representing the risk the earn-out will be achieved; indirectly, price the premium
it attributes as goodwill. Based on the information available to the acquirer at the acquisition
date, this was the amount it was prepared to pay in exchange for the business. Therefore, the
satisfaction, or otherwise, of the profit target should not change the value placed as a premium
(goodwill) on acquisition.

Apply and Analyse 6

On 1 January 20X1, Soleil purchased 80% of the share capital of Polaris for consideration
in the form of a combination of cash and shares. HK$5 million cash and 10,000 shares
in Soleil is payable immediately on 1 January 20X1. A further amount, payable in cash on
28 February 20X1, is subject to the amount of cash and debt in Polaris on finalisation of the
completion accounts on or before 28 February 20X1.

At the acquisition date:

• Soleil’s share price is HK$100 per share; and

• The estimated cash payable on 28 February is HK$850,000.

Calculate the consideration transferred to Polaris’s owners in the business combination.

Analysis

The consideration transferred is measured as follows.

HK$
Cash – 1 January 20X1 5,000,000
Fair value of Soleil’s shares (HK$100 × 10,000) 1,000,000
Cash payable – 28 February 20X1 (note 1) 850,000
Consideration transferred for the purchase of Polaris 6,850,000

Note 1: A price adjustment clause is not contingent consideration. Also, in this example,
discounting this amount is unnecessary given the short period involved.

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Apply and Analyse 7

Soleil was concerned that Polaris’s customers may cease doing business with the company
following the change in ownership. Hence, in negotiating the terms of the consideration for
the business, Soleil and Polaris’s former owners agreed that if, in the 12 months following
the acquisition, Polaris’s audited revenues improve by:

• At least 5% – Soleil will make a further payment of HK$100,000

• At least 10% – Soleil will make a further payment of HK$300,000

At the acquisition date, Soleil expects Polaris’s revenues to improve by approximately

7.5% over the next 12 months. Soleil estimates the fair value of the obligation on the
acquisition date to be HK$150,000.

Analyse how the possible future payment to Polaris’s former owners is treated.

Analysis

The possible future payment to Polaris’s former owners is made as part of the exchange
for their shareholdings. Hence, the payment is contingent consideration transferred in the
business combination.

In accordance with HKFRS 3 (Revised), the fair value of the obligation on the acquisition
date is included in determining the amount of consideration transferred. Accordingly, Soleil
should recalculate the consideration transferred for Polaris to include this amount, as follows:

HK$
Cash – 1 January 20X1 5,000,000
Fair value of Soleil’s shares (HK$100 × 10,000) 1,000,000
Cash payable – 28 February 20X1 850,000
Contingent consideration 150,000
Consideration transferred for the purchase of Polaris 7,000,000

As noted earlier in this section, in applying the acquisition method, the amount of
contingent consideration is not updated to reflect the amounts actually paid once the
contingency is resolved. That is, the changes are accounted for separately from the business
combination. How these changes are treated is discussed in Section 29.5.

Also, as identified earlier in this section, price adjustment clauses varying the final
purchase price dependent on the ‘completion accounts’ were identified as not being contingent
consideration as defined by the HKFRS. However, similar to contingent consideration, the
amount payable may change from that initially identified at the acquisition date. How this
change is treated is discussed in Section 29.3.3.

29.3.2 Recognising and Measuring Goodwill or a Gain

from a Bargain Purchase
The final step in applying the acquisition method of accounting for business combinations is
to recognise and measure any goodwill or gain from bargain purchase arising in the business

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combination. The recognition and measurement of goodwill or gain from bargain purchase
occurs at the acquisition date.

HKFRS
Goodwill is an asset representing the future economic benefits arising from other assets
3(R).App A acquired in a business combination not individually identified and separately recognised. The
amount of goodwill reflects the premium the acquirer places on both the pre-existing goodwill
HKFRS
(that was internally generated by the acquiree or acquired by it in prior business combinations)
3.BC316 and on the synergies it expects to obtain from combining the entities. In due course, with the
benefit of hindsight, it might be found to reflect the acquirer paying too much for the business,
which might ultimately be accounted for by impairing the goodwill (see Chapter 14). Although
an acquirer in an asset acquisition may similarly pay a premium to acquire the asset, unlike a
business combination, that premium is not separately recognised as goodwill.

The amount of goodwill is calculated as a residual component of the acquisition price and is
measured as the excess of the fair value of consideration transferred (Section 29.3.1) plus the
amount recognised as the non-controlling interest (Section 29.2.3.4) plus the fair value of any
previously held equity interest in the acquiree (see Section 29.3.2.1), over the amount
HKFRS
recognised for the identifiable net assets of the acquiree as of the acquisition date (Sections
3(R).32 29.2.3.2–29.2.3.3).

Recall that an acquirer has the option of measuring the NCI at acquisition date at fair value
or at the proportionate share of the acquiree’s identifiable net assets (see Section 29.2.3.4). The
effect of measuring the NCI as the proportionate share of the acquiree’s identifiable net assets
HKFRS
is that only goodwill related to the acquirer is reflected in the financial statements of the group
3.BC329 (hence, the reference to this measurement method as the partial goodwill method). The effect
of measuring the NCI at fair value is that the acquirer’s goodwill and the goodwill the NCI
attributes to its share of the acquiree is reflected in the financial statements of the group.

Apply and Analyse 8

Soleil’s management wants to understand how much it has paid for goodwill on the
company’s acquisition of 80% of Polaris’s equity. The group financial controller has asked
you to analyse the information it has gathered to date on the acquisition and compare the
extent of goodwill arising in the acquisition if Soleil were to measure the 20% NCI using the
partial goodwill method versus the full goodwill method.

Soleil determines the fair value of the NCI in Polaris is HK$1.75 million at the
acquisition date.

Analysis
To calculate the goodwill arising in the acquisition by using the information gathered
to date, Soleil needs to know the following: the consideration transferred; the amount
recognised for identifiable net assets at acquisition date; the amount attributed to NCI; and
the fair value of any previously held equity interests in Soleil.

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Apply and Analyse 8 (continued)

Soleil uses the information it has previously determined to calculate goodwill under the
two methods as follows:

Partial goodwill method Full goodwill method

(NCI as proportionate (NCI at fair value)
share of net assets)
HK$ HK$
Consideration transferred (refer 7,000,000 7,000,000
Section 29.3.1.2)
plus: Non-controlling interest (note 1) 1,730,500 1,750,000
plus: Fair value of previously held – –
interests (note 2)
less: Amount recognised for (8,652,500) (8,652,500)
identifiable net assets at acquisition
date (refer Section 29.2.3.3)
Goodwill on acquisition of Polaris 78,000 97,500

Note 1: Under the ‘partial goodwill’ method, the NCI is calculated as 20% × HK$8,652,500 =
HK$1,730,500.

Note 2: Assume Soleil did not hold any equity interests in Polaris prior to the acquisition.

The goodwill arising in the acquisition if Soleil were to measure the NCI using the
partial goodwill method is HK$19,500 lower than when measured under the full goodwill
method. The difference represents the amount of goodwill that the NCI is prepared to pay
to purchase the business.

In some instances, the amount recognised for the identifiable net assets at acquisition will
exceed the aggregate of consideration transferred, the amount attributable to the NCI, and
the fair value of the previously held interests (e.g. perhaps in a forced sale). These business
combinations are known as bargain purchases. A gain from bargain purchase could arise
where, for example, the acquiree needs urgent access to cash or wants a quick sale.

In accordance with paragraphs 34-36 of HKFRS 3 (Revised), the acquirer must:

• First, reassess whether it has correctly identified all of the assets acquired and all of the
liabilities assumed in the business combination transaction;

• Next, review the procedures used to measure the amounts in the goodwill calculation
to ensure that the measurements appropriately reflect all available information as of
the acquisition date; and

• Then, recognise any resulting gain in profit or loss on the acquisition date, attributing
the gain to the acquirer.

These steps are necessary because in most cases businesses are not expected to be sold
for less than their fair value.

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Illustrative Example 6
Assume that Soleil initially determines the consideration transferred for its purchase of
its 80% interest in Polaris to be HK$6,850,000. No amount is attributed to the earn-out.

Applying the acquisition method, Soleil initially assesses it has made a gain on
bargain purchase of HK$72,000 on the acquisition if it were to measure the NCI at the
proportionate share in the recognised amounts of identifiable net assets of Polaris at the
acquisition date. The gain is calculated as follows:

HK$
Consideration transferred 6,850,000
plus: Non-controlling interest 1,730,500
plus: Fair value of previously held interests –
less: Amount recognised for identifiable net assets at acquisition date (8,652,500)
Goodwill/(Gain on bargain purchase) on acquisition of Polaris (72,000)

Soleil’s management is uncertain of the assessment that it has made a gain on

bargain purchase is correct as it had been prepared to pay a premium for the business.
In accordance with HKFRS 3 (Revised), before concluding it has purchased Polaris for a
discount, Soleil first reviews its assessment of the identifiable assets acquired and liabilities
assumed. It determines that all the identifiable assets acquired and liabilities assumed are
recognised in accordance with HKFRS 3 (Revised).

Next, Soleil reviews the measurement of each identifiable asset acquired and liability
assumed and concludes it has not mis-measured any assets or liabilities based on the
information available on acquisition date. Soleil also reviews the measurement of the NCI
and determines this has been correctly calculated.

Following this, Soleil reviews the measurement of the consideration transferred in the
acquisition. It identifies it has not attributed a value to the earn-out clause even though the
facts and circumstances available at the acquisition date indicate the lower earn-out
threshold is likely to be achieved. That is, the fair value of the earn-out is unlikely
to be zero.

On updating the fair value of the contingent consideration to HK$150,000, Soleil

discovers the initially calculated gain on bargain purchase has been erased. Instead, Soleil
has paid a premium of HK$78,000 for the purchase of the business, representing goodwill.

Apply and Analyse 9

On 6 April 20X0, Safe Bet enters into an arrangement to acquire 75% of the share
capital of FMT, a boutique funds management company, for an upfront cash payment
of HK$1 million and a bonus payment of HK$200,000 if the fund’s performance doubles
from the previous financial year as reported in FMT’s audited financial statements. Safe
Bet estimates the fair value of the bonus payment to be HK$30,000 having regard to the
current and forecast future market conditions, which indicate that the market is shifting
from a bull market to a bear market. As FMT’s primary revenue-generating source is based

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Apply and Analyse 9 (continued)

on the return on the funds under management, Safe Bet does not think the fund will be
able to double its performance from the prior year.

At the acquisition date, the carrying amount of FMT’s assets and liabilities recognised in
accordance with HKFRSs was:

HK$
Assets
Property, plant and equipment 683,000
Intangible assets 100,050
Deferred tax assets 22,510
Investments 200,950
Trade receivables 236,000
Cash and cash equivalents 300,000
Total assets 1,542,510

Liabilities
Provisions 106,500
Trade and other payables 167,700
Total liabilities 274,200

Safe Bet noted the following:

• A contingent liability relating to a lawsuit against FMT should be recognised as

part of the business combination. It determines the fair value of that contingent
liability to be HK$60,000. Assume the contingent liability is not deductible for tax
purposes; and

• The fair value of the trade receivables is HK$250,000. Assume that doubtful debts
are not deductible for tax purposes until the debt is written off.

Safe Bet determines the carrying amount of FMT’s assets and liabilities are equal to
their fair values other than for the matters noted.

The tax rate is 16.5%. Safe Bet determines it controls FMT following the acquisition
of the shares. It adopts a policy to measure the NCI at the proportionate share of the
recognised assets acquired and liabilities assumed at acquisition date.

Analyse the business combination and determine whether Safe Bet has acquired the
business for a premium or at a discount.

Analysis

In consideration of the terms of the arrangement and the assets and liabilities acquired,
Safe Bet has acquired the business for a premium of HK$115,000. The premium is
recognised as goodwill.

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Apply and Analyse 9 (continued)

This conclusion is based on the following calculation:

HK$
Fair value of consideration transferred (HK$1million + HK$30,000) 1,030,000
plus: Non-controlling interest (25% × HK$1,220,000) 305,000
plus: Fair value of previously held interests –
less: Amount recognised for identifiable net assets at acquisition (1,220,000)
date (note 1)
Goodwill/(Gain on bargain purchase) on acquisition 115,000

Note 1: Amount recognised for identifiable net assets.

HK$
Carrying amount of recognised assets and liabilities at acquisition date 1,268,310
plus: Adjustment to measure trade receivables at fair value 14,000
less: Decrease in related deferred tax asset (14,000 × 16.5%) (note 2) (2,310)
less: Contingent liability not recognised by FMT (note 2) (60,000)
Total ‘fair value’ of identifiable net assets acquired 1,220,000

Note 2: Deferred tax impacts of adjustments on acquisition.

The higher fair value of the trade receivables compared to its carrying amount
indicates the recoverability of the receivables is higher than what FMT recognises (i.e. less
impairment of the receivables), resulting in a smaller deductible temporary difference
relating to the trade receivables.

The contingent liability is not deductible for tax purposes. Consequently, the tax base
of the liability is HK$60,000, calculated as the carrying amount (HK$60,000) + future taxable
amounts (zero) − future deductible amounts (zero) (see Chapter 19). As such, the net assets
acquired do not include any further temporary difference to recognise in this regard.

In the preceding exercise, Safe Bet has acquired a controlling interest in FMT by way of
its purchase of equity. As is discussed in Chapter 30, this will result in Safe Bet preparing
consolidated financial statements in which the acquired assets and liabilities are recognised at
fair value and the goodwill on consolidation is recorded. In its separate financial statements,
Safe Bet recognises its investment in FMT at cost or fair value (or using the equity method) in
accordance with HKAS 27 (2011) Separate Financial Statements, for example:

Debit Credit
HK$ HK$
Investment 1,030,000
Consideration payable 1,000,000
Contingent consideration payable 30,000

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However, assume Safe Bet acquires its FMT’s operations by directly buying 100% of FMT’s
assets and liabilities from the company for consideration of HK$1,335,000. In this case, there
will be no consolidated financial statements to prepare as Safe Bet has not acquired FMT
itself. Instead, in Safe Bet’s records, it directly recognises the identifiable assets and liabilities
acquired and any related goodwill arising on accounting for the business combination.

Safe Bet would record in its company financial statements the journal entry below:

Debit Credit
HK$ HK$
Property, plant and equipment 683,000
Intangible assets 100,050
Goodwill 115,000
Deferred tax assets 20,200
Investments 200,950
Trade receivables 250,000
Cash and cash equivalents 300,000
Provisions 106,500
Contingent liability 60,000
Trade and other payables 167,700
Consideration payable 1,335,000

29.3.2.1 Previously Held Interest in the Acquiree

In some cases, an acquirer may hold an equity interest in the acquiree before it adds to it and
gains control of the business. For example, an acquirer may initially make purchases to give
it a substantial shareholding before making a takeover bid for the business, or it may be an
associate for a time before acquiring control. Similarly, a joint operator may subsequently
gain control of the joint operation. Acquisitions of this form are commonly referred to as step
acquisitions or business combinations achieved in stages.

In applying the acquisition method, the fair value of any previously held interest in the
HKFRS
3(R).32, acquiree must be added to the calculation to determine the goodwill or gain on bargain
42-42A purchase in the transaction. This is so that in determining goodwill, the calculation compares
‘apples with apples’ so that 100% of the assets acquired and liabilities assumed are compared
against 100% of the equity interest in those assets and liabilities (Exhibit 29.9).

New shareholdings
purchased %
100% share capital

(fair valure)
100% of recognised
Previously held identifiable assets
Goodwill = shareholding % – acquired and liabilities
(fair value) assumed, measured at
‘fair value’
Shareholding
held by NCI %*

* NCI at acquisition is measured either (1) at fair value determined directly or (2) as a proportion
of the fair value of the net identifiable assets acquired

EXHIBIT 29.9 Determining goodwill

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29.3.3 Measurement Period Adjustments

In some acquisitions, the initial accounting for the acquisition may be incomplete by the end of
the reporting period in which the combination occurs, for example, an acquisition that occurs
close to the reporting year-end. In such cases, the reported consideration, NCI, assets and
liabilities and goodwill are fully or partly described as being provisionally determined.

HKFRS 3 (Revised) acknowledges that the acquirer may require a period of time to obtain
the information necessary to apply the acquisition method to the business combination. Hence,
the HKFRS contemplates a measurement period. During the measurement period, the
acquirer is able to retrospectively adjust the measurement of the provisionally determined
HKFRS amounts and recognise further assets and liabilities acquired in the business combination as if
3(R).45-46 the accounting for the business combination had been completed at the acquisition date.

However, the key principle is still that the measurement (and recognition) of consideration,
NCI and assets and liabilities acquired in the business combination transaction reflects facts
and circumstances that exist as of the acquisition date. Similar to adjusting events after the end
of the reporting period, only information obtained during the measurement period that
HKFRS informs of facts and circumstances that exist at the acquisition date is relevant to evaluating or
3(R).45 confirming the provisionally determined amounts.

The measurement period begins immediately after the acquisition date and ends on the
earliest of the three dates below:

1. As soon as the acquirer receives the information it was seeking about facts and
circumstances that existed as of the acquisition date;

2. As soon as the acquirer learns that more information is not obtainable; or

HKFRS
3(R).45 3. No longer than 12 months from the acquisition date.

An increase from the provisional amount recognised for an identifiable asset decreases the
HKFRS recognised goodwill. Similarly, an increase from the provisionally-determined amount of a
3(R).48 liability increases goodwill.

Illustrative Example 7
Under the terms of its purchase of Polaris, Soleil agreed to pay more to Polaris’s former
shareholders if specified revenue targets were achieved. By 30 September 20X1, it is
clear that neither revenue target will be met.

Soleil has obtained this information during the measurement period for the business
combination (within 12 months of the acquisition date). However, this information does
not provide more information of facts and circumstances existing at the acquisition date
but relates to facts and circumstances after the acquisition date. As such, this information
is not reflected as part of Soleil’s accounting for the business combination transaction.

As illustrated in Illustrative Example 8, retrospectively adjusting the provisionally

determined amounts is not necessarily straightforward. All the impacts flowing from that
adjusted measurement, including the adjustment to the goodwill or gain on bargain purchases
arising in the transaction, must be likewise accounted for.

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Illustrative Example 8
Robotics Limited (Robotics) acquired Big Computer Limited (BCL) on 30 September 20X7.
Robotics engaged an independent valuer to value an item of equipment acquired in
the combination. The valuation was not completed by 31 January 20X8 when Robotics
authorised for issue its 31 December 2017 annual financial statements. In those financial
statements, Robotics reported goodwill arising from the acquisition of BCL calculated by
using a provisional fair value of HK$300,000 for the equipment, which is the same as its
written-down carrying amount.

Robotics determines that the acquired equipment has a remaining useful life of
10 years at the acquisition date. Its policy is to depreciate equipment on a straight-line
basis over the equipment’s useful life. The residual value of the equipment is zero.

Robotics receives the valuation from the independent valuer on 5 February 20X8. The
valuation estimates the equipment’s acquisition-date fair value as HK$400,000. Assume
the tax base of the equipment is the same as its carrying amount and is not affected by the
valuation.

The relevant tax rate is 18.5%.

The valuation reveals more information about the fair value of the equipment based
on facts and circumstances existing on 30 September 20X7 and is obtained before the end
of the measurement period.

Therefore, Robotics must retrospectively adjust its business combination accounting in

its next financial statements to reflect the updated fair value estimate.

Adjusting the comparative financial statements

In its financial statements for the year ended 31 December 20X8, Robotics retrospectively
adjusts the 20X7 prior year information for the new information as follows:

(a) increases the carrying amount of equipment at 31 December 20X7 by HK$97,500.

Provisional Updated
measurement measurement
HK$ HK$
Fair value of equipment 300,000 400,000
Accumulated depreciation (7,500) (10,000)
Carrying amount 292,500 390,000
Adjustment to the carrying amount at 31 December 20X7
= HK$390,000 − HK$292,500
= HK$97,500

(b) increases depreciation expense for 20X7 by HK$2,500 (HK$10,000 − HK$7,500)

(c) recognises a deferred tax liability of HK$18,038 (18.5% × HK$97,500) at

31 December 20X7 for the temporary difference between the tax base of the
equipment (HK$292,500) and its revised carrying amount (HK$390,000).

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Illustrative Example 8 (continued)

(d) decreases the carrying amount of goodwill arising in the combination by
HK$81,500.

Adjustment to goodwill
HK$
Decreased by: increase in fair value of equipment 100,000
Increased by: recognition of a related deferred tax liability (18,500)
81,500

(e) decreases deferred tax expenses by HK$462 for the movement between the
acquisition-date deferred tax liability (HK$18,500) and the deferred tax liability at
31 December 20X7 (HK$18,038).

Knowledge Check Questions

Question 9
On 15 June 20X0, Gimlet Limited (Gimlet) transferred HK$10 million cash and 100,000 of
Gimlet’s ordinary shares to Screwdriver Limited’s (Screwdriver) shareholders in exchange
for its equity interest in Screwdriver. In addition, Gimlet promised to make a further
payment contingent on the performance of Screwdriver in the 12 months after settlement,
as follows:
• Audited revenues less than HK$100 million – zero;
• Audited revenues between HK$100 million and HK$200 million – HK$1 million; and
• Audited revenues between HK$201 million and HK$500 million – HK$3 million.

The fair value of Gimlet’s shares on 15 June 20X0 was HK$20 per share.
In the past three years, Screwdriver’s annual revenues approximated HK$190
million. Based on the information available on 15 June 20X0 and after an assessment of
probabilities of outcomes, Gimlet determined the fair value of the contingent consideration
to be HK$1.5 million.
On 14 June 20X1 Screwdriver’s revenue for the previous 12 months was HK$315 million.
Calculate the consideration transferred in exchange for Screwdriver.
A HK$12 million
B HK$13 million
C HK$13.5 million
D HK$15 million

Question 10
On 1 January 20X0, Hi-Lo Limited (Hi-Lo) acquired a 90% interest in Loud Sound Limited
(Loud Sound) for HK$500,000, payable in two years. The relevant discount rate is 10% p.a.
The amount recognised in accordance with HKFRS 3 (Revised) for the identifiable net assets
of Loud Sound on 1 January 20X0, being the date of acquisition, is HK$455,000.

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Knowledge Check Questions (continued)

The fair value of the 10% NCI interest in Loud Sound is HK$47,000.
Calculate the amount of goodwill or gain on bargain purchase arising on the
acquisition if Hi-Lo decides to measure the NCI at fair value and as a proportion of the fair
value of the net identifiable assets acquired. Explain how the amount recognised, if any,
should be initially accounted for.

Question 11
Identify which one of the following statements is true in applying the acquisition method to
account for a business combination.
A An entity must determine its accounting policy for measuring NCI at the acquisition date
of a business combination and apply it consistently to all acquisitions.
B Goodwill is determined by comparing the consideration transferred to the acquirer’s
proportionate interest in the fair value of the assets acquired and liabilities assumed.
C An acquirer has regard to the acquisition-date fair value of its existing 20% equity
interest in the acquiree in determining the goodwill arising in that business combination.
D In determining goodwill, an acquirer must update the value attributed to contingent
consideration transferred in a business combination to reflect post-acquisition date facts
and conditions until the contingency is resolved.

Question 12
The amount of consideration transferred for the acquisition of Polaris on 1 January 20X1
is subject to the level of cash and debt in the completion accounts. On the acquisition
date, Soleil provisionally estimates the fair value of this part of the consideration to be
HK$850,000. The completion accounts were accepted by Soleil on 20 February 20X1.
Based on those accounts, Soleil made a further payment of HK$840,000 to the acquiree’s
former owners.
Soleil’s reporting year end is 31 December 20X1.
Explain whether and how this information affects Soleil’s accounting for the business
combination transaction.

Question 13
Identify which one of the following factors is most likely to indicate that an adjustment
to the provisional measurement of an asset acquired in a business combination may be
warranted.
A The sale of an acquired asset to another entity in the group shortly after the acquisition
date for a nominal amount.
B The sale of an acquired asset to a third party 10 months after the acquisition date for an
amount that differs significantly from its provisional fair value on the acquisition date.
C The sale of an acquired asset to a third party shortly after the acquisition date for an
amount that differs significantly from its provisional fair value on the acquisition date.
D The sale of an acquired asset to a third party shortly after the acquisition date for an
amount that differs significantly from its provisional fair value measured at that date as
the asset was damaged by a storm after acquisition.

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Knowledge Check Questions (continued)

Question 14
As part of a business combination, an acquirer assumes its acquiree’s provision for
damages related to an accident suffered by an employee in one of the acquiree’s facilities.
On the acquisition date, the court has not yet determined the amount of the liability.
The acquirer’s financial statements disclose that the amount of the provision for
damages acquired in the business combination is still provisionally determined as part of
the business combination. Shortly after the financial statements were approved and during
the measurement period, the court rules in favour of the employee and sets the amount of
restitution.
Identify which of the following statements is false.
A There is no adjustment to goodwill.
B The court ruling is an example of new information about the acquisition-date fair value
of the liability.
C The acquirer retrospectively adjusts the measurement of the provision for damages.
D The measurement of the provision is not adjusted as the information relates to post
acquisition-date facts and circumstances.

2 9 . 4 IDENTIFYING WHAT IS PART OF THE

BUSINESS COMBINATION TRANSACTION

Only those transactions that form part of the business combination transaction are included
in the acquisition accounting and, therefore, impact the determination of goodwill. HKFRS 3
(Revised) explains that a transaction entered into primarily for the benefit of the acquirer or
the combined entity after the combination, rather than primarily for the benefit of the acquiree
(or its former owners) in exchange for the combination, is likely to be a separate transaction
from the business acquisition transaction and, therefore, is accounted for separately. Examples
include transactions that:

• Reimburse the acquiree or the former owners for paying the acquirer’s acquisition-
related costs;

• Remunerate employees of the acquiree for their future services; and

• Settle pre-existing relationships between the acquirer and the acquiree. A pre-existing
HKFRS relationship may be contractual (e.g. a licensor/ licensee) or non-contractual (e.g. a
3(R).52 lawsuit).

When assessing whether a transaction is entered into primarily for the benefit of the
HKFRS
3(R).52, acquirer or the combined entity after the combination, the acquirer considers the reason for
B50 the transaction, who initiated the transaction and the timing of the transaction. For example,
consider a scenario in which, shortly after the acquisition, Acquirer A grants options over its

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shares to employees of the acquiree, the options vesting at a future date and conditional on
the holder remaining employed with the group. Such contingent share-based payment
transactions may be initiated by the acquirer to limit employee turnover following the
acquisition and be reflective of continuing remuneration and, hence, primarily benefiting the
group rather than the acquiree or its former owners. Contrast this to a scenario in which, as
part of the negotiations, Acquirer A grants share options to the former owners of the acquiree,
exercisable when a specified share price is achieved. In this second scenario, the transaction
will more likely be entered into primarily for the benefit of the former owners rather than for
the acquirer or combined entity.

Identifying whether transactions form part of the business combination transaction and
how to carve out the measure that is included as part of the business combination is not always
straightforward, especially when share-based payments are involved. Some cases will require
more analysis or judgement than others. For example, in the previous second share-based
payment scenario, what if the former owners of the acquiree are continuing key employees of
the acquiree? The conclusion will depend on gaining an understanding of the reason for and
terms of the share-based payment arrangement. What if unvested employee share options in
the acquiree are exchanged for share options over shares of the acquirer? There may be some
amount to include as consideration as part of the business combination (reflective of pre-
combination services rendered) and another portion to treat separately (as remuneration for
post-combination services).
A pre-existing relationship may be settled as a consequence of a business combination.
Where the consideration offered, in part, reflects the settlement of the pre-existing relationship
(e.g. a lawsuit between an acquirer-defendant and acquiree-plaintiff being dropped or the
rights to a brand name reacquired by the acquirer-licensor), this aspect should be distinguished
from the business combination and accounted for separately. That is, a lower amount may be
recognised as consideration or fewer assets or liabilities recognised).

A pre-existing relationship may (but does not always) involve recognised assets or liabilities.
HKFRS
3(R).B52 The acquirer recognises a gain or loss on settlement of these relationships.

Key Learning Point

Consider whether all amounts exchanged are consideration for the business combination
or whether the amounts are consideration in exchange for another transaction (e.g. future
remuneration, settlement of pre-existing relationship).

Consider whether assets and liabilities have been acquired as part of the business
combination. Do certain assets or liabilities relate to settled relationships separately
accounted for?

29.4.1 Acquisition-related Costs

HKFRS Acquisition-related costs are the costs an acquirer incurs to effect a business combination and
3.59 usually occur between the acquirer and a third party who is not the acquiree. As suggested
earlier, in some arrangements, the acquiree could first incur these costs with the third party but
be reimbursed for such by the acquirer; such costs are acquisition-related costs of the acquirer.

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Acquisition-related costs are not regarded as part of the consideration transferred in

exchange for an entity; transactions that primarily benefit the acquirer rather than the acquiree
or its former owners are likely to be separate from the business combination transaction.
Instead, these costs are expensed when incurred, except for the costs of issuing debt and
equity securities, which are treated in accordance with HKFRS 9 Financial Instruments and HKAS
32 Financial Instruments: Presentation.

Consequently, acquisition-related costs are not accounted for in the determination of

goodwill (or gain from bargain purchase) and, similarly, are excluded from the carrying amount
of the ‘investment in subsidiary’ asset recognised in a parent’s separate (unconsolidated)
financial statements.

Acquisition-related costs might include the following:

• Finder’s fees;

• Advisory, legal, accounting, valuation and other professional or consulting fees;

• General administrative costs, including the costs of maintaining an internal acquisitions

department; and
HKFRS
3.59 • Costs of registering and issuing debt and equity securities.

Similar costs may be treated in a different manner under all HKFRSs. For example,
consider whether:

• Professional fees (e.g. legal fees) form part of the initial cost of property, plant and
equipment when the fees are directly attributable to bringing an acquired asset to
the location and condition necessary for it to be capable of operating in the manner
intended by management (review Chapter 7); and

• Transaction costs (incremental costs) directly attributable to the acquisition or issue

of a financial asset or financial liability are included in the initial measurement of the
financial instrument (review Chapter 12; the accounting differs depending on the
classification of the related financial instrument).

The disparate accounting treatments underscore the importance of getting the assessment
of whether an acquisition is a business combination right.

29.4.2 Deferred Tax Arising from a Business Combination

Section 29.2.3 highlights that acquired deferred tax assets and deferred tax liabilities are
recognised as part of the business combination, measured in accordance with HKAS 12. These
items include new (or reduction in) deferred tax assets reflecting the acquirer’s assessment of
the recoverability of any unused tax losses of the acquiree.

In addition, the business combination may affect the acquirer’s assessment of the
recoverability of the acquirer’s own unused tax losses and deductible temporary differences. For
example, as a result of the business combination, the acquirer may determine that it will be able
to utilise the benefit of its unused tax losses against the future taxable profit of the acquiree to a
different extent and, as such, recognise more deferred tax assets. Such changes in the
measurement of the acquirer’s deferred tax assets are recognised in the period of the change
HKAS
(i.e. the period of the business combination) but not as part of the accounting for the business
12.67 combination. When the business combination is completed via the acquisition of another entity

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(a subsidiary), the parent-acquirer may have future tax implications relating to its equity
investment. Such temporary differences, unlike the tax implications of fair value differences at
the acquisition date (from the recognised carrying amounts) (see Section 29.2.3.3.1),
are not part of the business combination transaction and are not included as part of the
recognised identifiable assets acquired and liabilities assumed in the business combination. As
such, these differences similarly do not affect the determination of goodwill. The accounting by a
parent-acquirer for deferred tax implications relating to its investment in a subsidiary is
discussed further in Chapter 30.

Knowledge Check Question

Question 15
Identify which one of the following is included as part of the business combination.
A Settlement of contingent consideration.
B Due diligence costs incurred in relation to the acquisition.
C Initial recognition of a contingent liability relating to a present obligation arising from a
past event.
D A temporary difference between the fair value of the consideration transferred and the
tax base of the investment in acquiree.

2 9 . 5 SUBSEQUENT MEASUREMENT
AND ACCOUNTING

In the main, an acquirer has regard to other HKFRSs for the subsequent accounting for
the assets and liabilities recognised as part of the business combination transaction. The
subsequent accounting transactions are separate transactions that are not part of the
business combination transaction. For example, as illustrated in the Illustrative Example 8 in
Section 29.3.3, depreciation expenses on equipment acquired in a business combination does
not affect the goodwill calculation.

HKFRS 3 (Revised) includes some limited guidance in respect of the subsequent accounting
for specific assets and liabilities acquired.

29.5.1 Recognised Contingent Liability

HKFRS 3 (Revised) sets out that a contingent liability recognised in a business combination
that is not an HKFRS 9 Financial Instruments contract should be subsequently measured at the
higher of:

• A HKAS 37-determined amount; and

• The amount initially recognised less, if appropriate, the cumulative amount of income
HKFRS recognised in accordance with the principles of HKFRS 15 Revenue from Contracts with
3(R).56 Customers.

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 FINANCIAL REPORTING

The absence of the standard-setter specifying requirements in this regard would have
resulted in an acquirer possibly derecognising the contingent liability immediately subsequent
to the acquisition. Consider why this would have been the case; in other words, what was the
reason a provision had not been previously recognised for the event?

29.5.2 Contingent Consideration

HKFRS 3 (Revised) clarifies that contingent consideration that is:

• Classified as equity (e.g. share options) – is not remeasured. The subsequent settlement
is recognised within equity (e.g. DR Share options CR Issued capital for the amount
determined at the acquisition date); and

• Not classified as equity (e.g. contingent cash payment) – is remeasured to its fair value
at each reporting date until settled. Changes in fair value are recognised in profit or loss
HKFRS (e.g. DR Gain on movement in contingent consideration CR Contingent consideration
3(R).58 payable).

Illustrative Example 9
Blue Limited (Blue) issues 100 share options to the former shareholders of Red Limited
(Red) as part of the consideration for Red. The share options are exercisable for HK$0
if a specified profit target is met 18 months following Blue’s acquisition of Red. The
contingent payment had a fair value of HK$2 per share option at the acquisition date.

The profit target was subsequently met, and Blue issued the additional shares. On that
date, Blue’s share price was HK$5 per share.

Blue appropriately classifies the contingent consideration as equity. As such, the

contingent consideration is not remeasured; that is, the share price at the share issue date
is not relevant.

Blue records the following journal entries in relation to the contingent consideration:

On acquisition date:

Debit Credit
HK$ HK$
Investment in Red 200
Share-based payment reserve 200

On settlement date:

Debit Credit
HK$ HK$
Share-based payment reserve 200
Share capital 200

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Apply and Analyse 10

Under its purchase of Polaris, Soleil agreed to pay more cash to Polaris’s former
shareholders if specified revenue targets were achieved. It valued the contingent
consideration at HK$150,000 on the acquisition date of 1 January 20X1.

The revenue targets were not met. Hence, on reporting date 31 December 20X1, the
fair value of the contingent consideration was zero.

Prepare the journal entry by Solaris to effect the change in the estimate of contingent
consideration payable.

Analysis

Soleil prepares the following journal entry:

Debit Credit
HK$ HK$
Contingent consideration (liability) 150,000
Gain on remeasurement of contingent consideration (p/l) 150,000

Alternative: Revenue target met

Instead, assume that on the back of advertising spend in the last quarter of 20X1, Polaris
met the lower revenue target entitling its former shareholders to a payout of HK$100,000.
Prepare the journal entry by Solaris to effect the change in contingent consideration
liability.

Analysis

Soleil prepares the following journal entry:

Debit Credit
HK$ HK$
Contingent consideration (liability) 50,000
Gain on remeasurement of contingent consideration (p/l) 50,000
(Movement in the fair value of the contingent payment from HK$150,000 to HK$100,000)

and, on payout to the vendor:

Debit Credit
HK$ HK$
Contingent consideration (liability) 100,000
Cash 100,000

In this example, the reporting date 31 December 20X1 is also the date of the
contingency is resolved (as the revenue target had to be met within 12 months of the
acquisition date). Where this is not the case, the entity must continue to remeasure
the liability as required by HKFRS 3 (Revised) until that time.

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29.5.3 Reacquired Rights

As is highlighted in Section 29.2.3.3, a reacquired right may be recognised as an intangible
asset. Consistent with their initial measurement, such rights are amortised over the remaining
HKFRS contractual period of the contract in which the right was granted (i.e. ignoring any probable
3(R).55 contract extensions).

The reacquired right intangible asset is derecognised if the right is on-sold.

29.5.4 Indemnification Assets

An indemnification asset is measured on the same basis as the indemnified item at the end of
each subsequent reporting period, subject to any contractual limitations on its amount (e.g. the
HKFRS cap) and its collectability (where not measured at fair value). It is derecognised when the
3(R).57 acquirer collects the asset, sells it or otherwise loses the right to it.

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SUMMARY

• A transaction must have the following features for it to be a business combination: A business
must be acquired, and the acquirer must control the business after the acquisition.

°° A ‘business’ includes at least one substantive process and inputs.

°° A substantive process would generally include acquiring access to a relevant organised

workforce.

• A parent (the acquirer) controls another entity (subsidiary-acquiree) or a business (acquiree)

when the parent is exposed or has rights to variable returns from its involvement with the
other entity or business and has the ability to affect those returns through its power over it.

• The acquisition method must be applied to account for a business combination. Applying the
acquisition method involves the following steps:

°° Identify the acquirer.

__ The acquirer is the entity that controls the acquired business following the business
combination.

°° Determine the acquisition date.

__ The acquisition date is the date the acquirer gains control of the acquiree (e.g. the date
on which the acquirer receives title to share interests in the acquiree).

°° Determine the consideration (including any contingent consideration) measured at fair

value at the acquisition date.
__ Acquisition-related costs are not included as part of the accounting for the business
combination transaction.

°° Recognise and measure the identifiable (tangible and intangible) assets acquired, the
liabilities assumed and any non-controlling interest in the acquiree.
__ Identifiable net assets of the acquiree must be separately recognised and measured at
their fair values on the acquisition date, with limited exceptions to these principles. This
may result in previously unrecognised assets (e.g. some intangible assets) and liabilities
(e.g. contingent liabilities) of the acquiree being recognised.
__ Any non-controlling interest that is entitled to share in the net assets of the acquiree
in the event of liquidation is measured at its fair value on the acquisition date or as a
proportionate share in the recognised amounts of the acquiree’s identifiable net assets.
This choice is made on a business-combination-by-business combination basis.

°° Recognise and measure goodwill or a gain from a bargain purchase.

__ Goodwill is an asset representing the future economic benefits arising from other assets
acquired in a business combination not individually identified and separately recognised.

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__ Goodwill is measured as the excess of the fair value of consideration plus the amount of
the NCI plus the fair value of any previously held equity interest in the acquiree over the
recognised amounts for identifiabl net assets of the acquiree on the acquisition date.
__ After double checking amounts determined in the preceding steps, an acquirer will
recognise a gain from bargain purchase in profit or loss when the recognised amount for
identifiable net assets of the acquiree exceeds the fair value of consideration plus the
amount of the non-controlling interest on the acquisition date.

• The acquirer must retrospectively adjust its accounting for a business combination for
measurement period adjustments: A measurement period adjustment is identified within
the 12-month period after the acquisition (this period may be shorter) and arises from new
information obtained that provides more information about the facts and circumstances at
the acquisition date.

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MIND MAP

WHAT IS A BUSINESS COMBINATION HOW TO ESTABLISH WHETHER A

TRANSACTION IS A BUSINESS COMBINATION
A transaction or other event in which an
acquirer obtains control of one or more There must be a ‘business’: Inputs, processes
businesses and (maybe) outputs. Includes 1+ substantive
process, organised workforce
KEY AREAS OF PROFESSIONAL
JUDGEMENT/ESTIMATION Acquirer gains control of a business
Control: Power, Variable Returns and
Identifying whether acquired a business
Current Ability to use power to affect the
(or just assets)
returns
Identifying the acquirer
Acquisition of net assets or acquisition of
Establishing when control passes share capital
(acquisition date)
HOW TO ACCOUNT FOR A BUSINESS
Valuing share consideration Business COMBINATION
Valuing contingent consideration combinations
(HKFRS 3 (Revised)) Acquirer applies the acquisition method at
Identifying all identifiable net assets
acquisition date
Valuing all identifiable net assets (typically
All valuation (fair value, limited exceptions)
at fair value)
is based on acquisition date facts and
New information in measurement circumstances
period = adjust goodwill?
Measurement period ≤ 12 months
NOT PART OF THE BUSINESS COMBINATION Acquisition Method
Transaction benefits acquirer/combined • Consideration + NCI + Previously Held Interests
entity vs primarily benefiting – Fair value (limited exceptions) of net assets
acquiree/former owners (acquired)
for example, = Goodwill (asset) or Gain on bargain purchase
• Acquisition-related costs: expensed, other
(income)
than debt/share issue costs (HKAS 32, HKFRS 9)
• In-effect settlement of pre-existing HKFRS 3 recognition and measurement principle
relationships • Separately recognise identifiable net assets at
• Remuneration for future services fair value (limited exceptions)
Also separate: • Result: Some unrecognised assets and
• Remeasurement/settlement of contingent liabilities brought onto the statement of
consideration financial position (e.g. certain intangible
• Remeasurement/settlement of contingent assets and contingent liabilities)
liability
NCI
Non-controlling interest (NCI) = shareholding
held by parties outside the group
Choice of measurement of NCI at acquisition
date for each acquisition: (1) proportion of
net assets, or (2) at fair value
Choice impacts the amount of goodwill or
gain on bargain purchase recognised

Answers to Knowledge Check Questions

Question 1
The arrangement between Soleil and Polaris is a business combination if a business
has been acquired and the acquirer has control over the business subsequent to the
transaction.
In this arrangement, Soleil is the acquirer of Polaris; therefore, Soleil needs to
determine whether the activities and assets it acquires through purchasing equity in
Polaris constitutes a business. To this end, it is concerned whether it has acquired inputs
and at least one substantive process critical to the ability of Polaris to continue producing
outputs (see Exhibit 29.3). In this instance, the equity purchase gives Solaris access to a
continuing operation that has outputs, employees and other assets (inputs) and processes.
As the entire operating company is acquired, including the workforce, Soleil concludes at
least one of the processes it acquires must be substantive. Because Solaris will not rebrand

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 FINANCIAL REPORTING

Polaris and that some of Polaris’s systems will be integrated with Soleil’s does not affect
this assessment as of the time of acquisition, all Polaris’s activities and assets (including an
organised workforce) will be acquired, enabling it to continue operating as a business.
By acquiring the majority equity interest in Polaris, Soleil:

• Holds a majority voting right, sufficient to give it the power to direct the operating
and financial activities of Polaris as the other shareholders cannot prevent Soleil
from implementing its decisions;
• Is exposed to returns (e.g. dividends) that vary with Polaris’s performance; and
• As the owner of the rights, can use the power conveyed by those rights to affect the
returns it receives.

That is, Soleil controls the business operated by Polaris after the acquisition.
Consequently, the arrangement between Soleil and Polaris is determined to be a
business combination.

Question 2
Answer A is incorrect. Alpha has acquired an asset rather than a business.
Answer B is incorrect. Aperol has acquired Gin in a business combination; however, as
the entities involved remain controlled by the same ultimate parent (Tequila) before and
after the combination and that control is not transitory, the transaction is scoped out
of HKFRS 3.
Answer C is incorrect. Amalfi’s ‘acquisition’ of Azur is not a business combination (as Azur
is not a business); therefore, it is not within the scope of HKFRS 3. Azur’s acquisition of
Cinque is a business combination but as the entities involved remain controlled by the
same ultimate parent (Amalfi) before and after the combination and that control is not
transitory, the transaction is scoped out of HKFRS 3.
Answer D is correct. Beta acquires a business when it acquires the HKSE-listed Xylon.
Because Beta is not an investment entity, the business combination is within the scope
of HKFRS 3.

Question 3
To have control, Candy must have substantive rights that give it power over Sweetie. In
this case, Candy’s rights through its ownership of the Class B shares do not give Candy the
current ability to direct Sweetie’s financial or operating activities. For example, the rights
it holds to vote on share dilution are protective rights, but these do not convey any ability
to vote on other operating and financing activities that significantly affect Candy’s returns,
such as whether to declare a dividend or executive recruitment decisions. As such, Candy
does not control Sweetie in the absence of any further information.

Question 4
For a business combination to be present, First Class must acquire a business that it
controls subsequent to the acquisition.
First Class first assesses whether it has acquired a business by evaluating whether it
has acquired an integrated set of activities and assets that represent at least an input and
a substantive process (or group of processes), and even outputs:

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• Inputs First Class acquires inputs, including the hotel buildings, the fixtures and
fittings, the customer lists and the contracts over the hotel workforce.
• Processes First Class acquires existing operational and other processes that can be
applied to inputs (in the form of an organised workforce, hotel rooms,
etc.) that can contribute to outputs. First Class identifies the operational
processes applied by the workforce, including managerial duties carried out
by managerial-level staff, to be critical to the ability of the hotels to continue
to deliver accommodation services.
• Outputs Even though First Class intends to rebrand the hotels and will not use some
existing processes, at acquisition First Class acquires outputs in the form of
accommodation services at these hotels as it has acquired relevant inputs
and processes that can produce these services to customers.

Having regard to the set of activities and assets, First Class assesses that it has acquired:

• Processes critical to continue producing outputs; and

• Inputs that include an organised workforce with the necessary skills, knowledge or
experience to perform those processes.

Accordingly, First Class concludes it has acquired a business because the set of
activities and assets acquired in its current condition and state is capable of being
conducted and managed for the purpose of providing a return to First Class’s owners.
Next, First Class must assess whether it controls the business subsequent to the
acquisition. First Class has control over the business if it has power over the business and
exposure to variable returns. It must also be able to use that power to affect its returns
from the business. In this case, through ownership of the hotel and its fixtures and fittings
and operating as the employer of the organised workforce, First Class has the ability and
right to direct the relevant activities of each hotel. First Class has exposure to variable
returns as its returns from the business are affected by each hotel’s performance. Hence,
First Class determines that it controls the business subsequent to the acquisition.
Consequently, First Class concludes it has entered into a business combination when it
acquires the hotels from Bekpax.

Question 5
The total amount of recognised identifiable assets acquired and liabilities assumed is:

HK$
Carrying amounts of Peyton’s recognised assets and liabilities at 4,161,800
acquisition date
less: Adjustment to measure recognised property at fair value (50,000)
add: Increase in related deferred tax balance (50,000 × 16.5%) 8,250
4,120,050

Note: Peyton and Omega’s different tax rates do not affect the measurement of the
deferred tax liabilities assumed. Review Chapter 19 to understand why (consider the tax
rate that applies when consuming the assets or settling the liabilities giving rise to those
future taxable amounts).

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Question 6
NCI at acquisition date = 10% × HK$4,120,050 = HK$412,005

Question 7
Answer A is incorrect. A factory building classified as property, plant and equipment is
measured at its acquisition-date fair value.
Answer B is incorrect. A lessor measures a building under operating leases at the building’s
acquisition-date fair value.
Answer C is incorrect. A recognised contingent liability is measured at its acquisition-date
fair value.
Answer D is correct. In applying the acquisition method, non-current assets held for sale
are measured at their fair value less costs to sell rather than at their acquisition-date
fair value.

Question 8
Answer A is incorrect. Future restructuring costs that an acquirer expects to incur do not
HKFRS meet the definition of a liability at acquisition date. Accordingly, under HKFRS 3 (Revised),
3.BC114 such costs are not a liability acquired as part of a business combination.
Answer B is correct. Because the acquirer has a present obligation (under the warranty)
in respect to a past event (sale of goods), the settlement of which is expected to result in
an outflow from the entity (i.e. the definition of a liability is met). The warranty obligation
would normally be transferred as part of the business combination rather than the result
of a separate transaction.
Answer C is incorrect. Under HKFRS 3 (Revised), expenses for legal services received in
HKFRS connection with a business combination are not capitalised (as part of goodwill). Such
3.BC114 expenses do not meet the definition of an asset at the acquisition date.
Answer D is correct. Because the definition of a liability is met although an outflow from
the acquiree under the obligation is improbable. Under HKFRS 3 (Revised), a contingent
liability that is a present obligation resulting from past events must be recognised.

Question 9
Answer A is incorrect. This response excludes the fair value of contingent consideration
from the calculation of the total consideration transferred.
Answer B is incorrect. This response measures contingent consideration having regard
to the payment most likely to be incurred based on history and does not price risk in the
contingency. Under HKFRS 3 (Revised), contingent consideration should be measured at its
fair value on acquisition date.
Answer C is correct. The answer is HK$13.5 million, calculated as the sum of:

HK$’000
Cash consideration 10,000
Share consideration (100,000 shares × HK$20) 2,000
Contingent consideration 1,500
13,500

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 B usiness Combinations

Answer D is incorrect. This response measures contingent consideration having regard to

the amount paid. Under HKFRS 3 (Revised), contingent consideration should be measured
at its fair value on acquisition date.

Question 10
Hi-Lo calculates the goodwill/gain from bargain purchase on the acquisition of
Loud Sound as:

NCI at NCI as
fair value proportion of
net assets
HK$ HK$
Fair value of consideration transferred (500,000 / 413,223 413,223
(1 + 0.1)2)
plus: Non-controlling interest 47,000 45,500a
plus: Fair value of previously held interests – –
less: Amount recognised for identifiable net assets (455,000) (455,000)
at acquisition date
Goodwill/(Gain on bargain purchase) on acquisition 5,223 3,723
a
10% × HK$455,000

If the NCI is measured as a proportionate share of the fair value of the net assets of
the acquiree, goodwill will arise. The goodwill will be capitalised as an asset and subject to
annual impairment testing.

Question 11
Answer A is incorrect. This is an acquisition-by-acquisition choice.
Answer B is incorrect. Though, in some cases, this might result in the same goodwill
number arising, this will not always be the case. For example, a different goodwill amount
would be calculated using this approach compared to the method specified by HKFRS 3
(Revised) if the NCI were measured at fair value or the acquirer held existing interests in
the acquiree.
Answer C is correct. In accordance with HKFRS 3 (Revised), the fair value of previously held
equity interests are added to the consideration transferred in the purchase that gives the
acquirer control of the business.
Answer D is incorrect. The measurement of contingent consideration is updated
subsequent to acquisition to ultimately reflect the resolution of the contingency
and settlement of the obligation. However, the re-measurement does not affect the
determination of goodwill, which is based on acquisition-date facts and circumstances.

Question 12
The completion accounts provide new information about the cash and debt levels that
existed at the acquisition date. As the information was obtained during the measurement
period (being within 12 months of the acquisition date), Soleil must adjust its estimate of
the fair value of the consideration transferred for this information. Resultantly, Soleil will
reduce any goodwill recognised in the combination by HK$10,000 (or recognise a larger
gain on bargain purchase).

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 FINANCIAL REPORTING

Because the measurement period ends by the end of Soleil’s financial year-end, Soleil
may not describe the business combination as being provisionally determined in its
financial statements for the year ended 31 December 20X1.

Question 13
Answer A is incorrect. The sale to a related party for a nominal amount does not provide
evidence an error exists in the provisional fair value measured on acquisition.
Answer B is incorrect. Paragraph 47 of HKFRS 3 (Revised) notes that information obtained
shortly after the acquisition date is more likely to reflect circumstances that existed at the
acquisition date than is information obtained several months later.
Answer C is correct. Paragraph 47 of HKFRS 3 (Revised) suggests that unless an
intervening event that changed its fair value can be identified, the sale of an asset to
a third party shortly after the acquisition date for an amount that differs significantly
from its provisional fair value measured at that date is likely to indicate an error in the
provisional amount.
Answer D is incorrect. The asset’s fair value changed as a consequence of an event that
occurred subsequent to the acquisition date. Therefore, it does not provide evidence of an
error in the provisional fair value measured on acquisition.

Question 14
Answer A is incorrect. In this case, goodwill will increase by the amount of the adjustment
to the provision but will decrease by the same amount by the adjustment to the claim
receivable from the insurer.
Answer B is incorrect. The court ruling is an example of new information about the
acquisition-date fair value of the liability.
Answer C is incorrect. The new information provides more evidence of the measurement
of the provision at acquisition date.
Answer D is correct. The court ruling is an example of new information about the
acquisition-date fair value of the liability. As such, the measurement of the provision at
acquisition date must be retrospectively adjusted, affecting the measurement of goodwill.

Question 15
Answer A is incorrect. Though contingent consideration transferred is recognised as part
of the business combination, the settlement of the obligation is not a measurement period
adjustment as it does not reflect facts and circumstances existing at the acquisition date.
Answer B is incorrect. Acquisition-related costs are not considered to be part of the
business combination transaction because the costs do not benefit the acquiree or its
former owners.
Answer C is incorrect. The initial recognition of a contingent liability that relates to
a present obligation arising from a past event is recognised as part of the business
combination.
Answer D is incorrect. The temporary difference is considered for recognition separately
from the business combination transaction.

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 B usiness Combinations

EXAM PRACTICE

QUESTION 1
Pepper Limited (Pepper) is in negotiations to acquire Salt Limited (Salt), which is closely
held by two shareholders. Salt manufactures an instant noodle product, which it sells to
wholesalers and retailers in Hong Kong.

Pepper and Salt’s shareholders enter into a contractual arrangement on 10 October

20X5. Under the terms of the arrangement, Pepper agrees to buy 75% of Salt’s ordinary
share capital from the shareholders on 15 November 20X5 in exchange for HK$1.5 million
cash and 1,000 shares in Pepper. The cash will be paid in three equal instalment payments
on 1 November 20X5, 1 November 20X6 and 1 November 20X7. Pepper and Salt will
exchange shares on 1 November 20X5. On that date, Pepper’s share price is HK$100. Salt’s
share price is HK$80.

In addition, the terms of sale include an earn-out clause. Under this clause, Pepper
agrees to pay Salt a further HK$300,000 if product sales grow by at least 10% per annum
between the date of acquisition and Pepper’s 31 December 20X7 financial year end. Salt’s
year-on-year growth to date has been steadily improving and approximates 6.5%; however,
its financial forecasts for the next two years target growth of 8.5% from the previous period.
It expects to achieve this growth through increasing its supply contracts with several of
its large wholesaler customers. Pepper engages the services of a valuation expert, who
determined the fair value of the earn-out payment on acquisition date to be HK$210,000.

The carrying amount of Salt’s assets and liabilities on the acquisition date are as follows:

HK$’000
Assets
Property, plant and equipment 800
Investments 380
Intangible assets 150
Deferred tax assets 200
Inventories 120
Trade and other receivables 90
Cash 420

Liabilities
Employee benefit provision 100
Trade payables 110

Pepper assesses the fair value of a machine used by Salt to be higher than its carrying
amount by HK$90,000. Pepper intends to sell that machine in its current condition and
has identified a buyer for it. In addition, Pepper identifies that Salt has an unrecognised
customer list. The fair value of that customer list is HK$40,000.

Pepper incurred legal costs of HK$15,000 and due diligence costs of HK$10,000 in
relation to the acquisition.

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 FINANCIAL REPORTING

Other information

• The estimated cost to sell the machine is HK$20,000.

• The tax base of the customer list is zero.

• On the acquisition date the written-down tax base of the machine is the same as its
net carrying amount.

• The tax rate is 16.5%.

• The discount rate is 10%.

• Pepper’s policy is to measure the NCI in a business combination at fair value. The
fair value of the NCI at acquisition date is HK$505,650.

You are the group finance manager of Pepper. Your junior accountant, Steve, is working
with you on the accounting for the acquisition.

A. Steve has asked if you could explain to him why you have determined that applying
the acquisition method to account for this transaction is appropriate. Prepare an email
responding to Steve.
B. Steve has calculated the total consideration transferred for the acquisition to be
HK$1.6 million. He explains to you that in determining this amount, he has not included
the possible earn-out payment as the most probable outcome is that Pepper will not be
required to make this future payment.

Determine whether using the amount calculated by Steve in applying the acquisition
method is appropriate.

C. Calculate the goodwill or gain on bargain purchase arising on the transaction.

D. On 30 April 20X6, Pepper’s CFO, Ms. Chung, receives a letter from Salt’s lawyers, advising
that the outstanding lawsuit brought against Salt has been dismissed. The CFO is
surprised because she was unaware of any open lawsuit at the time Salt was acquired.

On further investigation, the CFO learns that a consumer of Salt’s product had sued
Salt for ’long-term negative health impacts suffered from consuming Salt’s products’. The
consumer had argued that Salt should have included a health warning on its product
packaging. Salt’s lawyers contended the suit was frivolous and no link existed between the
consumer’s health issues and the product. The lawsuit was not disclosed in Salt’s latest
financial statements before the acquisition as the lawyers were 95% certain the case was
expected to be dismissed. At the time of acquisition, a hearing on the motion to dismiss was
still pending.

The CFO has come to you to inquire whether and, if so, how the information about the
lawsuit impacts the accounting for the acquisition. Prepare a memo responding to the CFO’s
concern. In the memo, justify your conclusions.

QUESTION 2
(Modified from June 2015 Exam Paper)

On 15 January 20X1, HKSE-listed company Bounce Limited (Bounce) entered into an

agreement to acquire 8,000 shares of Rubber Products Limited (RPL), representing an 80%
interest in RPL, for consideration comprising cash of HK$10 million and three million shares
in Bounce. In addition, one million more shares in Bounce will be issued to the sellers if RPL’s
net profit after tax for the year ending 30 June 20X2 exceeds HK$50 million.

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 B usiness Combinations

The acquisition was subject to the Bounce’s shareholders’ approval. Bounce’s

shareholders approved the acquisition on 2 February 20X1.

Bounce determines its 80% interest in RPL is sufficient to give it control over RPL on
fulfilment of certain other substantive pre-conditions in the agreement. The required
conditions were satisfied on 18 February 20X1.

The following information is available:

15 January 2 February 18 February

20X1 20X1 20X1
HK$ HK$ HK$
Per share fair value of each 1.50 1.45 1.60
Bounce share
Per share fair value of each RPL share 8 7 7.50
Fair value of contingent consideration 200,000 250,000 400,000

There were no differences between the carrying amount and the fair value of all assets
and liabilities of RPL except for plant with carrying amount of HK$100 million and fair value
of HK$120 million. In addition, Bounce observed that RPL has potential contracts totalling
HK$15 million from prospective new customers.

As part of its due diligence on the acquisition, Bounce observed that RPL has not
recognised deferred tax liabilities of HK$2 million due to the initial recognition exemptions
in HKAS 12 Income Taxes. In addition, RPL has not recognised HK$1 million of tax losses as
management considered that future taxable profit would probably not be available against
which those particular tax losses can be used. Following advice received, Bounce believes
it is probable that a further HK$250,000 of the tax losses will be utilisable following the
acquisition.

In total, Bounce incurred legal and advisory costs of HK$500,000 in relation to the
acquisition and HK$30,000 in costs to issue the new shares.

A. Gary Khoo from Bounce’s media team is preparing a draft presentation for the upcoming
Investors’ Meeting relating to the financial year-end 30 June 20X1. As part of his
materials, he wants to exclude for investors the impact of the contingent consideration
on Bounce’s profit or loss.
Analyse the contingent consideration payable to RPL’s former owners and explain
to Gary its impact on Bounce’s profit or loss at the date of acquisition and for the years
ending 30 June 20X1 and 30 June 20X2.
B. Explain how the consideration transferred should be measured and calculate the relevant
amount recognised for the acquisition.
C. Analyse the accounting implications of the prospective contracts, acquisition-related
costs and deferred taxation involved in the acquisition. Justify your response.

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 FINANCIAL REPORTING

ANSWERS TO EXAM PRACTICE

QUESTION 1
To: Steve

From: [Group Finance Manager]

Dear Steve,

As mentioned, applying the acquisition method is appropriate to account for the Salt
acquisition because the acquisition is a business combination.

To be a business combination, the acquirer (us: Pepper) must acquire a business and must
control that business following the acquisition.

In this instance, Pepper clearly controls any business acquired after the acquisition because
we hold the rights to 75% of Salt’s equity, which gives us a majority of the voting power of the
business. As such, the rights give our management the current ability to direct Salt’s operating
and financial activities. Our 75% equity interest in Salt also exposes us to returns variable on
Salt’s performance (e.g. if Salt only can make dividend distributions out of profits) but we can
use our rights to affect the return we obtain (e.g. by setting the dividend amount).

To qualify as a business, Pepper must acquire an integrated set of activities and assets that
is capable of being conducted and managed by a market participant. As Salt is an operating
company, through the equity purchase, Pepper acquires all of Salt’s inputs and outputs,
including access to its organised workforce and all its processes. The activities and assets
Pepper acquires include at least one substantive process that significantly contributes to the
ability of the acquired inputs to create outputs because:

• Its equity investment in Salt will give it access to at least one process critical to continue
producing outputs (e.g. the supply chain processes); and

• The acquired inputs include an organised workforce with the necessary skills,
knowledge or experience to perform that process.

Pepper concludes it has acquired a business as it can continue to operate Salt (i.e. produce
and sell instant noodles) without making any changes to Salt’s operations.

Kind regards

[Group Finance Manager]

(a) It is inappropriate to use the amount calculated by Steve in applying the acquisition
method because Steve’s calculation does not incorporate the fair value of the
contingent consideration nor include adjustment to recognise that part of the
consideration transferrable is on deferred terms.

The total consideration transferred in the business combination is:

HK$
Cash – 1 November 20X5 500,000
Fair value of Pepper’s shares (HK$100 × 1,000) 100,000
Cash payable – 1 November 20X6 (HK$500,000 / 1.1) 454,545

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 B usiness Combinations

HK$
Cash payable – 1 November 20X7 (HK$500,000/ 1.1^ ) 2
413,223
Fair value of contingent consideration 210,000
Consideration transferred for equity interests in Salt 1,677,768

(b) The goodwill arising on the transaction is calculated as follows.

HK$
Consideration (from Question 2) 1,677,768
NCI @ fair value 505,650
Previously held interest @ fair value –
2,183,418
less: Net assets acquired (see below) (2,041,850)
Goodwill on acquisition 141,568

Net assets acquired

HK$
Carrying amount of net assets reported by Salt 1,950,000
Adjustments:
: adjustment to recognise customer list 40,000
: adjustment to recognise related deferred tax liability (16.5% × 40,000) (6,600)
: adjustment to recognise machine at fair value less costs to sell 70,000
(HK$90,000 – HK$20,000)
: adjustment to recognise the related deferred tax liability (16.5% × (11,550)
HK$70,000)
2,041,850

Pepper classifies the machine as held for sale. As such, on acquisition Pepper
measures it at its fair value less costs to sell (FVLCTS) rather than at fair value.

The acquisition-related costs (legal fees and due diligence fees) are not part of the
business combination transaction. As such, these costs do not impact the goodwill
calculation but are expensed by Pepper as incurred.

(c) Memo

To: Ms Chung, Chief Financial Office

From: Group Finance Manager

Date: X May 20X6

Subject: Lawsuit against Salt

Dear Ms Chung,

The information about the lawsuit will not impact the previously determined accounting
for the acquisition. That is, no further liability will be recognised on the acquisition

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 FINANCIAL REPORTING

date, and consequently, no impact occurs to the amount of goodwill arising on the Salt
acquisition.

Because the information is obtained during the measurement period of the acquisition,
we would have been required to retrospectively adjust the accounting for the business
combination to recognise a further liability had it qualified for recognition. However, the
lawsuit is a contingent liability that relates to a possible obligation as a result of a past
obligating event and, as such, is not recognised under HKFRS 3 (Revised). The obligation
is only ‘possible’ at the acquisition date because Salt does not consider a link exists
between the consumer’s health issues and the product.

If we had known about the open lawsuit before the acquisition, we might have
considered the risk that the case would not be dismissed in setting the consideration
for the investment.

Kind regards,

[Group finance manager]

QUESTION 2
A. Gary,

Contingent consideration forms part of the consideration transferred for a business

combination. As such, it is accounted for in determining the goodwill on acquisition and,
hence, does not impact the profit or loss on acquisition.

The contingent consideration in this acquisition is for the issue of a further one million
shares of Bounce. Because the contingency is a liability of the company that is settled
by a non-variable number of Bounce’s equity instruments (its ordinary shares), on its
recognition (on the business combination acquisition date), it is classified as equity
in accordance with HKFRS 3 (Revised). As such, the contingency is not remeasured at
an interim reporting date and does not impact profit or loss for the year ended 30
June 20X1.

On 30 June 20X2, if RPL fulfils the profit target, one million shares will be issued. However,
there is still no remeasurement of the contingent consideration from its acquisition-date
fair value (to reflect the fair value of the one million shares on issue date). Hence, even
then the contingent consideration will not impact the profit or loss.

On 30 June 20X2, if Bounce does not fulfil the profit target, the one million shares will
not be issued. In accordance with HKFRS 3 (Revised), settlement of the contingent
consideration is accounted for within equity. As such, there will be no derecognition of
the acquisition-date fair value of the contingent consideration to profit or loss.

B. The consideration transferred in a business combination is measured as the sum of the

acquisition-date fair values of the assets transferred, liabilities incurred and the equity
interests issued by Bounce. The acquisition date is the date on which Bounce obtains
control over RPL, being 18 February 20X1, the date on which all the conditions to obtain
control were satisfied.

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 B usiness Combinations

The consideration transferred by Bounce is:

HK$
Cash 10,000,000
Fair value of 3 million Bounce shares @ HK$1.60 4,800,000
Fair value of contingent consideration 400,000
Total consideration transferred 15,200,000

C. Prospective contracts

The prospective contracts can be recognised as an acquired identifiable intangible asset

only if they meet the definition of an asset on the acquisition date and have a contractual-
legal basis or can be separated from RPL. The prospective contracts are not assets at
the acquisition date because they do not give RPL control over any present economic
resource (e.g. cash inflows) as a result of a past event (such as a signed contract).
Therefore, they are not recognised separately as part of the business combination, but
any value Bounce attributes to them is subsumed into goodwill.

Acquisition-related costs

Under HKFRS 3 (Revised), only those transactions that form part of the business
combination transaction are included in the acquisition accounting. Bounce’s acquisition-
related costs are not part of the consideration transferred in exchange for RPL because
they are incurred primarily to benefit the acquirer rather than the acquiree or its
former owners and, as such, are transactions separate from the business combination
transaction. In accordance with HKFRS 3 (Revised), Bounce must expense the legal and
advisory fees as incurred. The costs of issuing the three million shares are deducted
from equity in accordance with HKFRS 9 Financial Instruments and HKAS 32 Financial
Instruments: Presentation (i.e. they do not reduce the fair value of the shares included as
consideration transferred in the business combination).

Deferred tax consequences of the fair value adjustment to plant

In accordance with HKFRS 3 (Revised), the plant is recognised at its fair value as part of
the accounting for the business combination. Because the tax base of the plant is not
affected by the change in ownership of RPL, a taxable temporary difference will arise
on acquisition for the difference between the new carrying amount (fair value) and
its tax base in the consolidated financial statements. This difference (multiplied by an
appropriate tax rate) is recognised in Bounce’s consolidated financial statements as a
deferred tax liability assumed as part of the acquisition.
Deferred tax liabilities of HK$2 million

In its consolidated financial statements, Bounce should separately recognise the deferred
tax liabilities of HK$2 million that are unrecognised in RPL’s books. This is because the
initial recognition exemptions in HKAS 12 do not apply to assets and liabilities acquired
in a business combination. (The difference in the deferred tax liabilities recognised in
RPL’s own financial statements and its deferred tax liabilities as included in the group’s
consolidated financial statements will exist until the taxable temporary difference
is settled.)

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 FINANCIAL REPORTING

Tax losses

A deferred tax asset must be recognised for tax losses if they are probable of being
utilised. Accordingly, given that Bounce thinks it will be able to benefit from a further
HK$250,000 of RPL’s tax losses, these tax losses must be separately recognised as an
identifiable asset acquired as part of the business combination. (RPL should also reassess
whether these tax losses qualify for recognition in its own financial statements following
the business combination because its own assessment of their recovery may change.)

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 30
Consolidated Financial
Statements with a Simple
Group Structure

CHAPTER TOPIC LIST

30.1 Consolidated Financial 30.3 Simple Group

Statements with a Simple Structure Practice
Group Structure Overview 30.4 Consolidated Statement
30.1.1 Scope and Terminology of Cash Flows
30.1.2 Levels of Investment 30.4.1 Acquisition of a Subsidiary
30.2 Principles of Consolidation 30.5 Deferred Taxes
30.2.1 C oncept of Control (HKFRS 10)
30.2.2 Review of Consolidation 30.6 Current Developments
Procedures

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT

FOR BUSINESS TRANSACTIONS
LO2.07: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: Income Taxes
2.07.07 Account for deferred tax relating to investments in subsidiaries, associates and joint ventures
PRINCIPAL LO4: PREPARE, PRESENT AND APPRAISE GROUP FINANCIAL STATEMENTS WITH
COMPLEX GROUP STRUCTURES
LO4.03: C
 onstruct the financial statements for a group in accordance with Hong Kong Financial
Reporting Standards and statutory reporting requirements: Concepts of control and
consolidation
4.03.01 Describe the concept of a group as a single economic entity
4.03.02 Analyse what constitutes control and the impact of potential voting rights
4.03.03 Classify a subsidiary and determine when a group should start and stop consolidating a
subsidiary
4.03.04 Define investment entity
4.03.05 Explain the purpose of consolidated financial statements
4.03.06 Explain the importance of uniform accounting policies and coterminous year ends in the
preparation of consolidated financial statements
4.03.07 Account for adjustments required to measure differences in the length and timing of
accounting periods
4.03.08 Account for deferred tax arising from business combination
4.03.09 Evaluate and apply the appropriate accounting treatment of goodwill, including the
impairment of goodwill
4.03.10 Explain the importance of eliminating intragroup transactions
4.03.11 Account for the effects of intragroup trading
4.03.12 Account for non-controlling interest, including when the subsidiary has negative
equity balance
4.03.13 Construct a consolidated statement of profit or loss and other comprehensive income
4.03.14 Construct a consolidated statement of change in equity
4.03.15 Construct a consolidated statement of cash flows
4.03.16 Describe the concept of a group as a single economic entity

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 Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

OPENING CASE

THE SOLEIL GROUP

T he Soleil Group operates an extensive global logistics network across 600 locations in more
than 50 countries. The group provides a diverse range of transport and logistics solutions
covering road, air, sea and rail to meet global supply chain needs. The ultimate parent entity in
the group is Soleil Limited (Soleil).

Soleil is always on the lookout for strategic expansion opportunities. This may involve
acquiring existing business to gain entry into new geographical markets, eliminate local
competition, introduce a new service offering to the group’s customers or improve its back-end
operational capabilities. In some cases, Soleil expands its operations through entering into
a business relationship with one or more other investors to test a new business venture by
setting up a new company or acquiring an associate ownership interest in an existing company.

Soleil’s group structure in part looks as follows, with the indicated proportionate
shareholdings:

Soleil Limited

80% 100% 100% 80%

Astro Limited Mercury Limited Caelus Limited Polaris Limited

90%

Hercules Limited

Mercury Limited (Mercury) and Caelus Limited (Caelus) were set up by Soleil to manage the
bulk of the group’s transport and logistic operations. Astro Limited (Astro) and Polaris Limited
(Polaris) are existing businesses acquired by Soleil, primarily to eliminate local competition.

Soleil routinely conducts transactions with its subsidiaries, including the sale and purchase
of inventory or services on terms and conditions that are better than if each entity were to go
to market for the goods or services. The terms and conditions allow the selling entity to make
a small profit margin on the transaction. In addition, assets are occasionally transferred (sold)
between the group entities.

Soleil prepares consolidated financial statements in accordance with HKFRSs at each

reporting period end. Mercury, Polaris and Hercules Limited (Hercules) also prepare financial
statements in accordance with HKFRSs. Caelus, which is incorporated in China, prepares
financial statements in accordance with Chinese Accounting Standards for Business Enterprises
(CASBE). Soleil’s tax rate is 16.5%.

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 FINANCIAL REPORTING

OVERVIEW

The preparation of consolidated financial statements by parent entities can be complex in

practice. In this chapter, with reference to the Soleil group, you will learn how to identify
a parent entity and review and practice the principles underpinning the preparation and
presentation of such statements, including understanding the types of transactions for
which consolidation adjustments are required. By the end of this chapter, you should be
able to prepare a consolidated statement of financial position, consolidated statement of
profit or loss and other comprehensive income, consolidated statement of changes in equity
and a consolidated statement of cash flows for a parent with one or more subsidiaries with
straightforward transactions.

Business combinations achieved in stages (step acquisitions), disposals and disclosures are
addressed in Chapter 34. The impact of a foreign subsidiary on consolidation procedures is
discussed in Chapter 31.

Unless otherwise indicated, this chapter illustrates the tax impact of consolidation
procedures using a tax rate of 16.5%, and it assumes the tax base of the item is the same as its
net carrying amount in the books of the subsidiary immediately before the acquisition.

3 0 . 1 CONSOLIDATED FINANCIAL STATEMENTS

WITH A SIMPLE GROUP STRUCTURE
OVERVIEW

A business might be structured into separate legal entities for various reasons, including to
manage risks by quarantining certain risks in separate limited liability structures or because
local law requires an entity to be incorporated for business activity to be undertaken in a
particular jurisdiction. For reporting purposes, the results and financial position of these
entities are reported together, in ‘consolidated financial statements’. Consolidated financial
statements are also often referred to as group accounting or the group accounts.

The accounting for consolidated financial statements is primarily addressed by the

following accounting pronouncements:

• HKFRS 10 Consolidated Financial Statements establishes principles for presenting and

preparing consolidated financial statements when a parent controls one or more
subsidiaries;

• HKAS 1 Presentation of Financial Statements sets out details of what must be presented
on the face of consolidated financial statements and/or in the notes to the financial
statements; and

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 Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

• HKFRS 12 Disclosure of Interests in Other Entities specifies further disclosures about a

parent’s interests in subsidiaries (and other entities forming part of the group).

This section explains which entities must prepare consolidated financial statements,
highlighting key terminology relevant to understanding the applicable accounting
requirements. This section also provides direction to the applicable accounting treatment
where the extent of an investor’s influence over another entity is insufficient to require the
preparation of consolidated financial statements.

30.1.1 Scope and Terminology

In general, HKFRS 10 requires a parent (parent undertaking) that controls one or more
subsidiaries (subsidiary undertaking) to present consolidated financial statements.

A parent is defined as an entity that controls one or more entities; a subsidiary is an entity
controlled by another entity. An investor (parent) controls an investee (subsidiary) when it is
HKFRS
10.6, exposed, or has rights, to variable returns from its involvement with the investee and has the
App. A ability to affect those returns through its power over the investee. Control is discussed further
in Section 30.2, but at its simplest when involving companies, control is present when one
company holds the majority voting power through share ownership in another company. The
HKFRS portion of equity in a subsidiary that is not attributable, directly or indirectly, to the parent, is
10.App. A referred to as the non-controlling interest (NCI).
Consolidated financial statements must be prepared from when an entity (parent) gains
control of another entity (subsidiary), and consolidation of a subsidiary ceases only when the
parent loses control of that subsidiary. The consolidated financial statements are the
financial statements of the economic entity consisting of a parent and one or more of its
subsidiaries, that is, a group (see the comment in Section 30.1.2) 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’. That is, the consolidated financial statements recognise
HKFRS assets and liabilities of the subsidiaries in the group on a line-by-line basis as if they are the
10.App. A parent’s assets and liabilities.

Other than for several additional subtotals acknowledging that the profit and reserves in
the group ‘belong’ to the parent’s shareholders and NCI, the face of the consolidated financial
statements looks the same as the financial statements of an individual company.

Why consolidate? Consider the economic flows between a parent and its subsidiaries: for
example, net cash inflows to the parent include distributions to the parent from its subsidiaries
(e.g. dividends), which themselves are dependent on the subsidiaries’ performance. Because
consolidated financial statements provide information about the assets, liabilities, equity,
income and expenses of the parent and its subsidiaries as a single economic entity, that
summarised information provides useful information for existing and potential investors,
HKFRS
Conceptual lenders and other creditors of the parent to assess the parent’s prospects for future net
Framework.3.15 cash inflows.

The concept behind consolidation is the single economic entity. There may be transactions
between entities in a group, for example, intragroup sales and purchases of inventory.
In presenting information about the entities as a single economic entity, these transactions
are addressed; otherwise, the financial statements may present misleading information
(e.g. double counting) to users. Consolidation procedures (often called eliminations) are applied
to such transactions to prepare the consolidated financial statements.

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HKFRS Limited exceptions apply to the requirement for a parent to present consolidated financial
10.4, HK
Companies statements by HKFRS 10 Consolidated Financial Statements or by the Hong Kong Companies
Ordinance
Cap.622. Ordinance (Cap 622). In general, the exceptions are provided having regard to the cost benefits
s.379(3) of preparing consolidated financial statements, for example, where useful information about
the entity is sufficiently included in another set of consolidated financial statements or another
measurement basis provides more useful information.
HKFRS
10.4, 4B Exhibit 30.1 summarises the main HKFRS 10 scope exemptions.

Does the investor hold an interest in a

Is the investor Yes Yes subsidiary that is not an investment entity,
Is the investor an investment entity?
a parent? and whose main purpose and activities
are providing services that relate to the
No parent’s investment activities?

Is the investor a subsidiary of another No

Yes
entity, whose owners have been No
informed and do not object to Exempted from
consolidated financial statements preparing consolidated
not being presented? financial statements
Yes
The subsidiary must be consolidated
Are the investor’s debt/equity Yes
instruments traded on a public market
(e.g. listed securities)?

No Investor must prepare

consolidated financial
Has the investor filed (or is in the statement
process thereof) its financial
statements with a securities
commission or other regulatory Yes
organisation for the purpose of issuing
its instruments in a public market?
(i.e. the investor about to list its
securities?)

No

Does its parent (ultimate/intermediate)

produce publicly available
Yes Exempted from preparing
IFRS/HKFRS compliant financial
consolidated financial
statements in which the investor is
statements
consolidated or measured at fair value
through profit or loss?

EXHIBIT 30.1 Limited scope exemption from preparing consolidated financial statements

In addition to the scope exemptions set out in Exhibit 30.1, some entities may have
established and controlled employer post-employment or other long-term employee benefit
plans (e.g. a group defined benefit scheme open only to employees). Because a control
relationship exists, the entity meets the definition of a parent, and the plan meets the definition
of a subsidiary. However, these plans are accounted for in accordance with HKAS 19 Employee
Benefits to the extent they are within the scope of that Standard.

A parent that is an ‘investment entity’ is exempted from preparing consolidated financial

statements as described in Exhibit 30.1. Instead, the parent presents financial statements that
incorporate its subsidiaries by measuring the investments at fair value through profit or loss in
accordance with HKFRS 9 Financial Instruments. Such a parent may present separate financial
statements as its only financial statements.

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An investment entity is an entity that:

• Obtains funds from one or more investors for the purpose of providing those
investor(s) with investment management services;

• Commits to its investor(s) that its business purpose is to invest funds solely for returns
from capital appreciation, investment income, or both; and
HKFRS
10.27,
• Measures and evaluates the performance of substantially all of its investments on a fair
App. A value basis.

Examples of an investment entity include some (but not all) unit trusts and managed
investment schemes. The typical characteristics of an investment entity are:

• Multiple investments;

• Multiple non-related party investors; and

HKFRS
10.28 • Holds ownership interests in its investments in the form of equity or similar interests.

An investment entity may provide investment-related services (e.g. investment advisory

services, investment management, investment support and administrative services) to
customers, including its investors, either directly or through a subsidiary. It may also provide
management services, strategic advice or financial support to its investees; however, these
HKFRS
10.B85D– must not represent a separate substantial business activity or a separate substantial source of
85E income to the entity (as otherwise the definition of an investment entity will not be met).

An entity’s business purpose may be evidenced through:

• Documents, such as offering memoranda or publications distributed by the entity

communicating its investment objectives or by the manner in which the entity presents
itself to other parties. For example, the fact sheet for a managed investment scheme
may present its investment objective as ‘providing moderate income and capital growth
over the medium to longer term’; and

• Its investment plans, because an investment entity could be expected to have

considered its exit strategy from investments, for example, documentation of how the
entity plans to realise capital appreciation from most of its equity investments and
HKFRS
10.B85B, non-financial asset investments (e.g. sale of shares or real estate on market, through
85F-85G an initial public offering or a private placement, or via capital returns).

Illustrative Example 1
Xylon Limited (Xylon) jointly develops, produces or markets products with its investees.
Xylon is not an investment entity as the entity will earn returns from the development,
production or marketing activity as well as from its investments. That is, Xylon has
a business purpose inconsistent with the business purpose of an investment entity
because it is not investing funds solely for returns from capital appreciation and/or
investment income. Accordingly, Xylon must prepare consolidated financial statements
that consolidate its controlled investees.
(source: based on HKFRS 10.B85B)

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A parent may become, or cease to be, an investment entity. The accounting for the change
in status is outside the scope of this module. Just be aware that the entity must start or cease to
consolidate its subsidiaries from the date of the change in status.

30.1.2 Levels of Investment

As noted earlier, an investor that controls another entity has a parent-subsidiary relationship
and prepares consolidated financial statements. However, the extent of an investor’s influence
over another entity may be less than ‘control’.

Before discussing whether an investor controls another entity, it is useful to outline

the possible levels of investment and their related accounting bases, in addition to a
parent-subsidiary relationship. Exhibit 30.2 details the ‘levels’ of investment possible in
another entity.

‘Level’ of Characteristic Generally-associated Applicable Accounting

investment ownership interest accounting basis discussed in
Subsidiary Control More than 50% Consolidation Chapters 30,
31 and 34
Joint venture Joint control 50% Equity accounting Chapter 33
Joint operation Joint control 50% Share of assets, Chapter 33
liabilities, income
and expenses
Associate Significant Between 20 and 50% Equity accounting Chapter 32
influence
Financial asset Investment Less than 20% Fair value Chapter 12

EXHIBIT 30.2 Levels of investment

In practice, a parent may have interests in associates and/or joint ventures and/or financial
assets in addition to its interests in subsidiaries. That is, the group includes subsidiaries,
associates, joint ventures and other investments in other entities. The group financial
statements include consolidated subsidiaries, equity accounted joint ventures and associates
and financial assets measured at fair value in accordance with HKFRS 9. (However, key to
remember is that when HKFRSs refer to a group, at least one subsidiary must be present.)

Knowledge Check Question

Question 1
Skippy Limited (Skippy) is a publicly listed diversified multinational company with interests
in eight subsidiaries. Its business activities include funds management, superannuation,
life and general insurance, and estate planning. Skippy holds 85% of the share capital of
Wallaby Limited (Wallaby). Wallaby’s principal activity is the management of funds from its
investors to provide them with a steady income return.

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Knowledge Check Question (continued)

Identify which one of the following statements is true.
A Skippy prepares consolidated financial statements in which Wallaby is consolidated.
B Skippy has a choice as to whether to consolidate Wallaby or measure it at fair value
through profit or loss.
C Skippy prepares consolidated financial statements in which Wallaby is measured at fair
value through profit or loss.
D Skippy prepares financial statements in which Wallaby and its other subsidiaries are
measured at fair value through profit or loss.

3 0 . 2 PRINCIPLES OF CONSOLIDATION

The principles of consolidation are based on the concept of control. When control is present,
the accountants look through the legal form of a business structure to consider its economic
substance. Fundamentally, where a parent controls a subsidiary, it effectively controls the
underlying assets and assumes the underlying liabilities of that subsidiary. Accordingly,
regardless of whether a non-controlling interest (NCI) is present, the parent’s consolidated
financial statements represent 100% of its subsidiary’s assets and liabilities as if they are
directly held by the parent.

This section discusses what control is and when control is present before reviewing the
underlying principles of consolidation and procedures to prepare the consolidated financial
statements.

30.2.1 Concept of Control (HKFRS 10)

The concept of control that applies to the consolidation of subsidiaries was first introduced in
Chapter 29 in relation to acquisitions of businesses. For the purposes of consolidation similar
to the acquisition of businesses, ‘control’ exists when the following three features are present
from the perspective of the investor. The investor has:

1. Power over the entity;

HKFRS
3(R).7, B13, 2. Exposure, or rights to, variable returns; and
HKFRS
10.7 3. The ability to use that power to affect the amount of the acquirer’s returns.

Where these elements are present, the investor is a parent and the investee is a subsidiary.
A parent consolidates both subsidiaries in which it holds a direct interest (e.g. Soleil directly
holds an interest in Mercury) and those in which it holds an indirect interest (e.g. Soleil
indirectly holds an interest in Hercules through its interest in Mercury). So, for example, Soleil
must assess whether it controls Mercury, and separately assess whether it controls Hercules.

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A parent entity may control a subsidiary when it acquires an equity interest in an entity
that is not operating a business (e.g. by incorporating a new entity). In these cases, business
combination accounting will not apply to the initial acquisition. However, consolidated financial
statements will still need to be prepared consolidating the financial position and results of the
parent and the subsidiary.

Review Section 29.1.3.2 of Chapter 29 to re-familiarise how to assess whether control is

present. For teaching purposes, this chapter adopts the assumption that control is present
when an entity holds the majority shareholding in another entity. Practice should not
automatically presume that an entity currently holding the majority voting rights over another
entity controls that other entity. All facts and circumstances must be considered, for example,
whether the rights are substantial, whether other competing rights exist (e.g. exercisable
potential voting rights held by another party), or whether arrangements affect or change the
ability of the entity to wield its power to affect its returns.

30.2.2 Review of Consolidation Procedures

When consolidating, the starting point is the individual financial statements of the parent and
each subsidiary (those directly or indirectly held). At its simplest, the consolidation process
involves ‘adding across line-by-line’ the income, expenses, assets, liabilities and equity of all
the individual financial statements of the entities in the group except for the parent’s asset
‘investment in subsidiaries’ (so that the group does not show an investment in itself) and
the subsidiaries’ pre-acquisition equity (because that arose prior to the group coming into
existence).

Unfortunately, the consolidation process is not often this straightforward because

all transactions inconsistent with the notion of the group as a single economic entity
(e.g. intragroup sales) must be eliminated and because the group’s financial position and
results must then be attributed between the share attributable to the parent and that
attributable to NCIs.
In summary, the consolidation process involves:

• Adding together like items of assets, liabilities, equity, income, expenses and cash flows
of the parent with those of its subsidiaries;

• Eliminating the parent’s investment in each subsidiary against the pre-acquisition

equity of each subsidiary and, where there is a difference between the two, recognising
goodwill (or gain from bargain purchase);

• Eliminating in full intragroup assets, liabilities, equity, income, expenses and cash flows
relating to transactions between group entities (i.e. intragroup transactions); and

HKFRS • Allocating consolidated profit or loss and other comprehensive income (OCI) for the
10.B86 period and consolidated equity between the parent and the NCI.

Therefore, the account-keeping system needs to capture and retain information about the
acquisition and subsequent intragroup transactions and balances.

The second, third and fourth bullets above are often described as consolidation
adjustments, which are usually actioned via a consolidation worksheet. The consolidation
worksheet is merely a means to aggregate the financial results and positions of the entities in

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the group and to make adjustments to various line items to recognise the results and position
as a single economic entity. Consolidation adjustment journal entries are separately recorded
and are not posted in any ledger as the group does not have accounting records. Although in
theory the group could maintain its own ledger, in practice that does not happen as it would
be too onerous; it is more efficient to maintain a ledger for each separate legal entity, which is
a legal requirement, and periodically to make consolidation adjustments as described in this
chapter. Consequently, consolidation adjustment journal entries do not carry forward from
period to period and must be re-posted or refreshed as necessary each reporting period.
The consolidation worksheet can be used to aggregate the financial results and positions of
subsidiaries and of associates and joint ventures (see Chapter 32).

Because it is only an accounting tool, there is no fixed form or look to a consolidation

worksheet. Therefore, the financial statements included in the worksheet need not be
presented in accordance with the presentation requirements of HKAS 1, for example, including
all the necessary line items or subtotals.

30.2.2.1 Uniform Accounting Policies and Reporting Dates

The consolidated results are only useful if like with like is added together. For example, it would
not help a user of financial statements to have results of differing financial periods added
together because this would not give the user a good picture of the group’s performance for
a particular period. Similarly, a user is unlikely to find a reported financial statement line item
useful if it is comprised of similar items measured differently. Accordingly, so the information
presented is not misleading, when preparing consolidated financial statements, the financial
statements of the entities being consolidated should all reflect the same:

• Reporting date: Where a subsidiary has a different reporting date to the parent, it must
provide the parent with additional financial information to enable the parent to prepare
consolidated financial statements as of the same date and for the same period. Where
it would be impracticable to align reporting dates (e.g. where a subsidiary with a
different reporting year end is acquired shortly before the parent’s reporting date),
HKFRS 10 Consolidated Financial Statements allows the subsidiary’s reporting date to
differ from that of the parent, but by no more than three months, and the length of the
HKFRS
10.B92– reporting periods and any differences between the dates must be consistent from
B93 period to period.

In some jurisdictions, there may be a legal requirement for a subsidiary to align

its reporting date with its parent. For example, S.367(4) of the Hong Kong Companies
Ordinance (Cap. 622) requires the financial year of each subsidiary to be the same as
the parent’s financial year unless the directors of the parent have good reasons against
those financial years coinciding with each other.

• Accounting policies: Where a subsidiary uses different accounting policies from the
group in its own financial statements, adjustments must also be made as part of the
consolidation process so the consolidated financial statements reflect uniform
accounting policies. For example, if Caelus measures land on the cost basis in its own
financial statements when the Soleil group’s policy is to measure all land at fair value, a
HKFRS consolidation adjustment will be necessary to reflect Caelus’ land at fair value in the
10.19, B87 consolidated financial statements.

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Another basic adjustment necessary as part of the consolidation process is to ensure the
financial statements being added together are all presented in the same currency. For instance,
the resulting information would be meaningless if a US Dollar (USD) result were added to a
Renminbi result without acknowledgement of the different currencies. The impact of foreign
currency financial statements on the consolidation process is discussed in Chapter 31.

30.2.2.2 Subsidiaries with Non-controlling Interests

The basis underpinning consolidated financial statements is that the parent controls 100%
of the assets, liabilities, equity, income and expenses of a subsidiary through its control of
the subsidiary, and therefore, 100% of those items (after adjustments) must be recognised
in the financial statements reporting on the group’s financial position and performance. As
the defining feature is control of the subsidiary, it follows that amounts recognised in the
consolidated financial statements do not change if the subsidiary (e.g. Astro) is only partly
owned by the parent. Similarly, the amounts recognised are not capped even if the subsidiary is
loss-making or in a net deficit position.

Key Learning Point

During the period it is controlled, 100% of a subsidiary’s assets, liabilities, income and
expenses are recognised in the consolidated financial statements regardless of whether a
subsidiary is wholly owned, partly owned, profitable or in a net deficit position.

However, where an NCI exists, only the parent’s proportionate interest in the assets,
liabilities, equity, income and expenses (therefore, profit or loss) of the partly owned subsidiary
should be attributed to owners of the parent. The rest should be attributed to the NCI by
attributing to the NCI its share of the subsidiary’s post-acquisition contribution to consolidated
equity. This could result in the NCI being a net deficit in consolidated equity.
The parent and NCI’s proportionate interest in a subsidiary is determined on the basis of
their existing ownership interests in the subsidiary. The proportionate share does not reflect
the possible exercise or conversion of potential voting rights (e.g. share options) and other
derivatives containing potential voting rights held by the parent or NCI except where those
HKFRS
rights or derivatives give the entity current access to the returns associated with an ownership
10.B89–B90 interest (e.g. through a contractual agreement to pass on any dividends received).

Key Learning Point

Generally, potential voting rights that are substantive rights:

• Are considered when determining whether there is a subsidiary to be

consolidated; but

• Are not reflected in the ‘proportionate interest’ when attributing the group results
and financial position between the NCI and owners of the parent.

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30.2.2.3 Pre-acquisition Equity Elimination Adjustments

The consolidation process requires all transactions inconsistent with the notion of the group
as a single economic entity be eliminated. Because the group cannot invest in itself, this
includes eliminating a parent’s investment in its subsidiary against the parent’s portion of the
subsidiary’s acquisition-date equity (i.e. equity in the subsidiary that arose prior to it being
acquired by the parent). In so doing, the group eliminates the share capital, accumulated profits
and reserves attributable to those former owners of the subsidiary (the pre-acquisition profits)
because those amounts relate to periods before the group came into existence; therefore, it
would be inappropriate to include them in the group’s financial statements.

Eliminating the parent’s portion of the subsidiary’s acquisition date equity is a two-step
process:

1. First, where the parent has acquired a business (see Chapter 29), adjust the assets and
liabilities acquired to their fair values at acquisition; and

2. Next, eliminate the parent’s equity in the subsidiary and recognise goodwill or gain on
bargain purchase.

Fair Value Adjustments on Acquisition of a Business

Recall from Chapter 29 that when applying the acquisition method to account for a business
combination, HKFRS 3 Business Combinations specifies how a group is required to measure
the subsidiary’s identifiable assets and liabilities. In general, the requirement is for fair value
measurement although specific exceptions apply (see Section 29.2.3.3 of Chapter 29). These
amounts become the initial cost of the assets acquired and liabilities assumed to the group and
from which base the group’s accounting policies are applied.

When consolidating a subsidiary, the first set of consolidation adjustment entries that will
need to be made is to record the difference between acquisition date carrying amounts of
assets and liabilities in the subsidiary’s financial statements and the carrying amounts required
to be adopted in the group’s financial statements, by (1) writing back any recorded accumulated
depreciation, amortisation or allowance for impairment; and (2) restating the asset/liability to
its fair value (including for any newly recognisable identifiable assets and liabilities). Although
this adjustment can be actioned in different ways, this module illustrates it by setting up a
temporary account in the worksheet, for example, a ‘business combinations reserve’.

In practice, this adjusting entry is likely to be combined with the pre-acquisition elimination
entry described shortly under the heading ‘Eliminate the Parent’s Equity in the Subsidiary’,
negating the need for the temporary business combinations reserve.

Illustrative Example 2
Soleil acquired 80% of the ordinary share capital of Astro on 1 January 20X0. On
acquisition, Soleil assessed a building held by Astro to have a fair value of HK$15
million in excess of Astro’s carrying amount of HK$100 million. The building originally
cost HK$120 million and has accumulated depreciation of HK$20 million at the time of
acquisition.

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Illustrative Example 2 (continued)

When consolidating Astro, Soleil records the following consolidation adjustment
journal entries to ‘reset’ the carrying amount of the building from that in the subsidiary’s
records to its carrying amount to the group:

(1) Reset accumulated depreciation to nil before restating plant to cost of acquisition.

Debit Credit
HK$m HK$m
Accumulated depreciation – plant 20.0
Plant 20.0

For the purposes of this module, the detail of the consolidation worksheets
is limited to the level of the line items shown on the face of the financial
statements (i.e. assets and liabilities are shown at their net carrying amounts).
Consequently, this journal entry is not further illustrated in the exercises in
this chapter. However, this journal entry is important in practice because, for
example, note disclosures could be misstated; for example, HKAS 16 Property,
Plant and Equipment requires disclosure in the notes accompanying the financial
statements of the carrying amount of accumulated depreciation at the start and
end of the period (see Chapter 7).

(2) Record any increase or decrease to initially recognise the asset at fair value.

Debit Credit
HK$m HK$m
Plant (HK$115 million – HK$100 million) 15.0
Business combinations reserve 15.0

(3) Record any deferred tax effects related to the fair value adjustment.

A consolidation adjustment journal entry must also be recorded to recognise

changes in deferred tax balances arising on fair value adjustments on acquisition
because the consolidated carrying amount of the asset or liability is now likely to
differ from its tax base (the tax base remains that of the legal owner of the asset
or liability). Review Chapter 29 to appreciate the reasons for and the recognition
and measurement of new deferred tax assets and deferred tax liabilities arising
on acquisition of a subsidiary. This chapter assumes the relevant tax rate is 16.5%
and the tax base of an item is the same as its net carrying amount in the books
of the subsidiary immediately before the acquisition. Therefore, a deferred tax
liability arises on consolidation as the consolidated carrying amount of the asset
(HK$115 million) is greater than its tax base (HK$100 million).

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Illustrative Example 2 (continued)

Debit Credit
HK$m HK$m
Business combinations reserve 2.5
Deferred tax liability (16.5% HK$15 million) 2.5

This chapter assumes the relevant tax rate is 16.5% and the tax base of an item
is the same as its net carrying amount in the books of the subsidiary immediately
before the acquisition. This will not always be the case in practice; for example, a
different tax rate may be applicable to a foreign subsidiary (the applicable tax rate
is that of the subsidiary).

A fair value adjustment on acquisition will subsequently impact future consolidated

financial statements as the economic benefits in the asset or liability are consumed or
discharged. Consequently, a fair value adjustment on acquisition will also likely require
recording of an associated consolidation adjustment journal entry, for example, to recognise
any additional cumulative depreciation expense to the group associated with the increase in
fair value:

DR Depreciation expense (fair value adjustment/useful life) XXX

DR Deferred tax liability (reversal of deferred tax liability (DTL) as the additional XXX
economic benefits are consumed)
CR Plant (cumulative additional periodic consumption of economic XXX
benefits)
CR Income tax expense (additional available tax deduction) XXX

Eliminate the Parent’s Equity in the Subsidiary

The next consolidation adjustment entry eliminates the parent’s equity in its subsidiary. This
is actioned by eliminating the investment asset in the parent’s financial statements against the
parent’s share of the equity of the subsidiary at the time of acquisition. This pro forma journal
entry is the entry that results in any goodwill or gain on bargain purchase arising from the
acquisition of a subsidiary being recognised as part of the consolidated financial statements.

Effectively, this adjustment ‘brings into the consolidated financial statements the assets
and liabilities of the subsidiary at the time of acquisition. However, as 100% of these assets and
liabilities are recognised, where there is an NCI, the remainder of the equity of the subsidiary
must be attributed to the NCI. This reflects that part of the pre-acquisition equity of the
subsidiary is not equity to owners of the parent.

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The consolidation adjustment journal entry is:

DR Share capital (100% subsidiary share capital) XXX

DR Retained earnings (100% subsidiary retained earnings) XXX
DR Other reserves (100% subsidiary other reserves) XXX
DR Business combinations reserve (100% business combinations reserve) XXX
DR Goodwill (or CR Gain on bargain purchase) XXX
CR Investment in subsidiary XXX
CR Non-controlling interests (equity) XXX

Where the ‘fair value on acquisition’ consolidation adjustment and journal entry above are
combined, the entry is:

DR Share capital (100% subsidiary share capital) XXX

DR Retained earnings (100% subsidiary retained earnings) XXX
DR Other reserves (100% subsidiary other reserves) XXX
DR Assets and liabilities, for example, PPE (fair value adjustments on XXX
acquisition)
DR Goodwill XXX
CR Investment in subsidiary XXX
CR Non-controlling interests (equity) XXX

Where the parent holds potential voting rights in the subsidiary that do not form part of
its (in substance) ownership interest in the subsidiary, the potential voting rights are not
HKFRS eliminated when eliminating the parent’s investment in the subsidiary. Instead, the parent
10.B91 applies HKFRS 9 Financial Instruments to account for these potential voting rights, that is, the
potential voting rights held by the parent relating to the subsidiary are recognised in
the consolidated financial statements.

Goodwill on Consolidation
Under HKFRSs, goodwill only arises on acquisition of a business. Accordingly, any goodwill
arising on acquisition of a business through the acquisition of equity in a subsidiary is only
recognised in the consolidated financial statements. Therefore, any subsequent impairment
of that goodwill is only recognised in the consolidated financial statements via a journal entry
recorded in the consolidation worksheet to adjust the goodwill balance:

DR Impairment loss – goodwill XXX

CR Goodwill XXX

Review Chapters 11, 14 and 29 to refresh your understanding of the accounting for
goodwill, including how to assess when goodwill is impaired.

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30.2.2.4 Intragroup Transactions

As part of the consolidation process, all intragroup assets and liabilities, equity, income,
expenses and cash flows relating to transactions between the parent and its wholly owned
and partly owned subsidiaries (and between subsidiaries) are eliminated in full because only
transactions with external parties are relevant in assessing the performance and position of the
group. Transactions between group entities include:

• Borrowing and lending activity;

• The sale and purchase of services or inventory; the sale and purchase of non-current
assets; and

• Dividend distributions.

Each of these intragroup transactions will be considered in turn and illustrated in

Section 30.3. Eliminating an intragroup transaction involves reversing the effects of the
transaction by debiting/crediting line items of one entity against the related line items in the
ledger of another entity, to the extent appropriate. The effects of the reversal may extend
beyond the period of the initial intragroup transaction, for example, there may be additional
depreciation expenses that will also need to be reversed when eliminating an intragroup sale of
plant at a profit. Also, the effects of the transaction on the group’s income tax obligations must
be understood and taken into account as part of the elimination.
Each entity in the group, as a separate taxpayer, bears its own income tax obligations. For
example, a subsidiary may be taxed on profit it has made from an intragroup transaction as a
separate taxpayer even though from a group perspective that profit has not yet been realised.
From a group perspective, the amounts were not yet taxable, but income tax has been prepaid,
thereby reducing future taxable amounts.

When eliminating intragroup transactions, pay attention to the need for any tax
adjustments. Eliminating the tax effects of intragroup transactions is not as simple as fully
eliminating, for example, the income tax expense of one entity against income tax income of
another entity or fully eliminating deferred tax assets of one entity against the deferred tax
liabilities of another entity in the group. In some cases, the consolidation adjustment entries
may result in further deferred tax assets or deferred tax liabilities being recognised. In the
preceding example, from the group’s perspective, the prepayment of income taxes should be
reflected in the consolidated financial statements as a deferred tax asset until such time as that
profit is realised.

In practice, another consideration when preparing the consolidated financial statements

is whether the current and deferred tax balances of one entity can be offset against the
tax balances of another entity. That is, whether it is appropriate to record (or not record)
consolidation adjustments that eliminate different line items relating to income taxes. For
example, the tax obligations of group entities in different tax jurisdictions will unlikely be offset.
However, for teaching purposes, the illustrations and exercises in this chapter assume that
conditions for offset are met.

Review Chapter 19 to refresh your understanding of the accounting for income taxes,
including when current and deferred tax balances qualify for (and must be) offset.

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Key Learning Point

Key to identifying what consolidation adjustment journal entries are necessary is an
understanding of the effect of the transaction on the group. From the group’s perspective,
what has changed as a result of the transaction? Once this is identified, the adjustments
necessary to restate the results to reflect the group’s position should be clear.

Intragroup Borrowing and Lending

The effects of intragroup borrowing and lending activity must be eliminated on consolidation
because, from the group’s perspective, no additional asset or liability exists. Furthermore, the
group has not really earned more interest income or incurred more interest expense.

Eliminating the effect of intragroup borrowing and lending activity involves:

• Eliminating the loan/trade receivable against the loan/trade payable at the

reporting date;

• Eliminating the associated current period interest income against interest expense;

• Eliminating any associated interest receivable against interest payable at the

reporting date; and

• Making the necessary adjustments to reflect the tax effects of the intragroup
transaction to the group, for example, to eliminate a deferred tax liability against a
corresponding deferred tax asset, to the extent they can be offset.

Recording the elimination of related ‘income tax expense’ against ‘income tax income’ is
unnecessary because these appear together in a single line item in the statement of profit or
loss and other comprehensive income (OCI).

Intragroup Sales and Purchases of Services

The effects of intragroup sales and purchases of services must be eliminated on consolidation
because, from the group’s perspective, its economic position does not change.

Eliminating the effects of intragroup sales and purchases of services involves:

• Eliminating the associated sale against the purchase of services; and

• Making the necessary adjustments to reflect the tax effects of the intragroup
transaction to the group.

The elimination of intragroup sales and purchases of services is straightforward: the

income and expense line items are eliminated against each other for example:

DR Management fee revenue XXX

CR Management fee expense XXX

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Intragroup Sales and Purchases of Inventory

The effects of intragroup sales and purchases of inventory are eliminated on consolidation
because from the group’s perspective there is no change in its economic flows (ignoring any
tax implications) until the inventory is on-sold to an external party. There is no change in how
much the inventory costs the group to acquire or manufacture that inventory. The group has
not changed its overall financial position if all the inventory is still on hand at the reporting
date. Therefore, the group should not recognise any intragroup gain or loss on the sale of the
inventory.

Even when all the inventory purchased during the period has been on-sold to a party
external to the group during the reporting period, an adjustment must be made. This is
because the transactions affect different line items in the statement of profit or loss and OCI;
not eliminating the intragroup transaction would result in an overstatement of income and
expenses of the consolidated entity, which would provide misleading information to users of
the consolidated financial statements.

Removing the effects of intragroup sales and purchases of inventory involves:

• Eliminating associated sales revenue against purchases:

DR Sales revenue 100% of sale proceeds

CR Cost of Goods Sold 100% of sale proceeds

• Eliminating any associated unrealised profit or loss included in the carrying amount of
inventory still on hand:

DR Cost of Goods Sold unrealised profit/loss on 100% inventory sold

CR Inventory unrealised profit/loss on 100% inventory sold

and

DR Inventory realised profit/loss on % inventory on-sold by reporting date

CR Cost of Goods Sold realised profit/loss on % inventory on-sold by reporting date

• And making the necessary adjustments to reflect the tax effects of the intragroup
transaction to the group, for example:

DR Deferred tax asset applicable tax rate x unrealised profit in inventory at reporting
date (temporary difference)
CR Income tax expense applicable tax rate x temporary difference

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Where inventory purchased in an intragroup transaction remains on hand at the reporting

date, consolidation adjustment journal entries are required in the:

• Consolidation worksheet prepared at the end of that reporting period; and

• In the subsequent period’s consolidation worksheet.

Because consolidation worksheet adjustments are not ‘carried forward’ as you would do
in keeping normal ledger accounts, for inventory sold during the next reporting period, an
adjustment is required to the subsequent period’s consolidation worksheet to eliminate the
effect of any unrealised profit or loss embedded in the inventory balance at the start of the
reporting period, and consequently, included in (opening) retained earnings. Otherwise, the
cost of goods sold and income tax expense during that subsequent period would be overstated
or understated when the inventory is sold. This is actioned by recording an adjustment to cost
of goods sold (think about why the inventory account is not adjusted and, from the group’s
perspective, that inventory does not still exist at reporting date). As an example:

Pro forma journal entries to eliminate unrealised profit in opening retained earnings

DR Retained earnings unrealised after-tax profit in opening retained earnings

DR Income tax expense applicable tax rate x unrealised profit in opening inventory
CR Cost of Goods Sold unrealised profit in opening inventory

No further consolidation adjustment entry is required where the inventory is fully sold by
the end of the reporting period. Where some or all of the inventory continues to be held at year
end, a consolidation adjustment to eliminate any remaining unrealised profit and deferred tax
effect must be processed again.

Intragroup Sales and Purchases of Non-current Assets

The effects of intragroup sales and purchases of non-current assets must also be eliminated on
consolidation because, from the group’s perspective, there is no change in how much it costs
the group to acquire or construct the non-current asset. The group has not changed its overall
financial position or asset ledger if the non-current asset continues to be held by a group entity
at the reporting date. Therefore, like with the intragroup sale of inventory, the sale needs to
be eliminated and any unrealised gains or losses on the sale should not be recognised in the
consolidated financial statements. As with the intragroup sale of inventory, the tax implications
of the sale of the non-current asset should be recognised as part of the consolidation
adjustments in the consolidation worksheet.

This involves:

• Eliminating the sale against the purchase of the non-current asset, including eliminating
any unrealised gain or loss on sale of the non-current asset;

• Adjusting depreciation expense and accumulated depreciation to that which would

have applied had the intragroup sale not occurred; and

• Making the necessary adjustments to reflect the tax effects of the intragroup
transaction to the group.

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Illustrative Example 3
On 1 July 20X0, Astro sold a machine for HK$49.4 million cash to Soleil. Astro had
purchased the machine on 1 January 20X0 for HK$50 million. Soleil and Astro’s
accounting policy is to depreciate the machine on a straight-line basis over its useful
life. The machine was initially estimated to have a useful life of 10 years and nil residual
value, and these assumptions have not changed (i.e. Soleil determines the useful life of
the machine on acquisition to be 9.5 years).

On sale of the machine to Soleil, the tax base of the machine was reset to its purchase
price. Assume the machine is depreciated for tax purposes over the same period as used
for accounting and that the tax rate is 16.5%.

Soleil is preparing its consolidated financial statements for the year ended 31 December
20X0, that is, six months after Astro sold the machine to Soleil and 12 months after it was
originally purchased by Astro. To identify the consolidation adjustment journal entries that
might be necessary, Soleil prepares the following table:

Groupa Soleil Difference

HK$’000 HK$’000 HK$’000
Carrying amount of the 50,000 n/a
machine at 1 Jan 20X0
Depreciation expense (2,500) n/a
for six months
Carrying amount of the 47,500 49,400 1,900
machine at 1 July 20X0
(date of intragroup sale)
Depreciation expense (2,500) (2,600) (100)
for six months
Carrying amount of the 45,000 46,800 1,800
machine at 31 Dec 20X0
a
The machine’s cost and related depreciation as though the intragroup sale had not occurred.

From this table, Soleil can identify that, from the group’s perspective, on 31 December
20X0:

• The carrying amount of machinery is overstated by HK$1.8 million;

• Accumulated depreciation is overstated by HK$100,000; and

• It should recognise a further deferred tax asset of HK$297,000 (16.5%

HK$1.8 million).

Accordingly, Soleil determines that, as part of preparing its consolidated financial

statements, it will need to record the following consolidation adjustments to remove the
effects of the intragroup sale of the machine.

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Illustrative Example 3 (continued)

(1) 
Pro forma journal entry to reinstate accumulated depreciation as at the date of the
intragroup sale

This journal entry reinstates the accumulated depreciation associated with the
non-current asset as if the intragroup sale had not occurred (i.e. the accumulated
depreciation recognised prior to the intragroup sale).

Debit Credit
HK$’000 HK$’000
Property, plant and equipment 2,500.0
Accumulated depreciation 2,500.0

(2) Pro forma journal entry to eliminate the gain on sale

This journal entry partially restates the cost of the non-current asset to the position
prior to the intragroup sale by reversing the gain on sale.

Debit Credit
HK$ HK$
Gain on sale of machine 1,900.0
Deferred tax asset 313.5
Property, plant and equipment 1,900.0
Income tax expense 313.5

Observe that journal entries (1) and (2) have the effect of eliminating the sale
and purchase of the machine from the financial statements. Rather than reverse
each entry made to record the sale and purchase, respectively, recording the net
adjustments that need to be made is adequate.

A deductible temporary difference (HK$49,400,000 − HK$47,500,000

HK$1,900,000) resulting in a deferred tax asset (HK$1,900,000 16.5%
HK$313,500) arises because the consolidated carrying amount HK$47,500,000 is
now smaller than the tax base of the asset, being HK$49,400,000. That is, the group
will be able to claim more future tax deductions in respect of the asset compared
to future taxable amounts because, in effect, the group ‘prepays’ income tax on the
gain at the time of the sale, consistent with the gain on sale being crystalised for
Astro’s tax purposes.

(3) Pro forma journal entry to adjust depreciation and accumulated depreciation to
amounts as though intragroup sale had not occurred

This journal entry adjusts the cumulative consolidated depreciation expense to that
as if the intragroup sale had not occurred.

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Illustrative Example 3 (continued)

Debit Credit
HK$ HK$
Accumulated depreciation 100.0
Income tax expense (16.5% HK$100,000) 16.5
Deferred tax asset 16.5
Depreciation expense 100.0

Dividend Distributions
Dividends paid or payable from a subsidiary to a parent are eliminated in the same manner
as other intragroup transactions and balances; that is, the effect of the transaction must be
eliminated (reversed) when preparing the consolidated financial statements to the extent the
dividend (e.g. cash) does not leave the group.

For example, if wholly owned Subsidiary S1 declared a dividend of HK$200,000 to Parent P

(its sole shareholder), the following pro forma journal entries would be required:

Debit Credit
HK$ HK$
Dividend income 200,000
Retained earnings - dividend 200,000

and

Debit Credit
HK$ HK$
Dividend payable 200,000
Dividend receivable 200,000

These journal entries reverse the entries made by the subsidiary and parent in their
respective financial statements. A further journal entry to reflect the tax effect of the
transaction will be required if the dividend is taxable at the time of accrual.

However, consider the case where the subsidiary is not wholly owned. In this case, as the
parent’s financial statements records only its share of the dividend, that share is eliminated
when preparing the consolidated financial statements. For example, assume 80% owned
Subsidiary S2 declares a dividend of HK$2 million to its shareholders during the year ending
31 December 20X1 and that the dividend remains payable at the year-end. Assume the
dividend is exempt from income tax. Subsidiary S2’s parent entity would record the following
pro-forma journal entries to eliminate the intragroup dividend:

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Debit Credit
HK$’000 HK$’000
Dividend income recognised by parent (80% HK$2 million) 1,600
Retained earnings - dividend 1,600

and

Debit Credit
HK$ HK$
Dividend payable 1,600
Dividend receivable (recognised by parent) 1,600

The dividend paid or payable to the NCI (HK$400,000) has not been eliminated from the
consolidated financial statements. This is consistent with the instruction that intragroup
transactions are fully eliminated in preparing the consolidated financial statements because
that part of the dividend distribution is not an intragroup transaction but a transaction with
parties external to the group. Therefore, it must be reflected in the consolidated financial
statements. Consider: when the dividend is paid, cash will leave the group.
However, a further consolidation adjustment journal entry is necessary to ensure that
consolidated equity appropriately reflects that the NCI share of the group’s retained earnings
has been reduced by the amount of the dividend. This is discussed further in Section 30.2.2.5.

Key Learning Point

The consolidation worksheet journal entries adjust the position of the group to that as
though the intragroup transactions had not occurred. Therefore, it is possible to ‘work
backward’ to determine the appropriate elimination journal entries to be recorded if the
group results and position are understood.

30.2.2.5 Non-controlling Interests

A complete set of consolidated financial statements comprises:

• A consolidated statement of financial position as at the end of the period;

• A consolidated statement of profit or loss and other comprehensive income for

the period;

• A consolidated statement of changes in equity for the period;

• A consolidated statement of cash flows for the period (see Section 30.4);

• Notes, comprising material accounting policy information and other explanatory

information;

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• Comparative information in respect of the preceding period; and

HKAS • A third statement of financial position as at the beginning of the preceding period
1.10 where required by HKAS 1 Presentation of Financial Statements.

HKAS 1 specifies that the form and content of these consolidated financial statements is the
HKFRS
10.22, HKAS same as those for a single company (see Chapter 27) except that the face of the consolidated
1.54(q), 81B,
106(a), HKFRS
financial statements must also present the following information about the share of the results
12.12(e),12(f) and financial position of the group that is attributable to the NCI:

• Statement of financial position: NCIs, presented within equity;

• Statement of profit or loss and other comprehensive income (OCI):

°° Profit or loss for the period attributable to NCIs, separately from the profit or loss
attributable to owners of the parent;

°° Comprehensive income for the period attributable to NCIs, separately from

comprehensive income attributable to owners of the parent; and

• Statement of changes in equity: comprehensive income for the period attributable to

NCIs, separately from comprehensive income attributable to owners of the parent.

No additional disclosures are required on the face of the consolidated statement of cash
flows. Therefore, to construct the consolidated financial statements, having identified the
consolidated results and financial position is necessary to further distinguish these between
the portion attributable to the (shareholders of the) parent and the NCI. This section reviews
how these amounts are identified.

This chapter assumes you can construct the presentation of these statements using
the consolidated information determined as described earlier in Section 30.2 to meet the
requirements as specified by HKAS 1 and HKAS 7 (see Chapter 27).

Attributing Consolidated Profit or Loss and Comprehensive Income Between

the Parent and NCI
Consolidated profit or loss and comprehensive income, following the elimination of any
intragroup transactions, must be attributed between the parent and any NCI. The process
of measuring a partly owned subsidiary’s contribution to consolidated profit or loss and OCI
provides the information necessary for determining the NCI’s share of consolidated equity.

In addition to attributing the subsidiary’s reported profit or loss and OCI to the NCI, relevant
consolidation adjustments must also be attributed to the NCI. The approach commonly
adopted in practice, consistent with HKFRS 10 Consolidated Financial Statements, is for a
subsidiary’s reported profit or loss and OCI to be adjusted only for consolidation adjustments
that change the consolidated net asset position. That is, though all intragroup transactions
and balances continue to be eliminated in full as required by HKFRS 10, consolidation
adjustments that:

• Change the consolidated net asset position (group equity) are taken into consideration
to determine a subsidiary’s contribution to the consolidated profit or loss and OCI; and

• Do not change the consolidated net asset position do not affect the determination of a
subsidiary’s contribution to the consolidated profit or loss and OCI.

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Therefore, it is necessary to appreciate whether the direction of the intragroup

transaction is upstream, meaning from subsidiary to parent, or downstream. In summary, the
measurement of the NCI’s share of profit or loss (or comprehensive income) is calculated as:

Subsidiary reported profit or loss/

NCI share of profit or loss/ comprehensive income for the period,
NCI %
comprehensive income adjusted by consolidation adjustments that
affect consolidated net assets

Common consolidation adjustments that affect consolidated net assets and the NCI share
of the group results include:

• Recognition of more or less depreciation related to a fair value adjustment on

acquisition;

• Elimination of an unrealised gain or loss on an upstream intragroup sale of inventory;

• Elimination of an unrealised gain or loss on an upstream intragroup sale of

non-current assets;

• Recognition of more or less depreciation related to the intragroup sale of the

non-current asset; and
• Impairment of goodwill (only applicable where the ‘full goodwill approach’ is adopted).

Absent from this list are intragroup lending and borrowing activity and the intragroup sale
and purchase of services. This is because such transactions do not give rise to a consolidation
adjustment that affects consolidated net assets except where different amounts are recognised
by the entities in the statement of profit or loss and OCI.

The attribution to the NCI of its share of a subsidiary’s contribution to consolidated profit or
loss could be depicted in the consolidation worksheet in one of two ways:

1. By recording the NCI share of each consolidation adjustment as the consolidation

adjustment is recorded, and separately, recording a consolidation adjustment to
attribute to NCI its share of the subsidiary’s reported profit or loss and OC; and

2. By recording a single pro-forma journal entry to attribute to the NCI its share of the
subsidiary’s reported profit or loss and OCI after incorporating relevant consolidation
adjustments.

Approach 1 is more commonly employed in practice. The exercises and examples in this
module are presented using this approach.

The pro-forma journal entry to attribute profit or loss from the parent shareholders to
the NCI is:

DR Profit attributable to NCI NCI% x subsidiary profit/loss

CR Non-controlling interests (equity) NCI% x subsidiary profit/loss

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The pro-forma journal entry to attribute OCI from the parent shareholders to the NCI is:

DR Reserve (e.g. revaluation surplus) attributable to NCI NCI% x subsidiary OCI

CR Non-controlling interests (equity) NCI% x subsidiary OCI

Key Learning Point

The attribution of profit or loss to an NCI does not reduce consolidated profit or loss
but merely distinguishes the share ‘belonging’ to the owners of the parent from the
NCI. Similarly, the attribution of the OCI to NCI does not reduce consolidated other
comprehensive income but distinguishes the share ‘belonging’ to the owners of the parent
from that of the NCI.

Depreciation Related to a Fair Value Adjustment on Acquisition

Recall from Chapter 29 that at the time of a business combination the assets and liabilities
of the subsidiary are remeasured to their fair values (or other measurement, as specified)
where fair values differ from the carrying amounts recognised by the subsidiary. Because the
NCI is measured at that time at its fair value or by reference to the acquisition date values of
the recognisable net assets of the subsidiary, the NCI’s share of equity explicitly or implicitly
includes a share in any fair value adjustment to the carrying amounts of the assets and
liabilities of the subsidiary. Hence, the subsidiary’s post-acquisition contribution to consolidated
profit or loss must include an adjustment for any subsequent addition or reduction in
depreciation (and related income tax) relating to the fair value adjustments to assets acquired
and liabilities assumed on the acquisition of the subsidiary.

Illustrative Example 4
On acquisition of its 80% ownership interest in Astro on 1 January 20X0, Soleil assessed
a building held by Astro to have a fair value of HK$15 million in excess of Astro’s carrying
amount of HK$100 million (original cost HK$120 million, with related accumulated
depreciation of HK$20 million). The building is depreciated by Soleil and Astro on a
straight-line basis over its remaining useful life of five years to nil residual value.

Soleil records the following consolidation adjustment journal entry in its consolidation
worksheet for the year ending 31 December 20X0 to reflect the additional depreciation
resulting from the fair value measurement on acquisition:

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Illustrative Example 4 (continued)

Debit Credit
HK$’000 HK$’000
Depreciation expense (HK$15 million/5 1 year) 3,000
Deferred tax liability 495
Property, plant and equipment 3,000
Income tax expense (16.5% HK$3 million) 495
(Recognise additional depreciation expense on consolidation)

Under Approach 1, Soleil attributes a portion of that consolidation adjustment

to the NCI:

Debit Credit
HK$’000 HK$’000
Non-controlling interest (equity) 501
Profit attributable to NCI (20% (HK$3 million – HK$495,000)) 501
(Attribute to NCI its share of that additional depreciation, less tax)

Assume that Astro’s reported profit for the year ending 31 December 20X0 is
HK$170 million. In addition to the journal above, Soleil must also record the following
journal entry to attribute its share of Astro’s reported profit for the year to the NCI:

Debit Credit
HK$’000 HK$’000
Profit attributable to NCI (20% HK$170 million) 34,000
Non-controlling interest (equity) 34,000

Under Approach 2, rather than the two separate journal entries, Soleil records a single
consolidation adjustment journal entry to attribute its share of Astro’s reported profit for
the period to the NCI:

Debit Credit
HK$’000 HK$’000
Profit attributable to NCI (20% HK$167,495,000)a 33,499
Non-controlling interest (equity) 33,499
a
HK$170 million – (HK$3 million – HK$495,000).

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Unrealised Profit or Loss on Intragroup Sale of Inventory

Up to this point, it has not mattered whether the intragroup transactions between group
entities are upstream (sale from subsidiary to parent) or downstream (sale from parent
to subsidiary). However, this distinction is important when unrealised profits and losses
are involved.

If the subsidiary is the purchasing entity and the parent is the selling entity
(a downstream transaction), the subsidiary earns no profit. Hence, although a consolidation
adjustment exists, it would not be attributed to the subsidiary and, accordingly, does not
affect the NCI calculation.

However, if the subsidiary is the selling entity and the parent is the buying entity
(an upstream transaction), the subsidiary makes a profit or loss on the sale of inventory. Hence,
the subsidiary’s reported profit must be adjusted for the consolidation adjustment to eliminate
the unrealised gain from any of the inventory remaining on hand at the reporting date.
Therefore, a share of that consolidation adjustment is attributable to the NCI. See Section 30.3
for an illustration.

Intragroup Sale of Non-current Assets

Similar to an intragroup sale and purchase of inventory, the direction of the sale of a
non-current asset is important in identifying whether an unrealised gain or loss needs to be
eliminated before determining a subsidiary’s contribution to group profit for the purpose of
attributing a share of that profit to any NCI.

If the subsidiary is the purchasing entity, as the purchase does not affect the profit or loss
of the subsidiary, there is no adjustment to attribute to the NCI.

If the subsidiary is the selling entity at the time of the transaction:

• The subsidiary makes a gain or loss on the sale if the non-current asset is sold for an
amount different from the subsidiary’s carrying amount. Then, the subsidiary’s reported
net profit or loss must be adjusted by the consolidation adjustment to eliminate the
unrealised gain or loss on the sale; and

• The unrealised gain or loss on sale can be thought of as being earned (‘realised’) by the
subsidiary because the future economic benefits in the asset are consumed through
use of the asset (similar to how initially unrealised gains arising from intragroup sales
of inventory are realised when the inventory is on-sold to external parties). This is
reflected through adjusting the subsidiary’s reported net profit or loss by the periodic
consolidation adjustment to restate depreciation to that as though the asset continued
to be carried at its cost to the group).

The net effect of these two adjustments is to account for the remaining ‘unrealised’
gain on sale.

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Apply and Analyse 1

Recall from Illustrative Example 3 in Section 30.2.2.4 that on 1 July 20X0 Astro sold a
machine for HK$49.4 million cash to Soleil in an intragroup transaction. Prepare the
necessary consolidation adjustment for the year ended 31 December 20X0 to attribute
to the NCI its share of the consolidation adjustment to eliminate the intragroup sale of
the machine.

Analysis

From Illustrative Example 3 in Section 30.2.2.4, the consolidation adjustment to eliminate

the intragroup sale of the machine reduces Soleil and Astro’s combined profit by
HK$1.503 million as reported in their respective financial statements.

As the sale of the machinery is an upstream transaction and Astro’s reported net profit
for the year includes the gain on sale of the machine, part of the (unconsumed) unrealised
gain on sale, being a consolidation adjustment impacting consolidated net assets, must
be attributed to the NCI. Under Approach 1, this is actioned by recording the additional
journal entry as part of the consolidation adjustment to eliminate the intragroup sale of
the machine:

Debit Credit
HK$’000 HK$’000
Profit attributable to NCI (20% HK$1,503,000) 300.6
Non-controlling interest (equity) 300.6

Apply and Analyse 2

Determine what the NCI’s share of Soleil’s consolidated profit for the year ending
31 December 20X0 would have been had the intragroup sale of the machine been instead
of a sale from Soleil to Astro.

Analysis

In this case, the sale of the machine is a downstream transaction. Hence, even though the
group’s net assets are affected by the related consolidation adjustment, Astro’s reported
net profit for the year should not be adjusted for the unrealised gain on the sale of the
machine because this gain did not affect its net profit. All of that unrealised gain together
with the deferred tax impact are attributed to the owners of the parent.

When attributing its share of consolidated profit for the period to the NCI, it is necessary to
consider, as in applying consolidation procedures, intragroup transactions that have occurred
during the current period and the impacts of those transactions that have occurred in previous
reporting periods.

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NCI Share of Consolidated Equity

The NCI share of consolidated equity at reporting date comprises:

NCI share NCI at

of equity = acquisition +/– NCI share of post-acquisition movement in equity

NCI at NCI share of NCI share of NCI share of NCI share of

= acquisition +/– subsidiary +/– subsidiary +/– consolidation +/– other
(Section 2.2.3) post-acquisition post-acquisition adjustments movements in
profit or loss OCI equity
(Section 2.2.5.1) (Section 2.2.5.1) (Section 2.2.5.1) (e.g. dividends)

In accordance with HKAS 1 and HKFRS 10, the NCI share of consolidated equity must be
presented separately in the statement of financial position from the share attributable to
owners of the parent. To record this, the entity makes a pro-forma consolidation adjustment
journal entry for each relevant equity balance to move the NCI share of that balance to the NCI
line item in equity, for example:

DR Retained earnings (or reserve, as appropriate) XXX

CR Non-controlling interests - equity XXX

The attribution of equity on acquisition to the NCI and post-acquisition comprehensive

income were discussed in earlier sections. In addition, other changes in equity that do not
impact the statement of profit or loss and OCI must also be attributed between shareholders
of the parent and the NCI, for example, dividend distributions from the subsidiary or changes in
a share-based payment reserve.

For example, let’s revisit Illustrative Example 3 in Section 30.2.2.4 where 80% owned
Subsidiary S2 declares a dividend of HK$2 million to its shareholders during the year ending
31 December 20X1 and the dividend remains payable at the year-end. A further journal entry
to attribute the dividend distribution, which was not eliminated from the consolidated financial
statements, to the NCI interest (HK$400,000) is required:

Debit Credit
HK$’000 HK$’000
Non-controlling interests – equity 400
Retained earnings – dividend 400

This entry acknowledges that the NCI share of equity has decreased as part of the
cumulative profits have been declared as a dividend to NCI.

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Knowledge Check Questions

Question 2
On 1 July 20X3, Bonus Limited (Bonus) purchased 100% of subsidiary Gift Limited (Gift)
for cash consideration of HK$180,000 and contingent consideration valued at HK$50,000.
At the time of acquisition, the fair value of the identifiable net assets of Yang was
represented by:

HK$
Share capital 100,000
Retained earnings 110,000

The contingent consideration was settled for HK$35,000 on 30 June 20X5.

Bonus is preparing its consolidated financial statements for the year ended 30 June
20X5. Prepare the consolidation worksheet entry to eliminate Bonus’ investment in Gift.

A Debit Credit
HK$ HK$
Share capital 100,000
Retained earnings 110,000
Retained earnings – gain on bargain purchase 30,000
Investment in Gift 180,000

B Debit Credit
HK$ HK$
Share capital 100,000
Retained earnings 110,000
Goodwill 5,000
Investment in Gift 215,000

C Debit Credit
HK$ HK$
Share capital 100,000
Retained earnings 110,000
Goodwill 20,000
Investment in Gift 230,000

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Knowledge Check Questions (continued)

D Debit Credit
HK$ HK$
Share capital 100,000
Retained earnings 110,000
Goodwill 20,000
Contingent consideration 50,000
Cash 35,000
Gain on settlement of contingent consideration 15,000
Investment in Gift 230,000

Question 3
On 1 October 20X4, Ying Limited (Ying) purchased 80% of subsidiary Yang Limited (Yang)
for consideration of HK$220,000. The NCI was measured using the partial goodwill
approach. At the time of acquisition, the fair value of the identifiable net assets of Yang
was represented by:

HK$’000
Share capital 100
Retained earnings 175

At reporting date 30 September 20X5, the assets, liabilities and equity of Ying and Yang,
as reported in their respective financial statements, are as follows:

Ying Yang
HK$’000 HK$’000
Assets
Property, plant and equipment 400 100
Investment in Yang 220 –
Inventories 100 80
Trade and other receivables 80 90
Cash 350 200
Total assets 1,150 470
Liabilities
Loan 125 520
Trade payables 60 210
Total liabilities 185 730
Net assets/(liabilities) 965 (260)

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Knowledge Check Questions (continued)

Ying Yang
HK$’000 HK$’000
Equity
Share capital 100 100
Retained earnings 865 (360)
Total equity 965 (260)

Regarding the preceding information, identify which one of the following statements
is correct.
A Ying ceases to consolidate Yang until it returns to a net asset position.
B Ying attributes the entire net deficit to the owners of Ying. The NCI share of equity is nil.
C Ying attributes equity of (HK$55,000) to the NCI and (HK$205,000) to owners of
the parent.
D Ying must write down its investment in Yang to nil in its consolidated financial
statements.

3 0 . 3 SIMPLE GROUP STRUCTURE PRACTICE

The consolidation procedures described in Section 30.2 could be summarised into the
following steps:

1. Set up the consolidation worksheet by identifying the financial statements to be

consolidated and populate the left-hand columns of the worksheet with the parent and
subsidiary financial information;

2. Calculate and record any fair value adjustments that arose on the acquisition date of
the subsidiary, measured in accordance with HKFRS 3 Business Combinations re fair
value measurement;

3. Calculate goodwill (or gain from bargain purchase) on acquisition and prepare the
pre-acquisition equity elimination entries;

4. Calculate and record any additional (or reduction in) depreciation or amortisation
expense resulting from the acquisition date fair value adjustments;

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5. Identify and eliminate in full any intragroup balances (e.g. loan receivable and payable,
trade receivable and payable);

6. Identify and eliminate in full any intragroup transactions (e.g. interest income and
payable, dividend income and retained earnings, sales revenue/cost of goods sold);

7. Identify and eliminate in full any unrealised gains and losses (e.g. from sales of
inventory or non-current assets);

8. Allocate consolidated profit or loss and OCI for the current reporting period between
the parent and the NCI;

9. Calculate and allocate the NCI’s share of post-acquisition movements in equity of prior
periods (e.g. retained earnings and reserves), and the NCI’s share of any current period
changes arising from transactions with owners in their capacity as owners;

10. Add across each line item to derive adjusted amounts pertinent to the group; and

11. Use that information to prepare the consolidated financial statements presented in
accordance with HKAS 1 Presentation of Financial Statements and add the disclosures in
accordance with HKFRS 12 Disclosure of Interests in Other Entities (see Chapter 34) and
other pertinent HKFRSs.

Of course, in practice, the preceding steps may need to be added to or amended,

for example, to acknowledge situations where a subsidiary being consolidated employs
different accounting policies to the parent, has a different reporting date or has a different
presentation currency.

The following Illustrative Example illustrates the consolidation procedures reviewed in

Section 30.2. In addition, this example illustrates the additional line items that HKAS 1 requires
to be presented on the face of a consolidated statement of financial position, consolidated
statement of comprehensive income and consolidated statement of changes in equity.

Illustrative Example 5
On 1 January 20X0, Soleil acquired 80% of subsidiary Astro for cash consideration of
HK$600 million. At the time of acquisition, Astro’s equity was represented by:

HK$’000
Share capital 100,000
Retained earnings 528,000
Other reserves 50,000
678,000

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Illustrative Example 5 (continued)

Soleil and Astro’s statement of financial position and statement of profit or loss and
other comprehensive income at 31 December 20X1 are as follows:

Statement of financial position

Soleil Astro
HK$’000 HK$’000
Assets
Property, plant and equipment 500,000 870,000
Investment in Astro 600,000 –
Other financial assets (inc. investment in other entities) 725,000 138,000
Deferred tax assets 1,000 2,000
Inventories 80,000 127,000
Loans receivable 235,000 –
Other trade and other receivables 120,000 125,000
Cash 300,000 110,000
Total assets 2,561,000 1,372,000
Equity
Share capital 200,000 100,000
Retained earnings
Opening retained earnings 1,603,000 698,000
Dividends declared – (2,000)
Profit for the year 107,000 226,000
Closing retained earnings 1,710,000 922,000
Reserves
Cash flow hedge reserve – 1,670
Other reserves 282,000 50,000
Total equity 2,192,000 1,073,670
Liabilities
Bank and other loans 278,500 198,000
Deferred tax liabilities 5,500 8,000
Trade and other payables 85,000 92,330
Total Liabilities 369,000 298,330
Total equity and liabilities 2,561,000 1,372,000

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Illustrative Example 5 (continued)

Statement of profit or loss and other comprehensive income
Soleil Astro
HK$’000 HK$’000
Revenues 395,976 860,000
Interest income 52,000 –
Dividend income 60,000 –
Other income 2,000 –
Cost of sales (256,000) (406,000)
Administrative expenses (50,000) (62,000)
Interest expense (4,000) (15,000)
Other expenses (64,000) (52,610)
Profit before tax 135,976 324,390
Income tax expense (28,976) (98,390)
Profit for the year 107,000 226,000
Other comprehensive income
Items that may be reclassified subsequently to profit or loss:
Gain on cash flow hedge – 2,000
Income tax relating to gain on cash flow hedge – (330)
Other comprehensive income for the year – 1,670
Total comprehensive income for the year 107,000 227,670

During the year ended 31 December 20X0, the following transactions occurred:

• Soleil sold inventory for HK$10 million to Astro. The carrying amount (cost) of the
inventory in Soleil’s books immediately prior to the sale was HK$7 million. All the
inventory remained on hand on 31 December 20X0. The inventory was fully on-sold
by 31 December 20X1; and

• On 1 July 20X0, Astro sold a machine for HK$49.4 million cash to Soleil. Astro had
purchased the machine on 1 January 20X0 for HK$50 million. Soleil and Astro’s
accounting policy is to depreciate the machine on a straight-line basis over its
useful life. The machine was initially estimated to have a useful life of 10 years
and nil residual value, and these assumptions were not changed on the sale.
(see Sections 30.2.2.4 and 30.2.2.5).

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Illustrative Example 5 (continued)

During the year ended 31 December 20X1, the following transactions occurred:

• Astro has an outstanding loan payable to Soleil of HK$50 million on 31 December

20X1. The interest expense and interest income charged on that loan during the
year was HK$5 million;

• Soleil provided management services to Astro for a fee of HK$2 million. The
services were fully paid for by the reporting date;

• Astro sold inventory for HK$24 million to Soleil. The carrying amount (cost) of the
inventory in Astro’s books immediately prior to the sale was HK$16 million. 70% of
the inventory remained unsold at 31 December 20X1;

• Astro applied hedge accounting to a forward contract. At 31 December 20X1, the

hedging reserve is HK$1.67 million; and

• Astro declared a dividend of HK$2 million to its shareholders. The entire amount of
the dividend remains payable at year end.

Other information:

• Soleil measured the NCI in Astro at its fair value of HK$150 million on acquisition
date;

• On acquisition of Astro on 1 January 20X0, Soleil assessed a building held by

Astro to have a fair value of HK$15 million in excess of Astro’s carrying amount
of HK$100 million (original cost HK$120 million, with related accumulated
depreciation of HK$20 million). Soleil and Astro depreciate the building on a
straight-line basis over its remaining useful life of five years to nil residual value;

• Depreciation on the machine sold in the intragroup sale and the building
remeasured to fair value on acquisition are recorded in the line item ‘other
expenses’ in the statements of profit or loss and OCI; and

• Tax is payable separately by each entity on its results. Assume the gain on sale
of the machinery is taxable at the time of sale, and that dividend income is not
taxable to the recipient. The tax rate is 16.5%.

Step 1 of the consolidation procedures checklist. From the preceding information,

Soleil prepares the following journal entries to complete its consolidation worksheets
to determine the consolidated financial position and profit or loss and comprehensive
income of the group comprising Soleil and Astro for the year ended 31 December 20X1.

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Illustrative Example 5 (continued)

Notes (all amounts in HK$’000)

Step 2 of the consolidation procedures checklist. Pre-acquisition equity elimination

J1. 
entry to acknowledge the fair value uplift to building on acquisition. (In practice, the
accumulated depreciation on acquisition must be eliminated first.)

Debit Credit
HK$ HK$
Property, plant and equipment 15,000
Deferred tax liability (16.5% 15,000) 2,475
Business combinations reserve 12,525
Record fair value adjustment to building, including tax effect of the valuation increase.
A deferred tax liability (DTL) arises as the consolidated carrying amount of the building
(HK$115mil) is now greater than its tax base (HK$100 million), creating a taxable
temporary difference. The taxable temporary difference reflects that the group will be
taxed on future profits of HK$15 million generated by use of the building.

Note: In this example, the tax rate is assumed to be 16.5% for the parent and subsidiary.
Where the tax rates differ, the applicable tax rate is that of the jurisdiction in which the tax
would be charged, that is, tax rate of the subsidiary. (This scenario is covered in Chapter 31.)

Step 3 of the consolidation procedures checklist. Pre-acquisition equity elimination

J2. 
entries to:

• Eliminate Soleil’s investment in Astro; and

• Attribute to its share of Astro’s acquisition date equity the 20% NCI.

Debit Credit
HK$ HK$
Share capital 100,000
Retained earnings – opening 528,000
Other reserves 50,000
Business combinations reserve 12,525
Goodwill (see page 40) 59,475
Investment in subsidiaries 600,000
Non-controlling interest – equity 150,000
Eliminate pre-acquisition equity.

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Illustrative Example 5 (continued)

Goodwill

Goodwill on consolidation is calculated by applying the HKFRS 3 Business Combinations

acquisition method, as follows:

HK$’000
Consideration transferred 600,000
add: NCI (measured at fair value) (note 1) 150,000
750,000
less: HKFRS 3 recognised amounts of assets and liabilities (690,525)
(100,000+528,000+50,000+12,525)
Goodwill on acquisition of Astro 59,475

Note 1: If the NCI had been measured as the proportionate share of the net assets of the
subsidiary, goodwill on consolidation would have been calculated as HK$47.58 million
(being HK$600 million + [20% HK$690.525 million] less fair value of net assets acquired
HK$690.525 million) and the NCI at HK$138.105 million (being 20% HK$690.525 million).
Review Chapter 29 for an explanation of the differences in the measurements.

J3. Steps 4, 8 and 9 of the consolidation procedures checklist. Consolidation entry to

reflect two periods of additional depreciation expense arising from the acquisition
date fair value adjustment to building.

Debit Credit
HK$ HK$
Depreciation expense (15,000/5 years 1) 3,000
Retained earnings – opening 2,505
Deferred tax liability (2 years 495) 990
Property, plant and equipment (acc. depreciation – 2 years) 6,000
Income tax expense (16.5% 3,000) 495
Record additional depreciation charge of HK$3 million per annum based on the consolidated
carrying amount of plant revalued on acquisition. The related DTL reduces because the temporary
difference reduces over the period the asset is consumed. The cumulative impact of the additional
depreciation charge of prior periods, less tax, is recognised in opening retained earnings.

In addition, the consolidation adjustment to recognise additional depreciation

affects consolidated net assets and is fully attributable to the subsidiary. Therefore,
part of the excess depreciation charge must be attributed to NCI:

Debit Credit
HK$ HK$
Non-controlling interest (equity) 1,002
Profit attributable to NCI (20% (3,000 − 495)) 501
Retained earnings – opening (20% (3,000 − 495)) 501
Attribute its share of the additional depreciation charge of HK$3mil per annum to the NCI.

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Illustrative Example 5 (continued)

J4. Steps 5 and 6 of the consolidation procedures checklist. Consolidation entries to

eliminate in full the intragroup loan and related interest on the loan.

Debit Credit
HK$ HK$
Loan payable (Astro) 50,000
Loan receivable (Soleil) 50,000
Record elimination of the intragroup loan balance as the loan does not involve a transaction
with a party external to the group.

Debit Credit
HK$ HK$
Interest income (Soleil) 5,000
Interest expense (Astro) 5,000
Record elimination of the intragroup interest income and interest expense.

As the consolidated net asset position of the group is not affected, attribution
of the elimination to the NCI is unnecessary even though the transaction impacts
the net assets of the subsidiary.
Note: In addition to the illustrated journal entries, any outstanding intragroup interest pay-
able must be eliminated against the interest receivable at year end. It is necessary to elimi-
nate any deferred tax balances related to that payable and receivable to the extent these can
be offset.

Step 6 of the consolidation procedures checklist. Consolidation entry to eliminate

J5. 
in full the intragroup management services rendered.

Debit Credit
HK$ HK$
Management services income (Soleil) 2,000
Management services expenses (Astro) 2,000
Record elimination of the intragroup services rendered.

Because the consolidated net asset position of the group is not affected,
attribution of the elimination to the NCI is unnecessary even though the
transaction impacts the net assets of the subsidiary.
Note: In addition to the illustrated journal entries, any outstanding intragroup trade paya-
bles must be eliminated against the receivables at year-end. It is necessary to eliminate
any deferred tax balances related to that payable and receivable to the extent these can be
offset.

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Illustrative Example 5 (continued)

Steps 6 through 8 of the consolidation checklist. Consolidation entries to eliminate
J6. 
in full the intragroup sale of inventory from Astro to Soleil during the year ended
31 December 20X1.

Debit Credit
HK$ HK$
Sales revenue 24,000
Cost of goods sold 24,000
Record elimination of the sale and purchase transaction.

Debit Credit
HK$ HK$
Cost of goods sold 8,000
Inventory 8,000
Record elimination of the unrealised profit on sale (HK$24 million − HK$16 million
HK$8 million).

In the first journal entry, cost of goods sold has been credited with the
inventory selling price rather than cost price. The explanation for this adjustment
is that the consolidation process is making whatever adjustments are necessary to
reflect the group’s circumstances and the second journal entry immediately debits
cost of goods sold to bring the overall cost of goods sold down to cost price. The
journal entries above could also be presented in a combined form:

Debit Credit
HK$ HK$
Sales revenue 24,000
Cost of goods sold 16,000
Inventory (unrealised gain in inventory) 8,000
Eliminate 100% of the upstream intragroup sale.

The consolidation adjustment journal entries to eliminate the effects of

the intragroup sale recognises that once inventory is on-sold externally, that
percentage of the profits on the intragroup sale has now been earned by the
group; the group profit on the sale comprising the markup charged by Astro to
Soleil on the cost to Soleil and the further markup by Astro from its cost. Because
only the unrealised profit related to the remaining 70% of inventory still on hand
needs to be eliminated, a further journal entry is required.

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Illustrative Example 5 (continued)

Debit Credit
HK$ HK$
Inventory 2,400
Cost of goods sold 2,400
Recognise that 30% of the goods were on-sold by reporting date (30% of the profit on
sale is now realised): 30% HK$8 million HK$2.4 million.

In addition, the consolidation worksheet must record adjustments to reflect the

tax effect of the intragroup transaction on the group. The adjustment recognises
that, from the group’s perspective, income tax expense recognised by the seller
(Astro) should be eliminated because the tax expense is not yet incurred from the
group’s perspective, but that the group is presently obliged to make a prepayment
of tax on the profit. That prepayment represents a tax benefit on the eventual
sale of that inventory to a party outside the group (i.e. when the inventory is sold,
less tax on the profit on sale is payable). Another way of looking at it is that when
the intragroup transaction initially occurs, the tax base of the inventory to the
group is reset to HK$24 million (carrying amount HK$16 million + future amount
deductible HK$24 million – future amount taxable HK$16 million) compared to
its consolidated carrying amount of HK$16 million, giving rise to a deductible
temporary difference of HK$8 million and a deferred tax asset of HK$1.32 million
(16.5% HK$8 million). At reporting date, the remaining prepayment of tax relates
to the inventory that is still on hand.

Debit Credit
HK$ HK$
Deferred tax asset (16.5% 70% 8,000) 924
Income tax expense 924
Recognise tax effect of eliminating the unrealised gain in inventory.

Note: In this example, the tax rate is assumed to be 16.5% for the parent and subsidiary.
Where the tax rates differ, the applicable tax rate is the one applied to the asset being
­realised, that is, here, it is the tax rate of the parent.

The intragroup sale gives rise to a net consolidation adjustment (elimination of

unrealised profit on sale) of HK$4.676 million (HK$5.6 million − 16.5% HK$5.6 million).
Because the intragroup sale is an ‘upstream’ transaction, the sale affects Astro’s
reported profit or loss for the period. Consequently, part of the consolidation
adjustment must be attributed to the NCI:

Debit Credit
HK$ HK$
Non-controlling interest (equity) 935
Profit attributable to NCI (20% 4,676) 935
Attribute to NCI its share of the consolidation adjustment. (rounded).

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Illustrative Example 5 (continued)

J7 Steps 6 and 7 of the consolidation procedures checklist. Consolidation entries
to eliminate in full the unrealised gain in opening inventory arising from
the intragroup sale of inventory from Soleil to Astro during the year ended
31 December 20X0.

Debit Credit
HK$ HK$
Retained earnings – opening 2,505
Income tax expense (16.5% 3,000) 495
Cost of goods sold (10,000 − 7,000) 3,000
Record elimination of the unrealised gain in opening inventory.

Note: In this example, the tax rate is assumed to be 16.5% for the parent and subsidiary.
Where the tax rates differ, the applicable tax rate is the one applied to the asset being
realised, that is, here, it is the tax rate of the subsidiary.

The effect of the entry is to change the period in which the gain on the sale of
inventory is recognised by the group. If a portion of that inventory continued to remain
outstanding at year-end 31 December 20X1, the journal entries shown in J6 would
again be recorded to eliminate any remaining unrealised gain from the reporting
period’s results.

There is no amount to attribute to the NCI as the gain was recognised by Soleil.

J8. Steps 6 through 9 of the consolidation procedures checklist. Consolidation entries

to eliminate in full the prior period intragroup sale of machinery from Astro to Soleil

Debit Credit
HK$ HK$
Property, plant and equipment 2,500
Accumulated depreciation 2,500
Reinstate accumulated depreciation as at the date of the intragroup sale (not illustrated
in the worksheet).

Debit Credit
HK$ HK$
Retained earnings – opening (gain on sale) 1,900
Deferred tax asset (16.5% 1,900) 314
Property, plant and equipment 1,900
Retained earnings – opening (tax expense) 314
Record elimination of the unrealised gain on sale of machinery (rounded).

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Illustrative Example 5 (continued)

Debit Credit
HK$ HK$
Accumulated depreciation (1,900/9.5 yrs 1.5 yr) 300
Income tax expense (16.5% 200) 33
Deferred tax asset (16.5% 300) 50
Depreciation expense (1,900/9.5 yr 1) 200
Retained earnings – opening (100 − 16.5% 100) 83
Adjust cumulative consolidated depreciation expense to that as if the intragroup sale
had not occurred.

The excess depreciation charged over the 1.5 years since the intragroup sale is
eliminated from the consolidated results, consistent with the gross carrying amount
of the machinery being reset to its original carrying amount to the group. Income tax
expense correspondingly increases. The deductible temporary difference arising on the
sale reduces as the tax deduction is claimed by the taxpayer.

The intragroup sale gives rise to a consolidation adjustment (elimination of

unrealised gain on sale and subsequent depreciation) that affects consolidated net
assets. Consequently, as the intragroup sale is an upstream transaction, part of the
adjustment must be attributed to the NCI:

Debit Credit
HK$ HK$
Non-controlling interest – equity 317
Retained earnings – opening 317
Attribute to the NCI its share of the consolidation adjustment to eliminate the gain on
intragroup sale of machinery (20% HK$1.5865 million). (See section 30.2.2.5 for further
calculations.)

Debit Credit
HK$ HK$
Retained earnings – opening 17
Profit attributable to NCI 33
Non-controlling interest - equity 50
Attribute to the NCI its share of the consolidation adjustment to eliminate the excess
depreciation relating to the intragroup sale of machinery. The NCI share of cumulative
excess depreciation, less tax 20% (HK$300,000 − 16.5% HK$300,000) HK$50,100.

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Illustrative Example 5 (continued)

Steps 5, 6 and 9 of the consolidation procedures checklist. Parent’s share of the
J9. 
intragroup dividend is eliminated, and the NCI share of the dividend attributed to
the NCI.

Debit Credit
HK$ HK$
Dividend income recognised by parent (80% 2,000) 1,600
Non-controlling interests – equity (20% 2,000) 400
Retained earnings (dividend) 2,000
Eliminate intragroup dividend and attribute its share of the dividend to the NCI.

Debit Credit
HK$ HK$
Dividend payable (80% 2,000) 1,600
Dividend receivable (80% 2,000) 1,600
Eliminate intragroup dividend payable and receivable.

Because the dividend was not taxable to Soleil, there is no tax effect to address
as part of the consolidation process.

Steps 8 and 9 of the consolidation procedures checklist. Attribute its share of

J10. 
equity, other than dividends, to the NCI.

Debit Credit
HK$ HK$
Retained earnings – opening (20% (698,000 − 34,000
528,0000))a
Profit attributable to NCI (20% 226,000)a 45,200
OCI attributable to NCI (hedging reserve) (20% 1,670) 334
Non-controlling interests – equity 79,534
Attribute its share of share of the post-acquisition profit or loss and OCI to the NCI.
a
Alternative approach (Approach 2).

Alternatively, the consolidation worksheet could record a single entry to make

all adjustments to the NCI for the post-acquisition changes in Astro’s equity. In

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Illustrative Example 5 (continued)

this case, rather than separately recording the NCI share of each consolidation
adjustment, these are reflected cumulatively as a single adjustment; for example:

Debit Credit
HK$ HK$
Retained earnings – opening 33,199
Profit attributable to NCI 43,797
OCI attributable to NCI (hedging reserve) 334
Retained earnings (dividend) 400
Non-controlling interests – equity 76,930
Attribute its share of share of the post-acquisition equity to the NCI.

Calculation:

Debit Credit
HK$ HK$
NCI @ acquisition 150,000
Post-acquisition retained earnings (698,000 − 528,000) 170,000
Consolidation adjustments:
Additional depreciation on fair value uplift to building (2,505)
Gain on sale of machinery (1,586)
Excess depreciation on machinery 83
165,992
NCI share of equity @ 1 Jan 20X1 (20% 165,992) 33,199
Profit for the period 226,000
Consolidation adjustments:
Additional depreciation on fair value uplift to building (2,505)
Unrealised profit in closing inventory (4,676)
Excess depreciation on machinery 167
218,986
NCI share of profit for the period (20% 218,986) 43,797
NCI share of OCI (hedging reserve) (20% 1,670) 334
NCI share of dividend (20% 2,000) (400)
NCI @ 31 December 20X1 226,930

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M11_c30.indd 1604
Illustrative Example 5 (continued)
Consolidation Soleil Astro Fair value Pre- Depreciation Loan Management 20X1 20X0 Sale of Excess Dividend Share Consolidated
worksheet 31 HK$’000 HK$’000 uplift acquisition on fair value (J4) services Upstream Downstream machine depreciation (J9) to NCI HK$’000
December 20X1 (J1) equity uplift HK$’000 (J5) sale of sale of (J8) (J8) HK$’000 (J10)
HK$’000 (J2) (J3) HK$’000 inventory inventory HK$’000 HK$’000 HK$’000
HK$’000 HK$’000 (J6) (J7)
HK$’000 HK$’000

Statement of
financial position

Assets
FINANCIAL REPORTING

Property, plant and

equipment 500,000 870,000 15,000 (6,000) (1,900) 300 1,377,400

Investment in Astro 600,000 – (600,000) –

Other financial
assets (inc.
investment in other
entities) 725,000 138,000 863,000

Deferred tax assets 1,000 2,000 924 314 (50) 4,188

Goodwill – – 59,475 59,475

1604
Inventories 80,000 127,000 (5,600) 201,400

Loans receivable 235,000 – (50,000) 185,000

Other trade and

other receivables 120,000 125,000 (1,600) 243,400

Cash 300,000 110,000 410,000

Total assets 2,561,000 1,372,000 3,343,863

Equity

Share capital 200,000 100,000 (100,000) 200,000

Retained earnings

Opening retained
earnings 1,603,000 698,000 (528,000) (2,004) (2,505) (1,269) 66 (34,000) 1,733,288

[(2,004) = (2,505)+501] [(1,269) = (1900)+314+317] [66=83–17]

Dividends declared – (2,000) 2,000

Profit for the year 107,000 226,000 (2,004) (3,741) 2,505 134 (1,600) (45,200) 283,094

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M11_c30.indd 1605
Illustrative Example 5 (continued)
Consolidation Soleil Astro Fair value Pre- Depreciation Loan Management 20X1 20X0 Sale of Excess Dividend Share Consolidated
worksheet 31 HK$’000 HK$’000 uplift acquisition on fair value (J4) services Upstream Downstream machine depreciation (J9) to NCI HK$’000
December 20X1 (J1) equity uplift HK$’000 (J5) sale of sale of (J8) (J8) HK$’000 (J10)
HK$’000 (J2) (J3) HK$’000 inventory inventory HK$’000 HK$’000 HK$’000
HK$’000 HK$’000 (J6) (J7)
HK$’000 HK$’000

[(2,004) = (2,505)+501] [(3,741)=(4,676)+935]

Closing retained
earnings 1,710,000 922,000 2,016,382

Reserves

Business
combination
reserve – – 12,525 (12,525) –

Cash flow hedge

reserve – 1,670 (334) 1,336

Other reserves 282,000 50,000 (50,000) 282,000

Non-controlling
interest – equity 150,000 (1,002) (935) (317) 50 (400) 79,534 226,930

1605
[79,534 = 34,000+
[(1,002) = (501) + (501)] 45,200 + 334]

Total equity 2,192,000 1,073,670 2,726,648

Liabilities

Bank and other

loans 278,500 198,000 (50,000) 426,500

Deferred tax
liabilities 5,500 8,000 2,475 (990) 14,985

Trade and other

payables 85,000 92,330 (1,600) 175,730

Total equity and

liabilities 2,561,000 1,372,000 3,343,863
Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

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M11_c30.indd 1606
Illustrative Example 5 (continued)
Consolidation Soleil Astro Fair value Pre- Depreciation Loan Management 20X1 20X0 Sale of Excess Dividend Share Consolidated
worksheet uplift acquisition on fair value (J4) services Upstream Downstream machine depreciation (J9) to NCI
31 December (J1) equity (J2) uplift (J3) (J5) sale of sale of (J8) (J8) (J10)
20X1 inventory inventory (J7)
(J6)

Statement of
profit or loss
and other
comprehensive
income
FINANCIAL REPORTING

Revenues 395,976 860,000 (24,000) 1,231,976

Interest income 52,000 – (5,000) 47,000

Dividend income 60,000 – (1,600) 58,400

Other income 2,000 – (2,000) –

Cost of sales (256,000) (406,000) 18,400 (3,000) (646,600)

Administrative
expenses (50,000) (62,000) 2,000 (110,000)

1606
Interest expense (4,000) (15,000) 5,000 (14,000)

Other expenses (64,000) (52,610) (3,000) 200 (119,410)

Profit before tax 135,976 324,390 447,366

Income tax
expense (28,976) (98,390) 495 924 495 (33) (125,485)

Total assets 107,000 226,000 321,881

Other
comprehensive
income

Items that may

be reclassified
subsequently to
profit or loss

Gain on cash flow

hedge – 2,000 2,000

Income tax
relating to gain on
cash flow hedge – (330) (330)

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M11_c30.indd 1607
Illustrative Example 5 (continued)
Consolidation Soleil Astro Fair value Pre- Depreciation Loan Management 20X1 20X0 Sale of Excess Dividend Share Consolidated
worksheet uplift acquisition on fair value (J4) services Upstream Downstream machine depreciation (J9) to NCI
31 December (J1) equity (J2) uplift (J3) (J5) sale of sale of (J8) (J8) (J10)
20X1 inventory inventory (J7)
(J6)

Other
comprehensive
income for the
year – 1,670 1,670

Total
comprehensive
income for the
year 107,000 227,670 323,551

Profit for
the year
attributable to:

Owners of the

1607
parent 107,000 226,000 (2,004) – – (3,741) 2,505 – 134 (1,600) (45,200) 283,094

Non-controlling
interests (501) – – (935) – – 33 – 45,200 43,797

Profit for the

year 326,891

Total
comprehensive
income
attributable to:

Owners of the
parent 107,000 227,670 (2,004) – – (3,741) 2,505 – 134 (1,600) (45,534) 284,430

Non-controlling
interests (501) – – (935) – – 33 – 45,534 44,131

Total
comprehensive
income for the
year 328,561

An alternative manner of presenting a consolidation worksheet is illustrated in the solutions to the Knowledge Check Questions.
Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

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 FINANCIAL REPORTING

Illustrative Example 6
(Continuation of the previous Illustrative Example)

Using the information from its consolidated results and consolidated financial position,
Soleil can then prepare the following consolidated statement of changes in equity, which
separately presents the comprehensive income for the period attributable to the NCI from
that attributable to owners of the parent:

Share Retained Cash Other Total NCI Total

capital earnings flow reserves equity
hedge
reserve
HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
Balance at 200,000 1,733,288 – 282,000 2,215,288 183,199 2,398,487
1 Jan 20X1
Profit for the – 283,094 – – 283,094 43,797 326,891
year
Other – – 1,336 – 1,336 334 1,670
comprehensive
income for the
year
Total - 283,094 1,336 – 284,430 44,131 328,561
comprehensive
income for the
year
Dividends – – – – – (400) (400)
Balance at 200,000 2,016,382 1,336 282,000 2,499,718 226,930 2,726,648
31 Dec 20X1

Knowledge Check Questions

Question 4
During the year ending 30 June 20X3, Parent P sold inventory that cost it HK$60,000 to
the wholly owned Subsidiary S1 at a 20% markup from cost. S1 has on-sold 75% of that
inventory by the year-end to external parties for HK$75,600 (a markup of 40%). Prepare
the consolidation adjustment journal entries required to eliminate this transaction in
Parent P’s consolidated financial statements for the year ended 30 June 20X3. Assume the
tax rate is 16.5%.

Question 5
Parent P has sold its 80% owned entity Subsidiary S2 inventory costing Parent P HK$60,000
at a 20% markup. 25% of that inventory remains on hand at reporting date. S2’s reported
net profit for the year is HK$200,000. Prepare the consolidation adjustment journal entries
required to eliminate this transaction and calculate the NCI share of S2’s profit for the year.
Assume the tax rate is 16.5%.

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 Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

Knowledge Check Questions (continued)

Question 6
Regarding the intragroup transaction in Question 3, prepare the consolidation adjustment
journal entries that should be made in Parent P’s consolidation worksheet for the reporting
year ending 30 June 20X4. Assume the inventories were fully on-sold by 30 June 20X4.

30.4 CONSOLIDATED STATEMENT

OF CASH FLOWS

The discussion in Sections 30.2 and 30.3 was mainly focused on establishing the results
and financial position presented in the consolidated statement of profit or loss and other
comprehensive income (OCI), consolidated statement of financial position and consolidated
statement of changes in equity. However, a complete set of financial statements also includes
the consolidated statement of cash flows, prepared in accordance with HKAS 7 Statement of
Cash Flows.

The presentation and content of a consolidated statement of cash flows is consistent with
that for a single company (see Chapter 27) other than that cash flow effects of acquisitions and
HKFRS
12.B10, disposals of subsidiaries and any dividends paid to non-controlling interests (NCIs) need to be
HKAS 7.39 separately disclosed. Accordingly, this chapter does not review the foundational concepts for
preparing a statement of cash flows because these are consistent between the statement
prepared by an individual entity and by a group.

Consistent with the concept of the group as a single economic entity, the key principle with
preparing a consolidated statement of cash flows is consistent with the concept of the group as
a single economic entity, for cash flows to be reported net of cash flows between the entities
in the group. So, for example, neither the proceeds received by Astro from the loan from Soleil
of HK$50 million nor Soleil’s cash outflow would be reflected in the consolidated statement of
cash flows.

The consolidated statement of cash flows may be prepared using different approaches:

• One approach derives the statement from information provided by the consolidated
statement of financial position, consolidated statement of profit or loss and OCI and
consolidated statement of changes in equity, similar to the procedures discussed in
Chapter 27; and

• Another approach derives the statement by applying consolidation procedures to

combine each group entity’s respective statement of cash flows to determine the
consolidated cash flows, similar to the process reviewed in Sections 30.2 and 30.3.
This approach is not used in this module.

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 FINANCIAL REPORTING

Whichever approach is adopted:

• The group’s overall cash and cash equivalent position must be the same as the sum of
the cash held by each group entity (after adjustment for any cash-in-transit); and

• Net cash flows from operating, investing and financing activities may differ from the
sum of the subtotal determined by combining the individual cash flow statements
because the transacting parties may classify the transaction into different parts of the
statement of cash flows.

30.4.1 Acquisition of a Subsidiary

An entity must attend to the following when preparing its consolidated statement of cash flows
following the acquisition of a subsidiary during the period:

• How to reflect the cash consideration expended in exchange for control of the
subsidiary;

• How any cash and cash equivalents obtained on acquisition impacts the consolidated
statement of cash flows; and

• How other assets acquired and liabilities assumed on acquisition impact its
consolidated statement of cash flows.

When a subsidiary is acquired, the parent will normally incur an outflow of cash. HKAS 7
requires that cash outflow, net of any cash balances in the subsidiary at the time of acquisition,
HKAS
7.39, 41, to be classified as an investing cash flow, and reported separately from any cash flows on losing
42 control of a subsidiary. For example, in 20X0 Soleil acquired 80% of the ordinary share capital of
Astro for cash consideration of HK$600 million. Astro’s cash and cash equivalent balance on the
acquisition date was HK$27 million. In its consolidated statement of cash flows for the year
ended 31 December 20X0, to reflect the acquisition, Soleil reports HK$573 million (HK$600
million – HK$27 million) as an investing cash outflow ‘acquisition of subsidiary’.
An acquisition normally involves a parent acquiring control of assets and liabilities besides
cash and cash equivalents. Recall how a cash flow statement is constructed, for example, by
reference to the formula method. Therefore, when constructing the consolidated statement of
cash flows, an adjustment must be made to the ‘opening balances’ to acknowledge the assets
and liabilities acquired as part of the subsidiary.

Consider the following simple example. Parent P acquires Subsidiary S5 for HK$100
cash. S5 has a single asset at the time of acquisition, a receivable of HK$100. Payment of the
receivable was received in cash by the end of the reporting period. The group has no other
receivables at the beginning or end of the reporting period and made no sales. In this example,
the group has received cash of HK$100 and made a cash outflow of HK$100. However, if the
cash flow ‘formula’ of were to be applied without acknowledging the acquisition, the cash inflow
would be calculated as HK$nil (HK$0 + HK$0 − HK$0 − HK$0).

Opening trade receivable balance + Sales revenue − Credit

Receipts from customers impaired amounts (bad debts) written off − Closing trade
receivable balance

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 Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

Accordingly, in the year of acquisition, an entity should ‘tweak’ the formula such that
‘opening balances’ refers to the sum of the opening balance and the balance on acquisition
date. By so doing, the cash inflow from operating activities would be calculated as HK$100
(opening balance HK$0 + balance acquired HK$100 + sales HK$0 − bad debts HK$0 − closing
balance HK$0).

Apply and Analyse 3

On 1 January 20X1, Rose Limited (Rose) acquired 80% of Sky Limited (Sky) for a
combination of cash HK$45 million and 100 Rose shares. The fair value on acquisition date
of the shares issued as consideration was HK$40 million.

The following consolidated financial information is available for Rose Limited for the
year ended 31 December 20X1:

Consolidated statement of profit or loss and other

comprehensive income
20X1
HK$m
Gross profit 530
Interest expense (45)
Profit before tax 485
Income tax expense (75)
Profit for the year 410
Profit attributable to:
Owners of Rose 350
Non-controlling interest 60
410

Consolidated statement of financial position

20X1 20X0
HK$m HK$m
Assets
Property, plant and equipment 1,160 975
Goodwill 30 –
Inventories 590 520
Trade receivables 555 383
Cash 1,805 1,187
Total assets 4,140 3,065

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 FINANCIAL REPORTING

Apply and Analyse 3 (continued)

Consolidated statement of financial position

20X1 20X0
HK$m HK$m
Equity
Share capital 2,000 1,930
Retained earnings 1,065 725
Non-controlling interests 51 –
Total equity 3,116 2,655
Liabilities
Bank loans 782 248
Trade payables 150 84
Income tax payable 80 69
Accrued interest expense 12 9
Total liabilities 1,024 410
Total equity and liabilities 4,140 3,065

Additional information:

• Sky’s financial position on acquisition was represented by:

HK$m
Property, plant and equipment 50
Inventories 10
Trade receivables 8
Cash 37
Trade payables (20)
Income tax payable (5)
Fair value of net assets on acquisition date 80

• On 31 December 20X1, cash of HK$2 million remains payable to Sky’s former

shareholders;

• Rose and Sky declared dividends to shareholders during the year. Assume the Sky
dividend was made out of post-acquisition profits. All dividends were fully paid to
shareholders by 31 December 20X1;

• The group acquired HK$400 million of new property, plant and equipment (PPE)
during the period and sold PPE written down to HK$65 million for HK$90 million.
Depreciation expense for the period was HK$200 million;

• There were no repayments of bank loans during the period; and

• Rose measured the NCI on acquisition of Sky at fair value of HK$25 million.

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 Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

Apply and Analyse 3 (continued)

Prepare Rose’s consolidated statement of cash flows for the year ended 31 December
20X1, using the indirect method for presenting cash flows from operations.

Analysis

From the information available, Rose’s consolidated statement of cash flows presents
as follows:

Consolidated statement of cash flows

20X1 20X1
HK$m HK$m
Cash flows from operating activities
Profit before tax 485
Adjustment for non-cash flows:
Gain on sale of PPE (25)
Depreciation expense 200
Interest expense 45
Operating profit before working capital changes 705
less: Increase in trade receivables (555 − 383 − 8) (164)
less: Increase in inventories (590 − 520 − 10) (60)
add: Increase in trade payables (150 − 2 − 84 − 20) 44
Cash inflows from operations 525
Interest paid (9 + 45 − 12) (42)
Income tax paid (69 + 5 + 75 − 80) (69)
Net cash inflow from operating activities 414
Cash flows from investing activities
Purchases of PPE (400)
Proceeds from disposal of PPE 90
Acquisition of subsidiary (45 − 37 − 2) (6)
Net cash outflow from investing activities (316)
Cash flows from financing activities
Proceeds from issue of share capital (2,000 − 1,930 − 40) 30
Proceeds from bank loans (782 − 248) 534
Dividends paid to NCI (25 + 60 − 51) (34)
Dividends paid (725 + 350 − 1,065) (10)
Net cash inflow from financing activities 520
Net increase in cash and cash equivalents 618
Cash and cash equivalents at 1 January 20X1 1,187
Cash and cash equivalents at 31 December 20X1 1,805

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 FINANCIAL REPORTING

Knowledge Check Question

Question 7
Astro’s intragroup sale of inventory of HK$24 million to Soleil impacted the group’s
income taxes as part of the consolidation process (review Section 30.3 if necessary).
Explain whether, and if so, how, the tax effects of the intragroup transaction affect the
consolidated statement of cash flows.

3 0 . 5 DEFERRED TAXES

As has been shown in earlier sections, the elimination of an intragroup transaction could result
in the raising of ‘new’ deferred tax balances (e.g. representing ‘prepaid’ taxes) on consolidation.
Similarly, in preparing the consolidated financial statements, recognise whether any deferred
taxes exist with respect to a parent’s investment in a subsidiary even though the investment
asset is eliminated as part of the consolidation process.

Temporary differences arise where the tax base of an item differs from its carrying amount
in the financial statements. The tax base of a parent’s investment in a subsidiary will usually be
given by the cost of the acquisition (e.g. price paid for each ordinary share in subsidiary). In the
consolidated financial statements, the ‘carrying amount of the investment’ is represented by
the consolidated net assets of the subsidiary. It follows then that undistributed profits or losses
in the subsidiary, generally represented by changes in the net assets of the subsidiary in the
consolidated financial statements since acquisition, will give rise to a temporary difference.

In accordance with HKAS 12, a parent must recognise the deferred tax consequences
associated with its investments in subsidiaries. The requirement is to:

• Recognise a deferred tax liability for taxable temporary differences (arises when the
carrying amount of the investment exceeds its tax base), except where the parent
is able to control the timing of the reversal of that temporary difference and the
temporary difference will probably not reverse in the foreseeable future; and

• Recognise a deferred tax asset for deductible temporary differences (arises when the
carrying amount of the investment is lower than its tax base) only when the temporary
HKAS difference will reverse in the foreseeable future and taxable profit will be available
12.39, 44 against which to utilise that temporary difference.

In many cases, there will be no deferred tax liability to recognise with respect to the
investment in a subsidiary in the consolidated financial statements of a parent. This is because
HKAS a parent can control the timing of the reversal of the temporary difference and manage the
12.40 probability of its reversal through control of the subsidiary’s dividend policy.

In other cases, a deferred tax liability may have to be recognised.

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 Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

Illustrative Example 7
Since acquisition, Subsidiary S1 has made profits of HK$100. These profits have not yet
been distributed to Parent Co. As such, the undistributed profits of Subsidiary S1 give
rise to a taxable temporary difference associated with the entity’s investment in the
subsidiary.

Parent Co determines that the conditions for applying the exception from recognising a
deferred tax liability related to its investment in Subsidiary S1 are not satisfied as it expects
the subsidiary to distribute these profits in the foreseeable future (i.e. the temporary
difference will probably reverse in the foreseeable future when the subsidiary distributes
its undistributed profits). Consequently, in its consolidated financial statements, Parent Co
must record a deferred tax liability for the taxable temporary difference associated with its
investment in the subsidiary.

Assume Parent Co and Subsidiary S1 operate in a jurisdiction in which profits are

taxable at 20% only when distributed. In accordance with HKAS 12, the measurement
of the deferred tax liability should reflect the tax consequences that would follow from
the manner in which the entity expects, at the end of the reporting period, to recover or
settle the carrying amount of its assets and liabilities. Accordingly, to the extent Parent
Co expects to recover the carrying amount of its investment in Subsidiary S1 through
distributions of profits by the subsidiary (rather than sale of the subsidiary), it measures
the deferred tax liability by multiplying the taxable temporary difference of HK$100 by the
20% tax rate applicable to profit distributions.

In Hong Kong, investment income is not taxable. Hence, the measurement of any
recognised deferred tax liability will be nil. For this reason, the exercises in this module do not
illustrate any recognition of deferred tax liabilities in consolidated financial statements relating
to investments in subsidiaries.

3 0 . 6 CURRENT DEVELOPMENTS

The PIRs for IFRS 10, Consolidated Financial Statements, and IFRS 12 Disclosure of Interests in
Other Entities, were completed in June 2022 and that the standards were found to be working
as intended and meeting its objectives. A few minor matters were noted for future attention
but given a low priority.

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 FINANCIAL REPORTING

SUMMARY

• Consolidated financial statements present the results of a parent and its subsidiaries as a
single economic entity.

• Consolidated financial statements are prepared primarily to provide information about the
group to investors, creditors and lenders of the parent.

• Consolidation starts when a subsidiary is acquired and ceases only when the parent loses
control of the subsidiary.

• A complete set of consolidated financial statements comprises:

°° A consolidated statement of financial position as at the end of the period;

°° A consolidated statement of profit or loss and other comprehensive income for the period;

°° A consolidated statement of changes in equity for the period;

°° A consolidated statement of cash flows for the period;

°° Notes, comprising material accounting policy information and other explanatory
information;

°° Comparative information in respect of the preceding period; and

°° A third consolidated statement of financial position as at the beginning of the preceding

period, where required by HKAS 1.

• The non-controlled interest (NCI) in the consolidated statement of financial position is

presented within equity, separately from equity of the owners of the parent.
• NCI can be negative (i.e. a debit balance in equity).

• Consolidated financial statements are usually prepared using a consolidation worksheet,

which adds the individual financial statements or ledgers of each consolidating entity,
adjusting for transactions and balances that are inconsistent with the notion of the group as a
single economic entity (i.e. intragroup transactions and balances).

• In general, the individual financial statements should be for the same period and use the
same accounting policies.

• The consolidation process has the following 11 steps:

1. Set up the consolidation worksheet by identifying the financial statements to be

consolidated and populate the left-hand columns of the worksheet with the parent and
subsidiary financial information.

2. Calculate and record any fair value adjustments that arose as at the acquisition date of the
subsidiary, measured in accordance with HKFRS 3 (Revised) Business Combinations re fair
value measurement.

3. Calculate goodwill (or gain from bargain purchase) on acquisition and prepare the pre-
acquisition equity elimination entries.

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 Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

4. Calculate and record any additional (or reduction in) depreciation or amortisation expense
resulting from the acquisition date fair value adjustments.

5. Identify and eliminate in full any intragroup balances (e.g. loan receivable/payable, trade
receivable/payable).

6. Identify and eliminate in full any intragroup transactions (e.g. interest income/payable,
dividend income/retained earnings, sales revenue/cost of goods sold).

7. Identify and eliminate in full any unrealised gains and losses (e.g. from sales of inventory
or non-current assets).

8. Allocate consolidated profit or loss and other comprehensive income for the current
reporting period between the parent and the NCI.

9. Calculate and allocate the NCI’s share of post-acquisition movements in equity of prior
periods (e.g. retained earnings and reserves), and the NCI’s share of any current period
changes arising from transactions with owners in their capacity as owners.

10. Add across each line item to derive adjusted amounts pertinent to the group.

11. Use that information to prepare the consolidated financial statements presented in
accordance with HKAS 1 Presentation of Financial Statements and add the disclosures
in accordance with HKFRS 12 Disclosure of Interests in Other Entities and other
pertinent HKFRSs.

• Not all the income tax effects of an intragroup transaction can be eliminated. Resultantly, the
consolidation process may give rise to new deferred tax balances.

• Where NCI is present, identify whether an intragroup transaction that gives rise to unrealised
gains and losses is an ‘upstream’ or ‘downstream’ transaction. This is because unrealised gains
and losses are attributable to the NCI only in upstream transactions.

• Any changes to goodwill (e.g. impairment) are captured as part of the consolidation process.

• When determining the consolidated cash flows, care should be taken to acknowledge that
some assets and liabilities were acquired during the period as part of the acquisition of a
subsidiary.

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 FINANCIAL REPORTING

MIND MAP

WHO & WHEN WHAT’S INCLUDED IN CONSOLIDATED

FINANCIAL STATEMENTS
Who prepares–parent
When prepared–when the parent controls 100% of the financial results and financial
subsidiaries position of all entities in the group (parent and
subsidiaries) by adding together 100% of the
What entities are included–parent and
financial statements of the entities
subsidiaries
• Mid-year acquisitions → Chapter 34 Comparing apples with apples
• Same reporting period
Consolidation stops only when parent loses
• Same accounting policies
control of the subsidiary
• Adjustments required if different; Limitations
• Disposals → Chapter 34
CONSOLIDATED on how different they can be
PRESENTATION & DISCLOSURE FINANCIAL
Complete set of financial statements: looks STATEMENTS
like ‘company’ set of financial statements. (HKFRS 10) Consolidation adjustments required to
treat the combination of the separate
NCI share of results (profit, comprehensive entities as a single economic entity.
income) and consolidated equity separately Prepared via the ‘consolidation process’
identified on face

CONSOLIDATION PROCESS
Use a consolidation worksheet to prepare the consolidated
statement of financial position, statement of comprehensive
income: Starts afresh each period
‘Reset’ the cost of subsidiary assets and liabilities to reflect Business combination
the group’s cost is the fair value (limited exceptions) of the
net assets at the time of acquisition: impact on depreciation accounting (Chapter 29)
expenses
• How to calculate goodwill/gain
Recognise goodwill/gain from bargain purchase from bargain purchase
Remove effect of transactions that are not consistent with • How to measure the cost of
notion of the consolidated entity as a single economic entity assets and liabilities acquired
Consolidation process–Adjust for: • How to measure NCI on
Enables identification of • Fair value of net assets on acquisition and related acquisition
specified NCI line items additional/reduction in depreciation expenses
on the face of the financial • Eliminate investment in subsidiary against subsidiary equity
statements • Effect of intragroup transactions: loans, services rendered,
inventory sales, non-current asset sales, dividends
• Allocate to the NCI its share of the group's results and net assets
Consolidated cash flows (HKAS 7):
• Use consolidated amounts from the other statements to
calculate consolidated cash flows
• Payments for subsidiary, net of cash acquired, are classified
as an investing cash flow
• Acquisition of subsidiary–for calculating cash flows, treat assets
and liabilities acquired as though part of the ‘opening’ balance

Answers to Knowledge Check Questions

Question 1
Answer A is correct. Skippy does not meet any of the exemptions from consolidation; it is
not an investment entity (its business activities provide evidence that its business purpose
is not to invest funds solely for returns from capital appreciation and/or investment
income) and as it is a listed entity (its equity instruments are traded on a public market).
Answer B is incorrect. HKFRS 10 does not allow entities a choice in the accounting basis
that applies to subsidiaries.
Answer C is incorrect. As Skippy is not itself an investment entity, it must consolidate its
investments in all its subsidiaries.
Answer D is incorrect. As Skippy is not itself an investment entity, it must consolidate its
investments in all its subsidiaries.

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Question 2
Answer A is incorrect. Contingent consideration form part of Bonus’ investment in Gift,
and hence must be considered in the determination of goodwill or gain on bargain
purchase. Review Chapter 29 to refresh your understanding of the treatment of contingent
consideration.
Answer B is incorrect. The settlement of the contingent consideration is accounted for
separately from the business combination and, hence, does not affect the pre-acquisition
equity elimination entry (or goodwill) when settled. Review Chapter 29 to refresh your
understanding of the treatment of contingent consideration.
Answer C is correct. This journal entry correctly recognises that the settlement of the
contingent consideration is accounted for separately from the business combination,
and hence does not affect the pre-acquisition equity elimination entry (or goodwill)
when settled.
Answer D is incorrect. The settlement of the contingent consideration is not a consolidation
adjustment as it should have been recognised by Bonus in its own financial statements.

Question 3
Answer A is incorrect. Ying must consolidate Yang during the entire period the subsidiary
is controlled. Unlike equity accounting or accounting for an asset, when consolidating the
investor’s share of losses is not limited.
Answer B is incorrect. A share of the net deficit must be attributed to NCI, recognising that
not all of the loss position is suffered by owners of the parent.
Answer C is incorrect. The NCI share of equity is determined based on its proportionate
interest in the subsidiary, and there is no cap or floor on this amount. Also, the subsidiary’s
equity position on acquisition and the distinction between share capital and retained
earnings must be examined. The NCI share of the subsidiary is calculated as NCI at
acquisition (20% 100,000 + 20% 175,000) + NCI share of losses of the period (20%
535,000 [175,000 + 360,000]) 55,000 − 107,000 (52,000).
Answer D is correct. As Ying must continue to consolidate Yang, the investment in Yang
must be eliminated in the consolidated financial statements. In addition, Ying should
consider whether its investment in Yang is impaired and should have been written down in
its separate financial statements.

Question 4
The following consolidation adjustment journal entries must be recorded:

Debit Credit
HK$ HK$
Sales revenue (120% HK$60,000 HK$72,000) 72,000
Cost of Goods Sold 72,000
(Eliminate intragroup sale)

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 FINANCIAL REPORTING

Debit Credit
HK$ HK$
Cost of Goods Sold 12,000
Inventory 12,000
(Reduce inventory by the amount of the markup – 20% HK$60,000 HK$12,000)

Debit Credit
HK$ HK$
Inventory (HK$12,000 0.75) 9,000
Cost of Goods Sold 9,000
(Recognises that 75% of the inventory has been on-sold to parties external to the
group, and accordingly, that 75% of the markup is now earned by the group)

or, as a combined journal entry:

Debit Credit
HK$ HK$
Sales revenue (120% 60,000) 72,000
Cost of Goods Sold (72,000 − 12,000 + 9,000) 69,000
Inventory (25% (20% 60,000)) 3,000

The tax effect must also be recorded:

Debit Credit
HK$ HK$
Deferred tax asset (16.5% (HK$18,000 − HK$15,000)) 495
Income tax expense (p/l) 495
(Recognise the tax effect of the outstanding intragroup sale)

The net result of these adjustments to the consolidation worksheet when ‘adding
across’ is that:
• Cost of goods sold relating to this inventory becomes HK$45,000 (Parent P’s COGS
HK$60,000 + S1’s COGS HK$54,000 − HK$72,000 + HK$12,000 + HK$9,000; or 75%
HK$60,000);
• Inventory becomes HK$15,000 (Parent P’s inventory HK$nil + S1’s inventory
HK$18,000 − HK$12,000 + HK$9,000; or 25% HK$60,000); and
• Income tax expense becomes HK$5,049 (Parent P tax expense 16.5% gain
HK$12,000 + S1 tax expense 16.5% gain HK$21,600 − HK$540; or 16.5% tax on total
external sales HK$75,600 - COGS HK$45,000).

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These balances appropriately reflect the circumstances of the group as if the

intragroup sale had never occurred. However, because the intragroup sale resets the tax
base of the inventory, the inventory on hand at reporting date has a tax base of HK$18,000
compared to its consolidated carrying amount of HK$15,000. Therefore, a deferred tax
asset of HK$495 must also be reflected in the consolidated financial statements.

Question 5
Because the transaction is a ‘downstream’ transaction, the same journal entries apply as
prepared for Question 5. See the answer to Question 4.
Because the transaction is a downstream transaction, there is no adjustment to
attribute to the subsidiary. Consequently, the NCI share of S2’s profit for the year is
calculated as HK$40,000 (20% HK$200,000).
The following pro-forma journal entry could be processed in the consolidation
worksheet to depict the allocation of group profit to NCI:

Debit Credit
HK$ HK$
Profit attributable to NCI 40,000
Non-controlling interests – equity 40,000

Question 6

Debit Credit
HK$ HK$
Retained earnings 2,505
Income tax expense 495
Cost of goods sold 3,000

Parent P’s consolidation worksheet for the next reporting period must adjust for the
outstanding unrealised gain in opening inventory. The journal entry effectively eliminates
the unrealised gain from the prior reporting period (HK$3,000 less tax HK$495) and ‘puts it
into’ the current reporting period by crediting cost of goods sold and income tax expense.

Question 7
Income tax expense was reduced as part of eliminating the intragroup sale of inventory.
However, this does not change the group’s income taxes cash flows because, from the
group’s perspective, each entity is still liable for the amount of taxes payable to the tax
authority determined based on its own financial results and position. The group’s income
taxes cash flows should be equal to the sum of the income taxes cash flows reported in the
respective statements of cash flows.

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 FINANCIAL REPORTING

EXAM PRACTICE

QUESTION 1
Cardio Express Limited (CEL) is a company listed on the Main Board in Hong Kong and
is principally engaged in the production and distribution of heart monitors. CEL and its
subsidiaries (the ‘Group’) have a financial year end date at 31 March.

Rhythmic Sounds Limited

On 1 April 20X1, CEL acquires a 70% interest in Rhythmic Sounds Limited (RSL) for
HK$150 million when the equity of RSL is:

Equity HK$m
Share capital 100
Retained earnings 90
190

The carrying amounts of assets and liabilities of RSL are the same as their fair values.

Tachy Beats Limited

On 1 April 20X3, CEL acquires a 45% interest in Tachy Beats Limited (TBL) for cash
consideration of HK$45 million. The remaining shareholdings in TBL are widely held, with
no other shareholder holding more than a 0.5% interest in the company. In addition, CEL
holds share options to purchase another 6% of TBL from identified existing shareholders
for HK$10 per share. The share options are in-the-money at 31 March 20X4 but are not
exercisable before 1 May 20X4. CEL intends to exercise these share options once they
become exercisable.

At the time of acquisition, the equity of TBL is:

Equity HK$m
Share capital 20
Retained earnings 80
100

The carrying amounts of assets and liabilities of RSL are the same as their fair values.

Additional information

• The Group’s policy is to measure the non-controlling interests (NCIs) as the

proportionate share of the fair value of the identifiable net assets of the subsidiary
at the acquisition date.

• Included in the plant and machinery of CEL is a machine bought from RSL on 1 April
20X2 for HK$50 million. The machine had an original cost of HK$60 million and its
carrying amount was HK$40 million on 1 April 20X2. CEL depreciates the machine
on a straight-line basis over 10 years, with no residual value.

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• During the year ended 31 March 20X4, CEL sold to TBL some inventory, which cost
CEL HK$50 million, for HK$65 million. TBL sold 20% of the inventory to third parties
outside the group and still had 80% of the inventory on hand at 31 March 20X4.

• CEL and RSL’s retained earnings at 1 April 20X3 was HK$450 million and
HK$151 million, respectively.

• CEL is entitled to and has appointed four of the seven directors on the board of
directors of TBL, and its Chief Executive Officer (CEO) and Chief Financial Officer.

• There are no outstanding intragroup receivables or payables.

• The tax rate is 16.5%. Property, plant and equipment (PPE) is depreciated for both
tax and accounting over the same useful lives.

The following is the financial information in relation to CEL, RSL and TBL as at 31 March
20X4:

CEL RSL TBL

HK$m HK$m HK$m
Property, plant and equipment 560 150 50
Investment in RSL 150 – –
Investment in TBL 45 – –
Deferred tax assets – – –
Inventory 25 80 20
Current assets 195 120 55
Total assets 975 350 125
Share capital 250 100 20
Retained earnings 550 200 95
800 300 115
Non-current liabilities 100 26 –
Current liabilities 75 24 10
Total equity and liabilities 975 350 125
Total profit for the year 100 49 15

A. Assume that you are J. Chaw, the accounting manager. A. Moy, the CEO of CEL, raised the
following question:

‘At my last job, the head company also held a 45% interest in another company. It didn’t
consolidate this investment because its voting power was less than 50%. Am I right in
assuming that until CEL exercises its share option, it should not treat TBL as a subsidiary
and consolidate it?’

 raft a memorandum in response to the question raised by A. Moy. Justify your

D
response to the query.

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B. After considering the other information as set out in Question 1, prepare the
consolidated statement of financial position of CEL as at 31 March 20X4. Use a
consolidation worksheet to present your response. (Round the consolidated figures to
two decimal places.)

QUESTION 2
Eye Scam Limited (ESL) is a company listed on the Main Board in Hong Kong and is
principally engaged in the production and distribution of fake eyes. ESL and its 90% owned
subsidiary, Black Floater Limited (BFL) (the ‘Group’), have a financial year end date at 30 June.

Black Floater Limited (BFL)

BFL is acquired on 1 July 20X1 for cash consideration of HK$580 million plus a
HK$100 million bonus payable if BFL achieves a specified earnings target by March 20X2.
In March 20X2, the earnings target is met and the bonus is paid.

The equity of BFL on 1 July 20X1 is:

Equity HK$m
Share capital 100
Retained earnings 600
700

The following is financial information in relation to ESL and BFL as at 30 June 20X2 and
30 June 20X1:

ESL BFL
20X2 20X1 20X2 20X1
HK$m HK$m HK$m HK$m
Property, plant and equipment 237.00 200.00 450.00 519.50
Deferred tax asset 4.95 4.50 1.65 2.70
Inventory 198.05 170.50 133.35 117.30
Investments and other 700.00 30.00 – –
financial assets
Trade receivables 166.40 125.00 79.00 89.50
Dividend receivable 3.60 – – –
Cash and cash equivalents 220.00 742.00 258.00 151.00
Total assets 1,530.00 1,272.00 922.00 880.00
Share capital 100.00 100.00 100.00 100.00
Retained earnings – – – –
opening retained earnings 512.00 392.00 600.00 500.00
profit for the year 141.65 120.00 50.00 100.00
dividends – – (8.00) –
ending retained earnings 653.65 512.00 642.00 600.00

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ESL BFL
20X2 20X1 20X2 20X1
HK$m HK$m HK$m HK$m
Fair value reserve 8.35 – – –
Loan 464.00 361.20 100.00 95.00
Lease liability 26.00 48.80 – –
Trade and other payables 278.00 250.00 76.00 85.00
Dividend payable – – 4.00 –
Total equity and liabilities 1,530.00 1,272.00 922.00 880.00

Statement of profit or loss and other comprehensive income for the year ended
30 June 20X2
ESL BFL
HK$m HK$m
Sales revenue 691.00 475.00
Raw materials consumed and changes in inventories (255.00) (365.00)
Dividend income 9.00 –
Depreciation expense (43.00) (5.00)
Finance costs (80.00) (10.00)
Administration expenses (153.14) (36.10)
Profit before tax 168.86 58.90
Income taxes expense (27.21) (8.90)
Profit for the year 141.65 50.00
Other comprehensive income
Items that will not be subsequently reclassified to profit or loss
Fair value gain on financial assets 10.00 –
Tax on fair value gain on financial assets (1.65) –
Other comprehensive income 8.35 –
Total comprehensive income 150.00 50.00

Additional information

• The Group’s policy is to measure the NCIs as the proportionate share of the fair
value of the identifiable net assets of the subsidiary at the acquisition date.

• The fair value of the bonus payment on 1 July 20X1 is HK$80 million.

• In July 20X1, ESL determines the acquisition date fair value of machine held by BFL
is HK$20 million higher than its carrying amount at the date of acquisition. The
machine has a remaining useful life of five years and a residual value of nil.

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 FINANCIAL REPORTING

• During the year ended 30 June 20X2, BFL declares a dividend out of post-acquisition
profits of HK$8 million. The dividend is paid in two equal tranches on 31 March
20X1 and 15 July 20X2. ESL is not liable for income taxes on the dividend.

• During the year ended 30 June 20X2, BFL sells to ESL some inventory, which cost
BFL HK$60 million, for HK$90 million. ESL sells 60% of the inventory to third parties
outside the group and still has 40% of the inventory on hand at 30 June 20X2. BFL
has not yet been paid for the inventory.

• During the year ended 30 June 20X2, ESL makes lease payments of HK$25 million.
No existing leases ended and no new leases are entered into during the year.

• During the year ended 30 June 20X2, the Group disposes of property, plant and
equipment for HK$270.13 million. The gain on sale is HK$54.17 million.

• Included in the line item ‘Investments and other financial assets’ is a financial asset
measured at fair value through other comprehensive income (OCI) of HK$40 million
(20X1: HK$30 million). There are no acquisitions or disposals of investments and
other financial assets during the year. Gains on the financial asset are subject to tax
on disposal of the asset.

• No interest or income tax remains payable at year end 30 June 20X2 (20X1: nil)

• The Group does not repay any bank loans during the period.
• Dividends paid are classified as a financing cash flow.

• The tax rate is 16.5%. Deferred tax assets and deferred tax liabilities do not qualify
for offset.
A. Prepare the pre-acquisition equity elimination journal entry that ESL records as part of
its consolidation worksheet to prepare its consolidated financial statements for the year
ended 30 June 20X2.
B. Prepare the Group’s consolidated statement of changes in equity for the year ended
30 June 20X2 presented in accordance with HKAS 1 Presentation of Financial Statements.
(Round the consolidated figures to two decimal places.)
C. Prepare a consolidated statement of cash flows for the Group for the year ended 30 June
20X2, presented in compliance with HKAS 7 Statement of Cash Flows, using the indirect
method starting with profit before tax. (The comparative year is not required.)

ANSWERS TO EXAM PRACTICE

QUESTION 1
(a) Memo

To: A. Moy, Chief Operating Officer

From: J. Chaw

Date: X Month 20X4

RE: Subject: Accounting for Tachy Beats Limited (TBL)

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Dear A. Moy,

This is not quite correct. Though the percentage ownership interest in another company
is a useful indicator of whether the company should be consolidated, the criterion for
consolidation under HKFRS is ‘control’. Usually, control can be demonstrated by having
more than a 50% ownership interest (and hence, voting power) in the company as will
explicitly be the case with TBL when the share options are exercised.

With TBL, even though CEL currently holds only a 45% interest in the company, the
accounting team has concluded that CEL has de facto control of the company from the
acquisition date as it can demonstrate the three criteria evidencing control:

1. Power over TBL – even in the absence of a majority ownership stake, CEL has
the current ability to direct the relevant activities of TBL because it has the right
to appoint the majority of its Board of Directors and the two key management
positions. That is, through these avenues, CEL can direct how TBL should operate,
including making decisions about its revenue-generating operations, funding
and dividend policies. Adding weight to the conclusion that CEL can dominate
the decision making of TBL is the absolute size of its shareholding compared to
the relative size and dispersion of the remaining 55% shareholding such that no
other party is likely to be have control over the financial and operating activities of
TBL. The share options held, although in-the-money, are not substantive potential
voting rights and, accordingly, are not considered in the evaluation of whether
CEL currently has power over TBL. The share options are not substantive potential
voting rights as they are not currently exercisable.

2. Exposure to variable returns – CEL’s shareholding exposes it to variable returns

on its investment because CEL’s return through dividends (or sale of TBL) will be
subject to TBL’s ability to generate current and future profits.

3. Ability to exercise its power to affect the amount of returns – there is no evidence to
suggest that CEL is limited in its ability to exercise its power to affect the amount of
returns it is able to receive.

Accordingly, CEL should treat TBL as a subsidiary from the date of acquisition, and
consolidate it from that point. It would not be appropriate to delay consolidation until
such time as the share options are exercised.

Kind regards

J. Chaw.

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 FINANCIAL REPORTING

(b) The solution illustrates a different manner of preparing the consolidation worksheet
from the ‘spreadsheet approach’ shown in Section 30.3.

Consolidation adjustments
CEL RSL TBL DR CR Consolidated
HK$m HK$m HK$m HK$m Ref HK$m HK$m
Property, plant 560 150 50 2.00 4,3 10.00 752.00
and equipment
Goodwill – – – 17.00 1 17.00
Deferred tax asset – – – 1.65 3,4 0.32 3.31
1.98 6
Investment in RSL 150 – – 1 150.00 –
Investment in TBL 45 – – 2 45.00 –
Inventory 25 80 20 6 12.00 113.00
Other 195 120 55 370.00
current assets
Total assets 975 350 125 1,255.31
Share capital 250 100 20 100.00 1 250.00
20.00 2 –
Retained earnings
opening retained 450 151 80 90.00 1 487.44
earnings
80.00 2
8.35 3,4 0.84
0.25 5 2.50
18.30 7
profit for the year 100 49 15 0.16 4 1.00 131.62
0.25 5
65.00 6 54.98
22.95 8
550 200 95 – – – 619.06
Non-controlling – – – – 1 57.00 151.25
interests
2 55.00
2.50 5 0.50
7 18.30
8 22.95
Non-current 100 26 – 126.00
liabilities
Current liabilities 75 24 10 109.00
Total equity and 975 350 125 1,255.31
liabilities

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Workings (for reference only) (all amounts in HK$m)

Ref 1 – elimination of investment in RSL:

Debit Credit
HK$m HK$m
Share capital 100
Retained earnings 90
Goodwilla 17
Non-controlling interest 57
Investment in RSL 150
a
Goodwill consideration 150 + NCI 57 – fair value net assets 190 17.
NCI 30% fair value net assets 190 57.

Ref 2 – elimination of investment in TBL:

Debit Credit
HK$m HK$m
Share capital 20
Retained earnings 80
Goodwilla –
Non-controlling interest 55
Investment in RSL 45
a
Goodwill Consideration 45 + NCI 55 – Fair value net assets 100 nil.
NCI 55% Fair value net assets 100 55.

Refs 3 and 4 – intragroup sale of machine from RSL to CEL:

Debit Credit
HK$m HK$m
Deferred tax asset 1.65
Retained earnings – opening (10 − 1.65) 8.35
Property, plant and equipment (unrealised gain) 10

Gain on sale sale price 50 − carrying amount 40 10.

Deferred tax asset arising on consolidation 16.5% (carrying amount 40 − tax base
50) 1.65.

and:

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 FINANCIAL REPORTING

Debit Credit
HK$m HK$m
PPE – Accumulated depreciation (2 years 1) 2
Income tax expense (16.5% 1) 0.16
Deferred tax asset (2 0.165) 0.32
Depreciation expense 1
Retained earnings – opening (1 − (16.5% 1)) 0.84

Annual ‘excess’ depreciation to be eliminated as a result of the sale 10/10years 1.

Ref 5 – attribute to NCI its share of the consolidation adjustment for the intragroup sale of
machine and to eliminate excess depreciation:

Debit Credit
HK$m HK$m
Non-controlling interests – equity 2.5
Retained earnings – opening 2.5

Share of gain on sale 30% (10 − 16.5% 10) 2.5;

and:

Debit Credit
HK$m HK$m
Profit attributable to NCI 0.25
Retained earnings – opening 0.25
Non-controlling interests – equity 0.5

Share of elimination of the excess depreciation 30% (1 – 16.5% 1) 0.25 per annum.

Ref 6 – intragroup sale of inventory from CEL to TBL:

Debit Credit
HK$m HK$m
Sales revenue 65
Deferred tax asset (16.5% (80% 15)) 1.98
COGS (50 + (20% 15)) 53
Inventory (80% 15) 12
Income tax expense 1.98

Profit on sale sale price 65 – inventory 50 15.

Unrealised profit at reporting date 80% 15 12.

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Ref 7 – attribution to NCI its share of opening post-acquisition profits:

Debit Credit
HK$m HK$m
Retained earnings – opening 18.3
Non-controlling interests – equity 18.3

Change in RSL retained earnings 30% (151 − 90) 18.3.

Ref 8 – attribution to NCI its share of current year profits:

Debit Credit
HK$m HK$m
Profit attributable to NCI 22.95
Non-controlling interests 22.95

Share of RSL profit 30% 49 14.7.

Share of TBL profit 55% 15 8.25.

QUESTION 2

(a) Debit Credit

HK$m HK$m
Share capital 100
Retained earnings 600
Goodwill 14.97
Business combinations reserve 16.7
Non-controlling interests 71.67
Investment in BFL 660

Consideration for BFL cash 580 + fair value of bonus 80 660.

Goodwill consideration 660 + NCI 71.67 − fair value net assets (700 + 20 −
(16.5% 20)) 14.97.

(b) To prepare the consolidated statement of changes in equity, the consolidated profit and
total comprehensive income and NCI share of equity need to be identified. This is done
by first preparing the consolidation worksheets to identify the consolidated financial
position and financial performance.

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M11_c30.indd 1632
ESL BFL Fair Pre- Depreciation Dividend Upstream Intra- Share
value acquisition on fair value sale of group to NCI
uplift equity uplift inventory trade
balance
(all amounts in HK$m) 20X2 20X2 (J1) (J2) (J3) (J4) (J5) (J6) (J7) Consolidated
Statement of financial position
Assets
Property, plant and 237.00 450.00 20.00 (4.00) 703.00
equipment
FINANCIAL REPORTING

Deferred tax asset 4.95 1.65 1.98 8.58

Goodwill 14.97 14.97
Inventories 198.05 133.35 (12.00) 319.40
Investments and other 700.00 – (660.00) 40.00
financial assets
Trade receivables 166.40 79.00 (90.00) 155.40

1632
Dividend receivable 3.60 – (3.60) –
Cash and cash equivalents 220.00 258.00 478.00
Total assets 1,530.00 922.00 1,719.35
Equity
Share capital 100.00 100.00 (100.00) 100.00
Retained earnings
opening retained earnings 512.00 600.00 (600.00) 512.00
profit for the year 141.65 50.00 (3.01) (7.20) (9.02) (5.00) 167.42
dividends – (8.00) 8.00 –
653.65 642.00 679.42

10/26/2022 3:23:08 PM
M11_c30.indd 1633
ESL BFL Fair Pre- Depreciation Dividend Upstream Intra- Share
value acquisition on fair value sale of group to NCI
uplift equity uplift inventory trade
balance
(all amounts in HK$m) 20X2 20X2 (J1) (J2) (J3) (J4) (J5) (J6) (J7) Consolidated
Business combinations 16.70 (16.70) –
reserve
Fair value reserve 8.35 – 8.35
762.00 742.00 787.77
Non-controlling interests 71.67 (0.33) (0.80) (1.00) 5.00 74.54
Total equity 762.00 742.00 862.31
Liabilities
Loan 464.00 100.00 564.00
Deferred tax liability – – 3.30 (0.66) 2.64
Lease liability 26.00 – 26.00

1633
Trade payables 278.00 76.00 (90.00) 264.00
Dividend payable – 4.00 (3.60) 0.40
Total liabilities 768.00 180.00 857.04
Total equity and liabilities 1,530.00 922.00 1,719.35
Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

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M11_c30.indd 1634
ESL BFL Fair Pre- Depreciation Dividend Upstream Intra- Share
value acquisition on fair value sale of group to NCI
uplift equity uplift inventory trade
balance
(all amounts in HK$m) 20X2 20X2 (J1) (J2) (J3) (J4) (J5) (J6) (J7) Consolidated
Statement of profit or loss and other
comprehensive income
Sales revenue 691.00 475.00 (90.00) 1,076.00
Raw materials consumed and (255.00) (365.00) 78.00 (542.00)
changes in inventories
FINANCIAL REPORTING

Dividend income 9.00 – (7.20) 1.80

Depreciation expense (43.00) (5.00) (4.00) (52.00)
Finance costs (80.00) (10.00) (90.00)
Administration expenses (153.14) (36.10) (189.24)
Profit before tax 168.86 58.90 204.56

1634
Income taxes expense (27.21) (8.90) 0.66 1.98 (33.47)
Profit for the year 141.65 50.00 171.09

Other comprehensive income

Items that will not be
subsequently reclassified to
profit or loss
Fair value gain on financial 10.00 – 10.00
assets
Tax on fair value gain on (1.65) – (1.65)
financial assets
Other comprehensive 8.35 – 8.35
income

Total comprehensive 150.00 50.00 179.44

income

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M11_c30.indd 1635
ESL BFL Fair Pre- Depreciation Dividend Upstream Intra- Share
value acquisition on fair value sale of group to NCI
uplift equity uplift inventory trade
balance
(all amounts in HK$m) 20X2 20X2 (J1) (J2) (J3) (J4) (J5) (J6) (J7) Consolidated

Profit for the year

attributable to:
Owners of the parent 141.65 50.00 (3.01) (7.20) (9.02) (5.00) 167.42
Non-controlling interests (0.33) (1.00) 5.00 3.67
Profit for the year 171.09

Total comprehensive
income attributable to:
Owners of the parent 150.00 50.00 (3.01) (7.20) (9.02) (5.00) 175.77

1635
Non-controlling interests (0.33) (1.00) 5.00 3.67
Total comprehensive 179.44
income for the year
Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

10/26/2022 3:23:10 PM
 FINANCIAL REPORTING

Workings (for reference only) (all amounts in HK$m):

J1 – increase machine to fair value on acquisition:

Debit Credit
HK$m HK$m
Property, plant and equipment 20
Deferred tax liability (16.5% 20) 3.3
Business combinations reserve 16.7

J2 – elimination of investment in BFL (see solution to Question 1); and

J3 – record additional depreciation on machine remeasured to fair value on acquisition and

attribute to NCI its share of the consolidation adjustment:

Debit Credit
HK$m HK$m
Depreciation expense (20/5 years 1) 4
Deferred tax liability (16.5% 4) 0.66
Property, plant and equipment 4
Income tax expense 0.66

and:

Debit Credit
HK$m HK$m
Non-controlling interests – equity 0.33
Profit attributable to NCI (10% (4 − 0.66)) 0.33

J4 – eliminate intragroup dividend and attribute dividend to NCI:

Debit Credit
HK$m HK$m
Dividend payable (90% 4) 3.6
Dividend receivable 3.6

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 Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

Dividend was paid after year end, on 15 July 20X2:

Debit Credit
HK$m HK$m
Dividend income (90% 8) 7.2
Non-controlling interest – equity (10% 8) 0.8
Retained earnings (dividends) 8

J5 – eliminate intragroup sale of inventory from BFL to ESL and attribute to NCI its share of
the consolidation adjustment:

Debit Credit
HK$m HK$m
Sales revenue 90
Deferred tax asset (16.5% (40% 30)) 1.98
COGS (60 + (60% 30)) 78
Inventory (40% 30) 12
Income tax expense 1.98

Gain on sale sale price 90 − inventory 60 30Remaining gain at reporting date

40% 30 12:

Debit Credit
HK$m HK$m
Non-controlling interests – equity 1
Profit attributable to NCI (10% (90 − 78 − 1.98) 1

J6 – eliminate outstanding intragroup trade receivable and trade payable:

Debit Credit
HK$m HK$m
Trade payable 90
Trade receivable 90

J7 – attribute to NCI its share of profit for the year:

Debit Credit
HK$m HK$m
Profit attributable to NCI (10% 50) 5
Non-controlling interests – equity 5

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 FINANCIAL REPORTING

Using the information in the consolidated statement of financial position and

consolidated statement of profit or loss and other comprehensive income, the following
consolidated statement of changes in equity is prepared:

Consolidated statement of changes in equity

Share Retained Fair Total Non- Total
capital earnings value controlling equity
reserve interests
HK$m HK$m HK$m HK$m HK$m HK$m
Balance at 1 July 100.00 512.00 – 612.00 – 612.00
20X1
Profit for the – 167.42 – 167.42 3.67 171.09
year
Other – – 8.35 8.35 – 8.35
comprehensive
income for the
year
Total – 167.42 8.35 175.77 3.67 179.44
comprehensive
income for the
year
Acquisition of – – – – 71.67 71.67
subsidiary
Dividends – – – – (0.80) (0.80)
Balance at 100.00 679.42 8.35 787.77 74.54 862.31
30 June 20X2

(a) Consolidated statement of cash flows

20X1 20X1
HK$m HK$m
Cash flows from operating activities
Profit before tax 204.56
Adjustment for non-cash flows:
Loss on contingent consideration 20.00
Gain on sale of PPE (54.17)
Depreciation expense 52.00
Interest expense 90.00
Operating profit before working capital changes 312.39
add: Decrease in trade receivables (155.40 − 125 − 89.5) 59.10
less: Increase in inventories (319.4 − 170.5 − 117.3) (31.60)
less: Decrease in trade payables (264 − 250 − 85) (71.00)
Cash inflows from operations 268.89
Interest paid (90 − 2.2) (note 1) (87.8)

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 Consolid ate d F inancial S tate m ents w ith a S i m ple G roup S tructure

Consolidated statement of cash flows

20X1 20X1
HK$m HK$m
Income tax paid (note 2) (37.16)
Net cash inflow from operating activities 143.93
Cash flows from investing activities
Purchases of property, plant and equipment (note 3) (231.46)
Proceeds from disposal of property, plant 270.13
and equipment
Acquisition of subsidiary (680 − 151) (529.00)
Net cash outflow from investing activities (490.33)
Cash flows from financing activities
Proceeds from bank loans (564 − 361.20 − 95) 107.80
Lease payments (25.00)
Dividends paid to NCI (0 + 0.8 − 0.4) (0.40)
Net cash inflow from financing activities 82.40
Net decrease in cash and cash equivalents (264.00)
Cash and cash equivalents at 1 July 20X1 742.00
Cash and cash equivalents at 30 June 20X2 478.00

Note 1: Non-cash interest amortisation:

HK$’m
Lease liability at 1 July 20X1 48.80
− Lease payments (25.00)
+ Interest accretion 2.20
Lease liability at 30 June 20X2 26.00

Note 2: Income tax paid

The change in net deferred tax assets is:

HK$’m
Net deferred tax assets at 1 July 20X1 4.50
+ Deferred tax asset acquired 2.70
− Deferred tax liability recognised on acquisition of BFL (3.30)
− Net deferred tax assets at 30 June 20X2 (8.58 − 2.64) (5.94)
Deferred tax expense/(income) recognised in profit or (2.04)
loss and equity

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 FINANCIAL REPORTING

The deferred tax income of the period of 2.04 comprises:

• Deferred tax expense of 1.65 associated with the fair value gain on the financial
asset classified as fair value through other comprehensive income recognised
in equity;

• And consequently, deferred tax income of 3.69 recognised in profit or loss.

Current tax expense 33.47 (Income tax expense recognised in profit or loss) + 1.65
(Deferred tax expense recognised in equity) + 2.04 (Deferred tax income) 37.16.

As there is no current tax liability at the start or end of the year, the tax paid
during the period is 37.16.

Note 3: Cash acquisition of property, plant and equipment is determined from the following
reconciliation:

HK$’m
PPE at 1 July 20X1 200.00
+ Acquisition of subsidiary 519.50
+ Fair value uplift on acquisition 20.00
+ Acquisitions (cash) 231.46
− Disposals (270.13 − 54.17) (215.96)
− Depreciation (52.00)
PPE at 30 June 20X2 703.00

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 31
Foreign Exchange
and Consolidation
of Foreign Operations

CHAPTER TOPIC LIST

31.1 Foreign Exchange Overview 31.3.2 T ax Effects of Exchange

31.1.1 Scope and Terminology Differences
31.1.2 Determination of 31.3.3 Change in Presentation
Functional Currency Currency
31.2 Reporting Foreign Currency 31.4 Consolidation of Foreign
Transactions in the Subsidiaries
Functional Currency 31.4.1 G oodwill and Fair Value
31.2.1 Initial Recognition Adjustments
31.2.2 Subsequent Measurement 31.4.2 Intragroup Transactions
31.2.3 Change in Functional and Balances
Currency 31.4.3 Exchange Differences
31.3 Translation of Financial and Reserve
Statements into 31.4.4 Consolidated Cash Flows
Presentation Currency 31.4.5 Different Reporting Dates
31.3.1 T
 ranslation to the 31.5 Disclosure
Presentation Currency

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT

FOR BUSINESS TRANSACTIONS
LO2.08: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to: Effects of changes in foreign exchange rates
2.08.01 Determine the functional currency of an entity including foreign operation
2.08.02 Account for a change in presentation currency and functional currency
2.08.03 Account for foreign currency transactions and balances
2.08.04 Calculate and account for the exchange differences
2.08.05 Prepare the translation of foreign operation financial statements to the presentation currency
2.08.06 Prepare disclosure in respect of foreign exchange
LO4.04: C
 onstruct the financial statements for a group in accordance with Hong Kong Financial
Reporting Standards and statutory reporting requirements: Foreign subsidiary
4.04.01 Account for foreign currency transactions within an individual company and in the
consolidated financial statements
4.04.02 Account for disposal or partial disposal of a foreign operation

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 F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

OPENING CASE

THE SOLEIL GROUP

I ntroduced in earlier chapters, the Soleil Group operates an extensive global logistics network
across 600 locations in more than 50 countries. The group provides a diverse range of
transport and logistics solutions covering road, air, sea and rail to meet global supply chain
needs. The ultimate parent entity in the group is Soleil Limited (Soleil).

Soleil’s group structure in part looks as follows, with the indicated proportionate
shareholdings:

Soleil Limited

80% 100% 100% 80%

Astro Limited Mercury Limited Caelus Limited Polaris Limited

90%

Hercules Limited

Soleil, Mercury Limited (Mercury), Polaris Limited (Polaris) and Hercules Limited (Hercules)
are incorporated in Hong Kong, with their activities primarily based in Hong Kong. However,
from time to time, the entities undertake transactions that are denominated in a currency other
than Hong Kong Dollars (HK$).

In accordance with the Hong Kong Companies Ordinance (CO), Soleil prepares financial
statements in accordance with the HKFRSs. Caelus Limited (Caelus), which is incorporated
in China, prepares financial statements in accordance with International Financial Reporting
Standards (IFRSs). Caelus’ operations, which account for approximately 10% of the Soleil
group’s net profit, are primarily based in China and conducted in Renminbi.

Soleil routinely conducts transactions with its subsidiaries, including the sale and purchase
of inventory or services. The terms and conditions on which these transactions are undertaken
are superior to those that would apply if the entities were to transact directly with entities
external to the group. The terms and conditions allow the selling entity to make a small profit
margin on the transaction. In addition, occasionally, non-current assets are transferred (sold)
between the group entities.

The Hong Kong company tax rate is 16.5%. The company tax rate in Mainland China
is 25%.

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 FINANCIAL REPORTING

OVERVIEW

Understanding how to account for the impact of foreign exchange on an entity’s financial
statements has become more important as the rate of globalisation continues to increase.
More entities are conducting transactions with foreign entities and are establishing foreign
operations, whether through organic growth or by acquiring foreign entities. The existence of
these business activities means that entities are exposed to the economic impact of changes in
foreign exchange rates and must determine how the effect of these changes are appropriately
reflected in their general purpose financial statements.

This chapter discusses how to determine the functional currency of an entity (or
economic entity) and how to account for transactions that occur in a currency other than
the entity’s functional currency, for example, a Renminbi-priced sale by a retailer located
in Mainland China to a customer with primarily Hong Kong-based business operations.
Using the Soleil Group as an example, this chapter describes the process for translating
the financial statements prepared in an entity’s functional currency into the presentation
currency of the reporting entity.

In this chapter, you will be introduced to a common equity reserve account, the foreign
currency translation reserve, and among other accounting aspects, briefly learn what happens
to amounts accumulated in that reserve when a foreign operation is sold.

A foreign operation may be a subsidiary, associate, joint arrangement or branch of the

reporting entity. This chapter discusses only the accounting for foreign operations that are
subsidiaries.

Disclosures are also discussed in this chapter.

This module assumes the identified functional currency is not the currency of a
hyperinflationary economy. Specific requirements apply in these instances and are not
addressed in this module.

As a teaching aid, this chapter uses ‘LC’ to identify the functional currency of an entity and
‘PC’ to identify the presentation currency of an entity. This chapter also employs ‘FC’ to denote
an unspecified foreign currency.

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 F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

3 1 . 1 FOREIGN EXCHANGE OVERVIEW

Exposure to foreign exchange is not unique to any particular size or type of entity. For
example, Alibaba and small eBay online retailers are, prima facie, exposed to foreign exchange
because their online platforms allow them to sell to a global audience. Similarly, any entity
may purchase goods denominated in a different currency, maintain a local office, or have a
subsidiary incorporated in another jurisdiction. Other examples of an entity’s exposure to
foreign exchange (and the need to account for it) might be its foreign currency-denominated
bank account or payable or might be its interest in a subsidiary operating in a foreign
jurisdiction.

The accounting for foreign exchange is primarily specified by HKAS 21 The Effects of Changes
in Foreign Exchange Rates. In addition, HKAS 7 Statement of Cash Flows explains how foreign
exchange affects the preparation of the statement of cash flows.

For the purposes of preparing a set of general purpose financial statements, two key issues
deal with foreign exchange: identifying the applicable exchange rate and how to report the
effects of changes in exchange rates in the financial statements.

This section discusses the scope of HKAS 21 and terminology that features commonly in
the context of accounting for foreign exchange. In addition, this section discusses how an entity
determines its ‘functional currency’ (LC).

HKAS 31.1.1 Scope and Terminology

21.3–5,
8, 18 HKAS 21 and HKAS 7 set out how an entity:

• Accounts for transactions (e.g. sales and purchases) and balances (e.g.
foreign-denominated bank account or inventory) in foreign currencies, other than
derivative transactions and their associated balances within the scope of HKFRS 9
Financial Instruments. In addition, HKAS 21 does not apply to hedge accounting for
foreign currency items (see Chapter 12).

A foreign currency is a currency other than the functional currency of the entity. The
functional currency is the currency of the primary economic environment in which the
entity operates. An entity’s primary economic environment is normally the environment
or location in which the entity primarily generates and expends its cash. For example,
Soleil’s functional currency is Hong Kong Dollars (HK$) because Soleil conducts its
operations primarily in Hong Kong in HK$-denominated transactions. As such, any
transactions that Soleil undertakes (denominated or is settled) in a currency other than
HK$, for example, a USD-denominated purchase of equipment, is a foreign currency
transaction accounted for in accordance with HKAS 21; and

• Translates its functional currency-determined results and financial position and the
results and financial position of foreign operations that are included in the financial
statements of the entity by consolidation (see Chapter 31) or the equity method (see
Chapter 32 and Chapter 33) into a presentation currency.

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 FINANCIAL REPORTING

A foreign operation is an entity that is a subsidiary, associate, joint

arrangement, or branch of a reporting entity whose activities are based or
conducted in a country or currency other than those of the reporting entity.
For example, Caelus is a foreign operation of Soleil because its operations are
primarily conducted in Mainland China in Renminbi-denominated transactions;
Soleil’s activities are based in Hong Kong.

The presentation currency is the currency in which the financial statements

are presented. For example, HSBC Holdings Limited (HSBC Holdings), which is
incorporated in England and listed on the Hong Kong Stock Exchange (HKEx
stock code: 00005, HKEx stock name: HSBC Holdings) presents its IFRS-compliant
consolidated financial statements in USD. The presentation currency is an entity
election, and may differ from the entity’s functional currency. However, many
parent entities choose to present consolidated financial statements in the same
currency as the parent’s functional currency. For example, HSBC Holding’s functional
currency is also in USD. The financial statements may be presented in more than one
presentation currency.

This chapter does not explicitly discuss the translation of a foreign operation that is an
associate, joint arrangement, or a branch of the entity. However, the same principles as those
described in this chapter apply, amended as necessary to reflect the circumstance that the
foreign operation is not a subsidiary.
For teaching purposes, this module assumes that a group’s presentation currency is the
same as its parent’s functional currency, that is, there is no need for the parent to further
translate its functional currency ledger into the group presentation currency.

31.1.2 Determination of Functional Currency

The functional currency of an entity is the currency in which the entity measures items in
the financial statements. As can be seen in Exhibit 31.1, the determination of the functional
currency is key in establishing whether foreign currency transactions or balances are to be
recorded. Unlike the presentation currency, the determination of the functional currency is not
a choice but is an entity judgement based on available facts and circumstances.

Records foreign currency

Translates functional
Determines transactions in and Chooses group’s
currency ledger into
Parent A functional translates foreign presentation Parent A applies
the presentation
currency currency balances into currency consolidation
currency
the functional currency procedures to
prepare its
Records foreign currency consolidated
Translates functional
Determines transactions in and financial
currency ledger
Subsidiary B functional translates foreign statements
into the group’s
currency currency balances into
presentation currency
the functional currency

Adding like-with-like: The financial Adding like-with-like: The financial

records of an individual entity are statements to be consolidated are
maintained in a single currency presented in the same currency

EXHIBIT 31.1 How foreign exchange impacts the presentation of the consolidated financial
statements

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 F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

The functional currency of an entity is the currency of the primary economic environment in
which the entity operates. For some entities, determining the primary economic environment is
straightforward; for others, more extensive judgement is warranted. For example, it may be
difficult to determine the functional currency of a holding entity in a group comprising entities
operating in various countries or an investment holding entity with investments in entities
operating in different parts of the world or a global conglomerate undertaking activities in
various industries located around the world. By comparison, it would normally be
straightforward determining the functional currency of a business operating solely in its local
HKAS jurisdiction. The identified functional currency should be the one that most faithfully represents
21.9, 12 the economic effects of the underlying transactions, events and conditions.

In determining its functional currency, an entity considers various factors, as shown in

IAS Exhibit 31.2. Greater weight is given to the primary factors because these factors are linked to
21.BC9 the primary economic environment in which the entity operates.

Primary factors (given more weight) Additional factors (given less weight)
Currency of the country whose Currency in which funds from financing activities are
competitive forces and regulations generated
mainly determine the sales prices of the
entity’s goods and services
Currency that mainly influences the sales Currency in which receipts from operating activities are
prices for its goods and services (e.g. usually retained
the currency in which sales prices are
denominated and settled)
Currency that mainly influences labour, Closeness of its relationship with its investor, for example,
material and other costs of providing whether:
goods or services • Its activities are carried out as an extension of the
parent (e.g. the foreign operation only sells goods
obtained from the parent and remits the proceeds
to it) rather than being carried out with a significant
degree of autonomy;
• Transactions with the parent are a high or a low
proportion of the foreign operation’s activities;
• Cash flows from the activities of the foreign operation
directly affecting the cash flows of the parent and are
readily available for remittance to it; or
• Cash flows from the activities of the foreign operation
that are sufficient to service existing and normally
expected debt obligations without funds being made
available by the parent.
HKAS
21.9–12 EXHIBIT 31.2 Factors considered in identifying an appropriate functional currency

Judgement applies in weighting factors. Entities in some industries, for example, oil and gas
or aviation, are more likely than others to determine that their functional currency is not the
currency in which employees are paid or sales occur because more weight is placed on the
importance of the currency that predominantly dictates their performance. For example, in the
HKAS
21.9–10, 12, mining industry, sales prices for minerals are often denominated and settled in USD, and this
IAS 21.BC9 factor may be the primary factor dictating an entity’s performance.

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 FINANCIAL REPORTING

Illustrative Example 1
Soleil Limited (Soleil) is a Hong Kong-based company. Its operations are run out of a head
office located in Hong Kong and its operating costs (such as employee salaries, inventory
purchases, service fees) are primarily denominated in Hong Kong Dollars (HK$). Sales of
logistic solutions instigated from a Hong Kong location or Internet Protocol (IP) address
(e.g. courier of an item from Hong Kong to an overseas destination) are priced in HK$
and account for 90% of Soleil’s revenues. Other logistic solution sales are denominated in
the currency of the country in which the order was placed.

Soleil funds its operations through a combination of debt and equity funding. New share
issues are denominated in HK$. Loans are obtained from various Hong Kong-based financial
institutions. At the reporting date, Soleil has an outstanding HK$3 million loan balance.

Soleil determines its functional currency to be HK$. This is because its sales and
costs are primarily denominated and settled in HK$, the currency of the country whose
competitive forces and regulations mainly determine the sales prices of its goods
and services. The fact that Soleil finances its operations through HK$-denominated
debt and equity funding contributes to drawing the conclusion that Soleil’s functional
currency is HK$ but is of less weight. That is, Soleil is unlikely to change its conclusion as
to its functional currency if it were to obtain its financing instead from USD loans or a
USD-denominated equity raising.

Apply and Analyse 1

Caelus Limited (Caelus) is a foreign operation of Soleil supporting the group’s transport
and logistic operations in Asia. Its sales are primarily conducted with China-based
customers and are denominated in Renminbi. Its employees and inventory expenses are
settled in Renminbi, being the currency of the country in which the employees are based
and raw materials are purchased.

In addition, Caelus pays service fees to other entities in the Soleil Group as
compensation for outsourced delivery services executed by those entities. The service fees
are charged based on an internal pricing list and priced in Hong Kong Dollars (HK$), the
functional currency of the parent. The service fees are set at a level to ensure that both
the provider and the purchaser make a profit on the transaction. Caelus would use other
logistic companies to complete a customer order if Soleil Group entities were unable to
service it or if it made the order unprofitable. Any outstanding intragroup receivable or
payable is settled once a quarter.

Caelus operates a Renminbi-denominated bank account. To help finance its

operations, Caelus has a Renminbi denominated bank loan, for which Soleil provided a
financial guarantee. However, Caelus is not reliant on Soleil to service its liabilities. Caelus
historically declares a dividend of 30% of its annual profits.

Determine Caelus’ functional currency.

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 F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

Apply and Analyse 1 (continued)

Analysis

To determine Caelus’ functional currency, Caelus’ primary economic environment must be

identified from the fact that:

• The underlying economy that determines the pricing of Caelus’ sales and labour
and other operating costs is China, regarding where those transactions arise;

• Caelus operates a Renminbi bank account and has raised money in Renminbi; and

• Though Caelus trades with other members of the Soleil Group and declares
dividends, it:

°° Is not dependent on its parent to fund its liabilities or to generate

revenues; and

°° Does not only sell goods and services obtained from the parent and remit
substantially all of the proceeds to it. Caelus can employ other logistic
companies if necessary, and its intragroup transactions are priced so as not to
pass through all the profits from the sale to the parent.

Because Caelus’ operations are not integral with those of its parent, concluding that
Caelus’ functional currency must be the same as that of its parent would be inappropriate.
Also, though a portion of Caelus’ operating costs is settled in HK$ (intragroup service fees),
this is an internal pricing decision giving access to the competitive advantage offered by
being part of the group rather than being the currency that mainly influences its costs of
providing services. Consequently, overall, it can be concluded that the primary economic
environment in which Caelus’ operates is China, and its functional currency is the currency
of China, Renminbi. This is the currency:

• Of the country whose competitive forces and regulations mainly determine the
sales prices of its goods and services;

• That mainly influences its labour, material and other costs of providing goods or
services; and

• In which its financing is denominated.

Knowledge Check Question

Question 1
Identify which one of the following statements is true about functional currency.
A An entity is free to choose its functional currency.
B An entity can prepare its financial statements in more than one functional currency.
C The functional currency of a foreign operation might be the same as the functional
currency of the reporting entity.
D The functional currency of a foreign operation is that of the country in which the foreign
operations activities are based.

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3 1 . 2 REPORTING FOREIGN CURRENCY

TRANSACTIONS IN THE FUNCTIONAL
CURRENCY

Having determined its functional currency, an entity (e.g. a single company, the parent entity or
one of its subsidiary entities) can then identify its foreign currency transactions and balances;
that is, its transactions and balances denominated in a currency different from its functional
currency. These transactions and balances must be converted into the entity’s functional
currency to enable the general purpose financial statements to be prepared.

Key Learning Point

An entity does not need to have a foreign subsidiary to have foreign currency transactions
and balances.

Some entities may maintain a local currency ledger and a functional currency ledger (some
systems, for example, SAP, permit more than one ledger to be maintained). Other entities may
establish their functional currency results and position only at the time of preparing their
HKAS
financial statements. In either case, the relevant foreign currency exchange rates specified by
21.34 HKAS 21 must be used.

31.2.1 Initial Recognition

On initial recognition, a foreign currency transaction is recorded by converting the foreign
HKAS currency amount into the functional currency using the spot exchange rate at the date of the
21.21 transaction.

As a practical expedient, if the exchange rates do not fluctuate significantly, a rate that
HKAS appropriates the transaction date exchange rate may be used, for example, the average
21.22 exchange rate for the week or month for transactions undertaken during that period.

Apply and Analyse 2

On 1 December 20X2, Soleil (HK$ functional currency) makes a Foreign Currency FC10,000
purchase of inventory. At that time, the exchange rate was FC1 : HK$6.90.

Prepare the journal entry to record this transaction in Soleil’s functional currency.

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Apply and Analyse 2 (continued)

Analysis

The date of the transaction is 1 December 20X2. Soleil initially recognises the following
journal entry:

Debit Credit
HK$ HK$
Inventory (FC10,000 × 6.90) 69,000
Trade payables 69,000

More than one ‘date of the transaction’ can exist because transactions may be contracted
partly on advance terms. With limited exceptions, where consideration is paid or received in
advance of the transfer of goods and services (unless refundable, the prepayment will be a
HK(IFRIC)- non-monetary item (see Section 31.2.2)), the exchange rate used in respect to that portion of
22.8–9 consideration is the spot exchange rate at the date the consideration is transferred.

Illustrative Example 2
On 1 December 20X3, Soleil enters into an agreement to purchase FC10,000 of inventory.
On that date, it makes a non-refundable deposit on that inventory purchase of FC1,000;
the balance is due 120 days after the inventory is transferred.

The dates of the transaction are 1 December 20X3 and 31 December 20X3. On those
dates, the exchange rate is:

1 December 20X3 FC1 : HK$6.50

31 December 20X3 FC1 : HK$6.90

On 1 December 20X3, Soleil records the following journal entry:

Debit Credit
HK$ HK$
Prepayment (FC1,000 × 6.50) 6,500
Cash 6,500

On 31 December 20X3, the inventory is transferred to Soleil. Soleil records the

following journal entry to derecognise the prepayment and recognise the inventory:

Debit Credit
HK$ HK$
Inventory 68,600
Prepayment 6,500
Trade payable (FC9,000 × 6.90) 62,100

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31.2.2 Subsequent Measurement

At each subsequent reporting date, foreign currency items must be translated into the
functional currency. The applicable exchange rate depends whether the item is monetary or
non-monetary:

• A monetary item is a right to receive (or an obligation to deliver) a fixed or

determinable number of units of currency; and

• A non-monetary item is the absence of a right to receive (or an obligation to deliver)

a fixed or determinable number of units of currency.

HKAS In most circumstances, whether an item is monetary or non-monetary will be clear.

21.16 Exhibit 31.3 identifies common examples of monetary items and non-monetary items.

Monetary items Non-monetary items

Trade receivables and trade payables Inventories
Cash-settled pensions and wages Property, plant and equipment
Cash-settled provisions Right-of-use assets
Lease liabilities Goodwill and other intangible assets
Cash dividends Contract assets and contract liabilities
Contracts to deliver a variable number of the Prepaid goods and services
entity’s shares where the fair value to be delivered
equals a fixed or determinable number of units of
currency (e.g. a convertible bond)
Contract to receive a variable amount of assets Provisions settled by delivery of a non-monetary
where the fair value to be received equals a fixed asset (e.g. warranty provision to repair or
or determinable number of units of currency replace, rather than refund)

EXHIBIT 31.3 Examples of monetary items and non-monetary items

Non-monetary items

At each subsequent reporting date, non-monetary items measured at historical cost in a

foreign currency (e.g. property, plant and equipment measured on the cost basis) continue to
HKAS be translated at their transaction date exchange rate (i.e. the spot exchange rate at the
21.23 acquisition date).

Non-monetary items measured at fair value in a foreign currency are translated at the
HKAS exchange rate at the date of determining fair value, which may or may not coincide with the
21.23 reporting date.

Monetary items

HKAS At each subsequent reporting date, foreign currency monetary items are translated at the
21.23 reporting period’s closing rate.

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Foreign exchange gains and losses

The exchange rate movement from the last translation to the current translation will give rise to
a foreign exchange gain or loss. The foreign exchange gain or loss is recognised in the financial
statements as follows:

• Where a gain or loss on a non-monetary item is recognised in other comprehensive

income (e.g. fair value increase in property measured on a revaluation basis), the
exchange component of that gain or loss is also recognised in other comprehensive
income; and
HKAS
21.30 • In all other cases, the gain or loss is recognised in profit or loss.

Apply and Analyse 3

(This Apply and Analyse is a continuation of the previous Illustrative Example.)

Assume the outstanding FC9,000 trade payable relating to Soleil’s FC10,000 purchase of
inventory is still unpaid at its next interim reporting date, 31 March 20X4, and assume the
inventory is still on hand. The exchange rate on 31 March 20X4 is FC1 : HK$8.

Prepare the journal entries to reflect the foreign exchange effects of the transaction if
Soleil prepares financial statements for the interim period ended 31 March 20X4 financial
statements.

Analysis

Accounting for the foreign currency payable

The foreign currency trade payable is a monetary item. As such, it is translated into Soleil’s
functional currency at the closing rate on the reporting date (i.e. FC9,000 × 8 = HK$ 72,000).

Soleil records a journal entry to capture the foreign exchange movement in the
payable since last translated (from the transaction date):

Debit Credit
HK$ HK$
Foreign exchange loss (p/l) (HK$72,000 − HK$62,100) 9,900
Trade payables 9,900

Subsequent to processing this journal entry, the trade payable is measured at

HK$72,000 on 31 March 20X4 (62,100 + 9,900).

Accounting for the inventory

Inventory is a non-monetary item measured at historical cost in a foreign currency. It

continues to be measured at the exchange rate applicable at each transaction date. Hence,
no foreign exchange gains or losses arise, and to the extent the net realisable value of the
inventory remains higher than its cost, no journal entry is required because there is no
need to retranslate the item.

The carrying amount of the inventory at 31 March 20X4 is HK$69,000.

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Apply and Analyse 4

(This Apply and Analyse is a continuation of the previous exercise.)

On 30 April 20X4, Soleil settles its FC9,000 outstanding trade payable. The exchange rate
on that date is FC1: HK$6.70. Prepare the journal entries to reflect the settlement of
the payable.

Analysis

Debit Credit
HK$ HK$
Trade payables 72,000
Foreign exchange gain (p/l) (HK$ 72,000 − HK$ 60,300) 11,700
Cash (9000 × 6.70) 60,300

The overall movement in exchange rates was from 6.90 (transaction date) to 6.70
(settlement date), reflecting that, overall, Soleil has made an exchange rate gain of HK$
1,800 as a result of not settling the trade payable until 30 April 20X4. The net gain is
attributed across the reporting periods in which the payable is outstanding, as follows:

• Reporting period ended 31 December 20X3: no gain or loss;

• Interim reporting period ended 31 March 20X4: foreign exchange loss

HK$9,900; and

• Subsequent reporting period: foreign exchange gain HK$11,700.

Some non-monetary items measured at historical cost in a foreign currency may be

required to be measured at net realisable value or recoverable amount (e.g. inventory whose
cost is considered not recoverable, and impaired property, plant and equipment). If so, rather
than the historical transaction date exchange rate, the item is translated into the functional
HKAS currency using the exchange rate applying at the date the net realisable value or recoverable
21.25 amount (or other amount) was determined.

Illustrative Example 3
Soleil has a HK$ functional currency. It holds land in the United Kingdom that it
purchased for GBP100,000 on 1 January 20X1. Soleil carries the land at cost in its financial
statements. At year-end on 31 December 20X1, the land has a recoverable amount
(determined on 31 December 20X1) of GBP96,000. Soleil appears to have an impairment
loss of GBP4,000. However, Soleil must translate the respective carrying amounts at the
prevailing exchange rates to determine whether it has an impairment loss in HK$.

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Illustrative Example 3 (continued)

Assume

The exchange rate on 1 January 20X1 is GBP1 : HK$10.0

The exchange rate on 31 December 20X1 is GBP1 : HK$10.2

When Soleil prepares its functional currency financial statements, it recognises an

impairment loss of HK$20,800, calculated as follows:

HK$
Carrying amount before impairment (100,000 × 10.0) 1,000,000
Recoverable amount (96,000 × 10.2) (979,200)
Impairment loss 20,800

31.2.3 Change in Functional Currency

The functional currency of an entity should not change once it has been determined except
where there has been a change in the entity’s underlying transactions, events and conditions.
Any change is accounted for prospectively by translating all items into the new functional
HKAS 21.13, currency at the date of the change. For non-monetary items, the newly translated amount
35–37 becomes the item’s new historical cost.

Though not explicitly addressed in the standard, the resulting exchange differences should
be recognised in profit or loss except where the exchange difference relates to a gain or loss on
a non-monetary item recognised in other comprehensive income.

Knowledge Check Questions

Question 2
Pink Limited (Pink) has an HK$ functional currency. It holds land in the United Kingdom that
it purchased for GBP100,000 on 1 January 20X1 (equivalent to HK$1 million at that time). Pink
carries the land at cost in its financial statements. At year-end 31 December 20X1, the land
has a recoverable amount (determined on 31 December 20X1) of GBP96,000.
Determine the impairment loss, if any, recognised by Pink in its financial statements
for the year ended 31 December 20X1 if the exchange rate on 31 December 20X1 is
GBP1 : HK$10.5.

Question 3
Ginger Limited (Ginger) has a HK$ functional currency. It holds land in the United Kingdom
that it purchased for GBP200,000 on 1 January 20X1 (equivalent to HK$2 million at that
time). Ginger carries the land at cost in its financial statements.
The land’s recoverable amount on 31 December 20X1 is GBP201,000. The exchange
rate on that date is GBP1 : HK$9.95.
Analyse the impact of this information on Ginger’s financial statements for the year
ended 31 December 20X1.

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Knowledge Check Questions (continued)

Question 4
XYZ Limited’s (XYZ) functional currency is local currency (LC). On 1 March 20X1, XYZ loans
ABC Limited (ABC) FC1 million.
XYZ classifies the loan receivable from ABC as at fair value through profit or loss in
accordance with HKFRS 9 Financial Instruments. On reporting date 30 June 20X1, the fair
value of the investment is FC1.5 million.
The FC : LC exchange rate is:

1 March 20X1 FC1 : LC1.2

30 June 20X1 FC1 : LC1.1

Identify which one or more of the following statements about XYZ’s financial
statements for the period 30 June 20X1 is true.
A The carrying amount of the loan receivable from ABC on 30 June 20X1 is LC1,650,000.
B The carrying amount of the loan receivable from ABC on 30 June 20X1 is LC1,800,000.
C The fair value movement on the loan receivable from LC450,000 is recognised in
profit or loss.
D An exchange loss of LC150,000 on translation of the foreign currency loan is recognised
as follows: LC100,000 in profit or loss and LC50,000 in reserves.

Question 5
XYZ Limited’s (XYZ) functional currency is local currency (LC). On 15 March 20X1, XYZ
purchases land overseas for FC1 million. XYZ measures the land on the revaluation basis in
accordance with HKAS 16 Property, Plant and Equipment.
On reporting date 30 June 20X1, the fair value of the land is determined to be FC1.5
million. The FC : LC exchange rate is:

15 March 20X1 FC1 : LC1.2

30 June 20X1 FC1 : LC1.1

Identify which one or more of the following statements about XYZ’s separate financial
statements for the period 30 June 20X1 is true.
A An exchange loss of LC100,000 is recognised in profit or loss.
B The carrying amount of the revaluation surplus is LC450,000.
C The carrying amount of the revaluation surplus is LC550,000.
D The carrying amount of the land in ABC at 30 June 20X1 is LC1,750,000.

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3 1 . 3 TRANSLATION OF FINANCIAL STATEMENTS

INTO PRESENTATION CURRENCY

As illustrated in Exhibit 31.4, having determined the functional currency of the entity for which
financial statements are being prepared, the entity next needs to choose its presentation
currency. HKFRSs do not limit the choice of presentation currency. Accordingly,
HKAS HKFRS-compliant financial statements can be presented in more than one presentation
21.38 currency. For example, a US subsidiary of a Hong Kong parent may prepare a financial report
in USD presentation currency for its own regulatory reporting purposes and also
HK$-denominated financial statements for incorporation into the HK group’s consolidated
financial statements.

If an entity chooses a presentation currency different from its functional currency, it must
translate its functional currency financial statements into the presentation currency. Also,
because each entity in the group may have a different functional currency, when preparing the
consolidated financial statements, it is necessary to apply a common presentation currency
before applying the consolidation procedures (see Section 31.4 and Chapter 30).

This module assumes the presentation currency of the parent is the same as its
functional currency, and no translation in this regard is required at the parent entity level.
The discussion in this chapter is instead described in terms of the translation of a foreign
operation’s functional currency financial statements into the parent’s presentation currency
(as emphasised in Exhibit 31.4).

Addressed Addressed Addressed Addressed

in Section 1 in Section 2 in Section 3 in Section 4

Records foreign currency

Translates functional
Determines transactions in and Chooses group’s
currency ledger into
Parent A functional translates foreign presentation Parent A applies
the presentation
currency currency balances into currency consolidation
currency
the functional currency procedures to
prepare its
Records foreign currency consolidated
Translates functional
Determines transactions in and financial
currency ledger
Subsidiary B functional translates foreign statements
into the group’s
currency currency balances into
presentation currency
the functional currency

EXHIBIT 31.4 Translation of group financial statements into a common presentation currency

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31.3.1 Translation to the Presentation Currency

To prepare the financial statements, the process of converting the functional currency ledger to
a presentation currency ledger is referred to as foreign currency translation. In accordance with
HKAS 21, an entity translates its results and financial position from its functional currency into
its presentation currency as follows:

• Assets and liabilities at the closing rate at the reporting date of that statement of
financial position; and

• Income and expenses at exchange rates at the dates of the transactions. (An average
rate for the reporting period may be used as a proxy exchange rate to the extent that
HKAS the exchange rate does not fluctuate significantly. For the purposes of teaching, all
21.39–40 illustrations in this chapter assume use of an average rate is appropriate); and

HKAS • Cash flow resulting from a foreign currency transaction is translated into the functional
7.25 currency at the exchange rates applying at the date the cash flows occur.

Similar rules apply to any comparative information presented (using previous period
exchange rates).

For example, assume Caelus Limited’ (Caelus) functional currency is RMB and it has a trade
payable balance of RMB100,000 on 31 December financial year when the exchange rate is
RMB1 : HK$1.15. If Caelus’ presentation currency is HK$, this balance must be translated at the
year-end spot rate to HK$115,000. HK$115,000 then becomes the comparative carrying amount
in the next year’s financial statements.

The rates used to translate the functional currency financial statements into the
presentation currency are consistent with the idea that the statement of financial position is a
snapshot of the financial position of the entity at a particular point in time, and the statement
of profit or loss and other comprehensive income present a picture of the performance of the
entity over a defined period.

The ‘rules’ above do not describe how the equity section of the statement of financial
position should be translated. However, common practice is to translate:

• Share capital at the exchange rate at the date of issuance; and

• Reserves at the rate and on the date the amounts were initially recognised (e.g. the date
of a revaluation or the date of a dividend declaration).

HKAS The resulting exchange differences on translation are recognised in other comprehensive
21.39 income as a separate component of equity. The exchange differences are usually accumulated
in a reserve account ‘foreign currency translation reserve’ (FCTR). The exchange differences
remain in the FCTR until the foreign operation is disposed and a gain or loss on disposal is
recognised, at this time, the accumulated translation gain or loss:

• Relating to the parent, is reclassified from equity to profit or loss; and

HKAS • Relating to non-controlling interest (NCI), is derecognised, but is not reclassified to

21.48, 48B profit or loss.

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Apply and Analyse 5

Caelus Limited (Caelus) was incorporated on 1 January 20X1 with the issue of shares
in exchange for cash consideration of RMB 400 million. Caelus’ functional currency
is Renminbi.

Caelus’ RMB statement of financial position and statement of profit or loss for the year
ended 31 December 20X1 is as follows:

20X1
RMB’000
Statement of profit or loss
Revenues 350,000
Foreign exchange gain 21,250
Cost of sales (185,000)
Other expenses (96,250)
Profit for the year 90,000

Statement of financial position

Assets
Property, plant and equipment 400,000
Investments 39,300
Inventories 63,492
Trade and other receivables 93,258
Cash 200,750
Total assets 796,800

Equity
Share capital 400,000
Retained earnings 90,000
Total equity 490,000

Liabilities
Employee benefit provisions 250,000
Payables 56,800
Total liabilities 306,800
Total equity and liabilities 796,800

The foreign exchange gain relates to translation of Caelus’ HK$ cash balances at
reporting date into its RMB functional currency.

The exchange rate at different times during the reporting period ending 31
December 20X1 is:

1 January 20X1 RMB1 : HK$1.22

31 December 20X1 RMB1 : HK$1.28
Average exchange rate during the period RMB1 : HK$1.25

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Apply and Analyse 5 (continued)

Caelus is preparing its financial statements for presentation in HK$ so they can be
consolidated as part of reporting on the Soleil Group. From the information provided,
prepare Caelus’ HK$-denominated statement of financial position and statement of
profit or loss for the year ended 31 December 20X1 (i.e. translate Caelus’ RMB financial
statements into HK$ financial statements).

Analysis

Caelus translates its RMB financial statements into a HK$ presentation currency by
applying the appropriate exchange rate to each line item:

20X1 20X1
RMB’000 e/rate e/rate HK$’000
Statement of profit or loss
Revenues 350,000 average 1.25 437,500
Foreign exchange gain 21,250 average 1.25 26,563
Cost of sales (185,000) average 1.25 (231,250)
Other expenses (96,250) average 1.25 (120,313)
Profit for the year 90,000 112,500

Statement of financial position

Assets
Property, plant and equipment 400,000 closing 1.28 512,000
Investments 39,300 closing 1.28 50,304
Inventories 63,492 closing 1.28 81,270
Trade and other receivables 93,258 closing 1.28 119,370
Cash 200,750 closing 1.28 256,960
Total assets 796,800 1,019,904

Equity
Share capital 400,000 opening 1.22 488,000
Retained earnings 90,000 112,500
Foreign currency translation reserve - 26,700
Total equity 490,000 627,200

Liabilities
Employee benefit provisions 250,000 closing 1.28 320,000
Payables 56,800 closing 1.28 72,704
Total equity and liabilities 796,800 1,019,904

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Apply and Analyse 5 (continued)

The foreign exchange gain on the HK$ cash holding (monetary item) is not removed
following the translation of the financial statements into the presentation currency. This
is because, in substance, as the holding is in a different currency, the reporting entity is
exposed to a foreign exchange gain or loss as the currency strengthens or weakens. To
represent the economic phenomena, the form (choice of presentation currency) should
not result in the elimination of that foreign exchange gain.

Once Caelus’ financial statements are prepared in a common group presentation

currency, these financial statements can be now ‘added across’ with Soleil Group’s
financial statements (and the financial statements of the other subsidiaries) to prepare the
consolidated financial statements. Consolidations procedures, such as the elimination of
pre-acquisition equity and elimination of intragroup transactions and balances, can now be
applied (see Section 31.4).

Translating the current year financial statements in the preceding manner enables the
face of the consolidated statement of financial position and statement of profit or loss to be
prepared. However:

• It does not necessarily provide information about the exchange gain or loss for the year
presented in other comprehensive income, which is necessary to enable a statement
of changes of equity or statement of profit or loss and other comprehensive income
to be prepared (see Section 31.4.3 and Section 31.6 to understand what information is
missing); and

• It does not provide any check that the resultant foreign currency translation reserve
balance is appropriately determined. This can be determined by reconciling the foreign
currency translation reserve. The FCTR captures all the differences between translating
equity at the exchange rate at the date of issuance versus the rate at which assets and
liabilities represented by that equity are translated.

Illustrative Example 4
Caelus’ FCTR on 31 December 20X1 is HK$26,700,000. As it is Caelus’ first year of
operations, this amount is also the gain on translation for the period.

The FCTR can be reconciled as follows:

RMB’000 HK$’000 HK$’000

Opening equity 1/1/X1 400,000
@ closing rate 1 : 1.28 512,000
@ opening rate 1 : 1.22 (488,000) 24,000

Profit for the year 90,000

@ closing rate 1 : 1.28 115,200
@ average rate 1: 1.25 (112,500) 2,700
Translation gain/(loss) for the year presented in other 26,700
comprehensive income

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Illustrative Example 4 (continued)

In the next reporting period, this reconciliation is added to by performing a similar
reconciliation. The sum of the translation gains and losses from both reporting periods will
equal the carrying amount of the FCTR.

An alternative method of reconciling the FCTR is described in Section 31.4.3.

Key Learning Point

Retained earnings cannot be translated into the presentation currency directly. It is the
sum of profit or loss translated at the different exchange rates across the reporting
periods (less dividends and transfers).

31.3.2 Tax Effects of Exchange Differences

HKAS 12 Income Taxes requires the tax consequences of transactions and other events to be
accounted for in the same way as the transactions and other events themselves are accounted
for (see Chapter 19). Therefore, any tax effects of exchange differences arising on translating
HKAS the results and financial position of an entity into a different currency recognised in other
21.50 comprehensive income should be recognised in other comprehensive income.

The translation of a foreign operation’s financial statements into the presentation

currency is likely to give rise to temporary differences because the carrying amounts of assets
and liabilities will differ from the asset’s or liability’s tax base due to currency fluctuations.
Therefore, prima facie, deferred tax will exist to recognise in relation to amounts accumulated
in the foreign currency translation reserve.
However, as noted in Chapter 30, HKAS 12 provides an exemption from recognition of a
deferred tax liability or deferred tax asset for a parent’s investment in a subsidiary. A deferred
tax liability is not recognised where:

• The parent entity can control the timing of the reversal of the temporary difference; and
HKAS
12.39 • The temporary difference will probably not reverse in the foreseeable future.

Similarly, a deferred tax asset is recognised only to the extent that:

• The temporary difference will probably reverse in the foreseeable future; and

HKAS • Taxable profit will probably be available against which the temporary difference can be
12.44 utilised.

As a parent controls the dividend policy of its subsidiary, it can control the timing of the
reversal of taxable temporary differences associated with that investment. HKAS 12 clearly
HKAS states this includes temporary differences arising from any foreign exchange translation
12.40 differences. Accordingly, where the parent has determined that those profits will not be
distributed in the foreseeable future, there is no deferred tax liability arising from the foreign
currency translation reserve to recognise in the consolidated financial statements.

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A deferred tax liability arising for exchange differences accumulated in equity is recognised
by recording:

DR Foreign currency translation reserve (OCI) XXX

CR Deferred tax liability XXX

31.3.3 Change in Presentation Currency

An entity may change its presentation currency because it has changed its functional currency
(e.g. when the Euro was adopted) or for another reason, for example, comparability with other
entities listed on the same stock exchange. Though HKAS 21 does not explicitly address how
a change in presentation currency is to be treated, it probably is accounted as though it were
a change in accounting policy, meaning retrospectively. This means that any comparative
information should be restated into the new presentation currency so the financial statements
are reflected in the same currency across all reporting periods presented.

In theory, this sounds straightforward to do, and that may be the case for a single
entity. However, in practice, when a consolidated group changes its presentation currency,
determining the amounts of the different components of equity and the extent to which the
differences relate to each entity within the group could be difficult, especially when the group
is large, has been operating for a long period of time and has a large number of transactions
reflected in equity.

The foreign currency translation reserve will now capture a completely different set of
movements in exchange rates.

Knowledge Check Questions

Question 6
Turkey Limited (Turkey) has a LC functional currency. Its parent, Goose Limited (Goose)
prepares consolidated financial statements in presentation currency (PC). Turkey prepares
its financial statements in PC for the purposes of enabling Goose to prepare consolidated
financial statements. The following exchange rate information is available:

31 December 20X0 LC1 : PC1.5

31 December 20X1 LC1 : PC2.0
Average exchange rate during 20X0 LC1 : PC1.75
Average exchange rate during 20X1 LC1 : PC1.65

Turkey is preparing its PC financial statements for the year ended 31 December 20X1.
Identify the appropriate exchange rate that applies to translate each of the following items
into its presentation currency, assuming the average exchange rate is an appropriate proxy
for the exchange rate at the actual date of a transaction:
A Assets and liabilities at 31 December 20X1
B Assets and liabilities for the comparative year-end 31 December 20X0
C Income and expenses for the year ending 31 December 20X1
D Income and expenses for the comparative year ending 31 December 20X0

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 FINANCIAL REPORTING

Knowledge Check Questions (continued)

Question 7
Fox Limited (Fox) is established on 1 January 20X0 by Squirrel Limited (80% shareholder)
and Mouse Limited (20% shareholder). It has a functional currency (LC) and prepares its
financial statements in PC as its presentation currency. PC is the functional currency and
presentation currency of its parent entity, Squirrel Limited.
Fox’s LC statement of financial position at 31 December 20X1 is as follows:

20X1
LC
Statement of financial position
Assets
Property, plant and equipment 729
Inventories 100
Intangible assets 150
Trade and other receivables 120
Cash 27
Total assets 1,126

Equity
Share capital 100
Retained earnings 678
Total equity 778

Liabilities
Loan 220
Deferred tax liabilities 50
Payables 78
Total liabilities 348
Total equity and liabilities 1,126

During the year ended 31 December 20X1, Fox makes a profit of LC300. In the previous
reporting period, Fox makes a profit of LC478. On 1 February 20X1, Fox declares a dividend
to its shareholders of LC100.
The following exchange rate information is available:

1 January 20X0 LC1 : PC1.0

31 December 20X0 LC1 : PC1.5
1 February 20X1 LC1 : PC1.52
31 December 20X1 LC1 : PC2.0
Average exchange rate during 20X0 LC1 : PC1.70
Average exchange rate during 20X1 LC1 : PC1.65

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Knowledge Check Questions (continued)

Prepare Fox’s PC statement of financial position as of 31 December 20X1. Assume the
average exchange rate is an appropriate proxy for the exchange rate at the dates of
transactions over the year.

Question 8
This is a continuation of Question 7. Prepare a reconciliation of the foreign currency
translation reserve (FCTR) for the year ended 31 December 20X1.

3 1 . 4 CONSOLIDATION OF FOREIGN
SUBSIDIARIES

This section discusses the impact of foreign exchange on the consolidation process of a foreign
HKAS subsidiary. Where a subsidiary is not wholly-owned, the non-controlling interest (NCI) share of
21.41 any translation difference must be attributed to the NCI.

31.4.1 Goodwill and Fair Value Adjustments

Recall from Chapter 29 that the acquisition of a business often gives rise to goodwill and
may involve making fair value adjustments to the carrying amounts of recognised assets and
liabilities arising from that acquisition. For the purposes of HKAS 21, these are treated as assets
and liabilities of the foreign subsidiary and are stated in the functional currency (LC) of the
foreign operation. Accordingly, applying the earlier described HKAS 21 ‘rules’:

• The pre-acquisition equity elimination journal entries are translated into the
presentation currency at the acquisition date exchange rate; and

• Where still existing at the reporting date, goodwill and any remaining fair value
HKAS adjustment (and associated tax and depreciation impacts) must be translated into the
21.47 presentation currency at the closing exchange rate.

Any resulting exchange differences are captured in the translation reserve and attributed to
NCI as necessary.

Fair value adjustments should be treated as assets and liabilities of the foreign operation
because they pertain to the foreign operation. However, the rationale for requiring goodwill
to be treated as an ‘asset of the foreign operation’ (rather than as an ‘asset of the parent’)
and be affected by currency movements is not as readily apparent. Reasons for the
classification include:

• That goodwill may partly comprise intangible assets of the foreign operation that do not
qualify for separate recognition;

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 FINANCIAL REPORTING

• That goodwill only arises because of the parent’s investment in the foreign operation
and has no existence apart from the foreign operation; and

• That cash flows that support the continued recognition of goodwill are generated in the
IAS 21.BC31-
BC32 functional currency of the foreign operation.

Illustrative Example 5 shows how goodwill and fair value adjustments arising on acquisition
of a foreign subsidiary impact the consolidation process.

Illustrative Example 5
On 1 January 20X0, Flower Limited (Flower) acquires 80% of the share capital of Seed
Limited (Seed) for consideration of LC225. At that date, Seed’s equity comprises
share capital of LC200 and retained earnings of LC40. The carrying amounts of Seed’s
identifiable net assets on that date are equal to their fair values, except that an item of
plant with a carrying amount of LC100 is determined to have a fair value of LC112.

Assume:

• The NCI in Seed is measured as a proportionate share of the fair value of the net
identifiable assets acquired;
• The plant has a remaining useful life of four years, has nil residual value and is
depreciated on a straight-line basis;

• Flower’s tax rate is 25% and Seed’s tax rate is 16.5%; and

• Flower meets the conditions for non-recognition of a deferred tax liability for
taxable temporary differences arising on the investment in Seed.

Seed’s 20X0 profit after tax is LC260.

Flower and Seed’s respective statements of financial position on 31 December 20X1 are
as follows:

Statement of financial position

at 31 December 20X1
Flower Seed
PC LC
Assets
Property, plant and equipment 400.0 500.0
Investment in Seed 270.0 -
Goodwill

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Illustrative Example 5 (continued)

Statement of financial position
at 31 December 20X1
Flower Seed
PC LC
Trade and other receivables 130.0 250.0
Cash 190.0 100.0
Total assets 990.0 850.0

Equity
Share capital 100.0 200.0
Retained earnings
: Opening retained earnings 500.0 300.0
: Profit for the year 100.0 250.0
Total equity 700.0 750.0

Liabilities
Loan 222.0 80.0
Deferred tax liabilities 68.0 20.0
Total liabilities 290.0 100.0
Total equity and liabilities 990.0 850.0

Relevant exchange rates since acquisition are:

1 January 20X0 LC1 : PC1.2

31 December 20X0 LC1 : PC1.3
31 December 20X1 LC1 : PC1.5
Average exchange rate 20X0 LC1 : PC1.25
Average exchange rate 20X1 LC1 : PC1.6

To determine Flower’s consolidated financial position on 31 December 20X1, the

first step is to present the individual financial statements in a common currency so they
can be added across (review Section 31.3). Next, the usual consolidation adjustments
are processed, acknowledging that the assets and liabilities have a different functional
currency to the parent:

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M11_c31.indd 1668
Illustrative Example 5 (continued)
Consolidated statement of financial position as at 31 December 20X1
Translate Seed Apply consolidation procedures

LC financial NCI share

position of

into PC Pre- Goodwill at Fair value translation Additional NCI share NCI share NCI
acquisition uplift at of of share

Fair value equity closing rate closing adjustment depreciation adjustment retained of
uplift rate profits FCTR
FINANCIAL REPORTING

Flower Seed Seed (W1) (W2) (W3) (W4) (W4) (W5) (W5) (W6) (W7) Consolidated

PC LC e/r PC PC PC PC PC PC PC PC PC PC PC

Assets

Property, plant and 400.0 500.0 1.5 750.0 14.4 3.6 (9.0) 1,159.0
equipment

Investment in Seed 270.0 - - (270.0) -

1668
Goodwill 30.0 75 37.5

Trade and other 130.0 250.0 1.5 375.0 505.0

receivables

Cash 190.0 100.0 1.5 150.0 340.0

Total assets 990.0 850.0 1,275.0 2,041.5

Equity

Share capital 100.0 200.0 1.2 240.0 (240.0) 100.0

Retained earnings -

: Opening retained 500.0 300.0 * 373.0 (48.0) (3.1) 0.6 (65.0) 757.5
earnings

: Profit for the year 100.0 250.0 1.6 400.0 (4.0) 0.8 (80.0) 416.8

Business combinations 12.0 (12.0) -

reserve

Foreign currency -
translation reserve

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Illustrative Example 5 (continued)
Consolidated statement of financial position as at 31 December 20X1
Translate Seed Apply consolidation procedures

LC financial NCI share

position of

into PC Pre- Goodwill at Fair value translation Additional NCI share NCI share NCI
acquisition uplift at of of share

Fair value equity closing rate closing adjustment depreciation adjustment retained of
uplift rate profits FCTR

Flower Seed Seed (W1) (W2) (W3) (W4) (W4) (W5) (W5) (W6) (W7) Consolidated

PC LC e/r PC PC PC PC PC PC PC PC PC PC PC

: Opening FCTR ** 37.0 2.5 1.0 (0.2) (0.1) 0.05 (7.4) 32.8

: Translation gain or *** 75.0 5.0 2.0 (0.4) (0.3) 0.06 (15.0) 66.4
loss for the year (OCI)

Non-controlling 60.0 0.6 (1.5) 145.0 22.4 226.5

interests

1669
Total equity 700.0 750.0 1,125.0 1,600.0

Liabilities

Loan 222.0 80.0 1.5 120.0 342.0

Deferred tax liabilities 68.0 20.0 1.5 30.0 2.4 0.6 (1.5) 99.5

Total liabilities 290.0 100.0 150.0 441.5

Total equity and 990.0 850.0 1,275.0 2,041.5

liabilities

* 373 = (40 x 1.2) + (260

x 1.25)

** 37 = (240 x 1.3 – 1.2))

+ (260 x (1.3 – 1.25))

*** 75 = 500 x (1.5 – 1.3)

F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

+ 250 x (1.5 – 1.6))

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 FINANCIAL REPORTING

Illustrative Example 5 (continued)

Notes to explain the journal entries (all amounts in PC):

Debit Credit
HK$ HK$
W1 Property, plant and equipment (LC12 × 1.2) 14.4
Deferred tax liability (LC12 × 16.5% × 1.2) 2.4
Business combinations reserve (LC12 × (1-16.5%) × 1.2) 12.0
The carrying amount of the plant at acquisition date (LC100) is increased to its fair value
(LC112) on that date, using the exchange rate at the date of acquisition. The resultant deferred
tax liability arising is recorded, calculated as temporary difference × tax rate applicable to the
subsidiary (Chapter 30 explains why the subsidiary’s tax rate is used to calculate the DTL, rather
than that of the parent).

W2 Share capital (LC200 × 1.2) 240.0

Retained earnings (LC40 × 1.2) 48.0
Business combinations reserve (LC10 × 1.2) 12.0
Goodwill (LC25 × 1.2) 30.0
Investment in Seed (LC225 × 1.2) 270.0
NCI – equity (LC50 × 1.2) 60.0
The pre-acquisition equity in Seed is eliminated, using the exchange
rate at the date of acquisition. Goodwill of LC25 arises on
consolidation.

Goodwill
Consideration transferred LC225
NCI (20% × LC250) LC50
less: Fair value of net assets acquired (LC250)
Goodwill LC25

W3 Goodwill (LC25 × (1.5 – 1.2)) 7.5

FCTR − opening (LC25 × (1.3 – 1.2)) 2.5
FCTR (OCI) (LC25 × (1.5 – 1.3)) 5.0
Translation gains and losses arise when translating goodwill of LC25 for presentation in PC.
On reporting date 31 December 20X1, goodwill is LC25 = PC37.5 (LC25 × 1.5). The movement in
goodwill attributable to translation gains and losses (cumulatively, PC30 − PC37.5 = PC7.5) is
attributed to the periods to which the translation gain or loss relates.

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Illustrative Example 5 (continued)

Debit Credit
HK$ HK$
W4 Property, plant and equipment (LC12 × (1.5 – 1.2)) 3.6
Deferred tax liability (LC2 × (1.5 – 1.2)) 0.6
FCTR − opening (LC10 × (1.3 – 1.2)) 1.0
FCTR (OCI) (LC10 × (1.5 – 1.3)) 2.0
The fair value adjustment to the plant of LC12 and the resultant deferred tax liability of LC2
must be further translated to present using the exchange rate at reporting date, consistent
with the exchange rate applied to translate the carrying amount of the plant in Seed’s financial
statements. Following journal W1 and W4, plant LC112 is now presented in the consolidation
worksheet as plant PC168 (PC120* + PC14.4 + PC3.6 + PC30*), that is, LC112 × closing rate
1.5 = PC168.
*Translation of LC100 into PC currency at date of acquisition and movement thereafter

FCTR – opening (20% × PC1) 0.2

FCTR (OCI) (20% × PC2) 0.4
NCI – equity 0.6
The NCI share of the consolidation adjustment affecting equity (FCTR) is attributed to NCI.
Illustrated separately in the worksheet for teaching purposes.

W5 DTL (LC1 × 1.5) 1.5

Retained earnings (opening) (LC2.5 × 1.25) 3.1
Depreciation expense (LC3 × 1.6) 4.8
FCTR – opening (LC2.5 × (1.3 – 1.25)) 0.1
FCTR (OCI) (LC2.5 × (1.5 – 1.3)) + (LC2.5 × (1.5 – 1.6)) 0.3
Income tax expense (LC0.5 × 1.6) 0.8
PPE (LC6 × 1.5) 9.0
Additional depreciation of LC3 per year (LC12/4years) is charged on the plant. Related tax
of LC0.5 per year (LC3 × 16.5%) reverses. The expense and related tax is translated into the
presentation currency using the average exchange rate as a proxy for the rate at the date of
the transaction (1.25 or 1.6 as appropriate to the period). The LC deduction to the plant and
related DTL is translated into the presentation currency using the closing rate, consistent with
the exchange rate applied to translate the carrying amount of the plant in Seed’s financial
statements. The resultant translation differences are recognised in the FCTR, which can be
reconciled as the difference between the average rate applied to the profit or loss items and the
closing rate applied to assets and liabilities.

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Illustrative Example 5 (continued)

Debit Credit
HK$ HK$
NCI – equity 1.48
Profit attributable to NCI (20% × (PC4.8 – PC0.8)) 0.8
Retained earnings – opening (20% × PC3.1) 0.6
FCTR – opening (20% × PC0.1) 0.02
FCTR (OCI) (20% × PC0.3) 0.06
The NCI share of the consolidation adjustment affecting equity is attributed to NCI. Illustrated
separately in the worksheet for teaching purposes.

W6 Retained earnings – opening (20% × LC260 × 1.25) 65.0

Profit attributable to NCI (20% × LC250 × 1.6) 80.0
NCI – equity 145.0
The NCI share of post-acquisition changes in retained earnings, translated using the exchange
rates applicable at the date of the exchange, is attributed to NCI. Illustrated separately in the
worksheet for teaching purposes.

W7 FCTR – opening (20% × PC37) 7.4

FCTR (OCI) (20% × PC75) 15.0
NCI – equity 22.4
The NCI share of the retranslation difference arising from the translation of Seed’s net assets
to the closing rate is attributed to NCI. The calculations in this journal entry include capture of
the translation difference arising on retranslation of retained earnings from the exchange rates
applicable at the date of the exchange (see journal entry immediately above) to the closing rate.
Illustrated separately in the worksheet for teaching purposes.

The FCTR is sometimes regarded by practitioners as a convenient ‘balancing account’

to record unexplained differences. However, as shown by this Illustrative Example, the
FCTR is fully reconcilable. The calculation of the FCTR (proofs) is further discussed in
Section 31.4.3.

31.4.2 Intragroup Transactions and Balances

Regard must be had to the implications of foreign exchange in the context of the elimination
of intragroup transactions and balances. Where a transaction exists with a foreign subsidiary,
the group has created a ‘real’ foreign exchange exposure. Accordingly, this foreign exchange
exposure cannot be eliminated along with the elimination of the intragroup transaction or
balance but must be reflected in the consolidated financial statements.

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31.4.2.1 Intragroup Monetary Assets and Liabilities

Following translation of a foreign subsidiary’s financial statements into the group presentation
currency, intragroup monetary assets and liabilities will be presented at the same amounts.
Consequently, an intragroup receivable can be eliminated against the corresponding intragroup
payable by simply processing the following journal entry, for example:

Debit Credit
HK$ HK$
Foreign currency payable x,xxx (closing rate)
Receivable x,xxx

Now, consider the accounting for a foreign currency balance described in Section 31.2.2
and Apply and Analyse 5 exercise (in Section 31.3.1). Where the receivable or payable is
denominated in a currency other than the functional currency of both entities, even though the
intragroup monetary item must be itself eliminated, the results of currency fluctuations on the
item are not also eliminated in the consolidated financial statements.

As previously noted, this is because the monetary item represents a commitment to

convert one currency into another, thereby exposing the reporting entity to a foreign exchange
HKAS gain or loss as the currency strengthens or weakens, including in instances where the
21.45 transaction is between two group entities.

For example, assume Parent A (HK$ functional and presentation currency) loaned
Subsidiary B (FC functional currency and HK$ presentation currency) FC100 when the exchange
rate is HK$1 : FC1. At reporting date, the exchange rate moved to HK$1 : FC1.5. Parent A
records this loan initially as HK$100 and retranslates as a foreign currency monetary item
to HK$67, with the foreign exchange loss of HK$33 recognised in profit or loss. Subsidiary B
initially recognises the (not a foreign currency monetary item) loan at FC100 and retranslates
it for consolidation purposes to HK$67, with the translation gain of HK$33 recognised in the
translation reserve. In accordance with HKAS 21, the intragroup receivable and payable are
eliminated against each other. However, the currency exposure recognised in profit or loss is
not eliminated as a consolidation adjustment against the translation difference accumulated
in equity.

There is one exception to the requirement that the exchange difference resulting from
the translation of the foreign currency monetary item at the closing rate into the functional
currency is recognised in profit or loss in the consolidated result for the period: namely,
monetary items that are part of the reporting entity’s ‘net investment in a foreign operation’.
Where a monetary item is part of the reporting entity’s net investment in a foreign operation,
in the consolidated financial statements the exchange difference is recognised in other
comprehensive income (as part of the FCTR).

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A monetary item is part of the entity’s net investment in a foreign operation where it is a
receivable from or a payable to a foreign operation for which settlement is neither planned nor
HKAS likely to occur. The monetary item may be held by any subsidiary of the group. Examples
21.15, 15A include long-term receivables and loans but not trade receivables or trade payables. So, in the
Parent A/Subsidiary B example, if Parent A determines its loan to be part of its net investment
in foreign subsidiary B, it should record as a consolidation adjustment the following journal
entry for example:

Debit Credit
HK$ HK$
Foreign currency translation reserve 33
Foreign exchange loss (p/l) 33

31.4.2.2 Intragroup Sales and Purchases

For a downstream transaction, as part of eliminating the intragroup sale, the associated
cumulative effect of the change in exchange rates from the transaction date to the reporting
date must be removed from the FCTR as part of the consolidation adjustments required to
eliminate the unrealised gain or loss on the sale.

For an upstream transaction, as part of eliminating the intragroup sale, the asset is
restated to its original cost to the group. The foreign currency non-monetary item is recorded
at the spot rate at the date of intragroup transaction, reflecting that the asset is now held by
another entity.

Illustrative Example 6 – Downstream Transaction

(This Illustrative Example ignores tax effects of the transaction)

During the year ended 31 December 20X2, Soleil (HK$ functional and HK$ presentation
currency) sold inventory to subsidiary Caelus (RMB functional currency and HK$
presentation currency) for HK$100,000. The inventory originally cost HK$80,000.
All inventory remains with Caelus at the year-end.

Assume:

transaction date exchange rate HK$1 : RMB0.82

exchange rate 31 December 20X2 HK$1 : RMB0.85

Soleil initially records the following proforma consolidation adjustment journal entries
to eliminate the intragroup sale and the unrealised gain in inventory:

Debit Credit
HK$ HK$
Sales 100,000
Cost of Goods Sold 80,000
Inventory 20,000

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Illustrative Example 6 (continued)

However, Soleil’s gain on sale of HK$20,000 (100,000 − 80,000) is ‘held’ in the
foreign subsidiary, represented by RMB16,400 (20,000 × 0.82) of inventory. However,
when translated into the presentation currency, the inventory is shown as HK$19,294
(RMB16,400/0.85); not HK$20,000. The translation difference of HK$706 (20,000 − 19,294)
must also be addressed as part of the consolidation process:

Debit Credit
HK$ HK$
Inventory 706
Foreign currency translation reserve 706

Put another way, on the reporting date, Caelus translates RMB82,000 inventory into
HK$96,471. It makes an overall translation loss from the strengthening HK$ exchange rate
movement from 0.82 to 0.85. This translation loss is accumulated in equity. As a portion of
this loss relates to the exchange rate movement on the unrealised gain in inventory, when
eliminating the unrealised gain, the related translation difference should also be reversed.

The FCTR relating to the original cost of inventory (HK$80,000) that remains unsold is
not eliminated from the consolidated financial statements (FCTR = 80,000 × 100% unsold
× 0.82/0.85 − 80,000 = HK$2,824). This reflects that the group inventory is now held in
a foreign currency. Consequently, on 31 December 20X2, the consolidated financial
statements will show the HK$80,000 inventory only at HK$77,176.

Consolidation adjustments
Soleil Caelus DR CR Consolidated
HK$ HK$ HK$ Ref HK$ HK$
Statement of financial position (extract)
Inventory – 96,470 20,000 77,176
706
Retained earnings 20,000 20,000 –
Foreign currency translation reserve – (3,530)* 706 (2,824)

*This amount relates only to the translation of inventory.

Reflects HK$80,000 investory held
by the group and the currency
exposure of that inventory

Illustrative Example 7 – Upstream Transaction

(This example ignores tax effects of the transaction.)

During the year ended 31 December 20X3, Caelus sells inventory to Soleil for RMB82,000.
The inventory originally cost RMB60,000. All inventory remains with Soleil at the year-end.

Assume:

Transaction date exchange rate HK$1 : RMB0.82

Exchange rate on 31 December 20X3 HK$1 : RMB0.85

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Illustrative Example 7 (continued)

In preparing its HK$ consolidated financial statements, Soleil records the following
proforma journal entry to eliminate the intragroup sale and the unrealised gain in
inventory:

Debit Credit
HK$ HK$
Sales (82,000/0.82) 100,000
Cost of Goods Sold 73,170
Inventory (100,000 − 60,000/0.82) 26,830

After processing this entry, the carrying amount of consolidated inventory is

HK$73,170, which is equal to the original cost of the inventory to the group (60,000/
0.82 =73,170).

There is no entry to make against the FCTR as the inventory is not held by Caelus at
the year-end; therefore, nothing needs translating into the presentation currency, and no
exchange differences are recognised in the FCTR.

31.4.3 Exchange Differences and Reserve

Exchange differences are accumulated in equity in a translation reserve. The translation reserve
can be reconstructed without necessarily preparing a consolidation worksheet. This is actioned
by calculating for each financial statement element the difference between the presentation
currency exchange rate at original recognition (or last translation) and the closing rate of the
current reporting period, that is, the FCTR can be proofed.

Apply and Analyse 6

Using the information in Illustrative Example 5 (in Section 31.4.1), calculate the total
translation reserve to be presented in Flower’s consolidated statement of financial position
on 31 December 20X1.

Analysis

The total translation reserve on 31 December 20X1 can be calculated as:

Owners of NCI
the parent (20%)
(80%)
Translation reserve – Net assets
LC e/r PC
Net assets @ 1/1/X0 240.0 1.20 288.0
20X0 profit 260.0 1.25 325.0

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Apply and Analyse 6 (continued)

Owners of NCI
the parent (20%)
(80%)
Translation reserve – Net assets
LC e/r PC
613.0
Net assets @ 31/12/X0 500.0 1.30 650.0
Translation gain for period ended 31/12/X0 37.0

Net assets @ 1/1/X1 500.0 1.30 650.0

20X1 profit 250.0 1.60 400.0
1,050.0
Net assets @ 31/12/X1 750.0 1.50 1,125.0
Translation gain for period ended 31/12/X1 75.0

Cumulative translation reserve for net assets 112.0 89.6 22.4

Translation reserve – Goodwill

LC e/r PC
Goodwill @ 1/1/X0 25.0 1.20 30.0
Goodwill @ 31/12/X0 25.0 1.30 32.5
Translation gain for period ended 31/12/X0 2.5

Goodwill @ 1/1/X1 25.0 1.30 32.5

Goodwill @ 31/12/X1 25.0 1.50 37.5
Translation gain for period ended 31/12/X1 5.0

Cumulative translation reserve for goodwill 7.5 7.5 -

Translation reserve: Fair value adjustment on acquisition

LC e/r PC
PPE – Fair value adjustment @ 1/1/X0 12.0 1.20 14.4
20X0 depreciation (3.0) 1.25 (3.7)
10.7
PPE – Fair value adjustment @ 31/12/X0 9.0 1.30 11.7
Translation gain for period ended 31/12/X0 1.0
PPE – Fair value adjustment @ 1/1/X1 9.0 1.30 11.7

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Apply and Analyse 6 (continued)

Translation reserve: Fair value adjustment on acquisition

LC e/r PC
20X1 depreciation (3.0) 1.60 (4.8)
6.9
PPE – Fair value adjustment @ 31/12/X0 6.0 1.50 9.0
Translation gain for period ended 31/12/X1 2.1
Cumulative translation reserve for fair value uplift 3.1 2.5 0.6

Translation reserve: Tax on fair value adjustment on acquisition

LC e/r PC
DTL–Fair value adjustment @ 1/1/X0 2.0 1.20 2.4
20X0 change to DTL (0.5) 1.25 (0.6)
1.8
DTL–Fair value adjustment @ 31/12/X0 1.5 1.30 1.9
Translation loss for period ended 31/12/X0 (0.1)

DTL–Fair value adjustment @ 1/1/X1 1.5 1.30 1.9

20X1 change to DTL (0.5) 1.60 (0.8)
1.1
DTL–Fair value adjustment @ 31/12/X1 1.0 1.50 1.5
Translation loss for period ended 31/12/X1 (0.4)

Cumulative translation reserve for tax on fair value (0.5) (0.4) (0.1)
uplift

Total translation reserve (112 + 7.5 + 3.1 − 0.5) 122.1 99.2 22.9

(The net gain on translation recognised as other comprehensive income for the period
ended 31 December 20X1 is 75 + 5 + 2.1 − 0.4 = 81.7.)

HKAS The exchange differences accumulated in equity are reclassified from equity to profit
21.48-48A or loss only when the parent loses control of the related foreign subsidiary. Amounts
cumulated in the FCTR are reclassified to profit or loss by recording the following journal
entry, for example:

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Apply and Analyse 6 (continued)

Debit Credit
HK$ HK$
Foreign currency translation reserve (OCI)
NCI – equity (foreign currency translation) (OCI)
Exchange differences reclassified on disposal of foreign
operation (p/l)

Where there is only a partial disposal of a subsidiary that is a foreign operation (i.e.
no loss of control but ownership interest is reduced), the FCTR is not reclassified to profit
HKAS
or loss. Instead, there is a reallocation of amounts within equity of the consolidated entity
21.48C to reflect the changed share attributable to the parent and to NCI . Disposals and partial
disposals are discussed further in Chapter 34.

31.4.4 Consolidated Cash Flows

Cash flows of foreign operations should be translated into the group presentation currency at
the exchange rates applying at the date the cash flows occur. However, an exchange rate that
HKAS approximates the actual rate may be used instead, e.g. a weighted average exchange rate for
7.26–­27
the period (note: this cannot be the closing exchange rate).

The translation of the statement of cash flows will usually give rise to an exchange
difference, reflecting the difference between the exchange rate at the beginning of the period,
the rates prevailing when cash flows occurred during the period and the closing rate applied to
the cash and cash equivalent balance at reporting date. This difference is presented separately
in the cash flow statement, as shown in Exhibit 31.5.

$
Cash flows from operating activities x,xxx
Cash flows from investing activities x,xxx
Cash flows from financing activities x,xxx

Net increase/(decrease) in cash and cash equivalents x,xxx

Cash and cash equivalents at beginning of year x,xxx

Effect of exchange rate changes on cash and cash equivalents x,xxx

Cash and cash equivalents at end of year x,xxx

EXHIBIT 31.5 Presentation of exchange differences in the

statement of cash flows

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 FINANCIAL REPORTING

Apply and Analyse 7

This Apply and Analyse uses and extends the information in Illustrative Example 5.

Flower continues to hold its 80% interest in Seed throughout the financial year ended
31 December 20X2.

Flower’s consolidated statement of financial position for the year ended 31

December 20X2 is:

PC PC
20X2 20X1
Assets
Property, plant and equipment 1,102.2 1,159.0
Investment in Seed – –
Goodwill 35.0 37.5
Trade and other receivables 492.0 505.0
Cash 529.5 340.0
Total assets 2,158.7 2,041.5
Equity
Share capital 100.0 100.0
Retained earnings 1,430.4 1,174.3
Foreign currency translation reserve 25.9 99.2
Non-­controlling interests 235.7 226.5
Total equity 1,792.0 1,600.0
Liabilities
Loan 292.0 342.0
Deferred tax liabilities 52.7 99.5
Current tax liability 22.0 –
Total liabilities 366.7 441.5
Total equity and liabilities 2,158.7 2,041.5

Flower’s consolidated statement of profit or loss and other comprehensive income for
the year ended 31 December 20X2 is (comparative information has not been shown):

Year ended
31 Dec 20X2
PC
Sales revenue 1,058.0
Employee benefits expense (479.0)
Depreciation expense (248.7)
Finance costs (29.7)
Profit before tax 300.6
Income taxes expense (17.6)
Profit for the year 283.0

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Apply and Analyse 7 (continued)

Year ended
31 Dec 20X2
PC
Other comprehensive income
Translation loss for the period (91.0)
Total comprehensive income 192.0
Profit attributable to:
Parent entity (Flower) 256.1
Non-­controlling interest (Seed) 26.9
283.0
Total comprehensive income attributable to:
Parent entity (Flower) 182.8
Non-­controlling interest (Seed) 9.2
192.0

Flower’s consolidated statement of changes in equity for the year ended 31 December
20X2 is (comparative information has not been shown):

Share Retained FCTR Total NCI Total

capital earnings equity
PC PC PC PC PC PC
Balance at 100.0 1174.3 99.2 1373.5 226.5 1600.0
beginning of
the year

Profit for the – 256.1 – 256.1 26.9 283.0

year
OCI for the – – (73.3) (73.3) (17.7) (91.0)
year
Total – 256.1 (73.3) 182.8 9.2 192.0
comprehensive
income for the
year
Other changes – – – – – –
in equity
Balance at the 100.0 1430.4 25.9 1556.3 235.7 1792.0
end of the year

The relevant exchange rates during the period were:

1 January 20X2 LC1 : PC1.5

31 December 20X2 LC1 : PC1.4

Average exchange rate 20X2 LC1 : PC1.55

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Apply and Analyse 7 (continued)

The following additional information is available:

• Flower’s tax rate is 25%. Seed’s tax rate is 16.5%.

• during the year, Flower and Seed made cash purchases of property, plant and
equipment of PC90 and LC100 respectively. There are no disposals of property,
plant and equipment during the year.

• no new borrowings were made during the year.

• for the purposes of this exercise, doubtful debts and bad debts are ignored.

• the translation loss for the year is attributable to the following assets and liabilities:

PC
Property, plant and equipment (53.0)
Trade and other receivables (29.5)
Cash (12.25)
Loan 3.5
Deferred tax liabilities 0.5
Current tax liability 2.35
Net assets -­ translation loss for the period (88.4)
Translation gain/(loss) on consolidation adjustments:
Fair value uplift on consolidation (0.15)
Goodwill (2.5)
Tax related to fair value uplift 0.03
Total translation loss for the period (rounded) (91.0)

From the information provided, prepare Flower’s consolidated statement of cash flows
for the financial year ended 31 December 20X2.

Analysis

Using the information above, Flower prepares its consolidated statement of cash flows for
the year ended 31 December 20X2 as follows:

PC
Cash flows from operating activities
Profit before tax 300.6
Adjustment for non-­cash flows:
add back: Depreciation expense 248.7
add back: Interest expense 29.7
Operating profit before working capital changes 579.0

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Apply and Analyse 7 (continued)

PC
add: Decrease/(increase) in trade receivables (note 1) (16.5)
Cash inflows from operations 562.5

less: Interest paid (29.7)

less: Income tax paid (note 2) (39.5)
Net cash inflow from operating activities 493.3

Cash flows from investing activities

Purchases of property, plant and equipment (note 3) (245.0)
Net cash outflow from investing activities (245.0)

Cash flows from financing activities

Repayment of bank loans (note 4) (46.5)
Net cash inflow from financing activities (46.5)

Net increase in cash and cash equivalents 201.8

(PC493.3 -­ PC245.0 – PC46.5)
Cash and cash equivalents at 1 January 20X2 340.0
Effects of exchange rate changes on cash and cash
equivalents (rounded from 12.25) (note 5) (12.3)
Cash and cash equivalents at 31 December 20X2 529.5

Note 1

Trade receivables at 1 Jan 20X2 505.0

less: trade receivables 31 Dec 20X2 (492.0)
less: foreign exchange (loss)/gain for the period (29.5)
(Increase)/decrease in trade receivables for the period (16.5)

The effect of the foreign exchange loss must be removed as it otherwise decreases
the closing balance without an associated cash flow. For example, prima facie it appears
that there has been a cash inflow during the period as the trade receivable balance has
decreased from the start of the year to the end of the year. However, this is misleading
as the opening asset balance has been translated at 1:1.5 (e.g. LC100 = PC150) while the
closing asset balance is translated at 1:1.4 (e.g. LC100 = PC140). Like non-­cash depreciation,
a foreign exchange loss must be similarly eliminated in order to identify the actual cash
flow for the period.

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Apply and Analyse 7 (continued)

Note 2

Current and deferred tax balances at 1 Jan 20X2 99.5

add: income tax expense 17.6
less: income tax paid (balancing item) (39.5)
less: foreign exchange loss/(gain) for the period
(0.5 + 2.35 + 0.03) (rounded) (2.9)
Current and deferred tax balances at 31 Dec 20X2 (52.7 + 22) 74.7

The consolidated entity has made a foreign exchange gain on translation of its tax
liability balances as the year end exchange rate (1:1.4) is lower that the opening/average
exchange rate during the period. For example, a LC100 liability balance would now be
translated as PC140 rather than PC150, giving rise to a PC10 translation gain. As the
foreign exchange gain for the period reduces the closing balance of the liability without
an associated cash outflow, it must be eliminated in determining the cash outflow of
the period.

Note 3

PPE at 1 Jan 20X2 1,159.0

less: depreciation expense (248.7)
less: disposals of PPE –­
add: acquisition of PPE (balancing item) 245.0
less: foreign exchange (loss)/gain for the period (53 + 0.15) (53.1)
(rounded)
PPE at 31 Dec 20X2 1,102.2

The consolidated entity has made a foreign exchange loss on translation of its asset
balances as the year end exchange rate (1:1.4) is lower than the opening/average exchange
rate during the period. For example, a LC100 asset balance would now be translated as
PC140 rather than PC150, giving rise to a PC10 translation loss. As the foreign exchange
loss for the period reduces the closing balance of the asset without an associated cash
flow, it must be removed in determining the cash flows of the period.

In this exercise, there are no PPE disposals during the period. Disposals of PPE of a
foreign operation should be included in the statement of cash flows at the exchange rate
applying at the date of the disposal.

Note 4

Bank loans at 1 Jan 20X2 342.0

add: new borrowings –­
less: repayment of borrowings (balancing item) (46.5)
less: foreign exchange loss/(gain) for the period (rounded) (3.5)
Bank loans at 31 Dec 20X2 292.0

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Apply and Analyse 7 (continued)

Note 5
In practice, the line item ‘effects of exchange rate changes on cash and cash equivalents’
is often used as a balancing item that reconciles the cash flow statement to the cash
and cash equivalent balance recognised (at closing rate) in the financial statements.
However, in theory, similar to how the FCTR can be reconciled, it is possible to reconcile
the translation difference in the statement of cash flows, regarding its composition as a
summation of the exchange difference between the closing rate and the rate applied to
each line item.

Note that in practice, the consolidated statement of cash flows is prepared as shown
above, starting from the other financial statements. This gives the same result as if the
cash flows of the foreign operation were translated into the group presentation currency
at the exchange rates applying at the date the cash flows occur before that statement
of cash flows was aggregated with that of the parent entity (i.e. ‘adding across’ cash flow
statements). You can test this for yourself, using the following information in addition to
the information above, and assuming that the average exchange rate approximates the
actual exchange rates at the dates of the transactions:

Flower Seed
20X2 20X1 20X2 20X1
PC PC LC LC
Assets
Property, plant and equipment 370.0 400.0 520.0 500.0
Investment in Seed 270.0 270.0 –­ –­
Trade and other receivables 100.0 130.0 280.0 250.0
Cash 368.5 190.0 115.0 100.0
Total assets 1,108.5 990.0 915.0 850.0
Equity
Share capital 100.0 100.0 200.0 200.0
Retained earnings
: Opening retained earnings 600.0 500.0 550.0 300.0
: Profit for the year 148.5 100.0 89.3 250.0
Total equity 848.5 700.0 839.3 750.0

Liabilities
Loan 222.0 222.0 50.0 80.0
Deferred tax liabilities 38.0 68.0 10.0 20.0
Current tax liability –­ –­ 15.7 –­
Total liabilities 260.0 290.0 75.7 100.0
Total equity and liabilities 1,108.5 990.0 915.0 850.0

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Apply and Analyse 7 (continued)

Flower Seed
PC LC
Sales revenue 500.0 360.0
Employee benefits expense (200.0) (180.0)
Depreciation expense (120.0) (80.0)
Finance costs (22.0) (5.0)
Profit before tax 158.0 95.0
Income taxes expense (9.5) (5.7)
Profit for the year 148.5 89.3
Other comprehensive income –­ –­
Total comprehensive income 148.5 89.3

As additional practice, you may also like to use the above information to reconstruct
Flower’s consolidated statement of financial position, consolidated statement of
profit or loss and other comprehensive income, and the FCTR for the year ended
31 December 20X2.

31.4.5 Different Reporting Dates

Recall that the two key rates in translating a foreign operation to the presentation currency are
the closing rate and the average rate (where used to approximate the transaction date). Where
the reporting date of the foreign operation differs from that of the reporting entity (see
Chapters 30 and Chapter 32) and to avoid doubt, the HKAS clarifies that the ‘closing’ exchange
rate to be employed is the exchange rate at the end of the reporting period of the foreign
HKAS operation. However, adjustments may be necessary to reflect significant changes in exchange
21.46 rates up to the end of the reporting period of the reporting entity.

It follows that the average rate would be determined on a similar basis.

Knowledge Check Questions

Question 9
This question is a continuation of the data in Question 7. Assume that Squirrel made a
profit of PC nil during the year ended 31 December 20X1. Prepare an extract of Squirrel’s
consolidated statement of profit or loss and other comprehensive income for the year
ended 31 December 20X1, showing profit and total comprehensive income attributed to
owners of the parent and the NCI.

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Knowledge Check Questions (continued)

Question 10
Identify which one of the following statements is true.
A Cash flows of a foreign operation are translated into the presentation currency of the
consolidated group using the closing exchange rate.
B Cash flows of a foreign operation are translated into the presentation currency of the
consolidated group using an average exchange rate.
C The statement of cash flows cannot balance without recognising the difference
between the translated cash flows during the period and the translated cash balance at
the year-end.
D The exchange difference reported in the statement of cash flows arising from translation
of foreign operations into the presentation currency is recognised directly in other
comprehensive income.

Question 11
Parent A wholly owns Subsidiary B, a foreign operation. Parent A’s consolidated financial
statements include a foreign currency translation reserve of HK$100,000, being the
cumulative exchange differences recognised by the group on translating the financial
statements of Subsidiary B into the presentation currency.
During the year ended 31 December 20X2, Parent A disposes of its entire interest in
Subsidiary B.
Prepare the journal entry to recognise the effect of this transaction of the foreign
currency translation reserve.

Question 12
On 1 January 20X1, Rose Limited (Rose) acquires 100% of the share capital of Orchid
Limited (Orchid) for consideration of PC2.4 million. At that date, Orchid’s equity comprises
share capital of FC1.5 million and retained earnings of FC300,000. The carrying amounts of
Orchid’s identifiable net assets on that date are equal to their fair values.
The presentation currency of the consolidated group is PC. Orchid’s functional
currency is FC.
The relevant exchange rates are:

1 January 20X1 FC1 : PC 1.2

31 December 20X1 FC1 : PC 2.0

Identify the goodwill recognised in Rose’s consolidated financial statements on 31

December 20X1 and prepare any necessary consolidation adjustment journal entries.

Question 13
Explain whether the following statement is true or false: ‘The profit or loss in the
consolidated financial statements does not include any exchange gains or loss as these are
recognised in other comprehensive income’.

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3 1 . 5 DISCLOSURE

HKAS 21 The Effects of Changes in Foreign Exchange Rates is the primary standard setting out the
disclosures in respect of an entity’s foreign exchange exposure. However, disclosures
pertaining or relating to foreign exchange are also specified by other HKASs/HKFRSs. For
example, HKAS 1 Presentation of Financial Statements requires disclosure of the presentation
HKAS currency of the financial statements and material accounting policy information applied in
1.51, 117 preparing the financial statements (refer Chapter 27). Another example is the requirement
in HKFRS 7 Financial Instruments: Disclosures to disclose information about the sensitivity of
an entity’s results to changes in foreign exchange (refer Chapter 12).

Illustrative Example 8
Soleil might disclose the following accounting policy in its financial statements to comply
with HKAS 1:

Note X Foreign exchange

Items included in the financial statements of each group entity are measured using
the currency of the primary economic environment in which the entity operates (the
functional currency). The consolidated financial statements are presented in Hong
Kong dollars (HK$), which is the Soleil Group’s presentation currency.

Foreign currency transactions are translated into the relevant functional currency using
the exchange rates prevailing at the dates of the transactions or valuation where items
are remeasured. Foreign exchange gains and losses resulting from the settlement of such
transactions and from the translation of monetary assets and liabilities denominated
in foreign currencies by using the exchange rates at the end of the reporting period are
recognised in profit or loss except when deferred in other comprehensive income as
qualifying cash flow hedges or qualifying net investment hedges.

For subsidiaries, joint ventures and associates that have a functional currency different
from the group’s presentation currency, for the purpose of consolidation, assets
and liabilities for each statement of financial position presented are translated using
the closing rate at the end of the reporting period. Income and expenses for each
statement of profit or loss presented are translated at the exchange rate at the date
of the transactions (or at an average exchange rate for the reporting period where
the rate is a reasonable approximation of the cumulative effect of the rates prevailing
on the transaction dates). All resulting exchange differences are recognised in other
comprehensive income in the foreign currency translation reserve.

Goodwill and fair value adjustments arising on the acquisition of a foreign subsidiary
are treated as assets and liabilities of the foreign subsidiary and translated using the
closing rate at the end of the reporting period.

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Illustrative Example 8 (continued)

Upon disposal of a foreign subsidiary, the exchange differences accumulated in
equity in respect to that operation are reclassified as profit or loss. In the case
of a partial disposal that does not result in the Soleil Group losing control over a
foreign subsidiary, the proportionate share of accumulated exchange differences is
re-attributed to non-controlling interests and is not recognised in profit or loss. For
all other partial disposals, the proportionate share of the accumulated exchange
difference is reclassified to profit or loss.

In accordance with HKAS 21 and concerning foreign currency transactions, an entity

must disclose the amount of exchange differences recognised in profit or loss except for
those related to financial instruments measured at fair value through profit or loss (FVTPL) in
accordance with HKFRS 9 Financial Instruments.

This is often shown as a separate line item ‘foreign exchange gains or losses’ in the
statement of profit or loss or in the accompanying notes concerning foreign currency
translations, the net exchange differences recognised in other comprehensive income and
accumulated in a separate component of equity (e.g. the FCTR).

The entity must also disclose a reconciliation of the amount of such exchange differences at
the beginning and end of the period. An entity need not present such a reconciliation twice, as
part of complying with the disclosure requirement specified by HKAS 21 and that specified by
HKAS HKAS 1 Presentation of Financial Statements in respect to reconciliations of components in the
21.52,
HKAS statement of changes in equity. Hence, in many instances, this disclosure will be complied with
1.106(d) as part of preparing the statement of changes in equity.
In addition, HKAS 21 requires that, where applicable and appropriate, an entity
must disclose:

• That the (the group’s) presentation currency differs from the (the parent’s) functional
currency, the functional currency, and the reason for using a different presentation
currency; and

HKAS • Any change in the functional currency of the reporting entity or a significant foreign
21.53–54 operation during the period and the reason for the change.

Consideration should also be given to whether disclosure of the judgements the entity has
made in determining its functional currency is necessary to comply with the requirement in
HKAS 1 to disclose the judgements that management has made in the process of applying the
entity’s accounting policies. For example, an entity might disclose that its functional currency is
United States Dollars (USD), because ‘the US Dollar and currencies linked to it are the most
significant currencies relevant to the underlying transactions, events and conditions of the
HKAS entity and its subsidiaries, as well as representing a significant proportion of its funds
1.122 generated from financing activities’.

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Supplementary disclosures

An entity is not prohibited from presenting a ‘convenience translation’ as a supplementary

translation of its financial information where such translations do not comply with HKFRSs
(i.e. the requirements of HKAS 21). For example, a dual-listed entity incorporated in the United
States with a USD functional and presentation currency may decide to present its financial
statements in HK$ as a convenience to users of its financial reports. However, in such cases,
HKAS HKAS 21 requires the entity to clearly distinguish this information from the information that
21.55-57 complies with HKFRSs and to provide certain additional disclosures.

Knowledge Check Question

Question 14
YOLO Limited (Yolo) has determined it has a USD functional currency and an HK$
presentation currency. Yolo has a subsidiary FOMO Limited (Fomo) whose functional
currency is HK$. Identify which of the following is not a disclosure that Yolo must make in
its consolidated financial statements.
A Yolo must disclose that its functional currency is USD and its presentation
currency is HK$.
B Yolo must disclose that its functional currency is USD and that its subsidiary’s functional
currency is HK$.
C Yolo must disclose the net exchange difference recognised in other comprehensive
income during the period.
D Yolo must disclose a reconciliation of its foreign currency translation reserve from the
beginning to the end of the period.

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SUMMARY

• Below is the approach to addressing foreign exchange in the consolidated financial

statements:

Records foreign currency

Translates functional
Determines transactions in and Chooses group’s
currency ledger into
Parent A functional translates foreign presentation Parent A applies
the presentation
currency currency balances into currency consolidation
currency
the functional currency procedures to
prepare its
Records foreign currency consolidated
Translates functional
Determines transactions in and financial
currency ledger
Subsidiary B functional translates foreign statements
into the group’s
currency currency balances into
presentation currency
the functional currency

Adding like-with-like: The financial Adding like-with-like: The financial

records of an individual entity are statements to be consolidated are
maintained in a single currency presented in the same currency

• An entity’s functional currency is the currency of the primary economic environment in which
the entity operates. Each entity in a group could have a different functional currency. The
functional currency is determined having regard to the currency:

°° Of the country whose competitive forces and regulations mainly determine the sales prices
of its goods and services;

°° That mainly influences sales prices for goods and services (this will often be the currency in
which its sales prices are denominated and settled); and

°° That mainly influences labour, material and other costs of providing goods or services. The
entity also considers the currency in which funds from financing activities are generated and
receipts from operating activities are usually retained, and the closeness of its relationship
with its investor.

• Foreign currency transactions are recognised in functional currency:

Foreign currency item Applicable exchange rate

Transactions Date of underlying transaction
Monetary assets and liabilities Period-end rate
Non-monetary assets and liabilities Date of underlying transaction; or
date of determining fair value

• The foreign exchange gain or loss from the translation of the foreign currency balance into the
functional currency is recognised in profit or loss or other comprehensive income (if the gain/
loss is recognised in other comprehensive income).

• For consolidation, the functional currency ledger is translated into the group
presentation currency:

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Foreign currency item Applicable exchange rate

Income and expenses Date of underlying transaction
Assets and liabilities Period-end rate
Share capital Date of underlying transaction
Reserves Date of underlying transaction

• Exchange differences from translation into the presentation currency are recognised in other
comprehensive income. In the FCTR:

°° Exchange differences arising in relation to a partly-owned foreign subsidiary must partly be

attributed to the NCI; and

°° The cumulative exchange difference in the FCTR is reclassified to profit or loss on disposal
of the foreign operation.

• Goodwill and fair value adjustments on acquisition of a foreign operation are treated as assets
and liabilities of the foreign operation.

• The effects of exchange differences resulting from the translation of foreign currency
balances into the functional currency post-initial recognition might not be eliminated when
consolidating a foreign operation even though the balance might be eliminated where it is an
intragroup transaction.
• Disclosures to understand the impact of foreign exchange exposure on the financial
statements include disclosure of the (1) exchange difference recognised in profit or loss,
(2) exchange difference recognised in other comprehensive income, (3) reconciliation of the
FCTR and (4) effect of exchange rate changes on cash and cash equivalents.

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MIND MAP

REPORTING FOREIGN CURRENCY OVERVIEW

TRANSACTIONS IN THE FUNCTIONAL
Each entity in the group determines its
CURRENCY
functional currency
Currency of the primary economic • Records are maintained in a single currency
environment • Foreign currency transactions are recorded
Denomination of sales and costs – Financing, in the functional currency
dependence on parent, etc. • Foreign currency balances are translated
into the functional currency
Foreign currency transactions → transaction
date f/x rate All subsidiary functional currency financial
statements translated into a common group
Translate foreign currency balances at each
presentation currency (usually functional
reporting date
currency of parent)
• Monetary items (receivables,
• Consolidation procedures are applied to
payables) → closing f/x rate
these financial statements (See Chapter 30
• Non-monetary items at historical
and Chapter 34 for consolidation procedures)
cost → transaction date f/x rate
• Non-monetary items at fair TRANSLATION OF FINANCIAL STATEMENTS
value → fair value date f/x rate INTO PRESENTATION CURRENCY
Exchange difference from last translated Entity choice
amount → profit or loss or OCI
Exchange differences → FCTR (limited
Change in functional currency – treat exceptions: net investment, hedging)
prospectively
Translate:
Practical expedient • Assets & liabilities → closing f/x rate
Transaction date rate – Average rate FOREIGN EXCHANGE • Income & expenses → transaction date f/x rate
DISCLOSURE AND CONSOLIDATION • Share capital → transaction date f/x rate
OF FOREIGN • Other reserves → date of transaction giving
Amount recognised in profit or loss OPERATIONS rise to reserve amount
Amount recognised in other comprehensive (HKAS 21) • Cash flows → transaction date f/x rate
income Change in presentation currency – treat
Exchange difference to balance the cash retrospectively (i.e. restate comparatives)
flow statement Practical expedient
Reconciliation of the exchange differences Transaction date rate – Average rate
recognised in equity
CONSOLIDATION OF FOREIGN SUBSIDIARIES
Exchange differences in FCTR
• Reclassified to p/l on disposal of foreign
operation
• Reclassified from p/l to FCTR if relates to
a monetary item that is a net investment
in the foreign operation
• NCI – attribute to NCI its share of FCTR
Goodwill, fair value adjustments on
acquisition – treat as belonging to foreign
operation. Translate → closing f/x rate
Intragroup transactions – need to remove
f/x impact of unrealised gains and losses
Intragroup transactions – exchange
differences from translating balances into
functional currency remain in p/l, not
eliminated when the balances are eliminated
Tax rate applying to consolidation
adjustments – consider which entity holds
the asset or liability

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. The determination of an entity’s functional currency is not a free
choice but is based on management judgement having regard to the primary economic
environment in which the entity operates.
Answer B is incorrect. An entity has only one functional currency. However, it may present
its financial statements in more than one presentation currency.

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 FINANCIAL REPORTING

Answer C is correct. The functional currency of an entity is the currency of the primary
economic environment in which the entity operates. This can be the same as the reporting
entity (e.g. taking into consideration the close relationship between the foreign operation
and the parent).
Answer D is incorrect. The functional currency of an entity is the currency of the primary
economic environment in which the entity operates. Though it might often be the case,
this is not necessarily identical to the country in which the entity’s activities are based. For
example, an oil company might be incorporated in Australia but be conducting exploration
activities off the Indonesian coast. If its activities were primarily denominated in US
Dollars (USD), its functional currency is likely to be determined as the USD rather than the
Indonesian Rupiah (or Australian Dollar).

Question 2
The recoverable amount of the land is calculated as GBP96,000 × 10.5 = HK$1,008,000. As
this exceeds the land’s carrying amount of HK$1 million, Pink Limited (Pink) does not have
an impairment loss to recognise even though the land is impaired when considered in its
local currency. Pink continues to recognise the land in its HK$ functional currency financial
statements at HK$1 million.

Question 3
Considering the foreign currency amounts, the land does not appear to be impaired
because its GBP recoverable amount of GBP201,000 is higher than its GBP carrying amount
of GBP200,000. However, for inclusion in Ginger Limited’s HK$-functional currency financial
statements, the land’s carrying amount before impairment of HK$1 million must be
compared to its recoverable amount of HK$1,999,950 (GBP201,000 × 9.95). Consequently,
Soleil must recognise an impairment loss of HK$50 in its functional currency financial
statements for the year ended 31 December 20X1.

Question 4
Answers A and C are correct. A is correct because the foreign currency monetary item is
translated into the functional currency at the closing rate FC1 : LC1.1. Answer C is correct
because fair value gains and losses on debt instruments classified at fair value through
profit or loss are recognised in profit or loss.
Answer B is incorrect. The foreign currency monetary item is translated into the functional
currency at the closing rate FC1 : LC1 and not the transaction date exchange rate.
Answer D is incorrect. Because it relates to a foreign currency monetary item, the entire
exchange loss is recognised in profit or loss. The total exchange loss is LC100,000 relating
to the exchange movement on the initial investment. There is no exchange loss relating to
the fair value increase because this was done on 30 June 20X1 (transaction converted at
the spot rate). The journal recognised at reporting date is:

Debit Credit
HK$ HK$
Loan receivable LC450,000
Gain on remeasurement to fair value (p/l) LC450,000

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 F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

Question 5
Answer A is incorrect. The exchange loss should be recognised in other
comprehensive income.
Answer B is correct. B is correct because a non-monetary item measured at fair value in a
foreign currency is translated into the functional currency using the exchange rate at the
date fair value is determined. In accordance with HKAS 21, the exchange rate difference (as
well as the fair value movement) is recognised in other comprehensive income.

Cost of land at 15 March 20X1 FC1 million 1.2 LC1.2 million

n

Fair value of land at 30 June 20X1 FC1.5 million 1.1 LC1.65 million

Gain on revaluation (OCI) LC1.65 million LC1.2 million LC450,000

(The gain on revaluation includes an exchange rate loss of LC100,000.)

Answer C is incorrect. The exchange loss should also recognised in other
comprehensive income.
Answer D is incorrect. The non-monetary item should not be measured treating each
revaluation increase or decrease as a separate ‘transaction’ (i.e. 1,000,000 × 1.2 + 500,000
× 1.1 = 1,750,000). Instead, the land is measured using the exchange rate at the date fair
value is determined (FC1,500,000 × 1.1 = LC1,650,000).

Question 6

Assets and liabilities at 31 December 20X1 LC1 : PC2.0

Assets and liabilities at 31 December 20X0 LC1 : PC1.5
Income and expenses for the period 31 December LC1 : PC1.65
20X1
Income and expenses for the period 31 December LC1 : PC1.75
20X0

Question 7

20X1 20X1
LC e/ rate PC
Statement of financial position
Assets
Property, plant and equipment 729 2.0 1,458
Inventories 100 2.0 200
Intangible assets 150 2.0 300
Trade and other receivables 120 2.0 240
Cash 27 2.0 54
Total assets 1,126 2,252

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 FINANCIAL REPORTING

20X1 20X1
LC e/ rate PC
Equity
Share capital 100 1.0 100
Retained earnings (note 1) 678 1,156
Foreign currency translation - 300
reserve
Total equity 778 1,556
Liabilities
Loan 220 2.0 440
Deferred tax liabilities 50 2.0 100
Payables 78 2.0 156
Total liabilities 348 696
Total equity and liabilities 1,126 2,252

Note 1:

LC e/r PC
Profit for the year ending 31 December 20X0 478 1.70 813
Dividend declared 1 February 20X1 (100) 1.52 (152)
Profit for the year ending 31 December 20X1 300 1.65 495
Retained earnings at 31 December 20X1 678 1,156

Question 8
The FCTR on translation of the financial statement can be reconciled as follows:

LC PC PC
Opening equity 1/1/X0 100
@ closing rate LC1 : PC1.5 150
@ opening rate LC1 : PC1 (100) 50

Profit for the year 478

@ closing rate LC1 : PC1.5 717
@ average rate LC1 : PC1.70 (813) (96)

Translation gain/(loss) for the year (46)

FCTR balance at 31/12/X0 (46)

Opening equity 1/1/X1 578

@ closing rate LC1 : PC2 1,156
@ opening rate LC1 : PC1.5 (867) 289

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 F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

LC PC PC
Dividend 1/2/X1 (100)
@ closing rate LC1 : PC2 200
@ transaction date LC1 : PC1.52 (152) (48)

Profit for the year 300

@ closing rate LC1 : PC2 600
@ average rate LC1 : PC1.65 (495) 105

Translation gain/(loss) for the year 346

FCTR balance at 31/12/X1 (344 – 44) 300

Question 9
Consolidated statement of profit or loss and other comprehensive income (extract)

PC
Profit for the year 495 (see solution to Question 8)
Other comprehensive income
Items that may be reclassified to profit or loss:
Exchange difference on translating subsidiary 346 (see solution to Question 8)
Total comprehensive income 841

Profit for the year

: Owners of the parent 396 (80% × 495)
: Non-controlling interests 99 (20% × 495)
495
Total comprehensive income for the year
: Owners of the parent 673 (80% × 841)
: Non-controlling interests 168 (20% × 841)
841

Review Chapter 27 to refresh your understanding of the requirements of a statement of

profit or loss and other comprehensive income.

Question 10
Answer A is incorrect. Cash flows of a foreign operation are translated into the
presentation currency of the consolidated group at the exchange rates applying at the date
the cash flows occur.

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 FINANCIAL REPORTING

Answer B is incorrect. Cash flows of a foreign operation are translated into the
presentation currency of the consolidated group at the exchange rates applying at the date
the cash flows occur. The average exchange rate can be used as a proxy exchange rate
only where this approximates the actual rate.
Answer C is correct. The statement of cash flows cannot balance without recognising the
difference between the translated cash flows during the period and the translated cash
balance at the year-end because these are translated at different exchange rates.
Answer D is incorrect. The exchange difference reported in the statement of cash flows
is not recognised directly in other comprehensive income in the same manner as the
translation of a statement of financial position because of the nature of the cash flow
statement; it reports flows of the financial statement elements. The financial statement
elements themselves are translated.

Question 11

Debit Credit
HK$ HK$
Foreign currency translation reserve (OCI) 100,000
Exchange differences reclassified on disposal of 100,000
foreign operation (p/l)

Question 12
On acquisition date, goodwill is calculated as FC2 million (consideration) less FC1.8
million (fair value of net assets acquired) = FC 200,000. Goodwill is initially recognised as
PC240,000 (FC200,000 × 1.2).
On 31 December 20X1, goodwill is retranslated at the closing rate such that it is
recognised in the consolidated financial statements at PC400,000 (FC200,000 × 2.0). Rose
Limited (Rose) records the following consolidated adjustment journal entry to effect this
retranslation:

Debit Credit
HK$ HK$
Goodwill (400,000 − 240,000) 160,000
Foreign currency translation reserve 160,000

Question 13
The statement is false. The profit or loss in the consolidated financial statements may
include exchange gains or loss arising from:
• Translation of foreign currency items into the functional currency of the entity; or
• Reclassification of the exchange differences recognised in other comprehensive
income on disposal of a foreign operation.

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 F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

Question 14
Answer A is incorrect. HKAS 21 requires disclosure of the functional currency of the
parent where this is different to the presentation currency of the group. HKAS 1 requires
disclosure of the presentation currency of the consolidated financial statements.
Answer B is correct. HKAS 21 does not require the parent to disclose the functional
currencies of all its group entities.
Answer C is incorrect. HKAS 21 requires disclosure of the net exchange difference
recognised in other comprehensive income during the period.
Answer D is incorrect. The entity must disclose a reconciliation of the amount of
cumulative exchange differences recognised in other comprehensive income at the
beginning and end of the period.

EXAM PRACTICE

QUESTION 1
(based on June 2017 Exam Question 6)
Nu Esky Limited (NEL) has a 31 March year-end. The functional currency of NEL is Hong Kong
Dollars (‘HK$s’). The following events took place during the year ended 31 March 20X1:

Bank deposits denominated in FC

On 31 January 20X1, NEL placed deposits with a bank in Country X. The deposits were
denominated in the currency of Country F, the F Dollar (‘FC’).

The exchange rate of 1 FC against 1 HK$ is as follows:

31 January 20X1 1 FC : 12 HK$

31 March 20X1 1 FC : 14 HK$

Purchase of plant and equipment denominated in EC

NEL ordered the purchase of certain plant and equipment from an overseas supplier at a
price of EC100,000 on 30 September 20X0. The purchase was made on CIF terms. The plant
and equipment were received by NEL on 28 February 20X1. Payment for the goods was
made on 30 June 20X1.

The exchange rate of 1 EC against 1 HK$ is as follows:

30 September 20X0 1 EC : 8.6 HK$

28 February 20X1 1 EC : 8.8 HK$
31 March 20X1 1 EC : 8.5 HK$

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 FINANCIAL REPORTING

NEL’s accounting policy is to account for plant and equipment at cost less accumulated
depreciation and accumulated impairment.

Analyse how the preceding events are treated in the preparation of the NEC’s financial
statements for the year ended 31 March 20X1.

QUESTION 2
Chin Eng Limited (‘CEL’) is a company listed on the Main Board in Hong Kong and is
principally engaged in the production and distribution of toys. CEL has a financial year-end
date of 31 December.

CEL’s functional currency is HK$. It presents the consolidated financial

statements in HK$.

On 1 January 20X1, CEL acquired a 70% interest in Ron Sing Limited (‘RSL’) for cash
HK$170 million when the equity of RSL was:

Equity RMB’mil
Share capital 100
Retained earnings 105
205

The carrying amounts of assets and liabilities of RSL were the same as their fair values,
except for plant, which has a fair value of RMB15 million lower than its book value. The plant
is depreciated over its remaining useful life of three years to a residual value of nil on a
straight-line basis.

RSL, a toy retailer, is incorporated in China and has a 31 December year-end and sells
toys in retail outlets in China and online. RSL’s online trade accounts for 80% of its sales.
The online sales come from all over the world. On the platform, customers are able see
the Renminbi-quoted sales price and also the approximate foreign currency equivalent
amount. Customers are given an option of payment in Renminbi or in the foreign exchange
equivalent amount set by the online platform. However, all amounts are received by RSL
in Renminbi.

RSL’s sources its inventory from China-based manufacturers. Its staff is only based in
China and is paid in Renminbi.

The exchange rates during the year were:

1 January 20X1 RMB1 : HK$1.22

31 January 20X1 RMB1 : HK$1.24
31 December 20X1 RMB1 : HK$1.28
Average exchange rate RMB1 : HK$1.25

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 F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

CEL’s tax rate is 16.5% and RSL’s tax rate is 25%.

The following is draft financial information in relation to CEL and RSL as at

31 December 20X1.

CEL RSL
HK$’mil RMB’mil
Statement of financial position
Property, plant and equipment 493.0 170.0
Investment in subsidiaries 170.0 -
Deferred tax assets 10.0 -
Inventory 70.0 20.0
Trade and other receivables 107.0 115.0
Total assets 850.0 305.0
Share capital 250.0 100.0
Retained earnings
: opening retained earnings 400.0 105.0
: profit for the year 100.0 50.0
Ending retained earnings 500.0 155.0
Total equity 750.0 255.0
Bank and other loans 100.0 26.0
Deferred tax liability - 24.0
Total liabilities 100.0 50.0
Total liabilities and equity 850.0 305.0

Statement of profit or loss and other comprehensive income

Revenue 170.0 125.0
Foreign exchange gain/(loss) (3.0) 6.0
Depreciation expense (50.0) (15.0)
Other expenses (5.0) (56.0)
Profit before tax 112.0 60.0
Income tax expense (12.0) (10.0)
Profit after tax 100.0 50.0
Other comprehensive income - -
Total comprehensive income 100.0 50.0

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 FINANCIAL REPORTING

Other information

• The non-controlling interest (NCI) is initially measured as a proportionate share of

the fair value of the net assets of the subsidiary on acquisition date

• CEL meets the conditions for not recognising any deferred tax liability or deferred
tax asset relating to the undistributed profits and translation differences in RSL

• On 31 January 20X1, CEL loaned RSL HK$15 million. The loan is outstanding at 31
December 20X1.

(a) Assume you are Joey Tan, the accounting manager for RSL. Your junior staff member,
Casey Chia, has just come to you with the following question: ‘Joey, now that RSL has
a parent, does that mean we have to update our computer systems so our functional
currency matches theirs to enable our results to be added together?’

Explain to Casey whether it would be appropriate for RSL to change its functional
currency. In your response, identify the functional currency of RSL and provide
clarification for Casey so that he understands how RSL’s financial statements are
consolidated together with CEL’s.

(b) Analyse how the HK$15million intragroup loan is treated in the preparation of RSL’s
financial statements and for CEL’s consolidated financial statements for the year ended
31 December 20X1. Explain how the treatment would differ if the loan were considered
to be part of CEL’s net investment in RSL.

(c) Calculate the total translation reserve to be presented in CEL’s consolidated statement
of financial position for the year ended 31 December 20X1.

(d) Prepare CEL’s consolidated statement of financial position, consolidated statement of

profit or loss and other comprehensive income and consolidated statement of changes
in equity for the year ended 31 December 20X1.

ANSWERS TO EXAM PRACTICE

QUESTION 1
Bank deposits denominated in FC

As the functional currency of NEL is HK$, the bank deposit is treated as being denominated
in a foreign currency. Hence, the deposit should initially be recognised by NEC in HK$ in its
records using the exchange rate at the date of transaction (i.e. 1 FC : 12 HK$).

The bank deposits are monetary items as a deposit is a right to receive a fixed or
determinable number of units of currency. Accordingly, in accordance with HKAS 21, on
the reporting date 31 March 20X1, the deposits should be retranslated using the closing
exchange rate on that date (i.e. 1 FC : 14 HK$). The exchange difference from retranslating
the deposit balance at a different exchange rate is recognised in profit or loss of the
reporting period ending 31 March 20X1.

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Purchase of plant and equipment denominated in EC

The acquisition of the plant and equipment is a foreign currency transaction because
the purchase is denominated in a foreign currency to the HK$ functional currency of NEL
because the purchase is made on CIF terms, NEL does not gain control of the plant and
equipment until it receives the items. Accordingly, the plant and equipment is initially
recognised in HK$ by NEL on 28 February 20X1, translated at the spot exchange rate of
1 EC : 8.8 HK$ at the date of the transaction.

The plant and equipment are non-monetary items because they do not show a right to
receive a fixed or determinable number of units of currency. Also, they are measured on
the cost basis. Accordingly, in accordance with HKAS 21, the carrying amount of the plant
and equipment is not retranslated at the reporting date but remains at the initial recognised
amount. Depreciation is charged on the plant and equipment based on the initially
translated HK$ cost of the item.

On 31 March 20X1, EC 100,000 remains outstanding. The payable is initially recognised

using the exchange rate at the date of transaction (i.e. 28 February 20X1; DR Plant CR
Payable at 1EC:8.8HK$). A payable is a monetary item because it is an obligation to pay a
fixed or determinable number of units of currency. Hence, in accordance with HKAS 21,
for the purposes of reporting, the outstanding foreign currency payable is retranslated
using the closing rate at the end of the reporting period (31 March 20X1 at 1EC:8.5HK$).
The foreign exchange gain on retranslating the payable is recognised in profit or loss of the
reporting period ending 31 March 20X1.

QUESTION 2
(a) Casey: The ownership of the entity does not necessarily affect the functional currency
of the entity. The functional currency must be the currency of the primary economic
environment in which RSL operates. In our case, this has not changed with the change
in ownership of the entity: Our primary economic environment is still China, and our
functional currency is the RMB. We determined our primary economic environment to
be China because our sales and costs are priced in this currency, and RSL is affected
by changes to the Chinese economic environment (e.g. labour prices). However,
we will now have to prepare RSL financial statements in HK$ to enable our results
and financial position to be consolidated with CEL’s. These can be additional to or
replace the RMB financial statements that we present. To do this, our RMB-financial
statements are translated, generally using closing rates, to HK$. The resultant
net exchange difference is recorded in a new reserve called the foreign currency
translation reserve (FCTR).

(b) Because the functional currency of RSL is RMB, the HK$15 million loan is treated
as being denominated in a foreign currency. Hence, the loan should initially be
recognised by RSL in RMB in its records using the exchange rate at the date of
transaction (i.e. RMB1: HK$1.24). The loan is initially recognised at RMB12.1 million
(HK$15/1.24).

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 FINANCIAL REPORTING

The loan payable is a monetary item because the lender has an obligation to pay
a fixed or determinable number of units of currency. Accordingly, in accordance with
HKAS 21, on the reporting date 31 December 20X1, the foreign currency monetary
item should be retranslated using the closing exchange rate on that date (i.e. RMB1:
HK$1.28). The exchange difference from retranslating the loan balance at a different
exchange rate is recognised in RSL’s profit or loss of the reporting period ending
31 December 20X1.

Loan payable at 31 January 20X1 RMB12.1million

Loan payable at 31 December 20X1 (15/1.28) (RMB11.7million)
Gain on exchange rate movement (p/l) RMB0.4million

The loan payable is translated back into HK$ at the closing exchange rate on 31
December 20X1 because this is the group presentation currency. So, in RSL’s HK$
financial statements, the loan payable is shown as HK$15million.

The foreign exchange gain must also be translated into the presentation
currency. The average exchange rate may be used as a proxy for the exchange
rates applying at the date(s) of the transactions, to the extent it is an appropriate
representative. The foreign exchange gain is shown as HK$0.5 million (RMB0.4
million × 1.25) in RSL’s HK$ financial statements, included in a line item together
with other exchange gains and losses for the period.

On consolidation, the intragroup loan payable (HK$15 million) is eliminated

against the loan receivable of the same amount. However, the foreign exchange
gain of RMB0.4 million is not eliminated as part of the consolidation process as the
intragroup transaction has created a currency exposure for the group. The foreign
exchange gain remains included as part of the group profit for the year.

However, if CEL considers the loan to RSL to be part of its net investment in the
foreign subsidiary, on consolidation the foreign exchange gain recognised in profit
or loss is reassigned from being recognised in profit or loss to being recognised
in equity.

(c) There are other ways of calculating the translation reserve (see Section 31.4.3).

Owners
of the
parent NCI
(HK$) (HK$)
(all amounts in ‘millions)
Translation reserve – Fair value adjustment on acquisition
RMB e/r HK$
PPE – Fair value adjustment (15.00) 1.22 (18.300)
@ 1/1/X1
20X0 depreciation 5.00 1.25 6.250
(12.050)

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 F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

Owners
of the
parent NCI
(HK$) (HK$)
PPE – Fair value adjustment (10.00) 1.28 (12.800)
@ 31/12/X1
Translation loss for period ended 31/12/X1 (0.750) (0.525) (0.225)

Translation reserve – Tax on fair value adjustment on

acquisition
RMB e/r HK$
DTA – Fair value adjustment 3.750 1.22 4.575
@ 1/1/X1
20X0 change to DTA (1.250) 1.25 (1.563)
3.013
DTL – Fair value adjustment 2.500 1.28 3.200
@ 31/12/X0
Translation gain for period ended 31/12/X1 0.188 0.131 0.056

Translation reserve – Goodwill

RMB e/r HK$
Goodwill @ 1/1/X0 3.72 1.22 4.537
Goodwill @ 31/12/X0 3.72 1.28 4.761
Translation gain for period ended 31/12/X0 0.223 0.223 -

Translation reserve – Net assets

RMB e/r HK$
Net assets @ 1/1/X1 205.00 1.22 250.100
20X1 profit 50.00 1.25 62.500
312.600
Net assets @ 31/12/X1 255.00 1.28 326.400
Translation gain for period ended 31/12/X1 13.800 9.660 4.140

Total translation reserve 13.461 9.489 3.971

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M11_c31.indd 1706
(d) The consolidated statement of financial position is as follows:

Apply consolidation procedures

Translate RSL Fair value Pre- Goodwill at Fair value Excess Intragroup NCI share NCI share
RMB financial adjustment acquisition closing rate adjustment depreciation loan of retained of FCTR
statement into equity at closing profits
HK$ rate

CEL RSL RSL (W1) (W2) (W3) (W4) (W5) (W6) (W7) (W8) Consolidated

HK$’mil RMB’mil e/r HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil
FINANCIAL REPORTING

Property, plant 493.0 170.0 1.28 217.60 (18.300) (0.900) 6.400 697.800
and equipment

Investment in 170.0 - 1.28 - (170.000) -

subsidiaries

Goodwill 4.537 0.223 4.761

Deferred tax 10.0 - 1.28 - 4.575 0.225 (1.600) 13.200

assets

Inventory 70.0 20.0 1.28 25.60 95.600

1706
Trade and other 107.0 115.0 1.28 147.20 (15.000) 239.200
receivables

Total assets 850.0 305.0 390.40 1,050.561

Share capital 250.0 100.0 1.22 122.00 (122.000) 250.000

Retained
earnings

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M11_c31.indd 1707
Apply consolidation procedures

Translate RSL Fair value Pre- Goodwill at Fair value Excess Intragroup NCI share NCI share
RMB financial adjustment acquisition closing rate adjustment depreciation loan of retained of FCTR
statement into equity at closing profits
HK$ rate

CEL RSL RSL (W1) (W2) (W3) (W4) (W5) (W6) (W7) (W8) Consolidated

HK$’mil RMB’mil e/r HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil

: opening 400.0 105.0 1.22 128.10 (128.100) 400.00

retained
earnings

: profit for 100.0 50.0 1.25 62.50 3.281 (18.750) 147.031

the year

Business (13.725) 13.725 -

combinations
reserve

Translation 13.80 0.223 (0.4725) 0.079 (4.1) 9.489

reserve

Owners of the 750.0 255.0 326.40 806.521

1707
parent

Non-controlling - 70.913 (0.2025) 1.440 18.750 4.1 95.040

interests

Total equity 750.0 255.0 326.40 901.561

Bank and other 100.0 26.0 1.28 33.28 (15.000) 118.280

loans

Deferred tax - 24.0 1.28 30.72 30.720

liabilities

Total liabilities 100.0 50.0 64.00 149.000

Total liabilities 850.0 305.0 390.40 1,050.561

and equity
F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

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M11_c31.indd 1708
CEL’s statement of profit or loss and other comprehensive income is as follows:

Apply consolidation procedures

Translate RSL Fair value Pre- Goodwill at Fair value Excess Intragroup NCI share NCI share
RMB financial adjustment acquisition closing rate adjustment depreciation loan of retained of FCTR
statement into HK$ equity at closing profits
rate

CEL RSL RSL (W1) (W2) (W3) (W4) (W5) (W6) (W7) (W8) Consolidated

HK$’mil RMB’mil e/r HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil

Statements of profit or loss and other

FINANCIAL REPORTING

comprehensive income

Revenue 170.0 125.0 1.25 156.25 326.250

Foreign (3.0) 6.0 1.25 7.50 4.500

exchange gain/
(loss)

Depreciation (50.0) (15.0) 1.25 (18.75) 6.250 (62.500)

expense

Other expenses (5.0) (56.0) 1.25 (70.00) (75,000)

1708
Profit before tax 112.0 60.0 75.00 193.250

Income tax (12.0) (10.0) 1.25 (12.50) (1.563) (26.063)

expense

Profit after tax 100.0 50.0 62.50 167.188

Other
comprehensive
income

Fair value 13.80 0.223 (0.675) 0.113 13.461

gain/(loss) on
translation

Other 13.80 13.461

comprehensive
income

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M11_c31.indd 1709
Apply consolidation procedures

Translate RSL Fair value Pre- Goodwill at Fair value Excess Intragroup NCI share NCI share
RMB financial adjustment acquisition closing rate adjustment depreciation loan of retained of FCTR
statement into HK$ equity at closing profits
rate

CEL RSL RSL (W1) (W2) (W3) (W4) (W5) (W6) (W7) (W8) Consolidated

HK$’mil RMB’mil e/r HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil HK$’mil

Total 100.0 50.0 76.30 180.648

comprehensive
income

Profit for
the year
attributable to:

Owners of 100.0 50.0 62.50 3.281 (18.750) 147.031

the parent

Non- 1.406 18.750 20.156

controlling

1709
interests

Profit for the 100.0 50.0 62.50 167.188

year

Total comprehensive
income attributable to:

Owners of 100.0 50.0 76.30 0.223 (0.4725) 3.360 (18.750) (4.1) 156.521
the parent

Non- (0.2025) 1.440 18.750 4.1 24.128

controlling
interests

Total 100.0 50.0 76.30 180.648

comprehensive
income
F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

10/27/2022 10:00:43 PM
 FINANCIAL REPORTING

References for the consolidation worksheets:

Debit Credit
HK$m HK$m
W1 DTA (25% × RMB15 × 1.22) 4.575
Business combinations reserve 13.725
PPE (RMB15 × 1.22) 18.300

W2 Share capital (RMB100 × 1.22) 122.000

Retained earnings (RMB105 × 1.22) 128.100
Goodwill (RMB3.72 × 1.22) 4.537
Business combinations reserve 13.725
Investment in subsidiary 170.000
NCI – equity (58.1 × 1.22) 70.913

Goodwill: RMB
Consideration (HK$170/1.22) 139.344
NCI (30% × 193.75) 58.125
197.469
less: Fair value net assets (193.750)
(205 – 15 + 3.75)
Goodwill on acquisition 3.719

W3 Goodwill (RMB3.72 × (1.28 – 1.22) 0.223

FCTR (OCI) 0.223

W4 FCTR (OCI) 0.675

DTA (RMB3.75 × (1.28 – 1.22)) 0.225
PPE (RMB15 × (1.28 – 1.22)) 0.900
Translation loss on fair value adjustment.

NCI – equity (30% × 0.675) 0.203

FCTR (OCI) 0.203
Assign NCI share of translation loss on retranslating the fair value adjustment
on acquisition

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 F oreig n Ex chang e an d Consoli dation of F orei g n O p erations

Debit Credit
HK$m HK$m
W5 PPE (RMB5 × 1.28) 6.400
Income tax expense (RMB1.25 × 1.25) 1.563
Depreciation expense (RMB5 × 1.25) 6.250
DTA (RMB1.25 × 1.28) 1.600
FCTR (OCI) 0.113
Excess depreciation = 15/3years = 5p.a.
Related tax = 25% × 5 = 1.25

Profit attributable to NCI (30% × (RMB5 – 1.406

RMB1.25) × 1.25)
FCTR (OCI) (30% × 0.113) 0.034
NCI – equity 1.440
Assign NCI share of the consolidation adjustment

W6 Loan payable to CEL (RMB11.7 × 1.28) 15.000

Loan receivable from RSL 15.000

W7 Profit attributable to NCI (30% × RMB50 * 1.25) 18.750

NCI – equity 18.750
Attribute profit to NCI

W8 FCTR (OCI) (30% × HK$13.8) 4.1

NCI – equity 4.1
Attribute translation gain on translating RSL’s net assets to NCI

CEL’s consolidated statement of changes in equity is as follows (prepared using the

information from the consolidated statement of financial position and consolidated
statement of profit or loss and other comprehensive income)

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 FINANCIAL REPORTING

Consolidated statement of changes in equity

Share Retained FCTR Total Non- Total
capital earnings HK$m HK$m controlling equity
HK$m HK$m interests HK$m
HK$m
Balance at 1 250.00 400.00 – 650.00 – 650.00
January 20X1
Profit for the year – 147.03 – 147.03 20.16 167.19
Other – – 9.49 9.49 3.97 13.46
comprehensive
income for the
year
Total – 147.03 9.49 156.52 24.13 180.65
comprehensive
income for the
year
Acquisition of – – – – 70.91 70.91
subsidiary
Balance at 31 250.00 547.03 9.49 806.52 95.04 901.56
December 20X1

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 32
Investments
in Associates

CHAPTER TOPIC LIST

32.1 Investments in Associates 32.4.2 Implicit Goodwill and Fair

Overview Value Adjustments
32.1.1 Scope of HKAS 28 (2011) 32.4.3 Distributions and Other
32.1.2 Terminology Adjustments
32.2 Significant Influence 32.4.4 Impairment
32.4.5 Loss-making Associates
32.3 Equity Method 32.4.6 Disposal of an Associate
32.3.1 F inancial Statements in 32.4.7 Deferred Taxes
Which the Equity Method
32.5 Presentation and Disclosure
Is Applied
32.5.1 P resentation of Investments
32.3.2 Exemption from the Equity
in Associates
Method of Accounting
32.5.2 Disclosure of Investments in
32.4 Application of the Equity Associates
Method
32.4.1 Basic Principles
32.6 Current Developments

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO32: P
 REPARE, PRESENT AND APPRAISE GROUP FINANCIAL STATEMENTS WITH
COMPLEX GROUP STRUCTURES
LO32.01: C
 onstruct the financial statements for a group in accordance with Hong Kong Financial
Reporting Standards and statutory reporting requirements: Investments in associates
32.01.01 Describe an associate
32.01.02 Analyse significant influence and apply the principle to classify an associate
32.01.03 Analyse the reasons for, and impact of, equity accounting, including purchase price
allocation on initial acquisition, fair value adjustments, upstream and downstream
transactions, and uniform accounting policies
32.01.04 Account for investors’ share of losses of an associate in excess of its investments in
associates
32.01.05 Explain the impairment test and related treatments for investments in associates
32.01.06 Account for the disposal of an associate
32.01.07 Prepare and appraise the disclosure in respect of investments in associates
PRINCIPAL LO32: A
 PPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT
FOR BUSINESS TRANSACTIONS
LO32.02: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to income taxes
32.02.01 Account for deferred tax relating to investments in subsidiaries, associates and
joint ventures

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 I n v estments in A ssociates

OPENING CASE

THE SOLEIL GROUP

I ntroduced in earlier chapters, the Soleil group operates an extensive global logistics network
across 600 locations in more than 50 countries. The group provides a diverse range of
transport and logistics solutions covering road, air, sea and rail to meet global supply chain
needs. The ultimate parent entity in the group is Soleil Limited (Soleil).

Soleil is always on the lookout for strategic expansion opportunities. This may involve
acquiring existing businesses to gain entry into new geographical markets, eliminate local
competition, introduce a new service offering to the group’s customers or improve its back-end
operational capabilities. In some cases, Soleil expands its operations through entering into a
business relationship with one or more other investors to trial a new business venture either by
setting up a new company or acquiring an associate ownership interest in an existing company.

Soleil conducts part of its operations via its associates Comet Limited (Comet), Halley
Limited (Halley) and Bopp Limited (Bopp). Comet operates as a data and analytics solutions
specialist, offering business strategy tools, customer and market insight data assets, media
segmentation engines and more to companies. Halley and Bopp sell cloud-based warehouse
management solutions and other supply chain management tools.

The Soleil group structure includes in part (the percentages reflect the proportionate
shareholding):

Soleil Limited

100% 25%

Mercury Limited Bopp Limited

30% 5% 20%

6%
Comet Limited Halley Limited

In addition to its existing 20% direct shareholding in Halley, Soleil holds a call option giving
it the option to acquire a further 27% interest in Halley in two years’ time.

Soleil accounts for its associates using the equity method of accounting in its consolidated
financial statements.

The relevant tax rate is 16.5%. Investment income and capital gains are not taxable.

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 FINANCIAL REPORTING

OVERVIEW

In Chapters 29 and 30, you were introduced to the accounting for merger and acquisition (M&A)
activity and how to prepare consolidated financial statements. In this chapter, you will learn
how to account for another type of entity: an entity’s interest in an associate. The accounting
for associates is primarily specified by HKAS 28 (2011) Investments in Associates and Joint
Ventures and HKFRS 12 Disclosure of Interests in Other Entities.

An associate is an entity over which an investor (being the entity holding the ownership
interest) has significant influence. An investor often accounts for such interests in its financial
statements using the equity method of accounting. Applying the equity method of accounting
recognises that the investor’s interest in the associate is something more significant than just a
financial investment.

For example, we are told that Comet, Halley and Bopp are associates of Soleil Limited
and are reported in the Soleil consolidated financial statements using the equity method of
accounting. But how does Soleil determine that these companies are its associates? And what
is the equity method of accounting? By the end of this chapter, you will gain an understanding
of what is an associate and will be able to analyse whether significant influence is present in a
relationship. You will appreciate the reasons for requiring the equity method of accounting, and
in applying the equity method of accounting understand the impacts of the accounting method
on financial statements (including tax effects). This chapter also discusses how to account
for impairment, loss-making associates and the disposal of an associate. In addition, you will
become familiar with the information an investor discloses about its associates.

This chapter introduces the equity method of accounting. It does not deal with some of the
complications that may arise in practice in applying the equity method, for example, accounting
for step acquisitions of associates, reciprocal interests, transactions between associates and
distributions from pre-acquisition profits. This chapter does not address the accounting for
associates that are foreign operations.

3 2 . 1 INVESTMENTS IN ASSOCIATES OVERVIEW

An investor (the reporting entity) may have an ownership interest in another entity (the
investee) that is more than a passive investment interest but does not give it control over that
other entity. Such entities are described as associates of the entity.

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 I n v estments in A ssociates

The accounting for an entity’s investments in its associates is primarily detailed in Hong
Kong Accounting Standard (HKAS) 28 (2011) Investments in Associates and Joint Ventures and
Hong Kong Financial Reporting Standard (HKFRS) 12 Disclosure of Interests in Other Entities.
HKAS 28 (2011) prescribes the accounting for investments in associates and sets out the
requirements for the application of the equity method when accounting for investments
in associates. HKFRS 12 details the disclosures that an entity makes of its investments in
associates.

This section explains the scope of HKAS 28 (2011), describes an associate and introduces
the method of accounting that generally applies to these interests.

32.1.1 Scope of HKAS 28 (2011)

HKAS
28.3 HKAS 28 (2011) applies to all entities that have significant influence over an investee.

This accounting standard is historically associated with the accounting for investments in
associates. However, in its currently effective version (2011), the scope of the standard extends
beyond the accounting for an entity’s associates: it applies also to entities that are investors
with joint control, as certain such investors must account for their jointly controlled investments
in a similar manner to those entities that have significant influence over an investee. The
accounting by investors with joint control is discussed in Chapter 33 by cross-reference back to
the specified accounting in this chapter.

32.1.2 Terminology
Before proceeding, as this chapter concerns the accounting for investments in associates, it is
necessary to understand the term ‘associate’ and some related terms.

HKAS An associate is an entity over which an investor has significant influence, usually evidenced
28.3 through the extent of its ownership interest. An investor does not consolidate an associate.
Instead, with limited exceptions, an investor accounts for its ownership interest in the associate
in its financial statements using the equity method of accounting.

What significant influence means and how to determine whether an investor has significant
influence over another entity is discussed in Section 32.2. The equity method of accounting is
discussed in Sections 32.3 and 32.4.

In addition to its ownership interest in an associate, an investor may also hold other
interests in the associate. An investor’s net investment in its associate is the sum of its:

• Equity-accounted carrying amount of the investment; and

• Any long-term interests that in substance form part of the investor’s net investment in
the associate. Examples of long-term interests include preference shares and
unsecured loans to the associate for which repayment is not planned or likely to occur
but do not include secured receivables as the investor can recover these amounts
through the collateral pledged by the associate. Any long-term interests are accounted
HKAS for in accordance with HKFRS 9 Financial Instruments (see Chapter 12) before being
28.14A, 38 accounted for in accordance with HKAS 28 (2011) (see Sections 32.4.3 and 32.4.4).

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 FINANCIAL REPORTING

As illustrated in Exhibit 32.1, in practice, associates are normally regarded as being a ‘group
entity’. However, as mentioned in Chapter 30, strictly under HKFRSs, a group includes only
the parent and its subsidiaries. Therefore, an entity with investments in associates (and/or
joint arrangements) but without an investment in a subsidiary is not part of a group and does
not prepare group financial statements (consolidated financial statements). Instead the entity
prepares equity-accounted financial statements. This module assumes consolidated financial
statements will be prepared as the investor holds investment in a subsidiary or in subsidiaries;
however, a (consolidation) worksheet might similarly be used to prepare equity-accounted
financial statements.

Associate
(Chapter 32)
Parent

Joint
arrangement
(Chapter 33)
Subsidiary
(Chapter 30)

‘Group’ as commonly understood in practice

‘Group’ as defined by HKFRS 10

EXHIBIT 32.1 Entities in a group

3 2 . 2 SIGNIFICANT INFLUENCE

The assessment of whether an investor has significant influence over another entity is made
throughout the duration of the investor’s investment in that other entity (i.e. not just at
inception). An entity has significant influence over another entity when it has:

• The power (i.e. the rights) to participate in the financial and operating policy decisions
of that other entity; but
HKAS
28.3 • That power is insufficient to give the entity control or joint control of those policies.

HKAS An investor ceases to have significant influence when it loses that power. Similar to control
28.9 (see Chapter 30), this may occur without a change in the entity’s shareholding.

Indicators that an entity has the power to participate in the financial and operating policy
decisions of another entity include:

• Representation on the board of directors of that other entity;

• Participation in that other entity’s policy-making processes, including decisions about

dividends or other distributions;

• Material transactions between the two entities;

• Interchange of managerial personnel; and

HKAS
28.6 • Provision of essential technical information.

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 I n v estments in A ssociates

Exhibit 32.2 illustrates the ownership interest generally associated with different ‘levels’ of
investment (see also Exhibit 30.2 in Chapter 30). The rebuttable presumption in HKAS 28 (2011)
is that an entity holding (meaning controlling) directly or indirectly through its subsidiaries:

• ≥ 20% of the voting power of another entity has significant influence over that other
entity; and

HKAS • < 20% of the voting power of another entity does not have significant influence over
28.5 that other entity.

Joint arrangement
(Chapter 33)

Financial asset Associate Subsidiary

(Chapter 12) (Chapter 32) (Chapter 30)

20% 50% Ownership interest

EXHIBIT 32.2 Type of investment and its generally

associated ownership interest

This module assumes that voting power is demonstrated by the ownership interest.
However, this may not always be true in practice.
An investor holding 50% or more of the voting power of another entity would normally
have control or joint control, rather than just significant influence, over that other entity.
In such cases, the investor has the power (or co-power) to direct the relevant activities of
the investee (compared to merely being able to participate in the financial and operating
policy decision-making process). As such, the investor must account for the other entity
as a subsidiary (or joint arrangement) in accordance with HKFRS 10 Consolidated Financial
Statements or HKFRS 11 Joint Arrangements as appropriate. (Unlike HKAS 28 (2011), neither
HKFRS 10 nor HKFRS 11 take a rebuttable presumption approach but emphasises the
existence of control.)

Conversely, an investor holding less than 20% of the voting power of another entity would
normally be unable to significantly influence that other entity. In these cases, the investor
treats the investment as a financial asset within the scope of HKFRS 9 Financial Instruments
and measures it at fair value, either fair value through profit or loss or fair value through other
comprehensive income (see Chapter 12).

The rebuttable presumptions in HKAS 28 (2011) can be challenged if the evidence suggests
otherwise, for example:

• An investor’s ownership interest in an associate under administration does not

change but the entity may no longer have the power to participate in the financial
and operating policy decisions of the associate as the power now lies with the
administrator;

HKAS
• A contractual arrangement may provide evidence of an investor’s ability to significantly
28.5 influence another entity even though it holds less than 20% ownership interest; and

• In addition to its ownership interest, the investor holds currently exercisable potential
voting rights in the other entity.

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 FINANCIAL REPORTING

When assessing whether an entity has significant influence, potential voting rights
(e.g. share options, convertible notes) that are exercisable or convertible, including potential
voting rights held by other entities, must be considered. All facts and circumstances are
considered, except:

• Management’s intention; and

HKAS • The entity’s financial ability to convert the rights. When assessing control, the entity’s
28.7–8 financial ability to convert the rights is considered (see Chapter 29).

Illustrative Example 1
In addition to its existing 20% direct shareholding in Halley, Soleil holds a call option
giving it the option to acquire a further 27% interest in Halley in two years.

When evaluating whether it has significant influence over Halley (and, therefore,
whether Halley is an associate of the Soleil group), Soleil does not take consider the call
option it holds to acquire a further 27% interest in Halley in two years because that call
option is not exercisable. However, in two years, when the call option becomes exercisable,
it could change Soleil’s assessment of whether it has significant influence or control
over Halley.

The standard acknowledges an investor can still significantly influence another entity in
HKAS instances where the remaining ownership interest is held by a single investor that controls all
28.5 the financial and operating decisions of that other entity. For example, recall from Chapter 29
that Soleil acquired a controlling interest in Polaris Limited (Polaris). If the non-controlling
interest (NCI) in Polaris was held by a single investor, that investor might consider it appropriate
to treat Polaris as an associate despite Soleil having the controlling interest and consolidating
the company.

Apply and Analyse 1

Soleil holds 30% of Comet’s ordinary shares indirectly through its wholly owned subsidiary
Mercury, giving it 30% of the voting power of Comet. Comet’s constitution provides that
five out of its six directors must agree on any capital investment decisions in excess
of HK$3 million, and that 75% of its shareholders must ratify any dividend proposal.
In addition:

• The Soleil group has the right to nominate two of the six directors of Comet;

• There are inter-company transactions between Comet and other entities in the
group. Soleil estimates that about 2% of Comet’s trade is with the Soleil group; and

• There is an interchange of senior managerial personnel between Comet and Soleil.

Determine whether Comet is appropriately classified as an associate of Soleil.

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 I n v estments in A ssociates

Apply and Analyse 1 (continued)

Analysis

On the basis of its 30% ownership interest, Comet is an associate of Soleil. However, in
accordance with HKAS 28 (2011), this presumption is rebuttable where evidence suggests
otherwise. Accordingly, Soleil must also consider whether facts and circumstances would
lead Soleil to a different conclusion.

On review of the relevant facts and circumstances, Soleil observes that it does not
engage in any material transactions with Comet and, as such, is unlikely to have power
to participate in the financial and operating policy decisions of Comet through Comet’s
reliance on its trading support. However, Soleil observes:

• The Soleil group has the right to nominate two of the six directors of Comet;

• There is an interchange of senior managerial personnel between Comet and Soleil;

• The participation of Soleil-appointed directors is required to approve certain capital

investments; and

• Soleil can stop a dividend distribution.

Soleil’s 30% ownership and its right to nominate two of the six directors are insufficient
to enable it to compel Comet to act in a particular manner in relation to its relevant
activities. For example, the four other directors could vote together in a manner that does
not benefit Soleil. That is, the facts and circumstances do not provide evidence to lead
Soleil to conclude it has control of Comet. However, the available facts and circumstances
provide evidence supporting the rebuttable presumption that Soleil has the power to
participate in Comet’s financial and operating policy decisions, rather than providing
evidence that suggests that the group’s share of voting power of Comet does not give rise
to significant influence.

Hence, Soleil concludes that, on the basis of the available evidence, Comet is
appropriately classified as an associate of the Soleil group.

Apply and Analyse 2

Assume the remaining 70% of Comet’s ordinary shares is held by a single shareholder,
Titian Limited (Titian). Titian is not a related entity of the Soleil group. Titian has determined
it controls Comet and prepares financial statements in which Comet is consolidated.

Determine whether Comet would still be identified as an associate of Soleil in

this instance.

Analysis

On balance, regarding its ownership interest and its degree of engagement with Comet,
Soleil could still classify Comet as its associate. This is because Soleil could still influence
Comet through the directorships and its voting power in relevant financial and operating
policy decisions (capital investment and dividend approvals).

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 FINANCIAL REPORTING

Knowledge Check Questions

Question 1
Identify which of the following statements is true.
A An investor holding a 25% interest in another entity must apply the equity method of
accounting to account for that investment.
B An investor holding an 18% interest in another entity can be presumed not to have
significant influence over that other entity.
C An investor considers its ability and intention to exercise a potential voting right in its
assessment of whether it has significant influence over another entity.
D An investor has significant influence over another entity when it has power that gives it
the ability to direct activities of the other entity that affect the investor’s variable returns
and the ability to use that power.

Question 2
Identify in which of the following situations DEF Ltd is, prima facie, likely to be able to
significantly influence the investee.
A DEF Ltd and Investor S hold 15% and 24% of the voting power, respectively, in LMN Ltd.
DEF Ltd and Investor S have agreed to vote similarly in all cases.
B DEF Ltd holds 23% of the voting power in PQR Ltd. The remaining shareholding in PQR
Ltd is widely dispersed with no one other shareholder holding more than 15%.
C DEF Ltd and Investor Q hold 25% and 30% of the voting power, respectively, in XYZ Ltd.
ABC Ltd and Investor Q have a contractual agreement that gives DEF Ltd control over
Investors Q’s vote.
D DEF Ltd holds 18% of the voting power in STU Ltd. Investor Tu holds the remaining 82%
voting power. The CEO and CFO of DEF Ltd are also the CEO and CFO of STU Ltd. In
addition, a contractual agreement gives DEF Ltd the right to appoint two out of the six
board directors of STU Ltd.

3 2 . 3 EQUITY METHOD

HKAS 28 (2011) posits that because an investor has significant influence over an associate,
it has contributed to the associate’s performance and, accordingly, should reflect this in its
financial statements. Hence, with limited exceptions (discussed in Section 32.3.2), an investor
must account for an associate using the equity method of accounting (also referred to as equity
accounting) from the time it gains significant influence over the investment until such time as
the investor loses significant influence (e.g. through disposal or gaining control).

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 I n v estments in A ssociates

The equity method is a way of recognising that users of financial statements are likely to
HKAS want more information about the periodic performance of an associate beyond the dividend
28.11 return, commensurate with the investor’s extent of interest in that associate. Under the
equity method:

• The investment is initially recognised at cost; and

• Is adjusted thereafter for the post-acquisition change in the investor’s share of the
associate’s net assets.

HKAS Under the equity method, the investor’s comprehensive income includes its share of the
28.3 associate’s profit or loss and other comprehensive income.

Key Learning Point

It may be helpful to think of the carrying amount of the investment in associate as
being ‘revalued’ each reporting period, with the extent of the movement determined by
adjustments necessary to reflect the investor’s share of the post-acquisition change in the
associate’s net assets.

32.3.1 Financial Statements in Which the Equity Method Is Applied

Where HKAS 28 (2011) requires an associate to be accounted for using the equity method, the
equity method of accounting is applied to account for an associate in an investor’s:

• Consolidated financial statements – financial statements prepared by a parent

(e.g. those prepared by Soleil in respect of the Soleil group);

• Equity-accounted financial statements – financial statements prepared by an entity

that holds an interest in an associate but that is not a parent (e.g. those prepared by
Mercury that include Mercury’s associate Comet and Mercury’s financial investment in
Halley); and

• But not necessarily in the investor’s separate financial statements – financial statements
prepared by the investor where the associate is treated as an ‘investment asset’ rather
than ‘something more’.

In the investor’s separate financial statements, the associate may be measured:

• At cost;

• In accordance with HKFRS 9 (see Chapter 12); or

HKAS
27.10 • By applying the equity method.

The same accounting policy should be applied to account for all associates; it is not an
associate-by-associate choice.

Consequently, an investor must decide how it intends to maintain its records if it needs
to distinguish between the different measurement bases that apply to its presented financial
statements. Some entities may use a consolidation worksheet to record post-acquisition
movements related to its net investment in an associate. Other entities may post these
movements directly in their accounting records. Accordingly, the journal entries (or proforma

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 FINANCIAL REPORTING

journal entries) that are recorded could differ between entities. Care should be taken to
understand the appropriate journal entries that will need to be recorded.

As illustrated in this chapter, where a consolidation worksheet is used, consolidation

adjustments are made to ‘update’ the carrying amount of the investment in the investor’s
separate financial statements (in this chapter, assumed to be at cost) to the equity-accounted
amount. The difference from posting the movements directly into the accounting records is
that, in this case, an extra journal entry is required to capture the prior periods’ movements
to the investment balance (e.g. to increase the carrying amount by the investor’s share of the
associate’s profits of earlier periods).

32.3.2 Exemption from the Equity Method of Accounting

Some entities are exempted (if they so choose) from accounting for their interest in an
associate using the equity method of accounting. The exceptions relate to the nature of the
company or its circumstances, whereby a different measurement basis was considered by the
HKAS standard-setter to provide more relevant and decision-useful information to users of the
28.17–18 financial statements (or for cost-benefit reasons).

The flowchart in Exhibit 32.3 summarises the accounting by an investor for its associate.
This flowchart similarly applies to a joint venturer’s investments in joint ventures (refer to
Chapter 33).

And/Or Is the investor a wholly- No Is the investor a partially-

The investor Is the investor a parent?
has significant owned subsidiary? owned subsidiary?
influence over
the entity Yes Yes Yes No

Does HKFRS 10 exempt Do its other owners

the investor from preparing Is the investor traded on No object to the equity
consolidated financial a public market?
method not being
statements because Yes (e.g. listed securities)
applied?
it is a unlisted subsidiary
meeting specified
No
criteria?* Yes
(see Chapter 30)
Has the investor filed (or is
No in the process thereof) its Account for the investment
financial statements with Yes
in the associate using the
a securities commission or equity method
Is the investor a venture other regulatory organisation in consolidated/’equity
capitalist, mutual fund, unit for the purpose of issuing its accounted financial
trust, investment-linked instruments in a public market? statements’
insurance fund or similar, (i.e. is the investor about
or does it indirectly hold to list its securities?)
its investment in the
associate through one No
of these entities?
Does a parent (ultimate/
intermediate) produce publicly
Yes No
available IFRS/HKFRS
compliant financial statements Account for the investment
Account for the investment Account for the in which subsidiaries are in the associate in separate
in the associate in investment in the consolidated or measured at financial statements (if
consolidated financial associate in fair value through profit or loss? presented) by:
statements by: consolidated • Equity method; or
• Equity method; or financial Yes • Fair value through profit
• Fair value through profit statements using or loss (HKFRS 9)#; or
or loss (HKFRS 9) the equity method The investor is not required to • Cost
apply the equity method

* The criteria mirror those shown in this flowchart applying to an entity that is a wholly/partially-owned subsidiary.
# An investment measured in consolidated financial statements at FVTPL must be measured in the same way in the separate financial statements.

EXHIBIT 32.3 Accounting by an investor for its associate

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 I n v estments in A ssociates

As shown in Exhibit 32.3, an investor that is a venture capital organisation, mutual fund,
unit trust, or similar entity has an accounting policy choice. HKAS 28 (2011) permits the
investor to make the election whether to measure its investment in an associate at fair value
HKAS through profit or loss (or using the equity method) separately for each associate, at initial
28.18 recognition of the associate. That is, it is an investment-by-investment decision. This
exemption applies to a broader group of entities than those meeting the definition of an
investment entity.

An entity’s investment in an associate may be held indirectly only partially through an entity
that is a venture capital organisation, mutual fund, unit trust, or similar entity. In these
instances, HKAS 28 (2011) permits the investor to apply a split treatment to the investment to
HKAS (1) measure the interest held by the venture capitalist or similar entity at fair value through
28.19 profit or loss, and (2) the remaining interest using the equity method.

3 2 . 4 APPLICATION OF THE EQUITY METHOD

In this section, you will learn how to apply the equity method of accounting.

32.4.1 Basic Principles

Equity accounted investment

Cost x,xxx
Recognised in the investor’s
+ Share of associates net profit for the period x,xxx
profit or loss
+ Share of associates other comprehensive income for the period x,xxx
– Dividends received form associate x,xxx Recognised in the investor’s
+/– Other changes in net assets x,xxx other comprehensive income
Equity accounted carrying amount x,xxx

Recognised in the investor’s statement of financial position

EXHIBIT 32.4 Equity-accounted investment

As illustrated in Exhibit 32.4, the equity method is based on the following principles:

• The initial investment is brought to account at cost;

• The carrying amount of the investment is adjusted by the investor’s share

of an associate’s post-acquisition after-tax profits and losses and other
comprehensive income;

• The carrying amount of the investment is reduced by dividends received and receivable
from the associate;

• The investor’s share of the associate’s post-acquisition profits and losses is recognised
in the investor’s profit or loss, and its share of the associate’s post-acquisition
movements in other comprehensive income is recognised in the investor’s other
comprehensive income. These amounts may differ from adjusting the carrying amount
of the investment (this is discussed further in Section 32.4.2.2); and

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 FINANCIAL REPORTING

• The carrying amount of the investment or the investor’s share of an associate’s

post-acquisition profits and losses and other comprehensive income is adjusted to
eliminate the investor’s share of unrealised gains and losses arising on transactions
between itself and its associate.

The cost of an investment is not explicitly defined in the standard. However, practice
is to measure cost as the purchase price of the investment plus any directly attributable
expenditures necessary to obtain the investment unless classified in the separate financial
statements as at fair value through profit or loss. This is consistent with the measurement of
the investment asset as a financial asset within the scope of HKFRS 9 Financial Instruments.

Before proceeding any further, to be able to apply the equity method of accounting, the
following must be first appreciated: (1) features of an associate’s post-acquisition profits and
losses and other comprehensive income, and (2) determination of the investor’s ownership
interest for the purposes of being able to calculate its ‘share’ of the associate.

32.4.1.1 An Associate’s Profits and Losses and Other Comprehensive Income

An investor is unlikely to have the same degree of access to an associate’s financial records
as it is to a subsidiary. Hence, rather than considering the results and financial position of
each entity controlled (or equity-accounted) by the associate separately as in the case of
consolidating a subsidiary, the investor starts its accounting from the reported consolidated
financial statements of the associate.

Under the equity method of accounting, the investor recognises its share of its associate’s
after-tax (consolidated) profits and losses and other comprehensive income. The associate’s
financial statements used in determining these amounts must be:

• Adjusted for the effect of different accounting policies between the associate and the
investor, if any; and

• The most recently available financial statements and of the same date as the financial
statements of the investor unless impracticable. A difference of up to three months is
HKAS possible, but the associate’s financial statements must be adjusted to reflect the effect
28.33–36 of significant transactions and events that occur during this period.

This is so the investor’s financial statements are prepared using uniform accounting
policies for like transactions and events in similar circumstances and reflect results and the
financial position for similar periods. One exception to the requirement is for an investor to
adjust its associate’s financial statements so they reflect the application of accounting policies
similar to its own: An investor that holds an investment in an associate that is an investment
entity may retain the fair value measurement applied by the associate to the associate’s
subsidiaries.

For the purposes of teaching, this chapter assumes the associate’s accounting policies and
reporting periods align with those of the investor.

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32.4.1.2 The Investor’s Share of an Associate

Applying the equity method of accounting requires the investor to determine its ‘share’ of the
profit or loss and other comprehensive income of its associate. In most cases, the investor’s
share of an associate is based on the cumulative present ownership interest held by the
investor and its subsidiaries. It ignores:

• The possible conversion of potential voting rights or other derivatives containing

potential voting rights (e.g. share options, convertible notes and other similar
instruments) except in limited circumstances; and
HKAS 28.12,
13, 27 • Any ownership interest held by other associates or joint ventures in the group.

Where potential voting rights or other derivatives containing potential voting rights form
HKAS part of the investor’s share of its associate, those financial instruments are not also separately
28.14 recognised and measured in accordance with HKFRS 9.

Apply and Analyse 3

Regarding the ownership structure of the Soleil group, determine Soleil’s ownership
interest in its associate Halley (see the relevant company structure below). Remember that
Soleil holds a call option giving it the option to acquire a further 27% interest in Halley in
two years.

Soleil Limited

100%

Mercury Limited 20%

30% 5%

6%
Comet Limited Halley Limited

Analysis

Soleil’s share of Halley is 25%, determined as its 20% direct ownership interest plus its 5%
indirect ownership interest through its subsidiary Mercury. Soleil calculates its share of
associate Halley’s profit or loss for the period as 25% × Halley’s profit or loss (similarly, for
other comprehensive income).

In accordance with HKAS 28 (2011), the group’s share of Halley excludes Soleil’s option
to acquire another 27% ownership interest in Halley as it is a potential voting right and
excludes Comet’s 6% ownership interest in Halley as only interests held by the parent and
its subsidiaries are considered.

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Apply and Analyse 4

Assume that Soleil only held a 90% interest in Mercury. Determine the group’s ownership
interest if this were the case.

Analysis

Soleil’s ownership share of Halley for the purposes of applying the equity method of
accounting does not change even if Soleil only partially owned Mercury (i.e. it is still 25%).
This is because the ownership interest is determined based on both interests held directly
by the parent (20%) and indirectly through its subsidiaries (5%).

However, now, a portion of the group’s share of Halley’s profits would be to

attributable to the group’s NCI.

Apply and Analyse 5

Explain whether Soleil’s determination of its ownership interest in Halley would change if
the call option was exercisable now rather than only in two years.

Analysis

Soleil’s ownership interest would not change if the call option was exercisable now.
Whether the call option is presently exercisable is unimportant for the purposes of
determining the investor’s ownership interest in the associate. This is because the key
feature for determining the investor’s ownership interest in the associate is the present
ownership interest held. An unexercised call option is not a present ownership interest but
is only a potential ownership interest.

In general, a call option, convertible note, or other similar instrument that is:

• Presently exercisable is considered in determining whether significant influence

exists but is not included in determining the investor’s present ownership interest
in the associate; and

• Not presently exercisable is not considered in determining whether significant

influence exists and is excluded from determining the investor’s present ownership
interest in the associate.

Key Learning Point

Subtle differences exist between the interests considered when determining whether
the investor has significant influence over its investee and the interests considered when
determining the investor’s ‘ownership share’ for the purposes of applying the equity
method of accounting.

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32.4.2 Implicit Goodwill and Fair Value Adjustments

The first step in equity accounting an associate is to recognise the investment at cost. In
addition, equity accounting requires the investor to understand the assets and liabilities
underpinning its investment.

For the purposes of equity accounting, the investor must determine whether it has paid a
premium representing goodwill or whether it has acquired the investment at a discount. Similar
to the accounting for a business combination (see Chapter 29), the investor does this by
HKAS determining the difference between its share of the net fair value (see Chapter 4) of the
28.32 associate’s identifiable assets and liabilities and the cost of the investment. Identifying whether
the investor has paid for goodwill or purchased the investment at a discount is important, as
their impacts on the financial statements vary.

The investor subsequently has regard to the notional fair values it has assigned to the
acquired assets and liabilities in the determination of its share of the associate’s profit or loss,
by reflecting this as additional or reduced depreciation and amortisation expenses.

Sections 32.4.2.1 and 32.4.2.2 explain how goodwill/discount and fair value adjustments
affect the equity-accounted carrying amount of the investment.

32.4.2.1 Implicit Goodwill

HKAS
28.32 Goodwill or the discount on acquisition is calculated as depicted in Exhibit 32.5. Unlike the
acquisition of a business, when calculating the goodwill or discount on acquisition of an
associate, there is no need to determine the share of the net assets belonging to other
investors. This is because the net assets of the associate are not recognised by the investor in
its statement of financial position; only the investor’s share of the net assets is recognised.

Goodwill % ownership Net fair value of identifiable assets

= Cost – ×
(or discount on acquisition) interest and liabilities of the associate

EXHIBIT 32.5 Calculating the implicit goodwill or discount

Apply and Analyse 6

On 1 January 20X1, Soleil acquired 30% of Comet through its wholly owned subsidiary,
Mercury. The fair value of Comet’s identifiable net assets on that date was HK$18,930,000.

Soleil applies the equity method of accounting to account for its investment in Comet
in its consolidated financial statements. Calculate the goodwill or discount on acquisition
arising if the consideration paid for Comet was HK$6 million and HK$5.5 million. Assume
no directly attributable costs were related to acquiring Comet.

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 FINANCIAL REPORTING

Apply and Analyse 6 (continued)

Analysis

Soleil’s ‘share’ of Comet is 30%, being its present ownership interest in the entity.

The goodwill or discount on acquisition is calculated as follows:

Consideration Consideration
HK$6million HK$5.5million
HK$’000 HK$’000
Cost of the investment 6,000 5,500
less: Share of net fair value of identifiable assets and (5,679) (5,679)
liabilities (HK$18,930,000 × 30%)
Goodwill/(discount) on acquisition 321 (179)

The difference between the cost of the investment and the entity’s share of the net fair
value of the associate’s identifiable net assets is treated as follows:

• Goodwill, which is included implicitly in the initial carrying amount of the investment.
The entity might make a note to record this but makes no further journal entry.
A separate ‘goodwill’ asset is not recognised; and

• Discount on acquisition, which is recognised in profit or loss as part of the entity’s share
HKAS of the associate’s profit or loss in the period in which the investment is acquired.
28.32 A corresponding debit entry is made against the investment in the associate.

Increasing the initial carrying amount of the investment by the amount of the discount
ensures the carrying amount of the investment at acquisition reflects ‘the investor’s share of
the net fair value of the associate’s identifiable assets and liabilities’.

Illustrative Example 2
Assume the consideration for Comet was HK$5.5 million. To initially recognise the
investment in associate in its consolidated financial statements, Soleil records the
following journal entries in its consolidation worksheet:

Debit Credit
HK$ HK$
Investment in associate (Comet) 5,500,000
Investment 5,500,000
(Reclassify the line item in Mercury’s financial statements as an investment in associate in
Soleil’s consolidated financial statements, as necessary. Note: this journal entry is not illustrated
in the remainder of this chapter.)

and

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 I n v estments in A ssociates

Illustrative Example 2 (continued)

Debit Credit
HK$ HK$
Investment in associate (Comet) 179,000
Share of associate’s profit or loss 179,000
(Recognise discount on acquisition of the associate)

Immediately subsequent to the acquisition, Soleil’s equity-accounted carrying amount

of its investment in Comet is determined as:

HK$’000
Cost of the investment 5,500
add: Share of associate’s profit 179
Carrying amount of the associate 5,679

32.4.2.2 Fair Value Adjustments

Like consolidation, the book values of the net assets acquired may not reflect their fair values.
The investor should make notional fair value adjustments to these net assets in determining
the goodwill or discount on acquisition. Also, in addition to adjusting the associate’s financial
statements to reflect uniform accounting policies and consistent reporting periods, an
investor’s share of an associate’s post-acquisition profit or loss is determined after adjusting
the associate’s results to capture the periodic changes related to fair value adjustments
reflected in the initial accounting for the associate. For example, an associate’s reported profit
or loss may need to be adjusted to reflect more or less depreciation expenses based on the
HKAS notional fair value attributed to property, plant and equipment on the date equity
28.32 accounting begins.

Apply and Analyse 7

(This is a continuation of the previous Apply and Analyse exercise.)

Comet’s identifiable net assets of HK$18,930,000 on acquisition date 1 January 20X1

included a plant that had a fair value of HK$239,521 higher than its recognised carrying
amount (a related deferred tax liability of HK$39,521 (HK$239,521 × 16.5%) also notionally
arises as the carrying amount is higher than its tax base). The plant has a remaining useful
life of 10 years and nil residual value and is depreciated on a straight-line basis.

Comet’s net profit for the period post-acquisition to Soleil’s reporting date of
31 December 20X1 is HK$980,000. The amount of other comprehensive income is nil.

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Apply and Analyse 7 (continued)

Determine the equity-accounted carrying amount of the investment in Comet in Soleil’s
consolidated financial statements on 31 December 20X1 if the consideration paid for
Comet had been HK$6 million. Assume a tax rate of 16.5%.

Analysis

The equity-accounted carrying amount of Soleil’s investment in Comet on 31 December

20X1 is:

HK$’000
Acquisition of associate (cost) 6,000
add: Share of associates’ net profit for the period (note 1) 288
add: Share of associates’ other comprehensive income for the period –
Investment in associate at the end of the period 6,288

Soleil records the following journal entries in its consolidation worksheet to recognise
its share of Comet’s profit or loss for the year and the additional notional depreciation
expense arising on the fair value adjustment:

Debit Credit
HK$ HK$
Investment in associate (Comet) 294,000
Share of associate’s profit or loss (30% × 980,000) 294,000

and

Debit Credit
HK$ HK$
Share of associate’s profit or loss (30% × 20,000 ) a
6,000
Investment in associate (Comet) 6,000
a
Additional notional depreciation = 239,521/10years = 23,952.
Additional notional tax deduction = 23,952 × 16.5% = (3,952).
Total adjustment = 20,000.

32.4.3 Distributions and Other Adjustments

An investor may receive returns from its associate in the form of dividends. Also, the investor
(or its subsidiaries) may engage in trade with the associate. When preparing consolidated
financial statements, an investor eliminates fully (i.e. 100%) the effects of intragroup
transactions, including any intragroup balances.

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However, when doing equity accounting, an investor recognises the gains and losses
resulting from ‘upstream’ and ‘downstream’ transactions between the associate and its investor
HKAS (or the investor’s subsidiaries) in its financial statements to the extent of unrelated investors’
28.28 interests in the associate.

Now, what does this mean and how is this done in practice? Is this the same as determining
and attributing to non-controlling interests (NCIs) its share of consolidated profit and net
assets? Sections 32.4.3.1 and 32.4.3.2 explain how dividend distributions and other transactions
between the associate and the investor affect the determination of the equity-accounted
carrying amount of the investment and/or the investor’s share of its associate’s profit or loss
and other comprehensive income.

32.4.3.1 Distributions from an Associate to the Investor

A dividend distribution from an associate to its investor is not recognised by the investor as
HKAS dividend income, but as a reduction in the carrying amount of the net investment in the
28.10 associate. This avoids double-counting of the profits of the associate because, under the equity
method, the investor recognises in profit or loss its share of the associate’s profit or loss and
other comprehensive income.

To give effect to the above, the entity processes the following pro-forma journal entry in
its consolidation worksheet to adjust the amounts recognised in the investor’s own financial
statements:

Debit Credit
HK$ HK$
Dividend income x,xxx
Investment in associate x,xxx

This module assumes no adjustment is necessary to account for the tax effect of this
adjustment because, under Hong Kong tax law, investment income is not taxed.

Apply and Analyse 8

Assume that on 20 September 20X1, Comet declared a dividend of HK$80,000 to Mercury
out of its post-acquisition profits. Determine how the previously calculated equity-accounted
carrying amount of Comet in Soleil’s consolidated financial statements on 31 December 20X1
is affected by this dividend, if the consideration paid for Comet was HK$6 million.

Analysis

Soleil recalculates its equity-accounted carrying amount of its investment in Comet on

31 December 20X1 as:

HK$’000
Acquisition of associate (cost) 6,000
add: Share of associate’s net profit for the period (Section 32.4.2.2) 288
less: Dividends declared during the period (80)
Investment in associate at the end of the period 6,208

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32.4.3.2 Other Inter-company Transactions Between the Investor and the Associate
Inter-company transactions between the investor (or its subsidiaries) and its associate are
upstream (associate to investor) or downstream transactions (investor to associate). As
mentioned at the start of Section 32.4.3, when doing equity accounting, gains and losses
resulting from these transactions are recognised in the investor’s financial statements only to
the extent of unrelated investors’ interests in the associate. That is, the investor’s share of the
HKAS (after tax) gain or loss must be eliminated to the extent it is (from the investor’s perspective) not
28.28 yet earned (‘unrealised’) because the entity is in effect transacting with itself.

HKAS 28 (2011) is unclear about how the requirement to eliminate the investor’s share of
unrealised gains and losses from upstream and downstream transactions between the investor
and its associates is to be entered in the financial statements. As a result, practice varies. The
approach adopted usually reflects the practitioner’s view of the equity method as a valuation
methodology or a para consolidation exercise.

Some view an appropriate approach (‘the first approach’) to be for upstream and
downstream unrealised gains and losses to be eliminated against only the limited specified line
items relating to the associate (e.g. DR/CR Share of associate’s profit or loss DR/CR Investment
in associate), in effect, adjusting only the measurement of the investor’s share of associate’s
profit or loss or other comprehensive income for the period.

Others consider that the identity of the entity that records the gain or loss on the
transaction and the entity that holds the asset that is the subject of the transaction to be
relevant when determining the accounts to be adjusted (‘the second approach’). To an extent,
this approach accounts for the associate as though it were a member of the group, rather than
purely measuring the investment:

• Upstream transactions: eliminate the investor’s share of the unrealised gain or loss
by adjusting its share of the associate’s profit or loss or other comprehensive income
against the appropriate line item in the investor’s statement of financial position,
for example:
Sale of inventory

Debit Credit
HK$ HK$
Share of associate’s profit or loss x,xxx
Inventory x,xxx

Sale of non-current asset

Debit Credit
HK$ HK$
Share of associate’s profit or loss x,xxx
Property, plant and equipment x,xxx

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• Downstream transactions: eliminate the investor’s share of the unrealised gain or

loss by adjusting the relevant profit or loss and other comprehensive income account
against the investment in the associate, for example:

Sale of inventory

Debit Credit
HK$ HK$
Cost of goods sold x,xxx
Investment in associate x,xxx

or

Debit Credit
HK$ HK$
Revenue x,xxx
Cost of goods sold x,xxx

Sale of non-current assets

Debit Credit
HK$ HK$
Gain on sale of property, plant and x,xxx
equipment
Investment in associate x,xxx

Therefore, under the second approach, the ‘share of associate’s profit’ recognised in profit
or loss can differ from the amount by which the carrying amount of the investment in associate
is adjusted.

The gains and losses resulting from inter-company transactions are recognised in the
investor’s financial statements when they are realised. An unrealised gain or loss on sale of
inventory becomes realised when the inventory is on-sold to a third party (i.e. the gain or loss is
recognised in the investor’s profit or loss of the period of sale). The unrealised gain or loss on a
sale of non-current assets is earned (effectively ‘realised’) by the seller as the future economic
benefits in the asset are consumed through use of the asset.
From Chapter 30, you may recall that other intragroup transactions include the sale of
services or borrowings extended between the related parties. Likewise, an associate and its
investor may engage in similar activity. However, because these transactions do not typically
give rise to unrealised gains and losses, in applying the equity method, no adjustments are
necessary for these type of inter-company transactions to the extent there is no ‘unrealised’
component reflected in the recognised amounts. No elimination of inter-company balances is
necessary because, under the equity method, the line-by-line results and financial position of
the associate are not presented in the investor’s financial statements.

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Illustrative Example 3 – Upstream Sale of Inventory

Soleil’s ownership interest in its associate Bopp is 25%. On 1 January 20X3, the
equity-accounted carrying amount of Soleil’s investment in Bopp is HK$500,000. Bopp’s
net profit for the year ended 31 December 20X3 is HK$100,000. No other comprehensive
income was recognised during the period.

During the year, Bopp sold cardboard boxes to Soleil for HK$120,000 (an upstream
transaction). The cost of the boxes to Bopp is HK$50,000. That is, included in the
HK$100,000 profit was an inter-company gain on the sale of inventory of HK$70,000. All the
boxes remain on hand with Soleil at reporting date 31 December 20X3.

Under HKAS 28 (2011), only the share of the gain on the inter-company sale
attributable to external parties is recognised in Soleil’s equity-accounted financial
statements. Therefore, Soleil must eliminate its share of the unrealised gain of HK$70,000
that Bopp has made on the inter-company transaction. This share of the gain is considered
to be unrealised as Soleil still holds the inventory on 31 December 20X3.

To apply the equity method of accounting to the investment, Soleil first recognises its
share of the associate’s reported profit for the period:

Debit Credit
HK$ HK$
Investment in associate (Bopp) (25% × 100,000) 25,000
Share of associate’s profit or loss 25,000
(To record an increase equivalent to the investor’s share of the associate’s net profit for the
period)

Next, Soleil records a journal entry to eliminate its share of the upstream inter-company
sale. Under the first approach (adjust only the limited associate line items), the journal entry
to effect equity accounting would be:

Debit Credit
HK$ HK$
Share of associate’s profit or loss 25% × (1 – 16.5%) × 14,613*
70,000)
Investment in associate (Bopp) 14,613*
(To record the elimination of the investor’s share of the unrealised gain in inventory, with
tax effects, HK$14,613 has been rounded)

The statement of financial position reflects the equity-accounted associate at

HK$510,387 (HK$500,000 + HK$25,000 – HK$14,613).

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Illustrative Example 3 (continued)

Under the second approach to eliminating the inter-company transaction, the journal entry
might be instead:

Debit Credit
HK$ HK$
Share of associate’s profit or loss (25% × (1 – 16.5%) × 14,613
70,000)
Deferred tax asset (25% × 16.5% × 70,000) 2,887
Inventory (25% × 70,000) 17,500
(To record elimination of the investor’s share of the unrealised gain in inventory)

Consequently, under the second approach, the equity-accounted carrying amount

of Soleil’s investment in Bopp on 31 December 20X3 is HK$525,000 (HK$500,000 +
HK$25,000).

Apply and Analyse 9 – Upstream Sale of Inventory

Soleil is preparing its consolidated financial statements for the year ended 31 December
20X3. Using the information from Illustrative Example 3, prepare the consolidation
worksheet journal entries necessary under the first approach to equity account the
investment in Bopp, reflecting the sale of inventory. Ignore any necessary line item
reclassification of the investment.

Assume the following:

• Bopp is carried at cost of HK$370,000 in Soleil’s separate financial statements;

• There were no fair value adjustments on acquisition;

• Bopp’s other comprehensive income for the period and cumulatively is nil; and

• Soleil’s opening retained earnings position is HK$1,900 million.

Analysis

Adjustments
Soleil DR CR Total
HK$’000 HK$’000 Ref HK$’000 HK$’000
Statement of financial
position (extract)
Assets
Investment in associate 370.0 130.0 1,3 14.6 510.4
25.0 2

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Apply and Analyse 9 (continued)

Adjustments
Soleil DR CR Total
HK$’000 HK$’000 Ref HK$’000 HK$’000
Equity
Retained earnings: current
year profit
Opening retained earnings 1,900.0 1 130.0 1,770.0
Statement of profit or loss and other comprehensive
income (extract)
Share of associates’ profit – 14.6 3,2 25.0 10.4
for the year

Ref. 1: increases the carrying amount of the investment from that included in Soleil’s
separate financial statements (HK$370,000) to its opening equity-accounted position
(HK$500,000, given in Illustrative Example 3). The credit entry is made against retained
earnings to reflect the recognition in prior period income of Soleil’s share of Bopp’s profits
of those accounting periods.

Debit Credit
HK$ HK$
Investment in associate (Bopp) 130,000
Retained earnings (opening) 130,000

In this exercise, the credit entry is made fully against retained earnings as Bopp reports
no other comprehensive income. In practice, splitting the credit between retained earnings
and other comprehensive income may be appropriate to the extent that the investor has a
share of the associate’s other comprehensive income.

Ref. 2: increases the carrying amount of the investment by Soleil’s share of Bopp’s
profits for the year. The journal entry is illustrated in Illustrative Example 3.

Ref. 3: eliminates Soleil’s share of the unrealised gain in the inter-company sale of
inventory. The journal entry is illustrated in Illustrative Example 3.

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Illustrative Example 4 – Downstream Sale of Non-current Asset

Sparkle Limited (Sparkle) holds a 20% investment in associate Pop Limited (Pop).
On 1 January 20X2, Sparkle’s equity-accounted carrying amount of Pop is HK$300,000.

On 1 January 20X2, Sparkle sells a plant to Pop for HK$840,000 (a downstream

transaction). The carrying amount of the plant immediately before the sale is HK$800,000.
Pop depreciates the plant on a straight line basis over its useful life of 16 years. Pop’s net
profit after tax for the year ended 31 December 20X2 is HK$150,000. Assume the relevant
tax rate is 16.5%.

To apply the equity method of accounting to the investment, Sparkle first recognises its
share of the associate’s reported profit for the period:

Debit Credit
HK$ HK$
Investment in associate (Pop) 30,000
Share of associate’s profit or loss (20% × 150,000) 30,000
(To record an increase equivalent to the investor’s share of the associate’s after tax net
profit)

Next, Sparkle records a proforma journal entry to eliminate its share of the
downstream inter-company sale. Under the first approach (adjust only the limited
associate line items), the journal entry to effect equity accounting would be:

Debit Credit
HK$ HK$
Share of associate’s profit or loss 6,680
Investment in associate (Pop) (40,000 × (1 – 16.5%) × 6,680
20%)
(To record elimination of Sparkle’s share of the unrealised gain on sale of plant, under the
first approach, with tax effects)

and

Debit Credit
HK$ HK$
Investment in associate (Pop) 417.5
Share of associate’s profit or loss (40,000 × (1 – 16.5%) 417.5
/ 16 years × 20%)
(To recognise the ‘realisation’ to Sparkle of part of the unrealised gain on sale as Pop
depreciates the asset, under the first approach, with tax effects)

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Illustrative Example 4 (continued)

On 31 December 20X2, the equity-accounted carrying amount of Sparkle’s
investment in Pop is

HK$
Carrying amount at the start of the period 300,000
add: share of associate’s net profit for the period (20% × HK$150,000) 30,000
less: share of unrealised gain on downstream inter-company sale of (6,680)
plant, net tax impacts (20% × (HK$840,000 – HK$800,000) × (1 – 16.5%))
add: share of realisation of gain on downstream inter-company sale of 417.5
plant, net tax impacts (20% × HK$40,000/16 × 1 year) × (1 – 16.5%))
Investment in associate on 31 December 20X2 323,737.5

Under the second approach to eliminating the inter-company transaction, the journal
entry might be instead:

Debit Credit
HK$ HK$
Gain on sale of plant (20% × HK$40,000) 8,000
Deferred tax asset (16.5% × HK$8,000) 1,320
Investment in associate (Pop) 8,000
Deferred tax expense 1,320
(To record elimination of Sparkle’s share of the unrealised gain on sale of plant. Sparkle
recognises current tax expense on the sale as part of its line item ‘income tax expense’.
The tax effect of eliminating the unrealised gain on the inter-company sale is consequently
shown as part of the income tax expense line item and is recognised when the recognition
criteria are met.)

and

Debit Credit
HK$ HK$
Investment in associate (Pop) 500
Deferred tax expense (16.5% × HK$500) 83
Share of associate’s profit or loss (20% × HK$2,500) 500
Deferred tax asset 83
(To recognise the ‘realisation’ to Sparkle of part of the unrealised gain on sale as Pop
depreciates the asset under the second approach)

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Illustrative Example 4 (continued)

On 31 December 20X2, the equity-accounted carrying amount of Sparkle’s investment
in Pop is:

HK$
Carrying amount at the start of the period 300,000
add: share of associate’s net profit for the period (20% × HK$150,000) 30,000
less: share of unrealised gain on downstream inter-company sale of (8,000)
plant (20% × (HK$840,000 – HK$80,000))
add: share of realisation of gain on downstream inter-company sale of 500
plant (20% × (HK$40,000/16 × 1 year))
Investment in associate at 31 December 20X2 322,500

There are several downstream exceptions to the requirement to recognise gains and losses
only to the extent of external interests in the associate. Exhibit 32.6 summarises the accounting
in this regard.

Exception Accounting (HKAS 28.29-31A)

Evidence of a loss • Where the downstream transaction provides evidence of impairment or a
in the value of a reduction in the net realisable value of the asset, the investor recognises
transferred asset those losses in full
Non-monetary • Where the contribution lacks commercial substance and the investor
contributions to the does not receive monetary or non-monetary assets in that exchange
associate in exchange in addition to the equity interest, the entire gain or loss is treated as
for an equity interest ‘unrealised’ and eliminated against the investment in associate
• Where the contribution lacks commercial substance, but the investor
receives monetary or non-monetary assets in that exchange in addition
to the equity interest, the investor recognises in full in profit or loss the
portion of the gain or loss on the non-monetary contributions relating to
the monetary or non-monetary assets received
The investor recognises gains and losses on non-monetary contributions that
have commercial substance only to the extent of its external interests in the
associate.
Refer to Chapter 7 for a discussion on commercial substance.
Transfer of a business • Where the downstream transaction involves the transfer of assets that
constitute a business, the investor recognises the gain or loss in full
Refer to Chapters 15 and 34 for further discussion about disposals of assets
constituting a business (e.g. a discontinued operation or an operating
subsidiary).

EXHIBIT 32.6 Exceptions to the requirement to recognise gains and losses only to the extent of
external interests in the associate

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32.4.4 Impairment
In Section 32.1.2, the term ‘net investment’ in the associate was introduced. Both the
investor’s equity-accounted ownership interests and its other long-term interests (e.g. loans
and receivables accounted for in accordance with HKFRS 9) are subject to the impairment
requirements of HKAS 28 (2011).

HKAS 28.40,
The carrying amount of an investor’s net investment in an associate is subject to
HKAS 36.4 impairment testing when objective evidence shows the investment is impaired. Objective
evidence shows the investment is impaired when a loss event (or events) impacting the
estimated future cash flows from the investment has occurred, for example:

• The associate being in significant financial difficulty;

• The associate breaching a contract, for example, a default or delinquency in payments;

• The entity, for economic or legal reasons relating to its associate’s financial difficulty,
granting the associate a concession that the entity would not otherwise consider;

• The associate probably entering bankruptcy or other financial reorganisation;

• The disappearance of an active market for the investment because of the associate’s
financial difficulties;

• Significant changes with an adverse effect that have occurred in the technological,
market, economic or legal environment in which the associate operates, and which
indicate the investment may be unrecoverable; and

HKAS • A significant or prolonged decline in the fair value of an investment in an equity

28.41A–C instrument below its cost.

Where objective evidence shows impairment, the carrying amount of the investment is
tested for impairment as a single asset by comparing the recoverable amount of the
investment with its carrying amount. The implicit goodwill is not separately identified or tested.
HKAS The investment is written down to its recoverable amount (higher of its fair value less costs to
28.42 sell and value in use) if this is lower than its carrying amount.

The value in use of the net investment is calculated as follows:

• The investor’s share of the present value of the estimated future cash flows expected
to be generated by the associate, including the cash flows from the operations of the
associate and the proceeds from the ultimate disposal of the investment; or

HKAS • The present value of the estimated future cash flows expected to arise from dividends
28.42 to be received from the investment and from its ultimate disposal.

Where the recoverable amount of the net investment subsequently increases, a reversal of
the impairment loss may be recognised in accordance with HKAS 36 Impairment of Assets. Recall
from Chapter 14 that an impairment of goodwill arising in a business combination cannot be
reversed. Because goodwill implicit in the carrying amount of an associate is not separately
HKAS tested for impairment, the full amount of the impairment loss may be reversed, subject to the
28.42 constraints imposed by HKAS 36 (see Chapter 14).

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Illustrative Example 5
Jones Bones Limited (JBL) holds an 20% ownership interest in Free Fall Limited (FFL)
and has determined FFL is an associate of JBL. On 1 January 20X8, the equity-accounted
carrying amount of its investment in FFL was HK$100,000.

FFL reports a net loss after tax of HK$10,000 in its financial statements for the year
ended 31 December 20X8. However, before the year end, FFL suffers a significant loss
in public confidence in its latest product offering such that several large incomplete sale
orders making up 70% of its production forecasts over the next three years are cancelled.
The entity has not determined how to address the concern or how to rectify the product
issue to regain market confidence. The extent of the issue is so significant that the entity
may need to declare bankruptcy if a solution is not identified.

JBL determines objective evidence shows its investment in FFL is impaired.

Consequently, it assesses the recoverable amount of the investment. It determines the
value in use of the investment to be HK$60,000 and the fair value of the investment to be
HK$20,000.

The carrying amount of JBL’s equity-accounted investment is calculated as follows:

HK$
Carrying amount of associate at 1 January 20X8 100,000
less: Share of associate’s loss (20% × 10,000) (2,000)
less: Write down of associate to recoverable amount (38,000)
Carrying amount of associate at 31 December 20X8 60,000

32.4.5 Loss-making Associates

Unlike consolidation, under the equity method, the assets and liabilities of the associate are
not separately recognised in the statement of financial position of the investor. Instead, the
investor recognises its investment as a financial asset, for example, ‘investment in associate’.
As an asset, the minimum amount recognisable is nil. Hence, unlike the case for consolidated
entities, an investor stops recognising its share of losses of an associate once its net investment
in the associate is written down to zero. That is, equity accounting is suspended.

In these cases, the investor must continue to (1) record the movements so it can track when
amounts should once again be recognised in the financial statements (i.e. restart recognising its
HKAS share of the associate’s performance), and (2) recognise a liability for legal or constructive
28.38-39 obligations it has incurred on behalf of the associate.

Equity accounting ‘resumes’ once the unrecognised share of losses is fully recovered as the
associate returns to profits.

HKAS Losses are applied to the entity’s long-term interests in its associate regarding their priority
28.38 in liquidation (i.e. not on a proportionate basis across interests).

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Key Learning Point

An investor recognises a liability for legal or constructive obligations it has incurred on
behalf of the associate when it first meets the liability recognition criteria (see HKFRS
9 in Chapter 12). This may be at an earlier point in time to the suspension of equity
accounting. However, the amount recognised might be negligible until the associate starts
to encounter financial difficulties.

Illustrative Example 6
Investor Sam Corp Limited’s (Sam) opening statement of financial position includes the
following assets:

• Equity-accounted investment in its 40% owned Associate A1 of HK$10,000; and

• A loan to Associate A1 of HK$25,000. The terms of the loan provide that it becomes
repayable once Associate A1 is profitable for a continuous period of three years.
This has not yet occurred and there is no evidence to indicate that it will occur in
the foreseeable future. Sam regards the loan as part of its net investment in the
associate.

During the year, Associate A1 made an after-tax loss of HK$150,000. Sam has not
incurred any obligations (e.g. by providing a financial guarantee) on behalf of the associate.

In its financial statements for the reporting period, Sam records the following
journal entry:

Debit Credit
HK$ HK$
Share of losses of associate 35,000
Investment in associate 35,000

Sam’s share of Associate A1’s losses for the period is HK$60,000 (40% × HK$150,000).
However, in accordance with HKAS 28, its share of losses is capped to Sam’s net
investment in Associate A1 (HK$10,000 + HK$25,000). HK$35,000 of the losses suffered
are recognised, reducing Sam’s net investment in Associate A1 to nil at the reporting date.
Sam’s cumulative unrecognised loss balance is HK$25,000.

Assume in the next period Associate A1 makes a small profit of HK$50,000. Sam’s
share of those profits is HK$20,000. Sam does not recognise its share of these profits
because they are recovered against the unrecognised losses of HK$25,000. Hence, Sam’s
investment in Associate A1 at the end of the reporting period is still nil. However, Sam’s
cumulative unrecognised loss balance is now HK$5,000.

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Illustrative Example 6 (continued)

If, in the subsequent reporting period (i.e. two years after the loss year), Associate A1
makes a further profit of HK$82,500, the cumulative unrecognised loss balance will be fully
recovered, and Sam will resume recognising its share of the associate’s profits:

Debit Credit
HK$ HK$
Investment in associate 28,000
Share of profits of associate (40% × 82,500 – 5,000) 28,000

32.4.6 Disposal of an Associate

An investor ceases to apply the equity method of accounting when the investor ceases to have
HKAS significant influence over an entity. On losing significant influence through disposal of part or all
28.22–23 of its investment, the investor:

• Remeasures any retained interest to its fair value;

• Calculates the gain or loss on remeasurement as the difference between that retained
interest plus any proceeds from disposal, less the carrying amount of the investment at
the date the equity method was discontinued;

• Recognises that gain or loss in profit or loss; and

• Reclassifies to profit or loss any amounts recognised in other comprehensive income

that would normally be transferred on disposal of the related assets and liabilities
(e.g. amounts recognised in respect of investment in debt instruments classified as fair
value through other comprehensive income, hedging instruments, foreign exchange
translation).

If significant influence is not lost when an investor sells down its ownership interest, the
equity method continues to apply (to the new ownership interest held). A proportionate share
HKAS of the gain or loss recognised in other comprehensive income is reclassified to profit or loss on
28.25 the part disposal. The retained interest is not remeasured to fair value.

Recall the types of investment in Exhibit 32.2. An investor may cease to have significant
influence for reasons other selling down its interest in full or in part. For example, the investor
could lose significant influence:

• Through the actions of other parties without the investor undertaking any transaction
(e.g. dilution of its shareholding through the issue of new shares); or

• Because it has instead gained control or joint control from having increased its
shareholding. If significant influence is lost because joint control is gained and the
investor continues to equity account the investment, the retained interest will not be
remeasured to fair value.

The accounting when an investor loses significant influence but gains control is discussed in
Chapter 34.

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Classification as held for sale

Where the investment is classified as held for sale before disposal (i.e. the investor still has
significant influence over the associate), the carrying amount of the investment is remeasured
to the lower of its equity-accounted carrying amount and fair value less costs to sell in
HKAS accordance with HKFRS 5. Any loss on changing the measurement basis is recognised in profit
28.20 or loss, as follows:

Debit Credit
HK$ HK$
Loss on reclassification as held for sale (p/l) xxx
Investment in associate xxx

Only a portion of the investment may be classified as held for sale. The portion not held for
HKAS sale continues to be equity-accounted; this split accounting more faithfully reflects the natures
28.20 of the investment.

Apply and Analyse 10

Brown Limited (Brown) disposes part of its interest in its 40% owned associate Orange
Limited (Orange) on 1 January 20X8 for HK$80,000. After the sale, Brown holds 15% of
Orange and determines it no longer has significant influence over the entity.

On that sale date, the equity-accounted carrying amount of Orange is HK$100,000.

An amount of HK$3,000 recognised in the consolidated asset revaluation surplus and
HK$5,000 in the consolidated cash flow hedging reserve is attributable to the associate.
The fair value of the retained 15% interest is HK$28,000.

Prepare the journal entries to reflect the accounting for the sale.

Analysis

Brown recognises the following journal entries to reclassify the retained interest as a
financial asset and to recognise the gain or loss on remeasurement:

Debit Credit
HK$ HK$
Receivables/ cash 80,000
Investment in financial asset 28,000
Investment in associate 100,000
Gain on disposal of associate 8,000

and

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Apply and Analyse 10 (continued)

Debit Credit
HK$ HK$
Cash flow hedging reserve (OCI) 5,000
Gain arising on hedging instruments reclassified to 5,000
profit or loss (p/l)

The fair value of the retained interest on remeasurement is the financial asset’s ‘initial
recognition’ amount for the purposes of applying HKFRS 9. HKFRS 9 applies thereafter to
that financial asset (see Chapter 12).

In addition, current tax expense is recognised to the extent the gain on disposal of
the associate (and reclassification of the share of associate’s cash flow hedging reserve) is
taxable. Deferred tax balances are adjusted to reflect the temporary difference (if any) on
restatement of the carrying amount of the investment in Orange.

32.4.7 Deferred Taxes

In addition to considering any deferred tax implications in determining the equity-accounted
carrying amount of the investment in associate (see Sections 32.4.2 and 32.4.3), the investor
must attend to accounting for the temporary difference arising in respect to the associate
carrying amount and its tax base.

As discussed in Chapter 19, HKAS 12 requires deferred tax assets and deferred tax liabilities
to be recognised where a temporary difference exists, and recognition criteria are met (limited
exceptions apply). With respect to associates, a temporary difference arises in the financial
statements in which the investment is equity accounted when the carrying amount of an
entity’s investment in an associate differs from the investment’s tax base when, for example:

• There are undistributed taxable profits in the associate (the equity-accounted carrying
amount is higher than the cost of the investment);

• Foreign exchange rates affect the measurement of the associate; and

HKAS
12.38 • The carrying amount of the investment is impaired impacting its tax base.

An investor recognises, concerning its investments in associates, that:

• A deferred tax liability for all taxable temporary differences associated with its
investment except where the investor can control timing of the reversal of the
temporary difference; and
HKAS
12.39 • The temporary difference will probably not reverse in the foreseeable future.

For example, an investor does not recognise a deferred tax liability if it can control the
HKAS timing of the distribution of its share of the profits of the associate, and its share of the profits
12.43 will probably not be distributed in the foreseeable future. This is more likely to be the

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 FINANCIAL REPORTING

exception, rather than the default, unless the investor’s rights give the investor control
(rather than merely significant influence) to make decisions about this aspect of the associate.

• A deferred tax asset for all deductible temporary differences associated with its
investment only where it is probable;

• The temporary difference will reverse in the foreseeable future; and

HKAS
12.44 • Taxable profit will be available against which the temporary difference can be utilised.

Review Chapter 19 to understand how to make this assessment.

The deferred tax is recognised as income or an expense in profit or loss except where the
deferred tax arises from a transaction or event, which is recognised in other comprehensive
income or directly in equity. Where the deferred tax arises from a transaction or event, which is
recognised:

• In other comprehensive income, the deferred tax is also recognised in other

comprehensive income; and
HKAS
12.58, 61A • Directly in equity, the deferred tax is also recognised directly in equity.

Because the carrying amount of an entity’s investment in an associate may be different in

the consolidated financial statements (or equity-accounted financial statements) and the
HKAS separate financial statements, the temporary difference and, hence, any associated deferred
12.38 tax balance, may also be different.

Illustrative Example 7
Butterbear Limited (Butterbear) holds 30% of the ordinary shares of Honeybee Limited
(Honeybee). Butterbear has determined that it can significantly influence Honeybee and
applies the equity method of accounting to measure the investment.

At the reporting date, the equity-accounted associate is measured at HK$600,000.

Butterbear’s tax base for its investment in Honeybee is HK$500,000. The applicable tax
rate is 16.5%.

Butterbear recognises a deferred tax liability equivalent to HK$16,500 (16.5% ×

100,000) in its financial statements in which Honeybee is equity accounted.

This chapter assumes that no taxable or deductible temporary differences arise in relation
to the equity-accounted investment. This is consistent with investment income and gains on
sale of the investment not being taxable in Hong Kong. However, because the tax treatment
differs from jurisdiction to jurisdiction, there may be a related tax effect to recognise when
equity accounting an associate in practice.

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Knowledge Check Questions

Question 3
Parent P’s group structure is as shown in the diagram below. The percentages included in
the diagram represent the proportionate shareholding in the entity.

Parent P

80% 25%

14%
Subsidiary S1 Associate A3

20% 20%

Associate A2

On 1 January 20X8, Parent P’s equity-accounted carrying amount of its investment in

Associate A2 is HK$11,500. In its financial statements for the year ended 31 December
20X8, A2 reports a net profit after tax of HK$10,000.
Parent P is preparing its consolidated financial statements for the year ending
31 December 20X8. Prepare the journal entries required in Parent P’s consolidation
worksheet so the carrying amount of the investment in A2 is presented in accordance with
HKAS 28 (2011).

Question 4
Parent P’s group structure is as shown in the diagram below. The percentages included in
the diagram represent the proportionate shareholding in the entity.

Parent P

75%

Subsidiary S1 30%

20%

Associate A1

On 1 January 20X7, Parent P’s equity-accounted carrying amount of its investment in

Associate A1 is HK$15,000. In its financial statements for the year ended 31 December
20X7, A1 reports a net profit of HK$20,000. In addition, during the year, A1 declares a
dividend of HK$25,000 out of its post-acquisition retained earnings.
Parent P is preparing its financial statements for the year ending 31 December 20X7.
Calculate (1) Parent P’s share of A1’s profits recognised in its profit or loss, and (2) the
carrying amount of the investment in A1.

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Knowledge Check Questions (continued)

Question 5
Identify which one of the following statements is true.
A All changes to the equity-accounted carrying amount of an investment in an associate
are recognised in the investor’s profit or loss for the period.
B To avoid double-counting in the statement of profit or loss, an investor’s share of an
associate’s profit or loss must be reduced by the amount of the dividend declared by the
associate.
C An investment in an associate is treated as a financial asset within the scope of HKFRS 9
Financial Instruments in the investor’s separate financial statements.
D To calculate the investor’s share of an associate’s profit after tax for the period, the
associate’s reported after-tax profit or loss must be adjusted to reflect any additional or
reduced depreciation expenses, plus any related tax arising as a result of the notional
acquisition date fair value adjustments to the associate’s assets and liabilities.

Question 6
[upstream sale of plant]
Squid Limited (Squid) acquires 40% of the share capital of Clam Limited (Clam) for
HK$100,000. On the acquisition date, Clam’s equity reveals the following:

HK$
Share capital 100,000
Retained earnings 150,000

Squid equity accounts its investment in Clam.

On 1 January 20X3, Clam sells a plant to Squid for HK$500,000. The carrying amount of
the plant is HK$450,000. Squid depreciates the plant over five years.
Clam’s retained earnings on 1 January 20X3 is HK$230,000. It reports net profit after tax
for the year ending 31 December 20X3 of HK$120,000.
Assume the relevant tax rate is 16.5%. Prepare the consolidation worksheet journal
entries necessary under the first approach (adjust only the limited associate line items)
to account for Clam in Squid’s consolidated financial statements for the year ended
31 December 20X3.

Question 7
[downstream sale of inventory]
Albatross Limited (Albatross) acquires 25% of the share capital of Weka Limited (Weka) for
HK$62,500. On the acquisition date, Weka’s equity reveals the following:

HK$
Share capital 100,000
Retained earnings 150,000

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Knowledge Check Questions (continued)

Albatross equity accounts its investment in Weka.
During the reporting period, Albatross sells cardboard boxes to Weka for HK$120,000.
The cost of the boxes to Albatross is HK$50,000. 50% of the boxes remain on hand at
reporting date 30 June 20X3. Weka’s net profit for the year is HK$210,000.
On 1 July 20X2, the equity-accounted carrying amount of Albatross’ investment in Weka
is HK$120,000.
Prepare the consolidation worksheet journal entries necessary using the first approach
to account for Weka in Albatross’ consolidated financial statements for the year ended 30
June 20X3. Adjust only the limited associate line items. Assume the tax rate is 16.5%.

Question 8
Boo Limited (Boo) holds 40% of the share capital of Sully Limited (Sully). Boo equity
accounts its investment in Sully. The equity-accounted carrying amount of the investment
on 1 January 20X3 was HK$100,000.
During the year ended 31 December 20X3, Sully makes a net loss after tax of
HK$600,000. However, in the next financial year (20X4) the company makes an after-tax
profit of HK$750,000.
Identify which one of the following line items is correct. Boo recognises:

20X3 20X4
A. Investment in associate – (HK$140,000) Investment in associate – HK$160,000
B. Investment in associate – HK$0 Investment in associate – HK$160,000
C. Share of associates loss – HK$100,000 Share of associates profit – HK$300,000
D. Share of associates loss – HK$240,000 Share of associates profit – HK$300,000

3 2 . 5 PRESENTATION AND DISCLOSURE

Requirements relating to the presentation and disclosure of an entity’s investments in its

associates are set out in various HKFRSs, including HKAS 1 Presentation of Financial Statements,
HKFRS 12 Disclosure of Interests in Other Entities, HKAS 24 (Revised) Related Party Disclosures and
HKAS 27 (2011) Separate Financial Statements.

32.5.1 Presentation of Investments in Associates

An entity includes line items in its financial statements that pertain to its interests in associates
together with any interests it holds in joint ventures. In accordance with HKAS 1, the entity
must present line items in its statement of financial position and statement of profit or loss and
other comprehensive income that show:

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• The carrying amount for all investments accounted for using the equity method;

• The entity’s share of the profit or loss of associates (and any joint ventures) accounted
for using the equity method; and

• The entity’s share of the other comprehensive income of associates (and any joint
HKAS 1.54, ventures) accounted for using the equity method, separately identifying the share that
82, 82A will and will not be subsequently reclassified to profit or loss.

HKAS The investments are classified as non-current assets except where an investment meets the
28.15 conditions to be classified as held for sale in accordance with HKFRS 5 (see Chapter 15).

The presentation of an entity’s investments in its associates is illustrated in Exhibit 32.7.

Group Group
HK$’000 HK$’000
Statement of financial position (extract, amounts are illustrative only) Statement of comprehensive income (extract, amounts are illustrative only)
Assets Revenues 2,000,000
Property, plant and equipment 1,800,000 Interest income 55,000
Investment in associates 6,370 Dividend income 70,000
Other investments 900,000
Goodwill 59,700 Cost of sales (820,000)
Inventories 250,000 Distribution expenses (120,000)
Loans 1,200 Adminstration expenses (520,000)
Other trade and other receivables 230,000 Finance costs (40,000)
Cash 410,000 Share of profits of associates 270,000
Profit before tax 895,000
Total assets 3,657,270 Tax expense (100,125)
Profit for the year 794,875

Other comprehensive income

Items that will not be reclassified to profit or loss:
Gains on property revaluation –
Information about an entity’s equity Share of other comprehensive income of associate –
accounted associates is separately –
presented on the face of the
financial statements Items that will not subsequently reclassified to profit or loss:
Financial assets classified as fair value through OCI –
Share of other comprehensive income of associate –
–

Total comprehensive income for the year 794,875

EXHIBIT 32.7 Illustrative financial statements in which associates are equity accounted

32.5.2 Disclosure of Investments in Associates

In accordance with HKFRS 12, an entity must disclose information that enables users of its
financial statements to evaluate the nature of, and risks associated with, its investments
in associates and the effects of those interests on the entity’s financial position, financial
performance and cash flows. In addition as discussed in Chapter 21:

• HKAS 24 requires disclosure of the nature of the related party relationship and
information about transactions and outstanding balances (including commitments)
between the entity and its associates necessary for users to understand the potential
effect of the relationship on the financial statements; and
HKFRS 12.1,
HKAS 24.19, • HKAS 27 requires particulars about associates to be provided in separate financial
HKAS 27.17 statements, where presented.

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 I n v estments in A ssociates

HKFRS HKFRS 12 should cover all associates of the entity, including those that are not equity
12.5A, 6 accounted but instead are measured on a different basis in accordance with HKFRSs. However,
the extent of disclosure may differ depending on the nature of the investor and the accounting
applied to the investment.

To meet the disclosure objective set out in HKFRS 12, an entity discloses, separately from its
disclosures about its subsidiaries and joint ventures, information about the:

• Significant judgements and assumptions it has made in determining whether an

interest is an associate (or otherwise). The entity must also disclose any changes in its
assessment;

• Nature, extent and financial effects of its interests in associates, including the nature
and effects of its contractual relationship with other investors with significant influence
over the associate; and
HKFRS
12.7, 20 • Nature of, and changes in, the risks associated with its interests in associates.

The extent of disclosure required is subject to judgement and the materiality of an

associate to the entity. In addition to the amounts presented on the face of the financial
statements, key disclosures include:

• The particulars of an entity’s investments in associates (e.g. name, activity, place of

business, ownership interest) (Exhibit 32.8);
• A summarisation of financial information about each material associate (e.g. dividends
received from the associate, key subtotals and line items reported by the associate)
(Exhibit 32.9). The summarised information is based on the associate’s HKFRS-compliant
financial statements adjusted for differences in accounting policies and to reflect
adjustments made in the application of the equity method (e.g. fair value adjustments).
The associate’s financial statements are not adjusted for the effects of inter-company
transactions with the investor;

• A reconciliation of the summarised financial information presented to the carrying

amount of the equity-accounted associate;

• A summarisation of financial information about immaterial associates, in aggregate;

• The nature and extent of any significant restrictions on the ability of the associate to
transfer cash to the investor;

• The reporting date/period of the associate, if differing from the investor, and the reason
for the difference;

• The fair value of the associate if there is a quoted market price;

• The unrecognised share of losses of an associate; and

HKFRS
12.21–23, B16 • The contingent liabilities relating to its investments in associates.

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 FINANCIAL REPORTING

Exhibit 32.8 illustrates disclosure of particulars of an entity’s interests in associates, and

related prescribed information.

Name Place of % of Nature of Principal Accounting Fair value Carrying

business/ ownership relationship activity basis (quoted amount
country of interest share
incorporation price)
Comet Hong Kong 30% Associate Data and Equity n/a HK$x,xxx
analytics method
solutions

Halley Hong Kong 25% Associate Supply chain Equity n/a HK$x,xxx
management method
solutions

EXHIBIT 32.8 Illustrative disclosure of particulars: associates

Exhibit 32.9 illustrates disclosure of an investor’s summarised financial information about

its associates. A reconciliation is provided from this information to the recognised equity-
accounted carrying amount.

Associate 1 Associate 2
Current assets x,xxx x,xxx
Non-current assets x,xxx x,xxx
Current liabilities x,xxx x,xxx
Non-current liabilities x,xxx x,xxx
Equity attributable to owners of the parent x,xxx x,xxx
Non-controlling interest x,xxx x,xxx
Revenue x,xxx x,xxx
Profit or loss from continuing operations x,xxx x,xxx
Post-tax profit/(loss) from discontinued operations x,xxx x,xxx
Profit/(loss) for the year x,xxx x,xxx
Other comprehensive income attributable to the parent x,xxx x,xxx
Total comprehensive income x,xxx x,xxx
Dividends received from the associate during the year x,xxx x,xxx

EXHIBIT 32.9 Summarised financial information

Though HKFRS 12 identifies specific disclosures that assist in meeting the disclosure
objective, in preparing a set of financial statements, the preparer should assess whether the
disclosures presented are sufficient to meet the disclosure objective set out at the start of this
section. If not, additional disclosures, or further aggregation or disaggregation of information,
must be made.

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 I n v estments in A ssociates

Knowledge Check Questions

Question 9
Parent P holds a 15% investment in Associate A1. Identify which one of the following
disclosures Parent P need not include in its consolidated financial statements, assuming
the associate is material to Parent P.
A Parent P’s share of each key subtotal reported by A1
B Disclosure of its interest in Associate A1 and A1’s principal activity
C How Parent P has determined that it is able to significantly influence Associate A1
D A reconciliation of the summarised financial information presented to the carrying
amount of the investment in Associate A1

Question 10
Parent PQ holds a 20% investment in Associate A2. A2 is not material to Parent PQ. In its
financial statements for the year ended 31 December 20X1, Parent PQ does not separately
disclose the amount of A2’s contribution to its net profit for the period on the face of its
statement of profit or loss and other comprehensive income. Determine whether this
treatment is appropriate.

3 2 . 6 CURRENT DEVELOPMENTS

There are no current developments in relation to the accounting for associates. However, in
2014, the HKICPA issued Sale or Contribution of Assets between an Investor and its Associate or
Joint Venture (Amendments to HKFRS 10 and HKAS 28) to remove an inconsistency between the
requirements of HKFRS 10 and HKAS 28 (2011) relating to the extent to which a gain or loss is
recognised by the investor when it contributes/purchases assets representing a ‘business’ to/
from the associate or joint venture. The amendments clarify that:

• When an investor contributes or sells a business to its associate (or joint venture), the
investor recognises in full in its financial statements the gain or loss resulting from its
contribution (or sale);

• When an investor contributes or sells a subsidiary that does not contain a business to
its associate (or joint venture), the investor recognises a gain or loss only to the extent
of the unrelated investors’ interests in that associate (or joint venture). The remaining
part of the gain or loss is eliminated against the carrying amount of the investment in
the associate (or joint venture); and

• In applying the equity method, the investor’s share in the associate’s (or joint venture’s)
gains or losses resulting from ‘upstream’ transactions between the investor and the
associate (or joint venture) involving assets that constitute a business is not eliminated.

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 FINANCIAL REPORTING

In 2016, these amendments were deferred indefinitely; therefore, they are ineffective.
Nothing indicates they will be made effective. Before the original effective date of the
amendments, other issues with respect to the sale or contribution of assets between
an investor and its associate or joint venture had been brought before the International
Accounting Standards Board (IASB), and the IASB considered that it would prefer to address
those issues as part of a research project on equity accounting. As the IASB did not want
to impose change in this area on entities twice in a relatively short time, it deferred these
amendments. Likewise, the HKICPA deferred its corresponding amendments.

However, early application of the amendment is possible; that is, an entity may apply the
accounting previously described if it wishes.

The IASB’s research project on equity accounting is on hold and expected to re-commence
in 2020 following its post-implementation reviews of IFRS 10 Consolidated Financial Statements,
IFRS 11 Joint Arrangements and IFRS 12 Disclosure of Interests in Other Entities (equivalent to
HKFRS 10, HKFRS 11 and HKFRS 12, respectively). The project scope has not been determined
but may include a fundamental review of the equity method of accounting.

Some changes may come to the disclosures specified of associates and joint ventures
arising from the IASB’s post-implementation review of HKFRS 12, which is currently underway.

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 I n v estments in A ssociates

SUMMARY

• An associate is an entity over which the investor has significant influence.

• Significant influence exists when the investor has the power to participate in the financial and
operating policy decisions of the investee, but that power is insufficient to give it control or
joint control of those policies.

• Significant influence is generally associated with ownership holdings between 20% and 49.9%.

• With limited exceptions (e.g. investment-type entity, parent agreement), the investor accounts
for an associate using the equity method of accounting. The equity method is used, but
further additional requirements apply when the investment is:

°° Classified as held for sale (measure at lower of equity-accounted carrying amount and fair
value less costs to sell);

°° Impaired (measure at higher of equity-accounted carrying amount and recoverable

amount); and

°° Loss-making (stop recognising the investor’s share of losses when the net investment is nil,
resuming only when the unrecognising losses have been fully recovered).

• The equity method is a method of accounting whereby the investment is initially recognised
at cost and adjusted thereafter for the post-acquisition change in the investor’s share of the
investee’s net assets. Under the equity method, the investor’s profit or loss includes its share
of the investee’s profit or loss, and the investor’s other comprehensive income includes its
share of the investee’s other comprehensive income.

• The investment in an associate cannot reduce below nil. Entity must maintain records so it
knows when it must restart recognising the investor’s share of an associate’s profits.

• An investee’s reported profit or loss and other comprehensive income must be adjusted for
the effects of (1) fair value adjustments to the associate’s identifiable assets and liabilities and
(2) unrealised gains and losses on inter-company transactions in calculating the investor’s
share of the investee’s profit or loss.

• Dividends from the associate reduce the investor’s carrying amount of the associate.

• Goodwill on acquisition of an associate is not separately recognised. Nor is it separately tested

for impairment.

• A discount on acquisition is included as part of the investor’s share of the investee’s profit or
loss in the period of acquisition.

• The investment in an associate is tested for impairment when objective evidence of

impairment exists. It is written down to its recoverable amount where this is lower than the
carrying amount.

• Full reversal of impairment of the investment in an associate is possible (subject to HKAS 36

constraints); the restrictions on reversing goodwill do not apply.

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 FINANCIAL REPORTING

• In the separate financial statements, investments in associates are measured at cost, in

accordance with HKFRS 9, or by applying the equity method.

• Separately present on the face of the financial statements:

°° The carrying amount for all equity-accounted investments;

°° The share of the profit or loss of equity-accounted associates (and any joint ventures)
accounted for using the equity method; and

°° The share of the other comprehensive income of equity-accounted associates (and any joint
ventures), separately identifying amounts that will be subsequently reclassified to profit or
loss, and amounts that will not be subsequently reclassified.

• An investor discloses information that enables users of its financial statements to evaluate
the nature of, and risks associated with, its investments in associates and the effects of those
interests on the entity’s financial position, financial performance and cash flows. This includes
disclosure of information about the following matters:

°° Significant judgements and assumptions made in determining whether an interest is an

associate;

°° Nature, extent and financial effects of interests in associates; and

°° Nature of, and changes in, the risks associated with interests in associates.

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 I n v estments in A ssociates

MIND MAP

SIGNIFICANT INFLUENCE EQUITY METHOD AND ITS APPLICATION

Participation in policy decisions In ‘equity accounted financial statements’ or
20–49.9% voting power consolidated financial statements
Limited exceptions to equity method
Ceases when significant influence is lost
• Gain or loss on disposal recognised in
Control–Subsidiary (Chapter 30)
profit or loss
• Ability to direct policy decisions
• OCI amounts reclassified to profit or loss
• > 50% voting power
Cost + post-acquisition change in associate’s
Joint control–Joint venture (Chapter 33)
net assets
• Joint ability to direct policy decisions
• 50% voting power Minimum balance = 0
Financial asset (Chapter 10) Subject to impairment testing. Goodwill only
• No ability to direct or participate in notional
policy decisions Fair value adjustments on acquisition–adjust
• < 20% voting power share of associate’s profit or loss to reflect
SEPARATE FINANCIAL STATEMENTS INVESTMENT IN periodic excess/under depreciation
ASSOCIATES Eliminate share of inter-company
Choice of: (HKAS 28) transactions–2 approaches:
• Cost • Approach 1 – adjust Investment in associate;
• HKFRS 9 financial asset share of profit or loss, share of other
• Equity method comprehensive income
PRESENTATION AND DISCLOSURE • Approach 2 – adjust asset held by the investor
(Investment in associate or e.g. PPE, inventory).
Presentation
• Equity accounted investments
• Share of equity accounted profits
• Share of equity accounted other
comprehensive income
Disclosure
• How decide investment = associate
• Nature, extent & financial effects of associates
• Nature of risks

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. An investor applies the equity method of accounting only during the
period the investor has significant influence over the other entity. Evidence may indicate
the investor does not have significant influence even though it holds more than a 20%
interest in the investee.
Answer B is correct. An investor holding an 18% interest in another entity can be presumed
not to have significant influence over that entity unless it can be clearly demonstrated
otherwise.
Answer C is incorrect. An investor’s ability and intention to exercise a potential voting
right is not considered in an investor’s assessment of whether the investor has significant
influence over an entity. However, it is considered when assessing whether the investor
has control over that other entity (review Chapter 30).

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 FINANCIAL REPORTING

Answer D is incorrect. An investor has significant influence over another entity when it has
the power to participate in the financial and operating policy decisions of that other entity,
but that power is insufficient to give the entity control or joint control of those policies. If
an investor that has power that gives it the ability to direct activities of the other entity that
affect the investor’s variable returns and has the ability to use that power, it has control
over that other entity (review Chapter 30).

Question 2
Answer A is incorrect. Though DEF Ltd and Investor S may be able to significantly influence
LMN Ltd, DEF Ltd is, prima facie, unable to significantly influence LMN Ltd. DEF Ltd cannot
be said to hold additional voting power through the agreement to vote similarly.
Answer B is correct. DEF Ltd’s control of 23% of the voting power is sufficient to enable it to
at least significantly influence PQR Ltd in the absence of any information to the contrary.
Answer C is incorrect. The contractual agreement gives DEF Ltd control over 55% of the
voting rights. Prima facie, DEF Ltd has control over XYZ Ltd, rather than merely significant
influence.
Answer D is correct. Although DEF Ltd holds less than 20% of the voting power of STU Ltd,
it can participate in the financial and operating decisions of STU Ltd through its senior
management and board representation. DEF Ltd is unlikely to have control of STU Ltd
given Investor Tu’s voting power.

Question 3

Debit Credit
HK$ HK$
Investment in associate ((14% + 20%) × HK$10,000) 3,400
Share of associate’s profit for the year 3,400

In addition, in its consolidated financial statements, Parent P would attribute part of that
profit to the non-controlling interest (NCI) in S1.

Debit Credit
HK$ HK$
Profit attributable to NCI HK$400
Non-controlling interests – equity HK$400

Share of associate’s profit held directly = 14% × HK$10,000 = HK$1,400

Share of associate’s profit held indirectly = 20% × HK$10,000 = HK$2,000
NCI share of associate’s profit held indirectly = 20% × HK$2,000 = HK$400

Question 4
Parent P’s share of A1’s profits = (30% + 20%) × HK$20,000 = HK$10,000
Carrying amount of the investment = HK$15,000 (opening balance) + HK$10,000 (share
of profit for the year) – 50% × HK$25,000 (share of dividend) = HK$12,500

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 I n v estments in A ssociates

Question 5
Answer A is incorrect. Changes affecting the equity-accounted carrying amount of an
investment in an associate may also be recognised in other comprehensive income
(e.g. share of an associate’s post-acquisition movements in its asset revaluation reserve).
Answer B is incorrect. A dividend declared by the associate is recognised as a reduction
to the carrying amount of the investment and not as a reduction in the share of
the associate’s profit or loss for the period. To do so would result in the associate’s
contribution to the investor’s profit or loss for the period being misrepresented.
Answer C is incorrect. An investment in an associate may, but need not be, treated in
accordance with HKFRS 9 in the investor’s separate financial statements.
Answer D is correct. An associate’s reported after-tax profit or loss must be adjusted to
reflect any additional or reduced depreciation expenses, plus any related tax, arising as a
result of the notional acquisition date fair value adjustments to the associate’s assets and
liabilities.

Question 6
[upstream sale of plant]
Journal 1 – adjust opening carrying amount to the opening equity-accounted balance

Debit Credit
HK$ HK$
Investment in associate (Clam) 32,000
Retained earnings (40% × (230,000 – 150,000)) 32,000

Journal 2 – recognise share of associate’s profit for the period

Debit Credit
HK$ HK$
Investment in associate (Clam) 48,000
Share of associate’s profit for the year (40% × 120,000) 48,000

Journal 3 – eliminate the unrealised gain of HK$50,000 on the inter-company sale of plant
using the first approach (adjust only the limited associate line items)

Debit Credit
HK$ HK$
Share of associate’s profit for the year (40% × 16,700
(1 – 16.5%) × 50,000)
Investment in associate 16,700

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 FINANCIAL REPORTING

Journal 3b – reflect realisation of part of the unrealised gain on the inter-company

sale of plant

Debit Credit
HK$ HK$
Investment in associate 3,340
Share of associate’s profit for the year (16,700 × 3,340
1/5 years)

Question 7
Journal 1 – adjust opening carrying amount to the opening equity-accounted balance

Debit Credit
HK$ HK$
Investment in associate (Weka) 57,500
Retained earnings (120,000 – 62,500) 57,500

Journal 2 – recognise share of associate’s profit for the period

Debit Credit
HK$ HK$
Investment in associate (Weka) 52,500
Share of associate’s net profit for the year 52,500
(25% × 210,000)

Journal 3 – eliminate the unrealised gain on the inter-company sale of inventory using the
first approach (adjust only the limited line items for associates)

Debit Credit
HK$ HK$
Share of associate’s profit for the year (25% × 50% × 7,306
(120,000 – 50,000) × (1 – 16.5%))
Investment in associate (Weka) 7,306

Question 8
Answer A is incorrect. Boo recognises a liability in 20X3 only where it has incurred an
obligation relating to Sully and measures it in accordance with the HKFRS applicable to that
obligation (e.g. HKFRS 9). The measurement of this liability is not necessarily equal to Boo’s
unrecognised loss on the investment.

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 I n v estments in A ssociates

Answer B is correct. The amount of the loss recognised is limited to the Boo’s net
investment in Sully (HK$100,000). In 20X4, Boo’s share of Sully’s profit is applied first
against its share of the unrecognised cumulative losses (HK$140,000); the remaining share
(40% × 750,000; less 140,000) is recognised in profit or loss and increases the carrying
amount of the investment.
Answer C is incorrect. In 20X4, Boo’s share of Sully’s profit must be applied first against its
share of the unrecognised cumulative losses (HK$140,000); this amount is not recognised
in Boo’s profit or loss.
Answer D is incorrect. In 20X3, the amount of the loss recognised is limited to the Boo’s net
investment in Sully (HK$100,000). In 20X4, Boo’s share of Sully’s profit must be applied first
against its share of the unrecognised cumulative losses (HK$140,000); this amount is not
recognised in Boo’s profit or loss.

Question 9
Answer A is correct. Instead, Parent A should disclose the total amount for the subtotal as
reported by A1 (after making the adjustments for different accounting policies and for the
equity method).
Answer B is incorrect. The relationship should be disclosed, including Parent P’s
ownership interest in A1. This provides users of Parent P’s financial statements with useful
information to understand the nature of and risks associated with its investment in A1 and
the effects of the interests on the Parent P’s financial position, financial performance and
cash flows.
Answer C is incorrect. This disclosure provides information about the significant
judgements and assumptions Parent P has made in determining whether its 15% interest
in A1 is sufficient to give it significant influence over the entity.
Answer D is incorrect. HKFRS 12 requires the investor to disclose a reconciliation of the
summarised financial information presented to the carrying amount of the associate.
This information is useful to assist users to understand how the associate’s financial
information is incorporated into the amounts recognised in Parent P’s financial statements.

Question 10
Parent PQ does not have to separately identify its share of the profit or loss of A2. This is
because A2 is not material to Parent PQ. Though this is a specified minimum disclosure
in HKAS 1, an overarching concept of materiality applies to the preparation of financial
statements

EXAM PRACTICE

Case Study 1
On 1 January 20X0, Chung Li Limited (CLL), a listed robotics company, acquired 20% of
the share capital of Ang Do Limited (ADL), an information technology (IT) company, for
HK$320,000.

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 FINANCIAL REPORTING

The carrying amounts of ADL’s net assets recognised in its statement of financial position
at this date is HK$1,400,000. In addition, CLL has identified that the fair value of ADL’s
software is HK$119,760 higher than its carrying amount of the acquisition date. The software
has a remaining useful life of four years. CLL estimates the fair values of ADL’s other
identifiable net assets to be the same as their carrying amounts.

The tax rate is 16.5%. Assume the software is deductible for tax purposes.

Key events during the year ended 31 December 20X0

• ADL reports a net profit after tax of HK$200,000.

• ADL declares a dividend from post-acquisition profits to its shareholders of HK$150,000.

• In November 20X0, ADL’s main competitor introduces new technology, which is likely to
make ADL’s key products less attractive to purchase.

• CLL estimates ADL’s fair value less costs to sell on 31 December 20X0 to be HK$300,000.

• CLL estimates ADL’s value in use on 31 December 20X0 to be HK$310,000.

Key events during the year ended 31 December 20X1

During the year ended 31 December 20X1, ADL has been struggling to compete as
consumers purchase the new technology products produced by its main competitor. It
posts a net loss after tax of HK$1,575,000 for the period. However, ADL has signalled to the
market that its new generation products, expected to be released in 20X2–20X3, will have
technology that surpasses that of its main competitors.

Key events during the year ended 31 December 20X2

• On 1 January 20X2, CLL and a third party, Masters, enter into a contractual arrangement
for CLL to sell 50% of its ADL shares to Masters for HK$200,000. Neither Masters nor
its related parties currently hold any interest in ADL. The sale price is determined by an
independent valuer engaged by CLL and Masters and reflects the fair value of the parcel
of shares sold. After the sale, CLL retains a 10% interest in ADL. It has no access to ADL
beyond that of any other minor shareholder and does not trade with the company.

• In December 20X2, ADL launches its new generation products. The robotics
community has favourably reviewed the products, and ADL has received several large
orders for them.

• ADL reports a net profit after tax for the year of HK$45,000.

QUESTION 1
CLL’s Chairman, Khoo Li San, is currently meeting with the external audit team to discuss the
forthcoming audit of the financial statements.

In the meeting with the external audit team, Khoo Li San says:

‘Even though we own 20% of ADL, there is no need for us to present financial statements
in which the investment in ADL is equity accounted as our shareholders do not understand
what it represents. Our financial statements would more faithfully represent relevant
information to our users if our investment in ADL was measured at cost and the dividends
received from that investment shown as part of our net profit, so this is how we should
account for it.’

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 I n v estments in A ssociates

You are Tristan Choo, the audit manager on the engagement. Explain to the Chairman
whether CLL can account for ADL in the manner suggested in CLL’s consolidated financial
statements. In your response, identify a disclosure that might alleviate some of his concern
about the usefulness of accounting for the investment using the equity method.

QUESTION 2
Assuming that CLL applies the equity method to account for its investment in ADL, calculate
the carrying amount of the equity-accounted investment in ADL recognised in CLL’s
consolidated financial statements for the year ended 31 December 20X0 in accordance with
HKAS 28 (2011) Investments in Associates and Joint Ventures. Show all workings.

QUESTION 3
Prepare the journal entry to record CLL’s share of ADL’s results for the year ended
31 December 20X1. Show all workings.

QUESTION 4
You are Tristan Choo, the audit manager for CLL. On receiving CLL’s draft consolidated
financial statements for the year ended 31 December 20X2, you observe that it includes the
following information:

Statement of profit or loss (extract)

Gain on sale of associate HK$195,000

Statement of financial position (extract)

Investment in ADL HK$4,500

Note X: Associates (extract).

Name Place of business/ % of Accounting basis Principal activity

country of ownership
incorporation interest
Ang Do Limited Hong Kong 10% Equity method IT solutions

After considering the background information in the case study and in Questions 1–3,
analyse the information in the financial statements and document your concerns in a file
note for discussion with the CLL accounting team.

Case Study 2
Abbas Limited (Abbas) is a publicly listed Hong Kong company whose principal activity is
retailing operations, that is, supermarkets, general merchandise and specialty department
stores. Abbas prepares consolidated financial statements in accordance with HKFRSs and
has a 31 December financial year-end.

Fausto Limited (Fausto)

On 1 January 20X1, Abbas’ 80% owned subsidiary Path Labs Limited (Path Labs) acquired
125,000 ordinary shares in Fausto Limited (Fausto) for HK$4.5 million. Fausto has 500,000
ordinary shares on issue.

Fausto provides medical diagnosis services to various clinics and hospitals. It has a
31 December financial year-end.

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 FINANCIAL REPORTING

The summarised financial position of Path Labs and Fausto on 31 December 20X3 is
as follows:

Path Labs Fausto

HK$’000 HK$’000
Assets
Property, plant and equipment 3,400 20,410
Investment in Fausto 4,500 —
Other investments 35,000 520
Deferred tax assets 1,000 —
Inventories 4,580 200
Trade and other receivables 1,210 780
Cash 1,580 490
Total assets 51,270 22,400

Equity
Share capital 100 10,000
Retained earnings 50,170 11,750
Total equity 50,270 21,750
Liabilities
Provisions 320 200
Trade and other payables 680 450
Total liabilities 1,000 650
Total equity and liabilities 51,270 22,400

Path Labs and Fausto’s summarised statements of profit or loss for the financial year ended
31 December 20X3 are as follows:

Path Labs Fausto

HK$’000 HK$’000
Revenues 15,900 76,000
Dividends and other income 66,000 –
Changes in inventories of (100) (800)
finished goods
Depreciation expenses (300) (1,600)
Administration expenses (7,500) (2,400)
Employee benefits expenses (38,000) (39,000)
Income tax expense (4,100) (2,200)
Net profit after tax 31,900 30,000

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Path Labs and Fausto’s statements of changes in equity for the financial year ended 31
December 20X3 are as follows:

Path Labs Fausto

Share Retained Total Share Retained Total
capital earnings capital earnings
HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
Balance at 1 Jan 20X3 100 24,650 24,750 10,000 10,700 20,700
Profit for the year – 31,900 31,900 – 30,000 30,000
Other comprehensive – – – – – –
income for the year
Total comprehensive – 31,900 31,900 – 30,000 30,000
income for the year
Dividends – (6,380) (6,380) – (28,950) (28,950)
Balance at 31 Dec 20X3 100 50,170 50,270 10,000 11,750 21,750

Additional information:

• The tax rate is 16.5%. Dividends are non-taxable in the hands of the recipient. Capital
gains tax is inapplicable.

• Abbas has no plans to dispose of its interest in either Path Labs or Fausto.

• The fair value of Fausto’s identifiable net assets on 1 January 20X1 is HK$18 million.

• No changes have occurred to Fausto’s share capital since it was acquired.

• During the year ended 31 December 20X3, Fausto sells inventory to Path Labs. Fausto
makes a gain on the sale of HK$8 million. At the reporting date, all of that inventory
remains on hand with Path Labs.

QUESTION 1

You are Dylan Yeoh, Abbas’ senior financial accountant. You have received the following
email from Kellee Tan, the junior accountant on your team.

Sender: Kellee Tan

Date: XX November 20X3

To: Dylan Yeoh

Subject: Fausto Limited

Dear Dylan,

I am pulling together the information to account for Fausto Limited (Fausto). As you know,
this is my first year accounting for the group entities, and I want to make sure I get it right.
Before I proceed any further, I want to check that the group’s ownership percentage of
Fausto for the purposes of calculating its equity-accounted share of profit should be 20%.

In the previous year’s financial statements, this has been calculated as 25%. I think this is an
error and we should retrospectively adjust the financial statements to correct the cumulative
group profit and investment carrying amount.

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 FINANCIAL REPORTING

Please let me know if my understanding is correct.

Kind regards,

Kellee Tan

Prepare an email to Kellee responding her concerns.

QUESTION 2
Using a consolidation worksheet, demonstrate how the investment in Fausto would be
reflected in Abbas’ consolidated statement of financial position and consolidated statement
of profit or loss for the year ended 31 December 20X3. Assume Abbas eliminates unrealised
gains and losses on inter-company transactions by adjusting only the limited line items for
associates (i.e. approach 1).

Your response need only show relevant line items in the worksheet. Show all workings.

ANSWERS TO EXAM PRACTICE

Case Study 1
QUESTION 1
Your response to Khoo Li San could be as follows:

Mr. Khoo,

HKFRSs require CLL to equity account the investment in ADL if ADL is determined to
be an associate; there is no accounting policy choice available in this regard. Limited
exemptions are available but none of them apply to you as CLL is a listed robotics
company. 20% is usually regarded as a sufficient ownership interest that enables the
investor to have significant influence over the investee. However, if you can demonstrate
that CLL does not have significant influence over ADL, you will not need to equity
account the investment.

However, even if you determine that CLL is cannot significantly influence ADL, it would
be inappropriate to measure the investment in ADL at cost in the consolidated financial
statements. This is because ADL would have to be accounted for as a financial asset and
the requirements of HKFRS 9 would apply, requiring ADL to be measured at fair value
through other comprehensive income or at fair value through profit or loss.

You have indicated that you are concerned that users would want to know what the
dividends received or receivable from ADL are rather than know CLL’s share of ADL’s
profit for the year. Your shareholders will still have access to this information because
HKAS 28 (2011) requires CLL’s financial statements to include disclosure of summarised
financial information about each material associate, including the dividends received
from that associate.

QUESTION 2
The carrying amount of the equity-accounted investment in ADL on 31 December 20X0 is
HK$310,000, calculated as shown on page 57.

First, CLL must determine whether the investment was purchased at a premium or for
a discount:

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 I n v estments in A ssociates

HK$
Cost of the investment 320,000
less: Share of fair value of identifiable net assets (HK$1,519,760 × 20%) (303,952)
Goodwill on acquisition 16,048

Because the investment was purchased at a premium, there is no amount to add to the
share of associate’s profit for the period.

Next, CLL calculates its share of the associate’s after-tax profit for the period:

HK$
ADL’s reported after-tax net profit for the year 200,000
less: additional amortisation from fair value adjustment on acquisition (25,000)
(119,760 × (1 – 16.5%) × 1/4 years)
ADL’s adjusted profit for the year 175,000
ADL’s share of CLL’s adjusted profit for the year (20% × 175,000) 35,000

The carrying amount of the equity-accounted investment in ADL on 31 December 20X0 is

first determined as:

HK$
Cost 320,000
add: Share of associates net profit for the period 35,000
less: Dividends declared (20% × 150,000) (30,000)
Investment in ADL at 31 December 20X0 325,000

However, the investment must be tested for impairment if objective evidence shows
impairment and must be written down to its recoverable amount. The new technology
introduced by ADL’s competitor that is expected to make ADL’s key products much less
attractive to purchase provides evidence triggering an impairment assessment.

The recoverable amount of ADL is HK$310,000, being the higher of its fair value less
costs to sell and value in use. As this is lower than the equity-accounted carrying
amount of HK$325,000 determined above, an impairment loss of HK$15,000
(HK$325,000 – HK$310,000) must be recognised, thereby reducing the carrying amount of
the investment on 31 December 20X0 to HK$310,000.

QUESTION 3

Debit Credit
HK$ HK$
Share of associate’s loss for the period 310,000
Investment in associate (ADL) 310,000

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 FINANCIAL REPORTING

Share of loss for the period HK$320,000 (20% × (HK$1,575,000 + HK$25,000a))

Opening equity-accounted carrying amount (HK$310,000)
Unrecognised losses of associate HK$10,000

Additional amortisation (less tax) arising on the fair value of the net assets at acquisition.
a

QUESTION 4
File note

Preparer: Tristan Choo

Date: XX Month 20X3

Subject: Treatment of Ang Do Limited (ADL)

Summary of key relevant facts

On 1 January 20X2, the equity-accounted carrying amount of CLL’s investment in ADL is nil.

CLL sold 50% of its interest in ADL on 1 January 20X3 for HK$200,000. After the sale, CLL
holds only a 10% interest in ADL. The fair value of that interest on the sale date can be
estimated as HK$200,000, equivalent to the fair value of the equivalent parcel sold.

(It appears reasonable to estimate the fair value of the 50% retained interest by reference to
the fair value of the 50% sold as it was sold to a third party that does not currently hold any
interest in ADL. That is, after the sale, CLL and Masters hold only 10% of ADL.)

Concern 1: Accounting basis

Note X suggests that the equity method of accounting is applied to account for ADL.

However, significant influence can be presumed to be absent when the ownership interest is
10%. On review of the available information, no evidence suggests that ADL should continue
to be treated as an associate of CLL.

Concern 2: The gain on sale of associate is currently shown as HK$195,000

Prima facie, CLL no longer has significant influence over ADL and should cease equity
accounting the investment. In this case, the gain on sale of the associate would be calculated as:

Fair value of retained interest 200,000

+ Proceeds on sale 200,000
- Equity-accounted investment nil (ADL is in a loss-making position)
Gain on sale 400,000

Even if CLL still has significant influence over ADL, the gain of HK$195,000 still appears
incorrect. In this case, the gain would be determined to be HK$200,000.

Concern 3: Carrying amount of the investment at year end at HK$4,500

Prima facie, CLL no longer has significant influence over ADL and should cease equity
accounting the investment. In this case, HKAS 28 (2011) requires any retained interest to be
measured at fair value at the disposal date, and thereafter, the interest should be accounted
for as a financial asset in accordance with HKFRS 9.

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This would normally require the investment to be measured at its fair value on 31 December
20X2. It is unlikely that this is as low as HK$4,500 given the reception of the new products
introduced to market and the valuation at the start of the year at HK$200,000.

Even if CLL still has significant influence over ADL, the carrying amount of the investment
still appears incorrect as it ignores the cumulative unrecognised losses of the earlier periods
(HK$5,000) and the adjustment to profit necessary to reflect the additional amortisation
attributable to the fair value of the net assets on acquisition (10% × HK$25,000).

If equity accounted, the investment should be reported at nil because not all the cumulative
unrecognised losses will have yet been recovered as shown below:

Share of profit for the year (10% remaining shareholding × (HK$45,000 – HK$25,000)) HK$2,000
Share of cumulative unrecognised losses (50% shareholding retained × HK$10,000) (HK$5,000)
Remaining losses not yet recovered (HK$3,000)

Conclusion

Discussion with the CLL accounting team is necessary to understand the treatment of
the investment in the financial statements and to establish the extent of the error to be
corrected.

Notes (for reference only to show how the draft financial statement amounts were determined)

HK$
Proceeds on sale 200,000
– share of unrecognised losses recovered through sale (5,000)
195,000

HK$
Carrying amount at 1/1/X2 nil
Share of profit for the year (10% × HK$45,000) 4,500
Carrying amount at 31/12/X2 4,500

Case Study 2
QUESTION 1

To: Kellee Tan

From: Dylan Yeoh

Date: XX November 20X3

RE: Subject: Fausto Limited

Hi Kellee,

25% is correct. Though the group’s overall ownership interest in Fausto is 20% (80% ×
100,000 / 500,000), in accordance with HKAS 28 (2011), the group’s share of Fausto for the
purposes of calculating its equity-accounted share of profit is determined as Path Lab’s
interest of 25% (100,000/500,000).

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 FINANCIAL REPORTING

Part of that equity-accounted share of profit will be attributed to the non-controlled interest
(NCI) as part of the consolidation process.

Kind regards

Dylan Yeoh

QUESTION 2
(Some line items have been included for illustrative purposes only to show that the line item
is not affected)

Adjustments
Path DR CR Consolidated
Labs financial
statements
HK$’000 HK$’000 Ref HK$’000 HK$’000
Statement of financial position (extract)
Assets
Investment in Fausto 4,500.0 675.0 1 3,767.5
7,500.0 2
3 7,237.5
4 1,670
Deferred tax asset 1,000.0 1,000.0
Inventories 4,580.0 4,580.0
Equity
Share capital 100.0 100.0
Retained earnings 50,170.0 1 675.0 49,437.5
2 7,500.0
7,237.5 3
1,670.0 4

Statement of profit or
loss (extract)
Dividends and other income 66,000.0 7,237.5 3 58,762.5
Share of Fausto’s profit – 2 7,500.0 5,830.0
for the year
1,670.0 4
Income tax expense 4,100.0 4,100.0

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Workings (for reference only) (all amounts in HK$’000)

Ref 1: Restate opening carrying amount

Debit Credit
HK$ HK$
Investment in associate (Fausto) 675
Retained earnings 675

Retained earnings at 1/1/X1 = 8,000 (net assets 18,000 – share capital 10,000)

Retained earnings at 1/1/X3 = 10,700 (given)

Accumulated profits since acquisition = 10,700 – 8,000 = 2,700

Share of profits since acquisition = 25% × 2,700 = 675

Ref 2: Recognise share of profit of Fausto for the year

Debit Credit
HK$ HK$
Investment in associate (Fausto) 7,500
Share of associates’ profit after tax (25% × 30,000) 7,500

Ref 3: Recognise dividend received from Fausto

Debit Credit
HK$ HK$
Dividend income (25% × 28,950) 7,237.5
Investment in associate (Fausto) 7,237.5

Ref 4: Eliminate Abbas’ share of the unrealised gain in inventory (upstream transaction)

Debit Credit
HK$ HK$
Share of associates’ profit after tax 1,670
Investment in associate (Fausto) (25% × (1 – 16.5%) × 8,000) 1,670

Reconciliation of investment in associate (for reference only) (all amounts in HK$’000)

Path’s share of Fausto’s net assets on 31 Dec 20X3 (25% × book value of Fausto’s 5,437.5
equity 21,750)
+/– fair value adjustments –
+ implicit goodwill –
+/– downstream inter-company transactions (1,670)
Investment in associate on 31 Dec 20X3 3,767.5

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 33
Joint Arrangements

CHAPTER TOPIC LIST

33.1 Joint Arrangements Overview 33.3 Accounting for Joint Ventures

33.1.1 Scope and Terminology 33.3.1 Financial Statements of a
33.1.2 Joint Control Joint Venturer
33.1.3 Classification of Joint 33.3.2 Accounting by Participants
Arrangements Who Do Not Have Joint
33.2 Accounting for Joint Operations Control of the Joint Venture
33.2.1 Accounting for Rights and 33.4 Deferred Tax
Obligations to Share in 33.5 Presentation and Disclosure
Assets and/or Liabilities
33.5.1 Presentation of Joint
33.2.2 Transactions Between
Arrangements
the Joint Operator and
33.5.2 Disclosure of Joint
the Joint Operation
Arrangements
33.6 Current Developments

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO2: APPLY APPROPRIATE ACCOUNTING PRINCIPLES AND CONCEPTS TO ACCOUNT

FOR BUSINESS TRANSACTIONS
LO2.07: D
 escribe and account for business transactions in accordance with Hong Kong Financial
Reporting Standards as they relate to income taxes
2.07.07 Account for deferred tax relating to investments in subsidiaries, associates and
joint ventures
PRINCIPAL LO4: PREPARE, PRESENT AND APPRAISE GROUP FINANCIAL STATEMENTS WITH
COMPLEX GROUP STRUCTURES
LO4.06: C
 onstruct the financial statements for a group in accordance with Hong Kong Financial
Reporting Standards and statutory reporting requirements: Joint arrangements
4.06.01 Describe joint arrangements
4.06.02 Define joint control
4.06.03 Explain and contrast joint operations and joint ventures
4.06.04 Classify and account for a joint venture and joint operations
4.06.05 Account for the transactions between a venturer and a joint venture
4.06.06 Prepare and appraise disclosure in respect of joint arrangements

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 Joint A rrangements

OPENING CASE

THE SOLEIL GROUP

A s introduced in Chapter 29 and subsequent chapters, the Soleil Group operates an

extensive global logistics network across 600 locations in more than 50 countries. The
group provides a diverse range of transport and logistics solutions covering road, air, sea
and rail to meet global supply chain needs. The ultimate parent entity in the group is Soleil
Limited (Soleil).

Soleil is in final discussions to establish an arrangement with Rigel Limited (Rigel) to

manufacture packing materials that Soleil and Rigel will use in their own business operations.
Soleil and Rigel have tentatively decided the manufacturing will be actioned in a newly
incorporated company to be named Sogel Limited (Sogel). Sogel will be owned equally by Soleil
and Rigel; each holding 50% of the voting rights of Sogel. Soleil and Rigel must approve all
financial and operating policy decisions taken by Sogel.

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OVERVIEW

In Chapters 29 and 30, you were introduced to the accounting for merger and acquisition
activity and how to prepare consolidated financial statements. In Chapter 32, you learned how
to account for an entity’s interest in an associate using the equity method. In this chapter, you
will learn how to account for another type of investment interest: an entity’s interest in joint
arrangements.

A joint arrangement is an arrangement in which two or more parties share joint

control and is another way for investors to share costs and risks or to gain access to new
technology or markets. A joint arrangement may be structured such that the parties to the
joint arrangement share in assets and obligations of the joint arrangement (a joint operation)
or share in net assets of that joint arrangement (a joint venture). An entity that is a party
to a joint arrangement may be a joint operator, a joint venturer, a participant in the joint
arrangement, or merely a financial investor. The accounting for a joint arrangement depends
on the classification of the arrangement. Hence, for example, Soleil must determine whether
its proposed arrangement with Rigel is a joint arrangement and whether it is a joint operator,
joint venturer, or a participant in that arrangement to identify the applicable accounting for the
arrangement.

Joint arrangements are more prevalent in some industries compared to others. For
example, the mining sector engages in joint arrangements fairly frequently; the nature of
that industry is that an entity may have difficulty securing financing and entering into a joint
arrangement, which would allow miners to pool capital and share expertise.

By the end of this chapter, you will be aware of when a joint arrangement exists and
understand how to classify a joint arrangement as a joint operation or a joint venture. You
will understand how to account for a joint arrangement. In addition, you will have familiarised
yourself with the information an entity discloses about its joint arrangements.

3 3 . 1 JOINT ARRANGEMENTS OVERVIEW

A joint arrangement is another way for investors to share costs and risks or to gain access to
new technology or new markets. The accounting for a joint arrangement is primarily specified
by HKFRS 11 Joint Arrangements and HKAS 28 (2011) Investments in Associates and Joint Ventures.
In addition, HKFRS 12 Disclosure of Interests in Other Entities, HKAS 1 Presentation of Financial
Statements and HKAS 24 (Revised) Related Party Disclosures specify information that must be
disclosed by an entity about its investments in joint arrangements.

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 Joint A rrangements

A joint arrangement may be structured so that the parties to the joint arrangement share in
assets and obligations of the joint arrangement (a joint operation) or share in net assets of that
joint arrangement (a joint venture). Over the course of this chapter, you will learn to distinguish
the form of the arrangement (hint: the key is understanding the rights and obligations of the
parties). This is important because the accounting treatment differs depending on the form of
the arrangement.

This section describes a joint arrangement and its key feature (joint control). It also
discusses how to distinguish among the different types of joint arrangements.

33.1.1 Scope and Terminology

HKFRS HKFRS 11 applies to all entities that are a party to a joint arrangement, not just those that
11.3 jointly control the arrangement. A joint arrangement is an arrangement of which two or more
parties have joint control. In a joint arrangement the parties are bound by a contractual
arrangement, and the contractual arrangement gives two or more of those parties joint control
of the arrangement.

A joint arrangement is classified as a joint operation or a joint venture. An entity that is a

HKFRS party to a joint arrangement may be a joint operator, a joint venturer, a participant in the joint
11.4–6 arrangement, or merely a financial investor.
Where a joint arrangement is classified as a joint venture, HKFRS 11 directs the joint
venturer to apply the accounting set out in HKAS 28 (this is discussed in Section 33.3).

Key Learning Point

HKFRS 11 specifies or at least provides direction on the accounting by all parties to a joint
arrangement. An entity that is a participant in a joint arrangement but that does not jointly
control the arrangement must still consider the requirements of this HKFRS.

33.1.2 Joint Control

For a joint arrangement to be present, there must be the contractually agreed sharing of
control of an arrangement, meaning joint control. This exists only when decisions about the
relevant activities of the arrangement require the unanimous consent of the parties sharing
control. This does not mean all parties to the arrangement must have joint control; the HKFRS
HKFRS is clear that an arrangement can be a joint arrangement even though not all of its investors
11.7, 11 have joint control of the arrangement.

Establishing whether joint control exists is a two-step approach:

1. Collective control must occur. An entity must assess whether the contractual
arrangement (e.g. a contract and/or company charter or articles), whether explicitly or
implicitly, gives two or more parties control of the arrangement collectively. These
parties control the arrangement collectively when the parties must act together to
HKFRS direct the activities that affect the returns of the arrangement (i.e. the relevant
11.8, B5 activities).

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 FINANCIAL REPORTING

Control exists when the parties acting together are exposed or have rights to
variable returns from their involvement with the arrangement and can affect those
returns through their power over the arrangement. A party does not have control of an
HKFRS arrangement if it can block, but cannot itself direct, the relevant activities of the
11.B8 arrangement. (Review Chapter 30 if you need to refresh your understanding of when
control is present.)

2. Decisions require unanimous consent. Unanimous consent means being able to

prevent any of the other parties, or a group of the parties, from making unilateral
decisions about the relevant activities of the arrangement. When decisions about
the relevant activities require the unanimous consent of the parties that control the
arrangement collectively, the arrangement is subject to joint control.

An investor does not have joint control of an arrangement if the decisions for which
unanimous consent is required relate only to the investor’s protective rights (protective
HKFRS
11.9, B6, rights were discussed in Chapter 29). Similarly, unanimous consent on decisions, such
B9, B10 as the resolution of disputes, is not necessary for joint control to exist.

Illustrative Example 1 – Adapted from HKFRS 11.B8

Entities A, B and C establish an arrangement. The terms of the contractual arrangement
and the voting rights of each entity in that arrangement is as follows:

Entity A

50%

Contractual arrangement:
30% 20%
Entity B 75% of voting rights required Entity C
to make decisions about
relevant activities

The contractual arrangement implicitly gives Entities A and B control of the

arrangement through the terms reference to the arrangement’s decision-making process.
Entities A and B collectively control the arrangement because decisions about the relevant
activities cannot be made without Entities A and B coming to an agreement (i.e. unanimous
decision-making) as it is not possible to otherwise achieve the required 75% voting rights
threshold.

Therefore, Entities A and B have joint control over the arrangement.

A contractual arrangement requires a minimum proportion of voting rights to make

decisions about the relevant activities, and the minimum proportion can be achieved by more
than one combination of agreeing parties.

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 Joint A rrangements

In addition, the contractual arrangement must specify which of the parties to the arrangement
(or combination of parties) must agree unanimously to decisions about the relevant activities. This
HKFRS
detail distinguishes the parties with joint control of the arrangement from other participants to the
11.B8 arrangement. The arrangement is not a joint arrangement in the absence of this detail.

Illustrative Example 2 – Adapted from HKFRS 11.B8

Entities D, E and F establish an arrangement. The terms of the contractual arrangement
and the voting rights of each entity in that arrangement is as follows:

Entity D

50%

Contractual arrangement:
25% 25%
Entity E 75% of voting rights required Entity F
to make decisions about
relevant activities

In this arrangement, Entities D, E and F collectively control the arrangement as two or

more of the parties can act together to achieve the required 75% voting rights threshold
to direct the relevant activities. However, because the threshold can be achieved by
more than one combination of agreeing parties (Entities D and E or Entities D and F) and
in accordance with HKFRS 11m the arrangement is a joint arrangement only where the
contractual arrangement also specifies which combination of Entities D, E and F must
agree unanimously to decisions about the relevant activities.

For example, if the terms set out that Entities D and E must agree unanimously to
decisions about the relevant activities of the arrangement, the arrangement is a joint
arrangement jointly controlled by Entities D and E, but not by Entity F.

However, if the terms establish that Entity D may make decisions about the relevant
activities of the arrangement with Entity E or F, the arrangement will not be subject to joint
control because ‘unanimous decision-making’ is not a feature of the arrangement. This is
because Entity D can collaborate with Entity E or F to obtain sufficient voting rights to make
decisions about relevant activities. As the arrangement is not subject to joint control, the
arrangement is not a joint arrangement.

As always, all facts and circumstances must be considered when making an assessment of
HKFRS joint control. A change in facts and circumstances may result in a party to a joint arrangement
11.12–13 ceasing or gaining joint control of the arrangement.

Key Learning Point

The percentage ownership (or percentage held of voting power) need not be held in an
equal ratio (e.g. 50:50) for joint control to exist.

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33.1.3 Classification of Joint Arrangements

Having determined that an arrangement is a joint arrangement, an entity that is a party to
the joint arrangement, whether or not the entity jointly controls the arrangement, must
next determine its classification. Classifying the arrangement correctly is important as the
accounting differs based on the classification.

Although not explicitly stated in the HKFRS, in classifying the arrangement, the substance of
the arrangement is more important than its form: This is a more principles-based approach and
ensures that arrangements giving parties similar rights and obligations are accounted for similarly,
thereby promoting comparability. A joint arrangement may be structured so as to achieve a
particular economic outcome or to respond to tax or other regulatory requirements, but the
structure may not be representative of its underlying substance. Similarly, the activities of different
joint arrangements may be operationally similar, but the contractual arrangement may confer on
the parties different rights and obligations relating to the activities; for example, see the Illustrative
Examples concerning the joint arrangement between Soleil and Rigel later in this section.

The detail (substance) of the contractual arrangement determines the classification of a

joint arrangement. For example, the objective of the parties in entering into a joint arrangement
may be to jointly manufacture a product, but the detail set out in the contractual arrangement
could be: (1) each party being responsible for a specific task with each using its own assets
and incurring own liabilities; (2) each party being responsible for a specified proportion of the
assets, liabilities, costs and revenues in manufacturing the product; or (3) the product being
manufactured by a separate entity that is jointly established by the parties to the arrangement.

Joint arrangements may be classified as a joint operation or a joint venture. The difference
in the classification is the nature of the rights and obligations accorded to the party to the joint
arrangement:

• A joint arrangement that gives the jointly controlling parties rights and obligations to
share in assets and/or liabilities of the arrangement is a joint operation. The parties
jointly controlling these arrangements are called joint operators; and

• A joint arrangement that gives the jointly controlling parties rights and obligations to
HKFRS share in the net assets of the arrangement is a joint venture. The parties jointly
11.15-16 controlling these arrangements are called joint venturers.

Illustrative Example 3
Let’s revisit the first Illustrative Example. Assume Entities A and B jointly control the joint
arrangement.

Entity A

50%

Contractual arrangement:
30% 20%
Entity B 75% of voting rights required Entity C
to make decisions about
relevant activities

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 Joint A rrangements

Illustrative Example 3 (continued)

In this arrangement, if the joint arrangement is classified as a joint operation:

• Entities A and B are joint operators; and

• Entity C is a participant to the joint operation.

In this arrangement, if the joint arrangement is classified as a joint venture:

• Entities A and B are joint venturers; and

• Entity C is a participant to the joint venture.

Under HKFRSs, joint operations and joint ventures are accounted for differently reflecting
HKFRS
the different nature of the entity’s interests. An entity party to a joint arrangement establishes
11.2–3, 14 its type of joint arrangement by assessing its rights and obligations under the arrangement.

An entity that is a party to a joint arrangement assesses its rights and obligations arising
from the joint arrangement having regard to the facts and circumstances, including the
HKFRS 11.17, structure of the arrangement, its legal form (if any) and the terms of the contractual
B15–B16, B21,
B24, B33 arrangement. This is depicted in the decision tree in Exhibit 33.1:

Is the joint arrangement structured NO The joint arrangement is

as a separate vehicle?
a joint operation
(e.g. a separate company)

YES

Does the legal form of the vehicle give the

parties to the joint arrangement rights to
the net assets of the arrangement? NO
(i.e. is there separation between the parties
and the vehicle such that assets and liabilities
held in the vehicle are not themselves assets
and liabilities of the parties?)

YES

Do the terms of the contractual arrangement

change the rights accorded by the legal form YES
of the vehicle such that the parties no longer
have rights to the net assets of the vehicle?

NO

Is the joint arrangement designed such that: YES

• Its activities primarily aim to provide the
parties with output; and
• It depends on the parties on a continuous NO The joint arrangement is
basis for settling its liabilities? a joint venture

EXHIBIT 33.1 Classification of a joint arrangement

Points to note about the classification of a joint arrangement:

• The joint arrangement is structured as a separate vehicle.

A separate vehicle is defined in HKFRS 11 as a separately identifiable financial

structure, including separate legal entities or entities recognised by statute regardless

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HKFRS of whether those entities have a legal personality, for example, a company or a branch
11.App A
of a company. Therefore, it is important to be aware that it is possible but maybe less
common for an entity other than an incorporated entity to also be classified as a joint
venture. As illustrated by Exhibit 33.1, where the joint arrangement is not structured as
a separate vehicle, under HKFRSs it can only be classified as a joint operation. For
example, the parties to a joint arrangement wherein the parties share and operate an
asset together may not establish the arrangement as a separate structure because it is
unnecessary to do so.

• The vehicle’s legal form gives the parties rights to the net assets of the arrangement.

Where the joint arrangement is structured as a separate vehicle, it will often be clear
whether the vehicle’s legal form gives the parties to the arrangement rights to the
net assets of the arrangement. For example, a limited company structure would
normally give the parties to the arrangement rights to the net assets of the company
in proportion to their shareholding interest. A vehicle’s constitution or articles of
incorporation will normally clarify each party’s rights under the structure.

• Terms of the contractual arrangement change the legal rights of the parties.

The rights and obligations of the parties conferred by the legal form of the vehicle will in
many cases be consistent or at least will not conflict – with those agreed to in the
contractual arrangement. However, the parties through their contractual arrangement
may explicitly change those rights and obligations. For example, the contractual
arrangement may include terms that change the ownership interest in net assets of the
HKFRS parties to an arrangement to an interest instead in rights to assets and obligations for
11.B25–B26 liabilities in a specified proportion.

Exhibit 33.2 summarises common terms that might be found in a contractual

HKFRS arrangement and contrasts whether the terms evidence rights and obligations
11.B27 consistent with a joint operation or a joint venture.

• The primary purpose of the arrangement is to provide the parties with output.

In some cases, the terms of the contractual arrangement may not change the rights of
the parties to net assets of the vehicle, as accorded by the legal form of the vehicle.
However, other facts and circumstances, such as the establishment of the joint
arrangement to supply its output primarily to only the parties to the arrangement
(i.e. the parties to the arrangement are the vehicle’s primary source of financing its
continuing operations) may indicate the nature of the joint arrangement is that of a
joint operation instead of a joint venture. That is, despite the legal form, the substance
of the arrangement (that the liabilities of the arrangement are satisfied by cash flows
received primarily from the investors) may demonstrate the investors are responsible
for satisfying the obligations (and receiving the rights to assets) of the arrangement. As
per the Conceptual Framework for Financial Reporting (2018), for information to be useful,
Conceptual
Framework, ‘. . . financial information must not only represent relevant phenomena, but it must also
para 2.2 faithfully represent the substance of the phenomena that it purports to represent’. As
such, the classification and the resultant financial information should reflect that
substance rather than just the legal form of the arrangement.

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Joint operation Joint venture

Terms Establishes that the parties to the joint Establishes that the parties to the joint
arrangement hold rights to assets and arrangement hold rights to the net assets
obligations for liabilities relating to the of the arrangement.
arrangement.
Rights to assets Establishes that the parties to the Establishes that the joint arrangement
joint arrangement share all interests has the rights to the assets (whether
(e.g. rights, title and ownership) in the contributed by a party to the joint
arrangement’s assets in a specified arrangement or acquired by the
proportion. joint venture).
For example, in proportion to the
ownership interest, in proportion
to the activity carried out
through the arrangement directly
attributable to them.
Assets in a joint arrangement need not
be held jointly; assets may be owned
by a party to the joint arrangement
and used in the activity of the joint
arrangement.
Obligations for Establishes that the parties to the Establishes that the joint arrangement is
liabilities joint arrangement share all liabilities, liable for its debts and obligations.
obligations, costs and expenses relating Establishes that the parties to the joint
to the arrangement in a specified arrangement are liable only to the extent
proportion. of their respective investments in the
Establishes that the parties to the joint arrangement and/or to their obligation
arrangement are liable for third-party to contribute any further capital into the
claims made against the arrangement. arrangement.
Liabilities in a joint arrangement need Establishes that creditors of the joint
not be shared jointly; the obligation for arrangement do not have recourse
a liability may be attributed to a single against the parties to the joint
party to the joint arrangement. arrangement for the arrangement’s debts
and obligations.
Revenues, Establishes the allocation of revenues Establishes each party’s share in the
expenses, and expenses on the basis of the profit or loss of the joint arrangement.
profit or loss relative performance of each party to
the joint arrangement.
Allocate revenue and expense, for
example, based on the capacity each
party uses of a jointly controlled plant
(which may differ from the party’s
ownership interest).

EXHIBIT 33.2 Terms of the contractual arrangement

Whether the parties to the arrangement intend to use the output from the joint
arrangement as an input in their own operations or on-sell it in its existing form to a
HKFRS
third party does not impact that the substance of the arrangement is that of a joint
11.B31–32 operation.

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Apply and Analyse 1

Soleil is in final discussions to establish an arrangement with Rigel Limited (Rigel) to
manufacture packing materials, which Soleil and Rigel will use in their own business
operations. Soleil and Rigel have decided that the manufacture will be actioned by a newly
incorporated company (Sogel Limited) that the parties will equally own. Soleil and Rigel will
each hold 50% of the voting rights of Sogel and must approve all financial and operating
policy decisions taken by Sogel.

Soleil and Rigel have tentatively agreed that Sogel would be able to sell its output to
Soleil, Rigel, or to third parties, at a price set by Sogel’s management that will enable it to
generate a net profit.

How should Soleil classify this arrangement in its financial statements?

Analysis

Soleil must first determine whether the arrangement between itself and Rigel is a joint
arrangement. Soleil observes that:

• The parties must act together to direct the activities that significantly affect the
returns of the arrangement as decisions about the relevant activities cannot be
made without Soleil and Rigel agreeing (i.e. there is collective control); and
• Decisions about the relevant activities require the unanimous consent of Soleil
and Rigel.

Soleil concludes that these terms evidence joint control. Hence, as joint control is
present, Soleil concludes the arrangement between itself and Rigel is a joint arrangement.

Next, Soleil must classify the joint arrangement by considering its rights and obligations
under the arrangement. Soleil observes that:

• The arrangement will be structured in a separate vehicle (Sogel);

• The legal form of the vehicle confers on Soleil the rights to the net assets of Sogel
(through its shareholding) rather than a direct interest in the assets and liabilities
of Sogel itself. As such, there is separation between the parties and the vehicle;

• Soleil and Rigel have not planned for the terms of the arrangement to change the
rights conferred by the legal form of the vehicle; and

• As Sogel’s output can be sold to third parties at a price to be set by Sogel, and
Sogel will assume demand, inventory and credit risks. The activities of the joint
arrangement are not primarily aimed at supplying output to Soleil and Rigel, and
Sogel need not depend on Soleil and Rigel to fund the settlement of its liabilities
(e.g. trade payables incurred in acquiring raw materials used in the manufacture of
packing materials).

On review of these facts and circumstances, Soleil concludes that the joint arrangement
would be classified as a joint venture as Soleil has the rights to the net assets of the joint
arrangement rather than rights to the assets and obligations for the liabilities of the joint
arrangement.

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Apply and Analyse 2 – Adapted from HKFRS 11.B32

Assume the same fact pattern as in the immediately preceding Apply and Analyse.
However, Rigel is concerned that it may not be able to purchase output from Sogel
sufficient to meet its business objectives if Sogel is permitted to sell its output to third
parties.

Rigel has suggested that Soleil and Rigel instead sign agreements with Sogel to the
effect that:

• Soleil and Rigel will purchase all of the output of Sogel in a 50:50 ratio, at a price
that reflects Sogel’s costs of operation (i.e. Sogel will operate on a break-even
basis); and

• Sogel cannot sell output to third parties without the agreement of both Soleil and Rigel.

Determine whether this will change Soleil’s initial classification of the joint arrangement.

Analysis

Soleil’s review of the facts and circumstances now indicate that:

• The arrangement will be structured in a separate vehicle (Sogel);

• The legal form of the vehicle confers on Soleil the rights to the net assets of Sogel
(through its shareholding) rather than a direct interest in the assets and liabilities
of Sogel. As such, there is separation between the parties and the vehicle;

• Soleil and Rigel have not planned for the terms of the arrangement to change the
rights conferred by the legal form of the vehicle; and

• Sogel will primarily be established to supply output to Soleil and Rigel. As such,
Sogel will be dependent on Soleil and Rigel for the generation of its future cash
flows and, consequently, will also be dependent on these parties to fund the
settlement of its liabilities.

Because the facts and circumstances now indicate Soleil and Rigel will consume, and
have rights to most of the economic benefits of Sogel’s assets, Soleil would instead classify
the joint arrangement as a joint operation.

Key Learning Point

In classifying a joint arrangement, regard is had to the rights and obligations accorded to
the parties to the joint arrangement and not merely the legal form of the structure itself.

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Knowledge Check Questions

Question 1
Siew Ngap Limited (SNL) holds 33% of Ho Chiak Limited’s (HCL) ordinary shares. The
remaining 67% is held by a single other investor, Tam. HCL’s constitution provides that
70% of voting rights are required to make decisions about the relevant activities of HCL,
including dividend distributions.
Advise how SNL classifies the investment in HCL.

Question 2
Gummy Limited (Gummy) and Bears Limited (Bears) agree to share and operate a food
truck together. The food truck will sell dragon’s beard candy. The terms of the contractual
arrangement specify that Gummy and Bears will equally split the costs of purchasing
the food truck and the costs of operating that food truck. Any revenues from the sale of
food items will similarly be equally shared. The food truck cannot be sold without the
agreement of Gummy and Bears; if sold, any monies received will be equally shared.
Gummy and Bears must decide and agree on the pricing of the candy, the opening hours
of their truck, the locations it will visit and the production levels for the month at the start
of every month.
Determine whether the arrangement between Gummy and Bears is a joint
arrangement and, if so, whether it is a joint operation or a joint venture.

Question 3
Consider the following arrangement among Entities A, B and C. The percentages reflect the
proportionate voting power of each entity in the arrangement.

Entity A

35%

Contractual arrangement:
• 80% of voting rights required
45% to make decisions about 20%
Entity B relevant activities Entity C
• Entity A & Entity B must
unanimously agree on decisions
relating to relevant activities

Identify which one of the following statements is true in accordance with HKFRS 11.
A Entity A jointly controls the arrangement.
B Entity C jointly controls the arrangement.
C The arrangement is not a joint arrangement.
D Entities A, B and C control the arrangement.

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3 3 . 2 ACCOUNTING FOR JOINT OPERATIONS

An entity that is party to a joint arrangement applies the accounting applicable to its
classification as a joint operation or a joint venture. The applicable accounting enhances
the relevance and faithful representation of the joint arrangement in the entity’s financial
statements as it depicts whether the entity has rights to assets and/or obligations for liabilities
of the joint arrangement, or it has rights to net assets of the joint arrangement.

This section sets out the accounting that applies in the financial statements of a joint
operator or a participant who does not have joint control of the joint operation.

33.2.1 Accounting for Rights and Obligations to Share in Assets

and/or Liabilities
Recall that in a joint operation, the joint operator has an interest in specific assets and/
or obligations used in the arrangement, rather than an interest in the results of the overall
arrangement. Similarly, a participant in the joint operation that does not have joint control of
the operation may also have rights to assets and obligations for liabilities relating to the joint
operation.

This is reflected in the accounting prescribed by HKFRS 11 as a party to a joint operation

recognises the following in relation to its interest in a joint operation:

• Assets, including its share of any assets held jointly;

• Liabilities, including its share of any liabilities incurred jointly;

• Revenue from the sale of its share of the output arising from the joint operation;

• Shares of the revenue from the sale of the output by the joint operation; and
HKFRS
11.20, 23 • Expenses, including its share of any expenses incurred jointly.

The assets, liabilities, revenues and expenses are recognised, measured and accounted for
HKFRS
11.21
by the party to a joint operation in accordance with the HKFRSs applying to the particular
IFRS element. The HKFRS is clear that a joint operator has rights to an asset (or share thereof) and
11.BC39 not a ‘right to use’ the asset. Hence, for example, machinery used in the activity of the joint
operation (whether held solely by the operator, or jointly) is measured, and disclosures made,
in accordance with HKAS 16 Property, Plant and Equipment and not HKAS 38 Intangible Assets.
Where the interest in a joint operation is held for sale, the party to the joint operation should
IFRS account for the interest in accordance with HKFRS 5 Non-Current Assets Held for Sale and
11.BC51 Discontinued Operations.

A party’s ‘share’ is determined by reference to the party’s rights and obligations to the asset
or liability and not by its ownership interest in the separate vehicle (if any) set up to conduct the
activity of the joint arrangement.

Exhibit 33.3 illustrates, by reference to assets used in a joint operation, what a party to a
joint operation may recognise in its financial statements. As illustrated, Entities A and B
recognise a share of the jointly controlled machine as part of their assets. However, the

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Entity A Entity B
Joint
Operation

Entity A’s financial statements Entity B’s financial statements

EXHIBIT 33.3 Assets used in a joint operation

Conceptual
Framework Conceptual Framework for Financial Reporting (2018) explains that an asset is ‘a present economic
4.2 resource controlled by the entity as a result of past events’. Recognising a share of a jointly
controlled asset may appear inconsistent with this definition, with only joint control, the entity is
unable to itself (solely) direct the use of the asset. Hence, whether the entity can be said to
control the economic resource is questionable in the context of the Conceptual Framework.
Nevertheless, under the hierarchy the provisions of HKFRS 11 override the Conceptual
Framework, and accordingly, the share of the asset must be recognised as an asset of the party
to the joint operation.

33.2.1.1 Activity of the Joint Operation Constitutes a Business

In some cases, a joint operator may acquire an initial interest in a joint operation whose activity
constitutes a business (e.g. where one of the parties to the arrangement contributes a business
on formation of the joint operation). A business is defined in HKFRS 3 (Revised) Business
Combinations as ‘an integrated set of activities and assets that is capable of being conducted
and managed for the purpose of providing goods and services to customers, generating
HKFRS
investment income, such as dividends or interest, or generating other income from ordinary
3(R).App A activities’.

In general in these cases, in accounting for its rights and obligations to share in assets and/or
HKFRS
11.21A, liabilities, the entity applies the principles of business combination accounting that do not conflict
B33A-B33D with HKFRS 11 (see Chapter 29).

Illustrative Example 4
Ivy Limited (Ivy) and Sunflower Limited (Sunflower) have joint control of joint operation
Rose Limited (Rose). The contractual arrangement between Ivy and Sunflower establishes
that Ivy and Sunflower share the revenues, expenses, assets and liabilities of Rose on a
50:50 participant basis.

To establish the joint operation, Ivy contributed cash HK$100,000 and Sunflower
contributed equipment HK$70,000, inventory HK$20,000 and processes. The carrying
amount of the assets in Sunflower’s books immediately before the transfer was HK$90,000.
The assets and processes transferred by Sunflower constitute a business, which has been

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Illustrative Example 4 (continued)

valued at HK$100,000. Assume that the fair value of the assets transferred were the same
as their carrying amounts.

As a joint operator, Ivy recognises in its financial statements its share of the assets
and liabilities resulting from the contractual arrangement. As Ivy has acquired an interest
in a joint operation that is operating as a business, in accordance with HKFRS 11, it
applies the principles of business combination accounting in HKFRSs for identifying,
recognising, measuring and classifying the assets acquired and the liabilities assumed on
the acquisition of the interest in Rose but only to the extent those principles do not conflict
with the accounting for a joint operator otherwise set out in HKFRS 11.

To effect this, Ivy recognises its share in each jointly controlled asset transferred
by Sunflower into Rose measured at the item’s acquisition date’s fair value, consistent
with the accounting for a business combination, as such measurement does not conflict
with HKFRS 11. Ivy does not recognise 100% of Rose’s assets and liabilities (i.e. in effect,
recognising the shares of the other parties in Rose) because to do so would be inconsistent
with the requirements set out in HKFRS 11.

That is, on initial recognition of the joint operation, Ivy recognises:

• equipment HK$35,000 (its 50% share of the fair value of equipment HK$70,000);

• inventory HK$10,000 (its 50% share of the fair value of inventory HK$20,000); and

• cash HK$50,000 (its 50% share of the cash transferred to the joint operation).

In addition, Ivy recognises the excess of the consideration transferred over the amount
allocated to Ivy’s shares in the net identifiable assets as goodwill, calculated as follows:

Consideration transferred HK$50,000

Fair value of net assets acquired (HK$45,000)
Goodwill HK$5,000

33.2.1.2 Other Participants in the Joint Operation

The interest of a participant in the joint operation who does not have joint control of the
HKFRS operation; and does not have rights to the assets and obligations for the liabilities relating to
11.23 the joint operation is accounted for in accordance with the HKFRS applicable to that interest.
For example, HKFRS 9 Financial Instruments may be applicable if the participant’s interest was in
the form of a loan to the joint operation.

Apply and Analyse 3

Chung Ho Limited (CHL) enters into a joint arrangement with Wang San Limited (WSL) on
1 January 20X3. Under the terms of the arrangement, CHL and WSL agree to undertake
activity to manufacture capacitors, which CHL and WSL intend to use as inputs in their own
manufacturing processes.

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Apply and Analyse 3 (continued)

The terms of the contractual arrangement governing the joint arrangement set out
that CHL and WSL will jointly purchase the machine to produce the capacitors and share
equally in the costs of producing and selling the items. 90% of the output of the machine
will be shared by CHL and WSL in a 50:50 ratio and the remaining 10% will be sold to
external parties.

The machine was acquired on 1 October 20X3 for HK$12 million. Assume the machine
has a useful life of 10 years for accounting purposes and that its residual value is nil.

During the year ended 31 December 20X3, the joint arrangement incurred:

• Costs of HK$800,000 to produce the capacitors that were taken by CHL

and WSL; and

• Costs of HK$100,000 to produce and sell the capacitors that were sold. The
capacitors were sold at a markup of 10%. All the capacitors were sold by
31 December.

Calculate the amounts that CHL recognises in its financial statements for the year
ended 31 December 20X3 in relation to the joint operation assuming that all of its share of
capacitors remains on hand at the reporting date.

Analysis

CHL recognises in its financial statements:

Item Amount Calculation

HK$
Property, plant and 5,850,000 Share of machine = 50% × HK$12 million
equipment – machine = HK$6 million
less: depreciation for the period = HK$6 million /
10 years × 3/12 = HK$150,000
Inventory – capacitors 400,000 Share of output = 50% × HK$800,000 =
HK$400,000
(all the output remains on hand at reporting date)
Revenue – sale of 55,000 Sale of capacitors = HK$100,000 × 110%
capacitors = HK$110,000
Share of revenue from the sale = 50% ×
HK$110,000 = HK$55,000
Expenses (e.g. costs of 50,000 Costs of producing and selling capacitors
goods sold, marketing) = HK$100,000
Share of costs of producing and selling capacitors
= 50% × HK$100,000 = HK$50,000

33.2.2 Transactions Between the Joint Operator and the Joint Operation
A joint operator (or a participant in the joint operation that does not have joint control of the
operation may also have rights to assets and obligations for liabilities relating to the joint
operation) may transact with the joint operation, for example, by selling or contributing assets
to the joint operation or by purchasing assets from the joint operation. Similar to the principles

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guiding the accounting for intragroup transactions between a parent and its subsidiaries and
an investor and its associates, HKFRS 11 requires that in the event of a:

• Sale or contribution of assets to the joint operation, gains and losses are recognised by
the joint operator only to the extent of the other parties’ interest in the joint operation
HKFRS
except where the transaction provides evidence of impairment or a reduction in the net
11.22, B34 realisable value of the asset; and

• Purchase of assets from the joint operation, the joint operator’s share of any gain or
loss on the purchase is not recognised by the joint operator until it on-sells the assets to
HKFRS
a third party except where the transaction provides evidence of impairment or a
11.22, B36 reduction in the net realisable value of the asset.

HKFRS 11.22,
Where the transaction provides evidence of impairment or a reduction in the net realisable
B35, B37 value of the asset, the loss (or its share thereof) is recognised in full by the joint operator.

Though not explicitly stated in HKFRS 11 and consistent with the above, management
fees paid by a joint operation to a joint operator-manager should be recognised by the joint
operator-manager only to the extent of the other parties’ interest in the joint operation. This is
because the joint operator-manager cannot recognise a transaction with itself. If management
fees were recognised, the joint operator would be overstating line items for management fee
revenue and management fee expenses.

Illustrative Example 5
Soleil Limited (Soleil) enters into a joint arrangement with Rigel Limited (Rigel) on
1 January 20X4. Under the terms of the contractual arrangement underpinning the joint
arrangement, Soleil and Rigel set up a separate legal entity, Sogel Limited (Sogel), that
will manufacture packing materials to be used by Soleil and Rigel in their own business
operations. Soleil and Rigel each hold 50% of the ordinary shares of Sogel.

The contractual arrangement establishes that Soleil and Rigel each control 50%
of the rights and obligations of the assets, liabilities, revenues and expenses of the
joint arrangement. Assume the final terms of the arrangement are such that the joint
arrangement is appropriately classified as a joint operation.

As part of the arrangement, Soleil will sell to Sogel equipment for HK$10 million.
Assume capital gains tax does not apply to the sale, and, hence, no tax implications exist
for the gain on disposal. At the time of sale, the net carrying amount of the equipment in
Soleil’s records is HK$8 million.

In accordance with HKFRS 11, Soleil records the following journal entries to recognise
the sale:

Soleil’s financial statements

Debit Credit
HK$ HK$
Cash 10,000,000
Property, plant and equipment 8,000,000
Gain on sale – equipment 2,000,000

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Illustrative Example 5 (continued)

To pick up its share of the joint operation’s assets and liabilities, Soleil records:

Debit Credit
HK$ HK$
Property, plant and equipment (50% × 10,000,000) 5,000,000
Cash – joint operator (50% × 10,000,000) 5,000,000

However, implicit in the carrying amount of the property is an unrealised gain of HK$1
million (50% × (HK$10 million – HK$8 million)) because the sale transaction has been, in
part, conducted with itself. Accordingly, this gain must be eliminated:

Debit Credit
HK$ HK$
Gain on sale – equipment 1,000,000
Property, plant and equipment 1,000,000

Immediately following the transaction, Soleil’s financial statements reflect the following:

• Property, plant and equipment HK$4 million (50% of the carrying amount before sale)
• Gain on sale – equipment HK$1 million (gain attributable to external parties)
• (Increase in) Cash HK$5 million (share of cash relating to the sale
attributable to external parties)

Though not discussed in HKFRS 11, the policy seems reasonable that the unrealised
gain of HK$1 million is realised over time in the same manner as for consolidation
through the periodic adjustment to the joint operator’s share of the joint operation’s
depreciation expense.

(This Illustrative Example assumes the sale of the equipment attracts no tax
consequences. To the extent that income tax is payable on the sale of the equipment,
there will be tax implications to recognise on the transaction, resulting in the possible
recognition of a deferred tax asset.)

Apply and Analyse 4

[This is a continuation of the Illustrative Example 5.]

Prepare the journal entry that Rigel records to recognise its share of the transaction.

Analysis

Rigel records the following journal entry:

Debit Credit
HK$ HK$
Property, plant and equipment (50% × 10,000,000) 5,000,000
Cash – joint operator (50% × 10,000,000) 5,000,000

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Apply and Analyse 4 (continued)

(Observe that the equipment is recorded by Rigel at HK$5 million, compared to the
HK$4 million recognised by Soleil. This is because Rigel has no adjustment required for an
unrealised gain.)

Knowledge Check Questions

Question 4
Rainbow Limited and Leprechaun Limited are joint operators of a joint operation. The
activity of the joint operation is conducted through Charmed Limited, which is owned
equally by Rainbow Limited and Leprechaun Limited. Under the contractual arrangement
relating to the joint operation, the rights and obligations to assets, liabilities, revenues and
expenses of the arrangement are shared in a specified proportion that recognises the
value of Rainbow Limited’s expertise to the conduct of the activity of the joint operation:
• Rainbow Limited – 65%; and
• Leprechaun Limited – 35%.
Identify which of the following statements about the arrangement is correct.
A Rainbow Limited applies the equity method to account for its 50% interest in
Charmed Limited.
B Rainbow Limited recognises 65% of the assets, liabilities, revenues and expenses of
Charmed Limited.
C Leprechaun Limited recognises 50% of the assets, liabilities, revenues and expenses of
Charmed Limited.
D Leprechaun Limited recognises an investment in Charmed Limited, measured at 50% of
the net assets of Charmed Limited.

Question 5
Alpha Limited (Alpha), Beta Limited (Beta) and Zulu Limited (Zulu) agree to work together
to design and construct a road connecting their factories to a highway. The terms of the
contractual arrangement include:
• The participant share of each entity in the arrangement (Alpha – 50%, Beta – 30%,
Zulu – 20%). The participant share describes each investor’s rights and obligations
with respect to the arrangement’s revenues, expenses, assets and liabilities;
• Alpha and Beta jointly control the arrangement; and
• The activity of the joint arrangement conducted through a separate vehicle, Lambda
Limited (Lambda). To set up Lambda, the entities contributed the following amounts
in exchange for an ownership interest:

Alpha contributes HK$50,000 for 40% ownership interest;

Beta contributes HK$30,000 for 30% ownership interest;

Zulu contributes HK$20,000 for 30% ownership interest;

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Knowledge Check Questions (continued)

• All rights and obligations for assets, liabilities, revenues and expenses relating to
activities of the arrangement is shared by the participants based on their participant
shares; and
• Profit or loss resulting from activities of the arrangement is shared by the
participants on the basis of their participant shares.

On consideration of all relevant facts and circumstances, the arrangement has been
determined to be a joint operation.
At 31 December 20X1, Lambda reports assets of HK$900,000, liabilities of HK$776,000,
revenue of HK$200,000 and expenses of HK$176,000. Lambda’s net profit for the year was
HK$24,000.
Determine the amounts reported by each of Alpha, Beta and Zulu in their respective
financial statements for the year ended 31 December 20X1 in relation to the activity of the
joint operation.

Question 6
This question is a continuation of Question 4. During the year, the following
transactions occurred:
• Lambda paid management fees of HK$56,000 to Alpha;
• On 31 December 20X1, Beta sold equipment to Lambda for HK$120,000. The
carrying amount of the equipment in Beta’s records immediately before the sale was
HK$95,000; and
• Zulu purchased excess inventory for HK$35,000 from Lambda. The carrying amount
of the inventory in Lambda’s records immediately before the sale was HK$30,000. At
year end, Zulu had on-sold to its customers 40% of that inventory.
Determine how these transactions affect the amounts reported by each of Alpha,
Beta and Zulu in relation to the activity of the joint operation in their respective financial
statements for the year ended 31 December 20X1. Ignore income taxes.

3 3 . 3 ACCOUNTING FOR JOINT VENTURES

As highlighted in Section 33.2, an entity that is party to a joint arrangement applies the
accounting applicable to its classification as a joint operation or a joint venture. The applicable
accounting enhances the relevance and faithful representation of the joint arrangement in the
entity’s financial statements as it depicts whether the entity has rights to assets and/or
obligations for liabilities of the joint arrangement or has rights to net assets of the joint
arrangement.

This section sets out the accounting that applies in the financial statements of a joint
venturer and a participant who does not have joint control of the joint venture.

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In a joint venture, the joint venturer has an interest in the net assets of the arrangement,
rather than an interest in specific assets and/or obligations used in the arrangement. Under
HKFRS
11.24, current HKFRSs, the accounting that, except in limited cases, is considered to most relevantly
BC41 and faithfully represent a joint venturer’s interest is the equity method of accounting. A
participant who does not have joint control of the joint venture also has an interest in the net
assets of the arrangement; however because the nature of its interest is different, different
accounting requirements apply.

33.3.1 Financial Statements of a Joint Venturer

A joint venturer applies the equity method of accounting in its consolidated financial
statements or, where it does not control a subsidiary, its ‘equity accounted’ financial statements
being the set of financial statements in which the equity method of accounting is applied. The
equity method applies until joint control is lost. Application of the equity method is suspended
when the investment has been written down to nil and continues in a loss-making position.

In addition, a joint venturer may also present separate financial statements in which it
is permitted to apply a different measurement model to its investment in the joint venture
consistent with the information objective of those financial statements. In its separate financial
statements, a joint venturer may measure its investment in a joint venture either:

• at cost;
• in accordance with HKFRS 9 (at fair value) (see Chapter 12); or
HKFRS 11.26,
HKAS 27.10 • by applying the equity method (see Chapter 32).

In general, the same accounting policy should be applied by a joint venturer to account for
all its joint venture entities; it is not an arrangement-by-arrangement choice.

Revisit Chapter 32 to review how to account for an investment under the equity method of
accounting.
The flowchart in Exhibit 32.3 in Chapter 32 and the commentary following the flowchart
summarises the accounting that applies to a joint venturer in a joint venture, the starting
point being the entity being a joint venturer in the joint venture rather than, as shown in the
flowchart, an investor with significant influence over an entity. References in that flowchart
and the associated commentary to an investor should be read as referring to the joint venture.
References and commentary to the investment in the associate should be read as referring to
joint venture.

HKAS Unlike the accounting for a joint operation, under the equity method, it is the joint
28.27 venturer’s ownership interest (rather than its ‘share of’) that is relevant to the accounting.

33.3.2 Accounting by Participants Who Do Not Have Joint Control of

the Joint Venture
Similar to a joint operation, an entity may participate in a joint venture without being a joint
venture, that is, without having joint control. Such entities will also normally hold an interest in
the net assets of the arrangement. In these cases, the participant entity must evaluate whether
the nature of its interest is a:

• financial asset – the participant accounts for its interest in accordance with HKFRS 9
(see Chapter 12); and

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HKFRS • associate interest – the participant accounts for its interest in accordance with HKAS 28
11.25 (see Chapter 32), which may also require the equity method to be applied.

Where the nature of its interest is a financial asset, the participant entity applies the same
accounting for the interest regardless of the type of financial statements being prepared, for
example, consolidated financial statements, separate financial statements and ‘individual’
financial statements.

Where the nature of its interest is an associate interest, the participant entity may
additionally present separate financial statements. The manner in which it accounts for the
interest in these financial statements is described in Chapter 32.

Exhibit 33.4 summarises the accounting by parties to a joint arrangement in consolidated

financial statements.

Arrangement is a joint arrangement

The joint arrangement The joint arrangement

is a joint venture is a joint operation

Entity is a participant NO Is the entity Is the entity NO Entity is a participant

in the joint venture a joint venturer? a joint operator? in the joint operation

YES YES YES YES

Is the entity able to YES Apply equity method Recognise: Does the entity have
significantly influence of accounting (unless • Assets, including its share of YES rights to assets and
the joint venture? exception applies) any assets held jointly obligations for
• Liabilities, including its share liabilities relating to
NO of any liabilities incurred jointly the joint operation?
• Revenue from the sale of its
Apply HKFRS 9 share of the output arising from
the joint operation NO
• Share of the revenue from the
sale of the output by the joint
operation Apply HKFRSs
• Expenses, including its share of applicable to the
any expenses incurred jointly interest

EXHIBIT 33.4 Accounting by parties to joint arrangement

3 3 . 4 DEFERRED TAX

With respect to joint arrangements, a temporary difference arises when the carrying amount of
an entity’s investment in a joint arrangement differs from the tax base, for example, when:

• Undistributed profits are in the joint arrangement; Foreign exchange rates affect the
measurement of the joint arrangement; and
HKAS
12.38 • The carrying amount of an investment is impaired.

As discussed in Chapter 19, HKAS 12 requires deferred tax assets and liabilities to be
recognised where a temporary difference exists and recognition criteria are met (limited

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exceptions apply). The criteria that applies to the recognition of deferred taxes on associates
similarly applies to a joint venturer or joint operator. (Review Section 4.7 of Chapter 32 to
understand the applicable accounting.)

Apply and Analyse 5

[This exercise is a continuation of Apply and Analyse 3 in Section 33.2.1.]

The machine jointly purchased by Chung Ho Limited (CHL) and Wang San Limited (WSL) on
1 October 20X3 for HK$12 million is depreciated over eight years for tax purposes.

During the year ended 31 December 20X3, CHL made a taxable profit of HK$5,000 from
its joint operation’s activities.

Assume the tax rate is 16.5% and that income tax is payable by CHL and WSL on their
share of the joint arrangement.

Advise CHL of its tax implications from its interest in the joint arrangement.

Analysis

As CHL and WSL are responsible for making the tax payments for the joint operation,
CHL must consider the consequential tax implications relating to its share of the joint
operation’s assets, revenues and expenses.

In accordance with HKAS 12, CHL must recognise the deferred tax liability arising
from the machine in its financial statements if (1) it is unable to control the timing of the
reversal of that temporary difference and/or (2) the temporary difference will probably not
reverse in the foreseeable future. CHL cannot demonstrate these conditions are met as the
temporary difference relates to a tax depreciable item. As such, CHL must recognise the
deferred tax liability. In addition, in accordance with HKAS 12, CHL must recognise current
tax expense relating to its taxable profit for the period from the joint operation.

CHL recognises:

Item Amount Calculation

HK$
Deferred 6,188 Carrying amount of machine (50%) = HK$5,850,000
tax liability (see Section 33.2.1)

Tax base of 50% of machine = HK$5,850,000 − future

taxable amounts HK$5,850,000 + future deductible
amounts HK$5,812,500* = HK$5,812,500

Deferred tax liability = 16.5% × (5,850,000 − 5,812,500)

= HK$6,188
Income tax expense 7,013 Current tax expense = 16.5% × HK$5,000 = HK$825

Deferred tax expense = HK$6,188 (see above)

Total tax expense = HK$825 + HK$6,188 = HK$7,013

* Original tax base HK$6 million − tax depreciation to date HK$187,500 (HK$6 million/8 years × 3/12) = HK$5,812,500.

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3 3 . 5 PRESENTATION AND DISCLOSURE

Requirements pertaining to the presentation and disclosure of an entity’s interests in a joint

arrangement are set out in various HKFRSs, including HKAS 1 Presentation of Financial Statements,
HKFRS 12 Disclosure of Interests in Other Entities and HKAS 24 (Revised) Related Party Disclosures.

33.5.1 Presentation of Joint Arrangements

An entity that is a joint venturer includes line items in its financial statements that pertain to
its interests in joint ventures together with its investments in associates. In accordance with
HKAS 1, the entity must present line items in its statement of financial position and statement
of profit or loss and other comprehensive income that show:

• The carrying amount for all investments accounted for using the equity method;

• The entity’s share of the profit or loss of joint ventures (and any associates) accounted
for using the equity method; and

• The entity’s share of the other comprehensive income of joint ventures (and any
HKAS 1.54, associates) accounted for using the equity method, separately identifying the share that
582, 82A will and will not be subsequently reclassified to profit or loss.

An entity’s interest in a joint venture is classified as a non-current asset except where it

HKAS meets the conditions to be classified as held for sale in accordance with HKFRS 5 (see
28.15 Chapter 15).

Amounts related to an entity’s interests in a joint operation are not separately reported.

33.5.2 Disclosure of Joint Arrangements

In accordance with HKFRS 12, an entity must disclose information that enables users of its
financial statements to evaluate the nature of, and risks associated with, its investments in joint
arrangements and the effects of those interests on the entity’s financial position, financial
performance and cash flows. In addition, as discussed in Chapter 21, HKAS 24 requires
disclosure of the nature of the related party relationship and information about transactions
and outstanding balances (including commitments) between the entity and its joint ventures
HKFRS 12.1 necessary for users to understand the potential effect of the joint venture relationship on the
HKAS 24.17 financial statements. Further, if a joint operator acquired an interest in a joint operation whose
HKFRS activity constitutes a business, the joint operator must make the disclosures specified by
11.B33A HKFRSs of a business combination.

To meet the disclosure objective set out in HKFRS 12, an entity discloses (separately from its
disclosures about its associates and subsidiaries) information about the following:

• Significant judgements and assumptions it has made in determining whether an

interest is an joint arrangement (or otherwise) and the type of the arrangement (joint
venture or joint operator) when it has been structured through a separate vehicle. The
entity must also disclose any changes in its assessment;

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• The nature, extent and financial effects of its interests in joint arrangements, including
the nature and effects of its contractual relationship with other investors with joint
control over the joint arrangement; and

HKFRS
• The nature of, and changes in, the risks associated with its interests in joint ventures
12.7, 20 (e.g. commitments and contingent liabilities relating to its interests in a joint venture).

The extent of disclosure required is subject to judgement and having regard to the
materiality of the joint arrangement to the entity. In addition to amounts presented on the face
of the financial statements, key disclosures include the following:

• Particulars of an entity’s investments in joint arrangements (e.g. name, activity, place of

business, ownership interest);

• Summarised financial information about each material joint venture (e.g. dividends
received from the joint venture, key subtotals and line items reported by the joint
venture). The summarised information is based on the joint venture’s HKFRS-compliant
financial statements adjusted for differences in accounting policies and to reflect
adjustments made in the application of the equity method (e.g. fair value adjustments).
The joint venture’s financial statements are not adjusted for the effects of intercompany
transactions with the joint venturer;

• A reconciliation of the summarised financial information presented to the carrying

amount of the equity accounted joint venture;

• The nature and extent of any significant restrictions on the ability of the joint venture to
transfer funds to the entity;

• The unrecognised share of losses of an joint venture;

• Any commitments relating to an entity’s interests in joint ventures; and

HKFRS
12.21-23 • Any contingent liabilities relating to an entity’s interests in joint ventures.
HKFRS
12.21A A joint venture that is an investment entity is not required to make certain of these disclosures.

Although not explicitly stated, no requirement exists to disclose separately quantitative

information about an entity’s interests in joint operations except, of course, if necessary
to meet the objective of HKFRS 12. However, qualitative general information about these
arrangements should be disclosed.

Though HKFRS 12 identifies specific disclosures that assist in meeting the disclosure
objective, in preparing a set of financial statements, the preparer should assess whether
overall, the disclosures presented are sufficient to meet the disclosure objective set out at the
start of this section. If not, additional disclosures or further aggregation or disaggregation of
information must be made.

Many of the disclosures specified for joint arrangements are the same as those required
in respect of associates. Refer to Chapter 32 for some examples illustrating these presentation
and disclosure requirements.

Key Learning Point

The disclosures required of joint operations and joint ventures vary. An entity discloses
more information about its joint ventures than it does its joint operations. Also, disclosures
about joint arrangements are not limited to those described in HKFRS 12.

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Knowledge Check Questions

Question 7
Identify which of the following statements are true.
A Summarised financial information relating to all joint ventures must be disclosed in the
notes to the financial statements.
B An entity must disclose information about its future obligations to joint ventures in the
form of commitments and contingent liabilities.
C An entity applies judgement in determining the extent of disclosure required of joint
arrangements in its financial statements.
D The carrying amount of an entity’s interests in joint ventures accounted for using
the equity method is reported separately from its equity accounted investments in
associates on the face of the statement of financial position.

Question 8
Giant Limited (Giant) and Dwarf Limited (Dwarf) have established the joint venture entity
Gold Mine Limited (Gold Mine). Each party holds 50% of the ordinary shares of Gold Mine.
Determine which of the following disclosures Giant does not need to make in its
financial statements. Assume Gold Mine is material to an understanding of Giant’s financial
statements.
A ‘During the year, Giant received a dividend of HK$100,000 from Gold Mine.’
B ‘Giant jointly controls 50% of Gold Mine. Gold Mine operates a shopping centre in
Hong Kong.’
C ‘Issues relating to the banking system are currently preventing Gold Mine from remitting
any dividends to international shareholders. The issue has been ongoing for the past
10 months and there is no indication when the issue will be resolved.’
D ‘Gold Mine’s complete statement of financial position and statement of profit or loss and
other comprehensive income are as follows.’

3 3 . 6 CURRENT DEVELOPMENTS

The PIR for IFRS 11 Joint Arrangements was completed by the IASB in June 2022 and that the
standard was found to be working as intended and meeting its objectives. A few minor matters
were noted for future attention but given a low priority.

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SUMMARY

• A joint arrangement is an arrangement of which two or more parties share joint control and
is another way for investors to share costs and risks or to gain access to new technology or
new markets.

• In a joint arrangement, the parties are bound by a contractual arrangement, and the
contractual arrangement gives two or more of those parties joint control of the arrangement.

• For joint control to exist, there must be collective control and unanimous decision-making
over the relevant activities of the joint arrangement.

• A joint arrangement is classified as a joint operation or a joint venture:

° In a joint operation, the jointly controlling parties have rights and obligations to share in
assets and/or liabilities of the arrangement.

° In a joint venture, the jointly controlling parties have rights and obligations to share in the
net assets of the arrangement.

• To determine the classification of a joint arrangement, consider all facts and circumstances,
including the structure of the arrangement, its legal form (if any) and the terms of the
contractual arrangement.

• An entity party to a joint arrangement may be a joint operator, a joint venturer, a participant
in the joint arrangement or merely a financial investor.

• The accounting for a joint arrangement depends on the classification of the arrangement.

° A joint operator recognises the following in relation to its interest in a joint operation:
assets, including its share of any assets held jointly;

liabilities, including its share of any liabilities incurred jointly;

revenue from the sale of its share of the output arising from the joint operation;

a share of the revenue from the sale of the output by the joint operation; and

expenses, including its share of any expenses incurred jointly.

° In general, a joint venturer recognises its interest in a joint venture using the equity
method of accounting.

° Transactions between the joint operator or joint venturer and the joint arrangement may
give rise to unrealised gains and losses that must be eliminated.

• The accounting in a joint venturer’s separate financial statements may differ from the
accounting in its consolidated or equity-accounted financial statements. The accounting in a
joint operator’s separate financial statements is the same as that in its consolidated financial
statements (if any).

• A joint venturer or joint operator may need to recognise deferred tax assets or deferred tax
liabilities relating to the investment in a joint arrangement.

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• Separately present on face of the financial statements:

° the carrying amount for all equity accounted investments;

° a share of the profit or loss of equity accounted joint ventures (and any associates)
accounted for using the equity method; and

° a share of the other comprehensive income of equity accounted joint ventures (and any
associates), separately identifying amounts that will be subsequently reclassified, and
amounts that will not be subsequently reclassified.

• Information should be disclosed that enables users of its financial statements to evaluate the
nature of, and risks associated with, its investments in joint arrangements and the effects of
those interests on the entity’s financial position, financial performance and cash flows. This
includes information in these areas:

° significant judgements and assumptions it has made in determining whether an interest

is a joint arrangement;

° nature, extent and financial effects of its interests in joint ventures; and

° nature of, and changes in, the risks associated with its interests in joint arrangements.

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MIND MAP

CHARACTERISTICS CLASSIFICATION OF JOINT ARRANGEMENT

Contractual arrangement Joint venture – rights to net assets
Joint control: collective control and Joint operation – rights to assets and
unanimous decision-making obligations for liabilities
Relates to an activity Joint venture IF:
Joint venture or joint operation • Separate vehicle
• Legal form of vehicle –> rights to net assets
JOINT • Terms of arrangement do not change legal
ARRANGEMENTS form rights
(HKFRS 11) • Output ≠ primarily to venturers, not
dependent on venturers for settling liabilities

RECOGNITION AND MEASUREMENT

Consolidated or equity accounted financial
statement
• Joint venturer – equity accounting (unless
exception applies)
• Participant in a joint venture that is not an
associate – HKFRS 9
• Joint operator – recognise share of assets,
liabilities, revenue and expenses
PRESENTATION AND DISCLOSURE • Participant in a joint operation with
Presentation right to assets and obligations for
• Equity accounted investments liabilities – recognise share of assets,
• Share of equity accounted profits liabilities, revenue and expenses
• Share of equity accounted other • Participant in a joint operation without
comprehensive income rights to assets and obligations for
liabilities – apply an applicable HKFRS
Disclosure
• How decide investment = joint arrangement Separate financial statements
• Nature, extent and financial effects of • Joint venturer – cost, HKFRS 9, equity method
joint ventures • Joint operator – as per image
• Nature of risks of joint arrangement Deferred tax liability/asset might need to
• Commitment and contingent liabilities be recognised

Answers to Knowledge Check Questions

Question 1
Prima facie, HCL is an associate of SNL through its 33% shareholding. However, the
presumption that SNL’s 33% ownership interest gives it significant influence over HCL is
rebutted by the facts and circumstances, which provide evidence that SNL has more than
just the ability to participate in the financial and operating policy decisions of HCL because
SNL’s approval is required for decision-making. As such, it would be inappropriate for SNL
to classify HCL as an associate.
SNL and Tam’s shareholding percentages in combination with the contractual
requirement that 70% voting rights are required for decisions about the relevant activities
of HCL to be made show that SNL and Tam control HCL and must agree unanimously on
decisions pertaining to HCL. Hence, SNL and Tam jointly control HCL. SNL consequently
should classify HCL as a joint arrangement and determine whether its investment is in a
joint operation or a joint venture.

Question 2
An arrangement is a joint arrangement if joint control is present. The arrangement
between Gummy and Bears is a joint arrangement as the following features of the
contractual arrangement indicate that joint control is present:
• Gummy and Bears must make operating decisions on the use of the food truck and
the pricing of the candy; and
• Gummy and Bears must make decisions on the sale of the business.

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These terms indicate that Gummy and Bears collectively control the arrangement and
must unanimously consent to decisions about its relevant activities.
Gummy classifies the joint arrangement as a joint operation because the following features
of the contractual arrangement which indicate that the arrangement is a joint operation:
• There is no separate vehicle established to operate the food truck;
• The contractual arrangement between Gummy and Bears sets out how the costs of
operating the business will be shared;
• The contractual arrangement between Gummy and Bears sets out how any revenues
from the sale of candy will be shared; and
• The contractual arrangement between Gummy and Bears sets out each party’s rights
to the asset.

Question 3
Answer A is correct. Entities A and B jointly control the arrangement as together the
entities have sufficient voting power to direct the decisions about the relevant activities
of the arrangement (collective control) and as the contractual arrangement requires they
unanimously consent on decisions about the relevant activities.
Answer B is incorrect. Entity C does not have joint control as its voting power and consent
is not required for decisions about the relevant activities of the arrangement to be made.
Entity C is a participant in this joint arrangement.
Answer C is incorrect. The arrangement is a joint arrangement as Entity A and Entity B
jointly control the arrangement.
Answer D is incorrect. Entities A and B control the arrangement. Entity C does not control
the arrangement as its voting power is not required for decisions about the relevant
activities of the arrangement to be made.

Question 4
Answer A is incorrect. Rainbow Limited does not apply the equity method as the joint
arrangement is classified as a joint operation and not a joint venture. The accounting for
joint ventures is addressed in Section 33.3.
Answer B is correct. As a joint operator, Rainbow Limited must recognise its share of
the arrangement’s assets, liabilities, revenues and expenses. Rainbow Limited’s share
of the arrangement’s assets, liabilities, revenues and expenses is 65% as specified by
the contractual arrangement and not its ownership interest.
Answer C is incorrect. Leprechaun Limited must recognise its share of the arrangement’s
assets, liabilities, revenues and expenses. This may differ from its ownership interest.
Answer D is incorrect. As a joint operator, Rainbow Limited recognises its share of the
arrangement’s assets, liabilities, revenues and expenses rather than a single asset
‘investment in Charmed Limited’, which is equity accounted.

Question 5
Alpha and Beta are joint operators of the arrangement and, as per the terms of the
contractual arrangement, they jointly control the arrangement. Therefore, in accordance
with HKFRS 11, Alpha and Beta should recognise their respective share of Lambda’s
assets of HK$900,000, liabilities of HK$776,000, revenue of HK$200,000 and expenses of

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HK$176,000. In accordance with HKFRS 11, the entity’s share is determined based on its
participant share in the arrangement, and not its ownership interest in Lambda, that is,
Alpha’s share is 50% and not 40%.
Under the contractual arrangement, Zulu has rights to assets and obligation for
liabilities relating to the joint operation. As such, it is not an ‘other participant in the joint
operation’ (see Section 33.2.1.2) and, consequently, in accordance with HKFRS 11, must
also recognise its share of those assets, liabilities, revenue and expenses of Lambda.

Alpha (50%) Beta (30%) Zulu (20%)

HK$ HK$ HK$
Assets 450,000 270,000 180,000
Liabilities 388,000 232,800 155,200
Revenue 100,000 60,000 40,000
Expenses 88,000 52,800 35,200

Question 6
In determining their respective share of the joint operation’s assets, liabilities, revenues
and expenses, Alpha, Beta and Zulu must have regard to any intracompany transactions
that have occurred between themselves and the joint operation.
Alpha must eliminate its share of the management fee because it has, in part,
transacted with itself. It does so by reducing its revenue (e.g. management fee revenue)
and its share of Lambda’s management fee expenses (HK$28,000, calculated as HK$56,000
× 50%). Accordingly, Alpha’s share of expenses is determined as HK$88,000 (see solution to
Question 5) − HK$28,000 = HK$60,000.
Beta must eliminate its share of the gain on sale of equipment to Lambda because,
from Beta’s perspective, the gain is not yet realised. It does so by reducing the gain
recognised in its financial statements by its share of that gain (HK$7,500, calculated as
30% × (HK$120,000 − HK$95,000)). The adjustment is made against Beta’s share of the
equipment purchased by Lambda. Accordingly, Beta’s share of assets is determined as
HK$270,000 (see solution to Question 5) – HK$7,500 = HK$262,500.
On sale of the inventory to Zulu, Lambda made a gain of HK$5,000 (HK$35,000 −
HK$30,000), which forms part of its revenue for the period. Zulu’s share of that gain is
HK$1,000 (20% × HK$5,000). Because Zulu still holds 60% of the inventory at year end,
60% of Zulu’s share of that gain remains unrealised to Zulu (HK$600, calculated as 60% ×
HK$1,000). Consequently, in preparing its financial statements, Zulu must eliminate this
portion of its share of Lambda’s gain on sale of the inventory. Accordingly, Zulu’s share of
revenue is determined as HK$40,000 (see solution to Question 5) − HK$600 = HK$39,400.
The effect of the above transactions on Alpha, Beta and Zulu’s share of Lambda’s
assets, liabilities, revenues and expenses is shown in bold in the table below.

Alpha (50%) Beta (30%) Zulu (20%)

HK$ HK$ HK$
Assets 450,000 262,500 180,000
Liabilities 388,000 232,800 155,200
Revenue 100,000 60,000 39,400
Expenses 60,000 52,800 35,200

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Question 7
Answer A is incorrect. Summarised financial information is only required of material
joint ventures.
Answers B and C are correct. Answer B is correct as information about the entity’s future
obligations to joint ventures in the form of commitments and contingent liabilities must
be disclosed as part of providing information to users about the nature of and changes in
the risks associated with the entity’s interests in joint ventures. Answer C is correct as the
HKFRS requires sufficient information to be disclosed to meet the disclosure objective,
and accordingly, the determination of the form and extent of disclosure may vary between
entities depending on the significance of the information to the users of the entity’s
financial statements.
Answer D is incorrect. The carrying amount of an entity’s interest in joint ventures
accounted for using the equity method does not need to be reported separately from
its investments in associates also accounted for using the equity method. To the extent
the entity has no investments in associates, its interests in joint ventures will be reported
separately on the face of the statement of financial position.

Question 8
Answer A is incorrect. In accordance with HKFRS 12, the dividends received from the joint
venture should be disclosed as part of the Giant’s disclosure of summarised financial
information about Gold Mine.
Answer B is incorrect. In accordance with HKFRS 12, as part of providing information about
the nature, extent and financial effects of the entity’s interests in joint arrangements, Giant
should disclose the name of the joint arrangement, the nature of its relationship with the
joint venture, its principal place of business and its proportion of ownership interest held
in the joint venture.
Answer C is incorrect. In accordance with HKFRS 12, as part of providing information about
the nature, extent and financial effects of the entity’s interests in joint arrangements, Giant
should disclose the nature and extent of any significant restrictions on Gold Mine’s ability
to transfer funds to it.
Answer D is correct. Summarised financial information should be disclosed about each
material joint venture; however, the complete financial statements of the joint venture are
not required to be included in the joint venturer’s financial statements.

EXAM PRACTICE

QUESTION 1
Robin Limited (Robin) is a joint operator in a joint arrangement with Dove Limited (Dove).
The participant shares of the joint operators are 50:50. The activity of the joint operation is
conducted via a separate legal entity, Small Bird Limited (SBL), which Robin and Dove hold
equally. Robin and Dove each contributed HK$500,000 to set up the joint arrangement.

Under the terms of the contractual arrangement, Robin and Dove must unanimously
agree on the amount and timing of any dividend distribution from SBL. Robin is keen to
expand the operations of SBL by reinvesting its profits rather than receiving a distribution.
Dove would prefer to receive some distribution from its investment into the joint operation
each period.

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 Joint A rrangements

At the reporting date, the net assets of SBL are HK$1.2 million. Robin’s tax base for its
investment in SBL is HK$500,000.

Determine the amounts recognised by Robin. The applicable tax rate is 16.5%.

QUESTION 2
(Adapted from HKFRS 11 Illustrative Examples – Example 2.)

Second Shop Limited (SSL) is a public listed Hong Kong company whose principal activity is
retailing operations (supermarkets, general merchandise and specialty department stores).
SSL prepares consolidated financial statements in accordance with HKFRSs and has a 31
December financial year end.

Ba Boom Operations Limited

On 1 January 20X1, SSL and Food City Limited (FCL) set up Ba Boom Operations Limited
(BBOL). SSL invested HK$11 million in return for 110,000 ordinary shares in BBOL, and FCL
invested HK$9 million in return for 9,000 ordinary shares in BBOL. BBOL’s legal form gives
BBOL, not its shareholders, the rights to the assets and obligations for the liabilities relating
to the arrangement.

BBOL was established to acquire and operate a mall complex in Kwai Tsing. Its activities
include the rental of the space to retailers, management of the car park and play center and
maintenance of the mall complex and its facilities, such as the parents’ room and first-aid
station. BBOL is responsible for marketing and other activity to build the reputation and
customer base for the mall as a whole.

The terms of the contractual arrangement between SSL and FCL set out that:

• BBOL owns the land, buildings, fixtures and fittings and other structures that make
up the mall complex. The contractual arrangement does not specify that the parties
have rights to the acquired property or other assets owned by BBOL;

• Neither SSL nor FCL are liable in respect of the debts, liabilities or obligations of
BBOL. The liability of each party is capped to any unpaid amounts of its capital
contribution;

• SSL and FCL are not restricted from selling their interests in BBOL or using their
interest as collateral;

• Each party receives a share of the income from operating the mall complex in
accordance with its interest in BBOL. Unless otherwise agreed by the parties,
income is determined as the rental income from vendors and fees collected from
the carpark and play center, less operating costs; and

• The agreement of 60% of the shareholders is required for any financial and
operating policy decisions relating to the activities of BBOL to be made.

BBOL has a 31 December financial year-end.

Animal Farm Limited

On 15 January 20X8, SSL and Young Mare Limited (YML) set up Animal Farm Limited (AFL) to
process raw materials into packaged animal feed. AFL will house specialised processing plant
and equipment to which SSL and YML need access and is situated on land jointly purchased
by the parties and leased to AFL.

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 FINANCIAL REPORTING

The contractual arrangement between SSL and YML establishes:

• Both parties must agree to all financial and operating decisions relating to the
operation or extension of the plant and equipment;

• SSL and YML hold equal shares in AFL, which carry equal rights to the results of AFL;

• When the two parties can access the processing plant and equipment to produce
finished goods;

• The maintenance and other costs of the plant and equipment are met by AFL but
are reimbursed to the company by each of the parties equally;

• Each party provides the raw materials for and takes its share of the physical output
of AFL. Each party arranges its own sales to its customers;

• The plant and equipment were equally financed by the parties prior to the plant
and equipment being subscribed, together with the lease of the land on which it is
situated, to AFL for the shares therein; and

• Any profit made by AFL is distributed equally to SSL and YML based on their shares.
Any loss is reimbursed equally to AFL by the parties.

SSL expects AFL to significantly impact its operations by doubling its existing production
capacity, which it forecasts will translate into a significant increase in sales revenues.
The summarised financial position of SSL and BBOL at 31 December 20X7 is as follows:

SSL BBOL
HK$’000 HK$’000
Assets
Property, plant and equipment 3,400 20,410
Investment in BBOL 11,000 –
Other investments 35,000 520
Inventories 80 200
Trade and other receivables 1,210 780
Cash 1,580 490
Total assets 52,270 22,400

Equity
Share capital 100 20,000
Retained earnings 50,170 1,750
Total equity 50,270 21,750

Liabilities
Provisions 1,320 200
Trade and other payables 680 450
Total liabilities 2,000 650
Total equity and liabilities 52,270 22,400

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 Joint A rrangements

SSL and BBOL’s summarised statements of profit or loss for the financial year ended
31 December 20X7 are as follows:

SSL BBOL
HK$’000 HK$’000
Revenues 15,900 76,000
Dividends and other income 66,000 –
Changes in inventories of finished goods (100) (800)
Depreciation expenses (300) (1,600)
Administration expenses (7,500) (2,400)
Employee benefits expenses (38,000) (39,000)
Other operating expenses (4,100) (2,200)
Net profit after tax 31,900 30,000

SSL and BBOL’s statements of changes in equity for the financial year ended 31
December 20X7 are as follows:

SSL BBOL
Share Retained Total Share Retained Total
capital earnings capital earnings
HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
Balance at 1 Jan 20X7 100 24,650 24,750 20,000 700 20,700
Profit for the year 31,900 31,900 30,000 30,000
Other comprehensive – – – – –
income for the year
Total comprehensive 31,900 31,900 30,000 30,000
income for the year
Dividends (6,380) (6,380) (28,950) (28,950)
Balance at 31 Dec 20X7 100 50,170 50,270 20,000 1,750 21,750

Additional information:

(a) The tax rate is 16.5%. Dividends are not taxable in the hands of the recipient.

(b) SSL has no plans to dispose of its interest in BBOL and realise any capital gains or losses
on its investment.

(c) You are Arianna Liuw, SSL’s senior financial accountant. Bailey Yaw, the junior
accountant, has prepared the following file note pertaining to the accounting for BBOL
for your review:

File Note
Subject: Accounting for BBOL as part of SSL’s consolidated financial statements
Preparer: Bailey Yaw, Junior Accountant
Date: 15 January 20X1

Background/ Fact pattern

SSL acquired 110,000 ordinary shares in BBO Limited (BBOL), which is equal to 55% of
its share capital.

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 FINANCIAL REPORTING

Analysis

Because SSL controls a majority (55%) of the shares in BBOL, it has control of BBOL.

Conclusion

As SSL controls BBOL, and BBOL is a subsidiary of SSL. Accordingly, SSL should
consolidate BBOL’s financial position and results.

(a) Analyse the conclusion in the file note and prepare an email to Bailey Yaw indicating
whether you agree or disagree with it. If you disagree with Bailey’s conclusion,
determine the accounting basis that applies. Justify your responses.

b) Using a consolidation worksheet, demonstrate how the investment in BBOL would

be reflected in SSL’s consolidated statement of financial position and consolidated
statement of profit or loss for the year ended 31 December 20X7.

(c) SSL’s accounting team is preparing the note disclosure about events after the reporting
date for inclusion in its financial statements for the year ended 31 December 20X7. You
have been tasked with preparing the draft disclosure about SSL’s interest in Animal
Farm Pty Ltd.

Your response should address the type of investment acquired (including justification
for the conclusion) and how the investment will be accounted for in the future SSL financial
statements.

ANSWERS TO EXAM PRACTICE

QUESTION 1
Robin recognises assets, liabilities, revenues and expenses equivalent to its share of
SBL (HK$600,000). In addition, it must consider whether it has a deferred tax balance to
recognise.

The difference between the carrying amount of the investment (HK$600,000) and
its tax base (HK$500,000) is a taxable temporary difference, that is, if Robin sold its
investment in SBL, it would need to pay tax on the increase in the investment’s value since
acquisition, which gives rise to a deferred tax liability of HK$16,500 (HK$100,000 × 16.5%).
However, because:

• Robin can control the timing of the reversal of this temporary difference, the
undistributed profits giving rise to the difference cannot be distributed without Robin’s
agreement; and

• The temporary difference will probably not reverse in the foreseeable future; Robin
plans on reinvesting profits into the joint operation.

Robin does not recognise a deferred tax liability relating to its investment in the joint
operation.

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 Joint A rrangements

QUESTION 2
(a)
To: Bailey Yaw

From: Arianna Liuw

Date: XX January 20X1

Dear Bailey,

I have reviewed the file note. However, I disagree with the conclusion in the file note that
BBOL should be treated as a 55% owned subsidiary of SSL because HKFRS 11 explains that
a party does not have control if it can block but cannot direct the relevant activities of an
arrangement. In our case SSL’s 55% interest is sufficient to block but insufficient to enable to
direct the relevant activities of BBOL because FCL’s agreement must be had for any financial
and operating decisions about BBOL to be made.

However, SSL’s 55% interest is sufficient to give it joint control over the relevant activities
of BBOL because the 60% shareholder approval condition detailed in the contractual
arrangement means that:

• The other shareholder (FCL) and SSL must act together to direct the activities that
significantly affect the returns of the BBOL (i.e. there is collective control); and

• SSL, by way of its 55% shareholding, can prevent the other shareholders (FCL) from
making unilateral decisions about the operations of BBOL. Similarly, FCL can prevent
SSL from making unilateral decisions about the operations of BBOL because 60%
shareholder approval is required for any decisions. Because SSL and FCL must agree
on the decisions, the decisions require the unanimous consent of both parties to the
arrangement.

As such, BBOL is a joint arrangement of SSL (and also of FCL).

The accounting that applies to a joint arrangement depends on whether SSL has rights
to the assets and obligations for the liabilities of BBOL under the arrangement or whether
it has rights to share in the net assets of BBOL. Here, the joint activity (operating the mall
complex) is conducted via a separate vehicle (BBOL) whose legal form (a limited company)
causes the separate vehicle to be considered in its own right. That is, the assets and liabilities
held in BBOL are the assets and liabilities of BBOL and not the assets and liabilities of the
parties. SSL and FCL’s shareholding only gives them rights and obligations to share in the net
assets of BBOL.
Because the rights accorded by the legal form of the vehicle may be changed through
agreement between the parties, regard must be had to the terms of the contractual
arrangement between SSL and FCL. A review of the terms of the contractual arrangement
show that the arrangement does not specify that the parties have rights to assets owned by
BBOL. Also, the terms of the arrangement establish that the liability of each shareholder is
limited to any unpaid contributed capital relating to its shareholding. Accordingly, the terms
of the contractual arrangement do not change the rights accorded by the legal form of BBOL
such that SSL no longer has rights and obligations to only share in the net assets of BBOL.

A joint arrangement established primarily to provide output to the parties to the joint
arrangement and which depends on the parties on a continuous basis to settle its liabilities

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 FINANCIAL REPORTING

is designed to give the parties rights to substantially all the economic benefits of the assets
relating to the arrangement and obligations for the liabilities of the joint arrangement. BBOL
was established to acquire and operate a mall complex in Kwai Tsing. As such, the joint
arrangement was not designed such that its activities primarily aim to provide SSL and FCL
with physical output. Also, BBOL does not depend on SSL and FCL on a continuous basis for
settling its liabilities as it generates revenues from retailers and customers.

Considering the preceding evidence, we can conclude that SSL’s 55% interest gives it
rights and obligations to share in the net assets of BBOL. As such, SSL must be classified
as a joint venture. Accordingly, in SSL’s consolidated financial statements, BBOL must be
accounted for by applying the equity method of accounting to the investment.

Please update the file note to reflect the analysis and conclusions in this email.

Kind regards,

Arianna Liuw

(b)
Adjustments
SSL DR CR Consolidated financial
statements
HK$’000 HK$’000 Ref HK$’000 HK$’000
Statement of financial position
Assets –
Property, plant 3,400 3,400
and equipment
Investment in BBOL 11,000 385 1 11,962
16,500 2
3 15,923
Other investments 35,000 35,000
Inventories 80 80
Trade and other receivables 1,210 1,210
Cash 1,580 1,580
Total assets 52,270 53,232

Equity
Share capital 100 100
Retained earnings 50,170 1 385 51,132
2 16,500
15,923 3
Total equity 50,270 51,232

Liabilities
Provisions 1,320 1,320
Trade and other payables 680 680
Total liabilities 2,000 2,000
Total equity and liabilities 52,270 53,232

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 Joint A rrangements

Adjustments
SSL DR CR Consolidated financial
statements
HK$’000 HK$’000 Ref HK$’000 HK$’000
Statement of profit or loss
Revenues 15,900 15,900
Dividends and other income 66,000 15,923 3 50,077
Share of BBOL’s profit – 2 16,500 16,500
for the year
Changes in inventories of (100) (100)
finished goods
Depreciation expenses (300) (300)
Administration expenses (7,500) (7,500)
Employee benefits expenses (38,000) (38,000)
Other operating expenses (4,100) (4,100)
Net profit after tax 31,900 32,477

Workings (for reference only) (all amounts in HK$’000)

Ref 1 – restates the opening carrying amount (e.g. cost) of the investment to the opening
equity accounted carrying amount.

HK$’000 HK$’000
Investment in joint venture 385
Retained earnings (55% × 700) 385

Ref 2 – recognises SSL’s share of BBOL’s profits for the period

Investment in joint venture 16,500

Share of joint venture’s profit for the year (55% × 30,000) 16,500

Ref 3 – reduces the investment by the amount of the BBOL dividend

Dividend income (55% × 28,950) 15,923

Investment in joint venture 15,923

Notes:

• The tax base of the SSL’s investment in BBOL is HK$11 million while its carrying
amount is HK$11.962 million. Therefore, there is a taxable temporary difference
of HK$962,000. SSL does not recognise this temporary difference because it can
control when it is realised (by selling its shares in BBOL) and because the temporary
difference will probably not reverse in the foreseeable future (as SSL has no plans
to dispose of its interest in BBOL).

• As dividends are not taxable in the hands of the recipient, no deductible temporary
difference arises in this regard because there is no tax ‘prepaid’ relating to
the dividend.

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 FINANCIAL REPORTING

(c) In accordance with HKAS 10, the note disclosure should cover the nature of the non-adjusting
event and an estimate (if possible) of its financial effect.

Note X. Events after the Reporting Period

On 15 January 20X8, SSL and Young Mare Limited (YML) entered into a contractual
arrangement to produce packaged animal feed. The activity will be conducted through
a joint arrangement established for this purpose, which is Animal Farm Limited (AFL).
SSL has classified AFL as a joint operation as the terms of the arrangement are such that
SSL has rights to the assets and obligations for the liabilities of AFL: The produce from
AFL will be taken by SSL and YML and AFL is dependent on the two parties for funding its
operations. Also, the contractual arrangement establishes that SSL controls its share of
the plant and equipment housed in AFL, as well as raw materials and inventory.

SSL accounts for a joint operation by recognising its share of the assets, liabilities,
income and expenses of AFL in its financial statements. SSL expects this enterprise
to double its existing production capacity, which is expected to result in a significant
increase in reported future sales revenues. SSL’s cost of sales will likewise increase.

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 34
Consolidated Financial
Statements with Complex
Group Structure

CHAPTER TOPIC LIST

34.1 Complex Group Structures 34.3 Disclosure of Interests

34.1.1 Indirect Holdings in Other Entities
34.1.2 Structured Entities 34.3.1 Disclosure of
Consolidated Entities
34.2 Changes in Group Structure
34.3.2 Disclosure of Unconsolidated
34.2.1 Acquisitions
Subsidiaries
34.2.2 Disposals

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO4: PREPARE, PRESENT AND APPRAISE GROUP FINANCIAL STATEMENTS WITH
COMPLEX GROUP STRUCTURES
LO4.07: Construct the financial statements for a group in accordance with Hong Kong Financial
Reporting Standards and statutory reporting requirements: Changes in ownership
4.07.01 Consider and account for disposal of ownership interest in a subsidiary with and without
losing control
4.07.02 Consider and account for acquisition of a subsidiary achieved in stages

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 C onsolidated F inancial Statements with C omplex G roup S tructure

OPENING CASE

THE SOLEIL GROUP

I ntroduced in earlier chapters, the Soleil Group operates an extensive global logistics network
across 600 locations in more than 50 countries. The group provides a diverse range of
transport and logistics solutions covering road, air, sea and rail to meet global supply chain
needs. The ultimate parent entity in the group is Soleil Limited (Soleil).

To grow the business with the aim of delivering a return to its shareholders, Soleil must
have a business strategy and be responsive to external market indicators. This may involve
acquiring or setting up new businesses or entities to expand its operations but may
involve divesting or shutting down businesses that are poor performers or no longer in line
with the management vision for the company. It may also involve restructuring the group
structure (e.g. to introduce a flatter structure) or introducing new vehicles into the group.

In the periods since its acquisition by Soleil, Polaris Limited (Polaris) acquired a 45% interest
in Bopp Limited (Bopp). Soleil already held a 25% ownership interest at that time. Soleil’s group
structure (in part), with the indicated proportionate shareholdings, is shown in Exhibit 34.1.

Soleil Limited

80% 100% 100% 80%

Astro Limited Mercury Limited Caelus Limited Polaris Limited

25%
45%
90% 30% 5% 20% Bopp Limited
6%
Hercules Limited Comet Limited Halley Limited

EXHIBIT 34.1 Soleil’s group structure

During the year, Soleil received an offer to sell Polaris to a consortium of private investors.
Soleil is also considering increasing its ownership stake in its associate, Comet Limited
(Comet).

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 FINANCIAL REPORTING

OVERVIEW

As explained in Chapter 30, with limited exceptions, the Hong Kong Companies Ordinance
(CO) and HKFRS 10 Consolidated Financial Statements require a parent (parent undertaking) that
controls one or more subsidiaries (subsidiary undertaking) to present consolidated financial
statements. These 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.

Chapter 30 discussed the ongoing accounting procedures that apply to consolidate a

subsidiary. By reference to the Soleil Group, this chapter discusses how those procedures
change when an acquisition occurs mid-way through an accounting period or by a disposal of
the subsidiary. Also, as in practice, acquisition or disposal activity may be done through several
steps (e.g. an entity may acquire an associate interest in another entity before gradually gaining
a controlling interest), and this chapter discusses how the consolidation process is affected by
such changes in investments.

As alluded to in Chapter 30, what is often thought of as the group extends beyond directly
held consolidated subsidiaries, for example, the Soleil Group includes subsidiaries, associates
and jointly controlled entities. This chapter shows how group entities that are not directly held
consolidated subsidiaries are incorporated into a parent’s consolidated financial statements.

This chapter builds on the concepts taught in previous chapters in this module. Therefore,
there is an assumed knowledge in the content covered in these chapters. Please ensure
you have a good understanding of the content of Chapters 29 to 33 before continuing with
this chapter.

3 4 . 1 COMPLEX GROUP STRUCTURES

An investment in a subsidiary may be held directly or indirectly through the parent and/or
other group entities. Earlier chapters addressed the accounting where a parent holds a direct
interest in a subsidiary. In indirect group structures, the identification of control and the
controlling interest may not be as initially obvious, and the calculation of the group’s effective
interest in the subsidiary and goodwill is more complex.

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 C onsolidated F inancial Statements with C omplex G roup S tructure

34.1.1 Indirect Holdings

Indirect holdings include vertical groups and D-shaped groups.

A vertical group is one where a parent has a sub-subsidiary through a direct subsidiary
of the parent holding a controlling interest in another entity. Exhibit 34.2 illustrates a vertical
group structure.

Vertical group

Soleil Limited

80% 100% 100% 80%

Astro Limited Mercury Limited Caelus Limited Polaris Limited

90%

Hercules Limited

EXHIBIT 34.2 Example of a vertical group structure

As the consolidated financial statements are prepared from the perspective of the parent:

• Reserves and non-controlling interest (NCI) are determined based on the effective
group interest in the sub-subsidiary; and

• Only the parent’s share of the cost of the investment, rather than the entire
consideration transferred, is considered in the calculation of goodwill arising on the
acquisition of the subsidiary. The parent’s share of the cost of the investment in the
sub-subsidiary is based on its directly held interest in the subsidiary and not the
effective group interest in the sub-subsidiary.

Illustrative Example 1
Parent P owns 80% of Subsidiary S1, which acquires 90% of Subsidiary S1A for HK$100.
The fair value of Subsidiary S1A’s net assets on the acquisition date is HK$70. Assume
that non-controlling interests (NCIs) are measured as a proportionate share of the
acquiree’s identifiable net assets.

Here, Parent P’s effective group interest in Subsidiary S1A is 72% (80% × 90%) and
NCI 28%. In Parent P’s consolidated financial statements, goodwill arising from the
acquisition of Subsidiary S1A is calculated as:

HK$
Cost of indirect investment (80% × HK$100) 80.0
NCI (28% × HK$70) 19.6
less: Fair value of net assets of Subsidiary S1A (70.0)
Goodwill 29.6

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 FINANCIAL REPORTING

A D-shaped group is one where a parent entity and its subsidiary hold interests in another
entity, sufficient to leading the parent to have control of that other entity (a further subsidiary).
Exhibit 34.3 illustrates a D-shaped group structure, where Bopp Limited (Bopp) is controlled by
Soleil Limited (Soleil) through a combination of direct and indirect ownership of the entity.

Soleil Limited

80%

Polaris Limited
25%
45%
Bopp Limited

EXHIBIT 34.3 Example of a

D-shaped structure

Here, Soleil’s effective interest in Bopp is 61%, being the sum of its direct 25% holding plus
its indirect holding of 36% (80% × 45%). Assuming no other features would suggest that control
is absent, Soleil’s overall ownership interest is sufficient to give it control over (its apparent
associate) Bopp, leading it to treat Bopp as a subsidiary.

Apply and Analyse 1

Parent P acquired 75% of Subsidiary S2 on 1 January 20X1 for HK$120,000, which was
equal to 75% of the fair value of the identifiable net assets of Subsidiary S2 on that date
(i.e. nil goodwill). On 1 January 20X3, Parent P and Subsidiary S2 acquire 30%, respectively,
of Subsidiary S3 for HK$100,000 each. The fair value of Subsidiary S3’s net assets on the
acquisition date is HK$280,000.

Calculate the goodwill recognised in Parent P’s consolidated financial statements

with respect to Subsidiary S3. Assume non-controlling interests (NCIs) are measured as a
proportionate share of the acquiree’s identifiable net assets.

Analysis

Parent P’s effective group interest in Subsidiary S3 is 52.5%, being the sum of its direct
30% holding plus its indirect holding of 22.5% (75% × 30%). The NCI is therefore 47.5%
(100% − 52.5%).

In Parent P’s consolidated financial statements, goodwill arising from the acquisition of
Subsidiary S3 is calculated as:

HK$’000
Cost of direct investment 100.0
Cost of indirect investment (75% × HK$100,000) 75.0
NCI (47.5% × HK$280,000) 133.0
less: Fair value of net assets of Subsidiary S3 (280.0)
Goodwill 28.0

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 C onsolidated F inancial Statements with C omplex G roup S tructure

In vertical and D-shaped group structures, the date of acquisition of the indirectly held
subsidiary (Subsidiaries S1A and S3 in the preceding examples) is important because it impacts
the calculation of retained earnings and the NCI on acquisition:

• In Illustrative Example 1, the directly held subsidiary (S1) acquired a controlling interest
in the indirectly held subsidiary (S1A) on a date after the Parent had gained control
of S1. Accordingly, the group’s post-acquisition profits include profits arising in the
directly held subsidiary and the indirectly held subsidiary from those two dates; and

• The group acquires a controlling interest in the indirectly held subsidiary subsequent
to the date parent gains control of the directly held subsidiary; the two entities join the
group on different dates and, hence, have different acquisition dates:

°° The directly held subsidiary’s post-acquisition profits allocated to the group and NCI
for the subsidiary are calculated based on the date on which the parent acquired
the directly held subsidiary; and

°° The indirectly held subsidiary’s post-acquisition profits allocated to the group and
NCI for the subsidiary are calculated based on the date on which the group gains
control of the indirectly held subsidiary.

Apply and Analyse 2

(Continuation of Apply and Analyse 1 exercise)

The following financial information relates to Parent P and its subsidiaries at

31 December 20X3.

Parent P Subsidiary S2 Subsidiary S3

HK$’000 HK$’000 HK$’000
Investment in Subsidiary S2 (cost) 120.0 – –
Investment in Subsidiary S3 (cost) 100.0 100.0 –
Other net assets 480.0 280.0 330.0
Total net assets 700.0 380.0 330.0
Share capital 50.0 120.0 150.0
Retained earnings
opening retained earnings 550.0 180.0 130.0
profit for the year 100.0 80.0 50.0
Total equity 700.0 380.0 330.0

On 30 June 20X3, Subsidiary S2 sold inventory costing HK$300 to Subsidiary S3

for HK$360. All the inventory remained on hand at reporting date. Assume the tax
rate is 16.5%.

Prepare Parent P’s consolidated statement of financial position as at 31 December 20X3.

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 FINANCIAL REPORTING

Apply and Analyse 2 (continued)

Analysis

to NCI (W2) HK$‘000

to NCI (W2) HK$‘000

to NCI (W3) HK$‘000

Parent P HK$‘000

Profit attributable

Profit attributable

Profit attributable

Upstream sale of
equity (S2) (W1)

equity (S3) (W1)

Sub S2 HK$‘000

Sub S3 HK$‘000

Pre-acquisition

Pre-acquisition

inventory (W4)
Consolidation

Consolidated
31 December
worksheet

HK$‘000

HK$‘000

HK$‘000

HK$‘000
20X1

Investment in 120.0 – – (120.0) –

Subsidiary S2
(cost)
Investment in 100.0 100.0 – (175.0) (25.0) –
Subsidiary S3
(cost)
Goodwill – – – 28.00 28.0
Other net 480.0 280.0 330.0 (50.1) 1,039.9
assets
Total net 700.0 380.0 330.0 1,067.9
assets
Share capital 50.0 120.0 150.0 (120.0) (150.0) 50.0
Retained
earnings
Opening 550.0 180.0 130.0 (40.0) (130.0) (35.0) 655.0
retained
earnings
Profit for the 100.0 80.0 50.0 (20.0) (23.70) (37.6) 148.7
year
Owners of the 700.0 380.0 330.0 853.7
parent
Non- – – – 40.0 133.0 55.0 (25.0) 23.70 (12.5) 214.2
controlling
interest
Total equity 700.0 380.0 330.0 1,067.9

Debit Credit
HK$’000 HK$’000
W1 Share capital 120.0
Retained earnings – opening 40.0
Investment in Subsidiary S2 120.0
Non-controlling interests – equity (25% × 120/75%) 40.0
Eliminate pre-acquisition equity in Subsidiary S2. The NCI in Subsidiary S2 is 25% (100% − 75%
held by Parent P).

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Apply and Analyse 2 (continued)

Debit Credit
HK$’000 HK$’000

Share capital 150.0

Retained earnings – opening 130.0
Goodwill (calculated per previous Apply and Analyse exercise) 28.0
Investment in Subsidiary S3 (Parent) 100.0
Investment in Subsidiary S3 (Sub S2) 75.0
Non-controlling interests – equity 133.0
Eliminate pre-acquisition equity in Subsidiary S3. The NCI in Subsidiary S3 is 47.5% (100% − 30% −
(75% × 30% held by Subsidiary S2).
W2 Profit attributable to NCI (25% × 80) 20.0
Retained earnings – opening (25%*(180−40)) 35.0
Non-controlling interests – equity 55.0
Attribute post-acquisition profit of Subsidiary S2 to NCI.

Non-controlling interests – equity 25.0

Investment in Subsidiary S3 (Sub S2) (25% × 100) 25.0
Eliminate NCI share of Subsidiary S2’s investment in Subsidiary S3.
This entry recognises that part of the NCI share of post-acquisition profits of HK$35k are
effectively represented by the assets and liabilities of Subsidiary S3.
W3 Profit attributable to NCI (47.5% × 50) 23.75
Non-controlling interests – equity 23.75
Attribute post-acquisition profit of Subsidiary S2 to NCI.
W4 Sales 360.0
Cost of goods sold 300.0
Inventory 60.0
Eliminate intra-group sale of inventory.

Deferred tax asset (16.5% × 60) 9.9

Income tax expense 9.9
Eliminate tax effect of intra-group sale.

Non-controlling interest – equity (25% × (60−9.9)) 12.5

Profit attributable to NCI 12.5
Attribute to NCI its share of the consolidation adjustment.
If the sale had been between Subsidiary S3 and Parent, the relevant NCI share would be 47.5%.

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34.1.2 Structured Entities

As discussed in earlier chapters and shown in Exhibit 34.1, ‘control’ must be present for an
entity to be labelled a subsidiary. In a company structure, voting rights through ownership
interest are often the predeterminant of whether control is present. If an investor can require
the entity to act in a certain manner through holding greater than 50% of the voting power,
the features for control will generally be present (power, variable returns, ability to exercise
that power).

However, in some cases, an entity may have been designed in a manner so voting or similar
rights are not the dominant factor in deciding who controls the entity, such as when any voting
rights relate to administrative tasks only and the relevant activities are directed by means of
contractual arrangements. One common structure is a special purpose vehicle, such as a
securitisation vehicle. (Use of these vehicles could impact the assessment of whether
HKFRS receivables should be derecognised: see Chapter 12). Other examples include some investment
12.B24 funds or asset-backed financings.
HKFRS
12.B22,
Hong Kong Financial Reporting Standards (HKFRSs) refer to these entities as structured
App. A entities. A common layman’s perception of these entities is that they are dodgy structures to
hide losses or profits or to artificially engineer particular outcomes. A structured entity often
has features, such as restricted activities and/or a narrow and well-defined objective (e.g. to
effect a tax-efficient lease, carry out research and development activities, provide a source of
(HKFRS capital or funding to an entity, or provide investment opportunities for investors by passing on
12.B23) risks and rewards associated with the assets of the structured entity to investors).

A more sophisticated group may use such structures. These entities must be consolidated
where control is present although this might not be immediately apparent from the voting
rights. In some cases, a determination is made that control is absent in which case the entity
is not consolidated. However, to provide useful information to the users of the financial
statements, the standard-setters decide if it is insufficient for the financial statements to report
on such investments in the same manner as other ‘regular’ investments. Therefore, specific
disclosures are required of an investor’s interests, which is not limited to ownership interest, in
such group entities, whether or not consolidated.

This module does not require you to be able to analyse whether a structured entity
should be consolidated or otherwise, nor the specific additional disclosures that apply to such
interests. It is sufficient to know there are no special exceptions from consolidation for such
group entities and that additional disclosures are required.

3 4 . 2 CHANGES IN GROUP STRUCTURE

To succeed, an entity often has to grow or otherwise change its group structure. This section
discusses the accounting for changes in a parent’s ownership interest in a subsidiary.

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34.2.1 Acquisitions
The accounting for the acquisition of a subsidiary was first discussed in Chapter 29 (if the
subsidiary is a business) and in Chapter 30 (consolidation of the subsidiary).

This section discusses two common complexities in the acquisition of a subsidiary:

1. Step acquisitions – the accounting when the parent already holds a previously held
interest before it gains control; and

2. Mid-year acquisitions – how an acquisition that occurs partway through the reporting
period affects the consolidation process.

34.2.1.1 Subsidiary Acquired in Stages

As alluded to in the earlier chapters and illustrated in Exhibit 34.4, an entity may gradually
increase its influence over another entity until it gains control over that other entity, for
example, from an associate interest to a subsidiary interest. These are often referred to as
a step acquisitions. The accounting reflects the change in the status of the investor from the
owner of an investment asset in an entity to the owner of a controlling financial interest in all
of the underlying assets and liabilities of that entity. Moving from one classification to another
(e.g. from associate to joint venture, or from joint venture to subsidiary) is often referred to as
crossing an accounting boundary.

Financial Associate Joint Subsidiary

asset venture

EXHIBIT 34.4 Staged acquisition of a subsidiary

Recall from Chapter 29 that upon gaining control of a business, goodwill is determined
as follows:

HK$
Consideration transferred x,xxx
plus: Non-controlling interest x,xxx
plus: Fair value of previously held interests x,xxx
less: Amount recognised for identifiable net assets at acquisition date (x,xxx)
Goodwill/(Gain on bargain purchase) on acquisition x,xxx

Before the point of gaining control, the existing equity interest is accounted for in
accordance with the HKFRS applicable to the entity’s degree of influence over that other entity:
under HKFRS 9 Financial Instruments, HKAS 28 (2011) Investments in Associates and Joint Ventures,
or HKFRS 11 Joint Arrangements. When control is gained, whether through the acquisition
of additional voting interests or other factors, any existing ownership interest must be
remeasured to fair value at the date the additional ownership interest is acquired.

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A gain or loss may result, being the difference between the carrying amount of the existing
HKFRS interest and the fair value of the previously held interest. Any gain or loss is recognised in profit
3.42 and loss. The gain or loss recognised by the group is likely to differ from that (if any) recognised
by the investor in its separate financial statements.

When an additional interest is acquired in a financial asset turning the passive investment
into a subsidiary, two acceptable approaches exist to determining the cost of that subsidiary in
the separate financial statements of the parent:

1. Under the ‘fair value as deemed cost approach’, the previously held interest in the
(now) subsidiary is remeasured to fair value in the separate financial statements
of the parent. That is, the cost of the investment = fair value of existing interest +
consideration for additional interest. Accordingly, the consolidation adjustment
journal entry to eliminate the investment in subsidiary will need to recognise a gain on
remeasurement has been recorded in the separate financial statements. In practice, the
fair value as deemed cost approach is more commonly used.

2. Under the ‘accumulated cost approach’, the cost of the subsidiary consideration
for the existing interest + consideration for the additional interest. Therefore, the
consolidation adjustment journal entry to eliminate the investment in subsidiary
will need to account for the full gain or loss to the group on remeasurement of the
investment.
This chapter assumes the investment in subsidiary is measured at cost in the separate
financial statements of the parent rather than at fair value as permitted by HKAS 27. Business
combination accounting can only apply once on the change of the accounting boundary to
achieve control. This is the only time the net assets of the subsidiary are restated to their
fair values.

Illustrative Example 2
Soleil Limited (Soleil) holds a 10% interest in Twinkle Limited (Twinkle), which it acquired
for HK$8,200. On 1 January 20X6, Soleil purchases the remaining 90% of Twinkle for
HK$92,000. Following the second acquisition, Soleil determines it now controls Twinkle.

On 1 January 20X6, the fair value of Soleil’s 10% interest in Twinkle was HK$10,000. The
carrying amount of its investment on 31 December 20X5 was HK$9,500.

On 1 January 20X6, Twinkle’s equity was represented by share capital of HK$20,000

and retained earnings of HK$70,000. Assume the fair value of the net assets of Twinkle on
1 January 20X6 was the same as the carrying amounts.

Until 1 January 20X6, Soleil measured its investment in Twinkle at fair value through profit
or loss. Under the fair value as deemed cost approach on the acquisition of the additional
interest, Soleil records the following journal entry in its separate financial statements:

Debit Credit
HK$ HK$
Investment 500
Fair value gain on remeasurement (p/l) 500

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Illustrative Example 2 (continued)

Subsequently, the ‘cost’ of the investment to Soleil (if it measures the investment in
subsidiary on the cost basis) is HK$102,000, being HK$10,000 (fair value as deemed cost) +
HK$92,000.

In Soleil’s consolidated financial statements, goodwill arising relating to Twinkle is

calculated as:

HK$
Consideration transferred 92,000
plus: Non-controlling interest –
plus: Fair value of previously held interests 10,000
less: Fair value of identifiable net assets at acquisition date (90,000)
Goodwill on acquisition of Twinkle 12,000

On consolidation, Soleil processes the following pre-acquisition equity elimination

journal entry:

Debit Credit
HK$ HK$
Share capital 20,000
Retained earnings 70,000
Goodwill 12,000
Investment (10,000 + 92,000) 102,000

Illustrative Example 3
Soleil Limited (Soleil) holds a 30% interest in its associate Comet Limited (Comet), which it
acquired for HK$6 million. On 1 January 20X6, Soleil’s equity accounted carrying amount
of Comet is HK$7 million and its 30% interest in Comet was valued by market participants
at HK$7.2 million.

Also on 1 January 20X6, Soleil acquired another 50% in Comet for HK$12 million. At that
time, the fair value of the net assets of Comet was HK$23 million. Following the second
acquisition, Soleil determines it has control of Comet. Assume:

• That Soleil measures the non-controlling interest at its fair value of

HK$4.6 million; and

• Soleil applies the accumulated cost approach to measuring the cost of its
investment in Comet in its separate financial statements (i.e. HK$6 million +
HK$12 million = HK$18 million).

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Illustrative Example 3 (continued)

Under the accumulated cost approach, Soleil prepares the following pre-acquisition
equity elimination journal entry to eliminate its investment in Comet:

Debit Credit
HK$ HK$
Share capital, reserves and retained earnings 23,000,000
Goodwill 800,000
Non-controlling interest (equity) 4,600,000
Investment (6,000,000 + 12,000,000) 18,000,000
Retained earnings (equity accounted profits)a 1,000,000
Gain on remeasurement of existing interest (p/l)b 200,000
a
Share of equity accounted profits and reserves for the period Comet was an associate.
b
Increase in investment from remeasurement of existing interest from HK$7 million to HK$7.2 million.

Alternative journal entries to eliminate the investment:

The approach to eliminating the investment in the preceding subsidiary visibly links
to the carrying amount of the investment in the separate financial statements. Another
approach is to:

• Reflect the equity accounting journal entry for the investor’s share of the
associate’s accumulated profit or loss and reserves to the time control is gained;

• Recognise any gain or loss on remeasurement of the equity accounted carrying

amount to its fair value on the date control is gained; and

• Eliminate the cumulative investment balance against the pre-acquisition equity of

the subsidiary.

That is, the following journal entries could instead be presented in the consolidation
worksheet:

Debit Credit
HK$ HK$
Investment 1,000,000
Retained earnings (equity accounted profits) 1,000,000
(Recognise the equity accounted profits for the period Comet was held as an associate)

and

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Illustrative Example 3 (continued)

Debit Credit
HK$ HK$
Investment 200,000
Gain on remeasurement of existing interest (p/l) 200,000
(Recognise the remeasurement of the existing interest to fair value on acquisition of the
additional interest in Comet.)

and

Debit Credit
HK$ HK$
Share capital, reserves and retained earnings 23,000,000
Goodwill 800,000
Non-controlling interest (equity) 4,600,000
Investmenta 19,200,000
a
19,200,000 = separate financial statements (6,000,000 + 12,000,000) + equity accounted profits
(1,000,000) + gain on remeasurement (200,000).

In addition, if, for example, Comet measured property on a revaluation basis and
a share of the revaluation surplus was recognised in Soleil’s consolidated financial
statements, that amount will not be reclassified to profit or loss on the acquisition of
the additional interest, consistent with the requirements of HKAS 16 Property, Plant and
Equipment.

Tax Implications When Crossing an Accounting Boundary

Recall from previous chapters that the investor may recognise deferred tax assets or deferred
tax liabilities relating to its investments in financial assets, associates or joint ventures.
Consequently, when gaining control of a subsidiary via a step acquisition process, the parent
must also consider:

• Whether the amount of any temporary difference relating to its investment has
changed; and
• Whether deferred tax balances exist that no longer need to be recognised because the
conditions for exemption for recognition are now met.

Though such balances are not assets or liabilities of the (now) subsidiary, the balances do
not form part of the identifiable net assets acquired for the purposes of determining goodwill.

For example, assume that Entity A operates in a jurisdiction where there is a 15% capital
gains tax regime. The tax is payable when an investment is disposed. Entity A holds a 10%
interest in Entity B, which it originally purchased for HK$100 million and treats as a financial

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asset measured through profit or loss. At the reporting date, the investment is remeasured
to its fair value of HK$150 million, and a deferred tax liability of HK$7.5 million is recognised.
The next day, Entity A acquires a further 60% interest in Entity B and concludes it now controls
Entity B. The deferred tax liability of HK$7.5 million should be revisited for recognition in the
consolidated financial statements because the temporary difference relating to Entity A’s
investment in Entity B may have changed and because different exemptions from recognition
of a deferred tax asset or liability now apply to the investment.

Changes in Ownership Interest Subsequent to Gaining Control

Changes in a parent’s ownership interest in a subsidiary subsequent to gaining control of the
HKFRS
subsidiary are equity transactions. That is, the transaction is a transaction with owners in their
10.23 capacity as owners.

Key Learning Point

As an equity transaction:

• No additional goodwill arises on the acquisition of the further interest;

• No gain or loss is recognised in profit or loss on the acquisition of the further

interest; and

• No remeasurement of the subsidiary’s net assets occurs on the acquisition of the

further interest.

HKFRS 10 shows little guidance how to measure the amount to be allocated to the
parent and non-controlling interests (NCIs) to reflect a change in their relative interests in the
subsidiary. However, common practice is to:

• Reallocate an amount of the NCI proportionate to the additional interest acquired to

owners of the parent; and

• Recognise in equity the difference between the fair value of consideration paid and the
decrease in the NCIs.

That is, the parent records the following pro-forma journal entry in its consolidation
worksheet:

Debit Credit
HK$ HK$
Non-controlling interests (equity) x,xxx
Equity (e.g. capital reserve) x,xxx
Investment (additional interest acquired) x,xxx

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Illustrative Example 4
On 31 December 20X8, Soleil Limited (Soleil) purchases another 10% of Comet Limited
(Comet) for HK$2.6 million. Following this acquisition, Soleil holds 90% of Comet.

On 31 December 20X8, the carrying amount of the non-controlling interests in Comet is

HK$5 million.

In its separate financial statements, Soleil records the following journal entry to
recognise the transaction:

Debit Credit
HK$ HK$
Investment 2,600,000
Cash/Payables 2,600,000

In its consolidation worksheet to prepare its consolidated financial statements, to

record the consolidation adjustment necessary to account for the transaction Soleil
recognises:

Debit Credit
HK$ HK$
Non-controlling interests (equity) (5,000,000/20% × 10%) 2,500,000
Equity (e.g. capital reserve) 100,000
Investment 2,600,000

The debit to equity recognises that consolidated equity is reduced by the NCIs’ share of
any unrecognised changes in the fair value of the net assets of Comet, including goodwill,
which is reflected in the consideration paid by the parent for the additional interest.

The reduction in the reported equity attributable to the owners of the parent is likely to be
IFRS larger where the NCIs is measured initially as a proportionate share of the acquiree’s
3.BC218 identifiable net assets, compared to had it been measured at fair value.

34.2.1.2 Mid-year Acquisition

Up to this point in the module, the Illustrative Examples and exercises have assumed a
parent acquires control of a subsidiary at the start of its annual reporting period; in practice,
acquisitions can occur at any point during a reporting period (a mid-year acquisition).

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The key point to remember is that a parent consolidates a subsidiary only from the time it
controls the subsidiary. Therefore, with respect to a mid-year acquisition:

• The same pre-acquisition elimination procedures apply as to an acquisition occurring at

the start of a reporting period; and

• In the annual reporting period of acquisition, the results of the subsidiary are
consolidated only from the time control is gained:

For example, if Soleil had acquired Polaris on 15 June 20X1, Soleil does not consolidate
12 months of Polaris’ results. Only Polaris’ results (profit or loss, other comprehensive
income and cash flows) from 15 June 20X1 to 31 December 20X1 are included in
the group’s consolidated financial statements. To consolidate a period other than
this would misrepresent the economic entity’s results to Soleil’s owners. Similarly, if
Soleil acquired control of associate Comet during the year, the consolidated financial
statements should reflect that Comet is equity accounted for that first part of the year
(i.e. the consolidated profit or loss includes ‘share of associate’s profits’ in addition to
100% of Comet’s profit or loss from the date of acquisition).

• Similarly, in the annual reporting period of acquisition, only intragroup transactions

occurring subsequent to the acquisition are eliminated in preparing the consolidated
financial statements. (Intragroup balances at the year-end continue to be eliminated
as normal.)
A transaction between group entities when the entities are not in a
parent-subsidiary relationship is not an intragroup transaction; and

• In reporting periods subsequent to the period of acquisition, the results of the

subsidiary are consolidated for the full reporting period until the subsidiary is disposed.

The consolidated financial position at the end of a reporting period is the same, whether
the subsidiary was acquired at the start of a reporting period or during that reporting period.

As is mentioned in Section 34.3.1.1, if the parent held an existing equity interest before
control was gained during the year, the existing interest should be accounted for according to
its nature (as an financial asset, associate or joint venture) up to the time control is gained.

Key Learning Point

Consider the scenario if a new subsidiary company was incorporated during the year.
There would be no results to consolidate for the period it was not in existence. In the same
manner, the activity of an established business is not incorporated into the consolidated
results until it is controlled by the parent; the results before this time are ‘wrapped up’ in
the purchase consideration.

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Apply and Analyse 3

Soleil is preparing its consolidated financial statements for the year ending 31 December
20X0 consolidating itself and its 80% owned subsidiary, Solar Limited (Solar). Solar was
acquired on 1 October 20X0 in exchange for consideration of HK$48 million. At the time of
acquisition, Solar’s equity was represented by:

HK$’m
Share capital 10
Retained earnings 50
60

The carrying amount of the net assets was equal to their fair values on the acquisition
date.

During the year ended 31 December 20X0, the following transactions occurred:

• Solar provided management services to Soleil for a fee of HK$2 million on

15 February 20X0. All services were rendered and no amounts were outstanding
between the parties on the acquisition date;

• On 1 September 20X0, Soleil sold a machine for HK$49 million cash to Solar. Soleil
had purchased the machine on 1 January 20X0 for HK$50 million. Soleil and Solar’s
accounting policy is to depreciate the machine on a straight-line basis over its
useful life. The machine was initially estimated to have a useful life of 10 years
and nil scrap value, and these assumptions were not changed by Soleil upon its
acquisition; and

• Soleil sold inventory for HK$60,000 to Solar on 15 November 20X0. The carrying
amount (cost) of the inventory in Soleil’s books immediately prior to the sale was
HK$40,000. All the inventory remained on hand at 31 December 20X0.

On 31 December 20X0, Soleil and Solar’s financial position is as follows:

Soleil Solar
HK$’000 HK$’000
Statement of financial position
Assets
Property, plant and equipment 480,000 54,000
Investments 1,262,000 –
Inventories 76,190 15,000
Loans receivable 223,810 –
Trade and other receivables 129,300 16,000
Cash 281,700 10,000
Total assets 2,453,000 95,000

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Apply and Analyse 3 (continued)

Soleil Solar
HK$’000 HK$’000
Equity
Share capital 200,000 10,000
Retained earnings 1,603,000 55,000
Other reserves 282,000 –
Total equity 2,085,000 65,000
Loan 300,000 20,000
Deferred tax liabilities – 600
Payables 68,000 9,400
Total liabilities 368,000 30,000
Total equity and liabilities 2,453,000 95,000

Soleil and Solar’s financial performance during 20X0 was as follows:

Soleil Solar Solar

1 January 20X0 – 1 January 20X0 – 1 October 20X0 –
31 December 20X0 31 December 20X0 31 December 20X0
HK$’000 HK$’000 HK$’000
Statement of profit or loss
Revenues 395,976 36,000 9,960
Interest income 52,000 2,300 500
Dividend income 60,000 6,000 200
Gain on sale of assets 2,000 1,200 –
Cost of sales (256,000) (20,000) (3,500)
Depreciation expense (50,000) (4,480) (1,120)
Interest expense (4,000) (600) (110)
Other expenses (92,976) (6,620) (930)
Profit for the year 107,000 13,800 5,000

Prepare the consolidated statement of financial position and statement of profit or

loss for the group comprising Soleil and Solar with respect to the year ended 31 December
20X0. Assume the non-controlling interest is measured as the proportionate share of the

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Apply and Analyse 3 (continued)

fair value of the net assets of Solar on acquisition. For the purposes of this exercise, tax
is ignored.

Analysis

Consolidation adjustments
Soleil Solar DR CR Consolidated
HK$’000 HK$’000 HK$’000 Ref HK$’000 HK$’000
Statement of financial
position
Assets
Property, plant and 480,000 54,000 534,000
equipment
Investments 1,262,000 – 1 48,000 1,214,000
Inventories 76,190 15,000 2 20 91,170
Loans receivable 223,810 – 223,810
Trade and other 129,300 16,000 145,300
receivables
Cash 281,700 10,000 291,700
Total assets 2,453,000 95,000 2,499,980
Equity
Share capital 200,000 10,000 10,000 1 200,000
Retained earnings 1,603,000 55,000 50,000 1 1,606,980
20 2
1,000 3
Other reserves 282,000 – 282,000
Attributable to 2,085,000 65,000 2,088,980
owners of the parent
Non-controlling – – 1 12,000 13,000
interest
3 1,000
Total equity 2,085,000 65,000 2,101,980
Loan 300,000 20,000 320,000
Deferred tax – 600 600
liabilities
Payables 68,000 9,400 77,400
Total liabilities 368,000 30,000 398,000
Total equity and 2,453,000 95,000 2,499,980
liabilities

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Apply and Analyse 3 (continued)

Consolidation adjustments
Soleil Solar DR CR Consolidated
HK$’000 HK$’000 HK$’000 Ref HK$’000 HK$’000
Statement of profit or
loss
Revenues 395,976 9,960 60 2 405,876
Interest income 52,000 500 52,500
Dividend income 60,000 200 60,200
Gain on sale of assets 2,000 – 2,000
Cost of sales (256,000) (3,500) 2 40 (259,460)
Depreciation (50,000) (1,120) (51,120)
expense
Interest expense (4,000) (110) (4,110)
Other expenses (92,976) (930) (93,906)
Profit for the year 107,000 5,000 111,980
Profit for the year
attributable to:
Owners of the 110,980
parent
Non-controlling 1,000
interests
Profit for the year 111,980

Notes:

Refer to Chapter 30 to review how the amounts are determined:

• Ref 1 – pre-acquisition equity elimination entry;

• Ref 2 – entry to eliminate the unrealised profit on the intragroup sale of inventory; and

• Ref 3 – entry to attribute to the non-controlling interest its share of profit for
the period.

The sale of management services from Solar to Soleil occurred before Solar was acquired
by Soleil. Therefore, it is not eliminated from the consolidated results for the period. Similarly,
the sale of the machine from Soleil to Solar is not eliminated from the consolidated results
because it occurred before Soleil acquired Solar. Accordingly, there is no notional ‘excess
depreciation’ to account for, and there is no difference between the consolidated carrying
amount of the machine (at the higher amount) and its tax base (reset on acquisition by Soleil).

34.2.2 Disposals
As illustrated in Exhibit 34.5 and similar to a step acquisition, an investor may sell down its
ownership interest in a subsidiary so it loses control and only retains joint control, significant
influence or a passive interest or no interest after the transaction. As is discussed in Sections

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34.3.2.1–34.3.2.2, the extent of any gain or loss on the sale recognised in profit or loss depends
on the status of the investment after the disposal transaction.

Financial Associate Joint Subsidiary

asset venture

EXHIBIT 34.5 Disposal of a subsidiary

This chapter assumes that the subsidiary disposed is a business. Different requirements
may apply where the subsidiary disposed is not a business, and these requirements are beyond
the scope of this module.

This chapter assumes that the conditions for the subsidiary to be classified as held for sale
in accordance with HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations are
not met before the disposal occurs. To the extent the subsidiary meets the conditions to be
classified as held for sale, the carrying amounts of the disposal group may need to be written
down where specified by HKFRS 5 (see Chapter 15) before the disposal occurs.

Key Learning Point

In practice, more than one HKFRS may be relevant when accounting for an event. For
example, if HKFRS 5 was not appropriately applied, the resultant gain or loss on the
disposal of a subsidiary could be attributed across different reporting periods. HKAS 36
Impairment of Assets is another standard that might be relevant when considering the
disposal of a subsidiary.

34.2.2.1 Accounting for Full Disposal

After the parent fully disposes of its ownership interest in a subsidiary, it will usually lose
control over that subsidiary. The parent should cease consolidating that subsidiary from the
date control is lost (usually, the date of disposal). To achieve this, in the consolidated financial
statements, HKFRS 10 requires the parent to:

• Derecognise the assets and liabilities of the former subsidiary from the consolidated
statement of financial position, including any related goodwill;

• Derecognise non-controlling interests;

• Reclassify to profit or loss, or transfer directly to retained earnings if required by other

HKFRSs, the amounts recognised in other comprehensive income in relation to the
subsidiary as though the related assets and liabilities had been directly disposed;

• Recognise the fair value of the consideration received in exchange for the ownership
interest plus any distribution of shares of the subsidiary to owners in their capacity as
owners; and

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HKFRS • Recognise any resulting difference in profit or loss as a gain or loss associated with the
10.25,
B98–B99 loss of control attributable to the former controlling interest.

In the parent’s separate financial statements, the investment asset is derecognised:

• If the investment was recognised at cost, and the gain or loss on disposal (being
the difference between the consideration received and the carrying amount of the
investment) is recognised in profit or loss; and

• If the investment was recognised in accordance with HKFRS 9; the derecognition

provisions of that standard apply.

The gain or loss on disposal may be subject to tax. The tax might be calculated based on
the difference between the proceeds received on disposal and the tax base of the investment
held by the parent (usually, original cost of the shares acquired).

Illustrative Example 5
Soleil acquires 80% of Polaris Limited (Polaris) on 1 January 20X1 for HK$7 million. At
that time, the fair value of Polaris’ identifiable net assets is HK$8,652,500, represented by
HK$100,000 share capital and HK$8,552,500 retained earnings.

On 31 December 20X6, Soleil sells its entire interest in Polaris for HK$15 million. The
carrying amount of the net assets of Polaris on that date is HK$12 million, represented by
HK$100,000 share capital and HK$11.9 million retained earnings, including profit for the
year of HK$900,000. The carrying amount of goodwill related to the acquisition of Polaris is
HK$78,000 and the non-controlling interest in Polaris is HK$2.4 million.

The carrying amount of the investment in Soleil’s separate financial statements is

HK$7 million. Soleil’s accounting policy is to measure its investment in subsidiaries in the
separate financial statements at cost.

Soleil’s gain or loss is calculated as follows:

Soleil’s separate financial statements

HK$
Consideration received 15,000,000
less: Carrying amount of investment 7,000,000
Gain on disposal of investment 8,000,000

Soleil’s consolidated financial statements

HK$ HK$
Consideration received 15,000,000
less:
Carrying amount of net assets of Polaris 12,000,000
+ Goodwill 78,000
− Non-controlling interests in Polaris (2,400,000) (9,678,000)
Gain on disposal of investment 5,322,000

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Illustrative Example 5 (continued)

The difference between the gain on disposal of Polaris in Soleil’s separate financial
statements and the gain recognised in the consolidated financial statements is
represented by its share of the change in net assets of the subsidiary from the time control
was first gained to when it is lost. Hence, it can be reconciled as:

HK$
Group gain on disposal 5,322,000
add: Share of increase in reserves between acquisition and 2,678,000
disposal (80% × (12,000,000 − 8,652,500))
Gain recognised in Soleil’s separate financial statements 8,000,000

Recall the group structure of the Soleil group. On disposal of Polaris, Soleil will also lose
control of Bopp Limited (Bopp), and it will need to be deconsolidated. The gain or loss on
disposal of Bopp is considered separately from the disposal of Polaris.

34.2.2.2 Accounting for a Partial Disposal

Similar to a step acquisition, the accounting for a partial disposal depends on whether control is
lost following the disposal of the interest.

Partial Disposal with Loss of Control

When a parent partially disposes of its ownership interest in a subsidiary in a manner that
results in it losing control over that subsidiary, the parent ceases consolidating that subsidiary
from the date of disposal. To achieve this, HKFRS 10 requires the parent to:

• Derecognise the assets and liabilities of the former subsidiary from the consolidated
statement of financial position;

• Derecognise non-controlling interests;

• Reclassify to profit or loss, or transfer directly to retained earnings if required by

other HKFRSs, the amounts recognised in other comprehensive income in relation to
the subsidiary as though the related assets and liabilities had been directly disposed
of (e.g. gains and losses accumulated in reserves with respect to debt instruments
measured at fair value through other comprehensive income are reclassified to profit
or loss and, thereby, form part of the gain or loss on disposal);

• Recognise any retained interest at fair value at the date control is lost;

• Recognise the fair value of the consideration received in exchange for the ownership
interest, plus any distribution of shares of the subsidiary to owners in their capacity as
owners; and

HKFRS 10.25, • Recognise any resulting difference in profit or loss as a gain or loss associated with the
B98–B99 loss of control attributable to the former controlling interest.

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HKFRS The fair value of the retained interest at the date control is lost becomes the deemed cost
10.25 for its subsequent accounting as an associate, joint venture or financial asset. Where the
retained investment is a financial asset, the entity is not precluded from classifying investment
as at fair value through other comprehensive income – the date of losing control is treated as
the new ‘day 1’ for the purposes of HKFRS 9.

Illustrative Example 6
(This Illustrative Example uses the information from Apply and Analyse 3. It does not
illustrate the tax consequences of the disposal.)

Instead, assume that on 31 December 20X6, Soleil Limited (Soleil) sold 75% of its
interest in Polaris Limited (Polaris) for HK$11.25 million (i.e. it disposes of shares equivalent
to a 60% ownership of Polaris). It determines it loses control of Polaris on that date.

The carrying amount of the net assets of Polaris on that date is HK$12 million. On
the disposal date, goodwill related to the acquisition of Polaris is HK$78,000 and the
non-controlling interest in Polaris is HK$2.4 million. The fair value of the retained 20%
interest in Polaris is HK$3,750,000. Assume Soleil measures its investment in Polaris at fair
value following the disposal.

Soleil’s separate financial statements

Soleil records the following journal entry in its separate financial statements to
recognise the disposal and the remeasurement of its retained interest to fair value:

Debit Credit
HK$ HK$
Cash 11,250,000
Investment in Polaris (7 million – 3.75 million) 3,250,000
Gain on disposal 8,000,000

Following this entry, the retained interest in Polaris (20%) is measured at HK$3.75
million, which is regarded as its fair value on initial recognition of a financial asset in
accordance with HKFRS 9 or its cost on initial accounting for the retained interest as an
investment in an associate or joint venture.

Soleil’s consolidated financial statements

Soleil’s gain or loss in its consolidated financial statements on the partial disposal of its
interest in Polaris is calculated as follows:

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Illustrative Example 6 (continued)

Debit Credit
HK$ HK$
Soleil’s consolidated financial statements
Consideration received 11,250,000
Fair value of retained interest (20%) 3,750,000
less:
Carrying amount of net assets of Polaris 12,000,000
+ Carrying amount of goodwill 78,000
− Non-controlling interests in Polaris (2,400,000) (9,678,000)
Gain on disposal of the investment 5,322,000

The gain comprises two components, being:

Proceeds on disposal 11,250,000

less: Net assets disposed (60% × HK$12 million) (7,200,000)
less: Goodwill (78,000)
Gain on disposal (realised gain) 3,972,000
Fair value of retained interest (20%) 3,750,000
less: Net assets retained (20% × HK$12 million) (2,400,000)
Gain on revaluation of retained interest (unrealised gain) 1,350,000
Total gain on disposal of investment 5,322,000

At a group level, the accounting journal entry required to account for the
deconsolidation of Polaris is effectively:

Debit Credit
HK$ HK$
Cash 11,250,000
Non-controlling interests – equity 2,400,000
Investment in financial asset (20% Polaris) 3,750,000
Net assets of Polaris (e.g. Inventory) 12,000,000
Goodwill 78,000
Gain on disposal of subsidiary 5,322,000

However, this journal entry needs to be prepared through the lens of the consolidation
process and the use of a consolidation worksheet. Accordingly, to recognise the disposal
in its consolidated financial statements, Soleil makes the following consolidation
adjustment journal entries in its consolidation worksheets. Remember, the consolidation
adjustments add across the financial statements of the parent and the subsidiary. The

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Illustrative Example 6 (continued)

financial statements of the subsidiary to be included in the consolidation worksheet

reflects its financial position and financial performance on the date control is lost. In effect,
the consolidation worksheet adopts the formula Parent financial position (Year-End) +
Subsidiary financial position (Date of disposal) – Subsidiary financial position (Date of
disposal) = Consolidated financial position (Year End) to account for the disposal at a group
level. This is clearer on reviewing the consolidation journal entries shown following:

Consolidation adjustment journal entries

Debit Credit
HK$ HK$
Share capital 100,000
Retained earnings 8,552,500
Goodwill (refer Chapter 29) 78,000
Investment in Polaris 7,000,000
Non-controlling interests – equity 1,730,500
Eliminate pre-acquisition equity in Polaris

This journal entry is still required in the period of sale

Profit attributable to NCI (20% × 900,000) 180,000
Retained earnings – opening (20% × (11,000,000 − 489,500
8,552,500)
Non-controlling interests – equity 669,500
Attribute NCI share of profits up until the date control is lost

Investment in Polaris 7,000,000

Non-controlling interests – equity 2,400,000
Gain on disposala (8,000,000 − 5,322,000) 2,678,000
Net assets of Polaris at the disposal date 12,000,000
Goodwill 78,000
Recognise gain on deconsolidation
a
The adjustment reduces the gain recognised in the parent’s separate financial statements
to the gain recognised by the group on deconsolidation (see calculation above).

The consolidation worksheet and consolidated financial statements would present as

follows. (The parent and subsidiary financial statement amounts in these worksheets have
been included for illustrative purposes to highlight the amounts in each entity’s financial
statements relating to the deconsolidation of Polaris.)

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Illustrative Example 6 (continued)

Profit attributable
Sole il (reporting

Loss of control of
Polaris (date of
the purposes of
December 20X6

Pre-acquisition
Consolidation

Consolidated
worksheet 31

included for

illustration
* amounts

subsidiary
disposal)

equity

to NCI
date)
HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
Statement of financial
position
Investment in Polaris 3,750 – (7,000) 7,000 3,750
Goodwill – – 78 (78) –
Cash 11,250 1,000* (1,000) 11,250
Other net assets 4,985,000* 11,000* (11,000) 4,985,000
Total net assets 5,000,000* 12,000 5,000,000
Share capital 200,000 100 (100) 200,000
Reserves 282,000 – 282,000
Retained earnings
Opening retained 4,510,000* 11,000 (8,552.5) (489.5) 4,511,958
earnings
Profit for the year 8,000 900 (180) (2,678) 6,042
Owners of the parent 5,000.000 12,000 5,000,000
Non-controlling interest – – 1,730.5 669.5 (2,400) –
Total equity 5,000,000 12,000 5,000,000

Statement of profit or loss and other

comprehensive income
Gain on disposal of 8,000 – (2,678) 5,322
subsidiary
Other revenues and –* 900 900
expenses
Profit for the year 8,000* 900 6,222

Profit for the year

attributable to:
Owners of the parent 8,000 900 (180) (2,678) 6,042
Non-controlling – – 180 180
interests
Profit for the year 8,000 900 6,222

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Illustrative Example 6 (continued)

The consolidated statement of changes in equity can then be prepared:

Share Retained Reserves Total Non- Total

capital earnings controlling equity
interests
HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
Statement of
changes in equity
Balance at 1 January 200,000 4,511,958 282,000 4,993,958 2,220 4,996,178
20X6
Profit for the year – 6,042 – 6,042 180 6,222
Other – – – – – –
comprehensive
income for the year
Total comprehensive – 6,042 – 6,042 180 6,222
income for the year
Disposal of subsidiary – – – – (2,400) (2,400)
Balance at 31 200,000 4,518,000 282,000 5,000,000 – 5,000,000
December 20X6

Following the deconsolidation of the subsidiary, the retained interest in Polaris is

then accounted for as the appropriate of a financial asset or interest in associate. So, if
the disposal occurs during the period and the shares are subsequently accounted for
at fair value through other profit or loss or other comprehensive income, this will be
reflected in Soleil’s separate financial statements (i.e. the investment in Polaris may not
be shown as HK$3.75 million at year-end). If the disposal occurs during the period and
Polaris is subsequently treated as an associate, consolidation adjustment journal entries
will need to be processed to equity account the investment from its deemed cost of
HK$3.75 million.

Subsequent to losing control of a subsidiary, in the consolidated financial statements:

• The assets and liabilities of that subsidiary are not recognised in the consolidated
financial statements;

• No non-controlling interest in equity should relate to the disposed subsidiary;

• The results of the subsidiary are included in profit or loss and other comprehensive
income only until the date control is lost; and

• The non-controlling interest share of profit or loss and other comprehensive income
reflects only its share of those results.

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The consolidated statement of cash flows is prepared in an analogous manner to that for
an acquisition during the period where the assets and liabilities of the subsidiary disposed are
acknowledged in the asset and liability movements for the period.

Consider the following simple example: Parent P disposes of Subsidiary S5 for HK$100 million
cash. S5 has a single asset at the time of disposal: a receivable of HK$100 million. The group has
no other receivables at the beginning or end of the reporting period and has made no sales.
In this example, Parent P has had no cash movements related to the receivable. However, if the
cash flow ‘formula’ of:

Receipts from customers = Opening trade receivable balance + Sales revenue – credit impaired
amounts (bad debts) written off – Closing trade receivable balance

Without acknowledging the disposal, the cash inflow would be calculated as HK$100 million
(HK$100 million + HK$0 – HK$0 – HK$0). Accordingly, in the year of disposal, the formula needs
to be ‘tweaked’ so ‘closing balances’ refers to the sum of the closing balance of the group and
the balance on disposal date. Therefore, the cash inflow from operating activities would be
instead calculated as HK$nil (opening balance HK$100 million + sales HK$0 – bad debts HK$0 –
closing balance HK$0 – balance disposed HK$100 million).

When a subsidiary is disposed, the parent will normally receive an inflow of cash. HKAS 7
Statement of Cash Flows requires that cash inflow, net of any cash balances in the subsidiary at
HKAS
the time of disposal, to be classified as an investing cash flow and reported separately from
7.39, 41, 42 any cash flows on acquiring control of a subsidiary. So, for example, Soleil’s consolidated
statement of cash flows for the year ended 31 December 20X6 includes an investing line item
for ‘Disposal of subsidiary’, the amount being HK$10.25 million (HK$11.25 million – cash in
subsidiary at time of disposal HK$1 million). Following the deconsolidation of a subsidiary,
cash flows relating to the retained interest should be classified as operating or investing cash
flows as appropriate to the nature of the retained interest.

Partial Disposal Without Loss of Control

HKFRS A partial disposal without loss of control is treated as an equity transaction, similar to an
10.23 increase in ownership interest after control is initially gained (see Section 34.3.1.1.1).
As such, no gain or loss is recognised in profit or loss on the disposal. Goodwill is not
recalculated.

In Illustrative Example 7, on initial consolidation of Polaris, the NCI is measured as a

proportionate share of the fair value of the identifiable net assets on acquisition. The resultant
goodwill recognised under this approach to measuring NCI (the ‘partial goodwill’ approach)
reflects only goodwill attributable to the parent’s investment.

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Illustrative Example 7
(This Illustrative Example uses information from Apply and Analyse 3 and Illustrative
Example 6. It does not illustrate tax consequences of the disposal.)

Assume instead that Soleil Limited (Soleil) sells shares equivalent to an 8% ownership
of Polaris Limited (Polaris) for HK$1.2 million. Soleil determines it does not lose control of
Polaris following the disposal of part of its interest.

The carrying amount of the net assets of Polaris on that date is HK$12 million. On
the date of disposal, goodwill related to the acquisition of Polaris is HK$78,000 and the
non-controlling interest (NCI) in Polaris is HK$2.4 million.

On initial consolidation of Polaris, the NCI is measured as a proportionate share of the

fair value of the identifiable net assets on acquisition.

Soleil’s separate financial statements

Soleil records the following journal entry in its separate financial statements to
recognise the disposal of part of its investment:

Debit Credit
HK$ HK$
Cash 1,200,000
Investment in Polaris (8% × HK$7 million) 560,000
Gain on disposal of Polaris shares 640,000

Following this entry, the retained interest in Polaris (72%) continues to be measured
with reference to its original cost.

Soleil’s consolidated financial statements

Following the partial disposal, the NCI share of Polaris has increased from 20% to 28%.
The adjustment to NCI at the disposal date is calculated as:

HK$
NCI based on old shareholding (20% × HK$12 million) 2,400,000
NCI based on new shareholding (28% × HK$12 million) 3,360,000
NCI share of Polaris needs to increase by: 960,000

In accordance with HKFRS 10, the disposal is treated as an equity transaction.

Therefore, in addition to the standing journal entry to eliminate the investment in Polaris
and the journal entry to attribute to NCI its share of equity, Soleil records the following
consolidation adjustment journal entry in its consolidation worksheet to recognise the
disposal of part of its investment:

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Illustrative Example 7 (continued)

Debit Credit
HK$ HK$
Investment in Polaris 560,000
Gain on disposal of Polaris shares 640,000
Non-controlling interests – equity 960,000
Capital reserve a
240,000
a
Or other appropriate reserve to accumulate the difference. The amount reflects the
difference between the fair value of the consideration received (HK$1.2m) and the
proportionate share of the carrying amount of the net assets disposed (8% × HK$12m =
HK$960,000). In effect, it is the gain realised by owners of the parent on the sale of a share of
assets and liabilities still recognised by the group.

The consolidation worksheet presents as follows:

* amounts included
for the purposes of

Profit attributable
31 December 20X6

Sole il (reporting

Polaris (date of

Pre-acquisition

Disposal of 8%
Consolidation

Consolidated
illustration
worksheet

disposal)

interest
equity

to NCI
date)

HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000

Statement of financial position
Investment in 6,440 – (7,000) 560 –
Polaris
Goodwill – – 78 78
Cash 1,200 1,000* 2,200
Other net assets 4,985,000* 11,000* 4,996,000
Total net assets 4,992,640* 12,000 4,998,278
Share capital 200,000 100 (100) 200,000
Reserves 282,000 – 240 282,240
Retained earnings
opening retained 4,510,000* 11,000 (8,552.5) (489.5) 4,511,958
earnings
profit for the year 640 900 (180) (640) 720
Owners of the 4,992,640 12,000 4,994,918
parent
Non-controlling – – 1,730.5 669.5 960 3,360
interest
Total equity 4,992,640 12,000 4,998,278

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Illustrative Example 7 (continued)

the purposes of
December 20X6

Pre-acquisition
Consolidation

Consolidated
worksheet 31

Polaris (date

attributable
of disposal)
included for

8% interest
illustration

Disposal of
(reporting
* amounts

to NCI
equity
Sole il

Profit
date)
HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
Statement of profit or loss and
other comprehensive income
Gain on disposal of 640 – (640) –
shares in Polaris
Other revenues and –* 900 900
expenses
Profit for the year 640 900 900
Profit for the year
attributable to:
Owners of the 640 900 (180) (640) 720
parent
Non-controlling – – 180 180
interests
Profit for the year 640 900 900

However, if non-controlling interests are initially measured at fair value, the resultant
goodwill (‘the full goodwill’ approach) recognised reflects a share belonging to the parent’s
investment and a share belonging to the NCI’s investment in the subsidiary. Hence, if disposing
of some of the parent’s investment in an equity transaction, the adjustment to non-controlling
interests must recognise this.

Apply and Analyse 4

Recall that Soleil Limited (Soleil) acquired 80% of Polaris Limited (Polaris) on 1 January
20X1 for HK$7 million. At that time, the fair value of Polaris’ identifiable net assets is
HK$8,652,500, represented by HK$100,000 share capital and HK$8,552,500 retained
earnings. Assume instead that, on acquisition, the 20% NCI is measured at fair value
HK$1.75 million and resulting goodwill of HK$97,500 arises, rather than having a goodwill
of HK$78,000 as determined under the partial goodwill approach.

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Apply and Analyse 4 (continued)

Recalculate the adjustment to NCI on disposal of the 8% interest in Polaris for
HK$1.2 million, assuming all other information in the earlier exercises and examples
remain the same.

Analysis

Following the partial disposal, the NCI share of Polaris has increased from 20% to 28%.
The adjustment to NCI at the disposal date is calculated as:

HK$ HK$
NCI based on old shareholding (20% × HK$12 million) 2,400,000
NCI ‘share’ of goodwill (97,500 − 78,000) 19,500 2,419,500
NCI based on new shareholding (28% × HK$12 million) 3,360,000
NCI ‘share’ of goodwill (19,500/20% × 28%) 27,300 3,387,300
NCI share of Polaris needs to increase by: 967,800

The consolidation adjustment journal entry is now instead:

Debit Credit
HK$ HK$
Investment in Polaris 560,000
Gain on disposal of Polaris shares 640,000
Non-controlling interests – equity 967,800
Capital reservea
232,200

Tax Implications of Disposals

A partial disposal of an investment in a subsidiary may give rise to tax impacts relating to the
investment in addition to tax payable on the disposal gain or loss.

For example, where the disposal results in a loss of control the investor must consider
whether there is a deferred tax to recognise and/or a change in the amount of deferred tax.
For example, a change from subsidiary status (where the investor has control of the subsidiary’s
dividend policy and can control the timing of reversal of any temporary differences) to associate
status (where the investor does not control the subsidiary’s dividend policy) may result in
the investor having to recognise a deferred tax asset or liability relating to its investment in
the (former) subsidiary because it no longer meets the conditions for non-recognition of the
deferred tax balance specified by HKAS 12 Income Taxes. The calculation of that deferred tax
would also reference only a proportionate share of the undistributed profits of the investee
rather than all the profits or losses of the investee.

Similarly, on deconsolidating a subsidiary and treating the retained interest as an HKFRS 9

financial asset thereafter, the recognition exemptions for deferred tax balances applying to an

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investor’s interests in subsidiaries, associates and joint ventures no longer apply. The investor
must consider whether the difference between the fair value of the retained interest and its tax
base, which will not have changed, gives rise to a deferred tax asset or liability that must be
recognised in accordance with HKAS 12 because the initial recognition exemptions do not apply
HKAS because the deferred tax balance arises from the initial recognition of a financial asset in a
12.15, 24 transaction which affects accounting profit at the time of the transaction.

Whether there is a deferred tax balance to recognise and how to calculate the amounts
have been discussed in previous chapters (see Chapters 19 and 30–32).

34.2.2.3 Mid-year Disposal

In a similar manner to a mid-year acquisition, where a subsidiary is disposed during the
reporting period, the results of the subsidiary are included in the consolidated results for the
period only up to the date control is lost. If the parent disposes of its interest in the subsidiary
resulting in loss of control over that entity, the consolidated financial position at the end of the
reporting period will not include the assets and liabilities of the subsidiary entity (as it is now
de-consolidated). Therefore, there are no ‘intragroup balances’ to eliminate when determining
the consolidated financial position.

Apply and Analyse 5

Assume a parent only has one subsidiary, which it sells during the period. Explain whether
consolidated financial statements should be prepared in the period of disposal (because,
at the reporting date, the former parent no longer has a subsidiary) or whether the entity
is only required to prepare ‘company’ financial statements.

Analysis

Even though at the reporting date the parent no longer has a subsidiary, in the period of
disposal, the parent must prepare consolidated financial statements. This is because the
results of the subsidiary must be consolidated for the period up to disposal and because
comparative financial information forms part of the set of complete financial statements.

34.2.2.4 Disposal of a Foreign Operation

Chapter 31 discusses what a foreign operation is and how to translate the financial statements
of a foreign operation from its functional currency to the group’s presentation currency. The
chapter also discusses the effect on the foreign currency translation reserve of a full disposal or
partial disposal of a parent’s interest in a foreign operation.

The disposal (in full or in part) of a foreign operation that results in the loss of control of the
subsidiary involves the same steps as the disposal of a ‘local’ operation:

• The financial position of the foreign operation must be translated at the date
of disposal;

• The proportionate share of the cumulative amount of the exchange differences relating
to that operation held in the foreign currency translation reserve must be reclassified
(‘recycled’) to the profit or loss when control is lost; and

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• The proportionate share of the cumulative amount of the exchange differences

HKAS 21.48, relating to that operation attributed to the non-controlling interest is derecognised
48B when control is lost (it is not reclassified to profit or loss) (see Chapter 31).

If a foreign operation is disposed and an average rate used to translate its income and
expenses, the average rate should only have regard to the period from the beginning of the
period until the foreign operation is disposed.

Section 34.3.1.2.2 explained that the partial disposal of a subsidiary that does not result in a
loss of control of the subsidiary is treated as an equity adjustment. Consistently, on the partial
disposal of an interest in a subsidiary that is a foreign operation not resulting in the loss of
control, the proportionate share of the cumulative amount of the exchange differences
HKAS recognised in other comprehensive income is reattributed to the non-controlling interests in
21.48C that foreign operation.

34.2.2.5 Deemed Disposals

A parent entity could lose some of its ownership interest in a subsidiary without selling any
of its interest, for example, through dilution of its shareholding via the issue of new shares to
other parties. In such cases, the parent accounts for the deemed disposal of the ownership
interest as the appropriate of either a partial disposal without loss of control (refer to
Section 34.3.1.2.2) or resulting in a loss of control (refer to Section 34.3.1.2.1).

Knowledge Check Questions

Question 1
On 1 April 20X4, Jambalaya Limited (Jambalaya) acquires 50% of Hot Sauce Limited (HSL).
It determines it has control over HSL after the acquisition. The following information is
available about the subsidiary’s performance and financial position for the year ended
31 December 20X4:
• HSL’s profit for the period 1 January – 31 December 20X4 was HK$120 million
• HSL’s profit for the period 1 April – 31 December 20X4 was HK$100 million
Identify which of the following statements is true.
A HSL’s contribution to the consolidated profit of the group is HK$50 million.
B HSL’s contribution to the consolidated profit of the group is HK$60 million.
C HSL’s contribution to the consolidated profit of the group is HK$100 million.
D HSL’s contribution to the consolidated profit of the group is HK$120 million.

Question 2
On 31 October 20X6, Jambalaya Limited (Jambalaya) increases its ownership interest in Hot
Sauce Limited (HSL) to 80% by acquiring a further 30% of HSL for HK$34,000. Before the
acquisition, Jambalaya consolidates HSL.
On that date:
• The fair value of the net assets of HSL is HK$100,000; and
• The non-controlling interest in HSL is HK$45,000.

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Knowledge Check Questions (continued)

Identify which of the following statements is true.
A Goodwill is increased by HK$34,000.
B Jambalaya remeasures its existing 50% interest in HSL to HK$50,000.
C Consolidated equity attributable to owners of Jambalaya is credited by HK$7,000.
D The carrying amount of the non-controlling interest in HSL is reduced by HK$27,000.

Question 3
Guacamole Limited (Guacamole) has a wholly-owned subsidiary Chopped Tomato Limited
(CTL). On 1 October 20X5, Guacamole disposes of 90% of CTL. After the sale, Guacamole
determines it no longer controlled CTL.
The following information is available about the subsidiary’s performance and financial
position for the year ended 31 December 20X5:
• CTL’s net assets on 31 December 20X5 was HK$120 million;
• On 24 June 20X5, Guacamole provides administrative services to CTL for
HK$30 million. HK$10 million still owes on the services rendered; and
• On 15 November 20X5, CTL sells inventory to Guacamole for HK$40 million. The
inventory originally cost CTL HK$25 million. All the inventory remains on hand at
31 December 20X5.
Identify which one of the following statements is true.
A CTL’s contribution to the consolidated net assets of the group at 31 December is
HK$120 million.
B The sales revenue from the HK$30 million sale of services from Guacamole to CTL is
eliminated from the consolidated results for the year.
C The gain of HK$15 million on the sale of inventory from CTL to Guacamole must be
eliminated from consolidated inventory at 31 December.
D The HK$10 million receivable from CTL for the administrative services rendered
by Guacamole must be eliminated from the consolidated financial statements at
31 December.

Question 4
Xin Chia Limited (XCL) holds 90% of the ordinary share capital of subsidiary Hui Lin
Limited (HLL). XCL measures the non-controlling interest (NCI) at the time of acquisition
as a proportionate share of the fair value of the identifiable net assets of HLL and,
consequently, recognises goodwill of HK$2 million. On 1 December 20X5, XCL disposed
of shares equivalent to 41% of HLL for HK$50 million. After the sale, XCL determines its
remaining 49% interest was no longer sufficient to give it control of HLL. The fair value of
the retained interest is HK$54 million.
At the time of sale, the carrying amount of the net assets in HLL is HK$80 million. The
NCI share in the net assets is HK$10 million.
Calculate the gain or loss on disposal recognised by XCL in its consolidated profit or
loss for the period.

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Knowledge Check Questions (continued)

Question 5
Padron Limited (Padron) has a wholly-owned foreign subsidiary Green Peppers Limited
(GPL). On 1 March 20X0, Padron sells 40% of its interest in GPL. Padron assesses it
continues to have control over GPL after the sale. On 1 March 20X0, the foreign currency
translation reserve of GPL is HK$100 million.
Identify which of the following statements is true.
A The balance of the foreign currency translation reserve is HK$100 million after the sale.
B HK$40 million is reclassified from the foreign currency translation reserve to
profit or loss.
C HK$100 million is reclassified from the foreign currency translation reserve to
profit or loss.
D HK$40 million is reclassified from the foreign currency translation reserve to non-
controlling interests in equity.

3 4 . 3 DISCLOSURE OF INTERESTS
IN OTHER ENTITIES

Disclosure requirements pertaining to a parent’s interests in other entities are primarily set
out in HKFRS 12 Disclosure of Interests in Other Entities. However, other HKFRSs, such as HKFRS
5 Non-current Assets Held for Sale and Discontinued Operations, HKAS 7 Statement of Cash Flows,
HKAS 24 (Revised) Related Party Disclosures and HKAS 27 (2011) Separate Financial Statements
HKAS
require a parent to make disclosures. For example, HKAS 24 requires the parent to disclose the
24.13 relationships between itself and its subsidiaries.

This chapter addresses only disclosure requirements pertaining to a parent’s interests

in subsidiaries, in the financial statements in which the subsidiaries are consolidated, or are
measured at fair value through profit or loss as required by HKFRS 10 Consolidated Financial
Statements. Disclosure requirements pertaining to a parent’s interests in associates and joint
arrangements are discussed in Chapters 32 and 33, respectively.

In accordance with HKFRS 12, an entity must disclose information that enables users of its
financial statements to evaluate the nature of and risks associated with its interests in
subsidiaries and the effects of those interests on the entity’s financial position, financial
HKFRS performance and cash flows. The disclosures mainly apply to ‘continuing subsidiaries’ and
12.1 those subsidiaries that are held for sale (see Chapter 15).

Though HKFRS 12 identifies specific disclosures that assist in meeting the disclosure
objective, in preparing a set of financial statements, the preparer should assess whether overall
the disclosures presented are sufficient to meet the disclosure objective set out at the start of
this section. If not, additional disclosures must be made.

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34.3.1 Disclosure of Consolidated Entities

With respect to consolidated and unconsolidated subsidiaries, a parent discloses information in
the consolidated financial statements sufficient for users of these financial statements to:

• Understand its significant judgements and assumptions in determining it has control of

another entity and any changes to those judgements and assumptions;

• Understand the composition of the group and the interest that any non-controlling
interest (NCI) has in the group’s activities and cash flows;

• Evaluate the nature and extent of significant restrictions on the group’s ability to access
or use assets (including cash and cash equivalents held in subsidiaries), and settle
liabilities;

• Evaluate the nature of the risks associated with its interests in any consolidated
structured entities and any changes thereof;

• Evaluate the consequences of changes in its ownership interest in a subsidiary that do

HKFRS not result in a loss of control; and
12.7,10 and
HKAS 7.48 • Evaluate the consequences of losing control of a subsidiary during the reporting period.

Various disclosures are specified, including:

HKFRS • The particulars, extent of ownership interest and summarised financial information
12.12,
19A–19G,
about material non-wholly owned, consolidated subsidiaries. These disclosures help
B10(b) users to understand how NCIs impact the group’s activities and cash flows;

HKFRS • Information about the reporting date of a subsidiary, which is not aligned with the
12.11 parent; and

HKAS • Information that enables users to understand the impact of acquiring or disposing of a
7.40
subsidiary on the entity’s cash balances.

34.3.2 Disclosure of Unconsolidated Subsidiaries

Chapter 30 discusses an exception to consolidation for ‘investment entity’ parent entities,
that is, the investment entity subsidiaries of such parents need not be consolidated but are
measured at fair value through profit or loss in accordance with HKFRS 9. Such entities are
‘unconsolidated subsidiaries’. Consistent with the nature of such investments, to some extent,
different disclosures are necessary to provide users of the financial statements with useful
information to understand the contribution of such entities to the performance and financial
position of the investor. For example, the disclosure of summarised financial information about
material non-wholly owned subsidiaries may provide less useful information to users when that
subsidiary is not consolidated.

A parent that is an investment entity that accounts for its investments in subsidiaries at fair
value through profit or loss in accordance with HKFRS 9 Financial Instruments, rather than by
consolidating them must disclose, specifically, for example:

• The nature and extent of any significant restrictions on the ability of the subsidiary
to transfer funds in the form of cash dividends or to repay loans or advances from
the parent;

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• Its commitments or intentions to provide financial or other support to the subsidiary or

to assist the subsidiary in obtaining financial support;

• The type and amount of support provided to a subsidiary and the reasons for doing
so, where the subsidiary has received support from the parent or another subsidiary
during the period (other than those amounts the parent or other subsidiary is
HKFRS contractual obliged to the subsidiary for); and
12.19A–19E,
HKAS 27.16A • Where relevant, that it is only required to prepare separate financial statements.

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SUMMARY

• Where a subsidiary is acquired or disposed of during the period, the consolidated results
include the results of the subsidiary only for the period it is controlled (e.g. three months out
of 12 months).

• A change in ownership interest within the control boundary (e.g. going from an 80% to
90% ownership interest or vice versa) is treated as an equity transaction. No gain or loss is
recognised in profit or loss on the acquisition of the additional interest or partial disposal of
interest. A proportionate amount of equity is allocated to/from the non-controlling interests to
owners of the parent.

• When control is gained, any previously held equity interests in the subsidiary are remeasured
to fair value for the purposes of applying business combination accounting. The gain or
loss on remeasurement is recognised in profit or loss or in other comprehensive income
consistent with the accounting specified for that interest.

• When control is lost, any retained equity interests in the former subsidiary is remeasured
to fair value. This fair value becomes the base for the ongoing accounting applicable to the
retained interest.

• A gain or loss will normally arise when a subsidiary is derecognised. This gain or loss is
recognised in profit or loss.

• Disclosure is required of a parent’s interests in its subsidiaries, and of any interests in

structured entities that are not subsidiaries.

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MIND MAP

MID-YEAR ACQUISITIONS AND DISPOSALS SUBSIDIARY ACQUIRED IN STAGES

(HKFRS 3 & HKFRS 10)
Consolidate results only until the date
control is lost CONTROL, Business combination accounting applies
Mid-year acquisition — consolidated CONSOLIDATION only once: goodwill only determined once,
financial position = parent + subsidiary PROCEDURES net assets only remeasured once
assets and liabilities (CHAPTER 30) On gaining control, remeasure existing
Mid-year disposal — consolidated financial interest to fair value
position = excludes assets and liabilities Gain or loss on remeasurement recognised
of disposed subsidiary (if control is lost) in profit or loss or OCI, as appropriate
DISCLOSURE — INTERESTS IN OTHER Ownership interest change after gaining
ENTITIES control → equity transaction
CONSOLIDATED
Information to evaluate nature and risks FINANCIAL DISPOSALS (HKFRS 10)
associated with its interests in subsidiaries STATEMENTS: Deconsolidate when control is lost
and the effects of those interests on COMPLEX GROUP
financial position, financial performance Going forwards: Any retained interest
STRUCTURES
and cash flows measured in accordance with the
appropriate HKFRS
Certain different disclosures apply to
investment entities Reclassify OCI amounts to profit or loss,
where required
GROUP STRUCTURES
Gain or loss on deconsolidation recognised
The consolidated financial statements could include: in profit or loss
• Consolidated subsidiaries If control not lost → don't deconsolidate.
• Unconsolidated subsidiaries (investment entities) Equity transaction.
• Equity accounted (or fair value) associates → Chapter 32
• Equity accounted (or fair value) joint ventures → Chapter 33
• Joint operations → Chapter 33
• “Passive” investments (financial assets) → Chapter 12
• Unconsolidated structured entities (usually financial assets) → Chapter 12

Answers to Knowledge Check Questions

Question 1
Answer A is incorrect. The consolidation process requires 100% of the income and
expenses of the subsidiary to be consolidated (from the time control is gained). Review
Chapter 30 to understand how non-controlling interests (NCIs) impact the consolidated
financial statements.
Answer B is incorrect. The consolidation process requires 100% of the income and
expenses of the subsidiary to be consolidated and only from the time control is gained.
Review Chapter 30 to understand how NCIs impact the consolidated financial statements.
Answer C is correct. Only the results from the time the subsidiary is controlled is included
in the consolidated profit of the group.
Answer D is incorrect. The consolidation process requires 100% of the income and
expenses of the subsidiary to be consolidated but only from the time control is gained.

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Question 2
Answer A is incorrect. Goodwill is not ‘refreshed’ when the ownership interest is increased
subsequent to gaining control.
Answer B is incorrect. The existing interest in Hot Sauce Limited (HSL) is remeasured only if
business combination accounting applies.
Answer C is incorrect. This response correctly recognises that the transaction is treated as
an equity transaction. However, as Jambalaya Limited (Jambalaya) has paid more than the
corresponding book amount of the NCI, the consolidated equity attributable to the owners
of Jambalaya should be debited by HK$7,000. The consolidation worksheet journal entry is:

Debit Credit
HK$ HK$
Non-controlling interests (equity) 27,000
Capital reserve 7,000
Investment 34,000

Answer D is correct. The further acquisition is treated as an equity transaction. Accordingly,

an amount proportionate to the further interest acquired must be reallocated from the NCI
to owners of the parent. This amount is calculated as HK$45,000/50% × 30% = HK$27,000.

Question 3
Answer A is incorrect. As Guacamole Limited (Guacamole) no longer controls Chopped
Tomato Limited (CTL), CTL’s assets and liabilities are not included in Guacamole’s
consolidated financial position on 31 December.
Answer B is correct. The sales revenue from the HK$30 million sale of services from
Guacamole to CTL is an intragroup transaction and must be eliminated from the
consolidated results for the year.
Answer C is incorrect. As the transaction occurred subsequent to control being lost,
the transaction is not an intragroup transaction that is eliminated when preparing the
consolidated position for the period.
Answer D is incorrect. The HK$10 million receivable is not an intragroup balance, and
hence is not eliminated from the consolidated net assets of the group on 31 December.

Question 4

HK$’m HK$’m
Consideration received 50
Fair value of retained interest 54
less:
Carrying amount of net assets 80
+ Carrying amount of goodwill 2
− Non-controlling interests (10) (72)
Gain on disposal of the investment 32

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Question 5
Answer A is incorrect. The carrying amount of the reserve must be adjusted to reflect the
new proportionate ownership interests in Great Pics Limited (GPL).
Answer B is incorrect. Control has not been lost, and the cumulative exchange difference
held in other comprehensive income should not be reclassified to profit or loss.
Answer C is incorrect. Control has not been lost, and the cumulative exchange difference
held in other comprehensive income should not be reclassified to profit or loss.
Answer D is correct. Control has not been lost, and the partial disposal of the interest is
treated as an equity transaction. A proportionate amount is reattributed from the foreign
currency translation reserve to non-controlling interests.

EXAM PRACTICE

QUESTION 1
Winning Streak Limited (WSL) is a publicly listed Hong Kong company whose principal activity
is retailing operations (e.g. supermarkets, general merchandise and specialty department
stores). WSL prepares consolidated financial statements in accordance with HKFRSs and has
a 31 December financial year-end.

Naught Limited

Naught Limited (Naught) is incorporated by WSL to manage its supermarket operations.

On 30 June 20X3, WSL disposes 40% of its wholly owned subsidiary Naught Limited
for HK$6.6 million. On that date, the carrying amount of the net assets of Naught is
HK$16,265,000. WSL determines it continues to control Naught following the sale.

Cross Limited

On 1 January 20X1, WSL acquires 25% of Cross Limited (Cross) for HK$130,000. WSL
determines it has significant influence over Cross following the acquisition. On that date, the
retained profits of Cross are HK$350,000.

On 1 January 20X3, WSL acquired another 55% of Cross for HK$570,000, which was
sufficient to give it control over the entity.

The summarised financial positions of WSL, Naught and Cross on 31 December 20X3 are
as follows:

WSL Naught Cross

HK$’000 HK$’000 HK$’000
Assets
Property, plant and equipment 3,700 8,400 650
Investments in Naught and Cross 820 – –
Other investments 15,280 520 –
Inventories 1,600 4,200 400
Trade and other receivables 1,210 780 170

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WSL Naught Cross

HK$’000 HK$’000 HK$’000
Cash 5,560 3,500 220
Total assets 28,170 17,400 1,440
Equity
Share capital 100 200 150
Retained earnings 27,150 16,870 850
Reserves – (20) –
Total equity 27,250 17,050 1,000
Liabilities
Provisions 320 100 –
Trade and other payables 600 250 440
Total liabilities 920 350 440
Total equity and liabilities 28,170 17,400 1,440

The entities’ statements of changes in equity for the financial year ended 31 December 20X3
are as follows:

WSL Naught
Share Retained Total Share Retained Fair Total
capital earnings capital earnings value
reserve
HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
Balance at 1 Jan 100 18,650 24,750 200 15,340 (60) 15,480
20X3
Profit for the year – 8,500 2,500 1,530 – 1,530
Other – – – – 40 40
comprehensive
income for the
year, net of tax
Total – 8,500 2,500 – 1,530 40 1,570
comprehensive
income for the
year
Balance at 100 27,150 27,250 200 16,870 (20) 17,050
31 Dec 20X3

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Cross
Share Retained Total
capital earnings
HK$’000 HK$’000 HK$’000
Balance at 1 Jan 20X3 150 660 810
Profit for the year – 190 190
Other comprehensive income for the year – – –
Total comprehensive income for the year – 190 190
Balance at 31 Dec 20X3 150 850 1,000

Additional information:

• Income, expenses and other comprehensive income are earned evenly from
1 January to 31 December 20X3;

• WSL’s accounting policy is to initially measure non-controlling interest as a

proportionate share of the fair value of the net assets acquired;

• WSL measures its investments in Naught and Cross at cost in its separate financial
statements;

• The carrying amounts of the identifiable net assets of Cross on 1 January 20X1 and
1 January 20X3 are equal to their fair values;

• Naught’s fair value reserve is used to accumulate fair value gains and losses on debt
instruments classified as fair value through other comprehensive income;

• The fair value of WSL’s 25% interest in Cross on 1 January 20X3 is HK$210,000;

• The fair value of WSL’s 60% interest in Naught on 30 June 20X3 is HK$10 million;

• There are no transactions among WSL, Naught, or Cross;

• There are no changes to share capital; and

• Ignore income taxes.

Required:

A. Assume you are Nicolin Tan, the accounting manager for WSL. You have received the
following note from Alex Lee, the junior accountant, for your review.

File note

Topic: Changes to the accounting for Cross Limited, year-end 31 December 20X3
Preparer: Alex Lee, Junior Accountant
Date: 10 November 20X3

Because WSL has acquired a controlling interest in Cross, the entity must be
consolidated. Goodwill arising on the acquisition is determined as follows:

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Goodwill arising on acquisition of 25% interest

HK$
Consideration 130,000
Share of net assets of Cross (25% × 500,000) (125,000)
5,000

Goodwill arising on acquisition of 55% interest

HK$
Consideration 570,000
Share of net assets of Cross (55% × 810,000) (445,500)
124,500

Total goodwill on consolidation = HK$5,000 + HK$124,500 = HK$129,500.

Because the carrying amounts of the identifiable net assets of Cross on 1 January 20X1
and 1 January 20X3 are equal to their fair values, the following consolidation adjustment
journal entry will need to be processed to eliminate the investment when preparing the
consolidated financial statements for the year ending 31 December 20X3:

Debit Credit
HK$ HK$
Share capital (balance on 1 January 20X3) 150,000
Retained earnings (balance on 1 January 20X3) 660,000
Goodwill 129,500
Gain on acquisition (balancing number) 77,500
Non-controlling interest – equity (20% × 810,000) 162,000
Investment in Cross (130,000 + 570,000) 700,000

A. Analyse the note and conclude whether the proposed consolidation adjustment journal
entry has been correctly prepared. Justify your response, including revising the journal
entry as necessary.

B. Assume you are Nicolin Tan, the accounting manager for WSL. Advise management
of the effect of the disposal of WSL’s interest in Naught on the consolidated financial
statements for the year ended 31 December 20X3.

C. Prepare WSL’s consolidated statement of financial position and consolidated statement

of changes in equity for the year ended 31 December 20X3.

D. Assume WSL assesses it has only significant influence over Naught following the
sale of 40% of the entity. Analyse how the partial disposal would affect the group’s
consolidated financial statements for the period, including the impact to Naught’s fair
value reserve.

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ANSWERS TO EXAM PRACTICE

QUESTION 1
A. The proposed consolidation adjustment journal entry has not been correctly prepared.
This is because

• Goodwill has not been determined in the manner specified by HKFRS 3 Business
Combinations, leading to the wrong amounts for recognised goodwill on acquisition.
HKFRS 3 requires goodwill be to determined by reference to the net assets at the
date control is gained rather than by reference to the net asset position at each
acquisition date of an ownership interest. (In this exercise, because non-controlling
interests are measured as a proportionate share of the fair value of the identifiable
net assets acquired, the goodwill determination is not impacted by the existence of
non-controlling interests);

Goodwill arising on the acquisition of Cross should be determined as:

HK$
Consideration transferred 570,000
plus: Non-controlling interest (20% × 810,000) 162,000
plus: Fair value of previously held interests 210,000
less: Amount recognised for identifiable net assets at (810,000)
acquisition date (150,000 + 660,000)
Goodwill on acquisition 132,000

• The proposed consolidation adjustment journal entry includes a gain on acquisition,

derived as a balancing number. Under HKFRS 3, no such balancing gain arises in
the process of eliminating the investment in a subsidiary (the pre-acquisition equity
elimination journal entry). Rather, the journal entry has not yet accounted for WSL’s
share of Cross’ profits and reserves for the period Cross is held as an associate
[25% × (HK$660,000 – HK$350,000) = HK$77,500]. The combined impact of these
two mistakes is that the journal entry recognises previously earnt profits in the
current period; and

• At a group level, the (equity accounted) carrying amount of the previously held
equity interest is HK$207,500 (HK$130,000 + 25% × (HK$660,000 – HK$350,000).
However, HKFRS 10 requires the investment to be remeasured to fair value
when control is gained. The gain on remeasurement is HK$2,500 (HK$210,000 –
HK$207,500); this has not been reflected in the consolidation adjustment
journal entry.

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The pre-acquisition equity elimination journal entry should appear as:

Debit Credit
HK$ HK$
Share capital 150,000
Retained earnings 660,000
Goodwill 132,000
Non-controlling interest (equity) (20% × 810,000) 162,000
Investment in Cross (570,000 + 130,000) 700,000
Retained earnings (equity accounted profits) 77,500
Gain on remeasurement of existing interest (p/l) 2,500

B. Because WSL has determined it controls Naught following the partial disposal of the
subsidiary, WSL should consolidate the subsidiary in its financial statements for the
year ended 31 December 20X3. The disposal of interest is accounted for as an equity
transaction to acknowledge that, from 30 June 20X3, a non-controlling interest (NCI)
exists in the subsidiary. The NCI is initially measured at a proportionate share of the
carrying amount of Naught’s net assets when the disposal occurred. The adjustment to
NCI at the disposal date is calculated as:

HK$
NCI based on old shareholding (0% × HK$16,265,000) –
NCI based on new shareholding (40% × HK$16,265,000) a
6,506,000
NCI share of Naught at 30 June 20X3 6,506,000

a
Opening net assets HK$15,480,000 + Changes to net assets to 30 June 20X3 HL$785,000
(HK$1,530,000/2 + HK$40,000/2).

The difference between this and the consideration received is accumulated in

equity, generally in a reserve account, and represents the gain or loss effectively
crystalised on the disposal of the interest.

In accordance with HKFRS 10, the disposal is treated as an equity transaction.

Therefore, in addition to the standing journal entry to eliminate the investment in
Polaris Limited (Polaris) and the journal entry to attribute to NCI its share of equity,
Soleil Limited (Soleil) records the following consolidation adjustment journal entry in its
consolidation worksheet to recognise the disposal of part of its investment:

HK$ HK$
Investment in Naught (40% × 200,000) 80,000
Gain on disposala 6,520,000
Non-controlling interests – equity 6,506,000
Capital reserve 94,000
a
Reversal of the gain on disposal of the shares recognised in WSL’s separate
financial statements. HK$6,600,000 – (40% × 200,000) = HK$6,520,000.

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Naught’s profit or loss earned during the period 1 July 20X3 to 31 December
20X3 must be attributed between owners of WSL and the NCI. Similarly, the NCI
must be accordance with a share of consolidated equity in the consolidated financial
statements for the year ended 31 December 20X3.

C. Consolidated statement of financial position:

Pre-acquisition equity

Pre-acquisition equity
elimination – Naught
equity elimination –

elimination – Cross
Pre-acquisition

attributable to
Profit and OCI

Consolidated
disposal (W2)
Naught(W1)

NCI(W4)
Naught

Cross

(W3)
WSL

HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000

Assets
Property, plant 3,700 8,400 650 12,750
and equipment
Investments 820 – – (200) 80 (700) –
in Naught and
Cross
Other 15,280 520 – 15,800
investments
Goodwill 132 132
Inventories 1,600 4,200 400 6,200
Trade and other 1,210 780 170 2,160
receivables
Cash 5,560 3,500 220 9,280
Total assets 28,170 17,400 1,440 46,322
Equity
Share capital 100 200 150 (200) (150) 100.0
Retained
earnings
Opening 18,650 15,340 660 (582.5) 34,067.5
retained
earnings
Profit for the 8,500 1,530 190 (6,520) 2.5 (344) 3,358.5
year
Closing 27,150 16,870 850 37,426
retained
earnings
Reserves
Fair value – (20) – (8) (28.0)
reserve
Capital – – – 94 94.0
reserve

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 FINANCIAL REPORTING

Pre-acquisition equity

Pre-acquisition equity
elimination – Naught
equity elimination –

elimination – Cross
Pre-acquisition

attributable to
Profit and OCI

Consolidated
disposal (W2)
Naught(W1)

NCI(W4)
Naught

Cross

(W3)
WSL

HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000

Total equity
attributable to 27,250 17,050 1,000 37,592
owners of WSL
Non-controlling 6,506 162 352 7,020
interests
Total equity 27,250 17,050 1,000 44,612

Liabilities
Provisions 320 100 – 420
Trade and other 600 250 440 1,290
payables
Total liabilities 920 350 440 1,710
Total equity 28,170 17,400 1,440 46,322
and liabilities

Consolidated statement of changes in equity:

Consolidated
Share Retained Fair Capital Total NCI Total
capital earnings value reserve attributable equity
reserve
HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000 HK$’000
Balance at 1 Jan 100 34,067.5 (60) – 34,107.5 34,107.5
20X3
Profit/(loss) for – 3,358.5 – – 3,358.5 344 3,702.5
the year
Other – – 32 – 32 8 40
comprehensive
income for the
year
Total – 3,358.5 32 – 3,390.5 352 3,742.5
comprehensive
income for the
year
Gain of control of – – – – – 162 162
Cross on 1.1.X3
Partial disposal – – – 94 94 6,506 6,600
of Naught on
30.6.X3
Balance at 100 37,426 (28) 94 37,592 7,020 44,612
31 Dec 20X3

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 C onsolidated F inancial Statements with C omplex G roup S tructure

Workings –

W1 – as Naught is incorporated by WSL and the investment is measured at cost in WSL’s

separate financial statements, the entry to eliminate the investment is DR Share capital
200,000 CR Investment 200,000. No goodwill arises because WSL has not acquired Naught in
a business combination (because Naught was not operating a business).

W2 – see solution to Question 1(b).

W3 – see solution to Question 1(a).

W4 – The NCI share of Naught’s profits from 1.7.X3 and Cross’ profits from 1.1.X3 must be
attributed to NCI.

Debit Credit
HK$ HK$
Profit attributable to NCI 344,000
OCI attributable to NCI (gain recognised in fair 8,000
value reserve)
Non-controlling interests – equity 352,000
Attribute profit and other comprehensive income for the period to NCI.
NCI share of Naught’s profit for the year = 40% × 1,530,000/2 = 306,000
NCI share of Cross’ profit for the year = 20% × 190,000 = 38,000
Total profit for the year to attribute to NCI = 306,000 + 38,000 = 344,000
NCI share of Naught’s other comprehensive income = 40% × 40,000/2 = 8,000

D. If WSL assesses it has only significant influence over Naught following the sale of 40%
of its shareholding, it must deconsolidate the subsidiary from when it loses control
(30 June 20X3) and instead apply equity accounting to Naught from that date. WSL’s
consolidated financial statements for the year ended 31 December 20X3 include the
consolidated revenues, expenses and cash flows of WSL from 1 January 20X3 to 30 June
20X3 and, thereafter, an equity accounted share of Naught’s net profits and reserves
from transactions occurring between 1 July 20X3 to 31 December 20X3.

As part of ceasing to consolidate Naught, WSL will cease to consolidate Naught’s

assets and liabilities (and equity) from that date. Instead, WSL’s consolidated statement
of financial position on 31 December 20X3 will show a line item ‘Investment in
associate’, measured at HK$10,471,000. This is calculated as:

Deemed cost of associate interest 10,000,000

+ Share of associate’s profits (60% × 1.53 million/2) 459,000
+ Share of associate’s other comprehensive income 12,000
(60% × 40,000/2)
10,471,000

As Naught’s net assets have increased since incorporation, WSL’s consolidated financial
statements will report a gain on deconsolidation. This comprises a gain on disposal of the
40% interest and a revaluation gain on the 60% interest retained.

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 FINANCIAL REPORTING

The Group gain on the partial disposal of Naught is calculated as:

Consideration received 6,600,000

Fair value of retained interest 10,000,000
less:
Carrying amount of net assets 16,265,000
+ Goodwill –
− Non-controlling interests – (16,265,000)
less: Reclassification of fair value losses accumulated in (40,000)
the fair value reserve to p/l (opening losses HK$60,000 –
gains during the period to 30 June HK$20,000)a
Gain on partial disposal of Naught 295,000

a
Effect of the transaction on the fair value reserve.

If WSL treats Naught only as an associate following the partial disposal of its interest,
the fair value gains and losses previously recognised in other comprehensive income and
accumulated in the fair value reserve must be reclassified to profit or loss on loss of control
of the subsidiary on 30 June 20X3. This is because these amounts relate to debt instruments
measured at fair value through other comprehensive income, which in accordance with
HKFRS 10, are treated as though they were ‘disposed’ on loss of control of the subsidiary.
In accordance with HKFRS 9, these gains and losses must be reclassified to profit or loss
on disposal of the debt instrument. Accordingly, the gains and losses will form part of the
calculation of the gain on deconsolidation of Naught. Also, the reclassification of the gains
and losses will be included in the consolidated net profit of the group for the year.

However, because WSL has significant influence over Naught after this time, the fair
value reserve balance will not be nil on 31 December 20X3 because, in applying the equity
method to account for its interest in Naught, WSL must recognise in its other comprehensive
income (and hence, the fair value reserve) its share of movements in Naught’s reserves post
disposal, being the fair value gain of HK$12,000 (HK$20,000 × 60%).

(HK$40,000/2 = HK$20,000, as income, expenses and other comprehensive income were

incurred evenly during the period.)

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 35
Merger Accounting
for Common Control
Combinations

CHAPTER TOPIC LIST

35.1 Introduction to Merger 35.3.2 Consolidated Statement

Accounting for Common of Profit or Loss and Other
Control Combinations Comprehensive Income
35.1.1 Scope for a Merger
35.2 Merger Accounting Principles 35.4 Current Developments
35.3 Merger Accounting Procedures
35.3.1 The Practical Effects of
Merger Accounting

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 FINANCIAL REPORTING

LEARNING OUTCOMES

PRINCIPAL LO4: PREPARE, PRESENT AND APPRAISE GROUP FINANCIAL STATEMENTS WITH
COMPLEX GROUP STRUCTURES
LO4.08: C
 onstruct the financial statements for a group in accordance with Hong Kong Financial
Reporting Standards and statutory reporting requirements for: Merger accounting for
common control combinations
4.08.01 Describe the principles of merger accounting
4.08.02 Describe the procedures and practices of merger accounting
4.08.03 Illustrate how merger accounting is applied to a common control combination

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 M er g er A cco u nt ing for C ommo n C o nt r ol Com b in a t ions

OPENING CASE

AMBROSIA (HOLDINGS) LIMITED

A mbrosia (Holdings) Limited (Ambrosia), a real estate conglomerate operating in a number

of countries and undertaking various related business activities, including property
development and leasing, is listed on the Hong Kong Stock Exchange (HKEx). Ambrosia has
a number of subsidiaries all of which individually are engaged in a number of operating
segments related to real estate business.

Under a series of contractual arrangements entered into some years ago among Ambrosia,
Balsam Limited (Balsam) and Crocus Limited (Crocus), Ambrosia obtained control and can
recognise and receive substantially all the economic benefit of, the business and operations
of Crocus. The contractual arrangements, resulting in legal ownership, provided Ambrosia,
through Balsam Limited, with the right to receive the cash received by Crocus from its
operations and to control the management, financial and operating policies of Crocus.

The management of Ambrosia is now considering spinning-off the property development

arms of Balsam and Crocus into a new sub-group with a view to listing that sub-group.
Management would like advice on what financial reporting requirements it would need to
comply with and how this may impact on the reported profits and net assets previously
reported by Ambrosia (see Exhibit 35.1).

Existing structure Proposed structure

Ambrosia Ambrosia

Other Balsam Other New entity

Crocus Balsam

Crocus

EXHIBIT 35.1 Existing and proposed structure for Ambrosia

and its holdings

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 FINANCIAL REPORTING

OVERVIEW

Accounting for business combinations traditionally has two broad approaches, namely,
acquisition accounting and merger accounting.

HKFRS 3 (Revised) Business Combinations applies to business combinations as defined

in the standard and requires acquisition accounting. HKFRS 3 (Revised) distinctively
precludes business combinations involving entities under common control. An example of
such combinations is group restructuring. Group restructuring may involve, for example, a
subsidiary in the group selling its own subsidiary to the parent or the parent selling one of
its subsidiaries to another subsidiary. Under merger accounting, the conventional concept of
‘a purchase or acquisition of another entity/business’ (as per HKFRS 3) does not exist. From
the ultimate parent entity’s perspective, the combining entities under common control have
repooled their resources, but the assets and liabilities within the group remain the same. It is,
therefore, more appropriate to use merger accounting under these circumstances.

Accounting Guideline 5 (AG 5) Merger Accounting for Common Control Combinations

prescribes the underlying principles and procedures that typically apply under merger
accounting. AG 5 does not explain in detail what constitutes a common control combination.
Group reorganisations often take place as a precursor to an Initial Public Offering (IPO) where
the group to be listed may differ from a predecessor entity or entities.

AG 5 constitutes recommended practice only rather than a mandatory set of financial

reporting standards. It sets out the underlying principles and procedures that typically are
applied to a group reorganisation or common control combination. The largest section in AG 5
is an example of how these principles and procedures are applied.

AG 5 has been in place since 2005 when the Hong Kong Institute for Certified Public
Accountants (HKICPA) began to apply the Hong Kong Financial Reporting Standards (HKFRSs)
that were fully converged with the International Financial Reporting Standards (IFRSs). Prior
to 2005, the material in AG 5 was published as guidance. It was retained and revised to
provide preparers, auditors and users of financial statements with a statement not otherwise
covered in the HKFRSs. The issue of common control combinations was recently reviewed by
the HKICPA and the International Accounting Standards Board (IASB). The HKICPA undertook
a review of AG 5 which led to the publication of a Feedback Statement in 2018/19 and
amendments to AG 5 which were published in December 2020.

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 M er g er A cco u nt ing for C ommo n C o nt r ol Com b in a t ions

3 5 . 1 INTRODUCTION TO MERGER ACCOUNTING

FOR COMMON CONTROL COMBINATIONS

HKFRS 3 (Revised) applies to all business combinations except for the following situations:

• The accounting for the formation of a joint arrangement in the financial statements of
the joint arrangement itself;

• The acquisition of an asset or a group of assets that does not constitute a business;

• A combination of entities or businesses under common control; and

HKFRS
3.2(a) • Acquisitions by investment entities of an investment in a subsidiary that if FVTPL.

For combinations of entities or businesses under common control, there is no specific

accounting standard addressing the appropriate accounting treatment. An entity that has a
business combination under common control should select an appropriate accounting policy in
accordance with the requirements set out in HKAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors. Applying AG 5, which sets out the basic principles and procedures of
merger accounting for a common control combination, is considered to be best practice, but
AG 5 is not a mandatory accounting requirement. However, the HKFRSs require that AG5
HKFRS should normally be followed and members of the HKICPA should be prepared to explain
Preface.35 departures if called on to do so.

35.1.1 Scope
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’.

If the combining entities are, or the subject matter of the transfer is a business and it meets
the definition of a business combination under common control, then it should be accounted
for using merger accounting under AG 5.

The extent of non-controlling interests (NCIs) in each of the combining entities before and
after the business combination is irrelevant to determining whether the combination involves
entities under common control.

The following transactions are common examples of a business combination under

common control in practice:

• A parent transfers its controlling interest in several wholly or partially owned

subsidiaries into another subsidiary. That transaction is a change in legal organisation
but not a change in the reporting entity at the consolidated level;

• A partially owned subsidiary of the parent acquires the shares of another subsidiary
previously owned by the same parent; and

• A limited liability company is formed by combining entities under common control.

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 FINANCIAL REPORTING

• A common control transaction involving inserting a shell entity between a parent and
a subsidiary or a group of subsidiaries is not a business combination, and accordingly
is not a ‘common control combination’ under AG 5. This is because the shell entity is
not a business as defined in HKFRS 3 and therefore the transaction does not represent
the combination of two or more businesses. In this case, no substantive economic
change has occurred to the composition or ownership of the group. Accordingly, the
consolidated financial statements of the shell entity represent the continuation of
the financial statements of the subsidiary or the group of subsidiaries, and the equity
structure in the consolidated balance sheet of the shell entity reflects the equity
structure of the shell entity.

Exhibit 35.2 provides an example of a business combination under common control.

Before the business After the business

combination combination

Entity P Entity P
100% 100%
New parent 85%
Entity C entity Entity C
Entity A

100%
100% 100% 75%
100% 100%

Entity A Entity X Entity Y Entity X Entity Y

EXHIBIT 35.2 Business combination under common control

Illustrative Example 1
Referring again to the opening case, the establishment of a new entity which will become
the listing vehicle and into which the property development businesses are transferred,
is simply an insertion of a shell entity between the parent Ambrosia and its subsidiaries.
The new entity does not constitute a business as defined in HKFRS 3 and, therefore,
there was no combination of businesses under common control to which AG 5 applies.
The new entity prepares consolidated financial statements that reflect the continuation
of the financial statements of Balsam and Crocus, and an equity structure that identifies
Ambrosia as the shareholder.

The restructure shown in Exhibit 35.2 represents a business combination under common
control because (1) Entities A, X and Y are businesses as defined in HKFRS 3; (2) A combined
with X and Y; and (3) before and after the combination, all of the combining businesses A, X
and Y are ultimately controlled by P. Accordingly, merger accounting under AG 5 applies to the
restructure.

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 M er g er A cco u nt ing for C ommo n C o nt r ol Com b in a t ions

Key Learning Point

For AG 5 to be applied to a group reorganisation or an internal restructuring, the
businesses (or parts of businesses) must be under the common control both before and
after the transaction, and this control is not transitory.

From the controlling party’s point of view, the controlling party has direct or indirect
control over the businesses (or parts of businesses) before and after the organisation even
though the direct and indirect ownership interests may have changed as a result.

Knowledge Check Question

Question 1
Describe the condition or conditions that need to be present for AG 5 to apply.

3 5 . 2 MERGER ACCOUNTING PRINCIPLES

Common control combinations typically involve the reorganisation of pre-existing business and
intra-group ownership interests within a group of entities. As such, within the group, no new
business, entity, assets, or liabilities have been acquired or incurred. Accordingly, accounting
standards such as HKFRS 3 (Revised), HKAS 16 Property, Plant and Equipment and HKAS 40
Investment Property do not apply to such transactions.

On a consolidated basis, ownership interests are continued (completely or substantially), no

new capital is invested, no assets are distributed and post-combination ownership interests are
proportional to those before the combination. However, for businesses under common control
from the perspective of the selling entity, a disposal has occurred.

Unlike HKFRS 3 (Revised):

• A common control combination does not have an ‘acquisition date’ although there may
be a specified date on which the reorganisation either occurred or was completed.

• The entities and businesses subject to the common control combination are presented
in the consolidated financial statements for the current year and for all comparative
periods as if they had been under the group’s control since the date on which the
group originally acquired control over those businesses or entities and not simply on
a prospective basis as from the date on which the common control reorganisation
occurred or was completed.

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 FINANCIAL REPORTING

• AG 5 is a brief document serving the purpose of providing guidance on merger

accounting principles, where no other standards or guidance applies. Under AG 5:

°° The assets and liabilities of the pre-existing carrying amounts of the controlling
party are recognised (AG 5 refers to ‘existing book values from the controlling
parties’ perspective’). No fair value uplift is to be recognised on a consolidated basis
as a result of the common control combination;

°° No goodwill or gain on bargain purchase is to be recorded;

°° The reserves and the current-year profit of the combining entities are added
together as if the combination has taken place on the day the enterprises
are formed;

°° The difference between the amount recorded as share capital issued and the
amount recorded for share capital acquired is to be adjusted to equity or reserves
in the consolidated financial statements but not in the individual financial
statements; and

°° The same single uniform set of accounting policies applied in the group financial
statements are applied to the entities and businesses subject to the common
control combination.

The effects of all transactions between the combining entities or businesses, whether
occurring before or after the combination (e.g. inter-company balances, transactions and
unrealised profits), are or continue to be eliminated in preparing the consolidated financial
AG 5.7–9 statements of the combined entity.

Key Learning Point

Merger accounting is applied to common control combinations to reflect there is a
continuation of the risks and benefits, which existed prior to the combination, because no
acquisition has occurred and no gain or loss has arisen on the reorganisation (because the
controlling party cannot make a profit or incur a loss by trading with itself).

Transfers of assets and liabilities are recognised on a group basis at pre-existing

carrying amounts, no revaluation or fair valuation adjustments are made as a result of the
reorganisation. No goodwill is recognised.

Apply and Analyse 1

P is the parent company of A Ltd and B Ltd and directly holds 100% of their issued capital
(each HK$100,000). In a business combination under common control, A Ltd combined
with B Ltd on 31 December 20X5. A Ltd issued 80,000 of its shares at HK$1 per share to B
Ltd’s existing shareholders in exchange for their 100% shareholding in B Ltd.

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 M er g er A cco u nt ing for C ommo n C o nt r ol Com b in a t ions

Apply and Analyse 1 (continued)

The statements of financial position of A Ltd and B Ltd, before the preceding
transactions, were as follows:

A Ltd B Ltd
HK$’000 HK$’000
Land – 190
Other assets 250 –
250 190

Share capital 100 100

Retained earnings 50 10
Liabilities 100 80
250 190

A Ltd and B Ltd agreed that B Ltd’s land has a fair value of HK$200,000.

Assume the preceding business combination arises from group restructuring (and,
therefore, falls outside the scope of HKFRS 3 (Revised)), and assume the group chooses to
apply AG 5 in the preparation of the consolidated financial statements.

Required:
Prepare the consolidated statement of financial position for the group as of 31 December
20X5 using merger accounting.

(a) A Ltd will record the issuance of the shares as follows:

Debit Credit
HK$ HK$
Investment in B Ltd 80,000
Share capital 80,000

(b) A Ltd’s statement of financial position after the share issuance will be as follows:

HK$’000
Investment 80
Other assets 250
330

Share capital 180

Retained earnings 50
Liabilities 100
330

(c) The consolidation journal entry will be as follows:

Debit Credit
HK$ HK$
Share capital (B) 100,000
Investment in B Ltd. (elimination of investment account) 80,000
Merger reserve (OCI) 20,000

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 FINANCIAL REPORTING

Apply and Analyse 1 (continued)

(d) The consolidated statement of financial position will be as follows:

HK$’000
Land 190
Other assets 250
440

Share capital (180 + 100 − 100 from preceding (c)) 180

Merger reserve 20
Retained earnings (50 + 10) 60
Liabilities (100 + 80) 180
440

Analysis

The subsidiary’s land is brought into the consolidated statement of financial position at
book value and not at fair value if HKFRS 3 (Revised) applied:

• The subsidiary’s retained earnings at the date of the business combination

is treated as part of group’s retained earnings (it would be eliminated as
’pre-acquisition reserves’ if HKFRS 3 (Revised) applied); and

• There is a merger reserve arising on consolidation (no goodwill or gain on bargain

purchase).

Knowledge Check Question

Question 2
Explain the relevance of the date on which the common control reorganisation was
completed.

3 5 . 3 MERGER ACCOUNTING PROCEDURES

AG 5 sets out the practical effects of merger accounting, the impact on the consolidated
statement of profit or loss and other comprehensive income and provides an extensive
example of the application of the principles and procedures of merger accounting for a
common control reorganisation.

35.3.1 The Practical Effects of Merger Accounting

The procedures in relation to the consolidated financial statements and financial statement
AG 5.10 elements are summarised in the following. :

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• Assets and liabilities of the combining entities continue to be recognised at their

predecessor carrying values (including any pre-existing goodwill) reported in the
consolidated financial statements of the ultimate parent or the controlling party;

• Any assets or liabilities that were not recognised prior to the reorganisation are not
recognised as a consequence of the common control combination. This contrasts, for
example, with an acquisition accounted for under HKFRS 3 (Revised) where identifiable
intangible assets such as customer lists may be recognised and fair valued as a result of
the acquisition;

• Any difference between the cost of investment and the pre-existing carrying amount
of the share capital acquired is, in practice, often recognised as a merger reserve.
Accumulated profits (or losses) of a combining entity generated prior to the original
acquisition of that entity is eliminated. An adjustment is made to reflect the profits
attributable to any non-controlling interest in a combining entity generated prior to the
combination;

• 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; and

• Comparative amounts in the financial statements are stated as if the entities or

businesses had been combined at the beginning of the earliest period presented or
when the combining entities or businesses first came under common control if at a
later date.

Apply and Analyse 2

A Ltd issued 100,000 of its shares to the shareholders of B Ltd in exchange for 100,000 of
B Ltd’s shares. (Assume B Ltd’s revenue and expenses for 20X8 accrued evenly throughout
the year.)

Seven years ago, P acquired B, with a goodwill of HK$30,000, an amount which has not
be impaired since the acquisition. P acquired B with an investment of HK$200,000. On the
acquisition date, the preacquisition reserve of B by P was as follows:

HK$
Share capital 100,000
Retained earnings 70,000
Equity 170,000

At the date of the above transaction, the market value of A Ltd’s shares was HK$2 per
share, and B Ltd’s net assets were stated at their respective fair value except for the land,
which is deemed to be undervalued by HK$10,000. Any other excess payment was deemed
to be payment for advantage of affiliation.

Assume that A Ltd and B Ltd were 100% owned subsidiaries of P Ltd, that P’s
investment in A was HK$300,000 and investment in B was HK$200,000 (therefore, the
business combination fell outside the scope of HKFRS 3 (Revised)) and the group used
merger accounting.

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 FINANCIAL REPORTING

Apply and Analyse 2 (continued)

The financial statements of the companies for 20X8 will be as follows:

(a) Statements of financial position as at 31 December 20X8

A Ltd B Ltd
HK$’000 HK$’000
Land – 100
Investment 100 –
Inventory 200 100
Other assets 200 100
500 300

Share capital 300 100

Retained earnings 100 100
Long-term loan 100 100
500 300

(b) Statements of profit or loss and other comprehensive income for the year ended
31 December 20X8

A Ltd B Ltd
HK$’000 HK$’000
Sales 300 200
Cost of sales (100) (100)
Gross profit 200 100
Operating expenses (100) (40)
Profit before tax 100 60
Income tax (30) (20)
Profit after tax 70 40

Analysis

(a) Under merger accounting, the shares issued are recorded in A Ltd’s books at
pre-existing carrying amount

Debit Credit
HK$’000 HK$’000
Investment 100
Share capital 100

The market values are not relevant to a common control reorganisation; therefore,
the market value per share should not be used in the calculation.

(b) Under merger accounting, the assets and liabilities of the subsidiary are brought
to the consolidated financial statements at book value. For example, the land of

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Apply and Analyse 2 (continued)

the subsidiary, even though it has a fair value of HK$110,000, is reported in the
consolidated statement of financial position at its book value of HK$100,000.

(c) Under merger accounting, all the reserves and profit of the subsidiary are
brought into the consolidated financial statements as if the business combination
has taken place on the day the subsidiary was incorporated (i.e. the day B was
originated by P).

Under merger accounting, the amount recorded as the cost of investment may differ
from the amount recorded for the share capital acquired, which would be adjusted to
equity in the consolidated financial statements.

35.3.2 Consolidated Statement of Profit or Loss and Other

Comprehensive Income for a Merger
AG 5 sets out some brief guidance on the preparation of a consolidated statement of profit
or loss and other comprehensive income (OCI) following a common control combination. The
same procedures set out in HKFRS 10 are applied to the preparation of consolidated financial
statements. Consistent with the merger accounting procedures set out in Section 3.1, the
consolidated statement of profit or loss and OCI 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 (if later) when the combining entities or businesses first came under the
control of the controlling party or parties.

Expenditure incurred in relation to a common control combination is recognised as an

AG expense in the period in which it is incurred and is not otherwise capitalised to any of the
5.11–13 assets subject to the reorganisation, nor recognised as a separate asset or directly in equity.

Illustrative Example 2
Refer to the fact pattern in Apply and Analyse 2 (in Section 3.1); prepare A Ltd’s
consolidated statement of profit or loss and OCI and statement of financial position
post-merger and provide relevant workings.

The consolidation journal entries, consolidation worksheet and the consolidated

financial statements, are as follows:

(a) Consolidation journal entries

(i) Debit Credit

HK$’000 HK$’000
Share capital (B) 100
Investment in B Ltd 100
(elimination of investment account)

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Illustrative Example 2 (continued)

(b) Consolidation worksheet

A Ltd B Ltd Consolidated balances

HK$’000 HK$’000 HK$’000
Sales 300 200 500
Cost of sales 100 100 200
Gross profit 200 100 300
Expenses 100 40 140
Profit before tax 100 60 160
Income tax 30 20 50
Profit after tax 70 40 110
Profit for shareholders – – 110
Dividend 10 – 10
Retained earnings 60 40 100
Beginning retained earnings 40 60 i (10) 90
Ending retained earnings 100 200 171
Share capital 300 100 i (100) 300
Loan 100 100 200
Land – 100 100
Investment in B Ltd 100 – i (100) –
Inventory 200 100 300
Other assets 200 100 300

(c) Consolidated financial statements

A Ltd and its subsidiary consolidated statement of profit or loss and OCI for the
year ended 31 December 20X8

HK$’000
Sales 500
Cost of sales (200)
Gross profit 300
Operating expenses (140)
Profit before tax 160
Income Tax (50)
Profit after tax 110

A Ltd and its subsidiary consolidated statement of financial position as at

31 December 20X8

HK$’000
Share capital 300
Retained earnings 200
Long-term loan 200
700

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Illustrative Example 2 (continued)

HK$’000
Land 100
Inventory 300
Other assets 300
700

Knowledge Check Questions

Question 3
Consider that the cost of investment is less than the cost of share capital. Identify which of
the following, under merger accounting, best describes the difference between these two
amounts as it is recognised in the consolidated financial statements.
A As a capital (merger) reserve
B In the group’s retained earnings
C As an adjustment to the group’s goodwill
D Written off immediately to the group profit and loss

Question 4
Chilli Ltd (Chilli) and Bandit Ltd (Bandit) are 100% owns subsidiaries of Bingo Ltd (Bingo).
On 30 June 20X9, Chilli and Bandit enter into a merger accounting transaction, which has
been accounted for as a merger and is, accordingly, outside the scope of HKFRS 3 (Revised)
Business Combinations.
At the date of the transaction, the following amounts are relevant for Chilli:

Cost Fair value

HK$ HK$
Land 1,000,000 1,200,000
Plant 500,000 500,000
Investment in subsidiaries 2,000,000 2,300,000

Identify which of the following is the value of assets reported in the consolidated
statement of financial position on 30 June 20X9 relating to Chilli.
A HK$1.5 million
B HK$1.7 million
C HK$3.5 million
D HK$4 million

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3 5 . 4 CURRENT DEVELOPMENTS

At the time of writing, the IASB was considering how to deal with business combinations under
common control, including the relative merits of the acquisition and book value methods. It is
too early to judge the likely impact of the IASB project.

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SUMMARY

• HKFRS 3 (Revised) Business Combinations excludes combinations of entities or businesses

under common control from its scope.

• Accounting Guideline 5 (AG 5) sets out the basic principles and procedures of merger
accounting for a common control combination and is considered to be best practice, but AG 5
is not a mandatory accounting requirement.

• A business combination involving entities or businesses under common control is ‘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’.

• Assets and liabilities of the combining entities are recognised at their predecessor carrying
values reported in the consolidated financial statements of the ultimate parent or the
controlling party.

• There is no fair value uplift, no recognition of any additional goodwill and no recognition of
any new identifiable assets, liabilities and contingent liabilities.

• Any difference between the cost of investment and the nominal value of the share capital
acquired is put to a merger reserve.

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MIND MAP
INTRODUCTION TO MERGER ACCOUNTING MERGER ACCOUNTING PRINCIPLES
For business combinations outside the Does not have an ‘acquisition date’
scope of HKFRS 3 Involves the reorganisation of pre-existing
Scope of AG 5: business and intragroup ownership
• Combining entities are, or the subject interests within a group of entities
matter of the transfer, is a business The same single uniform set of accounting
• Meets the definition of a business under policies applied in the group financial
common control statements are applied to the entities and
MERGER ACCOUNTING
MERGER ACCOUNTING PROCEDURES FOR COMMON businesses subject to the reorganisation
Assets and liabilities → recognised at their CONTROL
predecessor carrying values reported in the COMBINATIONS
consolidated financial statements
Any assets or liabilities that was not
recognised prior to the reorganisation are
not recognised
Cost of investment > share capital
acquired = recognised in retained earnings
Cost of investment < share capital
acquired = recognised in capital (merger)
reserve
No amount is recognised as consideration
for goodwill or excess over cost at the time
of common control combination, to the
extent of the continuation of the controlling
party or parties’ interests
Comparative amounts in the financial
statements stated:
• As if the entities or businesses had been
combined at the beginning of the earliest
period presented; or
• When first under common control if at
a later date

Answers to Knowledge Check Questions

Question 1
The entity subject to the sale and purchase transaction (whether wholly or in part) is under
the direct or indirect control of the ultimate holding entity before and after the transaction
and the entity has been controlled for long enough that the control was not transitory.

Question 2
Generally, the date of the common control reorganisation is irrelevant because the new
organisational structure’s statements of financial position and financial performance are
based on the predecessor carrying amounts recognised prior to the common control
transaction as if the newly formed structure had been in existence throughout all
periods presented. Under AG 5, the consolidated statement of profit or loss and other
comprehensive income (OCI) 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 (if later) 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. A business combination acquisition accounted for
under HKFRS 3 (Revised) Business Combinations is not restated as a result of a subsequent
common control reorganisation nor is it the date of that acquisition changed to any earlier
or later date than that previously recognised.

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Question 3
Answer A is correct. The capital (merger) reserve recognises any difference between the
cost of investment and share capital acquired.
Answer B is incorrect. Under merger accounting, a difference may occur between the
amount recorded as the cost of investment and the amount recorded for the share capital
acquired. Where the cost of investment is larger than the share capital acquired, the
adjustment is made to the group’s retained earnings. In this case, the cost of investment
was smaller.
Answer C is incorrect. Where a difference exists between the amount recognised as the
cost of investment and amount recorded, the difference is not adjusted to goodwill. Where
the cost of investment is larger than the share capital acquired, the adjustment is made to
the group’s retained earnings.
Answer D is incorrect. Where a difference exists between the amount recognised as the
cost of investment and amount recorded, the difference is not written off immediately to
the group profit and loss. Where the cost of investment is larger than the share capital
acquired, the adjustment is made to the group’s retained earnings.

Question 4
Answer A is correct. Under merger accounting, the assets and liabilities of the subsidiary
are brought to the consolidated financial statements at book value, not fair value. Further,
the investment in subsidiaries will be eliminated on consolidation. Accordingly, the value of
assets reported in the consolidated financial position is: Land HK$1 million + Plant HK$0.5
million = HK$1.5 million.
Answer B is incorrect. Although B correctly identifies that the investment in subsidiaries
would be eliminated on consolidation, it values the assets at fair value (HK$1.2 million +
HK$ 0.5 million). Under merger accounting, the assets and liabilities of the subsidiary are
brought to the consolidated financial statements at book value.
Answer C is incorrect. Although C correctly identifies that under merger accounting, the
assets and liabilities of the subsidiary are brought to the consolidated financial statements
at book value, not fair value, it does not recognise that the investment in subsidiaries
would be eliminated on consolidation (HK$1 million + HK$0.5 million + HK$2 million).
Answer D is incorrect. D fails to recognise that under merger accounting, the assets and
liabilities of the subsidiary are brought to the consolidated financial statements at book
value, not fair value. Further, it fails to recognise that the investment in subsidiaries would
be eliminated on consolidation (HK$1.2 million + HK$0.5 million + HK$2.3 million).

EXAM PRACTICE

QUESTION 1
All of the following transactions exhibit a transfer of businesses. Explain which fact patterns
qualify to apply merger accounting under AG 5. You may also assume that greater than 50%
ownership provides control.

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Fact pattern 1
Before After

A A
100% 80% 100% 80%

B C B C

100% 100%

B1 B1

Fact pattern 2
Before After

A A
100% 5% (no control) 100% 5% (no control)

B C D B C D

100% 100%

B1 B1

Fact pattern 3
Before After

A A
100% 100% 100% 100%
Third party

B C B C Z

100%
80% 20%

B1 B1

Fact pattern 4
Before After

A A
100% 10% (no control) 100% 10% (no control)
100%

B C D C D

20% 80%
B

Fact pattern 5
Before After

A A
100% 100% 100% 100% Third party
Z

B C B C

100% 100% 100% 100%

45% 40%
B1 C1 B1 C1

100% 100% 100%

15%
B2 B3 B2 B3

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QUESTION 2
Magnolia Co. (Magnolia) wholly owns Neopolitan Co. (Neopolitan). Six months ago, Magnolia
purchased 100% of Olive Co. (Olive) from a third party Zena Co. (Zena) at 10% above Olive’s
net fair value and recognised goodwill. The acquisition was presented in Magnolia’s financial
report at year-end.

Magnolia plans to transfer Olive to Neopolitan at a nominal amount.

Using the previous facts, advise Magnolia what are the key facts of the case to determine
whether merger accounting under AG 5 or acquisition accounting under HKFRS 3 (Revised)
Business Combinations should apply, and in detail, explain the differences between the
accounting principles and procedures of both methods.

A NS W ERS T O E X A M P R A C TI C E

QUESTION 1
The focus of this question is to identify a business combination under common control,
assuming control exists and the control is not transitory.

Fact pattern 1

Before the transaction, B1 was wholly owned by B, and B is wholly owned by A. After the
transaction, B1 is wholly owned by C, and C is 80% owned by A. Assuming A has control over
C, then before and after the transaction, B1 is a business under common control of A. AG 5
is applicable to C for the accounting of the combination.

Fact pattern 2

Before the transaction, B1 was wholly owned by B, and B is wholly owned by A. After the
transaction, B1 is wholly owned by D, but D has no control over D. B1 is no longer a business
under common control. AG 5 is not applicable here.

Fact pattern 3

Before the transaction, B1 is wholly owned by B, and B is wholly owned by A.

B sold 80% of B1 to a sister company C and 20% of B1 to a third party Z. After the
transaction, B1 is 80% owned by C who is wholly owned by A. Assuming C has control over
B1, then before and after the transfer, B1 is a business under common control despite
its being 20% owned by a third party. AG 5 is applicable to C for the accounting of the
combination.

Fact pattern 4

Before the transaction, B is wholly owned by A. A sold 20% of B to its wholly owned
subsidiary C and 80% of B to D of which A owns 10% but has no control. After the
transaction, B is 20% owned by C, and C is wholly owned by A and is, therefore, 20%
indirectly owned by A. However, B is also 80% owned by D, and D is not controlled by A.
Therefore, B is no longer a business under common control. AG 5 is not applicable here.

Fact pattern 5

Before the transaction, B3 is wholly owned B1 and indirectly wholly owned by B and A. B1
sold 45% of B3 to its sister company C and 40% of B3 to a third party Z. B1 retained 15%

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ownership of B3. After the transaction, B3 is no longer wholly owned by any one party.
However, collectively, A retains 60% indirect ownership of B3. Assuming Z has no control
over B3, then before and after the transaction, B3 is a business under common control. AG 5
is applicable to C for the accounting of the combination.

QUESTION 2
Magnolia accounts for the disposal of Olive. Neopolitan accounts for the combination of
Olive and, therefore, decides which accounting method to apply.

Analysing the definition/criteria to the case

The focus here is whether transitory control exists even though there is a business
combination under common control.

Before transfering to Neopolitan, Magnolia owned 100% of Olive and, therefore, had direct
control over Olive. After transferring to Neopolitan, despite losing direct control, Magnolia
still had indirect control over Olive through 100% ownership of Neopolitan. Therefore,
before and after the transfer, Olive is a business under common control of Magnolia.
However, Magnolia purchased Olive six months ago; therefore, the question is whether
Magnolia had transitory control of Olive. If Magnolia had transitory control, Neopolitan
may be required to apply acquisition accounting for the combination. Otherwise, merger
accounting under AG 5 can be applied.
The key differences between methods

Under merger accounting:

• Neopolitan recognises Olive’s assets and liabilities at the predecessor carrying values
reported in Magnolia’s consolidated financial statements. This includes the goodwill
that Magnolia recognised when it acquired Olive from Zena.

• If the nominal consideration paid by Neopolitan is higher or lower than Olive’s net
book value, the difference will be recognised in a reserve in Neopolitan’s consolidated
statement of financial position.

• Neopolitan recognises Olive’s assets and liabilities in the comparative period of its
financial statements.

Under acquisition accounting:

• Neopolitan determines the date of the acquisition and recognises Olive’s assets and
liabilities at fair values as of that date. Neopolitan does not carry forward the amounts
recognised in Magnolia’s consolidated financial statements.

• If the nominal consideration paid by Neopolitan is higher or lower than Olive’s net
fair value, the difference will be recognised as goodwill in Neopolitan’s consolidated
statement of financial position or as a gain in Neopolitan’s consolidated statement of
financial performance.

• Neopolitan only recognises Olive’s assets and liabilities in its current financial period.

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 Part E
Current Issues and
Developments in
Financial Reporting

Chapter 36 Integrated Reporting/Sustainability Reporting

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 36
Integrated Reporting/
Sustainability Reporting

CHAPTER TOPIC LIST

36.1 Global Sustainability Initiatives 36.3 Integrated Reporting

and Frameworks
36.4 Current Developments
36.1.1 Increasing Importance of
36.4.1 ISSB’s Exposure Drafts
Business Sustainability
36.4.2 New HKEx Guidance
and Reporting
36.1.2 Global Initiatives
36.2 Sustainability and ESG
Reporting in Hong Kong
36.2.1 HKEx’s ESG Reporting Guide
36.2.2 Hong Kong’s Companies
Ordinance
36.2.3 Challenges in ESG Reporting

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LEARNING OUTCOMES

Principal LO5: Describe the current issues and developments in financial reporting
LO5.01: Describe the impact of current issues and developments in financial reporting
5.01.01 Describe the impact of current issues and developments in financial reporting both
in Hong Kong and internationally
LO5.02 Describe the social responsibilities
5.02.01 Describe the development of integrated reporting and sustainability reporting
in Hong Kong
5.02.02 Describe the current developments in integrated reporting and sustainability
reporting

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OPENING CASE

XYZ GROUP

X YZ Group (XYZ) is a major provider of electricity in the city. XYZ’s Environmental, Social and
Governance (ESG) Report (Report) has been structured in accordance with the five most
important ESG issues facing XYZ: business purpose, climate change, technology, cyber and data
security, and sustainable workforce. The Report explains why these issues are material and
how they are determined.

The ‘business purpose’ section of the Report sets out the board’s commitment to ESG, the
governance structure of XYZ’s ESG considerations and the board’s oversight role as well as the
link between the company’s business strategy and the ESG risks and opportunities.

XYZ referenced different reporting guidelines and frameworks to ensure its reporting is
comprehensive and aligns with international best practices. For instance, the Report considers
international guidelines, such as the United Nations Sustainable Development Goals (UNSDGs)
when devising its ESG strategies. Moreover, the Report is prepared in accordance with the
Global Reporting Initiative (GRI) Standards and it also reports on GRI G4 Electric Utilities Sector
Disclosure. It applies the International Integrated Reporting Council’s (IIRC) guiding principles
to illustrate how integrated thinking has been embedded in the Group and incorporated
the content specified in the International Integrated Reporting Framework. As a HKEx listed
company, the Report complies with HKEx’s Environmental, Social and Governance Reporting
Guide (ESG Guide or Guide).

The Report contains a table setting out the specific disclosures with reference to the
provisions of the various reporting guidelines and framework or recommendations, indicating
their compliance.

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OVERVIEW

The terms sustainability, corporate social responsibility (CSR), and environmental, social and
governance (ESG), have often been used synonymously, but they differ. The most cited definition
for sustainable development is ‘meet(ing) the needs of the present without compromising the
ability of future generations to meet their own needs’. Sustainability has a broader meaning
that encompasses CSR and ESG. Information contained in corporate communications relating
to CSR, ESG or sustainability is often referred to as non-financial information, as opposed to
financial information.

A sustainability or ESG Report is published by an entity about the economic,

environmental and social impacts caused by its business activities as well as the impacts of
these on the entity’s business.

In Hong Kong, ESG is the most widely adopted term by corporates as it is used by Hong
Kong Stock Exchange (HKEx) in its Listing Rules (LR).

Compared with an ESG Report that may only include the company’s ESG considerations,
an integrated report is intended to provide greater context as it includes financial and non-
financial information.

ESG and its reporting has now moved into the mainstream in the capital market. It is
no longer a ‘nice-to-have’ corporate communication. For Hong Kong listed companies, the
obligation for ESG information disclosure has been strengthened since 2012, with a majority
of the provisions in the Guide upgraded from voluntary to ‘comply or explain’. Following
market consultation conducted in 2019, HKEx has further updated and strengthened the
ESG Guide. For listed companies with financial years commencing on or after 1 July 2020, the
disclosure obligation for certain elements in the Guide are upgraded to mandatory whilst all
recommended disclosure provisions (i.e. subject to voluntary disclosure) have been upgraded
to ‘comply or explain’.

This chapter discusses the latest international and Hong Kong developments in corporate
reporting, business sustainability and ESG reporting, including integrated reporting. It will
highlight some of the issues in Hong Kong listed companies’ current ESG reporting, make
recommendations on best practices and explain the latest changes to HKEx’s Guide as well as
the rationale behind them.

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3 6 . 1 GLOBAL SUSTAINABILITY INITIATIVES

AND FRAMEWORKS

36.1.1 Increasing Importance of Business Sustainability and Reporting

Historically, corporates viewed sustainability as CSR in the sense of doing well by doing
good. It was seen as a reputational issue, to be dealt with by the public relations section of
the company. For investors, it was thought about as socially responsible investing, where
investors would exclude stocks and industries they disliked. They could be companies that
engaged in gambling, or selling or manufacturing tobaccos. However, the thinking has shifted
significantly in recent years, not least because it is now widely recognised that sustainability
and ESG practice and reporting creates value. Climate change and its potential terminal effects
have become a global focus, particularly after the Paris Agreement entered into force on
4 November 2016.

Business sustainability has taken on a more complex meaning; it now includes governance,
strategy, risk management, and metrics and targets. The increasing importance of business
sustainability can be attributed to a number of factors, with investor demand, regulatory
requirements, supply chain influence and increased awareness by corporate leaders being the
main drivers. The following sub-sections comment on each of these factors.

36.1.1.1 Investor Demand

By directing investment capital based on ESG reporting metrics, powerful investor groups,
including large asset management firms and pension funds, have been able to pressurise
corporates to improve their ESG practice and reporting. Many believe sustainability and ESG
reporting enables investors to get a fuller picture of the company’s governance, strategy and
risk management among others. Though financial reporting tells the story of a corporate’s past
performance, non-financial information contained in sustainability and ESG Reports is expected
to give an indication on its future: where the company is headed.

In 2016, Hong Kong’s Securities and Futures Commission (SFC) issued a set of ‘Principles
of Responsible Ownership’ aimed at guiding and assisting investors to determine how best
to meet their ownership responsibilities. The SFC is working on an updated version of the
Principles.

36.1.1.2 Regulatory Requirements

Globally, governments and regulators are imposing greater pressure on corporates to report
on ESG by introducing or upgrading the laws and regulations in this space. Hong Kong is
no exception. Since 2016, all companies listed on HKEx must publish ESG Reports annually,
although a company may call its report a CSR/sustainability report. HKEx’s ‘ESG Reporting
Guide’, which forms a part of the LR, has been reviewed and upgraded following consultation
conducted in 2019. The new Guide is effective for financial years starting on or after
1 July 2020.

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36.1.1.3 Supply Chain Influence

Larger businesses in the supply chain with advanced ESG practice have been able to drive and
influence others in their supply chain. They may, for instance, only award contracts to those
that practice good ESG disclosure.

36.1.1.4 Increased Awareness of Corporate Leaders

Corporations’ primary goals have refocused from profit maximisation to creating stakeholder
value while fulfilling their social and environmental responsibilities. The number of public
companies worldwide that disclose sustainability performance information has increased
significantly and today, most public companies around the world are disclosing their
sustainability performance. Integrated sustainability reporting is the process of disclosing
information relevant to both financial and non-financial key performance indicators (KPIs)
for all dimensions of sustainability performance. The goal of firm value maximisation under
business sustainability can be achieved when the interests of all stakeholders are considered.
The focus is on long-term shareholder value creation while considering trade-offs among other
apparently competing, and often conflicting, interests of society, creditors, employees, and
the environment. Business sustainability focuses on the achievement of long-term firm value
maximisation by creating value for shareholders and meeting the claims and interests of other
stakeholders. This growing trend towards sustainability reporting and assurance is expected to
continue worldwide.

36.1.2 Global Initiatives

Many global regulators, standard-setters and other professional organisations, including
the United Nations Global Compact (UNGC), Global Reporting Initiative (GRI), International
Integrated Reporting Council (IIRC), and more recently, the Task Force on Climate-related
Financial Disclosure (TCFD) established by the Financial Stability Board (FSB) are promoting
and making recommendations on sustainability reporting. These organisations and their
roles in the global promotion of sustainability reporting are presented in the following
sub-sections.

36.1.2.1 United Nations Global Compact (UNGC) and United Nations Sustainable
Development Goals (UNSDGs))
Officially launched in 2000, UNGC is the world’s largest business sustainability initiative. It is a
principles-based framework for businesses, stating 10 principles in the areas of human rights,
labour, the environment and anti-corruption.

The United Nations Sustainable Development Goals (UNSDGs) are a universal call to
action for all UN Member States to end poverty, protect the planet and improve the lives and
prospects of people in the world.

The UNSDGs were agreed by world leaders in a UN summit held in September 2015.
On 1 January 2016, the UNSDGs were enacted to address three sustainability dimensions
of economic development, social inclusion and environmental matters, and involve areas
such as climate change, diversity, economic inequality, innovation, sustainable production,

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consumption, and peace and justice. UNSDGs call on governments, corporates and non-
profit organisations to work together to end extreme poverty, fight inequality and protect our
environment.

The 17 UNSDGs (Exhibit 36.1) are related to sustainability reporting and assurance as they
address economic, social, ethics, governance and ecological sustainability performance. Large
global corporations frequently use these goals and link them to sustainability performance
from supply chain management to the sourcing of raw materials and inputs for production,
product innovations and other activities that lead to positive environmental, health or
society impacts.

1 2 3 4 5
No Poverty Zero Hunger Good Health and Quality Education Gender Equality
Well-being
6 7 8 9
Clean Water and Affordable and Decent Work and Industry, Innovation
Sanitation Clean Energy Economic Growth and Infrastructure
10 11 12 13
Reduced Inequality Sustainable Cities and Responsible Climate Action
Communities Consumption and
Production
14 15 16 17
Life Below Water Life on Land Peace and Justice Partnership to
Strong Institutions achieve the Goal

EXHIBIT 36.1 The 17 UN Sustainable Development Goals

Illustrative Example 1
The company may choose to focus on some of the SDGs that are most relevant to its
business in the reporting year. For instance, XYZ focused on four of the SDGs that are
most relevant to its business:

• SDG 13 – Climate Action;

• SDG 7 – Affordable and Clean Energy;

• SDG 8 – Decent Work and Economic Growth; and

• SDG 9 – Industry, Innovation and Infrastructure.

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36.1.2.2 Global Reporting Initiative (GRI)

Published in 2000, GRI’s Sustainability Reporting Standards are one of the firsts of its kind and
probably the most widely adopted global standards for sustainability reporting.

The current version, the ‘GRI Universal Standards’, was issued in October 2021 and will be
effective on 1 January 2023. This version consists of three series of standards:

–– the GRI Universal Standards,

–– the GRI Sector Standards, and

–– the GRI Topic Standards.

The GRI Universal Standards apply to all organisations. The GRI Sector Standards are
applicable to specific sectors. The GRI Topic Standards support each listing disclosures relevant
to a particular topic such as waste, occupational health and safety, and tax. Key concepts are
introduced to lay out the foundation of sustainability reporting and comprise impact, material
topics, due diligence, and stakeholder.

36.1.2.3 International Integrated Reporting Council (IIRC)

In December 2013, the IIRC released its first International Integrated Reporting Framework
(Framework). Aimed at promoting a more integrated approach to corporate reporting, the
Framework is designed to improve the quality and quantity of information disseminated to
providers of financial capital, including shareholders and other stakeholders. The purpose of an
integrated report is to extend a company’s financial reporting to include non-financial reporting
(see Section 36.3).

36.1.2.4 Climate Disclosure Standards Board (CDSB) and Carbon Disclosure Project (CDP)
The CDP (formerly the Carbon Disclosure Project) is an international, not-profit organisation
that runs the global disclosure system that enables entities and cities, states and regions
to measure and manage their risks and opportunities on climate change and other
environmental impacts.

The CDSB is an organisation that hosts multiple nongovernmental organisations (NGOs)

from around the globe. Similar to the CDP, the CDSB intends to improve the dissemination of
information regarding the environment through a framework that was released in 2010. On
6 November 2012, the CDP and the CDSB released the extensible business reporting language
(XBRL) climate change reporting taxonomy.

36.1.2.5 Task Force on Climate-related Financial Disclosure (TCFD)

Established in 2015, TCFD is an industry-led task force founded by the FSB at the request of
the G20 to consider climate risks. Designed to enhance market transparency and the efficient
allocation of capital in the transition to a low-carbon economy, TCFD’s recommendations
published in June 2017 (TCFD Recommendations) contain four themes of disclosure:

• governance,

• strategy,

• risk management,

• metrics and targets.

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The TCFD Recommendations are voluntary, climate-related financial disclosures for use by
companies in providing information to investors, lenders, insurers, and other stakeholders.

36.1.2.6 International Sustainability Standards Board (ISSB)

The ISSB was established by IFRS Foundation Trustees on 3 November 2021 to develop a
comprehensive global baseline of sustainability-­related disclosure standards for international
investors and other capital market participants with consistent, transparent, reliable and
comparable information about companies’ sustainability-­related risks and opportunities and
ease the comparability of sustainability reporting through standardised standards. It also aims
to provide users of general-­purpose financial reporting ESG disclosures to assess enterprise
value. The boards of IASB and ISSB work closely to ensure the compatibility between the
financial reporting standards and ISSB’s standards.

Knowledge Check Questions

Question 1
Zoom Ltd (Zoom) has been publishing ESG Reports annually in accordance with HKEx’s
ESG Reporting Guide for the last three years. A number of Zoom’s important overseas
investors have now asked about the company’s climate change strategies. They want to
understand how the company deals with climate change risks. Identify the standards,
recommendations and framework that is most appropriate for Zoom to refer to or adopt
to address the investors’ concerns.

Question 2
Explain whether a company can comply with more than one set of standards,
recommendations and framework.

Question 3
For each of the following organisations, list the key publications on sustainability reporting
published by them: GRI, IIRC, TCFD and HKEx.

3 6 . 2 SUSTAINABILITY AND ESG REPORTING

IN HONG KONG

HKEx as a major stock exchange and the frontline regulator of its listed companies was aware
of the need to promote ESG reporting to meet investor demands, attract capital flow and align
its regulatory regime with international best practices.

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36.2.1 HKEx’s ESG Reporting Guide

Since 2016, companies listed on HKEx must publish an ESG report annually and in respect of
the same period as the annual report. The Guide was substantially updated in 2021 with the
aim of strengthening it. It is also much closer to international best practice.

The current, revised Guide (current Guide) is effective for listed companies with financial
years commencing on or after 1 January 2021. The ESG report may be published as a part
of the company’s annual report. However, where the ESG report does not form a part
of the annual report, it must be published at the same time as the publication of their
annual report.

The following subsections highlight the main features of the current Guide:

The Guide now contains two levels of disclosure obligations:

(i) Mandatory Disclosure Requirements (MDRs); and

(ii) ‘Comply or Explain’ Provisions.

36.2.1.1 Mandatory Disclosure Requirements

The MDRs require the board to take responsibility for ESG considerations. It is mandatory for
the board to make a statement on the following matters in relation to the company’s ESG:

• Governance Structure

• Reporting Principles

• Reporting Boundary

Governance Structure
The board must make a statement (Mandatory Disclosure Requirement) on the governance
structure of the company’s ESG. The board’s statement to be made in the company’s ESG report
must contain:

• The board’s oversight of ESG issues;

• The board’s management approach and strategy, including the process used to identify,
evaluate and manage material ESG-related issues (including risks to the issuer’s
businesses); and

• How the board reviews progress made against ESG-related goals and targets with an
explanation of how they relate to the issuer’s businesses.

This effectively recommends that ESG issues should be considered at the board level.
As provided in most corporate governance codes, the setting of a company’s business
strategy and objectives, identifying and managing the associated material risks in achieving
the objectives are the board’s key responsibilities. ESG risks and opportunities could
have significant impacts on a company’s financial position and they should be given due
consideration by the board.

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Apply and Analyse 1

In the past two years, the ESG report of ABC Ltd has been prepared by its Investor
Relations department without much input from senior management or the board. The
board of ABC Ltd simply approved the draft reports shortly before its publication. Explain
why this approach is inadequate going forward.

Analysis

In preparation of the new ESG reporting regime, the board of ABC Ltd must be prepared to
take responsibility for making a board statement as required by the new ESG Guide. ESG
issues have to be elevated to the board level which means that the board must oversee
or take the lead in identifying potential ESG risks and opportunities, and ensure that
there is a process for stakeholder engagement for the purpose of materiality assessment.
Without such involvements, the board would not be able to issue a board statement in the
ESG report.

The board may delegate its functions, but such delegation does not exonerate the
board from its responsibility.

The subsections below provide more details on the four Reporting Principles, Reporting
Boundary, and Assurance.

Illustrative Example 2
XYZ Group’s ESG report (in the Opening Case) contains disclosure of the board’s
oversight of the ESG matters concerning XYZ, and it has a Stakeholder Engagement
Framework which sets out its engagement steps. The first step is to align engagement
objectives with XYZ’s business objectives.

Reporting Principles
Different regulators and standard setters have set different Reporting Principles but the key
ones are: materiality, quantitative, balance and consistency. The Guide contains these four
Reporting Principles and a Hong Kong listed company must include in its ESG report a board
statement containing a description or explanation on the application of three of the four
Reporting Principles, i.e. materiality, quantitative and consistency.
Materiality
Materiality is defined in the Guide as ‘The threshold at which ESG issues determined by
the board are sufficiently important to investors and other stakeholders that they should be
reported’. The importance of materiality assessment in ESG reporting cannot be overstated
and board involvement in this process is highly recommended. The process helps the

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company and its board to identify, prioritise and manage ESG issues (including ESG risks
and opportunities) and enables the company to better understand its stakeholders through
engagements with them. The process also ensures that the information contained in the
ESG report is relevant, meaningful, concise and as a result, useful for investors and other
important stakeholders.

Stakeholder engagement is the process by which a company involves parties who may
be affected by the decisions it makes or can influence the implementation of its decisions.
Important stakeholders are specific to the company; stakeholders important to one company
may not be so to another. Stakeholders for the company in one year may differ from the next,
as the business and operations of the company develop and change, and the environment in
which the company operates could also evolve. It may be unnecessary to engage with all the
stakeholders of the company year-on-year, as their views may not vary significantly from the
previous year. For the purpose of materiality assessment, the company should be mindful of
the changing business and environment, and identify new possible risks and opportunities and
engage new stakeholders as appropriate. Important stakeholders could include the company’s
investors, creditors, employees, customers/clients, suppliers and regulators.

Having conducted materiality assessment, the company should make the relevant
disclosure in its ESG report and explain how they have arrived at the conclusion.

Apply and Analyse 2

BRE Ltd is in the properties and construction industry. In the past, BRE Ltd’s ESG working
group has identified several stakeholders including its suppliers of construction materials,
and a number of their main contractors that provided workers to the company. They spoke
to the stakeholders or asked them to fill in a questionnaire on various ESG issues. Explain
how BRE Ltd and its board should link the company’s business strategy with ESG risks and
describe the board’s responsibility in this process.

Analysis

Going forward, BRE Ltd should link its business strategy to the potential ESG risks and
opportunities. For instance, if BRE Ltd’s strategy includes the building of a residential
complex, it would have to consider the environmental and societal impacts of the project.
Environmental issues may include the emissions and pollution caused by the construction
process, whether the buildings’ structures and windows would be able to withstand
typhoons that are ever increasing in strength. Buyers of the properties may be concerned
about whether the buildings constructed by the company can be classified as ‘green’.
Social issues may include labor standards, the health and safety of the workers, or the
impact of the construction work on the local community.

The board of BRE Ltd should take responsibility for identifying and managing material
ESG issues and disclose their process and findings in its board statement.

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Quantitative
ESG performance should be measured quantitatively to be reported. Thus, ESG KPIs need to be
classified, measured and reported. KPIs should be measurable and accompanied by a narrative
statement describing their purposes and impacts. They should contain comparative data to
demonstrate improvement or deterioration in the company’s ESG performance so as to enable
an evaluation of the effectiveness of the company’s ESG policies and management.

Exhibits 36.2 and 36.3 show examples of data and information provided to show the
effectiveness of ESG policies.

2020 2019 2018

SO2 (kT) 0.82 1.08 1.94
NO2 (kT) 5.33 5.41 7.59
RSP (kT) 0.12 0.13 0.18
CO2 (million T) 7.35 7.16 8.48
CO2e (million T) 7.39 7.19 8.51
CO2e per electricity unit sold (kg/kWh) 0.71 0.71 0.81

EXHIBIT 36.2 Extract of environmental statistics of Hong Kong Electric: air emissions

Target Progress update in 2021 report

1. To promote a high standard of corporate • Hosted the HKEX Green Asia Summit
governance among our listed issuers to • Launched the HKEX ESG Academy
improve the overall quality of our market
• Enhanced the Corporate Governance Code
2. To enhance the availability and transparency • 95 new Green, Social and Sustainable bonds
of ESG information of our listed issuers for listed on our market
investors to make informed decisions
• Introduced the LME passport
3. To advance low-­carbon and responsible Hosted the HKEX Biotech Summit
investment by promoting sustainable and
green finance products in our markets
4. To position Hong Kong as a market that
supports business, in particular, the fintech
and biotech sectors, throughout the full
lifecycle of growth

EXHIBIT 36.3 Extract of disclosures made on targets and progress made by the Hong Kong Stock
Exchange’s 2021 CSR Report

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Apply and Analyse 3

XYZ Group is concerned that the new Guide now requires disclosure of targets in relation
to Environmental KPIs. If the Group sets a target that is too high, it would not look good if
it missed the target and had to disclose in next year’s ESG report. Conversely, if the Group
sets the target too low, it would be meaningless. Describe the steps that BRE Group should
take to set targets.

Analysis

XYZ Group would benefit from taking the task seriously. Targets should be realistic, based
on the Group’s circumstances and available data. By setting specific targets and disclosing
the steps taken to achieve them would help the Group to take a closer look at its climate
change related strategy and enable it to better manage the associated risks. Investors
expect to see this information in the ESG report and this is an important part of TCFD’s
Recommendations. In Exhibit 36.2, Hong Kong Electric provided comparative data for the
previous years in Air Emissions. It may decide to set a target to reduce carbon dioxide by
10% by 2023. It should explain how this is to be achieved, for example, the measures that it
will put into place and/or the new technology it will employ.

Balance
In the Guide, a balanced report means that it should provide an unbiased picture of the
company’s performance, avoiding selections, omissions or presentation formats that may
mislead readers of the report.

Apply and Analyse 4

The corporate communications department is in charge of drafting XYZ Group’s ESG
report. Concerned about the Group’s reputation, it advised the board that certain bad
news relating to an environmental blunder should be kept quiet in the ESG report. Explain
whether the board should follow the corporate communication department’s advice.

Analysis

The board should not follow the corporate communications department’s advice as the
Group should not treat its ESG report as a public relations exercise. The ESG report should
be balanced, i.e. it should not mislead readers with good news only. If the Group faced
some challenges in dealing with ESG issues, it should disclose them in the ESG report with
an explanation on how they have been, or are to be, overcome.

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Consistency
Consistent methodology and measurable techniques should be applied to the report to enable
meaningful comparison of the company’s ESG data over time.

Apply and Analyse 5

If certain ESG data appear unfavourable when compared with last year’s, explain whether
XYZ Group should change the methods of calculation to fudge the issue.

Analysis

The ESG Guide requires consistent methodology. Instead of changing the calculation
method in an attempt to hide the unfavorable data, the Group should explain why the data
has deteriorated and whether plans exist to improve its performance in the future.

In any event, if the Company changes the calculation method that affects the
comparability of the ESG data, it must disclose the change in its ESG report.

Reporting Boundary
One of the most frequently asked questions about ESG reporting is reporting boundary. Some
poorly performing entities or operations of the company may have been chosen to be excluded
from the ESG report without explanation. This may lead to investors potentially being kept in
the dark about the company’s overall performance.

The Guide makes it mandatory for the board statement to include an explanation of
the ESG report’s reporting boundary and the process used to identify the specific entities or
operations that are included in the ESG report.

Apply and Analyse 6

Some of the subsidiaries of XYZ Group do not have material ESG issues. They might be
investment vehicles without business operations. Explain whether these subsidiaries
should be included in XYZ Group’s ESG report.

Analysis

Materiality is the key to producing concise ESG reports that are to the point and useful for
investors to make investment decisions. The Group does not need to include subsidiaries
that do not have material ESG issues in the ESG report as such information is irrelevant to
the Group’s ESG performance.

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36.2.1.2 ‘Comply or Explain’ Provisions

The ‘Comply or Explain’ part of the Guide contains two subject areas: Environmental and
Social. Corporate governance provisions are largely contained in a separate Corporate
Governance Code.

Each Subject Area contains various aspects (Aspects) under which there are general
disclosures (General Disclosures) which are subject to ‘comply or explain’. General Disclosures
are in respect of the issuer’s policies (Policies) and in some cases, information on compliance
with the relevant laws and regulations that have a significant impact on the issuer (Laws and
Regulations). To comply with the General Disclosures part under each of the Aspects, the
company must provide information in narrative form on the subject matter prescribed in the
Guide. If the company chooses not to comply with a specific General Disclosure, it must give
considered reasons.

All KPIs are subject to ‘comply or explain’.

There are four aspects under Environmental and eight aspects under Social. They are listed
in the below table.

Subject Areas Aspects KPIs (Examples)

Environmental Emissions • Types of emissions and respective emissions data.
• Direct (Scope 1) and energy indirect (Scope 2)
greenhouse gas emissions (in tonnes) and, where
appropriate, intensity (e.g. per unit of production
volume, per facility).
• Total hazardous waste produced (in tonnes) and, where
appropriate, intensity (e.g. per unit of production
volume, per facility).
Use of Resources • Direct and/or indirect energy consumption by type.
• Water consumption in total and intensity (e.g. per unit of
production volume, per facility).
• Total packaging material used for finished products
(in tonnes) and, if applicable, with reference to per
unit produced.
The Environment and • Description of the significant impacts of activities on
Natural Resources the environment and natural resources and the actions
taken to manage them.
Climate Change • Description of the significant climate-­related issues
which have impacted, and those which may impact, the
issuer, and the actions taken to manage them.
Social Employment and • Total workforce by gender, employment type (e.g., full-­
Labour Practices: or parttime), age group and geographical region.
Employment • Employee turnover rate by gender, age group and
geographical region.
Employment and • Number and rate of work-­related fatalities occurred in
Labour Practices: each of the past three years including the reporting year.
Health and Safety • Lost days due to work injury.

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Subject Areas Aspects KPIs (Examples)

Employment and • The percentage of employees trained by gender and
Labour Practices: employee category (e.g. senior management, middle
Development management).
and Training • The average training hours completed per employee by
gender and employee category.
Employment and • Description of measures to review employment
Labour Practices: practices to avoid child and forced labour.
Labour Standards • Description of steps taken to eliminate such practices
when discovered.
Operating Practices: • Number of suppliers by geographical region.
Supply Chain • Description of practices relating to engaging suppliers,
Management number of suppliers where the practices are being
implemented, and how they are implemented and
monitored.
Operating • Percentage of total products sold or shipped subject to
Practices: Product recalls for safety and health reasons.
Responsibility • Number of products and service related complaints
received and how they are dealt with
Operating Practices: • Number of concluded legal cases regarding corrupt
Anti-­corruption practices brought against the issuer or its employees
during the reporting period and the outcomes of
the cases.
• Description of preventive measures and whistle-­blowing
procedures, and how they are implemented and
monitored.
Community: • Focus areas of contribution (e.g. education,
Community environmental concerns, labour needs, health,
Investment culture, sport).
• Resources contributed (e.g. money or time) to the
focus area.

Key Learning Point

Early adoption of the Guide would demonstrate to investors and other stakeholders that
the company is ahead of the curve, and that it is committed to good governance and
leadership on ESG issues.

36.2.2 Hong Kong’s Companies Ordinance

Since 2014, a Hong Kong company (unless exempt) is required by Schedule 5 of the CO
to prepare a business review in its directors’ report consisting environmental and social
information. The CO requires:

• A discussion on the company’s environmental policies and performance;

• A discussion of its compliance with the relevant laws and regulations that have a
significant impact on the company; and

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• An account of the company’s key relationships with its employees, customers and
suppliers and others that have a significant impact on the company and on which the
company’s success depends.

In 2016, Schedule 5 of the CO has been incorporated into HKEx Listing Rules which means
that all companies listed on HKEx must also comply with these requirements.

Key Learning Point

A company listed on HKEx must comply with Schedule 5 of the Companies Ordinance as
the law has been incorporated into the LR.

36.2.3 Challenges in ESG Reporting

Though most corporate leaders agree that ESG is important and though all Hong Kong listed
companies have started ESG reporting, more needs to be done and done better. Some of the
main challenges of sustainability reporting are concern that:

• Though accounting and auditing standards have been established, sustainability

standards are new and lack consistency;

• Unaudited ESG information and KPIs may attract liabilities if inaccurate;

• ESG information disclosure would create increased expectations on future performance

improvement, which may be difficult to achieve; and

• It is difficult to disclose concise, accurate, reliable, complete and comparable ESG

information relevant and useful to all stakeholders.

3 6 . 3 INTEGRATED REPORTING

Integrated reporting has been defined as ‘a concise communication about how an

organisation’s strategy, governance, performance and prospects, in the context of its external
environment, lead to the creation of value in the short, medium and long term’.

Integrated reporting means presentation of a company’s performance in terms of financial

and non-financial information, intending to provide greater context for the company’s
performance. It encourages integrated thinking, particularly at the board level, to enable
the company to make better decisions. Compared with a sustainability/ESG Report, which
only includes the company’s ESG considerations, that is, how the ESG issues are identified,
prioritised and managed, and the company’s performance under ESG key performance
indicators, integrated reporting is preferred by investors and is likely to be the future of
corporate reporting.

In December 2013, the IIRC published a detailed International Integrated Reporting

Framework (Framework) following consultation and testing by businesses and investors from

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26 countries that participated in the IIRC Pilot Program. According to the Framework’s seven
Guiding Principles, an integrated report should demonstrate:

1. Strategic focus and future orientation: insight into the company’s strategy and how it
relates to the creation of value in the short, medium and long term, and its use of, and
effects, on the capitals;

2. Connectivity of information: painting a holistic picture of the combination,

inter-relatedness and dependencies of the factors that affect the company’s ability to
create value over time;

3. Stakeholder relationships: insight into the nature and quality of the company’s
relationships with its key stakeholders, including how the company understands and
responds to its legitimate interests and demands;

4. Materiality: information about issues that substantively affect the company’s ability to
create value in the short, medium and long term that should be disclosed;

5. Conciseness: sufficient for the understanding of the company’s strategy, governance

and prospects without irrelevant information;

6. Reliability and completeness: all material matters, presented in a balanced way, that is,
it should not only report on positive and excluding negative information; and
7. Consistency and comparability: the information in the report should be consistent over
time. It should also enable comparison with other organisations to the extent material
to the company’s own ability to create value.

Integrated reporting promotes a different way of thinking from the traditional reliance on
financial capital. Instead, it believes that what makes an organisation successful should rely on
a much broader set of capitals. These are outlined in Exhibit 36.4.

The skills and know-how of

an organisation’s personnel, Funds obtained through
their commitment and Human Financial financing or generated by
motivation that affect their business activities
ability to fulfill their roles

The relationships between

an organisation and its
Physical infrastructure Social and
Manufactured stakeholders, including
or technology Relationship
communities, governments,
suppliers and customers

Resources such as water, fossil fuels, Intangibles associated with

solar energy, crops and carbon sinks, brand and reputation as
which cannot be replaced and are Natural Intellectual well as patents, copyrights,
essential to the functioning of the organisational systems and
economy as a whole related procedures

EXHIBIT 36.4 Six capitals of integrated reporting

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Key Learning Point

The Framework is a voluntary guide. If the company is not ready to report in accordance
with the Framework, it could start by publishing its ESG Report at the same time as the
annual report and apply some of the more achievable principles and guidance.

Knowledge Check Questions

Question 4
Describe integrated reporting and contrast it with ESG reporting.

Question 5
Explain why investors prefer integrated reporting.

3 6 . 4 CURRENT DEVELOPMENTS

36.4.1 ISSB’s Exposure Drafts

In March 2022, ISSB issued two exposure drafts, IFRS S1 General Requirements for Disclosure of
Sustainability-­related Financial Information (S1) and IFRS 2 S2 Climate-­related Disclosures (S2) to
standardise the ESG reporting and cover important ESG topics relevant for investors’ financial
decision making.

36.4.1.1 IFRS S1 General Requirements for Disclosure of Sustainability-­related

Financial Information (S1)
The purpose of S1 is to require an entity to disclose information about its significant
sustainability-­related risks and opportunities that is useful to the primary users of general-­purpose
financial reporting when they assess enterprise value and decide whether to provide resources
to the entity. Enterprise value reflects expectations of the amount, timing and uncertainty of
future cash flows over the short, medium and long term and the value of those cash flows in
the light of the entity’s risk profile, as well as its access to finance and cost of capital. General
disclosure requirements are set out for sustainability-­related financial information including
an entity’s governance of sustainability-­related risks and opportunities and its strategy for
addressing them; the entity’s reputation, performance and prospects as a consequence of the
actions it has undertaken; the entity’s development of knowledge-­based assets; etc.

There are four core contents in the disclosures:

• governance,

• strategy,

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• risk management,

• metrics and targets.

The sustainability-­related financial disclosures shall be reported at the same time as

the entity’s related financial statements and for the same reporting period as the financial
statements.

36.4.1.2 IFRS 2 S2 Climate-­related Disclosures (S2)

The purpose of S2 is to require an entity to disclose information about its exposure to
significant climate-­related risks and opportunities, enabling users of an entity’s general-­purpose
financial reporting to assess the effects of such risks and opportunities when they assess
enterprise value, to understand the use of resources, and corresponding inputs, activities,
outputs and outcomes of the entity and to evaluate the entity’s ability to adapt its planning,
business model and operations to significant climate-­related risks and opportunities. An entity
is required to detail the impact of climate-­related risks and opportunities to enable users to
understand the governance processes, controls and procedures used to monitor and manage
climate-­related risks and opportunities. This includes information about the governance
body with oversight of climate-­related risks and opportunities. The disclosure requirements
are based on the recommendation of the TCFD but more detailed disclosure is required. It
proposes seven cross-­industry metric categories that all entities would be required to disclose:
• an absolute basis and intensity basis for greenhouse gas emissions;

• transition risks;

• physical risks;

• climate-­related opportunities;

• capital deployment towards climate-­related risks and opportunities;

• internal carbon pricing; and

• the percentage of executive management remuneration that is linked to climate-­related

consideration.

Qualitative disclosure about the current and anticipated effects of significant climate-­
related risks and opportunities on an entity’s value chain is required.

With the continuous development of ISSB standards to align ESG reporting, investors will be
able to compare the ESG disclosures similar to financial disclosures.

36.4.2 New HKEx Guidance

HKEx published the Guidance on Climate Disclosures in November 2021 to help companies
assess their response to risks arising from climate change. This guidance assists issuers in
preparing the Task Force on Climate-­related Financial Disclosures-­aligned (TCFD) climate
change reporting.

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Knowledge Check Questions

Question 6
Identify the challenges of ESG and sustainability reporting.

Question 7
Explain whether a HKEx listed company should respond to every ‘comply or explain’
provision in the Guide.

Question 8
Explain whether sustainability is beneficial to the corporates that issue such reports, or is it
for the benefit of investors and other stakeholders.

Question 9
If a HKEx listed company is not incorporated in Hong Kong, explain whether it is still
mandatory for it to comply with Schedule 5 of the CO.

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SUMMARY

• Sustainability has a broader meaning that encompasses the CSR and ESG.

• The ESG is the most commonly used term in Hong Kong as it is adopted by the HKEx.

• The ESG and its reporting has now moved to the mainstream in the capital market.

• Many global initiatives promote sustainability and ESG performance and reporting.

• The GRI developed one of the first sustainability standards, and it is probably the most
widely adopted by corporates worldwide. The GRI made its Standards available for free to all
companies.

• The TCFD’s Recommendations on climate-related financial disclosures for use by companies

in providing information to investors, lenders, insurers and other stakeholders are the most
recent guidance that have been widely endorsed by governments and regulators around the
world, including Hong Kong.

• The IIRC promotes integrated reporting and has released the first Integrated Reporting
Framework in 2013.

• Since 2016, Hong Kong’s listed companies must report on ESG.

• Since 2014, Hong Kong’s Companies Ordinance (CO) requires a Hong Kong company (unless
exempt) to prepare a business review in its directors’ report consisting environmental and social
information. Since 2016, this requirement has been incorporated into HKEx’s Listing Rules (LR).

• The HKEx’s current Guide was implemented in 2022. Whilst all listed companies must issue
ESG Reports, their disclosure obligation in respect of each provision in the Guide is either
‘comply or explain’ or voluntary.

• ESG reports must be published at the same time as annual reports for financial years
commencing on or after 1 January 2022.

• The HKEx New Guide has been amended to incorporate elements of the TCFD
recommendations such as requiring board’s oversight of ESG matters, targets for certain
environmental KPIs and disclosure of impact of significant climate-related issues.

• Climate change issues have gained increasing attention, particularly following on from the
Paris Agreement signed 4 November 2016.

• Integrated reporting is preferred by investors and is likely to be the future of sustainability

reporting.

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MIND MAP
GLOBAL SUSTAINABILITY INITIATIVES INTEGRATED REPORTING
AND FRAMEWORKS
Communication about company’s strategy,
Increasing Importance of Business governance, performance and prospects
Sustainability and Reporting leading to value creation
• Investor demand Framework:
• Regulatory requirements • Guiding Principles:
• Supply chain influence - Strategic focus and future orientation;
• Increased awareness of corporate leaders - Connectivity of information;
Global Initiatives - Stakeholder relationship;
• United Nations Global Compact (UNGC) and - Materiality;
United Nations Sustainable Development Goals - Conciseness;
(UNSDGs) - Reliability and completeness; and
• Global Reporting Initiative (GRI) - Consistency and comparability
• International Integrated Reporting • Six Capitals:
Council (IIRC) - Financial
• Climate Disclosure Standards Board (CDSB) - Manufactured
and Carbon Disclosure Project (CDP) - Intellectual
• Task Force on Climate-related Financial - Human
Disclosure (TCFD) - Social and relationship
• International Sustainability Standards Board (ISSB) - Natural
INTEGRATED
REPORTING/
SUSTAINABILITY
REPORTING

SUSTAINABILITY AND ESG REPORTING

IN HONG KONG CURRENT DEVELOPMENT
HKEx’s ESG Reporting Guide – Mandatory reporting HKEx’s New ESG Guide
• Board’s Responsibility • IFRS S1 General Requirements for Disclosure
• Reporting Principles of Sustainability-related Financial Information (S1)
HKEx’s ESG Reporting Guide – Comply or Explain provisions • IFRS 2 S2 Climate-related Disclosures (S2)
• Subject Areas • Guidance on Climate Disclosures published
• Aspects by HKEx
• General Disclosures
• KPIs
Companies Ordinance (Cap.622)

Answers to Knowledge Check Questions

Question 1
Zoom Ltd should refer to TCFD Recommendations, CDP and GRI Standards which contain
guidance for disclosures on climate change-related risks and their financial impacts.

Question 2
Yes, a company may adopt multiple standards. However, for a company listed on the
HKEx, it must report on the Guide even if it reports in accordance with international
initiatives, such as the GRI Standards, IIRC Framework or TCFD recommendations. Each of
the standards, recommendations and framework are different just as different companies
in different industries have different ESG concerns. It also depends on what types of
information that a company’s main stakeholders want to see. The company should choose
the standards, recommendations and framework most appropriate to it.

Question 3
The organisations’ publications are:
GRI: ‘GRI Standards’ issued in October 2021 and became effective on 1 January 2023.

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 Integrated R eporting / S ustainab ilit y R eporting

IIRC: International Integrated Reporting Council Framework published in December 2013.

TCFD: Final Recommendations Report published in June 2017.
HKEx: ESG Reporting Guide that forms part of its Listing Rules. Current version was
updated in 2021, effective from January 2022.

Question 4
Integrated reporting includes financial and non-financial information, providing greater
context for the company’s performance. It encourages integrated thinking at the board
level to enable the company to make better decisions. A sustainability and ESG Report
usually only includes the company’s ESG considerations.

Question 5
Integrated reporting is preferred by investors because it includes financial and non-financial
information, and therefore, provides greater context for the company’s performance. It
is designed to encourage integrated thinking, particularly at board level, to enable the
company to make better decisions.

Question 6
Potential challenges of sustainability reporting
(a) Though long-established accounting and auditing standards exist, sustainability
standards are new and lack consistency;

(b) Concerns that unaudited ESG information and KPIs may attract liabilities if
inaccurate;

(c) ESG information disclosure would create increased expectations on future

performance improvement, which may be difficult to achieve; and

(d) It is difficult to disclose concise, accurate, reliable, complete and comparable ESG
information that is relevant and useful to all stakeholders.

Question 7
The HKEx listed company must respond to each of the ‘comply or explain’ provisions in
the Guide, but it does not need to disclose on the information/data if the subject matter
is not material to the company’s operations. The listed company is expected to conduct
materiality assessment and only disclose on matters that are material. For example, KPI
A.3.1 of the Guide requires disclosure on a ‘comply or explain’ basis ‘significant impacts
of activities on the environment and natural resources and the actions taken to manage
them’. If the company’s operations do not have such significant impacts, it should disclose
this fact rather than make irrelevant disclosure.

Question 8
Sustainability is beneficial to the reporting corporate as well as to investors and other
stakeholders. The process of ESG reporting enables the company to identify ESG risks and
opportunities early so it can manage the risks better, and the company can benefit from
the opportunities. It also allows the company and its board to understand the company’s
operations better and communicate with stakeholders through the engagement process,
thereby contributing to the company’s long-term sustainability.

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 FINANCIAL REPORTING

Question 9
If the company is not incorporated in Hong Kong but listed on the HKEx, it is still subject to
Schedule 5 of the Hong Kong Companies Ordinance (CO), as this section of the CO has been
incorporated into the Listing Rules.

EXAM PRACTICE

QUESTION 1
ABC Ltd’s business involves manufacturing and sourcing low-cost garments for large
international retail chains. It’s headquarter is based in Hong Kong, with manufacturing plants
and factories based in Mainland China, Vietnam and Laos.

The manufacturing process includes colour dying garments that requires water, and it
has to deal with releasing used water from the manufacturing process into the local rivers
and employing low waged workers. Occasionally, the manufacturing process could be under
a tight time frame due to a rush to complete orders.

The board has to consider and identify the risks and opportunities associated with its
business strategy.

Required:

(a) Describe the role and responsibility of ABC Ltd’s board in ESG reporting.

(b) ABC Ltd is working on its materiality assessment process. It is considering the potential
stakeholders for the purpose of engagement. List five potential groups of stakeholders
and explain your choice.

(c) List three possible environmental issues that may affect the company that ABC Ltd
should seek stakeholders’ views.

(d) List three possible social issues that may affect the company should ABC Ltd seek
stakeholders’ views.

(e) Explain how the company should determine which potential issues are material.

(f) Once a list of issues are determined to be material, explain what the company
should do next.

QUESTION 2
DFE Group is a construction company based in Hong Kong with subsidiaries in Hong Kong
and Mainland China. Its business includes building residential complexes in Hong Kong and
Mainland China.

Last year, one of its subsidiaries in Hong Kong had a bad year in terms of workplace
safety, with a fatal accident and a couple of serious injuries at the subsidiary’s building site.
One of its senior managers in the Hong Kong operation was also found guilty of corruption by
taking bribes from a contractor in breach of the Prevention of Bribery (POB) Ordinance.

Required:

(a) Explain how the company should set its reporting boundary.

(b) List two of the potential environmental issues or risks faced by the company.

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 Integrated R eporting / S ustainab ilit y R eporting

(c) Identify two of the potential social issues facing the company.

(d) Explain whether the company should keep the fatality, the injuries and the breach of
the POB Ordinance quiet in its ESG Report to avoid damaging its reputation.

ANSWERS TO EXAM PRACTICE

QUESTION 1
(a) The board has overall responsibility for the company’s ESG strategy and reporting. The
board is responsible for evaluating and determining the company’s ESG-related risks
and ensuring that appropriate and effective ESG risk management and internal control
systems are in place.

(b) The following five groups of potential stakeholders should be engaged:

(i) Relevant local authorit(ies) in charge of water supply to ABC Ltd’s factories. Water
supply is crucial to the company’s operations, and securing the supply or knowing
its potential shortage may enable the company to mitigate the risk of disruption to
its production.
(ii) Employees, especially the low-wage workers. Feedbacks about their working
conditions, including health and safety considerations, whether they are getting
paid a fair wage, whether there is any child labour, and so on.
(iii) Investors. The issues they may care about in relation to the company, what
information and data they would like to see in terms of the company’s
ESG reporting. For instance, how does the company evaluate and manage
environmental risks, such as water shortage, and so on.
(iv) Supply chain partners. The company may need to enquire about its suppliers’ ESG
practice as poor ESG performance of may indirectly impact on the company’s own
ESG performance.
(v) Customers. The company may need to find out what its significant customers
care about in terms of ESG. For example, if the buyer of the company’s garments
is an international brand, it may have an interest in the company’s labor practice
among others.
(c) Potential environmental issues:

• The company’s operations have an impact on the environment in terms of use of

water, and it may be affected by a shortage of water, which is a type of natural
resources;

• There may be pollution from discharge of waste water; and

• The transportation of the garments will also have an impact on the environment
due to emissions of greenhouse gas.

(d) Potential social issues:

• Health and safety of the low-wage workers;

• Child labour – particularly those operations based in developing countries; and

• Product responsibility – is there a risk that materials used for the production may
contain harmful chemicals?

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 FINANCIAL REPORTING

(e) The company should conduct materiality assessment by engaging with stakeholders.
The process should include engaging with internal (e.g. employees) and external
(e.g. customers, clients, suppliers, investors/shareholders, governments/regulators, etc).
The stakeholders should be chosen on the basis that their views are most important
in relation to the ESG issues identified by the board. Having identified all the relevant
stakeholders, dependent on the company’s resources, it should reduce the list to a key
stakeholders’ list. The company should then decide on the most effective engagement
methods, which could include requests stakeholders to provide written comments or
responses to questionnaire, telephone interviews, meetings or workshops, and so on.

(f) The board’s oversight of the identification and management of the issues should
be included in the ESG Report, along with other information and data as required
by the Guide and other standards, recommendations and framework, if adopted by
the company.

Having determined the material ESG issues, the company should make plans
for mitigation and prevention, including setting targets and goals. If emissions of
greenhouse gas is of a particular concern in relation to the company’s business
operations, the company may wish to set a target for reducing the gases for the
coming year and explain in the ESG Report the ways in which it may be mitigated.
For instance, the company may choose a more environmentally friendly fuel for its
production process.

QUESTION 2
(a) The company must not exclude its poorly performing entities or operations from the
ESG Report without explanation because investors may be kept in the dark about the
company’s overall performance. The company should consider whether the entities or
operations have a material ESG impact, and if so, its information and data should be
disclosed in the ESG Report.

(b) Potential environmental issues, any of the following:

• emissions and pollutions caused by the construction process;

• physical risks from climate change, such as typhoon, floods; and

• transition risks such as change in policy and laws on building standards.

(c) Potential social issues, any of the following:

• health and safety of the workers;

• disturbance to the local community; and

• anti-corruption issues.

(d) The company should not keep quiet about the bad news on its ESG performance
from the ESG Report. One of the Reporting Principles is that the company must give
a balanced picture of its ESG performance. Any challenges should be disclosed and
explained, preferably with plans for improvement.

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 G l o s s a r y o f T er m s

G LOSSARY OF T ERMS

acceptable level a level at which a professional business an integrated set of activities and assets
accountant using the reasonable and informed that is capable of being conducted and managed
third party test would likely conclude that the for the purpose of providing goods and services
accountant complies with the fundamental to customers, generating investment income
principles. (such as dividends or interest) or generating other
accounting profit The profit or loss for a period income from ordinary activities.
before deducting tax expense. business combination a transaction or other
acquiree the business or businesses that the event in which an acquirer obtains control of one
acquirer obtains control of in a business or more businesses. Transactions sometimes
combination. referred to as ‘true mergers’ or ‘mergers of equals’
acquirer the entity that obtains control of the are also business combinations as that term is
acquiree. used in HKFRS 3 (Revised).

acquisition date the date on which the acquirer business ethics principles and practices to guide
obtains control of the acquiree. professional behaviour in business situations.

active market a market in which transactions for businesses under common control all of the
the asset or liability take place with sufficient entities or businesses are ultimately controlled by
frequency and volume to provide pricing the same party or parties both before and after
information on an ongoing basis. the business combination, and that control is not
transitory.
agricultural activity The management by an
entity of the biological transformation and harvest carrying amount the amount at which an asset is
of biological assets for sale or for conversion into recognised after deducting any accumulated
agricultural produce or into additional depreciation and accumulated impairment losses.
biological assets. capitalisation rate the weighted average of the
agricultural produce The harvested produce of borrowing costs applicable to all borrowings of
the entity’s biological assets. the entity that are outstanding during the period.
However an entity shall exclude from the
amortisation the systematic allocation of the
calculation borrowing costs applicable to
depreciable amount of an intangible asset over its
borrowings made specifically for the purpose of
useful life.
obtaining a qualifying asset until substantially all
associate an entity over which the investor has the activities necessary to prepare that asset for
significant influence. its intended use or sale are complete.
bearer plant A living plant that: cash-generating unit the smallest identifiable
• is used in the production or supply of group of assets that generates cash inflows that
agricultural produce are largely independent of the cash inflows from
• is expected to bear produce for more than other assets or groups of assets.
one period; and change in accounting estimates A change in
• has a remote likelihood of being sold as accounting estimate is an adjustment of the
agricultural produce except for incidental carrying amount of an asset or a liability, or the
scrap sales. amount of the periodic consumption of an asset,
biological asset A living animal or plant that results from the assessment of the present
biological transformation Comprises the status of, and expected future benefits and
processes of growth, degeneration, production, obligations associated with, assets and liabilities.
and procreation that cause qualitative or Changes in accounting estimates result from new
quantitative changes in a biological asset (refer information or new developments and,
below for further discussion). accordingly, are not corrections of errors.

borrowing costs interest and other costs that an chief operating decision maker the function
entity incurs in connection with the borrowing within an entity responsible for allocating
of funds.

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 FINANCIAL REPORTING

resources to and assessing the performance of (a) by an established pattern of past practice,
the entity’s operating segments. published policies or a sufficiently specific
climate change risks the TCFD Recommendations current statement, the entity has indicated
have classified climate change risks into two to other parties that it will accept certain
broad categories of risks: transition and physical. responsibilities; and
Transition risks are those relating to changes in (b) as a result, the entity has created a valid
policies, laws/regulations and market behavior. expectation on the part of those other parties
Physical risks include natural disasters, such as that it will discharge those responsibilities.
draught, severe storms, floods and persistent consolidated financial statements the financial
heat waves, etc. These risks may increase the statements of a group in which the assets,
company’s operating, compliance and other costs. liabilities, equity, income, expenses and cash
close members of the family of a person those flows of the parent and its subsidiaries are
family members who may be expected to presented as those of a single economic entity.
influence, or be influenced by, that person in their contingent consideration usually, an obligation
dealings with the entity. of the acquirer to transfer additional assets or
closing rate the spot exchange rate at the end of equity interests to the former owners of an
the reporting period acquiree as part of the exchange for control of the
code of ethics documented standards that acquiree if specified future events occur or
establish behavioural expectations and conditions are met. However, contingent
requirements to ensure business is conducted consideration also may give the acquirer the right
ethically. to the return of previously transferred
commencement date the date on which a lessor consideration if specified conditions are met.
makes an underlying asset available for use by contract an agreement between two or more
a lessee. parties that creates enforceable rights and
compensation includes all employee benefits (as obligations.
defined in HKAS 19 Employee Benefits) including contract asset an entity’s right to consideration in
employee benefits to which HKFRS 2 Share-based exchange for goods or services that the entity has
Payment applies. Employee benefits are all forms transferred to a customer when that right is
of consideration paid, payable or provided by the conditioned on something other than the
entity, or on behalf of the entity, in exchange for passage of time.
services rendered to the entity. It also includes contract liability an entity’s obligation to transfer
such consideration paid on behalf of a parent of goods or services to a customer for which the
the entity in respect of the entity. entity has received consideration (or the amount
component of an entity operations and cash is due) from the customer.
flows that can be clearly distinguished, contractual service margin A component of the
operationally and for financial reporting carrying amount of the asset or liability for a
purposes, from the rest of the entity. group of insurance contracts representing the
condensed financial statement is a financial unearned profit the entity will recognise as it
statement that includes, at a minimum, each of provides services under the insurance contracts in
the headings and subtotals that were included in the group.
its most recent annual financial statements and control of an investee an investor controls an
the selected explanatory notes as required by investee when the investor is exposed, or has
HKAS 34. Additional line items or notes shall be rights, to variable returns from its involvement
included if their omission would make the with the investee and has the ability to affect
condensed interim financial statements those returns through its power over the
misleading. investee.
confidentiality to protect sensitive information corporate assets assets other than goodwill that
acquired as a result of professional and business contribute to the future cash flows of both the
relationships. cash-generating unit under review and other
conflicts of interest a situation in which a party cash-generating units.
has competing and conflicting interests. corporate social responsibility (CSR) this term is
constructive obligation an obligation that derives often used interchangeably with ESG, although
from an entity’s actions where:

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 G l o s s a r y o f T er m s

companies listed on HKEX tend to use ESG as it is defined contribution plans an arrangement
the term used in the Guide. whereby the employer pays fixed contributions
cost the amount of cash or cash equivalents paid into a separate fund and has no legal or
or the fair value of the other consideration given constructive obligation to make further
to acquire an asset at the time of its acquisition or contributions if the fund does not hold sufficient
construction or, where applicable, the amount assets to pay all employee benefits
initially recognised in accordance with depreciable amount the cost of an asset, or other
another HKFRS. amount substituted for cost, less its
costs of disposal incremental costs directly residual value.
attributable to the disposal of an asset or cash- depreciation the systematic allocation of the
generating unit, excluding finance costs and depreciable amount of an asset over its useful life.
income tax expense. designation the process of identifying a
costs to sell the incremental costs directly relationship between a hedged item and a
attributable to the disposal of an asset (or qualifying (hedging) instrument for the purposes
disposal group), excluding finance costs and of applying hedge accounting.
income tax expense. derivative a financial instrument or other contract
coverage period The period during which the within the scope of this standard with all three of
entity provides coverage for insured events. This the following characteristics.
period includes the coverage that relates to all 1. its value changes in response to the change
premiums within the boundary of the insurance in a specified interest rate, financial
contract. instrument price, commodity price, foreign
credit loss the difference between all contractual exchange rate, index of prices or rates,
cash flows that are due to an entity in accordance credit rating or credit index, or other
with the contract and all the cash flows that the variable provided in the case of a non-
entity expects to receive (i.e. all cash shortfalls), financial variable that the variable is not
discounted at the original effective interest rate specific to a party to the contract
(or credit-adjusted effective interest rate for (sometimes called the underlying).
purchased or originated credit-impaired 2. it requires no initial net investment or an
financial assets). initial net investment that is smaller than
credit risk the risk that one party to a financial would be required for other types of
instrument will cause a financial loss for the other contracts that would be expected to have a
party by failing to discharge an obligation. similar response to changes in
current tax The amount of income taxes payable market factors.
(recoverable) with respect to the taxable profit 3. it is settled at a future date.
(tax loss) for a period. development the application of research findings
customer a party that has contracted with an or other knowledge to a plan or design for the
entity to obtain goods or services that are an production of new or substantially improved
output of the entity’s ordinary activities in materials, devices, products, processes, systems
exchange for consideration. or services before the start of commercial
decision maker an entity with decision-making production or use.
rights that is either a principal or an agent for discontinued operation a component of an entity
other parties. that has been disposed of or is classified as held
deferred tax assets The amounts of income taxes for sale and:
recoverable in future periods with respect to: (a) represents a separate major line of business
(a) deductible temporary differences; or geographical area of operations,
(b) the carryforward of unused tax losses; and (b) is part of a single co-ordinated plan to
(c) the carryforward of unused tax credits. dispose of a separate major line of business
or geographical area of operations or
deferred tax liabilities The amounts of income
taxes payable in future periods with respect to (c) is a subsidiary acquired exclusively with a
taxable temporary differences. view to resale.

defined benefit plan post-employment benefit disposal group a group of assets to be disposed
plans other than defined contribution plans. of, by sale or otherwise, together as a group in a
single transaction, and liabilities directly

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 FINANCIAL REPORTING

associated with those assets that will be ethics conceptual framework structured ethical
transferred in the transaction. The group guidance for professionals to apply the
includes goodwill acquired in a business fundamental principles of ethics to various
combination if the group is a cash-generating business situations.
unit to which goodwill has been allocated in events after the reporting period those events,
accordance with the requirements of paragraphs favourable and unfavourable, that occur
80–87 of HKAS 36 Impairment of Assets or if it is between the end of the reporting period and the
an operation within such as a cash- date when the financial statements are
generating unit. authorised for issue. Two types of events can be
effective interest method (EIM) the method that identified:
is used in the calculation of the amortised cost of Those that provide evidence of conditions that
a financial asset or a financial liability and in the existed at the end of the reporting period
allocation and recognition of the interest revenue (adjusting events after the reporting period); and
or interest expense in profit or loss over the Those that are indicative of conditions that arose
relevant period. after the reporting period (non-adjusting events
effective interest rate the rate that exactly after the reporting period).
discounts estimated future cash payments or exchange difference the difference resulting from
receipts through the expected life of the financial translating a given number of units of one
asset or financial liability to the gross carrying currency into another currency at different
amount of a financial asset or to the amortised exchange rates.
cost of a financial liability.
exchange rate the ratio of exchange for two
employee benefits all forms of consideration currencies.
given by an entity in exchange for service
expected credit losses the weighted average of
rendered by employees or for the termination of
credit losses with the respective risks of a default
employment.
occurring as the weights.
environmental, social and governance (ESG) in
exploration and evaluation (E&E) assets
the context of the HKEX’s Guide, it refers to
Comprises exploration and evaluation
environmental considerations (e.g. the company’s
expenditures which have been capitalised as
emissions, use of resources and the impacts of its
assets in accordance with the entity’s
operations on the environmental and natural
accounting policy.
resources) and social considerations (e.g.
employment and labour practices, development exploration and evaluation (E&E) expenditures
and training, supply chain management, product Costs incurred by an entity in connection with the
responsibility, anti-corruption and community exploration for and evaluation of mineral
investment). resources before the technical feasibility and
commercial viability of extracting a mineral
equity instrument an equity instrument is any
resource has been demonstrated.
contract that evidences a residual interest in the
assets of an entity after deducting all of its exploration and evaluation (E&E) of mineral
liabilities. resources The process of searching for mineral
resources, including minerals, oil, natural gas and
equity method a method of accounting whereby
similar nonregenerative resources after the entity
the investment is initially recognised at cost and
has obtained legal rights to explore in a specific
adjusted thereafter for the post-acquisition
area as well as the determination of the technical
change in the investor’s share of the investee’s net
feasibility and commercial viability of extracting
assets. The investor’s profit or loss includes its
the mineral resource.
share of the investee’s profit or loss and the
investor’s other comprehensive income includes fair value the amount for which an asset could be
its share of the investee’s other exchanged, or a liability settled, between
comprehensive income. knowledgeable, willing parties in an arm’s length
transaction.
ethical safeguards controls to prevent, detect,
and mitigate ethical dilemmas. finance lease a lease that transfers substantially
all the risks and rewards incidental to ownership
ethical threats situations in which there is a
of an underlying asset.(ch9)
potential for a breach to the fundamental
principles of ethics.

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 G l o s s a r y o f T er m s

financial asset a financial asset is any ° to exchange financial assets or financial

asset that is: liabilities with another entity under
• cash; conditions that are potentially
• an equity instrument of another entity; unfavourable to the entity; or

• a contractual right: • a contract that will or may be settled in the

entity’s own equity instruments and is:
° to receive cash or another financial asset
from another entity; or ° a non-derivative for which the entity is or
may be obliged to deliver a variable
° to exchange financial assets or financial number of the entity’s own equity
liabilities with another entity under
instruments; or
conditions that are potentially favourable
to the entity; or ° a derivative that will or may be settled
other than by the exchange of a fixed
• a contract that will or may be settled in the
amount of cash or another financial asset
entity’s own equity instruments and is:
for a fixed number of the entity’s own
° a non-derivative for which the entity is or equity instruments. For this purpose,
may be obliged to receive a variable rights, options, or warrants to acquire a
number of the entity’s own equity fixed number of the entity’s own equity
instruments; or instruments for a fixed amount of any
° a derivative that will or may be settled other currency are equity instruments if the
than by the exchange of a fixed amount of entity offers the rights, options, or
cash or another financial asset for a fixed warrants pro rata to all of its existing
number of the entity’s own equity owners of the same class of its own
instruments. For this purpose, the entity’s non-derivative equity instruments. Also,
own equity instruments do not include for these purposes, the entity’s own equity
puttable financial instruments classified as instruments do not include puttable
equity instruments in accordance with financial instruments that are classified as
Paragraphs 16A and 16B, instruments that equity instruments in accordance with
impose on the entity an obligation to deliver Paragraphs 16A and 16B, instruments that
to another party a pro rata share of the net impose on the entity an obligation to
assets of the entity only on liquidation and deliver to another party a pro-rata share of
are classified as equity instruments in the net assets of the entity only on
accordance with Paragraphs 16C and 16D, liquidation and are classified as equity
or instruments that are contracts for the instruments in accordance with
future receipt or delivery of the entity’s own Paragraphs 16C and 16D, or instruments
equity instruments. that are contracts for the future receipt or
financial guarantee contract a contract that delivery of the entity’s own equity
requires the issuer to make specified payments to instruments.
reimburse the holder for a loss it incurs because a financial risk The risk of a possible future change
specified debtor fails to make payment when due in one or more of a specified interest rate,
in accordance with the original or modified terms financial instrument price, commodity price,
of a debt instrument. currency exchange rate, index of prices or rates,
financial instrument a financial instrument is any credit rating or credit index or other variable,
contract that gives rise to a financial asset of one provided in the case of a non-financial variable
entity and a financial liability or equity instrument that the variable is not specific to a party to the
of another entity. contract.
financial interests ownership of stock shares, foreign currency currency other than the
physical or intangible assets, or other sources of functional currency of the entity
potential future financial gain. foreign currency transaction a transaction that is
financial liability a financial liability is any denominated or requires settlement in a foreign
liability that is: currency, including transactions arising when an
• a contractual obligation: entity:buys or sells goods or services whose price
is denominated in a foreign currency;
° to deliver cash or another financial asset to
another entity; or

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 FINANCIAL REPORTING

• borrows or lends funds when the amounts government grants are assistance by government
payable or receivable are denominated in a in the form of transfers of resources to an entity in
foreign currency; or return for past or future compliance with certain
• otherwise acquires or disposes of assets, or conditions relating to the operating activities of the
incurs or settles liabilities, denominated in a entity. They exclude those forms of government
foreign currency. assistance that cannot reasonably have a value
foreign operation an entity that is a subsidiary, placed upon them and transactions with
associate, joint arrangement, or branch of a government that cannot be distinguished from the
reporting entity, the activities of which are based normal trading transactions of the entity.
or conducted in a country or currency other than grants related to assets are government grants
those of the reporting entity. whose primary condition is that an entity
forgivable loans are loans which the lender qualifying for them should purchase, construct, or
undertakes to waive repayment of under certain otherwise acquire long-term assets. Subsidiary
prescribed conditions. conditions may also be attached restricting the
type or location of the assets or the periods
fulfilment cash flows An explicit, unbiased and
during which they are to be acquired or held.
probability-weighted estimate (i.e. expected value)
of the present value of the future cash outflows grants related to income are government grants
minus the present value of the future cash inflows other than those related to assets.
that will arise as the entity fulfils insurance gross investment in the lease the sum of:
contracts, including a risk adjustment for non- (a) the lease payments receivable by a lessor
financial risk. under a finance lease; and
functional currency the currency of the primary (b) any unguaranteed residual value accruing to
economic environment in which the entity the lessor.
operates. group a parent and its subsidiaries
function of expense (or ‘cost of sales’) harvest The detachment of produce from a
method expenses classified according to their biological asset or the cessation of a biological
function as part of cost of sales or, for example, as asset’s life processes.
distribution costs or administrative expenses. This highest and best use the use of a non-financial
method may provide more relevant information to asset by market participants that would maximise
users, but allocating costs to functions may require the value of the asset or the group of assets and
arbitrary allocations and judgement. liabilities (e.g. a business) within which the asset
general-purpose financial statements financial would be used.
statements that are intended to meet the needs highly probable significantly more likely than
of users who are not in a position to require an probable.
entity to prepare reports tailored to their
historical cost convention: The basis of
particular information needs.
accounting where assets are recorded at the
goodwill an asset representing the future amount of cash or cash equivalents paid or the fair
economic benefits arising from other assets value of the consideration given to acquire them at
acquired in a business combination that are not the time of their acquisition; and liabilities are
individually identified and separately recognised. recorded at the amount of proceeds received in
government government, government agencies exchange for the obligation, or in some
and similar bodies whether local, national or circumstances (for example, income taxes), at the
international. amounts of cash or cash equivalents expected to
government assistance is action by government be paid to satisfy the liability in the normal course
designed to provide an economic benefit specific of business.
to an entity or range of entities qualifying under impairment loss the amount by which the
certain criteria. Government assistance for the carrying amount of an asset or a cash-generating
purpose of this standard does not include unit exceeds its recoverable amount.
benefits provided only indirectly through action impracticable Applying a requirement is
affecting general trading conditions, such as the impracticable when the entity cannot apply it
provision of infrastructure in development areas after making every reasonable effort to do so. For
or the imposition of trading constraints on a particular prior period, it is impracticable to
competitors. apply a change in an accounting policy

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 G l o s s a r y o f T er m s

retrospectively or to make a retrospective and prospects, in the context of its external

restatement to correct an error if: environment, lead to the creation of value in the
(a) the effects of the retrospective application short, medium and long term.’ Integrated reporting
or retrospective restatement are not means presentation of a company’s performance in
determinable; terms of both financial and non-financial
(b) the retrospective application or information, providing a greater context for the
retrospective restatement requires company’s performance. It encourages integrated
assumptions about what management’s thinking, particularly at board level, to enable the
intent would have been in that period; or company to make better decisions.

(c) the retrospective application or interest rate implicit in the lease the rate of
retrospective restatement requires interest that causes the present value of (a) the
significant estimates of amounts and it is lease payments and (b) the unguaranteed
impossible to distinguish objectively residual value to equal the sum of (i) the fair value
information about those estimates that: of the underlying asset and (ii) any initial direct
costs of the lessor.
(i) provides evidence of circumstances that
existed on the date(s) as at which those interim financial report is a financial report
amounts are to be recognised, containing either a complete set of financial
measured, or disclosed; and statements or a set of condensed financial
statements for an interim period.
(ii) would have been available when the
financial statements for that prior interim period is a financial reporting period
period were authorised for issue from shorter than a full financial year.
other information. International Accounting Standards Board
inception date the earlier of the date of a lease (IASB) The IASB is an independent, private-sector
agreement and the date of commitment by the body that develops and approves International
parties to the principal terms and conditions of Financial Reporting Standards (IFRS). Its primary
the lease. role is to have complete responsibility for all IASB
technical matters, including preparing and issuing
independence performing professional
the IFRS (other than interpretation) and exposure
responsibilities with objectivity and without the
drafts, each of which is required to include any
influence of others.
dissenting opinions; and final approval of and
inducement an object, situation, or action that is issuing interpretations developed by the
used as a means to influence another individual’s Interpretations Committee.
behaviour, but not necessarily with the intent to
International Financial Reporting Standards
improperly influence that individual’s behaviour.
Interpretation Committee (IFRS IC) The IFRS IC
initial direct costs incremental costs of obtaining is the interpretative body of the IASB. The IFRS IC
a lease that would not have been incurred if the works with the IASB in supporting the application
lease had not been obtained, except for such of the IFRS. The IFRS IC responds to questions
costs incurred by a manufacturer or dealer lessor about the application of the IFRS and does other
in connection with a finance lease. work at the request of the IASB.
insurance contracts A contract under which one inventories assets:
party (the issuer) accepts significant insurance risk
• Held for sale in the ordinary course
from another party (the policyholder) by agreeing
of business;
to compensate the policyholder if a specified
uncertain future event (the insured event) • In the process of production for such sale; or
adversely affects the policyholder. • In the form of materials or supplies to be
insurance risk Risk, other than financial risk, consumed in the production process or in the
transferred from the holder of a contract to rendering of services.
the issuer. investment property property (land, a building or
integrity to be straightforward and honest in all part of a building, or both) held (by the owner or
professional and business relationships. by the lessee as a right-of-use asset) to earn
rentals, for capital appreciation, or both
intangible asset an identifiable non-monetary
rather than for:
asset without physical substance.
• use in the production or supply of goods or
integrated reporting integrated reporting has been
services or for administrative purposes; or
defined as ‘a concise communication about how an
organisation’s strategy, governance, performance • sale in the ordinary course of business.

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 FINANCIAL REPORTING

joint arrangement an arrangement of which two have not been reported, and other incurred
or more parties have joint control. insurance expenses.
joint control the contractually agreed sharing of liability for incurred claims An insurer’s
control of an arrangement, which exists only obligation to handle and pay valid claims for
when decisions about the relevant activities insured events that have occurred, including
require the unanimous consent of the parties those that are estimated to have occurred but
sharing control. have yet to be reported to the insurer.
joint operation a joint arrangement whereby the liability for remaining coverage An entity’s
parties that have joint control of the arrangement obligation to investigate and pay valid claims
have rights to the assets, and obligations for the under existing insurance contracts for insured
liabilities, relating to the arrangement. events that have not yet occurred (i.e. the
joint operator a party to a joint operation that has obligation that relates to the unexpired portion of
joint control of that joint operation. the coverage period).
joint venture a joint arrangement whereby the market participants Buyers and sellers in the
parties that have joint control of the arrangement principal (or most advantageous) market for the
have rights to the net assets of the arrangement. asset or liability that have all of the following
joint venturer a party to a joint venture that has characteristics:
joint control of that joint venture. • they are independent of each other, i.e. they
key management personnel that person (or are not related parties as defined in HKAS 24
persons) having authority and responsibility for although the price in a related party
planning, directing and controlling the activities of transaction may be used as an input to a fair
the entity, directly or indirectly, including any value measurement if the entity has evidence
director (whether executive or otherwise) of that the transaction was entered into at
that entity. market terms;

lease a contract, or part of a contract, that conveys • they are knowledgeable, having a reasonable
the right to use an asset (the underlying asset) for understanding about the asset or liability and
a period of time in exchange for consideration. the transaction using all available
information, including information that might
lease payments payments made by a lessee to a
be obtained through due diligence efforts
lessor relating to the right to use an underlying
that are usual and customary;
asset during the lease term.
• they are able to enter into a transaction for
lease term the non-cancellable period for which a
the asset or liability; and
lessee has the right to use an underlying asset.
• they are willing to enter into a transaction for
legal obligation an obligation that derives from:
the asset or liability, ie they are motivated but
(a) a contract (through its explicit or not forced or otherwise compelled to do so.
implicit terms);
material Information is material if omitting,
(b) legislation; or misstating, or obscuring it could reasonably be
(c) other operation of law. expected to influence decisions that the primary
(d) material financial statement information users of general purpose financial statements
that, if omitted or misstated, could influence make on the basis of those financial statements,
the decisions made by users when using the which provide financial information about a
financial statements. specific reporting entity.
lessee an entity that obtains the right to use an materiality the threshold at which ESG issues
underlying asset for a period of time in exchange become sufficiently important to investors and
for consideration. other stakeholders that they should be reported
lessor an entity that provides the right to use an (for ESG Reporting Guide).
underlying asset for a period of time in exchange measurement period the period after the
for consideration. acquisition date during which the acquirer may
liability for incurred claims An entity’s adjust the provisional amounts recognised for a
obligation to investigate and pay valid claims for business combination.
insured events that have occurred, including monetary items units of currency held and assets
events that have occurred but for which claims and liabilities to be received or paid in a fixed or
determinable number of units of currency.

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 G l o s s a r y o f T er m s

most advantageous market relating to transactions with other

the market that maximises the amount that would components of the same entity),
be received to sell the asset or minimises the (b) whose operating results are regularly
amount that would be paid to transfer the reviewed by the entity’s chief operating
liability, after taking into account transaction costs decision maker to make decisions about
and transport costs. resources to be allocated to the segment
nature of expense method depreciation, and assess its performance, and
purchases of materials, transport costs, employee (c) for which discrete financial information is
benefits and advertising costs. This method is available.
simple to apply because no allocations of expenses orderly transaction a transaction that assumes
to functional classification is required. exposure to the market for a period before the
net investment in a foreign operation the measurement date to allow for marketing
amount of the reporting entity’s interest in the net activities that are usual and customary for
assets of that operation. transactions involving such assets or liabilities; it
net investment in the lease the gross investment is not a forced transaction (e.g. a forced
in the lease discounted at the interest rate implicit liquidation or distress sale).
in the lease. ordinary shares shares that are subordinate to all
net realisable value estimated selling price in the other classes of an entity’s issued securities.
ordinary course of business less the estimated other comprehensive income Other
costs of completion and the estimated costs comprehensive income comprises items of
necessary to make the sale. income and expense (including reclassification
non-controlling interest (NCI) equity in a adjustments) that are not recognised in
subsidiary not attributable, directly or indirectly, profit or loss as required or permitted by
to the parent. other HKFRSs.
notes (to financial statements) contain other long-term employee benefits all employee
information additional to that presented in the benefits other than short-term employee benefits,
statement of financial position, statement of post-employment benefits and termination
profit or loss and other comprehensive income, benefits.
statement of changes in equity and statement of owner-occupied property property held (by the
cash flows. owner or by the lessee as a right-of-use asset) for
obligating event an event that creates a legal or use in the production or supply of goods or
constructive obligation that results in an entity services or for administrative purposes
having no realistic alternative to settling that parent an entity that controls one or more
obligation. entities.
onerous contract a contract in which the performance obligation a promise in a contract
unavoidable costs of meeting the obligations with a customer to transfer to the
under the contract exceed the economic benefits customer either:
expected to be received under it. (a) a good or service (or a bundle of goods or
operating cycle the time between the acquisition services) that is distinct; or
of assets for processing and their realisation into (b) a series of distinct goods or services that are
cash or cash equivalents (i.e. short-term, highly substantially the same and that have the
liquid investments readily convertible to known same pattern of transfer to the customer.
amounts of cash and subject to an insignificant policyholder A party that has a right to
risk of changes in value). compensation under an insurance contract if an
operating lease a lease that does not transfer insured event occurs.
substantially all the risks and rewards incidental portfolio of insurance contracts Insurance
to ownership of an underlying asset. contracts subject to similar risks and managed
operating segment an operating segment is a together.
component of an entity: post-employment benefits employee benefits
(a) that engages in business activities from (other than termination benefits and short-term
which it may earn revenues and incur employee benefits) that are payable after the
expenses (including revenues and expenses completion of employment.

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 FINANCIAL REPORTING

post-employment benefit plans post-­ Ordinance to mean a listed corporation (equity) or

employment benefit plans are formal or informal a listed collective investment scheme.
arrangements under which an entity provides qualifying asset an asset that necessarily takes a
post-employment benefits for one or more substantial period of time to get ready for its
employees. intended use or sale.
potential ordinary shares instruments that give qualifying item a recognised asset or liability, an
the holder the right to ordinary shares and may unrecognised firm commitment, a forecast
include options, warrants or other instruments transaction, or a net investment in a foreign
such as convertible notes issued by the company operation, that can be hedged under the
to acquire ordinary shares. requirements of HKFRS 9.
preference shares shares that have special rights reclassification adjustments (or ‘recycling’)
not possessed by ordinary shares, and therefore amounts that were recognised in other
superior to ordinary shares. comprehensive income in previous years (or the
presentation currency the currency in which the current year) but are reclassified (or ‘recycled’) to
financial statements are presented. the current period’s profit or loss.
principal market the market with the greatest recoverable amount (asset or cash-generating
volume and level of activity for the asset or unit) the higher of its fair value less costs of
liability. disposal and its value in use.
private Entity An entity that does not have public refund liability an entity’s obligation to refund
accountability. consideration to customers.
probable more likely than not. related party a person or entity that is related to
profit or loss total of income less expenses, the entity that is preparing its financial
excluding the items of other comprehensive statements.
income. related party transaction a transfer of resources,
property, plant and equipment tangible services or obligations between a reporting entity
items that: and a related party, regardless of whether a price
• are held for use in the production or supply is charged.
of goods or services, for rental to others, or reportable segment an operating segment which
for administrative purposes; and satisfies quantitative threshold tests in HKFRS 8
• are expected to be used during more than and for which segment disclosure is required.
one period. research original and planned investigation
prospective application of a change in accounting undertaken with the prospect of gaining new
policy and of recognising the effect of a change in scientific or technical knowledge and
an accounting estimate, respectively, are: understanding.

(a) applying the new accounting policy to residual value guarantee a guarantee made to a
transactions, other events and conditions lessor by a party unrelated to the lessor that the
occurring after the date as at which the value (or part of the value) of an underlying asset
policy is changed; and at the end of the lease will be at least a
specified amount.
(b) recognising the effect of the change in the
accounting estimate in the current and restructuring a programme that is planned and
future periods affected by the change. controlled by management, and materially
changes either:
public accountability: an entity that has debt or
equity instruments traded in a public market or is (a) the scope of a business undertaken by an
in the process of issuing such instruments for entity; or
trading in a public market; or holds assets in a (b) the manner in which the business is
fiduciary capacity for a broad group of outsiders conducted.
as one of its primary businesses (most banks, residual value the estimated amount that an entity
credit unions, insurance companies, securities would currently obtain from disposal of the asset,
brokers/dealers, mutual funds and investment after deducting the estimated costs of disposal, if
banks would meet this latter criterion). the asset were already of the age and in the
public interest entity (PIE) defined in the condition expected at the end of its useful life.
Financial Reporting Council (Amendment)

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 G l o s s a r y o f T er m s

retrospective application is applying a new period in which the employees render the
accounting policy to transactions, other events, or related service.
conditions as if that policy had always been applied. significant influence the power to participate in
retrospective restatement is correcting the the financial and operating policy decisions of the
recognition, measurement and disclosure of investee but is not control or joint control of those
amounts of elements of financial statements as if policies.
a prior period error had never occurred. Small and Medium-sized Entity (SME): Typically a
right-to-use asset an asset that represents a private company, company limited by guarantee
lessee’s right to use an underlying asset for the or a group of such companies satisfying
lease term. applicable size tests and/or shareholder approval
risk adjustment for non-financial risk The thresholds, excluding companies undertaken
compensation an entity requires for bearing the specified regulated business, such that they may
uncertainty about the amount and timing of the be permitted under the Companies Ordinance to
cash flows that arises from non-financial risk as prepare their financial statements in accordance
the entity fulfils insurance contracts. with the SME-FRF & SME-.
separate financial statements those presented spot exchange rate the exchange rate for
by an entity in which the entity could elect, subject immediate delivery
to the requirements in this Standard, to account stakeholder engagement the process by which a
for its investments in subsidiaries, joint ventures company involves parties who may be affected by
and associates either at cost, in accordance with the decisions it makes or can influence the
HKFRS 9 Financial Instruments, or using the equity implementation of its decisions.
method as described in HKAS 28 (2011) stand-alone selling price the price at which an
Investments in Associates and Joint Ventures. entity would sell a promised good or service
separate vehicle a separately identifiable separately to a customer.
financial structure, including separate legal statement of cash flows explains the movement
entities or entities recognised by statute in the cash balance of the entity for the
regardless of whether those entities have a legal reporting period; that is, the movement from
personality. the opening balance of cash to the closing
service concession arrangement Exists where: balance of cash.
• the grantor controls or regulates what statement of changes in equity provides
services the operator must provide with the information to users regarding changes in an
infrastructure, to whom it must provide them, entity’s net assets showing transactions with
and at what price, and shareholders.
• the grantor controls – through ownership, statement of financial position provides
beneficial entitlement or otherwise – any information regarding the financial position of
significant residual interest in the infrastructure the entity as at the end of the reporting period.
at the end of the term of the arrangement. statement of profit or loss and other
share-based payment arrangement is an comprehensive income provides information
agreement between the entity and annother party regarding the financial performance of the entity
that entitles the other party to receive equity for the reporting period. Income, expenses and
instruments of the entity or cash or other assests other comprehensive income (e.g. movements in
of the entity for amounts that are based on the asset revaluation surplus) are summarised in the
value of equity instruments of the entity. statement of profit or loss and other
share-based payment transaction is a transation comprehensive income to determine an entity’s
in which the entity receives goods or services total comprehensive income, the usual measure
from the supplier of those goods or services of an entity’s financial performance
(including an employee) in a share-based subsidiary an entity controlled by another entity.
payment arrangement. sustainability meeting the need of the present
short-term employee benefits employee without compromising the ability of future
benefits (other than termination benefits) that generations to meet their own needs. The term
are expected to be settled wholly before sustainability is not entirely the same as CSR or
12 months after the end of the annual reporting ESG, it has a broader meaning which
encompasses CSR and ESG.

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 FINANCIAL REPORTING

tax base The tax base of an asset or liability is the transaction price (for a contract with a
amount attributed to that asset or liability for tax customer) the amount of consideration to which
purposes. an entity expects to be entitled in exchange for
tax expense (tax income) The aggregate amount transferring promised goods or services to a
included in the determination of profit or loss for customer, excluding amounts collected on behalf
the period with respect to current and of third parties.
deferred taxes. transaction costs (for financial instruments)
taxable profit (tax loss) The profit (loss) for a incremental costs that are directly attributable to
period, determined in accordance with the rules the acquisition, issue or disposal of a financial
established by the taxation authorities, upon asset or financial liability. An incremental cost is
which income taxes are payable (recoverable). one that would not have been incurred if the
temporary differences Differences between the entity had not acquired, issued or disposed of the
carrying amount of an asset or liability in the financial instrument.
statement of financial position and its tax base. transport costs the costs that would be incurred
Temporary differences may be either: to transport an asset from its current location to
(a) taxable temporary differences, which are its principal (or most advantageous) market.
temporary differences that will result in true and fair view HKAS 1.15 states that true and
taxable amounts in determining taxable fair view requires the faithful representation of
profit (tax loss) of future periods when the the effects of transactions, other events and
carrying amount of the asset or liability is conditions in accordance with the definitions and
recovered or settled; or recognition criteria for assets, liabilities, equity,
(b) deductible temporary differences, which are income and expenses set out in the Conceptual
temporary differences that will result in Framework. The application of the HKFRSs, with
amounts that are deductible in determining additional disclosure when necessary, is
taxable profit (tax loss) of future periods presumed to result in financial statements that
when the carrying amount of the asset or achieve a true and fair view.
liability is recovered or settled. underlying asset an asset that is the subject of a
termination benefits employee benefits provided lease, for which the right to use that asset has
in exchange for the termination of an employee’s been provided by a lessor to a lessee.
employment. The employing entity provides unguaranteed residual value that portion of the
benefits to the employee in exchange for residual value of the underlying asset, the
termination. This may be a lump sum payment, or realisation of which by a lessor is not assured or is
some other benefit such as higher pension guaranteed solely by a party related to the lessor.
payments. useful life the period over which an asset is
total comprehensive income represents the expected to be available for use by an entity; or
change in equity during a period resulting from • The number of production or similar units
transactions and other events, other than those expected to be obtained from the asset by
changes resulting from transactions with an entity.
owners in their capacity as owners or value in use the present value of the future cash
shareholders and is represented by the flows expected to be derived from an asset or
aggregation of ‘profit or loss’ and ‘other cash-generating unit.
comprehensive income’. vertical group is one where a parent has a
transaction costs the costs to sell an asset or sub-subsidiary through a direct subsidiary of the
transfer a liability in the principal (or most parent holding a controlling interest in
advantageous) market for the asset or liability another entity.
that are directly attributable to the disposal of the vest means to become an entitlement. Under a
asset or the transfer of the liability and meet both share-based payment arrangement, the right of
of the following criteria: the employee or supplier to receive a share-based
• they result directly from and are essential to payment vests when their entitlement is no longer
that transaction; and conditional on the satisfaction of any vesting
• they would not have been incurred by the conditions.
entity had the decision to sell the asset or
transfer the liability not been made.

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 Ind ex

I NDEX

NOTE: Key Terms and their page references are given in bold

A business vs. acquisition of assets, 1488

concentration test, 1493
Abnormal costs, 275–276 Acquisition-­related costs, 1535–1536
Acceptable level, 115 Active market, 144
Accounting. See also Subsequent business Actuarial assumptions, 1206–1207
combinations Actuarial valuation method, 1203–1205
for joint operations, 1789–1796 Adjusting events after the reporting period, 935–936
for joint ventures, 1796–1798 examples of, 936
Accounting and Financial Reporting Council (AFRC), 8 vs. non-­adjusting events, 938–939
Accounting Bulletin 3 (AB 3), 1429–1431 updating disclosure about conditions, 943
Accounting bulletins (Abs), 17 Administrative overhead cost, 275
Accounting estimates Advocacy threat, 116
changes, 899–900 Agricultural activity, 1345–1346
disclosure, 900–902 Agricultural produce, 1346
Accounting for a partial disposal, 1841–1852 Agriculture assets
Accounting for borrowing costs, 508 current developments, 1352
Accounting for full disposal, 1839–1841 gains and losses, 1349–1350
Accounting guidelines (AGs), 16 measurement, 1348
Accounting policy, 373–374 recognition, 1347–1349
Accounting profit, 1019 scope, 1344–1345
Acquiree, 1486 terminology, 1345–1347
previously held interest, 1529 All About Furniture Limited (All About Furniture), 877
Acquirer, 1486 Ambrosia (Holdings) Limited, 1873
acquisition method, 1504 Amortisation, 553–554
Acquirer controls, business Ancillary services, 370–372
power, 1494–1495 Annual Financial Report, 1456–1460
affect returns, 1500–1501 Annual financial statements, 1465
with voting rights, 1496
Assets
without voting rights, 1497
ceiling (limit), 1208
protective rights, 1496
disposal groups held for distribution, 845
substantive rights, 1495–1496
disposal groups held for sale, 844–845
variability in returns, 1499–1500
financial statements, 29, 59
Acquisitions
liability, initial recognition of, 1037–1040
mid-­year acquisition, 1833–1838
measured using the cost model, 754
of subsidiary, 1610–1614
measured using the revaluation model, 754
subsidiary acquired in stages, 1827–1833
transfer, 335
Acquisition date, 1486
Associate, 1717
Acquisition method
Attributing benefit to periods of service, 1206
acquirer, 1505
date, 1505–1506
non-­controlling interests B
acquiree’s share, 1518–1520
Bank loan, 630
measurement principle, 1511–1512
Bargain purchase
deferred tax assets, 1512–1513
deferred tax exemption for consideration transferred
goodwill, 1514–1516 contingent consideration, 1521–1523
deferred tax liabilities, 1512–1513 deferred consideration, 1521
recognition principle, 1506–1511 goodwill, 1524–1529
Acquisition of business measurement period adjustments, 1530–1534
acquirer controls, 1494–1504 Bearer plant, 1346

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 FINANCIAL REPORTING

Best estimate of provision, 969–970 Capital approach, 1164

Beyond Entertainment Group (BEG), 507, 508 Capitalisation of borrowing costs, 511
Bill-­and-­hold arrangements, 231–232 cessation, 512
Biological assets, 1345 commencement, 512
current developments, 1352 eligibility, 508
gains and losses, 1349–1350 suspension, 512
government grants, 1350–1352 Capitalisation rate, 511
measurement, 1348 Capitalised contract costs, 220–221
recognition, 1347–1348 Carbon Disclosure Project (CDP), 1902
scope, 1344–1345 Carrying amounts, 301
terminology, 1345–1347 Cash flows, 595
Biological transformation, 1345 acquisition of subsidiary, 1610–1613
Bonus element, 1097 consolidated, 1679–1686
Borrowing costs, 80, 508, 509 foreign exchange transactions, 1676–1679
capitalisation, 511–512 hedge, 699–705
disclosure requirements for, 517 Cash-­generating unit, 733
eligible for capitalisation, 510 corporate assets, 770
general borrowings, 511 goodwill impairment, 771–792
recognition, 510–517 identify, 761–767
specific borrowings, 510–511 recognition of impairment loss, 769
Business, 1487 recoverable amount and carrying amount, 767–769
acquirer controls, 1494–1504 recoverable amount measurement, 807–809
vs. acquisition of assets, 1488 Cash-­settled share-­based payment transactions,
substantive process, 1489 1263, 1289
Business combinations, 1487 Changes to a plan of sale, 850–853
acquisition of business Chauffeur Services Limited (Chauffeur), 467
acquirer control, 1494–1504 Chief operating decision maker (CODM), 1315
business vs. acquisition of assets, 1488 China Construction Bank (Asia), 458, 459
concentration test, 1493 China Starch Holdings Limited (China Starch), 457–458
bargain purchase Climate change risks, 1903
consideration transferred, 1520–1521 Climate Disclosure Standards Board (CDSB), 1902
goodwill, 1524–1529 Close members of the person’s family, 1136
measurement period adjustments, 1530–1534 Code of Ethics, 108, 110
identifiable intangible assets, 1507–1510 Commencement date, 422
non-­controlling interests Common control transaction, 1485–1486
date, 1505–1506 Companies limited by guarantees, 62
identifying, 1505 Companies Ordinance’s requirements
scope, 1485–1486 approvals, 1429
subsequent measurement directors’ report and business review, 1428–1429
contingent consideration, 1538
reporting exemption, 1428
indemnification assets, 1540
statutory backing of accounting standards, 1428
reacquired rights, 1540
true and fair view, 1428
recognised contingent liability, 1537–1538
Compensation, 1145
terminology, 1486–1487
Complete set of financial statements, 1399, 1451
transaction
Complex group structures
acquisition-­related costs, 1535–1536
indirect holdings, 1821–1825
deferred tax arising from, 1536–1537
structured entities, 1826
Business combinations involving entities under
Component of an entity, 854
common control (BCUCC), 1485–1486
Compound financial instruments, 590
Business ethics, 108
fixed-­for-­fixed requirement, 636–637
HKICPA Code of Ethics, 110
split accounting, 638–640
International Ethics Standards Board for
Concentration test, business, 1493
Accountants (IESBA), 109–110
Conceptual Framework for Financial Reporting, 1790
Business model, 595
Condensed financial statement, 1452
Confidentiality, 112, 113
C Conflicts of interest, 107, 120
disclosure and consent, 120–121
Cabling Communications Limited (Cabling
identifying, 120
Communications), 425
threats, 120

1936

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 Ind ex

Consideration transferred, bargain purchase definition, 959

contingent consideration, 1528–1539 disclosure, 991–993
deferred consideration, 1528 vs. provision, 961
Consolidated entities, 1856 subsequent measurement, 1537–1538
Consolidated financial statements, 1561, 1718, Contingently issuable shares, 1110–1111
1723, 1821 Contract, 422
cash flows, 1610–1612 separating components of, 430–433
changes in group structure Contract asset, 212
acquisitions, 1827–1838 Contract balances, 245–247
disposals, 1838–1853 Contract costs, 219–221
complex group structures Contract liability, 212
indirect holdings, 1821–1825 Contractual cash flows of financial assets, 629
structured entities, 1826 Contractual service margin, 1358
consolidation. See Consolidation Convertible instruments, 1108
current developments, 1615 Corporate assets, 733
deferred taxes, 1614–1615 Corporate social responsibility (CSR), 1898
disclosure of interests in other entities, Cost, 302
1855–1857 approach, 157
investment level, 1564 directly attributable costs, 306–307
scope and terminology, 1561–1564 excluded costs, 308
simple group structure, 1590–1609 formulas, 279–280
Consolidation measurement of, 309–310
concept of control, 1565–1566 other, 307–308
foreign subsidiary purchase price, 306
consolidated cash flows, 1679–1686 Cost model
different reporting dates, 1686–1687 best estimate/discount rate, change in, 985
exchange differences and reserve, 1676–1679 investment property, 393–397
goodwill and fair value adjustments, 1665–1672 recognition, 314, 319–320
intragroup transactions and
Cost of inventories
balances, 1673–1676
costs of conversion, 274–275
intragroup sales and purchases
costs of purchase, 274
borrowing and lending, 1574
other costs, 275–277
dividend distributions, 1579–1580
retail method, 279
of inventory, 1575–1576
standard cost method, 277–278
of non-­current assets, 1576–1579
of services, 1574 Costs of conversion inventories, 274–275
non-­controlling interests Costs of disposal, 733, 738
consolidated equity, 1587 Costs of purchase inventories, 274
fair value adjustment on acquisition, 1583–1584 Costs to sell, 845
intragroup sale of non-­current Coverage period, 1356, 1357
assets, 1585–1586 Credit losses, 608
profit/loss and comprehensive expected credit losses, 608
income, 1581–1583 recognition of, 613–618
profit/loss, intragroup sale of inventory, 1585 three-­stage approach, 609
subsidiaries, 1568 trade and lease receivables, 612
pre-­acquisition equity elimination Credit risk, 609
adjustments, 1569–1572 significant increase in, 609
uniform accounting policies, reporting dates, 1567 Current tax, 1019, 1021
Contractual service margin, 1358 assets, 1023
Construction phase, 1371–1374 items recognised
Constructive obligation, 963, 980 outside profit or loss, 1049
Construct Today Limited (Construct Today), 432 in profit or loss, 1048–1049
Consumer price index (CPI), 442 liabilities, 1020–1021
Contingent assets, 959 measurement of, 1023
definition, 959, 967 tax assets, 1053
disclosure, 987–993 and tax liabilities, 1053
Contingent consideration, 1521 Customer loyalty programmes, 228–230
bargain purchase, 1520–1523 CWaves Ferry Holding Company Limited (CWaves),
subsequent business combinations, 1538 1313, 1449
Contingent liability, 960, 966–967, 1537 Cyber Surveillance Limited (Cyber), 474–477

1937

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 FINANCIAL REPORTING

D amount and timing, 716

for borrowing costs, 517
Date of authorisation, 934 contingent assets, 993
for financial statements to be issued, 942 contingent liability, 991–993
Decommissioning and restoration activities, 983–987 discontinued operation, 853
Deductible temporary difference, 1032–1037 events after the reporting period, 942–945
Deemed disposals, 1853 fair value, 168–169
Deferred consideration, bargain, 1521 financial position and performance, 716–718
Deferred taxes, 1747–1748, 1798–1799 future cash flows, uncertainty of, 716
business combinations impairment of assets, 806–810
arising from business combination, 1536–1537 of interests in other entities, 1855–1857
assets, 1512–1513
inventories, 284–286
exemption, goodwill, 1514–1516
of an impairment, 806–810
liabilities, 1517–1518
property, plant and equipment, 336–341
consolidated financial statements, 1614–1615
provision, 988–991
items recognised
qualitative disclosures, 652
outside profit or loss, 1049
quantitative disclosures, 652–653
in profit or loss, 1048–1049
risk management strategy, 715–716
measurement of, 1043–1044
statement of financial position, 649–651
tax assets, 1053–1054
Discontinued operation, 853, 854
tax base, 1027–1029
classification, 854
and tax liabilities, 1053–1054
component of an entity, 854
temporary differences, 1029–1043
disclosures, 856
Defined benefit plan, 1202
Disposal groups, 838
Defined contribution plans, 1199–1201
Disposals
Depreciable amount, 302
accounting for a partial, 1841–1852
Depreciable assets, grants related to, 1166
accounting for full, 1839–1841
Depreciation, 302
deemed, 1853
depreciation method, 324–325
of a foreign operation, 1852–1853
general requirements, 321–322
mid-­year disposal, 1852
residual value, 322–323
Distinguishing between defined
useful life, 323–324
contribution, 1198–1199
Derecognition, 1370
Distribution of Non-­cash Assets to Owners, 941
asset transfer, 335
Dividend distributions, 941
financial assets, 625–629
Downstream sale of non-­current asset, 1739–1741
financial liability, 629–633
Dragonfly Development Limited (Dragonfly), 363
financial statements, 33–34
D-­shaped group, 1822
gain/loss, 333
Dual-­purpose properties, 367–369
partial derecognition, 633–635
Designation, 680
Determining the deficit (Surplus), 1205 E
Development, 540–541
Diluted EPS Earnings, 1090–1094
adjustment to earnings, 1102 Earnings per share (EPS), 1089–1090
adjustment to shares, 1103 diluted. See Diluted EPS
dilutive potential ordinary shares, 1104–1111 and disclosure, 1115–1116
objective, 1101 earnings, 1090–1094
Dilutive potential ordinary shares as performance measure, 1113–1114
contingently issuable shares, 1110–1111 presentation, 1114–1115
contracts, 1111 shares, 1094–1097
convertible instruments, 1107 Easy Removalists Limited (Easy Removalists), 427
options, 1105–1106 E&E. See Exploration and evaluation (E&E)
warrants and their equivalents, 1105–1106 E&E expenditures. See Exploration and evaluation
Direct expenditure, 981 (E&E) expenditures
Directly attributable costs, 306–307 Effective interest rate, 598
Disaggregation of revenue, 244–245 Eligible private companies, 62
Disclosure Employee, 1241
accounting estimates, 898–900 Employee benefits, 738, 1187
accounting policies, 882–887 Employee contributions, 1208–1209

1938

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 Ind ex

Entity, 1137–1139 F
Entity-­wide disclosures, 1328–1329
Environmental, social and governance (ESG), 1898 Fair value, 139, 448
Equity-­accounted financial statements, 1723 adjustments, 1723–1724
Equity-­accounted investment, 1725 application to liabilities, 150–153
Equity instrument, 587, 673, 1241 asset or liability, 140–141
Equity method disclosure, 168–169
of accounting, 1797 entity’s own equity instruments, 150–153
basic principles, 1725–1728 hedge, 695–699
deferred taxes, 1747–1751 hierarchy, 164–166
disposal of an associate, 1745–1747 at initial recognition, 155
distributions and other adjustments, 1734–1743 inputs to valuation techniques, 161–166
exemption from accounting, 1724–1725 less costs to sell, 281
fair value adjustments, 1731–1732 market participants, 144–145
financial statements, 31, 59, 1723–1724 non-­financial assets, 148–150
goodwill, 1729–1731 of the equity instruments granted, 1241–1242
impairment, 1742–1743 of the goods or services received, 1241
loss-­making associates, 1743–1745 price, 146–147
Equity-­settled share-­based payment transactions, scope, 139
1244, 1289 transaction, 141–143
ESG reporting, sustainability and valuation techniques, 156–161
challenges in, 1912 Fair value model
HKEx’s ESG reporting guide, 1903–1911 double-­count assets, 377
Hong Kong’s Companies Ordinance, 1911–1912 investment property, 375–376
Ethics conceptual framework, 109 Fair value through other comprehensive income
Ethics fundamental principles (FVTOCI), 601
confidentiality, 112–113 Fair value through profit or loss (FVTPL), 595
integrity, 111–112 Familiarity threat, 116
objectivity, 112 Fast Limited (Fast), 1187
professional behaviour, 113 Finance lease, 422
professional competence and due care, 112 Finance lease accounting
Events after the reporting period, 935 financier lessors, 463
application of HKAS 10, 946 initial measurement
authorisation process, 934 interest rate implicit in lease, 465
manufacturer or dealer lessors, 466–467
disclosure, 942–945
net investment in lease, 464
dividends to shareholders, 940–941
unguaranteed residual value, 464
going concern assumption, 940
subsequent measurement
objective of, 932–933
after lease commencement, 469
scope of, 933
including lease modifications, 465–466
types of, 933
Financial assets, 585
Exchange of assets, 309–310
amortised cost and interest method,
Excluded costs, 308
597–598
Executory contracts, 959
derecognition, 625–633
Exit price, 146
fair value through other comprehensive income
Expected credit losses, 608
(FVTOCI), 601
Expected disposal of assets, 973
fair value through profit or loss, 604
Expenses
gains and losses, 607
financial statements, 31, 59
impairment and credit losses, 608–614
recognition, 284
initial measurement of, 594
Exploration and evaluation (E&E) assets, 1363
measurement classifications, 593–594
impairment of, 1366–1367
modified financial assets, 610
measurement of, 1364–1365
purchased credit-­impaired approach,
presentation of, 1366
612–613
recognition of, 1363–1364
purchase/sale of, 592–593
Exploration and evaluation (E&E) expenditures, 1363
reclassifications, 605–606
Exploration and evaluation (E&E) of mineral
transfer of, 653–655
resources, 1363
Financial capital maintenance, 36
External sources of information, 792–793

1939

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 FINANCIAL REPORTING

Financial guarantee contracts materiality and aggregation, 1400

initial recognition, 622 offsetting, 1400–1401
subsequent measurement, 622–623 true and fair view and compliance with
Financial instrument, 583 HKFRSs, 1399
compound financial instruments, 590, 635–638 historical cost, 34–35
derivatives, 640–648 identification of, 1403–1404
HKAS 7 financial instruments, 584 income, 31, 59
HKAS 9 financial instruments, 584 information relevance, 35–36
HKAS 32 financial instruments, 584 liabilities, 30, 59
HKFRS 9, 585 listing rules requirements
life cycle of, 584, 588, 592 Appendix 14, 1432
private entities, 79 Appendix 16, 1432–1433
puttable instrument, 589–590 Appendix 27, 1433–1434
Financial interest, 124 measurement basis, 35
Financial liability, 587 notes, 1420–1421
derecognition, 629–633 recognition criteria, 32–33
gains and losses, 621 recognition process, 31–32
initial measurement of, 619 scope, 1397
reclassifications, 621 statement of cash flows, 1421–1424
subsequent measurement of, 619–620 statement of changes in equity, 1418–1419
Financial Reporting Council (FRC), 8 statement of financial position, 1405–1409
Financial reporting framework statement of profit or loss and other
concepts of capital and capital maintenance, 36 comprehensive income, 1411–1417
elements of financial statements, 29–31 terminology, 1397–1398
going concern assumption, 28 Finished good inventories, 273
and HKAS 1 (revised) presentation of financial First-­In, First Out (FIFO) formula, 280
statements, 37–38 Five-­step model, HKFRS 15
measurement of financial statements, 34–36 allocate the transaction price to performance
objective of, 23–25 obligations, 184
purpose, status and scope, 22–23 discount, 207–209
qualitative characteristics of, 25–28 stand-­alone selling prices, 206–207
transaction price changes, 210
recognition and derecognition of financial
variable consideration, 209–210
statements, 31–34
contract with a customer, 185–189
reporting entity, 28
combination of contracts, 189–190
Financial Reporting Standards Committee
contract modifications, 190–192
(FRSC), 17, 18
contract with a customer, 192
Financial risk, 1355
performance obligation in the contract,
Financial statements, 37, 932, 1397
184, 192–196
asset, 29, 59
recognising revenue, satisfied performance
authorisation process, 934
obligations, 184
Companies Ordinance’s Requirements, 1427–1429
measuring progress towards complete
consistency of presentation, 1403 satisfaction of a performance
current developments, 1434–1435 obligation, 215–218
current liabilities, 1408–1409 performance obligations satisfaction,
current value, 35 211–213
date of authorisation for issue, 942 performance obligations satisfied at a point
derecognition, 33–34 in time, 215
directors’ emoluments and AB 3, 1429–1431 performance obligations satisfied over
disclosure of significant judgement and accounting time, 213–215
estimates, 1425–1426 transaction price, 184, 196–205
equity, 31, 59 Fixed-­for-­fixed requirement, 636–637
expenses, 31, 59 Fixed production overhead costs, 274
faithful representation, 36 Foreign currency, 1643
general features of Foreign currency translation reserve (FCTR),
accrual basis of accounting, 1400 1658, 1685
comparative information, 1401–1402 Foreign exchange, 1645
frequency of reporting, 1401 disclosure, 1688–1690
going concern, 1400

1940

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 Ind ex

foreign subsidiary, consolidation supply chain influence, 1900

consolidated cash flows, 1679 Task Force on Climate-­related Financial
different reporting dates, 1686 Disclosure, 1902–1903
exchange differences and reserve, United Nations Global Compact, 1900–1901
1676–1679 United Nations Sustainable Development
goodwill and fair value adjustments, 1665–1672 Goals, 1900–1901
intragroup transactions and Going concern assumption, 940
balances, 1672–1676 Goodwill, 1524, 1729–1732
functional currency bargain purchase, 1523–1529
change in, 1655–1656 on consolidation, 1572
determination of, 1647–1649
deferred tax exemption, 1514–1518
initial recognition, 1650–1651
foreign subsidiary, 1665–1672
subsequent measurement, 1652–1654
impairment
gains and losses, 1654
allocate, 769
presentation currency
testing, 772–774
change in, 1663–1665
Government, 1140, 1161
financial statements, 1657
Government assistance, 1161
tax effects of exchange differences, 1662–1663
Excluded from HKAS 20, 1168–1169
translation to, 1658–1661
HK(SIC) Int-­10 Government Assistance: No Specific
scope and terminology, 1645–1646
Relation to Operating Activities, 1170
Foreign operation, 1646
Government grants, 1160, 1161, 1350–1351
Foreign subsidiary, consolidation
disclosure of, 1172
consolidated cash flows, 1679
presentation related to assets, 1172
different reporting dates, 1686
presentation related to income, 1173–1174
exchange differences and reserve, 1676–1679
recognition and measurement of
goodwill and fair value adjustments, 1665–1672
below-­market rate of interest, 1167–1168
intragroup transactions and balances, 1672–1676
capital approach, 1164
Forgivable loans, 1162
compensation for expenses or losses, 1168
Forward contracts, 682
forgivable loan from, 1167
FreshPak Limited (FreshPak), 730 income approach, 1164
Fulfilment cash flows approach, 1357–1359 non-­monetary, 1165–1166
Full HKFRS, 82–94 repayment of, 1168–1169
Functional currency, 1653 Government related entities, 1147
change in, 1655–1656 Grant date, 1245–1246
consolidated financial statements, 1646 Grants related to assets, 1161
factors, 1657 Grants related to income, 1161
initial recognition, 1650–1651 Gross investment in the lease, 466
subsequent measurement, 1652–1654 Group, 1718
Function of expense (‘cost of sales’) method, 1415 Groups of ‘eligible’ private companies, 62
Future events, 972 Groups of private companies, 62–63
Future operating losses, 977–978 Groups of smaller companies limited by
guarantee, 63
G Groups of smaller entities, 63

Gain on bargain purchase, 1504

Gains and losses on settlement, 1207–1208 H
GEM Rules, 9–10 Harvest, 1346
Generally accepted accounting principles (GAAP), 11 Hedge accounting, qualifying criteria for,
General purpose financial statements, 12, 1397 690–693
Global Reporting Initiative (GRI), 1902 Hedged items, 685–686
Global sustainability initiatives and frameworks cash flow hedge, 699–705
Carbon Disclosure Project, 1902 designation of, 689
Climate Disclosure Standards Board, 1902 fair value hedge, 695–699
Global Reporting Initiative, 1902 qualifying items, 686–688
increased awareness of corporate leaders, 1900 Hedge ratio, 692–693
International Integrated Reporting Council, 1902 Hedging instruments, 679, 680
investor demand, 1899 designation of, 684–685
regulatory requirements, 1899 qualifying instruments, 681–684

1941

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 FINANCIAL REPORTING

Hedging relationships HKEx’s ESG reporting guide, 1904–1911

accounting for costs of, 710–714 HKFRS 5, non-­current asset
cash flow hedge, 699–705 acquisition, 841
discontinuation of, 709–710 assets held for distribution to owners, 838
fair value hedge, 695–699 assets to be abandoned, 842
foreign operation, 706–707 available for immediate sale in present
rebalance of, 707–709 condition, 838
Hierarchy, fair value changes to a plan of sale, 850–853
level 1 inputs, 164–165 classification, 838–844
level 2 inputs, 165 continued operations, 854
level 3 inputs, 165–166 discontinued operations, 853–857
Highest and best use, 148–150 disposal groups held for distribution, 845
Highly probable, 839–841 disposal groups held for sale, 844–845
Hi-­Rise Cranes Limited (HRC), 300 held for sale or distribution, 858
HKAS 8, accounting policies highly probable, 839–841
changes, 882–887 impairment losses, 845–850
consistency, 881 measurement, 844–853
disclosure, 887–898 plan of distribution to owners, 850–853
errors, 903 scope, 836–837
disclosures, 908–911 terminology, 837
limitations on retrospective HKFRS 8 operating segments, 1314–1315
restatement, 905–908 entity-­wide disclosures, 1328–1329
prior period error, 903–905 reportable segments, 1317–1318
scope, 879 aggregation criteria, 1318
selection and application, 880–881 disclosures, 1324–1328
terminology, 879 quantitative thresholds, 1319–1323
HKAS 19 employee benefits, 1188 scope, 1315
long-­term employment benefits, 1215 terminology, 1315–1317
disclosure, 1217 HKFRS 15, revenue
recognition and measurement, 1215–1217 contract costs, 219–221
post-­employment benefits, 1197–1198 five-­step model. See Five-­step model, HKFRS 15
defined benefit plans, 1198–1199, 1202–1214 presentation and disclosure
defined contribution plans, 1199–1201 assets recognised, 250
distinction between defined contracts with customers, 243–248
contribution, 1198–1199 significant judgements, 248–250
scope, 1189 revenue recognition issues
short-­term employee benefits, 1190–1191 bill-­and-­hold arrangements, 231–232
disclosure, 1197 consignment arrangements, 230–231
profit-­sharing and bonus plans, 1195–1196 customer loyalty programmes, 228–230
recognition and measurement, 1191–1197 licencing, 233–236
short-­term paid absences, 1192–1195 long-­term construction contracts, 238–242
termination benefits, 1218 loss-­making contracts, 237–238
disclosure, 1220 principal vs agent considerations, 232–233
recognition and measurement, 1218–1219 repurchase agreements, 236–237
terminology, 1189 sale with a right of return, 222–225
HKAS 36, impairment of assets warranty, 225–228
cash-­generating units, 761–792 scope, 183
current developments, 810–811 terminology, 183
disclosure, 806–810 HKFRS 2 share-­based payment
external sources, 734, 735 cancellations and settlements, 1268–1274
impairment loss, 788–802 cash-­settled share-­based payment
internal sources, 734, 735 transaction, 1263–1268
practical guidance, 735–736 choice of settlement, 1280–1282
principal, 731–732 current and deferred tax
recoverable amount measurement, 737–753 cash-­settled, 1289
scope, 732 equity-­settled, 1289
terminology, 732–733 group entities, 1289
timing of performing tests, 736 disclosures, 1291
two-­step process, 733–734 determination of fair value, 1294–1295

1942

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 Ind ex

effect on profit or loss and financial I

position, 1295–1296
nature and extent, 1291–1294 Identifiability, 534
equity-­settled share-­based payment Identifiable intangible assets, 1507–1510
transactions, 1244–1245 IFRS Interpretations Committee, 14
fair value of the equity instruments Impairment, 1742
granted, 1245–1246 Impairment loss, 733
fair value of the goods, 1245 assets measured using the cost model, 754
non-­vesting conditions, 1259–1260 assets measured using the revaluation model, 754
reload feature, 1260–1263 cash-­generating unit, 795
vesting conditions, 1246–1259 disposal groups, 846–847
group entities, 1282–1283 goodwill, 795
modifications, 1268–1271 individual asset, 793–795
parent entity grants, 1283–1286 individual assets, 845
parent entity pays cash, 1287–1288 measurement, 753–754
recognition, 1242–1244 recognition, 754, 769
scope, 1239–1240 reversing, 792–793
subsidiary grants, 1286 risk of impairment arising, 754–761
terminology, 1241 Inception date, 422, 433
with cash alternatives, 1275–1282 Income approach, 157–161, 1164–1165
HK(IFRIC) Int-­17, 941 Income, financial statements, 31, 59
HK(SIC) Interpretation 25 Income Taxes-­Changes in the Income taxes, 1019
Tax Status of an Enterprise or its Shareholders, 1062 disclosure of
HK(IFRIC) Interpretation 23 Uncertainty over Income Tax other disclosure requirements, 1059
Treatments, 1062–1063 tax reconciliation, 1056
Home Supplies Limited, 419, 426, 430, 432–433, interpretations
440–441, 444–445, 450 HK(SIC) Interpretation 25 Income Taxes-­
Hong Kong Dollars, 1645 Changes in the Tax Status of an Enterprise or its
Hong Kong Financial Reporting Standard for Private Shareholders, 1062
Entities (HKFRS-­PE), 82–94 HK(IFRIC) Interpretation 23 Uncertainty over
Hong Kong Financial Reporting Standards (HKFRS) Income Tax Treatments, 1062–1063
disclosure initiative, 45 presentation of
financial reporting standards, 12–14 tax assets, 1052–1054
first-­time adoption timeline, 41–42 tax expense, 1054
and tax liabilities, 1052–1054
Hong Kong (IFRIC) (HK(IFRIC)) interpretations,
private entities, 80
14–15
Indemnification assets, 1540
Hong Kong (SIC) Interpretations, 15–16
Independence, ethics, 111
mandatory exceptions, 43
Indirect holdings, 1821–1823
management commentary, 45
Individual companies, 61
optional exemptions, 43
Inducements, 125, 126
other professional pronouncements and exposure
InfoSpeed Limited (InfoSpeed), 425
drafts, 16–17
Initial costs, 302–303
presentation and disclosure, 44
Initial direct costs, 444
primary financial statements project, 45
Initial recognition, 1357
scope of, 40–41
Inputs to valuation techniques
for small-­and medium-­sized Entities, 14
bid and ask prices, 162
standard-­setting process, 17–21
fair value hierarchy, 164–166
terminology, 40
premiums and discounts, 162–163
timing application of, 14
Insurance contracts, 1355
transition steps, 43–44
recognition and measurement
Hong Kong Institute of Certified Public Accounting
coverage period, 1357
(HKICPA), 7–8
fulfilment cash flows approach,
Hong Kong Insurance Authority (HKIA), 11
1357–1359
Hong Kong Interbank Offered Rate (HIBOR), 595
initial recognition, 1357
Hong Kong Monetary Authority (HKMA), 11
insurance liabilities, 1357
Hong Kong’s Companies Ordinance, 1911–1912 premium allocation approach, 1359
Hong Kong Special Administrative Region (HKSAR), 437 terminology, 1355
Hong Kong Stock Exchange (HKEx), 1483, 1646 Insurance contract services, 1355

1943

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 FINANCIAL REPORTING

Insurance contract with direct participation development phase, 541–542

features, 1355 internally generated goodwill, 547
Insurance contract without direct participation research phase, 540–541
features, 1355 website development, 546–547
Insurance liabilities, 1357 Internal sources of information, 734, 735, 793
Insurance risk, 1355 International Accounting Standards Board (IASB),
Insured event, 1355 7, 183, 440, 509, 561, 810, 994, 1756
Intangible assets, 531 International Financial Reporting Standards (IFRS), 183
accounting policies, 559 climate-­related disclosures (S2), 1915
amortisation, 553–554 sustainability-­related financial information
business combination, 538–539 (S1), 1914–1915
characteristics of, 531 International Integrated Reporting Council
cost model, 549 (IIRC), 1902
definition, 531 Intimidation threat, 117
disclosure, 558–560 Intragroup sales and purchases
exchange of assets, 540 borrowing and lending, 1574
granted rights, 539 dividend distributions, 1579–1580
internally generated intangible asset, of inventory, 1575–1576
540–549 of non-­current assets, 1576–1579
operating system, 576 of services, 1574
patent, 576–577 Intragroup transactions
private entities, 80 monetary assets and liabilities, 1673–1674
retirements and disposals, 557 sales and purchases, 1674–1676
revaluation model, 549–551 Intrinsic value, 1263
separate acquisition, 538 Inventories, 273
useful life, 552–553 cost formulas, 279–280
website development costs, 576 cost of inventories
Intangible elements, 533 costs of conversion, 274–275
Integrated reporting, 1912–1914. See also costs of purchase, 274
Sustainability reporting other costs, 275–277
Integrity, 111, 112 retail method, 279
Inter-­company transactions, 1734–1741 standard cost method, 277–278
Interest rate, 681 disclosure, 284–286
Interest rate implicit in the lease, 465 net realisable value, 281–283
Interim financial reports, 1451 recognition an expense, 284
Annual Financial Report, 1456–1460 scope, 272–273
annual financial statements, 1462–1464 terminology, 273
disclosure requirements, 1455–1456 Investment, level of, 1564–1565
form and content of, 1453–1454 Investment component, 1355
guidance in, 1459 Investment property, 365
materiality, 1461 disclosures
minimum components of, 1453 cost model, 393–397
periods for, 1460–1461 fair value model, 393
recognition and measurement disposals, 390–391
costs incurred unevenly during the financial owner-­occupied property
year, 1466–1467 ancillary services, 370–372
examples of, 1467–1469 dual-­purpose properties, 367–369
impairment in, 1469 private entities, 80
revenues received seasonally, cyclically or recognition, 372
occasionally, 1465–1466 accounting policy, 373–374
same accounting policies, 1465 cost model, 374–375
use of estimates, 1467 fair value model, 375–382
restatement, 1470–1471 measurement at, 373
scope, 1451 scope, 365
significant events and transactions, 1454–1455 terminology, 365
terminology, 1451–1452 transfers, 383–389
Interim period, 1451 Investments in associates, 1716
Internally generated intangible asset current developments, 1755–1756
cost of, 542–543 disclosure of, 1752–1755

1944

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 Ind ex

equity method identifying, 423–437

basic principles, 1725–1728 IFRS 16, current active project, 480
deferred taxes, 1747–1751 scope, 421
disposal of an associate, 1745–1747 terms and conditions, 422
distributions and other adjustments, 1732–1741 Lease payments, 422, 443–444
exemption from accounting, 1724–1725 Lease term, 422
fair value adjustments, 1731–1732 commencement date of lease, 433–434
financial statements, 1723–1724 within control of lessee, 436
goodwill, 1729–1731 extension or termination option, 434–435
impairment, 1742–1743
for Hong Kong Land Leases, 437
loss-­making associates, 1743–1745
non-­cancellable period, 434
presentation of, 1751–1752
underlying asset, 434
scope of HKAS 28 (2011), 1717
Legal obligation, 978, 980
significant influence, 1718–1722
Lessee, 422. See also Lease
terminology, 1717–1718
accounting, 421
Investor’s share of an associate, 1727
disclosure
IPR&D, 576
financial statements, 456
ISSB’s exposure drafts, 1914–1915 lease liabilities of, 457–459
right-­of-­use assets, 456–458
J initial measurement of lease liability
in-­substance fixed payments, 443
Joint arrangements, 1778 regular or ongoing lease payments, 442–443
accounting residual value guarantee, 443
for joint operations, 1789–1796 initial measurement of right-­of-­use asset
for joint ventures, 1796–1798 initial direct costs, 444
classification of, 1782–1788 presentation, 455–456
current developments, 1802 reassessment of lease liability and
deferred tax, 1798–1799 modifications, 448–455
joint control, 1779–1781 recognition, 438
presentation and disclosure, 1800–1802 low-­value leases, 439–440
scope and terminology, 1779 short-­term leases, 438–439
Joint control, 1779–1781 separate component, 431
Jointly controlled entities, 80 subsequent measurement
Joint operation, 1778 of lease liability, 447
Joint operators, 1782 of right-­of-­use asset, 447–448, 450–452
Joint venture, 1778 Lessee Limited (Lessee), 449
Joint venturers, 1782 Lessor, 422. See also Lease
accounting, 421
classification of leases, 462–463
K disclosures
Key management personnel (KMP), finance leases, 470–471
1135, 1145–1146 operating leases, 469–470
compensation, 1145 finance lease accounting, 463–469
services, 1147 operating lease accounting, 469–470
separate component, 431–432
underlying asset, 461–462
L Liability
defined, 960
Lease, 422
financial statements, 29, 59
component or components, 430
Liability for incurred claims, 1357
HKFRS 16
Liability for remaining coverage, 1357
application of, 423–429
identified asset, 423–424 LIBOR, 442
lease agreements, 420–421 Licencing, 233–236
lease term, 433–437 Limitations on retrospective restatement,
period of use, 427 905–908
right to control use, 425–427 Long-­term employment benefits, 1215
separating components of contract, 430–433 disclosure, 1217
substantive right of substitution criteria, 424 recognition and measurement, 1215–1217
terminology, 422 Loss-­making associates, 1743–1745

1945

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 FINANCIAL REPORTING

Lucky Pastoral Company, 1343 subsidiaries, 1568

Luxury Limited (Luxury), 444–445, 450 measurement principle, 1511–1512
deferred tax assets, 1512–1513
deferred tax exemption for goodwill,
M 1514–1516
Management or administrative entity, 1146 deferred tax liabilities, 1512–1513
Mandatory Disclosure Requirements (MDRs), 1904 recognition principle. See Revenue
Market approach, 156 recognition principle
Market conditions, 1251 Non-­depreciable assets, grants related to, 1166
Market participants, 144, 145 Non-­derivative financial assets, 682
Market rental rates, 442 Non-­lease component or components, 430
Material, 1400 Non-­market conditions, 1252–1254
Materiality, 1905–1906 Non-­monetary assets, 309
Measurement date, 1294 Non-­monetary government grants, 1165–1166
Measurement period, 1530–1534 Non-­vesting conditions, 1259–1260
Merger accounting, 1874 Notes, 1398, 1420–1421
current developments, 1886 Not related parties, 1140
principles, 1877–1880
procedures O
consolidated statement of profit or
loss, 1883–1885 Obligating event, 963
practical effects of, 1880–1883 Ocean Bay Limited (Ocean Bay), 1395
scope, 1875–1877 Office Storage Limited (Office Storage), 427
Mid-­year acquisition, 1833–1838 Onerous contracts, 978
Mid-­year disposal, 1852 Operating cycle, 1408
Mineral resources Operating lease, 422
current developments, 1367 accounting, 469–470
exploration and evaluation (E&E) assets presentation, 470
impairment of, 1366–1367 recognition, measurement and
measurement of, 1364–1365 modifications, 469–470
presentation of, 1366 Operating segment, 1315–1317
recognition of, 1363–1364 Operating system, 576
scope, 1362 Operational phase, 1374–1375
terminology, 1363 Optical Solutions Limited (Optical Solutions), 425
Mixed groups, 63–64 OptiCom Limited (OptiCom), 425
Monetary item, 1652 Orderly transaction, 141
Most advantageous market, 142 Ordinary shares, 1089, 1090
capital changes, 1096–1097
dilutive potential, 1104–1111
N or cash, 1111
Nature of expense method, 1415 potential, 1090
Net investment, 1742 weighted average number of, 1095–1096
Net investment in the lease, 464 Other comprehensive income (OCI), 37–38,
Net realisable value (NRV), 273, 281–283 1416, 1883
Non-­adjusting events after the reporting period, 933 reclassification, 1416–1417
vs. adjusting events, 938 reclassification adjustments, 1417
disclosure requirements, 944 Other long-­term employee benefits, 1196
examples of, 938–939 Owner-­occupied property, 366
Non-­controlling interest (NCI), 1486, 1561, 1733 ancillary services, 370–372
acquiree’s share, 1518–1520 dual-­purpose properties, 367–369
consolidation
consolidated equity, 1587
P
fair value adjustment on acquisition, 1583
financial statements, 1580–1581 Parent, 1492, 1561
intragroup sale of non-­current Parent-­subsidiary relationships, 1142
assets, 1585–1586 Party to a joint arrangement, 1778
profit/loss and comprehensive Past event, 963–964
income, 1581–1583 Past service cost, 1207
profit/loss, intragroup sale of inventory, 1585 Performance conditions, 1251–1259

1946

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 Ind ex

Performance obligation, HKFRS 15, 192–196, 247 Profit or loss, 37–38

Physical capital maintenance, 36 Profit or loss attributable to ordinary
Plan of distribution to owners, 850–853 shareholders, 1090–1094
Polaris Limited (Polaris), 1483 Profit-­sharing and bonus plans, 1195–1196
Policyholder, 1355 Property, plant and equipment (PPE), 80, 300
Post-­employment benefit plans, 1198 depreciation
Post-­employment benefits, 1197–1198 general requirements, 321–322
defined benefit plans, 1198–1199, 1202–1214 specific aspects of, 322–332
defined contribution plans, 1199–1201 derecognition, 332–335
distinction between defined disclosure, 336–341
contribution, 1198–1199 recognition
Post-­implementation review (PIR), 20–21 cost model, 314, 319–320
Potential ordinary shares, 1090 elements of cost, 306–308
Power, acquirer, 1494–1495 initial costs, 302–303
affect returns, 1500–1503 measurement of cost, 309–314
with voting rights, 1496 revaluation model, 315–320
without voting rights, 1497 subsequent costs, 303–305
Preference shares, 1090 scope, 301–302
Premium allocation approach, 1359 terminology, 302
Presentation currency, 1646 Protective rights, acquirer, 1496
change in, 1663–1665 Provision, 960
financial statements, 1657 changes in, 977–978
tax effects of exchange differences, 1662–1663 vs. contingent liabilities, 963
translation to, 1658–1663 definition, 960
Prestige Vehicles Limited (Prestige), 467–469 disclosure, 988–991
Primary financial statements, 1434–1435 vs. other liabilities, 960, 961
Principal market, 145 present obligation, 963–964
Prior period error, 903–905 to present value, 971
Private entities (PE), 75, 76 probable outflow of resources embodying
borrowing costs, 80 economic benefits, 964–965
business combinations, 79 recognition criteria for, 962
criteria and eligibility, 76–77 reliable estimate of the obligation, 965
elements, 78 Public interest entity (PIE), 8
exchange differences, 81 Purchase price cost, 306
financial instruments, 79
financial reporting framework, 77 Q
HKFRS for, 82–94
income taxes, 80 Qualifying asset, 509–510
intangible assets, 80 Qualifying item, 680
investment property, 80
jointly controlled entities, 80
R
objective and qualitative characteristics,
77–78 Radio Licence, 559–560
omitted topics, 81 Raw material inventories, 273
property, plant and equipment (PPE), 80 Reacquired rights, 1540
recognition and measurement, 78 Reclassification adjustments, 1417
research and development (R&D) costs, 80 Recognition and measurement rules
simplified disclosure, 81 future operating losses, 977–978
simplified presentation, 81 onerous contracts, 978
Probable, 839 restructuring, 980–982
Professional accountants Recognition, financial statements of, 31–33
acting with sufficient expertise, 123 Recognition, property, plant and equipment
compensation and incentives linked to financial cost model, 314, 319–320
reporting, 123 elements of cost, 306–308
conflicts of interest, 120–121 initial costs, 302–303
and decision making, 123 measurement of cost, 309–314
financial interests, 123 revaluation model, 315–320
inducements preparation and reporting of subsequent costs, 303–305
information, 121–122 Recoverable amount, 733, 767–769

1947

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 FINANCIAL REPORTING

Recoverable amount measurement, 737–753 assets acquired and liabilities assumed, 1510–1511
cash-­generating units, 807–809 identifiable intangible assets, 1507–1510
fair value less costs of disposal, 738 Reversals
general principles, 737–738 disposal groups, 849
specific application issues, 746–751 individual assets, 848
value in use, 739–746 Reverse share split, 1097
Refund liability, 212–213 Right-­to-­use asset, 422
Regulatory authorities role Risk of impairment arising immediately upon
in Accounting and Financial Reporting revaluation, 754
Council (AFRC), 8 Risks and uncertainties, 970
in Hong Kong Institute of Certified Public
Accounting (HKICPA), 7–8
in Hong Kong Insurance Authority (HKIA), 11
S
in Hong Kong Monetary Authority (HKMA), 11 Safeguards
in Securities and Futures Commission (SFC), 10 created by legislation or regulation, 118
in Stock Exchange of Hong Kong Limited created by profession, 118
(HKEx), 8–10 in work environment, 118–119
Regulatory Oversight Board (ROB), 17, 18 Sale and leaseback transaction accounting, 478
Reimbursements, 974 transfer of asset, not a sale
Reinstatement of premises, 983–986 buyer-­lessor, 478
Related party, 1134, 1135, 1136 seller-­lessee, 478
disclosure transfer of asset, sale
all entities, 1142–1145 amount of adjustment, 478
government related entities, 1147–1148 buyer-­lessor, 473, 477
key management personnel (KMP), seller-­lessee, 473
1145–1146 Sales-­based royalty, 236
identifying related parties Sea Vessels Limited (Sea Vessels), 428, 429
entity, 1137–1139 Securities and Futures Commission (SFC), 10
not related parties, 1140 Self-­interest threat, 115
person, 1136–1137 Self-­review threat, 115
transactions, 1135, 1142–1144 Selling costs, 275–276
Reload feature, 1260–1263 Separate vehicle, 1783
Reportable segments, 1317–1318 Service concession arrangements
aggregation criteria, 1318 current developments, 1375
disclosures, 1324–1328 nature of, 1369–1370
general information, 1324 recognition and measurement of
information about profit or loss, assets and borrowing costs, 1375
liabilities, 1325–1327 construction phase, 1371–1374
reconciliations, 1327–1328 operational phase, 1374–1375
quantitative thresholds, 1319–1322 scope, 1370–1371
Repurchase agreements, 236–237 Service condition, 1247–1251
Research, 540–541 Share-­based payment arrangement, 1241
Residual value, 322–323 Share-­based payment transaction, 1241
Residual value guarantee, 443 Shares, 1094–1095
Restructuring, 980 Share split, 1097
features of, 981 Short-­term employee benefits, 1190
forms of, 980 disclosure, 1197
present obligation, 980–981 profit-­sharing and bonus plans, 1195–1196
probable outflow of resources embodying recognition and measurement, 1191–1196
economic benefits, 981 short-­term paid absences, 1192–1195
reliable estimate of the obligation, 981 Short-­term paid absences, 1192–1195
Retail method, 279 Significant influence, 1718–1721
Retrospective application, 878 Small and medium-­sized entity financial reporting
Revaluation model, 549–551 framework (SME-­FRF)
best estimate/discount rate, change in, 985 benefits, 59–60
Revaluation model, recognition, 315–317, 320 companies limited by guarantees, 62
Revenue. See HKFRS 15, revenue elements of financial statements, 59
Revenue recognition principle eligible private companies, 62

1948

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 Ind ex

exclusions from exemptions from full HKFRS, Steel Supplies Limited (Steel Supplies), 428, 429
60–61 Step acquisitions, 1827–1833
groups of ‘eligible’ private companies, 63 Stock Exchange of Hong Kong Limited (HKEx), 8–9
groups of private companies, 62–63 Storage costs, 275–276
groups of smaller companies limited by Storage Limited (Storage), 430
guarantee, 63 Structured entities, 1826
groups of smaller entities, 63 Subsequent business combinations
individual companies, 61 contingent consideration, 1537
mixed groups, 63–64 indemnification assets, 1540
qualifying criteria/size tests, 64–67 reacquired rights, 1540
qualitative characteristics, 58 recognised contingent liability, 1537–1538
recognition and measurement, 59 Subsequent costs, 303–305
smaller private companies, 62 Subsidiary, 1487, 1561
and SME-­FRS, 82–94 Substantive process/business, 1486
underlying assumptions, 58 Substantive rights, acquirer, 1495–1496
users of, 57–58 Sun Energy Limited (Sun Energy), 1238
Smaller private companies, 62 Supreme Bakery Limited, 931
SME Financial Reporting Standard (SME-­FRS), 68–74 Sustainability, 1898
SME-­FRF and, 82–94 current issues, 1914–1915
SME-­FRF. See Small and medium-­sized entity financial global sustainability initiatives and frameworks
reporting framework (SME-­FRF) Carbon Disclosure Project, 1902
Soleil group, 1483–1484, 1559, 1643, 1715, 1777, 1819 Climate Disclosure Standards Board, 1902
Solely payments of principal and interest (SPPI), 595 Global Reporting Initiative, 1902
Sparkle Limited, 957 increased awareness of corporate leaders, 1900
Specific identification method, 280 International Integrated Reporting Council, 1902
Split accounting, 638–640 investor demand, 1899
Staged acquisition of a subsidiary, 1827–1833 regulatory requirements, 1899
Stakeholder engagement, 1906 supply chain influence, 1900
Task Force on Climate-­related Financial
Stand-­alone selling prices, 206–207
Disclosure, 1902–1903
Standard cost method, 277–278
United Nations Global Compact, 1900
Standard-­setting process, HKFRS
United Nations Sustainable Development
Council of the HKICPA, 18
Goals, 1900–1901
on financial reporting issues, 20
integrated reporting, 1912–1913
Financial Reporting Standards Committee
New HKEx Guidance, 1915
(FRSC), 17, 18
sustainability and ESG reporting
IFRS relationship, 19
challenges in, 1912
interpretations, 20 HKEx’s ESG reporting guide, 1903–1911
post-­implementation review (PIR), 20–21 Hong Kong’s Companies Ordinance,
Regulatory Oversight Board (ROB), 17, 18 1911–1912
roles of the Council of the HKICPA, 17
rulings, 20
and structure, 18–19 T
Star Limited (Star), 1187
Tangible elements, 533–534
Star Provider Limited (Star Provider), 835
Task Force on Climate-­related Financial Disclosure
Star Reach Limited (SRL), 1483
(TCFD), 1902–1903
Statement of cash flows, 1421–1424, 1421, 1437
Taxable profit (tax loss), 1019
Statement of changes in equity, 1418–1419
Taxable temporary difference, 1029–1032
Statement of financial position, 1405
Tax assets and tax liabilities
current assets, 1408
current tax asset, 1053
current liabilities, 1408–1409
deferred tax asset, 1053–1054
disclosures required, 1409–1410
Tax base, 1025–1026
presentation of, 1405–1407
of asset, 1026
share capital disclosure, 1410
of liability, 1027–1028
Statement of profit or loss and other
Tax expense (tax income), 1019
comprehensive income, 1411
Tax liabilities
other comprehensive income, 1416–1417
current tax asset, 1053
presentation of, 1412–1416
deferred tax asset, 1053–1054

1949

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 FINANCIAL REPORTING

Tax reconciliation, 1056 U

Tech Savvy Limited (Tech Savvy), 440–441
Tellev Phones Limited (Tellev), 181 Unconsolidated subsidiaries, 1856–1857
Temporary difference, 1029 Underlying asset, 422, 430
asset or liability, initial recognition of, Unguaranteed residual value, 464
1037–1040 United Nations Global Compact (UNGC), 1900
deductible, 1032–1037 United Nations Sustainable Development Goals
taxable, 1029–1032 (UNSDGs), 1900–1901
unrecognised deferred tax assets, United States Dollars (USD), 1689
reassessment of, 1043 Unrecognised deferred tax assets,
and unused tax credits, 1040–1041 reassessment of, 1043
unused tax losses, 1040–1041 Unused tax credits, 1040–1041
Termination benefits, 1218 Unused tax losses, 1040–1041
disclosure, 1220 Upstream sale of inventory, 1737–1738
recognition and measurement, 1218–1219 Upstream transactions, 1734
Thought Leaders Limited (Thought Leaders), 436 Usage-­based royalty, 236
Threats Useful life, 302
advocacy, 116
familiarity, 116 V
intimidation, 117
self-­interest, 115 Valuation techniques
self-­review, 115 cost approach, 157
Time value of money, 971 income approach, 157–161
Timing of performing impairment tests, 736 market approach, 156
Total comprehensive income, 1412 Value in use, 733
Transaction, business combinations discount rate, 745–746
acquisition-­related costs, 1535–1536 vs. fair value, 743–744
deferred tax arising from, 1536–1537 future cash flows, 744–745
Transaction costs, 143 Variable production overhead costs, 274
Transaction price, 196 Vertical group, 1821
allocated to the remaining performance Vest, 1241
obligations, 248 Vesting condition, 1246
consideration payable to a customer, 204–205 Vesting period, 1246
entity’s estimate of, 196 VisionCo TVs Limited (VisionCo), 271, 272, 276
non-­cash consideration, 204
significant financing component, contract, W
201–203
variable consideration, 197–201 Weighted average cost, 280
Transactions, related party, 1133, 1142–1144 Work in progress inventories, 273
Transport costs, 143 Write down of inventory, 284
Treasury shares, 635
True and fair view, 12
X
Two-­step process, of assets impairment,
733–734 XYZ Group (XYZ), 1897

1950

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M11_bindex.indd 1951 10/27/2022 6:14:42 PM
M11_bindex.indd 1952 10/27/2022 6:14:42 PM
 Ind ex

VOLUME 2 QUALIFICATION PROGRAMME QU

PR

VO

HKICPA Qualification: Pr
M

A Pathway to Success
The Qualification Programme (QP) of the Hong Kong Institute of CPAs (HKICPA) provides
a pathway for the development of world-class practicing accountants. The HKICPA is
the statutory body established by the Professional Accountants Ordinance responsible
for the professional training, development and regulation of certified public accountants
in Hong Kong. Members of the Institute are entitled to the description “certified public
accountant” and to the designation CPA.

Since 1973, the HKICPA (previously known as the Hong Kong Society of Accountants)
has worked to further the public interest by promoting efficient accounting practices in
Hong Kong. Through its efforts in promulgating financial reporting, auditing and ethical
standards, the Institute has helped safeguard Hong Kong’s leadership as an international
financial centre.

Our QP assures the quality of entry into the profession by providing accountants with
the knowledge base they need to meet future market needs. Successful participants
develop skills by completing training courses, passing examinations and acquiring
practical experience.

The QP consists of three levels. At the Associate Level, participants develop a solid
technical foundation. The aim of the Professional Level is to deepen technical capabilities.
The Capstone integrates knowledge, skills and experiences and applies them to business
problems.

The QP provides accountants with relevant and portable skills that enhance their
employability and opens the door to opportunities in Hong Kong and around the world.

The Hong Kong Institute of Certified Public Accountants

37th Floor, Wu Chung House, 213 Queen’s Road East, Wanchai, Hong Kong
Tel: (852) 2287 7228
Fax: (852) 2137 3293

www.hkicpa.org.hk

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