Module A Financial Reporting

HKMAST13 (3" front binder)_Layout 1 02/08/2013 11:15 Page 1
Qualification Programme
Module A: Financial Reporting

4th EDITION F O U RT H E D I T I O N
LEARNING PACK
Module A
Financial Reporting
First edition 2010
Fourth edition 2013
ISBN 9781 4453 6965 5

Previous ISBN 9781 4453 6125 3
British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the
British Library
Published by
BPP Learning Media Ltd

BPP House, Aldine Place
142-144 Uxbridge Road
London W12 8AA
www.bpp.com/learningmedia
The copyright in this publication is jointly owned by

BPP Learning Media Ltd and HKICPA.
Printed in Singapore by Ho Printing
31 Changi South Street 1

Changi South Industrial Estate
Singapore
486769
Your learning materials, published by BPP Learning

Media Ltd, are printed on paper obtained from
traceable sustainable sources.
All rights reserved. No part of this publication may be

reproduced, stored in a retrieval system or transmitted in
any form or by any means, electronic, mechanical,
photocopying, recording or otherwise, without the prior
written permission of the copyright holders.
The contents of this book are intended as a guide and not

professional advice. Although every effort has been made
to ensure that the contents of this book are correct at the
time of going to press, BPP Learning Media, the Editor and
the Author make no warranty that the information in this
book is accurate or complete and accept no liability for any
loss or damage suffered by any person acting or refraining
from acting as a result of the material in this book.
Every effort has been made to contact the copyright

holders of any material reproduced within this publication.
If any have been inadvertently overlooked, BPP Learning
Media will be pleased to make the appropriate credits in
any subsequent reprints or editions.
We are grateful to HKICPA for permission to reproduce the

Learning Outcomes and past examination questions, the
copyright of which is owned by HKICPA.
©
HKICPA and BPP Learning Media Ltd
2013
ii
Contents
Page
Director's message v
Introduction vi
Module structure vii
Chapter features viii
Learning outcomes ix
Module A Financial Reporting
Part A Legal environment

1 Legal environment 3
Part B Financial reporting framework

2 Financial reporting framework 25
3 Small company reporting 65
Part C Accounting for business transactions

I Statements of financial position and comprehensive income
4 Non-current assets held for sale and discontinued operations 85
5 Property, plant and equipment 103
6 Investment property 123
7 Government grants 137
8 Intangible assets and impairment of assets 147
9 Leases 187
10 Inventories 213
11 Provisions, contingent liabilities and contingent assets 227
12 Construction contracts 245
13 Share-based payment 265
14 Revenue 291
15 Income taxes 317
16 Employee benefits 355
17 Borrowing costs 381
18 Financial instruments 393
II Statement of cash flows
19 Statements of cash flows 445
Introduction iii
Page
III Disclosure and reporting
20 Related party disclosures 475
21 Accounting policies, changes in accounting estimates and errors; events
after the reporting period 487
22 Earnings per share 505
23 Operating segments 527
24 Interim financial reporting 539
25 Presentation of financial statements 553
Part D Group financial statements

26 Principles of consolidation 579
27 Consolidated accounts: accounting for subsidiaries 613
28 Consolidated accounts: accounting for associates and joint arrangements 659
29 Changes in group structures 683
30 Consolidation of foreign operations 729
Answers to exam practice questions 753

Question bank – questions 799
Question bank – answers 823
Glossary of terms 869
Index 887
iv Financial Reporting
Director's message
Welcome to the Qualification Programme (QP) of the Hong Kong Institute of Certified Public
Accountants (HKICPA).
You have made the decision to complete the HKICPA's QP which entails completing the training
programme, passing professional examinations and acquiring practical experience under an
authorized employer or supervisor. This marks a further step on your pathway to a successful
business career as a CPA and becoming a valued member of the HKICPA.
The QP comprising four core modules and a final examination will provide you with a foundation for
life-long learning and assist you in developing your technical, intellectual, interpersonal and
communication skills. You will find this programme challenging with great satisfaction that will open
a wide variety of career opportunities bringing in attractive financial rewards.
A module of the QP involves approximately 120 hours of self-study over fourteen weeks,
participation in two full-day workshops and a three-hour open-book module examination at the
module end. We encourage you to read this Learning Pack which is a valuable resource to guide
you through the QP.
The four core modules of the QP are as follows:
Module B: Corporate Financing
Module C: Business Assurance
Module D: Taxation
Should you require any assistance at any time, please feel free to contact us on (852) 2287 7228.
May I wish you every success in your QP!
Jonathan Ng
Executive Director
Hong Kong Institute of Certified Public Accountants
Introduction v
Introduction
This is the fourth edition of the Learning Pack for Module A Financial Reporting of the HKICPA
Qualification Programme.
The Institute is committed to updating the content of the Learning Pack on an annual basis to keep
abreast of the latest developments. This edition has been developed after having consulted and
taken on board the feedback received from different users of the previous edition. Some of the
examples and self-test questions have been rewritten to better reflect current working practices in
industry and facilitate the learning process for users of the Learning Pack.
The Learning Pack has been written specifically to provide a complete and comprehensive
coverage of the learning outcomes devised by HKICPA, and has been reviewed and approved by
the HKICPA Qualification and Examinations Board for use by those studying for the qualification.
The HKICPA Qualification Programme comprises two elements: the examinations and the
workshops. The Learning Pack has been structured so that the order of the topics in which you
study is the order in which you will encounter them in the workshops. There is a very close inter-
relationship between the module structure, the Learning Pack and the workshops. It is important
that you have studied the chapters of the Learning Pack relevant to the workshops before you
attend the workshops, so that you can derive the maximum benefit from them.
On page (ix) you will see the HKICPA learning outcomes. Each learning outcome is mapped to the
chapter in the Learning Pack in which the topic is covered. You will find that your diligent study of
the Learning Pack chapters and your active participation in the workshops will prepare you to
tackle the examination with confidence.
One of the key elements in examination success is practice. It is important that not only you fully
understand the topics by reading carefully the information contained in the chapters of the Learning
Pack, but it is also vital that you take the necessary steps to practise the techniques and apply the
principles that you have learned.
In order to do this, you should:
 work through all the examples provided within the chapters and review the solutions,
ensuring that you understand them;
 complete the self-test questions within each chapter, and then compare your answer with the
solution provided at the end of the chapter; and
 attempt the exam practice questions that you will find at the end of the chapter. Many of
these are HKICPA past examination questions, which will give an ideal indication of the
standard and type of question that you are likely to encounter in the examination itself. You
will find the solutions to exam practice questions at the end of the book.
In addition, you will find at the end of the Learning Pack a bank of past HKICPA case-study style
questions. These are past ‘Section A’ examination questions, which present a case study testing a
number of different topics within the syllabus. These questions will provide you with excellent
examination practice when you are in the revision phase of your studies, bringing together, as they
do, the application of a variety of different topics to a scenario.
Please note that the Learning Pack is not intended to be a 'know-it-all' resource. You are required
to undertake background reading including standards, legislations and recommended texts for the
preparation for workshop and examination.
vi Financial Reporting
Module Structure
This module will enable you to exercise judgment in selecting and applying accounting policies to
prepare financial statements (both at individual company and group levels) in compliance with the
relevant Hong Kong Financial Reporting Framework and Hong Kong Accounting Standards
('HKFRSs'). Please refer to the QP Learning Centre for the six-month rule and examinable
standards.
Overall Structure of Module A (Financial Reporting)
Introduction vii
Chapter features
Each chapter contains a number of helpful features to guide you through each topic.
Topic list Tells you what you will be studying in the chapter. The topic items form the
numbered headings within the chapter.
Learning focus Puts the chapter topic into perspective and explains why it is important, both
within your studies and within your practical working life.
Learning The list of Learning Outcomes issued for the Module by HKICPA,
Outcomes referenced to the chapter in the Learning Pack within which coverage will be
found.
Topic highlights Summarise the key content of the particular section that you are about to
start. They are also found within sections, when an important issue is
introduced other than at the start of the section.
Key terms Definitions of important concepts. You really need to know and understand
these before the examination, and understanding will be useful at the
workshops too.
Examples Illustrations of particular techniques or concepts with a worked solution or

explanation provided immediately afterwards.
Case study An example or illustration not requiring a solution, designed to enrich your
understanding of a topic and add practical emphasis. Often based on real
world scenarios and contemporary issues.
Self-test questions These are questions that enable you to practise a technique or test your
understanding. You will find the answer at the end of the chapter.
Formula to learn You may be required to apply financial management formulae in Module B,
Corporate Financing.
Topic recap Reviews and recaps on the key areas covered in the chapter.
Exam practice A question at the end of the chapter to enable you to practise the
techniques that you have learned. In most cases this will be a past HKICPA
examination question, updated as appropriate. You will find the answers in a
bank at the end of the Learning Pack entitled Answers to Exam Practice
Questions.
Further reading In Modules B and D you will find references to further reading that will help
you to understand the topics and put them into the practical context. The
reading suggested may be books, websites or technical articles.
Bold text Throughout the Learning Pack you will see that some of the text is in bold
type. This is to add emphasis and to help you to grasp the key elements
within a sentence or paragraph.
viii Financial Reporting

Learning outcomes
HKICPA's learning outcomes for the Module are set out below. They are cross-referenced to the
chapter in the Learning Pack where they are covered.
Fields of competency
The items listed in this section are shown with an indicator of the minimum acceptable level of
competency, based on a three-point scale as follows:
1 Awareness
To have a general professional awareness of the field with a basic understanding of relevant
knowledge and related concepts.
2 Knowledge
The ability to use knowledge to perform professional tasks competently without assistance in
straightforward situations or applications.
3 Application
The ability to apply comprehensive knowledge and a broad range of professional skills in a
practical setting to solve most problems generally encountered in practice.
Topics
Chapter
where
Competency covered
LO1. Legal environment

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

requirement for a prospectus
LO1.05 Debt instruments and registration of charges: 2
1.05.01 Describe the procedure for the issue of debt 1
instruments
1.05.02 Describe the procedure for the registration of 1
charges over company debt
LO1.06 Statutory reporting and documentation requirements: 3
1.06.01 Explain the statutory registers that must be kept 1
by a company
1.06.02 Identify the financial statements that a company 1
must prepare
LO1.07 Appointment and removal of auditors: 3
1.07.01 Describe the procedures for the appointment, 1
removal and resignation of company auditors
LO1.08 Restructuring, including appointment of receivers and 1
liquidators:
1.08.01 Identify the reasons for which a company may 1
restructure, including the appointment of
receivers and liquidators
LO2. Financial reporting framework
Describe the financial reporting framework in Hong Kong and
the related implications for business activities
LO2.01 The role and setting of accounting standards: 2
2.01.01 Understand the role of accounting standards 2
2.01.02 Understand the role of the HKICPA, Securities 2
and Futures Commission (SFC), Financial
Reporting Council (FRC), the Hong Kong
Insurance Authority (HKIA), the Hong Kong
Monetary Authority (HKMA) and the Hong Kong
Stock Exchange (HKEx)
LO2.02 Hong Kong Financial Reporting Standards: 2
2.02.01 Describe how Hong Kong Financial Reporting 2
Standards are set
LO2.03 Small and Medium-sized Entity Financial Reporting 2
Framework and Financial Reporting Standard:
2.03.01 Identify the conditions under which an entity may 3
adopt the SME Financial Reporting Framework
and Financial Reporting Standard
2.03.02 Describe the requirements of the SME Financial 3
Reporting Framework and Financial Reporting
Standard
x Financial Reporting
Chapter
where
Competency covered
LO2.04 Hong Kong Financial Reporting Standard for Private 2

Entities
2.04.01 Identify the conditions under which an entity may 3
adopt the HKFRS for Private Entities
2.04.02 Describe the requirements of the HKFRS for 3
Private Entities
LO2.05 Code of Ethics for Professional Accountants: 3
2.05.01 Explain the requirements of the Code of Ethics for 2
Professional Accountants
LO2.06 Hong Kong (IFRIC) Interpretations, Hong Kong 2
Interpretations and Hong Kong (SIC) Interpretations:
2.06.01 Describe the status of Hong Kong (IFRIC) 2
Interpretations, Hong Kong Interpretations and
Hong Kong (SIC) Interpretations
LO2.07 Other professional pronouncements and exposure drafts: 2
2.07.01 Identify other professional pronouncements and 2
exposure drafts relevant to the financial reporting
Conceptual Framework
LO2.08 Regulatory bodies and their impact on accounting: 2
2.08.01 Identify relevant regulatory bodies and their 2
impact on accounting
LO2.09 Accounting principles and conceptual frameworks: 2
2.09.01 Explain what is meant by a conceptual framework 2
and GAAP
2.09.02 Identify the advantages and disadvantages of a 2
conceptual framework
2.09.03 Identify the components and requirements of the 2
HKICPA's Conceptual Framework
2.09.04 Explain those requirements of HKAS 1 2
Presentation of Financial Statements which
overlap with the HKICPA's Conceptual
Framework
LO2.10 Current developments 2
2.10.01 Identify areas of accounting in which current 2
developments are occurring
LO3. Accounting for business transactions
Account for transactions in accordance with Hong Kong
Financial Reporting Standards
LO3.01 Accounting policies, changes in accounting estimates and 3
errors:
3.01.01 Distinguish between accounting policies and 21
accounting estimates in accordance with HKAS 8
Introduction xi
Chapter
where
Competency covered
3.01.02 Account for a change in accounting policy 21
3.01.03 Account for a change in accounting estimate 21
3.01.04 Correct a prior period error 21
LO3.02 Revenue: 3
3.02.01 Define revenue and identify revenue within the 14
scope of HKAS 18
3.02.02 Measure revenue at the fair value of 14
consideration received
3.02.03 Identify revenue transaction including multiple 14
element arrangements
3.02.04 Determine the recognition criteria for specified 14

types of revenue items including sales of goods,
rendering of services and interest, royalties and
dividends
3.02.05 Disclose revenue as appropriate in the financial 14
statements
3.02.06 Explain the recognition and measurement 14
principles
LO3.03 Government grants and assistance: 3
3.03.01 Accounting and presentation of government grants 7
3.03.02 Disclosure of government grants and assistance
in accordance with HKAS 20 7
LO3.04 Employee benefits: 2
3.04.01 Identify short-term employee benefits in 16
accordance with HKAS 19 and apply the
recognition and measurement principles in
respect of short-term employee benefits
3.04.02 Distinguish between defined contribution plans 16
and defined benefit plans
3.04.03 Account for defined contribution plans 16
3.04.04 Identify termination benefits in accordance with 16
HKAS 19 and apply the recognition and
measurement principles in respect of termination
benefits
xii Financial Reporting

Chapter
where
Competency covered
LO3.05 Share-based payment: 2

3.05.01 Identify and recognise share-based payment 13
transactions in accordance with HKFRS 2
3.05.02 Account for equity-settled and cash-settled share- 13
based payment transactions
3.05.03 Account for share-based payment transactions 13
with cash alternatives
3.05.04 Account for unidentified goods or services in a 13
share-based payment transaction
3.05.05 Account for group and treasury share 13
transactions
3.05.06 Disclosure requirement of share option 13
LO3.06 Inventories: 3
3.06.01 Scope and definition of HKAS 2 Inventories 10
3.06.02 Calculate the cost of inventories in accordance 10
with HKAS 2
3.06.03 Use accepted methods of assigning costs 10
including the allocation of overheads to
inventories
3.06.04 Explain the potential impact of net realisable 10
value falling below cost and make the required
adjustments
3.06.05 Calculate and analyse variances in a standard 10
costing system and advise on the appropriate
accounting treatment to be adopted in respect of
inventories
3.06.06 Prepare a relevant accounting policy note and 10
other required disclosures in respect of
inventories
LO3.07 Construction contracts: 3
3.07.01 Define a construction contract 12
3.07.02 Explain when contract revenue and costs should 12
be recognised in accordance with HKAS 11
3.07.03 Explain how contract revenue and costs should 12
be measured and apply these principles
3.07.04 Account for the expected loss and changes in 12
estimates
3.07.05 Disclose information related to construction 12
contracts in the financial statements
Introduction xiii
Chapter
where
Competency covered
LO3.08 Property, plant and equipment: 3

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

Chapter
where
Competency covered
LO3.10 Investment property: 3

3.10.01 Identify an investment property within the scope 6
of HKAS 40 and situation when a property can be
transferred in and out of the investment property
category
3.10.02 Distinguish investment property from other 6
categories of property holdings and describe the
difference in accounting treatment
3.10.03 Apply the recognition and measurement rules 6
relating to investment property
3.10.04 Account for investment property 6
3.10.05 Disclose relevant information, including an 6
accounting policy note, for investment property
LO3.11 Financial assets, financial liabilities and equity 2

instruments:
3.11.01 Discuss and apply the criteria for the recognition 18
and de-recognition of a financial asset or financial
liability
3.11.02 Discuss and apply the rules for the classification 18
of a financial asset, financial liability and equity,
and their measurement (including compound
instrument)
3.11.03 Discuss and apply the treatment of gains and 18
losses arising on financial assets or financial
liabilities
3.11.04 Discuss the circumstances that give rise to and 18
apply the appropriate treatment for the
impairment of financial assets
3.11.05 Account for derivative financial instruments and 18
simple embedded derivatives, including the
application of own-use exemption
18
3.11.06 Disclose relevant information with regard to
financial assets, financial liabilities and equity
instruments
Introduction xv
Chapter
where
Competency covered
LO3.12 Borrowing costs: 3

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

Chapter
where
Competency covered
LO3.14 Leases: 3
3.14.01 Identify the types of lease within the scope of 9
HKAS 17 and define the terminology used in
relation to leases
3.14.02 Classify leases as operating or finance leases by 9
looking at the substance of the transaction
3.14.03 Account for operating leases from the perspective 9
of both the lessee and the lessor
3.14.04 Disclose the relevant information relating to 9
operating leases in the accounts of both the
lessee and the lessor
3.14.05 Account for finance leases from the perspective
9
of both the lessee and the lessor
3.14.06 Disclose the relevant information relating to
9
finance leases in the accounts of both the lessee
and the lessor
3.14.07 Account for manufacturer/dealer leases
9
3.14.08 Account for sale and leaseback transactions
9
3.14.09 Explain the term off-balance sheet finance and
9
the importance of substance over form
3.14.10 Explain how to determine whether an
9
arrangement contains a lease
LO3.15 Events after the reporting period: 3
3.15.01 Explain the period during which there is 21
responsibility for reporting events in accordance
with HKAS 10
3.15.02 Define adjusting and non-adjusting events 21
3.15.03 Explain when the financial statements should be 21
prepared on a basis other than going concern
LO3.16 Provisions, contingent liabilities and contingent assets: 3
3.16.01 Define provisions, contingent liabilities and 11
contingent assets within the scope of HKAS 37
3.16.02 Distinguish provisions from other types of 11
liabilities
3.16.03 Explain the criteria for recognition of provisions 11
and apply them to specific circumstances
3.16.04 Apply the appropriate accounting treatment for 11
contingent assets and liabilities
contingent liabilities in the financial statements
3.16.06 Account for decommissioning, restoration and 11
similar liabilities and their changes
contingent assets in the financial statements
Introduction xvii
Chapter
where
Competency covered
LO3.17 Hedge accounting: 2

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

Chapter
where
Competency covered
LO3.21 Non-current assets held for sale and discontinued 3

operations:
3.21.01 Define non-current assets (or disposal groups) 4
held for sale or held for distribution to owners and
discontinued operations within the scope of
HKFRS 5 4
3.21.02 Explain what assets are within the measurement
provision of HKFRS 5
4
3.21.03 Determine when a sale is highly probable
3.21.04 Measure non-current assets held for sale and 4
discontinued operations including initial
measurement, subsequent measurement and
change of plan
3.21.05 How to account for impairment loss and
4
subsequent reversals
3.21.06 Present the non-current asset held for sale and
4
discontinued operation in the financial statements
(including the prior year restatement)
LO3.22 Earnings per share: 3
3.22.01 Explain the meaning and significance of a 22
company's earnings per share
3.22.02 Calculate the earnings per share, including the 22
impact of a bonus issue, a rights issue and an
issue of shares at full market value in accordance
with HKAS 33
3.22.03 Explain the relevance of a company's diluted 22
earnings per share
3.22.04 Discuss the limitations of using earnings per 22
share as a performance measure
LO3.23 Operating segments: 3
3.23.01 Identify and discuss the nature of segmental 23
information to be disclosed in accordance with
HKFRS 8
3.23.02 Explain when operating segments should be 23
aggregated and disaggregated
3.23.03 Disclose the relevant information for operating 23
segments and appropriate entity-wide information
Introduction xix
Chapter
where
Competency covered
LO3.24 Interim financial reporting: 3

3.24.01 Identify the circumstances in which interim 24
financial reporting is required in accordance with
HKAS 34
3.24.02 Explain the purpose and advantages of interim 24
financial reporting
3.24.03 Explain the recognition and measurement 24
principle of interim financial statements and apply
them
3.24.04 Disclose the relevant information for interim 24
financial statements including seasonality
LO4. Preparation and presentation of financial statements
Prepare the financial statements for an individual entity in
accordance with Hong Kong Financial Reporting Standards and
statutory reporting requirements
LO4.01 Primary financial statement preparation: 3
4.01.01 Prepare the statement of financial position, the 19, 25
statement of profit or loss and other
comprehensive income, the statement of changes
in equity and the statement of cash flows of an
entity in accordance with Hong Kong accounting
standards 25
4.01.02 Explain the minimum line items that should be
presented in the financial statements and criteria
for additional line items
LO4.02 Financial statement disclosure requirements: 3
4.02.01 Disclose accounting policy and items required by 25
the HKFRS, Companies Ordinance and other
rules and regulations
4.02.02 Explain the importance to disclose significant 25
judgement and estimates
xx Financial Reporting
Chapter
where
Competency covered
Prepare the financial statements for a group in accordance with
Hong Kong Financial Reporting Standards and statutory
reporting requirements
LO4.03 Principles of consolidation: 3
4.03.01 Identify and describe the concept of a group as a 26
single economic entity
4.03.02 Define a subsidiary and when a group should 26
start and stop consolidating a subsidiary
4.03.03 Explain what constitutes control and the impact of 26
potential voting rights
4.03.04 Describe the reasons why the directors of a 26
company may not want to consolidate a
subsidiary and the circumstances in which non-
consolidation is permitted
4.03.05 Explain the purpose of consolidated financial 26
statements
4.03.06 Explain the importance of eliminating intra-group 26
transactions
4.03.07 Explain the importance of uniform accounting 26
policies and coterminous year ends in the
preparation of consolidated accounts
4.03.08 Apply the appropriate accounting treatment of 26
consolidated goodwill
4.03.09 Explain how to account for changes in parent's 29
ownership interest in a subsidiary without losing
control
LO4.04 Acquisition of subsidiaries: 3
4.04.01 Prepare a consolidated statement of financial 27
position for a simple/complex group structure
including pre and post acquisition profits, non-
controlling interests and goodwill
4.04.02 Prepare a consolidated statement of profit or loss 27
and other comprehensive income for a
simple/complex group structure, dealing with an
acquisition and the non-controlling interest
LO4.05 Disposal of subsidiaries: 3
4.05.01 Account for the disposal of a subsidiary by a 29
group
4.05.02 Account for the change of ownership in 29
subsidiaries without loss of control
Introduction xxi
Chapter
where
Competency covered
LO4.06 Business combinations: 3

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

Chapter
where
Competency covered
LO4.08 Interests in joint arrangements: 3

4.08.01 Define joint arrangements in accordance with 28
HKFRS 11
4.08.02 Explain the difference among jointly controlled 28
operations and joint ventures
4.08.03 Explain how an entity should account for a joint
venture 28
4.08.04 Account for the transactions between a venturer
and a joint venture 28
4.08.05 Disclose the relevant information in the venturer's
financial statements 28
LO4.09 Consolidated financial statement preparation 3
4.09.01 Prepare a consolidated statement of financial 27
position in compliance with HKFRS 10
4.09.02 Prepare a consolidated statement of profit or loss 27
and other comprehensive income
4.09.03 Prepare a consolidated statement of cash flows 19
LO4.10 Financial statement disclosure requirement 3
4.10.01 Disclose the relevant information for business 26
combinations occurred during and subsequent to
the reporting period
LO4.11 Merger accounting for common control combinations 2
4.11.01 Describe the principles and practices of merger 29
accounting
4.11.02 Apply merger accounting to a common control 29
combination
Introduction xxiii
xxiv Financial Reporting
Part A
Legal environment
The emphasis in this section is on the legal environment in Hong Kong. The purpose of this
section is to develop your understanding of the Hong Kong legal environment, including the
legal framework and the related implications for business activities. This is considered as the
basic knowledge and foundation for a future certified public accountant.
1
Financial Reporting
2
chapter 1
Legal environment
Topic list
1 Hong Kong legal framework

1.1 Types and relative advantages of alternative forms of organisation
1.2 Legal procedures for establishment of companies
1.3 Corporate governance
2 Obligations of directors and officers of companies
2.1 Directors’ responsibilities
2.2 Officers of companies
3 Legal requirements associated with company structure, share offerings, financial statements,
debt obligations and restructuring
3.1 Share issues and prospectus requirements
3.2 Debt instruments and registration of charges
3.3 Statutory reporting and documentation requirements
3.4 Appointment and removal of auditors
3.5 Restructuring, including appointment of receivers and liquidators
3.6 Financial statements requirements
Learning focus
This chapter is partly background knowledge to set the scene about the legal environment
before you look at financial reporting standards. It also discusses the legal framework and
related implications for business activities. It is important that you are aware of these both for
exam purposes and in practice.
3
Financial Reporting
Learning outcomes
In this chapter you will cover the following learning outcomes:
Competency
level
Describe the Hong Kong legal framework and related implications for
business activities
1.01 Types and relative advantage of alternative forms of 2
organisation
1.01.01 Identify the types and relative advantages of alternative forms of
organisation
1.02 Legal procedures for establishment and governance of 2
companies
1.02.01 Describe the legal procedures for the establishment and
governance of companies
1.03 Powers, duties and obligations of directors and company 2
secretaries
1.03.01 Describe the powers, duties and obligations of company directors
1.03.02 Describe the powers, duties and obligations of the company
secretary
1.04 Share issues and prospectus requirements 2
1.04.01 Describe the procedure for issuing shares and the requirement for a
prospectus
1.05 Debt instruments and registration of charges 2
1.05.01 Describe the procedure for the issue of debt instruments
1.05.02 Describe the procedure for the registration of charges over
company debt
1.06 Statutory reporting and documentation requirements 3
1.06.01 Explain the statutory registers that must be kept by a company
1.06.02 Identify the financial statements that a company must prepare
1.07 Appointment and removal of auditors 3
1.07.01 Describe the procedures for the appointment, removal and
resignation of company auditors
1.08 Restructuring, including appointment of receivers and 1
liquidators
1.08.01 Identify the reasons for which a company may restructure, including
the appointment of receivers and liquidators
4
1: Legal environment | Part A Legal environment
1 Hong Kong legal framework

Topic highlights
Certified public accountants need to understand the different forms of business entities that operate
in Hong Kong. You can apply the knowledge you obtain from this section of the Learning Pack to
demonstrate this competence.
The liability of the members of companies can be unlimited or limited. We are mainly concerned
with limited companies in this section.
1.1 Types and relative advantages of alternative forms of

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

A sole proprietorship also known as a sole trader, or simply proprietorship, is a type of
business entity which is owned and run by one individual and where there is no legal distinction
between the owner and the business. All profits and all losses accrue to the owner (subject to
taxation). All assets of the business are owned by the proprietor and all debts of the business are
their debts and they must pay them from their personal resources. This means that the owner has
unlimited liability. It is a "sole" proprietorship in the sense that the owner has no partners
(partnership). A sole proprietor may do business with a trade name other than his or her legal
name. This also allows the proprietor to open a business account with banking institutions.
This form of business has a major advantage in that it is easy and quick to set up. Furthermore
details of the business and its operation remain private as there is no requirement to file documents
such as accounts.
There are, however, drawbacks to operating as a sole trader, the main one being that the sole
trader is not legally separated from his business and therefore remains individually and personally
liable for any losses that the business makes.
In Hong Kong, all the investor needs to do is to apply for a business licence from the Business
Registration Office of the Inland Revenue Department. Every person carrying on a business shall
make such an application within one month of the commencement of the business.
1.1.2 Partnerships
A partnership is a business entity formed by the Hong Kong Partnerships Ordinance, which
defines a partnership as "the relation between persons carrying on a business in common with a
view of profit" and is not a joint stock company or an incorporated company.
There must be at least two partners, but not more than 20 partners, otherwise it would be treated
as a company (single entity) unless the partnership is a partnership of professional solicitors,
accountants and stockbrokers. The partners share any profits and losses and inject funding by way
of partners' capital.
There are two different kinds of partnership. If the business entity registers with the Registrar of
Companies it takes the form of a limited partnership defined in the Limited Partnerships Ordinance.
5
Financial Reporting
However, if this business entity fails to register with the Registrar of Companies, then it becomes a
general partnership as a default.
In a general partnership all partners are general partners so each one is liable for all debts and
obligations of the firm.
In a limited partnership the general partners are liable for all debts and obligations of the firm
while the limited partners are liable only for the capital they contributed to the firm.
In a limited partnership the general partners manage the firm while the limited partners may not
and should limited partners do so then they become personally liable for the debts of obligations of
the firm in the same manner as a general partner.
Unless a partnership agreement between the partners demand otherwise, (1) a majority of the
general partners decide ordinary business matters, (2) a limited partner may assign his partnership
interests, (3) a limited partner cannot dissolve a partnership, (4) the introduction of a new partner
does not require the consent of the existing limited partners.
A partnership business, in common with a sole trader business, is not required to make accounts
and other documents public. It also has the additional advantages of:
 greater access to capital since more individuals contribute to the business
 potentially a greater spread of skills provided by the partners
 shared risk
The disadvantages of a partnership include the issue of disputes in the running of the business,
and unlimited liability. Additionally, partners are jointly and severally liable for their partners,
meaning that any one may be held responsible for losses of the business.
1.1.3 Companies
A company is bound by applicable rules and regulations. This regulated formal structure is a
reason why companies are such a popular business structure. It is a comparatively safe and stable
system for different groups of people to join together in business activities.
The liabilities of the shareholders of companies in Hong Kong can be either limited or unlimited.
Extracts from Part 1 Division 3 Subdivision 1 of the new Companies Ordinance explain the
differences between unlimited companies and companies limited by shares or guarantee:
(a) Limited by shares – the members of the company are liable to pay the company's debts
only to the extent of the nominal value of their shares.
(b) Limited by guarantee – the members of the company are liable to pay the company's
debts only to the extent of a stated guarantee. This structure is often used by non-profit
organisations which do not want to have share capital, but want the benefits of using the
structure of a company.
(c) Unlimited – the members of the company are personally responsible for the debts of the
company. This type is less common but may suit partnerships who want to
use the more formal company structure for their business operation but are restricted by
some professional organisation from limiting their liability. In Hong Kong, sole proprietors
operating small businesses may also use this form of company.
Advantages of operating as a limited liability company
Advantages of a limited liability company include the following:
(a) The liability of the members is limited so reducing their personal exposure to debts should
the company fail.
(b) The separation of ownership and management may result in the smoother running of the
business and easier resolution of problems.
(c) A company may have better access to finance than unincorporated businesses and can
create a floating charge by the way of security.
6
(d) The ownership of the business is easily achieved through the transfer of shares.
Drawbacks of operating as a limited liability company
Drawbacks of a limited liability company include the following:
(a) The regulated formal operating structure comes at the cost of registration, secretarial and
audit fees.
(b) The stringent reporting requirements mean that details of the operation of the business are
made public and this increases the accountability of management.
(c) The process of operating is governed and sometimes inhibited by legal requirements. For
example, all limited companies are bound to compile accounts and to have their accounts
audited annually.
For these reasons, small business operators may prefer to operate as a sole trader or as a
partnership.
1.1.4 Joint ventures
A joint venture is a legal entity formed by two or more parties to undertake an economic activity
together. The entity formed (the joint venture) may be any type of legal structure including a
partnership or limited liability company.
Joint ventures are often the preferred, or required, method of entry into a new market. By forming a
joint venture with another company, entities can reduce the risks associated with accessing new
geographical or product markets. In certain jurisdictions, including Saudi Arabia, a foreign entity
cannot legally carry out business without forming an alliance with a national entity.
1.2 Legal procedures for establishment of companies

Companies are established under the provisions of the Companies Ordinance (Chapter 32 of the
Law of Hong Kong). A company operates under a memorandum or agreement between
subscribers or shareholders. It is common to also have articles of association for a company, which
are more detailed rules and regulations regarding meetings, resolutions and activities of the
company.
The new Companies Ordinance (the “new CO”) for Hong Kong was passed on 12 July 2012 with
21 Parts comprising 921 sections and 11 schedules, and will come into operation in 2014 after the
enactment of subsidiary legislation. The new CO was drafted with four major objectives:
1 enhancing corporate governance
2 ensuring better regulation
3 facilitating business
4 modernising the law
On disclosure, the new CO allows companies meeting specified size criteria (e.g. small and
medium enterprises or SME) to prepare simplified financial statements and directors’ reports. As
before, the new CO does not give a definition of what is a "true and fair view" for preparation of
financial statements.
The new CO abolishes the requirement to have a Memorandum of Association (“MA”) as a constitutional
document of a local company. A company incorporated in Hong Kong under the new CO is only required
to have Articles of Association (“AA”). Under the new CO, the information which was required to be
contained in the MA under the Companies Ordinance (Cap. 32) (“Cap. 32”) will be set out in the AA.
The AA of companies incorporated under the new CO must contain the following mandatory clauses (the
“Mandatory Articles”) :
 Company name (section 81)
 Members' liabilities (section 83)
 Liabilities or contribution of members (for limited companies) (section 84)
7
Financial Reporting
 Capital and initial shareholdings (for companies with a share capital) (section 85(1) and
section 8 of Part 5 of Schedule 2 to the new CO)
 For an association to be incorporated with a licence granted under section 103 or a limited
company granted with such a licence, its AA must state the company’s objects whilst the
licence remains in force (section 82).
The new CO adopts a mandatory system of no-par value for all local companies with a share
capital and retires the par value of shares, in line with international trends and to provide
companies with greater flexibilities in structuring their share capital.
Par value (also known as "nominal value") is the minimum price at which shares can generally be
issued. Before the implementation of the new CO, companies incorporated in Hong Kong and
having a share capital were required to have a par value ascribed to their shares. The
Administration has legislated for the migration to mandatory no-par. Relevant concepts such as
nominal value, share premium, and requirement for authorised capital will no longer be necessary
and will be abolished.
Schedule 11 part 4 Division 2 of the new CO contains transitional provisions in relation to the
abolition of par value. These state that at the beginning of the commencement date of the new
legislation, any amount standing to the credit of the company’s share premium account and capital
redemption reserve becomes part of the company’s share capital. Additionally, any amount that
would be required by a continuing provision to be transferred to a company’s share premium
account or capital redemption reserve on or after the commencement date of section 135 becomes
part of the company’s share capital.
Once registered with the Registrar of Companies, a company is issued with a certificate of
incorporation as evidence that all the requirements of the new CO have been met with respect to
the registration.
The most common form of business structure in Hong Kong is the limited liability company. Limited
companies can be private limited companies or public limited companies. Any company that
cannot meet the legal requirements to remain a private company must register as a public
company.
Private companies are devised for the small business and are intended for situations where the
members are also the managers of the company.
A private company is defined by new CO Part One Division 3 Subdivision 2 section 11 as a
company which by its articles:
(a) restricts the right to transfer its shares; and
(b) limits the number of members to 50, not including employees of the company and former
employees who were members of the company whilst employed and who have continued to
be members; and
(c) prohibits any invitation to the public to subscribe for any shares or debentures in the
company.
For the purposes of this section, two or more persons holding one share jointly are treated as one
member.
If a company's articles fail to satisfy the requirements of s.11, it is a public company, although the
term "public company" is not actually used in or defined by the new CO.
The main advantage of private companies is that they need not file accounts with their annual
return and, subject to a number of exceptions, they may waive compliance with certain
requirements as to the content of their accounts (s.359). When a private company sends its annual
return to the Registrar of Companies they are signed by a director or the secretary, stating that the
company has complied with s.11.
If a company alters its articles so that it no longer satisfies s.11, from the date of alteration the
company will cease to be a private company and within 14 days it must deliver to the Registrar a
8
prospectus or a statement in lieu of a prospectus in the form and containing the particulars
specified in the Companies (Winding up and Miscellaneous Provisions) Ordinance, which is the
revised name for the remaining provisions of the old Companies Ordinance. These documents are
also required before a company which is formed as a public company may allot any of its shares or
debentures.
Under the new CO s.94, the company must, within 15 days after the date on which the alteration takes
effect, deliver to the Registrar for registration:
(a) a notice of the change of the company’s status in the specified form; and
(b) a copy (certified by an officer of the company to be true) of the company’s annual financial
statements that are:
(i) prepared in accordance with section 379; and
(ii) prepared for the financial year immediately before the financial year in which the alteration
takes effect.
Under the new CO, the annual return of a public company or a guarantee company will no longer be
filed with reference to the date of Annual General Meeting ("AGM") as an AGM may be dispensed with
under s.612 of the new CO. The requirement is to deliver the annual return in respect of every financial
year of the company instead of in each calendar year.
Pursuant to sections 662(3) and (4) of the new CO, the annual return of a public company or a
guarantee company should be filed (together with certified true copies of the relevant financial
statements, directors' report and auditor's report) within 42 days after the company's return date.
The return date for a public company is 6 months after the end of the company's accounting reference
period while the return date for a guarantee company is 9 months after the end of the company's
accounting reference period.
The accounting reference period is the period by reference to which the company's annual financial
statements are to be prepared. For example, if a company prepares its financial statements up to 31
December every year, the accounting reference period is from the 1 January of a year to 31 December
of the same year.
There is no change in the requirement to file annual returns of private companies. Pursuant to sections
662(1) and (2) of the new CO, the annual return of a private company must be delivered for registration
within 42 days after the anniversary of the date of incorporation of the company.
1.3 Corporate governance

Topic highlights
Corporate governance has become increasingly important in recent years due to a number of
high profile corporate collapses. The new CO seeks to emphasise the importance of corporate
governance.
Key term
Corporate governance is the system by which companies are directed and controlled.
(Cadbury Report)
Corporate governance may be defined as the system and processes by which companies are
directed and controlled in response to the rights and expectations of shareholders and other
stakeholders. Corporate governance therefore covers a very wide range of issues and disciplines
from the appointment and the remuneration of directors, the procedures of the directors' meetings
and the role of non-executive directors, to the company's objectives, business strategy and risk
management, and to investor relations, employee relations and social responsibilities and so on.
9
Financial Reporting
Corporate governance has been the subject of much debate in the business world in recent
years. The trigger for this debate was the collapse of major international companies during the
1980s, including Maxwell, BCCI and Polly Peck. These collapses were often unexpected, and
dubious (or even fraudulent) activities were sometimes attributed to their owners and managers.
These events represented a nasty shock for countries, such as the UK and the USA, that felt they
had well-regulated markets and strong company legislation. It became obvious, however, that part
of the problem was the way in which regulation was spread between different national
authorities for these global conglomerates, so that no one national authority had the whole picture
of the affairs of such companies, nor full powers over the whole of the business.
Individual countries began to develop better guidelines for the corporate governance, and efforts
have been made to produce an international standard on corporate governance.
Since 1995, the Corporate Governance Committee of the Hong Kong Institute of CPAs has made a
series of recommendations for enhanced corporate governance disclosure in Hong Kong. In the
committee's latest report, Corporate Governance Disclosure in Annual Reports – A Guide to
Current Requirements and Recommendations for Enhancement, which was published in March
2001, the Committee repeated certain of those recommendations which have not yet been adopted
in the Listing Rules and made further recommendations for enhancement.
Some of the recommendations are extracted as follows:
(a) To communicate to shareholders the strength of their corporate governance structure,
policies and practices, listed companies and public corporation are encouraged to include in
their annual report a statement of corporate governance;
(b) To enhance comparability and transparency of the way directors are compensated, directors'
remuneration should be analysed between "performance based" and "non-performance
based";
(c) Disclosure requirements in respect of directors' share options should be extended to include
disclosure by individual director of the aggregate value realised. Aggregate value realised is
calculated as the excess of the market price on the day of exercise of the option over the
exercise price multiplied by the number of shares acquired as a result of the exercise of the
option;
(d) To aid communication with the reader of the financial statements, the directors should set
out in a separate statement their responsibilities in connection with the preparation of the
financial statements; and
(e) To increase transparency regarding auditors' independence, disclosure of non-audit fees
paid to auditors should be made.
The new CO in Hong Kong has introduced some measures for enhancing corporate governance, in
particular in the following areas:
(a) Strengthening the accountability of directors by requiring every private company to have
at least one natural person acting as director (rather than a corporate director, ie a company
acting as director) in order to enhance transparency and accountability.
(b) Enhancing shareholder engagement in the decision making process by:
 introducing detailed and comprehensive rules for the passing of written resolutions,
thus making it easier for shareholders to vote and companies to pass resolutions;
 by requiring companies to bear the expenses of circulating members’ statements
relating to AGMs, thus avoiding members being deterred from doing this by the cost;
 educing the threshold requirement for members to demand a poll from 10% to 5% of
the total voting rights
(c) Improving the disclosure of company information by requiring public companies and
large private companies (i.e. those that do not qualify for simplified reporting to prepare a
more comprehensive directors’ report, including a ‘business review’. This will include
10
information relating to environmental and employee matters, thus promoting corporate social
responsibility
(d) Fostering shareholder protection by:
 introducing rules to deal with directors’ conflicts of interests;
 requiring the approval of disinterested shareholders where shareholder approval is
required for transactions of public companies and their subsidiaries;
 introducing stricter rules for the ratification of the conduct of directors to prevent
conflicts of interest and abuse of power;
 extending the scope of the ‘unfair prejudice’ remedy
(e) Strengthening auditors’ rights by empowering auditors to require information or
explanations from a wider range of persons than was previously the case.
2 Obligations of directors and officers of companies

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

Directors are first and foremost responsible for the operation of a company, ensuring that it
operates as the shareholders intended within the corporate legal environment.
The new CO broadens the definition of director to "include any person occupying the position of
director by whatever name called". Directors' responsibilities are therefore imposed on the senior
management of a company, whether they are the directors, chief executives, senior managers or
other officers; it depends on the role they actually fulfil.
Section 456 of the new CO maintains the restriction on corporate directorship in public companies,
companies limited by guarantee and private companies which are members of a group of
companies of which a listed company is a member. This restriction, however, does not apply to
other private companies which are required to have at least one director who is a natural person.
The new CO requires every private company to have at least one director who is a natural person,
to enhance transparency and accountability.
The liability of directors is not specifically set out in the Companies Ordinance, and is generally
established by case law. In some situations, directors may be held personally liable for losses
caused to the company as a result of their actions. The new CO states that any provision in a
company’s articles or a contract which seeks to enable a director to avoid liability for any
negligence, default, breach of duty or breach of trust as a result of their actions will be void (Part
10 Division 3 section 468).
2.1.1 Duties and responsibilities
The Companies Registry issued “A Guide on Directors’ Duties” in July 2009. The general principles
of directors’ duties were explained as follows:
1 duty to act in good faith for the benefit of the company as a whole
2 duty to use powers for a proper purpose for the benefit of members as a whole
3 duty not to delegate powers except with proper authorisation and duty to exercise
independent judgment
4 duty to exercise care, skill and diligence
11
Financial Reporting
5 duty to avoid conflicts between personal interests and interests of the company
6 duty not to enter into transactions in which the directors have an interest except in
compliance with the requirements of the law
7 duty not to gain advantage from use of position as a director
8 duty not to make unauthorised use of the company’s property or information
9 duty not to accept personal benefit from third parties conferred because of position as a
director
10 duty to observe the company's memorandum and articles of association and resolutions
11 duty to keep proper books of account
These general principles involving duties and operation requirements are summarised further as
duties and powers below.
(a) Fiduciary duties
Directors must act honestly and in good faith for the benefit of the company.
In particular, directors must act in good faith in what they believe to be the best interests of
the company. Generally speaking, the interests of the company are to be equated with the
interests of its members as a whole. Directors must not act just for the economic advantage
of the majority of shareholders disregarding the interests of the minority. The position and
interests of creditors must be considered in any case where the company is not fully solvent.
The interests of the company's employees must also be taken into account.
Directors must act for a proper purpose. That is, directors must not abuse the powers
given to them by using those powers for purposes other than those for which they were
granted.
Directors must not obtain a personal profit from transactions entered into by the
company without the prior approval of the shareholders; otherwise such profits will be
regarded as being held in trust for the company and they may have to account for them.
Directors must not agree to fetter their discretion. As the powers delegated to directors
by the memorandum and articles are held in trust by them for the company, they must not
restrict their exercise of future discretion.
Directors must act in such a way that there is no possibility of conflict between
personal interests and company interests. Directors should also avoid any conflict of
interest by not using corporate property, information or opportunity for any purpose other
than in the company's interests.
(b) Duty to exercise skill and care
Directors must exercise reasonable care and skill in the performance of their duties.
The wide range of skills required of directors has meant that there have been no precise
standards of skill and care established in case law. In the past the courts have required that
directors display the degree of skill and care which may reasonably be expected from a
person with that director's knowledge and experience. If employed as having particular skills,
for example, as being a certified public accountant, a director should display the skill or
ability expected from a person of that profession. A certified public accountant may,
depending on the circumstances, be held professionally responsible if he or she should be
found negligent in the discharge of his or her duties as a director.
However, the new CO has introduced a statutory responsibility on directors to
exercise reasonable care, skill and diligence (s 465) which should make it easier for
courts to determine whether the duty of care has been exercised.
Statutory duty – various company law statutes impose a number of duties on
directors, such as the preparation of annual accounts and duties in relation to auditors.
12
(c) Directors' responsibilities in respect of financial reporting

Directors are responsible for ensuring that all information contained in prospectuses,
financial statements and other financial documents is accurate and is presented in
accordance with the laws and regulations that apply to the company. In respect of
directors' liabilities, directors can be subject to fines and penalties under the Companies
Ordinance or subject to other penalties by regulatory bodies and, in the event of legal
proceedings, may be personally sued for negligence by investors, shareholders or other
parties affected by their actions.
The directors are responsible for ensuring that:
 the company prepares financial statements that give a true and fair view of the
company’s financial positions and results
 the financial statements are accurate and presented in accordance with law
(especially for example the Companies Ordinance) and regulations
 roper books and accounts are kept
2.1.2 Powers and obligations

(a) Powers of directors
The general power of managing a company is usually vested in the directors. Formally the
powers of directors are defined by articles. The directors may meet together to despatch
business, adjourn, and otherwise regulate their meetings as they think fit under Table A,
art 100.
At common law, directors can only exercise their powers collectively by passing resolutions
at a properly convened meeting of the board of directors; they have no power to act
individually as agents for the company. However, a company's articles will usually empower
the board of directors to delegate its power to individual directors or to committees of
directors (Table A, art 104), and to the managing director (art 111), so that a meeting is not
required for each and every decision taken by the board of directors.
(b) Directors' obligations
If a person does not comply with his duties as a director he may be liable to civil or criminal
proceedings and may be disqualified from acting as a director.
Various important legal issues have been raised locally and overseas with regard to the fulfillment
of directors’ duties or the execution of their powers. Agency creation is an important topic. An
agency relationship is created when one person acquires the authority to act for another, the
principal. An agency relationship could be created by:
1. express appointment;
2. conduct of the parties;
3. necessity of the situation;
4. ratification; and
5. estoppel.
Some practical legal views related to the agency theory are as follows.
(a) Indoor Management Rule
The Indoor Management Rule, also known as the Turquand Rule (Royal British Bank v
Turquand (1856) 6 E&B 327), entitles an outsider to assume that the internal procedures of a
company have been complied with. This is a practical approach to solving problems facing
outsiders because an outsider would have difficulty in discovering what is going on in a
company, e.g. whether a company director has exceeded his authority as given to him by the
Articles of Association, or whether there has been some non-compliance with an internal
procedure.
13
Financial Reporting
(b) The doctrine of estoppel

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

Topic highlights
The secretary of a company is the chief administrative officer. The position involves
communications with the Companies Registry and with members in relation to all legal and
administrative issues. The secretary usually has actual power to bind the company in respect of
actions normally expected of a company secretary.
The term "officer" is a generic one that can be applied to directors, the secretary and some other
senior managers. Officers are usually accountable in law for certain actions specified in legislation.
Furthermore, they may be accountable under the principles established in decided cases.
The secretary is the chief administrative officer of the company as regards relations with members
and the Companies Registry.
Every company must have a secretary. The position may be filled by an individual or a company.
It is permitted to have more than one secretary. Details of the secretary must be registered in
Chinese and English.
The secretary can be a director of the company unless the company has only one member who is
also the only director (section 154, Companies Ordinance). Listed companies must segregate the
roles of chairman and secretary under the Listing Rules.
2.2.1 The role of the secretary
The secretary is the vital link between the company and the Companies Registry, and the company
and its members.
The secretary receives all formal communications from the Registry. The secretary is responsible
for submitting returns and registration of documents such as charges over assets, special
resolutions, loans to directors and so on (though it is the directors who are accountable for these
actions).
2.2.2 Powers and duties of the company secretary
The secretary:
 makes arrangements for meetings of the board of directors
 makes arrangements for annual and extraordinary general meetings
 records the formal minutes of meetings and makes these available for signature
 maintains the company's records, including the register of members
14
 deals with matters relating to liaison with members

 deals with formal communications between the company and the Companies Registry
3 Legal requirements associated with company

structure, share offerings, debt obligations and
restructuring
Topic highlights
There are legal requirements associated with the company structure, share offerings, debt
obligations and restructuring.
The issued share capital is made up of the shares already held by members. It is sometimes called
subscribed share capital.
A company does not have to issue all of its authorised share capital at once, or even at all if it
chooses not to do so. Share capital not issued is called unissued share capital.
3.1 Share issues and prospectus requirements

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

Debt instruments are a type of financial instrument. The accounting treatment of these is found in a
later chapter. Issuers of debt finance, such as banks, will often require security for their loan in
case a company is unable to meet repayments. This security is normally a charge over individual
assets (a fixed charge) or over a group of changing assets (a floating charge). Where the borrower
defaults on repayment, a floating charge crystallises and the lender takes control of the asset(s)
held as security and may sell it or them to realise funds.
3.2.1 Registration of charges
Part 8 of the new CO deals with registrtaion of charges. It specifies that two registers of charges
must be maintained:
(a) The Companies Registry must keep a record for each company (section 27)
(b) The company must keep its own register, either at its own office or at a location of which the
Registry is aware (Part 8 Division 7 section 352).
Fixed and floating charges must be registered at the Companies Registry within one month of their
execution.
Any charge not registered within this time period will be void against the liquidator and any creditor
of the company. This does not mean that the company no longer owes the money, but it does
15
Financial Reporting
relegate the obligation to the level of an unsecured creditor. Therefore, the charge remains valid
against the company. Irrespective of the terms of the debenture, failure to register makes the whole
debt immediately repayable. This will normally result in insolvency within a short period of time.
Any fixed charge on land and buildings must be registered in the Land Office within one month of
being executed. This also applies if any floating charge that includes land or buildings crystallises.
The requirement to register is set out in Part 8 Divisions 2 and 3 of the Companies Ordinance. Not
all charges have to be registered, but the exclusions generally fall outside the Module A syllabus.
Charges must be registered by the debtor company, though the creditor can perform this function
(Division 2 section 335). Registration secures the position of the creditor and also serves as an
indication of the obligation to prospective future lenders if they choose to search the register.
Once registration has occurred, a non-current asset that secures a fixed charge can only be sold
with the consent of the secured lender. Some debentures are issued under a trust deed so that
only one registration is necessary. Also, if the directors seek release from the charge they need
only approach the trustees instead of potentially many lenders.
As we have seen, the creation of a floating charge does not prevent dealing in the asset.
On liquidation, charges are prioritised using the following principles:
 Fixed charges rank ahead of floating charges
 Charges of the same kind are ranked in order of their date of creation
The security to the lender is the value of the asset at disposal and not the debt. Therefore, if a
company is liquidated and an asset is sold for $50,000 with a loan outstanding of $70,000, the
difference will rank as unsecured.
Some lenders reinforce their position by including a negative pledge clause in their floating charge
documents. This is a condition that states that the company will not create any later legal or
equitable charges over specific assets ranking in priority to a floating charge.
3.3 Statutory reporting and documentation requirements

A company must keep statutory registers of:
 members
 directors
 directors' interests, including loans to directors
 charges over the company's assets
 meetings
 resolutions
 substantial interests in shares
The records must be kept at the registered office or another location if permission is granted by the
Companies Registry.
The company must prepare a
 statement of financial position
 statement of profit or loss and other comprehensive income
Both of these documents must be approved and signed.
These financial statements have to be filed with the Registrar and sent to all members and
debenture holders.
A listed public company is permitted to produce summary financial statements for the members in
place of the full accounts.
Companies must keep proper accounting records to enable the accounts to be prepared with
reasonable accuracy. An annual return must be sent to the Registry.
16
3.4 Appointment and removal of auditors

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

liquidators
Companies may alter their capital structure or make other arrangements to improve profitability or
liquidity, increase efficiency or ultimately rescue the business. The law sets out to protect the
members and outside parties in the event of these actions.
3.5.1 Restructuring
Restructuring is a common response to a change in business conditions. A company may
restructure its financing arrangements, its assets or its operations in order to save money and
achieve efficiencies.
Debt restructuring is the process where a company with cash flow problems restructures or
renegotiates debts in order to improve or restore liquidity so that trading may continue.
17
Financial Reporting
Capital restructuring involves reallocating assets to improve liquidity. Certain assets are sold and
replaced with alternative assets which can be better utilised to earn revenue and profits.
The overall motives of restructuring are reduced risk, reduced cost of capital and increased
liquidity.
3.5.2 Liquidation
Key term
Liquidation is the "end of the road" for the company. It occurs when it is certain that the life of the
company will come to an end. The process by which this occurs is called winding up. You can use
the terms "liquidation" and "winding up" to mean broadly the same thing. However, the company
does not have to be in financial difficulties to be wound up. The members of the company may
decide at any time to take such action, and in some cases are obliged to do so (for example, if the
company were set up to achieve a specific purpose and this has been fully achieved, there is no
reason for the company to go on trading).
The liquidator is the person appointed to wind up the company and is an insolvency practitioner
(usually an accountant or solicitor) with expertise in such matters. Where a company is insolvent,
the liquidator is appointed by the Official Receiver, a civil servant acting on instructions from the
court. The Official Receiver is sometimes called the provisional liquidator.
3.5.3 Receivership
A receiver is different to both a liquidator and the Official Receiver. A receiver is a person or firm
appointed by creditors to act if a company has broken the conditions of a debenture, such as not
making payments when contractually obliged to do so. The job of the receiver is to get the money
back for the creditor. If he does so and the company can still survive, it does not mean that the
receiver's actions will bring an end to the company.
The receiver is appointed under the provisions of the debenture. A receiver may also be appointed
by the court or on the statutory basis provided by the Conveyancing and Property Ordinance:
"... there shall be implied in any legal charge or equitable mortgage by deed, where the
money has become due, a power exercisable in writing by the mortgagee and any person
entitled to give a receipt for the mortgage money on its repayment to appoint a receiver... to
remove any receiver... and appoint another in his place."
The court appoints a receiver if the security is in jeopardy.
When a receiver is appointed it is necessary to inform the Companies Registry within seven days
of appointment. From this time, the company's letterhead must make specific reference to the
receiver.
3.6 Financial statements requirements

Under the new CO, Hong Kong companies have a statutory duty to prepare financial statements
and file these financial statements with the Companies Registry unless exempted. Some of the
relevant Ordinance provisions are as follows:
 s.379 - a company's directors must prepare for each financial year financial statements that
comply with the ordinance requirements, and directors must instead prepare for the financial
year consolidated statements if the company is a holding company and not a wholly owned
subsidiary of another corporate
 s.380(1) - the annual financial statements must give a true and fair view of the financial
position of the company as at the end of the financial year and the financial performance of
the company for the financial year
18
 s.380(2) - the annual consolidated statements must give a true and fair view of the financial
position of the company and all the subsidiary undertakings as a whole as at the end of the
financial year, and the financial performance of the company and all the subsidiary
undertakings as a whole for the financial year
 s.380(3) – the financial statements for a financial year must comply with Part 1 and 2 of
Schedule 4, depending on reporting exemption
 s.380(4) – the financial statements for a financial year must comply with any other
requirements of the Ordinance in relation to the financial statements and the accounting
standards applicable to the financial statements
 s.380(5) - the financial statements must contain all additional information necessary to give a
true and fair view
 s.380(6) – the financial statements must contain the reasons for, and the particulars and
effect of, the departure from the Ordinance requirements to give a true and fair view
 s.381 – the annual consolidated financial statements for a financial year must include all the
subsidiary undertakings of the company, exclusion of one or more subsidiaries may be
possible subject to reporting exemption or materiality
 s.387 - a statement of financial position that forms part of any financial statements must be
approved by the directors and signed by 2 directors on the directors' behalf
The new CO defines accounting standards as statements of standard accounting practice issued or
specified by a body prescribed by its Regulations. However, the definition of a true and fair view
again is not provided.
19
Financial Reporting
Topic recap
Legal environment
HongHong
KongKong
LegalLegal Hong
Directors
Kong and
Legal
officers of a company Hong Legal
Kong requirements
Legal
Framework Framework Framework
Types of organisation: Directors’ duties and responsibilities Share issues:

Sole proprietor Fiduciary duties Prospectus required where
Partnerships Duty to exercise skill and care a public company seeks to
Companies Responsibilities in respect of raise capital from general
financial reporting public.
A business licence to Directors’ powers and obligations: Debt & charges:

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

type of legal structure.
Limited liability companies The company secretary is the chief Statutory reporting
are private or public. administrative officer. They: A company must:
Those which do not meet arrange board meetings maintain statutory registers
the conditions to remain arrange general meetings prepare statements of
private must register as record meeting minutes financial position and
public. maintain company records comprehensive income.
liaise with members
deal with formal
communications with the
Companies Registry
Corporate governance is Auditors
the system by which New auditors appointed at
companies are directed and AGM
controlled. Removal of auditors by
ordinary resolution
Resignation at any time in
writing
Restructuring
Debt restructuring
(renegotiate debts to
improve liquidity)
Capital restructuring
(reallocate assets to
improve liquidity)
Liquidation (winding
up the company)
Receivership
(recovery of money for
creditors)
20
Exam practice
Preparing financial statements 15 minutes

During an audit of the financial statements of a Hong Kong incorporated company listed on the
Main Board of The Stock Exchange of Hong Kong Limited, the auditor reported to the Audit
Committee of the company that no impairment assessment had been done by the management in
respect of the goodwill arising on an acquisition of a subsidiary in the prior year under HKAS 36
Impairment of Assets. In a meeting with the directors of the company, one of the executive
directors told the auditor that "We are not responsible for the preparation of financial statements.
We have delegated this task to our financial controller. Please talk to him directly." The financial
controller, being a professional accountant, responded that, "the financial statements will be
approved by the Board of Directors instead of me; it is not my problem if the financial statements
are not prepared in accordance with Hong Kong Financial Reporting Standards."
Required
Comment on the validity of the statements given by the executive director and the financial
controller of the company in respect of their responsibilities in the preparation of the financial
statements. (8 marks)
HKICPA May 2009
21
Financial Reporting
22
Part B
Financial reporting
framework
The emphasis in this section is on an in-depth understanding of the financial reporting

framework in Hong Kong. The purpose of this section is to develop your understanding about
the financial reporting framework in Hong Kong, the role of accounting standards and the
financial reporting requirements under Hong Kong Financial Reporting Standards.
23
Financial Reporting
24
chapter 2
Financial reporting
framework
Topic list 7.2 Advantages and disadvantages of a conceptual
framework
7.3 Generally Accepted Accounting Principles
1 Regulatory bodies and their impact on
(GAAP)
accounting
1.1 The role of the Hong Kong Institute of 8 The HKICPA’s Conceptual Framework
CPAs (HKICPA) 8.1 Preface
1.2 The role of the Stock Exchange of Hong 8.2 Introduction
Kong (SEHK) Ltd 8.3 Purpose and status
1.3 Securities and Futures Commission (SFC) 8.4 Scope
1.4 Financial Reporting Council (FRC) 8.5 Users and their information needs
1.5 Hong Kong Insurance Authority (HKIA) 8.6 The objective of financial statements
1.6 Hong Kong Monetary Authority (HKMA) 8.7 Information about economic resources, claims
and changes in resources and claims
2 Financial reporting requirements under
8.8 The reporting entity
HKFRS
9 Qualitative characteristics of financial information
3 Hong Kong Financial Reporting Standards
9.1 Fundamental qualitative characteristics
3.1 The setting of HKFRS and due process
9.2 Enhancing qualitative characteristics
3.2 Current Hong Kong FRS
9.3 The cost constraint on useful financial reporting
3.3 Scope of HKFRS
9.4 Underlying assumption
3.4 Accounting standards and choice
10 The elements of financial statements
4 Other sources of financial reporting guidance
10.1 Financial position
4.1 HK(IFRIC) Interpretations, Hong Kong
10.2 Performance
Interpretations and HK(SIC) Interpretations
10.3 Capital maintenance
4.2 Conceptual Framework for Financial
10.4 Section summary
Reporting (the Conceptual Framework)
4.3 Accounting Guidelines and implementation 11 Recognition of the elements of financial
guidance statements
4.4 Accounting Bulletins 11.1 Probability of future economic benefits
11.2 Reliability of measurement
5 Additional requirements for listed companies
11.3 Recognition of items
5.1 Companies listed on the Main Board
5.2 Companies listed on GEM 12 Measurement of the elements of financial
5.3 Acceptance of Mainland Accounting and statements
Auditing Standards
13 Fair presentation and compliance with HKFRS
6 Code of Ethics for Professional Accountants 13.1 Extreme case disclosures
6.1 Fundamental principles 13.2 Break-up basis accounts
6.2 Obligation to comply with the Code of
Ethics 14 Management commentary
6.3 Revision to Code of Ethics 14.1 Purpose
14.2 Contents
7 Conceptual Framework and GAAP
7.1 A conceptual framework 15 Current developments
15.1 Conceptual Framework
15.2 Other IASB Projects
25
Financial Reporting
Learning focus
The content of the HKICPA's Conceptual Framework is vital as it underpins all HKFRS. Both in
exams and in practice, when an accounting standard does not appear to provide guidance on
a particular topic, you may be required to fall back on the basic principles of the Conceptual
Framework.
Learning outcomes

Competency
level
Describe the financial reporting framework in Hong Kong and the related
implications for business activities
2.01 The role and setting of accounting standards 2
2.01.01 Understand the role of accounting standards
2.01.02 Understand the role of the HKICPA, Securities and Futures
Commission (SFC), Financial Reporting Council (FRC), the Hong
Kong Insurance Authority (HKIA), the Hong Kong Monetary
Authority (HKMA) and the Hong Kong Stock Exchange (HKEx)
2.02 Hong Kong Financial Reporting Standards 2
2.02.01 Describe how Hong Kong Financial Reporting Standards are set
2.05 Code of Ethics for Professional Accountants 3
2.05.01 Explain the requirements of the Code of Ethics for Professional
Accountants
2.06 Hong Kong (IFRIC) Interpretations, Hong Kong Interpretations 2
and Hong Kong (SIC) Interpretations
2.06.01 Describe the status of Hong Kong (IFRIC) Interpretations, Hong
Kong Interpretations and Hong Kong (SIC) Interpretations
2.07 Other professional pronouncements and exposure drafts 2
2.07.01 Identify other professional pronouncements and exposure drafts
relevant to the financial reporting Conceptual Framework
2.08 Regulatory bodies and their impact on accounting 2
2.08.01 Identify relevant regulatory bodies and their impact on accounting
2.09 Accounting principles and conceptual frameworks 2
2.09.01 Explain what is meant by a conceptual framework and GAAP
2.09.02 Identify the advantages and disadvantages of a conceptual
framework
2.09.03 Identify the components and requirements of the HKICPA's
2.09.04 Explain those requirements of HKAS 1 Presentation of Financial
Statements which overlap with the HKICPA's Conceptual
Framework
2.10 Current developments 2
2.10.01 Identify areas of accounting in which current developments are
occurring
26
2: Financial reporting framework | Part B Financial reporting framework
1 Regulatory bodies and their impact on accounting

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

The HKICPA issues HKFRS and non-mandatory guidance documents including Accounting
Guidelines and Accounting Bulletins.
The HKICPA is the only statutory accounting body in existence in Hong Kong responsible for the
establishment of accounting and auditing standards and guidelines, as well as for the
administration and regulation of the accounting profession in Hong Kong.
Pursuant to the Professional Accountants Ordinance (Chapter 50), the Council of the HKICPA (the
Council) may, in relation to the practice of accountancy, issue or specify any standards of
accounting practices required to be observed, maintained or otherwise applied by members of the
Hong Kong Institute of CPAs. In this respect, the objectives of the Council are to:
(a) develop, in the public interest, a single set of high quality, understandable and enforceable
accounting standards that require high quality, transparent and comparable information in
financial statements and other financial reporting to help participants in the capital markets
and other users of the information to make economic decisions
(b) promote the use and rigorous application of those standards
(c) promote, support and enforce compliance with those standards by members of the HKICPA
whether as preparers or auditors of financial information
(d) bring about convergence of accounting standards with International Financial Reporting
Standards (IFRS).
1.2 The role of the Stock Exchange of Hong Kong (SEHK) Ltd
The principal function of the SEHK is to provide a fair, orderly and efficient market for the trading of
securities, under the Stock Exchange Unification Ordinance.
To enhance the competitiveness of the Hong Kong securities market so as to meet the challenge of
an increasingly globalised market, there was a comprehensive market reform of the securities and
futures market in March 2000, under which the SEHK, the Hong Kong Futures Exchange Ltd
(HKFE) and the Hong Kong Securities Clearing Company Ltd (HKSCC) were amalgamated under
a holding company, Hong Kong Exchanges and Clearing Ltd (HKEx).
Currently, there are two established exchanges under the SEHK, the Main Board and the Growth
Enterprise Market (GEM) Board, on which companies are listed in Hong Kong.
Companies listed on the Main Board are required to comply with the Listing Rules whereas
companies listed on the GEM Board are required to comply with the GEM Rules.
The SEHK regulates the financial reporting compliance of listed companies through a Regulatory
Affairs Group and a GEM Department for companies listed on the Main Board and the GEM Board
respectively.
27
Financial Reporting
1.3 Securities and Futures Commission (SFC)

Topic highlights
The Securities and Futures Commission (SFC) is an independent non-governmental statutory body,
and is established by the Securities and Futures Commission Ordinance (SFCO). It is outside the
civil service, responsible for regulating the securities and futures markets in Hong Kong.
The SFC is responsible for administering the laws governing the securities and futures markets in
Hong Kong and facilitating and encouraging the development of these markets.
The statutory regulatory objectives as set out in the SFO are to:
 maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness
of the securities and futures industry;
 promote understanding by the public of the operation and functioning of the securities and
futures industry;
 provide protection for members of the public investing in or holding financial products;
 minimise crime and misconduct in the securities and futures industry;
 reduce systemic risks in the securities and futures industry; and
 assist the Financial Secretary in maintaining the financial stability of Hong Kong by taking
appropriate steps in relation to the securities and futures industry.
In carrying out their mission, the SFC aims to ensure Hong Kong's continued success and
development as an international financial centre.
The SFC is divided into four operational divisions: Corporate Finance, Intermediaries and
Investment Products, Enforcement, and Supervision of Markets. The Commission is supported by
the Legal Services Division and Corporate Affairs Division.
1.3.1 Whom, what and how: SFC regulation
Areas of regulation Methods
Licensed corporations and  Set licensing standards to ensure that all practitioners are
individuals carrying out the fit and proper
following regulated activities:
 Approve licenses and maintain a public register of
 Dealing in securities licensees
 Dealing in futures contracts  Issue codes and guidelines to inform the industry of its
 Leveraged foreign exchange expected standard of conduct
trading  Monitor licensees' financial soundness and compliance
 Advising on securities with the Ordinance, codes, guidelines, rules and
regulations
 Advising on futures contracts
 Handle misconduct complaints against licensees
 Advising on corporate
finance  Investigate and take action against misconduct
 Providing automated trading

services
 Securities margin financing
 Asset management
28
Areas of regulation Methods
Investment products offered  Set standards for the authorisation and regulation of
to the public investment products
 Authorise investment products offered to the public and
their promotion (including advertisements and marketing
materials)
Listed companies  Approve changes to the Listing Rules
 Monitor announcements and vet listing application
materials under the Dual Filing regime
 Administer the Codes on Takeovers and Mergers and
Share Repurchases
 Consider requests for exemptions from prospectus
requirements under the Companies Ordinance
 Enquire into listed companies' suspected prejudicial or
fraudulent transactions or provision of false or misleading
information to the public
Hong Kong Exchanges and  Oversee the performance of its role as the frontline
Clearing Limited (HKEx) regulator of listing related matters
 Approve the creation of new markets, new products and
changes to its rules and regulations
 Monitor HKEx's own compliance with the Listing Rules
 Monitor the trading of shares, options and futures on its
markets
 Oversee its systems and technology
Approved share registrars  Approve the Federation of Share Registrars as an
association whose members shall be approved share
registrars
 Require approved share registrars to comply with the
requirements of the Code of Conduct for Share Registrars
Investor Compensation  Recognise the ICC as an independent compensation
Company Limited (ICC) company
 Approve the rules and any amendment of rules of the ICC
 Require the ICC to prepare and regularly submit financial
statements, auditors' report and other documents to the
SFC
All participants in trading  Monitor unusual market movements and direct trade
activities suspension of related stocks to maintain an informed and
orderly market
 Investigate and take action against market misconduct
and other breaches of the law
1.4 Financial Reporting Council (FRC)

The FRC is an independent statutory body set up under the Financial Reporting Council Ordinance,
which was enacted on 13 July 2006. The FRC was established on 1 December 2006. It became
fully operational on 16 July 2007.
29
Financial Reporting
The role of the FRC is to:

 conduct independent investigations into possible auditing and reporting irregularities in
relation to listed entities
 enquire into possible non-compliance with financial reporting requirements on the part of
listed entities
 require listed entities to remove any non-compliance identified
The FRC may initiate investigations into a possible relevant irregularity or enquiries upon receipt of
complaints or on its own initiative an enquiry into possible relevant non-compliance with financial
reporting requirements on the part of listed entities.
Relevant irregularity means an auditing or reporting irregularity. It is defined in section 4 of the
Financial Reporting Council Ordinance (the "FRC Ordinance").
Any auditing or reporting irregularity exists if an auditor in respect of the audit of the financial
statements of a listed entity or a reporting accountant in respect of the preparation of an
accountants' report required for a listing document:
(a) falsified or caused to be falsified a document;
(b) made a statement, in respect of a document, that was material and that he knew to be false
or did not believe to be true;
(c) has been negligent in the conduct of his profession;
(d) has been guilty of professional misconduct;
(e) did or omitted to do something that would reasonably be regarded as bringing or likely to
bring discredit upon the auditor or reporting accountant himself, the Hong Kong Institute of
Certified Public Accountants (HKICPA) or the accountancy profession;
(f) failed to comply with a professional standard, i.e. any (a) statement of professional ethics; or
(b) standard of accounting, auditing and assurance practices, as issued or specified by the
council of the HKICPA from time to time;
(g) failed to comply with the provisions of any bylaw or rule made or any direction lawfully given
by the council of the HKICPA.
A relevant non-compliance exists if a relevant financial report of a listed entity does not comply with
a relevant requirement. A relevant non-compliance is defined in section 5 of the Financial
Reporting Council Ordinance (the "FRC Ordinance").
A relevant requirement refers to accounting requirements as provided in:
 the Companies Ordinance;
 the standards of accounting practice issued or specified by the Council of the Hong Kong
Institute of Certified Public Accountants (i.e. the Hong Kong Financial Reporting Standards);
 the International Financial Reporting Standards issued by the International Accounting
Standards Board;
 the Listing Rules;
 any generally acceptable accounting principles allowed for usage under the Listing Rules; or
 the relevant SFC Codes or guidelines.
Any person who possesses information and/or evidence which suggest that there are or may be
auditing and reporting irregularities or non-compliance with financial reporting requirements may
lodge a complaint with the FRC.
Any auditing or reporting irregularities identified by the FRC will be referred to the HKICPA for
follow-up action. Any non-compliance relevant to the Listing Rules will be referred to the Securities
30
and Futures Commission or The Stock Exchange of Hong Kong Limited for follow-up action. The
FRC is not empowered to discipline or prosecute.
1.5 Hong Kong Insurance Authority (HKIA)

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

The Hong Kong Monetary Authority (HKMA) was established on 1 April 1993 by merging the Office
of the Exchange Fund with the Office of the Commissioner of Banking. Its main functions and
responsibilities are governed by the Exchange Fund Ordinance and the Banking Ordinance and it
reports to the Financial Secretary.
31
Financial Reporting
The HKMA is the government authority in Hong Kong responsible for maintaining monetary and
banking stability. Its main functions are:
 maintaining currency stability within the framework of the Linked Exchange Rate system
 promoting the stability and integrity of the financial system, including the banking system
 helping to maintain Hong Kong's status as an international financial centre, including the
maintenance and development of Hong Kong's financial infrastructure
 managing the Exchange Fund.
2 Financial reporting requirements under HKFRS

Topic highlights
The Companies Ordinance provides the legal requirements for companies.
The financial reporting regulations and requirements currently in place in Hong Kong applicable to
limited liability companies are derived from a number of sources, including those bodies mentioned
above. Some are mandatory and some are advisory.
Those sources which are mandatory include:
(a) Legal requirements set out in the Companies Ordinance.
(b) Hong Kong Financial Reporting Standards (HKFRS, taken for the purpose of this Learning
Pack to include both HKAS and HKFRS) and HKAS Interpretations (HKAS-lnt) issued by the
Hong Kong Institute of Certified Public Accountants (Hong Kong Institute of CPAs).
(c) For companies listed in Hong Kong, the requirements set out in the Rules Governing the
Listing of Securities (the Listing Rules) and the Rules Governing the Listing of Securities on
the Growth Enterprise Market (the GEM Rules), both issued by The Stock Exchange of Hong
Kong Ltd (SEHK) pursuant to section 34 (1) of the Stock Exchanges Unification Ordinance
(Cap. 361).
Those sources which are advisory in nature include:
(a) Accounting Guidelines (AGs) issued by the Hong Kong Institute of CPAs.
(b) Accounting Bulletins (ABs) issued by the Financial Accounting Standards Committee (FASC)
of the Hong Kong Institute of CPAs.
(c) Pronouncements of the International Accounting Standards Board (IASB), formerly known as
International Accounting Standards Committee (IASC), and leading national standard setting
bodies such as those from Australia, Canada, New Zealand, the United Kingdom and the
United States of America.
3 Hong Kong Financial Reporting Standards

HKFRS set out recognition, measurement, presentation and disclosure requirements dealing with
transactions and events that are important in general purpose financial statements.
HKFRS are the most authoritative source of accounting principles generally accepted in Hong
Kong (HK GAAP).
Although HKFRS do not have any statutory backing, their authority is ensured by the requirement
of the Hong Kong Institute of CPAs that they should be observed by its members involved (either
as preparers or as auditors) with financial statements intended to give a true and fair view, unless
there are justifiable reasons for a departure in very exceptional circumstances.
32
For the purpose of this Learning Pack, the terms accounting standards, Standards and
Interpretations, Hong Kong Accounting Standards and Hong Kong Financial Reporting Standards
are used interchangeably and include all Hong Kong Financial Reporting Standards (HKFRS),
Hong Kong Accounting Standards (HKAS) and HKAS Interpretations (HKAS-Int) approved by the
Council and currently in issue unless otherwise specified.
3.1 The setting of HKFRS and due process

Topic highlights
The Financial Reporting Standards Committee (FRSC) of HKICPA has a mandate to develop
financial reporting standards to achieve convergence with the International Financial Reporting
Standards (IFRS) issued by the International Accounting Standards Board (IASB).
Within this remit, the HKICPA Council permits the FRSC to work in whatever way it considers most
effective and efficient and this may include forming advisory subcommittees or other forms of
specialist advisory groups to give advice in preparing new and revised HKFRS. The process for the
development of an HKFRS normally involves the following steps:
(a) Identifying and reviewing all the issues associated with an Exposure Draft or a draft
Interpretation issued by the IASB for possible adoption in Hong Kong or any other topics and
considering the application of the Conceptual Framework to the issues, if needed.
(b) Studying pronouncements of the IASB and other standard-setting bodies and accepted
industry practices about the issues.
(c) Consulting the Standard Setting Steering Board of the HKICPA (SSSB) about the advisability
of adding the topic to the FRSC's agenda.
(d) Forming an advisory group to give advice to the FRSC on the project.
(e) Publishing for public comment a discussion document. (In the case of the IASB issuing a
discussion document, also issuing an invitation to comment in Hong Kong with an earlier
deadline than that imposed by the IASB, so as to allow the FRSC a reasonable time to
consider the comments before the Council makes a submission to the IASB.)
(f) Publishing for public comment an Exposure Draft or a draft Interpretation. (In the case of the
IASB issuing an Exposure Draft or a draft Interpretation, issuing an invitation to comment in
Hong Kong on that Exposure Draft or draft Interpretation with a request for comment before
the comment deadline imposed by the IASB so as to allow the FRSC a reasonable time to
consider the comments before the Council makes a submission to the IASB.)
(g) Publishing within an Exposure Draft a basis for conclusions.
(h) Considering all the comments received within the comment period on Discussion Papers and
Documents, Exposure Drafts and draft Interpretations and those received in response to the
Hong Kong invitation to comment on the IASB documents and, when appropriate, preparing
a comment letter to the IASB.
(i) Following publication of the finalised IFRS or Interpretation of IFRS, considering the changes
made, if any, by the IASB and adopting the finalised IFRS or Interpretation of IFRS in Hong
Kong with the same effective date.
(j) Approving a standard or an Interpretation, including those converged with the equivalent
IFRS or Interpretation of IFRS, by the Council.
(k) Publishing within a standard a basis for conclusions, if appropriate, explaining how the
conclusions were reached and giving background information that may help users of HKFRS
to apply them in practice or, in the case of a standard that is converged with IFRS, publishing
within the standard the IASB Basis for Conclusions with an explanation of the extent to which
33
Financial Reporting
the Council agrees with the IASB Basis for Conclusions so as to enable users to understand
any changes made to the IFRS.
3.2 Current Hong Kong FRS

HKFRS set out recognition, measurement, presentation and disclosure requirements dealing with
transactions and events that are important in general purpose financial statements.
The following table shows the list of Hong Kong Accounting Standards in issue as at 31 May 2013:
Hong Kong Accounting Standards
HKAS 1
Presentation of Financial Statements
(Revised)
HKAS 2 Inventories
HKAS 7 Statement of Cash Flows
HKAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
HKAS 10 Events After the Reporting Period
HKAS 11 Construction Contracts
HKAS 12 Income Taxes
HKAS 16 Property, Plant and Equipment
HKAS 17 Leases
HKAS 18 Revenue
HKAS 19
Employee Benefits
(Revised)
HKAS 20 Accounting for Government Grants and Disclosure of Government Assistance
HKAS 21 The Effects of Changes in Foreign Exchange Rates
HKAS 23
Borrowing Costs
(Revised)
HKAS 24
Related Party Disclosures
(Revised)
HKAS 26 Accounting and Reporting by Retirement Benefit Plans
HKAS 27
Separate Financial Statements
(2011)
HKAS 28
Investments in Associates and Joint Ventures
(2011)
HKAS 29 Financial Reporting in Hyperinflationary Economies
HKAS 32 Financial Instruments: Presentation
HKAS 33 Earnings Per Share
HKAS 34 Interim Financial Reporting
HKAS 36 Impairment of Assets
HKAS 37 Provisions, Contingent Liabilities and Contingent Assets
HKAS 38 Intangible Assets
HKAS 39 Financial Instruments: Recognition and Measurement
34
Hong Kong Accounting Standards
HKAS 40 Investment Property

HKAS 41 Agriculture
HKFRS 1
First-time Adoption of Hong Kong Financial Reporting Standards
(Revised)
HKFRS 2 Share-based Payment
HKFRS 3
Business Combinations
(Revised)
HKFRS 4 Insurance Contracts
HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations
HKFRS 6 Exploration for and Evaluation of Mineral Resources
HKFRS 7 Financial Instruments: Disclosures
HKFRS 8 Operating Segments
HKFRS 9 Financial Instruments
HKFRS 10 Consolidated Financial Statements
HKFRS 11 Joint Arrangements
HKFRS 12 Disclosure of Interests in Other Entities
HKFRS 13 Fair Value Measurement
HKFRS for
HKFRS for Private Entities
PEs
You need to keep yourself up to date with Hong Kong Accounting Standards as they are issued or
reviewed.
Various Exposure Drafts and Discussion Papers are currently at different stages within the HKFRS
process, and by the end of your financial reporting studies, you should know all the Standards,
Exposure Drafts and Discussion Papers.
3.3 Scope of HKFRS

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

It is sometimes argued that companies should be given a choice in matters of financial reporting on
the grounds that accounting standards are detrimental to the quality of such reporting. There are
arguments on both sides.
In favour of accounting standards (both national and international), the following points can be
made:
(a) They reduce or eliminate confusing variations in the methods used to prepare accounts.
(b) They provide a focal point for debate and discussions about accounting practice.
(c) They oblige companies to disclose the accounting policies used in the preparation of
accounts.
(d) They are a less rigid alternative to enforcing conformity by means of legislation.
35
Financial Reporting
(e) They have obliged companies to disclose more accounting information than they would
otherwise have done if accounting standards did not exist, for example HKAS 33 Earnings
Per Share.
Many companies are reluctant to disclose information which is not required by national legislation.
However, the following arguments may be put forward against standardisation and in favour of
choice:
(a) A set of rules which give backing to one method of preparing accounts might be
inappropriate in some circumstances. For example, HKAS 16 on depreciation is
inappropriate for investment properties (properties not occupied by the entity but held solely
for investment), which are covered by HKAS 40 on investment property.
(b) Standards may be subject to lobbying or government pressure (in the case of national
standards). For example, in the USA, the accounting standard FAS 19 on the accounts of oil
and gas companies led to a powerful lobby of oil companies, which persuaded the SEC
(Securities and Exchange Commission) to step in. FAS 19 was then suspended.
(c) Many national standards are not based on a conceptual framework of accounting,
although HKFRS are.
(d) There may be a trend towards rigidity, and away from flexibility in applying the rules.
You should be able to discuss:
 due process of the HKICPA
 use and application of HKFRS
 future work of the HKICPA
One of the competencies you are required to demonstrate is to recognise and apply the external
legal and professional framework and regulations to financial reporting. The information in this
chapter will give you knowledge to help you demonstrate this competence.
4 Other sources of financial reporting guidance

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

Conceptual Framework)
The Conceptual Framework sets out the concepts underlying the preparation and presentation of
financial statements for external users. Its objectives are to:
(a) assist the Council in the development of future accounting standards and guidelines and in
its review of existing accounting standards and guidelines;
36
(b) assist preparers of financial statements in applying accounting standards and guidelines and
in dealing with topics that have yet to form the subject of an accounting standard or
guideline;
(c) assist auditors in forming an opinion as to whether financial statements conform with
accounting standards;
(d) assist users of financial statements in interpreting the information contained in financial
statements prepared in conformity with accounting standards and guidelines; and
(e) provide those who are interested in the work of the Council with information about its
approach to the formulation of accounting standards and guidelines.
The Conceptual Framework is discussed in more detail in sections 8 to 12 of this chapter.
4.3 Accounting Guidelines and implementation guidance

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

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

Topic highlights
The SEHK requires listed companies to comply with its Listing Rules.
37
Financial Reporting
5.1 Companies listed on the Main Board

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

The disclosure requirements for companies listed on the GEM, both in respect of annual financial
reporting and interim financial reporting, are principally set out in Chapter 18 Financial Information
of the GEM Rules.
38
Companies listed on the GEM are subject to tighter reporting requirements. For example, they are
required to publish annual reports within three months; and half-yearly reports and quarterly reports
within 45 days after the end of each relevant financial period.
The disclosure requirements for annual reporting under the GEM Rules are in many ways similar to
the Listing Rules though there are some specific disclosures which are only applicable under the
GEM Rules. For instance, companies listed on GEM are subject to the following additional
disclosure requirements:
(a) A comparison of actual business progress with business objectives stated in listing
documents (for a few reporting periods after the year of listing only).
(b) Extension of the disclosure of directors' emoluments by showing the amount of emoluments
by director on an anonymous basis.
(c) The interests (if any) of the sponsor, and its directors, employees and associates, and of the
interests of the management shareholders of the issuer.
(d) As regards the compliance with corporate governance disclosure, specification of work
undertaken by the audit committee and number of meetings held, and so on.
For companies listed on GEM, the principal means of information dissemination on GEM is
publication on the Internet website operated by the SEHK. Companies listed on GEM are not
generally required to issue paid announcements in the press.
A GEM issuer that does not have its own website will be in breach of the Listing Rules.
5.3 Acceptance of Mainland Accounting and Auditing Standards

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

Topic highlights
Members of the HKICPA are bound by its Code of Ethics.
Certified public accountants in business owe certain legal duties towards their employers.
Additionally, they have ethical duties towards the HKICPA. The Council of HKICPA requires
members of the Institute (and therefore certified public accountants) to comply with the Code of
Ethics for Professional Accountants (the Code). Apparent failures by certified public accountants to
comply with the Code are liable to be enquired into by the appropriate committee established under
the authority of the Institute, and disciplinary action may result. Disciplinary action may include an
order that the name of the certified public accountant be removed from the Institute's membership
register.
39
Financial Reporting
The Code of Ethics is likely to be taken into account when the work of a certified public accountant
is being considered in a court of law or in other contested situations.
6.1 Fundamental principles

All certified public accountants, whether in business or in public practice, are required to comply
with the following fundamental principles:
(a) Integrity: a certified public accountant should be straightforward and honest in all
professional and business relationships. Integrity also implies fair dealing and truthfulness.
In particular, section 110 of the Code of Ethics requires that a certified accountant should not
be associated with reports, returns, communications or other information where they believe
that the information: (1) contains a materially false or misleading statement; (2) contains
statements or information furnished recklessly; or (3) omits or obscures information required
to be included where such omission or obscurity would be misleading. A certified public
accountant should not be associated with such reports, returns, communications or other
information unless the certified public accountant provides a modified report in respect of the
above mentioned matters.
(b) Objectivity: a certified public accountant should not allow bias, conflict of interest or undue
influence of others to override professional or business judgments.
In particular, section 120 of the Code of Ethics requires that all certified public accountants
should not compromise their professional or business judgment because of bias, conflict of
interest or the undue influence of others. Relationships that bias or unduly influence the
professional judgment of the certified public accountant should be avoided.
A certified public accountant may be exposed to situations that may impair objectivity. It is,
however, impracticable to define and prescribe all such situations.
(c) Professional competence and due care: a certified public accountant has a continuing
duty to maintain professional knowledge and skill at the level required to ensure that a client
or employer receives competent professional service based on current developments in
practice, legislation and techniques. A certified public accountant should act diligently and in
accordance with applicable technical and professional standards when providing
professional services.
(d) Confidentiality: a certified public accountant should respect the confidentiality of information
acquired as a result of professional and business relationships and should not disclose any
such information to third parties without proper and specific authority unless there is a legal
or professional right or duty to disclose. Confidential information acquired as a result of
professional and business relationships should not be used for the personal advantage of
the certified public accountant or third parties.
(e) Professional behaviour: a certified public accountant should comply with relevant laws and
regulations and should avoid any action that discredits the profession.
Ethics in accounting is of utmost importance to accounting professionals and those who rely on
their services. Accounting professionals know that people who use their services, especially
decision makers using financial statements, expect them to be highly competent, reliable, and
objective. Those who work in the field of accounting must not only be well qualified but must also
possess a high degree of professional integrity. A professional's good reputation is one of his or her
most important assets.
There is a very fine line between acceptable accounting practice and management's deliberate
misrepresentation in the financial statements.
40
The financial statements must meet the following criteria:

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

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

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

The Code of Ethics for Professional Accountants (the Code) was revised in 2010 so as to maintain
convergence with the revised Code of Ethics for Professional Accountants issued by the IESBA in
July 2009. The revisions clarify requirements for all professional accountants and significantly
strengthen the independence requirements of auditors. The revised Code came into effect from
1 January 2011.
In addition to the IESBA Code, the Hong Kong Code contains additional local requirements in
Part D, such as the Prevention of Bribery Ordinance. These form an integral part of the Code, and
members should ensure that they are aware of the additional requirements and comply with them.
41
Financial Reporting
7 Conceptual Framework and GAAP

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

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

Advantages
(a) Standards do not have to be developed on a haphazard, reactive basis, concentrating
resources on combating a problem that has been identified in practice, rather than
developing a consistent suite of standards that cover all problems.
(b) The standard-setting process in many countries in the past has been subject to political
interference, where interested parties have tried to influence the setting of standards in their
favour. For example, pharmaceutical companies may argue for the costs of research and
development to be capitalised in all situations, regardless of the likely recoverability of the
cost. A standard-setter should be better able to stand firm against pressure, if standards can
be seen to be deriving from a published conceptual framework.
(c) In the past, some standards seem to have concentrated on the income statement (the
calculation of profit or loss), while others have concentrated on the statement of financial
position (the valuation of net assets).
Disadvantages
(a) Financial statements are drawn up to serve the interests of a variety of user groups, and it
is not clear that a single conceptual framework can be devised that will satisfy the
information needs of all users.
(b) It can be argued that different accounting statements should be drawn up to achieve different
purposes. For example inventory might be of most use when measured at marginal cost in a
decision-making statement, and at full absorption cost in a financial reporting statement.
(c) The experience in countries that have issued conceptual frameworks is that little notice is
taken of them by standard-setting bodies when deciding on new standards.
42
Prior to a review of the HKICPA's attempt to bring forth the conceptual framework, it is important to
consider the generally accepted accounting principles (or practice) or GAAP.
7.3 Generally Accepted Accounting Principles (GAAP)

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

content of financial statements, and audits of companies incorporated in Hong Kong. The
new Hong Kong Companies Ordinance was issued in 2012, is being enacted by subsidiary
legislation and will become effective during 2014. Further detail on some of the sections
relevant to Module A was provided in Chapter 1.
(b) Hong Kong Financial Reporting Standards (HKFRS). The term HKFRS includes both
Standards (HKFRS and HKAS) and Interpretations (HK(IFRIC)-Ints, HK(SIC)-Ints, and
HK-Ints).
(i) Standards and Interpretations are developed by the Financial Accounting Standards
Committee of the Hong Kong Institute of Certified Public Accountants (HKICPA).
(ii) Standards and Interpretations are virtually identical to their international equivalents
(International Financial Reporting Standards) except for three Hong Kong
Interpretations (HK-Ints) which have been developed locally by the HKICPA.
43
Financial Reporting
(c) Listing Rules. The Stock Exchange of Hong Kong Limited (SEHK) has adopted rules
governing the listing of securities on its Main Board (the Listing Rules) and on its Growth
Enterprise Market (the GEM Rules). These include some accounting and disclosure
requirements.
Other sources of GAAP
Hong Kong Accounting Standard 8 Accounting Policies, Changes in Accounting Estimates and
Errors (HKAS 8, which is identical to IAS 8) states:
10. In the absence of a HKFRS that specifically applies to a transaction, other event or
condition, management shall use its judgment in developing and applying an accounting
policy that results in information that is:
(a) relevant to the economic decision-making needs of users; and
(b) reliable, in that the financial statements:
(i) represent faithfully the financial position, financial performance and cash flows
of the entity;
(ii) reflect the economic substance of transactions, other events and conditions,
and not merely the legal form;
(iii) are neutral, i.e. free from bias;
(iv) are prudent; and
(v) are complete in all material respects.
11. In making the judgment described in paragraph 10, management shall refer to, and
consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in HKFRS dealing with similar and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities,
income and expenses in the Conceptual Framework.
12. In making the judgment described in paragraph 10, management may also consider the
most recent pronouncements of other standard-setting bodies that use a similar conceptual
framework to develop accounting standards, other accounting literature* and accepted
industry practices, to the extent that these do not conflict with the sources in paragraph 11.
*In the context of Hong Kong, other accounting literature includes Accounting Guidelines and
Accounting Bulletins.
The Accounting Guidelines and Accounting Bulletins referred to in the footnote to paragraph 12 of
HKAS 8 (above) are "best practice" guidance documents that have been published by the HKICPA
to assist its members in applying HKFRS. Accounting Guidelines, and Industry Accounting
Guidelines, are persuasive in intent and, while not mandatory, should normally be followed.
Accounting Bulletins are intended to assist members of the HKICPA in dealing with accounting
issues and to stimulate debate on subjects of topical interest.
TechWatch is a monthly publication prepared by the HKICPA to alert HKICPA members to topics
and issues that impact on accountants and their working environment. It is intended for general
guidance only.
7.3.2 GAAP for Small and Medium-sized Entities
The HKICPA released its own Small and Medium-sized Entity Financial Reporting Framework and
Financial Reporting Standard (SME-FRF & FRS) in August 2005. The SME-FRF and FRS became
effective for optional use by a qualifying entity's first financial statements that cover a period
beginning on or after 1 January 2005. Entities that qualify include Hong Kong incorporated
companies that meet certain legal requirements and overseas companies that have no public
accountability, meet size requirements and where the owners agree to use the SME-FRF and FRS.
Those entities which do not meet the criteria to use the SME-FRF and FRS may be able to use the
HKFRS for Private Entities, issued in 2010. Both of these options are discussed in more detail in
the next chapter.
44
8 The HKICPA's Conceptual Framework

Topic highlights
The Conceptual Framework provides the basis for the development of HKFRS / HKAS.
In June 1997 the HKICPA produced a document, Framework for the Preparation and Presentation
of Financial Statements (the Framework). This is, in effect, the conceptual framework upon which
all HKFRS are based and hence it determines how financial statements are prepared and the
information they contain.
The Framework is currently being revised with the project taking place in several stages and
Exposure Drafts being issued as each progress stage approaches completion. The first
amendments to the Framework were issued in October 2010, and the HKICPA has decided to
amend the Framework on a piecemeal basis, so the revised parts of the Framework sit alongside
the old Framework. The Framework has been renamed the Conceptual Framework for Financial
Reporting.
The revised Conceptual Framework for Financial Reporting consists of several sections or
chapters, following on after a preface and introduction. These chapters are as follows:
 The objective of general purpose financial reporting (issued October 2010)
 The reporting entity (not yet issued)
 Qualitative characteristics of useful financial information (issued October 2010)
 The Framework (1997): The Remaining Text
– Underlying assumption
– The elements of financial statements
– Recognition of the elements of financial statements
– Measurement of the elements of financial statements
– Concepts of capital and capital maintenance
Much of the content of the chapters is also included in HKAS 1 (revised), and covered in sections
10 to 12 of this chapter. As you read through them, think about the impact the Conceptual
Framework has had on HKFRS, particularly the definitions.
8.1 Preface
Financial statements are prepared and presented for external users worldwide, and although they
may appear similar, differences are caused by social, economic and legal circumstances.
The HKICPA wishes to narrow these differences by harmonising all aspects of financial
statements, including the regulations governing their accounting standards and their preparation
and presentation.
The HKICPA believes that financial statements prepared for the purpose of providing information
that is useful in making economic decisions meet the common needs of most users. The types of
economic decisions for which financial statements are likely to be used include the following:
 Decisions to buy, hold or sell equity investments
 Assessment of management stewardship and accountability
 Assessment of the entity's ability to pay employees
 Assessment of the security of amounts lent to the entity
 Determination of taxation policies
 Determination of distributable profits and dividends
 Inclusion in national income statistics
 Regulations of the activities of entities
45
Financial Reporting
Any additional requirements imposed by national governments for their own purposes should not
affect financial statements produced for the benefit of other users.
The Conceptual Framework recognises that financial statements can be prepared using a variety
of models. Although the most common is based on historical cost and a nominal unit of currency
(such as the Hong Kong dollar), the Conceptual Framework can be applied to financial statements
prepared under a range of models.
8.2 Introduction
The introduction to the Conceptual Framework lays out the purpose, status and scope of the
document. It then looks at different users of financial statements and their information needs.
8.3 Purpose and status

The introduction gives a list of the purposes of the Conceptual Framework.
(a) To give guidance to the Council of HKICPA in developing new financial reporting standards
and reviewing existing standards. Accounting standards will be more consistent and logical if
they are developed from an orderly set of concepts.
(b) To assist preparers of financial statements in applying HKFRS. The concepts guide
preparers in their broader fulfilment of GAAP.
(c) To assist auditors in forming an opinion as to whether financial statements conform with
HKFRS. An independent review by the auditor of the recognition and measurement
decisions by preparers relating to revenues, expenses, assets and liabilities in the financial
statements can be undertaken by reference to the details about primary elements.
(d) To assist users of financial statements in interpreting the information. The quality of
disclosures can be judged by users against the list of qualitative characteristics.
(e) To provide those who are interested in the work of the Council with information about its
approach to the formulation of HKFRS. The process of communication between the Council
of HKICPA and its constituents can be enhanced because the conceptual underpinnings of
proposed accounting standards will be more apparent.
The Conceptual Framework is not an HKFRS and so does not overrule any individual HKFRS. In a
limited number of cases there may be a conflict between an HKFRS and the Conceptual
Framework; here, the HKFRS will prevail. The number of such cases will diminish over time as
the Conceptual Framework is used as a guide in the production of new HKFRS. The Conceptual
Framework itself will be revised occasionally depending on the experience of the HKICPA in using
it.
8.4 Scope
The Conceptual Framework deals with the following:
(a) The objective of financial reporting.
(b) The qualitative characteristics of useful information.
(c) The definition, recognition and measurement of the elements from which financial
statements are constructed.
(d) Concepts of capital and capital maintenance.
The Conceptual Framework is concerned with "general purpose" financial statements (that is, a
normal set of annual statements), but it can be applied to other types of accounts. A complete set
of financial statements includes:
(a) a statement of financial position
(b) a statement of profit or loss and other comprehensive income
(c) a statement of changes in financial position (e.g. a statement of cash flows)
(d) notes, other statements and explanatory material
46
Supplementary information may be included, but some items are not included in the financial
statements themselves, namely commentaries and reports by the directors, the chairman,
management and so on.
All types of financial reporting entities are included whether commercial, industrial, business;
public or private sector.
Key term
A reporting entity is an entity for which there are users who rely on the financial statements as
their major source of financial information about the entity. (Conceptual Framework)
CF.OB5 8.5 Users and their information needs

Users of financial statements include investors, employees, lenders, suppliers and other trade
creditors, customers, government and their agencies and the public.
The Conceptual Framework places particular emphasis on existing and potential investors, lenders
and other creditors. It states that other users of financial statements may find general purpose
financial statements useful, however those reports are not primarily directed towards those other
groups.
Self-test question 1
What are the information needs of the users of financial information? Your answer should not be
restricted to the groups of users identified by the Conceptual Framework as the primary users.
(The answer is at the end of the chapter)
CF.OB2-12 8.6 The objective of financial statements

Topic highlights
The Conceptual Framework states that:
"The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to existing and potential investors, lenders and other creditors in
making decisions about providing resources to the entity."
This section of the Conceptual Framework was amended in September 2010. As a result of the
amendments, there is a new emphasis on specific users of accounts, namely investors, potential
investors, lenders and creditors. They require information which is useful in making decisions about
buying, selling or holding equity and debt instruments, and providing or settling loans and other
forms of credit.
The type of information required by investors, creditors and lenders is that which provides an
indication of potential future net cash inflows. Such information includes that relating to:
 the resources of the entity
 claims against the entity
 how efficiently and effectively the management have used the entity’s resources, protected
the entity’s resources from the unfavourable effects of factors such as price changes and
ensured that the entity complies with applicable laws and regulations.
Most investors, creditors and lenders cannot require entities to provide information directly to them,
and therefore rely on general purpose financial statements. Although such financial statements do
include a large amount of information, the Conceptual Framework states that general purpose
financial statements do not and they cannot provide all of the information that investors, lenders
47
Financial Reporting
and other creditors need. Therefore, these users must also consider information from other
sources, such as general economic conditions and expectations, political events and political
climate, and industry and company outlooks.
This section of the Conceptual Framework also clarifies that:
 general purpose financial statements are not designed to show the value of an entity,
although information contained within them may aid a valuation
 the management of an entity need not rely on general purpose financial statements as they
can obtain necessary financial information internally
 other parties such as regulators and members of the public may also find general purpose
financial reports useful, however, these reports are not primarily directed to these groups.
8.7 Information about economic resources, claims and changes

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

This section of the Conceptual Framework has not yet been issued. An Exposure Draft was issued
in 2010 in which a reporting entity is defined as follows:
"A reporting entity is a circumscribed area of economic activities whose financial information has
the potential to be useful to existing and potential equity investors, lenders, and other creditors
who cannot directly obtain the information they need in making decisions about providing
resources to the entity and in assessing whether the management and the governing board of
that entity have made efficient and effective use of the resources provided."
48
A reporting entity has three features:

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

Topic highlights
The Conceptual Framework states that qualitative characteristics are the attributes that make the
information provided in financial statements useful to existing and potential investors, lenders and
creditors. The two fundamental qualitative characteristics are relevance and faithful representation.
These are supported by four enhancing qualitative characteristics of comparability, verifiability,
timeliness and understandability.
This section of the Conceptual Framework was revised in September 2010 and as a result, two
fundamental and four enhancing qualitative characteristics replace the previous qualitative
characteristics of relevance, reliability, comparability and understandability.
The two fundamental qualitative characteristics are relevance and faithful representation; the four
enhancing characteristics are comparability, verifiability, timeliness and understandability.
If financial information is to be useful, it must be relevant and faithfully represent what it purports to
represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely
and understandable.
The revised Conceptual Framework states that the qualitative characteristics of useful financial
information apply not only to financial information provided in financial statements, but also to
financial information provided in other ways.
CF.QC5-16 9.1 Fundamental qualitative characteristics

The fundamental qualitative characteristics are relevance and faithful representation.
9.1.1 Relevance
Relevant financial information is capable of making a difference in the decisions made by users.
Information may be capable of making a difference in a decision even if some users choose not to
take advantage of it or are already aware of it from other sources. Financial information is capable
of making a difference in decisions if it has predictive value, confirmatory value or both. Financial
information has a confirmatory value if it confirms or changes previous evaluations.
Materiality
Materiality is related to relevance. Information is material if omitting it or misstating it could
influence decisions that users make on the basis of financial information about a specific reporting
entity. Materiality is an entity-specific aspect of relevance based on the nature or magnitude, or
both, of the items to which the information relates in the context of an individual entity’s financial
49
Financial Reporting
report. It is impossible to specify a quantitative threshold for materiality or predetermine what could
be material in a particular situation as it depends on the individual entity.
9.1.2 Faithful representation
To be useful, in addition to being relevant, financial information must also faithfully represent the
phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would
have three characteristics – it would be complete, neutral and free from error.
Faithful representation does not mean accurate in all respects. Information that is complete means
all necessary information is included for the user to understand the item being depicted. Neutral
information is prepared without bias in the selection or presentation of the information. Free from
error means there are no errors or omissions in the description of the item, and the process used to
produce the reported information has been selected and applied with no errors in the process.
CF.QC17-18 9.1.3 Application of the fundamental qualitative characteristics
Useful information must be both relevant and faithfully represented; neither a faithful representation
of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps
users to make good decisions.
The most efficient and effective process for applying the fundamental qualitative characteristics
would usually be as follows:
(a) Identify an economic phenomenon that has the potential to be useful to users of an entity’s
financial information
(b) Identify the type of information about that phenomenon that would be most relevant, if
available and can be faithfully represented
(c) Determine whether that information is available and can be faithfully represented
(d) If so, the process of satisfying the fundamental qualitative characteristics ends; if not, the
process is repeated with the next most relevant type of information.
CF.QC19-32 9.2 Enhancing qualitative characteristics

Comparability, verifiability, timeliness and understandability are qualitative characteristics that
enhance the usefulness of information that is relevant and faithfully represented.
9.2.1 Comparability
Users' decisions involve choosing between alternatives, for example, selling or holding an
investment, or investing in one reporting entity or another. Consequently, information about a
reporting entity is more useful if it can be compared with similar information about other entities and
with similar information about the same entity for another period or another date.
Comparability is the qualitative characteristic that enables users to identify and understand
similarities in, and differences among, items. Unlike the other qualitative characteristics,
comparability does not relate to a single item. A comparison requires at least two items.
Consistency, although related to comparability, is not the same. Consistency refers to the use of
the same methods for the same items, either from period to period within a reporting entity or in a
single period across entities. Comparability is the goal; consistency helps to achieve that goal.
9.2.2 Verifiability
Verifiability helps assure users that information faithfully represents the economic phenomena it
purports to represent. Verifiability means that different knowledgeable and independent observers
could reach consensus, although not necessarily complete agreement, that a particular depiction is
a faithful representation.
Verification can be direct or indirect. Direct verification means verifying an amount through direct
observation, for example, by counting cash. Indirect verification means checking the inputs to a
model, formula or other technique and recalculating the outputs using the same methodology.
50
9.2.3 Timeliness
Timeliness means having information available to decision-makers in time to be capable of
influencing their decisions. Generally, the older the information is the less useful it is. However,
some information may continue to be timely long after the end of a reporting period because, for
example, some users may need to identify and assess trends.
9.2.4 Understandability
Classifying, characterising and presenting information clearly and concisely makes it
understandable.
Some transactions are inherently complex and cannot be made easy to understand. While
excluding information about those transactions from financial reports might make the information in
those financial reports easier to understand, this may mean that information would be incomplete
and therefore potentially misleading.
The revised Conceptual Framework states that financial reports are prepared for users who have a
reasonable knowledge of business and economic activities and who review and analyse the
information diligently. At times, even the well-informed, diligent users may need to seek the aid of
an adviser to understand information about complex economic phenomena.
CF.QC33-34 9.2.5 Application of the enhancing qualitative characteristics
Enhancing qualitative characteristics should be maximised to the extent possible. However, the
enhancing qualitative characteristics, either individually or as a group, cannot make information
useful if that information is irrelevant or not faithfully represented.
CF.QC35-39 9.3 The cost constraint on useful financial reporting

Cost is a constraint on the information that can be provided by financial reporting. Reporting
financial information imposes costs, and it is important that those costs are justified by the benefits
of reporting that information. There are several types of costs and benefits to consider.
Providers of financial information expend most of the effort involved in collecting, processing,
verifying and disseminating financial information, but users ultimately bear those costs in the form
of reduced returns. Users of financial information also incur costs of analysing and interpreting the
information provided. If needed information is not provided, users incur additional costs to obtain
that information elsewhere or to estimate it.
Reporting financial information that is relevant and faithfully represents what it purports to represent
helps users to make decisions with more confidence.
CF.4.1 9.4 Underlying assumption

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

Topic highlights
Transactions and other events are grouped together in broad classes according to their economic
characteristics. These broad classes are the elements of financial statements: assets, liabilities,
equity, income and expenses.
51
Financial Reporting
This chapter of the Conceptual Framework is taken from the 1997 Framework. It lays out these
elements as follows:
Elements of
Measurement of financial Measurement of performance

position in the statement in the statement of profit or
of financial position loss and other comprehensive
income
n Assets n Income
n Liabilities n Expenses
n Equity
A process of sub-classification then takes place for presentation in the financial statements, e.g.
assets are classified by their nature or function in the business to show information in the best way
for users to take economic decisions.
CF.4.4 – 4.7 10.1 Financial position

The elements related to the measurement of financial position are assets, liabilities and equity.
Key terms
 Asset. A resource controlled by an entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
 Liability. A present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
 Equity. The residual interest in the assets of the entity after deducting all its liabilities.
(Conceptual Framework)
These definitions are important, but they do not cover the criteria for recognition of any of these
items, which are discussed in the next section of this chapter. This means that the definitions may
include items which would not actually be recognised in the statement of financial position because
they fail to satisfy recognition criteria particularly, as we will see below, the probable flow of any
economic benefit to or from the business.
Whether an item satisfies any of the definitions above will depend on the substance and
economic reality of the transaction, not merely its legal form. For example, consider finance
leases (see Chapter 9).
CF.4.8-4.14 10.1.1 Assets
Key term
Future economic benefit. The potential to contribute, directly or indirectly, to the flow of cash and
cash equivalents to the entity. The potential may be a productive one that is part of the operating
activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a
capability to reduce cash outflows, such as when an alternative manufacturing process lowers the
cost of production. (Conceptual Framework)
Assets are usually employed to produce goods or services for customers; customers will then pay
for these and so contribute to the cash flow of the entity.
The existence of an asset is not reliant on:
 physical form or
 legal ownership
52
Non-physical items such as patents are assets provided that they are controlled and provide
probable future economic benefits; similarly non-owned items, such as machinery obtained under a
finance lease are assets, provided that they are controlled and provide probable future economic
benefits.
Transactions or events in the past give rise to assets; those expected to occur in the future do not
in themselves give rise to assets. For example, an intention to purchase a non-current asset does
not, in itself, meet the definition of an asset.
CF.4.15-4.18 10.1.2 Liabilities
An essential characteristic of a liability is that the entity has a present obligation.
Key term
Obligation. A duty or responsibility to act or perform in a certain way. Obligations may be legally
enforceable as a consequence of a binding contract or statutory requirement. Obligations also
arise, however, from normal business practice, custom and a desire to maintain good business
relations or act in an equitable manner. (Conceptual Framework)
It is important to distinguish between a present obligation and a future commitment. A

management decision to purchase assets in the future does not, in itself, give rise to a present
obligation.
Settlement of a present obligation will involve the entity giving up resources embodying economic
benefits in order to satisfy the claim of the other party. This may be done in various ways, not just
by payment of cash.
Liabilities must arise from past transactions or events. In the case of, say, recognition of future
rebates to customers based on annual purchases, the sale of goods in the past is the transaction
that gives rise to the liability.
CF.4.19 10.1.3 Provisions
Some liabilities can be measured only with a degree of estimation for example payments to be
made under existing warranties. These liabilities are known as provisions.
Key term
Provision. A present obligation which satisfies the rest of the definition of a liability, even if the
amount of the obligation has to be estimated. (Conceptual Framework)
Consider the following situations. In each case, do we have an asset or liability within the
definitions given by the Conceptual Framework? Give reasons for your answer.
(a) Manu Co. has purchased a patent for $20,000. The patent gives the company sole use of a
particular manufacturing process which will save $3,000 a year for the next five years.
(b) Hirecar Co. paid Michael Wood $10,000 to set up a car repair shop, on condition that priority
treatment is given to cars from the company's fleet.
(c) Sellcar Co. provides a warranty with every car sold.
CF.4.20-4.23
10.1.4 Equity
Equity is defined above as a residual, but it may be sub-classified in the statement of financial
position. This is relevant to the decision-making needs of the users as it will indicate legal or other
restrictions on the ability of the entity to distribute or otherwise apply its equity. Some reserves are
required by statute or other law, e.g. for the future protection of creditors. The amount shown for
53
Financial Reporting
equity depends on the measurement of assets and liabilities. It has nothing to do with the
market value of the entity's shares.
CF.4.24-4.28 10.2 Performance

Profit is used as a measure of performance, or as a basis for other measures (eg earnings per
share).
It depends directly on the measurement of income and expenses, which in turn depend (in part) on
the concepts of capital and capital maintenance adopted.
The elements of income and expense are therefore defined.
Key terms
 Income. Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants.
 Expenses. Decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants. (Conceptual Framework)
Income and expenses can be presented in different ways in the statement of profit or loss and
other comprehensive income, to provide information relevant for economic decision-making. For
example, distinguish between income and expenses which relate to continuing operations and
those which do not.
Items of income and expense can be distinguished from each other or combined with each other.
CF.4.29-4.32 10.2.1 Income
Both revenue and gains are included in the definition of income. Revenue arises in the course of
ordinary activities of an entity and may be referred to by names including sales, fees, interest,
dividends rent or royalties.
Key term
Gains. Increases in economic benefits. As such they are no different in nature from revenue.
(Conceptual Framework)
Gains include those arising on the disposal of non-current assets. The definition of income also
includes unrealised gains, for example, on revaluation of marketable securities.
CF.4.33-4.35 10.2.2 Expenses
As with income, the definition of expenses includes losses as well as those expenses that arise in
the course of ordinary activities of an entity.
Key term
Losses. Decreases in economic benefits. As such they are no different in nature from other
expenses. (Conceptual Framework)
Losses will include those arising on the disposal of non-current assets. The definition of expenses
will also include unrealised losses, for example, exchange rate effects on borrowings.
10.3 Capital maintenance

Capital maintenance refers to the concept that profits can only be made when the capital of an
organisation is restored to, or maintained at the level that it was at the start of an accounting
54
period. The concept is commonly separated into two types: physical and financial capital
maintenance.
Under the physical capital maintenance concept, a profit is earned only when the operating
capability of an organisation at the end of a period exceeds the operating capability at the start of
the period.
Under the financial capital maintenance concept, a profit is earned when the money value of net
assets at the end of a period exceeds their money value at the start of the period.
CF.4.36 10.3.1 Capital maintenance adjustments
A revaluation gives rise to an increase or decrease in equity.
Key term
Revaluation. Restatement of assets and liabilities. (Conceptual Framework)
These increases and decreases meet the definitions of income and expenses. They are not
included in the statement of profit or loss under certain concepts of capital maintenance, however,
but rather in equity.

Make sure you learn the important definitions.
 Financial position:
– Assets
– Liabilities
– Equity
 Financial performance:
– Income
– Expenses
11 Recognition of the elements of financial

CF.4.37-4.39
statements
Topic highlights
Items which meet the definition of assets or liabilities may still not be recognised in financial
statements because they must also meet certain recognition criteria.
Key term
Recognition. The process of incorporating in the statement of financial position or statement of
profit or loss and other comprehensive income an item that meets the definition of an element and
satisfies the following criteria for recognition:
(a) It is probable that any future economic benefit associated with the item will flow to or from the
entity.
(b) The item has a cost or value that can be measured with reliability. (Conceptual Framework)
Regard must be given to materiality (see above).
55
Financial Reporting
CF.4.40
11.1 Probability of future economic benefits
Probability here means the degree of uncertainty that the future economic benefits associated
with an item will flow to or from the entity. This must be judged on the basis of the characteristics
of the entity's environment and the evidence available when the financial statements are
prepared.
CF.4.41-4.43 11.2 Reliability of measurement

The cost or value of an item, in many cases, must be estimated. The Conceptual Framework
states, however, that the use of reasonable estimates is an essential part of the preparation of
financial statements and does not undermine their reliability. Where no reasonable estimate can be
made, the item should not be recognised, although its existence should be disclosed in the notes,
or other explanatory material.
Items may still qualify for recognition at a later date due to changes in circumstances or
subsequent events.
CF.4.44-4.53 11.3 Recognition of items

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

CF.4.54-4.56 statements
Topic highlights
A number of different measurement bases are used in financial statements. They include:
 historical cost
 current cost
 realisable (settlement) value
 present value of future cash flows
Key term
Measurement. The process of determining the monetary amounts at which the elements of the
financial statements are to be recognised and carried in the statement of financial position and
statement of profit or loss and other comprehensive income. (Conceptual Framework)
56
This involves the selection of a particular basis of measurement. A number of these are used to
different degrees and in varying combinations in financial statements. They include the following:
Key terms
Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair
value of the consideration given to acquire them at the time of their acquisition. Liabilities are
recorded at the amount of proceeds received in exchange for the obligation, or in some
circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected
to be paid to satisfy the liability in the normal course of business.
Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be
paid if the same or an equivalent asset was acquired currently.
Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be
required to settle the obligation currently.
Realisable (settlement) value.
 Realisable value. The amount of cash or cash equivalents that could currently be obtained by
selling an asset in an orderly disposal.
 Settlement value. The undiscounted amounts of cash or cash equivalents expected to be
paid to satisfy the liabilities in the normal course of business.
Present value. The present discounted value of the future net cash flows in the normal course of
business. (Conceptual Framework)
Historical cost is the most commonly adopted measurement basis, but this is usually combined
with other bases, e.g. inventory is carried at the lower of cost and net realisable value.
13 Fair presentation and compliance with HKFRS

Topic highlights
Compliance with HKFRS is presumed to result in financial statements that achieve a fair
HKAS presentation.
1.15,16,18-20
Most importantly, financial statements should present a true and fair view of the financial position,
financial performance and cash flows of an entity. Compliance with HKFRS is presumed to result
in financial statements that achieve a fair presentation and true and fair view.
The following points made by HKAS 1 expand on this principle:
(a) Financial statements should be prepared using the accrual basis, i.e. income and expenses
are recognised as they arise rather than when the related cash is received or paid.
(b) Financial statements should be prepared on a going concern basis unless it is planned for
the entity to cease trading.
(c) Compliance with HKFRS should be disclosed.
(d) All relevant HKFRS must be followed if compliance with HKFRS is disclosed.
(e) Use of an inappropriate accounting treatment cannot be rectified either by disclosure of
accounting policies or notes/explanatory material.
There may be (very rare) circumstances when management decides that compliance with a
requirement of an HKFRS would be misleading. Departure from the HKFRS is therefore required
to achieve a fair presentation.
57
Financial Reporting
The following should be disclosed in such an event:

(a) Management confirmation that the financial statements fairly present the entity's financial
position, performance and cash flows.
(b) Statement that all HKFRS have been complied with except departure from one HKFRS to
achieve a fair presentation.
(c) Details of the nature of the departure, why the HKFRS treatment would be misleading, and
the treatment adopted.
(d) Financial impact of the departure.
This is usually referred to as the "true and fair override".
HKAS 13.1 Extreme case disclosures

1.17,23
In very rare circumstances, management may conclude that compliance with a requirement in a
standard or interpretation may be so misleading that it would conflict with the objective of
financial statements set out in the Conceptual Framework, but the relevant regulatory framework
prohibits departure from the requirements.
In such cases the entity needs to reduce the perceived misleading aspects of compliance by
disclosing:
(a) the title of the standard, the nature of the requirement and the reason why management has
reached its conclusion.
(b) for each period, the adjustment to each item in the financial statements that would be
necessary to achieve fair presentation.
HKAS 1 states what is required for a fair presentation:
(a) Selection and application of accounting policies.
(b) Presentation of information in a manner which provides relevant, reliable, comparable and
understandable information.
(c) Additional disclosures where required.
HKAS 13.2 Break-up basis accounts

1.25,26
HKAS 1 requires that, when preparing financial statements, management should assess the ability
of an entity to continue as a going concern.
Financial statements should be prepared on a going concern basis unless management either
intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so.
In assessing whether an entity is a going concern, management must take into account all
available information about the future, being at least 12 months from the end of the reporting
period. They may consider current and expected profitability, debt repayment schedules and
potential sources of replacement financing.
Where an entity is not a going concern, the financial statements are prepared on a basis other than
that of a going concern, most commonly the break-up basis.
13.2.1 Content of break-up basis accounts
The term break-up basis is not defined in accounting standards and may be interpreted differently
by different people.
If the accounts are prepared on a basis other than that of a going concern, it does not automatically
mean that all assets are written down to their scrap value, nor that provision is made for all the
costs of winding up the business. All of the normal rules of accounting still apply, other than that of
going concern. The recognition, measurement and presentation of assets and liabilities will be
affected as follows.
58
Assets
(a) Non-current assets should be assessed for impairment, and written down to their
recoverable amount if this is less than their carrying amount.
As we shall see later in the Learning Pack, recoverable amount is the higher of net realisable
value and value in use.
 Realisable value was defined in section 12 as the amount of cash or cash equivalents
that could currently be obtained by selling the asset.
 Value in use is the present value of the future cash flows associated with the asset.
It should be remembered that the value in use is likely to be lower than previously expected
since the time frame for use will be shorter than if the company were a going concern.
Therefore, realisable value will often be taken as the recoverable amount.
(b) In addition, inventories will continue to be measured at the lower of cost and net realisable
value, however when an entity is not a going concern, it becomes more likely that cost will
exceed net realisable value.
(c) Amounts receivable are stated at their realisable value i.e. the cash expected to be
recovered. Practically this will be equal to gross receivables net of irrecoverable debts and
an allowance for receivables as usual, however in the context of a company which is not a
going concern the identification of irrecoverable debts and calculation of an allowance may
require additional consideration.
(d) Monetary items, such as cash are stated at their face value.
(e) It is sometimes said that all non-current assets should be reclassified as current assets in
break-up basis accounts. This would only be the case, however, if their use had changed.
If they were still held for use within the business (if only for a short time) then they are still
non-current assets.
Liabilities
(a) Liabilities are normally only recognised where an obligation exists at the reporting date and
the normal rules in HKAS 37 have been met. Therefore, legal and other costs related to an
insolvency are only recognised when incurred.
(b) Some non-current liabilities will be reclassified as current. A common example of this is
where the company is in breach of loan covenants at the year end meaning that the loan
facility will be withdrawn and so repayment is required in the short term.
13.2.2 Disclosure
When management is aware of material uncertainties related to events or conditions that may cast
significant doubt upon an entity’s ability to continue as a going concern, the entity should disclose
those uncertainties.
Where an entity does not prepare financial statements on a going concern basis, it must disclose
that fact together with the basis on which it prepared the financial statements and the reason why
the entity is not regarded as a going concern.
14 Management commentary
A management commentary (known as management discussion and analysis in Hong Kong) is a
narrative report that accompanies financial statements as part of an entity's financial reporting.
It explains the main trends and factors underlying the development, performance and position of the
entity's business during the period covered by the financial statements. It also explains the main
trends and factors that are likely to affect the entity's future development, performance and position.
59
Financial Reporting
An IFRS Practice Statement was issued on Management Commentary in December 2010. This is
a broad, non-binding framework for the presentation of narrative reporting to accompany financial
statements prepared in accordance with IFRS.
The Practice Statement is not an IFRS. Therefore, entities applying IFRS are not required to
comply with the Practice Statement, unless specifically required by their jurisdiction.
14.1 Purpose
The purpose of management commentary is to help investors to:
(a) interpret and assess the related financial statements in the context of the environment in
which the entity operates.
(b) assess what management views as the most important issues facing the entity and how it
intends to manage those issues.
(c) assess the strategies adopted by the entity and the potential for those strategies to succeed.
14.2 Contents
A number of principles and qualitative characteristics should underlie the preparation and
presentation of the management commentary.
In particular, the management commentary should:
 supplement and complement financial statement information.
 provide an analysis of the entity through the eyes of management.
 have an orientation to the future.
 possess the fundamental characteristics of relevance and faithful representation and
maximise the enhancing characteristics of comparability, verifiability, timeliness and
understandability.
15 Current developments
15.1 Conceptual Framework
As we saw earlier in this chapter, the IASB and FASB completed the first phase of their joint project
to develop a common Conceptual Framework for Financial Reporting in 2010. As a result, they
have issued a Conceptual Framework which includes new chapters on the objective of financial
statements and qualitative characteristics together with the remaining chapters from the old
Framework. This revised Conceptual Framework has been adopted by the HKICPA.
The remaining phases of the project relate to:
 elements and recognition
 measurement
 the reporting entity
 presentation and disclosure
Subsequent to the completion of phase 1 of the project in 2010, remaining work was deferred. In
late 2012, however, the project was reactivated as an IASB-only project. The IASB is currently
working towards a discussion paper covering all remaining phases of the project and this is
expected to be issued during the course of 2013. The IASB aims to complete the project by 2015.
15.2 Other IASB projects

The IASB is engaged in a number of ongoing projects. These are discussed in more detail in the
relevant chapters of this Learning Pack.
60
Topic recap
Hong
Financial
Kong Legal
Reporting
Framework
Hong Regulatory
Kong Legalbodies HongFinancial
Kong Legal
Reporting CodeLegal
Hong Kong of Ethics
Framework Framework
requirements Framework
HKICPA regulates the HKFRS set out recognition, Professional accountants must
accounting profession. The FR measurement, presentation comply with the Code
Standards Committee within and disclosure
the HKICPA issues HKFRS. requirements. They should
be observed to achieve a
true and fair view.
HK(IFRIC) Interpretations Fundamental principles:

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

mandatory) are indicators of
best practice.
Accounting Bulletins (non

mandatory) are publications
on subjects of topical
interest.
SEHK regulates the financial

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

reporting irregularities in listed
companies.
HKIA is the regulatory body

related to the insurance
industry.
HKMA is responsible for

maintaining monetary and
banking stability.
61
Financial Reporting
A statement of generally accepted theoretical principles which

form the frame of reference for financial reporting.
The HKICPA’s Conceptual Framework
Purpose of the Conceptual Framework:

Aid development of new standards/review of existing
standards
Assist application of HKFRS
Assist auditors in forming opinion
Assist users to interpret financial information
Conceptual framework Qualitative characteristics Elements of FS
To provide financial Fundamental:

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

going concern otherwise it is probable future economic benefit will flow to/from the entity
break-up basis accounts. cost or value can be measured reliably
Measure at:
historical cost realisable (settlement)
current cost value
PV of future cash flows
Fair presentation
Presumed to be achieved by compliance with HKFRS
Departure from HKFRS is allowed if necessary to achieve fair presentation
“True and fair override” disclosures are necessary in the case of a departure
Management commentary (Management discussion and analysis)

Narrative report to accompany financial statements
IFRS Practice Statement issued 2010
62
Answers to self-test questions
Answer 1
(a) Investors are the providers of risk capital.
(i) Information is required to help make a decision about buying or selling shares, taking
up a rights issue and voting.
(ii) Investors must have information about the level of dividend, past, present and future
and any changes in share price.
(iii) Investors will also need to know whether the management has been running the
company efficiently.
(iv) As well as the position indicated by the statement of profit or loss and other
comprehensive income, statement of financial position and earnings per share (EPS),
investors will want to know about the liquidity position of the company, the company's
future prospects, and how the company's shares compare with those of its
competitors.
(b) Employees need information about the security of employment and future prospects for jobs
in the company, and to help with collective pay bargaining.
(c) Lenders need information to help them decide whether to lend to a company. They will also
need to check that the value of any security remains adequate, that the interest repayments
are secure, that the cash is available for redemption at the appropriate time and that any
financial restrictions (such as maximum debt/equity ratios) have not been breached.
(d) Suppliers need to know whether the company will be a good customer and pay its debts.
(e) Customers need to know whether the company will be able to continue producing and
supplying goods.
(f) Government's interest in a company may be one of creditor or customer, as well as being
specifically concerned with compliance with tax and company law, ability to pay tax and the
general contribution of the company to the economy.
(g) The public at large would wish to have information for all the reasons mentioned above, but
it could be suggested that it would be impossible to provide general purpose accounting
information which was specifically designed for the needs of the public.
Answer 2
(a) This is an asset, albeit an intangible one. There is a past event, control and future economic
benefit (through cost savings).
(b) This cannot be classified as an asset. Hirecar Co. has no control over the car repair shop
and it is difficult to argue that there are "future economic benefits".
(c) The warranty claims in total constitute a liability; the business has taken on an obligation.
It would be recognised when the warranty is issued rather than when a claim is made.
63
Financial Reporting
Exam practice
Fair presentation 11 minutes

"Financial statements should be prepared on a going concern basis and measured with historical
cost in order to present fairly the financial position of an entity." Comment on this statement.
(6 marks)
HKICPA June 2012
Mr. Kong 9 minutes

Mr. Kong, a member of Hong Kong Institute of Certified Public Accountants (the "Institute"), is the
Chief Financial Controller of a company. At the end of the financial period, the company has
certain old and obsolete inventories kept in the warehouse. In order to avoid recognising an
impairment loss in the financial statements, Mr. Kong has asked the accounting manager Ms.
Yuen, who is also a member of the Institute, to create a forged purchase order from an existing
customer for the inventories at a selling price above the cost, with a delivery date six months later.
He has asked her to provide a copy to the auditor as evidence that the inventory does not require
writing down to net realisable value. Mr. Kong has also threatened Ms. Yuen with dismissal if she
is not willing to comply with his wishes.
Required
Discuss the behaviour of Mr. Kong and what Ms. Yuen should do in accordance with the Code of
Ethics for Professional Accountants.
(5 marks)
HKICPA June 2011
64
chapter 3
Small company reporting
Topic list
1 Background
2 Financial reporting in Hong Kong
2.1 Three financial reporting options
3 SME-FRF and SME-FRS
3.1 Companies which qualify for reporting under the SME-FRF and SME-FRS
3.2 The requirements of the SME-FRF and SME-FRS
4 Introduction to the HKFRS for Private Entities
4.1 Development of the HKFRS for Private Entities
4.2 Eligibility to use the HKFRS for Private Entities
5 Contents of the HKFRS for Private Entities
5.1 Overview
5.2 Simplified accounting
5.3 Simplified presentation
5.4 Omitted topics
5.5 Examples of options in full HKFRS not included in the HKFRS for Private Entities
5.6 Simplified disclosure
5.7 Updates and amendments to the HKFRS for Private Entities
6 Impact of the HKFRS for Private Entities
6.1 Key concerns
6.2 Comparison with full HKFRS
Learning focus
The HKFRS for Private Entities was issued in April 2010. It provides an option for non-publicly
accountable entities which do not qualify for the SME-FRS to use simplified accounting and
disclosure rules.
65
Financial Reporting
Learning outcomes
Competency
level
LO2.03 Small and Medium-sized Entity Financial Reporting Framework 2
and Financial Reporting Standard:
2.03.01 Identify the conditions under which an entity may adopt the
SME Financial Reporting Framework and Financial
Reporting Standard
2.03.02 Describe the requirements of the SME Financial Reporting
Framework and Financial Reporting Standard
LO2.04 Hong Kong Financial Reporting Standard for Private Entities 2
2.04.01 Identify the conditions under which an entity may adopt the
HKFRS for Private Entities
2.04.02 Describe the requirements of the HKFRS for Private
Entities
66
3: Small company reporting | Part B Financial reporting framework
1 Background
Topic highlights
The SME-FRF and SME-FRS provide a framework for simplified reporting for smaller companies in
Hong Kong.
The HKFRS for Private Entities was issued in April 2010 and is based on the IASB’s International
Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs).
The objective of financial statements is to provide information about the financial position and
performance of an entity that is useful to users of such information. Financial statements show the
results of management's stewardship of, and accountability for, the resources entrusted to it.
For small and medium-sized entities (SMEs), the most significant users are likely to be owners,
government and creditors, who may have the power to obtain information additional to that
contained in the financial statements. These users do not generally require the detailed
disclosures required by full HKFRS, and indeed the preparing entities generally find the provision of
such disclosures onerous in terms of the time and cost of preparation.
In Hong Kong, there are therefore two options for simplified reporting for smaller, non-listed
entities:
1 the SME-FRF and SME-FRS
2 the new HKFRS for Private Entities.
This chapter considers each of these options, including who can use them and what simplifications
are made compared to the use of full HKFRS.
2 Financial Reporting in Hong Kong

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

As a result of the introduction of the HKFRS for Private Entities, Hong Kong now has three financial
reporting options:
1 The SME-FRF & FRS which can only be applied by certain unlisted entities (see section 3)
2 The new HKFRS for Private Entities which can be applied by any private entity (see section 4.2)
3 Full HKFRS which must be applied by publicly listed entities and may be applied by any
private entity.
67
Financial Reporting
The options available to each type of entity are summarised in the following table:
Can apply:
Non-listed companies which meet the criteria to – SME-FRF & FRS

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

Topic highlights
The SME-FRF and SME-FRS can only be applied by certain unlisted entities. The SME-FRF
provides a conceptual framework for small company reporting and the SME-FRS sets out recognition,
measurement, presentation and disclosure requirements for companies reporting under it.
SME-FRF sets out the conceptual basis and qualifying criteria for the preparation of financial
statements in accordance with the Small and Medium-sized Entity Financial Reporting Standard
(SME-FRS).
SME-FRS sets out the recognition, measurement, presentation and disclosure requirements for an
entity that prepares and presents the financial statements in accordance with the SME-FRS.
SME-FRS 16 3.1 Companies which qualify for reporting under the SME-FRF
and SME-FRS
Both Hong Kong incorporated and overseas unlisted companies may qualify for reporting under the
SME-FRF and preparing financial statements in accordance with the SME-FRS.
3.1.1 Qualifying Hong Kong companies
Those companies which satisfy the criteria set out in Part 9 Division 2 section 359 of the new CO
qualify for reporting under the SME-FRF and so can apply the SME-FRS in preparing their financial
statements. Reporting under this regime is not, however, a requirement for such companies, but a
choice.
A company applying s.359 above should obtain agreement from all of the shareholders of the
company in writing that the financial statements are properly prepared. Thus the interests of the
minority shareholders are protected.
Section 359 does not apply to:
 a private company which is itself a holding company of subsidiaries
 a private company which is a subsidiary of another company formed and registered under
the Companies Ordinance.
A Hong Kong company which has a controlled investment in the PRC which does not meet the
legal definition of a subsidiary does, however, satisfy the criteria for reporting under s.359 and
therefore can apply the SME-FRS.
68
Part 9 (“Accounts and Audit”) of the new CO, contains the accounting and auditing provisions in
relation to the keeping of accounting records, the preparation and circulation of annual financial
statements, directors’ and auditor’s reports and the appointment and rights of auditors.
New provisions are introduced to make it easier and more efficient for SMEs to be able to use
simplified accounting and reporting requirements, to require public and large companies to include
an analytical business review in directors’ reports, and to enhance auditors’ right to information.
This Part also introduces new sanctions relating to the contents of auditor’s reports.
3.1.2 Facilitating Simplified Reporting
It becomes easier for SMEs to prepare simplified financial and directors’ reports in the following
ways:
 a private company (with the exception of a bank/deposit-taking company, an insurance
company or a stockbroker) will automatically qualify for simplified reporting if it qualifies as a
“small private company”.
 Small private company (defined in new CO Schedule 3 section 1)
If it meets any two of the following size criteria for two consecutive periods:
annual revenue ≤ HK$100 million
total assets ≤ HK$100 million
employees ≤ 100 employees
For example, a company with a property valued at more than HK$100 million can still apply to use
the SME-FRS if its annual revenue is less than HK$100 million and it has less than 100 employees.
 the holding company of a group of companies that qualifies as a “group of small private
companies” will also qualify for simplified reporting (Part 9 Division 2 section 365).
 a private company that is not a member of a corporate group may adopt simplified reporting
with the agreement of all the members.
Allowing small guarantee companies and groups of small guarantee companies, which have a total
annual revenue of not more than $25 million, to qualify for simplified reporting (Part 9 Division 2
sections 363 and 366).
A private company or a group of private companies which is not qualified as a “small private
company” or a “group of small private companies” respectively may prepare simplified reports if it
meets a higher size criteria and if the members holding 75% of the voting rights so resolve and no
member objects.
Making the summary financial reporting provisions more user-friendly and extending their
application to companies in general (rather than confining them to listed companies, as in the
current Companies Ordinance).
SME-FRS 17, 3.1.3 Overseas companies
22-24
A company incorporated outside Hong Kong is not bound by the new CO and should prepare its
separate financial statements in accordance with the requirements imposed by the law in its place
of incorporation. Provided that the specific requirements of the place of incorporation are met,
these companies may report under the SME-FRF and apply the SME-FRS if:
1 They have no public accountability. An entity has public accountability for the purposes of
the SME-FRF if:
(a) at any time during the current or preceding reporting period, the entity (whether in the
public or private sector) is an issuer of securities, that is, its equity or debt securities
are publicly traded or it is in the process of issuing publicly traded equity or debt
securities;
(b) the entity is an institution authorised under the Banking Ordinance;
(c) the entity is an insurer authorised under the Insurance Companies Ordinance; or
69
Financial Reporting
(d) the entity is a corporation which is granted a licence under the Securities and Futures
Ordinance to carry on business in a regulated activity in Hong Kong.
2 They meet any two of the following size criteria for two consecutive periods:
annual revenue ≤ HK$50 million
total assets ≤ HK$50 million
employees ≤ 50 employees
For example, a company with a property valued at more than HK$50 million can still apply to
use the SME-FRS if its annual revenue is less than HK$50 million and it has less than 50
employees. (Note that the size criteria for overseas companies are different from the
requirement applicable to Hong Kong companies as stated in Section 3.1.1 of this Learning
Pack.)
3 All owners agree to apply the SME-FRS. (A shareholder agreement should be signed every year.)
These qualifying conditions are applicable to all overseas companies, including a subsidiary or an
intermediate holding company of a listed entity.
SME-FRS 20 When a company has not been considered to be an SME in terms of its size under section 3.1.2
point 2 above and subsequently becomes an SME, the company will not qualify for reporting under
the SME-FRF until the company has been determined to be an SME for two consecutive reporting
periods.
Now the Companies Ordinance, Part 16 (“Non-Hong Kong Companies”) deals with companies
incorporated outside Hong Kong which have established a place of business in Hong Kong.
There is no fundamental change to the current rules.
Example
An overseas company meets the size criteria for reporting under the SME-FRF as follows:
Year ended Company A
31 December 20X5 Criteria not met

31 December 20X6 Criteria met
In what period(s), if any, may the company report under the SME-FRF?
Solution
 In 20X5 the company does not satisfy the criteria and so cannot report under the SME-FRF.
 In 20X6 and 20X7, the company does meet the criteria, however will not have been
determined to be an SME for two consecutive reporting periods and so cannot report under
the SME-FRF.
 In 20X8 the company satisfies the criteria for two consecutive reporting periods and so
qualifies for reporting under the SME-FRF.
SME-FRS 21 Where a company has previously qualified for reporting under the SME-FRF in terms of section
3.1.2, the company will no longer qualify for reporting under the SME-FRF in terms of size criteria
set in section 3.1.2 point 2 above until the company is no longer an SME for two consecutive
reporting periods.
70
Example
An overseas company, Company B, previously qualified as an SME and reported under the SME-
FRF with the following changes:
Year ended Company B
31 December 20X5 Criteria continue to be met

May Company B qualify to report under the SME-FRF for the year ending 31 December 20X6 and
onwards?
Solution
 In 20X6 and 20X7 Company B continues to qualify for reporting under the SME-FRF until
Company B is no longer an SME for two consecutive reporting periods.
 In 20X8 Company B is no longer an SME for three consecutive reporting periods and should
transfer to HKFRS for its financial statements starting from the year ending 31 December 20X8.
For an entity that qualifies for reporting under the SME-FRF, the appropriate application of the
SME-FRS, with additional disclosure when necessary, would result in financial statements that
achieve a proper presentation appropriate for SMEs.
For a company applying s.141D of the Hong Kong Companies Ordinance, compliance with the
SME-FRF and SME-FRS is necessary in order for financial statements to give a true and correct
view.
3.2 The requirements of the SME-FRF and SME-FRS

Sections 1 to 17 of SME-FRS set out detailed financial reporting requirements for entities reporting
under SME-FRF and SME-FRS. You should refer to the original text of SME-FRF and SME-FRS
when it is necessary.
The SME FRS is in the most part a simplified version of the full HKFRS regime, However, the
SME-FRS differs from the full HKFRS regime in certain key areas, which include the following:
(a) There is no requirement to include a cash flow statement in a set of SME-FRS financial
statements (FRS 1.1).
(b) Changes in equity may be disclosed in a note rather than in a separate primary statement
(FRS 1.29).
(c) Leasehold interests in land from the Government of the HKSAR, or elsewhere with similar
features, are accounted for as property, plant and equipment (FRS 3.13).
(d) There is no separate category of "investment property". Instead, the definition of property,
plant and equipment includes properties held for rental purposes or investment potential
(FRS section on definitions & FRS 3.1)
(e) The recognition of deferred tax is prohibited (FRS 14.4). Instead the only tax expense
recognised is that calculated based on profits assessed for tax purposes for the period i.e. as
is payable to the taxation authorities in respect of that period.
(f) Investments cannot be carried at fair value. Instead, all held-to-maturity securities are stated
at amortised cost, other current investments are stated at the lower of cost and net realisable
value and other long-term investments are stated at cost less accumulated impairment
losses (FRS 6.7 & 6.8).
71
Financial Reporting
(g) Entities can decide whether or not to use a discounting technique in the impairment test and
in estimating any provisions (FRS 9.8 and 10.3).
(h) The SME-FRS does not have specific section dealing with employee benefits, and therefore
does not have specific requirements covering the matters within the scope of HKAS 19,
Employee benefits, and HKFRS 2, Share based payment . Instead, example 5 of Appendix
1 to the SME-FRS indicates that provisions for long service pay and for other post
employment retirement schemes would fall under section 10 "Provisions, contingent liabilities
and contingent assets" of the SME-FRS.
(i) The rules on accounting for speculative and non-speculative forward foreign exchange
contracts (FRS 15.6-15.8) appear to have been drafted based on SSAP 11, Foreign
currency translation , and therefore still refer to calculating "discounts and premiums" on the
contracts, as well as "gains and losses"
4 Introduction to the HKFRS for Private Entities

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

The HKFRS for Private Entities is based on the International Financial Reporting Standard for
Small and Medium-sized Entities (IFRS for SMEs), which was issued in July 2009. Despite its
name, this IFRS for SMEs was developed by the IASB to apply to entities which are not publicly
accountable and publish general purpose financial statements for external users, (rather
than those which meet certain size definitions).
The Council considered that a variation of the IFRS for SMEs should be adopted in Hong Kong as
a reporting option for eligible non-listed companies, and as a result issued the HKFRS for Private
Entities.
4.1.1 Amendments made to the IFRS for SMEs in developing the HKFRS for
Private Entities
The HKFRS for Private Entities is based on the IASB’s IFRS for SMEs, however the following
amendments are made to make the standard more relevant to Hong Kong:
(a) The term "SMEs" is replaced by "Private Entities"
The term SMEs is widely used in Hong Kong and associated with the locally developed
SME-FRF & FRS. For clarity and differentiation, this HKFRS which is based on the "IFRS for
SMEs" is called "Hong Kong Financial Reporting Standard for Private Entities" (HKFRS for
Private Entities).
(b) The recognition and measurement principles in section 29 Income Tax of the IFRS for SMEs
is replaced by the extant version of HKAS 12 Income Taxes
The Council considers that it is more appropriate to include the recognition and
measurement principles contained in the extant version of HKAS 12 Income Taxes in the
new HKFRS. The relevant disclosures contained in the IFRS for SMEs are, however,
retained.
72
(c) The measurement of deferred tax liabilities associated with an investment property
measured at fair value is capped at the amount of tax that would be payable on its sale to an
unrelated market participant at fair value at the end of the reporting period
This amendment will restrict the amount of deferred taxation recognised in relation to
revaluation gains of investment properties as such tax is in practice never paid in Hong
Kong. This provision removes an anomaly currently in HKAS 12 Income Taxes.
4.2 Eligibility to use the HKFRS for Private Entities

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

An entity is defined as having public accountability (and so may not use the new standard) if:
 its debt or equity instruments are traded in a public market (or it is in the process of issuing
its debt or equity instruments for trading in a public market), or
 it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary
businesses.
A public market means any domestic or foreign stock exchange market, or an over-the-counter
market.
In general, an entity that holds assets in a fiduciary capacity as one of its primary businesses may
be a bank, insurance company, securities broker/dealer, mutual fund or investment bank.
If an entity holds assets in a fiduciary capacity for a broad group of outsiders for reasons that are
incidental to its primary business, it is not considered to have public accountability. Such entities
may include schools, travel agents and charities.
4.2.2 General purpose financial statements

HKFRS are designed to apply to the general purpose financial statements of profit-oriented entities.
General purpose financial statements are directed towards the common information needs of a
wide range of users, for example, shareholders, creditors, employees and the public at large. The
objective of financial statements is to provide information about the financial position,
performance and cash flows of an entity that is useful to those users in making economic
decisions.
4.2.3 Subsidiaries
A subsidiary of a group which applies full HKFRS may use the HKFRS for Private Entities provided
that the subsidiary itself meets the eligibility criteria.
5 Contents of the HKFRS for Private Entities

5.1 Overview
Topic highlights
The HKFRS for Private Entities is a self-contained standard incorporating accounting principles that
are based on full HKFRS, but which have been simplified to suit the private entities within its scope.
73
Financial Reporting
It includes simplifications that reflect the needs of users of private companies' financial statements
and the cost-benefit considerations of preparers. It facilitates financial reporting by unlisted entities
by:
 simplifying requirements for recognition and measurement;
 eliminating topics and disclosure requirements that are not generally applicable to private
entities;
 removing certain accounting treatments permitted under full HKFRS.
Note that entities are not permitted to mix and match the requirements of the HKFRS for Private
Entities and full HKFRS, except for the option to apply the recognition and measurement rules of
HKAS 39 (HKFRS 9) with regard to financial instruments.
The HKFRS for Private Entities became effective immediately upon its issuance on 30 April 2010.
Eligible entities are permitted to use HKFRS for Private Entities to prepare financial statements for
prior period(s) where the relevant financial statements have not been finalised and approved.
5.1.1 Cost-benefit considerations
In order to provide additional relief to preparers of financial statements under the HKFRS for
Private Entities, an "undue cost or effort" principle has been introduced in some sections of the
standard to replace the "impracticability" relief criterion in the full HKFRS (a requirement is
considered "impracticable" if an entity cannot apply it after making every reasonable effort to do
so).
Although the notion of "undue cost or effort" is not defined, it focuses on the concept of balancing
costs and benefits, which might in turn require management's judgment of when a cost is
considered excessive. In other words, the "undue cost or effort" principle implies that cost is always
considered.
5.2 Simplified accounting

The HKFRS for Private Entities simplifies certain recognition and measurement principles in full
HKFRS. The more useful simplifications are highlighted below.
(a) Research and development costs and borrowing costs must be expensed immediately.
(b) Financial instruments
Financial instruments meeting specified criteria are measured at cost or amortised cost. All
others are measured at fair value through profit or loss.
In addition, a simplified principle is established for derecognition and hedge accounting
requirements are simplified and tailored to private entities.
(c) Property, plant and equipment and intangibles
Only the cost model is allowed. There is no need to review residual value, useful life and
depreciation method unless there is an indication that they have changed since the most
recent reporting date.
(d) Goodwill and other indefinite-life intangibles
An impairment test is performed only if there are indications of impairment (rather than
annually). Goodwill is measured at cost less accumulated amortisation and impairment
losses. All intangible assets are considered to have a finite useful life. If a reliable estimate of
goodwill or intangible assets cannot be made, it is presumed to be ten years.
(e) Investments in associates and jointly-controlled entities
The cost model, equity model and fair value model are permitted as an accounting policy
choice that should be applied to the whole class of associates or jointly-controlled entities.
An entity using the cost model must measure an investment for which there is a published
price using the fair value model.
74
(f) Exchange differences

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

In order to reduce costs for preparers, while still meeting the needs of users, the HKFRS for Private
Entities has simplified financial statement presentation requirements as follows:
(a) An entity is not required to present a statement of financial position at the beginning of the
earliest comparative period when the entity applies an accounting policy retrospectively or
makes a retrospective restatement of items in its financial statements, or when it reclassifies
items in its financial statements as required under HKAS 1.
(b) An entity is permitted to present a single statement of income and retained earnings in place
of separate statements of comprehensive income and changes in equity if the only changes
to its equity during the periods for which financial statements are presented, arise from profit
or loss, payment of dividends, corrections of prior period errors, and changes in accounting
policy.
(c) All deferred tax assets and liabilities are classified as non-current assets or liabilities.
75
Financial Reporting
5.4 Omitted topics

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

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

Entities:
Property, plant and equipment and Revaluation model
intangible assets
Borrowing costs Capitalisation of borrowing costs
Defined pension plans Deferral of actuarial gains and losses
Financial instruments* Available-for-sale and held-to-maturity
classifications are not available
Government grants Various accounting options excluded
Investment property Accounting policy choice
Consolidation Measurement of the non-controlling interest at
fair value
* Note. Entities are permitted to choose to apply HKAS 39 Financial Instruments: Recognition and
Measurement in its entirety rather than the financial instruments section of the HKFRS for Private
Entities. Note also that full HKFRS no longer allow these categories (HKFRS 9) and no longer
allows deferred recognition (HKAS 19).
5.6 Simplified disclosure

A number of disclosure requirements contained in full HKFRS have been omitted from the HKFRS
for Private Entities for the following reasons:
 They relate to topics covered in full HKFRS but omitted from the HKFRS for Private Entities.
 They relate to recognition and measurement principles contained in full HKFRS that have
been replaced by simplifications.
 They relate to options in full HKFRS that are not included in the HKFRS for Private Entities.
 Some disclosures are not included on the basis of users' needs or cost-benefit
considerations.
Examples of simplified and reduced disclosure requirements include the following:
 There is no requirement to disclose the fair value of the carrying amount for property, plant
and equipment and investment property.
 The vast majority of the disclosure requirements of HKFRS 7 Financial Instruments:
Disclosures are not required.
76
 There is no requirement to disclose estimates used to measure the recoverable amount of

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

The HKICPA expects to undertake a review of HKFRS for Private Entities in accordance with the
IASB timetable to review its IFRS for SMEs. The IASB is currently in the middle of a
comprehensive post-implementation review of user entities' experience in applying the IFRS for
SMEs. A Request for Information was issued in 2012 and the Board is currently discussing
responses. It will consider whether to amend the IFRS for SMEs for:
1 issues identified in the review
2 new and amended full IFRS adopted since the IFRS for SMEs was issued.
Beyond this, the IASB anticipate that the standard will be amended approximately once every three
years, with proposed changes issued in one go within an ‘omnibus Exposure Draft’.
Therefore, the number and frequency of amendments is reduced compared to those made to full
standards, and so the burden on companies to keep up to date is also reduced.
6 Impact of the HKFRS for Private Entities

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

A key area of concern for all businesses, especially individual companies in Hong Kong, is to
ensure that the benefits of application of the HKFRS for Private Entities outweigh the costs
associated with doing so.
The principal issue is therefore to ensure that the financial costs of preparation do not increase and
the needs of stakeholders are still met.
The HKFRS addresses this concern, ensuring that
 financial statements are based on the same conceptual framework as full HKFRS,
condensed and specifically tailored for private entities; and
 the burden of preparing financial statements in accordance with full HKFRS is reduced.
77
Financial Reporting
6.2 Comparison with full HKFRS

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

The HKFRS for Private Entities aims to simplify and reduce the potentially ever-increasing
reporting requirements of the full HKFRS. However, in determining whether to adopt the HKFRS for
Private Entities, management is advised to consider the facts and circumstances of the PE,
including but not limited to the following matters.
78
Must all PEs apply the HKFRS for Private Entities?

No. The adoption of the HKFRS for Private Entities is an option for PEs. If compliance with the full
HKFRS is required, desired or preferred by a PE, the PE may continue using or adopt the full
HKFRS and need not adopt the HKFRS for Private Entities.
Will the financial statements of a PE meet the needs of users?
PEs will have to consider whether financial statements prepared under the HKFRS for Private
Entities meet the needs of their own specific users. The financial statements of PEs generally are
not widely circulated, and the needs of individual users of those financial statements tend to be
specific, but not necessarily the same.
The HKFRS for Private Entities is based on the same framework as the full HKFRS. In developing
the IFRS for SMEs, the IASB attempted to consider the needs of users of the financial statements
of an SME. However, due to the specific needs of individual users, careful assessment will be
needed by each SME to determine whether the IFRS for SMEs will meet their needs. The IFRS for
SMEs concentrates on items such as short-term cash flows, liquidity, and balance sheet strength.
The IASB concluded that the full IFRS at times provided too much information for the needs of an
SME user, while in other situations other needs were not being met by the full IFRSs.
The HKICPA has held meetings with the Inland Revenue Department of the HKSAR Government
and representatives of Hong Kong Association of Banks since the issuance of the IFRS for SMEs.
Both parties acknowledged the standard setting role of the HKICPA and have no objection in principle
to relieving PEs from complying with the full HKFRS in the preparation of financial statements.
Are there any long-term considerations that should be taken into account?
The PE's long-term plans need to be considered; where such plans include becoming publicly
accountable or a possible listing of debt or equity instruments, this could affect the choices made
by the PE. A PE with such plans would be precluded from using the HKFRS for Private Entities in
the future, as it would fail to meet the definition of a PE. This would then force the PE into a second
conversion to the full HKFRS.
Another consideration is whether a PE's holding company reports (or will report) under the full
HKFRS. In such cases, it may be easier for that PE to also report under the full HKFRS in order to
facilitate the consolidation process in its parent company – thereby avoiding the need for dual
reporting.
79
Financial Reporting
Topic recap
Small company reporting
Financial reporting options in Hong Kong
Full HKFRS HKFRS for Private SME-FRF & FRS

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

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

IASB's IFRS for criteria set out in SME-FRF
SMEs this is a
self-contained
standard
Compared to full HKFRS, provides: Recognition, measurement,

simplified accounting eg all R&D costs presentation and disclosure
expensed as incurred. requirements provided in
simplified presentation eg all SME-FRS
deferred tax balances classified as non-
current
omitted topics eg EPS
simplified disclosure eg most HKFRS 7
disclosures not required
80
Exam practice
HKFRS for Private Entities 16 minutes

Sigma Technology Limited (STL) was established in the Macau Special Administration Region
(MSAR) in 2008 by Mr. Ong and is engaged in trading computer hardware. More than 50 staff are
employed by the company. STL has prepared its financial statements in accordance with the Small
and Medium-sized Entity Financial Reporting Framework (SME-FRF) since it was established for
both internal and external users. For the three years ended 31 December 20X1, STL reported the
following data in its management accounts:
20W9 20X0 20X1
HK$'000 HK$'000 HK$'000
Revenue 43,528 53,456 48,621
Profit for the year 8,602 11,731 8,980
Total assets 20,984 32,327 28,489
Total liabilities 13,729 16,341 14,201
Required
(a) Explain whether STL can report under the SME-FRF for the years ended
31 December 20X0 and 31 December 20X1. (3 marks)
(b) Explain whether STL can report under the Hong Kong Financial Reporting Standard for
Private Entities (HKFRS for Private Entities) for the year ended 31 December 20X1.
(2 marks)
(c) "Revaluation and impairment of property, plant and equipment are prohibited under HKFRS
for Private Entities". Explain whether this statement is correct. (2 marks)
(d) Assuming that Mr. Ong plans to list STL on the Growth Enterprise Market of The Stock
Exchange of Hong Kong Limited and is considering incorporating the financial information of
the entity for each of the two years ended 31 December 20X1 and 6 months ended 30 June
20X2 in the prospectus, explain whether STL can report the historical financial information in
its prospectus under the SME-FRF or the HKFRS for Private Entities. (2 marks)
(Total = 9 marks)
HKICPA December 2012 (amended)
81
Financial Reporting
82
Part C
Accounting for business

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

relating to transactions. The purpose of this section is to develop your knowledge about
different accounting standards categorised into three areas: Statements of Financial Position
and Comprehensive Income, Statements of Cash Flows, and Disclosure and Reporting. You
should be able to identify and apply relevant accounting standards in resolving the accounting
issues to be faced in the examination and the business world.
83
Financial Reporting
84
chapter 4
Non-current assets held for

sale and discontinued
operations
Topic list
1 HKFRS 5 Non-current assets Held for Sale and Discontinued Operations

1.1 Introduction and definitions
1.2 Scope
2 Classification of assets held for sale or for distribution to owners
2.1 Highly probable sale
2.2 Assets held for distribution to owners
2.3 Assets to be abandoned
2.4 Summary decision tree
3 Measurement of assets held for sale
3.1 Initial measurement
3.2 Subsequent measurement
3.3 Impairment losses
3.4 Reversal of impairment losses
3.5 Measurement where assets are no longer classified as held for sale
4 Presentation of assets held for sale
4.1 Presentation of a non-current asset or disposal group classified as held for sale
4.2 Additional disclosures
5 Discontinued operations
5.1 Definition of discontinued operations
5.2 Presentation of discontinued operations
Learning focus
The measurement requirements for non-current assets and disposal groups held for sale are
particularly important both for exam and practical purposes.
85
Financial Reporting
Learning outcomes
Competency
level
Account for transactions in accordance with Hong Kong Financial
Reporting Standards
3.21 Non-current assets held for sale and discontinued operations 3
3.21.01 Define non-current assets (or disposal groups) held for sale or held
for distribution to owners and discontinued operations within the
scope of HKFRS 5
3.21.02 Explain what assets are within the measurement provision of
HKFRS 5
3.21.03 Determine when a sale is highly probable
3.21.04 Measure non-current assets held for sale and discontinued
operations including initial measurement, subsequent measurement
and change of plan
3.21.05 How to account for impairment loss and subsequent reversals
3.21.06 Present the non-current asset held for sale and discontinued
operation in the financial statements (including the prior year
restatement)
86
4: Non-current assets held for sale and discontinued operations | Part C Accounting for business transactions
1 HKFRS 5 Non-current Assets Held for Sale and

Discontinued Operations
Topic highlights
HKFRS 5 requires assets and disposal groups "held for sale" to be presented separately in the
statement of financial position.
The results of discontinued operations should be presented separately in the statement of profit or
loss and other comprehensive income.
HKFRS 5,
Appendix A
1.1 Introduction and definitions
HKFRS 5 requires assets and groups of assets ("disposal groups") that are "held for sale" to be
presented separately in the statement of financial position.
It also requires that the results of discontinued operations are presented separately in the
statement of profit or loss and other comprehensive income.
These requirements ensure that users of financial statements are better able to make projections
about the financial position, profits and cash flows of the entity.
Key terms
Disposal group. A group of assets to be disposed of, by sale or otherwise, together as a group in
a single transaction, and liabilities directly associated with those assets that will be transferred in
the transaction. (In practice, a disposal group could be a subsidiary, a cash-generating unit or a
single operation within an entity.)
Discontinued operation. A component of an entity that either has been disposed of or is classified
as held for sale and:
(a) represents a separate major line of business or geographical area of operations
(b) is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations or
(c) is a subsidiary acquired exclusively with a view to resale.
(HKFRS 5)
HKFRS 1.2 Scope

5.2,5,5A
The classification and presentation requirements of HKFRS 5 (sections 2 and 4) apply to all
recognised non-current assets and to all disposal groups.
The measurement requirements of the HKFRS (section 3) apply to all recognised non-current
assets other than those listed below, which continue to be measured in accordance with the
relevant HKFRS noted:
(a) Deferred tax assets (HKAS 12)
(b) Assets arising from employee benefits (HKAS 19)
(c) Financial assets (HKAS 39/HKFRS 9)
(d) Investment properties accounted for in accordance with the fair value model (HKAS 40)
(e) Agricultural and biological assets that are measured at fair value less costs to sell (HKAS 41)
(f) Insurance contracts (HKFRS 4)
The measurement requirements of the standard also apply to all disposal groups and such a group
may include any assets and liabilities including current assets, current liabilities and those assets
listed above which are excluded from the scope of the standard on an individual basis.
87
Financial Reporting
Where a non-current asset forms part of a disposal group, the measurement requirements of
HKFRS 5 are applied to the group as a whole rather than to each asset within it on an individual
basis.
The classification, presentation and measurement requirements in this HKFRS applicable to a non-
current asset (or disposal group) that is classified as held for sale apply also to a non-current asset
(or disposal group) that is classified as held for distribution to owners acting in their capacity as
owners (held for distribution to owners).
2 Classification of assets held for sale or for

HKFRS 5.6,7 distribution to owners
Topic highlights
A non-current asset (or disposal group) should be classified as held for sale if its carrying amount
will be recovered principally through a sale transaction rather than through continuing use.
In order for this to be the case:
(a) the asset must be available for immediate sale in its present condition, and
(b) its sale must be highly probable (i.e., significantly more likely than not).
HKFRS 2.1 Highly probable sale

5.8,8A,9,11
For an asset to qualify as being held for sale, the sale must be "highly probable". The following
must apply:
(a) Management must be committed to a plan to sell the asset.
(b) There must be an active programme to locate a buyer.
(c) The asset must be actively marketed for sale at a price that is reasonable in relation to its
current fair value.
(d) The sale should be expected to take place within one year from the date of classification.
(e) It is unlikely that significant changes to the plan will be made or that the plan will be
withdrawn.
The probability of shareholders' approval (if required in the jurisdiction) should be considered as
part of the assessment of whether the sale is highly probable.
An entity that is committed to a sale plan involving loss of control of a subsidiary shall classify all
the assets and liabilities of that subsidiary as held for sale when the criteria are met, regardless of
whether the entity will retain a non-controlling interest in its former subsidiary after the sale.
If an asset (or disposal group) is not sold within one year, it can still be classified as held for sale
only when the delay has been caused by events or circumstances beyond the entity's control.
The entity is required to produce sufficient evidence to show its commitment to sell the asset or
disposal group, otherwise it must cease to classify the asset as held for resale.
When a disposal group (e.g., a subsidiary) is acquired solely with a view to its subsequent disposal,
an entity is allowed to classify it as an asset held for sale only if the sale is expected to occur within
a year and it is highly probable that all the criteria mentioned above will be satisfied within a short
period (normally three months) after the acquisition of the disposal group.
HKFRS 5.12A 2.2 Assets held for distribution to owners

A non-current asset (or disposal group) is classified as held for distribution to owners when the
entity is committed to distribute the asset (or disposal group) to the owners.
88
For this to be the case:

 the assets must be available for immediate distribution in their present condition, and
 the distribution must be highly probable.
In order for the distribution to be considered highly probable:
1 actions to complete the distribution should have been initiated
2 these actions should be expected to be completed within 12 months of the date of
classification.
Actions required to complete the distribution should indicate that it is unlikely that significant
changes to the distribution will be made or that the distribution will be withdrawn. The probability of
shareholders' approval (if required in the jurisdiction) should be considered as part of the
assessment of whether the distribution is highly probable.
HKFRS 5.13 2.3 Assets to be abandoned

An asset that is to be abandoned should not be classified as held for sale. Since its carrying
amount is to be recovered principally through continuing use rather than sale, it should not be
classified as held for sale. However separate disclosure may be required (see section 5 below)
when a disposal group to be abandoned meets the definition of a discontinued operation.
89
Financial Reporting
2.4 Summary decision tree

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

sold or abandoned?
Sold
No
Available for sale in present
condition?
Yes
Sale highly probable? Consider

sub criteria:
Management committed
to plan No
No
Active programme to Acquired with a view to
locate buyer resale?
Marketed at fair value

Yes
Significant changes to
plan unlikely
No
Yes Highly probable that sub-
criteria met within three
Yes months of purchase?
No
Sale expected within one year?
Yes
Criterial met before the end of No

the year?
Yes
Classify as held for sale and Disclose as non-adjusting

event after the reporting Do not classify as held
re-measure and disclose in
period (see Chapter 22) for sale
Should the following be classified as held for sale at a 31 December 20X1 year end?
1 Lawnmo is committed to a plan to sell a manufacturing facility in its present condition and
classifies the facility as held for sale at 31 March 20X1. After a firm purchase commitment is
obtained, the buyer's inspection of the property identifies environmental damage not
previously known to exist. Lawnmo is required by the buyer to make good the damage, and
this is likely to mean that the sale will not be completed until the end of August 20X2.
Lawnmo has initiated actions to make good the damage, and satisfactory rectification of the
damage is highly probable.
90
2 Ficus is committed to a plan to sell its head office building and has engaged the services of
an agent to locate a buyer. Ficus will use the building until the completion of its new
premises, currently under construction. The existing head office will not be transferred to a
buyer until such time as Ficus vacates the property.
3 Measurement of assets held for sale
Key terms
Fair value. The price that would be received to sell an asset or paid to transfer a liability in an
HKFRS 5
Appendix A
orderly transaction between market participants at the measurement date.
Costs to sell. The incremental costs directly attributable to the disposal of an asset (or disposal
group), excluding finance costs and income tax expense.
Recoverable amount. The higher of an asset's fair value less costs to sell and its value in use.
Value in use. The present value of estimated future cash flows expected to arise from the
continuing use of an asset and from its disposal at the end of its useful life. (HKFRS 5)
HKFRS
5.15,15A
On transfer to the held for sale category, a non-current asset (or the net assets of a disposal group)
should be measured at the lower of carrying amount and fair value less costs to sell.
An entity shall measure a non-current asset (or disposal group) classified as held for distribution to
owners at the lower of its carrying amount and fair value less costs to distribute.
HKFRS 5.16 3.1.1 Carrying amount
HKFRS 5 clarifies that the carrying amount is that amount at which the asset or disposal group
would have been included in the financial statements had the classification to the held for sale
category not occurred. This carrying amount is measured in accordance with applicable HKFRS.
HKFRS 5.17 3.1.2 Fair value less costs to sell
Fair value less costs to sell is equivalent to net realisable value. When the sale is expected to occur
beyond one year, the standard specifies that costs to sell should be measured at present value.
Any increase in the present value arising from the passage of time is recognised in profit or loss as
a financing cost.
HKFRS
5.19,25
3.2 Subsequent measurement
Once classified as held for sale (or part of a disposal group held for sale), a non-current asset is
not depreciated or amortised. Interest attributable to the liabilities of a disposal group does however
continue to be recognised.
On subsequent measurement of a disposal group, the carrying amount of those assets which are
part of the disposal group but individually outside the scope of HKFRS 5 (see section 1.2) should
be re-measured in accordance with the relevant HKFRS before the fair value less costs to sell of
the disposal group is re-measured.
HKFRS 5.20 3.3 Impairment losses

Assets held for sale are outside the scope of HKAS 36 and the guidance on impairments provided
within HKFRS 5 applies instead.
91
Financial Reporting
Where fair value less costs to sell is lower than carrying amount, the asset or disposal group held
for sale is impaired, and the difference between carrying amount and fair value less costs to sell
must be recognised as an impairment loss.
Example: Tang Co.

Tang Co. has owned a printing machine for several years. The machine cost $400,000 and is being
depreciated over a period of 10 years. At 1 October 20X8, the machine is carried in the statement
of financial position at $280,000. On 31 March 20X9 the management of Tang Co. decided to sell
the machine and immediately instructed a specialist selling agency to market the machine. The
current market value of such a machine is $270,000 and Tang Co. has agreed to pay a 5%
commission to the specialist selling agency.
At what value should the machine be included in the statement of financial position at
30 September 20X9, assuming that it has not yet been sold and that fair values remain unchanged
since classification as held for sale?
Solution
At the date of transfer to held for sale the carrying amount was:
$280,000 – ($400,000/10 years  6/12) = $260,000
The fair value less costs to sell was:
$270,000  95% = $256,500
On transfer to the held for sale category an impairment of $3,500 is recognised. Thereafter no
depreciation is charged, meaning that the asset held for sale is included in the statement of
financial position at 30 September 20X9 as a current asset carried at $256,500.
HKFRS 5.23 3.3.1 Impairment losses and disposal groups

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

Random Co. makes the decision to dispose of a division of its business on 15 February 20X9 and
immediately begins an active programme to find a buyer. The assets of this division make up a
disposal group, and are measured as follows:
Carrying amount at
15 February
20X9
$'000
Goodwill 450
Intangible asset 1,000
Property, plant and equipment 2,000
Inventory 1,300
Other current assets 900
Total 5,650
The fair value of the disposal group is $5.4 million and costs to sell are $290,000.
An impairment loss is therefore recognised on transfer of the disposal group to held for sale of
$540,000, and this is allocated to the non-current assets which fall within the scope of the
92
measurement provisions of HKFRS 5. Therefore, no impairment loss is allocated to inventory or the

other current assets.
The loss is allocated in the first place to goodwill and thereafter to other non-current assets on a
pro-rata basis:
Carrying
Carrying amount after
amount at allocation of
15 February Impairment impairment
20X9 loss loss
$'000 $'000 $'000
Goodwill 450 (450) –
Intangible asset 1,000 (30) 970
Property, plant and equipment 2,000 (60) 1,940
Inventory 1,300 – 1,300
Other current assets 900 900
Total 5,650 540 5,110
HKFRS 5.21 3.4 Reversal of impairment losses

Where an asset or disposal group held for sale is measured at fair value less costs to sell, any
subsequent increase in fair value less costs to sell is recognised, however not in excess of
cumulative impairment losses recognised in accordance with HKFRS 5 or HKAS 36.
HKFRS 5.27 3.5 Measurement where assets are no longer classified as held
for sale
A non-current asset (or disposal group) that is no longer classified as held for sale (for example,
because the sale has not taken place within one year) is measured at the lower of:
(a) its carrying amount before it was classified as held for sale, adjusted for any depreciation,
amortisation or revaluations that would have been charged had the asset not been classified
as held for sale
(b) its recoverable amount at the date of the decision not to sell.
4 Presentation of assets held for sale

HKFRS 5.38-
40
4.1 Presentation of a non-current asset or disposal group
classified as held for sale
Separate classifications are to be presented in the statement of financial position for non-current
assets and disposal groups. Likewise separate disclosure is also required for the liabilities of a
disposal group in the statement of financial position.
(a) Assets and liabilities held for sale should not be offset.
(b) The major classes of assets and liabilities held for sale should be separately disclosed
either in the statement of financial position or in the notes.
If the disposal group is a newly acquired subsidiary that meets the criteria to be classified as held
for sale on acquisition, disclosure of the major classes of assets and liabilities is not required.
Re-presentation of prior year comparatives is not required to reflect those assets classified as held
for sale only in the current year.
93
Financial Reporting
Example: Colway Co.

At the end of 20X9, Colway Co. decides to dispose of a machine and Division D of its business.
Division D is a disposal group. Both of these intended disposals meet the criteria to be classified as
held for sale, and their carrying amount after this classification is:
$'000
Machine 15
Non-current assets of Division D 340
Current assets of Division D 120
Liabilities of Division D 260
Presentation in the statement of financial position of Colway Co. is therefore as follows:
$'000 $'000
Non-current assets X X
Current assets X X
Non-current assets classified as held for sale 475 X
Total assets X X
Equity X X
Non-current liabilities X X
Current liabilities X X
Liabilities associated with non-current assets classified as
held for sale 260 X
Total equity and liabilities X X
HKFRS
5.41,42
4.2 Additional disclosures
The following disclosures are required when a non-current asset (or disposal group) is either
classified as held for sale or sold during a reporting period:
(a) A description of the non-current asset (or disposal group)
(b) A description of the facts and circumstances of the disposal
(c) Any gain or loss recognised when the item was classified as held for sale
(d) If applicable, the reportable segment in which the non-current asset (or disposal group) is
presented in accordance with HKFRS 8 Operating Segments
When an entity reclassifies an asset as no longer held for sale, it should disclose the facts and
circumstances leading to the decision and its resultant effect.
5 Discontinued operations
HKFRS 5.32 5.1 Definition of discontinued operations
A discontinued operation was defined at the start of this chapter as a component of an entity that
has either been disposed of, or is classified as held for sale, and:
(a) represents a separate major line of business or geographical area of operations
(b) is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations, or
(c) is a subsidiary acquired exclusively with a view to resale
A component of an entity comprises operations and cash flows that can be clearly distinguished
from the rest of the entity, both operationally and for financial reporting purposes.
94
HKFRS 5 requires that the results of a discontinued operation are disclosed separately in order to
enable users of the financial statements to evaluate the financial effects of discontinued operations.
Discuss whether these situations meet the definition of discontinued operations in HKFRS 5.
(i) Wong Co. had used two factories to manufacture office equipment. A general slump in the
economy has resulted in a reduced demand for such equipment and the company has
decided to move all the production facilities to one of the factories but keep the now empty
factory in the hope that there will be an upturn in demand and require the return to two
factory output.
(ii) In addition to the manufacture of office equipment, Wong Co. supplied office stationery to
private education establishments. In order to raise much needed cash the office stationery
supply business was sold. The office stationery supply business was operated separately
from the manufacturing activities.
HKFRS 5.33-
35,37
5.2 Presentation of discontinued operations
An entity should disclose a single amount in the statement of profit or loss and other
comprehensive income comprising the total of:
(a) the post-tax profit or loss of discontinued operations and
(b) the post-tax gain or loss recognised on the measurement to fair value less costs to sell or
on the disposal of the assets or disposal group(s) constituting the discontinued operation.
An entity should also disclose an analysis of the above single amount into:
(a) the revenue, expenses and pre-tax profit or loss of discontinued operations
(b) the related income tax expense
(c) the gain or loss recognised on the measurement to fair value less costs to sell or on the
disposal of the assets or the discontinued operation
(d) the related income tax expense
The analysis may be shown separately from continuing operations, in a section identified as
discontinued operations, in the statement of profit or loss and other comprehensive income. As an
alternative, it may also be presented in the notes to the financial statements. Such disclosure is not
necessary where the discontinued operation relates to a newly acquired subsidiary that has been
classified as held for sale.
Disclosures relating to the net cash flows attributable to the operating, investing and financing
activities of the discontinued operations may be presented on the face of the statement of cash
flows. Alternatively, they may be shown in the notes.
The required disclosures must be re-presented for prior periods presented in the financial
statements so that the disclosures relate to all operations that have been discontinued by the most
recent reporting date.
Any current year adjustments made to amounts previously presented in discontinued operations
and directly related to the disposal of a discontinued operation in a prior period are classified
separately in discontinued operations.
The gains or losses arising from the reassessment of a disposal group, which is held for sale and is
not a discontinued operation, should be incorporated in the profit or loss from continuing
operations.
95
Financial Reporting
Illustration
The following illustration is taken from the implementation guidance to HKFRS 5. Profit for the year
from discontinued operations would be analysed in the notes.
Smart Group
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR
ENDED 31 DECEMBER 20X9
20X9 20X8
$'000 $'000
Continuing operations
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Other expenses (X) (X)
Finance costs (X) (X)
Share of profit of associates X X
Profit before tax X X
Income tax expense (X) (X)
Profit for the year from continuing operations X X
Discontinued operations
Profit for the year from discontinued operations X X
Profit for the year X X
Period attributable to:
Owners of the parent X X
Non-controlling interest X X
X X
The analysis of the profit from discontinued operations may also be presented in a separate
column in the statement of profit or loss and other comprehensive income.
96
A&Z
20X1 20X0
$'000 $'000
Revenue 3,000 2,200
Cost of sales (1,000) (700)
Gross profit 2,000 1,500
Distribution costs (400) (300)
Administrative expenses (900) (800)
Profit before tax 700 400
Income tax expense (210) (120)
Profit for the year 490 280
Other comprehensive income for the year, net of tax 40 30
Total comprehensive income for the year 530 310
During the year the company ran down a material business operation with all activities ceasing on
26 December 20X1. The results of the operation for 20X0 and 20X1 were as follows:
20X1 20X0
$'000 $'000
Revenue 320 400
Cost of sales (150) (190)
Gross profit 170 210
Administrative expenses (100) (90)
Loss before tax (50) (10)
Income tax expense 15 3
Loss for the year (35) (7)
Total comprehensive income for the year (30) (3)
The company recognised a loss of $30,000 on initial classification of the assets of the discontinued
operation as held for sale, followed by a subsequent gain of $120,000 on their disposal in 20X1.
These have been netted against administrative expenses. The income tax rate applicable to profits
on continuing operations and tax savings on the discontinued operation's losses is 30%.
Required
Prepare the statement of profit or loss and other comprehensive income for the year ended 31
December 20X1 for A&Z complying with the provisions of HKFRS 5.
97
Financial Reporting
Topic recap
HKFRS 5 Non-Current Assets Held for Sale and Discontinued Operations
Non-current assets/disposal groups held Discontinued operations

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

classified as held for sale if: sale and:
available for immediate sale in present represents a separate major
condition, and business/geographical area
the sale is highly probable: is part of a plan to dispose of a separate
– Management committed to sale plan; major business/geographical area
– Active programme to locate buyer; is a subsidiary acquired with a view to
– Marketed at reasonable price; resale
– Sale expected to take place < 12
months
– Unlikely that sale plan will be
changed.
Measurement Disclosure
Lower of carrying amount and fair value Disclose single amount in statement of profit
less costs to sell. or
comprehensive
loss and otherincome
comprehensive
comprising:income
Post tax profit or loss of the
comprising:
postdiscontinued
tax profit or loss
operations
of the discontinued
and
operations
Post taxandgain or loss on
If FV less costs to sell < carrying amount postdisposal/measurement
tax gain or loss on to fair
recognise impairment loss. In disposal disposal/measurement
value less costs to sell.
to fair value less
group set against: costs to sell.
1. goodwill
2. other assets on pro rata basis
No further depreciation/amortisation Disclose further analysis of the single amount

in the SPLOCI or notes.
Disclosure
Disclose net cash operating, investing and

financing cash flows of the discontinued
Disclose separately as current assets / operation.
current liabilities held for sale without
offsetting
Disclose separate classes of assets /
liabilities held for sale
98
Answer 1
1 The manufacturing facility should be classified as held for sale. Although the sale will not be
completed within 12 months of classification, the delay is caused by circumstances beyond
Lawnmo’s control and Lawnmo is clearly committed to the sale.
2 The building should not be classified as held for sale. The delay in transferring the building to
a buyer demonstrates that it is not available for immediate sale. This is the case even if a
firm purchase commitment were obtained.
Answer 2
(i) The closure of the factory does not result in the disposal of a separate major line of business
or geographical area of operation nor is the factory being held for sale. The closure therefore
does not appear to result in a need to classify any of the performance of Wong Co. as
discontinued in these circumstances. Nothing has been discontinued, merely production
reduced to a more competitive level until demand returns.
(ii) The office stationery supply business will probably be considered to represent a separate
major line of business and should therefore be classified as a discontinued operation with
separate disclosure of its activities in the statement of profit or loss as required by HKFRS 5.
Its disposal will probably have been a single co-ordinated plan, further confirming the
business as a discontinued operation.
Answer 3
A&Z
20X1 20X0
$'000 $'000
Revenue (3,000 – 320)/(2,200 – 400) 2,680 1,800
Cost of sales (1,000 – 150)/(700 – 190) (850) (510)
Gross profit 1,830 1,290
Distribution costs (400 – 120)/(300 – 130) (280) (170)
Administrative expenses (900 – 100)/(800 – 90) (800) (710)
Profit before tax 750 410
Income tax expense (210 + 15)/(120 + 3) (225) (123)
Profit for the year from continuing operations 525 287
Loss for the year from discontinued operations (35) (7)
Profit for the year 490 280
Total comprehensive income for the year 530 310
99
Financial Reporting
Note. Discontinued operations

During the year the company ran down a material business operation with all activities ceasing on
26 December 20X1. The results of the operation were as follows:
20X1 20X0
$'000 $'000
Revenue 320 400
Cost of sales (150) (190)
Gross profit 170 210
Administrative expenses (100 + 90) (190) (90)
Loss before tax (140) (10)
Income tax expense (15 + (90  30%)) 42 3
Loss after tax (98) (7)
Post-tax gain on remeasurement and subsequent
disposal of assets classified as held for sale (90  70%) 63 –
Loss for the year (35) (7)
Total comprehensive income for the year (30) (3)
100
Exam practice
Disposal Groups 22 minutes

Super Shoes Limited ("SS") is the holding company of Rocket Running Limited ("RR") and Soft
Walking Limited ("SW"). At the board meeting of SS on 30 June 20X9, the management decided
to dispose of all the assets of RR to an independent third party and close down the retailing
operation of SW by the end of October 20X9. The assets of RR and SW as at 30 June 20X9 are
measured in the consolidated financial statements before classification as held for sale and / or
adjustment for impairment as a result of sales / closure of operation, if applicable, as follows:
RR SW
HK$'000 HK$'000
Goodwill 2,400 2,700
Intangible assets 12,500 -
Property, plant and equipment 48,300 18,800
Inventories 16,600 6,400
Trade receivables 4,500 1,300
Financial assets held for trading 8,000 -
TOTAL 92,300 29,200
Taking into consideration the range of the price offered by the potential buyer, the management
estimates that the fair value less costs to sell of the group of assets of RR amounts to
HK$85,000,000.
Almost all of the property, plant and equipment of SW are leasehold improvement of retailing shops
located at premises rented under operating leases which would be abandoned upon the early
termination of the lease terms. No proceeds are expected to be received even upon disposal.
SW would continue to sell its inventories but at an estimated discount of 40% of the cost. The
trade receivables are expected to be fully recovered.
Required
Explain and calculate the impairment loss to be made to each of the assets of RR and SW.
(12 marks)
HKICPA February 2010
101
Financial Reporting
102
chapter 5
Property, plant and

equipment
Topic list
1 HKAS 16 Property, Plant and Equipment

1.1 Scope
1.2 Definitions
1.3 Recognition of non-current assets
1.4 Measurement
1.5 Depreciation
1.6 Revaluations
1.7 Impairment
1.8 Retirements and disposals
1.9 Disclosure
1.10 Current developments
Learning focus
Non-current assets form a large part of many entities' statements of financial position.
Accounting for them is not necessarily straightforward and you may need to think critically and
deal with controversial issues. This chapter deals with property, plant and equipment; how to
account for transactions involving them, and the principles and methods of depreciation.
103
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.08 Property, plant and equipment 3
3.08.01 Identify the non-current assets which fall within or outside the scope
of HKAS 16
3.08.02 State and apply the recognition rules in respect of property, plant
and equipment
3.08.03 Determine the initial measurement of property, plant and
equipment, including assets acquired by exchange or transfer
3.08.04 Determine the accounting treatment of subsequent expenditure on
3.08.05 Determine the available methods to measure property, plant and
equipment subsequent to initial recognition
3.08.06 Account for the revaluation of property, plant and equipment
3.08.07 Define "useful life" and allocate an appropriate useful life for an
asset in a straightforward scenario
3.08.08 Explain the different methods of depreciation: straight line and
diminishing balance, and calculate the depreciation amount in
respect of different types of asset
3.08.09 Account for the disposal of property, plant and equipment
3.08.10 Disclose relevant information relating to property, plant and
equipment in the financial statements
104
5: Property, plant and equipment | Part C Accounting for business transactions
1 HKAS 16 Property, Plant and Equipment

Topic highlights
HKAS 16 covers all aspects of accounting for property, plant and equipment. This represents the
bulk of items which are "tangible" non-current assets.
HKAS 16.2,3 1.1 Scope

HKAS 16 should be followed when accounting for property, plant and equipment unless another
accounting standard requires a different treatment.
HKAS 16 does not apply to the following:
(a) Property, plant and equipment classified as held for sale in accordance with HKFRS 5
(b) Biological assets related to agricultural activity
(c) The recognition and measurement of exploration and evaluation assets
(d) Mineral rights and mineral reserves, such as oil, gas and other non-regenerative resources.
However, the standard applies to property, plant and equipment used to develop the assets
described in (b) and (d).
HKAS 16.6 1.2 Definitions

The standard gives a large number of definitions.
Key terms
Property, plant and equipment are tangible items that are:
 held for use in the production or supply of goods or services, for rental to others, or for
administrative purposes
 expected to be used during more than one period
Cost is the amount of cash or cash equivalents paid or the fair value of other consideration given to
acquire an asset at the time of its acquisition or construction.
Residual value is the estimated amount that an entity would currently obtain from disposal of the
asset, after deducting the estimated costs of disposal, if the asset were already of the age and in
the condition expected at the end of its useful life.
Entity specific value is the present value of the cash flows an entity expects to arise from the
continuing use of an asset and from its disposal at the end of its useful life, or expects to incur
when settling a liability.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
Carrying amount is the amount at which an asset is recognised after deducting any accumulated
depreciation and accumulated impairment losses.
An impairment loss is the amount by which the carrying amount of an asset exceeds its
recoverable amount.
Recoverable amount is the higher of an asset's fair value less costs to sell and its value in use.
(HKAS 16)
105
Financial Reporting
HKAS 16.7 1.3 Recognition of non-current assets

An item of property, plant and equipment should be recognised in the statement of financial
position as an asset when:
(a) it is probable that future economic benefits associated with the asset will flow to the entity.
(b) the cost of the asset to the entity can be measured reliably.
1.3.1 First criterion: Future economic benefits
The degree of certainty attached to the flow of future economic benefits must be assessed. This
should be based on the evidence available at the date of initial recognition (usually the date of
purchase). The entity should thus be assured that it will receive the rewards attached to the asset
and it will incur the associated risks, which will only generally be the case when the rewards and
risks have actually passed to the entity. Until then, the asset should not be recognised.
1.3.2 Second criterion: Cost measured reliably
It is generally easy to measure the cost of an asset as the transfer amount on purchase, i.e. what
was paid for it. Self-constructed assets can also be measured easily by adding together the
purchase price of all the constituent parts (labour, materials and so on) paid to external parties.
HKAS 1.3.3 Application to specific types of asset
16.8,9,11,13,14
Small separate assets
Smaller items, such as tools, dies and moulds, are sometimes classified as consumables and
written off as an expense. Where these are classified as property, plant and equipment, it is usual
to aggregate similar items together and treat them as one.
Spare parts and stand-by equipment
Spare parts, stand-by equipment and servicing equipment are recognised as property, plant and
equipment when they meet the definition of property, plant and equipment. Otherwise they are
classified as inventory.
Safety and environmental equipment
When items of safety and environmental equipment are acquired they will qualify for recognition
where they enable the entity to obtain future economic benefits from related assets in excess of
those it would obtain otherwise. The recognition will only be to the extent that the carrying amount
of the asset and related assets does not exceed the total recoverable amount of these assets.
Complex assets
For very large and specialised items, an apparently single asset should be broken down into its
composite parts. This occurs where the different parts have different useful lives and different
depreciation rates are applied to each part, e.g. an aircraft, where the body and engines are
separated as they have different useful lives. Expenditure incurred in replacing or renewing a
component of an item of property, plant and equipment must be recognised in the carrying amount
of the item (and then depreciated to the next replacement date).
Inspections and overhauls
Certain assets require periodic overhauls or inspections in order to operate. The cost of these
overhauls/inspections should be included in the carrying amount of the relevant asset and
depreciated as a separate element of the asset to the date of the next overhaul/inspection.
HKAS 16.12 1.3.4 Subsequent expenditure
Subsequent expenditure on a non-current asset may be capitalised where the expenditure
enhances the economic benefits of the asset beyond its current standard or performance. This may
be achieved through extension of the asset's life, improved quality of output or an increased
operating capacity. Day to day servicing costs, repairs and maintenance do not meet this criteria
and therefore must be expensed to profit or loss.
106
1.4 Measurement
HKAS 16.15- 1.4.1 Initial measurement
22
Once an item of property, plant and equipment qualifies for recognition as an asset, it will initially
be measured at cost.
The standard lists the components of the cost of an item of property, plant and equipment.
(a) Purchase price, less any trade discount or rebate
(b) Import duties and non-refundable purchase taxes
(c) Directly attributable costs of bringing the asset to working condition for its intended use,
for example:
(i) The cost of site preparation
(ii) Initial delivery and handling costs
(iii) Installation costs
(iv) Testing
(v) Professional fees (architects, engineers)
(d) Initial estimate of the unavoidable cost of dismantling and removing the asset and restoring the
site on which it is located (HKAS 37 Provisions, Contingent Liabilities and Contingent Assets).
(e) Any borrowing costs incurred related to building the asset may be capitalised within the
assets too (HKAS 23 Borrowing Costs).
Additional guidance is provided on directly attributable costs included in the cost of an item of
property, plant and equipment.
(a) These costs bring the asset to the location and working conditions necessary for it to be
capable of operating in the manner intended by management, including those costs to test
whether the asset is functioning properly.
(b) They are determined after deducting the net proceeds from selling any items produced when
bringing the asset to its location and condition.
The standard also states that income and related expenses of operations that are incidental to the
construction or development of an item of property, plant and equipment should be recognised in
profit or loss. These include:
 costs of opening a new facility
 costs of introducing a new product or service
 costs of conducting business in a new location or with a new class of customer
 administration and other general overhead costs
In addition, the capitalisation of costs must cease when an asset is in the location and condition
necessary for it to be capable of normal operation. Therefore, the following may not be capitalised:
 Costs incurred when an item is capable of normal use however is operating at less than full
capacity
 Initial operating losses
 The costs of relocating or reorganising the entity's operations.
All of these will be recognised as an expense rather than an asset.
In the case of self-constructed assets, the same principles are applied as for acquired assets.
If the entity makes similar assets during the normal course of business for sale externally, then the
cost of the asset will be the cost of its production under HKAS 2 Inventories. This also means that
abnormal costs (wasted material, labour or other resources) are excluded from the cost of the asset.
An example of a self-constructed asset is when a building company builds its own head office.
107
Financial Reporting
HKAS 16.24 1.4.2 Exchanges of assets

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

A ship owner has properties with a carrying value of $10m. He is going to exchange his properties
for a ship which has a market value of $20m by paying an additional sum of cash of $5m.
Solution
The ship owner shall capitalise the ship at a value of $20m. The properties are deemed to be
disposed of at $15m ($20m – $5m), thus a gain of $5m ($15m – $10m) is recognised on disposal
of the properties.
Expressed as journal entries, we can see:
$m $m
DEBIT Property, plant and equipment (Ship) 20
CREDIT Gain on disposal 5
Property, plant and equipment (Properties) 10
Cash 5
HKAS 1.4.3 Measurement subsequent to initial recognition

16.30,31
HKAS 16 offers two possible treatments here, requiring you to choose between keeping an asset
recorded at cost or revaluing it to fair value.
(a) Cost model. Carry the asset at its cost less any accumulated depreciation and any
accumulated impairment losses.
(b) Revaluation model. Carry the asset at a revalued amount, being its fair value at the date of
the revaluation less any subsequent accumulated depreciation and subsequent accumulated
impairment losses. HKAS 16 makes clear that the revaluation model is available only if
the fair value of the item can be measured reliably.
Depreciation, revaluation and impairment are discussed in more detail in the next three sections of
the chapter.
1.5 Depreciation
Topic highlights
Where assets held by an entity have a limited useful life to that entity it is necessary to apportion
the value of an asset over its useful life.
With the exception of land held on freehold or very long leasehold, every non-current asset
eventually wears out over time. Machines, cars and other vehicles, fixtures and fittings, and even
buildings do not last for ever. When a business acquires a non-current asset, it will have some idea
about how long its useful life will be, and it might decide what to do with it.
(a) Keep on using the non-current asset until it becomes completely worn out, useless, and
worthless.
108
(b) Sell off the non-current asset at the end of its useful life, either by selling it as a
second-hand item or as scrap.
Since a non-current asset has a cost, and a limited useful life, and its value eventually declines, it
follows that a charge should be made in profit or loss to reflect the use that is made of the asset by
the business. This charge is called depreciation.
Depreciation must be charged even where an asset appears to be increasing in value over time.
Other than assets classified as held for sale, to which HKFRS 5 applies, the only type of asset for
which non-depreciation is permissible is freehold land.
Key terms
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.
HKAS 16.6
Depreciable assets are assets which:
 are expected to be used during more than one accounting period
 have a limited useful life
 are held by an entity for use in the production or supply of goods and services, for rental to
others, or for administrative purposes.
Useful life is one of two things:
 The period over which an asset is expected to be available for use by an entity.
 The number of production or similar units expected to be obtained from the asset by an entity.
Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual
value.
HKAS 1.5.1 The mechanics of depreciation

16.48,50,55,
58,60 The standard states the following:
(a) The depreciable amount of an item of property, plant and equipment should be allocated on
a systematic basis over its useful life.
(b) The depreciation method used should reflect the pattern in which the asset's economic
benefits are consumed by the entity.
(c) The depreciation charge for each period should be recognised as an expense unless it is
included in the carrying amount of another asset.
Land and buildings are dealt with separately even when they are acquired together because land
use right normally is considered as a lease and accounted for in accordance with the requirements
under HKAS 17. Buildings do have a limited life and must be depreciated. Any increase in the
value of land on which a building is standing will have no impact on the determination of the
building's useful life.
Depreciation is usually treated as an expense, but not where it is absorbed by the entity in the
process of producing other assets. For example, depreciation of plant and machinery can be
incurred in the production of goods for sale (inventory items). In such circumstances, the
depreciation is included in the cost of the new assets produced.
Depreciation should commence when an asset is available for use. In other words it is in the
location and condition necessary for ordinary use.
HKAS 1.5.2 Useful life
16.56,57
The useful life of a depreciable asset is estimated based on the following factors:
 Expected physical wear and tear
 Obsolescence
 Legal or other limits on the use of the assets
109
Financial Reporting
The judgment on useful life is based on the entity's past experience with similar assets or classes
of assets. The task of estimating the useful life will be much more onerous when an entirely new
type of asset is acquired (i.e. through technological advancement or through use in producing a
brand new product or service).
It is indicated in the standard that the useful life of an asset might be shorter than its physical life.
The physical wear and tear the asset is likely to endure is one of the key factors that we need to
look at. It is affected by circumstances such as the entity's repair and maintenance programme and
number of shifts for which the asset will be used, and so on. Other factors such as obsolescence
(due to technological advance, improvements in production, reduction in demand for the product or
service produced by the asset) and legal restrictions, for example, the length of a related lease,
also play a role in determining the useful life of an asset.
HKAS 16.53 1.5.3 Residual value
The residual value of an asset is likely to be immaterial in most instances. However, if the
residual value is expected to be significant, it must then be estimated at the date of acquisition or at
any subsequent revaluation. The residual value should be estimated based on the current situation
with other similar assets, used in the same way, which are now at the end of their useful lives. Any
future cost relating to the disposal should be netted off against the gross residual value.
HKAS 1.5.4 Depreciation methods
16.60,62
HKAS 16 requires the depreciation method used to reflect the pattern in which the asset's future
economic benefits are expected to be consumed by the entity. A variety of methods are available
and these include the straight line method, the diminishing balance method and the units of
production method.
Straight line depreciation results in a constant annual depreciation charge. This method simply
spreads the depreciable amount evenly over the useful life.
Diminishing balance depreciation results in a higher depreciation charge in the earlier years of
an asset's useful life and a lower charge in later years. It is calculated as a constant percentage of
an asset's carrying amount.
The units of production method results in a charge based on expected output. The charge is
therefore higher in periods of higher output and lower when there is a lower output.
Consistency is important. The depreciation method selected should be applied consistently from
period to period unless altered circumstances justify a change. When the method is changed, the
effect should be quantified and disclosed and the reason for the change should be stated. Change
of policy is not allowed simply because of the profitability situation of the entity.
A computer system cost $20,000 and is being depreciated at 10% using the diminishing balance
method. How does this asset appear in the statement of financial position in the first and second
year of ownership?
Why is the diminishing balance method more appropriate for such an asset?
DSyne Co acquired an item of plant for $1.8m on 1 January 20X1. It identified that the asset had
three major components as follows:
Component Useful life Cost
$'000
1 15 years 900
2 5 years 650
3 10 years 250
110
Under the terms of the 15-year licence agreement for the use of the plant, component 1 (but not
the other components) was to be dismantled at the end of the licence period.
Dismantling costs were initially estimated at a total cost of $280,000 payable in 15 years' time.
DSyne’s discount rate appropriate to the risk specific to this liability is 7% per annum.
Component 1 developed a fault on 1 January 20X2 and had to be sold for scrap for $140,000.
A replacement was purchased at a cost of $910,000 on 1 January 20X2, for use until the end of the
licence period, when dismantling costs on this component estimated at $250,000 would be
payable.
At a rate of 7% per annum the present value of $1 payable in 15 years' time is 0.3624 and of $1
payable in 14 years' time is 0.3878.
Required
Calculate
(a) the carrying amount of the machinery at 31 December 20X1
(b) the profit/loss on the disposal of the faulty component
(c) the carrying amount of the machinery at 31 December 20X2
HKAS 16.51 1.5.5 Review of useful life and residual value

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

A machine costs $100,000 and has a useful life of 10 years since its acquisition in 20X7. At the end
of the second year of use, the asset is assessed to have a remaining useful life of five years. The
company adopts the straight line depreciation method.
What will be the depreciation charge for 20X9?
Solution
$
Original cost 100,000
Depreciation 20X7 – 20X8 (100,000  2/10) (20,000)
Carrying amount at 1 January 20X9 80,000
Remaining life = 5 years
80,000
Depreciation charge years 20X9 – 20Y3 = $16,000
5
HKAS 16.61 1.5.6 Review of depreciation method

The depreciation method should also be reviewed at least at each financial year end and, if
there has been a significant change in the expected pattern of economic benefits from those
assets, the method should be changed to suit this changed pattern. When such a change in
depreciation method takes place the change should be accounted for as a change in accounting
estimate and the depreciation charge for the current and future periods should be adjusted.
111
Financial Reporting
Example: Review of depreciation method

Using the same data as above, assume that at the end of the second year the company changes
from the straight line method to the diminishing balance method of depreciation, at a rate of 25%
per annum.
The carrying amount of $80,000 is therefore written off from 20X9 onwards using the diminishing
balance method over its remaining useful life.
The depreciation charge for 20X9 is therefore $20,000 (25%  $80,000).
HKAS 16.31 1.6 Revaluations

Where an entity chooses to apply the revaluation model to property, plant and equipment, the
revalued assets are carried at a revalued amount less subsequent depreciation and impairment
losses. Revalued amount is the fair value of the asset at the date of revaluation.
HKFRS 13.9- 1.6.1 Fair value
33,76,81,86
HKFRS 13, issued in May 2011, amended the definition of fair value contained within HKAS 16 to
"the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date".
HKFRS 13 also deleted the HKAS 16 guidance on establishing fair value and replaced this with a
requirement to instead refer to the requirements of HKFRS 13 Fair Value Measurement.
This standard requires that the following are considered in determining fair value:
1 The asset being measured.
2 The principal market (i.e. that where the most activity takes place) or where there is no
principal market, the most advantageous market (i.e. that in which the best price could be
achieved) in which an orderly transaction would take place for the asset.
3 The highest and best use of the asset and whether it is used on a standalone basis or in
conjunction with other assets.
4 Assumptions that market participants would use when pricing the asset.
Having considered these factors, HKFRS 13 provides a hierarchy of inputs for arriving at fair value.
It requires that level 1 inputs are used where possible:
Level 1 Quoted prices in active markets for identical assets that the entity can access at the
measurement date.
Level 2 Inputs other than quoted prices that are directly or indirectly observable for the asset.
Level 3 Unobservable inputs for the asset.
HKAS 16.34 1.6.2 Frequency of revaluations
Valuations must be kept up to date so that the carrying amount of a revalued asset does not differ
materially from its fair value. In some cases annual revaluation is necessary, whereas in others it
may be necessary to revalue the item only every three or five years.
HKAS 1.6.3 Consistency of revaluation
16.36,38
When an item of property, plant and equipment is revalued, the whole class of assets to which it
belongs should be revalued.
All items within a class should be revalued simultaneously. In this way, selective revaluation of
certain assets and disclosure of a mixture of costs and values from different dates in the financial
statements can be avoided. Entities are permitted to have revaluation on a rolling basis if the
112
revaluations are kept up to date and the revaluation of the entire class is accomplished in a short
period of time.
HKAS 1.6.4 Accounting for a revaluation
16.39,40
How should any increase in value be treated when a revaluation takes place? The debit will be
the increase in value in the statement of financial position, but what about the credit? HKAS 16
requires the increase to be credited to other comprehensive income and accumulated in a
revaluation surplus (i.e. part of owners' equity), unless the increase is reversing a previous
decrease which was recognised as an expense. Where this is the case, the increase is recognised
as income to the extent of the previous expense; any excess is then taken to the revaluation
surplus.
A decrease in value is recognised in the same way as an impairment loss (see section 1.7 below).
Example: Revaluation
Paddington has acquired numerous buildings and accounts for these using the revaluation model.
One particular piece of land is carried in Paddington’s statement of financial position at $560,000 at
1 January 20X1. At 31 December 20X1, further to a revaluation exercise, a fair value of $710,000
is identified in respect of this building.
How is this revaluation accounted for assuming that
(a) the buildings have only ever risen in value
(b) further to an economic downturn, at the time of the last revaluation exercise, an impairment
of $80,000 was identified and recognised in profit.
Ignore depreciation.
Solution
(a) The double entry is:
$ $
DEBIT Buildings 150,000
CREDIT Other comprehensive income (revaluation surplus) 150,000
(b) The double entry is:

$ $
DEBIT Buildings 150,000
CREDIT Administrative expenses (profit or loss) 80,000
Other comprehensive income (revaluation surplus) 70,000
Note. The line item for the credit to profit or loss is not specified in the standard, but it is generally
made to the same account as any depreciation and other costs relating to the buildings.
The case is similar for a decrease in value on revaluation. Any decrease should be recognised as
an expense, except where it offsets a previous increase taken as a revaluation surplus in owners'
equity. Any decrease greater than the previous upwards increase in value must be taken as an
expense in profit or loss.
Example: Revaluation decrease

Rupert Co. acquired a building for an original cost of $3.5 million at the start of 20X1. It was
revalued upwards to $3.8 million in January 20X3. The value has now fallen to $3 million at
31 December 20X3.
How should the decrease in value be recorded at 31 December 20X3?
113
Financial Reporting
Solution
The double entry is:
$ $
DEBIT Other comprehensive income (revaluation surplus) 300,000
Administrative expenses (profit or loss) 500,000
CREDIT Building 800,000
1.6.5 Depreciation of revalued assets

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

Roosevelt Co. purchased a property on 1 January 20X1. Details are as follows:
 Cost $9million
 Useful life 50 years
On 1 January 20X6 the property was revalued to $8.5million, with the useful life unchanged.
(a) Account for the revaluation.
(b) Calculate depreciation for the year ended 31 December 20X6 and the amount that may be
transferred to retained earnings from the revaluation surplus in that year.
Solution
(a) On 1 January 20X6 the carrying value of the property is $9m – (5  $9m  50) = $8.1m.
For the revaluation:
$ $
DEBIT Asset value 400,000
CREDIT Other comprehensive income (revaluation surplus) 400,000
(b) The depreciation for the year ended 31 December 20X6 will be $8.5m  45 = $188,889,
compared to depreciation on cost of $9m  50 = $180,000. So each year, the extra $8,889
can be treated as part of the surplus which has become realised:
$ $
DEBIT Revaluation surplus 8,889
CREDIT Retained earnings 8,889
This is a movement on owners' equity only, disclosed in the statement of changes in equity.
1.7 Impairment
An impairment loss should be treated in the same way as a revaluation decrease i.e. the
decrease should be recognised as an expense. However, a revaluation decrease (or impairment
loss) should be charged directly against any related revaluation surplus to the extent that the
decrease does not exceed the amount held in the revaluation surplus in respect of that same asset.
114
A reversal of an impairment loss should be treated in the same way as a revaluation increase,
i.e. a revaluation increase should be recognised as income to the extent that it reverses a
revaluation decrease or an impairment loss of the same asset previously recognised as an
expense.
HKAS 16.68 1.8 Retirements and disposals

When an asset is permanently withdrawn from use, or sold or scrapped, and no future
economic benefits are expected from its disposal, it should be withdrawn from the statement of
financial position.
Gains or losses are the difference between the estimated net disposal proceeds and the carrying
amount of the asset. They should be recognised as income or expense in profit or loss.
HKAS 1.8.1 Derecognition
16.67,68,68A
An entity is required to derecognise the carrying amount of an item of property, plant or
equipment that it disposes of on the date the criteria for the sale of goods in HKAS 18 Revenue
would be met. This also applies to parts of an asset.
An entity cannot classify as revenue a gain it realises on the disposal of an item of property, plant
and equipment.
However, an entity that, in the course of its ordinary activities, routinely sells items of property,
plant and equipment that it has held for rental to others shall transfer such assets to inventories at
their carrying amount when they cease to be rented and become held for sale. The proceeds from
the sale of such assets shall be recognised as revenue in accordance with HKAS 18 Revenue.
HKFRS 5 does not apply when assets that are held for sale in the ordinary course of business are
transferred to inventories.
Example: Derecognition
A property was purchased at a cost of $10m and has a useful life of 50 years. At the end of
Year 20, the property was revalued to $30m and its useful life remains unchanged. The property
was sold at the beginning of Year 22 for $33m.
Solution
Accounting entries:
At the end of Year 20, the following accounting entries reflect the revaluation:
$m $m
30
DEBIT Property ($30m – ( /50  $10m)) 24
CREDIT Revaluation surplus 24
In Year 21, the following adjustments are to be made:

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

CREDIT Retained profits 0.8
Being realisation of part of revaluation reserve due to additional depreciation provided on
revaluation surplus.
115
Financial Reporting
In Year 22, the following adjustments are to be made:

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

The following analysis shows that the distributable profits remain the same, whether the property is
revalued or not:
$m
Without revaluation of the asset
Cost 10.0
Less: Accumulated depreciation ($0.2  21 years) (4.2)
Carrying amount 5.8
Disposal proceeds (33.0)
Profit realised on disposal 27.2
$m
With revaluation of the asset
Gain on disposal (as above) 4.0
Revaluation surplus transferred to retained profits 23.2
27.2
A business purchased two rivet making machines on 1 January 20X5 at a cost of $15,000 each.
Each had an estimated life of five years and a nil residual value. The straight line method of
depreciation is used.
Owing to an unforeseen slump in market demand for rivets, the business decided to reduce its
output of rivets, and switch to making other products instead. On 31 March 20X7, one rivet making
machine was sold (on credit) to a buyer for $8,000.
Later in the year, however, it was decided to abandon production of rivets altogether, and the
second machine was sold on 1 December 20X7 for $2,500 cash.
Required
Prepare the machinery account, provision for depreciation of machinery account and disposal of
machinery account for the accounting year to 31 December 20X7.
HKAS
16.73,74,77,
1.9 Disclosure
79 The standard has a long list of disclosure requirements, for each class of property, plant and
equipment.
(a) Measurement bases for determining the gross carrying amount (if more than one, the gross
carrying amount for that basis in each category).
(b) Depreciation methods used.
(c) Useful lives or depreciation rates used.
116
(d) Gross carrying amount and accumulated depreciation (aggregated with accumulated
impairment losses) at the beginning and end of the period.
(e) Reconciliation of the carrying amount at the beginning and end of the period showing:
(i) Additions
(ii) Disposals
(iii) Acquisitions through business combinations (see Chapter 27)
(iv) Increases/decreases during the period from revaluations and from impairment losses
(v) Impairment losses recognised in profit or loss
(vi) Impairment losses reversed in profit or loss
(vii) Depreciation
(viii) Net exchange differences (from translation of statements of foreign entity)
(ix) Any other movements.
The financial statements should also disclose the following:
(a) Any recoverable amounts of property, plant and equipment
(b) Existence and amounts of restrictions on title, and items pledged as security for liabilities
(c) Accounting policy for the estimated costs of restoring the site
(d) Amount of expenditures on account of items in the course of construction
(e) Amount of commitments to acquisitions
Revalued assets require further disclosures, in addition to those required by HKFRS 13 Fair Value
Measurement:
(a) Basis used to revalue the assets
(b) Effective date of the revaluation
(c) Whether an independent valuer was involved
(d) Carrying amount of each class of property, plant and equipment that would have been
included in the financial statements had the assets been carried at cost less accumulated
depreciation and accumulated impairment losses
(e) Revaluation surplus, indicating the movement for the period and any restrictions on the
distribution of the balance to shareholders
The standard also encourages disclosure of additional information, which the users of financial
statements may find useful.
(a) The carrying amount of temporarily idle property, plant and equipment
(b) The gross carrying amount of any fully depreciated property, plant and equipment that is still
in use
(c) The carrying amount of property, plant and equipment retired from active use and held for
disposal
(d) The fair value of property, plant and equipment when this is materially different from the
carrying amount
117
Financial Reporting
The following format (with notional figures) is commonly used to disclose non-current assets
movements:
Land and Plant and
buildings equipment Total
$ $ $
Cost or valuation
At 1 January 20X8 40,000 10,000 50,000
Revaluation surplus 12,000 – 12,000
Additions in year – 4,000 4,000
Disposals in year – (1,000) (1,000)
At 31 December 20X8 52,000 13,000 65,000
Depreciation
At 1 January 20X8 10,000 6,000 16,000
Charge for year 1,000 3,000 4,000
Eliminated on disposals – (500) (500)
At 31 December 20X8 11,000 8,500 19,500
Carrying amount
At 31 December 20X8 41,000 4,500 45,500
At 1 January 20X8 30,000 4,000 34,000

The IASB proposed amendments to IAS 16 in December 2012. As HKAS 16 is converged with IAS
16, these will also affect HKAS 16. The amendments would clarify that depreciation methods must
reflect a pattern of consumption of economic benefits from an asset rather than a pattern of
generation of economic benefits by an asset. Therefore a revenue-based method of depreciation
is not allowed.
A revenue-based method of depreciation is a method whereby the depreciation charge in a given
year is calculated based on the revenue earned in that year as a proportion of total revenues
expected to be generated by the asset over its useful life.
Comments on the Exposure Draft are due by 2 April 2013. Finalised amendments are expected in
the fourth quarter of 2013.
118
Topic recap
HEADING
HKAS 16 Property, Plant and Equipment
Recognise an asset when:

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

where it enhances the benefits of the asset.
Initial Subsequent measurement Depreciation

measurement
Cost model Revaluation model
Measured at cost Carrying amount = Carrying amount = Allocate depreciable

including: cost – accumulated revalued amount – amount (revalued
purchase price depreciation – accumulated amount) less residual
duties and accumulated depreciation – value over useful life.
taxes impairment losses. accumulated
directly impairment losses. Land usually not
attributable depreciated.
costs
dismantling Review useful life,
costs (HKAS 37) Rules: residual value and
borrowing Valuations must be kept up to date. depreciation method
costs (HKAS 23) at least each financial
Model must be applied to the whole class of year.
asset.
Changes accounted for
prospectively.
Upwards revaluation
Carrying amount = Downwards
Carrying amount =
recognised as other
cost – accumulated revaluation
revalued amount –
comprehensive
depreciation – charged to
accumulated
income in revaluation
accumulated revaluation
depreciationsurplus
– to
surplus.
impairment losses. the extent it exists in
accumulated
respect of the
impairment asset
losses.
then as an expense.
Disclosure requirements:
Measurement bases Recoverable amounts
Depreciation methods and Restrictions on title
estimations Estimated costs of restoring site
Reconciliation of cost/revalued Expenditure on assets under
amount and accumulated construction
depreciation b/f to the same Capital commitments
amounts c/f Additional disclosure for revalued
assets
119
Financial Reporting
Answer 1
First year Second year
$ $
Cost 20,000 20,000
Accumulated depreciation
Yr 1 ($20,000  10%) (2,000) (2,000)
Yr 2 ($18,000  10%) – (1,800)
Carrying amount 18,000 16,200
The diminishing balance method of depreciation is used instead of the straight line method when it
is considered fair to allocate a greater proportion of the total depreciable amount to the earlier
years and a lower proportion to the later years on the assumption that the benefits obtained by the
business from using the asset decline over time.
It may be argued that this method links the depreciation charge to the costs of maintaining and
running the computer system. In the early years these costs are low and the depreciation charge is
high, while in later years this is reversed.
Answer 2
(a)
Cost Depreciation Carrying amount
$ $ $
Component 1
Cost 900,000
Dismantling 101,472
($280,000  1,001,472 66,765 934,707
0.3624)
Component 2 650,000 130,000 520,000
Component 3 250,000 25,000 225,000
1,679,707
(b) Proceeds 140,000
CV at disposal (934,707)
Loss on disposal (794,707)
(c)
Cost Depreciation Carrying amount
$ $ $
Component 1
Cost 910,000
Dismantling 96,950
($250,000  1,006,950 71,925 935,025
0.3878)
Component 2 650,000 260,000 390,000
Component 3 250,000 50,000 200,000
1,525,025
120
Answer 3
20X7
$ $
31 Mar DEBIT Loss on disposal 250
Accumulated depreciation* 6,750
Account receivable (sale price) 8,000
CREDIT Non-current asset (cost) 15,000
Being recording sales proceeds for disposal
31 Dec DEBIT Loss on disposal 3,750
Accumulated depreciation** 8,750
Cash (sale proceeds) 2,500
CREDIT Non-current asset (cost) 15,000
Being recording sales proceeds for disposal
* Depreciation at date of disposal = $6,000 + $750
** Depreciation at date of disposal = $6,000 + $2,750
You should be able to calculate that there was a loss on the first disposal of $250, and on the
second disposal of $3,750, giving a total loss of $4,000.
WORKINGS
1 At 1 January 20X7, accumulated depreciation on the machines will be:
$15,000
2 machines  2 years  per machine pa = $12,000, or $6,000 per machine
5
$3,000
2 Monthly depreciation is = $250 per machine per month
12
3 The machines are disposed of in 20X7.
(a) On 31 March – after 3 months of the year.
Depreciation for the year on the machine = 3 months  $250 = $750
(b) On 1 December – after 11 months of the year.
Depreciation for the year on the machine = 11 months  $250 = $2,750
121
Financial Reporting
Exam practice
Phoenix Real Estate 16 minutes

Phoenix Real Estate Limited ("Phoenix") is a property developer in China. In 20X3, Phoenix
acquired the land use rights of two pieces of land in Beijing for hotel development:
Property One – Since the date of the acquisition of the land, the board of Phoenix has decided to
run the hotel on its own and commenced the pre-operating activities of the hotel on 1 January 20X5
when the development is completed and the hotel is available for its intended use. The hotel's
grand opening took place on 1 July 20X5.
Property Two – Since the date of the acquisition of the land, the board of Phoenix decided to lease
the whole property to earn rental income. A lease agreement was entered into to lease the whole
property to its holding company (the "Tenant") for a period of eighteen years for the operation of a
hotel.
The monthly revenue amount of the hotel operation is provided by the Tenant at the close of
business of each month-end date.
Other information on these two properties:
Property One Property Two
RMB'000 RMB'000
Cost of land use right 45,000 48,000
Cost of construction (excluding the right 303,000 267,000
amortisation of land use right)
Fair value of land use right at 31 December 60,000 100,000
20X5
Fair value of the building at existing status as at 560,000 340,000
31 December 20X5
Date of purchase of land use right 1 July 20X3 1 October 20X3
Term of land use right of the property 75 years 60 years
Estimated useful life of the property 50 years 40 years
Completion of construction of the building December 20X4 June 20X5
Phoenix has adopted the cost model under HKAS 16 for property, plant and equipment and the fair
value model under HKAS 40 for investment property (buildings only). Depreciation is provided to
write off the cost of property, plant and equipment using the straight line method. The land use right
is considered as a lease and accounted for in accordance with the requirements under HKAS 17.
Amortisation of the cost of the land during the construction period is capitalised as part of the
development cost of the property.
Required
Calculate the amount of (1) land use right and (2) carrying amount of the building for each property
to be reflected in Phoenix's statement of financial position as at 31 December 20X5. (9 marks)
HKICPA September 2006 (amended)
122
chapter 6
Investment property
Topic list
1 HKAS 40 Investment Property

1.1 Definitions
1.2 Recognition
1.4 Measurement subsequent to initial recognition
1.5 Transfers
1.6 Disposals
1.7 Summary of accounting treatment of property
1.8 Disclosure requirements
Learning focus
Some entities own land or buildings and treat them as an investment, i.e. in order to generate
income and cash flows independently of the other assets held by the entity. It is important that
you understand the difference between investment properties and other classes of assets,
and how to account for them.
123
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.10 Investment property 3
3.10.1 Identify an investment property within the scope of HKAS 40 and
situation when a property can be transferred in and out of the
investment property category
3.10.2 Distinguish investment property from other categories of property
holdings and describe the difference in accounting treatment
3.10.3 Apply the recognition and measurement rules relating to investment
property
3.10.4 Account for investment property
3.10.5 Disclose relevant information, including an accounting policy note,
for investment property
124
6: Investment property | Part C Accounting for business transactions
1 HKAS 40 Investment Property

Topic highlights
Land and building may be acquired for investment purpose rather than for use in the business.
The cash flows generated by this investment are largely independent of other assets held by the
entity. The accounting treatment of investment property is covered by HKAS 40.
HKAS 40 Investment Property was published in March 2000 with the objective of regulating the
accounting treatment for investment property and related disclosure requirements.
HKAS 40 does not deal with issues covered in HKAS 17. It includes investment property held
under a finance lease or leased out under an operating lease.
HKAS 40.5
1.1 Definitions
Key terms
Investment property is property (land or a building – or part of a building – or both) held (by the
owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both,
rather than for:
(a) use in the production or supply of goods or services or for administrative purposes
(b) sale in the ordinary course of business.
Owner-occupied property is property held by the owner (or by the lessee under a finance lease) for
use in the production or supply of goods or services or for administrative purposes.
Cost is the amount of cash or cash equivalents paid or the fair value of other consideration given to
acquire an asset at the time of its acquisition or construction.
Carrying amount is the amount at which an asset is recognised in the statement of financial
position.
A property interest that is held by a lessee under an operating lease may be classified and
accounted for as an investment property, if and only if the property would otherwise meet the
definition of an investment property and the lessee uses the HKAS 40 fair value model. This
classification is available on a property-by-property basis. (HKAS 40.5)
HKAS 40.8- The standard provides the following examples of investment properties:
12,
15 (a) Land held for long-term capital appreciation rather than for short-term sale in the ordinary
course of business.
(b) Land held for a currently undetermined future use.
(c) A building owned by the reporting entity (or held by the entity under a finance lease) and
leased out under an operating lease.
(d) A building that is vacant but held to be leased out under one or more operating leases.
(e) Property that is being constructed or developed for future use as investment property.
(f) A building held by an entity and leased to a parent or another subsidiary. Note, however,
that while this is regarded as an investment property in the individual entity's financial
statements, in the consolidated financial statements this property will be regarded as
owner-occupied (because it is occupied by the group) and will therefore be treated in
accordance with HKAS 16.
125
Financial Reporting
The standard also clarifies that the following are not investment properties, but are instead within
the scope of the named standards:
(a) Property intended for sale in the ordinary course of business (HKAS 2)
(b) Property being constructed or developed for sale in the ordinary course of business
(HKAS 2)
(c) Property being constructed or developed on behalf of third parties (HKAS 11)
(d) Owner occupied property (HKAS 16), which includes:
(i) property held for future owner-occupation
(ii) property held for future development before owner-occupation
(iii) property occupied by employees regardless of whether they pay market rent
(iv) owner-occupied property awaiting disposal
(e) Property leased to another entity under a finance lease.
Where a property is partly owner-occupied and partly held to earn rentals or for capital
appreciation, its treatment depends on whether or not the portions of the property could be sold
separately. If they could not be sold separately, the property is only treated as investment property
if an insignificant portion is held for owner-occupier use.
Where an entity provides ancillary services to the occupants of a property it holds:
 The property is treated as investment property where those ancillary services are
insignificant to the arrangement as a whole
 The property is treated as owner-occupied where the ancillary services are significant, for
example the services provided to a hotel guest by the owner of the hotel indicate that a hotel
is owner-occupied.
Propex had the following properties but is unsure how to account for them:
1 Tennant House which cost $150,000 five years ago. The property is freehold and is let out to
private individuals for six-monthly periods. The current market value of the property is
$175,000.
2 Stowe Place which cost $75,000. This is used by Propex as its headquarters. The building
was acquired 10 years ago.
3 Crocket Square is a recently started development which is two-thirds complete. Propex
intends to let this out to a company called Speedex in which it has a controlling interest.
4 Smith Tower is an office complex let out to a number of commercial tenants. Propex
provides these tenants with security and maintenance services in the building.
Propex depreciates its buildings at 2% per annum on cost.
Required
Describe the most appropriate accounting treatment for each of these properties.
126
Below is the decision tree showing which HKFRS should be applied to various kinds of property:
Is the asset complete and

held for use in the production
or supply of goods or services
or for administrative purposes
i.e. wholly owner occupied
(including occupied by
another group entity in the Yes
case of consolidated
accounts)? Asset is accounted for as
PPE (HKAS 16)
No
Is the asset under
development for future owner
Yes
occupation?
No
Is the asset complete and
held for sale in the ordinary
Yes
course of business?
No Asset is accounted for as
inventories (HKAS 2)
Is the asset being constructed
or developed for sale in the
Yes
ordinary course of business?
No
Is the asset being constructed Yes Asset is accounted for as
or developed on behalf of construction contract
third parties? (HKAS 11)
No
Is the asset partly owner Can the part which is owner
occupied? occupied be sold or leased
Yes
under a finance lease in a
separate transaction?
No
Is the asset leased out under Yes Asset is accounted for
a finance lease? under HKAS 17
No Yes
No
Asset should be recognised Yes Is the part of the asset Asset should be
as an investment property which is owner occupied separated into
under HKAS 40 insignificant? component parts. The
portion which is not
No
owner occupied is
Asset is recognised as investment property
property, plant and (HKAS 40); the portion
equipment under HKAS 16 which is owner occupied
is PPE (HKAS 16)
127
Financial Reporting
HKAS 40.16 1.2 Recognition

Investment property should be recognised as an asset when two conditions are met:
(a) It is probable that the future economic benefits that are associated with the investment
property will flow to the entity, and
(b) The cost of the investment property can be measured reliably.
HKAS
40.20,25
An investment property should be measured initially at its cost, including transaction costs.
A property interest held under a lease and classified as an investment property shall be accounted
for as if it were a finance lease. The asset is recognised at the lower of the fair value of the property
and the present value of the minimum lease payments. An equivalent amount is recognised as a
liability.
HKAS
40.30,34
1.4 Measurement subsequent to initial recognition
Topic highlights
Entities can choose between:
 Fair value model, with changes in fair value being measured
 Cost model – the treatment most commonly used under HKAS 16
HKAS 40 requires an entity to choose between two models:

 The fair value model
 The cost model
Whatever policy it chooses should be applied to all of its investment property.
Where an entity chooses to classify a property held under an operating lease as an investment
property, there is no choice. The fair value model must be used for all the entity's investment
property, regardless of whether it is owned or leased.
HKAS 1.4.1 Fair value model
40.33,35, 53,
HKFRS 13.9- Where the fair value model is chosen, the following rules apply:
33,76, 81, 86
1 An entity that chooses the fair value model should measure all of its investment property at
fair value, except in the extremely rare cases where this cannot be measured reliably. In
such cases it should apply the HKAS 16 cost model.
2 A gain or loss arising from a change in the fair value of an investment property should be
recognised in net profit or loss for the period in which it arises.
HKAS 40 was the first time that the HKICPA has allowed a fair value model for non-financial
assets. This is not the same as a revaluation of assets where increases in carrying amount above a
cost-based measure are recognised as revaluation surplus (i.e., as a reserve, in equity). Under the
fair value model all changes in fair value are recognised in profit or loss.
HKFRS 13 Fair Value Measurement, issued in May 2011, deleted much of the guidance provided
in HKAS 40 in respect of the determination of fair value. Instead the requirements of HKFRS 13
apply in measuring the fair value of investment properties.
128
This standard requires that the following are considered in determining fair value:
1 The asset being measured
2 The principal market (i.e. that where the most activity takes place) or where there is no
principal market, the most advantageous market (i.e. that in which the best price could be
achieved) in which an orderly transaction would take place for the asset
3 The highest and best use of the asset and whether it is used on a standalone basis or in
conjunction with other assets
4 Assumptions that market participants would use when pricing the asset.
Having considered these factors, HKFRS 13 provides a hierarchy of inputs for arriving at fair value.
It requires that level 1 inputs are used where possible:
Level 1 Quoted prices in active markets for identical assets that the entity can access at the
measurement date.
Level 2 Inputs other than quoted prices that are directly or indirectly observable for the asset.
Level 3 Unobservable inputs for the asset.
The guidance which remains in HKAS 40 is as follows:
(a) Double counting should be prevented in deciding on the fair value of the assets. For
example, elevators or air conditioning, which form an integral part of a building should be
incorporated in the investment property rather than recognised separately.
(b) According to the definition in HKAS 36 Impairment of Assets, fair value is not the same as
"value in use". The latter reflects factors and knowledge as relating solely to the entity, while
the former reflects factors and knowledge applicable to the market.
(c) In those uncommon cases in which the fair value of an investment property cannot be
determined reliably by an entity, the cost model in HKAS 16 must be employed until the
investment property is disposed of. The residual value must be assumed to be zero.
1.4.2 Operating lease and investment property
In respect of leased property that qualifies as an operating lease, the lessee has the option to
classify the leased property as investment property provided that the lessee uses the fair value
model of HKAS 40 and the relevant criteria are met and all of the investment property must only be
accounted for under the fair value model. This means that the components of land and buildings of
the lease need not be split in order to calculate whether it is a finance lease or operating lease.
HKAS 40.56 1.4.3 Cost model

The model here is the same as the cost model in HKAS 16. Investment property should be
measured at depreciated cost, less any accumulated impairment losses. If an entity chooses
the cost model, it should disclose the fair value of its investment property.
HKAS 40.31 1.4.4 Changing models
An entity should apply its chosen fair value model or cost model to all its investment property.
It should not change its model unless the change will result in a more appropriate
presentation. HKAS 40 states that it is very unlikely that a change from the fair value model to the
cost model will end up in a more appropriate presentation.
HKAS 40.57-
65
1.5 Transfers
Transfers to or from investment property are justified only when there is a change in the use of
the property.
129
Financial Reporting
1.5.1 Transfers from investment property

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

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

property property up to the date of change in use. The entity
shall treat any difference at that date between the
carrying amount of the property in accordance with
HKAS 16 and its fair value in the same way as a
revaluation in accordance with HKAS 16. (See Note
below)
Note. Any resulting decrease in the carrying amount of the property is recognised in profit or loss.
However, to the extent that an amount is included in revaluation surplus for that property, the
decrease is recognised in other comprehensive income and reduces the revaluation surplus within
equity.
130
Any resulting increase in the carrying amount is treated as follows:

(a) To the extent that the increase reverses a previous impairment loss for that property, the
increase is recognised in profit or loss. The amount recognised in profit or loss cannot
exceed the amount needed to restore the carrying amount to the carrying amount that would
have been determined (net of depreciation) had no impairment loss been recognised; and
(b) Any remaining part of the increase is recognised in other comprehensive income and
increases the revaluation reserve within equity. On subsequent disposal of the investment
property, the revaluation surplus included in equity may be transferred to retained earnings.
The transfer from revaluation reserve to retained earnings is not made through the statement
of profit or loss and other comprehensive income.
HKAS 1.6 Disposals

40.66,69,72
An investment property should be derecognised (eliminated from the statement of financial
position) on disposal or when it is permanently withdrawn from use and no future economic
benefits are expected from its disposal.
A gain or loss on disposal arises when there is a difference between the net disposal proceeds and
the carrying amount of the asset. It should generally be recognised in profit or loss as income or
expense.
Compensation from third parties for investment property that was impaired, lost or given up should
be recognised in profit and loss when the compensation becomes receivable.
1.7 Summary of accounting treatment of property

Depending on which standard's scope a property falls within, it may be subject to significantly
different accounting treatment:
HKAS 16 HKAS 16 HKAS 2 HKAS 40 HKAS 40

cost model revaluation cost model fair value
model model
Measurement Cost less Revalued Lower of cost Cost less Fair value
in statement depreciation amount less and net depreciation
of financial less depreciation realisable less
position impairment less value impairment
losses impairment losses (same
losses as cost model
in HKAS 16)
Gains and Depreciation Revaluations No Depreciation Changes in

losses and recognised in depreciation and impairment fair value
impairment other recognised in recognised
recognised in comprehensive profit or loss in profit or
profit or loss income loss. No
depreciation
131
Financial Reporting
HKAS 40.75 1.8 Disclosure requirements

Disclosures in respect of investment properties are particularly important due to the choice of
accounting treatment provided by the standard. Users must be aware of whether the carrying
amount represented in the statement of financial position relates to cost or fair value.
Where the fair value model is used, users have an indication of the achievable proceeds on a sale
of an investment property; where the cost model is used, the requirement to disclose fair value
achieves the same end.
In addition, detail of amounts recognised in profit or loss, such as rental income and changes in fair
value, help users to determine the quality of an investment property in generating returns.
The following must be disclosed:
 Whether an entity applies the cost model or fair value model
 Whether property interests held as operating leases are included in investment property
 Criteria for classification as investment property
 Use of independent professional valuer (encouraged but not required)
 Amounts recognised in profit or loss for:
– rental income
– direct operating expenses from property that did generate rental income
– direct operating expenses from property that did not generate rental income
– cumulative change in fair value recognised in profit or loss on sale of an investment
property from a pool of assets in which the cost model is used to a pool in which the
fair value model is used
 Any restrictions or obligations associated with the investment property
HKAS 40.76 - 1.8.1 Fair value model – additional disclosures
78
An entity that adopts the fair value model must also disclose the following:
(a) A reconciliation of the carrying amount of the investment property at the beginning and end
of the period, including separate details for those properties for which reliable fair value
cannot be determined.
(b) Disclosure of adjustments to valuations obtained (for example to avoid double counting).
(c) Where fair value cannot be established reliably:
(i) A description of the property
(ii) Explanation of why fair value cannot be established reliably
(iii) A range of estimates within which fair value is likely to lie (where possible)
(iv) The carrying amount of any property disposed of and gain or loss recognised.
HKAS 40.79 1.8.2 Cost model – additional disclosures

An entity that adopts the cost model must also disclose:
 depreciation methods used
 useful lives or depreciation rates used
 the gross carrying amount and accumulated depreciation at the start and end of the period
 a reconciliation of the carrying amount of the investment property at the beginning and end
of the period
 the fair value of investment property
132
Topic recap
HKAS 40 Investment Property
HEADING Definition HEADINGMeasurement HEADING Disclosure
Disclose
Land, building
singleoramount
part ofinbuilding
statement
heldofby Whichsingle
Disclose measurement
amount inmodel
statement
is applied
of
comprehensive
the owner (or lessee
incomeunder
comprising:
finance lease) Criteria for classification
comprehensive income comprising:
as investment property
Post
to earn rentals/for
tax profit
capital
or loss
appreciation
of the rather UsePost
of independent
tax profit or valuer
loss of the
than fordiscontinued
use/sale in the
operations
ordinaryand course of Amounts
discontinued
recognised
operations
in profitand
or loss
Post
business. Includes:
tax gain or loss on Restrictions
Post tax gain
or obligations
or loss onassociated with the
Land disposal/measurement
held for undeterminedtofuturefair use property.
disposal/measurement to fair
Property
value being
less costs
constructed
to sell. for use as an value less costs to sell.
investment property
A building held by one group company and Fair value

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

costs
Subsequently choose and apply to all investment

property:
Cost model Fair value model

Measured at depreciated cost Measured to fair value at
less impairment losses (as reporting date
HKAS 16) Changes in fair value
recognised in profit or loss
133
Financial Reporting
Answer to self-test question
Answer 1
1 Tennant House
 Held for its investment potential and not for use by Propex
 Treat as investment property in accordance with HKAS 40
 Rental income to profit or loss
 If following fair value model – revalue to market value of $175,000. The difference of
$25,000 credited to profit or loss
 If following cost model – depreciate based on cost and do not revalue. Depreciation for
current period is $3,000 and net book value is $135,000 (150,000 – (5  3,000))
 Need to be consistent and use either fair value or cost model for all investment
properties.
2 Stowe Place
 Held for use by Propex
 Considered as owner-occupied property and accounted for in accordance with
HKAS 16
 Depreciate over useful life 75,000  2% = 1,500 per annum to profit or loss
 Carrying value of $75,000 – ($1,500  10) = 60,000 to be shown in statement of
financial position.
3 Crocket Square
 Not yet complete so accounting treatment relates to the cost incurred to date
 Propex is constructing the property to let out to another company, Speedex. During
construction, and after completion, the property is therefore within the scope of
HKAS 40 and should be accounted for as an investment property in Propex’s
individual accounts
 As Speedex is a subsidiary of Propex, the property will be owner-occupied from a
group perspective and therefore HKAS 16 is applied at a consolidation level.
4 Smith Tower
 The service and maintenance services provided by Propex to its tenants would be
deemed insignificant to the arrangement as a whole. Therefore, Propex should treat
Smith Tower as an investment property and apply the provisions of HKAS 40.
134
Exam practice
Cliff Land Limited 27 minutes

Cliff Land Limited (CLL) owns the following three buildings in Hong Kong:
Building A Building B Building C
Usage Warehouse Director's quarter Earning rental

income
Date of acquisition 1 January 20X0 1 January 20W8 1 January 20X5
Cost of the building $20 million $36 million $18 million
Fair value of the $28 million $22 million $22 million
building at 31 December
20X7
In the board meeting held on 30 September 20X7, the management of CLL determined to sell
Buildings B and C. A property agency was appointed in the following month to identify potential
buyers. In addition, CLL moved the storage of its inventories in Building A to a new production plant
in Shenzhen. At 31 December 20X7, all three buildings were vacant.
CLL has accounted for (i) the building under property, plant and equipment at cost basis and
depreciated the cost with the estimated useful life of 30 years, (ii) the investment property at fair
value model, and (iii) the land cost as operating lease under HKAS 17. Cost and fair value of the
land are assumed to be zero. Cost to sell the buildings is estimated at 0.5% of the disposal value of
the asset.
Required
Determine the statement of financial position classification of these three buildings and calculate
the respective amounts to be recognised on the statement of financial position as at 31 December
20X7. (15 marks)
HKICPA February 2008 (amended)
135
Financial Reporting
136
chapter 7
Government grants
Topic list
1 HKAS 20 Government Grants

1.1 Scope
1.2 Definitions
1.3 Government grants
1.4 Excluded government assistance
1.5 Disclosure
1.6 HK(SIC) Int-10 Government Assistance – no specific relation to operating activities
Learning focus
Entities in many different countries receive government grants for all sorts of reasons, very
often to encourage growth and industry in certain areas, or to help them overcome external
difficulties, such as economic difficulties. This chapter covers how to account for government
grants.
137
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.03 Government grants and assistance 3
3.03.01 Accounting and presentation of government grants
3.03.02 Disclosure of government grants and assistance in accordance with
HKAS 20
138
7: Government grants | Part C Accounting for business transactions
1 HKAS 20 Government Grants

Topic highlights
In many countries entities may receive government grants for various purposes (grants may be
called subsidies, premiums, or given other titles). They may also receive other types of assistance
which may be in many forms. The treatment of government grants is covered by HKAS 20
Accounting for Government Grants and Disclosure of Government Assistance.
HKAS 20.2 1.1 Scope

HKAS 20 does not cover the following situations:
(a) Accounting for government grants in financial statements reflecting the effects of changing
prices
(b) Government assistance given in the form of "tax breaks"
(c) The government acting as part-owner of the entity
(d) Government grants covered by HKAS 41 Agriculture
HKAS 20.3-5 1.2 Definitions

These definitions are provided in the standard.
Key terms
Government. Government, government agencies and similar bodies whether local, national or
international.
Government assistance. Action by government designed to provide an economic benefit specific
to an entity or range of entities qualifying under certain criteria.
Government grants. Assistance by government in the form of transfers of resources to an entity in
return for past or future compliance with certain conditions relating to the operating activities of the
entity. They exclude those forms of government assistance which cannot reasonably have a value
placed upon them and transactions with government which cannot be distinguished from the
normal trading transactions of the entity.
Grants related to assets. Government grants whose primary condition is that an entity qualifying
for them should purchase, construct or otherwise acquire non-current assets. Subsidiary conditions
may also be attached restricting the type or location of the assets or the periods during which they
are to be acquired or held.
Grants related to income. Government grants other than those related to assets.
Forgivable loans. Loans which the lender undertakes to waive repayment of under certain
prescribed conditions.
Fair value. This is the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date.
(HKAS 20.3)
Government assistance can be of various forms since both the type of assistance and the
conditions related to it may differ. It may have the impact of encouraging an entity to undertake
something it otherwise would not have done.
139
Financial Reporting
How will the financial statements be affected by the receipt of government assistance?
(a) Any resources transferred to an entity must be accounted for using an appropriate method.
(b) Disclosure in the notes to the accounts is required to show the magnitude to which an entity
has benefited from such assistance.
HKAS 20.7-
11
1.3 Government grants
Government grants (including non-monetary grants at fair value) should only be recorded when the
entity has reasonable assurance that:
 the entity will comply with any conditions attached to the grant
 the entity will actually receive the grant
The receipt of the grant does not mean that the conditions attached to it have been or will be
fulfilled.
The manner of receipt of the grant, whether it is in cash or as a reduction in a liability to the
government, is irrelevant in the treatment of the grant.
Once a grant has been recognised, any contingency associated with it should be accounted for
under HKAS 37 Provisions, Contingent Liabilities and Contingent Assets.
When a forgivable loan (as given in the key terms above) is received from the government and it
is reasonably assured that the entity will meet the appropriate terms for forgiveness, it should be
treated in the same way as a government grant. In addition, a loan at a below-market rate of
interest is to be dealt with as a government grant.
A benefit of a government loan at a below-market rate of interest is treated as a government
grant. The loan shall be recognised and measured in accordance with HKFRS 9 Financial
Instruments. The benefit of the below-market rate of interest shall be measured as the difference
between the initial carrying value of the loan determined in accordance with HKFRS 9 and the
proceeds received. The benefit is accounted for in accordance with this standard. The entity shall
consider the conditions and obligations that have been, or must be, met when identifying the costs
for which the benefit of the loan is intended to compensate.
HKAS 20.12- 1.3.1 Accounting treatment of government grants

22
There are two methods which could be used to account for government grants, and the arguments
for each are given in HKAS 20.
(a) Capital approach: the grant is recognised outside profit or loss.
(b) Income approach: the grant is recognised in profit or loss over one or more periods.
What are the different arguments used in support of each method?
HKAS 20 requires that the income approach should be adopted in the recognition of grants. In
other words, grants received should be recognised in profit or loss on a systematic basis over the
relevant accounting periods in which the entity recognises as expenses the related costs.
A systematic basis of matching should be used to avoid a violation of the accrual assumption to
treat grants in profit or loss on a receipts basis. This latter basis would only be acceptable when no
other basis was available.
The related cost to a government grant can easily be identified and thereby the period(s) in which
the grant should be recognised in profit or loss, i.e. when the costs are incurred by the entity.
Grants received relating to a depreciating asset will be recognised, in the same proportion, over the
periods in which the asset is depreciated.
140
On 1 January 20X8, Xenon Co. purchased a non-current asset for cash of $100,000 and received
a grant of $20,000 towards the cost of the asset. Xenon Co.'s accounting policy is to treat the grant
as deferred income. The asset has a useful life of five years.
Required
Show the accounting entries to record the asset and the grant in the year ended 31 December
20X8.
Certain obligations may have to be fulfilled for grants relating to non-depreciable assets. In such
a case, the grant should be recognised in profit or loss over the periods in which the cost of
meeting the obligation is incurred. For example, if a piece of land is granted on the condition that a
building is erected on it, then the grant should be recognised in profit or loss over the building's life.
If a series of conditions, in the form of a package of financial aid, are attached to the grant, then
the entity must be careful in identifying precisely those conditions which give rise to costs which in
turn determine the periods in which the grant will be earned. The grant may also be split into parts
and allocated on different bases.
Grants received as compensation for expenses or losses which an entity has already incurred
and grants given merely to provide immediate financial support where there are no foreseeable
related costs, should be recognised in profit or loss of the period in which they become receivable.
HKAS 20.23 1.3.2 Non-monetary government grants

When a non-monetary asset, such as a piece of land or other resources, is given by the
government to an entity as a grant, the fair value of the asset is assessed and used to account for
both the asset and the grant. On the other hand, both may be recorded at a nominal value.
HKAS 20.24- 1.3.3 Presentation of grants related to assets

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

In the year ended 31 December 20X8, Tiger-Lily Co. receives a grant of $100,000 towards the cost
of a new freehold property in a development zone. The cost of the property is $700,000, and the
purchase was completed on 30 June 20X8. The property is to be depreciated at an annual rate of
2% on cost.
Illustrate how the grant will affect the financial statements of Tiger-Lily for the years ended
31 December 20X8, 20X9 and 20Y0 assuming profits before depreciation in those years of
$250,000, $280,000 and $315,000.
141
Financial Reporting
Solution
The results of the company would be as follows:
(a) Reducing the cost of the asset
20X8 20X9 20Y0
$ $ $
Profits
Profit before depreciation 250,000 280,000 315,000
Depreciation* 12,000 12,000 12,000
Profit 238,000 268,000 303,000
*The depreciation charge on a straight line basis, for each year, is 2% × ($700,000 
$100,000) = $12,000.
STATEMENT OF FINANCIAL POSITION AT YEAR END (EXTRACT)
$ $ $
Non-current asset at cost 600,000 600,000 600,000
Depreciation 12,000 24,000 36,000
Carrying amount 588,000 576,000 564,000
(b) Treating the government grant as deferred income
20X8 20X9 20Y0
$ $ $
Profits
Profit before grant
and depreciation 250,000 280,000 315,000
Depreciation (14,000) (14,000) (14,000)
Government grant 2,000 2,000 2,000
Profit 238,000 268,000 303,000
STATEMENT OF FINANCIAL POSITION AT YEAR END (EXTRACT)

$ $ $
Non-current asset at cost 700,000 700,000 700,000
Depreciation (14,000) (28,000) (42,000)
Carrying amount 686,000 672,000 658,000
Deferred income
Government grant
deferred income 98,000 96,000 94,000
Whichever of these methods is used, the cash flows in relation to the purchase of the asset and
the receipt of the grant are often disclosed separately because of the significance of the
movements in cash flow.
HKAS 20.29- 1.3.4 Presentation of grants related to income
31
Grants related to income are a credit in the statement of profit or loss and other comprehensive
income. There are two alternative methods of disclosure.
(a) Present as a separate credit or under a general heading, e.g. "other income".
(b) Deduct from the related expense.
The disclosure has been a subject of controversy. Some would argue that it is not good practice to
offset income and expenses in the statement of profit or loss and other comprehensive income,
others would say that offsetting is acceptable since the expenses would not have been incurred
had the grant not been available. A proper understanding of the financial statements is required
142
for the disclosure of the grant, particularly the effect on any item of income or expense which is to
be separately disclosed.
HKAS 20.32- 1.3.5 Repayment of government grants
33
If a grant must be repaid it should be accounted for as a change in an accounting estimate.
In other words, the revision is accounted for prospectively. HKAS 8 requires that the nature and
amount of such a change in an accounting estimate is disclosed.
(a) Repayment of a grant related to income: apply first against any unamortised deferred income
set up in respect of the grant; any excess should be recognised immediately as an expense.
(b) Repayment of a grant related to an asset: increase the carrying amount of the asset or
reduce the deferred income balance by the amount repayable. The cumulative additional
depreciation that would have been recognised to date in the absence of the grant should be
immediately recognised as an expense.
The circumstances relating to repayment may entail a reassessment of the asset value and an
impairment of the new carrying amount of the asset.
HKAS 20.34-
36
1.4 Excluded government assistance
The definition of government grants does not include some forms of government assistance.
(a) Some forms of government assistance cannot reasonably have a value placed on them,
e.g. free technical or marketing advice, provision of guarantees.
(b) There are transactions with government which cannot be distinguished from the entity's
normal trading transactions, e.g. government procurement policy resulting in a portion of
the entity's sales. Any segregation would be arbitrary.
The government assistance may have to be disclosed because of its significance; nature, extent
and duration.
HKAS 20.39 1.5 Disclosure

Disclosure is required of the following:
(a) Accounting policy adopted, including method of presentation.
(b) Nature and extent of government grants recognised and other forms of assistance received.
(c) Unfulfilled conditions and other contingencies attached to recognised government
assistance.
1.6 HK(SIC) Int-10 Government Assistance – no specific relation

to operating activities
The aim of government assistance to entities in some countries is to encourage entities or to
provide long-term support of business activities either in certain regions or industry sectors.
Conditions to receive assistance may have no particular relationship with the operating activities of
the entity. Examples of this kind of assistance are transfers of resources by governments to entities
which:
 operate in a specific industry.
 continue to operate in newly privatised industries.
 commence or continue to operate in underdeveloped areas.
If the government assistance is considered as a "government grant" within the scope of HKAS 20,
then it should be accounted for in accordance with this standard.
Even if there are no circumstances particularly relating to the operating activities of the entity other
than the requirement to operate in certain regions or industry sectors, government assistance to
entities still meets the definition of government grants in HKAS 20 and should not be credited
directly to equity.
143
Financial Reporting
Topic recap
HKAS 20 Government Grants
Government Grants Government Assistance
Transfer of
Disclose single
resources
amount from
in statement
government of Outside definition
Disclose single amount
of grants:
in statement of
comprehensive
to an entity in return
incomefor comprising:
compliance comprehensive
1. Government income
assistance
comprising:
without
with certain
Post conditions.
tax profit or loss of the Post
valuetax
e.g.
profit or loss of the
discontinued operations and discontinued operations
Free technical adviceand
Includes: Post
tax gain or
Provision of loss on
guarantees
forgivable
disposal/measurement
loans to fair disposal/measurement to fair
below value less interest
market costs to loans
sell. 2. Transactions
value less costs
withtogovernment
sell.
non-monetary assets (grant = fair value of that cannot be distinguished
asset) from normal trading
Excludes government assistance without transactions.
value.
Disclose single
Recognise when amount
there in statement of
is reasonable Disclose if significant
comprehensive
assurance that: income comprising:
the
1. Postentity
tax profit or loss with
will comply of the
conditions
discontinued
attached to theoperations
grant and
disposal/measurement
2. the entity will receive the to fair
grant.
Grants related to assets

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

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

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

1. Reduce any unamortised
deferred income balance
2. Recognise excess as expense.
Disclose
Disclosuresingle amount in statement of
comprehensive income comprising:
Accounting policy
Postand
Nature taxextent
profit or
of loss of the
grants recognised
anddiscontinued operations
other assistance receivedand
Post tax
Unfulfilled gain or loss
conditions andon
other
disposal/measurement to fair
contingencies.
144
Answer 1
The standard gives the following arguments in support of each method.
Capital approach
(a) The grants are a financing device, so should go through the statement of financial position.
In the statement of profit or loss and other comprehensive income they would simply offset
the expenses which they are financing. No repayment is expected by the government, so the
grants should be recognised outside profit or loss.
(b) Grants are not earned, they are incentives without related costs, so it would be wrong to
take them to profit or loss.
Income approach
(a) The grants are not received from shareholders so should not be recognised directly in
equity, but should be recognised in profit or loss in appropriate periods.
(b) Grants are not given or received for nothing. They are earned by compliance with
conditions and by meeting obligations. They should therefore be recognised in profit or loss
over the periods in which the entity recognises as expenses the related costs for which the
grant is intended to compensate.
(c) Grants are an extension of fiscal policies and so as income taxes and other taxes are
expenses, so grants should be recognised in profit or loss.
Answer 2
Acquisition of the asset and receipt of the grant on 1 January 20X8:
$ $
DEBIT Non current assets 100,000
CREDIT Cash 100,000
To record the asset at its cost
DEBIT Cash 20,000
CREDIT Deferred income 20,000
To record the receipt of the grant
In the year ended 31 December 20X8 the asset is depreciated and a portion of the grant is
released to the statement of profit or loss:
DEBIT Depreciation expense ($100,000 / 5 years) 20,000
CREDIT Accumulated depreciation 20,000
DEBIT Deferred income ($20,000 / 5 years) 4,000

CREDIT Operating expenses 4,000
The release of the deferred income is matched to the depreciation expense, so the net effect is an
expense of $16,000 relating to the asset.
145
Financial Reporting
Exam practice
PMT and WY 9 minutes

Peak Medical Technology Corporation ("PMT") conducts research and product development for an
anaesthetic injection under contract with WY Corporation ("WY"), a pharmaceutical company. The
research and development contract requires that WY pays PMT an up-front amount of $1.5 million
when the contract is signed, $2 million upon the successful completion of clinical trials, and
$1.5 million upon the delivery of the first pilot unit of the injection. All payments are non-refundable.
The total cost of completion of the project is estimated to be $3 million.
PMT has invested $25 million in equipment for its research and development centre, which has an
anticipated useful life of eight years. Depreciation is charged on a straight-line basis. In the period
of acquisition, PMT received a government grant of $10 million towards purchase of the equipment,
which is conditional on certain employment targets being achieved within the next four years.
Required
Determine how PMT should recognise and measure the government grant by reference to the
relevant accounting standards. (5 marks)
HKICPA May 2007 (amended)
146
chapter 8
Intangible assets and

impairment of assets
Topic list
1 HKAS 38 Intangible Assets 4 HKAS 36 Impairment of Assets

1.1 The objectives of the standard 4.1 Introduction
1.2 The scope of the standard 4.2 Scope
1.3 Definition of an intangible asset 4.3 Definitions
1.4 Recognition of an intangible asset 4.4 Identification of a possible impairment
1.5 Initial measurement of an intangible asset 4.5 Impairment test
1.6 Subsequent measurement of an intangible 4.6 Recognition and measurement of an
asset impairment loss
4.7 Subsequent accounting for an impaired
2 Research and development costs
asset
2.1 Definitions
4.8 Cash generating units
2.2 Recognition
4.9 Goodwill and impairment
4.10 Corporate assets
2.4 Recognition of an expense
4.11 Allocating an impairment loss to the assets
2.5 Measurement of intangible assets
of a cash generating unit
subsequent to initial recognition
4.12 Reversal of an impairment loss
2.6 Amortisation of intangible assets
4.13 Disclosure
2.7 Disposals/retirements of intangible assets
2.9 HK(SIC) Int-32 Intangible Assets –
Website Costs
3 Goodwill (HKFRS 3 (revised))
3.1 What is goodwill?
3.2 Purchased goodwill
3.3 HKFRS 3 (revised) Business Combinations
Learning focus
Impairment of assets is particularly relevant in the current economic climate and several
companies are now having to apply the requirements with regard to accounting for impairment
for the first time.
147
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.09 Intangible assets 3
3.09.01 Define an intangible asset and scope of HKAS 38
3.09.02 Apply the definition of an intangible asset to both internally-
generated and purchased intangibles
3.09.03 Account for the recognition and measurement of intangible assets
in accordance with HKAS 38
3.09.04 Describe the subsequent accounting treatment of intangible assets
including amortisation
3.09.05 Distinguish between research and development and describe the
accounting treatment of each
3.09.06 Explain how goodwill arises
3.09.07 Account for goodwill
3.09.08 Disclose relevant information in respect of intangible assets under
HKAS 38
3.13 Impairment of assets 3
3.13.01 Identify assets that are within the scope of HKAS 36
3.13.02 Identify an asset that may be impaired by reference to common
external and internal indicators
3.13.03 Identify the cash generating unit an asset belongs to
3.13.04 Calculate the recoverable amount with reference to value-in-use
and fair value less cost to sell
3.13.05 Calculate the impairment loss, including the loss relating to cash-
generating units
3.13.06 Allocate impairment loss and account for subsequent reversal
3.13.07 Disclose relevant information with regard to impairment loss,
including critical judgment and estimate
148
8: Intangible assets and impairment of assets | Part C Accounting for business transactions
1 HKAS 38 Intangible Assets

Topic highlights
Intangible assets are defined by HKAS 38 as non-monetary assets without physical substance.
They must be:
 identifiable.
 controlled as a result of a past event.
 able to provide future economic benefits.
HKAS 38 Intangible Assets was issued in August 2004 and revised in May 2009 to reflect changes
introduced by HKFRS 3 (revised) Business Combinations.
1.1 The objectives of the standard

(a) To establish the criteria for when an intangible asset may or should be recognised.
(b) To specify how intangible assets should be measured.
(c) To specify the disclosure requirements for intangible assets.
HKAS 38.2,3 1.2 The scope of the standard

HKAS 38 applies to all intangible assets with the following exceptions:
 Financial assets (HKAS 32)
 The recognition and measurement of exploration and evaluation assets (HKFRS 6)
 The development and extraction of minerals, oils, gas and other non-regenerative resources
(HKFRS 6)
 Intangible assets held for sale in the ordinary course of business (HKAS 2 and HKAS 11)
 Deferred tax assets (HKAS 12)
 Leases within the scope of HKAS 17
 Assets arising from employee benefits (HKAS 19)
 Goodwill acquired in a business combination (HKFRS 3 (revised))
 The recognition and measurement of insurance contracts (HKFRS 4)
 Intangible assets within the scope of HKFRS 5 Non-current Assets Held for Sale and
Discontinued Operations
HKAS 38.8-
10
1.3 Definition of an intangible asset
Key terms
An intangible asset is an identifiable non-monetary asset without physical substance.
An asset is a resource which is:
(a) controlled by the entity as a result of events in the past
(b) something from which the entity expects future economic benefits to flow
Examples of items that might be considered as intangible assets therefore include computer
software, patents, copyrights, motion picture films, customer lists, franchises, brands and fishing
rights.
149
Financial Reporting
An item should not be recognised as an intangible asset, however, unless it meets this definition in
full. In other words it is:
(a) identifiable
(b) controlled by the entity as a result of past events, and
(c) expected to result in future economic benefits.
Each of these elements of the definition is considered in turn below.
HKAS 1.3.1 Identifiable
38.11,12
An asset is identifiable if it:
(a) is separable, i.e. if it could be rented or sold either individually or together with a related
contract or asset, or
(b) arises from contractual or other legal rights regardless of whether those rights are separable.
Goodwill, whether purchased or internally generated, is not identifiable and is therefore not
considered to be an intangible asset within the scope of HKAS 38.
Other internally generated intangible items, such as brands and customer lists do, however,
meet these criteria, however, they may not meet the remaining two criteria within the definition of
an intangible asset, or the recognition criteria (section 1.4).
Purchased intangible assets, such as a purchased patent or brand are normally identifiable.
HKAS 38.13- 1.3.2 Control by the entity
16
An entity controls an asset if the entity has the power to obtain the future economic benefits flowing
from the underlying resource and to restrict the access of others to those benefits.
Whereas the application of the control criteria to purchased assets is relatively simple, it is less
straightforward in the case of internally generated assets. Therefore, additional guidance is
provided as follows:
Market and technical knowledge
The following provide evidence that an entity can control access to the future economic benefits
arising from expenditure to develop market and technical knowledge:
 The existence of copyrights
 A legal duty of employees to maintain confidentiality with regard to the knowledge
If such a legal right exists, and provided that the knowledge is identifiable and is expected to result
in future economic benefits, it qualifies as an intangible asset.
Skilled staff
Expenditure on training results in more skilled staff, and often increased revenues and better
efficiency. The costs of such training, however, are very unlikely to qualify as an intangible asset
because an entity does not control the future actions of its staff. These staff may leave the
organisation at any time.
Market share/customer base
Expenditure on advertising and building customer relationships results in the growth of market
share and a loyal customer base. However, unless relationships with customers are protected by
legal rights, the entity can not control the actions of its customers, and they may change to a
different supplier. Therefore, such expenditure on creating market share does not qualify as an
intangible asset.
HKAS 38.17 1.3.3 Expected future economic benefits

An item can only be recognised as an intangible asset if economic benefits are expected to flow in
the future from ownership of the asset.
150
Future economic benefits may include:

 revenue from the sale of products or services
 cost savings
 other benefits resulting from the use of an asset by an entity
Again, this element of the definition is easily applied to purchase intangible assets, such as patents
or copyrights allowing production of items to sell. It may be more difficult to apply to expenditure on
internally generated items such as research and development projects, as the success of such a
project may be hard to gauge. For this reason, HKAS 38 considers research and development in
more detail and this is covered in section 2 of this chapter.
HKAS 38.21-
23
1.4 Recognition of an intangible asset
An intangible asset meeting the definition above should be recognised if, and only if, both the
following apply:
(a) It is probable that the future economic benefits that are attributable to the asset will flow to
the entity.
(b) The cost of the asset can be measured reliably.
Management has to exercise its judgment in assessing the degree of certainty attached to the flow
of economic benefits to the entity. External evidence is best.
HKAS 38.25 1.4.1 Separately acquired intangible assets
Normally, the fact that an entity purchases an intangible asset indicates an expectation that the
expected future economic benefits embodied in the asset will flow to the entity. In addition, the cost
can clearly be measured reliably.
Therefore, purchased intangible assets are normally recognised in the financial statements.
HKAS 38.33- 1.4.2 Intangible assets acquired as part of a business combination
34
In accordance with HKFRS 3 (revised), any intangible asset for which a fair value can be reliably
determined should be recognised separately. This is the case even where the purchased entity
does not recognise the asset in its own statement of financial position.
Sufficient information exists to measure the fair value of an asset reliably where it is separable or
arises from contractual or other legal rights.
HKAS 1.4.3 Internally generated assets
38.48,51,52,
63 Internally generated goodwill does not meet the definition of an intangible asset and therefore is
never recognised in the financial statements.
Other internally generated assets may meet the recognition criteria, however due to the difficulty of
assessing future economic benefits and determining a reliable cost of an internally generated
asset, HKAS 38 requires that all internal expenditure that may result in an intangible asset is
classified as research or development, and provides more detailed recognition guidance which is
applicable. This is considered in greater detail in section 2 of the chapter.
In any case, internally-generated brands, mastheads, publishing titles, customer lists and
items similar in substance shall not be recognised as intangible assets.
HKAS 38.24 1.5 Initial measurement of an intangible asset

An intangible asset is initially measured at cost.
HKAS 38.27- 1.5.1 Separately acquired intangible assets
29
The cost of a separately acquired intangible asset includes its purchase price and any directly
attributable costs of preparing the asset for its intended use.
151
Financial Reporting
Directly attributable costs may include professional fees and testing costs, but not advertising and
promotional expenditure or administration and general overhead costs.
HKAS 38.33 1.5.2 Intangible assets acquired as part of a business combination
When an intangible asset is acquired as part of a business combination (where one company
has acquired the shares of another company), the cost of the intangible asset is its fair value at the
date of the acquisition.
For example, if company A has acquired company B, and company B owns a drilling licence with a
fair value of $2m at the date of acquisition, then the cost of the licence in the consolidated accounts
will be $2m.
HKAS 38.44 1.5.3 Intangible assets acquired by way of government grant
According to HKAS 38, intangible assets acquired by way of government grant and the grant itself
may be recorded initially either at cost (which may be zero) or fair value.
HKAS 38.45 1.5.4 Exchanges of assets
Fair value is used to measure the cost of the intangible asset acquired if one intangible asset is
exchanged for another unless:
(a) the exchange lacks commercial substance, or
(b) the fair values of both the asset received and the asset given up cannot be measured
reliably.
In such cases, the cost of the intangible asset acquired is measured at the carrying amount of the
asset given up.
1.5.5 Internally generated assets
Internally generated intangible assets are recognised at cost. The elements of this are discussed in
more detail in section 2.
HKAS
38.72,74,75
1.6 Subsequent measurement of an intangible asset
After recognition, an entity may choose to apply either the cost model or revaluation model.
Intangible assets are therefore carried at either:
 cost less accumulated amortisation less accumulated impairment losses, or
 fair value at date of revaluation less subsequent accumulated amortisation and subsequent
accumulated impairment losses.
The detailed rules with regard to revaluation and amortisation are considered in more detail later in
this chapter after the recognition rules and initial measurement rules for research and development
costs are discussed.
2 Research and development costs

HKAS
38.8,52
Topic highlights
Research costs are always recognised as an expense. Development costs must be recognised as
an asset if they meet certain criteria.
HKAS 38 requires that internally generated assets are classified into research and development
phases.
152
2.1 Definitions
Key terms
Research is original and planned investigation undertaken with the prospect of gaining new
scientific or technical knowledge and understanding.
Development is the application of research findings or other knowledge to a plan or design for the
production of new or substantially improved materials, devices, products, processes, systems or
services before the start of commercial production or use.
HKAS 38 provides examples of both research and development as follows.
HKAS 38.56 2.1.1 Examples of research costs

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

Although it defines the terms research and development, HKAS 38 provides the accounting
treatment for the "research phase" and "development phase" of a project. If an entity cannot
distinguish between these phases, the standard requires that costs are treated as if incurred in the
research phase only.
HKAS 38.55 2.2.1 Research phase
Research activities, which are carried out at the research stage of a project, do not meet the
recognition criteria under HKAS 38. It is uncertain that future economic benefits will flow to the
entity from the project at the research stage of a project and there is too much doubt about the
likely success or otherwise of the project.
Research costs should therefore be written off as an expense as they are incurred.
HKAS 38.57 2.2.2 Development phase
Development costs must be recognised as intangible assets when the following strict criteria can
be demonstrated:
(a) The technical feasibility of completing the intangible asset so that it will be available for use
or sale.
(b) Its intention to complete the intangible asset and use or sell it.
(c) Its ability to use or sell the intangible asset.
153
Financial Reporting
(d) How the intangible asset will generate probable future economic benefits. Among other
things, the entity should demonstrate the existence of a market for the output of the
intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of
the intangible asset.
(e) Its ability to measure the expenditure attributable to the intangible asset during its
development reliably.
When these criteria are not met, development costs should be written off as an expense as incurred.
HKAS 38.65-
66, 71
Topic highlights
Internally generated intangible assets are initially measured at cost
The costs allocated to an internally generated intangible asset should only be those costs that can
be directly attributed or allocated on a reasonable and consistent basis to creating, producing or
preparing the asset for its intended use. The principle here is similar to that applied to the cost of
non-current assets and inventory.
The cost of an internally operated intangible asset is the sum of the expenditure incurred from
the date when the intangible asset first meets the recognition criteria. If, as often happens,
considerable costs have already been recognised as expenses before management could
demonstrate that the criteria have been met, this earlier expenditure should not be retrospectively
recognised at a later date as part of the cost of an intangible asset.
Mountain Co. is developing a new production process. During 20X1, expenditure incurred was
$500,000, of which $310,000 was incurred before 1 December 20X1 and $190,000 between
1 December 20X1 and 31 December 20X1. Mountain can demonstrate that, at 1 December 20X1,
the production process met the criteria for recognition as an intangible asset. How should the
expenditure be treated?
At this stage it may be useful to summarise the rules seen for the recognition and initial
measurement of separately purchased intangibles, intangibles acquired as part of a business
acquisition and internally generated development expenditure.
Summary of the recognition and initial measurement requirements of HKAS 38
Intangible acquired Internally generated

Separately as part of business intangible –
purchased intangible combination development
Recognise as an  Meets definition of  Meets definition of  Technically feasible

asset if: intangible asset intangible asset  Intention to complete
 Probable economic  Probable economic  Commercially viable
benefits benefits
 Probable economic
 Cost reliably  Fair value reliably benefits
measured measured
 Resources available
to complete
 Expenditure reliably
measured
154
Intangible acquired Internally generated

Separately as part of business intangible –
purchased intangible combination development
Initially Cost + directly Fair value at date of Directly attributable costs

measured at: attributable costs in acquisition from date when criteria
preparing asset for use first met
HKAS 38.68– 2.4 Recognition of an expense

70
Expenditure on an intangible should be expensed as incurred when it does not meet the criteria
for recognition either as an identifiable intangible asset or as goodwill arising on an acquisition.
Examples of such expenditure are stated in the HKAS:
 Start up costs, i.e. costs of establishing a new business
 Training costs
 Advertising and promotional costs
 Business relocation or reorganisation costs
Prepaid costs for services, for example advertising or marketing costs for campaigns that have
been prepared but not yet launched, can still be recognised as a prepayment.
HKAS 38 2.4.1 Advertising and promotional activities
BC46A-46H
There is often confusion as to whether the costs of advertising and promotional activities qualify as
an intangible asset. HKAS 38 has been amended to clarify that for advertising and promotional
activities:
(a) In the case of goods, an expense is recognised when the entity has the right to access those
goods.
(b) In the case of services, an expense is recognised when the entity receives those services.
(c) A right to access goods is received by the entity when the supplier has made them available
to the entity.
(d) The contract terms for the supply of goods or services determine when an expense should
be recognised.
(e) A prepayment can be recognised as an asset when payment has been made in advance of
the entity obtaining the right to access the goods or receiving the services.
The amendment clarifies that catalogues are considered to be a form of advertising and
promotional activity. Expenses incurred in printing mail order catalogues are recognised once the
catalogues are printed and not when they are distributed to customers.
HKAS
38.72,74,75,81
2.5 Measurement of intangible assets subsequent to initial
recognition
HKAS 38 allows two methods of measuring for intangible assets after they have been first
recognised:
1 Cost model: an intangible asset is carried at its cost, less any accumulated amortisation
and less any accumulated impairment losses.
2 Revaluation model: an intangible asset is carried at a revalued amount, which is its fair
value at the date of revaluation, less any subsequent accumulated amortisation and any
subsequent accumulated impairment losses.
The rules with regard to the application of the revaluation model are as follows:
(a) The fair value must be measured reliably with reference to an active market in that type of
asset.
155
Financial Reporting
(b) The entire class of intangible assets of that type must be revalued at the same time (to
prevent a business from choosing to revalue only those particular assets that have enjoyed
favourable price movements, and retaining the others at cost).
(c) If an intangible asset in a class of revalued intangible assets cannot be revalued because
there is no active market for this asset, the asset should be carried at its cost less any
accumulated amortisation and impairment losses.
(d) Revaluations should be made with such regularity that the carrying amount does not differ
from that which would be determined using fair value at the end of the reporting period.
HKAS 2.5.1 Active market
38.8,78
Key term
An active market is a market in which all the following conditions exist:
(a) The items traded in the market are homogenous
(b) Willing buyers and sellers can normally be found at any time; and
(c) Prices are available to the public.
Since an active market for an intangible asset will not usually exist, the revaluation model will
usually not be available. For example, intangible assets such as copyrights, publishing rights and
film rights are each sold at unique sale value, so a continuous active market is not accessible.
A revaluation to fair value would therefore be inappropriate. However, a fair value might be
obtainable for assets such as fishing rights, quotas or taxi cab licences.
HKAS 38.85- 2.5.2 Accounting for a revaluation
87
Where the carrying amount of an intangible asset is revalued upwards to its fair value, the amount
of the revaluation should be credited to other comprehensive income and accumulated in a
revaluation surplus in equity.
However, a revaluation surplus resulting from a reversal of a previous revaluation decrease that
has been charged to profit or loss can be recognised as income.
On the other hand, the amount of a downward revaluation on an intangible asset should be
charged as an expense against income, unless an upward revaluation has previously been
recorded on the same intangible asset. In such case, the revaluation loss should be first debited to
other comprehensive income against any previous revaluation surplus recorded for the asset.
A non-current asset with a carrying value of $160m was impaired and written down to its
recoverable value of $120m two years ago.
After an upturn in business, the asset has a market value of $135m. Had the impairment not taken
place, the carrying value of the asset would have been $130m.
Required
Consider how this impairment is reversed.
When the revaluation model is adopted, the cumulative revaluation surplus of an intangible asset
may be transferred to retained earnings when the asset is disposed of and the surplus is
eventually realised. However, the surplus may also be realised over the period in which the
intangible asset is being used by the entity. The amount of the surplus realised each year is
calculated as the difference in amortisation charges based on the revalued amount of the asset
and the historical cost of the asset. The realised surplus should not be included in profit or loss,
156
instead it should be transferred from revaluation surplus directly to retained earnings and disclosed
in the statement of changes in equity.
2.6 Amortisation of intangible assets

Topic highlights
Capitalised intangible assets are amortised over their expected useful life. Where this is indefinite,
an annual impairment test replaces amortisation.
HKAS 2.6.1 Useful life

38.88,90,94
An intangible asset may have a finite or indefinite useful life. An indefinite useful life, in this
sense, means that there is no foreseeable limit to the period over which the asset is expected to
generate net cash inflows for the entity.
The useful life of an intangible asset is affected by many factors, including: technical, technological,
commercial or other types of obsolescence; expected usage; life cycles of typical product; the level
of maintenance expenditure required; the stability of the industry; expected actions by competitors;
and legal or similar restrictions on the use of the asset, such as the expiry dates of related leases.
Intangible assets which are susceptible to technological obsolescence, such as computer software,
normally have short lives. However, uncertainty does not justify the choice of a life that is
unrealistically short.
The useful life of an intangible asset may originate from contractual or other legal rights. It
should not exceed the period of the rights, though it may be shorter depending on the duration in
which the asset is to be used by the entity.
HKAS 38.100 2.6.2 Residual value
The residual value of an intangible asset with a finite useful life is assumed to be zero. This is not
the case when a third party has a commitment to buying the intangible asset at the end of its useful
life or when an active market exists for that type of asset (so that its expected residual value can be
measured) and it is likely that there will be a market for the asset at the end of its useful life.
HKAS 38.97, 2.6.3 Amortisation period

104
An intangible asset with a finite useful life is amortised over its expected useful life, starting when
the asset is available for use.
Amortisation should cease at the earlier of the date that the asset is classified as held for sale in
accordance with HKFRS 5 Non-current Assets Held for Sale and Discontinued Operations and the
date that the asset is derecognised.
Annual review of the amortisation period of an intangible asset with finite useful life should be
carried out at the end of each financial year.
HKAS 2.6.4 Amortisation method

38.98,104
The amortisation method used should reflect the pattern in which the asset's future economic
benefits are consumed. If such a pattern cannot be predicted reliably, the straight line method
should be used.
HKAS 38 has been amended to remove wording perceived as prohibiting the use of the unit of
production method if it results in a lower amount of accumulated amortisation than under the
straight line method. Entities may use the unit of production method when the resulting
amortisation charge reflects the expected pattern of consumption of the expected future economic
benefits embodied in an intangible asset.
The amortisation method used for an intangible asset with a finite useful life should be reviewed at
each financial year end.
157
Financial Reporting
HKAS 38.99 2.6.5 Accounting for amortisation

The amortisation charge for a period is recognised in profit or loss in the same way as depreciation
on tangible non-current assets.
HKAS 2.6.6 Intangible assets with indefinite useful lives
38.107-109
An intangible asset with an indefinite useful life should not be amortised, instead HKAS 36
requires that such an asset is tested for impairment at least annually.
The useful life of an intangible asset that is not being amortised should be reviewed each year to
determine whether it is still appropriate to assess its useful life as indefinite. Reassessing the useful
life of an intangible asset as finite rather than indefinite is an indicator that the asset may be
impaired and in these circumstances it should be tested for impairment as well as being amortised
over its remaining life.
It can be difficult to establish the useful life of an intangible asset in practice. Write brief notes on
factors to consider when determining the useful life of a purchased brand name and how to provide
evidence that its useful life might, in fact, exceed 20 years.
Example: Computer software and hardware

The treatments can be illustrated by reference to computer software and hardware. The treatment
depends on the nature of the asset and its origin.
Asset Origin Treatment
Computer software Purchased Capitalise

Operating system for Purchased Include in hardware cost
hardware
Computer software Charge to expense until "Development criteria"
Operating system for Internally are met. Amortise over useful life, based on
hardware developed pattern of benefits (straight line is default)
(For use or sale)
HKAS 2.7 Disposals/retirements of intangible assets

38.112-113
An intangible asset should be derecognised from the statement of financial position when it is
disposed of or when there is no further expected economic benefit from its future use. On disposal
the gain or loss arising from the difference between the net disposal proceeds and the
carrying amount of the asset should be taken to profit or loss as a gain or loss on disposal
(i.e. treated as income or expense).
For example, if a fishing licence with a carrying amount of $2m is sold for $3m, then the licence is
derecognised from the statement of financial position and $1m profit on disposal is taken to profit.
HKAS
38.118,122,
124,126 Extensive disclosure is required for intangible assets as listed in the standard. The accounting
policies for intangible assets that have been adopted are to be disclosed in the financial
statements.
158
For each class of intangible assets, disclosure is required of the following:

(a) The method of amortisation used (e.g., straight line method).
(b) The useful life of the assets or the amortisation rate used.
(c) The gross carrying amount, the accumulated amortisation and the accumulated impairment
losses as at the beginning and the end of the period.
(d) A reconciliation of the carrying amount as at the beginning and at the end of the period
(additions, retirements/disposals, revaluations, impairment losses, impairment losses reversed,
amortisation charge for the period, net exchange differences, other movements).
(e) The carrying amount of internally-generated intangible assets.
The financial statements should also disclose the following:
(a) In the case of intangible assets that are assessed as having an indefinite useful life, the
carrying amounts and the reasons supporting that assessment.
(b) For intangible assets acquired by way of a government grant and initially recognised at fair
value, the fair value initially recognised, the carrying amount, and whether they are
carried under the cost model or the revaluation model for subsequent remeasurements.
(c) The carrying amount, nature and remaining amortisation period of any intangible asset that
is material to the financial statements of the entity as a whole.
(d) The existence (if any) and amounts of intangible assets whose title is restricted and of
intangible assets that have been pledged as security for liabilities.
(e) The amount of any commitments for the future acquisition of intangible assets.
Where intangible assets are accounted for at revalued amounts, disclosure is required of the
following:
(a) The effective date of the revaluation (by class of intangible assets).
(b) The carrying amount of revalued intangible assets.
(c) The carrying amount that would have been shown (by class of assets) if the cost model
had been used, and the amount of amortisation that would have been charged.
(d) The amount of any revaluation surplus on intangible assets, as at the beginning and end of
the period, and movements in the surplus during the year (and any restrictions on the
distribution of the balance to shareholders).
The financial statements should also disclose the amount of research and development
expenditure that has been charged as an expense of the period.
2.9 HK(SIC) Int-32 Intangible Assets – Website Costs

Websites are being used for business purposes to a large extent, including taking orders for
products or services; promotion and advertising of products and services; and trading access to
information contained on the website.
Many companies incur significant costs in developing such websites, and these may include the
following:
(a) Planning costs – including, for example, the costs of undertaking feasibility studies,
determining the objectives and functionalities of the website, exploring ways of achieving the
desired functionalities, identifying appropriate hardware and web applications and selecting
suppliers and consultants.
(b) Application and infrastructure development costs – including the costs of obtaining and
registering a domain name and of buying or developing hardware and operating software
that relate to the functionality of the site (for example, updateable content management
159
Financial Reporting
systems and e-commerce systems, including encryption software, and interfaces with other
IT systems used by the entity).
(c) Content costs – expenditure incurred on preparing, accumulating and posting the website
content.
(d) Operating costs.
The issue arises as to how these costs should be treated within the financial statements.
2.9.1 HK(SIC) Int-32 treatment
HK(SIC) Int-32 resolves that a website developed by an entity and funded by internal expenditure
is viewed as an internally generated intangible asset that is subject to the requirements of HKAS 38
Intangible Assets. This is the case whether the website is for internal or external access.
Specifically, the treatment is as follows:
(a) Website planning costs are an expense charged to profit or loss.
(b) Application and infrastructure development costs. Expenditure which can be directly
attributed, or allocated on a reasonable and consistent basis, to preparing the website for its
intended use is to be included in the cost of the website and recognised as an intangible
asset. Examples include expenditure on purchasing or creating content (other than content
for marketing an entity's own products and services) solely for a website, and expenditure to
enable use of the content (such as acquisition fee of a licence to reproduce) on the website.
These expenditures should be included in the cost of development when the condition is
met. However, HKAS 38 does not allow the recognition of an expenditure as part of the cost
of an intangible asset at a later date if the expenditure was initially recognised as an expense
in previous financial statements (for instance, when the content of a fully amortised copyright
is subsequently provided on a website).
(c) Content development. According to HKAS 38, expenditure incurred in the content
development stage to advertise and promote an entity's own products and services (such as
digital photographs of products) should be recognised as an expense when incurred. For
example, expenditure on professional services for taking digital photographs of an entity's
products and for enhancing their display should be recorded as an expense when the
professional services are received, not when the digital photographs are displayed on the
website.
(d) Operating. The operating stage commences when the development of a website is
complete. Unless expenditure meets the criteria in HKAS 38, it should be recognised as an
expense when it is incurred.
A website which is recognised as an intangible asset under HK(SIC) Int-32 should be measured
after initial recognition by applying the requirements as stated in HKAS 38. The useful life of a
website is best estimated to be short.

The IASB proposed amendments to IAS 38 in December 2012. As HKAS 38 is converged with IAS
38, these will also affect HKAS 38. The amendments would clarify that amortisation methods must
reflect a pattern of consumption of economic benefits from an asset rather than a pattern of
generation of economic benefits by an asset. Therefore a revenue-based method of amortisation
is not allowed.
A revenue-based method of amortisation is a method whereby the amortisation charge in a given
year is calculated based on the revenue earned in that year as a proportion of total revenues
expected to be generated by the asset over its useful life.
Comments on the Exposure Draft are due by 2 April 2013. Finalised amendments are expected in
the fourth quarter of 2013.
160

 An intangible asset should be recognised only on the condition that it is probable that future
economic benefits will flow to the entity and the cost of the asset can be measured reliably.
 An asset is initially recorded at cost but carried either at cost or revalued amount in
subsequent periods.
 Expense the costs as incurred if the recognition criteria are not met.
 Amortisation of an intangible asset with finite useful life should be spread over the useful life
of the asset. No amortisation should be recorded for an intangible asset with an indefinite
useful life.
Stauffer is a public listed company reporting under HKFRS. It has asked for your opinion on the
accounting treatment of the following items:
(a) The Stauffer brand has become well known and has developed a lot of customer loyalty
since the company was set up eight years ago. Recently, valuation consultants valued the
brand for sale purposes at $14.6m. Stauffer's directors are delighted and plan to recognise
the brand as an intangible asset in the financial statements. They plan to report the gain in
the revaluation surplus as they feel that crediting it to profit or loss would be imprudent.
(b) On 1 October 20X5 the company was awarded one of six licences issued by the government
to operate a production facility for five years. A "nominal" sum of $1m was paid for the
licence, but its fair value is actually $3m.
(c) The company undertook an expensive, but successful advertising campaign during the year
to promote a new product. The campaign cost $1m, but the directors believe that the extra
sales generated by the campaign will be well in excess of that over its four year expected
useful life.
(d) Stauffer owns a 30-year patent which it acquired two years ago for $8m which is being
amortised over its remaining useful life of 16 years from acquisition. The product sold is
performing much better than expected. Stauffer's valuation consultants have valued its
current market price at $14m.
(e) On 1 August 20X6, Stauffer acquired a smaller company in the same line of business.
Included in the company's statement of financial position was an in-process research and
development project, which showed promising results (and was the main reason why
Stauffer purchased the other company), but was awaiting government approval. The project
was included in the company's own books at $3m at the acquisition date, while the
company's net assets were valued at a fair value of $12m (excluding the project).
Stauffer paid $18m for 100% of the company and the research and development project was
valued at $5m by Stauffer's valuation consultants at that date. Government approval has
now been received, making the project worth $8m at Stauffer's year end.
Required
Explain how the directors should treat the above items in the financial statements for the year
ended 30 September 20X6.
161
Financial Reporting
3 Goodwill (HKFRS 3 (revised))

Topic highlights
Purchased goodwill arising on consolidation is retained in the statement of financial position as an
intangible asset under HKFRS 3 (revised). It must then be reviewed annually for impairment under
HKAS 36.
Goodwill is a type of intangible asset, however as we have seen in the earlier sections of this
chapter, it does not fall within the scope of HKAS 38. Instead, HKFRS 3 applies, providing
guidance on the calculation and accounting treatment of goodwill.
The detailed calculation of goodwill, and accounting treatment is considered in more detail in the
chapters of the Learning Pack which cover group accounting. Here we introduce the concept of
goodwill and its treatment in the accounts.
3.1 What is goodwill?

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

Topic highlights
Purchased goodwill is shown in the statement of financial position because it has been paid for.
It has no tangible substance, and so it is an intangible non-current asset.
Whereas a business which builds up internally generated goodwill over time cannot objectively
value this goodwill, at such time as that business is sold, its goodwill becomes measurable. This is
because the price paid to purchase an existing business will generally exceed the sum of the
values of the individual assets within the business. The excess represents payment for the goodwill
of the business.
3.2.1 Measurement of purchased goodwill
When a business is sold, the selling price is likely to include a premium for goodwill.
162
The calculation of this premium is not really a problem for accountants, who must simply record the
goodwill in the accounts of the new business. The value of the goodwill is a matter for the
purchaser and seller to agree upon in fixing the purchase/sale price. Two approaches may be
taken to this issue:
1 The selling price of the business is agreed by the seller and the buyer without specifically
considering the value of goodwill. The purchased goodwill will then be the excess of the
purchase consideration over the value of the identifiable net assets of the new business.
2 Negotiation is a major element in the computation of goodwill. There are various ways of
valuing goodwill and a majority of them are related to the profit record of the acquired
business.
It does not matter how goodwill is calculated, the amount recorded by the buyer will be the
difference between the purchase consideration and his own valuation of the net assets acquired.
If A values his net assets at $40,000, goodwill is agreed at $21,000 and B agrees to pay $61,000
for the business when the net assets are valued at only $38,000, then the goodwill recorded by B
will be $23,000 ($61,000 – $38,000).
3.3 HKFRS 3 (revised) Business Combinations

Topic highlights
Purchased goodwill is retained in the statement of financial position as an intangible asset under
the requirements of HKFRS 3 (revised). It must then be reviewed for impairment annually.
HKFRS 3 (revised) deals with the accounting treatment of goodwill obtained through a business
combination, in other words goodwill arising when one company (the parent) acquires a controlling
interest in another company (the subsidiary).
Various definitions for goodwill are possible. HKFRS 3 (revised) defines goodwill differently from
the traditional definition and places much emphasis on benefits, rather than the method of
computation.
Key term
Goodwill. Future economic benefits arising from assets that are not capable of being individually
identified and separately recognised. (HKFRS 3 (revised))
HKFRS 3.32 3.3.1 Accounting for goodwill arising in a business combination

Acquired goodwill is initially measured at cost and recognised as an asset in the accounts. Cost is
the excess of the purchase consideration over the fair value of the acquiree's identifiable assets,
liabilities and contingent liabilities.
After initial recognition, acquired goodwill is not amortised, but is then measured at cost less any
accumulated impairment losses. According to HKAS 36 Impairment of Assets, goodwill is to be
tested for impairment at least once a year.
3.3.2 Goodwill and non-controlling interests
Where the parent company acquires less than 100% of the equity shares in the subsidiary
company, another party will own some of the subsidiary. This party is referred to as the non-
controlling interest.
The revised HKFRS 3 considers the group as an economic entity. All providers of equity including
non-controlling interests are treated as shareholders in the group, even if they are not shareholders
in the parent.
Therefore, it may be necessary to recognise goodwill attributed to the non-controlling interest.
163
Financial Reporting
We will have a discussion on this in a later chapter.

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

Topic highlights
HKAS 36 Impairment of Assets covers the write down of assets where their carrying value exceeds
the recoverable amount.
4.1 Introduction
The fundamental principle of HKAS 36 is relatively simple. If an asset's carrying value is higher
than its "recoverable amount", then the asset is said to have suffered an impairment loss. Its value
should therefore be reduced by the amount of the impairment loss.
HKAS 36 provides guidance on:
(a) when an asset should be tested for a possible impairment
(b) how the impairment test is carried out
(c) how any resulting impairment loss is accounted for and disclosed
Before we consider each of these in turn, the next two sections explain the scope of HKAS 36 and
provide a list of important definitions within it.
164
HKAS 36.2 4.2 Scope

HKAS 36 applies to all tangible, intangible and financial assets including those which have been
revalued, except for the following:
 Inventories
 Assets arising from construction contracts
 Deferred tax assets
 Assets arising under HKAS 19 Employee Benefits
 Financial assets within the scope of HKFRS 9 Financial Instruments
 Investment property measured at fair value
 Biological assets related to agricultural activity that are measured at fair value less costs to
sell
 Deferred acquisition costs and intangible assets arising from an insurer's contractual rights
under insurance contracts within the scope of HKFRS 4 Insurance Contracts
 Non-current assets held for sale, which are dealt with under HKFRS 5 Non-current Assets
Held for Sale and Discontinued Operations
Instead, the relevant standard's requirements for recognition and measurement of assets should be
applied.

HKAS 36 provides a number of definitions, including the following:
Key terms
Impairment loss. The amount by which the carrying amount of an asset exceeds its recoverable
amount.
Carrying amount. The amount at which an asset is recognised after deducting any accumulated
depreciation (amortisation) and accumulated impairment losses thereon.
Recoverable amount of an asset is the higher of its fair value less costs to sell and its value in
use.
Value in use is the present value of the future cash flows expected to be derived from an asset.
(HKAS 36)
HKAS 36.10 4.4 Identification of a possible impairment

An impairment test is required for all assets when there is an indication of impairment at the
reporting date. In addition, certain assets should be tested for impairment annually. They are:
 goodwill acquired in a business combination
 intangible assets with an indefinite useful life
 intangible assets which are not yet available for use.
Note that the concept of materiality applies, and only material impairment needs to be identified.
HKAS 36.12 4.4.1 Indications of impairment
The various ways in which the indications of a possible impairment of assets might be recognised
are suggested in HKAS 36. These suggestions are mostly based on common sense.
165
Financial Reporting
(a) External sources of information

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

Topic highlights
Impairment is determined by comparing the carrying amount of the asset with its recoverable
amount.
The recoverable amount of an asset is the higher of the asset's fair value less costs to sell and
its value in use.
Where there are indications of impairment, or for those assets which require testing annually, an
impairment test must be performed. This involves comparing the carrying amount of the asset with
its recoverable amount.
We have already defined recoverable amount as the higher of fair value less costs to sell and value
in use.
HKAS 36.28 4.5.1 Fair value less costs to sell
Fair value is established in accordance with the requirements of HKFRS 13 Fair Value
Measurement. As we have already seen, it is defined as the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date.
While HKAS 36 provides no guidance on establishing fair value, it does clarify that costs of
disposal may include legal costs, stamp duty and similar transaction taxes, costs of removing the
asset, and direct incremental costs to bring an asset into condition for its sale. They do not,
however, include termination benefits (as defined in HKAS 19) and costs associated with reducing
or reorganising a business following the disposal of an asset are not direct incremental costs to
dispose of the asset.
HKAS 4.5.2 Value in use
36.30,33,39,
44,54-56 Value in use is the present value of the future cash flows expected to be derived from an asset.
166
The pre-tax cash flows and a pre-tax discount rate should be employed to calculate the present
value.
The calculation of value in use must reflect the following:
(a) An estimate of the future cash flows the entity expects to derive from the asset
(b) Expectations about possible variations in the amount and timing of future cash flows
(c) The time value of money
(d) The price for bearing the uncertainty inherent in the asset
(e) Other factors that would be reflected in pricing future cash flows from the asset
The standard provides further guidance in the assessment of cash flows and choice of discount rate.
Cash flows
The HKAS states the following:
(a) Cash flow projections should be based on "reasonable and supportable" assumptions.
(b) Projections of cash flows, normally up to a maximum period of five years, should be based
on the most recent budgets or financial forecasts.
(c) A steady or declining growth rate for each subsequent year (unless a rising growth rate
can be justified) can be used in extrapolating short-term projections of cash flows beyond
this period. Unless a higher growth rate can be justified, the long-term growth rate employed
should not be higher than the average long-term growth rate for the product, market, industry
or country.
HKAS 36 further states that future cash flows may include:
(a) Projections of cash inflows from continuing use of the asset.
(b) Projections of cash outflows necessarily incurred to generate the cash inflows from
continuing use of the asset.
(c) Net cash flows received/paid on disposal of the asset at the end of its useful life assuming
an arm's length transaction.
An asset's current condition is the basis for estimating future cash flows. It should be noted that
future cash flows associated with restructurings to which the entity is not yet committed, or to future
costs to add to, replace part of, or service the asset are excluded.
Estimates of future cash flows should exclude the following:
(a) Cash inflows/outflows from financing activities.
(b) Income tax receipts/payments.
Foreign currency future cash flows should initially be prepared in the currency in which they will
arise and will be discounted using an appropriate rate. Translation of the resulting figure into the
reporting currency should then be based on the spot rate at the year end.
Discount rate
The discount rate should be a current pre-tax rate (or rates) that reflects:
 the current assessment of the time value of money, and
 the risks specific to the asset.
A rate that reflects current market assessments of the time value of money and the risks specific to
the asset is the return that investors would require if they were to choose an investment that
would generate cash flows of amounts, timing and risk profile equivalent to those that the
entity expects to derive from the asset.
This rate is estimated from:
 the rate implicit in current market transactions for similar assets, or
167
Financial Reporting
 the weighted average cost of capital of a listed entity that has a single asset which is similar
to that under review in terms of service potential and risks
The discount should not include a risk weighting if the underlying cash flows have already been
adjusted for risk.
Example: Recoverable amount

An entity has a single manufacturing plant which has a carrying value of $749,000. A new
government elected in the country passes legislation significantly restricting exports of the product
produced by the plant. As a result, and for the foreseeable future, the entity's production will be cut
by 40%. Cash flow forecasts have been prepared derived from the most recent financial
budgets/forecasts for the next five years approved by management (excluding the effects of
general price inflation):
Year 1 2 3 4 5
$'000 $'000 $'000 $'000 $'000
Future cash flows 230 211 157 104 233
(including
disposal
proceeds)
If the plant was sold now it would realise $550,000, net of selling costs.
The entity estimates that the pre-tax discount rate specific to the plant is 15%, excluding the effects
of general price inflation.
Required
Calculate the recoverable amount of the plant.
Note. PV factors at 15% are as follows.
Year PV factor at 15%
1 0.86957
2 0.75614
3 0.65752
4 0.57175
5 0.49718
Solution
 The fair value less costs to sell is given as $550,000
 The value in use is calculated as $638,000:
Year Future cash PV factor at Discounted
flows 15% future cash flows
$'000 $'000
1 230 0.86957 200
2 211 0.75614 160
3 157 0.65752 103
4 104 0.57175 59
5 233 0.49718 116
638
The recoverable amount is the higher of $550,000 and $638,000, thus $638,000.
168
4.6 Recognition and measurement of an impairment loss

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

An impairment loss is measured as the excess of carrying amount over recoverable amount. When
impairment is identified, the impaired asset must be written down to its recoverable amount.
HKAS 36.59- 4.6.2 Recognition of an impairment loss
61
If the recoverable amount of an asset is less than its carrying amount in the statement of financial
position, an impairment loss has occurred. This loss should be recognised immediately.
(a) The asset's carrying amount should be reduced to its recoverable amount in the statement
of financial position.
(b) The impairment loss should be recognised immediately.
The recognition of an impairment loss depends on whether the asset in question is held at historic
cost or a revalued amount.
Where an asset is held at historic cost any impairment loss is recognised in profit or loss.
Where an asset is held at a revalued amount any impairment loss is recognised as follows:
(a) To the extent that there is a revaluation surplus held in respect of the asset, the impairment
loss should be charged to revaluation surplus.
(b) Any excess should be charged to profit or loss.
169
Financial Reporting
4.6.3 Summary decision tree

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

than the carrying amount of the should remain at carrying
asset? amount in the financial
statements
Yes
The asset is impaired and the
difference between the
carrying amount and
recoverable amount is the
impairment loss
Is the asset’s carrying amount No Debit the impairment loss to

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

The accountant of Louella Co. has identified a machine which she believes to be impaired. The
machine cost $68,000 on 1 January 20X7 and was revalued to $75,000 on 31 December of that
year, resulting in a revaluation surplus of $10,400. The machine continued to be depreciated over
the remaining nine years of its ten-year life.
By 31 December 20X8, the development of new technology meant that the machine had fallen in
value such that its fair value less costs to sell was just $42,000. The accountant calculated a value
in use of $45,000.
What impairment loss should the accountant recognise and where should it be recorded?
170
Solution
 The recoverable amount is $45,000, being the higher of fair value less costs to sell and value
in use.
 The carrying amount of the machine is $66,667 ($75,000  8/9).
 Therefore an impairment loss of $21,667 must be recognised.
 The revaluation surplus at the year end in relation to the machine is $8,867 ($10,400 –
($75,000/9 – $68,000/10) being the depreciation reserves transfer).
 Therefore $8,867 is charged to other comprehensive income against the revaluation surplus
and the remaining $12,800 is charged to profit or loss.
HKAS
36.63,110,114,
4.7 Subsequent accounting for an impaired asset
117,119 After reducing an asset to its recoverable amount, the depreciation charge on the asset should
then be based on its new carrying amount, its estimated residual value (if any) and its estimated
remaining useful life.
The annual review of assets to determine whether there may have been some impairment should
be applied to all assets, including assets that have already been impaired in the past.
4.7.1 Reversal of impairment losses
In some cases, the recoverable amount of an asset that has previously been impaired might turn
out to be higher than the asset's current carrying value. An impairment loss recognised previously
for an asset should be reversed if, and only if, there has been a change in the estimates used to
determine the asset's recoverable amount since the last impairment loss was recognised.
(a) The reversal of the impairment loss should be recognised immediately as income in profit
or loss for the year.
(b) The carrying amount of the asset should be increased to its new recoverable amount.
The asset cannot be revalued to a carrying amount that is higher than its value would have been if
the asset had not been impaired originally, i.e. its depreciated carrying value had the impairment
not taken place. Depreciation of the asset should now be based on its new revalued amount, its
estimated residual value (if any) and its estimated remaining useful life.
HKAS
36.6,66
4.8 Cash generating units
Topic highlights
When it is not possible to calculate the recoverable amount of a single asset, then that of its cash
generating unit (CGU) should be measured instead.
HKAS 36 explains the important concept of cash generating units. As a basic rule, the recoverable
amount of an asset should be calculated for the asset individually. However, there will be
occasions when it is not possible to estimate such a value for an individual asset, particularly in the
calculation of value in use. This is because cash inflows and outflows cannot be attributed to the
individual asset.
If it is not possible to calculate the recoverable amount for an individual asset, the recoverable
amount of the asset's cash generating unit should be measured instead.
171
Financial Reporting
Key term
A cash generating unit is the smallest identifiable group of assets for which independent cash
flows can be identified and measured.
HKAS 4.8.1 Identifying the cash generating unit to which an asset belongs
36.69,72
If the recoverable amount cannot be determined for an individual asset, an entity should identify
the smallest aggregation of assets that generate largely independent cash inflows.
As part of the identification process, an entity may take into account:
 How management monitors the entity's operations (for example, by product line, business or
location)
 How management makes decisions about continuing or disposing of the entity's operations
and assets.
An asset or a group of assets is identified as a cash generating unit when an active market exists
for the output produced by the asset or the group. This is so even if some or all of the output is
used internally.
Unless a change is justified, it is necessary to identify consistently from period to period, the cash
generating units for the same type of asset.
The group of net assets (less liabilities) considered for impairment and those considered in the
computation of the recoverable amount should be alike. (For the treatment of goodwill and
corporate assets see below.)
Shrub is a retail store belonging to Forest, a chain of such stores. Shrub makes all its retail
purchases through Forest's purchasing centre. Pricing, marketing, advertising and human
resources policies (except for hiring Shrub's cashiers and salesmen) are decided by Forest. Forest
also owns five other stores in the same city as Shrub (although in different neighbourhoods) and 20
other stores in other cities. All stores are managed in the same way as Shrub. Shrub and four other
stores were purchased five years ago and goodwill was recognised.
What is the cash generating unit for Shrub?
Motorbike Publishing Co. owns 100 magazine titles of which 40 were purchased and 60 were self-
created. The price paid for a purchased magazine title is recognised as an intangible asset. The
costs of creating magazine titles and maintaining the existing titles are recognised as an expense
when incurred. Cash inflows from direct sales and advertising are identifiable for each magazine
title. Titles are managed by customer segments. The level of advertising income for a magazine
title depends on the range of titles in the customer segment to which the magazine title relates.
Management has a policy to abandon old titles before the end of their economic lives and replace
them immediately with new titles for the same customer segment.
What is the cash generating unit for the company?
172
4.9 Goodwill and impairment

HKAS 4.9.1 Allocating goodwill to cash generating units
36.80,84
Acquired goodwill does not generate independent cash flows and has to be allocated to the cash
generating units (or groups of cash generating units) of the buyer. These units are expected to
benefit from the synergies of the combination and should:
(a) represent the lowest level within the entity at which the goodwill is monitored for internal
management purposes.
(b) not be larger than an operating segment as defined by HKFRS 8 Operating Segments
before aggregation.
Pragmatically, the allocation of goodwill may not be completed before the first reporting date after a
business combination, especially if the buyer uses provisional values to account for the
combination for the first time. The initial allocation of goodwill must be done before the end of the
first reporting period after the date of acquisition.
HKAS 36.88, 4.9.2 Testing cash generating units with goodwill for impairment
90
We have to consider the following two situations:
(a) where goodwill has been allocated to a cash generating unit.
(b) where goodwill has been allocated to a group of units because allocation to a specific cash
generating unit is impossible.
In the first instance, the annual impairment test is to be carried out on the cash generating unit to
which goodwill has been allocated. The carrying amount of the unit, including goodwill, is
compared with the recoverable amount. An impairment loss must be recognised when the
carrying amount of the unit is bigger than the recoverable amount.
In the second instance, where goodwill is not allocated to a CGU, the impairment test of that CGU
is carried out by comparing its carrying amount (excluding goodwill) with its recoverable
amount. An impairment loss must be recognised if the carrying amount is bigger than the
recoverable amount.
The annual impairment test must be performed at the same time every year although it may be
performed at any time during an accounting period.
4.9.3 Impairment of goodwill where there is a non-controlling interest
If there is a non-controlling (minority) interest in a cash generating unit to which goodwill has
been allocated, and the non-controlling interest is measured as a proportion of the net assets of the
subsidiary, adjustment is required before comparing carrying amount and recoverable amount.
You may find it easier to come back to this section after studying the groups chapters where
alternative measurements of the non-controlling interest are discussed.
The issue here is that without adjustment, we are not comparing like with like:
 The carrying amount of goodwill represents only that goodwill attributable to the parent
company, however,
 The recoverable amount of the cash-generating unit includes the value of full goodwill
including that attributable to the non-controlling interest which is not recognised in the
Therefore, the carrying amount of the goodwill should be grossed up to include the goodwill
attributable to the non-controlling interest before the impairment test is conducted.
173
Financial Reporting
Example: Non-controlling interest

On 1 January 20X9 a parent acquires a 75% interest in a subsidiary for $2,400,000, when the
identifiable net assets of the subsidiary are $1,800,000. The non-controlling interest is measured as
a proportion of the net assets of the subsidiary. The subsidiary is a cash generating unit.
At 31 December 20X9, the recoverable amount of the subsidiary is $1,400,000. The carrying
amount of the subsidiary's identifiable assets is $1,600,000.
Calculate the impairment loss at 31 December 20X9.
Solution
At 31 December 20X9 the cash generating unit consists of the subsidiary's identifiable net assets
(carrying amount $1,600,000) and goodwill of $1,050,000 (2,400,000 + (25%  1,800,000) –
1,800,000). Goodwill is grossed up to reflect the 25% non-controlling interest.
At 31 December 20X9: Goodwill Net assets Total
$'000 $'000 $'000
Carrying amount 1,050 1,600 2,650
Unrecognised non-controlling interest 350 – 350
1,400 1,600 3,000
Recoverable amount (1,400)
Impairment loss 1,600
Allocation of impairment loss
– unrecognised (goodwill) (350) –
– recognised (goodwill / net assets) (1,050) (200)
Carrying value – 1,400
HKAS 4.10 Corporate assets

36.100,102
Corporate assets include group and divisional assets that do not generate cash inflows
independently from other assets and hence their carrying amount cannot be fully attributed to a
cash generating unit under review. Head office building, equipment or a research centre are
examples of corporate assets.
An entity should identify all the corporate assets that relate to a cash generating unit in an
impairment test of that unit.
(a) An entity compares the carrying amount of the unit (including the portion of the asset) with its
recoverable amount when a portion of the carrying amount of a corporate asset can be
allocated to the unit on a reasonable and consistent basis.
(b) If a portion of the carrying amount of a corporate asset cannot be reasonably and
consistently allocated to the unit, the entity:
(i) recognises the impairment loss by comparing the carrying amount of the unit
(excluding the asset) with its recoverable amount.
(ii) allocates a portion of the carrying amount of the asset on a reasonable and consistent
basis by identifying the smallest group of cash generating units that includes the cash
generating unit to which the asset belongs.
(iii) recognises the impairment loss by comparing the carrying amount of that group of
cash generating units (including the portion of the asset allocated to the group of units)
with the recoverable amount of the group of units.
174
Example: Corporate assets

Rainbow has identified three CGUs within its business, and allocated assets to each as follows:
Carrying value of allocated assets
CGU 1 $640,000
CGU 2 $2,150,000
CGU 3 $1,300,000
Rainbow operates from a corporate campus with a carrying value of $2 million. This has not yet
been allocated to the CGUs, however it is considered that it can be allocated in full based on
carrying value.
The recoverable values of CGUs 1 to 3 are $980,000, $3,145,000 and $1,800,000 respectively.
What impairment losses (if any) have the CGUs suffered?
Solution
CV of assets HO allocation Total Recoverable Impairment
amount loss
$ $ $ $ $
CGU 1 640,000 312,958 952,958 980,000 -
CGU 2 2,150,000 1,051,345 3,201,345 3,145,000 56,345
CGU 3 1,300,000 635,697 1,935,697 1,800,000 135,697
4,090,000 2,000,000 6,090,000 192,042
Head office allocation:

CGU 1 640/4,090  $2 million = $312,958
CGU 2 2,150/4,090  $2 million = $1,051,345
CGU 3 1,300/4,090  $2 million = $635,697
HKAS
36.104,105
4.11 Allocating an impairment loss to the assets of a cash
generating unit
An impairment loss should be recognised for a cash generating unit if the recoverable amount for
the cash generating unit is less than the carrying amount in the statement of financial position for
all the assets in the unit.
When an impairment loss is recognised for a cash generating unit, the loss should be allocated
between the assets in the unit in the following order:
(a) First, to the goodwill allocated to the cash generating unit (if any).
(b) Then, to all other assets in the cash generating unit within the scope of HKAS 36 (see
section 4.2), on a pro rata basis.
In allocating an impairment loss, the carrying amount of an asset should not be reduced below the
highest of:
(a) its fair value less costs to sell,
(b) its value in use (if determinable), or
(c) zero.
Any remaining amount of an impairment loss should be recognised as a liability if required by other
HKAS.
Example: Impairment loss (1)

On 31 December 20X1 Invest purchased all the shares of MH for $2 million. The net fair value of
the identifiable assets acquired and liabilities assumed of MH at that date was $1.8 million.
175
Financial Reporting
MH made a loss in year ended 31 December 20X2 and at 31 December 20X2 the net assets of MH
– based on fair values at 1 January 20X2 – were as follows:
$'000
Property, plant and equipment 1,300
Capitalised development expenditure 200
Net current assets 250
1,750
An impairment review on 31 December 20X2 indicated that the recoverable amount of MH at that
date was $1.5 million. The capitalised development expenditure has no ascertainable external
market value and the current fair value less costs to sell of the property, plant and equipment is
$1,120,000. Value in use could not be determined separately for these two items.
Required
Calculate the impairment loss that would arise in the consolidated financial statements of Invest as
a result of the impairment review of MH at 31 December 20X2 and show how the impairment loss
would be allocated.
Solution
Asset values Allocation of Carrying
at 31 Dec impairment value after
20X2 before loss impairment
impairment (W1)/(W2) loss
$'000 $'000 $'000
Goodwill (2,000 – 1,800) 200 (200) –
Property, plant and equipment 1,300 (180) 1,120
Development expenditure 200 (70) 130
Net current assets 250 – 250
1,950 (450) 1,500
WORKINGS
1 Impairment loss
Carrying value 1,950
Recoverable amount 1,500
Impairment loss 450
Amount to allocate against goodwill 200

Amount to allocate pro-rata against other assets 250
2 Allocation of the impairment losses on pro-rata basis
Initial Impairment NBV if Reallocation Actual Impaired
value pro-rated fully loss value
allocated allocated
$'000 $'000 $'000 $'000 $'000 $'000

PPE (250  1,300 217 1,083 (37) 180 1,120
1,300/1,500)
Dev exp (250  200 33 167 37 70 130
200/1,500)
The amount not allocated to the PPE because they cannot be taken below their recoverable
amount is allocated to other remaining assets pro-rata, in this case all against the development
expenditure.
176
Hence the development expenditure is reduced by a further 37 (217 – 180), making the total
impairment 70 (33 + 37).
The net current assets are not included when pro-rating the impairment loss as they are outside the
scope of HKAS 36.
Example: Impairment loss (2)

The Burgos Group is made up of two cash generating units (as a result of a combination of various
past 100% acquisitions), plus a head office, which was not allocated to any given cash generating
unit as it supports both divisions.
Due to falling sales as a result of an economic crisis, an impairment test was conducted at the year
end. The consolidated statement of financial position showed the following net assets at that date.
Division A Division B
Head Unallocated Total
office goodwill
$m $m $m $m $m
Property, plant & equipment (PPE) 780 620 90 - 1,490
Goodwill 60 30 - 10 100
Net current assets 180 110 20 - 310
1,020 760 110 10 1,900
The recoverable amounts (including net current assets) at the year end were as follows:
$m
Division A 1,000
Division B 720
Group as a whole 1,825 (including Head office PPE at fair value less costs to sell of $80m)
The recoverable amounts of the two divisions were based on value in use. The fair value less costs
to sell of any individual item was substantially below this.
No impairment losses had previously been necessary.
Required
Discuss, with suitable computations showing the allocation of any impairment losses, the
accounting treatment of the impairment test.
Solution
Where there are multiple cash generating units, HKAS 36 Impairment of Assets requires two levels
of tests to be performed to ensure that all impairment losses are identified and fairly allocated.
First Divisions A and B are tested individually for impairment. In this instance, both are impaired
and the impairment losses are allocated first to any goodwill allocated to that unit and second to
other non-current assets (within the scope of HKAS 36) on a pro-rata basis. This results in an
impairment of the goodwill of both divisions and an impairment of the property, plant and
equipment in Division B only.
A second test is then performed over the whole business including unallocated goodwill and
unallocated corporate assets (the Head office) to identify if those items which are not a cash
generating unit in their own right (and therefore cannot be tested individually) have been impaired.
The additional impairment loss of (W2) $15m is allocated first against the unallocated goodwill of
$10m, eliminating it and then to the unallocated head office assets reducing them to $85m.
Divisions A and B have already been tested for impairment so no further impairment loss is
allocated to them or their goodwill as that would result in reporting them at below their recoverable
amount.
177
Financial Reporting
Carrying values after impairment test:

Division Division Head Unallocated Total
A B office goodwill
$m $m $m $m $m
PPE 780/(620 – 10)/(90 – 5) 780 610 85 - 1,475
Goodwill (60 – 20)/(30 – 30)/(10 – 10) 40 - - - 40
Net current assets 180 110 20 - 310
1,000 720 105 - 1,825
WORKINGS
1 Test of individual CGUs:
Division A Division B
$m $m
Carrying value 1,020 760
Recoverable amount (1,000) (720)
Impairment loss 20 40
Allocated to:
Goodwill 20 30
Other assets in the scope of HKAS 36 - 10
20 40
2 Test of group of CGUs:

$m
Revised carrying value (1,000 + 720 + 110 + 10) 1,840
Recoverable amount (1,825)
Impairment loss 15
Allocated to:
Unallocated goodwill 10
Other unallocated assets 5
15
HKAS
36.122,123, 4.12 Reversal of an impairment loss
124
Topic highlights
Impairment of goodwill may never be reversed.
Where a cash generating unit has been impaired in the past, this impairment can be reversed. The
reversal of the loss is allocated to the assets of the unit, except for goodwill pro rata with the
carrying amounts of those assets. The increases in carrying amounts are treated in the same way
as reversals of individual asset impairment, in other words, the carrying amount of an asset cannot
increase above the lower of:
(a) its recoverable amount
(b) the carrying amount of the asset net of depreciation had no impairment been recognised
previously.
178
Cannon Co. operates in a number of countries, with its operations in each being classified as
separate cash generating units. In one of the countries of operation, Adascus, legislation was
passed two years ago restricting exports, and as a result management of Cannon expected
production to decrease by 30% in their Adascan operation. Accordingly the Adascan CGU was
tested for impairment and an impairment of $1.473 million recognised in profit:
Goodwill Assets
$'000 $'000
Cost at 1 January 20X1 1,000 2,000
Depreciation – (167)
1,000 1,833
Impairment (1,000) (473)
CV at 31 December 20X1 – 1,360
The average remaining useful life of assets remained unchanged after the impairment, at 11 years.
Two years later at 31 December 20X3, it is thought that the effect of the legislation is less drastic
than expected, and production is expected to increase by 25%. The recoverable amount of the
Adascan CGU is now $1.91 million.
Required
Calculate the reversal of the impairment loss.
HKAS 4.13 Disclosure

36.126,130,
131 HKAS 36 calls for substantial disclosure about impairment of assets. The information to be
disclosed includes the following:
For each class of asset:
(a) The amount of impairment losses recognised in profit or loss in the period and the line item
in the statement of profit or loss and other comprehensive income where they are included.
(b) The amount of reversals of impairment losses recognised in the period and the line item in
the statement of profit or loss and other comprehensive income where they are included.
(c) The amount of impairment losses on revalued assets recognised in other comprehensive
income in the period.
(d) The amount of reversals of impairment losses on revalued assets recognised in other
comprehensive income in the period.
For each material impairment loss recognised or reversed during the period for an individual
asset, including goodwill, or a cash generating unit:
(a) The events and circumstances that led to the recognition or reversal of the impairment loss.
(b) The amount of the impairment loss recognised or reversed.
(c) For an individual asset:
– the nature of the asset
– if the entity reports segment information in accordance with HKFRS 8, the reportable
segment to which the asset belongs
179
Financial Reporting
(d) For a cash generating unit:

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

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

The main aspects of HKAS 36 to consider are:
 indications of impairment of assets
 measuring recoverable amount, as net selling price or value in use
 measuring value in use
 cash generating units
 accounting treatment of an impairment loss, for individual assets and cash generating units
 reversal of an impairment loss
180
Topic recap
HKAS 38 Intangible Assets
Identifiable non-monetary asset without physical substance

controlled by the entity as a result of a past event
from which the entity expected future benefits to flow
Separately acquired Acquired in business Internally generated

combination
Research Development
Investigation Application of
undertaken to gain research findings for
new knowledge the production of
new or improved
materials, processes
etc
Expense to profit or
loss
Recognise if: Recognise if: Recognise if:

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

directly value at date of since date when recognition criteria
attributable costs. acquisition. met.
Subsequent measurement
Cost model or Revaluation model Amortisation
Cost less Revalued amount Amortise over useful life

accumulated less subsequent Residual value assumed to be nil
amortisation less amortisation less Where useful life is indefinite an annual
accumulated subsequent impairment test replaces amortisation
impairment losses impairment losses
Only allowed where there is an active market i.e.

items are homogenous
willing buyers and sellers exist
prices are public
Goodwill
Internally generated goodwill is not recognised (HKAS 38)

Purchased positive goodwill is recognised in the statement of financial position at cost less impairment losses
(HKFRS 3)
A bargain purchase (negative goodwill) is reviewed and then recognised as a gain in profit or loss (HKFRS 3)
181
Financial Reporting
HKAS 36 Impairment
Indicators of impairment Testing Accounting
External sources: Asset held at historic cost:

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

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

amount
Higher of
Fair value less costs to Value in use

sell
Future cash flows expected

to be derived from asset
discounted to present value
using pre-tax rate.
Disclosure requirements:
Impairment losses/reversals recognised in period on assets held at cost & assets at revalued amount
Additional disclosures for material impairment losses/reversals
182
Answer 1
At the end of 20X1, the production process is recognised as an intangible asset at a cost of
$190,000. This is the expenditure incurred since the date when the recognition criteria were met,
that is 1 December 20X1. The $310,000 expenditure incurred before 1 December 20X1 is
expensed, because the recognition criteria were not met. It will never form part of the cost of the
production process recognised in the statement of financial position.
Answer 2
The reversal of the impairment loss is recognised to the extent it increases the carrying amount of
the non-current asset to what it would have been had the impairment not taken place.
This means that the reversal of the impairment loss can only be recognised at $10m. The asset is
recognised at $130m and a reversal of the impairment loss of $10m is recognised in the statement
of profit or loss.
Answer 3
Factors to consider would include the following:
(a) Legal protection of the brand name and the control of the entity over the (illegal) use by
others of the brand name (i.e. control over piracy).
(b) Age of the brand name.
(c) Status or position of the brand in its particular market.
(d) Ability of the management of the entity to manage the brand name and to measure activities
that support the brand name (e.g. advertising and PR activities).
(e) Stability and geographical spread of the market in which the branded products are sold.
(f) Pattern of benefits that the brand name is expected to generate over time.
(g) Intention of the entity to use and promote the brand name over time (as evidenced perhaps
by a business plan in which there will be substantial expenditure to promote the brand
name).
Answer 4
Stauffer brand
The Stauffer brand is an "internally generated" intangible asset rather than a purchased one.
HKAS 38 specifically prohibits the recognition of internally generated brands, on the grounds that
they cannot be reliably measured in the absence of a commercial transaction. Stauffer will not
therefore be able to recognise the brand in its statement of financial position.
183
Financial Reporting
Licence
The licence is an intangible asset acquired by a government grant. It can be accounted for in one
of two ways:
 The asset is recorded at the nominal price (cash paid) of $1m and depreciated at $200,000
per annum of its five year life, or
 The asset is recorded at its fair value of $3m and a government grant is shown as deferred
income at $2m. The asset is depreciated over the five years at an annual rate of $600,000
per annum. The grant is amortised as income through profit or loss over the same period at
a rate of $400,000 per annum. This results in the same net cost of $200,000 in profit or loss
per annum as the first method.
Advertising campaign
The advertising campaign is treated as an expense. Advertising expenditure cannot be capitalised
under HKAS 38, as the economic benefits it generates cannot be clearly identified so no intangible
asset is created.
Patent
The patent is amortised to a nil residual value at $500,000 per annum based on its acquisition cost
of $8m and remaining useful life of 16 years.
The patent cannot be revalued under the HKAS 38 rules as there is no active market as a patent is
unique. HKAS 38 does not permit revaluation without an active market as the value cannot be
reliably measured in the absence of a commercial transaction.
Acquisition
The difference between the price that Stauffer paid and the fair value of the net assets of the
acquired company will represent goodwill. The research and development project must also be
valued at fair value in a business combination to ensure the goodwill is stated accurately, while in
the acquiree's own financial statements it would not be revalued as there is no active market
because it is unique. Consequently, in a business combination HKAS 38/HKFRS 3 (revised) permit
intangible assets that do not have an active market to be valued on an "arm's length" basis.
The values attributed in the group financial statements on the acquisition date are therefore:
$m
Net assets (excluding R&D project) 12
R&D project 5
Goodwill (remainder) 1
Purchase price 18
The fair value of the research and development project is measured at the acquisition date, not at
the year end and so it is not recorded at $8m. The project will be amortised over the expected
useful life of the product developed once the product is available for production.
Answer 5
Goodwill may be distinguished from other intangible non-current assets by reference to the
following characteristics.
(a) It is incapable of realisation separately from the business as a whole.
(b) Its value has no reliable or predictable relationship to any costs which may have been
incurred.
(c) Its value arises from various intangible factors such as skilled employees, effective
advertising or a strategic location. These indirect factors cannot be valued.
184
(d) The value of goodwill may fluctuate widely according to internal and external circumstances
over relatively short periods of time.
(e) The assessment of the value of goodwill is highly subjective.
It could be argued that, because goodwill is so different from other intangible non-current assets it
does not make sense to account for it in the same way. Thus the capitalisation and amortisation
treatment would not be acceptable. Furthermore, because goodwill is so difficult to value, any
valuation may be misleading, and it is best eliminated from the statement of financial position
altogether. However, there are strong arguments for treating it like any other intangible non-current
asset. This issue remains controversial.
Answer 6
In identifying Shrub's cash generating unit, an entity considers whether, for example:
(a) Internal management reporting is organised to measure performance on a store-by-store
basis.
(b) The business is run on a store-by-store profit basis or on a region/city basis.
All Forest's stores are in different neighbourhoods and probably have different customer bases.
So, although Shrub is managed at a corporate level, Shrub generates cash inflows that are largely
independent from those of Forest's other stores. Therefore, it is likely that Shrub is a cash
generating unit.
Answer 7
It is likely that the recoverable amount of an individual magazine title can be assessed. Even
though the level of advertising income for a title is influenced, to a certain extent, by the other titles
in the customer segment, cash inflows from direct sales and advertising are identifiable for each
title. In addition, although titles are managed by customer segments, decisions to abandon titles
are made on an individual title basis.
Therefore, it is likely that individual magazine titles generate cash inflows that are largely
independent one from another and that each magazine title is a separate cash generating unit.
Answer 8
 At 31 December 20X3, the carrying amount of the assets are:
$'000
CV at 31 December 20X1 1,360
Depreciation X2 (1,360/11) (124)
Depreciation X3 (124)
1,112
 Recoverable amount is $1.91 million and the excess over carrying amount is therefore
$798,000.
 The impairment of goodwill cannot be reversed.
 The impairment of assets can be reversed provided that the new carrying amount is not in
excess of the carrying amount had no impairment arisen ie $1.5 million ($1.833m  9/11
years).
 Therefore, a reversal of $388,000 ($1.5m – $1.112m) is recognised in profit or loss.
185
Financial Reporting
Exam practice
York Marble Limited 32 minutes

York Marble Limited ("YM") has operated a tile manufacturing plant in the city centre for more than
15 years. Due to a recent change in government policy on environmental protection and city
development, YM was ordered to close the production plant by the end of September 20Y1 and
return the leasehold land to the government early at a consideration based on the market price of
land with a similar remaining lease term and location.
As at 31 May 20Y1, YM had the following assets related to the production plant:
$m
Buildings and infrastructure 23.8
Production equipment 48.0
Electricity generator 5.2
Land under operating lease up to 20Z4 13.0
Inventories – Raw materials 8.4
Inventories – Finished products 6.4
According to the original lease, YM is required to dismantle the buildings and infrastructure before
returning the bare land to the government. Previously, the company has recognised a provision for
the dismantling to be carried out by the end of the lease term of the land in the cost of these
assets. The carrying amount of the provision at 31 May 20Y1 is $1.5 million. Based on a quotation
from a contractor, it costs $3 million for this exercise to be carried out by September 20Y1.
All production equipment will be relocated to another manufacturing plant of YM 60 km away for
continuing usage. The relocation and installation costs are estimated to be $4 million. YM agreed
to sell the electricity generator to another company at $4 million. The relocation cost will be borne
by the buyer.
Although the final consideration of the leasehold land to be paid by the government has yet to be
determined, the government has indicated to YM that the amount would be not less than
$35 million.
YM will continue manufacturing until the end of August and it is expected that all the raw materials
will be consumed for the production of tiles and sold at a profit. Half of the finished products were
made to order with a gross profit of 20% and delivered to customers in early June 20Y1. The
remaining half is obsolete and old model items which could only be sold at 40% of the cost.
Required
Discuss the accounting treatment under Hong Kong Financial Reporting Standards that should be
adopted by YM for each individual asset as at 31 May 20Y1.
(18 marks)
HKICPA December 2011
186
chapter 9
Leases
Topic list
1 HKAS 17 Leases 6 Interpretations relating to lease accounting

1.1 Scope of HKAS 17 6.1 HK(SIC) Int-27 Evaluating the Substance
1.2 Types of lease of Transactions in the Legal Form of a
1.3 Other definitions Lease
1.4 Section summary 6.2 HK(IFRIC) Int-4 Determining whether an
Arrangement contains a Lease
2 Lessee accounting 6.3 HK-Int 4 Lease – Definition of the Length
2.1 Operating leases of Lease Term in respect of Hong Kong
2.2 Finance leases Land Leases
2.3 Recap
3 Lessor accounting
3.1 Operating leases
3.2 Finance leases
3.3 Manufacturer or dealer lessors
3.4 Lessors' disclosures for finance leases
4 Sale and leaseback transactions
5 Off-balance sheet finance explained
5.1 Reasons for off-balance sheet finance
5.2 The problem with off-balance sheet finance
Learning focus
Leasing transactions are extremely common in business and you will often come across
them in both your business and personal capacity. It is important for the accountant to be able
to advise from the perspective of both the lessor and the lessee. Off-balance sheet finance
and substance over form are both vital issues of which the accountant should be aware.
187
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.14 Leases 3
3.14.01 Identify the types of lease within the scope of HKAS 17 and define
the terminology used in relation to leases
3.14.02 Classify leases as operating or finance leases by looking at the
substance of the transaction
3.14.03 Account for operating leases from the perspective of both the
lessee and the lessor
3.14.04 Disclose the relevant information relating to operating leases in the
accounts of both the lessee and the lessor
3.14.05 Account for finance leases from the perspective of both the lessee
and the lessor
3.14.06 Disclose the relevant information relating to finance leases in the
accounts of both the lessee and the lessor
3.14.07 Account for manufacturer/dealer leases
3.14.08 Account for sale and leaseback transactions
3.14.09 Explain the term off-balance sheet finance and the importance of
substance over form
3.14.10 Explain how to determine whether an arrangement contains a lease
188
9: Leases | Part C Accounting for business transactions
1 HKAS 17 Leases
Topic highlights
HKAS 17 covers the accounting for lease transactions by both lessees and lessors. A lease is a
contract for the hire of a specific asset.
A lease is a contract between a lessee and lessor for the hire of a specific asset. The lessor retains
ownership of the asset but conveys the right of the use of the asset to the lessee for an agreed
period of time in return for the payment of specified rentals.
HKAS 17.2 1.1 Scope of HKAS 17

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

Topic highlights
There are two forms of lease: finance lease and operating lease.
In some cases, leasing can be considered to be a medium-term or long-term source of finance.

From the point of view of the lessee, therefore, leasing such an asset is very similar to
purchasing it using a loan. The lessee has all of the benefits and responsibilities of ownership
except for the capital allowances. These types of longer-term lease are known as finance leases.
Other leases are of a very different nature. For example, a businessman may decide to hire (lease)
a car for a week while his own is being repaired. A lease of this nature is for a short period of time
compared with the asset's useful life and the lessor will expect to lease it to many different lessees
during that life. Furthermore, the lessor rather than the lessee will be responsible for maintenance.
These types of lease are known as operating leases.
HKAS 17.4 1.2.1 Definitions
HKAS 17 Leases classifies leases as either finance leases or operating leases and requires that
different accounting treatment is applied for each.
In distinguishing between them, the standard gives the following definitions.
189
Financial Reporting
Key terms
Lease. An agreement whereby the lessor conveys to the lessee in return for a payment or series of
payments the right to use an asset for an agreed period of time.
Finance lease. A lease that transfers substantially all the risks and rewards incidental to ownership
of an asset. Title may or may not eventually be transferred.
Operating lease. A lease other than a finance lease. (HKAS 17)
The classification of a lease as either finance or operating is therefore largely dependent upon the
transfer of risks and rewards. The next section explains what is meant by this term.
HKAS 17.7- 1.2.2 Risks and rewards
11
Risks are the risks of ownership, not other types of risk. These include:
 possibility of losses from idle capacity
 possibility of losses from technological obsolescence
 variations in return due to changing economic conditions.
Rewards are represented by:
 the expectation of profitable operation over the asset's economic life
 unrestricted access to the asset
 any gain from appreciation in value or realisation of a residual value.
HKAS 17 applies the same definitions and accounting principles to both lessees and lessors, but
the different circumstances of each may lead each to classify the same lease differently.
An assessment of risks and rewards may be inconclusive in deciding what type of lease a
particular arrangement is. In this instance, the standard provides examples of situations which
indicate an arrangement is a finance lease.
HKAS 17 provides the following examples of finance lease:
(a) The lease transfers ownership of the asset to the lessee by the end of the lease term.
(b) The lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable such that, at
the inception of the lease, it is reasonably certain that the option will be exercised.
(c) The lease term is for the major part of the economic life of the asset even if title is not
transferred.
(d) At the inception of the lease the present value of the minimum lease payments amounts to at
least substantially all of the fair value of the leased asset.
(e) The leased assets are of a specialised nature such that only the lessee can use them
without major modifications being made.
There are also some indicators of situations which individually or in combination could also lead to
a lease being classified as a finance lease.
(a) If the lessee can cancel the lease, the lessor's losses associated with the cancellation are
borne by the lessee.
(b) Gains or losses from the fluctuation in the fair value of the residual fall to the lessee (e.g. in
the form of a rent rebate equalling most of the sales proceeds at the end of the lease).
(c) The lessee has the ability to continue the lease for a secondary period at a rent which is
substantially lower than market rent.
190
HKAS 1.2.3 Classification of a lease

17.13,15A
Classification is made at the inception of the lease. Any revised agreement should be treated as
a new agreement over its term. In contrast, changes in estimates (e.g. of economic life or residual
value of the property) or changes in circumstances (e.g. default by the lessee) do not lead to a new
classification of a lease for accounting purposes.
Land and buildings
When a lease includes both land and building elements, an entity must consider each of these
elements in turn and classify them as finance or operating lease separately. With regard to the
land, the standard states that an important consideration is that land normally has an indefinite
economic life. This is likely to result in the land element being classified as an operating lease in
view of the low level of risks and rewards associated with the land which would have been
transferred to the lessee during the lease period.
HKAS 17.4 1.3 Other definitions

HKAS 17 gives a substantial number of definitions.
Key terms
Minimum lease payments. The payments over the lease term that the lessee is or can be
required to make, excluding contingent rent, costs for services and taxes to be paid by and be
reimbursable to the lessor, together with:
(a) For a lessee, any amounts guaranteed by the lessee or by a party related to the lessee.
(b) For a lessor, any residual value guaranteed to the lessor by one of the following:
(i) The lessee
(ii) A party related to the lessee
(iii) An independent third party financially capable of meeting this guarantee.
However, if the lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than fair value at the date the option becomes exercisable for it to be reasonably
certain, at the inception of the lease, that the option will be exercised, the minimum lease payments
comprise the minimum payments payable over the lease term to the expected date of exercise of
this purchase option and the payment required to exercise it.
Interest rate implicit in the lease. The discount rate that, at the inception of the lease, causes the
aggregate present value of the:
(a) minimum lease payments, and
(b) unguaranteed residual value
to be equal to the sum of:
(a) the fair value of the leased asset
(b) any initial direct costs
Initial direct costs are incremental costs that are directly attributable to negotiating and
arranging a lease, except for such costs incurred by manufacturer or dealer lessors. Examples of
initial direct costs include amounts such as commissions, legal fees and relevant internal costs.
Lease term. The non-cancellable period for which the lessee has contracted to lease the asset
together with any further terms for which the lessee has the option to continue to lease the asset,
with or without further payment, when at the inception of the lease it is reasonably certain that the
lessee will exercise the option.
191
Financial Reporting
Key terms (cont'd)

A non-cancellable lease is a lease that is cancellable only in one of the following situations:
(a) Upon the occurrence of some remote contingency.
(b) With the permission of the lessor.
(c) If the lessee enters into a new lease for the same or an equivalent asset with the same
lessor.
(d) Upon payment by the lessee of an additional amount such that, at inception, continuation of
the lease is reasonably certain.
The inception of the lease is the earlier of the date of the lease agreement and the date of
commitment by the parties to the principal provisions of the lease. As at this date:
(a) A lease is classified as either an operating lease or a finance lease
(b) In the case of a finance lease, the amounts to be recognised at the lease term are
determined.
Economic life is either the:
(a) period over which an asset is expected to be economically usable by one or more users
(b) number of production or similar units expected to be obtained from the asset by one or more
users
Useful life is the estimated remaining period, from the beginning of the lease term, without
limitation by the lease term, over which the economic benefits embodied in the asset are expected
to be consumed by the entity.
Guaranteed residual value is:
(a) for a lessee, that part of the residual value which is guaranteed by the lessee or by a party
related to the lessee (the amount of the guarantee being the maximum amount that could, in
any event, become payable).
(b) for a lessor, that part of the residual value which is guaranteed by the lessee or by a third
party unrelated to the lessor who is financially capable of discharging the obligations under
the guarantee.
Unguaranteed residual value is that portion of the residual value of the leased asset, the
realisation of which by the lessor is not assured or is guaranteed solely by a party related to the
lessor.
Gross investment in the lease is the aggregate of:
(a) the minimum lease payments receivable by the lessor under a finance lease
(b) any unguaranteed residual value accruing to the lessor
Net investment in the lease is the gross investment in the lease discounted at the interest rate
implicit in the lease.
Unearned finance income is the difference between the:
(a) gross investment in the lease
(b) net investment in the lease
The lessee's incremental borrowing rate of interest is the rate of interest the lessee would have
to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease,
the lessee would incur to borrow over a similar term, and with a similar security, the funds
necessary to purchase the asset.
Contingent rent is that portion of the lease payments that is not fixed in amount but is based on a
factor other than just the passage of time (e.g. percentage of sales, amount of usage, price indices,
market rates of interest).
(HKAS 17)
192
Some of these definitions are only of relevance when we look at lessor accounting in section 3.
1.4 Section summary

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

by the end of the lease term?
No
Does the lease contain a Yes

bargain purchase option?
No
Is the lease term for a Yes

major part of the asset's
useful life?
No
Is the present value of minimum

lease payments greater than Yes
or substantially equal to the
asset's fair value?
No
Operating lease Finance lease
2 Lessee accounting
Topic highlights
Lessee accounting:
 Operating leases: recognise rental expense on a straight line basis.
 Finance leases: record an asset in the statement of financial position and a liability to pay
for it (at the lower of fair value of the asset or present value of minimum lease payments);
apportion the finance charge to give a constant periodic rate of return.
HKAS 17.33 2.1 Operating leases

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

Flora Co. entered an operating lease agreement in order to obtain use of a photocopier for a period
of three years starting on 1 October 20X9. The terms of the lease stated that payment of $2,500
193
Financial Reporting
should be made annually in arrears for each of the three years of the lease in addition to an initial
non-refundable deposit of $1,500.
What expense is recognised in Flora Co.'s financial statements for the year ended 31 December
20X9?
Solution
Total amount payable $1,500 + (3  $2,500) = $9,000
Annual expense $9,000/3 years = $3,000
Expense for y/e 31 Dec 20X9 $3,000  3/12 = $750
2.1.1 HK(SIC) Int-15 Operating Leases – Incentives

In negotiating a new or renewed operating lease, the lessor may provide incentives for the lessee
to enter into the agreement. Examples include an up-front cash payment to the lessee. The
question arises as to how incentives in an operating lease should be recognised in the financial
statements of both the lessee and the lessor.
HK(SIC) Int-15 provides that all incentives for the agreement of a new or renewed operating lease
should be recognised as an integral part of the net consideration agreed for the use of the leased
asset, irrespective of the incentive's nature or the form or the timing of payments.
The lessee should recognise the aggregate benefit of incentives as a reduction of rental expense
over the lease term, generally on a straight line basis.
Costs incurred by the lessee, including costs in connection with a pre-existing lease should be
accounted for in accordance with the relevant HKAS.
Example: Operating lease incentives

Fauna Co. enters into an operating lease agreement on 1 August 20X8 in order to obtain use of a
machine. The lease term is four years and $5,000 is payable annually in advance. As an incentive,
the lessor has agreed a reduction of 40% off the first year's rental payment.
What expense is recorded by Fauna Co. in the year ended 31 December 20X8 in respect of this
agreement?
Solution
Total amount payable ($5,000  4) – $2,000 = $18,000
Annual expense $18,000/4 years = $4,500
Expense for y/e 31 Dec 20X8 $4,500  5/12 = $1,875
HKAS 17.35 2.1.2 Lessees' disclosures for operating leases

Disclosures of the following, which are in addition to the requirements under HKFRS 7 (see
Chapter 18), are required:
 The total of future minimum lease payments under non-cancellable operating leases for
each of the following periods:
– Not later than one year
– Later than one year and not later than five years
– Later than five years.
 The total of future minimum sublease payments expected to be received under
non-cancellable subleases at the end of the reporting period.
 Lease and sublease payments recognised as an expense for the period, with separate
amounts for minimum lease payments, contingent rents, and sublease payments.
194
 A general description of the lessee's significant leasing arrangements including, but not
limited to, the following:
– Basis on which contingent rent payments are determined
– Existence and terms of renewal or purchase options and escalation clauses
Restrictions imposed by lease arrangements, such as those concerning dividends, additional debt,
and further leasing.
2.2 Finance leases

From the lessee's point of view there are two main accounting problems:
(a) Whether the asset should be capitalised as if it had been purchased.
(b) How the lease charges should be allocated between different accounting periods.
HKAS 2.2.1 Accounting treatment
17.20,25,27,
28 HKAS 17 requires that a finance lease is accounted for as follows:
1 An asset and corresponding liability are recorded
At the inception of the lease an asset and corresponding liability are recorded at the lower of
the fair value of the leased asset and the present value of the minimum lease payments.
Note that HKAS 17 uses the term "fair value" in a way that differs from the definition of fair
value in HKFRS 13 Fair Value Measurement. Therefore, in respect of leases fair value
should be measured in accordance with HKAS 17 rather than HKFRS 13.
The interest rate implicit in the lease is used to determine the present value of the minimum
lease payments. If it is not practical to determine this rate then the lessee's incremental
borrowing rate may be used.
Any initial direct costs of the lessee are added to the amount recognised as an asset. These may
be incurred in connection with securing or negotiating the lease, but should only include costs
which are directly attributable to activities performed by the lessee to obtain the finance lease.
2 The asset is depreciated
The asset held under the finance lease is depreciated over the shorter of the lease term and
the useful life of the asset.
If there is a reasonable certainty that the lessee will obtain ownership at the end of the lease,
the asset should be depreciated over the asset's useful life. The policy of depreciation
adopted should be consistent with similar non-leased assets and calculations should follow
the bases set out in HKAS 16 (see Chapter 5).
HKAS 17 (revised) introduced guidance on impairment of leased assets by referring to HKAS 36.
3 Lease payments are recorded
Minimum lease payments should be split into the finance charge under the finance lease and
a reduction of the outstanding obligation for future amounts payable.
The finance charge allocated to the accounting periods should produce a constant periodic
rate of interest on the outstanding balance of the lease obligation for each accounting
period, or a reasonable approximation thereto.
The normal method applied in order to achieve this is the actuarial method, discussed in the
next section. An alternative method is the sum of digits method, however this is not examinable.
Contingent rents should be charged in the periods in which they are incurred.
195
Financial Reporting
2.2.2 Actuarial method

The actuarial method, which is the best and most scientific method for interest allocation, is
derived from the assumption that interest charged by the lessor will be the same as the lessor's
desired rate of return, multiplied by its capital investment.
(a) The capital investment is identical to the fair value of the asset (less any initial deposit paid
by the lessee) at the commencement of the lease.
(b) The amount of capital invested reduces as each instalment is paid. The interest on the lease
decreases gradually as capital is repaid. It follows that the interest accruing is greatest in the
early part of the lease term. We will go through a simple example of the actuarial method in
this section.
Example: Finance lease with payments in arrears
On 1 January 20X0, Gordon Co. leased an asset with a fair value of $38 million and a useful life of
five years. The lease term was five years and the interest rate implicit in the lease was 9.9%.
The company is required to make five annual instalments of $10 million on 31 December, with the
first payment on 31 December 20X0.
Show the lease obligation working for each year of the lease and identify amounts to be recognised
in profit or loss in 20X0.
Solution
Interest is calculated as 9.9% of the outstanding capital balance at the beginning of each year.
The outstanding capital balance reduces each year by the capital element comprised in each
instalment. The outstanding capital balance at 1 January 20X0 is the $38 million fair value at which
both the asset and liability are initially recorded. Depreciation on the plant is to be provided for at
the rate of 20% per annum on a straight line basis assuming a residual value of nil.
Annual lease
Balance of lease Interest payment at Balance of lease
Year at 1 Jan 9.9% 31 Dec at 31 Dec
$'000 $'000 $'000 $'000
20X0 38,000 3,762 (10,000) 31,762
20X1 31,762 3,144 (10,000) 24,906
20X2 24,906 2,466 (10,000) 17,372
20X3 17,372 1,720 (10,000) 9,092
20X4 9,092 908 (10,000) -
Amounts to be included in profit or loss in 20X0 are: $m
Depreciation (38m/5 years) 7.600
Finance cost 3.762
Note that the $10m lease payment in 20X0 includes payment of the $3.762m interest for the year
plus a capital amount of $6.238m.
Example: Finance lease with deposit and payments in arrears

On 1 January 20X5 Jennifer Co. acquired a machine from Alice Co. under a finance lease. The
cash price of the machine was $7,710 while the minimum payments in the lease agreement totalled
$10,000. The agreement required the immediate payment of a $2,000 deposit with the balance
being settled in four equal annual instalments commencing on 31 December 20X5. The finance
charge of $2,290 represents interest of 15% per annum, calculated on the remaining balance of the
liability during each accounting period.
Required
Show the breakdown of each instalment between interest and capital, using the actuarial method.
196
Solution
Interest is calculated as 15% of the outstanding capital balance at the beginning of each year. The
outstanding capital balance reduces each year by the capital element comprised in each instalment. The
outstanding capital balance at 1 January 20X5 is $5,710 ($7,710 fair value less $2,000 deposit).
Capital at Interest Capital at
Year 1 Jan 15% Instalment 31 Dec
$ $ $ $
20X5 5,710 856 2,000 4,566
20X6 4,566 685 2,000 3,251
20X7 3,251 488 2,000 1,739
20X8 1,739 261 2,000 –
2,290 8,000
In the above examples, repayments are made at the end of each reporting period i.e. in arrears. It
may be that repayments are made at the start of a reporting period, i.e. in advance, and in this
case the lease obligation table takes a slightly different format. The following example illustrates
this.
Example: Finance lease with payments in advance
Jesmond acquired an asset by way of a five-year term finance lease on 1 July 20X0. The asset had
a fair value of $102,500 and a useful life of five years and the lease contract required five equal
payments in advance of $25,000 each. The interest rate implicit in the lease is 11%. Jesmond’s
year end is 30 June.
Draw up the lease liability table for Jesmond for the whole five-year period, identifying amounts for
inclusion in the statement of profit or loss for the year ended 30 June 20X1.
Solution
B/f Repayment C/f Interest at C/f
11%
$ $ $ $ $
30.6.X1 102,500 (25,000) 77,500 8,525 86,025
30.6.X2 86,025 (25,000) 61,025 6,713 67,738
30.6.X3 67,738 (25,000) 42,738 4,701 47,439
30.6.X4 47,439 (25,000) 22,439 2,468 24,907
30.6.X5 24,907 (25,000)*
* There is a rounding difference of $93.
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 30 JUNE 20X1 $
Depreciation ($102,500/5 years) 20,500
Finance cost 8,525
Note that in this example, interest is calculated after the repayment ie it is based on the amount
owed throughout a period. Therefore, the table includes items in a different order to that seen
previously.
2.2.3 Finance leases with different payment schedules

In the examples above, all finance leases agreements have involved one annual payment. In some
cases, payments are required monthly or quarterly. Where this is the case, the working should be
drawn up as we have seen, with one row representing each payment period. Therefore, where
there are quarterly repayments, the table will include four rows for each accounting year:
197
Financial Reporting
B/f Interest 7% Repayment C/f

31.3.X1 119,400 8,358 (20,000) 107,758
30.6.X1 107,758 7,543 (20,000) 95,301
30.9.X1 95,301 6,671 (20,000) 81,972
31.12.X1 81,972 5,738 (20,000) 67,710
28,310
Finance charge Year end liability
HKAS 17.31 2.2.4 Lessees' disclosure for finance leases

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

These disclosure requirements will be illustrated for Gordon Co. (the first example in section 2.2.2).
We will assume that Gordon Co. makes up its accounts to 31 December and uses the actuarial
method, as shown in the example above, to apportion finance charges.
Solution
The company's accounts for the first year of the lease, the year ended 31 December 20X0, would
include the information given below.
198
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X0 (EXTRACTS)

$'000 $'000
Non-current assets
Assets held under finance leases
Plant and machinery at cost 38,000
Less accumulated depreciation ($38,000/5 years) 7,600
30,400
Non-current liabilities
Obligations under finance leases
(Balance at 31 December 20X1) 24,906
Current liabilities
Obligations under finance leases (31,762 – 24,906) 6,856
(Note that only the outstanding capital element is disclosed under liabilities, i.e. the total of the
minimum lease payments with future finance charges separately deducted.)
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 DECEMBER 20X0 (EXTRACT)
$'000
Interest payable and similar charges
Interest on finance leases 3,762
Potter leases an asset (as lessee) on 1 January 20X1, incurring $20,000 of costs in setting up the
agreement. Potter agrees to pay a non-refundable deposit of $58,000 on inception together with six
annual instalments of $160,000, payable in arrears.
Potter also guaranteed to the lessor that the lessor would receive at least $80,000 when the asset
is sold in the general market at the end of the lease term.
The fair value of the asset (equivalent to the present value of minimum lease payments) on
1 January 20X1 is $800,000. Its useful life to the company is five years.
The interest rate implicit in the lease has been calculated as 10%.
Required
(a) Prepare the relevant extracts from the financial statements of Potter in respect of the above
lease for the year ended 31 December 20X1.
(b) Explain what would happen at the end of the lease if the asset could be sold by the lessor:
(i) For $80,000
(ii) For only $60,000
2.2.5 Arguments against capitalisation

The main argument in favour of capitalisation of assets acquired under a finance lease is
substance over form. The substance of the arrangement is that the lessee owns the asset, since
the risks and rewards of ownership have transferred to them and they in effect pay for the asset by
way of a financing arrangement.
The main arguments against capitalisation are as follows:
(a) Legal position. The benefit of a lease to a lessee is an intangible asset, not the ownership
of the equipment. It may be misleading to users of accounts to capitalise the equipment
when a lease is legally quite different from a loan used to purchase the equipment.
199
Financial Reporting
Capitalising leases also raises the question of whether other executory contracts should be
treated similarly, for example contracts of employment.
(b) Complexity. Many small businesses will find that they do not have the expertise necessary
for carrying out the calculations required for capitalisation.
(c) Subjectivity. To some extent, capitalisation is a somewhat arbitrary process and this may
lead to a lack of consistency between companies.
(d) Presentation. The impact of leasing can be more usefully described in the notes to financial
statements. These can be made readily comprehensible to users who may not understand
the underlying calculations.
2.3 Recap
The following diagram gives a useful summary of the accounting treatment for a finance lease
by a lessee.
Accounting for a finance lease by a lessee
200
3 Lessor accounting
Topic highlights
Lessor accounting:
 Operating leases: record as long-term asset and depreciate over useful life, record income
on a straight line basis over the lease term.
 Finance leases: record the amount due from the lessee in the statement of financial position
at the net investment in the lease, recognise finance income to give a constant periodic rate
of return.
To a certain extent at least, the accounting treatment of leases adopted by lessors will be a mirror
image of that used by lessees.
HKAS 17.49-
53
3.1 Operating leases
3.1.1 Accounting treatment
Statement of financial position
An asset held by a lessor under an operating lease is treated as a long-term asset and
depreciation is recorded over its useful life. The depreciation basis should be the same as the
lessor's policy on similar non-lease assets which shall follow the guidance in HKAS 16.
In determining whether there is an impairment of the leased asset, the lessor should refer to the
issues discussed in HKAS 36.
Statement of profit or loss and other comprehensive income
Income under an operating lease, excluding charges for services such as insurance and
maintenance, should be recognised over the period of the lease on a straight line basis. This is
so even if the receipts are not on such a basis, unless another systematic and rational basis is
identified as more representative of the time pattern in which the benefit from the leased asset is
receivable.
In accordance with HK(SIC)Int-15 Operating Leases – Incentives (see section 2.1.1), the lessor
should recognise the aggregate cost of incentives as a reduction of rental income over the lease
term, generally on a straight line basis.
Initial direct costs incurred by lessors in negotiating and arranging an operating lease should be
capitalised and amortised over the lease term. These costs are included in the carrying amount of
the leased asset and recognised as an expense over the lease term on the same basis as lease
income.
HKAS 17.56 3.1.2 Lessors' disclosures for operating leases

The following should be disclosed (on top of HKFRS 7 requirements).
 For each class of asset, the gross carrying amount, the accumulated depreciation and
accumulated impairment losses at the end of the reporting period:
– Depreciation recognised in income for the period
– Impairment losses recognised in income for the period
– Impairment losses reversed in income for the period.
 The future minimum lease payments under non-cancellable operating leases in the
aggregate and for each of the following periods:
– Not later than one year
– Later than one year and not later than five years
201
Financial Reporting
– Later than five years.

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

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

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

Hire Co. leased an asset to another company with effect from 1 January 20X8. The terms of the
lease were as follows:
 Lease term of eight years
 Rentals of $11,000 are payable in advance
 The interest rate implicit in the lease is 12.8%
The fair value of the asset on 1 January 20X8 was $59,500 and legal fees associated with the
lease amounting to $500 were payable by Hire Co. on this date.
What amounts are recognised in Hire Co.'s financial statements for the year ended 31 December
20X8 in respect of the lease?
Solution
The net investment in the lease is calculated as:
$
Amount due from lessee (fair value of the asset) 59,500
Direct costs 500
60,000
202
This net investment reduces over the period of the lease due to payments received; it will also
increase due to interest receivable. In other words, the movement is the direct opposite of the
movement seen in the finance lease obligation of a lessee:
$
Balance 1 January 20X8 60,000
Instalment 1 January 20X8 (11,000)
Balance c/f 49,000
Interest at 12.8% 6,272
Balance at 31 December 20X8 55,272
Instalment 1 January 20X9 (11,000)
Balance c/f 44,272
Therefore, in the statement of financial position of Hire Co., a current and non-current asset is
recognised.
Non-current asset: Net investment in finance lease $44,272
Current asset: Net investment in finance lease (55,272 – 44,272) $11,000
Interest receivable of $6,272 is recognised in the statement of profit or loss and other
comprehensive income.
HKAS 17.42- 3.3 Manufacturer or dealer lessors

46
In some instances, manufacturers lease out assets which they have made, rather than sell them.
Similarly, dealers acquire assets for resale but in some circumstances may instead lease these out
to third parties.
Unlike normal lessor companies which buy assets at their fair value and in leasing them out make a
profit only on the financing arrangements, these companies acquire the asset in the first place for
less than fair value:
 Manufacturers acquire the asset for cost
 Dealers generally acquire the asset at a discount
Therefore, the manufacturer or dealer makes two types of income:
1 A profit or loss (being the difference between the cost /reduced price and fair value), and
2 Interest from financing arrangements.
HKAS 17 therefore requires the following accounting treatment:
(a) The selling profit/loss is recognised in income for the period as if it was an outright sale.
For this purpose:
– revenue is the lower of the fair value of the asset or the present value of the minimum
lease payments calculated using a market rate of interest
– cost of sales is the cost (or carrying amount if different) of the asset less the present
value of any unguaranteed residual value.
(b) If interest rates are artificially low, the selling profit is restricted to that which would apply
had a commercial rate been applied.
(c) Costs incurred in connection with negotiating and arranging a lease are recognised as an
expense when the selling profit is recognised (at the start of the lease term).
HKAS 17.55 3.3.1 Manufacturers or dealers and operating leases
A lessor who is a manufacturer or dealer should not recognise any selling profit on entering into
an operating lease because it is not the equivalent of a sale. The manufacturer or dealer has
retained the assets with a view to using them to generate rental income.
203
Financial Reporting
HKAS 17.47 3.4 Lessors' disclosures for finance leases

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

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

Osborne Co. owned an asset with a carrying amount of $840,000 on 1 March 20X8. On this date
Osborne Co. sold the asset to a bank for $1,320,000, being the present value of the minimum
lease payments, and then undertook to lease it back under a 40-year finance lease.
204
The annual rental is $39,000 payable in advance.

End of reporting period for Osborne Co. is 28 February.
Required
How should the transaction be accounted for by Osborne Co.?
Solution
At the date of sale/inception of the lease
$ $
On the sale of the asset:
DEBIT Cash 1,320,000
CREDIT Asset 840,000
Deferred income 480,000
On the lease back of the asset:

DEBIT Asset 1,320,000
CREDIT Finance lease obligation 1,320,000
On the payment of the first instalment:
DEBIT Finance lease obligation 39,000
CREDIT Cash 39,000
Amounts charged to the statement of profit or loss and other comprehensive income for the year
ended 28 February 20X9 will include:
 depreciation of the asset ($1,320,000/40 years) $33,000
 a release of the deferred income ($480,000/40 years) $12,000
 interest accrued on the lease at the implicit rate
Example: Sale and operating leaseback

On 1 January 20X2 Cable Co. owned an asset with a carrying amount of $80,000. The fair value of
the asset on that date was $90,000.
In order to improve its liquidity position, Cable Co. has negotiated possible agreements to sell the
asset and lease it back under an operating lease for seven years. The financial controller is
currently assessing the four agreements.
The agreements are as follows:
Agreement 1 Sale for $90,000 with annual future lease payments at a market rate of $15,000
Agreement 2 Sale for $75,000 with annual future lease payments of $15,000
How would each of these agreements be accounted for in Cable Co.'s financial statements?
Solution
Agreement 1 Sale is for fair value and therefore a profit of $10,000 is recognised immediately
in profit or loss.
Agreement 2 Sale is for less than fair value however the loss is not compensated for by low
future rentals. Therefore, the loss of $5,000 is recognised immediately.
Agreement 3 Sale is for less than fair value and the loss is compensated for by low future
rentals. Therefore, the loss of $30,000 is recognised in the statement of financial
position and released to profit or loss over the lease term.
205
Financial Reporting
Agreement 4 Sale is for more than fair value. Therefore, a profit of $10,000 being the
difference between the fair value and carrying amount is recognised in profit or
loss immediately and the excess profit of $20,000 is recognised in the statement
of financial position and released to profit over the lease term.
5 Off-balance sheet finance explained

Topic highlights
HKAS 17 (revised) has closed many loopholes, but some still argue that it is open to
manipulation.
Key term
Off-balance sheet finance is the funding or refinancing of a company's operations in such a way
that, under legal requirements and traditional accounting conventions, some or all of the finance
may not be shown in its statement of financial position.
"Off-balance sheet transactions" are transactions which meet the above objective. These
transactions may involve the removal of assets from the statement of financial position, as well as
liabilities, and they are also likely to have a significant impact on profit or loss.
5.1 Reasons for off-balance sheet finance

Off-balance sheet transactions may be entered into for a number of reasons, including the
following:
(a) In some countries, companies traditionally have a lower level of gearing than companies in
other countries. Off-balance sheet finance is used to keep gearing low, probably because of
the views of analysts and brokers.
(b) A company may need to keep its gearing down in order to stay within the terms of loan
covenants imposed by lenders.
(c) A listed company with high borrowings is often expected (by analysts and others) to declare
a rights issue in order to reduce gearing. This has an adverse effect on a company's share
price and so off-balance sheet financing is used to reduce gearing and the expectation of a
rights issue.
(d) Analysts' short-term views are a problem for companies developing assets which are not
producing income during the development stage. Such companies will match the borrowings
associated with such developing assets, along with the assets themselves, off-balance
sheet. They are brought back into the statement of financial position once income is being
generated by the assets. This process keeps return on capital employed higher than it would
have been during the development stage.
(e) In the past, groups of companies have excluded subsidiaries from consolidation in an off-
balance sheet transaction because they carry out completely different types of business and
have different characteristics. The usual example is a leasing company (in say a retail group)
which has a high level of gearing. This exclusion is now disallowed.
You can see from this brief list of reasons that the overriding motivation is to avoid
misinterpretation.
In other words, the company does not trust the analysts or other users to understand the reasons
for a transaction and so avoids any effect such transactions might have by taking them off-balance
206
sheet. Unfortunately, the position of the company is then misstated and the user of the accounts is
misled.
You must understand that not all forms of 'off-balance sheet finance' are undertaken for cosmetic
or accounting reasons. Some transactions are carried out to limit or isolate risk, to reduce interest
costs and so on. In other words, these transactions are in the best interests of the company, not
merely a cosmetic repackaging of figures which would normally appear in the statement of financial
position.
5.2 The problem with off-balance sheet finance

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

6.1 HK(SIC) Int-27 Evaluating the Substance of Transactions in
the Legal Form of a Lease
HK(SIC) Int-27 addresses issues that may arise when an arrangement between an entity and an
investor involves the legal form of a lease. It contains the following provisions:
(a) Accounting for arrangements between an entity and an investor should reflect the substance
of the arrangement. All aspects of the arrangement should be evaluated to determine its
substance, with weight given to those aspects and implications that have an economic effect.
In this respect, HK(SIC) Int-27 includes a list of indicators that individually demonstrate that an
arrangement may not, in substance, involve a lease under HKAS 17 Leases:
(i) An entity retains all of the risks and rewards of ownership of an underlying asset and
enjoys substantially the same rights to its use as before the arrangement.
(ii) The primary reason for the arrangement is to achieve a particular tax result.
(iii) An option is included on terms that make its exercise almost certain.
These indicators are particularly relevant in the case of sale and leaseback transactions,
where the substance of the transaction may be a secured loan.
(b) If an arrangement does not meet the definition of a lease, and is therefore outside the
scope of HKAS 17, HK(SIC) Int-27 considers:
(i) whether a separate investment account and lease payment obligation that might exist
represent assets and liabilities of the entity.
(ii) how the entity should account for other obligations resulting from the arrangement.
(iii) how the entity should account for a fee it might receive from an investor.
207
Financial Reporting
HK(SIC) Int-27 includes a list of indicators that collectively demonstrate that, in substance,
a separate investment account and lease payment obligations do not meet the definitions
of an asset and a liability and should not be recognised by the entity.
Other obligations of an arrangement, including any guarantees provided and obligations
incurred upon early termination, should be accounted for under HKAS 37 or HKAS
39/HKFRS 9, depending on the terms. Further, it agreed that the criteria in HKAS 18.20
should be applied to the facts and circumstances of each arrangement in determining when
to recognise a fee as income that an entity might receive.
(c) A series of transactions that involve the legal form of a lease is linked, and therefore should
be accounted for as one transaction, when the overall economic effect cannot be
understood without reference to the series of transactions as a whole.
6.2 HK(IFRIC) Int-4 Determining whether an Arrangement contains

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

respect of Hong Kong Land Leases
6.3.1 The issue
This Interpretation addresses the issue of how the length of the lease term of a Hong Kong land
lease should be determined for the purpose of applying the amortisation (depreciation)
requirements under HKAS 16 and HKAS 17, as appropriate.
208
6.3.2 HK-Int 4 treatment

The lease term of a Hong Kong land lease for the purpose of applying the amortisation
(depreciation) requirements under HKAS 16 and HKAS 17, as appropriate, shall be determined by
reference to the legal form and status of the lease. Renewal of a lease is assumed only when the
lessee has a renewal option and it is reasonably certain at the inception of the lease that the lessee
will exercise the option. Options for extending the lease term that are not at the discretion of the
lessee shall not be taken into account by the lessee in determining the lease term.
Consequently, lessees shall not assume that the lease term of a Hong Kong land lease will be
extended for a further 50 years, or any other period, while the HKSAR Government retains the sole
discretion as to whether to renew. Any general intention to renew certain types of property leases
expressed by the HKSAR Government is not sufficient grounds for a lessee to include such
extensions in the determination of the lease term for amortisation (depreciation).
Similarly, for the leases in the New Territories expiring shortly before 30 June 2047, the legal limit
in these leases shall be assumed to be the maximum lease term.
For those leases which extend beyond 30 June 2047 (e.g. those with an original lease term of 999
years), lessees shall assume that any legal rights under the leases that extend the lease term to
beyond 30 June 2047 will be protected for the full duration of the lease in the absence of any
indication to the contrary.
In August 2010, the IASB and American standards board, FASB, issued an Exposure Draft of a
new standard which is intended to replace IAS 17. It is highly likely that such a new standard will in
turn be adopted by the HKICPA and so replace HKAS 17.
The Exposure Draft proposes that there is no distinction between operating and finance leases,
and instead all leases are accounted for in the same way. A "right of use" approach is suggested
for both lessees and lessors; this would result in the recognition of a liability for payments and an
asset, being the right to use the underlying asset.
The IASB intends to re-expose the topic of leases during the course of 2013 and as yet there is no
target date for the issue of a new IFRS, and hence HKFRS.
209
Financial Reporting
Topic recap
HKAS 17 Leases
Lease – contract for the hire of a specific

asset
Finance lease Operating lease
A lease that transfers substantially all of the A lease other than a finance lease
risks and rewards incidental to ownership of an
asset. Legal title may or may not pass at the
end of the lease term
Lessee accounting Lessor accounting Lessee accounting Lessor accounting
Record asset and Record amount due Recognise rental Recognise non-
corresponding liability at from lessee at net expenditure on a current asset and
lower of fair value and investment in lease. straight line basis. depreciate.
PV of minimum lease
payments. Recognise finance Record income on
income to give constant a straight line basis
Depreciate asset over periodic rate of return. over the lease
shorter of lease term term.
and UL of asset. Manufacturers / dealers
recognise the difference
Allocate finance charge between cost of the
to give constant periodic asset and fair value as
rate of return (actuarial an outright sale.
method).
Sale and finance leaseback Sale and operating leaseback
Profit or loss deferred and amortised over the lease Sale at FV Recognise profit/loss
term immediately
Sale > FV Defer excess profit
If substance is a secured loan record proceeds as a Sale < FV Recognise profit/loss
financial liability (HK(SIC)Int 27) immediately but defer any
loss where compensated
for by low future lease
payments
210
Answer 1
(a) Financial statement extracts
STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X1
$
Depreciation [(800,000 + 20,000 – 80,000)/5)] 148,000
Finance costs (Working) 74,200
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X1 (EXTRACT)

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

At the end of the lease, the lessee will have an asset at residual value of $80,000 in its
statement of financial position and a finance lease liability of $80,000 representing the
residual value guaranteed to the lessor.
(i) If the lessor is able to sell the asset for the value guaranteed by the lessee, the lessee
has no further liability and derecognises the asset and lease liability:
$ $
DEBIT Finance lease liability 80,000
CREDIT Leased asset 80,000
(ii) If the lessor is unable to sell the asset for the value guaranteed by the lessee, the
lessee has a liability to make up the difference of $80,000 – $60,000 = $20,000:
Recognise impairment loss on asset (as soon as known during the lease term):
$ $
DEBIT Profit or loss 20,000
Make guaranteed payment to lessor and derecognise the asset and lease liability:
$ $
DEBIT Finance lease liability 80,000
CREDIT Cash 20,000
211
Financial Reporting
Exam practice
Thompson Manufacturing Inc. 27 minutes

On 1 January 20X7, Thompson Manufacturing Inc. (TMI), the lessor, entered into a non-cancellable
lease agreement for equipment with Silver Rod Company (SRC), the lessee. The following
information pertains to the lease:
Annual lease payment due at the beginning of each year, beginning on
$53,069
1 January 20X7
Option to purchase at the end of lease term $10,000
Lease term 5 years
Economic useful life of leased equipment 8 years
Lessor's manufacturing cost $200,000
Fair value of leased equipment at 1 January 20X7 $227,500
Estimated unguaranteed residual value of leased equipment at the end of
$30,000
lease term
Lessor's implicit rate 12.93%
Lessee's incremental borrowing rate 10%
Required
(a) Discuss how the purchase option at the end of the lease term offered by TMI to SRC will
affect the classification of this lease by SRC. (3 marks)
(b) Prepare an amortisation schedule that would be suitable for TMI for the lease term.
(5 marks)
(c) Prepare all the journal entries that TMI should make for each of the years ended
31 December 20X7 and 20X8. (7 marks)
(Total = 15 marks)
HKICPA September 2008 (amended)
212
chapter 10
Inventories
Topic list
1 Accounting for inventories

1.1 Scope
1.2 Definitions
1.3 Measurement of inventories
1.4 Cost of inventories
1.5 Techniques for the measurement of cost
1.6 Cost formulae
1.7 Net realisable value (NRV)
1.8 Recognition as an expense
Learning focus
Inventory and short-term work-in-progress valuation has a direct impact on a company's gross
profit and it is usually a material item in any company's accounts. This is therefore an
important subject area as far as the statement of profit or loss is concerned as there are
different accounting treatments for inventories.
213
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.06 Inventories 3
3.06.01 Scope and definition of HKAS 2 Inventories
3.06.02 Calculate the cost of inventories in accordance with HKAS 2
3.06.03 Use accepted methods of assigning costs including the allocation of
overheads to inventories
3.06.04 Explain the potential impact of net realisable value falling below
cost and make the required adjustments
3.06.05 Calculate and analyse variances in a standard costing system and
advise on the appropriate accounting treatment to be adopted in
respect of inventories
3.06.06 Prepare a relevant accounting policy note and other required
disclosures in respect of inventories
214
10: Inventories | Part C Accounting for business transactions
1 Accounting for inventories

Topic highlights
Inventory is measured at the lower of cost and net realisable value.
The inventory balance is significant to many companies both as an asset and due to its impact on
profits. The measurement of inventory, however, remains a highly subjective area and a number of
different methods may be used in practice.
HKAS 2 provides guidance on the measurement of inventory and its recognition as an expense.
HKAS 2.2,3 1.1 Scope

HKAS 2 applies to all inventories other than:
 work in progress under construction contracts (covered by HKAS 11 Construction
Contracts)
 financial instruments (covered by HKFRS 9 Financial Instruments)
 biological assets (covered by HKAS 41)
The standard does not apply to the measurement of inventories held by:
 producers of agricultural and forest products
 commodity-broker traders
HKAS 2.6,8 1.2 Definitions

The standard provides the following definitions:
Key terms
Inventories are assets:
 held for sale in the ordinary course of business
 in the process of production for such sale
 in the form of materials or supplies to be consumed in the production process or in the
rendering of services
Net realisable value is the estimated selling price in the ordinary course of business less the
estimated costs of completion and the estimated costs necessary to make the sale.
orderly transaction between market participants at the measurement date. (HKAS 2)
The definition of inventories in effect refers to:

 finished goods, being those held for sale
 work in progress (WIP), being those in the process of production, and
 raw materials, being those supplies to be consumed in the production process.
HKAS 2.9 1.3 Measurement of inventories

The standard states that "Inventories shall be measured at the lower of cost and net realisable
value."
These terms are explained in more detail in sections 1.4 and 1.7 of the chapter.
215
Financial Reporting
HKAS 2.10 1.4 Cost of inventories

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

 costs of purchase
 costs of conversion
 other costs incurred
Each of these types of cost is covered in turn below.
HKAS 2.11 1.4.1 Costs of purchase
HKAS 2 states that the costs of purchase may include all of:
 purchase price
 import duties and other irrecoverable taxes
 transport, handling and any other cost directly attributable to the acquisition of finished
goods, services and materials
Costs of purchase should be net of trade discounts, rebates and other similar amounts when
measuring inventory.
HKAS 2.12- 1.4.2 Costs of conversion
14
Costs of conversion of inventories includes:
(a) costs directly related to the units of production, e.g. direct materials, direct labour.
(b) a systematic allocation of fixed and variable production overheads that are incurred in
converting materials into finished goods.
Key terms
Fixed production overheads are defined by the standard as those indirect costs of production
that remain relatively constant regardless of the volume of production such as depreciation and
maintenance of factory buildings and equipment and the cost of factory management and
administration.
Variable production overheads are defined as those indirect costs of production that vary
directly, or nearly directly, with the volume of production, such as indirect materials and labour.
216
Key terms (cont'd)

Fixed production overheads must be allocated to items of inventory on the basis of the normal
capacity of the production facilities. Normal capacity is the expected achievable production based
on the average over several periods/seasons, under normal circumstances, and taking into account
the capacity lost through planned maintenance. The standard makes the following additional
points:
 If it approximates to the normal level of activity then the standard states that the actual level
of production can be used.
 Low production or idle plant will not result in a higher fixed overhead allocation to each
unit.
 Unallocated overheads must be recognised as an expense in the period in which they were
incurred.
 In periods of abnormally high production, the fixed production overhead allocated to each
unit will be decreased, so that inventories are not measured at more than cost.
 Variable production overheads are allocated to each unit on the basis of the actual use of
production facilities.
When a production process results in the simultaneous production of more than one product, and
the costs of conversion are not separately identifiable, they should be allocated between products
on a rational and consistent basis. An example of an appropriate basis given in the standard is the
sales value of each product when complete.
HKAS 2.15- 1.4.3 Other costs
17
Other costs are included in the cost of inventories if they are incurred in bringing the inventories to
their present location and condition. Examples of such costs are non-production overheads and
the costs of designing products for specific customers. In limited circumstances, as identified by
HKAS 23, borrowing costs are also included in the cost of inventories.
The standard lists types of cost which would not be included in cost of inventories but should be
recognised as an expense in the period they are incurred:
(a) Abnormal amounts of wasted materials, labour or other production costs.
(b) Storage costs (except costs which are necessary in the production process before a further
production stage).
(c) Administrative overheads not incurred to bring inventories to their present location and
conditions.
(d) Selling costs.
Example: Cost of inventory

Highdef Co. manufactures component parts used in the production of televisions. The following
details are relevant to a production run in August 20X4:
Cost of raw materials per unit $85 after 15% trade discount
Import duty (raw materials) 5%
Labour costs per unit $25
Production overheads $400,000
Expected (normal) output 50,000 units
Actual output 40,000 units
217
Financial Reporting
The cost of each unit is therefore calculated as:

$
Direct materials 85.00
Import duty (5%  $85) 4.25
Direct labour 25.00
Overheads allocation ($400,000/50,000) 8.00
Cost 122.25
HKAS 2.19 1.4.4 Cost of inventory of a service provider

Service providers sometimes have inventory, for example the work in progress of a lawyer. This
work in progress should be measured at cost i.e. the costs of labour and attributable overheads,
excluding any profit margin.
Labour and costs relating to sales and general administrative personnel and non-attributable
overheads are not included in the cost of work in progress. They are expensed as incurred.
HKAS
2.21,22
1.5 Techniques for the measurement of cost
HKAS 2 allows that techniques for the measurement of cost may be used for convenience where
these approximate to cost. The two methods mentioned within the standard are as follows:
(a) Standard costs, which take into account normal levels of raw materials used, labour time
and so on. They are reviewed and revised on a regular basis.
(b) The retail method, which is often used in the retail industry where there are large numbers
of items with a rapid turnover and similar margins. Here, the only practical method of
inventory valuation may be to take the total selling price of inventories and deduct an overall
average profit margin, thus reducing the value to an approximation of cost. The percentage
must take into consideration reduced price lines. Sometimes different percentages are
applied to different retail departments.
Example: Measurement of cost

Assume that a manufacturing company has a budgeted standard total production cost of $1 per
unit for the year, based on a forecasted production of 1,000,000 units. There is no opening
inventory and the year end accounts show actual production of 1,000,000 units, closing inventory
of 200,000 units and an unfavourable cost variance of $100,000. The analysis shows that $80,000
of the variance comes from a charge in a purchase cost of goods resulting from a foreign currency
alignment early in the year and the remaining $20,000 is from a labour strike mid-year.
The $20,000 unfavourable variance from the labour strike is a period cost wholly recognised as an
expense since it was not incurred under normal operating conditions.
Unless the exchange movement happened under unusual circumstances, the price variance
resulting from exchange difference is regarded as arising under normal operating conditions. To
better reflect the cost of goods sold and the cost of closing inventory, the price variance will be
allocated between inventories and cost of goods sold based on the closing inventories of $200,000
as a percentage of the total number of units produced. The closing inventories at standard cost of
$200,000 are 20% of the actual production, so inventories will be allocated 20% of the $80,000
price variance i.e. $16,000. Cost of goods sold will be charged with the balance of $64,000. Closing
inventories will therefore amount to $216,000.
218
HKAS
2.23,25-27
1.6 Cost formulae
Topic highlights
Where inventory is not interchangeable, cost should be specifically identified. Where inventories
consist of interchangeable items, cost is assigned using the First in, First out (FIFO) or weighted
average formula.
Where items of inventory are not normally interchangeable or goods or services are produced and
segregated for specific projects, the cost of inventories should be specifically identified.
Where inventories consist of a number of interchangeable items, cost is assigned by using the
First In, First Out (FIFO) or weighted average cost formulae. Last In, First Out (LIFO) is not
permitted.
Under the weighted average cost method, a recalculation can be made after each purchase, or
alternatively only at the period end.
HKAS 2 requires that an entity should use the same cost formula for all inventories having
similar nature and use to the entity. For inventories with different nature or use (for example,
certain commodities used in one business segment and the same type of commodities used in
another business segment), different cost formulae may be justified. A difference in geographical
location of inventories (and in the respective tax rules), by itself, is not sufficient to justify the use of
different cost formulae.
Example: Inventory valuation (1)

Arneson Co. trades in widgets and has bought and sold the following inventory during the month of
September 20X1:
Date Volume Cost
1 September opening stock 100 units $2.00 each
3 September purchase 100 units $2.30 each
5 September sale 75 units
What is the value of inventory at 30 September using
(a) FIFO
(b) Weighted average cost (period end)
(c) Weighted average cost (continuous)?
219
Financial Reporting
Solution
FIFO
Sales
Opening stock 100  $2.00 5 September 75 units
18 September 25 units
3.9 Purchase 100  $2.30 18 September 55 units
29 September 45 units
Closing stock 75 units
Sales are matched to the earliest purchases such that closing stock is made up of 75 units
purchased on 25 September. Closing stock is therefore measured at $180 (75 units  $2.40).
Weighted average (period end)
The weighted average cost of stocks during September is:
100 units  $2.00 200.00
100 units  $2.30 230.00
50 units  $2.35 117.50
80 units  $2.40 192.00
330 units 739.50
therefore weighted average cost per unit $2.24
Closing stock is therefore measured at $168 (75 units  $2.24)
Weighted average (continuous)
Date Purchases Sales Balance Weighted average price
1.9 100  $2 100 $2
3.9 100  $2.30 200 100  $2  100  $2.30 
 $2.15
100  100
5.9 75 125 $2.15
10.9 50  $2.35 175  50  $2.35   125  $2.15 
 $2.21
50  125
18.9 80 95 $2.21
25.9 80  $2.40 175  80  $2.40    95  $2.21
 $2.30
80  95
29.9 100 75 $2.30
Therefore, closing stock is measured at $172.50 (75 units × $2.30)
HKAS 2.28- 1.7 Net realisable value (NRV)

33
Topic highlights
NRV is the estimated selling price of an item of inventory less estimated costs to complete and sell
it.
Prudence requires that assets are not overstated. In the case of inventories, this means that they
should not be measured at an amount greater than the price that is expected to be realised from
their sale.
220
In some cases the cost of inventory may be greater than the amount for which it can be sold, for
example where:
 goods are damaged or obsolete
 the costs to completion have increased
 the selling price has fallen
 the goods are to be sold at a loss as part of a marketing strategy
 production errors have led to increased costs.
In these cases, inventory is carried at the NRV which is less than cost.
Inventory is normally written down on an item by item basis, but sometimes it may be appropriate
to group similar or related items together. This grouping together is acceptable for, say, items in
the same product line, but it is not acceptable to write down inventories based on a whole
classification (e.g. finished goods) or a whole business.
The assessment of NRV should be based on the most reliable evidence available and should take
place at the same time as estimates are made of selling price. Fluctuations of price or cost should
be taken into account if they relate directly to events after the reporting period, which confirm
conditions existing at the end of the period.
The reasons why inventory is held should also be taken into account. For example, where
inventory is held to satisfy a firm contract, its NRV will be the contract price. Any additional
inventory of the same type held at the period end will, in contrast, be assessed according to
general sales prices when NRV is estimated.
At each period end, NRV must be reassessed and compared with cost. Where circumstances have
changed since the end of the previous period and there is a clear increase in NRV, then the
previous write down must be reversed to the extent that the inventory is then valued at the lower of
cost and the new NRV. This situation may arise when selling prices have fallen in the past and then
risen again.
On occasion a write down to NRV may be of such size, incidence or nature that it must be
disclosed separately.
HKAS 2.34 1.8 Recognition as an expense

An expense related to inventory is recognised in profit or loss in the following circumstances:
(a) When inventories are sold, the carrying amount of those inventories is recognised as an
expense.
(b) Any write down of inventories to NRV and all losses of inventories are recognised as an
expense in the period the write down or loss occurs.
(c) Any reversal of a previous write down of inventories, arising from an increase in NRV, is
recognised as a reduction in the amount of inventories recognised as an expense in the
period in which the reversal occurs.
Example: Inventory valuation (2)

Given Co. has the following categories of inventory:
Cost Selling price Costs to sell
$m $m $m
Product A 4 6 0.5
Product B 10 11 1.5
Product C 8 12 2
Product D 14 16 3
Required
Determine the amount at which inventory should be valued.
221
Financial Reporting
Inventory must be valued line by line rather than as a whole, taking lower of cost and NRV in each
case:
$m
Product A (Cost) 4.0
Product B (NRV) 9.5
Product C (Cost) 8.0
Product D (NRV) 13.0
34.5
Ramsbottom Co. is a manufacturer of components used in the motor industry. It makes two
products, XX1 and ZZ2.
Certain parts of the production process give rise to indirect costs specifically identifiable with only
one of these products, although other costs are not separately identifiable.
Budgeted cost information for March 20X1 is as follows:
XX1 ZZ2 Total
Budgeted output 1,000 units 1,200 units
$ $ $
Direct cost 365,000 380,000 745,000
Indirect production overheads
Identifiable 65,000 55,000 120,000
Other 80,000
During the month, costs were incurred in line with the budget, but due to a failure of calibration to a
vital part of the process, only 1,050 units of ZZ2 could be taken into inventory. The remainder
produced had to be scrapped, for zero proceeds.
Ramsbottom allocates indirect costs which are not specifically identifiable to an individual product
by reference to relative selling prices. This results in 55% being allocated to XX1 and 45% to ZZ2.
Required
Calculate the cost attributable to each product.
HKAS 2.36-
39
HKAS 2 requires the financial statements to disclose the following:
(a) The accounting policies adopted in measuring inventories, including the cost formula used
(b) The total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity
(c) The carrying amount of inventories carried at fair value less costs to sell
(d) The amount of inventories recognised as an expense during the period
(e) The amount of any write down of inventories to net realisable value recognised as expense
and in the period
(f) The amount of any reversal of any write down of inventories to net realisable value
recognised as reduction in “the amount of inventories recognised as an expense in the
period”
(g) The circumstance or events that led to the reversal of a write down of inventories
(h) The carrying amount of inventories pledged as security for liabilities.
222
Information about the carrying amounts held in different classifications of inventories and the extent
of the changes in these assets is useful to financial statement users. Common classifications of
inventories are merchandise, production supplies, materials, work in progress and finished goods.
The inventories of a service provider may be described as work in progress.
Some entities adopt a format for profit or loss that results in amounts being disclosed other than the
cost of inventories recognised as an expense during the period. Under this format, an entity
presents an analysis of expenses using a classification based on the nature of expenses. In this
case, the entity discloses the costs recognised as an expense for raw materials and consumables,
labour costs and other costs together with the amount of the net change in inventories for the
period.
223
Financial Reporting
Topic recap
HKAS 2 Inventories
Finished goods
Work in progress
Raw materials
Measure at the lower of:
Cost Net realisable value
Includes: Estimated selling price in the ordinary course

Cost of purchase of business less estimated costs of
Direct costs of conversion completion and estimated costs to make
Allocated overheads during the sale.
conversion
Costs of bringing the inventory to its
present location and condition
Where inventory items are not interchangeable

identify specific cost.
Where inventory items are interchangeable use

cost formulae to assign cost to an item:
FIFO Weighted average

Inventory is assumed to move A weighted average cost to be
"first in, first out" therefore cost allocated to each item of inventory
allocated to inventory items is is calculated either on a periodic or
the most recent purchase continuous basis.
prices.
Disclosures:
Accounting policies and cost formulae used
Carrying amount of inventories classified by type
Carrying amount of inventories measured at fair value less costs to sell
Inventories recognised as an expense in the period
Inventory write downs / reversal of write downs recognised in the period and circumstances that led to the
write down / reversal.
Carrying amount of inventories pledged as security
224
Answer 1
The total cost attributable to XX1 is calculated as:
$365,000 + $65,000 + (55%  $80,000) = $474,000
The cost per unit therefore being $474,000 / 1,000 = $474 each.
The total cost $474,000 attributable to XX1 can all be allocated to the inventories of XX1.
The total cost attributable to ZZ2 is:
$380,000 + $55,000 + (45%  $80,000) = $471,000
The cost per unit therefore being $471,000 / 1,200 = $392.50 each.
The allocation of the cost for ZZ2 is therefore:
$392.50  1,050 = $412,125 as inventories
$392.50  150 = $58,875 as an expense
The indirect costs not specifically identifiable with either product which are allocated to the
scrapped ZZ2 cannot be recovered into the cost of XX1.
225
Financial Reporting
Exam practice
Lotto 9 minutes
After its end of year physical inventory count and valuation, the accounts staff of Lotto have
reached a valuation of $153,699 at cost for total inventories held at the year end.
However, on checking the figures, the chief bookkeeper has come across the following additional
facts.
(a) The count includes damaged goods which originally cost $2,885. These could be repaired at
a cost of $921 and sold for $3,600.
(b) The count excludes 300 units of item 730052 which were sold to a customer SC on a sale or
return basis, at a price of $8 each. The original cost of the units was $5 each. SC has not yet
indicated to Lotto whether these goods have been accepted, or whether they will eventually
be returned.
(c) The count includes 648 units of item 702422. These cost $7.30 each originally but because
of dumping on the market by overseas suppliers, a price war has flared up and the unit cost
price of the item has fallen to $6.50. The price reduction is expected to be temporary, lasting
less than a year or so, although some observers of the market predict that the change might
be permanent. Lotto has already decided that if the price reduction lasts longer than six
months, it will reduce its resale price of the item from $10.90 to about $10.
Required
Calculate the closing inventory figure for inclusion in the annual accounts of Lotto, making
whatever adjustments you consider necessary in view of items (a) to (c). Explain your treatment of
each item. (5 marks)
226
chapter 11
Provisions, contingent
liabilities and contingent
assets
Topic list
1 HKAS 37 Provisions, Contingent Liabilities and Contingent Assets

1.1 Objective
1.2 Definitions
2 Provisions
2.1 Recognising a provision
2.2 Measuring a provision
2.3 Reimbursements
2.4 Changes in provisions
2.5 Use of provisions
2.6 Common scenarios
2.7 Disclosure of provisions
3 Contingent liabilities and contingent assets
3.1 Contingent liabilities
3.2 Contingent assets
3.3 Summary
4 Interpretations relating to provision accounting
4.1 HK(IFRIC) Int-1 Changes in Existing Decommissioning, Restoration and Similar Liabilities
4.2 HK(IFRIC) Int-5 Rights to Interests from Decommissioning, Restoration and Environmental
Rehabilitation Funds
Learning focus
Accounting for uncertainty and contingencies requires some judgment and supporting
evidence in applying the accounting standards. You must learn the recognition criteria for
provisions and be able to apply them. You should also be able to advise the directors on the
implications for the financial statements of the changes proposed.
227
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.16 Provisions, contingent liabilities and contingent assets 3
3.16.01 Define provisions, contingent liabilities and contingent assets within
the scope of HKAS 37
3.16.02 Distinguish provisions from other types of liabilities
3.16.03 Explain the criteria for recognition of provisions and apply them to
specific circumstances
3.16.04 Apply the appropriate accounting treatment for contingent assets
and liabilities
3.16.05 Disclose the relevant information relating to contingent liabilities in
the financial statements
3.16.06 Account for decommissioning, restoration and similar liabilities and
their changes
3.16.07 Disclose the relevant information relating to contingent assets in the
228
11: Provisions, contingent liabilities and contingent assets | Part C Accounting for business transactions
1 HKAS 37 Provisions, Contingent Liabilities and

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

The following definitions are provided within the standard:
Key terms
A provision is a liability of uncertain timing or amount.
A liability is a present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
A contingent liability is:
(a) a possible obligation that arises from past events and whose existence will be confirmed only
by the occurrence or non-occurrence of one or more uncertain future events not wholly
within the control of the entity, or
(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.
A contingent asset is a possible asset that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the entity.
(HKAS 37.10)
We shall meet more definitions as we consider the accounting treatment of provisions and
contingencies.
229
Financial Reporting
2 Provisions
Provisions are differentiated from other liabilities such as trade payables and accruals by the
HKICPA. The main difference is that there is uncertainty about the timing or amount of the future
expenditure for a provision. For certain accruals, uncertainty, though it exists, is generally much
less than for provisions.
HKAS 37 includes the criteria for recognising a provision as a liability in the statement of financial
position and also provides guidance for measuring such a provision. In addition, and due to the
subjective nature of the topic matter, it gives examples of common situations in which a provision
can be made.
HKAS 37.14 2.1 Recognising a provision

Topic highlights
Under HKAS 37, a provision should be recognised:
 When an entity has a present obligation, legal or constructive
 It is probable that a transfer of economic benefits will be required to settle it
 A reliable estimate can be made of its amount
HKAS 37 states that a provision should be recognised as a liability in the financial statements when:
 an entity has a present obligation (legal or constructive) as a result of a past event;
 it is probable that an outflow of resources embodying economic benefits will be required
to settle the obligation; and
 a reliable estimate can be made of the obligation.
Some of these terms require further explanation, and this is given in the next two sections of the
chapter.
HKAS 37.17- 2.1.1 Obligation
22
A legal obligation is a fairly easy idea to understand: it is a duty to act in a certain way deriving from
a contract, legislation, or some other operation of the law.
You should note that an event which does not currently give rise to a legal obligation may do so at
a later date due to changes in the law. In this case the obligation arises when new legislation is
virtually certain to be enacted as drafted; in many cases this is impossible to ascertain before
actual enactment.
You may not know what a constructive obligation is.
Key term
HKAS 37 defines a constructive obligation as:
"An obligation that derives from an entity's actions where:
 By an established pattern of past practice, published policies or a sufficiently specific current
statement, the entity has indicated to other parties that it will accept certain responsibilities,
and
 As a result, the entity has created a valid expectation on the part of those other parties that it
will discharge those responsibilities."
The following question shows how this definition is applied and will help your understanding of a
constructive obligation.
230
(a) Black Gold Oil Co. drills for oil in locations worldwide. Mindful of the public perception of
such oil companies after recent disasters involving oil spills, Black Gold Oil Co. has recently
used press and television advertisements to promote its green credentials, and in particular,
has pledged to clean up any contamination that it causes.
In the year ended 31 December 2010, Black Gold Oil Co. causes extensive contamination in
a country in which there is no environmental legislation.
Does a constructive obligation exist at 31 December 2010?
(b) A well-known retailer is under legal obligation to refund money to customers who return
unwanted goods within a 28-day period. The retailer has announced a policy of extending
this return period to 60 days, and accordingly has printed this promise on its carrier bags.
Does the retailer have a present obligation as a result of a past event?
In some instances, for example when a court case is underway, it is not clear whether there is a
present obligation. In these cases, all available evidence should be considered, and if it is more
likely than not that a present obligation exists at the reporting date, then a present obligation as a
result of a past event is deemed to exist.
HKAS 37.23- 2.1.2 Probable transfer of economic benefits

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

In the case of a warranty obligation of a company, though the probability of an outflow of economic
resources (transfer of economic benefits) may be extremely small in respect of one specific item,
the probability of some transfer of economic benefits is quite likely to be much higher when the
population is considered as a whole. A provision should be made for the expected amount when
there is a greater than 50% probability of some transfer of economic benefits.
HKAS 37.36-
38, 41
2.2 Measuring a provision
Topic highlights
The amount recognised as a provision should be the best estimate of the expenditure required to
settle the present obligation at the year end. This may be calculated using expected values when
the provision involves a large population of items.
The third criterion which must be met in order to recognise a provision is that a reliable estimate
can be made of the obligation.
HKAS 37 provides detailed guidance on how this estimate should be made. The overriding
requirement is that the amount recognised as a provision shall be the best estimate of the
expenditure required to settle the present obligation at the end of the reporting period.
231
Financial Reporting
The standard goes on to say that this is the amount that an entity would pay to settle the obligation
or transfer it to a third party at the reporting date, even though a settlement or transfer at this time
will often be impossible or prohibitively expensive.
The estimates will be determined by the judgment of the entity's management supplemented by
the experience of similar transactions, and in some cases the reports from independent experts.
A provision should be measured before any related tax effect.
HKAS 37.40 2.2.1 Most likely outcome
Where a single obligation is being measured, the most likely outcome may be the best estimate of
the liability. HKAS 37 does, however, stipulate that all possible outcomes are considered and
where these are mostly higher (or mostly lower) than the expected outcome, the best estimate will
be higher (or lower).
HKAS 37.39 2.2.2 Expected values

Where the provision being measured involves a large population of items, the obligation is
estimated by weighting all possible outcomes by their associated probabilities, i.e. expected value.
Alice Co. sells goods with a warranty under which customers are covered for the cost of repairs of
any manufacturing defect that becomes apparent within the first six months of purchase. The
company's past experience and future expectations indicate the following pattern of likely repairs.
% of goods sold Defects Cost of repairs if all goods
suffered from the defect
$m
75 None –
20 Minor 1.0
5 Major 4.0
What is the expected cost of repairs?
HKAS 37.42- 2.2.3 Other considerations when measuring a provision

52
HKAS 37 requires that the following are considered when measuring a provision:
Risks and uncertainties
Risks and uncertainties surrounding an event should be taken into consideration when making the
best estimate of a provision required. Uncertainty does not, however, justify the creation of
excessive provisions or an overstatement of liabilities.
Discounting
Where the effect of the time value of money is material, the amount of a provision should be the
present value of the expenditure required to settle the obligation.
An appropriate discount rate should be used, and the standard requires this to be a pre-tax rate
that reflects current market assessments of the time value of money. The discount rate(s) should
not reflect risks for which future cash flow estimates have been adjusted.
Future events
Future events which may affect the amount required to settle the entity's obligation should be taken
into account where there is sufficient evidence that they will occur.
These events may include future changes in technology or new legislation. The standard does,
however state that in the case of new legislation, in most cases sufficient objective evidence will
not exist until the legislation is actually enacted.
232
Expected disposal of assets

Gains from the expected disposal of assets should not be taken into account in measuring a
provision, even if the expected disposal is closely linked to the event giving rise to the provision.
HKAS 37.53-
57
2.3 Reimbursements
Some or all of the expenditure needed to settle a provision may be expected to be recovered from
a third party through insurance contracts, indemnity clauses or supplier’s warranties. These
amounts may be reimbursed to the entity or paid directly to the party to who the amount is due.
If so, the reimbursement shall be recognised when, and only when, it is virtually certain that
reimbursement will be received if the entity settles the obligation.
Generally, however, the entity will remain liable for the amount due, and would be required to pay
all of this if the third party failed to pay. This is reflected in the accounting treatment:
 A provision is recognised for the full amount of the liability.
 The reimbursement should be treated as a separate asset, and the amount recognised
should not be greater than the provision itself.
 The provision and the amount recognised for reimbursement may be netted off in the
statement of profit or loss.
In some cases the entity will not be liable for the costs if the third party fails to pay. In this case
these costs are not included in the provision.
HKAS 37.59-
60
2.4 Changes in provisions
Provisions should be reviewed at each reporting date and adjusted to reflect the current
best estimate. If it is no longer probable that a transfer of economic benefits will be required to
settle the obligation, the provision should be reversed.
Where the effect of the time value of money is significant, so that a provision has been measured
at present value, the discount is unwound each year with a resulting increase to the provision. This
increase is recognised as a finance cost in profit or loss.
HKAS 37.61-
62
2.5 Use of provisions
A provision should be used only to set off expenditure for which the provision was originally recognised.
It is not permitted to set off expenditure against a provision formerly organised for another purpose
since this would conceal the impact of two different events.
HKAS 37.63-
65
2.6 Common scenarios
2.6.1 Future operating losses
No provisions should be recognised for future operating losses which do not meet the definition of
a liability and the general recognition criteria stated in the standard.
Expected future operating losses may, however, be indication of the impairment of assets related
to that operation.
HKAS 37.66- 2.6.2 Onerous contracts

68
Key term
An onerous contract is a contract in which the unavoidable costs of meeting the obligations under
the contract exceed the economic benefits expected to be received under it. The unavoidable costs
under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost
of fulfilling it and any compensation or penalties arising from failure to fulfil it. (HKAS 37.10)
233
Financial Reporting
If an entity has a contract that is onerous, the present obligation under the contract should be
recognised and measured as a provision.
A common example would be leasehold property which is vacated before the lease term ends. For
the remaining years of the lease, the cost of the property (future lease payments) exceeds the
benefits derived from the property (likely to amount to nil if it is to be left vacant). In this case,
provision should be made for the future unavoidable lease payments as at the date on which the
property is vacated. The provision is released as these payments are made in future years.
The provision is disclosed as current/non-current in accordance with HKAS 1. Practically this is
likely to mean that the total provision is split between the amount payable within one year and the
amount payable thereafter.
There is no obligation where cancellation of a contract does not result in the need to pay
compensation to another party.
HKAS 37.70- 2.6.3 Provisions for restructuring
83
One of the main purposes of HKAS 37 was to target abuses of provisions for restructuring.
Accordingly, HKAS 37 lays down strict criteria to determine when such a provision can be made.
Key term
HKAS 37 defines a restructuring as:
A programme that is planned and controlled by management and materially changes either:
 the scope of a business undertaken by an entity, or
 the manner in which that business is conducted
(HKAS 37.10)
The HKAS gives the following examples of events that may fall under the definition of
restructuring.
 The sale or termination of a line of business
 The closure of business locations in a country or region or the relocation of business
activities from one country or region to another
 Changes in management structure, for example, the elimination of a layer of management
 Fundamental reorganisations that have a material effect on the nature and focus of the
entity's operations
The question is whether or not an entity has an obligation at the year end. In respect of
restructuring, the standard states that there is a constructive obligation if:
 the entity has a detailed formal plan for the restructuring, and
 the entity has raised a valid expectation in those affected that it will carry out the
restructuring by starting to implement that plan or announcing its main features to those
affected by it.
A mere management decision is not normally sufficient. Management decisions may
sometimes trigger off recognition, but only if earlier events such as negotiations with employee
representatives and other interested parties have been concluded subject only to management
approval.
When the sale of an operation is involved in the restructuring, HKAS 37 states that no obligation is
to be recognised until the entity has entered into a binding sale agreement. Until then, the entity
will be able to alter its decision and withdraw from the sale even if its intentions have been
announced publicly.
234
The HKAS states that a restructuring provision should include only the direct expenditures arising
from the restructuring that are both:
 necessarily entailed by the restructuring, and
 not associated with the ongoing activities of the entity.
The following costs should specifically not be included within a restructuring provision:
 Retraining or relocating continuing staff
 Marketing
 Investment in new systems and distribution networks
 Future operating losses
 Losses or gains on the expected disposal of assets
HKAS 37 2.6.4 Other scenarios

Appendix C
(a) Warranties. A provision is appropriate where on past experience it is probable, i.e. more
likely than not, that some claims will emerge. The provision must be estimated, however, on
the basis of the class as a whole and not on individual claims. There is a clear legal
obligation in this case.
(b) Major repairs. In the past it has been quite popular for companies to provide for expenditure
on a major overhaul to be accrued gradually over the intervening years between overhauls.
Under HKAS 37 this is not permissible as HKAS 37 would argue that this is a mere intention
to carry out repairs, not an obligation. The entity can always sell the asset in the meantime.
The only solution is to treat major assets such as aircraft, ships, furnaces etc. as a series of
smaller assets where each part is depreciated over shorter lives. Therefore, any major
overhaul may be argued to be replacement and therefore classified as capital rather than
revenue expenditure.
(c) Self insurance. A number of companies have created a provision for self insurance based
on the expected cost of making good fire damage and so on instead of paying premiums to
an insurance company. Under HKAS 37 this provision is not justifiable as the entity has no
obligation until a fire or accident occurs. No obligation exists until that time.
(d) Environmental contamination. If the company has an environment policy such that other
parties would expect the company to clean up any contamination or if the company has broken
current environmental legislation then a provision for environmental damage must be made.
(e) Decommissioning or abandonment costs. When an oil company initially purchases an
oilfield it is put under a legal obligation to decommission the site at the end of its life. Prior to
HKAS 37 most oil companies built up the provision gradually over the life of the field so that
no one year would be unduly burdened with the cost.
HKAS 37, however, insists that a legal obligation exists on the initial expenditure on the field
and therefore a liability exists immediately. This would appear to result in a large charge to
profit or loss in the first year of operation of the field. However, the HKAS takes the view that
the cost of purchasing the field in the first place is not only the cost of the field itself but also
the costs of putting it right again. Therefore, all the costs of abandonment may be
capitalised.
HKAS
37.84,85,92
2.7 Disclosure of provisions
Disclosures for provisions fall into two parts.
 Disclosure of details of the change in carrying value of a provision from the beginning to
the end of the year, including:
– carrying amount at the beginning and end of the period
– additional provisions made in the period
– amounts incurred and charged against the provision in the period
– unused amounts reversed in the period
235
Financial Reporting
– the increase in the period in the discounted amount arising from the passage of time
and effect of any change in the discount rate
Note that comparative information is not required.
 Disclosure of the background to the making of the provision and the uncertainties affecting
its outcome, including for each class of provision:
– a brief description of the nature of the obligation and expected timing of any resulting
outflows of economic benefits
– an indication of the uncertainties about the amount or timing of outflows
– the amount of any expected reimbursement stating the amount of any asset that has
been recognised for the expected reimbursement.
In very rare circumstances, such disclosure may prejudice seriously the position of the entity in a
dispute with other parties on the subject matter of the provision. In this case disclosure of the
above information is not required, however the following should be disclosed:
 the general nature of the dispute
 the fact that, and reason why, the information has not been disclosed.
3 Contingent liabilities and contingent assets

Topic highlights
An entity should not recognise a contingent liability, but they should be disclosed where there is a
possible outflow of economic resources.
An entity should not recognise a contingent asset, but they should be disclosed where there is a
probable inflow of economic resources.
Now you understand provisions it will be easier to understand contingent assets and liabilities.
HKAS 37.10 3.1 Contingent liabilities

We saw the definition of a contingent liability earlier in the chapter. To recap, a contingent liability
is:
(a) A possible obligation that arises from past events and whose existence will be confirmed
only by the occurrence or non-occurrence of one or more uncertain future events not wholly
within the entity's control
(b) A present obligation that arises from past events but is not recognised because:
– it is not probable that a transfer of economic benefits will be required to settle the
obligation
– the amount of the obligation cannot be measured with sufficient reliability
In other words, a contingent liability is an obligation that does not meet the HKAS 37 recognition
criteria for a provision because there is no present obligation, or the transfer of resources is only
possible or the amount cannot be measured reliably.
HKAS 37.27- 3.1.1 Accounting treatment
28
Contingent liabilities should not be recognised in financial statements but they should be
disclosed, unless the probability of an outflow of economic resources is remote.
HKAS 37.86- 3.1.2 Disclosure: contingent liabilities
88,92
A brief description must be provided of all material contingent liabilities unless they are likely to
be remote.
236
In addition, the following should be provided for each class of contingent liability, where practicable:
 An estimate of their financial effect
 Details of any uncertainties relating to the amount or timing of the outflow
 The possibility of any reimbursement
When determining classes of contingent liability, an entity should consider whether the nature of
items is sufficiently similar for aggregated amounts to fulfil the disclosure requirements.
Where a provision and contingent liability result from the same circumstances, an entity should
indicate the link between the provision and contingent liability.
dispute with other parties on the subject matter of the contingent liability. In this case disclosure of
the above information is not required, however the following should be disclosed:
 The general nature of the dispute
 The fact that, and reason why, the information has not been disclosed.
3.2 Contingent assets

Earlier in the chapter we defined a contingent asset as a possible asset that arises from past
events and whose existence will be confirmed by the occurrence of one or more uncertain future
events not wholly within the entity's control.
37.31,33,34
A contingent asset must not be recognised. Only when the realisation of the related economic
benefits is virtually certain should recognition take place. At that point, the asset is no longer a
contingent asset.
Where a contingent asset offers a probable inflow of resources, it should be disclosed.
HKAS 3.2.2 Disclosure: contingent assets
37.89,92
Contingent assets must only be disclosed in the notes if they are probable.
In that case the following should be provided:
 a brief description of the nature of the contingent asset
 an estimate of its likely financial effect, where practicable, or a statement to the effect that it
is not practicable.
dispute with other parties on the subject matter of the contingent asset. In this case disclosure of
the above information is not required, however the following should be disclosed:
 the general nature of the dispute
 the fact that, and reason why, the information has not been disclosed.
3.3 Summary
 The objective of HKAS 37 is to ensure that appropriate recognition criteria and measurement
bases are applied to provisions and contingencies and that sufficient information is disclosed.
 The HKAS seeks to ensure that provisions are only recognised when a measurable
obligation exists. It includes detailed rules that can be used to ascertain when an obligation
exists and how to measure the obligation.
 The standard attempts to eliminate the "profit smoothing" which has gone on before it was
issued.
237
Financial Reporting
Explain the accounting treatment required in the following scenarios at 31 December 20X0:
(a) Rango Co., a healthcare provider, has been informed that due to upcoming legislation, it is
required to fit carbon monoxide detectors in all of its properties at a cost of HK$40,000. Any
failure to do so by 30 September 20X1 will result in penalties of $5,000. Rango has not
undertaken the work by 31 December 20X0.
(b) Greenfingers Co. specialises in the sale of gardening equipment. As part of a strategy to
streamline operations, the company has decided to divest its plant division. A probable
purchaser has been identified, although no agreement has been reached by 31 December
20X0. Until an agreement has been formalised, the directors of Greenfingers will not advise
their employees of the divestment. Redundancy costs associated with the restructuring are
expected to be $120,000, and a further $50,000 will be spent on retraining certain staff
members to work in the furniture division of the company.
You may wish to study the flow chart below, taken from HKAS 37, which is a good summary of its
requirements.
Cobo Co. manufactures goods which are sold with a one year warranty against defects.
(a) Should a provision be recognised for the cost of repairing faulty goods?
(b) Cobo Co.'s sales for the year are $40m. They anticipate that 60% of goods will not be faulty,
30% will need minor repairs that would cost $2m if all items were affected and 10% of goods
will need major repairs that would cost $4m if all items were affected. How much should be
provided for repairs?
238
4 Interpretations relating to provision accounting

4.1 HK(IFRIC) Int-1 Changes in Existing Decommissioning,
Restoration and Similar Liabilities
4.1.1 The issue
HK(IFRIC) Int-1 applies where an entity has included decommissioning, restoration and similar
costs within the cost of an item of property, plant and equipment under HKAS 16 and as a provision
(liability) under HKAS 37.
An example would be a liability that was recognised by the operator of an oil rig for costs that it
expects to incur in the future when the rig is shut down (decommissioned). Such a provision should
be discounted to present value.
HK(IFRIC) Int-1 addresses changes in the value of the provision that may arise from:
(a) changes in the discount rate
(b) revised estimates of the timing and amount of costs
4.1.2 Required treatment
Where an entity applies the cost model to property, plant and equipment, these changes in value of
the provision are required to be capitalised as part of the cost of the asset and depreciated over the
remaining life of the item to which they relate.
Where an entity applies the revaluation model to property, plant and equipment, the changes in
value of the provision must be recognised as follows:
(a) A decrease in the liability is recognised in other comprehensive income and accumulated
within the revaluation surplus (other than where it reverses a revaluation deficit on the asset
that was previously recognised in profit or loss)
(b) An increase in the liability is recognised in profit or loss (other than where a credit balance
exists in the revaluation surplus in respect of that asset, in which case it is recognised in
other comprehensive income and reduces the revaluation surplus).
HK(IFRIC) Int-1 also deals with an increase in the liability that reflects the passage of time – also
referred to as the unwinding of the discount. This is recognised in profit or loss as a finance
cost as it occurs.
4.2 HK(IFRIC) Int-5 Rights to Interests from Decommissioning,

Restoration and Environmental Rehabilitation Funds
4.2.1 The issue
Some entities have an obligation to decommission assets or to perform environmental restoration.
Such entities may make contributions to a fund which is established to reimburse those costs of
decommissioning, restoration or rehabilitation when they are incurred. This fund may be set up to
meet the decommissioning costs of one contributor or for a number of contributors.
Matters for discussion with reference to HK(IFRIC) Int-5 are:
(a) How should the interest in a fund be dealt with by a contributor?
(b) How should an obligation be accounted for when a contributor has an obligation to make
additional contributions?
4.2.2 HK(IFRIC) Int-5 treatment
The following treatments are specified in HK(IFRIC) Int-5:
(a) If an entity recognises a decommissioning obligation under HKFRS and contributes to a fund
to segregate assets to pay for the obligation, it should apply HKFRS 10 Consolidated
Financial Statements, HKFRS 11 Joint Arrangements and HKAS 28 Investments in
239
Financial Reporting
Associates and Joint Ventures, to determine whether decommissioning funds should be

consolidated or accounted for under the equity method.
(b) When a fund is not consolidated or accounted for under the equity method, and that
fund does not relieve the contributor of its obligation to pay decommissioning costs, the
contributor should recognise:
(i) its obligation to pay decommissioning costs as a liability
(ii) its rights to receive reimbursement from the fund as a reimbursement under
HKAS 37
(c) A right to reimbursement should be measured at the lower of the:
(i) amount of the decommissioning obligation recognised
(ii) contributor's share of the fair value of the net assets of the fund attributable to
contributors
Changes in the carrying amount of this right (other than contributions to and payments from
the funds) should be recognised in profit or loss.
(d) When a contributor has an obligation to make potential additional contributions to the fund,
that obligation is a contingent liability within the scope of HKAS 37. When it becomes
probable that the additional contributions will be made, a provision should be recognised.
The IASB and FASB added a project on Liabilities to their active agenda in 2002 and issued an
Exposure Draft in 2005; the topic was re-exposed in 2010.
The ED proposed the following:
 The "probable" recognition criterion is removed, and instead uncertainty is reflected in the
measurement of a liability i.e. through use of a probability-weighted average of the outflows
for the range of possible outcomes.
 A liability is measured at the amount an entity would pay at the end of a reporting period to
be relieved of the present obligation. This should be determined as:
– the present value of the resources required to fulfil the obligation, or
– the amount an entity would have to pay to cancel the obligation, or
– the amount an entity would have to pay to transfer the obligation to a third party.
 If the liability is to pay cash to a counterparty, the outflows would be any expected cash
payments plus associated costs.
 If the liability is to undertake a service at a future date, the outflows would be the amounts
that the entity estimates it would pay a contractor at the future date to undertake the service
on its behalf.
The effects of these proposals would include the recognition of far more provisions than at present,
and where these are measured by reference to third party payment, a profit margin would be
included so increasing the amount of the provision.
The project was deferred in 2010 and added to the IASB’s research programme in 2012. The
issues will now be considered in conjunction with the Conceptual Framework work on elements
and measurement and a discussion paper is expected on this during the course of 2013.
240
Topic recap
HKAS 37 Provisions,
Contingent Liabilities and
Contingent Assets
= accounting for uncertainty
Provisions Contingencies
Liability of uncertain timing and/or amount Liability of uncertain timing and/or amount Contingent asset
Recognise if: Possible obligation that arises from past Possible asset arising from past events
present obligation (legal or events and whose existence will be whose existence will be confirmed by
constructive) as the result of a past confirmed by uncertain future events uncertain future events
event Or
probable outflow of economic benefits Present obligation arising from past
reliable estimate can be made of the events which is not recognised because:
obligation (i) outflow is not probable
(ii) amount can't be reliably
measured
Measure at:
best estimate of expenditure Do not recognise unless virtually certain
use expected values for a large (in which case not a contingent asset)
Do not recognise
population of items
discount if the time value of money is
material
Disclose: Disclose the following unless the outflow Disclose where probable inflow:
Reconciliation of the carrying value of of resources is remote: description of contingency
provisions at the start of the period to Description of contingency estimate of financial effect
that at the end Estimate of financial effect
Background to the provision Details of uncertainties
Possibility of reimbursement
241
Financial Reporting
Answer 1
(a) Black Gold Oil Co. has a constructive obligation, as the advertising campaign has created a
valid expectation on the part of those affected by it that the entity will clean up the
contamination it has caused.
(b) The retailer has a legal obligation to refund money for unwanted goods within a 28-day
period after the sale, and a constructive obligation to provide refunds for 32 days beyond
this.
The past event is the sale, and therefore the retailer has a present obligation as a result of a
past event.
Answer 2
The cost is found using "expected values" (75%  $NIL) + (20%  $1.0m) + (5%  $4.0m) =
$400,000
Answer 3
(a) At 31 December 20X0, there is no legal obligation to fit the carbon monoxide detectors, and
therefore Rango should not make a provision for either the cost of doing so or the fines
which would be incurred if it were in breach of the legislation.
If Rango has still not fitted the detectors at the 20X1 year end (i.e. when the legislation is in
force), then it should make a provision for the penalty of $5,000 for which it is liable (rather
than the $40,000 cost of fitting the detectors). This is because there is still no obligation for
the costs of fitting detectors because no obligating event has occurred (the fitting of the
detectors). However, an obligation might arise to pay fines or penalties under the legislation
because the obligating event has occurred (the non-compliant operation of Rango).
(b) Greenfingers is planning a restructuring of its business. A provision in respect of
restructuring can only be made when a year-end obligation is evidenced by a detailed formal
plan and an expectation on the part of those affected that the restructuring will happen. As at
31 December 20X0, the employees of Greenfingers are unaware of the plan and therefore
this criterion is not met. Therefore, no provision can be made.
If a provision could be made (i.e. if the sale had been announced to employees, so giving
rise to a valid expectation that the restructuring will occur and thus creating a constructive
obligation) then provision would be for the $120,000 redundancy costs but not the $50,000
retraining costs.
Answer 4
(a) Yes. Cobo Co. cannot avoid the expenditure on repairing faulty goods.
A provision should be made for the estimated cost of repairs.
(b) The cost of the provision is found using expected values: (60%  $0m) + (30%  $2m) +
(10%  $4) = $1m.
242
Exam practice
Darren Company Limited 23 minutes

Darren Company Limited ("DCL") is engaged in the manufacture of batteries. On the unaudited
statement of financial position as at 30 June 20X8, it has recognised the following provisions as
current liabilities:
(a) A provision for late delivery penalty
In May 20X8, DCL received a sales order for 7,000,000 units of rechargeable batteries for
which the agreed delivery date is 31 August 20X8. It is expected that DCL would earn a
gross profit of $1 per unit. Due to a shortage in the supply of raw materials, at the reporting
date, the management realised that they could only supply the goods at the earliest on
10 September 20X8. According to the sales contract, DCL would compensate the customer
for late delivery at $0.01 per unit per day.
(b) A provision for annual safety inspection of the production line
The last inspection was carried out in June 20X7. Due to a large backlog of sales orders, the
management decided to postpone the annual inspection until mid-September 20X8.
(c) A provision for the loss on sales of aged finished goods
The products were manufactured in late 20X6 with an expected normal usage period of two
years from the date of production. Due to the short expiry period, they were sold at a price
below cost in July 20X8.
(d) A provision for bonus payments to two executive directors
In accordance with the directors' service contract, two executive directors are entitled to
receive, in addition to monthly salaries, a bonus of equivalent to 5% of the profit before
taxation and the accrued bonus.
Required
Discuss the appropriateness of the provisions recognised by DCL. (13 marks)
HKICPA February 2008 (amended)
243
Financial Reporting
244
chapter 12
Construction contracts
Topic list
1 HKAS 11 Construction contracts

1.1 The accounting problem
1.2 Scope of the standard
1.3 Definitions
1.4 Contract revenue and contract costs
1.5 Combining and separating construction contracts
2 Accounting for construction contracts
2.1 Reliable estimate of outcome
2.2 Accounting treatment: outcome can be reliably estimated
2.3 Accounting treatment: outcome cannot be reliably estimated
2.4 Summary of the treatment of construction contracts in the statement of profit or loss
2.5 Construction contracts in the statement of financial position
2.6 Changes in estimates
2.7 Section summary
2.8 Disclosures
Learning focus
Long-term contracts are an everyday part of business in many industry sectors, particularly
construction. You should be able to advise a client how this type of contract is accounted for
and why.
245
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.07 Construction contracts 3
3.07.01 Define a construction contract
3.07.02 Explain when contract revenue and costs should be recognised in
3.07.03 Explain how contract revenue and costs should be measured and
apply these principles
3.07.04 Account for the expected loss and changes in estimates
3.07.05 Disclose information related to construction contracts in the
246
12: Construction contracts | Part C Accounting for business transactions
1 HKAS 11 Construction Contracts

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

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

Suppose that a contract is started on 1 January 20X1, with an estimated completion date of
31 December 20X2. The final contract price is $2,000,000. In the first year, to 31 December 20X1:
(a) Costs incurred amounted to $800,000.
(b) Half the work on the contract was completed.
(c) Certificates of work completed have been issued, to the value of $1,000,000. (Note. It is
usual, in a construction contract, for a qualified person such as an architect or engineer to
inspect the work completed, and if it is satisfactory, to issue certificates. This will then be the
notification to the customer that progress payments are due to the contractor. Progress
payments are commonly the amount of valuation on the work certificates issued, minus a
precautionary retention of 10%.)
(d) It is estimated with reasonable certainty that further costs to completion in 20X2 will be
$800,000.
What is the contract profit in 20X1, and what entries would be made for the contract at
31 December 20X1 if:
(a) profits are deferred until the completion of the contract?
(b) a proportion of the estimated revenue and profit is credited to profit or loss in 20X1?
Solution
(a) If profits are deferred until the completion of the contract in 20X2, the revenue and profit
recognised on the contract in 20X1 would be nil, and the value of work in progress on
31 December 20X1 would be the costs incurred of $800,000.
$'000 $'000
DEBIT Work-in-progress 800
CREDIT Cash 800
HKAS 11 takes the view that this policy is unreasonable, because in 20X2, the total profit of
$400,000 would be recorded. Since the contract revenues are earned throughout 20X1 and
20X2, a profit of nil in 20X1 and $400,000 in 20X2 would be contrary to the accruals concept
of accounting.
247
Financial Reporting
(b) It is fairer to recognise revenue and profit throughout the duration of the contract.
As at 31 December 20X1 revenue of $1,000,000 should be matched with cost of sales of
$800,000 in the statement of profit or loss, leaving an attributable profit for 20X1 of
$200,000.
$'000 $'000
DEBIT Account receivable 1,000
Cost of sales 800
CREDIT Sales 1,000
Cash 800
The only entry in the statement of financial position as at 31 December 20X1 is a receivable
of $1,000,000 recognising that the company is owed this amount for work done to date. No
balance remains for work in progress, the whole $800,000 having been recognised in cost of
sales.
1.2 Scope of the standard

Topic highlights
HKAS 11 applies to construction contracts which span a period end.
HKAS 11 is applied in accounting for construction contracts in the financial statements of

contractors.
A construction contract within the scope of HKAS 11 does not have to last for a period of more than
one year. The main point is that the contract activity starts in one financial period and ends in
another, thus creating the problem: to which of two or more periods should contract income and
costs be allocated?
Where the rendering of services is directly related to a construction contract, for example services
provided by a project manager or architect, these services are also accounted for in accordance
with HKAS 11. In all other cases, the rendering of services, even where a service contract spans a
period end, is within the scope of HKAS 18.
HKAS 11.3-6 1.3 Definitions

HKAS 11 provides the following definitions.
Key terms
Construction contract. A contract specifically negotiated for the construction of an asset or a
combination of assets that are closely interrelated or interdependent in terms of their design,
technology and function or their ultimate purpose or use.
A fixed price contract is a construction contract in which the contractor agrees to a fixed contract
price, or a fixed rate per unit of output, which in some cases is subject to cost escalation clauses.
A cost plus contract is a construction contract in which the contractor is reimbursed for allowable
or otherwise defined costs, plus a percentage of these costs or a fixed fee.
(HKAS 11)
248
The definition of a construction contract includes:

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

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

Loriload has a fixed price contract for $9 million to build a bridge. By the end of year 1 it is apparent
that the associated costs have increased by around 5% and accordingly in year 2 the customer
approves a variation of $500,000. The contract is completed in year 3.
What amount should be used as contract revenue in calculations in relation to the construction
contract at the end of the three years?
Solution
Year 1 $9 million
Year 2 $9.5 million
Year 3 $9.5 million
249
Financial Reporting
HKAS 11.16- 1.4.2 Contract costs

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

Alphabeta has commenced a contract on 1 August 20X1 for the construction of a motorway.
Information on contract costs incurred in the year ended 31 December 20X1 is as follows:
$'000
Surveyors' fees 12
Direct labour costs 134
Materials delivered to the site 250
Transport of heavy plant to site 10
The following information is also relevant:
 Overheads are to be apportioned at 35% of direct labour costs
 Inventory of materials on site at the 20X1 year end is $76,000
 The heavy plant was acquired at a cost of $90,000 two years ago and is being depreciated
over 10 years on a straight line basis.
What are contract costs incurred as at 31 December 20X1?
250
Solution
$'000
Surveyors’ fees 12
Direct labour costs 134
Overheads (35%  $134,000) 46.9
Materials (250,000 – 76,000) 174
Transport of heavy plant to site 10
Depreciation of heavy plant (5/12  10%  $90,000) 3.75
380.65
HKAS 11.7-9 1.5 Combining and separating construction contracts

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

Topic highlights
Revenue and costs associated with a contract should be recognised according to the stage of
completion of the contract when the outcome of the activity can be estimated reliably. If a loss
is predicted on a contract, then it should be recognised immediately.
HKAS 2.1 Reliable estimate of outcome

11.23,24
The accounting treatment applied to a construction contract depends on whether the outcome of
the contract can be measured reliably. HKAS 11 provides guidance on when this is the case for
both fixed price and cost plus contracts:
(a) Fixed price contracts
In the case of a fixed price contract, the outcome of a construction contract can be estimated
reliably when all of the following conditions are satisfied:
(i) Total contract revenue can be reliably measured.
(ii) It is probable that economic benefits of the contract will flow to the entity.
(iii) Stage of contract completion at the period end and costs to complete the contract can
be reliably measured.
(iv) Costs attributable to the contract can be identified clearly and be reliably measured so
that actual costs can be compared to previous estimates.
251
Financial Reporting
(b) Cost plus contracts

In the case of a cost plus contract, the outcome of a construction contract can be estimated
reliably when both of the following conditions are satisfied:
(i) it is probable that economic benefits of the contract will flow to the entity,
(ii) the costs attributable to the contract (whether or not reimbursable) can be identified
clearly and be reliably measured.
HKAS 11.30 2.1.1 Determining the stage of completion
Topic highlights
The stage of completion of a contract is normally measured using the costs basis, sales basis or
physical completion basis.
One of the criteria listed above which indicates that the outcome of a fixed price contract can be
estimated reliably is that the stage of contract completion can be reliably measured.
How should you decide on the stage of completion of any contract? The standard lists several
methods:
 Proportion of contract costs incurred for work carried out to date
 Surveys of work carried out
 Physical proportion of the contract work completed
The proportion that contract costs incurred for work performed to date bear to the estimated total
contract costs:
Costs incurred to date  WIP inventories
% on total costs =  100%
Total costs  variation
Surveys of work performed, or physical proportion of the contract work completed:
Work certified
% on work performed =  100%
Total revenue  variation
2.2 Accounting treatment: outcome can be reliably estimated

HKAS 2.2.1 Profitable contract
11.22,26
Where the outcome of a contract can be reliably estimated and the contract is expected to be
profitable based on contract revenue, costs to date and expected costs to complete, the
percentage completion method is applied.
The percentage of completion method is an application of the accruals assumption. Contract
revenue is matched to the contract costs incurred in reaching the stage of completion, so revenue,
costs and profit are attributed to the proportion of work completed:
(a) Contract revenue is recognised as revenue in the accounting periods in which the work is
performed.
(b) Contract costs are recognised as an expense in the accounting period in which the work to
which they relate is performed.
(c) Where amounts have been recognised as contract revenue, but their collectability from the
customer becomes doubtful, such amounts should be recognised as an expense, not a
deduction from revenue.
252
Example: Profitable contract with reliably estimated outcome

Gosforth Construction assesses the stage of completion of its contracts by reference to costs
incurred as a percentage of total costs. The company commenced Contract A in 20X1. The
contract has a fixed price of $890,000, recorded costs during 20X1 are $389,000, of which $10,000
relates to unused inventory. Expected future costs are $150,000.
Required
How much profit should be reported in 20X1 in accordance with HKAS 11?
Solution
$
Costs incurred to date (389 – 10) 379,000
Estimated future costs (150 + 10) 160,000
Total estimated costs 539,000
The contract is therefore 70.3% (379,000/539,000) complete
Revenue to be recognised: $890,000  70.3% = $625,670
The profit earned to date is therefore $246,670 ($625,670 – $379,000)
Example: Inclusion in financial statements

Discovery Construction commenced a $4 million contract to build a velodrome in the year ended
31 December 20X3. Details of the contract costs are as follows:
31 Dec 20X3 31 Dec 20X4 31 Dec 20X5
Estimated total costs $3.2 million $3.3 million $3.3 million
Costs incurred to date $1.2 million $2.475 million $3.3 million
What amounts should be included in Discovery Construction’s financial statements for each of
these years?
Solution
1 Calculate expected profit
20X3 20X4 20X5
$'000 $'000 $'000
Contract price – estimated 800 700 700
total costs
2 Calculate percentage of completion
Costs incurred/total costs 37.5% 75% 100%
3 Calculate cumulative statement of profit or loss amounts
Revenue (% complete  1,500 3,000 4,000
revenue)
Cost of sales (costs incurred) (1,200) (2,475) (3,300)
Profit (% complete  300 525 700
expected profit)
253
Financial Reporting
4 Calculate statement of profit or loss amounts for each year (cumulative amounts minus
amounts previously recognised)
$'000 $'000 $'000
Revenue 1,500 1,500 1,000
Cost of sales (1,200) (1,275) (825)
Profit 300 225 175
It is evident from the first example above that when the contract costs incurred to date is used to
determine the stage of completion, then only the contract costs reflecting the work to date should
be incorporated in costs incurred to date.
 Costs relating to future activity, e.g. cost of materials delivered but not yet used, are to be
excluded.
 Payments in advance made to subcontractors are to be excluded.
HKAS 2.2.2 Loss-making contract

11.36,37
Topic highlights
When the outcome of a contract can be reliably estimated and the project is loss-making, the loss
must be recognised in the current year in full.
Any loss on a contract should be recognised as soon as it is foreseen. The loss will be the
amount by which total expected contract revenue is exceeded by total expected contract costs.
The amount of the loss is not affected by:
 whether work has started on the contract
 the stage of completion of the work
 profits on other contracts (unless they are related contracts treated as a single contract).
Example: Loss-making contract (1)

Randall has a contract to construct a new head office for a multinational company. The contract
price has been agreed as $7 million. When Randall first signed the contract, the estimated total
costs to completion were assessed as $6.2 million. By the end of the first year of the contract,
however, price rises have meant that estimated total costs are now $7.1 million. The contract is
assessed as 28% complete by the end of the first year, based on costs incurred.
What amounts should be recognised in profit or loss in the first year of the contract?
Solution
The expected loss of $100,000 must be recognised in full, and forms part of cost of sales.
Therefore:
$'000
Revenue (balancing figure) 1,988
Cost of sales (28%  $7.1m) + $100,000 (2,088)
Loss (100)
254
HKAS 11.32-
34
2.3 Accounting treatment: outcome cannot be reliably estimated
Topic highlights
When the outcome of a contract cannot be reliably estimated no profit or loss is recognised;
revenue is recognised to the extent that recognised costs incurred are recoverable.
When the contract's outcome cannot be reliably estimated the following treatment should be
followed:
1 Contract costs are recognised as an expense as incurred
2 Revenue is recognised to the extent that contract costs are recoverable
This no profit/no loss approach reflects the situation near the beginning of a contract, i.e. the
outcome cannot be reliably estimated, but it is likely that costs will be recovered.
Contract costs which cannot be recovered should be recognised as an expense straight away.
HKAS 11 lists the following situations where this might occur:
 The contract is not fully enforceable, i.e. its validity is seriously in question
 The completion of the contract is subject to the outcome of pending litigation or legislation
 The contract relates to properties which will probably be expropriated or condemned
 The customer is unable to meet its obligations under the contract
 The contractor cannot complete the contract or in any other way meet its obligations under
the contract
Where these uncertainties cease to exist, contract revenue and costs should be recognised as
normal, i.e. by reference to the stage of completion.
255
Financial Reporting
2.4 Summary of the treatment of construction contracts in the

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

project be estimated reliably? incurred.
Recognise revenue to the
extent that contract costs are
recoverable.
Yes
Is the project expected to No Recognise the expected loss

make a profit? immediately.
Yes
Apply the percentage

completion method: revenue,
costs and profits are
recognised according to the
stage of completion of the
contract.
256
HKAS
11.43,44
2.5 Construction contracts in the statement of financial
position
The accounting treatment of construction contracts is profit or loss driven. Any amount included in
the statement of financial position is a balancing amount, calculated as:
Contract costs incurred X
Recognised profits less recognised losses X/(X)
Progress billings (X)
Amounts due from/to customers X/(X)
 Where an amount due from customers is calculated, this is normally shown within inventories.
 Where an amount due to customers is calculated, this is normally shown as ''payments on
account'' within payables.
 Any amount invoiced but unpaid is shown as a receivable.
Example: Loss-making contract (2)

Assume that in the previous example the customer had been billed a total of $1.5million, and had
paid $1,280,000 of this.
The amounts reported in the statement of financial position would therefore be:
$'000
Amounts due from customers (W) 388
Receivables 220
(W) $'000
Contract costs incurred 1,988
Recognised profits less recognised losses (100)
Progress billings (1,500)
Amounts due from customers 388
HKAS 11.38 2.6 Changes in estimates

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

Revenues and costs relating to a three-year contract commencing 1 January 20X5 are as follows:
20X5 20X6 20X7
$'000 $'000 $'000
Revenue per contract 1,200 1,200 1,200
Agreed variation - - 200
Total contract revenue 1,200 1,200 1,400
Contract costs incurred to date 263 700 1,320
Contract costs to completion 789 600 –
Total contract costs 1,052 1,300 1,320
Overall profit 148 (100) 80
% complete, using costs basis 25% 54% 100%
257
Financial Reporting
The 20X6 contract costs incurred to date include $200,000 which relates to additional work
required for unforeseen extras. In 20X6 the contractor negotiated with the customer to recover the
cost of this additional work, but it was not until 20X7 that it became probable that the customer
would accept this contract variation.
Required
What amounts should be recognised in profit or loss in each of the three years?
Solution
$'000
20X5 25%  expected profit of $148,000 37
20X6 Loss is expected and is recognised in full (100)

Less: profit previously recognised (37)
Loss recognised in 20X6 (137)
$'000
20X7 Overall actual profit 80
Add: cumulative loss previously recognised 100
Profit recognised in 20X7 180
2.7 Section summary

A methodical approach is crucial for the valuation of long-term construction contracts and the other
disclosure requirements under HKAS 11. The following method suggests a breakdown of the
process into five logical steps, and is to be applied where the outcome of a contract can be
estimated reliably.
1 The contract value is compared to the estimated total costs (costs to date plus estimated
costs to completion) to be incurred on the contract. If a foreseeable loss on the contract is
expected (that is, if the estimated total costs exceed the contract value), then this loss must
be charged against profits. If a loss has already been charged previously, then only the
difference between this loss and the loss currently estimated needs to be charged.
2 Apply the percentage of completion to date (or other formula given in the question) to the
calculation of the sales revenue attributable to the contract for the period (for example,
percentage of completion  total contract value, less revenue already recognised in previous
periods).
3 Calculate the cost of sales on the contract for the period.
$
Total contract costs  percentage complete (or follow instructions in question) X
Less any costs charged in previous periods (X)
X
Add foreseeable losses in full (not previously charged) X
Cost of sales on contract for the period X
4 Deduct the cost of sales for the period as calculated above (including any foreseeable loss)
from the sales revenue calculated at step 2 to give profit (loss) recognised for the period.
258
5 Calculate amounts due to/from customers for inclusion in the statement

of financial position
$
Contract costs incurred to date X
Recognised profits/(losses) to date X
X
Progress billings to date (X)
Amounts due from/(to) customers X
Note. The progress billings figure above represents the total billed revenue. Unpaid billed revenue
will be shown under trade receivables.
HKAS
11.39,40,42
2.8 Disclosures
The following should be disclosed in respect of construction contracts:
 The amount of contract revenue recognised as revenue in the period
 The methods used to determine the contract revenue recognised in the period
 The methods used to determine the stage of completion of contracts in progress
In addition, the following should be disclosed for contracts in progress at the reporting date:
 The aggregate amount of costs incurred and recognised profits (less recognised losses) to date
 The amount of advances received (amounts received before the related work is performed)
 The amount of retentions (amounts billed but unpaid until defects are rectified or conditions
specified in the contract are met)
An entity should also present:
 The gross amount due from customers for contract work as an asset
 The gross amount due to customers for contract work as a liability.
At the start of 20X1 Globalle Company negotiated a fixed price contract of $14.0 million with
Oceanic for the construction of a container port. Globalle had estimated the costs of the contract to
be $13.3 million. Globalle estimates the stage of completion on its construction contracts by
reference to the physical proportion of the work completed.
During 20X1 the contract suffered protracted delays and difficulties, such that Globalle concluded
that there would be material cost overruns. It negotiated with Oceanic to try to get some
recompense for these unexpected difficulties in the form of contract variations, but without success.
At 31 December 20X1 when the contract was 30% physically complete, the costs incurred
amounted to $4.9 million and the costs to complete were estimated at $11.2 million.
Throughout 20X2 Globalle continued to try to win recompense from Oceanic, but without success. At 31
December 20X2 when the contract was 80% physically complete, the costs incurred amounted to $12.6
million and the costs to complete were estimated at $3.5 million. On that day and after these figures had
been drafted, Oceanic suddenly agreed in principle to a contract variation of $3.5 million, provided that
Globalle agreed to pay Oceanic a penalty for late completion of $280,000. Globalle agreed to these
terms and the relevant adjustments were made to the draft figures.
Required
Determine the following amounts in respect of the container port contract in Globalle’s financial
statements according to HKAS 11 Construction Contracts.
(a) The profit or loss to be recognised in the year ended 31 December 20X1
(b) The revenue to be recognised in the year to 31 December 20X2
(c) The profit or loss to be recognised in the year ended 31 December 20X2
259
Financial Reporting
Aero Company has the following information in respect of a construction contract:
Total contract price $100,000
Cost incurred to date $48,000
Estimated cost to completion $32,000
Progress billings
(of which $50,000 has been received) $58,000
Percentage complete (cost basis) 60%
Required
(a) Prepare relevant extracts from the statement of profit or loss and statement of financial
position.
(b) Show how the statement of financial position would differ if progress billings were $64,000
(of which $50,000 received).
The IASB and FASB issued an Exposure Draft in relation to revenue recognition in June 2010. It is
proposed that the resulting standard will replace both IAS 18 Revenue and IAS 11 Construction
Contracts (and so their HKAS equivalents).
A revised exposure draft on the topic of revenue from contracts with customers was issued in
November 2011, which simplifies a number of the original proposals. A final standard is expected during
the course of 2013.
This project is considered in more detail in Chapter 14.
260
Topic recap
HKAS 11 Construction Contracts
Cost plus contract: contract in Contract specifically negotiated for the Fixed price contract: contract with
which the contractor is reimbursed construction of an asset or combination of a fixed price sometimes subject to
for costs plus a percentage of costs interrelated assets cost escalation clauses
or fixed fee
HKAS 11 applies where a contract spans

the period end
For a cost plus contract: Accounting treatment depends on whether For a fixed price contract:
Probable economic benefits will the outcome of the contract can be Contract revenue can be
flow to the entity reliably estimated reliably measured
Contract costs can be clearly Probable economic benefits
identified and measured will flow to entity
Stage of completion of contract
reliably measured
Costs to complete reliably
measured
Contract costs can be clearly
identified and measured
Can be reliably measured Can't be reliably measured
Profitable contract Loss-making contract No profit or loss is recognised.

Revenue is recognised to the extent
that recognised costs incurred are
recoverable
Revenue, costs and profit are Loss is recognised in full as soon as it is

recognised based on stage of foreseen
completion
Disclose:
Revenue recognised in period
Methods to determine revenue recognised
Methods to determine stage of completion
Costs incurred plus recognised profits (less recognised losses) to date
Advances received
Retentions
Amounts due from/to customers:
Costs incurred x
Recognised profits/losses x/(x)
Progress billings (x)
x/(x)
261
Financial Reporting
Answer 1
(a) $(2,100,000)
(b) $9,576,000
(c) $2,996,000
Profit / loss on contract 20X1 20X2
$'000 $'000
Contract price 14,000 14,000
Variation – 3,500
Penalty – (280)
14,000 17,220
Costs incurred to date (4,900) (12,600)
Estimated costs to completion (11,200) (3,500)
Profit / loss on contract (2,100) 1,120
Amounts to be recognised 20X2 20X2

20X1 cumulative (cum – 20X1)
$'000 $'000 $'000
Revenue (30%  $14m / 80%  $17.22m) 4,200 13,776 9,576
Costs (β) (6,300) 6,580
Loss (in full) (2,100)

Profit (80%  $1.12m) 896 2,996
At 31 December 20X1 the expected loss must be recognised immediately.

Under the agreement made on 31 December 20X2, the contract revenue is increased by the
variation and reduced by the penalty.
The profit for the year ended 31 December 20X2 is the profit to date, PLUS the loss recognised in
20X1.
262
Answer 2
(a) STATEMENT OF PROFIT OR LOSS (EXTRACTS) $
Revenue (60%  100,000) 60,000
Expenses (60%  80,000) (48,000)
Profit 12,000
STATEMENT OF FINANCIAL POSITION (EXTRACTS)

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

Less: cash received (50,000)
8,000
WORKING
Overall expected profitability $

Total revenue 100,000
Total expected costs (48,000 + 32,000) (80,000)
Overall expected profit 20,000
(b) STATEMENT OF FINANCIAL POSITION (EXTRACTS) $
Current assets
Trade receivables
Progress billings to date 64,000
Less: cash received (50,000)
14,000
Current liabilities
Gross amounts due to customers
Contract costs incurred to date 48,000
Recognised profits 12,000
60,000
Less: progress billings to date (64,000)
(4,000)
263
Financial Reporting
Exam practice
Construction contracts 22 minutes

(a) "It is not prudent to recognise profit on outstanding work in progress in construction
contracts. Revenue and cost should only be recognised upon the completion of the
construction work." Discuss. (5 marks)
(b) At 30 June 20X9, Vertical Construction Company ("VC") had a fixed price construction
contract in progress, named Waterfall Golf Villa, a project to construct 80 condominium units.
60 units have been completed and the remaining 20 units are expected to be completed in
the last quarter of 20X9. A survey of completed construction work will be carried out upon
completion of all units. Construction was begun in April 20X8 and the outcome of the
contract could not be estimated reliably at 30 June 20X8. According to the original bid
estimate, VC would have a profit margin of 20%. Based on the actual costs incurred and the
latest information, there will be an increase in the estimated total costs because of a 15%
increase in the price of construction material. However, a loss is not anticipated. An
instalment contract sum for the construction has been received by VC in accordance with the
contracted payment schedule.
Required
Explain how VC should account for this construction contract in the financial statements for
the year ended 30 June 20X9. (7 marks)
(Total = 12 marks)
HKICPA May 2009
264
chapter 13
Share-based payment
Topic list
1 HKFRS 2 Share-Based Payment

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

schemes are common.
265
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.05 Share-based payment 2
3.05.01 Identify and recognise share-based payment transactions in
3.05.02 Account for equity-settled and cash-settled share-based payment
transactions
3.05.03 Account for share-based payment transactions with cash
alternatives
3.05.04 Account for unidentified goods or services in a share-based
payment transaction
3.05.05 Account for group and treasury share transactions
3.05.06 Disclosure requirement of share option
266
13: Share-based payment | Part C Accounting for business transactions
1 HKFRS 2 Share-Based Payment

Topic highlights
Share-based payment transactions are those transactions where an entity receives goods or
services in return for its own equity instruments or an amount of cash related to the value of its
equity instruments.
1.1 Introduction
It is increasingly common for entities to issue shares or share options to other parties, such as
suppliers or employees, in return for goods or services received. In some instances neither shares
nor share options are issued, but cash consideration is promised at a later date, measured in
relation to share price. All of these transactions are examples of share-based payments.
Share option schemes are a common feature of directors’ remuneration packages and many
organisations also use such schemes to reward other employees. Share-based payments are also
a very common form of consideration for internet businesses which are notoriously loss making in
early years and therefore cash poor.
1.1.1 The accounting problem
Prior to the issue of HKFRS 2, no accounting guidance existed in relation to share-based
payments. This resulted in inconsistent treatment of expenses: those paid in cash were recognised
in profit or loss while those involving a share-based payment were not, because share options
initially had no value (since the exercise price is generally more than the market price of the share
on the date the option is granted).
As we shall see in this chapter, the issue of HKFRS 2 meant that companies were required to
recognise an expense in relation to share-based payments. As a result those companies which
made share-based payments saw a reduction in earnings, in some cases of a significant amount.
For this reason, HKFRS 2 remains controversial in practice.
HKFRS 2.1-6 1.2 Objective and scope

HKFRS 2 requires an entity to reflect in its profit or loss and financial position the effects of
share-based payment transactions, including expenses associated with transactions in which
share options are granted to employees.
The standard must be applied to all share-based payment transactions whether or not the goods or
services received under the share-based payment transaction can be individually identified,
including:
(a) Equity-settled share-based payment transactions
(b) Cash-settled share-based payment transactions
(c) Transactions in which the entity receives or acquires goods or services and the terms of the
arrangement provide either the entity or the supplier of those goods or services with a choice
of whether the entity settles the transaction in cash (or other assets) or by issuing equity
instruments.
The standard also applies to group-settled share-based transactions. That is where one group
entity receives goods or services and another entity within the group settles the share-based
payment transaction. In this case HKFRS 2 applies to both entities.
Certain transactions are outside the scope of the HKFRS:
(a) Transactions with employees and others in their capacity as a holder of equity instruments of
the entity (for example, where an employee receives additional shares in a rights issue to all
shareholders)
267
Financial Reporting
(b) The issue of equity instruments in exchange for control of another entity in a business
combination, or business under common control or the contribution of a business on the
formation of a joint venture.
HKFRS 2,
Appendix A
1.3 Definitions
The standard provides the following definitions.
Key terms
Share-based payment transaction is a transaction in which the entity:
(a) receives goods or services from the supplier of those goods or services (including an
employee) in a share-based payment arrangement, or
(b) incurs an obligation to settle the transaction with the supplier in a share-based payment
arrangement when another group entity receives those goods or services.
Share-based payment arrangement is an agreement between the entity (or another group entity)
and another party (including an employee) that entitles the other party to receive:
(a) cash or other assets of the entity for amounts that are based on the price (or value) of equity
instruments (including shares or share options) of the entity or another group entity, or
(b) equity instruments (including shares or share options) of the entity or another group entity
provided the specified vesting conditions are met.
Equity instrument is a contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities.
Equity instrument granted is the right (conditional or unconditional) to an equity instrument of the
entity conferred by the entity on another party, under a share-based payment arrangement.
Share option is a contract that gives the holder the right, but not the obligation, to subscribe to the
entity's shares at a fixed or determinable price for a specified period of time.
Fair value is the amount for which an asset could be exchanged, a liability settled, or an equity
instrument granted could be exchanged, between knowledgeable, willing parties in an arm's length
transaction.
Grant date is the date at which the entity and another party (including an employee) agree to a
share-based payment arrangement, being when the entity and the other party have a shared
understanding of the terms and conditions of the arrangement. At the grant date the entity confers
on the other party (the counterparty) the right to cash, other assets, or equity instruments of the
entity, provided the specified vesting conditions, if any, are met. If that agreement is subject to an
approval process (for example, by shareholders), the grant date is the date when that approval is
obtained.
Intrinsic value is the difference between the fair value of the shares to which the counterparty has
the (conditional or unconditional) right to subscribe or which it has the right to receive, and the price
(if any) the other party is (or will be) required to pay for those shares. For example, a share option
with an exercise price of $15 on a share with a fair value of $20, has an intrinsic value of $5.
268
Key terms (cont'd)

Measurement date is the date at which the fair value of the equity instruments granted is
measured. For transactions with employees and others providing similar services, the
measurement date is grant date. For transactions with parties other than employees (and those
providing similar services), the measurement date is the date the entity obtains the goods or the
counterparty renders service.
Vest means to become an entitlement. Under a share-based payment arrangement, a
counterparty's right to receive cash, other assets, or equity instruments of the entity vests when the
counterparty’s entitlement is no longer conditional on the satisfaction of any vesting conditions.
Vesting conditions are the conditions that determine whether the entity receives the services that
entitle the counterparty to receive cash, other assets or equity instruments of the entity, under a
share-based payment arrangement. Vesting conditions are either service conditions or
performance conditions. Service conditions require the counterparty to complete a specified period
of service. Performance conditions require the counterparty to complete a specified period of
service and specified performance targets to be met (such as a specified increase in the entity’s
profit over a specified period of time). A performance condition might include a market condition.
Vesting period is the period during which all the specified vesting conditions of a share-based
payment arrangement are to be satisfied.
Note that the definition of fair value within HKFRS 2 differs from that within HKFRS 13 Fair Value
Measurement. When applying HKFRS 2, the definition contained within that standard should be
used rather than HKFRS 13.
2 Recognition and measurement of share-based

HKFRS 2.7-8
payments
The basic principle presented in HKFRS 2 with regard to recognition is that an entity should
recognise goods or services received or acquired in a share-based payment transaction when it
obtains the goods or as the services are received.
The goods or services received should be recognised as an expense, or asset where appropriate.
The corresponding accounting entry depends on whether the share-based payment will be equity
or cash-settled.
HKFRS 2.10 2.1 Equity settled share-based payment transactions

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

should be recognised in equity:
DEBIT Expense / asset
CREDIT Equity
Before considering when this accounting entry is made, we must consider how an equity settled
share-based payment is measured.
269
Financial Reporting
HKFRS 2.11- 2.1.1 Measurement of equity-settled share-based payment transactions

13
The general principle in HKFRS 2 is that an entity should measure a share-based payment
transaction at the fair value of the goods or services received.
In the case of equity-settled transactions, the application of this rule depends on who the
transaction is with:
(a) Where the transaction is with employees and forms part of their remuneration package, it is
not normally possible to measure directly the services received. Therefore the transaction is
measured by reference to the fair value of the equity instruments granted at the grant date
(the indirect method).
(b) Where the transaction is with parties other than employees, there is a rebuttable
presumption that the fair value of the goods or services received can be estimated reliably,
and therefore the transaction is measured at this amount (the direct method).
(c) Where this is not the case, the entity should measure the transaction’s value using the
indirect method.
Where the indirect method (by reference to the fair value of the equity instruments granted) is
adopted to measure a transaction, fair value is based on the market prices, if available, taking into
consideration the terms and conditions upon which those equity instruments were granted.
In the absence of market prices, the fair value of the equity instruments granted should be
approximated using a valuation technique. (These are not within the scope of this exam.)
Example: Measurement of equity-settled share-based transactions

Barbar Co. issues 100 share options to each of its 1,000 employees on 1 July 20X1.
The fair value of the share options is $8 on grant date.
Required
How is the share-based transaction measured?
Solution
Equity-settled transactions with employees are measured by reference to the fair value of the
equity instruments granted on the grant date.
Therefore 100 options  1,000 employees  $8 = $800,000
HKFRS 2.1.2 Recognition of equity-settled share-based payment transactions

2.14,15
Where the equity instruments granted vest immediately i.e. the recipient party becomes entitled to
them immediately, then the transaction is accounted for in full on the grant date. This is normally
the case with transactions with parties other than employees, which are:
 measured at the fair value of the goods or services received, and
 recognised when the goods or services are provided.
Where the counterparty to the transaction has to meet specified conditions before they are entitled
to the equity instruments, and these are to be met over a specified vesting period, the expense is
spread over this vesting period. This is normally the case with transactions with employees,
discussed in more detail in the next section.
270
HKFRS 2.1.3 Transactions with employees

2.14,15
Where the equity instruments granted to employees vest immediately (i.e. the employee is not
required to complete a specified period of service before becoming unconditionally entitled to the
equity instruments), it is presumed that the services have already been received (in the absence of
evidence to the contrary). The entity should therefore recognise the transaction in full on the grant
date, by recognising the fair value of the equity instruments granted as an expense and a
corresponding increase in equity.
Where the equity instruments granted do not vest until the counterparty completes a specified
period of service, the entity should account for those services as they are rendered by the
employee during the vesting period. For example, if an employee is granted share options on
condition that he or she completes three years' service, then the services to be rendered by the
employee as consideration for the share options will be received in the future, over that three-year
vesting period. Therefore, the fair value of the equity instruments granted should be spread over
the three years, with an expense and corresponding increase in equity recognised in each year.
The expense recognised in each year of the vesting period should be based on the best available
estimate of the number of equity instruments expected to vest. That estimate should be revised if
subsequent information indicates that the number of equity instruments expected to vest differs
from previous estimates.
On the vesting date, the entity should revise the estimate to equal the number of equity instruments
that actually vest.
Once the goods and services received and the corresponding increase in equity have been
recognised, the entity should make no subsequent adjustment to total equity after the vesting date.
Example: Equity-settled share-based payment transaction – vesting period (1)

Continuing with the example above:
(a) Assume that the share options issued by Barbar Co. to its employees vest immediately and
there is a three-year period over which the employees may exercise the share options.
Employees are entitled to exercise the options regardless of whether or not they remain in
the entity’s employment during the period of exercise.
(b) Assume that the share options issued by Barbar Co. on 1 July 20X1 do not vest until 1 July
20X3, and this is conditional upon the individual employees remaining in employment with
the company. It is not anticipated that any employees will leave before this date. This
assumption is confirmed at 1 July 20X3 when all 1,000 employees remain in employment.
Required
When is the transaction recognised in each instance assuming a year end of 30 June?
Solution
As we saw earlier, the total fair value for the share options issued at grant date is:
$8  1,000 employees  100 options = $800,000
(a) In this situation the options vest immediately i.e. the employees are immediately entitled to
them. It is therefore assumed that Barbar has already benefited from the services provided
by the employees in exchange for the options. Barbar Co. should therefore charge $800,000
to profit or loss as employee remuneration on 1 July 20X1 and the same amount will be
recognised as part of equity on that date.
(b) In the second situation, the options do not vest until two years have passed, and they only
vest for those employees who continue to work for Barbar at this date.
It is assumed that all employees will continue to work for Barbar.
271
Financial Reporting
Therefore in this case the $800,000 is spread over the two years ended 30 June 20X2 and
20X3 with $400,000 recognised as an expense and in equity in each year:
20X2 20X3
$ $
Remuneration expense in profit or loss 400,000 400,000
Equity 400,000 800,000
This ensures that the expense associated with the share-based payment is matched to the
period in which Barbar benefits from the employees’ services.
We shall consider in later examples how this might differ if some employees left Barbar Co.
before the vesting date.

Whiston Co. provides each of 200 managers with 500 share options on 1 January 20X1. Each
option has a fair value of $8 at the grant date, $10 on 1 January 20X2, $13 on 1 January 20X3 and
$12 on 31 December 20X3.
The options do not vest until 31 December 20X3 and are dependent on continued employment.
All 200 managers are expected to remain with the company.
Required
Explain the accounting treatment of the share options in each of the years 20X1, 20X2 and 20X3.
Solution
The total expense to be recognised over the three-year vesting period is:
200  500  $8 = $800,000
Note that the changes in the value of the options after grant date do not affect the charge to profit
or loss for equity-settled transactions.
The remuneration expense should be recognised over the vesting period of three years. An amount
of $266,667 should be recognised for each of the three years 20X1, 20X2 and 20X3 in profit or loss
with a corresponding credit to equity.

The circumstances are as in the example above, however managers are expected to leave the
company as follows:
 At 31 December 20X1, it is estimated that 10% of managers will have left by the end of 20X3.
 At 31 December 20X2, it is estimated that 14% of managers will have left by the end of 20X3.
 By the end of 20X3, 20% of the original managers awarded share options have actually left.
Required
Explain the accounting treatment in each of the years 20X1, 20X2 and 20X3.
272
Solution
The expense to be recognised in each year in relation to the share options over the vesting period
is based on the estimated number of shares expected to vest. As options held by employees who
leave the company will not vest, these must be excluded from the amount recognised. Therefore:
Total expense
20X1 200 managers  90%  500 options  $8 fair value $720,000
This is divided by the three-year vesting period to give an annual expense in 20X1 of $240,000
To date two years of expense should have been recognised i.e. $688,000  2/3 $458,667
As $240,000 was recognised in 20X1, the 20X2 expense is $458,667 – $240,000 $218,667
All expense should now have been recognised as the vesting period is complete.
Therefore in 20X3 the expense is $640,000 – $240,000 – $218,667 $181,333
Armley Co. issues 10,000 options to each of the 50 directors and senior managers on 1 July 20X1.
The exercise price of the options is $4.50 per share. The scheme participants have to stay with the
company for four more years before being able to exercise their options.
At 31 December 20X1, it is estimated that 75% of the current directors and senior managers will
remain with the company for four years or more. The estimated figure is 70% by 31 December
20X2.
The fair value of an option is $3 at the grant date.
Required
Show how the option scheme would be reflected in the financial statements for the years ended
31 December 20X1 and 31 December 20X2.
An entity grants 100 share options on its $1 shares to each of its 500 employees on 1 January
20X5. Each grant is conditional upon the employee working for the entity over the next three years.
The fair value of each share option as at 1 January 20X5 is $15.
On the basis of a weighted average probability, the entity estimates on 1 January that 20% of
employees will leave during the three-year period and therefore forfeit their rights to share options.
Required
Show the accounting entries which will be required over the three-year period in the event of the
following:
 20 employees leave during 20X5 and the estimate of total employee departures over the
three-year period is revised to 15% (75 employees)
 22 employees leave during 20X6 and the estimate of total employee departures over the
three-year period is revised to 12% (60 employees)
273
Financial Reporting
 15 employees leave during 20X7, so a total of 57 employees left and forfeited their rights to
share options. A total of 44,300 share options (443 employees  100 options) are vested at
the end of 20X7.
2.1.4 Multiple vesting dates

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

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

(133,333)
66,667
20X2 2,000  3 = 6,000  50 = 300,000 300,000

(200,000)
100,000
274
The expense in relation to the share-based payment scheme is recognised by (HK$):

$ $
20X0 DEBIT Directors’ remuneration (200,000 + 133,333) 333,333
CREDIT Share-based payment reserve 333,333
20X1 DEBIT Directors’ remuneration (100,000 + 66,667) 166,667
20X2 DEBIT Directors’ remuneration 100,000
HKFRS
2.31,32
2.2 Cash-settled share-based payment transactions
Topic highlights
Cash-settled share-based payment transactions are recognised as a liability and measured at the
fair value of that liability. They are remeasured at the end of each reporting period.
The following may be included as cash-settled share-based payment transactions:

 The grant of share appreciation rights to employees: instead of the entitlement to an equity
instrument, the employees are entitled to a future cash payment which is based on the
increase in the entity's share price from a specified level over a specified period of time, or
 The grant to its employees of a right to receive a future cash payment by giving them a right
to shares that are redeemable
A liability should be recognised where goods or services are received or acquired in a cash-settled
share-based payment transaction. It is recorded by a debit to an expense or asset account and a
credit to a liability account.
DEBIT Expense/asset
CREDIT Liability
HKFRS 2.30 2.2.1 Measurement of cash-settled share-based payment transactions
The primary principle is that the fair value of the liability is used to measure the goods or services
acquired and the liability incurred by the entity.
The fair value of the liability should be reassessed at each reporting date till its settlement and
also at the date of settlement. Any changes in fair value are recorded as profit or loss for the
period.
HKFRS 2.32 2.2.2 Recognition of cash-settled share-based payment transactions
The services received from the employees, and a liability to pay for those services should be
recognised as services are rendered. For example, if a specified period of service has to be
completed by the employees before share appreciation rights are vested, the services received and
the related liability should then be recognised over that period.
Example: Cash-settled share-based payment transaction

Arthing Co. has provided a share incentive scheme to a number of its employees on 1 January
20X1. This allows for a cash payment to be made to the individuals concerned equal to the share
price at the end of a three-year period subject to the following conditions.
1 Vesting will be after three years
2 The share price must exceed $4
3 The employee must be with the company on 31 December 20X3
275
Financial Reporting
Each scheme issued will result in payment, subject to the conditions outlined, equal to the value of
10 shares at the end of the three-year period if the conditions are satisfied. The payments, once
earned, are irrevocable.
The Chief Operating Officer has been issued 20 such schemes.
The share prices over the next three years were as follows:
31 December 20X1 $4.20
Required
(a) Prepare the journal entries for the transactions of the share incentives issued to the Chief
Operating Officer.
(b) Assuming that on 1 January 20X1 four other individuals were also granted equivalent rights
to the Chief Operating Officer and that on 1 January 20X2, two of those individuals left the
company, prepare the journal entries for the transactions relating to the incentive schemes.
Solution
(a) Journal entries for transactions: Chief Operating Officer
The transactions are settled in cash and hence liabilities are created.
31 December 20X1 $ $
DEBIT Remuneration expense 280
CREDIT Remuneration liability 280
It is assumed that the current share price is the best estimate of the final share price.
(calculation note: 20  10  $4.20  1/3 = $280)
31 December 20X2
DEBIT Remuneration liability 280
CREDIT Remuneration expense 280
Reverses entries for 20X1 as share price is less than minimum
31 December 20X3
DEBIT Remuneration expense 880
CREDIT Cash 880
(calculation note: 20  10  $4.40  3/3 = $880)
(b) Journal entries for transactions: all individuals
31 December 20X1 $ $
DEBIT Remuneration expense 1,400
CREDIT Remuneration liability 1,400
(calculation note: 20  10  5  $4.20  1/3 = $1,400)
31 December 20X2:
DEBIT Remuneration liability 1,400
CREDIT Remuneration expense 1,400
31 December 20X3
CREDIT Cash 2,640
(calculation note: 20  10  3  $4.40  3/3 = $2,640)
276
2.3 Share-based payments with a choice of settlement

Topic highlights
Where there is a choice of settlement and the counterparty has that choice, both a debt and equity
component of the share-based transaction is identified and accounted for separately.
Where there is a choice of settlement and the entity has that choice, a liability must be recognised
to the extent there is an obligation to deliver cash.
Accounting for share-based transactions with a choice of settlement depends on which party has
the choice.
 Where the counterparty has a choice of settlement, the entity is deemed to have granted a
compound instrument, and a liability component and an equity component are identified.
 Where the entity has a choice of settlement, the whole transaction is treated either, as cash-
settled or as equity-settled, depending on whether the entity has an obligation to settle in
cash.
HKFRS 2.3.1 Counterparty has choice of settlement
2.35,36,38
Where the counterparty to the transaction has a choice of settlement, a compound instrument has
been granted i.e. a debt and equity component must be identified.
Where the transaction is with parties other than employees and the fair value of the goods or
services received is measured directly, the entity shall measure the equity component of the
compound financial instrument as the difference between the fair value of the goods or
services received and the fair value of the debt component, at the date when the goods or
services are received.
Where the transaction is with employees, the fair value of the compound instrument is estimated as
a whole. The debt and equity components must then be valued separately. Normally transactions
are structured in such a way that the fair value of each alternative settlement is the same.
The entity is required to account separately for the goods or services received or acquired in
respect of each component of the compound financial instrument. The debt component is
accounted for in the same way as a cash-settled share-based payment. The equity component is
recognised in the same way as an equity-settled share-based payment.
HKFRS 2.41- 2.3.2 Entity has choice of settlement
43
Where the entity chooses what form the settlement will take, a liability should be recognised to the
extent that there is a present obligation to deliver cash.
This is the case where, for example, the entity is prohibited from issuing shares or where it has a
stated policy, or past practice, of issuing cash rather than shares.
Where a present obligation exists, the entity should record the transaction as if it is a cash-settled
share-based payment transaction.
If no present obligation exists, the entity should treat the transaction as if it was purely an equity-
settled transaction. On settlement, if the transaction was treated as an equity-settled transaction
and cash was paid, the cash should be treated as if it was a repurchase of the equity instrument by
a deduction against equity.
Example: Choice of settlement

On 1 January 20X7 an entity grants an employee a right under which he can, if he is still employed
on 31 December 20X9, elect to receive either 10,000 shares or cash to the value, on that date, of
9,000 shares.
277
Financial Reporting
The market price of the entity's shares is $310 at the date of grant, $370 at the end of 20X7, $430
at the end of 20X8 and $520 at the end of 20X9, at which time the employee elects to receive the
shares. The entity estimates the fair value of the share route to be $290. Show the accounting
treatment.
Solution
This arrangement results in a compound financial instrument.
The fair value of the cash route is:
9,000  $310 = $2.79m
The fair value of the share route is:
10,000  $290 = $2.90m
The fair value of the equity component is therefore:
$110,000 ($2,900,000 less $2,790,000)
The share-based payment is recognised as follows:
Liability Equity Expense
$ $ $
20X7 1/3  9,000  $370 1,110,000 1,110,000
$110,000  1/3 36,667 36,667
20X8 2/3  9,000  $430 2,580,000 1,470,000
$110,000  1/3 36,667 36,667
20X9 9,000  $520 4,680,000 2,100,000
$110,000  1/3 36,666 36,666
As the employee elects to receive shares rather than cash, $4,680,000 is transferred from liabilities
to equity at the end of 20X9. The balance on equity is $4,790,000.
2.4 Section summary

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

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

 Only the residual amount is expensed to statement of profit or loss
 Expensed annually over the vesting period
Choice of settlement – counterparty’s choice
 Compound instrument is split into debt and equity components
 Debt component is accounted for as a cash-settled transaction
 Equity component is accounted for as an equity-settled transaction
278
Choice of settlement – entity’s choice

 Account for as cash-settled if there is an obligation to deliver cash
 Account for as equity-settled otherwise
3 Share-based payment transactions – further issues

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

Amendments to HKFRS 2 Share-based Payment: Group Cash-Settled Share-Based Payment
Transactions, which are effective for periods beginning on or after 1 January 2010 clarify how an
individual subsidiary in a group should account for some share-based payment arrangements in its
own financial statements.
HKFRS 3.1.1 Share-based payment transactions among group entities
2.43A-D
HKFRS 2 applies when an entity enters into a share-based payment transaction regardless of
whether the transaction is to be settled by the entity itself, or by another group member on behalf of
the entity.
The amendments to HKFRS 2 clarify the classification of share-based payment transactions for
both the entity that receives the goods or services, and the entity that settles the share-based
payment transaction.
The entity receiving the goods or services will recognise the transaction as an equity-settled
share-based payment transaction only if:
 the awards granted are its own equity instruments
 it has no obligation to settle the transaction
In all other circumstances, the entity will measure the transaction as a cash-settled share-based payment.
Subsequent remeasurement of such equity-settled transactions will only be carried out for changes
in non-market vesting conditions.
The entity responsible for settling the transaction will recognise it as an equity-settled share-
based payment only if the transaction is settled in its own equity instruments. In all other
circumstances, the transaction will be recognised by the entity that settles the award as a cash-
settled share-based payment.
The guidance can be illustrated for the most commonly occurring scenarios as follows.
Classification
Obligation to
Entity settle share- Subsidiary's
receiving based individual Consolidated
goods and payment financial financial
services transaction How is it settled? statements statements
Subsidiary Subsidiary Equity of the subsidiary Equity Equity

Subsidiary Subsidiary Cash Cash Cash
Subsidiary Subsidiary Equity of the parent Cash Equity
279
Financial Reporting
Classification
Obligation to
Entity settle share- Subsidiary's
receiving based individual Consolidated
goods and payment financial financial
services transaction How is it settled? statements statements
Subsidiary Parent* Equity of the parent Equity Equity

Subsidiary Parent* Cash Equity Cash
*The same classification will result if the settlement obligation lies with the shareholders or another
group entity (e.g. a fellow subsidiary).
As the classification may be different at the subsidiary and parent level, the amount recognised by
the entity receiving the goods or services may differ from the amount recognised by the entity
settling the transaction and in the consolidated financial statements.
Intragroup repayment arrangements will not affect the application of the principles described above
for the classification of group-settled share-based payment transactions.
Example: group cash-settled share-based transaction
On 1 January 20X1, Principal Co. implemented a share incentive scheme for the five members of
senior management at its subsidiary Sublime Co..
Principal will make a cash payment to the senior managers on 31 December 20X2 based on the
price of Sublime’s shares at that date, provided that the managers remain in service.
Ten share appreciation rights (SARs) are granted to each senior manager on 1 January 20X1,
each with a fair value of $80. The fair value of each SAR at 31 December 20X1 is $70 and at
31 December 20X2 is $90.
All five senior managers are expected to remain in employment until the settlement date.
Required
What entries are required to record this transaction in the financial statements of Principal, Sublime
and the Group?
Solution
Principal
Principal is the entity responsible for settling the transaction. As the transaction will not be settled in
Principal’s own equity instruments it must be recognised as a cash-settled share-based payment
transaction.
On initial recognition of the liability based on the fair value of the SARs at the grant date, a debit is
made to the cost of investment in Sublime. Remeasurements of the liability due to subsequent
movements in the fair value of the SARs are recognised in profit or loss. The reason for this will
become apparent shortly.
$ $
20X1 DEBIT Cost of investment in Sublime 2,000
(5  10 SARs  $80)/2 years
To record the liability after one year’s service based on initial fair value of the SARs.
$2,000 – (5  10 SARs  $70)/2 years
CREDIT Profit or loss 250
To remeasure the liability based on the period end fair value of the SARs.
280
$ $
20X2 DEBIT Cost of investment in Sublime
(5  10 SARs  $80) – 2,000 2,000
To record the liability after two years’ service based on initial fair value of the SARs.
$ $
DEBIT Profit or loss 750
(5  10 SARs  $90) – $3,750
To remeasure the liability prior to settlement based on the period end fair value of the
SARs.
CREDIT Cash 4,500
To record the settlement of the transaction.
Sublime
Sublime is the entity receiving the services of the five senior managers. It has no obligation to settle
the transaction itself and therefore it must be recognised as an equity-settled share-based payment
transaction:
$ $
20X1 DEBIT Remuneration expense 2,000
(5  10 SARs  $80)/2 years
CREDIT Equity 2,000
To record the first year’s service expense and corresponding increase in equity.
20X2 DEBIT Remuneration expense 2,000
(5  10 SARs  $80) – $2,000
CREDIT Equity 2,000
To record the second year's service expense and corresponding increase in equity.
As the transaction is treated as equity-settled in Sublime’s financial statements, no re-

measurement takes place.
Group
The Principal Group as the receiving entity has the obligation to settle in cash and therefore in the
consolidated accounts the transaction is accounted for as cash-settled:
$ $
20X1 DEBIT Expense 1,750
(5  10 SARs  $70)/2 years
To recognise the liability at the end of the first year of service based on the fair value of
the SARs at this date.
20X2 DEBIT Expense 2,750
(5  10 SARs  $90) – $1,750
To remeasure the liability at the settlement date based on the fair value of the SARs at
this date.
281
Financial Reporting
$ $
CREDIT Cash 4,500
To record the settlement of the transaction.
It should now be apparent why the entries in Principal’s records are split between amounts related
to the initial fair value of the SARs (debited to Cost of Investment) and subsequent
remeasurements (debited/credited to profit or loss).
On consolidation the cost of investment in Principal must be cancelled against the equity and
reserves in Sublime. As HKFRS 2 requires that the movement in equity in Sublime’s accounts is
based on the $80 fair value at the grant date, and not remeasured, it follows that the movement in
the cost of investment in Principal’s accounts must be based on the same amount. Therefore, any
remeasurements must be dealt with separately through profit or loss.
3.2 Treasury share transactions

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

HKFRS 2.44 HKFRS 2 has extensive disclosure requirements including:
(a) Information that enables users of the financial statements to understand the nature and
extent of share-based payment arrangements that existed during the period.
(b) Information that enables users of the financial statements to understand how the fair value
of the goods or services received, or the fair value of the equity instruments granted,
during the period was determined.
(c) Information that enables users of the financial statements to understand the effect of share-
based payment transactions on the entity’s profit or loss for the period and on its financial
position.
HKFRS 2.45 4.1 Nature and extent of share-based payment arrangements

Information which aids an understanding of the nature and extent of share-based payment
arrangements includes the following:
(a) A description of each type of share-based payment arrangement that existed at any time
during the period.
(b) The number and weighted average exercise priced of share options outstanding at the
beginning of the period, granted during the period, forfeited during the period, exercised
during the period, expired during the period, outstanding at the end of the period and
exercisable at the end of the period.
(c) For share options exercised during the period, the weighted average share price at the date
of exercise.
282
(d) For share options outstanding at the end of the period, the range of exercise prices and
weighted average remaining contractual life.
HKFRS 2.47-
49
4.2 Determination of fair value
Information which enables an understanding of how fair value is determined includes the
disclosures below:
(a) If the entity has measured directly the fair value of goods or services received during the
period, the entity shall disclose how that fair value was determined.
(b) If the entity has rebutted the presumption that goods or services from parties other than
employees can be measured reliably, it shall disclose that fact, and give an explanation of
why the presumption was rebutted.
(c) If the entity has measured the fair value of goods or services received as consideration for
equity instruments of the entity indirectly, by reference to the fair value of the equity
instruments granted:
– For share options granted during the period, the weighted average fair value of those
options at the measurement date and information on how that fair value was
measured.
– For other equity instruments granted during the period (i.e. other than share options),
the number and weighted average fair value of those equity instruments at the
measurement date, and information on how that fair value was measured.
HKFRS
2.50,51
4.3 Effect on profit or loss and financial position
Information which enables an understanding of the effect of share-based payment transactions on
profit or loss and financial position includes the following:
(a) The total expense recognised for the period arising from share-based payment
transactions in which the goods or services received did not qualify for recognition as
assets and hence were recognised immediately as an expense, including separate
disclosure of that portion of the total expense that arises from transactions accounted for as
equity-settled share-based payment transactions.
(b) The total carrying amount of liabilities arising from share-based payment transactions at the
end of the period and the total intrinsic value at the end of the period of liabilities for which
the counterparty’s right to cash or other assets had vested by the end of the period.
5 Share-based payment transactions and deferred

tax
Topic highlights
A share-based payment will result in a deductible temporary difference and so deferred tax asset.
HKAS As we have seen, an entity is required to recognise an expense in relation to share options over
12.68A-C the vesting period. The related tax deduction is not, however, received until the options are
exercised. In addition, the accounting expense is based on the fair value of the options at the grant
date, whereas the tax allowable expense is based on the share price at the exercise date.
There is therefore a deferred tax implication. This is also true of other forms of share-based
payments where the tax deduction differs from the cumulative remuneration expense.
283
Financial Reporting
5.1 Measurement of temporary difference

The deductible temporary difference is measured as:
Carrying amount of share-based payment expense X
Less: tax base of share-based payment expense
(estimated amount tax authorities will permit as a deduction
in future periods, based on year end information) (X)
Temporary difference (X)
Deferred tax asset at X% X
If the amount of the tax deduction (or estimated future tax deduction) exceeds the amount of the
related cumulative remuneration expense, this indicates that the tax deduction relates also to an
equity item.
The excess is therefore recognised directly in equity.
Example: Deferred tax implications of share-based payment
Lamar Co. has the following share option scheme at 31 December 20X1:
Fair value
of options
Director’s Options at grant Exercise Vesting
name Grant date granted date price date
$ $
N Yip 1 January 20X0 20,000 2.50 3.75 12/20X1
D Chan 1 January 20X1 90,000 2.50 5.00 12/20X3
The price of the company’s shares at 31 December 20X1 is $7 per share and at 31 December
20X0 was $7.50 per share.
The directors must be working for Lamar on the vesting date in order for the options to vest.
No directors have left the company since the issue of the share options and none are expected to
leave before December 20X3. The shares can be exercised on the first day of the month in which
they vest.
In accordance with HKFRS 2 an expense of $25,000 has been charged to profits in the year ended
31 December 20X0 in respect of the share option scheme. The cumulative expense for the two
years ended 31 December 20X1 is $110,000.
Tax allowances arise when the options are exercised and the tax allowance is based on the
option’s intrinsic value at the exercise date.
Assume a notional tax rate of 16%.
Required
What are the deferred tax implications of the share option scheme?
Solution
Year to 31 December 20X0
Deferred tax asset:
$
Fair value (20,000  $7.50  1/2) 75,000
Exercise price of option (20,000  $3.75  1/2) (37,500)
Intrinsic value (estimated tax deduction) 37,500
Tax at 16% 6,000
284
The cumulative remuneration expense is $25,000, which is less than the estimated tax deduction of
$37,500. Therefore:
 a deferred tax asset of $6,000 is recognised in the statement of financial position
 there is deferred tax income of $4,000 (25,000  16%)
 the excess of $2,000 goes to equity
Year to 31 December 20X1
Deferred tax asset:
$
Fair value
(20,000  $7.50) 150,000
(90,000  $7  1/3) 210,000
360,000
Exercise price of options
(20,000  $3.75) (75,000)
(90,000  $4.50  1/3) (135,000)
Intrinsic value (estimated tax deduction) 150,000
Tax at 16% 24,000
Less: previously recognised (6,000)
18,000
The cumulative remuneration expense is $110,000, which is less than the estimated tax deduction
of $150,000. Therefore:
 a deferred tax asset of $24,000 is recognised in the statement of financial position at
31 December 20X1
 there is potential deferred tax income of $18,000 for the year ended 31 December 20X1
 of this, $13,600 (16% ($110,000 – $25,000)) is recognised in the statement of profit or loss
 the remainder ($4,400) is recognised in equity.
6 Modifications to the terms and conditions on

which equity instruments were granted, including
cancellations and settlements
Topic highlights
An entity might modify the terms and conditions on which the equity instruments were granted.
For example, it might reduce the exercise price of options granted to employees (i.e. reprice the
options), which increases the fair value of those options. The requirements to account for the
effects of modifications are expressed in the context of share-based payment transactions with
employees. However, the requirements shall also be applied to share-based payment transactions
with parties other than employees that are measured by reference to the fair value of the equity
instruments granted.
HKFRS 2.27-
29
6.1 Measurement in modification
The entity shall recognise, as a minimum, the services received measured at the grant date fair
value of the equity instruments granted, unless those equity instruments do not vest because of
failure to satisfy a vesting condition (other than a market condition) that was specified at grant date.
285
Financial Reporting
This applies irrespective of any modifications to the terms and conditions on which the equity
instruments were granted, or a cancellation or settlement of that grant of equity instruments. In
addition, the entity shall recognise the effects of modifications that increase the total fair value of
the share-based payment arrangement or are otherwise beneficial to the employee.
If a grant of equity instruments is cancelled or settled during the vesting period (other than a grant
cancelled by forfeiture when the vesting conditions are not satisfied):
(a) Cancellation
The entity shall account for the cancellation or settlement as an acceleration of vesting, and
shall therefore recognise immediately the amount that otherwise would have been
recognised for services received over the remainder of the vesting period.
(b) Payment made
Any payment made to the employee on the cancellation or settlement of the grant shall be
accounted for as the repurchase of an equity interest, i.e. as a deduction from equity,
except to the extent that the payment exceeds the fair value of the equity instruments
granted measured at the repurchase date. Any such excess shall be recognised as an
expense. However, if the share-based payment arrangement included liability components,
the entity shall remeasure the fair value of the liability at the date of cancellation or
settlement. Any payment made to settle the liability component shall be accounted for as an
extinguishment of the liability.
(c) New equity instruments are granted
If new equity instruments are granted to the employee and, on the date when those new
equity instruments are granted, the entity identifies the new equity instruments granted as
replacement equity instruments for the cancelled equity instruments, the entity shall account
for the granting of replacement equity instruments in the same way as a modification of the
original grant of equity instruments. The incremental fair value granted is the difference
between the fair value of the replacement equity instruments and the net fair value of the
cancelled equity instruments, at the date the replacement equity instruments are granted.
The net fair value of the cancelled equity instruments is their fair value, immediately before
the cancellation, less the amount of any payment made to the employee on cancellation of
the equity instruments that is accounted for as a deduction from equity.
If the entity does not identify new equity instruments granted as replacement equity
instruments for the cancelled equity instruments, the entity shall account for those new
equity instruments as a new grant of equity instruments.
If an entity or counterparty can choose whether to meet a non-vesting condition, the entity
shall treat the entity’s or counterparty’s failure to meet that non-vesting condition during the
vesting period as a cancellation.
If an entity repurchases vested equity instruments, the payment made to the employee shall
be accounted for as a deduction from equity, except to the extent that the payment exceeds
the fair value of the equity instruments repurchased, measured at the repurchase date. Any
such excess shall be recognised as an expense.
Example: Cancellation
Flummery Co. granted 3,000 share options to each of its 50 managers on 1 January 20X1. The
options only vest if the managers are still employed by the entity on 31 December 20X3.
The fair value of the options was estimated at $12 on the grant date and the entity estimated that
the options would vest with 48 managers.
In 20X2 the entity decided to base all incentive schemes around the achievement of performance
targets and as a result the existing share option scheme was cancelled on 30 June 20X2 when the
fair value of the options was $28 and the market price of the entity’s shares was $45.
Compensation was paid to the 49 managers in employment at that date, at the rate of $36 per
option.
286
Required
How should the entity recognise the cancellation?
Solution
The original cost to the entity for the share option scheme was:
3,000 shares  48 managers  $12 = $1,728,000
This was being recognised at the rate of $576,000 in each of the three years.
At 30 June 20X2 the entity should recognise a cost based on the amount of options it had vested
on that date. The total cost is:
3,000  49 managers  $12 = $1,764,000
After deducting the amount recognised in 20X1, the 20X2 charge to profit or loss is $1,188,000.
The compensation paid is:
3,000  49  $36 = $5,292,000
Of this, the amount attributable to the fair value of the options cancelled is:
3,000  49  $28 (the fair value of the option, not of the underlying share) = $4,116,000
This is deducted from equity as a share buyback. The remaining $1,176,000 ($5,292,000 less
$4,116,000) is charged to profit or loss.
287
Financial Reporting
Topic recap
HKFRS 2 Share-Based Payment
Share-based payments are transactions where an entity receives goods

or services in return for its own equity instruments or an amount of cash
related to the value of its own equity instruments.
Where one group entity receives goods or services and another group
company settles the transaction the recipient company must still apply
the provisions of HKFRS 2
Equity-settled SBP Cash-settled SBP Choice of settlement
Transaction with Transaction with other Recognise as a liability Counterparty has Entity has choice
employees party measured at fair value choice
of the liability
Measure at fair value Measure at fair value of Identify debt and equity Recognise liability
of equity instrument goods/services Remeasure liability at component and to the extent there
on grant date received each reporting date account for each is an obligation to
until settlement and at separately deliver cash
settlement date
Recognise as Recognise as an
expense/in equity asset/expense and in
over the vesting equity, normally
period immediately
Modifications
On cancellation or settlement the amount that would have been recognised over the remainder of the vesting period is measured
immediately
If payment is made to the other party on cancellation or settlement this is accounted for as the repurchase of an equity interest (and
expense where the payment exceeds fair value of the equity instruments)/extinguishment of liability.
Disclosures:
Information about the nature and extent of share-based payment arrangements
Information to enable users to understand how fair values were determined
Information to enable users to determine the effect on profit or loss and financial position
Share-based payments and deferred tax

A share-based payment results in a deductible temporary difference and so a deferred tax asset
288
Answer 1
The remuneration expense in respect of the options for the year ended 31 December 20X1 is
calculated as follows:
Fair value of options expected to vest at grant date:
(75%  50 employees)  10,000 options  $3 =$1,125,000
Annual charge to profit or loss therefore $1,125,000 / 4 years = $281,250
Charge to profit or loss for y/e 31 December 20X1 = $281,250  6/12 months = $140,625
The accounting entry for the year ending 31 December 20X1 is:
$ $
CREDIT Equity 140,625
In 20X2 the remuneration charge is for the whole year, and is calculated as:
(70%  50 employees)  10,000 options  $3 = $1,050,000
Charge to date is $1,050,000  1.5/4 years = $393,750
Therefore charge for the year is $393,750 – $140,625 = $253,125
The accounting entry is:

Answer 2
20X5 $
Equity c/d and P/L expense ((500 – 75)  100  $15  1/3) 212,500
$ $
DEBIT Expenses 212,500
20X6 $
Equity b/d 212,500
Profit or loss expense 227,500
Equity c/d ((500 – 60)  100  $15  2/3) = 440,000
$ $
20X7 $
Equity b/d 440,000
Profit or loss expense 224,500
Equity c/d (443  100  $15) = 664,500
$ $
289
Financial Reporting
Exam practice
Nextap Company Limited 18 minutes

Nextap Company Limited (NCL) granted each of its 240 managerial staff 20,000 share options on 1
July 20X1. Each option entitles the holder to subscribe to one share of NCL at HK$7.5. 8,000
share options (Type A) were immediately vested. The remaining 12,000 share options (Type B) do
not vest until 30 June 20X3 and are conditional upon the continued employment of the staff on that
day. The market price of NCL's shares at 1 July 20X1 was HK$8. NCL estimated that the fair
value of the Type B share option is HK$1.5 and 15% of the managerial staff will leave during the
two-year period and therefore forfeit their rights to the share options. During the financial year
ended 30 June 20X2, 22 managerial staff had left the company and 10 exercised the Type A option
to subscribe to the shares on 30 April 20X2. NCL has not revised its estimate of the total
managerial staff departures over the two-year period.
Required
(a) Prepare the journal entries for the share options issued by NCL during the year ended 30
June 20X2. (7 marks)
(b) Explain how the estimate of the total number of managerial staff departures will affect the
accounting for the share-based payment. (3 marks)
(Total = 10 marks)
290
chapter 14
Revenue
Topic list
1 Revenue recognition
1.1 Accrual accounting
1.2 Recognition at point of sale
1.3 Recognition at other times
2 HKAS 18 Revenue
2.1 Scope
2.2 Definitions
2.3 Measurement of revenue
2.4 Identification of the transaction
2.5 Recognition: sale of goods
2.6 Recognition: rendering of services
2.7 Recognition: interest, royalties and dividends
2.8 Determining whether an entity is an agent or principal
2.9 Revenue recognition: examples
2.10 Disclosure
3 Interpretations relating to revenue recognition
3.1 HK(IFRIC) Int-12 Service Concession Arrangements
3.2 HK(IFRIC) Int-13 Customer Loyalty Programmes
3.3 HK(IFRIC) Int-15 Agreements for the Construction of Real Estate
Learning focus
Revenue is an important part of any commercial organisation’s financial statements. You

should therefore be able to explain the recognition and measurement criteria of HKAS 18 and
apply them in practice.
291
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.02 Revenue 3
3.02.01 Define revenue and identify revenue within the scope of HKAS 18
3.02.02 Measure revenue at the fair value of consideration received
3.02.03 Identify revenue transaction including multiple element
arrangements
3.02.04 Determine the recognition criteria for specified types of revenue
items including sales of goods, rendering of services and interest,
royalties and dividends
3.02.05 Disclose revenue as appropriate in the financial statements
3.02.06 Explain the recognition and measurement principles
292
14: Revenue | Part C Accounting for business transactions
1 Revenue recognition
Topic highlights
Revenue recognition is straightforward in most business transactions, but can be complicated in
some situations.
1.1 Accrual accounting

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

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

There are times when revenue is recognised at other times than at the completion of a sale,
for example in the recognition of profit on long-term construction contracts. Under HKAS 11
Construction Contracts contract revenue and contract costs associated with the construction
contract should be recognised as revenue and expenses respectively by reference to the stage of
completion of the contract activity at the year end, once the outcome on the contract can be
estimated reliably.
293
Financial Reporting
(a) Owing to the length of time taken to complete such contracts, to defer taking profit into
account until completion may result in the statement of profit or loss reflecting, not so much a
fair presentation of the activity of the company during the year, but rather the results relating
to contracts which have been completed by the year end.
(b) Revenue in this case is recognised when production on, say, a section of the total contract is
complete, even though no sale can be made until the whole is complete.
2 HKAS 18 Revenue
Topic highlights
HKAS 18 Revenue is concerned with the recognition of revenues arising from fairly common
transactions.
 The sale of goods
 The rendering of services
 The use by others of entity assets yielding interest, royalties and dividends
Income, as defined by the HKICPA's Framework document, includes both revenues and gains.
Revenue is income arising in the ordinary course of an entity's activities and it may be called
different names, such as sales, fees, interest, dividends or royalties.
HKAS 18 governs the recognition of revenue in specific (common) types of transaction, being:
 the sale of goods
 the rendering of services
 interest income
 royalty income
 dividend income
The standard also includes an appendix which provides examples of the measurement and
recognition rules in particular circumstances.
HKAS 18.1-6 2.1 Scope

HKAS 18 covers the revenue from specific types of transaction or events:
 Sale of goods (manufactured products and items purchased for resale)
 Rendering of services
 Use by others of entity assets yielding interest, royalties and dividends
Interest, royalties and dividends are included as income because they arise from the use of an
entity's assets by other parties.
Various types of revenue arising from leases, changes in value of financial instruments or other
current assets, insurance contracts, natural increases in agricultural assets and mineral ore
extraction, are covered by other standards and are therefore specifically excluded from this
standard. Reference can be made to the other specific standards for the accounting treatment of
these types of revenue.
294
HKAS 18.7,8 2.2 Definitions

The following definitions are given in the standard.
Key terms
Revenue is the gross inflow of economic benefits during the period arising in the course of the
ordinary activities of an entity when those inflows result in increases in equity, other than increases
relating to contributions from equity participants.
orderly transaction between market participants at the measurement date. (HKAS 18)
Revenue does not include items which do not represent a flow of economic benefit into the entity,
e.g. sales taxes, value added taxes or goods and service taxes which are only collected for third
parties. The same should apply to revenues collected by an agent on behalf of a principal.
Revenue for the agent is only the commission earned from the principal for acting as an agent.
HKAS 2.3 Measurement of revenue

18.9,10
Topic highlights
Revenue is measured at the fair value of consideration received or receivable.
Revenue shall be measured at the fair value of the consideration received or receivable,
taking into account the amount of any trade discounts and volume rebates allowed by the
entity.
This is usually decided by agreement between the buyer and seller.
HKAS 18.11 2.3.1 Deferred consideration
When consideration is deferred, the fair value of the amount receivable may be less than the
nominal amount of cash receivable.
In this case, the arrangement effectively constitutes a financing transaction resulting in both
revenue (sales) income and interest income. The fair value of sales consideration is determined by
discounting all amounts receivable using an imputed rate of interest. This is the more clearly
determinable of either:
 the prevailing rate for a similar instrument of an issuer with a similar credit rating; or
 a rate of interest that discounts the nominal amount of the instrument to the current cash
sales price of the goods or services.
The difference between the fair value and nominal amount of consideration is recognised as
interest revenue.
Example: Sofa Co.

Sofa Co. manufactures and sells furniture. It provides all customers with two years' "interest free
credit". On 31 March 20X9, the last day of the accounting year, Sofa Co. made sales of $790,000,
with all customers taking advantage of the interest free credit option.
Sofa Co. has an imputed rate of interest of 6%.
What amounts are recorded in the financial statements of Sofa Co. in respect of the above sale in
the years ended 31 March 20X9, 20Y0 and 20Y1?
295
Financial Reporting
Solution
Sofa Co. must discount the $790,000 before recording revenue in respect of the sales:
2
$790,000  1/1.06 = $703,097
This discounted amount is recognised as revenue in the year ended 31 March 20X9 and as a
receivable:
$ $
DEBIT Receivable 703,097
CREDIT Revenue 703,097
In the year ended 31 March 20Y0, the discount is unwound and the receivable increased by
$42,186 (6%  $703,097) to $745,283. This amount is also recognised as interest income:

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

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

CREDIT Receivable 790,000
HKAS 18.12 2.3.2 Exchanges of goods and services

Where goods and services are exchanged for other goods and services of a similar nature and
value, the transaction is not considered to generate revenue.
Where goods and services are exchanged for dissimilar goods or services, the transaction is
regarded as generating revenue, and the revenue is measured at the fair value of the goods or
services received (less any cash or cash equivalents paid).
Where the fair value of the goods or services received cannot be reliably measured, revenue is
measured at the fair value of goods or services given up (less any cash transfer).
HKAS 18.13 2.4 Identification of the transaction

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

On 1 March 20X4 Mainframe Co. contracted to deliver a customer a computer system on that date
and provide support and maintenance services for the following three years. The price of the
contract to provide both the computer system and support and maintenance services is $800,000.
The cost of providing support and maintenance services is $50,000 per annum and Mainframe
charges a standard 50% profit mark-up
What revenue is recognised in the financial statements of Mainframe in the year ended
31 December 20X4?
296
Solution
The revenue must be broken down into that relating to the provision of the computer system and
that relating to the three years of support and maintenance.
The revenue relating to the support and maintenance is calculated based on the profit mark-up of
50%:
3 years  $50,000  150% = $225,000
Therefore, the revenue relating to the supply of the system is the balance of $800,000 – $225,000
= $575,000.
Revenue recognised in the year ended 31 December 20X4 is $637,500 ($575,000 + 10/36 
$225,000).
Conversely, seemingly separate transactions must be considered together if apart they lose
their commercial meaning. An example would be to sell an asset and at the same time enter into
an agreement to buy it back at a later date. The second transaction negates the substance of the
first and so both must be considered together. This sale and repurchase situation is considered in
more detail in section 2.9 of this chapter.
HKAS 18.14 2.5 Recognition: sale of goods

Topic highlights
Generally revenue is recognised on the sale of goods when the entity has transferred to the buyer
the significant risks and rewards of ownership and when the revenue can be measured
reliably.
All of the following five conditions have to be fulfilled before revenue from the sale of goods can be
recognised:
(a) The entity has transferred to the buyer the significant risks and rewards of ownership of the goods
(b) The entity retains neither continuing managerial involvement to the degree usually
associated with ownership, nor effective control over the goods sold
(c) The amount of revenue can be measured reliably
(d) It is probable that the economic benefits associated with the transaction will flow to the entity
(e) The costs incurred or to be incurred in respect of the transaction can be measured reliably
HKAS 18.15- 2.5.1 Transfer of risks and rewards
17
The transfer of risks and rewards can only be decided by examining each transaction. Usually, the
transfer occurs at the same time as either the transfer of legal title, or the passing of
possession to the buyer. This is what happens when you buy something in a shop – both title and
possession pass from the seller to the purchaser when the purchaser buys the goods and leaves
the shop with them.
If significant risks and rewards remain with the seller, then the transaction is not a sale and
revenue cannot be recognised yet, for example if the receipt of the revenue from a particular sale
depends on the buyer receiving revenue from his own sale of the goods.
It is possible for the seller to retain only an "insignificant" risk of ownership and for the sale and
revenue to be recognised. The main example here is where the seller retains title only to ensure
collection of what is owed on the goods. This is a common commercial situation, and when it arises
the revenue should be recognised on the date of sale.
297
Financial Reporting
HKAS 2.5.2 Probable economic benefits

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

When the outcome of a transaction involving the rendering of services can be estimated reliably,
the associated revenue should be recognised by reference to the stage of completion of the
transaction at the reporting date.
HKAS 2.6.1 Estimated reliably
18.20,23
The outcome of a transaction can be estimated reliably when all of the following conditions are
satisfied:
(a) The amount of revenue can be measured reliably.
(b) It is probable that the economic benefits associated with the transaction will flow to the entity.
(c) The stage of completion of the transaction at the reporting date can be measured reliably.
(d) The costs incurred for the transaction and the costs to complete the transaction can be
measured reliably.
The parties to the transaction will normally have to agree the following before an entity can make
reliable estimates.
(a) Each party's enforceable rights regarding the service to be provided and received by the
parties
(b) The consideration to be exchanged
(c) The manner and terms of settlement
HKAS 2.6.2 Stage of completion
18.24,25
There are various possible methods of determining the stage of completion of a transaction,
including:
 surveys of work performed
 services performed to date as a percentage of total services to be performed
 costs incurred to date as a percentage of total estimated costs
For practical purposes, when services are performed by an indeterminate number of acts over a
period of time, revenue should be recognised on a straight line basis over the period, unless
there is evidence for the use of a more appropriate method. If one act is of more significance than
the others, then the significant act should be carried out before revenue is recognised.
298
HKAS 18.26- 2.6.3 Outcome cannot be estimated reliably

28
In uncertain situations, when the outcome of the transaction involving the rendering of services
cannot be estimated reliably, the standard requires that revenue is recognised only to the extent
of the expenses recognised that are recoverable.
This is particularly likely during the early stages of a transaction, but it is still probable that the
entity will recover the costs incurred. So the revenue recognised in such a period will be equal to
the expenses incurred, with no profit.
If the costs are not likely to be reimbursed, then they must be recognised as an expense
immediately. When the uncertainties cease to exist, revenue should be recognised as laid out in
the first paragraph of section 2.6.
HKAS 18.29 2.7 Recognition: interest, royalties and dividends

Revenue arising from the use by others of the entity's assets yielding interest, royalties and
dividends is recognised when:
(a) it is probable that the economic benefits associated with the transaction will flow to the entity,
and
(b) the amount of the revenue can be measured reliably
Once again, the points made above about probability and collectability on sale of goods also
apply here.
HKAS 2.7.1 Interest
18.30,32
Interest is recognised on a time proportion basis that takes into account the effective yield on the
asset.
The effective yield is the rate of interest required to discount the stream of future cash receipts
expected over the life of the asset to equate to the initial carrying amount of the asset.
When unpaid interest has accrued before an interest-bearing investment is acquired, the
subsequent interest received is allocated between pre and post acquisition periods. Only that
amount allocated to the post acquisition period is recognised as revenue.
HKAS 2.7.2 Royalties
18.30,33,
Illustrative Royalties are recognised on an accruals basis in accordance with the substance of the relevant
Guidance 20
agreement.
Royalties are usually recognised on the same basis that they accrue under the relevant
agreement. Practically this is often on a straight line basis over the life of the agreement.
Sometimes the true substance of the agreement may require some other systematic and rational
method of recognition.
Where rights are assigned for a fixed amount, the licensee is permitted to exploit those rights freely
and the licensor has no remaining obligations to perform, then the assignment is in effect a sale
and revenue should be recognised immediately. An example of this situation is a licensing
agreement to use software which is immediately downloaded by the purchaser.
In some cases the receipt of a royalty is contingent on a future event. Here revenue is recognised
only when it is probable that the royalty will be received. This is normally when the event has
occurred.
2.7.3 Dividends
Dividends are recognised when the shareholder's right to receive payment is established.
299
Financial Reporting
HKAS 18,
Illustrative
2.8 Determining whether an entity is an agent or principal
Guidance 21
Rules for determining whether an entity is acting as an agent were amended in 2009. In an agency
relationship, the gross inflows of economic benefits include amounts collected on behalf of the
principal and which do not result in increases in equity for the entity. The amounts collected on
behalf of the principal are not revenue. Instead, revenue is the amount of commission.
An entity is acting as a principal when it has exposure to the significant risks and rewards
associated with the sale of goods or the rendering of services. Features that indicate that an entity
is acting as a principal include:
(a) the entity has the primary responsibility for providing the goods or services to the customer
or for fulfilling the order, for example by being responsible for the acceptability of the
products or services ordered or purchased by the customer;
(b) the entity has inventory risk before or after the customer order, during shipping or on return;
(c) the entity has latitude in establishing prices, either directly or indirectly, for example by
providing additional goods or services; and
(d) the entity bears the customer’s credit risk for the amount receivable from the customer.
An entity is acting as an agent when it does not have exposure to the significant risks and rewards
associated with the sale of goods or the rendering of services. One feature indicating that an entity
is acting as an agent is that the amount the entity earns is predetermined, being either a fixed fee
per transaction or a stated percentage of the amount billed to the customer.
HKAS
18,Illustrative
2.9 Revenue recognition: examples
examples
The appendix to HKAS 18 provides a number of examples of the application of the recognition
criteria. These examples assume that the amount of revenue can be measured reliably, it is
probable that economic benefits will flow to the entity and costs can be measured reliably.
The following transactions are common in practice.
2.9.1 Consignment sales
Consignment sales are transactions whereby one entity (the seller) sells goods to another (the
buyer) and that entity undertakes to sell the goods to a third party on behalf of the seller. The
goods which are transferred are often referred to as consignment inventory. The seller normally
retains legal title to the goods until such time as they are sold on to a third party.
This form of arrangement is common in the motor trade whereby a manufacturer sells cars to a
dealer who sells them on to the ultimate customer. Often where an onward sale is not achieved,
the dealer can return the cars to the manufacturer.
In this situation, the risks and rewards are not deemed to have passed from the seller (the
manufacturer) to the buyer (the dealer) until such time as an onward sale is made. Therefore, the
manufacturer does not record a sale until a car is sold to a third party. In the meantime, although
the cars are in the dealer’s showroom, they remain the inventory of the manufacturer.
2.9.2 Bill and hold sales
Bill and hold sales refer to those sales where the buyer requests that delivery of goods purchased
is delayed, however in the meantime accepts legal title and billing.
In these circumstances, revenue is recognised when the buyer takes title, provided that:
(a) it is probable that delivery will be made
(b) the goods are available for delivery
(c) the buyer acknowledges the delayed delivery
(d) normal payment terms apply
300
2.9.3 Sale and repurchase agreements

A sale and repurchase agreement refers to a transaction where one party sells an asset to another,
but the terms of the sale provide for the asset to be repurchased by the seller at a later date under
certain conditions.
This form of arrangement is common amongst whisky distillers, who sell their stocks to banks while
they mature. When the whisky has matured, it is re-purchased by the distillery. The whisky is not, in
the meantime physically transferred to bank premises, but remains on site at the distillery. In this
case, the substance of the transaction is obviously a secured loan: the bank is effectively lending
money to the distillery secured on the whisky.
These arrangements should be accounted for in accordance with their commercial substance. Not all
situations will be as straightforward as the whisky example, and the appendix to HKAS 18 states that
consideration should be given as to whether the risks and rewards of ownership have been
transferred to the buyer (regardless of legal title). Where this is the case, a sale should be recorded.
HKAS
18.35,36
2.10 Disclosure
The following items should be disclosed.
(a) The accounting policies adopted for the recognition of revenue, including the methods
used to determine the stage of completion of transactions involving the rendering of services.
(b) The amount of each significant category of revenue recognised during the period
including revenue arising from:
(i) the sale of goods
(ii) the rendering of services
(iii) interest
(iv) royalties
(v) dividends
(c) The amount of revenue arising from exchanges of goods or services included in each
significant category of revenue.
Any contingent gains or losses, such as those relating to warranty costs, claims or penalties
should be treated according to HKAS 37 Provisions, Contingent Liabilities and Contingent Assets
(covered earlier).
Consider the following scenarios and discuss how HKAS 18 should be applied to each
(a) Bradley Co. owns an office building which cost $5m and has a market value of $7m. On
1 April 20X2, Bradley Co. sold the building to Beck Co., a finance company, for $5.5m.
Bradley Co. has entered into an agreement to repurchase the building in three years' time for
$7m and Bradley Co. will continue to occupy the building after sale.
(b) Marianne Alltraders entered into a six-month contract to undertake accountancy training for a
customer over the period 1 September 20X2 to 28 February 20X3. The value of services
performed to the year end amounts to $45,000 out of a total contract value of $60,000.
All costs are expected to be recoverable.
(c) Maximum Velocity sold some bicycles to a customer for $15,000 on 1 October 20X2.
The customer has the right to return any unsold bikes before 30 April 20X3 for a full refund.
(d) Admen performed advertising services for a customer costing $4,450 relating to a fixed price
$20,000 contract covering the period 1 December 20X2 to 31 March 20X3. Due to
fluctuating advertising costs, the expected total cost cannot be reliably measured at the year
end, but Admen is certain that the customer will pay the costs incurred to date.
The year end in all cases is 31 December 20X2.
301
Financial Reporting
3 Interpretations related to revenue recognition

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

3.1.1 What is a service concession arrangement?
Key term
Service concession arrangements are arrangements whereby a government or other body
grants contracts for the supply of public services – such as roads, energy distribution, prisons or
hospitals – to private operators. The objective of this project of the HK(IFRIC) is to clarify how
certain aspects of existing HKICPA literature are to be applied to service concession
arrangements. (HK(IFRIC) Int-12)
3.1.2 Two types of service concession arrangements

HK(IFRIC) Int-12 identifies two types of service concession arrangement:
(a) One in which the operator has a contractual right to receive cash or another financial asset
from the government
(b) One in which the operator receives an intangible asset being the right to charge for access
to the public sector asset that it constructs or upgrades.
HK(IFRIC) Int-12 allows for the possibility that both types of arrangement may exist within a
single contract: to the extent that the government has given an unconditional guarantee of
payment for the construction of the public sector asset, the operator has a financial asset; to the
extent that the operator has to rely on the public using the service in order to obtain payment, the
operator has an intangible asset.
3.1.3 Accounting – Financial asset model
For the first type of arrangement the operator recognises a financial asset measured at fair value
to the extent that it has an unconditional contractual right to receive cash or another financial asset
from or at the direction of the grantor for the construction services.
The operator has an unconditional right to receive cash if the grantor contractually guarantees to
pay the operator:
(a) specified or determinable amounts;
(b) the shortfall, if any, between amounts received from users of the public service and specified
or determinable amounts, even if payment is contingent on the operator ensuring that the
infrastructure meets specified quality or efficiency requirements.
3.1.4 Accounting – Intangible asset model
The operator recognises an intangible asset measured at fair value to the extent that it receives a
right (a licence) to charge users of the public service.
302
3.1.5 Operating revenue

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

Electricity Co. is a private sector entity, which has entered into an arrangement with government to
supply a minimum quantity of electricity for 30 years to the public within a specific district.
Electricity Co. designs and builds a power plant on government land to produce the needed
electricity and maintains control over all significant aspects of operating the power plant within the
terms of the agreement. The agreement provides for the following:
 The legal title to the power plant will be transferred to the government body at the end of the
arrangement.
 Electricity Co. is responsible for repairs, maintenance, and capital expenditure related to the
power plant.
 Electricity Co. must stand ready to deliver a minimum quantity of electricity each month.
 Electricity Co. is paid by the public directly, charge is based primarily on their own usage.
 The government regulates the prices that Electricity Co. may charge to the public such that
Electricity Co.'s return is capped by reference to operating costs and capital investment. The
government does not guarantee any minimum level of income for Electricity Co.
How should the above transaction be accounted for?
Solution
The transaction illustrates certain characteristics of a service concession arrangement that falls
within the scope of HK(IFRIC) 12:
 The arrangement is between a public sector entity (the government) and an entity from the
private sector (Electricity Co.);
 An infrastructure asset is constructed by Electricity Co. for the purpose of the arrangement,
and is used to supply electricity to public;
 The government (the grantor) has control over the use of the power plant through the
following means:
– The government specifies the goods to be delivered (electricity) and to whom the
electricity should be provided (the public in the specified district); and
– The income that Electricity Co. needs to generate to cover both its operating costs and
the initial capital outlay from constructing the facility is wholly dependent on the user’s
demand for the electricity, the demand risk borne by Electricity Co.. However, the
arrangement still falls within the scope of HK(IFRIC) 12 as the government controls
the pricing through a capping mechanism (provided the cap is considered to be
substantive) and controls the residual interest in the facility, through the agreement
specifying that the facility must revert to government at the end of the concession
period.
Electricity Co. provides construction services to the grantor by constructing the facility. However,
instead of receiving an unconditional right to receive cash, it has obtained a right to charge the
public for electricity usage, i.e. it has obtained an intangible asset.
As stated in HK(IFRIC) 12, Electricity Co. does not recognise the facility as its own property, plant
and equipment, even though it is fully exposed to demand risk in respect of the electricity users.
303
Financial Reporting
During the construction phase:

DEBIT Intangible asset
CREDIT Construction revenue
Being the fair value of construction service provided under development
DEBIT Construction cost
CREDIT Cash
Being construction costs incurred
During the operating phase:
DEBIT Cash
CREDIT Operating revenue
Being electricity charges levied on the users
DEBIT Operating costs
CREDIT Cash
Being operating cost incurred (e.g. fuel, employee cost etc.)
DEBIT Operating costs
CREDIT Intangible asset
Being amortisation and/or impairment of the intangible asset during the year
If the government had guaranteed that Electricity Co. would receive a minimum amount, i.e.
had agreed to top up a short-fall in receipts from the public, Electricity Co. would recognise a financial
asset to the extent that it had an unconditional contractual right to receive cash (or another financial
asset) and an intangible asset for the right to receive cash from users above the guaranteed minimum.
3.2 HK(IFRIC) Int-13 Customer Loyalty Programmes

3.2.1 The issue
Customer loyalty programmes are programmes whereby customers who buy goods or services are
awarded credits by an entity. These may include reward points or travel miles and can be
redeemed in the future for free or discounted goods.
HK(IFRIC) Int-13 Customer Loyalty Programmes addresses accounting for such arrangements by
the entities which grant the credits.
The deferred amount is recognised as revenue only when the entity has fulfilled its obligations by
supplying the awards itself or paying a third party to do so.
3.2.2 Key provisions
The Interpretation requires that the proceeds of the initial sale are split between:
 revenue, and
 deferred revenue associated with the credits awarded
The proceeds recognised as deferred revenue are measured by reference to the fair value of the
credits awarded. The fair value of award credits should take into account:
 the amount of discounts or incentives that would otherwise be offered to customers who
have not earned award credits from an initial sale; and
 the proportion of award credits that are not expected to be redeemed by customers (any
expected forfeitures), If customers can choose from a range of different awards, the fair
value of the award credits will reflect the fair values of the range of available awards,
weighted in proportion to the frequency with which each award is expected to be selected.
304
The deferred amount is recognised as revenue only when the entity has fulfilled its obligations by
supplying the awards itself or paying a third party to do so.
HK(IFRIC) Int-13 gives a choice as to whether the amount allocated to the award credits should be:
(a) Equal to their fair value (irrespective of the fair values of the other components); or
(b) A proportion of the total consideration based on the fair value of the award credits relative to
the fair values of the other components of the sale.
In developing the HK(IFRIC) Int-13, it was decided that it should not be more prescriptive than
HKAS 18 Revenue, which does not specify which of the above should be used.
If at any time the expected costs of meeting the obligation exceed the consideration received, the
entity has an onerous contract for which HKAS 37 would require recognition of a liability.
If HK(IFRIC) Int-13 causes an entity to change its accounting policy for customer loyalty awards,
HKAS 8 applies.
Example: Loyalty points

Loyalty points can arise in one of two ways – either by the entity implementing its own loyalty
programmes (e.g. Park-N-Shop) or by a third party applying such loyalty programmes (e.g. HSBC
credit card providing the programme for the retailers who participate in its programme). The entity
can also recognise this deferred revenue by either allocating the deferred revenue systematically
(amortisation) or on a sale-by-sale basis. The following examples are shown on a sale-by-sale
basis for convenience.
Case 1 is easy, according to paragraph 7 of the Interpretation:
If the entity supplies the awards itself, it shall recognise the consideration allocated to
award credits as revenue when award credits are redeemed and it fulfils its obligations to
supply awards. The amount of revenue recognised shall be based on the number of award
credits that have been redeemed in exchange for awards, relative to the total number
expected to be redeemed.
What that essentially means is this: take Park-N-Shop for example, who award one point for every
$100 that a customer spends: every 100 points can be redeemed for goods with a retail price of
$100. The accounting entries following a sale of goods for $200 would be:
$ $
DEBIT Cash/credit card receivables 200
CREDIT Deferred revenue – Loyalty points ($200/$100  1 point) 2
CREDIT Revenue 198
A portion of the consideration paid by the customer will be allocated to deferred revenue as above,
measured as the fair value of the points awarded. Then when the customer utilises their points the
next time they spend:
$ $
DEBIT Deferred revenue 2
CREDIT Revenue 100
So in essence a proportion of revenue is deferred until later.
Case 2 refers to paragraph 8 of the Interpretation:
If a third party supplies the awards, the entity shall assess whether it is collecting the
consideration allocated to the award credits on its own account (i.e. as the principal in the
transaction) or on behalf of the third party (i.e. as an agent for the third party).
(a) If the entity is collecting the consideration on behalf of the third party, it shall:
(i) measure its revenue as the net amount retained on its own account, i.e. the
discounts or incentives that otherwise would be offered to customers that have
not earned the award credits; and
305
Financial Reporting
(ii) recognise this net amount as revenue when the third party becomes obliged to
supply the awards and entitled to receive consideration for doing so. These
events may occur as soon as the award credits are granted. Alternatively, if the
customer can choose to claim awards from either the entity or a third party,
these events may occur only when the customer chooses to claim awards from
the third party.
(b) If the entity is collecting the consideration on its own account, it shall measure its
revenue as the gross consideration allocated to the award credits and recognise the
revenue when it fulfils its obligations in respect of the awards.
In paragraph 8(a)(i) and (ii) of the Interpretation the entity supplying the award credits is acting as
an agent of the third party supplying the awards, which may be the case with airline loyalty
programmes where retailers or other service firms pay the airline a cost per mile for using their
loyalty programmes. However in case (b) the reference is to a similar programme but where the
retailer acts as a principal on their own account.
Look first at the accounting entries in the situation of Paragraph 8(a). Say that a retailer has a
loyalty programme arrangement with an airline such that, for every $10 that the customer spends
with the retailer, he is awarded one point which can be redeemed for one mile.
The face value of each point is $1. For each point issued, the retailer will pay $0.8 to the airline.
If the retailer makes a sale of $200 the accounting entries would be:
$ $
CREDIT Commission income (20  $0.2) 4
Liability to airline (20  $0.8) 16
Revenue 180
The retailer acts as an agent of the airline and earns commission of $0.2 per point issued. A sale of
$200 leads to the issue of 20 points and commission income of 20  $0.2 = $4.
The benefits of such a scheme to the retailer are that they do not have to incur resources to
administer the scheme (the airline administers the redemptions) and they can exit the scheme at
any time with no obligation for the outstanding points.
If the retailer has collected the consideration allocated to the points on its own account, i.e. acting
as a principal rather than as an agent, then it is entitled to measure its income from the points as
the gross $20 in the example above, but must separately recognise the $16 payable to the airline
as an expense. In either case the net income of $4 is ultimately recognised from the transaction.
$ $
CREDIT Income from loyalty programme (20 x $1) 20
Revenue 180
And
DEBIT Loyalty programme expense (20 x $0.8) 16
CREDIT Liability to airline 16
3.3 HK(IFRIC) Int-15 Agreements for the Construction of Real

Estate
HK(IFRIC) Int-15 Agreements for the Construction of Real Estate is effective for annual periods
beginning on or after 1 January 2009.
3.3.1 Reasons for issuing HK(IFRIC) Int-15
The issues addressed in the Interpretation were first published in a draft Interpretation D21 Real
Estate Sales in July 2007. In response to concerns expressed in relation to improving the
articulation between HKAS 11 Construction Contracts and HKAS 18 Revenue and providing
306
additional guidance on how to account for revenue in HKAS 18, the Hong Kong Financial Reporting
Interpretations Committee (HK(IFRIC)) provides guidance on the following two issues in HK(IFRIC)
Int-15:
 Determining whether an agreement for the construction of real estate is within the scope of
HKAS 11 or HKAS 18
 When revenue from the construction of real estate should be recognised
The Interpretation standardises accounting practice across jurisdictions for the recognition of
revenue among real estate developers for sales of units, such as apartments or houses, "off plan",
that is, before construction is complete.
3.3.2 Main features of HK(IFRIC) Int-15
The detailed guidance in HK(IFRIC) Int-15 assumes that the entity has previously analysed the
agreement for the construction of real estate and any related agreements and concluded that it will
retain neither continuing managerial involvement to the degree usually associated with ownership
nor effective control over the constructed real estate to an extent that would preclude recognition of
some or all of the consideration as revenue. If recognition of some of the consideration as revenue
is precluded, the following discussion applies only to the part of the agreement for which revenue
will be recognised.
In some circumstances, agreements may need to be split into separately identifiable components,
with each such component being accounted for separately and the fair value of the total
consideration received or receivable for the agreement allocated to each component. The seller
then applies the requirements of HK(IFRIC) Int-15 to any components for the construction of real
estate in order to determine whether each component is within the scope of HKAS 11 or HKAS 18.
3.3.3 Determining whether the agreement is within the scope of HKAS 11 or
HKAS 18
HKAS 11 applies when the agreement meets the definition of a construction contract set out in
paragraph 3 of HKAS 11. An agreement for the construction of real estate meets the definition of a
construction contract when the buyer is able to specify:
(a) the major structural elements of the design of the real estate before construction begins,
and/or
(b) major structural changes once construction is in progress (whether or not it exercises that
ability).
In contrast, if construction could take place independently of the agreement and buyers have only
limited ability to influence the design of the real estate, the agreement will be for the sale of goods
or the rendering of services and within the scope of HKAS 18.
3.3.4 Accounting for revenue from construction of real estate
Construction contracts (within the scope of HKAS 11)
Where the agreement is a construction contract under HKAS 11, and the outcome of the contract
can be estimated reliably, revenue is recognised by reference to the stage of completion of the
contract activity in accordance with HKAS 11. HK (IFRIC) Int-15 has not introduced any new
requirements or guidance that will affect such contracts.
Agreements for the rendering of services (HKAS 18)
Where the agreement falls within the scope of HKAS 18, and the entity is not required to acquire
and supply construction materials, it may be only an agreement for the rendering of services. This
may arise, for example, in arrangements where the customer acts in essence as its own general
contractor and enters into agreements with individual suppliers for specific goods and services.
Where the entity is responsible only for assembling materials supplied by others (i.e. it has no
inventory risk for the construction materials), the agreement is an agreement for the rendering of
services.
307
Financial Reporting
In such circumstances, if the criteria in HKAS 18 are met, revenue is recognised by reference to
the stage of completion of the transaction using the percentage of completion method.
The requirements of HKAS 11 are generally applicable to the recognition of revenue and the
associated expenses for such a transaction.
Agreements for the sale of goods (HKAS 18)
An agreement for the construction of real estate will be an agreement for the sale of goods under
HKAS 18 if it involves the provision of services together with construction materials. For such
contracts, the applicable recognition criteria are those set out in HKAS 18.
The Interpretation focuses on the criteria that revenue can only be recognised when the entity has
transferred to the buyer control and the significant risks and rewards of ownership of the goods,
and distinguishes between circumstances in which these criteria are met "at a single point in time"
and "continuously as construction progresses".
If transfer of control and the significant risks and rewards of ownership of the real estate in its
entirety occurs at a single point of time (e.g. at completion, upon or after delivery), revenue is
recognised only when all the criteria in HKAS 18 are satisfied. Assuming that all of the other criteria
in HKAS 18 are met, this will be upon the occurrence of that single critical transfer of control and
the significant risks and rewards of ownership.
The Interpretation also envisages that the entity may transfer to the buyer control and the
significant risks and rewards of ownership of the work in progress in its current state as
construction progresses. In this case, if all of the criteria in HKAS 18 are met continuously as
construction progresses, revenue is recognised by reference to the stage of completion using the
percentage of completion method. The requirements of HKAS 11 are generally applicable to the
recognition of revenue and the associated expenses for such a transaction.
3.3.5 Disclosures
When an entity recognises revenue using the percentage of completion method for agreements
that meet all the criteria in HKAS 18 continuously as construction progresses (see above), the
following disclosures are required:
 How the entity determines which agreements meet all the criteria in HKAS 18 continuously
as construction progresses
 The amount of revenue arising from such agreements in the period
 The methods used to determine the stage of completion of agreements in progress
For any such agreements that are in progress at the reporting date, the following disclosures are
also required:
 The aggregate amount of costs incurred and recognised profits (less recognised losses) to
date
 The amount of advances received
Consequential amendments to the Appendix in HKAS 18
HK(IFRIC) Int-15 superseded the real estate guidance (Example 9) in HKAS 18.
Additional guidance
HK(IFRIC) Int-15 is accompanied by an information note which, although not part of the
Interpretation, summarises its requirements in the form of two flowcharts, which are reproduced in
the Appendix.
In addition, three illustrative examples designed to assist in the application of the Interpretation
accompany HK(IFRIC) Int-15.
308
Effective date and transition

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

An entity is developing residential real estate and starts marketing individual units (apartments)
while construction is still in progress. Buyers enter into a binding sale agreement that gives them
the right to acquire a specified unit when it is ready for occupation. They pay a deposit that is
refundable only if the entity fails to deliver the completed unit in accordance with the contracted
terms. Buyers are also required to make progress payments between the time of the initial
agreement and contractual completion.
The balance of the purchase price is paid only on contractual completion, when buyers obtain
possession of their unit. Buyers are able to specify only minor variations to the basic design but
they cannot specify or alter major structural elements of the design of their unit. In the jurisdiction,
no rights to the underlying real estate asset transfer to the buyer other than through the agreement.
Consequently, the construction takes place regardless of whether sale agreements exist.
How should the above transaction be accounted for?
Solution
In this transaction, the terms of the agreement and all the surrounding facts and circumstances
indicate that the agreement is not a construction contract. The agreement is a forward contract that
gives the buyer an asset in the form of a right to acquire, use and sell the completed real estate at
a later date and an obligation to pay the purchase price in accordance with its terms.
Although the buyer might be able to transfer its interest in the forward contract to another party, the
entity retains control and the significant risks and rewards of ownership of the work in progress in
its current state until the completed real estate is transferred. Therefore, revenue should be
recognised only when all the criteria of HKAS 18 are met (at completion in this example).
Alternatively, assume that, in the jurisdiction, the law requires the entity to transfer immediately to
the buyer ownership of the real estate in its current state of completion and that any additional
construction becomes the property of the buyer as construction progresses.
The entity would need to consider all the terms of the agreement to determine whether this change
in the timing of the transfer of ownership means that the entity transfers to the buyer control and
the significant risks and rewards of ownership of the work in progress in its current state as
construction progresses. For example, the fact that if the agreement is terminated before
construction is complete, the buyer retains the work in progress and the entity has the right to be
paid for the work performed, might indicate that control is transferred along with ownership. If it
does, and if all the criteria in HKAS 18 are met continuously as construction progresses, the entity
recognises revenue by reference to the stage of completion using the percentage of completion
method taking into account the stage of completion of the whole building and the agreements
signed with individual buyers.
309
Financial Reporting
(a) Realbuild operates in the house building sector and currently does not report under HKFRS.
In the market in which Realbuild operates, the custom is to sign a contract which includes a
completion date when funds are transferred and the keys passed to the buyer. Realbuild's
accounting policy is to recognise revenue on signing the contract. Where there is still
building work to be completed after the keys are passed to the buyer, Realbuild delays
revenue recognition until the completion of the work.
(b) BCN Productions is a film production house. The company licenses one of its new films to a
distributor in a foreign country over which BCN Productions has no control. The film is
expected to appear before the public over a period of six months and BCN Productions
intends to recognise the revenue over this period.
(c) KSoft is a start-up company that will develop bespoke software systems for corporate clients.
The company's policy is to invoice fixed amounts which include the software development
and fees for ongoing post-delivery support while the new software system is implemented.
KSoft intends to recognise the revenue for both elements on installation of the software.
Required
Advise the directors as to the acceptability of the above accounting policies for revenue recognition
under HKAS 18 Revenue.
310
Analysis of a single agreement for the construction of real estate
Can components other than for the construction of real No

estate be identified within the agreement (e.g. a sale of land A
or provision of property management service)?
Yes
Split the agreement into separately identifiable components
Allocate the fair value of the consideration received or

receivable to each component
Separate components
Component(s) for the delivery of other Component for the construction of real estate
goods or services and directly related services (in accordance A
with HKAS 18)
Apply HKAS 18
Does the agreement or Yes The agreement or component is Revenue and costs are
A component meet the definition a construction contract within recognised by reference to the
of a construction contract? the scope of HKAS 11* stage of completion
No
Is the agreement or component Yes The agreement or component is Revenue and costs are
only for the rendering of for the rendering of services recognised by reference to the
services? within the scope of HKAS 18 stage of completion
No
The agreement or component is Are the criteria for recognising Revenue and costs are
for the sale of goods within the revenue from the sale of goods Yes recognised by reference to the
scope of HKAS 18 ** met on a continuous basis? stage of completion
No Revenue is recognised when all

the conditions in paragraph 14
of HKAS 18 have been satisfied
* The construction contract may need to be segmented in accordance with paragraph 8 of HKAS 11
** Directly related services may need to be separated in accordance with paragraph 13 of HKAS 18
311
Financial Reporting
The IASB and FASB issued an Exposure Draft (ED) in relation to revenue recognition in June
2010. A revised exposure draft on the topic of revenue from contracts with customers was issued in
November 2011, which simplifies a number of the original proposals. A new standard is expected
during the course of 2013 and this will replace both IAS 18 Revenue and IAS 11 Construction
Contracts (and so their HKAS equivalents).
The proposals would require an entity to:
1 Identify a contract with a customer.
2 Identify separate performance obligations in the contract (such that if more than one good or
service is promised, each is accounted for separately only if it could be sold separately or the
customer could benefit from the good or service either alone or together with resources
which are readily available).
3 Determine the transaction price as the amount of consideration to which an entity expects to
be entitled in exchange for transferring promised goods or services to a customer, excluding
amounts collected on behalf of third parties.
4 Allocate the transaction price to the separate performance obligations in proportion to the
standalone selling price of the goods or services underlying each performance obligation.
5 Recognise revenue when each performance obligation is satisfied by the transfer of the
promised good or service to the customer.
The ED also proposes that the costs of obtaining a contract are recognised as an asset if the entity
expects to recover those costs.
Costs of fulfilling a contract which are not eligible for capitalisation in accordance with another
standard would be capitalised only if they:
 relate directly to a contract
 generate or enhance resources which will be used to satisfy future performance obligations,
and
 are expected to be recovered.
For many companies this new approach will not result in a significant change to the amount or
timing of revenue recognised. In other cases there will be a change, for example, when a mobile
phone contract is sold and a handset is provided free of charge, the standard would now require
separate up front recognition of revenue relating to the handset.
312
Topic recap
HKAS 18 Revenue Recognition
Measure at the fair value of consideration received or

receivable.
Discount deferred consideration; difference between cash
receivable and discounted amount is interest receivable.
Sale of goods Provision of services Interest, royalties and

dividends
Recognise when: Recognise when: Recognise when:

significant risks and rewards revenue can be measured probable economic
transferred to buyer reliably benefits will flow to the
no retention of managerial probable economic benefits entity
involvement / effective control will flow revenue can be
revenue can be measured stage of completion can be measured reliably
reliably measured reliably
probable economic benefits costs can be measured
will flow reliably
costs can be measured reliably
Examples:
Consignment sales recognised as revenue
when goods sold on to third party
Bill and hold sales revenue recognised when
buyer takes title provided that the goods are
available, payment terms are normal, delayed
delivery is acknowledged and delivery is
probable.
Sale and repurchase agreements may in
substance be secured loans.
Disclose:
Accounting policies
The amount of each significant category of revenue
The amount of revenue arising from exchanges of goods or services in each category.
HKAS
HK (IFRIC)
18 Revenue
Interpretations
Recognition
HK(IFRIC) Int-12 Service HK(IFRIC) Int-13 Customer HK(IFRIC) Int-15 Agreements

Concession Arrangements Loyalty Programmes for Construction of Real Estate
Recognise when: Where a customer is HKAS 11 applies where the

financial asset model applies awarded “credits” when buyer can specify major
where unconditional making a purchase, sales structural elements of design
contractual right to receive proceeds are split between before construction begins /
cash immediate revenue major structural changes once
intangible asset model applies deferred revenue associated construction is in progress.
to extent there is right to with the credits
charge users of service Otherwise HKAS 18 applies.
HKAS 11/18 may be applied.
313
Financial Reporting
Answer 1
(a) There are a number of factors that suggest the substance of this transaction is different to its
legal form. First, the building has a market value of $7m and is being sold for less than
market value, which immediately looks odd. Second, there is an agreement for Bradley Co.
to repurchase the assets in the future. If it were a genuine sale, this would be an unlikely
clause. Third, Bradley Co. retains occupancy of the building – again, if this were a genuine
sale it would be very unlikely that an asset would be sold and not occupied or used by the
purchaser.
Therefore, it seems obvious that the substance of this transaction is a secured loan. Bradley
Co. should continue to recognise the building in the statement of financial position as they
have the risks and rewards of ownership. The cash received from Beck Co. should be
recorded as a non-current liability and the finance on the loan should be charged in the
statement of profit or loss over the three-year period. The finance charge could be calculated
as the difference between the "sale" proceeds and the repurchase amount.
(b) Revenue should be accrued by Marianne Alltraders based on value of work performed rather
than accrued on a time apportioned basis in accordance with HKAS 18. Revenue recognised
is therefore $45,000.
(c) Maximum Velocity should not recognise any revenue in respect of the bicycles as the
significant risks and rewards of ownership have not been transferred at the year end. The
bikes remain in Maximum Velocity’s inventories until confirmation has been received from
the customer that they have been sold on and any money received from him is treated as a
payment in advance.
(d) Since the outcome of the service transaction cannot be reliably measured at the year end,
only $4,450 is recognised as revenue by Admen rather than on a time apportioned basis.
This matches with the costs recognised ensuring that no profit is recorded until the outcome
can be reliably measured.
Answer 2
(a) The general rule under HKAS 18 Revenue is that revenue is recognised when the significant
risks and rewards of ownership have been transferred and there is no continuing managerial
involvement or effective control.
HK(IFRIC) 15 provides additional guidance regarding real estate sales and states that
revenue is recognised when the entity transfers control as well as the risks and rewards of
ownership, i.e. when the legal completion occurs and the keys are handed over in this case.
Realbuild's current policy recognises the revenue before this is the case: revenue should be
recognised on the contract completion date rather than on signing the contract.
Where there is continuing building work to be undertaken, revenue can be recognised
provided the property has been delivered, so Realbuild's policy needs to be amended here
as well. However, a provision is also required to be recognised for the cost of work yet to be
performed and this is charged to profit or loss at the same time as the revenue is recognised,
i.e. on delivery of the property.
Note. A house-builder such as Realbuild selling to the general public is entering into
contracts to sell goods rather than a construction contract, as the buyer is not able to specify
the major structural elements of the design, which would be an indication of a construction
contract.
314
(b) Licence fees (and royalty income) are normally recognised straight line over the life of the
agreement. However, where the licensee has no remaining obligations to perform, or, as in
this case, no control over the use of the images once licensed, the substance of the
transaction is a sale, and revenue should be recognised at the time of sale, so BCN
Productions' policy is not appropriate.
(c) HKAS 18 provides guidance on the recognition of revenue from the development of
customised software: it should be recognised by reference to the stage of completion of the
development including completion of the services provided for post-delivery support.
Consequently, it is not appropriate to recognise the revenue on installation: it should be
recognised over the period of development and support (although not necessarily straight
line as can be matched to the level of work done in each period).
315
Financial Reporting
Exam practice
Nero Fashion 29 minutes

Nero Fashion Limited (NFL) is a clothing manufacturer in mainland China and distributes its
products through the following channels:
 Counter sales at department stores – walk-in customers purchase and collect the goods
upon the issue of an invoice by and make cash or credit card payments to the department
stores. In accordance with the consignment contract signed between the department store
and NFL, the selling price is determined and inventory is managed by NFL, the sales teams
are employed by NFL while the cashier service is provided by the department stores. The
department stores pay 80% of the retail price of the goods sold to NFL on a monthly basis.
The department stores accept returns or exchanges of goods within 7 days of the invoice
date and all these items are returned to NFL and the amounts deducted from the total
remitted to NFL.
 Distributors – NFL ships the goods to the designated location in accordance with the
instructions of the distributors, including the items and quantity requested. Distributors can
open their own retail store to sell the goods, but NFL will determine the retail prices for the
goods, which are normally the same as the prices offered in counter sales at department
stores. Goods are not returnable except for items with quality problems which can be
returned within 7 days of delivery. The distributors have to sign and return an acceptable
confirmation at the completion of quality inspection or 7 days of delivery, whichever is earlier.
NFL will issue an invoice to the distributors at 50% of the pre-determined retailing price of
items delivered on a monthly basis.
Based on the past three years historical data, less than 0.1% of sales were returned from
customers of department stores within the 7-day period and around 5% of sales were returned from
distributors before signing the confirmation under the above return policies.
Required
(a) Discuss how NFL should account for the sales revenue through these channels, with
reference to HKAS 18 Revenue.
(i) Counter sales at department stores (7 marks)
(ii) Distributors (6 marks)
(b) Discuss how NFL should account for monthly revenue if it will give a 10% discount of the
invoiced amount to the distributors when the respective annual quantity delivered is above
100,000 pieces. (3 marks)
(Total = 16 marks)
HKICPA June 2012 (amended)
316
chapter 15
Income taxes
Topic list 5 Measurement of deferred tax

5.1 Full provision method
1 Current tax 5.2 Applicable tax rate
1.1 Definitions 5.3 Discounting
1.2 Recognition of current tax liabilities and
6 Recognition of deferred tax
assets
1.3 Measurement of current tax 7 Presentation of deferred tax
1.4 Recognition of current tax
1.5 Presentation of current tax 8 Summary flowchart
2 Introduction to deferred tax 9 Disclosure of income taxes

2.1 Calculation of deferred tax 9.1 Reconciliation
2.2 Definitions 10 Deferred taxation and business
2.3 Measurement of deferred tax combinations
2.4 Recognition of deferred tax 10.1 Temporary differences arising as a result
3 Taxable temporary differences of business combinations
3.1 Examples of taxable temporary differences 10.2 Recognition criteria
3.2 Taxable temporary differences which do 10.3 Application of the recognition criteria
not result in deferred tax liabilities 10.4 Recognition of deferred tax assets
arising from business combinations
4 Deductible temporary differences 10.5 Section summary
4.1 Examples of deductible temporary
differences 11 Interpretations relating to deferred tax
4.2 Recognition of deferred tax assets 11.1 HK(SIC) Int-21 Income Taxes –
4.3 Deductible temporary differences which do Recovery of Revalued Non-depreciable
not result in deferred tax assets Assets
4.4 Tax losses and credits carried forward 11.2 HK(SIC) Int-25 Income Taxes – Changes
4.5 Reassessment of unrecognised deferred in the Tax Status of an Entity or its
tax assets Shareholders
Learning focus
Tax in one form or another is relevant to all organisations. You should therefore ensure that
you fully understand its operation in the financial statements. Hence this topic may appear with
other topics. You must study it and understand its relationship with other assets and liabilities.
Of course, in a business situation, the deferred tax consideration is always an important topic
as it may change the investment decision.
317
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.18 Income taxes 2
3.18.01 Account for current tax liabilities in accordance with HKAS 12
3.18.02 Record entries relating to income tax in the accounting records
3.18.03 Identify temporary differences (both inside and outside difference)
and calculate deferred tax amounts
3.18.04 Account for tax losses and tax credits
3.18.05 Identify initial recognition exemption for assets and liabilities
3.18.06 Account for deferred tax relating to investments in subsidiaries,
associates and joint ventures
3.18.07 Determine when tax assets and liabilities can be offset
3.18.08 Disclose relevant information with regard to income taxes
318
15: Income taxes | Part C Accounting for business transactions
1 Current tax
Topic highlights
Taxation consists of two components:
 Current tax
 Deferred tax
HKAS 12 Income Taxes covers both current and deferred tax.

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

These are some of the definitions given in HKAS 12. We will look at the rest later.
Key terms
Accounting profit. Profit or loss for a period before deducting tax expense.
Taxable profit/(tax loss). The profit (loss) for a period, determined in accordance with the rules
established by the taxation authorities, upon which income taxes are payable (recoverable).
Tax expense/(tax income). The aggregate amount included in the determination of profit or loss
for the period in respect of current tax and deferred tax.
Current tax. The amount of income taxes payable (recoverable) in respect of the taxable profit (tax
loss) for a period. (HKAS 12)
HKAS
12.12,13
1.2 Recognition of current tax liabilities and assets
Topic highlights
Current tax is the amount payable to the tax authorities in relation to the trading activities during
the period. It is generally straightforward.
The amount of tax payable (or receivable) must be calculated and then charged (or credited) to
profit or loss for the period and shown in the statement of profit or loss and other comprehensive
income.
Any unpaid tax in respect of the current or prior periods must be recognised as a liability.
Conversely, any excess tax paid in respect of current or prior periods over what is due should be
recognised as an asset.
1.2.1 Over and underprovisions
The year end tax liability (or asset) is generally an estimated amount, not settled until a later date.
It is often the case, therefore, that the liability (or asset) recognised is not equal to the amount
eventually paid (or recovered):
319
Financial Reporting
 Where the estimated tax liability exceeds the tax later paid to the authorities, tax has been
overprovided.
 Where the estimated tax liability is less than the tax later paid to the authorities, tax has been
underprovided.
This under- or over-provision must be adjusted for in the following year’s tax charged to profit or loss:
$
Estimated current year tax charge X
Under/over provision in respect of prior year X/(X)
Income tax charge for the year X
Moorland operates in Hong Kong and is subject to a 16.5% tax rate. In the year ended
31 December 20X1, the company had tax-adjusted profits of $760,000. In the year ended
31 December 20X0, a current year tax liability of $130,000 was recognised; tax subsequently paid
in respect of the year was $126,700.
(a) What amounts are recognised in Moorland’s financial statements in respect of tax in the year
ended 31 December 20X1?
(b) How does your answer change if the tax paid in respect of 20X0 was $131,000?
HKAS 12.14 1.2.2 Tax losses carried back

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

Dredger operates in a jurisdiction where trading losses may be carried back one year to offset
against trading profits for the purposes of tax. In the year ended 31 December 20X1, Dredger had
tax-adjusted profits of $126,000; in the following year, the company reported a tax-adjusted loss of
$46,000. Dredger pays tax at 20%.
Required
Calculate the tax effect and prepare the corresponding journal entry for 20X2.
Solution
Tax due on profits in 20X1 is $25,200 ($126,000  20%)
Tax repayment due on losses in 20X2 is $9,200 ($46,000  20%)
The taxable profits of 20X1 are sufficient to absorb the losses of 20X2 and therefore a repayment
for the full $9,200 can be claimed.
The double entry will be:
$ $
DEBIT Tax receivable (statement of financial position) 9,200
CREDIT Tax repayable (statement of profit or loss and
other comprehensive income) 9,200
The tax receivable will be shown as an asset until the repayment is received from the tax
authorities.
320
HKAS 12.46 1.3 Measurement of current tax

The measurement of current tax liabilities (assets) for the current and prior periods is
straightforward. Their measurement is the amount expected to be paid (or recovered from) the tax
authorities. The enacted (or substantively enacted) tax rates (and tax laws) at the end of reporting
period should be used.
HKAS
12.58,61A
1.4 Recognition of current tax
Current tax payable or repayable is recognised in profit or loss in the period to which it relates.
There are three exceptions to this rule:
(a) Tax arising from a business combination which is an acquisition (refer to sections 10 and
10.4 of this chapter).
(b) Tax arising from a transaction or event recognised in other comprehensive income
(c) Tax arising from a transaction or event recognised directly in equity
If a transaction or event is charged or credited to other comprehensive income or directly to equity,
it is logical to show its related tax in other comprehensive income or equity.
An example of this is where, under HKAS 8, a change in accounting policy that is applied
retrospectively, or a correction of a material prior period error is adjusted to the opening balance of
the retained earnings.
HKAS 12.77 1.5 Presentation of current tax

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

Topic highlights
Deferred tax is an accounting measure, used to match the tax effects of transactions with their
accounting impact. It is quite complex.
Deferred tax is an accounting measure which recognises the future tax impact of assets and
liabilities currently held in the statement of financial position. It is important to realise that deferred
321
Financial Reporting
tax is not an amount currently payable to the tax authorities, or relevant to tax practitioners; it is
quite simply an accounting adjustment.
For example, if an entity holds an asset in its statement of financial position, it is reasonable to
assume that at some point in the future that asset will be realised (for example, an amount owed
will be received). At such a time as the asset is realised, tax will be payable on the related income
(assuming that tax arises on the cash receipt rather than when the asset is recognised for
accounting purposes). This tax payable at some point in the future is referred to as a deferred tax
liability.
Example: Deferred tax liability

Lightning Co. owns a non-current asset that cost $300 and has a carrying amount of $200.
Cumulative depreciation for tax purposes (sometimes known as capital allowances) is $180 and
the tax rate is 16.5%.
What is the deferred tax impact?
Solution
To date Lightning Co. has claimed tax depreciation on the asset of $180, and so received tax relief
for this amount.
In the future, as Lightning Co. continues to use the asset, it will recover the $200 carrying amount
of the asset (i.e. it will earn that $200 in revenue – and probably more besides).
Also in the future Lightning Co. will be able to claim a further $120 of tax depreciation ($300 original
cost less the $180 tax relief already claimed). This value for tax purposes is known as the "tax
base".
The net effect in the future is $80 taxable income ($200 carrying amount – $120 tax base). This is
known as a "taxable temporary difference".
When applying a tax rate of 16.5%, tax payable in the future on the net taxable income amounts to
$13.20.
Lightning Co. therefore recognises a deferred tax liability of $13.20.
Equally, if an entity has a liability, and tax relief is provided when payment is actually made to settle
the liability (rather than when the liability is recognised for accounting purposes), then there is a
future tax benefit, known as a deferred tax asset.
Example: Deferred tax asset

Monarchy Co. operates in a jurisdiction where general provisions for bad debts recognised in the
statement of financial position do not benefit from tax relief until such time as they are certified as a
bad debt. Monarchy Co. recognises such a provision in 20X1 for $200,000. It expects to be
certified as a bad debt in two years' time. The company has always paid tax on all income at 16.5%
and does not believe that this will change in the near future.
What is the deferred tax impact?
Solution
 In 20X1, Monarchy recognises a provision for a bad debt (a liability balance and
corresponding accounting expense) of $200,000.
 When the balance is certified as a bad debt (e.g. because the client’s company is liquidated)
Monarchy will be able to reduce taxable profits by the $200,000. This is not expected to
happen until 20X3.
322
 When the $200,000 is included as an allowable expense within taxable profits, it will result in
a reduction in tax payable of $33,000 ($200,000  16.5%).
 The $33,000 is not recognised as a current tax asset (i.e. a receivable) as the benefit is not
yet virtually certain.
 Instead, a deferred tax asset of $33,000 may be recognised in respect of the doubtful debt.
 This asset is only recognised if Monarchy Co. expects to have sufficient profits in two years'
time against which the bad debt expense may be relieved.
The remainder of this section of the chapter provides an overview of the process to recognise and
measure deferred tax. Later sections then consider each of the stages in the process in more
detail.
2.1 Calculation of deferred tax

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

for bad debt
1 What is the carrying value of the item in the $200 asset ($200,000)
statement of financial position? provision
Note that for the purposes of this exercise, liabilities
should be regarded as negative amounts.
2 What is the "tax base" of the item? $120 asset Nil
Tax base is defined in the next section, but in (there is no liability
simple terms think of it as the carrying value of the / expense from the
item in a tax version of the statement of financial tax perspective
position. until the case is
certified as bad
debt)
3 What is the difference between carrying value and $80 ($200,000)
tax base – known as temporary difference?
4 What type of temporary difference?
A taxable temporary difference arises where Taxable Deductible
carrying value > tax base.
A deductible temporary difference arises where
tax base > carrying value
5 Apply tax rate to the temporary difference $13.20 $33,000
6 Deferred tax asset or liability?
A deferred tax liability arises from a taxable Liability Asset
temporary difference.
A deferred tax asset arises from a deductible
temporary difference.
The table above includes a number of new terms such as tax base and temporary difference. The
next section considers the HKAS 12 definitions of each of them.
323
Financial Reporting
Key terms
Deferred tax liabilities are the amounts of income taxes payable in future periods in respect of
taxable temporary differences.
Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:
 Deductible temporary differences
 The carry forward of unused tax losses
 The carry forward of unused tax credits
Temporary differences are differences between the carrying amount of an asset or liability in the
statement of financial position and its tax base. Temporary differences may be either:
 Taxable temporary differences, which are temporary differences that will result in taxable
amounts in determining taxable profit (tax loss) of future periods when the carrying amount
of the asset or liability is recovered or settled; or
 Deductible temporary differences, which are temporary differences that will result in
amounts that are deductible in determining taxable profit (tax loss) of future periods when the
carrying amount of the asset or liability is recovered or settled.
The tax base of an asset or liability is the amount attributed to that asset or liability for tax
purposes. (HKAS 12)
HKAS 12 provides further guidance on some of the definitions seen above, and sections 2.2.1 to
2.2.3 below consider tax base, temporary differences and deferred tax asset/liability in turn.
HKAS 12.7 2.2.1 Tax base
The tax base of an asset is the amount that will be deductible for tax purposes against any
taxable economic benefits that will flow to the entity when it recovers the carrying amount of the
asset.
Where those economic benefits are not taxable, the tax base of the asset is the same as its
carrying amount.
Make sure that you understand this idea by attempting the following self-test question.
State the tax base of each of the following assets:
(a) Interest receivable has a carrying amount of $1,000. The related interest revenue is not
taxable.
(b) Dividends receivable from a subsidiary have a carrying amount of $5,000. The dividends are
not taxable.
(c) A machine cost $10,000. For tax purposes, depreciation of $3,000 has already been
deducted in the current and prior periods and the remaining cost will be deductible in future
periods, either as depreciation or through a deduction on disposal. Revenue generated by
using the machine is taxable, any gain on disposal of the machine will be taxable and any
loss on disposal will be deductible for tax purposes.
(d) Trade receivables have a carrying amount of $10,000. The related revenue has already
been included in taxable profit (tax loss).
(e) A loan receivable has a carrying amount of $1 million. There are no tax consequences for
repayment of the loan.
324
HKAS 12.8 The tax base of a liability is its carrying amount, less any amount that will be deductible for tax
purposes in relation to the liability in future periods.
For revenue received in advance, the tax base of the resulting liability is its carrying amount, less
any amount of the revenue that will not be taxable in future periods.
State the tax base of each of the following liabilities:
(a) Current liabilities include accrued expenses with a carrying amount of $1,000. The related
expense will be deducted for tax purposes on an accrual basis.
(b) Current liabilities include revenue received in advance, with a carrying amount of $1,000.
The related revenue was taxed on an accrual basis.
(c) Current liabilities include accrued fines and penalties with a carrying amount of $100. Fines
and penalties are not deductible for tax purposes.
(d) A loan payable has a carrying amount of $1 million. There are no tax consequences for
repayment of the loan.
HKAS 12, HKAS 12 gives the following examples of circumstances in which the carrying amount of an asset
Illustrative or liability will be equal to its tax base.
Examples
 Accrued expenses have already been deducted in determining an entity's current tax
liability for the current or earlier periods.
 A loan payable is measured at the amount originally received and this amount is the same
as the amount repayable on final maturity of the loan.
 Accrued expenses will never be deductible for tax purposes.
 Accrued income will never be taxable.
2.2.2 Temporary differences

As we have already seen, a temporary difference (which may be taxable or deductible) arises
where there is a difference between the carrying amount of item and its tax base:
 Where carrying amount > tax base there is a taxable temporary difference
 Where carrying amount < tax base there is a deductible temporary difference
The approach to calculating temporary differences provided within HKAS 12 is known as a
"balance sheet approach". This is because the carrying amount of an item is found in the statement
of financial position and the tax base of an item is in effect its carrying amount for tax purposes.
It may be easier to think about the reason for deferred tax from a profit or loss point of view instead
(remembering that assets and liabilities are of course related to income and expenses!).
Accounting profits and taxable profits are different, as you will know from your tax studies. There
are two reasons for the differences:
(a) Permanent differences occur when revenue or expenses included in accounting profits are
excluded from the computation of taxable profits (for example, client entertainment expenses
may not be allowable for tax purposes).
(b) Temporary differences occur when revenue or expenses are included in both accounting
profits and taxable profits, but in different accounting periods. We have already seen two
examples of this – where depreciation on an asset is charged faster for tax purposes than for
accounting purposes, and where a provision is recognised as an expense when payable but
does not benefit from tax relief until paid.
325
Financial Reporting
In the long run, there is no difference between total taxable profits and total accounting profits
(except for permanent differences) so that temporary differences originate in one period and will be
reversed in one or more subsequent periods. Deferred tax is caused by temporary differences.
Sections 3 and 4 of this chapter consider taxable and deductible temporary differences in more detail.
2.2.3 Deferred tax assets and liabilities
Temporary differences give rise to deferred tax liabilities and assets:
 A taxable temporary difference results in a deferred tax liability.
 A deductible temporary difference results in a deferred tax asset.
Deferred tax assets also arise from unused tax losses that tax law allows to be carried forward.
HKAS 12.47 2.3 Measurement of deferred tax

A deferred tax asset or liability is measured by applying the tax rate to the temporary difference
calculated.
The tax rate applied to the temporary difference should be that which is expected to apply to the
period when the asset is realised or the liability is settled, based on tax laws in place by the
reporting date.
More detailed measurement rules are provided in section 5 of this chapter.
HKAS 12.58 2.4 Recognition of deferred tax

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

The following is relevant to Casares Co. in the year ended 31 December 20X1:
 Non-current assets originally cost $780,000. Accumulated depreciation to date is $210,000
and tax allowances given amount to $320,000 on a cumulative basis
 Interest receivable in Casares' statement of financial position is $160,000. This will not be
taxed until it is received in the year ended 31 December 20X2.
 A provision for $98,000 for legal expenses payable is included in the statement of financial
position. This will not be allowable for tax purposes until it is paid in the year ended
31 December 20X2.
The tax rate applicable to Casares is 16.5%, and since all tax arises within the same taxation
authority deferred tax assets and liabilities may be offset.
At 31 December 20X0 the deferred tax liability reported in Casares' financial statements was
$22,430.
Required
Calculate amounts to be recognised in Casares’ financial statements in respect of deferred tax in
the year ended 31 December 20X1.
326
Solution
First, the deferred tax asset or liability must be considered for each of the items separately:
Non-current assets
Carrying amount (780,000 – 210,000) $570,000
Tax base (780,000 – 320,000) $460,000
Temporary difference $110,000
Taxable or deductible? Taxable since CA > TB
Deferred tax liability (110,000  16.5%) $18,150
Interest receivable
Carrying amount $160,000
Tax base $nil *
Deferred tax liability (160,000  16.5%) $26,400
*The tax base of an asset is the amount that will be deductible for tax purposes in the future. Here
nothing will be deductible – instead an amount will be taxable.
Provision
Carrying amount ($98,000)
Tax base $nil **
Taxable or deductible? Deductible since CA < TB
Deferred tax asset (98,000  16.5%) $16,170
** The tax base of a liability is its carrying amount ($98,000) less any amount deductible for tax
purposes in the future ($98,000).
In summary therefore:
$
Deferred tax liability 1 18,150
Deferred tax liability 2 26,400
Deferred tax asset (16,170)
Net deferred tax liability 28,380
The increase in deferred tax liability since 31 December 20X0 is $5,950 (28,380 – 22,430) and this
is accounted for by:
$ $
DEBIT Tax charge 5,950
CREDIT Deferred tax liability 5,950
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR CASARES
FOR THE YEAR ENDED 31 DECEMBER 20X1
$
Tax charge – deferred tax 5,950
STATEMENT OF FINANCIAL POSITION FOR CASARES AT 31 DECEMBER 20X1
$
Deferred tax liability 28,380
327
Financial Reporting
3 Taxable temporary differences

Topic highlights
Deferred tax liabilities arise from taxable temporary differences.
Remember the basic rule that a taxable temporary difference arises where the carrying amount of
an item in the statement of financial position exceeds its tax base, and this taxable temporary
difference results in a deferred tax liability.
Try to understand the reasoning behind the recognition of deferred tax liabilities on taxable
temporary differences.
(a) When an asset is recognised, it is expected that its carrying amount will be recovered in
the form of economic benefits that flow to the entity in future periods.
(b) If the carrying amount of the asset is greater than its tax base, then taxable economic benefits
will also be greater than the amount that will be allowed as a deduction for tax purposes.
(c) The difference is therefore a taxable temporary difference and the obligation to pay the
resulting income taxes in future periods is a deferred tax liability.
(d) As the entity recovers the carrying amount of the asset, the taxable temporary difference will
reverse and the entity will have taxable profit.
(e) It is then probable that economic benefits will flow from the entity in the form of tax
payments, and so the recognition of all deferred tax liabilities (except those excluded below)
is required by HKAS 12.
The following are examples of circumstances that give rise to taxable temporary differences.
HKAS 12, 3.1 Examples of taxable temporary differences

Illustrative
Examples HKAS 12 provides a number of examples of situations where taxable temporary differences may arise.
3.1.1 Transactions affecting the statement of profit or loss and other
comprehensive income
(a) Depreciation of an asset is accelerated for tax purposes. When new assets are purchased,
allowances may be available against taxable profits which exceed the amount of
depreciation chargeable on the assets in the financial accounts.
(b) Development costs which have been capitalised will be amortised in profit or loss, but they
were deducted in full from taxable profit in the period in which they were incurred.
Example: Taxable temporary differences (1)
Leeming Bar Co. is engaged in research and development activities. In the year ended 31 August
20X2, the company spent $740,000 on such activities. $310,000 of this meets the requirements of
HKAS 38 and has been capitalised. To date no amortisation has been charged. For tax purposes
the full $740,000 qualifies for 100% relief in the year of expenditure. The applicable tax rate is
16.5%.
Required
What is the deferred tax impact of this expenditure?
Solution
Tax base $nil *
Therefore deferred tax liability (310,000  $51,150
16.5%)
328
*The tax base of an asset is the amount that will be deductible for tax purposes in the future. Here
nothing will be deductible in the future as tax relief has already been given.
HKAS 12, 3.1.2 Transactions that affect the statement of financial position
Illustrative
Examples (a) Depreciation of an asset is not deductible for tax purposes. No deduction will be available
for tax purposes when the asset is sold/scrapped.
(b) A borrower records a loan at proceeds received (amount due at maturity) less transaction
costs. The carrying amount of the loan is subsequently increased by amortisation of the
transaction costs against accounting profit. The transaction costs were, however, deducted
for tax purposes in the period when the loan was first recognised.
(c) A loan payable is measured on initial recognition at net proceeds (net of transaction costs).
The transaction costs are amortised to accounting profit over the life of the loan. Those
transaction costs are not deductible in determining the taxable profit of future, current or prior
periods.
(d) The liability component of a compound financial instrument (e.g. a convertible bond) is
measured at a discount to the amount repayable on maturity, after assigning a portion of the
cash proceeds to the equity component (see HKAS 32). The discount is not deductible in
determining taxable profit.
(e) Development costs may be capitalised and amortised over future periods in determining
accounting profit but deducted in determining taxable profit in the period in which they are
incurred. Such development costs have a tax base of nil as they have already been
deducted from taxable profit. The temporary difference is the difference between the carrying
amount of the development costs and their tax base of nil.
Example: Taxable temporary differences (2)

A company purchased a machine for production costing $200,000. At the end of 20X9 the carrying
amount is $120,000. The total depreciation allowance for tax purposes is $90,000 and the current
tax rate is 16.5%.
Required
Calculate the deferred tax liability for the machinery.
Solution
Tax base (200,000 – 90,000) $110,000
Therefore deferred tax liability (10,000  16.5%) $1,650
The logic behind this liability is as follows: In order to recover the carrying amount of $120,000, the
entity must earn taxable income of $120,000, but it will only be able to deduct $110,000 as a
taxable expense. The entity must therefore pay income tax of $10,000  16.5% = $1,650 when the
carrying amount of the asset is recovered.
HKAS 12.20 3.1.3 Fair value adjustments and revaluations

In the following examples, an asset in the statement of financial position is adjusted to be carried at
fair value, however such an adjustment is not made for tax purposes and original cost remains the
tax base.
329
Financial Reporting
(a) Current investments or financial instruments carried at fair value.

(b) Investment properties carried at fair value.
In the case of revalued property, plant and equipment, there is a taxable temporary difference
only where the revaluation does not affect current taxable profits.
If the revaluation affects the taxable profit for the current period, the tax base of the asset changes
to become equal to fair value (and so carrying value) and no temporary difference arises.
Example: Revaluation
During the year ended 31 December 20X1, Marshall revalues a non-current asset to $8,000,000.
The asset cost $6,000,000 three years ago and was being depreciated at 2% straight line. Capital
allowances were available at 4% straight line. Marshall’s rate of tax is 16.5%.
What deferred tax arises on the revaluation in 20X1, assuming that the revaluation gain is not
taxable in 20X1?
Solution
$'000
Carrying value of non-current asset prior to revaluation
($6,000,000  94%) 5,640
Revalued amount 8,000
Taxable temporary difference = revaluation gain 2,360
Therefore deferred tax liability (16.5%  2.36m) 389.4
HKAS
12.21,22
3.2 Taxable temporary differences which do not result in deferred
tax liabilities
There are two circumstances given in the standard where a taxable temporary difference does
not result in a deferred tax liability:
(a) The deferred tax liability arises from the initial recognition of goodwill.
(b) The deferred tax liability arises from the initial recognition of an asset or liability in a
transaction which:
(i) is not a business combination (see section 8)
(ii) at the time of the transaction affects neither accounting profit nor taxable profit (tax
loss).
HKAS 12.22 3.2.1 Initial recognition of an asset or liability
A temporary difference can arise on initial recognition of an asset or liability, e.g. if part or all of the
cost of an asset will not be deductible for tax purposes. The nature of the transaction which led to
the initial recognition of the asset is important in determining the method of accounting for such
temporary differences.
If the transaction affects either accounting profit or taxable profit, an entity will recognise any
deferred tax liability or asset. The resulting deferred tax expense or income will be recognised in
profit or loss.
Where a transaction affects neither accounting profit nor taxable profit it would be normal for an
entity to recognise a deferred tax liability or asset and adjust the carrying amount of the asset or
liability by the same amount. However, HKAS 12 does not permit this recognition of a deferred tax
asset or liability as it would make the financial statements less transparent. This will be the case
both on initial recognition and subsequently, nor should any subsequent changes in the
unrecognised deferred tax liability or asset as the asset is depreciated be made.
330
An example of the initial recognition of an asset in a transaction which does not affect either
accounting or taxable profit at the time of the transaction is an intangible asset with a finite life
which attracts no tax allowances. In this case, taxable profit is never affected, and amortisation is
only charged to accounting profit after the transaction.
Example: Initial recognition

As an example of the last paragraph, suppose Perris Co. intends to use an asset which cost
$10,000 in 20X7 through its useful life of five years. Its residual value will then be nil. The tax rate is
16.5%. Any capital gain on disposal would not be taxable (and any capital loss not deductible).
Depreciation of the asset is not deductible for tax purposes.
Required
State the deferred tax consequences in each of years 20X7 and 20X8.
Solution
As at 20X7, as it recovers the carrying amount of the asset, Perris Co. will earn taxable income of
$10,000 and pay tax of $1,650. The resulting deferred tax liability of $1,650 would not be
recognised because it results from the initial recognition of the asset.
As at 20X8, the carrying value of the asset is now $8,000. In earning taxable income of $8,000, the
entity will pay tax of $1,320. Again, the resulting deferred tax liability of $1,320 is not recognised,
because it results from the initial recognition of the asset.
The following question on accelerated depreciation should clarify some of the issues and introduce
you to the calculations.
Jojo Co. buys equipment for $50,000 on 1 January 20X1 and depreciates it on a straight line basis
over its expected useful life of five years. For tax purposes, the equipment is depreciated at 25%
per annum on a straight line basis. The tax rate is 15%.
Required
Show the current and deferred tax impact in years 20X1 to 20X5 of the acquisition of the
equipment.
4 Deductible temporary differences

Topic highlights
Deferred tax assets arise from deductible temporary differences.
The standard states that deferred tax assets can only be recognised when sufficient future
taxable profits exist against which they can be utilised.
Remember the basic rule that a deductible temporary difference arises where the carrying amount
of an asset or liability is less than its tax base, and this deductible temporary difference normally
results in a deferred tax asset.
Try to understand the reasoning behind the recognition of deferred tax assets on taxable
temporary differences:
(a) When a liability is recognised, it is assumed that its carrying amount will be settled in the
form of outflows of economic benefits from the entity in future periods.
331
Financial Reporting
(b) When these resources flow from the entity, part or all may be deductible in determining
taxable profits of a period later than that in which the liability is recognised.
(c) A temporary tax difference then exists between the carrying amount of the liability and its
tax base.
(d) A deferred tax asset therefore arises, representing the income taxes that will be
recoverable in future periods when that part of the liability is allowed as a deduction from
taxable profit.
(e) Similarly, when the carrying amount of an asset is less than its tax base, the difference
gives rise to a deferred tax asset in respect of the income taxes that will be recoverable in
future periods.
The following are common examples of situations that result in a deductible temporary difference.
HKAS 12,
Illustrative
4.1 Examples of deductible temporary differences
Examples HKAS 12 provides a number of examples of deductible temporary differences.
4.1.1 Transactions affecting the statement of profit or loss and other
(a) Retirement benefit costs (pension costs) are deducted from accounting profit as service is
provided by the employee. They are not deducted in determining taxable profit until the entity
pays either retirement benefits or contributions to a fund. (This may also apply to similar
expenses.)
(b) Accumulated depreciation of an asset in the financial statements is greater than the
accumulated depreciation allowed for tax purposes up to the end of the reporting period.
(c) The net realisable value of inventory, or the recoverable amount of an item of property,
plant and equipment falls and the carrying value is therefore reduced, but that reduction is
ignored for tax purposes until the asset is sold.
(d) Research costs (or organisation/other start-up costs) are recognised as an expense for
accounting purposes but are not deductible against taxable profits until a later period.
(e) Income is deferred in the statement of financial position, but has already been included in
taxable profit in current/prior periods.
A non-taxable government grant related to an asset is deducted in arriving at the carrying amount
of the asset but, for tax purpose, is not deducted from the asset’s depreciable amount (in other
words its tax base); the carrying amount of the asset is less than its tax base and this gives rise to
a deductible temporary difference. Government grants may also be set up as deferred income in
which case the difference between the deferred income and its tax base of nil is a deductible
temporary difference. (Note. Whichever method of presentation an entity adopts, a deferred tax
asset may not be recognised here according to the standard.)
Example: Deductible temporary differences (1)

Teide Co. owns a specialised machine which originally cost $4,000,000. In the year ended
31 October 20X2 as the result of economic recession, Teide undertook an impairment review and
found that the recoverable amount of the machine was $2,600,000, this being $800,000 lower than
carrying amount. At 31 October 20X2, tax allowances given in respect of the machine amounted to
$1,000,000.
Required
What amount of deferred tax is recognised in respect of the machine at 31 October 20X2?
332
Solution
Carrying amount (recoverable amount) $2,600,000
Tax base (4,000,000 – 1,000,000) $3,000,000
Therefore deferred tax asset (400,000  16.5%) $66,000
4.1.2 Fair value adjustments and revaluations

A fair value which is lower than cost may be shown for current investments or financial instruments.
However, no equivalent adjustment for tax is to be made.
HKAS 12.27-
30
4.2 Recognition of deferred tax assets
Although the circumstances listed above will result in a deductible temporary difference, they will
not necessarily result in a deferred tax asset.
This is because the recognition criteria of HKAS 12 state that a deferred tax asset can only be
recognised to the extent that it is probable that taxable profit will be available against which it can
be utilised.
4.2.1 Sufficient taxable profit
When can we be sure that sufficient taxable profit will be available against which a deductible
temporary difference can be utilised? HKAS 12 states that this will be assumed when sufficient
taxable temporary differences exist which relate to the same taxation authority and the same
taxable entity. These should be expected to reverse as follows:
(a) In the same period as the expected reversal of the deductible temporary difference.
(b) In periods into which a tax loss arising from the deferred tax asset can be carried back
or forward.
Only in these circumstances is the deferred tax asset recognised, in the period in which the
deductible temporary differences arise.
4.2.2 Insufficient taxable profit
What happens when there are insufficient taxable temporary differences (relating to the same
taxation authority and the same taxable entity)? It may still be possible to recognise the deferred
tax asset, but only to the following extent.
(a) Taxable profits are sufficient in the same period as the reversal of the deductible temporary
difference (or in the periods into which a tax loss arising from the deferred tax asset can be
carried forward or backward), ignoring taxable amounts arising from deductible temporary
differences arising in future periods.
(b) Tax planning opportunities exist that will allow the entity to create taxable profit in the
appropriate periods.
With reference to (b), tax planning opportunities are actions that an entity would take in order to
create or increase taxable income in a particular period before the expiry of a tax loss or tax credit
carry forward. For example, in some countries it may be possible to increase or create taxable
profit by electing to have interest income taxed on either a received or receivable basis, or
deferring the claim for certain deductions from taxable profit.
In any case, where tax planning opportunities advance taxable profit from a later period to an
earlier period, the utilisation of a tax loss or a tax credit carry forward will still depend on the
existence of future taxable profit from sources other than future originating temporary differences.
333
Financial Reporting
If an entity has a history of recent losses, then this is evidence that future taxable profit may not
be available.
Example: Deductible temporary differences (2)

Rombauld Co. recognises a liability of $75,000 for accrued product warranty costs on 31 December
20X1. These product warranty costs will not be deductible for tax purposes until the entity pays
claims. The tax rate is 16.5%.
Required
State the deferred tax implications of this situation.
Solution
Carrying amount ($75,000)
Tax base $nil *
Therefore deferred tax asset (75,000  16.5%) $12,375
*The tax base of the liability is nil (carrying amount of $75,000 less the $75,000 that will be
deductible for tax purposes when the warranty costs are paid).
The logic behind this is as follows: when the liability is settled for its carrying amount, the entity's
future taxable profit will be reduced by $75,000 and so its future tax payments by $75,000  16.5%
= $12,375.
4.3 Deductible temporary differences which do not result in

deferred tax assets
HKAS 12.33 4.3.1 Initial recognition of an asset or liability
There are circumstances where the overall rule for recognition of deferred tax asset is not allowed.
This applies where the deferred tax asset arises from initial recognition of an asset or liability in a
transaction which is not a business combination, and at the time of the transaction, affects neither
accounting nor taxable profit/tax loss.
The example given by the standard is of a non-taxable government grant related to an asset,
deducted in arriving at the carrying amount of the asset. For tax purposes, however, it is not
deducted from the asset's depreciable amount (i.e. its tax base). The carrying amount of the asset
is less than its tax base and this gives rise to a deductible temporary difference, however this is not
recognised as a deferred tax asset.
HKAS 12.34-
36
4.4 Tax losses and credits carried forward
HKAS 12 states that a deferred tax asset may be recognised by an entity which has unused tax
losses or credits (i.e. which it can offset against taxable profits) at the end of a period, to the extent
that it is probable future taxable profits will be available to set off the unused tax losses/credits.
The recognition criteria for deferred tax assets here is identical to the recognition criteria for
deferred tax assets arising from deductible differences. The fact that future taxable profits may not
be available is confirmed by the existence of unused tax losses. For an entity with a past record of
recent tax losses, a deferred tax asset arising from unused tax losses or credits should be
recognised only to the extent that it has adequate taxable temporary differences or where it is
certain that taxable profit will be available to set off the unused losses/credits.
334
The following are important criteria for assessing the probability that taxable profit will be available
against which unused tax losses/credits can be utilised:
 Availability of sufficient taxable temporary differences (same tax authority/taxable entity)
against which unused tax losses/credits can be utilised before they expire
 The likelihood that the entity will have taxable profits before the expiry of the unused tax
losses/credits
 The unlikely recurrence of unused tax losses resulting from identifiable causes
 Availability of tax planning opportunities (see above)
Deferred tax asset is not recognised if it is probable that taxable profit will not be available.
Example: Taxable profit not available

Jerome Co. has made trading profits for a number of years, however due to an economic downturn
in the first half of the year, reported a taxable loss of $270,000 in the year ended 31 December
20X1. In accordance with local tax law, Jerome intends to carry $130,000 of this back to 20X0 to
set against the taxable profits of that year, and carrying the remaining $140,000 forward
indefinitely. By the end of 20X1, management had identified an upturn in orders and felt that
Jerome would return to profit in 20X2.
What is the deferred tax impact, if any, of Jerome’s losses?
Jerome pays tax at 16.5%.
Solution
 The $130,000 carried back to 20X0 is relevant to current tax rather than deferred tax, and a
receivable of $21,450 should be recognised.
 It appears that the $140,000 carried forward will be able to be utilised by Jerome and
therefore a deferred tax asset of $23,100 can be recognised (16.5%  $140,000).
HKAS 12.37 4.5 Reassessment of unrecognised deferred tax assets

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

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

HKAS 12 adopts the full provision method of providing for deferred tax, in other words deferred tax
is provided for on all temporary differences, irrespective of the future plans of an entity.
This method has the advantage that it recognises that each temporary difference at the year end
has an effect on future tax payments. The disadvantage of full provision is that, under certain
types of tax system, it gives rise to large liabilities that may fall due only far in the future.
335
Financial Reporting
HKAS 12.47 5.2 Applicable tax rate

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

Clio Co. has an asset with a carrying amount of $100,000 and a tax base of $60,000. If the asset
were sold, a tax rate of 18% would apply. A tax rate of 25% would apply to other income.
Required
State the deferred tax consequences if the entity:
(a) sells the asset without further use.
(b) expects to keep the asset and recover its carrying amount through use.
Solution
(a) A deferred tax liability is recognised of $(100,000 – 60,000)  18% = $7,200.
(b) A deferred tax liability is recognised of $(100,000 – 60,000)  25% = $10,000.
HKAS 12.51C In 2010, HKAS 12 was amended to include a rebuttable presumption that deferred tax on
investment properties carried at fair value under HKAS 40 should be measured based on recovery
through sale rather than use. The amendment was intended to avoid any subjective assessment in
trying to decide whether the carrying amount of an investment property will be recovered through
use or through sale.
As there is no capital gains tax in Hong Kong, this amendment will generally result in the deferred
tax liability on such investment properties being limited to the tax effect of any claw back on sale of
any depreciation allowances previously given. No deferred tax arises in respect of the excess of
fair value over cost.
336
Example
A company based in Hong Kong owns an investment property with a fair value carrying amount of
$10 million. The property cost $9 million. The tax base of the property is $8 million and the tax rate
on income is 16.5%.
Prior to the amendment to HKAS 12, if it were presumed that the carrying value of the property
would be recovered through use, the deferred tax liability would have been $330,000 (16.5% 
($10 million – $8 million)).
The amendment, however, means that it is presumed that the carrying value will be recovered
through sale. Therefore, the deferred tax liability is restricted to the excess of allowances given
i.e. $165,000 (16.5%  ($9million – $8million)).
The presumption is rebutted where the investment property is depreciable and is held with the
intention of consuming substantially all the economic benefits of the property through use rather
than sale, in other words, where the entity expects the asset’s income-generating ability to wear out
while the asset is still owned by the entity.
Crescent Co. owns a building with an original cost of $10m. In 20X1, the carrying value was $8m
and the asset was revalued to $15m. No equivalent adjustment was made for tax purposes. Total
depreciation allowance for tax purposes is $3m and the tax rate is 30%. If the asset is sold for more
than cost, the total tax depreciation allowance of $3m will be included in taxable income but sale
proceeds in excess of cost will not be taxable.
Required
(a) expects to recover the carrying value through use,
(b) expects to sell the building.
The facts are as in Self-test question 5 above, except that if the building is sold for more than cost,
the total tax depreciation allowance will be included in taxable income (taxed at 30%) and the sale
proceeds will be taxed at 40% after deducting an inflation-adjusted cost of $11m.
Required
(a) expects to recover the carrying value through use,
(b) expects to sell the building.
If the tax base is not immediately apparent in Self-test question 6 above, it may be helpful to
consider the fundamental principle of HKAS 12: that an entity should recognise a deferred tax
liability (asset) whenever recovery or settlement of the carrying amount of an asset or liability would
make future tax payments larger (smaller) than they would be if such recovery or settlement would
have no consequences.
337
Financial Reporting
HKAS
12.53,54
5.3 Discounting
The standard does not allow deferred tax assets and liabilities to be discounted. This is because
the complexities and difficulties involved will affect reliability.
Discounting would require detailed scheduling of the timing of the reversal of each temporary
difference, but this is often impracticable. In addition, if discounting were permitted, it would affect
comparability.
It is, however the case that some temporary differences are based on discounted amounts e.g.
retirement benefit obligations.
6 Recognition of deferred tax

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

HKAS 12.74 Deferred tax assets and liabilities can be offset only if:
(a) the entity has a legally enforceable right to set off current tax assets against current tax
liabilities, and
(b) the deferred tax assets and liabilities relate to income taxes levied by the same taxation
authority on either:
(i) the same taxable entity, or
(ii) different taxable entities which intend either to settle current tax liabilities and assets
on a net basis, or to realise the assets and settle the liabilities simultaneously, in each
future period in which significant amounts of deferred tax liabilities or assets are
expected to be settled or recovered.
338
8 Summary flowchart
The following flowchart will help to summarise the approach to deferred tax that we have seen
throughout sections 2 to 7 of the chapter.
Is the item’s tax base different from its No No deferred tax implications
carrying value in the statement of
financial position?
Yes
Calculate the temporary difference

between the tax base and carrying
value of the item.
Does a taxable temporary difference No Is it probable that taxable

result (this is the case where tax base profits will be available in the
< carrying value) future against which the
deductible temporary
difference can be used?
Yes No
Apply the relevant tax rate to the A deferred tax asset is not
temporary difference. recognised in the financial
statements but the related
deductible temporary
difference should be disclosed.
Recognise the movement in the .

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

assets and liabilities only where there
is a legally enforceable right and they
relate to the same taxation authority.
339
Financial Reporting
9 Disclosure of income taxes

The following disclosures are required in relation to income taxes:
1 The major components of tax expense in profit or loss, including the following:
(a) Current tax expense
(b) Adjustments recognised in the period for the current tax of previous periods;
(c) The amount of deferred tax expense (income) relating to the origination and reversal
of temporary differences;
(d) The amount of deferred tax expense (income) relating to changes in tax rates or the
imposition of new taxes;
2 The aggregate deferred tax relating to items that are charged or credited directly to equity.
3 The amount of income tax (including deferred tax) relating to each component of other
4 An explanation of the relationship between tax expense and accounting profit in either or
both of the following forms:
(a) A numerical reconciliation between tax expense and the product of accounting profit
multiplied by the applicable tax rate(s), or
(b) A numerical reconciliation between the average effective tax rate and the applicable
tax rate.
5 An explanation of changes in the applicable tax rate(s) compared to the previous accounting
period.
6 The amount (and expiry date, if any) of deductible temporary differences, unused tax losses
and unused tax credits for which no deferred tax asset is recognised in the statement of
financial position.
7 In respect of each type of temporary difference:
(a) The amount of deferred tax assets and liabilities recognised in the statement of
financial position.
(b) The amount of deferred tax income or expense recognised in profit or loss.
8 The amount of a deferred tax asset and the nature of evidence supporting its recognition
when:
(a) the utilisation of the deferred tax asset is dependent on future taxable profits in excess
of the profits arising from the reversal of existing taxable temporary differences, and
(b) the entity has suffered a loss in either the current or preceding period in the tax
jurisdiction to which the deferred tax asset relates.
9.1 Reconciliation
Disclosure point number (4) listed above refers to a reconciliation between tax expense and
accounting profit. Two possible forms are suggested. The following example shows both possible
forms:
340
Example: Reconciliation
Rugby Co. reports a profit before tax for the year ended 31 December 20X3 of $8.775m and a tax
expense of $3.977m. The tax rate applicable to the jurisdiction in which Rugby operates is 40%
(38% 20X2). Included in Rugby’s statement of profit or loss are the following items:
 Charitable donations of $500,000
 Fines for environmental pollution of $700,000
 A gain on disposal of machinery of $125,000
Net taxable temporary differences at 1 January 20X3 were $1,850,000.
Required
Draft the tax reconciliation as required by HKAS 12 in the two forms allowed.
Solution
The first form allowed reconciles between the product of accounting profit multiplied by the
applicable tax rate(s) and tax expense:
$'000 $'000
Profit before tax 8,775
Tax at applicable rate of 40% 3,510
Tax effect of expenses that are not deductible in determining
taxable profit:
Charitable donations (40%  500,000) 200
Fines for environmental pollution (40%  700,000) 280
480
Tax effect of income that is not taxable in determining taxable
profit:
Gain on disposal of property, plant and equipment (40%  (50)
125,000)
Increase in opening deferred tax resulting from an increase in 37
tax rate (1,850,000  2%)
Tax expense 3,977
The alternative form of the required disclosure reconciles the applicable tax rate to the average
effective tax rate:
%
Applicable tax rate 40.0
Tax effect of expenses that are not deductible for tax purposes:
Charitable donations (200/8,775  100%) 2.3
Fines for environmental pollution (280/8,775  100%) 3.2
Tax effect of income that is not taxable in determining taxable profit:
Gain on disposal of property, plant and equipment (50/8,775  100%)) (0.6)
Effect on opening deferred taxes of reduction in tax rate (37/8,775  100%) 0.4
Average effective tax rate 45.3
10 Deferred taxation and business combinations

Topic highlights
Temporary differences may arise as a result of business combinations.
341
Financial Reporting
There are a number of deferred tax implications of a business combination. Everything that
HKAS 12 states in relation to deferred tax and business combinations is brought together in this
section. Please note that accounting for business combinations is covered in the final section of
this book, Part D on group financial statements (chapters 26 to 30).
10.1 Temporary differences arising as a result of business

combinations
Earlier in the chapter we considered a number of common situations which result in either a taxable
or deductible temporary difference.
When interests are held in subsidiaries, branches, associates or joint ventures, temporary
differences arise because the carrying amount of the investment (i.e. the parent's share of the net
assets including goodwill) becomes different from the tax base (often the cost) of the investment.
Reasons for these differences include the following:
 The existence of undistributed profits of subsidiaries, branches, associates and joint
ventures
 Changes in foreign exchange rates when a parent and its subsidiary are based in different
countries
 A reduction in the carrying amount of an investment in an associate to its recoverable
amount
The temporary difference in the consolidated financial statements may be different from the
temporary difference associated with that investment in the parent's separate financial statements
when the parent carries the investment in its separate financial statements at cost or revalued
amount.
HKAS 12 provides examples of both taxable and deductible temporary differences.
HKAS 12, 10.1.1 Taxable temporary differences
Illustrative
Examples In a business combination, such as when one company buys all the shares of another company,
the cost of the acquisition must be allocated to the fair values of the identifiable assets and
liabilities acquired as at the date of the transaction. Temporary differences can arise when the tax
bases of the identifiable assets and liabilities acquired are not affected by the business
combination. For example, where the carrying amount of an asset is increased to fair value but the
tax base of the asset remains at cost to the previous owner, a taxable temporary difference arises
which results in a deferred tax liability and this will also affect goodwill.
The following are also provided by the standard as examples of situations which will result in a
taxable temporary difference:
(a) Unrealised losses resulting from intragroup transactions are eliminated by inclusion in
the carrying amount of inventory or property, plant and equipment.
(b) Retained earnings of subsidiaries, branches, associates and joint ventures are included in
consolidated retained earnings, but income taxes will be payable if the profits are distributed
to the reporting parent.
(c) Investments in foreign subsidiaries, branches or associates or interests in foreign joint
ventures are affected by changes in foreign exchange rates.
(d) An entity accounts in its own currency for the cost of the non-monetary assets of a foreign
operation that is integral to the reporting entity's operations but the taxable profit or tax
loss of the foreign operation is determined in the foreign currency.
342
On 31 December 20X1, Basil Co. acquired a 60% stake in Lemongrass Co.. Among Lemongrass’s
identifiable assets at that date was inventory with a carrying amount of $8,000 and a fair value of
$12,000. The tax base of the inventory was the same as the carrying amount.
The consideration given by Basil Co. resulted in the recognition of goodwill acquired in the
business combination.
Income tax is payable by Basil Co. at 25% and by Lemongrass at 20%.
Required
What is the deferred tax impact of this transaction in the Basil group financial statements?
HKAS 12, 10.1.2 Deductible temporary differences

Illustrative
Examples In a business combination, when a liability is recognised on acquisition but the related costs are
not deducted in determining taxable profits until a later period, a deductible temporary difference
arises resulting in a deferred tax asset. A deferred tax asset will also arise when the fair value of an
identifiable asset acquired is less than its tax base. In both these cases goodwill is affected (see
below).
The standard also provides the following examples of situations will result in a deductible
temporary difference:
(a) Unrealised profits resulting from intragroup transactions are eliminated from the
carrying amount of assets, such as inventory or property, plant or equipment, but no
equivalent adjustment is made for tax purposes.
(b) Investments in foreign subsidiaries, branches or associates or interests in foreign joint
ventures are affected by changes in foreign exchange rates.
(c) A foreign operation accounts for its non-monetary assets in its own (functional) currency.
If its taxable profit or loss is determined in a different currency (under the presentation
currency method) changes in the exchange rate result in temporary differences. The
resulting deferred tax is charged or credited to profit or loss.
Oregano Co. owns 70% of Thyme Co.. During 20X1 Thyme sold goods to Oregano for $120,000 at
a mark-up of 20% above cost. Half of these goods are held in Oregano’s inventories at the year
end. The rate of income tax is 30%.
Required
What is the deferred tax impact of this transaction in the Oregano group financial statements?
10.2 Recognition criteria

HKAS 12 provides recognition criteria for both deferred tax liabilities and assets in a business
combination situation.
HKAS 12.39 10.2.1 Deferred tax liability
Entities should recognise a deferred tax liability for all taxable temporary differences associated
with investments in subsidiaries, branches and associates, and interests in joint ventures, except to
the extent that both of these conditions are satisfied:
343
Financial Reporting
(a) The parent/investor/venturer is able to control the timing of the reversal of the temporary
difference.
(b) It is probable that the temporary difference will not reverse in the foreseeable future.
HKAS 12.44 10.2.2 Recognition of deferred tax asset
HKAS 12 requires that a deferred tax asset should be recognised for all deductible temporary
differences arising from investments in subsidiaries, branches and associates, and interests in joint
ventures, to the extent that (and only to the extent that) both these are probable that:
(a) the temporary difference will reverse in the foreseeable future
(b) taxable profit will be available against which the temporary difference can be utilised
The prudence principle discussed above for the recognition of deferred tax assets should be
considered.
10.3 Application of the recognition criteria

HKAS 12.40 10.3.1 Undistributed profits
Where a parent company controls the dividend policy of its subsidiary, it can control the timing of
the reversal of temporary differences. In addition, it would often be impracticable to determine the
amount of income taxes payable when the temporary differences reverses.
Therefore, when the parent has determined that those profits will not be distributed in the
foreseeable future, the parent does not recognise a deferred tax liability. The same applies to
investments in branches.
HKAS 12.41 10.3.2 Foreign exchange
Where a foreign operation's taxable profit or tax loss (and therefore the tax base of its non-
monetary assets and liabilities) is determined in a foreign currency, changes in the exchange rate
give rise to temporary differences. These relate to the foreign entity's own assets and liabilities,
rather than to the reporting entity's investment in that foreign operation, and so the reporting entity
should recognise the resulting deferred tax liability or asset. The resulting deferred tax is charged
or credited to profit or loss.
HKAS 12.42 10.3.3 Associates

An investor in an associate does not control that entity and so cannot determine its dividend
policy. Therefore, unless there is an agreement requiring that the profits of the associate should not
be distributed in the foreseeable future, the investor should recognise a deferred tax liability arising
from taxable temporary differences associated with its investment in the associate. Where an
investor cannot determine the exact amount of tax, but only a minimum amount, then the deferred
tax liability should be that amount.
HKAS 12.43 10.3.4 Joint arrangements
In a joint arrangement, the agreement between the parties usually deals with profit sharing. When
a joint venturer or joint operator can control the sharing of profits and it is probable that the profits
will not be distributed in the foreseeable future, a deferred liability is not recognised.
HKFRS 3.24,
HKAS
10.4 Recognition of deferred tax arising from business
12.15,66-68 combinations
HKFRS 3 Business Combinations requires an entity to recognise any deferred tax assets (to the
extent that they meet the relevant recognition criteria) or deferred tax liabilities resulting from
temporary differences on a business combination as identifiable assets and liabilities at the date of
acquisition.
These deferred tax assets and deferred tax liabilities, consequently, will affect the amount of
goodwill or the bargain purchase gain the entity recognises.
344
An entity will not, however, recognise deferred tax liabilities arising from the initial recognition of
goodwill.
A business combination may result in a change in the probability of realising a pre-acquisition
deferred tax asset of the acquirer. There is a chance that the acquirer will recover its own deferred
tax asset that was not recognised before the combination of the businesses, e.g. by setting off
unused tax losses against the future taxable profit of the acquiree.
Alternatively, as a result of the business combination it might no longer be probable that future
taxable profit will allow the deferred tax asset to be recovered. The acquirer should recognise a
change in the deferred tax asset in the period of the business combination, but does not take it into
account in calculating the goodwill or bargain purchase gain it recognises in the business
combination.
The potential benefit of the acquiree's income tax loss carry forwards or other deferred tax assets
might not satisfy the criteria for separate recognition when a business combination is initially
accounted for but might be realised subsequently. An entity shall recognise acquired deferred tax
benefits that it realises after the business combination as follows:
(a) Acquired deferred tax benefits recognised within the measurement period that result from
new information about facts and circumstances that existed at the acquisition date shall be
applied to reduce the carrying amount of any goodwill related to that acquisition. If the
carrying amount of that goodwill is zero, any remaining deferred tax benefits shall be
recognised in profit or loss.
(b) All other acquired deferred tax benefits realised shall be recognised in profit or loss (or, if this
standard so requires, outside profit or loss).
On 1 September 20X1, Orchid acquired 90% of the ordinary share capital of Daffodil for
consideration totalling $1.75million. At the date of acquisition, Daffodil’s statement of financial
position showed net assets of $1.8million, although the fair value of inventory was assessed to be
$100,000 above its carrying amount.
Required
Explain the deferred tax implications, assuming a tax rate of 16.5%.
Dandelion purchased 75% of the ordinary share capital of Bluebell for $1.1m when the net assets
of Bluebell were $1m, giving rise to goodwill of $350,000. At 31 December 20X1 the following is
relevant:
1 Goodwill has not been impaired
2 The net assets of Bluebell amount to $1.2m
Required
What temporary difference arises on this investment at 31 December 20X1?
Example: Deferred tax arising from business combinations

In recent years, Lily Co. has made the following acquisitions of other companies:
 On 1 January 20X6, it acquired 90% of the share capital of Blossom, resulting in goodwill of
$1.4 million.
345
Financial Reporting
 On 1 July 20X6 it acquired the whole of the share capital of Snowdrop for $6 million. At this
date the fair value of the net assets of Snowdrop was $4.5 million and their tax base was
$4 million.
The following information is relevant to Lily Group’s year ended 31 December 20X6:
Blossom
1 Blossom has made a provision amounting to $1.8 million in its accounts in respect of
litigation. This is tax allowable only when the cost is actually incurred. The case is expected
to be settled within 12 months.
2 Blossom has a number of investments classified as at fair value through profit or loss in
accordance with HKFRS 9. The remeasurement gains and losses recognised in profit or loss
for accounting purposes are not taxable/tax allowable until such date as the investments are
sold. To date the cumulative unrealised gain is $2.5 million.
3 Blossom has sold goods to Lily in the year making a profit of $1 million. A quarter of these
goods remain in Lily’s inventory at the year end.
Snowdrop
1 At its acquisition date, Snowdrop had unrelieved brought forward tax losses of $0.4 million.
It was initially believed that Snowdrop would have sufficient taxable profits to utilise these
losses and a deferred tax asset was recognised in Snowdrop’s financial statements at
acquisition. Subsequent events have proven that the future taxable profits will not be
sufficient to utilise the full brought forward loss.
2 At acquisition Snowdrop’s retained earnings amounted to $3.5 million. The directors of Lily
Group have decided that in each of the next four years to the intended listing date of the
group, they will realise earnings through dividend payments from the subsidiary amounting to
$600,000 per annum. Snowdrop has not declared a dividend for the current year. Tax is
payable on remittance of dividends.
3 $300,000 of the purchase price of Snowdrop has been allocated to intangible assets. The
recognition and measurement criteria of HKFRS 3 and HKAS 38 do not appear to have been
met, however the directors believe that the amount is allowable for tax and have calculated
the tax charge accordingly. It is believed that this may be challenged by the tax authorities.
Required
What are the deferred tax implications of the above issues for the Lily Group?
Solution
Acquisitions
Any fair value adjustments made for consolidation purposes will affect the group deferred tax
charge for the year.
A taxable temporary difference will arise where the fair value of an asset exceeds its carrying
value, and the resulting deferred tax liability should be recorded against goodwill.
A deductible temporary difference will arise where the fair value of a liability exceeds its carrying
value, or an asset is revalued downwards. Again, the resulting deferred tax amount (an asset)
should be recognised in goodwill.
In addition, it may be possible to recognise deferred tax assets in a group which could not be
recognised by an individual company. This is the case where tax losses brought forward, but not
considered to be an asset, due to lack of available taxable profits to set them against, can now be
used by another group company.
Goodwill
Goodwill arose on both acquisitions. According to HKAS 12, however, no provision should be made
for the temporary difference arising on this.
346
Blossom
1 A deductible temporary difference arises when the provision is first recognised. This results
in a deferred tax asset calculated as $540,000 (30%  $1.8m). The asset may, however,
only be recognised where it is probable that there will be future taxable profits against which
the future tax allowable expense may be set. There is no indication that this is not the case
for Blossom.
2 A taxable temporary difference arises where investments are revalued upwards for
accounting purposes but the uplift is not taxable until disposal. In this case the carrying
value of the investments has increased by $2.5 million, and this has been recognised in
profit or loss. The tax base has not, however changed. Therefore, a deferred tax liability
should be recognised on the $2.5 million, and in line with the recognition of the underlying
revaluation, this should be recognised in profit or loss.
3 This intra-group transaction results in unrealised profits of $250,000 which will be eliminated
on consolidation. The tax on this $250,000 will, however, be included within the group tax
charge (which comprises the sum of the individual group companies' tax charges). From the
perspective of the group there is a temporary difference. Deferred tax should be provided on
this difference using the tax rate of Lily (the recipient company).
Snowdrop
1 Unrelieved tax losses give rise to a deferred tax asset only where the losses are regarded as
recoverable. They should be regarded as recoverable only where it is probable that there
will be future taxable profits against which they may be used. It is indicated that the future
profits of Snowdrop will not be sufficient to realise all of the brought forward loss, and
therefore the deferred tax asset is calculated only on that amount expected to be recovered.
2 Deferred tax is recognised on the unremitted earnings of investments, except where:
(a) the parent is able to control the payment of dividends
(b) it is unlikely that the earnings will be paid out in the foreseeable future
Lily controls Snowdrop and is therefore able to control its dividend payments, however it is
indicated that $2.4million will be paid as dividends in the next four years. Therefore, a
deferred tax liability related to this amount should be recognised.
3 The directors have assumed that the $300,000 relating to intangible assets will be tax
allowable, and the tax provision has been calculated based on this assumption. However,
this is not certain, and extra tax may have to be paid if this amount is not allowable.
Therefore, a liability for the additional tax amount should be recognised.

In relation to deferred tax and business combinations you should be familiar with:
 circumstances that give rise to taxable temporary differences
 circumstances that give rise to deductible temporary differences
 their treatment once an acquisition takes place
 reasons why deferred tax arises when investments are held
 recognition of deferred tax on business combinations
347
Financial Reporting
11 Interpretations relating to deferred tax

11.1 HK(SIC) Int-21 Income Taxes – Recovery of Revalued Non-
depreciable Assets
HK(SIC) Int-21 deals with cases where a non-depreciable asset (freehold land) is carried at
revaluation under HKAS 16.
The Interpretation deems that no part of such an asset’s carrying amount will be recovered through
use. Therefore the deferred tax asset or liability that arises from revaluation must be measured
based on recovery through sale of the asset.
In some jurisdictions, this will result in the use of a capital gains tax rate rather than the rate
applicable to corporate earnings.
HK(SIC) Int-12 has been incorporated into HKAS 12 as part of the amendments to HKAS 12 issued
in December 2010. It is therefore withdrawn for accounting periods starting on or after 1 January
2012.
11.2 HK(SIC) Int-25 Income Taxes – Changes in the Tax Status of

an Entity or its Shareholders
A change in the tax status of an entity or its shareholders may have consequences for an entity by
increasing or decreasing its tax liabilities or assets.
This may, for example, occur upon:
 the public listing of an entity's equity instruments
 the restructuring of an entity's equity
 a controlling shareholder's move to a foreign country.
As a result of such an event, an entity may be taxed differently; it may for example gain or lose tax
incentives or become subject to a different rate of tax in the future.
A change in the tax status of an entity or its shareholders may have an immediate effect on the
entity's current tax liabilities or assets. The change may also increase or decrease the deferred tax
liabilities and assets recognised by the entity, depending on the effect the change in tax status has
on the tax consequences that will arise from recovering or settling the carrying amount of the
entity's assets and liabilities.
A change in the tax status of an entity or its shareholders does not give rise to increases or
decreases in amounts recognised directly in equity. The current and deferred tax consequences of
a change in tax status shall be included in net profit or loss for the period, unless those
consequences relate to transactions and events that result, in the same or a different period, in a
direct credit or charge to the recognised amount of equity. Those tax consequences that relate to
changes in the recognised amount of equity, in the same or a different period (not included in net
profit or loss), shall be charged or credited directly to equity.
348
Topic recap
HKAS 12 Income Taxes
Current
Currenttaxtax Current
Deferred
taxtax
Tax charge is adjusted for under/over Accounting measure to match tax

provision of previous period. effects of transactions with their
accounting impact
Tax charge is adjusted for under/over Compares carrying amount (CA) of

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

Recognise in profit or loss for the asset or liability for tax purposes.
period other than:
tax on business combination
tax on item of OCI
tax on item in equity
CA > TB CA < TB
Taxable Deductible
temporary temporary
difference difference
Apply tax rate expected to apply when asset is

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

liability asset
Do not discount to present value
Recognise only if
profits available
in future
Recognise in profit or loss unless deferred tax

arises from:
an item recognised in OCI
an item recognised in equity
a business combination (acquisition)
Offset deferred tax assets and liabilities only if:

legally enforceable right of set off
relate to taxes levied by the same authority
349
Financial Reporting
Answer 1
(a) $
Current year tax liability ($760,000  16.5%) 125,400
Overprovision in 20X0 ($130,000 – $126,700) 3,300
Therefore
 $125,400 is recognised as a current tax liability in the statement of financial position at
31 December 20X1
 $122,100 ($125,400 – $3,300) is recognised as tax charge in the statement of profit or
loss and other comprehensive income for the year ended 31 December 20X1
(b) If the previous year’s tax was settled at $131,000, tax was underprovided. Therefore the
underprovision of $1,000 is added to the 20X1 tax charge to make it $126,400. The liability in
the statement of financial position remains unchanged at $125,400.
Answer 2
(a) The tax base of the interest receivable is $1,000.
(b) The tax base of the dividend is $5,000.
(c) The tax base of the machine is $7,000.
(d) The tax base of the trade receivables is $10,000.
(e) The tax base of the loan is $1 million.
In the case of (b), in substance the entire carrying amount of the asset is deductible against the
economic benefits. There is no taxable temporary difference. An alternative analysis is that the
accrued dividends receivable have a tax base of nil and a tax rate of nil is applied to the resulting
taxable temporary difference ($5,000). Under both analyses, there is no deferred tax liability.
Answer 3
(a) The tax base of the accrued expenses is $1,000.
(b) The tax base of the revenue received in advance is $1,000.
(c) The tax base of the accrued fines and penalties is $100.
(d) The tax base of the loan is $1 million.
Answer 4
The temporary differences associated with the equipment are as follows:
Year
20X1 20X2 20X3 20X4 20X5
$ $ $ $ $
Carrying amount 40,000 30,000 20,000 10,000 –
Tax base 37,500 25,000 12,500 – –
Taxable temporary difference 2,500 5,000 7,500 10,000 –
Opening deferred tax liability – 375 750 1,125 1,500
Deferred tax expense (income): bal fig 375 375 375 375 (1,500)
Closing deferred tax liability @ 15% 375 750 1,125 1,500 –
350
Answer 5
The tax base of the building is $7m ($10m – $3m).
(a) If the entity expects to recover the carrying amount by using the building, it must generate
taxable income of $15m, but will only be able to deduct depreciation of $7m. On this basis
there is a deferred tax liability of $2.4m (($15m – $7m)  30%).
(b) If the entity expects to recover the carrying amount by selling the building immediately for
proceeds of $15m the deferred tax liability will be computed as follows:
Taxable temporary Deferred
difference Tax rate tax liability
$'000 $'000
Total tax depreciation allowance 3,000 30% 900
Proceeds in excess of cost 5,000 Nil –
Total 8,000 900
Note. The additional deferred tax that arises on the revaluation is charged directly to equity:
see Answer 6 below.
Answer 6
(a) If the entity expects to recover the carrying amount by using the building, the situation is as
in answer 5 (a) in the same circumstances.
(b) If the entity expects to recover the carrying amount by selling the building immediately for
proceeds of $15m, the entity will be able to deduct the indexed costs of $11m. The net profit
of $4m will be taxed at 40%. In addition, the total tax depreciation allowance of $3m will be
included in taxable income and taxed at 30%. On this basis, the tax base is $8m ($11m –
$3m), there is a taxable temporary difference of $7m and there is a deferred tax liability of
$2.5m ($4m  40% plus $3m  30%).
Answer 7
The excess of an asset’s fair value over its tax base at the time of a business combination results
in a deferred tax liability. As it arises in Lemongrass, the tax rate used is 20% and the liability is
$800 (($12,000 – $8,000)  20%).
The recognition of a deferred tax liability in relation to the initial recognition of goodwill is
specifically prohibited by HKAS 12.
Answer 8
There is an unrealised profit relating to inventories still held within the group of ½  $20,000 =
$10,000, which must be eliminated on consolidation. But the tax base of the inventories is
unchanged, so it is higher than the carrying amount in the consolidated statement of financial
position and there is a deductible temporary difference of $10,000.
Answer 9
 The carrying amount of the inventory in the group accounts is $100,000 more than its tax
base (being carrying amount in Daffodil’s own accounts).
 Deferred tax on this temporary difference is 16.5%  $100,000 = $16,500.
 A deferred tax liability of $16,500 is recognised in the group statement of financial position.
 Goodwill is increased by ($16,500  90%) = $14,850.
351
Financial Reporting
Answer 10
 The tax base of the investment in Bluebell is the cost of $1.1m. The carrying value is the
share of net assets (75%  $1.2m) + goodwill of $350,000 = $1.25m
 The temporary difference is therefore $1.25m – $1.1m = $150,000.
 This is equal to the group share of post acquisition profits: 75%  $200,000 change in net
assets since acquisition.
352
Exam practice
Healthy Supplement Inc 29 minutes

Healthy Supplement Inc. (HSI) was incorporated on 1 October 20X1 and is engaged in the design
and manufacture of nutrition products. Below is the computation of income tax for the first financial
year ended 30 September 20X2:
HK$'000
Profit before tax 54,018
Adjusted for:
Non-taxable interest income (1,039)
Release of government grant to P/L (1,200)
Depreciation charged to P/L 15,933
Non-deductible legal and professional fees 1,358
Provision for product warranty charged to P/L 4,200
Depreciation allowance (38,500)
Government grant received 9,600
Warranty expenses paid (1,248)
Assessable profit 43,122
Income tax prepaid on 30 June 20X2 4,600
During the year, HSI acquired plant and equipment of HK$94,334,000 which are depreciated on a
straight line basis over useful lives of 3 to 10 years, all of them were still in use by the entity.
Included in this amount is HK$4,388,000 related to certain expenditure which is not tax deductible
under tax law. The non-tax deductible items were acquired on 1 April 20X2 and depreciated for half
a year out of an estimated useful life of 5 years up to the end of the reporting period.
An asset-related government grant is taxable upon receipt while HSI adopted HKAS 20 to
recognise the grant to profit or loss over the expected useful lives of the related assets.
Warranty expenses are tax deductible when payment is made.
The standard income tax rate for HSI is 20%. A 2% tax rate deduction is provided for an entity's
first year of operation.
Required
(a) Calculate the current tax expense for the year ended and the current tax payable as at 30
September 20X2. (2 marks)
(b) Calculate the deferred tax assets/liabilities as at 30 September 20X2 and the deferred tax
credit/charge for the year then ended. (8 marks)
(c) Prepare the tax reconciliation for disclosure in the financial statements of HSI for the year
ended 30 September 20X2. (6 marks)
(Total = 16 marks)
HKICPA December 2012 (amended)
353
Financial Reporting
354
chapter 16
Employee benefits
Topic list
1 HKAS 19 Employee Benefits

1.1 Employee benefits 5.3 Step 1 – Determine the deficit or surplus
1.2 The accounting problem 5.4 Step 2 – Determine the amount of the
1.3 Definitions net defined benefit liability (asset)
5.5 Step 3 – Determine amounts to be
2 Short-term employee benefits recognised in profit or loss
2.1 Recognition and measurement 5.6 Step 4 – Determine amounts to be
2.2 Short-term paid absences recognised in other comprehensive
2.3 Profit-sharing schemes and bonus plans income
3 Post-employment benefits 5.7 Further issues – past service costs and
3.1 Types of post-employment benefits settlements
3.2 Multi-employer plans 5.8 Further issues – the asset ceiling
5.9 Summary of accounting treatment
4 Defined contribution plans 5.10 Disclosure of defined benefit plans
4.1 Recognition and measurement
4.2 Disclosure 6 Termination benefits
6.1 Recognition
5 Defined benefit plans 6.2 Measurement
5.1 Introduction to accounting treatment
5.2 Accounting steps 7 Current developments
Learning focus
An increasing number of companies and other entities now provide a pension and other
employee benefits as part of their employees' remuneration package. In view of this trend, it is
important that there is standard best practice for the way in which employee benefit costs are
recognised, measured, presented and disclosed in the sponsoring entities' accounts. You
must ensure that you understand and can apply the rules of HKAS 19 as amended in 2011.
355
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.04 Employee benefits 2
3.04.01 Identify short-term employee benefits in accordance with HKAS 19
and apply the recognition and measurement principles in respect of
short-term employee benefits
3.04.02 Distinguish between defined contribution plans and defined benefit
plans
3.04.03 Account for defined contribution plans
3.04.04 Identify termination benefits in accordance with HKAS 19 and apply
the recognition and measurement principles in respect of
termination benefits
356
16: Employee benefits | Part C Accounting for business transactions
1 HKAS 19 Employee Benefits

Topic highlights
HKAS 19 Employee Benefits provides guidance on the accounting treatment to be applied to short-
term employment benefits, post-employment benefits (pensions), other long-term employment
benefits and termination benefits. Amendments to the standard in 2011 reduced the complexity of
accounting for employee benefits.
Before we look at HKAS 19, we should consider the nature of employee benefit costs and why
there is an accounting problem which must be addressed by a standard.
HKAS 19.5 1.1 Employee benefits

Companies generally provide their employees with a package of pay and benefits, which may
include some or all of the following:
 Short-term benefits including:
– wages and salaries
– contributions to Mandatory Provident Fund
– paid annual leave
– paid sick leave
– paid maternity/paternity leave
– profit shares and bonuses paid within 12 months of the year end
– paid jury service
– paid military service
– non-monetary benefits, e.g. medical care, cars, free goods
 Post-employment benefits, e.g. pensions and post-employment medical care
 Other long-term benefits, e.g. profit shares, bonuses or deferred compensation payable later
than 12 months after the year end, sabbatical leave, long-service benefits
 Termination benefits, e.g. early retirement payments and redundancy payments
Benefits may be paid to the employees themselves, to their dependants (spouses, children, etc.) or
to third parties.

In the case of the short-term benefits listed above, the employee will receive the benefit at about
the same time as he or she earns it. The accounting is therefore relatively straightforward with the
costs of providing the benefit recognised as an expense in the employer's financial statements.
Accounting for the cost of deferred employee benefits is less clear cut. This is because of the
long time scale, complicated estimates and uncertainties involved in these types of benefit. In
addition, the costs could be viewed in a number of ways, for example as deferred salary to the
employee or as a deduction from the employee’s true gross salary.
In the past, entities accounted for these benefits simply by making a charge to the profit or loss of
the employing entity on the basis of actual payments made. This led to substantial variations in
reported profits of these entities and disclosure of information on these costs was usually sparse.
357
Financial Reporting
1.2.1 The accounting solution

HKAS 19 addresses the problem described above by prescribing how employee benefits should be
recognised and measured.
The standard requires an entity to recognise:
(a) a liability when an employee has provided a service in exchange for benefits to be received
by the employee at some time in the future.
(b) an expense when the entity receives the economic benefits from a service provided by an
employee regardless of when the employee received or will receive the benefits for providing
the service.
The application of these basic rules to each of the categories of employee benefits described in
section 1.1 is provided in HKAS 19 and described throughout the remainder of this chapter. First,
however, we must consider a number of important definitions within the standard.

You should refer back to the following definitions as necessary as you work through the rest of this
chapter.
Key terms
Definitions of employee benefits

Employee benefits are all forms of consideration given by an entity in exchange for service
rendered by employees.
Short-term employee benefits are employee benefits (other than termination benefits) that are
expected to be settled wholly before 12 months after the end of the annual reporting period in
which the employees render the related service.
Post-employment benefits are employee benefits (other than termination benefits and short-term
employee benefits) which are payable after the completion of employment.
Termination benefits are employee benefits provided in exchange for the termination of an
employee’s employment as a result of either:
(a) an entity's decision to terminate an employee's employment before the normal retirement
date, or
(b) an employee's decision to accept an offer of benefits in exchange for the termination of
employment.
Other long-term employee benefits are all employee benefits other than short-term employee
benefits, post-employment benefits and termination benefits.
Definitions relating to classification of plans
Post-employment benefit plans are formal or informal arrangements under which an entity
provides post-employment benefits for one or more employees.
Defined contribution plans are post-employment benefit plans under which an entity pays fixed
contributions into a separate entity (a fund) and will have no legal or constructive obligation to pay
further contributions if the fund does not hold sufficient assets to pay all employee benefits relating
to employee service in the current and prior periods.
Defined benefit plans are post-employment benefit plans other than defined contribution plans.
358
Key terms (cont'd)

Multi-employer plans are defined contribution plans (other than state plans) or defined benefit
plans (other than state plans) that:
(a) pool the assets contributed by various entities that are not under common control; and
(b) use those assets to provide benefits to employees of more than one entity, on the basis that
contribution and benefit levels are determined without regard to the identity of the entity that
employs the employees concerned.
Definitions relating to the net defined benefit liability (asset)
The net defined benefit liability (asset) is the deficit or surplus, adjusted for any effect of limiting
a net defined benefit asset to the asset ceiling.
The deficit or surplus is:
(a) the present value of the defined benefit obligation less
(b) the fair value of plan assets (if any).
The asset ceiling is the present value of any economic benefits available in the form of refunds
from the plan or reductions in future contributions to the plan.
The present value of a defined benefit obligation is the present value, without deducting any
plan assets, of expected future payments required to settle the obligation resulting from employee
service in the current and prior periods.
Plan assets comprise:
(a) Assets held by a long-term employee benefit fund
(b) Qualifying insurance policies
Fair value is the amount for which an asset could be exchanged or a liability settled between
knowledgeable, willing parties in an arm’s length transaction.
Definitions relating to defined benefit cost
Service cost comprises:
(a) current service cost which is the increase in the present value of the defined benefit
obligation resulting from employee service in the current period.
(b) past service cost, which is the change in the present value of the defined benefit obligation
for employee service in prior periods, resulting from a plan amendment (the introduction or
withdrawal of, or changes to, a defined benefit plan) or a curtailment (a significant reduction
by the entity in the number of employees covered by a plan); and
(c) any gain or loss on settlement.
Net interest on the defined benefit liability (asset) is the change during the period in the net
defined benefit liability (asset) that arises from the passage of time.
Remeasurements of the net defined benefit liability (asset) comprise:
(a) actuarial gains and losses
(b) the return on plan assets, excluding amounts included in net interest on the defined benefit
liability (asset); and
(c) any change in the effect of the asset ceiling, excluding amounts included in net interest on
the net defined benefit liability (asset).
359
Financial Reporting
Key terms (cont'd)

Actuarial gains and losses are changes in the present value of the defined benefit obligation
resulting from:
(a) experience adjustments (the effects of differences between the previous actuarial
assumptions and what has actually occurred), and
(b) the effects of changes in actuarial assumptions.
The return on plan assets is interest, dividends and other income derived from the plan assets,
together with realised and unrealised gains or losses on the plan assets, less:
(a) any cost of managing plan assets; and
(b) any tax payable by the plan itself, other than tax included in the actuarial assumptions used
to measure the present value of the defined benefit obligation.
A settlement is a transaction that eliminates all further legal or constructive obligations for part or
all of the benefits provided under a defined benefit plan, other than a payment of benefits to, or on
behalf of employees that is set out in the terms of the plan and included in the actuarial
assumptions.
(HKAS 19)
2 Short-term employee benefits

Topic highlights
Short-term employee benefits are those benefits that are expected to be settled wholly before
12 months after the end of the period in which the employees provide the related services. The
cost of the benefits to be paid in exchange for the employee's services should be recognised in the
period on an accruals basis.
As mentioned in section 1.1, short-term employee benefits include:

 monetary benefits such as wages and salaries, annual leave, sick leave, maternity leave,
and profit shares and bonuses paid within 12 months.
 non-monetary benefits such as medical care, housing and company cars.
HKAS 19.11 2.1 Recognition and measurement

HKAS 19 requires that short-term employee benefits are recognised in the period in which the
related service is provided by the employee as:
(a) a liability (after deducting any amount already paid), and
(b) an expense unless another standard (such as HKAS 2 or HKAS 16) requires or permits
inclusion in the cost of an asset.
The amount recognised should not be discounted.
Where the amount already paid exceeds the undiscounted amount of the benefits, the resulting
asset should be recognised as a prepayment to the extent that it will lead to a reduction in future
payments or refund.
The standard explains how these rules are applied in the case of short-term compensated
absences and profit-sharing and bonus plans.
360
HKAS
19.13-18
2.2 Short-term paid absences
Short-term paid absences include paid holiday leave, sick leave, maternity or paternity leave and
jury service leave. These are classified by the standard as either:
 accumulating compensated absences, or
 non-accumulating compensated absences.
Accumulating absences are those that can be carried forward and used in future periods if the
current period’s entitlement is not used in full; non-accumulating absences are those which cannot
be carried forward and lapse if the current year entitlement is not used.
2.2.1 Accounting treatment
The cost of accumulating absences should be recognised as an expense when the employee
provides the service which results in entitlement to such absences. Where there is an unused
entitlement at the reporting date, a liability is recognised, based on an estimated amount.
The cost of non-accumulating absences should be recognised as an expense when the absences
occur.
Example: Sick pay

An entity has 10 employees, each of whom is entitled to seven days of paid sick leave per annum.
Unused sick leave may be carried forward for one year. Current year leave must be used before carried
forward leave. At 31 December 20X8, each employee had, on average, two days of leave unused.
Based on past experience the entity expects eight employees to take no more than seven days of sick
leave in the coming year. The remaining two employees are expected to take nine days each.
Assuming that each sick day costs the entity $60, what liability for sick leave must be accrued in
the statement of financial position as at 31 December 20X8?
Solution
A liability must be recognised in the statement of financial position to the extent that the entity
expects to have to pay sick leave next year as a result of the entitlement that has accumulated at
31 December 20X8:
2 employees  2 days  $60 = $240
$ $
DEBIT Employee expense 240
CREDIT Liability 240
Being sick leave entitlement at 31 December 20X8 expected to be paid next year
HKAS
19.19-24
2.3 Profit-sharing schemes and bonus plans
HKAS 19 requires that an entity recognises the expected cost of profit-sharing and bonus
payments only when:
 the entity has a present legal or constructive obligation to make such payments as a result of
past events, and
 a reliable estimate of the obligation can be made.
In this case an expense and liability should be recognised.
Often conditions are attached to bonus payments, for example an employee must still be in the
entity's employment when the bonus becomes payable.
361
Financial Reporting
Therefore, an estimate should be made based on the expectation of the level of bonuses that will
ultimately be paid. A reliable estimate can only be made when:
 the formal terms of the plan include a formula to determine the amount of the benefit;
 the entity determines the amount payable before the financial statements are authorised for
issue; or
 past practice provides clear evidence of the amount of a constructive obligation.
Example: Bonus plan

Lowdown Co. has a contractual agreement to pay a total of 5% of its net profit each year as a
bonus. The bonus is divided between the employees who are with the entity at its year end. The
following data is relevant:
Net profit $2,000,000
Average employees 50
Employees at start of year 60
Employees at end of year 40
Required
How should the expense be recognised?
Solution
An expense should be recognised for the year in which the profits were made and therefore the
employees' services were provided, for:
$2m  5% = $100,000
Each of the 40 employees remaining with the entity at the year end is entitled to $2,500. A liability
of $100,000 should be recognised if the bonuses remain unpaid at the year end.
3 Post-employment benefits
Topic highlights
There are two types of retirement benefit plan:
 Defined contribution plans
 Defined benefit plans
HKAS 3.1 Types of post-employment benefits

19.26-30
Post-employment benefits are those benefits provided to employees after they have stopped
working. They may include:
 retirement benefits (pensions), and
 other benefits such as post-employment life insurance or medical care.
Post-employment benefit schemes are often referred to as "plans". Employers (and sometimes
employees) make regular contributions to the plan and this money is invested in long-term assets
such as stocks and shares.
The return on the plan assets, and sometimes the proceeds of the sale of plan assets, is used to
pay for the post-employment benefits.
There are two types of post-employment benefit plans:
 defined contribution, and
 defined benefit.
362
3.1.1 Defined contribution plans

These plans involve fixed amounts (normally a percentage of an employee's salary) being paid into
the plan each year. These amounts, or contributions, may be made by the employer and current
employees.
The level of benefits paid out to former employees is resultant on how the plan's investments have
performed. In other words there is no guarantee of a fixed amount of benefit.
3.1.2 Defined benefit plans
These plans involve fixed amounts being paid out of the plan to former employees as benefits. The
fixed amount is normally calculated as a percentage (based on the number of years' service) of
final salary.
As before, contributions are made by the employer (and possibly current employees) and these are
invested. The level of contributions is not, however, fixed. Instead it is set at an amount that is
expected to result in sufficient investment returns to meet the obligation to pay the defined post-
retirement benefits.
Where it appears that there are insufficient assets in the fund, the employer will be required to
make increased contributions; where it appears that there are surplus assets in the fund, the
employer may stop paying contributions for a period (known as a contributions holiday).
HKAS
19.32-39
3.2 Multi-employer plans
Multi-employer plans were defined above in section 1.3. They are retirement benefit plans in which
various entities contribute assets to a pool. These pooled assets are then used to provide benefits
to employees of the various contributing entities.
HKAS 19 requires that an entity should classify such a plan as a defined contribution plan or a
defined benefit plan, under the terms of the plan (including any constructive obligation that exceeds
the formal terms of the plan).
If the multi-employer plan is a defined contribution plan, it is accounted for as normal, by
recognising the contributions made to the plan as an expense.
If, on the other hand, the multi-employer plan is a defined benefit plan, then HKAS 19 requires the
entity to account for it as a defined benefit plan. However, it should do so only on a proportional
basis. In other words it recognises its proportionate share of the obligation, assets and cost
associated with the plan. It should also make all of the normal disclosures for defined benefit plans.
However, determining the extent to which an entity participates in a defined benefit multi-employer
plan may be problematic. Therefore, it may be difficult to determine reliably the appropriate
proportionate share of the relevant data. In this case, where there is insufficient information to
determine the relevant amounts to use defined benefit accounting, then the entity should recognise
the plan as a defined contribution plan. However, it should also make as many additional
disclosures as possible to enable users to understand the nature of the plan. For example, an
entity should disclose that the plan is, in fact, a defined benefit plan and information about any
known surplus or deficit.
4 Defined contribution plans

Topic highlights
Contributions to a defined contribution plan are recognised as an expense in the period in which
they are payable.
363
Financial Reporting
HKAS
19.51-52
4.1 Recognition and measurement
Accounting for defined contribution plans is relatively straightforward:
1 Contributions to a defined contribution plan should be recognised as an expense in the
period they are payable (except to the extent that labour costs may be included within the
cost of assets).
2 Any liability for unpaid contributions that are due as at the end of the period should be
recognised as a liability (accrued expense).
3 Any excess contributions paid should be recognised as an asset (prepaid expense), but
only to the extent that the prepayment will lead to, for example, a reduction in future
payments or a cash refund.
Where contributions are not payable during the period (or within 12 months of the end of the
period) in which the employee provides the services to which they relate, the amount recognised
should be discounted, to reflect the time value of money.
Example: Defined contribution plan

Highlife Co. agrees to contribute 4% of employees' total remuneration into a post-employment plan
each period.
In the year ended 31 December 20X1, the company paid total salaries of $16 million. A bonus of
$4 million based on the income for the period was paid to the employees in March 20X2.
The company had paid $760,000 into the plan by 31 December 20X1.
Required
Calculate the total expense for post-employment benefits for the year and the accrual which will
appear in the statement of financial position at 31 December 20X1.
Solution
$
Salaries 16,000,000
Bonus 4,000,000
20,000,000  4% = $800,000
$ $
DEBIT Staff costs expense 800,000
CREDIT Cash 760,000
Accrual 40,000
HKAS 19.53 4.2 Disclosure

HKAS 19 requires that the following is disclosed in respect of defined contribution schemes:
(a) A description of the plan
(b) The amount recognised as an expense in the period
5 Defined benefit plans

Topic highlights
Defined benefit plans are recognised in the statement of financial position. Changes in the plan are
broken down into their constituent parts and recognised in profit or loss or other comprehensive
income immediately.
364
5.1 Introduction to accounting treatment

As we have already discussed, contributions made to defined benefit plans may vary considerably
from year to year. The accounting treatment applied to defined contribution plans is therefore not
appropriate here, as expensing contributions would result in volatile profits.
Instead, HKAS 19 requires a net defined benefit liability (asset) to be shown in the statement of financial
position. This is defined as the deficit or surplus in a defined benefit plan and is calculated as:
(a) the present value of the defined benefit obligation (i.e. the obligation to pay future benefits to
employees) less
(b) the fair value of any plan assets
Where the present value of the defined benefit obligation exceeds the fair value of plan assets, a
plan is in deficit and an overall net defined benefit liability is recognised; where the fair value of plan
assets exceeds the present value of the defined benefit obligation, a plan is in surplus and an
overall net defined benefit asset is recognised.
Both the present value of the obligation and the fair value of the plan assets are normally
calculated and advised by an actuary. HKAS 19 provides guidance on this. The role of the
accountant is therefore to recognise the changes in these amounts from year to year in accordance
with HKAS 19.
HKAS 19.61 5.1.1 Constructive obligation

In determining the extent of the obligation to provide retirement benefits, an entity must assess not
only its legal obligation under the formal terms of a defined benefit plan, but also any constructive
obligation that arises from the entity’s informal practices.
Informal practices give rise to a constructive obligation where the entity has no realistic alternative
but to pay employee benefits, for example, where a change in an entity’s informal practices would
cause unacceptable damage to its relationship with employees.
HKAS 19.57 5.2 Accounting steps

HKAS 19 provides a four-step approach to accounting for defined benefit plans:
1 Determine the deficit or surplus (i) Use an actuarial technique in order to make a reliable
estimate of the cost to the entity of providing the post-
employment benefit that employees have earned in
current and past periods
(ii) discount that benefit to determine the present value of
the defined benefit obligation
(iii) deduct the fair value of plan assets from the present
value of the defined benefit obligation
2 Determine the amount of the The amount of deficit or surplus calculated in step 1 may
net defined benefit liability require adjustment for the effect of limiting a net defined
(asset) benefit asset to the asset ceiling.
3 Determine amounts to be These may include:
recognised in profit or loss (i) current service cost
(ii) past service cost and gain or loss on settlement
(iii) net interest on the defined benefit liability (asset)
4 Determine remeasurements to These may include:

be recognised in other (i) actuarial gains and losses
(ii) return on plan assets excluding amounts included in net
interest on the defined benefit liability (asset)
365
Financial Reporting
(iii) any change in the effect of the asset ceiling excluding

amounts included in net interest on the defined benefit
liability (asset).
Each of these steps is considered in more detail in the following sections of the chapter.
HKAS
19.58-59
5.3 Step 1 – Determine the deficit or surplus
Measurement of the deficit or surplus is not required at every period end. However, it must be
made sufficiently regularly such that reported amounts are not materially different from the actual
value at the reporting date.
HKAS 19 encourages, but does not require, the use of a qualified actuary.
The cost of providing future benefits in respect of current and past services should be estimated
using an actuarial technique, the projected unit credit method.
HKAS 5.3.1 Estimation of future cost using the projected unit credit method
19.67-68,75-80
The projected unit credit method assumes that each period of an employee’s service gives rise to
an additional "unit" of future benefit. Each of these units is measured separately and they are
added together to calculate the total obligation.
In measuring the obligation, the actuary must make a number of actuarial assumptions, both
demographic and financial, for example:
 What the defined benefits will be (this depends upon factors such as length of service and
final salary)
 When benefits will be paid (this depends upon retirement age)
 How many employees will draw a pension (this depends upon factors such as mortality rate)
The standard requires actuarial assumptions to be unbiased and mutually compatible. They should
also be based on "market expectations" at the year end, over the period during which the
obligations will be settled.
HKAS 5.3.2 Discount the future benefit to present value
19.83-86
After the future cost of the defined benefit obligation has been measured, it must be discounted to
present value using an appropriate discount rate.
The standard requires that this is determined by reference to market yields at the end of the
reporting period on high quality corporate bonds.
In the absence of a "deep" market in such bonds, the yields on comparable government bonds
should be used as reference instead.
The corporate bonds that are used to determine a discount rate should have a term to maturity that
is consistent with the expected maturity of the post-employment benefit obligations, although a
single weighted average discount rate is sufficient.
HKAS 5.3.3 Fair value of plan assets
19.8,113-115
In order to determine the deficit or surplus, the fair value of plan assets must be deducted from the
present value of the defined benefit obligation.
Plan assets are:
(a) assets such as stocks and shares, held by a fund that is legally separate from the reporting
entity, which exists solely to pay employee benefits.
(b) insurance policies, issued by an insurer that is not a related party, the proceeds of which can
only be used to pay employee benefits.
Investments which may be used for purposes other than to pay employee benefits are not plan
assets.
366
The standard requires that the plan assets are measured at fair value, defined as the amount for
which an asset could be exchanged or a liability settled between knowledgeable, willing parties in
an arm’s length transaction. HKAS 19 includes the following specific requirements:
(a) The plan assets should exclude any contributions due from the employer but not yet paid.
(b) Plan assets are reduced by any liabilities of the fund that do not relate to employee benefits,
such as trade and other payables.
HKAS 5.4 Step 2 – Determine the amount of the net defined benefit
19.63-64
liability (asset)
In the statement of financial position, the amount recognised as a defined benefit liability (or
asset) should be the following.
(a) The present value of the defined obligation at the year end, minus
(b) The fair value of the assets of the plan as at the year end (if there are any) out of which
the future obligations to current and past employees will be directly settled.
Where there is a net defined benefit asset, the amount of this may be limited by the "asset ceiling".
We shall discuss this in more detail later in the chapter.
HKAS 19.120 5.5 Step 3 – Determine amounts to be recognised in profit or loss

The change in the net defined benefit liability (asset) as measured by an actuary at the start and
the end of a financial period can be attributed to contributions made into the plan, payments made
out of the plan and three further components:
(a) service costs
(b) net interest on the net defined benefit liability (asset), and
(c) remeasurements.
The first two of these components are recognised in profit or loss. The third is recognised in other
comprehensive income and is dealt with in section 5.6.
5.5.1 Service costs
Service costs include:
 current service cost, being the increase in the present value of the defined benefit obligation
resulting from employee services during the current period
 past service cost, being the change in the obligation relating to employee services in prior
periods arising from amendments or curtailments to the pension plan
 gains or losses on settlement of a defined benefit plan.
Current service costs normally arise in each financial year; past service costs and gains or losses
on settlement arise only where a pension plan is amended, curtailed or settled in a period. We shall
therefore concentrate on current service costs here and consider past service costs and gains or
losses on settlement in more detail in section 5.7.
The current service cost is the increase in the present value of the defined benefit obligation
resulting from employee service in the current period. This increase arises from the fact that most
defined benefit pensions provide an incremental benefit for each year of service. The current
service cost is calculated using the projected unit credit method which we mentioned earlier.
Consider a situation where a defined benefit plan provides for a benefit of 2.5% of the employee's
salary in his/her final year, for each full year of service. The pension is payable from the age of 65.
If an employee is expected to earn $10,000 in his final year of employment, then each year of
service will result in an extra $250 for each year of retirement (assuming a 40-year working life). If
the employee is expected to live for 15 years after retirement, the benefit payable is the discounted
value at retirement date of $250 per annum for 15 years. The current service cost is the present
value of this discounted amount.
367
Financial Reporting
The current service cost increases the plan obligation and is charged to operating expenses in
profit or loss.
HKAS 5.5.2 Net interest on the net defined benefit liability (asset)
19.83, 123
Annual interest arises in respect of both the defined benefit obligation and the plan assets:
(i) An interest charge arises on the unwinding of the discount on the defined benefit obligation
as time passes, and
(ii) Interest income is recognised on the plan assets.
HKAS 19 requires that these two interest elements are calculated on a net basis as:
Net defined benefit liability (asset)  discount rate
 The net defined benefit liability (asset) should be determined as at the start of the
accounting period, taking account of changes during the period as a result of contributions
paid into the scheme and benefits paid out.
 The discount rate is that determined by reference to market yields (at the year end) on
high quality fixed-rate corporate bonds.
The net interest cost is charged to finance costs in profit or loss.
HKAS
19.122, 127
5.6 Step 4 – Determine amounts to be recognised in other
The third component of changes in a net defined benefit liability (asset) is remeasurements. These
are recognised in other comprehensive income and are never reclassified to profit or loss.
Remeasurements may include:
(a) actuarial gains and losses;
(b) the return on plan assets (excluding amounts included in net interest on the net defined
benefit liability (asset)); and
(c) any change in the effect of the asset ceiling (excluding amounts included in net interest on
the net defined benefit liability (asset)).
The asset ceiling is a complication that is not relevant in every case, so it is dealt with separately,
later in the chapter.
HKAS 19.128 5.6.1 Actuarial gains and losses
We have already seen, in section 5.3.1, that in measuring the defined benefit obligation, the
actuary must make a number of actuarial assumptions regarding issues such as mortality and
salary increases.
Actuarial gains and losses arise from changes to the defined benefit obligation because of changes
in actuarial assumptions and experience adjustments:
(a) Actual events: The calculation of the plan obligation and the current service cost is based
on estimates of numbers of employees remaining in the plan during the current year as well
as estimates about salary changes during the current year. Where staff leave or salaries are
increased by amounts different from those expected, the year end obligation will be different
from that previously expected.
(b) Actuarial assumptions are revised: The valuation of the plan obligation depends upon a
number of what are called actuarial assumptions. These include the discount rate, estimates
of staff remaining in the plan until retirement, projected salaries on retirement, mortality rates
and the length of time over which benefits need to be paid. These estimates can be changed
as the entity, or its actuaries, reassess the future.
368
(c) Actual returns on plan assets: The valuation of the plan assets includes an estimated rate
of return for the current year. At the year end the plan assets may have grown by an amount
different from that expected.
Such actuarial gains and losses are recognised in other comprehensive income.
5.6.2 Return on plan assets
A new valuation of the plan assets is carried out at each period end, using current fair values. Any
difference between the new value, and what has been recognised up to that date (normally the
opening balance, interest, and any cash payments into or out of the plan) is treated as a
"remeasurement" and recognised in other comprehensive income.
Example: Defined benefit plan

The following information relates to a defined benefit pension plan operated by Snow Co.:
$m
Present value of defined benefit obligation at 1 January 20X1 100
Present value of defined benefit obligation at 31 December 20X1 120
Fair value of plan assets at 1 January 20X1 60
Fair value of plan assets at 31 December 20X1 55
Current service cost 18
Contributions made into the scheme 12
Payments made to members of the scheme 15
The yield on a high quality corporate bond is 5%.
Calculate amounts to be recognised in profit or loss and other comprehensive income in the year
ended 31 December 20X1 and the value of the net defined benefit liability in the statement of
financial position at that date.
Solution
Net defined
Obligation Assets benefit liability
$m $m $m
At 1 January 20X1 100 60 40
Contributions 12
Payments (15) (15)
Interest (5%  100m)/(5%  60m) 5 3
108 60
Remeasurements (β) 12 (5)
At 31 December 20X1 120 55 65
In the statement of profit or loss and other comprehensive income, the following amounts will
be recognised:
In profit or loss $m
Net interest on net defined benefit liability (5 – 3) 2
In other comprehensive income
Remeasurement losses on defined benefit liability (12 + 5) 17
[Note that the remeasurement in relation to both the asset and liability is a loss as it decreases the
asset and increases the liability.]
In the statement of financial position, the net defined benefit liability of $65m (120 – 55) will be
recognised.
369
Financial Reporting
JSX, a listed entity, has a defined benefits pension scheme. The following information relates to the
pension scheme for the year ended 31 October 20X8:
$
Current service cost 362,600
Contributions to scheme 550,700
Benefits paid 662,400
Fair value of scheme assets at 1 November 20X7 10,660,000
Fair value of scheme assets at 31 October 20X8 11,204,000
Present value of defined benefit obligation at 1 November 20X7 13,290,000
Present value of defined benefit obligation at 31 October 20X8 14,210,000
The yield on a high quality corporate bond was 4%.
Calculate the amount to be recognised in other comprehensive income in respect of the pension
scheme for the year ended 31 October 20X8.
5.7 Further issues – past service costs and settlements

Topic highlights
Past service costs arise when a pension plan is amended or curtailed; they are recognised
immediately in profit or loss.
Settlements occur when plan benefits are reduced. Gains or losses on settlement are recognised in
profit or loss immediately.
Although we have now met the most common items which reconcile the plan surplus or deficit at
the start and end of a period, there are two further complications which you must be able to deal
with:
 Past service cost
 Settlements
HKAS 5.7.1 Past service cost
19.102-106
Past service costs arise as a result of the amendment or curtailment of a defined benefits plan.
A plan amendment arises when an entity introduces a new defined benefits plan, withdraws an
existing plan, or changes the benefits payable under an existing plan.
A curtailment occurs when an entity significantly reduces the number of employees covered by a
plan.
In either case, the past service cost is the resulting change in the present value of the defined
benefit plan. The past service cost may be positive where new benefits are introduced or negative
where existing benefits are withdrawn. The amount is advised by an actuary.
Past service costs are recognised as an expense in profit or loss at the earlier of the following
dates:
(a) when the plan amendment or curtailment occurs
(b) when the entity recognises related restructuring costs in accordance with HKAS 37 or
termination benefits in accordance with HKAS 19 (see section 6).
370
HKAS 5.7.2 Settlements

19.109,111
A settlement occurs when an employer enters into a transaction to eliminate all or part of its post-
employment benefit obligations, for example, a one-off transfer of obligations under a plan to an
insurance company through the purchase of an insurance policy.
The gain or loss on a settlement is the difference between:

(a) the present value of the defined benefit obligation being settled, as valued on the date of
the settlement; and
(b) the settlement price, including any plan assets transferred and any payments made by the
entity directly in connection with the settlement.
Any gains or losses on settlement are recognised immediately in profit or loss when the settlement
occurs.
A defined benefit plan provides for retirement benefits at the rate of 1% of salary per annum for all
employees from the commencement of their employment. On 31 December 20X1, the defined
benefit obligation is measured at $18 million and the plan assets have a fair value of $15.5 million.
Corresponding amounts at 31 December 20X2 are $22.5 million and $16 million.
On 1 January 20X2, the rules of the plan are changed to provide for benefit at the rate of 2% of
salary for employees with 15 or more years' service and the defined benefit obligation on the new
basis is $20 million. Other relevant information is as follows:
 Current service cost is $3 million for the year ended 31 December 20X2
 Market yields on high quality corporate bonds were 4% at 1 January 20X2 and
4.5% at 31 December 20X2
 An overall remeasurement loss of $1.2 million was identified.
Required
What amount is recognised in profit or loss in respect of the defined benefit plan in the year ended
31 December 20X2?
HKAS
19.64-65, 83
5.8 Further issues – the asset ceiling
In section 5.4 we said that a net defined benefit asset is limited by the "asset ceiling". This term
relates to a threshold established by HKAS 19 to ensure that any pension surplus is carried at no
more than its recoverable amount. In other words, the net defined benefit asset is restricted to the
amount of cash savings available to the entity in the future.
HKAS 19 defines the asset ceiling as: "the present value of any economic benefits available in the
form of refunds from the plan or reductions in future contributions to the plan".
The standard further requires that the discount rate used to calculate the present value of future
economic benefits is the same as that used to calculate the net interest on the net defined benefit
liability (asset) i.e. a rate determined by reference to market yields at the end of the reporting
period on high quality corporate bonds.
Where the net defined benefit asset is reduced to the asset ceiling threshold, the related write
down is treated as a remeasurement and recognised in other comprehensive income.
371
Financial Reporting
Example: The asset ceiling

Rowan Co. operates a defined benefit pension scheme for its employees. At 1 January 20X1 the
present value of the defined benefit obligation was $5 million and the fair value of the plan assets
was $5.7 million. Equivalent values at 31 December 20X1 were $5.94 million and $7.1 million.
For the year ended 31 December 20X1:
 Current service cost was $1.5 million
 The interest rate applicable to the net defined benefit asset was 3%
 Contributions of $2 million were made to the plan
 $800,000 was paid out to former employees of Rowan
The present value of future economic benefits in relation to the plan is $1.1 million.
What amount of remeasurement is recognised in other comprehensive income in the year ended
31 December 20X1?
Solution
Net defined
Obligation Assets benefit asset
$'000 $'000 $'000
At 1 January 20X1 5,000 5,700 700
Contributions 2,000
Payments (800) (800)
Interest (3%  5m)/(3%  5.7m) 150 171
5,850 7,071
Remeasurements (β) 90 29
At 31 December 20X1 5,940 7,100 1,160
Remeasurement due to asset ceiling (60)
Asset ceiling 1,100
Therefore, the total remeasurement amount recognised in other comprehensive income is:
$'000
Remeasurement loss on obligation 90
Remeasurement gain on assets (29)
Remeasurement loss due to asset ceiling 60
Net remeasurement loss 121
5.9 Summary of accounting treatment

This section summarises the accounting treatment that we have met so far.
Opening figures Net defined benefit liability (asset):

 Present value of obligation, less
 Fair value of plan assets
As advised by actuary
Contributions As advised by the actuary DEBIT Plan assets
CREDIT Cash / other assets
Benefits paid Pension payments made to retired DEBIT Plan obligation
former employees CREDIT Plan assets
372
Current service Increase in plan obligation as a result DEBIT Operating expense (profit or loss)
cost of one extra year’s service. CREDIT Plan obligation
Past service cost Change in plan obligation as a result Improvement of benefits:
of improvement or withdrawal of DEBIT Operating expense (profit or loss)
benefits. CREDIT Plan obligation
Withdrawal of benefits:
DEBIT Plan obligation
CREDIT Operating expense (profit or
loss)
Gains or losses Difference between the present value Loss on settlement:
on settlement of the obligation on settlement date DEBIT Operating expense (profit or loss)
and the settlement amount. CREDIT Plan obligation
Gain on settlement:
DEBIT Plan obligation
CREDIT Operating expense (profit or
loss)
Net interest on Based on high quality corporate bond DEBIT Finance cost (profit or loss)
net defined yield at end of period and net defined CREDIT Plan obligation
benefit liability benefit liability (asset) at start of And
(asset) period.
DEBIT Plan assets
Discount rate %  net defined benefit
CREDIT Finance cost (profit or loss)
liability (asset) b/f
Remeasurements Due to actuarial differences, the actual DEBIT Other comprehensive income
return on plan assets differing from the CREDIT Plan obligation / assets
return calculated within net interest Or
and change in the effect of the asset
DEBIT Plan obligation / assets
ceiling. Calculated as a balancing
figure CREDIT Other comprehensive income
Closing figures Net defined benefit liability (asset):

 Present value of obligation, less
 Fair value of plan assets
HKAS
19.63-64
5.10 Disclosure of defined benefit plans
5.10.1 The statement of financial position
In the statement of financial position, the amount recognised as a net defined benefit liability
should be calculated as:
$
Present value of defined benefit obligation at year end X
Fair value of plan assets at year end (X)
Net defined benefit liability X/(X)
If this total is a negative amount, there is a net defined benefit asset and this should be shown in
the statement of financial position as the lower of (a) and (b) below.
(a) The net defined benefit asset as calculated above
(b) The asset ceiling (see section 5.8)
373
Financial Reporting
HKAS 19.120 5.10.2 The statement of profit or loss and other comprehensive income
The following amounts should be recognised in profit or loss:
 Current service cost
 Past service cost
 Gain or loss on settlement
 Net interest on the net defined benefit liability (asset)
Remeasurements should be recognised in other comprehensive income.
Lewis, a public limited company, has a defined benefit plan for its employees. The present value of
the future benefit obligations at 1 January 20X7 was $890m and fair value of the plan assets was
$1,000 million. Further data concerning the year ended 31 December 20X7 is as follows:
$m
Benefits paid to former employees 150
Contributions paid to plan 104
Present value of benefit obligations at 31 December 1,100 As valued by

Fair value of plan assets at 31 December 1,230 professional actuaries
Interest cost (gross yield on "blue chip" corporate bonds) 10%

On 1 January 20X7 the plan was amended to provide additional benefits with effect from that date
subject to a minimum employment period of eight years. The present value of the additional
benefits was calculated by actuaries at $30 million.
The present value of future economic benefits available to Lewis in respect of the plan was
$120 million at 31 December 20X7.
Required
Prepare the required notes to the statement of profit or loss and other comprehensive income and
statement of financial position for the year ended 31 December 20X7.
Assume the contributions and benefits were paid on 31 December 20X7.
6 Termination benefits
Topic highlights
Termination benefits are recognised as a liability and expense when an entity is demonstrably
committed to them.
Termination benefits are those employee benefits provided in exchange for the termination of an
employee's employment as a result of either:
 an entity's decision to terminate an employee's employment before the normal retirement
date; or
 an employee's decision to accept an offer of benefits in exchange for the termination of
employment.
374
These benefits are dealt with separately in HKAS 19 as unlike other benefits, the event which gives
rise to an obligation is the termination rather than the service of the employee.

HKAS 19 states that termination benefits should be recognised in full as a liability and an expense
at the earlier of:
(i) when the entity can no longer withdraw the offer of termination benefits; and
(ii) when the entity recognises costs for a restructuring that is within the scope of HKAS 37 and
involves the payment of termination benefits.
HKAS 19.169 6.2 Measurement

Termination benefits are measured in accordance with the nature of the employee benefit:
 If the termination benefits are an enhancement of post-employment benefits, they are
accounted for as such.
 Otherwise:
– if the termination benefits are expected to be settled wholly before 12 months after the
end of the annual reporting period in which the termination benefit is recognised, then
they are accounted for as short-term employee benefits.
– if the termination benefits are not expected to be settled wholly before 12 months after
the end of the annual reporting period, then they are accounted for as other long-term
employee benefits.
The IASB issued an exposure draft in March 2013 which proposes to amend IAS 19 (and so HKAS
19 which is aligned with IAS 19). The proposed amendments specify that contributions from
employees or third parties set out in the terms of a defined benefit plan are recognised as a
reduction in the service cost in the same period in which they are paid, provided that the
contributions are linked solely to the employees' service rendered in that period. This is the case
where, for example, the contributions are a fixed percentage of salary and the percentage does not
change from year to year.
375
Financial Reporting
Topic recap
HKAS 19 Employee
Benefits
Short-term employee Post-employment benefits Termination benefits

benefits
e.g. e.g. Benefits provided in

Annual leave Pensions exchange for termination of
Sick pay Post-employment an employee's employment
Medical care medical care
Recognise in the period Recognise as a liability and

the related service is expense at the earlier of:
provided by the employee when the entity can no
as a: longer withdraw the
liability offer of termination
expense benefits.
when the entity
recognises a cost for
restructuring involving
the payment of
termination benefits.
Defined contribution Defined benefit
Recognise contributions as an Recognise the net defined benefit liability/asset in the

expense in the period in which statement of financial position:
they are payable.
Accruals/prepayments may arise. Present value of obligation X
Less Fair value of plan assets (X)
Net defined benefit liability/(asset) X/(X)
An asset is limited by the asset ceiling to the present

value of future economic benefits in relation to the plan.
Each element of the change in the present value of the

obligation and fair value of plan assets is recognised
individually:
Obligation Assets Recognised in:

b/f X X
Contributions X
Benefits paid out (X) (X)
Current service cost X Profit or loss
Past service cost X/(X) Profit or loss
Loss on settlement X Profit or loss
Gain on settlement (X) Profit or loss
Net interest on defined X X Profit or loss
benefit liability / asset
Remeasurements X/(X) X/(X) Other
comprehensive
income
c/f X X
376
Answer 1
Assets Obligation
$ $
At 1 November 20X7 10,660,000 13,290,000
Contributions 550,700
Benefits paid (662,400) (662,400)
Net interest (4%  b/f assets/obligation) 426,400 531,600
Remeasurement loss on plan obligation (β) 688,200
Remeasurement gain on plan assets (β) 229,300
At 31 October 20X8 11,204,000 14,210,000
The remeasurement loss recognised in other comprehensive income is $458,900 (688,200 –
229,300)
Answer 2
The past service cost measured as the increase in the defined benefit obligation is $20m – $18m =
$2 million.
Net interest is calculated using the year-end market rate on a high quality corporate bond. This
rate is applied to the net defined benefit liability at the start of the year.
Therefore the total charge to profit or loss is:
$
Current service cost 3,000,000
Past service cost 2,000,000
Net interest 4.5%  (18m – 15.5m) 112,500
5,112,500
Answer 3
STATEMENT OF FINANCIAL POSITION
$m
Net defined benefit asset 1 120
NOTE TO THE STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

Defined benefit expense recognised in profit or loss
$m
Past service cost 30
Interest cost 10%  (1,000 – 890) (11)
Defined benefit costs recognised in other
Remeasurement gain on defined benefit pension plan 52
(176 – 114 – 10) (W)
377
Financial Reporting
WORKINGS
Changes in the present value of the defined benefit obligation
$m
Opening defined benefit obligation 890
Past service cost 30
Interest cost 10%  890m 89
Benefits paid (150)
Remeasurement loss (β) 114
Closing defined benefit obligation 1,100
Changes in the fair value of plan assets
$m
Opening fair value of plan assets 1,000
Interest 10%  1,000 100
Contributions 104
Benefits paid (150)
Remeasurement gain (β) 176
Closing fair value of plan assets 1,230
Asset ceiling test
$m
Closing fair value of plan assets 1,230
Closing defined benefit obligation (1,100)
Closing net defined benefit asset 130
Asset ceiling (120)
Remeasurement loss 10
378
Exam practice
Employee benefits 29 minutes

(a) HKAS 19 as amended in July 2011 requires that all actuarial gains and losses (or
remeasurements) are recognised immediately in other comprehensive income. Prior to these
amendments, entities were permitted to defer actuarial gains and losses in excess of 10% of
the value of the plan assets or obligation and recognise them over an extended period, either
in profit or loss or in other comprehensive income.
Required
What will be the effect of the new requirements on the financial statements of entities which
previously chose to defer actuarial gains and losses? (4 marks)
(b) The following information relates to the defined benefit employee compensation scheme of
Rhodes Co.:
Present value of obligation at start of 20X8 ($'000) 20,000
Market value of plan assets at start of 20X8 ($'000) 20,000
20X8 20X9
$'000 $'000
Current service cost 1,250 1,430
Benefits paid out 987 1,100
Contributions paid by entity 1,000 1,100
Present value of obligation at end of the year 23,000 20,400
Market value of plan assets at end of the year 21,500 17,840
Yield on corporate bonds at end of year 8% 9%
During 20X8, the benefits available under the plan were improved. The resulting increase in
the present value of the defined benefit obligation was $1 million.
On the final day of 20X9, Rhodes Co. divested of part of its business, and as part of the sale
agreement, transferred the relevant part of its pension fund to the buyer. The present value
of the defined benefit obligation transferred was $5.7 million and the fair value of plan assets
transferred was $5.4 million. Rhodes also made a cash payment of $200,000 to the buyer in
respect of the plan.
Assume that all transactions occur at the end of the year.
Required
(i) Calculate the net defined benefit liability as at the start and end of 20X8 and 20X9
showing clearly any remeasurement gain or loss on the plan each year. (6 marks)
(ii) Show amounts to be recognised in the financial statements in each of the years 20X8
and 20X9 in respect of the plan. (6 marks)
(Total = 16 marks)
379
Financial Reporting
380
chapter 17
Borrowing costs
Topic list
1 HKAS 23 Borrowing Costs

1.1 Definitions
1.2 Recognition
Learning focus
Borrowing costs may be considered in the context of non-current assets or may be considered
in isolation. HKAS 23 concentrates particularly on the situation where the related borrowings
are applied to the construction of certain assets.
381
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.12 Borrowing costs 3
3.12.01 Identify the expenses which constitute borrowing costs in
3.12.02 Identify the assets which are qualifying assets
3.12.03 Determine when the capitalisation of borrowing costs shall
commence, be suspended and cease
3.12.04 Calculate the amount of borrowing costs to be capitalised from
specific borrowing and general borrowing
3.12.05 Prepare journal entries for borrowing costs, including expensed and
capitalised borrowing costs
3.12.06 Disclose relevant information with regard to borrowing costs
382
17: Borrowing costs | Part C Accounting for business transactions
1 HKAS 23 Borrowing Costs

Topic highlights
HKAS 23 looks at the treatment of borrowing costs, particularly where the related borrowings are
applied to the construction of certain assets. These are what are usually called "self-constructed
assets", where an entity builds its own inventory or non-current assets over a substantial period of
time.

Only two definitions are given by the standard.
Key terms
Borrowing costs. Interest and other costs incurred by an entity in connection with the borrowing of
funds.
Qualifying asset. An asset that necessarily takes a substantial period of time to get ready for its
intended use or sale. (HKAS 23)
HKAS 23.6 1.1.1 Borrowing costs

The standard lists what may be included in borrowing costs:
(a) Interest expense calculated using the effective interest method as described in HKFRS 9
Financial Instruments
(b) Finance charges in respect of finance leases recognised in accordance with HKAS 17
Leases (See Chapter 9)
(c) Exchange differences arising from foreign currency borrowings to the extent they are
regarded as an adjustment to interest costs
HKAS 23.7 1.1.2 Qualifying assets
The standard says that any of the following may be qualifying assets:
 Inventories
 Manufacturing plants
 Power generation facilities
 Intangible assets
 Investment properties
Financial assets and inventories manufactured or produced over short periods are not qualifying
assets, nor are assets ready for sale or their intended use when purchased.
HKAS 23.8,9 1.2 Recognition

All eligible borrowing costs must be capitalised.
Only borrowing costs that are directly attributable to the acquisition, construction or production of
a qualifying asset can be capitalised as part of the cost of that asset. The standard lays out the
criteria for determining which borrowing costs are eligible for capitalisation.
All other borrowing costs are expensed to profit or loss.
The journal entry to record borrowing costs is therefore:
DEBIT Qualifying asset cost Eligible borrowing costs
Finance cost Ineligible borrowing costs
CREDIT Cash/Accrual Total borrowing costs
383
Financial Reporting
HKAS 23.10- 1.2.1 Borrowing costs eligible for capitalisation

15
It is necessary to identify those borrowing costs that are directly attributable to the acquisition,
construction or production of a qualifying asset. These borrowing costs would have been avoided
had the expenditure on the qualifying asset not been made. This is straightforward where funds
have been borrowed for the financing of one particular asset.
Where an entity uses a number of debt instruments to finance a variety of assets, difficulties
arise since there is no direct link between particular borrowings and a specific asset. For example,
central borrowings are lent to different parts of the group or entity. Judgment is therefore
necessary, particularly where more complex situations can arise (e.g. foreign currency loans).
Once the relevant borrowings are identified with a specific asset, the amount of borrowing costs
to be capitalised during a period will be the actual borrowing costs incurred on those borrowings,
less any investment income on the temporary investment of those borrowings. It is not unusual to
invest some or all of the funds before they are actually used to finance the qualifying asset.
On 1 January 20X9 Vitality Co. borrowed $1.5 million to finance the production of two assets, both
of which were expected to take a year to build. Work started at the beginning of 20X9. Expenditure
was as follows, with the remaining funds invested temporarily.
Asset A Asset B
$'000 $'000
1 January 20X9 250 500
1 July 20X9 250 500
The loan rate was 8% and Vitality Co. can invest surplus funds at 5%.
Required
Ignoring compound interest, calculate the borrowing costs which may be capitalised for each of the
assets and consequently the cost of each asset as at 31 December 20X9. Show the relevant
journal entries with regard to borrowing costs.
In a situation where general borrowings are acquired and applied in part to finance a qualifying
asset, then the amount of borrowing costs eligible for capitalisation is arrived at by applying the
“capitalisation rate” to the capital expenditure on the asset.
The capitalisation rate is computed as the weighted average of the borrowing costs applicable to
the entity's outstanding borrowings during the period, excluding specific borrowings made to obtain
a qualifying asset. However, the amount of these borrowing costs must not exceed actual
borrowing costs incurred.
It may be more appropriate to compute a weighted average for borrowing costs for individual
parts of the group or entity, though an overall weighted average can be used for a group or entity
sometimes.
Example: Capitalising interest

On 1 March 20X5 Dunedin Co. drew down $500,000 from existing general borrowings in order to
finance the construction of a new asset. Existing borrowings were as follows:
Bank loan $2,000,000 5% annual interest
Loan notes $6,000,000 8% annual interest
Construction of the asset commenced on 1 April 20X8 and was completed on 31 March 20X9.
What amount of interest must be capitalised in accordance with HKAS 23?
384
Solution
The weighted average cost of borrowing is:
5%  2m/(2m + 6m) + 8%  6m/(2m + 6m) = 7.25%
Therefore, interest to be capitalised is calculated as:
7.25%  $500,000  12/12 = $36,250
Tumble Co. had the following loans in place at the beginning and end of 20X8.
1 January 31 December
20X8 20X8
$m $m
9% Bank loan repayable 20Y0 150 150
8% Bank loan repayable 20Y1 90 90
7.5% debenture repayable 20Y2 – 200
The 7.5% debenture was issued to fund the construction of a qualifying asset (a piece of mining
equipment), construction of which began on 1 July 20X8.
On 1 January 20X8, Tumble Co. began construction of a qualifying asset, a piece of machinery for
a hydro-electric plant, using existing borrowings. Expenditure drawn down for the construction was:
$25 million on 1 January 20X8, $30 million on 1 October 20X8.
Required
Calculate the borrowing costs that can be capitalised for the hydro-electric plant machine.
HKAS 23.16 1.2.2 Carrying amount exceeds recoverable amount

As required by other HKFRS, the carrying amount of a qualifying asset must be written down or
written off in situations where the carrying amount (or expected ultimate cost) of the asset
exceeds its recoverable amount or net realisable value. These written down amounts may be
written back in future periods under certain circumstances (again as allowed by other HKFRS).
HKAS 23.17- 1.2.3 Commencement of capitalisation

19
Three events or transactions must be taking place for capitalisation of borrowing costs to be
started:
(a) Expenditure on the asset is being incurred
(b) Borrowing costs are being incurred
(c) Activities are in progress that are necessary to prepare the asset for its intended use or sale
Expenditure must result in cash payments, transfer of other assets or assumption of interest-
bearing liabilities. Any progress payments or grants received in connection with the asset will be
treated as deductions from expenditure. It is allowed by HKAS 23 to use the average carrying
amount of the asset during a period (including capitalised borrowing costs) as a reasonable
approximation of the expenditure to which the capitalisation rate is applied in the period.
Presumably more exact calculations can be used.
Activities necessary to prepare the asset for its intended sale or use encompass not only
physical construction work, but also technical and administrative work prior to construction, e.g.
obtaining permits. However, holding an asset when no production or development that changes the
asset's condition is taking place, e.g. where land is held without any associated development
activity, is to be excluded.
385
Financial Reporting
HKAS 23.20- 1.2.4 Suspension of capitalisation

21
Capitalisation of borrowing costs should be suspended for any extended periods where active
development is interrupted.
Any borrowing costs incurred during such periods should be expensed through profit or loss.
Capitalisation of borrowing costs is not normally suspended during:
 a period when substantial technical and administrative work is being carried out
 a temporary delay occurs which is a necessary part of getting an asset ready for intended
use, e.g. while inventories are maturing
HKAS 23.22- 1.2.5 Cessation of capitalisation

25
Once all the activities necessary to prepare the qualifying asset for its intended use or sale are
substantially complete, the capitalisation of borrowing costs should come to an end. This will
normally be the case when the physical construction of the asset is completed, though routine
administrative work and minor modifications may still be outstanding.
An asset may be completed in parts or stages and each part can be used while construction is still
in progress on the other parts. Capitalisation of borrowing costs should be terminated for each part
as it is completed. The example quoted in the standard is a business park consisting of several
buildings.
Example: Commencement, suspension and cessation of capitalisation

Lam Co. borrowed $10 million on 1 January 20X8 in anticipation of commencing work to build a
new head office later in the year. The interest rate provided by Lam Co.’s bank was 8% per annum,
and the loan had a term of five years. Construction began on 15 February and the property was
occupied for use on 20 December 20X8.
The following information is relevant:
1 February Expenditure on building materials began to be incurred
15 February Building work began
6 May Building work was suspended due to tropical storms, common to the
region through May and June
16 May Building work recommenced
30 November Building work is completed and approved by the regulatory authorities
1 December Decoration and finishing of the property to Lam Co.’s specification
commences
15 December Decoration and finishing work is completed.
What journal entries are required to record the borrowing costs in the year ended 31 December
20X8?
Solution
 Total borrowing costs incurred in the year are $10 million  8% = $800,000
 Capitalisation of borrowing costs commences on 15 February when building work
commences and both expenditure and borrowing costs are being incurred.
 Capitalisation ceases on 30 November when the physical construction of the property is
complete. Decoration and finishing qualify as minor modifications not construction.
 Capitalisation does not cease during the temporary suspension of work for inclement
weather in May.
386
 Therefore, capitalised costs are:

$10 million  8%  288/365 days = $631,233
$ $
DEBIT Property under construction 631,233
Finance costs (800,000 – 631,233) 168,767
CREDIT Cash / interest accrual 800,000
HKAS 23.26 1.2.6 Disclosure

The following should be disclosed in the financial statements in relation to borrowing costs:
(a) Amount of borrowing costs capitalised during the period.
(b) Capitalisation rate used to determine the amount of borrowing costs eligible for
capitalisation.
On 1 January 20X8 Allan Lee Co. borrowed $20 million to finance the production of two assets,
both of which were expected to take a year to build. Production started at the beginning of 20X8.
The loan facility was drawn down on 1 January 20X8, and was utilised as follows, with the
remaining funds invested temporarily:
Asset X Asset Y
$m $m
1 January 20X8 4.0 6.0
1 July 20X8 7.0 3.0
The loan rate was 10% and Allan Lee can invest surplus funds at 8%.
Required
Ignoring compound interest, calculate the borrowing costs which may be capitalised for each of the
assets and consequently the cost of each asset as at 31 December 20X8.
Autofact, a car manufacturer, prepares its accounts to 30 June each year. On 1 July 20X8, it
purchased for $20million a leasehold interest in a site on which it began to construct a factory with
an estimated useful life of 30 years. The building cost $7million to construct and the plant and
equipment cost $5million. The construction of the factory was complete on 31 March 20X9 and it
was brought into use on 1 July 20X9.
To finance this project, Autofact borrowed $32million on 1 July 20X8. The rate of interest on the
loan was 5% per annum and it was repaid on 31 December 20X9.
Required
Calculate the total amount to be included at cost in property, plant and equipment in respect of this
project at 30 June 20X9.
387
Financial Reporting
Topic recap
HKAS 23 Borrowing Costs
Eligible borrowing costs on qualifying assets MUST be

capitalised.
Eligible borrowing costs Qualifying assets
Borrowing costs Eligible
Interest and other costs Directly attributable to the An asset that necessarily
incurred by an entity in acquisition, construction or takes a substantial period of
connection with the production of a qualifying time to get ready for its
borrowing of funds. asset. intended use or sale.
Includes: Where general borrowings Includes:

Interest expense are acquired calculate the Inventories
calculated using the eligible borrowing cost as: Manufacturing plants
effective interest method weighted average interest Power generation facilities
Finance charges in rate of general borrowings Intangible assets
respect of finance leases ("capitalisation rate") × Investment properties
Exchange differences on capital expenditure on the Excludes:
foreign currency qualifying asset Financial assets
borrowings to the extent Inventories manufactured
they are regarded as an over short periods
adjustment to interest Assets ready for
costs. sale/intended use when
purchased
Commence capitalisation when: 1 expenditure on the asset is being incurred

2 borrowing costs are being incurred
3 activities are in progress to prepare the asset for use or sale
Suspend capitalisation when active development is interrupted for extended periods.
Cease capitalisation when the activities to prepare the asset for use or sale are substantially complete.
Disclose:
Amount of borrowing costs capitalised in period
Capitalisation rate used to determine the borrowing costs
eligible for capitalisation.
388
Answer 1
Asset A Asset B
$ $
Borrowing costs
To 31 December 20X9 ($0.5m, $1m)  8% 40,000 80,000
Less: investment income
To 30 June 20X9 ($0.25m, $0.5m)  5%  6/12 (6,250) (12,500)
33,750 67,500
Cost of assets
Expenditure incurred 500,000 1,000,000
Borrowing costs 33,750 67,500
533,750 1,067,500
Capitalisation of borrowing costs

$ $
DEBIT Asset A 40,000
DEBIT Asset B 80,000
CREDIT Accrued interest 120,000
Receipt of investment income by investing surplus funds

$ $
DEBIT Cash 18,750
CREDIT Asset A 6,250
CREDIT Asset B 12,500
Answer 2
 150   90 
Capitalisation rate = weighted average rate =  9%   +  8%   = 8.625%
 150  90   150  90 
3
Borrowing costs = ($25m  8.625%) + ($30m  8.625%  /12)
= $2.803m
Answer 3
Asset X Asset Y
$'000 $'000
Borrowing costs
6
To 30 June 20X8 $4.0m/$6.0m  10%  /12 200 300
6
To 31 December 20X8 $11.0m/$9.0m  10%  /12 550 450
750 750
Less: investment income
6
To 30 June 20X8 $7.0m/$3.0m  8%  /12 (280) (120)
470 630
Cost of assets
Expenditure incurred 11,000 9,000
Borrowing costs 470 630
11,470 9,630
389
Financial Reporting
Answer 4
The total amount to be included in property, plant and equipment at 30 June 20X9 is as follows:
$'000
Lease 20,000
Building 7,000
Plant and equipment 5,000
Interest capitalised ($32,000  5%  9/12) 1,200
33,200
HKAS 23 states that capitalisation of borrowing costs must cease when substantially all the
activities necessary to prepare the asset for its intended use or sale are complete. Accordingly,
only nine months' interest (1 July 20X8 to 31 March 20X9) can be capitalised.
390
Exam practice
Rondo Hospitality Enterprise 27 minutes

Rondo Hospitality Enterprise (RHE) is a hotel operator. The management is considering investing
in a new hotel project with 150 rooms. The construction of the hotel building and installation of
equipment, furniture and fixtures is scheduled to commence on 1 March 20X3 and be completed by
the end of June 20X4. The hotel would be available for use at the same time. The total cost of
HK$200 million will be payable in five equal instalments beginning 1 March 20X3 and then payable
every 4 months.
Without any delay in the completion of the construction and other unforeseen events, RHE plans to
have the pre-opening activities for three months and then commence the operation of the new hotel
by 1 October 20X4.
RHE co-ordinates its financing activities through a centralised treasury function, with borrowings
being raised from various sources such as bond issues and bank loans, to finance general
requirements, including the acquisition and development of qualifying assets. It is expected that
the borrowing requirements of RHE will be much greater than the amounts to be incurred for the
hotel project.
The expected useful life of the hotel property is 30 years. It is expected that RHE needs to replace
certain equipment and furniture in the hotel rooms every five years in addition to carrying out
regular repair and maintenance works. Around HK$40 million of the budgeted expenditure is
attributable to these capitalised items. The structure of the building can be used until the end of the
hotel's useful life.
Required
(a) Calculate the borrowing costs to be capitalised for qualifying assets for the year ending 31
December 20X3 and 20X4. Assume the capitalisation rate to be applied to the expenditure
on the qualifying asset is 6.5%. (3 marks)
(b) Discuss the factors the management of RHE should consider in relation to the depreciation
of the hotel property. (6 marks)
(c) Calculate the depreciation to be charged for the year ending 31 December 20X4 with the
explanation, assuming a straight line basis is adopted by RHE for depreciation.
(6 marks)
(Total = 15 marks)
391
Financial Reporting
392
chapter 18
Financial instruments
Topic list 4.4 Trade date v settlement date accounting
4.5 Reclassification
1 Financial instruments 4.6 Section summary
1.1 Background
5 HKFRS 9: Embedded derivatives
1.2 Definitions
5.1 Examples of embedded derivatives
2 HKAS 32: Presentation of financial 5.2 Accounting treatment of embedded
instruments derivatives
2.1 Objective 5.3 Reassessment of embedded derivatives
2.2 Scope
6 HKAS 39: Hedging
2.3 Classification of financial instruments as
6.1 Introduction
financial assets, financial liabilities and
6.2 Definitions
equity
6.3 Types of hedge
2.4 Specific classification rules
6.4 Conditions for hedge accounting
2.5 Offsetting a financial asset and a
6.5 Accounting treatment
financial liability
6.6 Exposures qualifying for hedge
2.6 Interest, dividends, losses and gains
accounting
2.7 Section summary
6.7 Recap
3 HKFRS 9: Recognition of financial
7 HKFRS 7: Disclosure of financial
instruments
instruments
3.1 Scope
7.1 Objective
3.2 Initial recognition
7.2 Classes of financial instruments and
3.3 Reclassification of financial assets
levels of disclosure
3.4 Derecognition
7.3 Statement of financial position
3.5 Section summary
disclosures
4 HKFRS 9: Measurement of financial 7.4 Statement of profit or loss and other
instruments comprehensive income disclosures
4.1 Initial measurement 7.5 Other disclosures
4.2 Subsequent measurement of financial 7.6 Nature and extent of risks arising from
assets financial instruments
4.3 Subsequent measurement of financial 7.7 Capital disclosures
liabilities
Learning focus
This is a highly controversial and very complex topic. You should concentrate on the essential
points. It is also the subject of ongoing change, as over a period of time HKAS 39 is being
replaced by HKFRS 9.
You need plenty of practice on the topics in this chapter in order to familiarise yourself with this
difficult area.
393
Financial Reporting
Learning outcomes
Competency
level
Reporting Standards
3.11 Financial assets, financial liabilities and equity instruments 2
3.11.01 Discuss and apply the criteria for the recognition and de-recognition
of a financial asset or financial liability
3.11.02 Discuss and apply the rules for the classification of a financial
asset, financial liability and equity, and their measurement
(including compound instrument)
3.11.03 Discuss and apply the treatment of gains and losses arising on
financial assets or financial liabilities
3.11.04 Discuss the circumstances that give rise to and apply the
appropriate treatment for the impairment of financial assets
3.11.05 Account for derivative financial instruments and simple embedded
derivatives, including the application of own-use exemption
3.11.06 Disclose relevant information with regard to financial assets,
financial liabilities and equity instruments
3.17 Hedge accounting 2
3.17.01 Identify fair value hedges, cash flow hedges and hedges for net
investment in accordance with HKAS 39
3.17.02 Account for fair value hedges, cash flow hedges and hedges for net
investment
394
18: Financial instruments | Part C Accounting for business transactions
1 Financial instruments
Topic highlights
Accounting guidance on financial instruments is provided in four standards:
 HKAS 32 Financial Instruments: Presentation
 HKAS 39 Financial Instruments: Recognition and Measurement
 HKFRS 7 Financial Instruments: Disclosures
 HKFRS 9 Financial Instruments
1.1 Background
Financial instruments have, in recent years, become increasingly complex. They vary from
straightforward, traditional instruments, such as loan stock or shares through to complex "derivative
instruments".
The emergence of more complex instruments towards the end of the 20th century created a
problem in that existing accounting guidance was insufficient. Accounting standards boards
worldwide were forced to address this through the development of lengthy and detailed standards.
In Hong Kong the relevant standards were:
 HKAS 32 Financial Instruments: Presentation, issued in 2004, which originally dealt with:
– the classification of financial instruments between liabilities and equity
– presentation of certain compound instruments
– disclosure of financial instruments
 HKAS 39 Financial Instruments: Recognition and Measurement, issued in 2006, which dealt
with:
– recognition and derecognition of financial instruments
– the measurement of financial instruments
– hedge accounting
Both of these standards have, subsequent to their original issue, been amended numerous times
as the topic to which they relate continually evolves. In addition, two new standards have been
issued:
 HKFRS 7 Financial Instruments: Disclosures, issued in 2005 replaced the part of HKAS 32
dealing with disclosure. In doing so, it revised, simplified and added to financial instrument
disclosure requirements.
 HKFRS 9 Financial Instruments, originally issued in 2009 replaced certain parts of HKAS 39,
in particular with respect to the classification of financial assets. HKFRS 9 was expanded in
2010 to include guidance on the classification and measurement of financial liabilities and
the derecognition of financial assets and liabilities. This standard continues to be a work in
progress and in due course will be developed further to replace HKAS 39 in its entirety.
This chapter is based on those parts of all four standards in issue at 31 May 2013. The HKICPA
operates a six-month rule, meaning that new or revised standards which have been issued by the
cut-off date (31 May 2013 for December 2013 exams and 30 November 2013 for June 2014
exams) are only examined where they have been effective or will become effective within 13
months from the first day of the month in which the examination takes place. In the case of HKFRS
9, the effective date is January 2015 so it is examinable. Any subsequent amendments made to
HKFRS 9 will be examined according to the six-month rule as stated above.
395
Financial Reporting
HKAS 32.11,
HKFRS 9,
1.2 Definitions
Appendix A
A number of definitions are common to all four standards.
Key terms
Financial instrument. Any contract that gives rise to both a financial asset of one entity and a
financial liability or equity instrument of another entity.
Financial asset. Any asset that is:
(a) cash;
(b) an equity instrument of another entity;
(c) a contractual right to receive cash or another financial asset from another entity; or to
exchange financial instruments with another entity under conditions that are potentially
favourable to the entity; or
(d) a contract that will or may be settled in the entity's own equity instruments and is a:
(i) non-derivative for which the entity is or may be obliged to receive a variable number of
the entity's own equity instruments
(ii) derivative that will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity's own equity
instruments
Financial liability. Any liability that is a:
(a) contractual obligation to:
(i) deliver cash or another financial asset to another entity
(ii) exchange financial instruments with another entity under conditions that are potentially
unfavourable
(b) contract that will or may be settled in the entity's own equity instruments and is a:
(i) non-derivative for which the entity is or may be obliged to deliver a variable number of
the entity's own equity instruments
(ii) derivative that will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity's own equity
instruments
Equity instrument. Any contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities.
Derivative. A financial instrument or other contract with all three of the following characteristics:
(a) Its value changes in response to the change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit
index, or other variable (sometimes called the "underlying")
(b) It requires no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to
changes in market factors
(c) It is settled at a future date (HKAS 32 and HKFRS 9)
396
HKAS 32.13- Some of the terms used within the definitions themselves need defining:
14
(a) A "contract" need not be in writing, but it must comprise an agreement that has "clear
economic consequences" and which the parties to it cannot avoid, usually because the
agreement is enforceable in law.
(b) An "entity" here could be an individual, partnership, incorporated body or government
agency.
HKAS 1.2.1 Financial assets and liabilities

32.AG4, AG8,
AG11-12, The definitions of financial assets and financial liabilities may seem complicated, but the
AG20-21
essential point is that while there may be a chain of contractual rights and obligations, it will lead
ultimately to the receipt or payment of cash or the acquisition or issue of an equity instrument.
Examples of financial assets and liabilities may include:
Financial assets Financial liabilities

Trade receivables Trade payables
An investment in shares Loans payable
A loan made to another party Redeemable preference shares
HKAS 32 makes it clear that the following items are not financial assets or liabilities:
 Physical assets, e.g. inventories, property, plant and equipment, leased assets and
intangible assets (patents, trademarks etc.)
 Prepaid expenses, deferred revenue and most warranty obligations
 Liabilities or assets that are not contractual in nature
 Contractual rights/obligations that do not involve transfer of a financial asset, e.g.
commodity futures contracts, operating leases
Why do you think that physical assets and prepaid expenses do not qualify as financial
instruments?
Contingent rights and obligations meet the definition of financial assets and financial liabilities
respectively, even though many do not qualify for recognition in financial statements. This is
because the contractual rights or obligations exist because of a past transaction or event (e.g.
assumption of a guarantee).
HKAS 1.2.2 Primary and derivative instruments
32.AG15
The examples of financial assets and liabilities given in the previous section may be referred to as
"primary instruments". You should also be aware of derivative financial instruments.
A derivative is a financial instrument that derives its value from the price or rate of an underlying
item. Common examples of derivatives include the following:
 Forward contracts which are agreements to buy or sell an asset at a fixed price at a fixed
future date.
 Futures contracts, which are similar to forward contracts except that contracts are
standardised and traded on an exchange.
 Options, which are rights (but not obligations) for the option holder to exercise at a pre-
determined price; the option writer loses out if the option is exercised.
 Swaps, which are agreements to swap one set of cash flows for another (normally interest
rate or currency swaps).
397
Financial Reporting
A simple example of a forward contract may help you to understand how it derives its value from an
underlying item. Say a forward contract exists to sell an asset for $8 on a given date. At today's
date the market price of the asset is $5 and therefore it would be fair to say that the contract is
worth $3. This value cannot, however, be established without reference to the price of the
underlying item, being the market price of the asset. If the underlying item is volatile, then the
settlement of the derivative can lead to a very different result from the one originally envisaged.
Derivatives usually have no, or very little, initial cost. Therefore, before the development of
HKAS 32 and HKAS 39, they may not have been recognised in the financial statements at all, or
recognised at a value bearing no relation to the current value. This is obviously misleading and
leaves users of the accounts unaware of the uncertainty and risk to which a company holding
derivatives is exposed.
Part of the reason why HKAS 32 and HKAS 39 were developed was in order to correct this
situation.
2 HKAS 32: Presentation of financial instruments

HKAS 32.2 2.1 Objective
The objective of HKAS 32 is:
To establish principles for presenting financial instruments as liabilities or equity and for
offsetting financial assets and financial liabilities. It applies to the classification of financial
instruments, from the perspective of the issuer, into financial assets, financial liabilities and
equity instruments; the classification of related interest, dividends, losses and gains; and
the circumstances in which financial assets and financial liabilities should be offset.
(HKAS 32)
HKAS 32.4 2.2 Scope
HKAS 32 should be applied in the presentation of all types of financial instruments, whether
recognised or unrecognised.
Certain items are excluded:
(a) Interests in subsidiaries, associates and joint ventures, unless these are accounted for using
HKFRS 9 as allowed by HKAS 27, HKAS 28 and HKAS 31
(b) Employers' rights and obligations under employee benefit plans (HKAS 19: Chapter 16)
(c) Insurance contracts
(d) Financial instruments, contracts and obligations under share-based payment transactions
(HKFRS 2: Chapter 13)
2.3 Classification of financial instruments as financial assets,

financial liabilities and equity
Topic highlights
Financial instruments are classified as financial assets, financial liabilities or equity. Financial
instruments issued to raise capital must be classified as liabilities or equity.
The critical feature of a financial liability is the contractual obligation to deliver cash or another
financial instrument.
398
HKAS 32 requires that the issuer of a financial instrument classifies it, or its component parts, as a
financial asset, financial liability or equity based on:
 the substance of the contractual arrangement on initial recognition
 the definitions in the Key terms provided in section 1.2 above
The classification of the financial instrument is made when it is first recognised and this
classification will continue until the financial instrument is removed from the entity's statement of
financial position.
HKAS 32.16 2.3.1 Distinguishing financial liabilities and equity
Distinguishing a financial liability from equity may not be straightforward and therefore HKAS 32
provides additional guidance. The underlying principle is that of substance over form. Although
substance and legal form are often consistent with each other, this is not always the case.
An instrument is an equity instrument only if there is no contractual obligation to deliver cash or
another financial asset to another entity or to exchange another financial instrument with the
holder under potentially unfavourable conditions to the issuer.
Therefore, for example, a redeemable preference share is classified as a liability, rather than
equity, as there is an obligation to deliver cash at the redemption date. On the other hand, ordinary
shares are classified as equity as, although the holder of an equity instrument may be entitled to a
pro rata share of any distributions out of equity, the issuer does not have a contractual obligation to
make such a distribution.
A financial liability exists regardless of the way in which the contractual obligation to deliver
cash or a financial asset will be settled. The issuer's ability to satisfy an obligation may be
restricted, e.g. by lack of access to foreign currency, but this is irrelevant as it does not remove the
issuer's obligation or the holder's right under the instrument.
During the financial year ended 31 December 20X5, Kim issued the financial instrument described
below. Identify whether it should be classified as liability or equity, explaining in not more than 40
words the reason for your choice. You should refer to the relevant Hong Kong Accounting
Standards.
Redeemable preference shares with a coupon rate 5%. The shares are redeemable on
31 December 20X9 at premium of 20%.
2.4 Specific classification rules

As well as providing the general classification rules explained in the section above, HKAS 32 also
provides guidance on the classification of specific instruments and instruments with specific
characteristics. They are:
 puttable financial instruments and obligations arising on liquidation
 financial instruments with contingent settlement provisions
 financial instruments with settlement options
 compound instruments
 rights issues
The remainder of this section deals with each in turn.
HKAS 2.4.1 Puttable financial instruments and obligations arising on liquidation
32.16A-B,E
HKAS 32 was amended in 2008 to introduce criteria for certain puttable instruments and
obligations arising on liquidation to be classified as equity. Prior to these amendments, these
instruments would have been classified as financial liabilities.
399
Financial Reporting
Puttable financial instruments

A puttable financial instrument is an instrument where the holder can "put" the instrument i.e.
require the issuer to redeem it in cash. For example, some ordinary shares are puttable, and prior
to the revision to HKAS 32, these were classified as liabilities. They are now classified as equity,
but only if:
(a) the holder is entitled to a pro-rata share of the entity's net assets on liquidation.
(b) the instrument is in the class of instruments that is the most subordinate and all instruments
in that class have identical features.
(c) the instrument has no other characteristics that would meet the definition of a financial liability.
(d) the total expected cash flows attributable to the instrument over its life are based
substantially on the profit or loss, the change in the recognised net assets or the change in
the fair value of the recognised and unrecognised net assets of the entity (excluding any
effects of the instrument itself). Profit or loss or change in recognised net assets for this
purpose is as measured in accordance with relevant HKFRS.
In addition to the criteria set out above, the entity must have no other instrument that has terms
equivalent to (d) above and that has the effect of substantially restricting or fixing the residual
return to the holders of the puttable financial instruments.
Where the specified criteria are no longer met, or when they are subsequently met, the instrument
should be reclassified. If the instrument presented as equity is reclassified as a financial liability, it
will be measured at fair value at the date of reclassification with any difference between the fair
value and the carrying amount to be recognised in equity. When the inverse applies, the financial
liability will be reclassified to equity at its carrying amount at the date of reclassification.
HKAS 32.16C Obligations arising on liquidation
As a result of the amendment mentioned above, instruments imposing an obligation on an entity to
deliver to another party a pro-rata share of the net assets on liquidation should be classified as
equity.
The following examples illustrate the types of instruments impacted by the new requirements:
Classification Classification
under HKAS 32 under amended
Issued financial instrument before amendment HKAS 32
Share puttable throughout its life at fair value, Liability Equity

that is also the most subordinate, does not
contain any other obligation, with discretionary
dividends based on profits of the issuer
Share puttable at fair value, that is not the most Liability Liability
subordinate
Share puttable at fair value only on liquidation, Liability Compound (part
that is also the most subordinate, but contains equity, part liability)
a fixed non-discretionary dividend
Share puttable at fair value only on liquidation, Liability Equity
that is also the most subordinate, but contains
a fixed discretionary dividend and does not
contain any other obligation
Any of the instruments described above issued Liability Liability
by a subsidiary held by non-controlling parties,
in the consolidated financial statements
400
Even though the amendments permit certain instruments that were previously presented as
financial liabilities to now be presented as equity, derivatives over such equity instruments may not
be presented as equity.
Puttable instruments and instruments puttable only on liquidation that are classified as equity in the
separate or individual financial statements of the issuing entity and represent non-controlling
interests should be classified as financial liabilities in the consolidated financial statements of the
group.
HKAS 32.25 2.4.2 Financial instruments with contingent settlement provisions
The settlement of some financial instruments depends on events which are beyond the control of
both the holder and issuer of the instrument:
(a) The occurrence or non-occurrence of uncertain future events
(b) The outcome of uncertain circumstances
For example, an entity might have to deliver cash instead of issuing equity shares. In this situation
it is not immediately clear whether the entity has an equity instrument or a financial liability.
Such financial instruments should be classified as financial liabilities unless the possibility of
settlement is remote.
HKAS 32.26 2.4.3 Financial instruments with settlement options
When a derivative financial instrument gives one party a choice over how it is settled (e.g., the
issuer can choose whether to settle in cash or by issuing shares) the instrument is a financial
asset or a financial liability unless all the alternative choices would result in it being an equity
instrument.
HKAS 2.4.4 Compound financial instruments
32.28,29,32
Topic highlights
Compound instruments are split into equity and liability parts and presented accordingly in the
Where a financial instrument contains both a liability and an equity element, HKAS 32 requires that
these component parts are classified separately according to the substance of the contractual
arrangement and the definitions of a financial liability and an equity instrument.
A common type of compound instrument is convertible debt. On the issue of such debt, the holder
is granted an option to convert it into an equity instrument (usually ordinary shares) of the issuer
rather than redeem it. This is the economic equivalent of the issue of conventional debt plus a
warrant to acquire shares in the future.
In this case the instrument is presented as part liability, part equity, and the usual way to calculate
the split is to:
(a) calculate the value for the liability component based on similar instruments with no
conversions rights, and
(b) deduct this from the instrument as a whole to leave a residual value for the equity component.
The reasoning behind this approach is that an entity's equity is its residual interest in its assets
amount after deducting all its liabilities.
The sum of the carrying amounts assigned to liability and equity will always be equal to the
carrying amount that would be ascribed to the instrument as a whole.
The following example should make this split clearer.
401
Financial Reporting
Example: Valuation of compound instruments

Strauss Co. issues 1,000 convertible bonds at the start of 20X0. The bonds have a three-year term,
and are issued at par with a face value of $2,500 per bond, giving total proceeds of $2,500,000.
Interest is payable annually in arrears at a nominal annual interest rate of 5%. Each bond is
convertible at any time up to maturity into 300 common shares.
When the bonds are issued, the prevailing market interest rate for similar debt without conversion
options is 8%. At the issue date, the market price of one common share is $2. The dividends
expected over the three-year term of the bonds amount to 11 cents per share at the end of each
year. The risk-free annual interest rate for a three-year term is 4%.
Required
What is the value of the equity component in the bond issue?
Solution
The liability component is valued first, and the difference between the proceeds of the bond issue
and the fair value of the liability is assigned to the equity component. The present value of the
liability component is calculated using a discount rate of 8%, the market interest rate for similar
bonds having no conversion rights, as shown.
$
Present value of the principal: $2,500,000 payable at the end of three years
($2.5m  1/1.083)* 1,985,000
Present value of the interest: $125,000 payable annually in arrears for three
years ($125,000  (1/1.08 + 1/1.082 + 1/1.083) 322,137
Total liability component 2,307,137
Equity component (balancing figure) 192,863
Proceeds of the bond issue 2,500,000
* Note. Both the present value figures can be found using tables using an 8% discount factor for
the principal of 0.794 and for the interest of 2.577. In the case of the second (present value of the
interest), if tables are used, the present value is $322,125, giving an equity component balancing
figure of $192,875. The difference is due to rounding.
The split between the liability and equity components remains the same throughout the term of the
instrument, even if there are changes in the likelihood of the option being exercised. This is
because it is not always possible to predict how a holder will behave. The issuer continues to have
an obligation to make future payments until conversion, maturity of the instrument or some other
relevant transaction takes place.
On 1 January 20X1, an entity issued 100,000 6% convertible bonds at their par value of $20 each.
The bonds will be redeemed on 1 January 20X6. Each bond is convertible at the option of the
holder at any time during the five-year period. Interest on the bond will be paid annually in arrears.
The prevailing market interest rate for similar debt without conversion options at the date of issue
was 8%.
Required
At what value should the equity element of the hybrid financial instrument be recognised in the
financial statements of the entity at the date of issue?
402
Convertible debt instruments where conversion is at the option of the issuing entity are not
compound instruments and do not require the split-accounting approach described above. Instead,
such instruments are accounted for as a liability in their entirety.
HKAS 32.16 2.4.5 Rights issues

A 2009 amendment to HKAS 32 (effective for periods starting on or after 1 February 2010) requires
that rights, options or warrants to acquire a fixed number of the entity's own equity
instruments for a fixed amount of any currency are equity instruments if the entity offers the
rights, options or warrants pro rata to all of its existing owners of the same class of its own
non-derivative equity instruments.
This is a very narrow amendment and does not extend to other instruments that grant the holder
the right to purchase the entity's own equity instruments such as the conversion feature in
convertible bonds.
Example: Rights issue

Background
On 1 December 20X2, ABC offered all of its existing shareholders rights to acquire one new
common share for every three common shares held at a price of $15 per share. ABC's functional
currency is Y, and ABC has only one class of shares outstanding. There were a total of 3,000 rights
offered and they initially traded at $2 each.
The rights were subject to expiry on 31 December 20X2 and were fully subscribed on that date.
On 31 December 20X2, the common share price was $18 per share and the closing fair value of
the rights was $3 per share (i.e. $18 – $15).
Exchange rate: $/Y = 1.5/1
Accounting treatment prior to amendment
The rights offered in $ would have been accounted for as derivative liabilities. On 1 December
20X2, a liability of Y4,000 ($2  3,000 ÷ 1.5) would have been recognised with a corresponding
debit to equity, representing the distribution of the rights to common shareholders. Subsequently,
the liability would have been re-measured at fair value, increasing to Y6,000 (3,000  $3 ÷ 1.5),
and a loss of Y2,000 (Y6,000 – Y4,000) would have been recognised in profit or loss. On exercise
of the rights, the cash proceeds of Y30,000 ($15  3,000 ÷ 1.5) and the closing fair value of the
rights of Y6,000 would have been credited to equity.
Accounting treatment after the amendment
The rights offered in $ would be classified as equity. Hence, no liability or gain or loss would be
recognised in respect of the rights. On exercise of the rights, the cash proceeds of $30,000 would
be credited to equity.
Journal entries for accounting treatment prior to amendment
Y Y
1 December 20X2
DEBIT Equity (statement of changes in equity) 4,000
CREDIT Derivative liability 4,000
Being the issue of rights
31 December 20X2
DEBIT Profit or loss 2,000
CREDIT Derivative liability 2,000
Being the remeasurement of the liability to fair value
31 December 20X2
DEBIT Derivative liability 6,000
Cash 30,000
Being the exercise of rights in full
403
Financial Reporting
Journal entries for accounting treatment after the amendment

Y Y
31 December 20X2
DEBIT Cash 30,000
Being the exercise of rights in full
HKAS 32.42 2.5 Offsetting a financial asset and a financial liability

Financial assets and liabilities are normally presented separately in the statement of financial
position. A financial asset and financial liability should only be offset, with the net amount reported
in the statement of financial position, when an entity:
(a) has a legally enforceable right of set off
(b) intends to settle on a net basis, or to realise the asset and settle the liability simultaneously,
i.e. at the same moment
This will reflect the expected future cash flows of the entity in these specific circumstances. In all
other cases, financial assets and financial liabilities are presented separately.
HKAS An amendment was made to HKAS 32 in December 2011 in order to clarify the existing offsetting
32.AG38A-F rules as detailed above.
 In order to result in the offset of a financial asset and financial liability, a right of set-off must
be available immediately rather than being contingent on a future event.
 The right of set-off must be exercisable by either counterparty.
The amendment also clarified situations which may be classified as simultaneous realisation of an
asset and settlement of a liability.
HKAS 32.35 2.6 Interest, dividends, losses and gains

Topic highlights
Interest, dividends, losses and gains are treated according to whether they relate to an equity
instrument or a financial liability.
The HKAS 32 guidance considered so far all relates to the classification of financial instruments for
presentation in the statement of financial position. The standard also considers how financial
instruments are presented in the statement of profit or loss and other comprehensive income and
statement of changes in equity:
Financial liabilities Equity instruments

Interest, dividends, gains and losses are Dividends are recognised directly in equity
recognised in profit or loss. (and so disclosed in the statement of changes
in equity).
Transaction costs are a deduction from equity.
You should look at the requirements of HKAS 1 Presentation of Financial Statements for further
details of disclosure, and HKAS 12 Income Taxes for disclosure of tax effects.
404
2.7 Section summary

 Financial instruments issued to raise capital must be classified as liabilities or equity.
 The substance of the financial instrument is more important than its legal form.
 The critical feature of a financial liability is the contractual obligation to deliver cash or
another financial instrument.
 Compound instruments are split into equity and liability parts and presented accordingly.
 Interest, dividends, losses and gains are treated according to whether they relate to an
equity instrument or a financial liability.
3 HKFRS 9: Recognition of financial instruments

Topic highlights
HKFRS 9 applies to the recognition of financial assets and liabilities.
The guidance on recognition of financial instruments now comes from HKFRS 9.
3.1 Scope
All entities are required to apply HKFRS 9 to all types of financial instruments with the exception of
the following:
(a) Investments in subsidiaries, associates, and joint ventures that are accounted for under
HKASs 27, 28 and 31.
(b) Leases covered in HKAS 17.
(c) Employee benefit plans covered in HKAS 19.
(d) Insurance contracts.
(e) Equity instruments issued by the entity e.g. ordinary shares issued, or options and
warrants.
(f) Financial guarantee contracts.
(g) Contracts for contingent consideration in a business combination, covered in HKFRS 3.
(h) Contracts requiring payment based on climatic, geological or other physical variables.
(i) Loan commitments that cannot be settled net in cash or another financial instrument.
(j) Financial instruments, contracts and obligations under share-based payment transactions,
covered in HKFRS 2.
HKFRS 9,
3.1.1
3.2 Initial recognition
Topic highlights
Financial instruments are recognised when the entity becomes a party to the contractual provisions
of the instrument.
Financial assets are classified as measured at amortised cost or fair value. Financial liabilities are
classified at fair value through profit or loss or amortised cost.
HKFRS 9 requires that financial instruments are recognised in the statement of financial position
when the entity becomes a party to the contractual provisions of the instrument.
405
Financial Reporting
Notice that this is different from the recognition criteria in the Conceptual Framework and in most
other standards. Items are normally recognised when there is a probable inflow or outflow of
resources and the item has a cost or value that can be measured reliably.
HKFRS 9, 3.2.1 Classification of financial assets

4.1.1-4.1.2
On recognition, HKFRS 9 requires that financial assets are classified as measured at either:
 amortised cost, or
 fair value
This classification is made on the basis of both:
(a) the entity's business model for managing the financial assets, and
(b) the contractual cash flow characteristics of the financial asset.
A financial asset is classified as measured at amortised cost where:
(a) the objective of the business model within which the asset is held is to hold assets in order to
collect contractual cash flows, and
(b) the contractual terms of the financial asset give rise on specified dates to cash flows that are
solely payments of principal and interest on the principal outstanding.
An application of these rules means that equity investments may not be classified as measured at
amortised cost and must be measured at fair value. This is because contractual cash flows on
specified dates are not a characteristic of equity instruments. In addition, all derivatives are
measured at fair value.
A debt instrument may be classified as measured at either amortised cost or fair value depending
on whether it meets the criteria above. Even where the criteria are met at initial recognition, a debt
instrument may be classified as measured at fair value through profit or loss if doing so eliminates
or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an
"accounting mismatch") that would otherwise arise from measuring assets or liabilities or
recognising the gains and losses on them on different bases.
The following decision tree may help you to classify financial assets in accordance with HKFRS 9:
Is the financial asset held in No
order to collect future
contractual cash flows?
Yes
Do the contractual terms of the No
financial asset give rise to
cash flows on specified dates?
Yes
Are the cash flows solely No
payments of principal and
interest on the principal
outstanding?
Yes
Measure at amortised cost Measure at fair value
Note that the HKFRS 9 requirement to classify financial assets on recognition as one of two types
is a significant simplification of the previous HKAS 39 rules. These required financial assets to be
classified as one of four types, being:
 at fair value through profit or loss
 held to maturity
 available for sale, and
 loans and receivables
406
HKFRS 9, 3.2.2 Classification of financial liabilities

4.2.1
On initial recognition, HKFRS 9 requires that financial liabilities are classified as either:
(a) at fair value through profit or loss, or
(b) financial liabilities at amortised cost
A financial liability is classified at fair value through profit or loss if:
(a) it is held for trading, or
(b) upon initial recognition it is designated at fair value through profit or loss.
Derivatives are always measured at fair value through profit or loss.
These classification rules are unchanged from those previously contained within HKAS 39.
HKFRS 9,
4.4.1-4.4.2
3.3 Reclassification of financial assets
Topic highlights
Financial assets may be reclassified from one category to another in certain circumstances.
Although on initial recognition financial assets must be classified in accordance with the
requirements of HKFRS 9, in some cases they may be subsequently reclassified.
When an entity changes its business model for managing financial assets, it should reclassify all
affected financial assets. This reclassification applies only to debt instruments, as equity
instruments must be classified as measured at fair value.
HKFRS 9 prohibits the reclassification of financial liabilities.
HKFRS 9,
3.2.3-3.2.6
3.4 Derecognition
Topic highlights
Financial assets should be derecognised when the rights to the cash flows from the asset expire
or where substantially all the risks and rewards of ownership are transferred to another party.
Financial liabilities should be de-recognised when they are extinguished.
HKFRS 9 now provides the rules with regard to derecognition. Derecognition refers to the removal of
a previously recognised financial instrument from an entity's statement of financial position.
3.4.1 Derecognition of financial assets
A financial asset should be derecognised by an entity when:
(a) the contractual rights to the cash flows from the financial asset expire, or
(b) the entity transfers substantially all the risks and rewards of ownership of the financial
asset to another party
HKFRS 9 includes the following examples of the transfer of substantially all risks and rewards of
ownership:
 An unconditional sale of a financial asset
 A sale of a financial asset together with an option to repurchase the financial asset at its fair
value at the time of repurchase
The standard also provides examples of situations where the risks and rewards of ownership have
not been transferred:
 A sale and repurchase transaction where the repurchase price is a fixed price or the sale
price plus a lender's return
407
Financial Reporting
 A sale of a financial asset together with a total return swap that transfers the market risk
exposure back to the entity
 A sale of short-term receivables in which the entity guarantees to compensate the transferee
for credit losses that are likely to occur.
3.4.2 Derecognition of financial liabilities
A financial liability is derecognised when it is extinguished i.e. when the obligation specified in the
contract is discharged or cancelled or expires.
Where an existing borrower and lender of debt instruments exchange one financial instrument for
another with substantially different terms, this is accounted for as an extinguishment of the original
financial liability and the recognition of a new financial liability.
Similarly, a substantial modification of the terms of an existing financial liability or a part of it should
be accounted for as an extinguishment of the original financial liability and the recognition of a new
financial liability.
For this purpose, a modification is "substantial" where the discounted present value of cash flows
under the new terms, discounted using the original effective interest rate, is at least 10% different
from the discounted present value of the cash flows of the original financial liability.
The difference between the carrying amount of a financial liability (or part of a financial liability)
extinguished or transferred to another party and the consideration paid, including any non-cash
assets transferred or liabilities assumed, shall be recognised in profit or loss.
Example: Derecognition
A number of years ago Beijing Company issued loan stock with the following terms:
 Interest to be paid annually in arrears at a rate of 5.5%
 Loan to be repaid on 31 December 20X7
Taking into account the transaction costs, the effective interest rate was 6%. Beijing had paid all
interest and capital due up to 31 December 20X1, and at that date the carrying amount of the loan
was $10 million.
During 20X1, the worldwide economic recession caused Beijing to suffer financial difficulties, and
an agreement to revise the terms of the loan stock from 20X2 onwards was reached with lenders.
The revised terms included an extension to the term of the loan and an increase to the coupon
rate.
The effective interest rate of the revised terms, excluding transaction costs was 8% per annum.
The present value of the cash flows, excluding transaction costs, under the revised terms was
$10.5 million at 6% and $9.5 million at 8%.
Transaction costs of $700,000 were payable on 1 January 20X2 in respect of the negotiations for
the revised terms.
How should the revision to the terms of the loan be treated in Beijing’s financial statements?
Solution
The revised terms negotiated by Beijing are such that the original loan should be derecognised and
a new financial liability recognised.
Derecognition of the old loan and recognition of the new liability is required if the present value of
the cash flows under the new terms is 10% or more different from the present value of the original
loan. The cash flows under the new terms must be discounted at the 6% effective interest rate of
the original loan and include the $700,000 transaction costs.
HKFRS 9. With transaction costs payable at the start of the period of the revised terms, they are added on in
B3.3.6 full to the $10.5m present value, giving a total of $11.2m. This is 12% different from the $10.0m
408
present value of the old loan, so the original loan should be derecognised and the new financial
liability recognised.
Discuss whether the following financial instruments would be derecognised.
(a) ABC sells an investment in shares, but retains a call option to repurchase those shares at
any time at a price equal to their current market value at the date of repurchase.
(b) DEF enters into a stocklending agreement where an investment is lent to a third party for a
fixed period of time for a fee.
(c) XYZ sells title to some of its receivables to a debt factor for an immediate cash payment of
90% of their value. The terms of the agreement are that XYZ has to compensate the factor
for any amounts not recovered by the factor after six months.
A financial liability which is extinguished i.e., when the obligation specified in the contract is
discharged or cancelled or expires, should be derecognised by an entity.
HKFRS 9, 3.4.3 Partial derecognition

3.2.2
Partial derecognition of a financial asset or liability is possible on condition that the derecognised
part comprises only:
(a) identifiable cash flows
(b) a share of the total cash flows on a fully proportionate (pro rata) basis
For example, a holder of bonds has the right to two separate sets of cash inflows: those relating to
the principal and those relating to the interest. It could retain the right to receive the principal and
sell the right to receive interest to another party.
Where only part of a financial asset is derecognised, the carrying amount of the asset should be
allocated between the part retained and the part transferred based on their relative fair values on the
date of transfer. A gain or loss should be recognised based on the proceeds for the portion transferred.
On derecognition, the amount to be included in net profit or loss for the period is calculated as
follows:
$ $
Carrying amount of asset/liability (or the portion of asset/liability) transferred X
Less: proceeds received/paid X
any cumulative gain or loss reported as other comprehensive income X
(X)
Profit or loss X
3.5 Section summary

 HKFRS 9 applies to the recognition of financial assets and liabilities. Financial instruments
are recognised when the entity becomes a party to the contractual provisions of the
instrument.
 Financial assets are classified as measured at amortised cost or fair value; financial liabilities
are classified at fair value through profit or loss or amortised cost.
 Financial assets may be reclassified from one category to another in certain circumstances.
Financial liabilities may not be reclassified.
409
Financial Reporting
 Financial assets should be derecognised when the rights to the cash flows from the asset
expire or where substantially all the risks and rewards of ownership are transferred to
another party.
 Financial liabilities should be derecognised when they are extinguished.
4 HKFRS 9: Measurement of financial instruments

Topic highlights
Financial instruments are initially measured at fair value. Transaction costs increase this amount
for financial assets classified as measured at amortised cost and decrease this amount for financial
liabilities classified as measured at amortised cost.
The classification of financial assets and financial liabilities is of particular importance in terms of
how they are measured throughout their life.
HKFRS 9, 4.1 Initial measurement

5.1.1, 5.1.2A
Financial assets
HKFRS 9 requires that financial assets are initially measured at the transaction price, i.e. the fair
value of consideration given, except where part of the consideration given is for something other
than the financial asset. In this case the financial asset is initially measured at fair value evidenced
by a quoted price in an active market for an identical asset (i.e. an HKFRS 13 level 1 input) or
based on a valuation technique that uses only data from observable markets. The difference
between the fair value at initial recognition and the transaction price is recognised as a gain or loss.
In the case of financial assets classified as measured at amortised cost, transaction costs directly
attributable to the acquisition of the financial asset increase this amount.
Financial liabilities
HKFRS 9 requires that financial liabilities are initially measured at transaction price, i.e. the fair
value of consideration received except where part of the consideration received is for something
other than the financial liability. In this case the financial liability is initially measured at fair value
determined as for financial assets (see above). Transaction costs are deducted from this amount
for financial liabilities classified as measured at amortised cost.
HKFRS 9,
5.2.1
4.2 Subsequent measurement of financial assets
Topic highlights
Financial assets are subsequently measured at:
 fair value with changes in value normally recognised in profit or loss, or
 amortised cost with interest recognised in profit or loss.
As the classifications suggest, financial assets are measured, subsequent to initial recognition at:
 fair value, or
 amortised cost.
HKFRS 4.2.1 Financial assets measured at fair value

13.76,81,86
Where a financial asset is classified as measured at fair value, fair value is established at each period
end in accordance with HKFRS 13 Fair Value Measurement. That standard requires that a fair value
hierarchy is applied with three levels of input:
410
Level 1 inputs Unadjusted quoted prices in active markets for identical assets or liabilities that
the entity can access at the measurement date.
Level 2 inputs Inputs other than quoted prices included within Level 1 that are observable for
the asset or liability, either directly or indirectly. These may include quoted
prices for similar assets or liabilities in active markets or quoted prices for
identical or similar assets and liabilities in markets that are not active.
Level 3 inputs Unobservable inputs for the asset or liability.
Any changes in fair value are normally recognised in profit or loss. There is an exception to this rule
where the financial asset is an investment in an equity instrument not held for trading. In this case
the entity can make an irrevocable election to recognise changes in the fair value in other
Example: Asset measurement

On 6 November 20X3 Stripe Co. acquires a listed equity investment with the intention of holding it
in the long term. The investment cost $500,000. At Stripe Co.'s year end of 31 December 20X3, the
market price of an identical investment is $520,000. How is the asset initially and subsequently
measured?
Stripe Co. has elected to present the equity investment in other comprehensive income.
Solution
 The asset is initially recognised at the fair value of the consideration, being $500,000
 At the period end it is remeasured to $520,000
 This results in the recognition of $20,000 in other comprehensive income.
HKAS 39.9 4.2.2 Financial assets measured at amortised cost

HKFRS 9 does not itself define amortised cost, however it does refer to the definition of this and
other relevant terms within HKAS 32 and HKAS 39. The example which follows the definitions will
help you to understand their application.
Key terms
Amortised cost of a financial asset or financial liability is the amount at which the financial asset or
liability is measured at initial recognition minus principal repayments, plus or minus the cumulative
amortisation using the effective interest method of any difference between that initial amount and
the maturity amount, and minus any reduction (directly or through the use of an allowance account)
for impairment or uncollectability.
The effective interest method is a method of calculating the amortised cost of a financial
instrument and of allocating the interest income or interest expense over the relevant period. The
effective interest rate is the rate that exactly discounts estimated future cash payments or
receipts through the expected life of the financial instrument to the net carrying amount of the
financial asset or liability. (HKAS 39)
Example: Financial asset measured at amortised cost

On 1 January 20X5 Abacus Bee Co. (ABC) purchases a debt instrument for its fair value of
$100,000. The debt instrument is due to mature on 31 December 20X9. The instrument has a
principal amount of $125,000 and the instrument carries fixed interest at 4.72% that is paid
annually. (The effective interest rate is 10%.)
How should ABC account for the debt instrument over its five-year term?
411
Financial Reporting
Solution
ABC will receive interest of $5,900 (125,000  4.72%) each year and $125,000 when the
instrument matures.
ABC must allocate the discount of $25,000 and the interest receivable over the five-year term at a
constant rate on the carrying amount of the debt. To do this, it must apply the effective interest rate
of 10%.
The following table shows the allocation over the years:
Profit or loss: Interest received during
Amortised cost at Interest income year Amortised cost
Year beginning of year for year (@10%) (cash inflow) at end of year
$ $ $ $
20X5 100,000 10,000 (5,900) 104,100
20X6 104,100 10,410 (5,900) 108,610
20X7 108,610 10,861 (5,900) 113,571
20X8 113,571 11,357 (5,900) 119,028
20X9 119,028 11,872 (125,000 + 5,900) –
Each year the carrying amount of the financial asset is increased by the interest income for the
year and reduced by the interest actually received during the year.
Investments whose fair value cannot be reliably measured should be measured at cost.
Note that interest income is recognised in profit or loss each year, being the amount of interest
actually received plus the interest income related to the winding up of the financial asset to its
redemption value.
4.2.3 "Old" rules for subsequent measurement of financial assets
As we have already said, HKFRS 9 has superseded HKAS 39 in respect of providing guidance for
the accounting for financial assets. An understanding of the "old" rules with regard to subsequent
accounting for financial assets will help you to understand the reduction in complexity afforded by
the introduction of HKFRS 9.
Old HKAS 39 Category Measured at Gains and losses

Financial asset at fair value through profit or Fair value Profit or loss
loss
Available for sale financial asset Fair value Other comprehensive income
Financial asset held to maturity Amortised cost Profit or loss
Loans and receivables Amortised cost Profit or loss
While the treatment under HKAS 39 seems very similar to that under HKFRS 9, the initial
classification of each financial instrument was more complex as certain instruments could fall into
more than one category or indeed fall foul of strict classification rules after initial classification and
have to be reclassified.
The transition to HKFRS 9 must be applied retrospectively, although the business model
assessment need only be made on the date of initial application of the new standard.
St Ives purchased a $20 million 6% debenture at par on 1 January 20X1 when the market rate of
interest was 6%. Interest is paid annually on 31 December. The debenture is redeemable at par on
31 December 20X2.
The market rate of interest on debentures of equivalent term and risk changed to 7% on
31 December 20X1.
412
Required
Show the charge or credit to profit or loss for each of the two years to 31 December 20X2 if the
debentures are classified as:
(a) financial assets at amortised cost.
(b) financial assets at fair value through profit or loss.
Fair value is to be calculated using discounted cash flow techniques.
HKFRS 9, 4.3 Subsequent measurement of financial liabilities

5.3.1
Topic highlights
Financial liabilities are subsequently measured at fair value or amortised cost with gains and losses
Except for financial liabilities at fair value through profit or loss (including most derivatives), all
financial liabilities should be recognised and measured at amortised cost. The exceptions should
be measured at fair value. However, if the fair value cannot be measured reliably, they should then
be measured at cost.
4.3.1 Financial liabilities measured at amortised cost
The definitions seen above in relation to financial assets at amortised cost remain relevant here.
Again, their application is best seen through examples.
Example: Finance cost

On 1 January 20X5 a company issued $200,000 loan notes. Issue costs were $320. The loan
notes do not carry interest, but are redeemable at a premium of $41,613 on 31 December 20X6.
The effective finance cost of the loan notes is 10%.
What is the finance cost in respect of the loan notes for the year ended 31 December 20X6, and
what is the carrying amount of the loan notes at that date?
Solution
The premium on redemption of the loan notes represents a finance cost. The effective rate of
interest must be applied so that the debt is measured at amortised cost.
At the time of issue, the loan notes are recognised at their net proceeds of:
$199,680 (200,000 – 320).
The finance cost for the year ended 31 December 20X6 is calculated as follows:
B/f Interest @ 10% C/f
$ $ $
20X5 199,680 19,968 219,648
20X6 219,648 21,965 241,613
On 1 January 20X2, an entity issued a debt instrument with a coupon rate of 5% at a par value of
$1,000,000. The directly attributable costs of issue were $30,000. The debt instrument is repayable
on 31 December 20X8 at a premium of $260,000.
413
Financial Reporting
Required
What is the total amount of the finance cost associated with the debt instrument?
A $294,000
B $318,000
C $514,000
D $640,000
Grumble Co. issues a bond for $839,619 on 1 January 20X2. No interest is payable on the bond,
but it will be held to maturity and redeemed on 31 December 20X4 for $1m. The bond has not been
designated as at fair value through profit or loss.
Required
Calculate the charge to profit or loss of Grumble Co. for the year ended 31 December 20X2 and
the balance outstanding at 31 December 20X2.
HKFRS 9, 4.3.2 Financial liabilities at fair value through profit or loss

5.7.1
Financial liabilities which are held for trading and classified as fair value through profit or loss are
remeasured to fair value each year in accordance with HKFRS 13 (see section 4.2.1) with any gain
or loss recognised in profit or loss.
HKFRS 9 HKFRS 9 requires that financial liabilities which are designated as measured at fair value through
B5.7.16 profit or loss are treated differently. In this case the gain or loss in a period must be classified into:
 gain or loss resulting from credit risk; and
 other gain or loss.
The gain or loss resulting from credit risk is established either:
1 as the amount of change in the fair value that is not attributable to changes in market
conditions giving rise to market risk, or
2 using an alternative method which an entity believes to more faithfully represent changes in
value due to credit risk.
The gain or loss as a result of credit risk is recognised in other comprehensive income, unless it
creates or enlarges an accounting mismatch (in which case it is recognised in profit or loss). The
other gain or loss is recognised in profit or loss.
On derecognition any gains or losses recognised in other comprehensive income are not recycled
to profit or loss.
HKFRS 9,
3.1.2-3.1.6,
4.4 Trade date v settlement date accounting
Appendix A A regular way purchase or sale of financial assets shall be recognised and derecognised using
trade date accounting or settlement date accounting.
Key terms
A regular way purchase or sale is a purchase or sale of a financial asset under a contract whose
terms require delivery of the asset within the time frame established generally by regulation or
convention in the marketplace concerned.
414
HKFRS 9 refers to two methods of accounting, being trade date and settlement date accounting.
An entity shall apply the same method consistently for all purchase and sales of financial assets
that are classified in the same way in accordance with HKFRS 9. For this purpose, assets that the
definition of held for trading form a separate classification from assets designated as measured at
fair value through profit or loss. In addition, investments in equity instruments accounted for using
the option provided in HKFRS 9 (irrevocable election to present in other comprehensive income
subsequent changes in the fair value of an investment in an equity instrument) form a separate
classification.
The trade date is the date on which an entity commits to purchase or sell an asset, and trade date
accounting results in:
 the recognition of an asset to be received and liability to pay for it on the trade date, and
 the derecognition of an asset to be sold and corresponding receivable on the trade date
(together with any gain or loss).
The settlement date is the date on which an asset is delivered to or by an entity, and settlement
date accounting results in:
 the recognition of an asset on the settlement date and
 the derecognition of an asset on the settlement date.
When trade date accounting is used interest does not start to accrue until the settlement date when
title passes.
When settlement date accounting is used:
(a) An asset subsequently measured at amortised cost is recognised initially at its fair value on
the trade date.
(b) Any change in the fair value of the asset to be received between the trade and settlement
date is not recognised for assets measured at amortised cost.
(c) Any change in the fair value of the asset to be received between the trade and settlement
date is recognised in profit or loss or other comprehensive income for assets measured at
fair value.
Example: Trade date and settlement date accounting

Gaylord entered into a contractual commitment on 27 December 20X4 to purchase a financial
asset for $1,000. On 31 December 20X4, the entity’s reporting date, the fair value was $1,005.
The transaction was settled on 5 January 20X5 when the fair value was $1,007. The entity has
classified the asset as at fair value through profit or loss.
Required
How should the transactions be accounted for under trade date accounting and settlement date
accounting?
Solution
Trade date accounting
 On 27 December 20X4, the entity should recognise the financial asset and the liability to the
counterparty at $1,000.
 At 31 December 20X4, the financial asset should be remeasured to $1,005 and a gain of $5
 On 5 January 20X5, the liability to the counterparty of $1,000 will be paid in cash. The fair
value of the financial asset should be remeasured to $1,007 and a further gain of $2
415
Financial Reporting
Settlement date accounting

 No transaction should be recognised on 27 December 20X4.
 On 31 December 20X4, a receivable of $5 should be recognised (equal to the fair value
movement since the trade date) and the gain recognised in profit or loss.
 On 5 January 20X5, the financial asset should be recognised at its fair value of $1,007. The
receivable should be derecognised, the payment of cash to the counterparty recognised and
the further gain of $2 recognised in profit or loss.
HKAS 39.58 4.4.1 Impairment and uncollectability of financial assets
Topic highlights
Financial assets measured at amortised cost must be tested for impairment when there is objective
evidence of impairment. Any loss is recognised in profit or loss.
At each year end, an entity should assess whether there is any objective evidence that a financial
asset or group of assets is impaired. Although HKFRS 9 now applies to the recognition and
measurement of financial assets, HKAS 39 continues to provide the guidance on impairments.
Due to the reduced number of classifications of financial assets under HKFRS 9, this area is less
complex than it was prior to the issue of the new standard, and only those financial assets
classified as measured at amortised cost need be tested for impairment.
Can you think of three examples of indications that a financial asset or group of assets may be
impaired?
HKAS 39.59- 4.4.2 Objective evidence of impairment

60
Where there is objective evidence of impairment, an entity should determine the amount of any
impairment loss.
It may not be possible to identify a single, discrete event that caused the impairment. Rather the
combined effect of several events may have caused the impairment. Losses expected as a result
of future events, no matter how likely, are not recognised.
Objective evidence that a financial asset or group of assets is impaired includes observable data
that comes to the attention of the holder of the asset about the following events:
(a) Significant financial difficulty of the issuer or obligor.
(b) A breach of contract, such as a default or delinquency in interest or principal payments.
(c) The lender, for economic or legal reasons relating to the borrower's financial difficulty, granting
to the borrower a concession that the lender would not otherwise consider.
(d) It becoming probable that the borrower will enter bankruptcy or other financial reorganisation.
(e) The disappearance of an active market for that financial asset because of financial difficulties.
(f) Observable data indicating that there is a measurable decrease in the estimated future cash
flows from a group of financial assets since the initial recognition of those assets, although the
decrease cannot yet be identified with the individual financial assets in the group, including:
416
(i) Adverse changes in the payment status of borrowers in the group (e.g. an increased
number of delayed payments or an increased number of credit card borrowers who
have reached their credit limit and are paying the minimum monthly amount).
(ii) National or local economic conditions that correlate with defaults on the assets in the
group (e.g. an increase in the unemployment rate in the geographical area of the
borrowers, a decrease in property prices for mortgages in the relevant area, a
decrease in oil prices for loan assets to oil producers, or adverse changes in industry
conditions that affect the borrowers in the group).
The disappearance of an active market because an entity's financial instruments are no longer
publicly traded is not evidence of impairment. A downgrade of an entity's credit rating is not, of
itself, evidence of impairment, although it may be evidence of impairment when considered with
other available information. A decline in the fair value of a financial asset below its cost or
amortised cost is not necessarily evidence of impairment (for example, a decline in the fair value of
an investment in a debt instrument that results from an increase in the risk-free interest rate).
HKAS 39.63- 4.4.3 Impairment of financial assets carried at amortised cost
65
The impairment loss is the difference between the asset's carrying amount and its recoverable
amount. The asset's recoverable amount is the present value of estimated future cash flows,
discounted at the financial instrument's original effective interest rate.
The amount of the loss should be recognised in profit or loss.
If the impairment loss decreases at a later date (and the decrease relates to an event occurring
after the impairment was recognised) the reversal is recognised in profit or loss. The carrying
amount of the asset must not exceed the original amortised cost.
Example: Impairment
Floribunda has a 7% loan receivable of $1m. Interest is payable annually in arrears and the
principal is repayable in three years' time. The amortised cost of the loan is $1m. The original
effective rate of interest was 7% and the current effective interest rate is 8%.
The borrower is in financial difficulty and Floribunda has granted a concession in that no annual
interest is payable and the principal will be repaid in three years' time at a premium of 10%.
Required
Explain how the carrying amount of the loan should be calculated.
Solution
 The financial difficulty of, and the granting of a concession to, the issuer are both objective
evidence of impairment.
 The recoverable amount should be calculated as $839,185 by discounting the $1.1m agreed
repayment at the original effective interest rate of 7% over a four-year period.
 An impairment loss of $160,815 is therefore recognised in profit or loss.
 In Year 1, interest income of $58,743 (7%  $839,185) should be recognised and the
carrying amount of the loan increased to $897,928. This process should be repeated through
Years 2 to 4, at which point the loan will be carried at $1.1m immediately prior to repayment.
HKFRS 9,
5.6.1-5.6.3 4.5 Reclassification
Earlier we saw that an entity may reclassify financial assets from one category to another.
Where financial assets are reclassified, that reclassification is applied prospectively from the
reclassification date. Previously recognised gains, losses or interest are not restated.
417
Financial Reporting
If an entity reclassifies a financial asset so that it is now measured at fair value, its fair value is
determined at the reclassification date. Any gain or loss arising from a difference between the
previous carrying amount and fair value is recognised in profit or loss.
If an entity reclassifies a financial asset so that it is now measured at amortised cost, its fair value
at the reclassification date becomes its new carrying amount.
4.6 Section summary

 Financial instruments are initially measured at fair value. Transaction costs increase this
amount for financial assets classified as measured at amortised cost and decrease this
amount for financial liabilities classified as measured at amortised cost.
 Financial assets are subsequently measured at:
– fair value with changes in value normally recognised in profit or loss, or
– amortised cost with interest recognised in profit or loss.
 Financial liabilities are subsequently measured at fair value or amortised cost with gains and
losses recognised in profit or loss.
 Financial assets measured at amortised cost must be tested for impairment when there is
objective evidence of impairment. Any loss is recognised in profit or loss.
5 HKFRS 9: Embedded derivatives

Topic highlights
Embedded derivatives are derivative instruments that are embedded within a host contract that
may or may not be a financial instrument.
Derivative contracts may be "embedded" in contracts that are not themselves derivatives (and may
not be financial instruments). These non-derivatives are known as host contracts, and may
comprise:
 leases
 sale or purchase contracts
 insurance contracts
 construction contracts
 a debt or equity instrument
5.1 Examples of embedded derivatives

Possible examples include:
(a) Contingent rentals based on sales included as a term in a lease of retail premises:
"Host"
Lease Accounted for as normal
contract
Embedded Contingent Treat as derivative, i.e. re-

derivative rentals measured to fair value with
changes recognised in profit or
loss
(b) A bond which is redeemable in five years' time with part of the redemption price based on
the increase in the Hong Kong Index.
418
(c) An embedded derivative caused by changes in the foreign exchange can be found in a
construction contract which is priced in a foreign currency.
HKFRS 9,
4.3.2-4.3.4
5.2 Accounting treatment of embedded derivatives
Topic highlights
Where the host contract is within the scope of HKFRS 9 the hybrid contract is accounted for as one
instrument. Otherwise, HKFRS 9 requires that the embedded derivative is separated from the host
contract where certain conditions are met and accounted for separately.
HKFRS 9 now provides the accounting guidance in relation to embedded derivatives.

Unless the host contract is a financial asset within the scope of the standard, HKFRS 9 requires
that an embedded derivative is separated from its host contract and accounted for as a
derivative when the following conditions are met:
(a) The economic characteristics and risks of the embedded derivative are not closely related to
the economic characteristics and risks of the host contract.
(b) A separate instrument with the same terms as the embedded derivative would meet the
definition of a derivative.
(c) The hybrid (combined) instrument is not measured at fair value with changes in fair value
recognised in profit or loss (a derivative embedded in a financial liability need not be
separated out if the entity holds the combined instrument at fair value through profit or loss).
The host contract is accounted for in accordance with relevant accounting standards.
HKFRS 9, 5.2.1 Financial asset host contract
4.3.2
Where the host contract is a financial asset within the scope of the standard, the classification and
measurement rules of the standard are applied to the entire hybrid contract.
This is a simplification of the rules which applied to financial assets as well as other host contracts
prior to the issue of HKFRS 9.
HKFRS 9,
B4.3.1
5.3 Reassessment of embedded derivatives
As a result of the expansion of HKFRS 9, the contents of HK(IFRIC) Int-9 Reassessment of
Embedded Derivatives have been incorporated into the standard and the Interpretation itself has
been withdrawn.
The standard states that an entity is not permitted to reassess the treatment of an embedded
derivative throughout the life of a contract unless there is a significant change to the terms of the
contract.
6 HKAS 39: Hedging

Topic highlights
Hedge accounting means designating one or more instruments so that their change in fair value is
offset by the change in fair value or cash flows of another item.
6.1 Introduction
It is normal business practice for a company to engage in hedging activities in order to reduce their
exposure to risk and uncertainty, such as changes in prices, interest rates or foreign exchange
419
Financial Reporting
rates. For example, an entity may have a fixed amount of foreign currency to pay on a particular
date, and hedge against unfavourable exchange rate movements by taking out a forward contract
to purchase the currency it needs to meet its obligation from a third party at a particular exchange
rate.
In this instance the forward contract is a derivative and so measured at fair value with changes in
value recognised in profit or loss. An accounting hedge involves recognising these changes in
value at the same time as any opposite gain or loss on a year end revaluation and then settlement
of the payable so as to minimise the impact on profit or loss of the transaction. This is an example
of a hedge that happens automatically.
HKAS 39 provides the guidance relating to hedging and requires hedge accounting where there
is a designated hedging relationship between a hedging instrument and a hedged item. It is
prohibited otherwise.

The definitions in HKAS 39 relevant to hedging are given below.
Key terms
Hedging, for accounting purposes, means designating one or more hedging instruments so that
their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of
a hedged item.
A hedged item is an asset, liability, firm commitment, or forecasted future transaction that:
(a) exposes the entity to risk of changes in fair value or changes in future cash flows, and that
(b) is designated as being hedged.
A hedging instrument is a designated derivative or (in limited circumstances) another financial
asset or liability whose fair value or cash flows are expected to offset changes in the fair value or
cash flows of a designated hedged item. (A non-derivative financial asset or liability may be
designated as a hedging instrument for hedge accounting purposes only if it hedges the risk of
changes in foreign currency exchange rates.)
Hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged
item attributable to a hedged risk are offset by changes in the fair value or cash flows of the
hedging instrument. (HKAS 39)
Generally only assets, liabilities etc. that involve external parties can be designated as hedged
items. The foreign currency risk of an intragroup monetary item (e.g. payable/receivable between
two subsidiaries) may qualify as a hedged item in the group financial statements if it results in an
exposure to foreign exchange rate gains or losses that are not fully eliminated on consolidation.
This can happen (per HKAS 21) when the transaction is between entities with different functional
currencies.
In addition, the foreign currency risk of a highly probable group transaction may qualify as a
hedged item if it is in a currency other than the functional currency of the entity and the foreign
currency risk will affect profit or loss.
HKAS 39.86 6.3 Types of hedge

There are three types of hedge covered by HKAS 39:
(a) Fair value hedges, which involve hedging against a change in the value of a recognised
asset or liability (the above example involving a foreign currency payable is an example of a
fair value hedge)
420
(b) Cash flow hedges, which involve hedging against a change in the value of future certain
cash flows (for example, where an entity is due to receive a payment in foreign currency),
and
(c) Net investment hedges, which involves hedging an investment in a foreign group company.
The formal definitions of each type of hedge are as follows:
Key terms
Fair value hedge. A hedge of the exposure to changes in the fair value of a recognised asset or
liability, or an identified portion of such an asset or liability, that is attributable to a particular risk
and could affect profit or loss.
Cash flow hedge. A hedge of the exposure to variability in cash flows that:
(a) is attributable to a particular risk associated with a recognised asset or liability (such as all or
some future interest payments on variable rate debt) or a highly probable forecast
transaction (such as an anticipated purchase or sale), and that
(b) could affect profit or loss.
Hedge of a net investment in a foreign operation. HKAS 21 defines a net investment in a
foreign operation as the amount of the reporting entity's interest in the net assets of that operation.
(HKAS 39)
We shall consider each type of hedge in detail in a moment, but first it is important to understand
the conditions for hedge accounting.
HKAS 39.88 6.4 Conditions for hedge accounting

Topic highlights
Hedge accounting is permitted in certain circumstances, provided the hedging relationship is
clearly defined, measurable and actually effective.
Before a hedging relationship qualifies for hedge accounting, all of the following conditions must
be met:
(a) The hedging relationship must be formally documented (including the identification of the
hedged item, the hedging instrument, the nature of the hedged risk and the assessment of
the hedging instrument's effectiveness in offsetting the exposure to changes in the hedged
item's fair value or cash flows attributable to the hedged risk). The hedging relationship must
also be designated at its inception as a hedge based on the entity's risk management
objective and strategy.
(b) There is an expectation that the hedge is highly effective in offsetting changes in fair value or
cash flows ascribed to the hedged risk. (Note. The hedge does not have to be fully
effective.)
(c) For cash flow hedges, it must be highly probable that there is a forecast transaction since
such a transaction is the subject of the hedge. In addition, the transaction must present an
exposure to variations in cash flows that could eventually affect profit and loss.
(d) Reliable measurement of the effectiveness of the hedge.
(e) The assessment of the hedge is carried out on an ongoing basis (annually) and it has been
effective during the reporting period.
421
Financial Reporting
Effectiveness
Hedge effectiveness must be tested regularly and must fall within the range 80% to 125%. If it falls
outside e.g. 75% or 130%, then hedge accounting cannot be applied. Both the hedged item and
hedging instrument will be accounted for based on their respective accounting standard.
Change in hedging instrument
Hedge effectiveness =
Change in hedged item
6.5 Accounting treatment

Topic highlights
There are three types of hedge: fair value hedge; cash flow hedge; hedge of a net investment in a
foreign operation. The accounting treatment of a hedge depends on its type.
HKAS 39.89 6.5.1 Fair value hedges

In a fair value hedge, the hedged item is a recognised asset or liability. When hedge accounting is
applied, this is remeasured to fair value at the period end in accordance with HKFRS 13 Fair Value
Measurement and any gain or loss on the hedged item attributable to the hedged risk is
The hedging instrument is a derivative and in accordance with HKAS 39 / HKFRS 9 any gain or
loss resulting from re-measuring the hedging instrument at fair value is also recognised in profit
or loss.
Example: Fair value hedge (1)

A company owns inventories of 30,000 gallons of oil which cost $660,000 on 1 December 20X8.
In order to hedge the fluctuation in the market value of the oil the company signs a futures contract
to deliver 30,000 gallons of oil on 31 March 20X9 at the futures price of $25 per gallon.
The market price of oil on 31 December 20X8 is $27 per gallon and the futures price for delivery on
31 March 20X9 is $30 per gallon.
Required
Explain the impact of the transactions on the financial statements of the company:
(a) without hedge accounting
(b) with hedge accounting.
Solution
The futures contract was intended to protect the company from a fall in oil prices (which would
have reduced the profit when the oil was eventually sold). However, oil prices have actually risen,
so that the company has made a loss on the contract.
Without hedge accounting
The futures contract is a derivative and therefore must be remeasured to fair value at 31 December
20X8 under HKAS 39. The loss on the futures contract is recognised in profit or loss:
$ $
DEBIT Profit or loss (30,000  (30 – 25)) 150,000
CREDIT Financial liability 150,000
422
With hedge accounting

The loss on the futures contract is recognised in profit or loss as before, however with hedge
accounting, the inventories are also remeasured to fair value:
$
Fair value at 31 December 20X8 (30,000  27) 810,000
Cost (660,000)
Gain 150,000
The gain is also recognised in profit or loss:
$ $
DEBIT Inventory 150,000
CREDIT Profit or loss 150,000
With hedging the net effect on profit or loss is zero compared with a loss of $150,000 without
hedging.

As at 1 January 20X3, a company purchases a debt instrument that has a principal amount of
$1 million at a fixed interest rate of 6% per year. The instrument is classified as a financial asset
measured at fair value. The fair value of the instrument is $1 million.
The company is exposed to a risk of the decline in the fair value of the instrument if the market
interest rate increases because of the fixed interest rate.
The company enters into an interest rate swap. It exchanges the fixed interest rate payments it
receives on the bond for floating interest rate payments, in order to offset the risk of a decline in fair
value. If the derivative hedging instrument is effective, any decline in the fair value of the bond
should be offset by opposite increases in the fair value of the derivative instrument. The company
designates and documents the swap as a hedging instrument. On entering into the swap, the swap
has a fair value of zero.
Assuming market interest rates have increased to 7%, the fair value of the bond will have
decreased to $960,000.
At the same time, the company determines that the fair value of the swap has increased by
$40,000. Since the swap is a derivative, it is measured at fair value with changes in fair value
recognised in profit or loss. The changes in fair value of the hedged item and the hedging
instrument exactly offset each other; the hedge is 100% effective and the net effect on profit or loss
is zero.
Required
Explain the impact of the transactions on the financial statements of the company with hedge
accounting.
423
Financial Reporting
Solution
20X3 20X3
$'000 $'000 $'000
Debt instrument (hedged item) 1,000 (40) 960
Derivative asset (hedging instrument) – 40 40
Cash (1,000)
$'000
Loss on debt instrument (40)
Gain on derivative 40
No ineffectiveness –
Gains and losses on hedged item and hedging instrument are both taken to the statement of profit
or loss.

Assuming the information is the same as above. However, the company determines that the fair
value of the swap has increased by $45,000 instead of $40,000.
Required
Explain the impact of the transactions on the financial statements of the company.
Solution
Change in hedging instrument
Hedge effectiveness =
Change in hedged item
$45,000
=
$40,000
= 112.5%
Hedge effectiveness of 112.5% is still within the window of 80% – 125%. Thus, hedge accounting
may be applied.
20X3 20X3
$'000 $'000 $'000
Debt instrument (hedged item) 1,000 (40) 960
Derivative asset (hedging instrument) – 45 45
Cash (1,000)
$'000
Loss on debt instrument (40)
Gain on derivative 45
Ineffective hedge 5
This results in an ineffective hedge of $5,000 gain recognised in profit or loss.
424
HKAS 39.95 6.5.2 Cash flow hedges

A cash flow hedge involves hedging future cash flows. Initially therefore, only the hedging
instrument (the derivative) is recognised.
The part of the gain or loss arising from an effective hedge of a hedging instrument is recognised
in other comprehensive income while the ineffective portion of the gain or loss on the hedging
instrument should be recognised in profit and loss.
In the case where a hedging transaction results in the recognition of a non-financial asset or
liability, changes in the value of the hedging instrument recognised in other comprehensive income:
(a) are adjusted against the carrying value of the asset or liability
(b) are reclassified from equity to profit or loss as a reclassification adjustment in the same
period or periods during which the hedged forecast cash flows affect profit or loss (such as in
the periods that depreciation expense is recognised).
Example: Basic cash flow hedge

Randall Co. expected to purchase an item of plant for 20 million South African Rand in one year's
time on 31 August 20X2. In order to offset the risk of movement in the exchange rate, Randall
enters into a forward contract to purchase Rand 20 million in one year for a fixed amount
($20,500,000). The forward contract is designated as a cash flow hedge and has an initial fair value
of zero.
At the year end (31 December 20X1), the Rand has appreciated and the value of Rand 20 million is
$20,650,000. The machine will still cost Rand 20 million so the company concludes that the hedge
is 100% effective. Thus the entire change in the fair value of the hedging instrument is recognised
directly in other comprehensive income:
$ $
DEBIT Forward contract 150,000
CREDIT Other comprehensive income 150,000
The effect of the cash flow hedge is to lock in the price of Rand 20 million for the item of plant. The
other comprehensive income of $150,000 will either:
(i) be reclassified to profit or loss as the machine is depreciated, or
(ii) be deducted from the initial carrying amount of the machine.
Example: Cash flow hedge

Sparkle is a manufacturer and retailer of gold jewellery.
On 31 October 20X1, the cost of Sparkle's inventories of finished jewellery was $8.280 million with
a gold content of 24,000 troy ounces. At that date their sales value was $9.938 million.
The selling price of gold jewellery is heavily dependent on the current market price of gold (plus a
standard percentage for design and production costs).
Sparkle's management wished to reduce their business risk of fluctuations in future cash inflow
from sale of the jewellery by hedging the value of the gold content of the jewellery. In the past this
has proved to be an effective strategy.
Therefore, it sold futures contracts for 24,000 troy ounces of gold at $388 per troy ounce at
31 October 20X1. The contracts mature on 30 October 20X2.
On 30 September 20X2 the fair value of the jewellery was $9.186m and the forward price of gold
per troy ounce for delivery on 30 October 20X2 was $352.
425
Financial Reporting
Required
Explain how the above transactions would be treated in Sparkle's financial statements for the year
ended 30 September 20X2.
Solution
Sparkle is hedging the volatility of the future cash inflow from selling the gold jewellery. The futures
contracts can be accounted for as a cash flow hedge in respect of those inflows, providing the
criteria for hedge accounting are met.
The gain on the forward contract should be calculated as:
$
Forward value of contract at 31.10.X1 (24,000  $388) 9,312,000
Forward value of contract at 30.9.X2 (24,000  $352) 8,448,000
Gain on contract 864,000
The change in the fair value of the expected future cash flows on the hedged item (which is not
recognised in the financial statements) should be calculated as:
$
At 31.10.X1 9,938,000
At 30.9.X2 9,186,000
752,000
As this change in fair value is less than the gain on the forward contract, the hedge is not fully
effective and only $752,000 of the gain on the forward should be recognised in other
comprehensive income. The remainder should be recognised in profit or loss:
$ $
DEBIT Financial asset (Forward a/c) 864,000
Profit or loss 112,000
Note that the hedge is still highly effective (and hence hedge accounting should continue to be
used):
$864,000/$752,000 = 115% which is within the 80% – 125% range.
Example: Cash flow hedge – interest rate swap

On 1 January 20X1, Arlington Co. lends $10 million to another entity, with a maturity date of three
years later on 31 December 20X3. The interest rate attached to the loan is variable at HIBOR +
2%, and interest is due annually on 31 December.
Arlington expects interest rates to decline and so simultaneously enters an interest rate swap on
1 January 20X1 in order to hedge its position.
The terms of the swap are as follows:
 There is no initial cost
 The notional principal is $10 million
 Arlington will receive fixed interest at 7%
 Arlington will pay variable interest at HIBOR
 Net settlement is made annually on 31 December, and the swap is also repriced on this
date.
426
The fair value of the swap, determined by projecting future settlement amounts using the current
year's variable rate and discounting these to present value is:
31 December 20X1 $300,000
31 December 20X2 $125,000
31 December 20X3 nil
HIBOR at each of these dates is:

31 December 20X1 7%
31 December 20X2 6%
31 December 20X3 5%
All criteria for cash flow hedge accounting have been met and the hedging relationship is expected
to be 100% effective at inception and on an ongoing basis.
What journal entries are required in respect of the loan and cash flow hedge throughout the three-
year term?
Solution
The purpose of the cash flow hedge is to fix the interest receivable at 9%. Interest receivable per
the terms of the loan agreement is:
31 December 20X1 $10m  (7% + 2%) = $900,000
31 December 20X2 $10m  (6% + 2%) = $800,000
31 December 20X3 $10m  (5% + 2%) = $700,000
The net settlement in respect of the swap on each of these dates is:
Date Swap receipt at 7% Swap payment at Swap net
HIBOR
$ $ $
31 December 20X1 700,000 (700,000) Nil
31 December 20X2 700,000 (600,000) 100,000
31 December 20X3 700,000 (500,000) 200,000
Therefore, in each of the three years, the total amount of the interest income (i.e. loan interest
income + net position on the swap) is $900,000.
The journal entries are as follows:
1 January 20X1
$ $
DEBIT Loan receivable 10,000,000
CREDIT Cash 10,000,000
To record the inception of the loan.

(Note. No entry is required in respect of the swap as it was acquired at no cost)
31 December 20X1
DEBIT Cash 900,000
To record the receipt of interest in respect of the loan.
DEBIT Interest rate swap 300,000

To record the fair value of the interest rate swap.
427
Financial Reporting
31 December 20X2
DEBIT Cash 800,000
DEBIT Cash 100,000

To record the cash received on net settlement of the interest rate swap.
DEBIT Other comprehensive income 100,000

To recycle into earnings amounts in OCI on account of the cash flow hedge, so that they are
matched with the relevant cash flow.

CREDIT Interest rate swap 175,000
To reduce the carrying value of the interest rate swap from its initial fair value of $300,000 to
current fair value of $125,000.
31 December 20X3
DEBIT Cash 700,000
DEBIT Cash 200,000

To record the cash received on net settlement of the interest rate swap.

To recycle into earnings amounts in OCI on account of the cash flow hedge, so that they are
matched with the relevant cash flow.

CREDIT Interest rate swap 125,000
To adjust the carrying value of the interest rate swap to current fair value.
DEBIT Cash 10,000,000

CREDIT Loan receivable 10,000,000
To record repayment of the loan at the maturity date.
428
HKAS 39.102 6.5.3 Hedges of a net investment

Hedges of a net investment arise in the consolidated accounts where a parent company takes a
foreign currency loan in order to buy shares in a foreign subsidiary. The loan and the investment
need not be denominated in the same currency, however assuming that the currencies perform
similarly against the parent company's own currency, it should be the case that fluctuations in the
exchange rate affect the asset (the net assets of the subsidiary) and the liability (the loan) in
opposite ways, hence gains and losses are hedged.
In this type of accounting hedge, the hedging instrument is the foreign currency loan rather than a
derivative.
You may understand this type of hedge better after studying Chapter 30, Foreign Currency
Transactions, but in a simple sense, without applying hedging rules:
(a) The loan would be retranslated to the parent's own currency at the year end using the spot
exchange rate; any resultant gain or loss would be recognised in profit or loss.
(b) Prior to consolidation, the subsidiary's accounts would be translated into the parent's own
currency with any gain or loss recognised in other comprehensive income.
(c) On consolidation, the gain or loss on the loan would affect consolidated profit or loss and the
loss or gain on the translation of the subsidiary's net assets would affect consolidated
reserves.
The net investment hedge ensures that the gains and losses are both recognised in other
comprehensive income and accumulated in reserves by:
 recognising the portion of the gain or loss on the hedging instrument that is determined to be
effective in other comprehensive income
 recognising the ineffective portion in profit or loss
Any gain or loss recognised in other comprehensive income is reclassified to profit or loss on the
disposal or partial disposal of the foreign operation.
6.6 Exposures qualifying for hedge accounting

HKAS 39 was amended in 2008 to clarify what can be designated as a hedged risk and when an
entity may designate a portion of the cash flows of a financial instrument as a hedged item.
The risks specified are:
 interest rate risk
 foreign currency rate risk
 credit risk
 prepayment risk
The portions of the cash flows of a financial instrument that may be designated as a hedged item
are one or more of the following:
(a) The cash flows of a financial instrument for part of its time period to maturity.
(b) A percentage of the cash flows of a financial instrument.
(c) The cash flows of a financial instrument associated with a one-sided risk of that instrument.
(d) Any contractually specified cash flows of a financial instrument that are independent from the
other cash flows of that instrument.
(e) The portion of the cash flows of an interest bearing financial instrument that is equivalent to a
financial instrument with a risk-free rate.
(f) The portion of the cash flows of an interest bearing financial instrument that is equivalent to a
financial instrument with a quoted or variable inter-bank rate.
429
Financial Reporting
6.7 Recap
 Hedge accounting means designating one or more instruments so that their change in fair
value is offset by the change in fair value or cash flows of another item.
 Hedge accounting is permitted in certain circumstances, provided the hedging relationship
is clearly defined, measurable and actually effective.
 There are three types of hedge: fair value hedge; cash flow hedge; hedge of a net
investment in a foreign operation.
 The accounting treatment of a hedge depends on its type.
7 HKFRS 7: Disclosure of financial instruments

Topic highlights
HKFRS 7 specifies the disclosures required for financial instruments. In addition, HKFRS 13
disclosures are applied where financial instruments are measured at fair value. HKFRS 7 requires
qualitative and quantitative disclosures about exposure to risks arising from financial instruments
and specifies minimum disclosures about credit risk, liquidity risk and market risk.
HKFRS 7 was issued in 2005 to replace the disclosure requirements of HKAS 32. In doing so it has
revised and enhanced disclosure requirements in response to new techniques and approaches to
measuring risk management. The standard requires qualitative and quantitative disclosures
about exposure to risks arising from financial instruments, and specifies minimum disclosures
about credit risk, liquidity risk and market risk.
The HKICPA maintains that users of financial instruments need information about an entity's
exposures to risks and how those risks are managed, as this information can influence a user's
assessment of the financial position and financial performance of an entity or of the amount,
timing and uncertainty of its future cash flows.
In June 2011 HKFRS 13 Fair Value Measurement was issued. As a result, disclosures in relation to
financial instruments measured at fair value were relocated from HKFRS 7 to HKFRS 13.
HKFRS 7.1 7.1 Objective

The objective of HKFRS 7 is to require entities to provide disclosures in their financial statements
that enable users to evaluate:
(a) the significance of financial instruments for the entity's financial position and performance.
(b) the nature and extent of risks arising from financial instruments to which the entity is
exposed during the period and at the reporting date, and how the entity manages those
risks.
The principles in HKFRS 7 complement the principles for recognising, measuring and presenting
financial assets and financial liabilities in HKAS 32 Financial Instruments: Presentation, HKAS 39
Financial Instruments: Recognition and Measurement and HKFRS 9 Financial Instruments.
HKFRS 7.6 7.2 Classes of financial instruments and levels of disclosure

When HKFRS 7 requires disclosures by class of financial instrument, an entity must group financial
instruments into classes that are appropriate to the nature of the information disclosed and that
take into account the characteristics of those financial instruments. Sufficient information should be
provided to permit reconciliation to the line items presented in the statement of financial position.
430
HKFRS 7.7-
19
7.3 Statement of financial position disclosures
The following must be disclosed in the notes to the financial statements:
(a) Carrying amount of financial assets and liabilities by HKAS 39 or HKFRS 9 category.
(b) Details of financial instruments designated as at fair value through profit or loss and financial
assets designated as at fair value through other comprehensive income.
(c) Reason for any reclassification between fair value and amortised cost (and vice versa).
(d) The carrying amount of financial assets the entity has pledged as collateral for liabilities
or contingent liabilities and the associated terms and conditions.
(e) When financial assets are impaired by credit losses and the entity records the impairment in
a separate account (e.g. an allowance account used to record individual impairments or a
similar account used to record a collective impairment of assets) rather than directly reducing
the carrying amount of the asset, it must disclose a reconciliation of changes in that
account during the period for each class of financial assets.
(f) The existence of multiple embedded derivatives, where compound instruments contain
these.
(g) Defaults and breaches.
HKFRS 7.13C The December 2011 amendment to HKFRS 7 in respect of offsetting financial assets and financial
liabilities requires an entity to disclose information about rights of offset and related arrangements.
As a minimum the following should be disclosed:
(a) The gross amounts of financial assets and financial liabilities under an enforceable master
netting agreement (i.e. an agreement whereby a single net settlement of all financial
instruments covered by the arrangement may be made) or similar;
(b) Amounts offset in accordance with the HKAS 32 criteria;
(c) Net amounts presented in the statement of financial position;
(d) Amounts subject to an enforceable master netting agreement not included in (b);
(e) The net amount after deducting (d) from (c).
HKFRS 7.20 7.4 Statement of profit or loss and other comprehensive income
disclosures
The entity must disclose the following items of income, expense, gains or losses, either on the
face of the financial statements or in the notes:
(a) Net gains/losses by HKAS 39 or HKFRS 9 category (broken down as appropriate: for
example, interest, fair value changes, dividend income)
(b) Interest income/expense
(c) Impairment losses by class of financial asset.
HKFRS 7.21 7.5 Other disclosures

Entities must disclose in the summary of significant accounting policies the measurement basis
used in preparing the financial statements and the other accounting policies that are relevant to an
understanding of the financial statements.
431
Financial Reporting
HKFRS 7.22- 7.5.1 Hedge accounting

24
Disclosures must be made relating to hedge accounting, as follows:
(a) Description of hedge.
(b) Description of financial instruments designated as hedging instruments and their fair value
at the reporting date.
(c) The nature of the risks being hedged.
(d) For cash flow hedges, periods when the cash flows will occur and when they will affect
profit or loss.
(e) For fair value hedges, gains or losses on the hedging instrument and the hedged item.
(f) The ineffectiveness recognised in profit or loss arising from cash flow hedges and net
investments in foreign operations.
HKFRS 7.25, 7.5.2 Fair value
26,29
HKFRS 7 retains the following general requirements in relation to the disclosure of fair value for
those financial instruments measured at amortised cost:
(a) For each class of financial assets and financial liabilities an entity shall disclose the fair
value of that class of assets and liabilities in a way that permits it to be compared with its
carrying amount.
(b) In disclosing fair values, an entity shall group financial assets and financial liabilities into
classes, but shall offset them only to the extent that their carrying amounts are offset in the
It also states that disclosure of fair value is not required where:
 carrying amount is a reasonable approximation of fair value
 for investments in equity instruments that do not have a quoted market price in an active
market for an identical instrument, or derivatives linked to such equity instruments
HKFRS HKFRS 13 provides disclosure requirements in respect of the fair value of financial instruments
13.91,93, 95, measured at fair value. It requires that information is disclosed to help users assess:
97
(a) for assets and liabilities measured at fair value after initial recognition, the valuation
techniques and inputs used to develop those measurements.
(b) for recurring fair value measurements (i.e. those measured at each period end) using
significant unobservable (level 3) inputs, the effect of the measurements on profit or loss or
other comprehensive income for the period.
In order to achieve this, the following should be disclosed as a minimum for each class of financial
assets and liabilities measured at fair value (asterisked disclosures are also required for financial
assets and liabilities measured at amortised cost but for which fair value is disclosed):
1 The fair value measurement at the end of the period
2 The level of the fair value hierarchy within which the fair value measurements are
categorised in their entirety
3 For assets and liabilities measured at fair value at each reporting date (recurring fair value
measurements), the amounts of any transfers between level 1 and level 2 of the fair value
hierarchy and reasons for the transfers
4 For fair value measurements categorised within level 2 and 3 of the hierarchy, a description
of the valuation techniques and inputs used in the fair value measurement, plus details of
any changes in valuation techniques
5 For recurring fair value measurements categorised within level 3 of the fair value hierarchy
432
6 A reconciliation from the opening to closing balances

7 The amount of unrealised gains or losses recognised in profit or loss in the period and the
line item in which they are recognised
8 A narrative description of the sensitivity of the fair value measurement to changes in
unobservable inputs
9 For recurring and non-recurring fair value measurements categorised within level 3 of the fair
value hierarchy, a description of the valuation processes used by the entity.
An entity should also disclose its policy for determining when transfers between levels of the fair
value hierarchy are deemed to have occurred.
Example: Fair value disclosures

For assets and liabilities measured at fair value at the end of the reporting period, the HKFRS
requires quantitative disclosures about the fair value measurements for each class of assets and
liabilities. An entity might disclose the following for assets to comply with points 1 and 2 above:
HK$'000 Fair value measurements at the end of the

reporting period using
Description 31.12.X9 Level 1 Level 2 Level 3
inputs inputs inputs
Trading equity securities 45 45 – –
Non-trading equity securities 32 – – 32
Corporate securities 90 9 81 –
Derivatives – interest rate 78 – 78 –
contracts
Total recurring fair value 245 54 159 32

measurements
7.6 Nature and extent of risks arising from financial instruments

In undertaking transactions in financial instruments, an entity may assume or transfer to another
party one or more of different types of financial risk as defined below. The disclosures required
by the standard show the extent to which an entity is exposed to these different types of risk,
relating to both recognised and unrecognised financial instruments.
Credit risk The risk that one party to a financial instrument will cause a financial loss for
the other party by failing to discharge an obligation.
Currency risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in foreign exchange rates.
Interest rate risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market interest rates.
Liquidity risk The risk that an entity will encounter difficulty in meeting obligations
associated with financial liabilities.
Loans payable Loans payable are financial liabilities, other than short-term trade payables
on normal credit terms.
Market risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices. Market risk comprises three
types of risk: currency risk, interest rate risk and other price risk.
433
Financial Reporting
Other price risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices (other than those arising from
interest rate risk or currency risk), whether those changes are caused by
factors specific to the individual financial instrument or its issuer, or factors
affecting all similar financial instruments traded in the market.
Past due A financial asset is past due when a counterparty has failed to make a
payment when contractually due.
HKFRS 7.33 7.6.1 Qualitative disclosures

For each type of risk arising from financial instruments, an entity must disclose:
(a) the exposures to risk and how they arise.
(b) its objectives, policies and processes for managing the risk and the methods used to
measure the risk.
(c) any changes in (a) or (b) from the previous period.
HKFRS 7.34- 7.6.2 Quantitative disclosures
38
For each financial instrument risk, summary quantitative data about risk exposure must be
disclosed. This should be based on the information provided internally to key management
personnel. More information should be provided if this is unrepresentative of an entity's exposure to
risk.
Information about credit risk must be disclosed by class of financial instrument:
(a) Maximum exposure at the year end without taking account of collateral held or other credit
enhancements. (This disclosure is not required where the carrying amount of financial
instruments best represents the maximum exposure to credit risk.)
(b) A description of collateral held as security and of other credit enhancements, and their
financial effect, in respect of the maximum exposure to credit risk (whether as disclosed in
(a) or represented by carrying amount).
(c) Information about the credit quality of financial assets that are neither past due nor impaired.
(d) Information about the credit quality of financial assets whose terms have been renegotiated.
(e) An analysis of the age of financial assets that are past due as at the end of the reporting
period but not impaired.
(f) An analysis of financial assets that are individually determined to be impaired as at the end
of the reporting period, including the factors the entity considered in determining that they
are impaired.
(g) Collateral and other credit enhancements obtained during the reporting period and held at
the reporting date, including the nature and carrying amount of the assets and policy for
disposing of assets not readily convertible into cash.
Example: Credit risk disclosure (1)
An entity holds equity investments in other entities. Its management asserts that the HKFRS 7
credit risk disclosures are not relevant.
Do the credit risk disclosures required by HKFRS 7 apply to an entity's holdings of equity
investments?
Solution
The definition of equity in HKAS 32 requires the issuer to have no obligation to pay cash or transfer
other assets. It follows that such equity investments are subject to price risk, not credit risk. Most of
the HKFRS 7 credit risk disclosures are not therefore relevant to investments in equity instruments.
However, HKFRS 7 requires entities to disclose an analysis of financial assets that are impaired.
This disclosure is relevant and should be given for impaired equity investments that are available
for sale.
434
Example: Credit risk disclosure (2)

HKFRS 7 defines credit risk as "the risk that one party to a financial instrument will cause a
financial loss for the other party by failing to discharge an obligation". If an entity issues a financial
guarantee, the financial loss will not result from a default by the other party of the contract (the
holder), but from a default by the third party (the debtor). Does this mean that the credit risk of
financial guarantees can be excluded from the disclosure of the maximum exposure to credit risk?
Solution
No, the credit risk of financial guarantees should be included in the disclosures, as HKFRS 7
clarifies that the definition of credit risk includes that arising from financial guarantees.
HKFRS 7.39 7.6.3 Liquidity risk

For liquidity risk entities must disclose:
 a maturity analysis of both derivative and non-derivative financial liabilities
 a description of the way risk is managed
Within the maturity analysis, any amounts repayable under a loan agreement that includes a clause
giving the lender the unconditional right to demand repayment at any time must be classified in the
earliest time bracket.
Example: Liquidity risk (1)

HKFRS 7 requires the disclosure of a maturity analysis for financial liabilities that shows the
remaining contractual maturities.
Should the following financial instruments be shown in one maturity bracket, or split across the
maturity brackets in which the cash flows occur?
(a) A derivative which has multiple cash flows
(b) A loan which has annual contractual interest payments
(c) A loan which has annual contractual interest and principal repayments
Solution
All the financial instruments should be split across the maturity brackets in which the cash flows
occur. The requirement is to disclose each of the contractual payments in the period when they are
due (including principal and interest payments). The objective of this particular disclosure is to
show the liquidity risk of the entity.
Example: Liquidity risk (2)

HKFRS 7 requires entities to disclose (a) a maturity analysis for financial liabilities that shows the
remaining contractual maturities; and (b) a description of how it manages the liquidity risk inherent
in (a).
Does this mean that a maturity analysis for financial assets based on remaining contractual
maturities, is no longer required?
Solution
Yes, HKFRS 7 requires a maturity analysis based on the remaining contractual maturity only for
financial liabilities. Management can choose to disclose the maturity analysis showing remaining
contractual maturity for financial assets also as one of the disclosures to comply with the
requirement in HKFRS 7. However, it is not obligatory.
435
Financial Reporting
In practice, an entity should disclose a maturity analysis of financial assets and financial liabilities
showing expected maturity if this is the information provided to key management personnel to
manage the business. However, a maturity analysis based on the remaining contractual maturity
for financial liabilities should be disclosed.
HKFRS 7.40- 7.6.4 Market risk: sensitivity analysis

41
An entity shall disclose a sensitivity analysis for each type of market risk to which the entity is
exposed at the reporting date, showing how profit or loss and equity would have been affected by
changes in the relevant risk variable that were reasonably possible at that date; the methods and
assumptions used in preparing the sensitivity analysis; and changes from the previous period in the
methods and assumptions used, and the reasons for such changes.
Assuming that a reasonably possible change in the relevant risk variable had occurred at the
reporting date and had been applied to the risk exposures in existence at that date:
Disclosures required in connection with market risk are:
(a) sensitivity analysis, showing the effects on profit or loss of changes in each market risk.
(b) if the sensitivity analysis reflects interdependencies between risk variables, such as interest
rates and exchange rates the method, assumptions and limitations must be disclosed.
7.6.5 Risk variables that are relevant to disclosing market risk
Market risk
Interest
rate risk Yield curve of market interest rates
Currency risk Foreign exchange rates
Other price
risk
Equity price risk Prices of equity instruments
Commodity price risk Market prices of commodities
Prepayment risk
Residual value risk
7.7 Capital disclosures

Certain disclosures about capital are required. An entity's capital does not relate solely to financial
instruments, but has more general relevance. Accordingly, those disclosures are included in
HKAS 1, rather than in HKFRS 7.
436
8.1 IFRS 9 development
The issue of IFRS 9 (HKFRS 9) and its subsequent expansion in 2010 represent the first stages of
the culmination of a long-standing project carried out by the IASB and FASB concerned with
reducing the complexity surrounding financial instruments.
HKICPA are following the lead of the IASB and it is intended that HKFRS 9 will ultimately replace
HKAS 39 in its entirety. The IASB continue to work on the replacement project and in response to
requests from interested parties that the accounting for financial instruments should be improved
quickly, the project to replace IAS 39 (and in turn HKAS 39) has been divided into phases.
As each phase is completed, the relevant portions of IAS 39 will be deleted and chapters in IFRS 9
will be created to replace the requirements in IAS 39. As the IASB issues new sections of IFRS 9,
HKICPA will adopt these to form HKFRS 9.
Phases 1 and 2 of the project relating to the classification and measurement of financial assets and
financial liabilities are now obviously complete.
Phase 3 of the project relates to impairment methodology. The Request for Information on the
feasibility of an expected loss model for the impairment of financial assets was published on
25 June 2009. This formed the basis of an Exposure Draft, Financial Instruments: Amortised Cost
and Impairment, published in November 2009. A supplement to the ED was issued in January
2011 and the topic was re-exposed in March 2013. The latest exposure draft builds upon previous
EDs to develop a more forward-looking provisioning model which recognises credit losses on a
more timely basis. IAS 39 currently applies an incurred loss model, requiring that credit losses
(impairments) are recognised only when a credit loss event has occurred; the ED proposes that
credit losses are recognised before a credit loss event occurs.
Phase 4 of the project relates to hedge accounting. Proposals in respect of general hedge
accounting have been exposed and final amendments to IFRS 9 are expected during the course of
2013. As a result of the proposed new hedge accounting requirements, companies will be able to
reflect their risk management activities better in the financial statements, and there will be
enhanced presentation and disclosure requirements.
8.2 Other proposals

In addition to the on-going development of IFRS 9, limited amendments to the classification and
measurement requirements of IFRS 9 which are already in issue have also been proposed. These
address application questions raised by entities which have adopted the standard early on a
voluntary basis. They also reduce the differences between IFRS and US GAAP in accounting for
financial instruments. The proposed amendments would:
 Improve the contractual cash flow test and
 Introduce a fair value through OCI category for simple debt instruments.
437
Financial Reporting
Topic recap
HKAS 32 Presentation of Financial

Instruments
Financial assets Financial liabilities Equity
Cash Contractual obligation to

Any contract that evidences
Equity instrument of another deliver cash/another financial
a residual interest in the
entity asset
assets of an entity after
Contractual right to receive Contractual obligation to
deducting all of its liabilities
cash/a financial asset exchange financial
Contractual right to exchange instruments under
financial instruments under unfavourable conditions
favourable conditions Certain contracts settled by
Certain contracts settled by delivery of entity's own equity
receipt of entity's own equity instruments
instruments.
Puttable financial instruments may be classified as either liability

or equity depending on the conditions.
Financial instruments with

contingent settlement
provisions are financial
liabilities unless possibility of
settlement is remote.
Financial instruments with settlement options are either financial assets

Text
or financial liabilities
Compound financial instruments are split into a debt and equity

component.
Rights
issues/options/warrants are
equity where the entity offers
them pro rata to all existing
owners.
Financial assets and liabilities are only offset where an entity:

has a legally enforceable right of set off and
intends to settle on a net basis or realise the asset and liability
simultaneously.
438
HKFRS 9 Financial Instruments
Financial assets Financial liabilities

Classified as measured at either: Classified as measured at either:
Amortised cost Fair value Amortised cost FV through profit or

If: loss
aim is to hold assets If:
to collect contractual held for trading or
cash flows and designated as FV
cash flows of through profit or
principal and interest loss on initial
arise on specified recognition.
dates.
Equity instruments Derivatives

Derivatives
May be reclassified if an entity changes its business Reclassification is not allowed.

model for managing financial assets.
Initially measured at transaction price/fair value. Initially measured at transaction price/fair value.
Transaction costs are added for assets measured at Transaction costs are deducted for liabilities
amortised cost. measured at amortised cost.
Interest on amortisation Remeasured annually Interest on amortisation Remeasured annually

recognised in profit or with changes in fair recognised in profit or with changes in fair
loss. value recognised in loss. value recognised in
Tested for impairment profit or loss unless profit or loss. If
when indications exist, asset is equity not held designated as
with any loss for trading (OCI). measured at FV then
recognised in profit or gains or losses due to
loss. credit risk are
recognised in OCI.
Derecognise when: Derecognise when the obligation specified in the

contractual rights to cash flows of asset contract is discharged or cancelled or expires.
expire, or Substantial modification of the terms of a financial
risks and rewards of ownership transferred liability is an extinguishment.
Embedded derivatives
Derivatives embedded within host contracts
such as leases or a debt instrument.
If host contract is a financial asset, HKFRS 9 rules If host contract is not a financial asset, split derivative
are applied to the whole hybrid contract. and host contract and account separately.
439
Financial Reporting
HKAS 39 Hedging
Conditions for hedge accounting:

1 Hedge is formally documented
2 Hedge is expected to be highly effective (80% – 125%)
3 Forecast transaction is highly probable (cash flow
hedges)
4 Effectiveness of hedge can be measured reliably
assessment of hedge carried out on ongoing basis
and effective during period.
Fair value hedge Cash flow hedge Net investment hedge
Hedged item (an asset or liability) is Hedged item is a future cash flow. Hedged item is the investment in a
remeasured to fair value at the period foreign subsidiary within consolidated
end and the gain or loss recognised in Hedging instrument (derivative) is accounts.
profit or loss. remeasured to fair value and the
effective gain or loss is recognised in Hedging instrument is the loan taken to
Hedging instrument (derivative) is also OCI. fund the acquisition of the subsidiary.
remeasured to fair value and the gain
or loss recognised in profit or loss. This is reclassified to profit or loss Gains and losses on both are matched
when the effect of the future cash flow in other comprehensive income.
is recognised in profit or loss.
HKFRS 7 Disclosure of Financial Instruments
Significance of financial instruments on Nature and extent of risks arising from financial
financial position and performance instruments and their management
Statement of financial position disclosures Qualitative and quantitative disclosure for:

Statement of comprehensive income credit risk
disclosures currency risk
Hedge accounting interest rate risk
Fair value of financial instruments at liquidity risk
amortised cost loans payable
market risk
other price risk
past due (overdue asset)
440
Answer 1
Refer to the definitions of financial assets and liabilities given in section 1.2:
(a) Physical assets: control of these creates an opportunity to generate an inflow of cash or
other assets, but it does not give rise to a present right to receive cash or other financial
assets.
(b) Prepaid expenses, etc.: the future economic benefit is the receipt of goods/services rather
than the right to receive cash or other financial assets.
Answer 2
Liability. The preference shares require regular distributions to the holders but more importantly
have the debt characteristic of being redeemable. Therefore, according to HKAS 32 Financial
Instruments: Presentation they must be classified as liability.
Answer 3
Note. The method to use here is to find the present value of the principal value of the bond, $2m
(100,000  $20) and the interest payments of $120,000 annually (6%  $2m) at the market rate for
non-convertible bonds of 8%, using the discount factor tables. The difference between this total
and the principal amount of $2m is the equity element.
$
Present value of principal $2m  0.681 1,362,000
Present value of interest $120,000  3.993 479,160
Liability value 1,841,160
Principal amount 2,000,000
Equity element 158,840
Answer 4
(a) ABC should derecognise the asset as its option to repurchase is at the prevailing market
value.
(b) DEF should not derecognise the asset as it has retained substantially all the risks and
rewards of ownership. The stock should be retained in its books even though legal title is
temporarily transferred.
(c) XYZ has received 90% of its transferred receivables in cash, but whether it can retain this
amount permanently is dependent on the performance of the factor in recovering all of the
receivables. XYZ may have to repay some of it and therefore retains the risks and rewards of
100% of the receivables amount. The receivables should not be derecognised. The cash
received should be treated as a loan.
The 10% of the receivables that XYZ will never receive in cash should be treated as interest
over the six-month period; it should be recognised as an expense in profit or loss and
increase the carrying amount of the loan.
At the end of the six months, the receivables should be derecognised by netting them
against the amount of the loan that does not need to be repaid to the factor. The amount
remaining is bad debts which should be recognised as an expense in profit or loss.
441
Financial Reporting
Answer 5
(a) Amortised cost (b) FV through P/L
20X1 20X2 20X1 20X2
$'000 $'000 $'000 $'000
Profit or loss
Interest income (W1)/(W2) 1,200 1,200 1,200 1,387
Gain/(loss) due to change in
FV (W2) – – (187) –
1,200 1,200 1,013 1,387
Statement of financial
position
Financial asset (W1)/(W2) 20,000 – 19,813 –
WORKINGS
1 Amortised cost
$'000
Cash – 1.1.20X1 20,000
Effective interest at 6% (same as nominal as no discount on 1,200
issue/premium on redemption)
Coupon received (nominal interest 6%  20m) (1,200)
At 31.12.20X1 20,000
Effective interest at 6% 1,200
Coupon and capital received ((6%  20m) + 20m) (21,200)
At 31.12.20X2 –
2 Fair value
$'000
Cash 20,000
Effective interest (as above) 1,200
Coupon received (as above) (1,200)
Fair value loss (balancing figure) (187)
At 31.12.20X1 (W3) 19,813
Interest at 7% (7%  19,813) 1,387
Coupon and capital received ((6%  20m) + 20m) (21,200)
At 31.12.20X2 –
3 Fair value at 31.12.20X1
$'000
Interest and capital due on 31.12.20X2 at new market rate 19,813
(21.2m/1.07)
Answer 6
D $
Issue costs 30,000
Interest $1,000,000  5%  7 350,000
Premium on redemption 260,000
Total finance cost 640,000
442
Answer 7
The bond is a "deep discount" bond and is a financial liability of Grumble Co.. It is measured at
amortised cost. Although there is no interest as such, the difference between the initial cost of the
bond and the price at which it will be redeemed is a finance cost. This must be allocated over the
term of the bond at a constant rate on the carrying amount.
To calculate amortised cost we need to calculate the effective interest rate of the bond:
1,000,000
= 1.191 over three years
839,619
1/3
To calculate an annual rate, we take the cube root, (1.191) = 1.06, so the annual interest rate is
6%
The charge to the statement of profit or loss and other comprehensive income is $50,377
($839,619  6%)
The balance outstanding at 31 December 20X2 is $889,996 ($839,619 + $50,377)
Answer 8
A financial asset or group of assets is impaired when its recoverable amount is less than its
carrying amount. Possible indications would be:
(a) a trade receivable balance where it is now learnt that the credit customer is in financial
difficulties
(b) a borrower not paying an interest payment on time
(c) an investment in shares where the underlying company has filed for bankruptcy protection
443
Financial Reporting
Exam practice
Sonna Inc. 30 minutes

(a) On 1 January 20X1, Sonna Inc. (SC) issued HK$2,000 million of three-year Hong Kong
Interbank Borrowing Rate (HIBOR) plus 180 basis points variable rate bond at par value.
Interest is payable annually. On the same date, SC entered into an interest rate swap with a
bank by paying 2 per cent fixed interest amount and receiving HIBOR plus 180 basis points
for three-year and exchange at the dates of interest payment dates. SC measures the bond
at amortised cost.
Required:
(i) Explain the difference between the fair value interest rate risk and the cash flow
interest rate risk in the context of a bank loan. (2 marks)
(ii) Explain what a hedged item and hedging instrument are and discuss how hedge
accounting affects the accounting treatment of a hedging instrument in the financial
statements under cash flow hedges. (6 marks)
(iii) Assuming hedge accounting is not adopted, explain the accounting treatment for the
bond and interest rate swap if the market interest rate is increased by 0.5% on 30
September 20X1, the current year end date (no quantification of the effect is required).
(5 marks)
(b) On 1 August 20X1, SC entered into a non-cancellable purchase order to acquire equipment
from Monta Corporation, a Japanese entity, at Yen 300 million. Payment is made upon
delivery of the equipment to Hong Kong on 31 December 20X1. On 30 September 20X1,
SC entered into a forward contract to exchange Yen 300 million at a pre-determined
exchange rate between the Yen and Hong Kong dollar on 31 December 20X1. The
functional currency of SC is the Hong Kong dollar.
Required
Discuss the accounting implications for the purchase contract and forward contract if fair
value hedge accounting is adopted. (4 marks)
(Total = 17 marks)
HKICPA June 2012 (amended)
444
chapter 19
Statements of cash flows
Topic list
1 Cash flows and HKAS 7

1.1 Cash flows: advantages
1.2 HKAS 7 Statement of Cash Flows
2 Single company statements of cash flows
2.1 Presentation of a statement of cash flows
2.2 Cash generated from operations
2.3 Specific cash flows
2.4 Disclosure
2.5 Producing a statement of cash flows
3 Consolidated statements of cash flows
3.1 Acquisitions and disposals of subsidiaries
3.2 The non-controlling interest
3.3 Associates and joint ventures
3.4 Foreign currency cash flows
Learning focus
Statements of cash flows are very relevant in practice. They are a required element of a set of
financial statements and often provide more useful information than that within the other
financial statements with regard to liquidity.
445
Financial Reporting
Learning outcomes
Competency
level
Prepare the financial statements for an individual entity in accordance
with Hong Kong Financial Reporting Standards and statutory reporting
requirements
4.01 Primary financial statement preparation 3
4.01.01 Prepare the statement of cash flows of an entity in accordance with
Hong Kong accounting standards
4.09 Consolidated financial statement preparation 3
4.09.03 Prepare a consolidated statement of cash flows
446
19: Statements of cash flows | Part C Accounting for business transactions
1 Cash flows and HKAS 7

Topic highlights
Statements of cash flows are a useful addition to the financial statements of companies because
it is recognised that accounting profit is not the only indicator of a company's performance.
A statement of cash flows focuses on the sources and uses of cash and is a useful indicator of
company’s liquidity and solvency.
Cash is a key element of any business. It must be monitored and managed in order to maintain a
liquid position. While the statement of financial position provides a period end cash balance, this in
itself does not provide any indication of how an entity generates, uses and manages its cash.
Similarly, profit, while providing a good indication of the performance of an entity does not provide
any indication of the liquidity of a business, since it is calculated using the accrual basis.
The statement of cash flows is therefore required to form part of a set of financial statements by
HKAS 1. HKAS 1 does not, however, prescribe the format and content of a statement of cash
flows. This guidance is provided within HKAS 7 Statement of Cash Flows.
Before considering the standard, it is important to appreciate the advantages of cash flow
information.
1.1 Cash flows: advantages

The main advantages of using cash flow accounting (including both historical and forecast cash
flows) are as follows.
(a) A company's ability to generate cash affects its survival. Cash flow accounting addresses
this critical issue.
(b) Since "profit" is dependent on accounting conventions and concepts, cash flow is viewed as
more comprehensive.
(c) Cash flow is factual, objective and is not subject to as much manipulation as profits.
(d) Both long-and short-term creditors have more interest in an entity's ability to repay them than
in its profitability. Cash flow accounting is more direct than "profits" in pointing out the
availability of cash.
(e) Cash flow reporting is better than traditional profit reporting in the comparison of the results
of different companies.
(f) The needs of all users are better satisfied by cash flow reporting.
(i) It provides management with information that is useful in decision making ("relevant
costs" to a decision are future cash flows in management accounting). Traditional
profit accounting does not provide exclusive help in decision making.
(ii) A satisfactory basis for stewardship accounting is provided by cash flow accounting for
shareholders and auditors.
(iii) Cash flow accounting better serves the information needs of creditors and employees.
(g) When compared with profit forecasts, cash flow forecasts are more useful and easier to
prepare.
(h) It is easier to audit cash flow accounts than accounts prepared based on the accruals
concept.
(i) The accrual concept can be confusing whereas cash flows are easily understood.
(j) Cash flow accounting can be retrospective and also prospective in providing a forecast for
the future. This information can be of great value to all users of accounting information.
447
Financial Reporting
(k) Variance statements, which compare actual cash flows against the forecast, can be used to
monitor forecasts.
Looking at the same question from a different angle, readers of accounts can be misled by the
profit figure.
(a) Shareholders might believe that if a company makes a profit after tax of, say $1 million then
this is the amount which it could afford to pay as a dividend. Unless the company has
sufficient cash available to stay in business and also to pay a dividend, the shareholders'
expectations would be wrong.
(b) Employees might believe that if a company makes profits, it can afford to pay higher wages
next year. This opinion may not be correct: the ability to pay wages depends on the
availability of cash.
(c) Creditors might consider that a profitable company is a going concern.
(i) If a company builds up large amounts of unsold inventories of goods, their cost
would not be chargeable against profits, but cash would have been used up in making
them, thus weakening the company's liquid resources.
(ii) A company might capitalise large development costs, having spent considerable
amounts of money on research and development, but only charge small amounts
against current profits. As a result, the company might show reasonable profits, but
get into severe difficulties with its liquidity position.
(d) Management might suppose that if their company makes a historical cost profit, and
reinvests some of those profits, then the company must be expanding. This is not the case:
in a period of inflation, a company might have a historical cost profit but a current cost
accounting loss, which means that the operating capability of the firm will be declining.
(e) Survival of a business entity depends not so much on profits as on its ability to pay its debts
when they fall due. Such payments might include "profit and loss" items such as material
purchases, wages, interest and taxation etc., but also capital payments for new non-current
assets and the repayment of loan capital when this falls due (e.g. on the redemption of
debentures).
1.2 HKAS 7 Statement of Cash Flows

Topic highlights
HKAS 7 provides the format of a statement of cash flows and guidance on the required content.
1.2.1 Objective
The objective of this standard is to require the provision of information about the historical changes
in cash and cash equivalents of an entity by means of a statement of cash flows which classifies
cash flows during the period from operating, investing and financing activities.
1.2.2 Scope
Users of an entity's financial statements are interested in how the entity generates and uses cash
and cash equivalents. This is the case regardless of the nature of the entity's activities. Therefore,
all entities must provide a statement of cash flows as an integral part of an entity's financial
statements.
HKAS 7.6-9 1.2.3 Definitions
The standard gives the following definitions, the most important of which are cash and cash
equivalents.
448
Key terms
Cash comprises cash on hand and demand deposits.
Cash equivalents are short-term, highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of changes in value.
Cash flows are inflows and outflows of cash and cash equivalents.
Operating activities are the principal revenue-producing activities of the entity and other activities
that are not investing or financing activities.
Investing activities are the acquisition and disposal of long-term assets and other investments not
included in cash equivalents.
Financing activities are activities that result in changes in the size and composition of the
contributed equity and borrowings of the entity. (HKAS 7)
The standard expands on the definition of cash equivalents: they are held to meet short-term cash
commitments rather than for investment or other long-term purposes. They are required to:
1 be readily convertible to a known amount of cash and therefore their maturity date should
normally be three months from its acquisition date
2 be subject to an insignificant risk of changes in value.
Based on the definition, therefore:
 Deposits available on demand are cash equivalents;
 Deposits with a fixed maturity of more than three months are not cash equivalents;
 Pledged deposits (amounts held by banks as security) are not cash equivalents;
 Money market holdings, short-term government bonds and treasury bills are cash
equivalents;
 Equity investments (i.e. holdings of ordinary shares in other companies) are not cash
equivalents;
 Preference share investments are cash equivalents where acquired within a short period
of their maturity and with a specified redemption date;
 Where bank overdrafts are repayable on demand and are treated as part of an entity's total
cash management system, an overdrawn balance is included in cash and cash equivalents;
 Loans and other borrowings are not cash equivalents, but instead are classified as cash
flows from financing activities.
Movements between different types of cash and cash equivalents are not included in cash flows.
The investment of surplus cash in cash equivalents is part of cash management, not part of
operating, investing or financing activities.
2 Single company statements of cash flows

Topic highlights
Cash flows are classified as cash flows from operating, investing and financing activities in a
statement of cash flows. Cash flows from operating activities may be calculated using the direct or
indirect method.
449
Financial Reporting
HKAS
7.10,11
2.1 Presentation of a statement of cash flows
According to HKAS 7, reported cash flows during a period should be classified into operating,
investing and financing activities in a statement of cash flows.
The way of presenting cash flows under operating, investing and financing activities is dependent
on the nature of the reporting entity. The classification enables users to understand the impact of
each activity on cash and cash equivalents and their interrelationship.
HKAS 7.13- 2.1.1 Operating activities

15
This section of the statement of cash flows shows whether, and to what extent, companies can
generate cash from their operations. It is this cash from day-to-day trading which must, in the
end pay for all cash outflows relating to other activities, such as paying loan interest, tax and
dividends.
The standard gives the following as examples of cash flows from operating activities.
 Cash receipts from the sale of goods and the rendering of services
 Cash receipts from royalties, fees, commissions and other revenue
 Cash payments to suppliers for goods and services
 Cash payments to and on behalf of employees
 Cash payments/refunds of income taxes unless they can be specifically identified with
financing or investing activities
 Cash receipts and payments from contracts held for dealing or trading purposes
The effects of these transactions are all included in the calculation of profit or loss, however certain
items may be included in the net profit or loss for the period which do not relate to operational cash
flows. For example, the profit or loss on the disposal of property, plant and equipment will be
included in net profit or loss, but the cash flows will be classed as investing. However, cash
payments to manufacture or acquire assets held for rental to others and subsequently held for sale
as described in paragraph 68A of HKAS 16 Property, Plant and Equipment are cash flows from
operating activities. The cash receipts from rents and subsequent sales of such assets are also
cash flows from operating activities.
HKAS 7.16 2.1.2 Investing activities
Cash flows from investing activities show the extent of new investment in assets that will generate
future income and cash flows. Only expenditures that result in a recognised asset in the statement
of financial position are eligible for classification as investing activities.
The standard gives the following examples of cash flows arising from investing activities.
 Cash payments to acquire property, plant and equipment, intangibles and other long-term
assets, including those relating to capitalised development costs and self-constructed
 Cash receipts from sales of property, plant and equipment, intangibles and other long-term
assets
 Cash payments to acquire shares or debentures of other entities
 Cash receipts from sales of shares or debentures of other entities
 Cash advances and loans made to other parties
 Cash receipts from the repayment of advances and loans made to other parties
 Cash payments for or receipts from futures/forward/option/swap contracts except when the
contracts are held for dealing purposes, or the payments/receipts are classified as financing
activities
450
HKAS 7.17 2.1.3 Financing activities

Cash flows from financing activities show the share of cash claimed by capital providers during the
period. This serves as an indicator of likely future interest and dividend payments.
The standard gives the following examples of cash flows which might arise under these headings:
 Cash proceeds from issuing shares
 Cash payments to owners to acquire or redeem the entity's shares
 Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short- or
long-term borrowings
 Cash repayments of amounts borrowed
 Cash payments by a lessee for the reduction of the outstanding liability relating to a finance
lease
2.1.4 Example of statement of cash flows
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X9
$'000 $'000
Cash flows from operating activities
Cash receipts from customers 34,630
Cash paid to suppliers and employees (32,400)
Cash generated from operations 2,230
Interest paid (320)
Income taxes paid (820)
Net cash from operating activities 1,090
Cash flows from investing activities
Purchase of property, plant and equipment (840)
Proceeds from sale of equipment 30
Interest received 250
Dividends received 250
Net cash used in investing activities (310)
Cash flows from financing activities
Proceeds from issuance of share capital 330
Proceeds from long-term borrowings 330
Payment of finance lease liabilities (100)
Dividends paid* (1,250)
Net cash used in financing activities (690)
Net increase in cash and cash equivalents 90
Cash and cash equivalents at beginning of period 230
Cash and cash equivalents at end of period 320
* This could also be shown as an operating cash flow
Cash and cash equivalents:
20X9 20X8
$'000 $'000
Cash on hand and balances with banks 50 35
Short-term investments 270 195
Cash and cash equivalents 320 230
451
Financial Reporting
HKAS 7.18 2.2 Cash generated from operations

The standard offers a choice of method for the calculation of cash generated from operations:
(a) The direct method involves disclosing major classes of gross cash receipts and gross cash
payments
(b) The indirect method involves adjusting the profit or loss for the effects of:
1 transactions of a non-cash nature
2 any deferrals or accrual of past or future operating cash receipts or payments and
3 items of income or expense associated with investing or financing cash flows
The example shown above in section 2.1.4 uses the direct method.
HKAS 7.19 2.2.1 The direct method
The direct method involves listing cash receipts and cash payments in respect of day-to-day
transactions. A simple example may be as follows:
$
Cash in respect of cash sales X
Cash received from credit customers X
Cash purchases (X)
Cash paid to credit suppliers (X)
Cash expenses paid (including wages) (X)
Cash generated from operations X
The most obvious way to obtain information about gross cash receipts and payments is simply to
extract the information from the accounting records. An alternative method involves adjusting sales,
cost of sales and other items in the statement of profit or loss for:
 changes in inventories, receivables and payables during the period
 other non-cash items
 other items for which the cash effects are investing or financing cash flow.
Practically, this involves reconstructing nominal ledger accounts in order to extract cash flows. This
may be a laborious task, however, and the indirect method described below may be easier.
HKAS 7.20 2.2.2 The indirect method

This method is undoubtedly easier from the point of view of the preparer of the statement of cash
flows. The profit or loss for the period is adjusted for the following:
 Changes during the period in inventories, operating receivables and payables
 Non-cash items, e.g. depreciation, provisions, profits/losses on the sales of assets
 Other items, the cash flows from which should be classified under investing or financing
activities.
A proforma of such a calculation is as follows:
$
Profit before taxation (statement of profit or loss) X
Depreciation X
Loss (profit) on sale of non-current assets (working capital) X
(Increase)/decrease in inventories (X)/X
(Increase)/decrease in receivables (X)/X
Increase/(decrease) in payables X/(X)
Cash generated from operations X
Interest (paid)/received (X)
Income taxes paid (X) )
Net cash flows from operating activities X
452
It is important to understand why certain items are added and others subtracted. Note the
following points:
(a) Depreciation is not a cash expense, but is deducted in arriving at the profit figure in the
statement of profit or loss. It makes sense, therefore, to eliminate it by adding it back.
(b) By the same logic, a loss on a disposal of a non-current asset (arising through
underprovision of depreciation) needs to be added back and a profit deducted.
(c) An increase in inventories means less cash – you have spent cash on buying inventory.
(d) An increase in receivables means the company's debtors have not paid as much, and
therefore there is less cash.
(e) A decrease in payables means the company has paid more to suppliers and so has less
cash.
The illustration below shows a full statement of cash flows using the indirect method.
Illustration: Indirect method

STATEMENT OF CASH FLOWS (INDIRECT METHOD) FOR THE YEAR ENDED 31 DECEMBER
20X9
$'000 $'000
Profit before taxation 2,630
Adjustments for:
Depreciation 540
Investment income (450)
Interest expense 390
3,110
Increase in trade and other receivables (600)
Decrease in inventories 1,000
Decrease in trade payables (1,280)
Interest paid (320)
Income taxes paid (820)
Net cash from operating activities 1,090
Purchase of property, plant and equipment (840)
Proceeds from sale of equipment 30
Dividends received 250

Proceeds from issue of share capital 330
Proceeds from long-term borrowings 330
Payment of finance lease liabilities (100)
Dividends paid* (1,250)
Net cash used in financing activities (690)

Net increase in cash and cash equivalents 90
Cash and cash equivalents at beginning of period 230
Cash and cash equivalents at end of period 320
* This could also be shown as an operating cash flow
453
Financial Reporting
Cash and cash equivalents:

20X9 20X8
$'000 $'000
Cash on hand and balances with banks 50 35
Short-term investments 270 195
Cash and cash equivalents 320 230
2.2.3 Indirect versus direct

Use of the direct method is encouraged, but not required, by HKAS 7, as this method provides
information which may be useful in estimating future cash flows, which is not available under the
indirect method.
2.3 Specific cash flows

HKAS 2.3.1 Interest and dividends
7.31,34
Sources (cash inflows) and uses (outflows) of cash relating to interest and dividends should be
separately disclosed. Each cash flow should be classified consistently from period to period either
as operating, investing or financing.
Dividends paid by the entity can be classified in one of two ways:
(a) As a financing cash flow, showing the cost of obtaining financial resources.
(b) As a component of cash flows from operating activities so that users can assess the
entity's ability to pay dividends out of operating cash flows.
Interest paid or received is calculated by reference to the statement of profit or loss amount for the
year adjusted for any accrual or other statement of financial position amount.
Dividends paid or received are identified in the notes to a set of financial statements.
Example: Interest
Odile Co. reports the following amounts in its financial statements relating to interest:
$
Finance costs in the statement of profit or loss 8.7
Interest accrued at start of year 1.2
Interest accrued at end of year 3.1
What is Odile Co.’s interest paid?
Solution
Interest paid is calculated as 1.2m + 8.7m – 3.1m = $6.8 million.
HKAS 2.3.2 Taxes on income

7.35,36
Cash flows relating to taxes should also be separately disclosed. They should be classified as
items under operating activities unless they can be specifically identified with financing and
investing activities.
It is often difficult to match cash flows arising from taxes with the originating underlying transaction,
therefore tax cash flows are usually classified as arising from operating activities.
Tax paid (or refunded) is calculated by reference to the tax charge (or credit) for the year, adjusted
for any statement of financial position amounts.
454
Example: Taxes on income

Allister's estimated tax payable for the year ended 31 March 20X1 is $89,100. The equivalent figure
for the year ended 31 March 20X0 was $97,200. The tax charge reported in the statement of profit
or loss for the year ended 31 March 20X1 was $101,000, which included a $12,000 increase in
deferred tax.
What tax was paid in the year?
Solution
$
Tax liability b/f 97,200
Tax charge ($101,000 – $12,000) 89,000
186,200
Tax liability c/f (89,100)
Tax paid 97,100
2.3.3 Finance lease payments

Rentals under a finance lease include capital and interest elements. These are split out for the
purpose of inclusion in the statement of cash flows and reported as "financing" and "operating"
cash flows respectively.
Example: Lotus Co.

The notes to the financial statements of Lotus Co. show the following in respect of finance leases:
Year ended 31 December 20X9 20X8
$'000 $'000
Amounts payable within one year 12 8
Within 2-5 years 110 66
122 74
Less finance charges allocated (14) (8)
108 66
Additions to non-current assets acquired under finance leases were shown in the non-current asset
note at $56,000.
What is the capital repayment to be shown in the statement of cash flows for Lotus Co. in the year
ended 31 December 20X9?
Solution
Finance leases
$'000
Balance at 31 December 20X8 66
Additions for the year 56
Balance at 31 December 20X9 (108)
Capital repayment (balancing fig) 14
2.3.4 Cash flows associated with non-current assets

Where non-current assets are acquired through purchase, rather than lease, the additions figure in
the non-current asset note (adjusted for any outstanding amount owed) equates to the cash
outflow.
455
Financial Reporting
Where non-current assets are disposed of, the cash proceeds is calculated by adding any profit on
disposal (or deducting any loss) to (from) the carrying value of the disposals (identified from the
non-current asset note).
Example: Cash flows associated with non-current assets
The following extracts are taken from the financial statements of Rooibus for the year ended
30 September 20X0:
20X0 20W9
$m $m
Cost of PPE 520 420
Accumulated depreciation 165 189

Depreciation charge 55
Loss on disposal of PPE 5.5
Other comprehensive income
Revaluation surplus (land) 20
Assets costing $85m were disposed of in the year.
Required
What cash has Rooibus paid to acquire new non-current assets in the period, and what are the
proceeds of sale of old non-current assets?
Solution
Cost $m Depreciation $m
b/f 420 b/f 189
Additions (balancing) 165 Charge 55
Revaluation 20 Disposals (balancing) (79)
Disposal (85) c/f 165
c/f 520
Cash paid to acquire non-current assets $165m
Proceeds of sale of non-current assets (85m – 79m – 5.5m) $0.5m
2.3.5 Borrowings and share capital

When calculating the proceeds of a share or loan issue or loan repaid, the balance outstanding at
the start of the period should be compared with the balance at the end of the period.
2.4 Disclosure
HKAS 7.43 2.4.1 Non cash transactions
Investing and financing transactions that do not require the use of cash or cash equivalents shall
be excluded from a statement of cash flows. Such transactions shall be disclosed elsewhere in the
financial statements in a way that provides all the relevant information about these investing and
financing activities.
HKAS 2.4.2 Components of cash and cash equivalents
7.45,46
The components of cash and cash equivalents should be disclosed and a reconciliation should be
presented, showing the amounts in the statement of cash flows reconciled with the equivalent
items reported in the statement of financial position.
456
It is also necessary to disclose the accounting policy used in deciding the items included in cash
and cash equivalents, in accordance with HKAS 1, but also because of the wide range of cash
management practices worldwide.
HKAS 2.4.3 Other disclosures

7.48,50
All entities should disclose, together with a commentary by management, any other information
likely to be of importance.
(a) Restrictions on the use of or access to any part of cash equivalents.
(b) The amount of undrawn borrowing facilities which are available.
(c) Cash flows which increased operating capacity compared to cash flows which merely
maintained operating capacity.
2.5 Producing a statement of cash flows

Remember the steps involved in preparation of a statement of cash flows using the indirect
method:
Step 1
Set out the proforma leaving plenty of space.
Step 2
Complete the reconciliation of profit before tax to net cash from operating activities, as far as
possible.
Step 3
Calculate the following where appropriate.
 Tax paid
 Dividends paid
 Interest paid/received
 Purchase and sale of non-current assets
 Issues of shares
 Repayment of loans
Step 4
Work out the profit if not already given using: opening and closing balances, tax charge and
dividends.
Step 5
Slot the figures into the statement and any notes required.
Example: Kowloon Co.

Set out below are the financial statements of Kowloon Co.. You are the financial controller, faced
with the task of implementing HKAS 7 Statement of Cash Flows.
457
Financial Reporting
KOWLOON CO.
$'000
Revenue 2,553
Cost of sales (1,814)
Gross profit 739
Other income: interest received 25
Distribution costs (125)
Administrative expenses (264)
Finance costs (75)
Profit before tax 300
Income tax expense (140)
Profit for the year 160
KOWLOON CO.
STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER
20X9 20X8
Assets $'000 $'000
Non-current assets
Property, plant and equipment 380 305
Intangible assets 250 200
Investments – 25
Current assets
Inventories 150 102
Receivables 390 315
Short-term investments 50 –
Cash at bank 2 1
Total assets 1,222 948
Equity and liabilities
Equity
Share capital 360 300
Revaluation surplus 100 91
Retained earnings 260 180
Long-term loan 170 50
Current liabilities
Trade payables 127 119
Bank overdraft 85 98
Taxation 120 110
Total equity and liabilities 1,222 948
The following information is available:
(a) The proceeds of the sale of non-current asset investments amounted to $30,000.
(b) Fixtures and fittings, with an original cost of $85,000 and a net book value of $45,000, were
sold for $32,000 during the year.
(c) The following information relates to property, plant and equipment.
31.12.20X9 31.12.20X8
$'000 $'000
Cost 720 595
Accumulated depreciation (340) (290)
Net book value 380 305
(d) 50,000 $1 ordinary shares were issued during the year at a premium of 20 cents per share.
(e) The short-term investments are highly liquid and are close to maturity.
(f) Dividends of $80,000 were paid during the year.
458
Required
Prepare a statement of cash flows for the year to 31 December 20X9 using the format laid out in
HKAS 7.
Solution
KOWLOON CO.
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X9
$'000 $'000
Profit before tax 300
Depreciation charge (W1) 90
Loss on sale of property, plant and equipment (45 – 32) 13
Profit on sale of non-current asset investments (30 – 25) (5)
Interest expense (net) (75 – 25) 50
(Increase)/decrease in inventories (102 – 150) (48)
(Increase)/decrease in receivables (315 – 390) (75)
Increase/(decrease) in payables (127 – 119) 8
333
Interest paid (75)
Dividends paid (80)
Tax paid (110 + 140 – 120) (130)
Net cash from operating activities 48
Payments to acquire property, plant and equipment (W2) (201)
Payments to acquire intangible non-current assets (250 – 200) (50)
Receipts from sales of property, plant and equipment 32
Receipts from sale of non-current asset investments 30
Issue of share capital (360 – 300) 60
Long-term loan (170 – 50) 120
Net cash from financing activities 180
Increase in cash and cash equivalents 64
Cash and cash equivalents at 1.1.X9 (97)
Cash and cash equivalents at 31.12.X9 (33)
ANALYSIS OF CASH AND CASH EQUIVALENTS
31.12.X9 31.12.X8
$'000 $'000
Cash at bank 2 1
Short-term investments 50 -
Overdraft (85) (98)
(33) (97)
459
Financial Reporting
WORKINGS
1 Depreciation charge
$'000
Accumulated depreciation at 31 December 20X8 290
Accumulated depreciation on assets sold (85 – 45) (40)
Accumulated depreciation 31 December 20X9 (340)
Charge for the year (90)
2 Purchase of property, plant and equipment
$'000
Cost at 31 December 20X8 595
Revaluation (100 – 91) 9
Cost on assets sold (85)
Cost 31 December 20X9 (720)
Purchase for the year (balancing fig) (201)
3 Consolidated statements of cash flows

Topic highlights
A consolidated statement of cash flows includes extra line items for cash flows associated with:
 acquisitions and disposals of subsidiaries
 non-controlling interests
 associates and joint ventures
Note that accounting for group financial statements is covered in Section D of this Learning Pack.
HKAS Consolidated statements of cash flows are prepared in the same way as a single company
7.37,39 statement of cash flows, however they include extra line items:
 Acquisitions and disposals of subsidiaries are reported as cash flows from investing activities
 Dividends paid to the non-controlling interests are reported as cash flows from financing
activities
 Dividends received from associates and joint ventures accounted for using the equity
method are reported as cash flows from operating activities
Cash flows that are internal to the group should be eliminated in the preparation of a consolidated
statement of cash flows.
Example: Elimination of intra-group cash flows
Cann Co. disposed of property, plant and equipment with a carrying value of $215,000 in the year
ended 31 October. The company reported a profit on the combined disposals of $39,500. Included
within the disposal figures was a machine sold to Cann's subsidiary Wood Co. for $12,400.
During the year, Wood disposed of property, plant and equipment with a carrying value of $43,000,
recording a loss on disposal of $5,600. All disposals were made to companies outside the group.
What amount will be reported as proceeds on disposal of property, plant and equipment in the
consolidated statement of cash flows?
460
Solution
Cann $'000 $'000
Carrying amount on disposal 215.0
Profit on disposal 39.5
254.5
Less: intercompany proceeds (12.4)
242.1
Wood
Carrying amount on disposal 43.0
Loss on disposal (5.6)
37.4
Consolidated proceeds on disposal 279.5
You should also remember that adjustments made to consolidated profit for non-cash items in the
reconciliation to cash flows from operating activities should reflect the amounts included within the
consolidated statement of profit or loss and other comprehensive income. Therefore, for example,
the amount of depreciation or profit on disposal should take into account any consolidation
adjustment.
Example: Consolidation adjustments
Landon Co. acquired 80% of Crowther Co. a number of years ago. In the year ended 31 December
20X1, Landon reported a depreciation charge of $560,000 and Crowther reported a depreciation
charge of $320,000. At the start of that year, Landon transferred a machine to Crowther with a
resulting increase in depreciation of $10,000 per annum.
The adjustment required to consolidated profit for the purposes of calculating cash flows from
operating activities is therefore:
$'000
Landon depreciation 560
Crowther depreciation 320
Consolidation adjustment (10)
Added back to profit in respect of depreciation 870
HKAS
7.39,42
3.1 Acquisitions and disposals of subsidiaries
Where a subsidiary undertaking joins or leaves a group during a financial year the cash flows of
the group should include the cash flows of the subsidiary undertaking concerned for the same
period as that for which the group's statement of profit or loss and other comprehensive income
includes the results of the subsidiary undertaking.
If a subsidiary is acquired or disposed of during the accounting period the net cash effect of the
purchase or sale transaction should be shown separately under "Cash flows from investing
activities".
The net cash effect is the cash purchase price/cash disposal proceeds net of any cash or cash
equivalents acquired or disposed of:
Subsidiary acquired Subsidiary disposed of

Cash price (X) Cash proceeds X
Subsidiary's cash and cash equivalents Subsidiary's cash and cash equivalents
at acquisition date X at disposal date (X)
Cash to acquire subsidiary (X) Proceeds of sale of subsidiary X
461
Financial Reporting
As the cash effect of the acquisition/disposal of the subsidiary is dealt with in a single line item,
care must be taken not to double count the effects of the acquisition/disposal when looking at the
movements in individual asset balances.
Each of the individual assets and liabilities of a subsidiary acquired/disposed of during the period
must be excluded when comparing group statements of financial position for cash flow calculations
as follows:
 Where a subsidiary is acquired in the period: property, plant and equipment, inventories,
payables, receivables etc. at the date of acquisition should be subtracted from the movement
on these items.
 Where a subsidiary is disposed of in the period: property, plant and equipment,
inventories, payables, receivables etc. at the date of disposal should be added to the
movement on these items.
Example: Disposal of subsidiary
Extracts from the statements of financial position of the Burke Group at 31 December are as
follows:
20X2 20X1
$'000 $'000
Current assets
Inventory 664 791
Trade receivables 515 532
Cash 214 431
Current liabilities
During the year ended 31 December 20X2, the Burke Group sold its controlling interest in Bryan
Co. for $6.5 million in cash. On the disposal date, balances included in Bryan’s statement of
financial position were as follows:
$'000
Current assets
Inventory 103
Trade receivables 45
Cash 79
Current liabilities
Trade payables 67
(a) What adjustments are required to consolidated profit in respect of working capital in order to
calculate cash flows from operating activities?
(b) What is the cash flow reported in investing activities in respect of the disposal of Bryan Co.?
Solution
(a) Working capital adjustments must take account of the disposal of Bryan Co.
$'000
Inventory
b/f 791
c/f 664
Decrease 127
Less: amount attributable to disposal (103)
Decrease in inventory (added back to profit) 24
462
Trade receivables
b/f 532
c/f 515
Decrease 17
Increase in receivables (deducted from profit) (28)
Trade payables
b/f 645
c/f 590
Decrease 55
Increase in payables (added back to profit) 12
(b) Proceeds from disposal of Bryan Co.

$'000
Cash proceeds 6,500
Cash in Bryan Co. at disposal (79)
Proceeds from disposal of Bryan Co. 6,421
HKAS 7.40 3.1.1 Disclosure

An entity shall disclose, in aggregate, in respect of both obtaining and losing control of subsidiaries
or other businesses during the period each of the following:
(a) The total consideration paid or received.
(b) The portion of the consideration consisting of cash and cash equivalents.
(c) The amount of cash and cash equivalents in the subsidiaries or other businesses over which
control is obtained or lost.
(d) The amount of the assets and liabilities other than cash or cash equivalents in the
subsidiaries or other businesses over which control is obtained or lost, summarised by each
major category.
Disclosures (c) and (d) are not required in respect of subsidiaries controlled by investment entities
and measured at fair value through profit or loss.
HKAS 7.42A 3.1.2 Changes in ownership interest with no loss of control

Changes in ownership interests in a subsidiary that do not result in a loss of control, such as the
subsequent purchase or sale by a parent of a subsidiary's equity instruments, are accounted for as
equity transactions (see HKFRS 10 Consolidated Financial Statements) unless the subsidiary is
held by an investment entity and measured at fair value through profit or loss.
Accordingly, the resulting cash flows are classified in the same way as other transactions with
owners, as cash flows from financing activities.
3.2 The non-controlling interest

The group statement of cash flows should only deal with flows of cash and cash equivalents which
are external to the group, so all intra-group cash flows should be eliminated.
Dividends paid to non-controlling interests should be included under the heading "Cash from
financing activities" and disclosed separately.
463
Financial Reporting
Example: Non-controlling interest

The following are extracts of the consolidated results for Marcus Company for the year ended
31 December 20X9.
CONSOLIDATED STATEMENT OF PROFIT OR LOSS (EXTRACT)
$'000
Group profit before tax 200
Income tax expense (32)
Profit for the year 168
Profit attributable to:
Owners of the parent 126
Non-controlling interests 42
168
CONSOLIDATED STATEMENT OF FINANCIAL POSITION (EXTRACT)
20X9 20X8
$'000 $'000
Non-controlling interests 362 345
Calculate the dividends paid to the non-controlling interest during the year.
Solution
The non-controlling interests share of profit after tax represents retained profit plus dividends paid.
NON-CONTROLLING INTEREST
$'000
Balance as at 31 December 20X8 345
Profit for the period 42
Balance as at 31 December 20X9 (362)

Dividend paid (balancing fig) 25
3.3 Associates and joint ventures

The following cash flows should be included in a consolidated statement of cash flows in respect of
an associate or joint venture:
 Cash inflows from sales to the associate or joint venture
 Cash outflows from purchases from the associate or joint venture
 Dividends from the associate or joint venture
 Investments in an associate or joint venture
As transactions and balances between group companies and associates/joint ventures are not
cancelled for the purpose of producing consolidated financial statements, the normal approach to
adjusting consolidated operating profit for movements in working capital will ensure that cash
inflows from sales to associates/joint ventures and cash outflows on purchases from
associates/joint ventures are included within consolidated cash flow from operating activities.
Within the reconciliation of profit to cash flows from operating activities, however, the share of profit
from a joint venture or associate must be eliminated. This is treated as a non-cash item of income
and deducted from consolidated profit in calculating consolidated cash flows from operating
activities.
Instead, the dividend actually received from the associate/joint venture is included in the operating
cash flows section of the statement of cash flows. This is calculated by reconciling the opening
investment in associate/joint venture balance to the closing balance.
464
Where a group invests in or divests of an associate or joint venture in the year, the associated cash
flow is disclosed within the investing activities section of the statement of cash flows.
Example: Associate
The following are extracts of the consolidated results of Connie Company for the year ended
31 December 20X9.
CONSOLIDATED STATEMENT OF PROFIT OR LOSS (EXTRACT)
$'000
Group profit before tax 224
Share of associate's profit after tax 36
260
Tax (group) 42
Profit after tax 218
CONSOLIDATED STATEMENT OF FINANCIAL POSITION (EXTRACTS)

20X9 20X8
$'000 $'000
Investment in associate 312 306
Calculate the dividend received from the associate.
Solution
The associate profit after tax represents retained profit plus dividend.
ASSOCIATE
$'000
Balance as at 31 December 20X8 306
Share of profit for the period 36
Balance as at 31 December 20X9 (312)

Dividend received from associate (balancing fig) 30
3.4 Foreign currency cash flows

Foreign exchange issues are relevant to the consolidated statement of cash flows in two situations:
(i) Where an entity has transacted during the period in a currency other than its own
functional/reporting currency
(ii) Where a subsidiary has a different functional currency from that of the rest of the group.
3.4.1 Transactions in foreign currency – settled
In accordance with HKAS 21, where transactions denominated in a foreign currency have taken
place during a period, and been subsequently settled, any foreign exchange gain or loss is
For the purposes of preparing the statement of consolidated cash flows, no adjustment is required
in respect of these exchange gains or losses, as they represent amounts realised in cash flows.
The following example will help you to understand this.
465
Financial Reporting
Example: Settled transactions

Flora Co. sold goods denominated in pounds sterling in the year ended 31 October 20X1. At the
date of the transaction, a trade receivable and revenue of $40,000 were recorded after applying the
spot exchange rate on the date of the transaction. Before the period end, the customer paid the
amount due, which on the date of payment could be exchanged by Flora for $37,000. Accordingly,
Flora recognised an exchange loss of $3,000.
HKAS 7 requires that the applicable exchange rate in the case of foreign currency cash flows is
that applied on the date of the cash flow. Therefore, $37,000 must be reported as a cash inflow
within cash flows from operating activities in Flora's statement of cash flows.
As this amount is already included within profit for the year, no further adjustment is required:
$'000
Revenue 40
Exchange loss (3)
Net amount reported in profit 37
3.4.2 Transactions in foreign currency – unsettled

Where a foreign currency transaction has taken place during the period, however is not settled at
the period end, any monetary items are re-translated in accordance with HKAS 21 giving rise to an
exchange difference recognised in profit or loss. In addition a "foreign currency" balance is included
in the year-end statement of financial position.
On preparation of the statement of cash flows, therefore:
(i) the exchange gain or loss forms an adjustment within the reconciliation of profit to cash flows
from operating activities;
(ii) the exchange gain or loss is taken into account when calculating the movement in the
relevant monetary balance.
The following example will help you to understand why this is the case.
Example: Unsettled transactions

Webb Co. purchased goods denominated in Zloty during the year ended 31 December 20X2 for
ZTY 150,000. This was Webb’s first transaction with a new supplier. At the date of the purchase
the ZTY:$ exchange rate was 1.25:1 and accordingly a purchase and payable were recorded at
$120,000. At the period end, Webb had not paid the amount due to the supplier and the trade
payable balance was retranslated using the closing rate to $100,000, resulting in an exchange gain
of $20,000.
In respect of this transaction, a $100,000 expense is therefore reported in profit ($120,000
purchases net of $20,000 exchange gain).
In preparing the statement of cash flows, HKAS 7 requires that the gain on retranslation is
deducted from profits (which include the $100,000 net expense) as a non-cash item, so meaning
that the transaction in Zloty has a net effect on cash of:
$'000
Expense within profit figure (100)
Deduct non-cash gain (20)
(120)
It is clear from the scenario that no cash flow has occurred in respect of this transaction and the
adjustment for movement in payables must therefore serve to eliminate the $120,000. In order to
make the increase in trade payables equal to the $120,000 and so eliminate it in full, the exchange
gain must once again be taken into account:
466
$'000
ZTY payables b/f –
ZTY payables c/f 100
Increase 100
Remove effect of exchange gain 20
Increase in trade payables (add back to profit in reconciliation) 120
Therefore, the net effect on cash flows from operating activities is nil ($100,000 expense – $20,000
gain + $120,000 increase in payables).
3.4.3 Foreign subsidiary

The cash flows of a foreign subsidiary must be translated into the functional currency of the group
for inclusion in the consolidated statement of cash flows.
The applicable exchange rate is the spot rate on the dates of the cash flows, however the average
rate for a period may be used if this approximates to the actual rate. HKAS 21 does not allow the
use of the closing rate.
The draft consolidated accounts for Bestway Co. are shown below:
DRAFT CONSOLIDATED STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31
DECEMBER 20X8
$'000
Operating profit 13,365
Share of profits after tax of associates 4,950
Finance cost (1,350)
Profit before taxation 16,965
Income tax (4,860)
Profit for the year 12,105
Attributable to: owners of the parent 11,205
non-controlling interest 900
12,105
DRAFT CONSOLIDATED STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER
20X8 20X7
$'000 $'000 $'000 $'000
Assets
Non-current assets
Buildings 18,675 19,800
Machinery 16,200 2,700
34,875 22,500
Goodwill 900 -
Investments in associates 13,590 12,690
49,365 35,190
Current assets
Inventories 17,775 9,000
Trade receivables 16,650 11,475
Cash 40,635 16,380
75,060 36,855
124,425 72,045
467
Financial Reporting
20X8 20X7
$'000 $'000 $'000 $'000
Equity
Share capital 61,407 36,855
Retained earnings 31,005 22,500
92,412 59,355
Non-controlling interest 1,035 –
93,447 59,355
Loans 19,530 6,030
Deferred tax 270 117
19,800 6,147
Current liabilities
Trade payables 6,660 4,320
Income tax 4,158 1,953
Accrued finance charges 360 270
11,178 6,543
124,425 72,045
Notes
1 There had been no acquisitions or disposals of buildings during the year. The depreciation
charge for the year was $1,125,000 for buildings and $1,800,000 for machinery. Machinery
costing $3m was sold for $3m resulting in a profit of $900,000.
2 On 1 January 20X8 Bestway Co. acquired a 75% interest in Oneway Co.. The net assets at
acquisition were as follows:
$'000
Machinery 1,485
Inventories 288
Trade receivables 252
Cash 1,008
Trade payables (612)
Income tax (153)
2,268
Non-controlling interest (567)
1,701
Goodwill 900
2,601
7,920,000 shares issued as part consideration 2,475
Balance of consideration paid in cash 126
2,601
3 A dividend of $2,700,000 was paid during the year.
Required
Prepare a consolidated statement of cash flows for the Bestway Group for the year ended
31 December 20X8 as required by HKAS 7.
468
Topic recap
HKAS 7 Statement of Cash Flows
A statement of cash flows is a useful indicator of a

company's liquidity and solvency.
Presentation Consolidated statement of cash flows
Cash flows from operating activities Direct method: Acquisition/Disposal of subsidiary

may include: include gross Cash paid on acquisition/received on
cash receipts from sales operating cash flows disposal is stated net of cash in the
cash payments for operating subsidiary on disposal date
expenses Acquisition/disposal is taken into account
cash flows associated with income Indirect method: when calculating movements in working
tax adjust profit for non- capital and cash flows.
interest paid cash items, accrued
dividends paid /deferred amounts
and non-operating
cash flows.
Non-controlling interest
Include dividends paid to the non-controlling
may include:
interest as a cash flow from financing
receipts from the sale of non-
activities.
current assets and investments
payments to acquire non-current
assets and investments
Associates/joint ventures
interest received
Eliminate share of profit or loss in
dividends received
calculation of cash generated from
operations
Include dividend received from
associate/JV as cash flow from operating
activities
Cash flows from financing activities Foreign currency cash flows

may include: Do not adjust for exchange
proceeds of share / debt issue differences on settled amounts
payments on redemption of shares Adjust for exchange differences on
repayments of debt unsettled amounts
dividends paid Translate cash flows of a foreign
subsidiary at spot rate on the date of the
cash flows (or average rate) for inclusion
in consolidated statement of cash flows
Change in cash and cash
equivalents (including deposits
available on demand, money market
holdings, government bonds, treasury
bills, overdrafts repayable on demand)
Disclose: Non-cash transactions Components of cash & cash

equivalents
469
Financial Reporting
Answer 1
BESTWAY CO
CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER
20X8
$'000 $'000
Net profit before tax 16,965
Adjustments for:
Depreciation (1,125 + 1,800) 2,925
Profit on sale of plant (900)
Share of associate's profits (4,950)
Interest payable 1,350
Operating profit before working capital changes 15,390
Increase in trade and other receivables (16,650 – 11,475 – 252) (4,923)
Increase in inventories (17,775 – 9,000 – 288) (8,487)
Increase in trade payables (6,660 – 4,320 – 612) 1,728
Interest paid (270 + 1,350 – 360) (1,260)
Income taxes paid (W1) (2,655)
Net cash used in operating activities (207)
Purchase of subsidiary undertaking (W2) 882
Purchase of property, plant and equipment (W3) (15,915)
Proceeds from sale of plant 3,000
Dividends from associate (W4) 4,050
Dividends paid to non-controlling interest (W5) (432)
Net cash used in investing activities (8,415)
Issue of ordinary share capital (W6) 22,077
Issue of loan notes (19,530 – 6,030) 13,500
Dividends paid (2,700)
Net cash from financing activities 32,877
Net increase in cash and cash equivalents 24,255
Cash at 1.1.X8 16,380
Cash at 31.12.X8 40,635
470
WORKINGS
1 Taxation
$'000 $'000
Opening balance
Income tax 1,953
Deferred tax 117
2,070
Statement of profit or loss expense 4,860
On acquisition of subsidiary 153
Closing balances
Income tax 4,158
Deferred tax 270
(4,428)
Cash outflow 2,655
2 Purchase of subsidiary
$'000
Cash received on acquisition 1,008
Less cash consideration (126)
Cash inflow 882
3 Purchase of tangible non-current assets: machinery
$'000
Carrying value at 1 Jan X8 2,700
Depreciation (1,800)
Disposal (3,000 – 900) (2,100)
On acquisition of subsidiary 1,485
285
Cash outflow on additions 15,915
Carrying value at 31 Dec 20X8 16,200
4 Dividends from associate
$'000
Opening balance 12,690
Share of profit after tax 4,950
17,640
Closing balance (13,590)
Cash inflow 4,050
5 Non-controlling interest
$'000
Opening balance –
Profit for year 900
On acquisition 567
1,467
Closing balance (1,035)
Cash outflow 432
6 Issue of ordinary share capital
$'000
Closing balance 61,407
Non-cash consideration (2,475)
Opening balance (36,855)
Cash inflow 22,077
471
Financial Reporting
Exam practice
Chong Co. 36 minutes

Chong Co. provides bookkeeping services for over 1,000 clients. The company now plans to
expand into banking and finance services but feels to do so it may have to expand the office. This
has prompted worries about the company's current cash flow position, especially the cash flow
from its present operations, and whether the cash flow is sufficient to support such a relocation and
expansion.
The directors of Chong Co. require cash flow information quickly and have asked you to provide a
calculation of the company’s net cash flow from operating activities for the year ended 31 October
20X7. Unfortunately, the urgency of the request has meant that the company's statement of profit
or loss and other comprehensive income is not yet available. However, they have provided you
with the following information:
SUMMARISED DRAFT STATEMENTS OF FINANCIAL POSITION AS AT 31 OCTOBER
20X7 20X6
$'000 $'000
Assets
Non-current assets
Property, plant and equipment at cost 1,240 1,016
Less depreciation 276 232
964 784
Current assets
Receivables 380 319
Cash at bank 64 1
444 320
Total assets 1,408 1,104

Capital and reserves
Equity share capital 740 460
Retained profits 224 86
964 546
Long-term bond 120 280
Deferred taxation 72 44
192 324
Current liabilities
Bank overdraft - 56
Taxation payable 40 32
252 234
1,408 1,104
472
Additional cash flow information:

(i) Property, plant and equipment costing $52,000, and in respect of which $32,000
depreciation had been provided, was disposed of during the year. The items were sold for
$16,000. Operating profit includes any profits or losses on disposal.
(ii) The company paid a dividend of $40,000 during the year.
(iii) A finance charge of $15,000 has been recognised as an expense for the year. The actual
cash payment was $12,000.
(iv) The tax charge of $88,000 includes deferred tax of $28,000.
(v) Part of the bond was repaid during the year. This incurred a redemption penalty of $8,000
which has been written off against income.
Required
(a) Prepare a statement of cash flows in accordance with HKAS 7 to calculate the company's
net cash flow from operating activities. (Note: a full statement of cash flows showing "cash
flow from investing activities" and "cash flow from financing activities" is NOT required in
answer to this part of the question.) (12 marks)
(b) Comment on whether the "net cash flow from operating activities" calculated in (a) above is
sufficient to support the proposed expansion of the office. (8 marks)
(Total = 20 marks)
473
Financial Reporting
474
chapter 20
Related party disclosures
Topic list
1 HKAS 24 Related Party Disclosures

1.1 Objective
1.2 Scope
1.3 Definitions
1.4 Disclosure
1.5 The importance of disclosure
1.6 Section summary
Learning focus
Related party transactions are a controversial area of accounting. They are, however,
relatively common in practice. You must be able to identify related parties and make the
necessary disclosures.
475

Module A Financial Reporting - Part 1

Uploaded by

Copyright:

Available Formats

Module A Financial Reporting - Part 1

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Module A Financial Reporting - Part 1

Uploaded by

Copyright:

Available Formats

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

Module A: Financial Reporting

ISBN 9781 4453 6965 5

British Library Cataloguing-in-Publication Data

BPP Learning Media Ltd

The copyright in this publication is jointly owned by

Printed in Singapore by Ho Printing

31 Changi South Street 1

Your learning materials, published by BPP Learning

All rights reserved. No part of this publication may be

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

Every effort has been made to contact the copyright

We are grateful to HKICPA for permission to reproduce the

Part A Legal environment

Part B Financial reporting framework

Part C Accounting for business transactions

Part D Group financial statements

Answers to exam practice questions 753

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

viii Financial Reporting

LO1. Legal environment

1.04.01 Describe the procedure for issuing shares and the 1

LO2.04 Hong Kong Financial Reporting Standard for Private 2

3.02.04 Determine the recognition criteria for specified 14

xii Financial Reporting

LO3.05 Share-based payment: 2

LO3.08 Property, plant and equipment: 3

xiv Financial Reporting

LO3.10 Investment property: 3

LO3.11 Financial assets, financial liabilities and equity 2

LO3.12 Borrowing costs: 3

xvi Financial Reporting

LO3.17 Hedge accounting: 2

xviii Financial Reporting

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

LO3.24 Interim financial reporting: 3

LO4.06 Business combinations: 3

xxii Financial Reporting

LO4.08 Interests in joint arrangements: 3

1 Hong Kong legal framework

In this chapter you will cover the following learning outcomes:

1 Hong Kong legal framework

1.1 Types and relative advantages of alternative forms of

1.1.1 Sole trader business

1.2 Legal procedures for establishment of companies

1.3 Corporate governance

2 Obligations of directors and officers of companies

2.1 Directors' responsibilities

(c) Directors' responsibilities in respect of financial reporting

2.1.2 Powers and obligations

(b) The doctrine of estoppel

2.2 Officers of companies

 deals with matters relating to liaison with members

3 Legal requirements associated with company

3.1 Share issues and prospectus requirements

3.2 Debt instruments and registration of charges

3.3 Statutory reporting and documentation requirements

3.4 Appointment and removal of auditors